Explanation:
A factor portfolio can be hedged by opening opposite positions with the same factor exposure. A factor portfolio has a factor-beta equal to one for a single risk factor, and factor betas equal to zero on the remaining factors. By shorting the hedge portfolio, the investor will offset the factor risks of the original portfolio. Since Kevin has a 0.4 exposure to the Brazilian GDP factor and a 0.3 exposure to the Brazilian Real factor, he can hedge the risk by shorting a factor portfolio that allocates 40% exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor portfolio, and the rest to the risk-free assets. This strategy will effectively neutralize the risks associated with the Brazilian GDP and the Brazilian Real, thereby protecting the value of his portfolio from potential losses due to fluctuations in these two factors.
Choice B is incorrect. Buying 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 would double the original portfolio's exposure to those risk factors instead of hedging it.
Choice C is incorrect. Buying a hedge portfolio with incorrect weights does not effectively hedge the original factor exposures and increases long exposure rather than offsetting the risk.
Choice D is incorrect. Hedging requires neutralizing the specific factor betas using their respective factor portfolios, not by indiscriminately mixing risk-free assets and the general market portfolio without regard to the specific GDP and Real betas.
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Q.243 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.
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