Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

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Which asset pricing model includes the risk-free rate and the market return?

A two-factor model.
A single-factor model.
Not a factor model.
A three-factor model.

The correct answer is: A two-factor model.

The asset pricing model that includes both the risk-free rate and the market return is typically the Capital Asset Pricing Model (CAPM), which is a single-factor model. This model explains how the return on an asset relates to its systematic risk, characterized by the asset's beta, which measures the asset's volatility in relation to the overall market. The formula for CAPM includes the risk-free rate, the expected market return, and the beta of the asset, emphasizing the linear relationship between expected return and beta. A two-factor model would include an additional factor beyond the market risk, such as a variable to account for size or value, but it would still primarily rely on the relationship established by the risk-free rate plus the market return component. A three-factor model extends this further by incorporating two additional factors, often size and value, which are outside the two primary factors noted. In this context, since the question specifically asks for a model that includes the risk-free rate and market return, a single-factor model fits this description best, as it directly incorporates these elements to derive expected asset returns based on market risk exposure.