Question

One popular methodology to create factor portfolios is to form hedged portfolios like the size and value-growth factors in the fama-french three-factor model. which of the following statements correctly describes the feature of this methodology? select one:

a. the goal of the methodology is to hedge out the effect of the factor while maintain exposure to the market risk
b. the factor formation process typically uses the information of all the stocks in the universe
c. the factor assumes a linear relationship between factor characteristics and future return
d. the hedged factor portfolio is a pure factor mimicking portfolio

Answer 1

The correct feature of the methodology used for creating factor portfolios like those in the Fama-French three-factor model is that it assumes a linear relationship between factor characteristics and future returns. The correct answer is option C.

Step-by-step explanation:

The correct statement that describes the feature of the methodology used to create factor portfolios, like the size and value-growth factors in the Fama-French three-factor model, is c. the factor assumes a linear relationship between factor characteristics and future return.

This premise is that certain characteristics of stocks (like size or book-to-market value) systematically influence their expected returns. In a hedged portfolio, these characteristics are isolated, allowing for a purer assessment and potential profit from these factor premiums.

This means that while a factor portfolio may maintain exposure to broader market risk, it specifically taps into and leverages these factor characteristics for its investment strategy. The correct answer is option C.