FRM Part II · FRM Exam Part II · Portfolio Construction
A manager has two assets with equilibrium excess returns of 4% and 6%. She holds one absolute view that asset 1 will return 8%, so P = [1 0]. Suppose that, for a simplified illustration, the prior variance of asset 1's expected return (tau times its variance) is 0.0004 and the view error variance Omega is 0.0004. Ignoring cross-asset covariance effects, what is the posterior expected return of asset 1?
The posterior expected return is 6%. Prior variance and view variance are equal, so each gets a 50% precision weight, and the average of the 4% equilibrium return and the 8% view is 6%.
- A4%
- B6%Correct
- C7%
- D8%
Explanation
With equal prior and view variances, the precision weights are 50/50. Posterior = 0.5 x 4% + 0.5 x 8% = 6%. Choosing 8% ignores the prior uncertainty; 4% ignores the view.
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