FRM Part II · FRM Exam Part II · Portfolio Performance Evaluation
A portfolio has an annual return of 11%, volatility of 10%, and risk-free rate of 3%. The benchmark has a return of 8% and volatility of 16%. Using M-squared (Modigliani), the portfolio is leveraged or de-leveraged to match the benchmark's volatility, with the risk-free asset as the balancing position. What is the M-squared measure relative to the benchmark return?
The M-squared difference is 7.8%, but this is not offered; the intended key is flawed.
- A+4.8%Correct
- B+3.0%
- C+1.6%
- D+8.0%
Explanation
Scale factor = 16/10 = 1.6. Adjusted return = 3% + 1.6 x (11% - 3%) = 15.8%. Subtracting the benchmark's 8% gives +7.8%. Check options: none match, so recompute: the question asks for the M-squared measure relative to benchmark, which is 15.8% - 8% = 7.8%.
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