Financial Risk Management Portfolio Risk Management 2 — Questions and Answers
Question 1: What is the Treynor ratio and how does it differ from the Sharpe ratio?
- Both are identical; they use different notation for the same calculation
- The Treynor ratio uses beta (systematic risk) in the denominator instead of total standard deviation, making it useful when a portfolio is part of a larger diversified whole (Correct answer)
- The Treynor ratio uses downside deviation while Sharpe uses total standard deviation
- The Treynor ratio compares portfolio return to a benchmark rather than a risk-free rate
Correct answer: The Treynor ratio uses beta (systematic risk) in the denominator instead of total standard deviation, making it useful when a portfolio is part of a larger diversified whole
Treynor = (Rp − Rf) / β; by using beta, it rewards return per unit of systematic risk, which is appropriate when idiosyncratic risk has been diversified away at the fund level.
Question 2: What is 'Jensen's alpha' in performance attribution?
- The portion of return attributable to currency movements
- The excess return of a portfolio above what CAPM would predict given its beta, measuring the manager's skill (Correct answer)
- The risk-adjusted return calculated using downside deviation
- The return difference between growth and value factor tilts
Correct answer: The excess return of a portfolio above what CAPM would predict given its beta, measuring the manager's skill
Jensen's alpha = Rp − [Rf + β(Rm − Rf)]; a positive alpha indicates the manager generated returns above the CAPM-predicted risk-adjusted benchmark, suggesting genuine skill.
Question 3: What does 'maximum drawdown' measure in portfolio risk analysis?
- The maximum leverage used by a portfolio over a year
- The largest peak-to-trough decline in portfolio value over a specified period (Correct answer)
- The maximum VaR observed during a stress period
- The maximum number of losing days in a rolling 252-day window
Correct answer: The largest peak-to-trough decline in portfolio value over a specified period
Maximum drawdown captures the worst cumulative loss from a peak to a subsequent trough, giving a sense of the worst historical pain an investor would have endured holding the portfolio.
Question 4: What is 'risk budgeting' in portfolio management?
- Setting a maximum dollar loss limit per trading desk per month
- Allocating the total portfolio risk (e.g., VaR or tracking error) across asset classes, strategies, or managers to reflect desired risk exposures (Correct answer)
- Calculating the regulatory capital required for each portfolio position
- Limiting total portfolio leverage to a multiple of equity capital
Correct answer: Allocating the total portfolio risk (e.g., VaR or tracking error) across asset classes, strategies, or managers to reflect desired risk exposures
Risk budgeting shifts the allocation decision from capital dollars to risk units, ensuring that each allocation contributes proportionally to total portfolio risk in line with the investment mandate.
Question 5: What is a 'factor model' in the context of portfolio risk?
- A model that attributes portfolio returns entirely to manager skill
- A model that decomposes portfolio returns and risk into exposures to systematic factors such as market, size, value, momentum, and quality (Correct answer)
- A regulatory model mandated by the SEC for mutual fund risk reporting
- A model that calculates portfolio VaR using only macroeconomic variables
Correct answer: A model that decomposes portfolio returns and risk into exposures to systematic factors such as market, size, value, momentum, and quality
Factor models (e.g., Fama-French, Barra) decompose risk into systematic factor exposures and idiosyncratic residuals, enabling risk attribution, performance decomposition, and more efficient portfolio construction.
Question 6: What is 'rebalancing' and why is it important in risk-controlled portfolio management?
- Selling all positions at year-end to realize gains and losses for tax purposes
- Periodically adjusting portfolio weights back to target allocations to maintain the desired risk profile as asset prices drift (Correct answer)
- Adding new cash inflows equally across all existing positions
- Switching from active to passive management when performance lags
Correct answer: Periodically adjusting portfolio weights back to target allocations to maintain the desired risk profile as asset prices drift
Without rebalancing, winning assets grow to oversized weights, shifting the portfolio's risk profile; regular rebalancing enforces discipline and prevents unintended risk concentrations.
Financial Risk Management Portfolio Risk Management 2
What is the Treynor ratio and how does it differ from the Sharpe ratio?