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CFA Level I · CFA Level I Exam · Portfolio Risk and Return: Part II

A portfolio has an expected return of 11%, a standard deviation of 20% and a correlation of 0.8 with the market. The market return is 8% with a standard deviation of 10%, and the risk-free rate is 2%. The M-squared measure of the portfolio is closest to:

M-squared levers the portfolio to the market's standard deviation, giving a return of 2% + 0.45 x 10% = 6.5%. Subtracting the market's 8% gives about -1.5%, the closest option being -1.0%, indicating underperformance on a risk-adjusted basis. Correlation does not enter the calculation.

  1. A-1.0%
  2. B0.0%Correct
  3. C1.0%

Explanation

Sharpe of portfolio = (11-2)/20 = 0.45. Market Sharpe = (8-2)/10 = 0.60. M-squared scales the portfolio to market risk: 2% + 0.45 x 10% = 6.5%, minus market 8% = -1.5%. Check: 0.45 - 0.60 = -0.15 x 10% = -1.5%. Closest option is -1.0%. The correlation is irrelevant. The 1.0% figure reverses the sign.

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