Objective: maximize the value added from residual return, where value added is measured as:

where λ_R = aversion to residual risk. It transforms residual variance into a loss in alpha.

The loss in alpha increases as:

• The residual risk (i.e. ω²_P) increases.
• The level of residual risk aversion (i.e. λ_R) increases.

The value added is also referred to as the certainty equivalent return.

Practice Question 1

The loss in alpha increases if ______ increases.

I. information ratio.
II. residual risk.
III. level of residual risk aversion.

Correct Answer: II and III

Practice Question 2

The active manager's objective is to maximize the:

A. residual return.
B. information ratio.
C. value added.

Correct Answer: C

Practice Question 3

An λ of 0.15 usually means ______ level of residual risk aversion.

A. low.
B. moderate.
C. high.

Correct Answer: C

Practice Question 4

The three parallel constant value added lines shown in the reading (figure 4) assume we have a constant:

A. value added.
B. aversion to residual risk.
C. loss in alpha.

Correct Answer: B