Exhibit 2: Risk Factor Actual Value (%) Expected Value (%) Fund D's Factor Sensitivity Active Factor Risk (% Squared) Time horizon risk 2.6 2.0 1.6 24 Inflation risk 1.5 0.8 –0.4 16 Martinez considers whether Fund D would be a suitable investment for Lakemont University's endowment. The endowment has an investment horizon of 30 years. The activities it supports have historically been subject to cost increases running above the average rate of inflation. Question Based solely on the factor model, is Fund D an appropriate investment for Lakemont University? A.Yes B.No, because of Fund D's sensitivity to inflation risk C.No, because of Fund D's sensitivity to time horizon risk Solution Incorrect because the activities supported by Lakemont University are sensitive to inflation risk. Therefore, Fund D's negative factor sensitivity to inflation risk does not help Lakemont University in reducing its exposure to inflation risk. Correct because Fund D has a positive factor sensitivity to time horizon risk and a negative factor sensitivity to inflation risk. Investors may tilt their strategic asset allocation or investments within an asset class to capture the associated risk premiums for risks that do not much affect them. Lakemont University has an investment time horizon of 30 years and is not much affected by time horizon risk. Therefore, it has a comparative advantage in bearing time horizon risk. However, the activities supported by Lakemont University are sensitive to inflation risk. Therefore, Fund D's negative factor sensitivity to inflation risk does not help Lakemont University in reducing its exposure to inflation risk. Incorrect because Lakemont University has an investment time horizon of 30 years and is not much affected by time horizon risk. Therefore, it has a comparative advantage in bearing time horizon risk.

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Let's analyze whether Fund D is suitable for Lakemont University's endowment. Lakemont has a 30-year investment horizon and activities sensitive to inflation. Fund D shows positive sensitivity to time horizon risk at 1.6, and negative sensitivity to inflation risk at minus 0.4. The positive time horizon sensitivity is actually beneficial for a long-term investor like Lakemont, but the negative inflation sensitivity creates a problem. Let's examine the time horizon risk factor. Lakemont University has a 30-year investment horizon, which means it's less sensitive to short-term market volatility. This gives the university a comparative advantage in bearing time horizon risk. Fund D's positive sensitivity of 1.6 to time horizon risk means it can capture the associated risk premium. For long-term investors like Lakemont, this positive sensitivity is actually beneficial, as they can afford to wait through market cycles. Now we see the critical problem with Fund D. Lakemont University's activities are sensitive to inflation risk, meaning their costs rise above average inflation rates. The university needs investments that provide inflation protection. However, Fund D has a negative sensitivity of minus 0.4 to inflation risk. This means when inflation increases, Fund D's value actually decreases. This creates a dangerous mismatch - exactly when the university faces higher costs due to inflation, Fund D performs poorly, providing no hedge against this risk. Let's summarize our analysis with a decision matrix. For time horizon risk, Fund D's positive sensitivity of 1.6 matches well with the university's low sensitivity to this risk - this is an advantage. However, for inflation risk, Fund D's negative sensitivity of minus 0.4 creates a severe mismatch with the university's high exposure to inflation. The conclusion is clear: Fund D is not suitable for Lakemont University. The primary reason is that Fund D's negative inflation sensitivity works directly against the university's need for inflation protection. Based on our factor model analysis, the answer is B: No, because of Fund D's sensitivity to inflation risk. While Fund D's positive time horizon sensitivity is actually beneficial for Lakemont University's long investment horizon, the critical issue is Fund D's negative inflation sensitivity of minus 0.4. Since the university's activities are subject to cost increases above average inflation, Fund D's negative inflation sensitivity creates a harmful mismatch. When inflation rises and the university faces higher costs, Fund D's value would decrease, providing no protection against this key risk exposure.