Portfolio Risk Management Flashcards

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

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

Risk parity (popularized by Bridgewater's All Weather fund) typically results in overweighting low-volatility assets (bonds) and underweighting high-volatility assets (equities) relative to traditional portfolios.

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

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

Perfect negative correlation means when one asset rises the other falls by the same magnitude — the perfect hedge; combining them in the right ratio theoretically eliminates all portfolio variance.

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

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

IR = Alpha / Tracking Error; a high IR indicates the manager consistently generates alpha relative to the active risk taken, making it superior to alpha alone for evaluating active managers.

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

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

LDI matches duration, inflation sensitivity, and cash flows of assets to liabilities, minimizing the risk that assets are insufficient to meet future obligations regardless of market movements.

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

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

A coherent risk measure must satisfy: monotonicity (more risk = more capital), sub-additivity (diversification cannot increase risk), positive homogeneity (scaling), and translation invariance; VaR fails sub-additivity, while Expected Shortfall satisfies all four.

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

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

MVO is highly sensitive to expected return estimates — small input errors lead to extreme, concentrated portfolios; practitioners use shrinkage estimators, robust optimization, or Black-Litterman to mitigate this.