Subject 4. The optimal level of residual risk
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:
- There are more opportunities.
- There is less residual risk aversion.
The implied level of residual risk aversion:
Practice Question 1Which factors determine the manager's optimal level of residual risk?
II. information ratio.
III. residual risk aversion.
IV. loss in alpha.
Practice Question 2If the information ratio is 1 and residual risk aversion is 0.05, the optimal level of residual risk is:
IR/(2λ) = 1/(2x0.05) = 10.
Practice Question 3__________, the higher the level of aggressiveness.
I. The greater our opportunities
II. The less our opportunities
III. The higher the residual risk aversion
IV. The lower the residual risk aversion
Practice Question 4A risk aversion (λ) of 0.05 usually indicates a ______ residual risk aversion.
Practice Question 5If the information ratio is 0.75 and residual risk aversion is 0.10, the optimal level of residual risk is:
C. 7.50%.Correct Answer: A
IR/(2λ) = 0.75/(2x0.10) = 3.75.
Study notes from a previous year's CFA exam:
d. calculate the optimal level of residual risk to assume for given levels of manager ability and investor risk aversion;