Final answer:
The multifactor model best describes security returns by accounting for multiple factors influencing investment risks and returns, going beyond simple market risk to include various economic and company-specific variables.
Step-by-step explanation:
The multifactor model provides a better description of security returns as it allows for several variables that can affect the return on a security, such as market risk, interest rates, economic cycles, and company-specific events. The model attempts to explain the market and other risks that might influence the performance of a security, going beyond the single factor that is the market risk in models like the CAPM (Capital Asset Pricing Model).
The multifactor model may indirectly relate to concepts like exchange rate fluctuations through its impact on international investments, which could be one of the factors considered in the model, but it is primarily known for its direct association with analyzing security returns. Exchange rates can indeed impact securities, especially those of companies with significant international exposure; however, the primary focus of multifactor models in financial literature and application is on security returns.
Investors use multifactor models to determine the risks associated with different securities and to better understand the expected rate of return based on various risk factors. For instance, a rise in domestic interest rates could affect bond and stock prices, which would be factored into a multifactor analysis.