IN COMMENT 2, DOES WILEY CORRECTLY STATE THE ACTIVE FACTOR RISK AND ACTIVE SPECIFIC RISK

16. In Comment 2, does Wiley correctly state the active factor risk and active specific risk?

A. Yes.

B. No, she is incorrect about active specific risk.

C. No, she is incorrect active factor risk.

The following information relates to questions 17 – 20.

Yash Aggarwal, an equity portfolio manager for Southeast Investments, is meeting with Satish

Jha, senior analyst at the firm, to discuss ways to improve the current research methods of

evaluating securities.

Jha begins by stating that multifactor models are very useful in modeling stock returns. He adds,

“We are currently using two types of multifactor models that can explain stock returns:

Model 1

In this model, stock returns are determined by factors which are surprises in macroeconomic

variables such as GDP growth and the level of interest rates.

Model 2

Here, stock returns are a linear function of factors that are company or stock attributes such as

price-earnings ratio and market capitalization.

The intercept is interpreted as the expected return to stock in both models, the factor

sensitivities are defined differently in the two models.”

Aggarwal observes, “A multifactor Arbitrage Pricing Model (APT) is also useful in explaining

expected portfolio returns and evaluating portfolio risk exposures.” She uses the information

given below in Exhibit 1 to illustrate the advantages of the multifactor APT model. The current

risk-free rate is 3 percent.

Exhibit 1: Factor Sensitivities and Risk Premia

Risk Factor Factor Sensitivities Factor Risk

Premium (%)

Portfolio X Portfolio Y Benchmark

Confidence Risk 0.90 0.05 0.60 5.0

Inflation Risk -0.20 -0.60 -0.33 -1.8

Business Cycle

Risk 1.37 0.10 1.00 5.8

Aggarwal then makes the following statement:

“Exhibit 1 shows that Portfolio X will benefit from a growing economy and improving

confidence because the factor sensitivities for confidence risk and business cycle risk are greater

than the factor sensitivities for the benchmark. Portfolio Y is a factor portfolio for inflation risk

because of relatively high exposure to inflation risk, and low factor sensitivities for confidence

risk and business cycle risk.”

Aggarwal wants to know how active management is contributing to portfolio performance.

Jha responds, “Results from our analysis show that Portfolio X has annual tracking error of 6%

and an information ratio of 2.1 while Portfolio B has annual tracking error of 0.65% and an

information ratio of 0.8.”