FRM Part II · FRM Exam Part II · Portfolio Construction
A pension fund sets a risk budget in which equities may use at most 70% of total tracking-error variance. After a rally, equities contribute 82% of risk. What is the most appropriate response under risk budgeting?
The fund should cut or hedge equity exposure to bring its risk contribution back to the 70% budget. Risk budgeting is governed by risk contributions, not capital weights, so an 82% share is a breach even if capital weights appear acceptable.
- ADo nothing because the capital weight is still within its strategic range
- BReduce equity exposure or hedge so its risk contribution returns to the budgetCorrect
- CIncrease equity exposure since it is performing well
- DReplace the risk budget with a capital-weight budget
Explanation
Risk budgeting monitors risk contributions rather than capital weights. A breach of the 70% allowance requires reducing the exposure or hedging it back toward the budget.
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