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

A fund's optimal portfolio satisfies the condition for risk-budget efficiency. Which condition describes it?

At the optimum, the ratio of each asset's expected excess return to its marginal contribution to risk is the same across all assets. Otherwise capital could be shifted to the asset with the higher ratio to improve risk-adjusted return. Equal risk contributions are a special case, not the general condition.

  1. AEach asset's contribution to risk is equal
  2. BEach asset's ratio of expected excess return to marginal contribution to risk is equal across assetsCorrect
  3. CEach asset's weight is equal
  4. DEach asset's standalone volatility is equal

Explanation

At the optimum, the ratio of expected excess return to marginal contribution to risk must be equal across assets and equal to the Sharpe ratio scaled by portfolio volatility. If one asset had a higher ratio, shifting capital toward it would raise return per unit of risk. Equal risk contributions describe risk parity, which is optimal only under special assumptions.

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