FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods
A risk manager runs a regression of a fund's excess returns on the market's excess returns and obtains an R-squared of 0.64 and a total fund volatility of 20%. Which is the fund's residual volatility?
Residual volatility is 12.0%. With an R-squared of 0.64, 36% of variance is unexplained by the market, so residual volatility equals 20% times the square root of 0.36, which is 20% times 0.6.
- A12.0%Correct
- B7.2%
- C14.4%
- D16.0%
Explanation
Unexplained variance share = 1 - 0.64 = 0.36. Residual volatility = 20% x sqrt(0.36) = 20% x 0.6 = 12.0%. Option C (20% x 0.72?) is not correct; option D is 20% x 0.8, which is the systematic volatility, not the residual.
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