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FRM Part I · FRM Exam Part I · Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)

A manager's portfolio is one of many held in a investor's well-diversified total wealth, and the portfolio is added as one sleeve among several. Which performance measure is most appropriate for assessing this sleeve?

The Treynor ratio is most appropriate. When the portfolio is one sleeve within a well-diversified total holding, unsystematic risk is diversified away and only beta is rewarded. Sharpe uses total risk and suits an investor's whole, undiversified portfolio.

  1. ASharpe ratio, because it uses total risk
  2. BTreynor ratio, because only systematic risk matters in a diversified portfolioCorrect
  3. CStandard deviation alone, because it ignores returns
  4. DTracking error alone, because it ignores the market

Explanation

When the portfolio is a small part of a well-diversified total holding, idiosyncratic risk is diversified away, so beta is the relevant risk and the Treynor ratio fits. Sharpe suits a portfolio that is the investor's entire holding.

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