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. LO.g.
Set 2 Questions
The following information relates to questions 1 - 4.
Brie Lars is a portfolio manager for Mega Inc., an appliance manufacturer. At the quarterly
meeting with the client, Brie explains that she uses multifactor models as a guide to asset
allocation. In particular she uses the arbitrage pricing theory (APT) to model asset return. She
describes the three main assumptions of the APT model:
Assumption 1: A factor model can be used to explain asset returns.
Assumption 2: No arbitrage opportunities are possible in a well-diversified portfolio.
Assumption 3: Adding assets to a diversified portfolio, adds to factor risk and to its specific risk.
She explains that she evaluates different funds in the market and seeks to exploit arbitrage
opportunities among them. She presents an example of different portfolios using a one-factor
model that explains returns. The data is presented below:
Exhibit 1: Portfolio information for a one-factor model
Portfolio Expected return Factor sensitivity
A 15.0% 0.8
B 16.0% 1.0
C 19.0% 1.2
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