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Answer: Short sell a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.
## Explanation To hedge factor risks, an investor needs to take opposite positions that offset the factor exposures of the original portfolio. **Key Points:** - Kevin's portfolio has Brazilian GDP beta = 0.40 and Brazilian Real beta = 0.30 - A factor portfolio has factor-beta = 1 for a single risk factor and factor betas = 0 for other factors - By short selling a hedge portfolio with matching factor exposures, the investor can neutralize the factor risks **Why Option A is Correct:** - Short selling a portfolio with 40% exposure to Brazilian GDP factor portfolio and 30% exposure to Brazilian Real factor portfolio creates negative factor exposures - These negative exposures exactly offset Kevin's positive factor exposures (0.40 and 0.30) - The remaining 30% in risk-free assets doesn't introduce additional factor risk **Why Other Options are Incorrect:** - **Option B**: Buying the hedge portfolio would increase factor exposures rather than hedge them - **Option C**: Incorrect allocation percentages (30% GDP, 40% Real) don't match the portfolio's actual betas - **Option D**: This strategy doesn't specifically target the Brazilian GDP and Real factors that Kevin wants to hedge This hedging strategy effectively protects the portfolio from losses due to fluctuations in Brazilian GDP and Brazilian Real value.
Author: Tanishq Prabhu
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Kevin Brett is an American portfolio manager who manages an emerging factor market portfolio that focuses on the blue-chip firms from Brazil. He fears that the stocks of these blue-chip firms are highly dependent on factors like the GDP of Brazil and the value of the Brazilian Real. He believes his portfolio can decline in value due to changes in these two main factors. The portfolio's Brazilian GDP beta is 0.40 and the Brazilian Real beta is 0.3. Which of the following strategies should Brett accept in order to hedge both factors?
A
Short sell a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.
B
Buy a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.
C
Buy a hedge portfolio that allocates 30% exposure to the first Brazilian GDP factor portfolio, 40% to the Brazilian Real factor portfolio, and 30% to the market portfolio.
D
Short sell a hedge portfolio that allocates 70% exposure to the risk-free asset and 30% to the market portfolio.