ASSUMING THE INFLATION SURPRISE IS 1

13. Assuming the inflation surprise is 1.5% and the GDP surprise is 0%, the expected return for

the technology sector (using equally weighted securities) would be closest to:

A. 15.2%.

B. 16.7%.

C. 20.0%.

The following information relates to questions 14 – 16.

Ann Wiley, is a portfolio manager at Brooks Capital, a firm providing investment consulting and

portfolio management services to institutional clients. Wiley is meeting with a new assistant,

Paula Slater. Wiley begins the meeting with the following comment:

Comment 1: “We evaluate securities using multifactor models to determine the expected return

and risk of securities. Depending on our requirement, we choose one from the three types of

multifactor models: a macroeconomic factor model, a fundamental factor model, or a statistical

factor model. For macroeconomic factor models, the factors are the surprises in the selected

macroeconomic variables. For fundamental factor models, the factors are cross-sectional

differences in companies’ returns. In statistical factor models, we apply statistical techniques,

such as factor analysis or principal component analysis, to historical securities’ returns to identify

factors that best explain historical variances and covariances.”

Slater states: “What is the return generating process given by the arbitrage pricing theory (APT)

equation which is also a form of a multifactor model?”

Wiley responds, “APT specifies the appropriate number of factors to use in a multifactor model,

helps identify those factors, and gives the expected return of the asset being evaluated.”

Wiley continues:

Comment 2: “Multifactor models are also used to explain the active risk of a portfolio. In

analyzing risk, using active risk squared can be decomposed into two components: active factor

risk and active specific risk. Active factor risk is due to portfolio’s different-from-benchmark

exposures relative to factors specified in the risk model. Active specific risk measures the

residual risk of the portfolio.”