Financial Risk Management Portfolio Risk Management 3

Question 1

What is the 'risk-parity' portfolio construction approach?

Accepted Answer

Allocating portfolio weights so that each asset class contributes equally to total portfolio risk rather than equal capital allocation

Answer

Weighting assets equally by market capitalization

Answer

Maintaining a 50/50 split between equities and fixed income at all times

Answer

Matching portfolio duration to the investment liability horizon

Question 2

What does a correlation coefficient of −1 between two assets imply for portfolio risk?

Accepted Answer

The two assets move in perfect opposite directions, allowing complete elimination of risk when combined in the right proportions

Answer

The two assets are independent and provide no diversification benefit

Answer

The portfolio would have maximum variance

Answer

The assets have identical returns and no diversification value

Question 3

What is the 'information ratio' (IR) used to assess in portfolio management?

Accepted Answer

The consistency and magnitude of active return (alpha) relative to tracking error, measuring the efficiency of active management

Answer

The ratio of private information trades to public information trades in a portfolio

Answer

The ratio of fundamental analysis to quantitative analysis used by a portfolio manager

Answer

The percentage of portfolio positions that outperformed the benchmark

Question 4

What is 'liability-driven investing' (LDI) and who primarily uses it?

Accepted Answer

An investment strategy that aligns asset portfolios with the characteristics of a defined liability stream, primarily used by pension funds and insurance companies

Answer

An approach used by hedge funds to maximize absolute returns using leverage

Answer

A trading strategy that profits from mispricings between assets and their derivatives

Answer

A strategy that holds only liability-free assets such as cash and government bonds

Question 5

In the context of the FRM exam, what is a 'coherent risk measure'?

Accepted Answer

A risk measure satisfying four properties: monotonicity, sub-additivity, homogeneity, and translation invariance

Answer

Any risk measure approved by a financial regulator

Answer

A risk measure that is consistent across all asset classes and geographies

Answer

A risk measure that uses only observable market data without model assumptions

Question 6

What is 'mean-variance optimization' (MVO) and what is its main practical limitation?

Accepted Answer

A mathematical framework by Markowitz that finds the efficient frontier by maximizing return for a given variance; main limitation is extreme sensitivity to small changes in expected return inputs

Answer

A trading strategy maximizing average daily variance; limitation is high transaction costs

Answer

A risk model that uses rolling means and variances; limitation is look-ahead bias

Answer

A regulatory approach to capital allocation; limitation is the one-size-fits-all nature