Skip to content

FRM Part II · FRM Exam Part II · Factor Theory

Which statement about the stochastic discount factor (SDF) is correct?

An asset whose payoff is negatively correlated with the stochastic discount factor earns a positive risk premium. The SDF is high in bad states, so such an asset pays off poorly when it is most needed and investors demand extra return.

  1. AThe SDF is always constant across states of the world
  2. BA positive covariance between an asset's payoff and the SDF implies a higher expected return than the risk-free rate
  3. CThe SDF is high in good states and low in bad states
  4. DAn asset whose payoff is negatively correlated with the SDF commands a positive risk premiumCorrect

Explanation

The SDF is high in bad states, when marginal utility is high. An asset whose returns are negatively correlated with the SDF pays off poorly in bad times and therefore requires a positive premium. A positive covariance would imply a premium below the risk-free rate (a hedge).

Did you get it right without looking?

One question tells you little. A timed set on Factor Theory shows your real accuracy, how long you take and where you lose marks.

Practise Factor TheoryFree diagnostic mock

More Factor Theory questions