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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A trend-following CTA has an annualized volatility target of 12% and its models hold a position in a futures contract whose realized annualized volatility rises from 10% to 20% while the signal remains unchanged. Assuming the fund allocates risk equally and scales positions by inverse volatility, how should the position size in that contract change, and what is the effect on that contract's risk contribution?

The position should be halved. Volatility targeting sizes positions inversely to volatility, so when volatility doubles from 10% to 20%, the position falls by half, leaving the contract's risk contribution roughly constant, since risk is approximately position size multiplied by volatility.

  1. ADouble the position; risk contribution doubles
  2. BHold the position; risk contribution doubles
  3. CHalve the position; risk contribution stays approximately constantCorrect
  4. DHalve the position; risk contribution halves

Explanation

Inverse-volatility scaling sets position proportional to 1/volatility. Volatility doubling from 10% to 20% halves the position. Risk contribution is roughly position times volatility, so half times double equals unchanged. Holding the position would double risk; doubling would quadruple it.

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