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P2.T8.700. Theory of factor risk premiums (Andrew Ang)

Nicole Seaman

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Learning objectives: Provide examples of factors that impact asset prices, and explain the theory of factor risk premiums. Describe the capital asset pricing model (CAPM) including its assumptions, and explain how factor risk is addressed in the CAPM. Explain implications of using the CAPM to value assets, including equilibrium and optimal holdings, exposure to factor risk, its treatment of diversification benefits, and shortcomings of the CAPM.


700.1. Andrew Ang develops an analogy, writing "factors are to assets what nutrients are to food." His theory of factor risk premiums includes each of the following three ideas EXCEPT which is not in the theory?

a. Assets are bundles of factors (just as most foods are combinations of nutrients)
b. Factors do matter but asset classes do not (just as healthy eating is about the nutrients not the labels)
c. Different investors prefer and/or need different factors (just as different people have different nutritional needs)
d. Because factors represent different good times, most investors should seek exposure to most investable factors (just as most people should seek a balanced diet of most nutrients)

700.2. Andrew Ang introduces the capital asset pricing model (CAPM) in Chapter 6 (Factor Theory) with these words: "The CAPM was revolutionary because it was the first cogent theory to recognize that the risk of an asset was not how that asset behaved in isolation but how that asset moved in relation to other assets and to the market as a whole. Before the CAPM, risk was often thought to be an asset’s own volatility. The CAPM said this was irrelevant and that the relevant measure of risk was how the asset covaried with the market portfolio—the beta of the asset." What else does he say is TRUE about the CAPM?

a. CAPM is known to be a spectacular failure with respect to its predictive power
b. Neither finance professors nor Chief Financial Officers (CFO) employ the CAPM in practice
c. Equilibrium asserts that factors are temporary because arbitrageurs eventually eliminate factors
d. Investors make very different predictions about asset returns, variances and correlations; equilibrium is the theory that says this diversity of beliefs is reconciled via the market price mechanism of supply and demand

700.3. In regard to the capital asset pricing model (CAPM), Andrew Ang is able to catalog both its failures and successes, where success refers to "ideas the CAPM gets right." Each of the following is an assumption of the CAPM, but only one is TRUE IN PRACTICE and therefore useful. Which of the following assumptions (or implications) of the CAPM is a genuine success such that it is both true in practice and useful to us?

a. Information is costless and available to all investors: technology has reduced information friction to roughly zero
b. Risk is factor exposure: The risk of an individual asset is measured in terms of the factor exposure of that asset
c. Investors have mean-variance utility: asset owners care only about means (which they like) and variances (which they dislike)
d. Investors have homogeneous expectations: investors have identical expectations with respect to the necessary inputs into the portfolio decision

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