FRM Part II · FRM Exam Part II · Factor Theory
A risk committee notes that during a stagflation episode, both equities and nominal government bonds fell together. Which implication for factor-based portfolio construction is most appropriate?
Asset class diversification does not guarantee factor diversification. Stocks and nominal bonds are both exposed to growth and inflation shocks, and their correlation shifts across regimes, so a stagflation shock can hurt both. Managers should assess exposures to the underlying macroeconomic factors directly.
- ADiversification across asset classes does not guarantee diversification across macro factors, so exposures to growth and inflation factors should be assessed directlyCorrect
- BAsset class diversification is sufficient, since equities and bonds always have negative correlation
- CInflation risk can be ignored because it is fully diversifiable
- DOnly the equity market factor matters, because bonds have no macroeconomic exposure
Explanation
Asset classes bundle exposures to underlying macro factors such as growth and inflation. Correlations between stocks and bonds change with the inflation regime, so asset-class diversification can hide concentrated factor risk. Inflation is a systematic risk and not diversifiable.
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