FRM Part I · FRM Exam Part I · Futures Markets
A manager hedging a diversified equity portfolio with index futures finds that the hedged position still shows meaningful return variability even though the beta was set correctly at zero. Which is the most likely explanation?
The remaining variability most likely comes from idiosyncratic risk that index futures cannot remove, along with basis risk. A beta hedge neutralizes only the sensitivity to market movements. Stock-specific returns still move the hedged portfolio, so it is not risk-free even with zero beta.
- AIdiosyncratic (non-market) risk in the portfolio is not removed by the index futuresCorrect
- BIndex futures cannot hedge systematic risk
- CThe hedge ratio should have been set using the portfolio's standard deviation rather than its beta
- DA zero-beta portfolio must earn the market return
Explanation
Beta hedging removes exposure to market movements only. Stock-specific risk remains, as does basis risk between the futures and the index. Index futures do hedge systematic risk, so option B is wrong. Option D is wrong because a zero-beta portfolio is expected to earn the risk-free rate, not the market return.
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