FRM Part II · FRM Exam Part II · Portfolio Construction

A pension plan sets a risk budget allocating 70% of total tracking error risk to its active equity managers and 30% to active fixed income managers. Which statement best describes the purpose of this risk budget?

A risk budget allocates the plan's total acceptable risk among its sources, here equity and fixed income active managers, so actual risk usage can be monitored against limits. It does not fix capital weights, guarantee returns, or remove the need for correlation estimates.

1. AIt fixes the capital weights of equity and fixed income
2. BIt guarantees that active returns will be proportional to risk allocated
3. CIt limits and allocates the total risk the plan is willing to take across sources of active risk, so it can be monitored against actual usageCorrect
4. DIt eliminates the need to measure correlations between managers