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

Why does APT conclude that only systematic factor exposure, and not idiosyncratic risk, earns a risk premium?

Idiosyncratic risk can be diversified away in a large portfolio because firm-specific shocks are uncorrelated and average out. Since it can be eliminated at no cost, arbitrage forces its premium to zero, leaving only systematic factor exposures priced.

  1. ABecause investors are assumed to be risk neutral toward firm-specific events
  2. BBecause idiosyncratic risk can be diversified away in large portfolios, so arbitrage prevents it from being pricedCorrect
  3. CBecause idiosyncratic risk is perfectly correlated across assets and cancels out
  4. DBecause regulators require firm-specific risk to be fully hedged

Explanation

In a well-diversified portfolio, idiosyncratic residuals average out as the number of assets grows. If such risk carried a premium, investors could exploit it through arbitrage, which drives the premium to zero. Idiosyncratic risk is uncorrelated, not perfectly correlated, across assets.

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