Explanation:
When hedging two securities where one involves a real rate of return (e.g., TIPS) and the other a nominal rate of return (e.g., standard Treasury bonds), their price sensitivities are influenced by different underlying risk factors. Nominal rates include inflation expectations, whereas real rates do not. Because real and nominal yields do not always move perfectly together in a parallel fashion, single-factor risk measures like DV01, PV01, or duration are insufficient on their own. They fail to capture the differential movements caused by changes in inflation expectations, meaning the market risk cannot be accurately measured by DV01 alone.
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Q.1604 Hedging is an investment strategy used to minimize the risk of adverse asset price movements. The hedge is normally carried out by taking an offsetting position in a related financial instrument. When hedging two securities, one with the real rate of return while the other with the nominal rate of return, it should be understood that:
A
the market risk of the two securities can be measured accurately by DV01 alone.
B
the market risk of the two securities cannot be measured accurately by DV01 alone.
C
the market risk of the two securities can be measured accurately by PV01 alone.
D
the market risk of the two securities can be measured accurately by duration alone.
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