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IAI Actuarial Core Principles · Economic Modelling · Single and multifactor models for investment returns

Which feature distinguishes a multifactor model of returns from a single-index model?

A multifactor model lets security returns depend on several systematic factors, such as inflation, interest rates or industrial output, each with its own sensitivity, plus a specific residual. A single-index model uses only one factor, the market return.

  1. AReturns depend on several systematic factors, such as inflation or interest-rate changes, each with its own sensitivityCorrect
  2. BReturns depend only on the market portfolio
  3. CResidual terms are assumed perfectly correlated across securities
  4. DReturns are assumed to be deterministic given the factors
  5. Only a single beta is estimated for each security

Explanation

A multifactor model expresses returns as a linear function of several factors, each with a sensitivity, plus a specific residual. The single-index model uses only the market. The other options contradict the structure of multifactor models.

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