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IAI Actuarial Core Principles · Economic Modelling · Measures of investment risk

A pension fund's trustees care only about returns falling below a required 6% a year and are indifferent to upside variability. Which feature makes downside semi-variance more suitable for them than ordinary variance?

Semi-variance suits these trustees because it counts only deviations below the target return, so good outcomes above 6% are not treated as risk. Ordinary variance penalises upside and downside equally, which does not match their concern about shortfall.

  1. AIt penalises only deviations below the target, so favourable outcomes do not add to measured riskCorrect
  2. BIt is always smaller than the standard deviation for every distribution
  3. CIt is unaffected by the choice of target return
  4. DIt guarantees that the portfolio meets the 6% target
  5. It can be computed only for Normally distributed returns

Explanation

Downside semi-variance sums squared shortfalls below a chosen target only, so gains above the target are not treated as risk. Variance treats upside and downside symmetrically. Semi-variance depends on the target and does not guarantee any result.

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