AdvancedMultiple choice
Hedging out the market · Part 3 of 3
A signal portfolio has a market beta of 0.3 and residual volatility of 6% a year, uncorrelated with the market. The market’s volatility is 16% a year, and the portfolio’s alpha is 3% a year.
You short index futures to bring the beta to zero, leaving the alpha and residual risk unchanged. What happens to the ratio of alpha to volatility?
- AIt stays at about 0.39, since the alpha is unchanged
- BIt rises from about 0.39 to 0.50
- CIt falls, because the hedge costs the market’s expected return
- DIt rises to about 0.63, dividing the alpha by the market-free share of the volatility
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