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FRM Part II · FRM Exam Part II · VaR and Risk Budgeting in Investment Management

A pension plan allocates capital to several external managers and sets a separate tracking-error budget for each. Which statement best describes the main benefit of a decentralised risk-budgeting structure in which each manager monitors risk against their own allocated budget?

Decentralised risk budgeting lets each manager take risk within an allocated limit, so risk is used where skill exists, while the sponsor controls total plan risk by setting and monitoring budgets. It does not remove the need to measure correlations or make total VaR a simple sum.

  1. AIt guarantees that the total plan VaR equals the sum of the individual manager VaRs
  2. BIt lets managers take risk where they have skill, while the sponsor limits total risk by setting and monitoring budgetsCorrect
  3. CIt eliminates the need for the sponsor to measure correlations between managers
  4. DIt ensures every manager earns the same information ratio

Explanation

Decentralised risk budgeting delegates risk-taking to managers within allocated budgets, so risk is deployed where skill exists while the sponsor controls aggregate risk. Total VaR is not the simple sum of manager VaRs because diversification matters, and correlations still must be measured at the total-plan level.

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