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FRM Part I · FRM Exam Part I · The Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Which statement best describes alpha in a multifactor model when a manager hedges away all factor exposures?

Alpha is the expected return not explained by the portfolio's factor exposures. When all factor exposures are hedged, the portfolio's return above the risk-free rate is attributable to alpha, not to systematic risk premiums or to residual variance.

  1. AThe remaining expected return not explained by factor exposures, which is the hedged portfolio's return above the risk-free rateCorrect
  2. BThe return earned from bearing systematic factor risk premiums
  3. CThe residual variance of the portfolio after factor hedging
  4. DThe sum of factor betas multiplied by factor risk premiums

Explanation

Alpha is the expected return in excess of what the factor exposures justify. After hedging all factors, what remains above the risk-free rate is alpha. Factor premiums are compensation for beta, residual variance is risk not return, and the sum of beta times premium is the factor-explained return.

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