FRM Part II · FRM Exam Part II · Portfolio Construction
A fund has an information coefficient of 0.10 and 64 independent bets, giving a basic-law IR of 0.80. Because of long-only constraints, its transfer coefficient is 0.70. The target active risk is 5%. Using the extended law IR = TC x IC x sqrt(breadth), what expected alpha does the fund achieve?
Expected alpha is 2.80%. The constrained information ratio is the transfer coefficient 0.70 times the information coefficient 0.10 times the square root of 64, which is 0.56. Multiplying by 5% active risk gives 2.80%. Ignoring the constraint would overstate alpha at 4.00%.
- A2.80%Correct
- B4.00%
- C5.71%
- D0.56%
Explanation
Realized IR = 0.70 x 0.10 x sqrt(64) = 0.70 x 0.10 x 8 = 0.56. Alpha = IR x active risk = 0.56 x 5% = 2.80%. Option 4.00% ignores the transfer coefficient (0.80 x 5%). Option 5.71% divides 4% by 0.70, wrongly adjusting the opposite way.
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