FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)
Under the fundamental law of active management, the expected information ratio is approximately IR = IC × √BR. A manager has an information coefficient of 0.05 and makes 400 independent bets per year. If the manager targets 4% annual active risk, what is the expected active return (alpha)?
The expected alpha is 4.0%. The information ratio equals 0.05 times the square root of 400, which is 1.0. Multiplying the information ratio by the 4% active risk target gives an expected active return of 4.0%.
- A1.0%
- B2.0%Correct
- C4.0%
- D8.0%
Explanation
IR = 0.05 × √400 = 0.05 × 20 = 1.0. Alpha = IR × active risk = 1.0 × 4% = 4.0%. Check: the arithmetic gives 4.0%, so the correct option is 4.0%, not 2.0%.
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