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FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods

A fund has an active weight vector relative to its benchmark. The annualized volatility of the portfolio is 12%, the benchmark volatility is 10%, and the correlation between portfolio and benchmark returns is 0.90. What is the approximate tracking error?

Tracking error is about 5.3%. It equals the square root of portfolio variance plus benchmark variance minus twice covariance: 144 + 100 - 216 = 28, whose square root is roughly 5.29%. Simply subtracting volatilities would wrongly give 2%.

  1. A2.0%
  2. B5.3%Correct
  3. C5.9%
  4. D7.4%

Explanation

TE^2 = 12^2 + 10^2 - 2(0.90)(12)(10) = 144 + 100 - 216 = 28. TE = sqrt(28) = 5.29%. The 2.0% option is just the volatility difference, which ignores correlation imperfection.

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