FRM Part II · FRM Exam Part II · Portfolio Construction
A manager's unconstrained portfolio has an expected information ratio of 0.80 with a transfer coefficient of 1. After adding a no-short-sales constraint and a turnover limit, the transfer coefficient falls to 0.60. The target active risk (tracking error) is 5%. What is the expected active return after the constraints?
Expected active return is 2.4%. The constraints reduce the information ratio to 0.60 times 0.80, or 0.48, and multiplying by the 5% tracking error gives 2.4%. The figure 4.0% would wrongly ignore the transfer coefficient loss.
- A2.4%Correct
- B4.0%
- C3.0%
- D1.6%
Explanation
Constrained information ratio = TC x IR = 0.60 x 0.80 = 0.48. Expected active return = IR x tracking error = 0.48 x 5% = 2.4%. Using the unconstrained IR gives 4.0%, which ignores the constraint loss.
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