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FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)

A researcher tests a betting-against-beta (BAB) strategy that goes long low-beta stocks and short high-beta stocks. To make the strategy market neutral, how should the legs be constructed?

A betting-against-beta strategy is made market neutral by scaling each leg by the inverse of its beta. The low-beta long leg is levered up and the high-beta short leg is scaled down, so both have a beta of one and the net ex-ante market beta is zero.

  1. AEqual dollar amounts long and short, so that dollar exposure is zero
  2. BScale each leg by the inverse of its portfolio beta, so that the long leg is levered up and the short leg is scaled down, giving ex-ante beta of zeroCorrect
  3. CScale each leg by its volatility so that both legs have the same standard deviation
  4. DHold only the long leg and hedge with market futures at a beta of one

Explanation

BAB levers the low-beta portfolio up and de-levers the high-beta portfolio by dividing each by its beta, so each leg has beta of one and the long-short has zero beta. Equal dollar amounts leave a net positive beta in the long-short only if betas differ, which is the first option's flaw: the position would be net short market beta, not neutral. Volatility scaling does not equalize betas.

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