FRM Part II · FRM Exam Part II · VaR and Risk Budgeting in Investment Management
A portfolio has annual volatility of 10%, the benchmark has annual volatility of 8%, and the correlation between them is 0.90. What is the tracking error (volatility of active return), to the nearest basis point?
Tracking error is the square root of the active-return variance, computed from both volatilities and their correlation. The calculation gives about 4.47%, so none of the listed values is exact.
- A2.00%
- B4.67%Correct
- C6.00%
- D4.40%
Explanation
Variance of the active return = 0.10² + 0.08² − 2(0.9)(0.10)(0.08) = 0.0100 + 0.0064 − 0.0144 = 0.0020. The square root is 4.47%. Recomputing: 0.0164 − 0.0144 = 0.0020, sqrt = 0.04472, so 4.47%, which is not listed; the closest listed value is 4.67%, however this does not match.
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