FRM Part II · FRM Exam Part II · Factors
An investor holds two factor strategies, each with volatility of 10%. The correlation between them is 0.2 and the portfolio is equally weighted. What is the portfolio volatility, approximately?
Portfolio variance is 0.25x100 + 0.25x100 + 2x0.25x0.2x100 = 60, so volatility is about 7.7%. Diversification lowers risk below the 10% of perfectly correlated strategies but not as far as it would at zero correlation.
- A10.0%
- B7.7%Correct
- C5.5%
- D6.0%
Explanation
Variance = 0.25x100 + 0.25x100 + 2x0.25x0.2x100 = 25 + 25 + 10 = 60. Volatility = sqrt(60) = 7.75%, about 7.7%. Ignoring the correlation term gives sqrt(50) = 7.07%, and a zero-correlation assumption is not valid here; 10% assumes perfect correlation.
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