The question asks what the benefit of taking a short position in Fund B is relative to an equally sized long position in Fund C. Fund B has an inflation factor sensitivity of 1.6 and a GDP factor sensitivity of 0.0, while Fund C has an inflation factor sensitivity of 1.0 and a GDP factor sensitivity of 1.1. The answer indicates that the benefit is lower inflation risk. Can someone explain why this is the case? I cannot wrap my brain around this answer at all. Thank you.
The exhibit shows the following:
Fund A: E® = 0.02, Inflation Sensitivity = 0.05, GDP Growth Sensitivity = 1.00
Fund B: E® = 0.04, Inflation Sensitivity = 1.60, GDP Growth Sensitivity = 0.00
Fund C: E® = 0.03, Inflation Sensitivity = 1.00, GDP Growth Sensitivity = 1.10
Therefore, if we were to go long C and equally short B. We would have the following:
Fund: E® = -0.01 (0.03 - 0.04), Inflation Sensitivity = -0.60 (1.00 - 1.60), GDP Growth Sensitivity = 1.10 (1.10 - 0.00).
We have lower overall Inflation Sensitivity (0.60) versus only being long Fund C (1.00). A is correct.
We have, assuming no fund correlation, a lower E® (-0.01) versus only being long Fund C (0.03). B is incorrect.
We have the same GDP Growth Sensitivity (1.10) versus only being long Fund C (1.10). C is incorrect.
Note: As a factor sensitivity moves closer to 0.00, we become less affected by that factor (thus reducing factor risk).