Financial Risk Management Exam Level Ii - Factor Theory (topic 62)

1. One way to think of investment assets is that each asset contains many different _____ _____, and exposure to these ______ _____ earn a risk premium.

Factor Risks

Industry Norms

Currency Fluctuations

Market Trends

Investment assets are subjected to various factor risks which need to be considered for earning a risk premium. Market trends, industry norms, and currency fluctuations are important factors to consider but they do not directly refer to the concept of factor risks in investment assets.

Explanation

Investment assets are subjected to various factor risks which need to be considered for earning a risk premium. Market trends, industry norms, and currency fluctuations are important factors to consider but they do not directly refer to the concept of factor risks in investment assets.

2. Examples of underlying ______ of investment assets include the market (known as beta in risk models), interest rates, investing styles (E.g. value/growth, momentum, high volatility), or inflation.

Factors

Indicators

Variables

Catalysts

In this context, the correct term to fill in the blank is 'factors' as it refers to the various elements that can influence the performance of investment assets.

Explanation

In this context, the correct term to fill in the blank is 'factors' as it refers to the various elements that can influence the performance of investment assets.

3. _____ _____ is based on an analysis of factor risks. Each factor risk represents exposures to bad times, hence risk premiums are provided for taking on the factor risk.

Factor Theory

Market Volatility

Risk Analysis

Risk Assessment

Factor theory is based on analyzing factor risks and providing risk premiums for taking on these risks which represent exposures to bad times.

Explanation

Factor theory is based on analyzing factor risks and providing risk premiums for taking on these risks which represent exposures to bad times.

4. Three Primary Principles of Factor theory are: - Factors are important, not _____. It's important to understand the underlying risk factors of an _____. - _____ represent bundles of factors. For example, corporate bonds may contain equity risk, interest rate risk, volatility risk, and default risk. - Investors differ in their ______ risk exposures, so will take on different exposures to risk factors.

Liabilities

Equities

Securities

Assets, assetAssetsoptimal

5. The ______ ______ ______ ______ measures the covariance of an asset with the market portfolio (E.g. S&P 500 or DJIA) in a measure called Beta (the risk premium is determined only by the asset's Beta). This model assumes that the only factor is the market portfolio.

Capital asset pricing model (CAPM)

Security market line (SML)

Efficient market hypothesis (EMH)

Random walk theory (RWT)

The correct answer is capital asset pricing model (CAPM) because it is the specific model that analyzes the relationship between an asset's risk and return in relation to the market portfolio. The incorrect answers are not directly related to measuring the covariance of an asset with the market portfolio and determining risk premium based on Beta.

Explanation

The correct answer is capital asset pricing model (CAPM) because it is the specific model that analyzes the relationship between an asset's risk and return in relation to the market portfolio. The incorrect answers are not directly related to measuring the covariance of an asset with the market portfolio and determining risk premium based on Beta.

6. What is the mathematical formula for the Capital Asset Pricing Model (CAPM)?

E(Ri) + Rf = ?? - ?? * [E(Rm) + Rf]

E(Ri) − Rf= ?? + ?? ∗ [E(R?) − Rf ]

E(Ri) - Rf = ?? - ?? * [E(Rm) - Rf]

E(Ri) + Rf = ?? + ?? * [E(Rm) + Rf]

The correct formula for CAPM is E(Ri) - Rf = ?? + ?? * [E(Rm) - Rf]. This formula represents the expected return on individual stock (Ri), risk-free rate (Rf), market return (Rm), and systematic risk of an asset.

Explanation

The correct formula for CAPM is E(Ri) - Rf = ?? + ?? * [E(Rm) - Rf]. This formula represents the expected return on individual stock (Ri), risk-free rate (Rf), market return (Rm), and systematic risk of an asset.

7. What is the mathematical formula for Beta?

Cov(Ri, Rm) * var(Rm)

Cov(Ri, Rm) / var(Rm) Beta is the covariance of the individual stock's return with the market (co-movement with the market) divided by the variance of the market returns.

Cov(Ri, Rm) - var(Rm)

Cov(Ri, Rm) + var(Rm)

Beta is calculated as the covariance of the individual stock's return with the market divided by the variance of the market returns. This ratio indicates the co-movement of the stock with the market.

Explanation

Beta is calculated as the covariance of the individual stock's return with the market divided by the variance of the market returns. This ratio indicates the co-movement of the stock with the market.

8. Six takeaways from the CAPM: Takeaway #1: Hold the _____, not the individual _____.

Hold the risk, not the return.

Hold the asset, not the factor.

Hold the portfolio, not the market.

Hold the factor, not the asset. An investor can eliminate idiosyncratic risk (firm-specific) by diversifying. Systematic risk will still exist, even after diversifying.
?CAPM says that diversifying improves the risk-return trade off of a portfolio, which improves the Sharpe ratio as well.

An investor can eliminate idiosyncratic risk (firm-specific) by diversifying. Systematic risk will still exist, even after diversifying. CAPM says that diversifying improves the risk-return trade off of a portfolio, which improves the Sharpe ratio as well.

Explanation

An investor can eliminate idiosyncratic risk (firm-specific) by diversifying. Systematic risk will still exist, even after diversifying. CAPM says that diversifying improves the risk-return trade off of a portfolio, which improves the Sharpe ratio as well.

9. The mean-variance efficient frontier is a graph that shows how investors can optimally hold the risky asset and the risk-free asset in their portfolio. The risky asset and risk-free asset (risk-return) tradeoff is represented by the _______ allocation line.

Efficient allocation line

Risk allocation line

Optimal allocation line

?mean-variance efficient frontiercapital allocation lineThe Tangency Portfolio is the mean-variance efficient market portfolio, which represents the maximum Sharpe ratio (best risk adjusted return)

The mean-variance efficient frontier is a crucial concept in portfolio theory, showing the optimal trade-off between risk and return for investors. The capital allocation line represents the efficient combination of a risky asset and a risk-free asset in a portfolio, providing the best risk-adjusted return.

Explanation

The mean-variance efficient frontier is a crucial concept in portfolio theory, showing the optimal trade-off between risk and return for investors. The capital allocation line represents the efficient combination of a risky asset and a risk-free asset in a portfolio, providing the best risk-adjusted return.

10. Six takeaways from the CAPM - Takeaway #2: Every investor holds the same mean-variance efficient portfolio, but the proportion of the risk-asset held differs between investors. In other words, each investor has their own _______ factor risk exposures.

Optimal

Assigned

Common

Unique

In the context of CAPM, investors aim to find the optimal factor risk exposures for their portfolios, which will vary based on individual preferences and risk tolerance.

Explanation

In the context of CAPM, investors aim to find the optimal factor risk exposures for their portfolios, which will vary based on individual preferences and risk tolerance.

11. Six takeaways from the CAPM - Takeaway #3: The average investor is ______ invested in the market. The average investor's risk ______ is the risk aversion of the market, so they hold the risky mean variance efficient market portfolio.

75% invested. risk affinity.

100% invested. risk ?aversion

25% invested. risk evasion.

50% invested. risk tolerance.

The correct answer states that the average investor is 100% invested in the market and their risk aversion is aligned with the market, resulting in holding the risky mean variance efficient market portfolio.

Explanation

The correct answer states that the average investor is 100% invested in the market and their risk aversion is aligned with the market, resulting in holding the risky mean variance efficient market portfolio.

12. Six takeaways from the CAPM - Takeaway #4: Exposure to factor risk must be rewarded. The risk premium is proportional to the market _______. As market _______ increases, the risk premium also increases.

Variance

Liquidity

Correlation

Volatility

In the context of the CAPM, the risk premium is proportional to the market variance. This means that as market variance increases, the risk premium also increases to compensate for the higher risk exposure.

Explanation

In the context of the CAPM, the risk premium is proportional to the market variance. This means that as market variance increases, the risk premium also increases to compensate for the higher risk exposure.

13. Six takeaways from the CAPM - Takeaway #5:?Risk is measured as _______ exposure. The CAPM implies that securities with higher ______ should have higher average excess returns (and lower diversification benefits). Also, average returns are linear in the ______.Low _____ assets do comparatively well when markets perform poorly.

Delta deltas? ?deltas? ?delta? E(rit) –rft= &delta i[E(rMt) –rft]. .

Alpha alphas? ?alphas? ?alpha? E(rit) –rft= &alpha i[E(rMt) –rft]. .

Gamma gammas? ?gammas? ?gamma? E(rit) –rft= &gamma i[E(rMt) –rft]. .

Beta betas? ?betas? ?beta? E(rit) –rft= βi[E(rMt) –rft].

14. Six takeaways from the CAPM - Takeaway #6: Valuable assets have _____ risk premiums.

Extreme

Low ?This is because the market portfolio is the risk factor and bad times result in low market returns. Low beta assets will have positive payoffs compared to the market during bad times, which makes them valuable to investors.

High

Moderate

Valuable assets have low risk premiums because they are less risky during bad times compared to the market portfolio. This makes them attractive to investors seeking stable returns.

Explanation

Valuable assets have low risk premiums because they are less risky during bad times compared to the market portfolio. This makes them attractive to investors seeking stable returns.

15. Shortcoming of the CAPM - Assumption #1: Investors only have _______ wealth.

Material

?financial ??Investors have many factors that contribute to wealth, such as human capital

Physical

Monetary

The correct answer 'financial' pertains to wealth measured in terms of money or monetary value, while the incorrect answers 'material,' 'monetary,' and 'physical' do not accurately describe wealth in the context of investors.

Explanation

The correct answer 'financial' pertains to wealth measured in terms of money or monetary value, while the incorrect answers 'material,' 'monetary,' and 'physical' do not accurately describe wealth in the context of investors.

16. 7 Shortcoming of the CAPM - Assumption #2: Investors have mean-_______ utility.

Mean-?variance ?most investors dislike losses more than they like gains. The CAPM assumes that investors dislike losses and like gains equally.

Median-variance most investors prefer gains over losses. The CAPM assumes that investors treat gains and losses equally.

Average-deviation most investors view gains and losses as equally important. The CAPM assumes that investors prioritize avoiding losses.

Mode-variance most investors have a preference for gains over losses. The CAPM assumes that investors are indifferent between gains and losses.

17. 7 Shortcoming of the CAPM - Assumption #3: Investors have a _______ period investment horizon?

Permanent

Limited

?single ?In the real world, investors need to rebalance their portfolio, which is a multi-period strategy.

Random

In the real world, investors need to rebalance their portfolio, which is a multi-period strategy.

Explanation

In the real world, investors need to rebalance their portfolio, which is a multi-period strategy.

18. 7 Shortcomings of the CAPM - Assumption #4: Investors have ___________ expectations.

Identical

Unique

Homogenous ? - The assumption that all investors share the same expectations is not realistic.

Divergent

The correct answer is 'homogenous', as it refers to the assumption that all investors share the same expectations. The other incorrect answers do not accurately capture the essence of the assumption mentioned in the question.

Explanation

The correct answer is 'homogenous', as it refers to the assumption that all investors share the same expectations. The other incorrect answers do not accurately capture the essence of the assumption mentioned in the question.

19. Shortcoming of the CAPM - Assumption #5: Markets are ___________. This means that the CAPM assumes that markets have no taxes or transaction costs.

Rational

Efficient

?frictionless Transaction costs are higher for illiquid securities

Perfect

The correct answer is 'frictionless' because the CAPM assumes that markets are frictionless, implying no taxes or transaction costs. This assumption simplifies calculations but may not hold true in reality.

Explanation

The correct answer is 'frictionless' because the CAPM assumes that markets are frictionless, implying no taxes or transaction costs. This assumption simplifies calculations but may not hold true in reality.

20. Shortcoming of the CAPM - Assumption #6: All investors are price _____?

Takers ?Large investors, such as institutional investors, can move the market with large trades. These types of investors are price setters.

Observers

Makers

Influencers

In the CAPM model, the assumption is that all investors in the market are price takers, meaning they accept the market price as given and do not have the power to influence it. However, this assumption is not always true, as large investors such as institutional investors can impact prices with their trades.

Explanation

In the CAPM model, the assumption is that all investors in the market are price takers, meaning they accept the market price as given and do not have the power to influence it. However, this assumption is not always true, as large investors such as institutional investors can impact prices with their trades.

21. 7 Shortcoming of the CAPM - Assumption #7: Information is free and ________ to everyone.

Restricted

?available ?Information is not equally available to everyone in reality.

Unavailable

Limited

In reality, information is not equally available to everyone, which goes against the assumption in the CAPM model.

Explanation

In reality, information is not equally available to everyone, which goes against the assumption in the CAPM model.

22. Six lessons from multifactor models - Lesson #1: ________ is beneficial in that the tradable version of the market removes idiosyncratic (firm specific) risk.

Concentration

Leverage

Timing

?Diversification

Diversification is key to reducing risk by spreading investments across different assets. Concentration, leverage, and timing may not offer the same level of risk reduction as diversification does.

Explanation

Diversification is key to reducing risk by spreading investments across different assets. Concentration, leverage, and timing may not offer the same level of risk reduction as diversification does.

23. Six lessons from multifactor models - Lesson #2: Investors have ________ exposures.

Equal Investors have equal exposures to all factors for optimal diversification.

Random Investors have random exposures based on market conditions.

?optimal Investors have different preferences, so each may have a different optimal exposure to the market and other factors.

Fixed Investors have fixed exposures that do not change over time.

Each incorrect answer provides a different perspective on how investors may have exposures to factors in multifactor models, emphasizing the importance of understanding optimal exposure based on individual preferences.

Explanation

Each incorrect answer provides a different perspective on how investors may have exposures to factors in multifactor models, emphasizing the importance of understanding optimal exposure based on individual preferences.

24. Six lessons from multifactor models - Lesson #3: The average investor holds the ______? portfolio.

Cash

Bond

?market

Diversified

In the context of multifactor models, Lesson #3 typically refers to the market portfolio as the correct answer. The market portfolio represents a diversified portfolio of all investments in the market, which the average investor is considered to hold according to multifactor models.

Explanation

In the context of multifactor models, Lesson #3 typically refers to the market portfolio as the correct answer. The market portfolio represents a diversified portfolio of all investments in the market, which the average investor is considered to hold according to multifactor models.

25. Six lessons from multifactor models - Lesson #4: ?Exposure to _______ risk must be rewarded.

Market

Liquidity

?factor ?each factor has its own risk premium.

Operational

In multifactor models, exposure to each factor must be rewarded as each factor has its own risk premium.

Explanation

In multifactor models, exposure to each factor must be rewarded as each factor has its own risk premium.

26. Six lessons from multifactor models - Lesson #5: Risk is measured by a _____ factor.

Gamma each factor in a multifactor model has a gamma factor that measures its risk.

Alpha each factor in a multifactor model has an alpha factor that measures its risk.

?beta ?each factor in a multifactor model has a beta factor that measures its risk

Delta each factor in a multifactor model has a delta factor that measures its risk.

In multifactor models, risk is typically measured using beta factors, which represent the sensitivity of an asset's returns to movements in each factor. Alpha, delta, and gamma are not commonly used in this context for measuring risk.

Explanation

In multifactor models, risk is typically measured using beta factors, which represent the sensitivity of an asset's returns to movements in each factor. Alpha, delta, and gamma are not commonly used in this context for measuring risk.

27. Six lessons from multifactor models - Lesson #6: Valuable assets have ____ risk premiums.

Low ?investors expect less returns for assets with higher probability of positive payoffs

High, as investors expect high returns for assets with high risk

Average, as valuable assets tend to have moderate risk premiums

Fluctuating, reflecting the uncertainty associated with valuable assets

In Lesson #6, it is highlighted that valuable assets generally have low risk premiums because investors are willing to accept lower returns for assets with a higher likelihood of positive payoffs. This principle is based on the concept of risk-return tradeoff and the perceived value of investments.

Explanation

In Lesson #6, it is highlighted that valuable assets generally have low risk premiums because investors are willing to accept lower returns for assets with a higher likelihood of positive payoffs. This principle is based on the concept of risk-return tradeoff and the perceived value of investments.

28. A _________ discount factor represents a random variable used in pricing an asset. This represents an index of bad times represented by different factors. CAPM is a special case in which the ______ discount factor moves linearly with the market return.

Linear pricing kernel (LPK)

?stochastic ?discount factor (SDF) - also called a pricing kernel the SDF is denoted as m:m = a + b * Rm We can expand the SDF to consider many factors: m = a + b1f1 + b2f2 + ... + bifi

Random pricing kernel (RPK)

Deterministic pricing kernel (DPK)

The correct term for the described discount factor is a stochastic pricing kernel (SDF), which is also known as the pricing kernel. This SDF is represented by a formula that includes various factors. The incorrect answers have been made up to provide plausible alternatives but do not accurately reflect the concept described in the question.

Explanation

The correct term for the described discount factor is a stochastic pricing kernel (SDF), which is also known as the pricing kernel. This SDF is represented by a formula that includes various factors. The incorrect answers have been made up to provide plausible alternatives but do not accurately reflect the concept described in the question.

29. Difference between Pricing Kernel and Discount Rate Models: With a discount rate model, the price of an asset can be determined by discounting all future cash flows at a calculated discount rate. This discount rate can be calculated with the _____: E(Ri) = Rf + Bi * (E(Rm) - Rf) (1 + E(Ri)) would be the discount rate for the first period, (1 + E(Ri)/2)^2 for the second period, (1 + E(Ri)/2)^3 for the third period, and so on. The _____ model can be used to calculate an asset's price: Pi = E[m * payoffi] Note: m is a discount factor.

Black-Scholes Model

DCF

SDF

CAPM SDF? (Stochastic discount factor)?

The correct answer is CAPM (Capital Asset Pricing Model) which is used to calculate the discount rate in the pricing kernel. SDF (Stochastic Discount Factor) is the incorrect answer as it is not used in this context. DCF (Discounted Cash Flow) is a common method but not specific to pricing kernel. Black-Scholes Model is used for valuing options, not discount rates for assets.

Explanation

The correct answer is CAPM (Capital Asset Pricing Model) which is used to calculate the discount rate in the pricing kernel. SDF (Stochastic Discount Factor) is the incorrect answer as it is not used in this context. DCF (Discounted Cash Flow) is a common method but not specific to pricing kernel. Black-Scholes Model is used for valuing options, not discount rates for assets.

30. The below is an example of an ______ model, where B1 represents market risk, B2 represents inflation risk, and B3 represents economic growth: E(Ri) = Rf + B1*E(f1) + B2*E(f2) + B3*E(f3).

CDDS (Conditional Drawdown at Risk)

CAPM (Capital Asset Pricing Model)

SDF? (Stochastic discount factor)

VAR (Value at Risk)

The formula provided indicates the application of a Stochastic Discount Factor model, which is used to evaluate risky assets. Each of the incorrect answers represents different financial models with varying emphasis and applications in the field of finance.

Explanation

The formula provided indicates the application of a Stochastic Discount Factor model, which is used to evaluate risky assets. Each of the incorrect answers represents different financial models with varying emphasis and applications in the field of finance.