FRM Part II · FRM Exam Part II · Portfolio Construction
A portfolio manager moves from a capital-weighted 60/40 equity/bond allocation to a risk parity allocation. Equities have much higher volatility than bonds. Which change is the most likely result of this move?
Risk parity equalizes risk contributions across assets. Since equities are far more volatile than bonds, the allocation shifts away from equities toward bonds by capital weight, compared with a 60/40 portfolio, so that each asset contributes the same share of total risk.
- AA lower allocation to equities and a higher allocation to bonds, by capital weightCorrect
- BA higher allocation to equities and a lower allocation to bonds, by capital weight
- CAn equal capital weight in each asset regardless of volatility
- DWeights proportional to expected returns of each asset
Explanation
Risk parity equalizes each asset's contribution to total portfolio risk. Because equities are much more volatile, they need a smaller capital weight and bonds a larger one. Equal capital weights ignore risk, and return-proportional weights are not risk parity.
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