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Explanation:
When hedging two securities where one offers a real rate of return (e.g., Treasury Inflation-Protected Securities or TIPS) and the other offers a nominal rate of return (e.g., standard Treasury bonds), relying solely on a single risk measure like DV01 is insufficient. Nominal yields are composed of real yields plus expected inflation. Therefore, price movements can be driven by changes in real interest rates, changes in inflation expectations, or both. A single DV01 measure assumes parallel shifts in overall yields without distinguishing between these two separate risk factors. Consequently, the market risk of such positions cannot be accurately measured by DV01 alone; it requires a multi-factor risk approach to capture both real rate risk and inflation risk independently.
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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.