Explanation:
Option B is correct because:
Why the other options are incorrect:
Option A: Factor betas are primarily used to hedge systematic risk (common factors), not idiosyncratic risk. Idiosyncratic risk is typically diversified away rather than hedged using factor betas.
Option C: Factor hedging can work well with both linear and nonlinear factor models. The performance depends on the model's ability to capture the relevant risk factors, not specifically on linearity.
Option D: In theory, an investor can construct a portfolio with a beta exactly equal to zero by taking appropriate offsetting positions in factors. This is the fundamental principle behind factor-neutral or market-neutral portfolios.
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An analyst at a family endowment fund is studying the use of a factor analysis approach to hedge an investment portfolio. The analyst reviews the characteristics of factor analysis and best practices in implementing the approach. Which of the following statements is correct for the analyst to make?
A
Factor betas can be used in the process of hedging idiosyncratic risk, but they cannot be used in hedging systematic risk.
B
Choosing the frequency to adjust factor-based hedges requires making a decision that balances the hedging cost and the tracking error.
C
Factor hedging performs well when linear factor models are used, but performs poorly when nonlinear factor models are used.
D
While an investor can take positions in factors to construct a portfolio with a beta close to zero, the investor cannot theoretically construct a portfolio with a beta exactly equal to zero.