The value added curve is a curve that is tangent to the residual frontier at portfolio P* (i.e. the optimal portfolio).
As the risk increases, both the expected return and the penalty for risk increase.
The optimal level of residual risk (ω*) which maximizes VA[ωP] is
The optimal level of residual risk increases if:
The implied level of residual risk aversion:
II. information ratio.
III. residual risk aversion.
IV. loss in alpha.
IR/(2λ) = 1/(2x0.05) = 10.
I. The greater our opportunities
II. The less our opportunities
III. The higher the residual risk aversion
IV. The lower the residual risk aversion
IR/(2λ) = 0.75/(2x0.10) = 3.75.