Asset pricing models...

Question

BlackTom AI · Accepted Answer

Let's restate the question and the options in my own words to set the stage for analysis.
Question: Asset pricing models...
Options:
 a. None of the options provided.
 b. all describe the relation between expected stock returns and some source(s) of firm-specific risk.
 c. all describe the relation between expected stock returns and some source(s) of unsystematic risk.
 d. all predict a higher expected return on those stocks which tend to perform badly in good times and well in bad times.

Now, evaluate each option in turn, drawing on standard asset pricing principles.
Option a: None of the options provided. This statement claims that none of the other statements correctly describe how asset pricing models relate expected returns to risk factors. To assess this, we must see whether any of b, c, or d actually describe a correct feature of asset pricing. If any of them were accurate, a would be false; if all of them are incorrect, a could be true. We will determine this by checking the content of the other options.

Option b: all describe the relation between expected stock returns and some source(s) of firm-specific risk. In typical asset pricing frameworks (e.g., CAPM and most modern theories), expected returns are determined by systematic risk, i.e., risk that cannot be diversified away. Firm-specific risk (unsystematic risk) can be diversified away in a large portfolio and is not priced into expected returns. Therefore, statements claiming that all models relate returns to firm-specific risk are inconsistent with canonical models. This makes option b incorrect.

Option c: all describe the relation between expected stock returns and some source(s) of unsystematic risk. This is a more explicit phrasing of the idea in option b, naming unsystematic risk directly. Since asset pricing models price expected returns with respect to systematic risk factors rather than unsystematic risk, this option is also incorrect. It contradicts the fundamental insight that diversifiable risk is not rewarded with higher expected returns.

Option d: all predict a higher expected return on those stocks which tend to perform badly in good times and well in bad times. This seems to describe a contrarian or anti-cyclical performance pattern—stocks that do poorly when the economy is strong and do well when the economy worsens. Traditional asset pricing models generally associate higher expected returns with higher systematic risk (beta) in good times and bad times, i.e., being more sensitive to overall market movements. The described pattern (bad in good times, good in bad times) does not align with typical pricing of risk where higher risk in aggregate tends to command higher returns, and the specific anti-cyclical performance described is not a standard, universally priced risk factor in the canonical models. Consequently, option d is not a correct general characterization.

In summary, each of options b, c, and d asserts a relationship between expected stock returns and a form of risk that asset pricing theory typically does not price in (firm-specific/unsystematic risk) or advocates a pattern that is not a standard implication of basic models. Since the question asks about asset pricing models in general, and given the conventional view that only systematic risk is priced, while unsystematic risk is diversifiable, none of b, c, or d provides the correct description. Therefore, option a follows as the remaining viable claim among the given choices.

Asset pricing models...

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