Financial Risk Management Portfolio Risk Management 1 — Questions and Answers
Question 1: What does 'diversification' mean in the context of portfolio risk management?
- Investing only in assets with the highest expected returns
- Spreading investments across assets with low or negative correlations to reduce overall portfolio risk without proportionally reducing expected return (Correct answer)
- Allocating equally across all available asset classes regardless of risk
- Concentrating in one asset class to maximize Sharpe ratio
Correct answer: Spreading investments across assets with low or negative correlations to reduce overall portfolio risk without proportionally reducing expected return
Diversification exploits the fact that imperfectly correlated assets do not all lose value simultaneously, so combining them reduces portfolio volatility relative to individual asset volatility.
Question 2: What is the Sharpe ratio used to measure?
- The total return of a portfolio over its benchmark
- The risk-adjusted return of a portfolio, calculated as excess return above the risk-free rate divided by portfolio standard deviation (Correct answer)
- The maximum drawdown of a portfolio over a year
- The correlation between a portfolio and its benchmark index
Correct answer: The risk-adjusted return of a portfolio, calculated as excess return above the risk-free rate divided by portfolio standard deviation
The Sharpe ratio (= (Rp − Rf) / σp) measures how much excess return is earned per unit of total risk, allowing comparison of portfolios with different risk levels.
Question 3: What is 'systematic risk' (market risk) versus 'idiosyncratic risk' (specific risk)?
- Systematic risk can be diversified away; idiosyncratic risk cannot
- Systematic risk affects all assets and cannot be diversified away; idiosyncratic risk is specific to individual assets and can be reduced through diversification (Correct answer)
- Both types of risk can be eliminated by holding a large portfolio
- Idiosyncratic risk is the dominant risk in a well-diversified portfolio
Correct answer: Systematic risk affects all assets and cannot be diversified away; idiosyncratic risk is specific to individual assets and can be reduced through diversification
Systematic risk (beta) stems from macroeconomic factors affecting all assets — it cannot be diversified away. Idiosyncratic risk from individual company events averages out in large portfolios.
Question 4: What does 'beta' measure in the Capital Asset Pricing Model (CAPM)?
- The expected return of an asset given its credit rating
- The sensitivity of an asset's return to movements in the overall market portfolio (Correct answer)
- The standard deviation of an asset's daily returns
- The alpha generated by active portfolio management
Correct answer: The sensitivity of an asset's return to movements in the overall market portfolio
A beta of 1 means the asset moves with the market; beta > 1 means amplified market moves; beta < 1 means dampened market moves; beta can be negative for defensive assets.
Question 5: What is the 'efficient frontier' in modern portfolio theory?
- The minimum-variance portfolio for a given expected return target
- The set of portfolios that maximize expected return for each level of risk, or equivalently minimize risk for each level of expected return (Correct answer)
- The portfolio that achieves the highest absolute return in all market conditions
- The set of portfolios that contain only risk-free assets
Correct answer: The set of portfolios that maximize expected return for each level of risk, or equivalently minimize risk for each level of expected return
The efficient frontier represents the optimal trade-off between expected return and risk; rational investors should hold portfolios on this frontier rather than portfolios dominated by higher-return / lower-risk alternatives.
Question 6: What is 'tracking error' in portfolio management?
- The absolute difference between a portfolio's return and the market return
- The standard deviation of the difference between a portfolio's return and its benchmark return (Correct answer)
- The number of positions that deviated from the model portfolio
- The total cost of trading errors in a given month
Correct answer: The standard deviation of the difference between a portfolio's return and its benchmark return
Tracking error measures how closely a portfolio follows its benchmark; low tracking error means the portfolio returns closely mirror benchmark returns, high tracking error indicates more active deviation.
Financial Risk Management Portfolio Risk Management 1
What does 'diversification' mean in the context of portfolio risk management?