Given the opportunities described by the information ratio, the active manager should choose the portfolio that maximizes value added._{P}] is

The value added curve is a curve that is tangent to the residual frontier at portfolio P* (i.e. the optimal portfolio).

Mathematically:

As the risk increases, both the expected return and the penalty for risk increase.

The optimal level of residual risk (ω*) which maximizes VA[ω

The optimal level of residual risk increases if:

- There are more opportunities.
- There is less residual risk aversion.

The implied level of residual risk aversion:

Which factors determine the manager's optimal level of residual risk?

Correct Answer: II and III

I. aggressiveness.

II. information ratio.

III. residual risk aversion.

IV. loss in alpha.

Correct Answer: II and III

If the information ratio is 1 and residual risk aversion is 0.05, the optimal level of residual risk is:

Correct Answer: B

A. 5%.

B. 10%.

C. 20%.

Correct Answer: B

IR/(2λ) = 1/(2x0.05) = 10.

__________, the higher the level of aggressiveness.

Correct Answer: I and IV

I. The greater our opportunities

II. The less our opportunities

III. The higher the residual risk aversion

IV. The lower the residual risk aversion

Correct Answer: I and IV

A risk aversion (λ) of 0.05 usually indicates a ______ residual risk aversion.

Correct Answer: C

A. restrained.

B. moderate.

C. aggressive.

Correct Answer: C

If the information ratio is 0.75 and residual risk aversion is 0.10, the optimal level of residual risk is:

B. 3.33%.

C. 7.50%.

Correct Answer: A

A. 3.75%.

B. 3.33%.

C. 7.50%.

Correct Answer: A

IR/(2λ) = 0.75/(2x0.10) = 3.75.