FRM Part II · FRM Exam Part II · Factor Theory
Which statement best distinguishes a risk-based explanation from a behavioral explanation for the existence of a factor premium such as value?
A risk-based explanation says the factor premium compensates investors for bearing losses in bad economic times, whereas a behavioral explanation says it stems from investor biases or errors that persist because of limits to arbitrage. The two differ in the source of the premium, not in market correlation.
- AA risk-based explanation holds that the premium compensates investors for bearing losses in bad times, while a behavioral explanation attributes it to investor biases or errors that may not be arbitraged awayCorrect
- BA risk-based explanation holds that the premium arises from mispricing, while a behavioral explanation holds that it compensates for systematic risk
- CBoth explanations imply the premium should vanish once it is publicly known and widely traded
- DBoth explanations require the factor to have a zero correlation with the market portfolio
Explanation
Risk-based theories link premiums to compensation for systematic risk and bad-time losses; behavioral theories link them to persistent biases combined with limits to arbitrage. The reversed statement is wrong, and neither theory requires zero market correlation.
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