FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies
A fund of funds invests equally in two hedge funds. Each has annual volatility of 10% and the correlation between them is 0.50. The FoHF charges no extra volatility effects. What is the FoHF's annual return volatility before FoHF fees?
The portfolio volatility is 8.66%. With equal weights of 50%, variance is 0.0025 + 0.0025 + 2×0.25×0.5×0.01 = 0.0075, and its square root is 8.66%. Correlation of 0.5 means diversification is only partial.
- A8.66%Correct
- B10.00%
- C7.07%
- D5.00%
Explanation
Variance = 0.5²(0.1²)+0.5²(0.1²)+2(0.5)(0.5)(0.5)(0.1)(0.1)=0.0025+0.0025+0.0025=0.0075. Square root = 8.66%. Using correlation 0 gives 7.07%, the key mistake option.
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