FRM Part II · FRM Exam Part II · Portfolio Performance Evaluation
A portfolio has total volatility of 12%, benchmark volatility of 10%, and a correlation of 0.90 between the portfolio and benchmark returns. What is the tracking error?
Tracking error is the standard deviation of the difference in returns: sqrt(12² + 10² − 2×0.9×12×10) = sqrt(28), about 5.29%. Simply subtracting the volatilities gives 2%, which ignores that imperfect correlation creates additional active risk.
- A2.00%
- B5.29%Correct
- C4.00%
- D5.83%
Explanation
Variance of active return = 12^2 + 10^2 - 2(0.9)(12)(10) = 144 + 100 - 216 = 28. Tracking error = sqrt(28) = 5.29%. 2.00% is the simple volatility difference. 4.00% uses 1-0.9 incorrectly with wrong scaling. 5.83% uses sqrt(34), omitting part of the covariance term.
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