FRM Part II · FRM Exam Part II · Liquidity and Leverage
A fund with assets of $200 million and equity of $50 million has asset returns with annual volatility of 5%. Assuming the funding cost is fixed and certain, what is the approximate volatility of the return on equity?
Equity return volatility is about 20%. Leverage of 4 times (assets of $200 million over equity of $50 million) multiplies the 5% asset volatility fourfold when funding costs are fixed, so equity returns are four times as variable as asset returns.
- A5%
- B10%
- C20%Correct
- D25%
Explanation
Leverage = 200/50 = 4. With a fixed funding cost, equity return volatility equals leverage times asset volatility = 4 x 5% = 20%. Using 5% ignores leverage; 10% uses the debt-to-equity ratio... actually 3 x 5% would be 15%, and 25% mistakenly applies 5x.
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