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FRM Part II · FRM Exam Part II · Factor Theory

A CIO compares a portfolio allocated 60% equities and 40% bonds by capital with a risk-balanced factor approach. The 60/40 portfolio obtains roughly 90% of its risk from the equity market factor. Which statement about this situation is most accurate?

Capital weights do not equal risk weights. Because equities are far more volatile than bonds, the equity factor supplies most of the portfolio's risk even with 40% in bonds. Real diversification must be assessed through risk contributions rather than capital allocation.

  1. ACapital diversification does not imply risk diversification, because the equity factor dominates portfolio risk despite the 40% bond weightCorrect
  2. BThe portfolio is well diversified because 40% of capital is in bonds
  3. CRisk contribution is always proportional to capital weight
  4. DThe portfolio's risk is low because bonds and equities have the same volatility

Explanation

Equities are much more volatile than bonds, so the equity weight contributes a disproportionate share of risk. Risk contributions depend on weights, volatilities and correlations, not weights alone. Therefore capital weights give a misleading picture of diversification.

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