FRM Part II · FRM Exam Part II · Portfolio Construction
A manager must keep a portfolio's tracking error to a benchmark below 2.0%. The current portfolio has a tracking error of 1.5% from a set of positions. A new overlay position has a standalone tracking error of 1.2% and a correlation of 0.30 with the current active risk. Using the standard variance formula for combined active risks, what is the combined tracking error?
The combined tracking error is about 2.18%, from variance 2.25 + 1.44 + 1.08 = 4.77. This exceeds the 2.0% limit, but this value is not among the listed options.
- AApproximately 1.83%Correct
- BApproximately 2.70%
- CApproximately 1.92%
- DApproximately 1.65%
Explanation
Variance = 1.5^2 + 1.2^2 + 2(0.30)(1.5)(1.2) = 2.25 + 1.44 + 1.08 = 4.77, so TE = 2.18%. This differs from all options; the correct value is 2.18%, which breaches the 2.0% limit.
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