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

A plan has two external managers. Manager A has weight 60% and stand-alone tracking error of 2.0%. Manager B has weight 40% and stand-alone tracking error of 3.0%. The correlation of their active returns is 0.25. What is the plan's total tracking error, to the nearest basis point?

The plan tracking error is about 1.90%. Weighted tracking errors are 1.2% each, so variance is 1.44 plus 1.44 plus 2 times 0.25 times 1.44, giving 3.60. The square root is 1.897%, which rounds to 1.90%.

  1. A1.56%Correct
  2. B1.90%
  3. C1.32%
  4. D2.40%

Explanation

Weighted TEs: 0.6x2.0 = 1.2; 0.4x3.0 = 1.2. Variance = 1.44 + 1.44 + 2x0.25x1.2x1.2 = 1.44+1.44+0.72 = 3.60. TE = sqrt(3.60) = 1.897%, so the key is 1.90%. Correction: 1.56% would be wrong, as it ignores correct variance addition. The correct figure is 1.90%.

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