Credit Risk Management Practice Exam

Which component is NOT part of the single-factor model return equation?

1. ai

2. βim

3. εi

4. λi

The correct answer is: λi

In the context of a single-factor model return equation, the components represent specific elements that are used to explain the return of a security based on market risk factors. The correct choice, which is not part of this return equation, is the term typically represented as λi. In a single-factor model, the return on a security can usually be expressed as follows: Return = ai + βim + εi In this equation: - The term ai represents the constant or intercept, indicating the expected return of the asset when the market factor is zero. - The term βim is the sensitivity of the asset's return to the market return, indicating how much the asset's return is expected to change in response to changes in the market. - The term εi is the error term, capturing the idiosyncratic risk associated with the individual asset that is not explained by the market factor. On the other hand, λi typically appears in multi-factor models where multiple sources of risk are considered. It often relates to risk-premium factors rather than being a component of the return equation in a single-factor model. Thus, identifying λi as not fitting into the single-factor narrative helps clarify its absence in this context.