Introduction to Multifactor Models Question Bank

LO.a: Describe arbitrage pricing theory (APT), including its underlying assumptions and
its relation to multifactor models.

1. Which of the following statements about arbitrage pricing theory (APT) is most likely true?
A. APT represents an assets risk as a linear function of factors representing unsystematic
risk.
B. The number of underlying factors in APT is fixed.
C. A key assumption of APT is that there are many investable assets such that asset specific
risk can be diversified.

LO.b: Define arbitrage opportunity and determine whether an arbitrage opportunity

exists.

2. An arbitrage opportunity is:

A. a transaction that generates a risk-free return as a guaranteed pay-off.
B. a transaction that is risk-free and requires no net investment of money but earns an
expected positive net profit.
C. a transaction that earns a return in excess of the risk-free rate with minimal risk.

3. The one year futures of DMX Co. are selling at $11. The current stock price is $10 and the
risk-free rate is 8%. There are no further costs or benefits of holding the future contracts.
John Harper is considering shorting futures. Which of the following statements is most likely
true?
A. There exists an arbitrage opportunity as the transaction will yield a return higher than the
risk-free rate without assuming any risk.
B. There is no arbitrage opportunity because the transaction does not yield a return higher
than the risk-free rate.
C. There is no arbitrage opportunity because the transaction is not risk-free.

LO.c: Calculate the expected return on an asset given an assets factor sensitivities and the
factor risk premiums.

4. The following table shows the factor sensitivities and expected returns of three well-
diversified portfolios each sensitive to the same factor:

Portfolio Factor Sensitivity Expected Return

A 0.5 6.5%
B -0.6 3.2%
C 0.7 7.1%

Assuming a single factor explains returns and no arbitrage opportunity exists, a risk-free rate
of 5%, the factor risk premium of is closest to:
A. 3.0%.
B. 5.1%.
C. 11.4%.

Copyright IFT. All rights reserved. Page 1

 Introduction to Multifactor Models Question Bank

5. Belta Inc. has an expected return of 9%. The risk-free rate is 3%. The only factor
representing systematic risk is Factor X with an expected return of 5%. The companys
sensitivity to Factor X is closest to:
A. 0.0
B. 1.2
C. 1.0

LO.d: Describe and compare macroeconomic factor models, fundamental factor models,
and statistical factor models.

6. Which of the following statements regarding multi factor models is most likely true?
A. Fundamental factor models present sensitivities of the company to external economic
factors that affect its fundamentals
B. Factor analysis models and principal component models are instances of fundamental
factor models
C. Macro-economic factor model includes factors such as interest rates and inflation

7. A potential difference between macroeconomic factor models and fundamental factor models
is that:
A. macroeconomic factor models explain past returns whereas fundamental factor models
explain expected return.
B. macroeconomic factor models use regression to estimate sensitivities whereas
fundamental factor models do not use regression.
C. in macroeconomic models the factor is stated as a surprise whereas in fundamental factor
models the factor is stated as a return.

LO.e: Explain sources of active risk and interpret tracking risk and the information ratio.

8. Active risk is due to:

A. different-from-benchmark exposures relative to factors specified in the risk model only.
B. different-from-benchmark weights on individual assets only.
C. both different-from-benchmark exposures to factors in the model and different-from-
benchmark weights of individual assets.

9. The active risk decomposition of two portfolios, A and B is given below:

Portfolio Active Factor Active Specific

Industry Style factor
A 15 10 17
B 5 8 2
Note: Entries are in % squared
Which of the following statements is most likely true?
A. Style factor contributed more to Portfolio Bs active risk than Portfolio A.
B. Portfolio Bs active risk is higher than that of portfolio A.
C. The low active specific risk of portfolio B suggests a passively managed portfolio.

Copyright IFT. All rights reserved. Page 2

 Introduction to Multifactor Models Question Bank

10. The track record of three fund managers is given below:

Average Active return Tracking Error

Fund Manager A 5% 2%
Fund Manager B 2% 1%
Fund Manager C 6% 4%
Based on the data, which fund manager has the best risk-adjusted record?
A. Fund Manager A.
B. Fund Manager B.
C. Fund Manager C.

LO.f: Describe uses of multifactor models and interpret the output of analyses based on
multifactor models.

11. Which of the following statements regarding multifactor models is most likely true?
A. Multifactor models can be used to predict alpha in passively managed portfolios.
B. Factor models have sensitivity of -1 to a particular factor and 0 to all other factors.
C. Multifactor models can be used to replicate a benchmarks risk exposures for a passively
managed portfolio.

LO.g: Describe the potential benefits for investors in considering multiple risk dimensions
when modeling asset returns.

12. Which of the following is least likely a benefit of using multifactor models in modeling asset
returns?
A. Investors can better analyze their comparative advantage in bearing risk.
B. Investors can achieve better-diversified portfolios.
C. Investors can determine the optimum allocation between a risk-free asset and market
portfolio.

Copyright IFT. All rights reserved. Page 3

 Introduction to Multifactor Models Question Bank

Solutions
1. C is correct. APT explains an assets return based on factors representing systematic risk only. It
assumes that asset specific risk can be diversified away. Section 3.

2. B is correct. An arbitrage opportunity is an opportunity to conduct a transaction that is risk-free and

requires no net investment of money but earns an expected positive net profit. Section 3.

3. A is correct. Buying the stock and shorting the futures gives a guaranteed return of 10% i.e. 11/10 -1
= 10%. The RF rate is 8%. The transaction gives a pay-off, i.e. risk-free. As the expected return is
higher than the RF rate, an arbitrage opportunity exists. Section 3.

4. A is correct. Because the single factor explains returns, E(Rp) = RF + 0.5 x factor risk premium ()
given E(RA) = 0.065 = 0.05 + 0.5(). = (0.065 - 0.05)/0.5 = 0.03 = 3%. Section 3.

5. B is correct. 9% = 3% + Factor sensitivity (5%). Factor sensitivity is therefore 1.2. Section 3.

6. C is correct. Macroeconomic models represent asset returns correlated to surprises in some factors
related to macroeconomic variables. These include interest rates, inflation risk, business cycle risk,
GDP growth etc. Section 4.1.

7. C is correct. In macro-economic models the factor is stated as a surprise whereas in

fundamental factor models the factor is stated as a return. Section 4.3.

8. C is correct. Active risk has two components: 1) active factor risk which is the risk due to
portfolios different-from-benchmark exposures relative to factors specified in the risk model
and 2) asset selection risk which is the risk resulting from the portfolios active weights of
individual assets. Section 5.2.

9. A is correct. Style contributed 10/42 = 23.8% to portfolio As active risk and 8/15=53.3% to
portfolio Bs active risk. Section 5.2.

10. A is correct. Fund Manager As IR (information ratio) is 5/2 = 2.5, Fund Manager Bs IR is
2/1 = 2 and Fund Manager Cs IR is 6/4 = 1.5. Fund Manager A has the highest IR. Section
5.2.

11. C is correct. Multifactor models can be used to replicate risk exposures of a benchmark for a
passively managed portfolio when number of stocks in a benchmark may be too high or
investing in all stocks is not possible. Section 5.3.

12. C is correct. Multifactor models do not provide an optimum allocation rather they are used to
understand the varying sources of risk in a portfolio. This can lead to more efficient
portfolios. Section 5.4.

Copyright IFT. All rights reserved. Page 4