Skip to content

FRM Part II · FRM Exam Part II · VaR and Risk Budgeting in Investment Management

A sponsor evaluates two managers using information ratios (IR). Manager A has alpha of 2.4% with tracking error of 4%. Manager B has alpha of 2.0% with tracking error of 2.5%. The sponsor has an active risk budget of 5% tracking error to be split so that all is deployed, and the managers' active returns are uncorrelated. Under a simple optimal-allocation logic where expected alpha per unit of risk drives allocation, which conclusion is correct?

Manager B should receive the larger share of the risk budget. B's information ratio is 2.0 divided by 2.5, or 0.80, versus 0.60 for A. With uncorrelated active returns, risk should be allocated in proportion to information ratios, not to raw alpha.

  1. AManager B has the higher IR (0.80 vs 0.60), so B should receive a larger share of the risk budget than ACorrect
  2. BManager A has the higher alpha, so A should receive the larger share regardless of tracking error
  3. CBoth managers should receive equal risk budgets because their tracking errors are uncorrelated
  4. DManager A has the higher IR (0.60 vs 0.80 for B), so A should receive the larger share

Explanation

IR_A = 2.4/4 = 0.60; IR_B = 2.0/2.5 = 0.80. With uncorrelated active returns, the optimal risk allocation is proportional to IR, so B merits more risk budget. Ranking on raw alpha ignores the risk taken, and equal allocation ignores differing IRs. The last option misstates the computed IRs.

Did you get it right without looking?

One question tells you little. A timed set on VaR and Risk Budgeting in Investment Management shows your real accuracy, how long you take and where you lose marks.

Practise VaR and Risk Budgeting in Investment ManagementFree diagnostic mock

More VaR and Risk Budgeting in Investment Management questions