Risk & Investment Management

FRM® Part II, published weight 15%. Factor theory, risk budgeting, attribution, hedge funds, illiquid assets.

What the outline covers

Factor theory and portfolio construction
Risk budgeting and risk monitoring for investment portfolios
Portfolio performance measurement and attribution
Hedge fund strategies, structures and risks
Illiquid assets and valuation of private holdings
Risk-adjusted performance measures
Portfolio VaR and risk decomposition

Sample questions

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Question 1

A small allocation to an asset with high volatility and high correlation to the rest of the portfolio can dominate the risk budget. The measure that reveals this is:

A. The position weight
B. Marginal contribution to risk
C. The Sharpe ratio of the position
D. The position’s standalone volatility

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B. Marginal contribution to risk accounts for both the volatility and the correlation with the existing portfolio, which a weight or standalone volatility cannot.

Reading: Risk and Investment Management — Risk Budgeting

Question 2

When a hedge fund joins an index, the index provider adds the fund’s prior track record. The resulting distortion is:

A. Survivorship bias
B. Backfill bias
C. Selection bias in the risk-free rate
D. Smoothing bias

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B. Backfill bias arises because funds tend to join after a strong period, so the added history inflates reported index performance.

Reading: Risk and Investment Management — Hedge Fund Indices

Question 3

Reported returns on an illiquid private portfolio display strong positive autocorrelation. Unsmoothing the series will:

A. Lower the estimated volatility and raise the Sharpe ratio
B. Raise the estimated volatility and lower the Sharpe ratio
C. Leave volatility unchanged but raise correlation
D. Lower both volatility and correlation

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B. Smoothing understates true volatility and correlation. Correcting for it raises volatility, which reduces the Sharpe ratio.

Reading: Risk and Investment Management — Illiquid Assets

Question 4

Factor theory holds that assets earn a risk premium because they:

A. Belong to a particular asset class
B. Perform poorly in bad times
C. Have high historical volatility
D. Are held by institutional investors

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B. Premia compensate exposure to bad times, not asset labels. Two differently labelled assets with the same factor exposure should earn similar returns.

Reading: Risk and Investment Management — Factor Theory

Question 5

A manager reports strong alpha, but a factor regression shows most of the excess return is explained by a persistent value tilt. The appropriate conclusion is that the return reflects:

A. Genuine manager skill
B. Systematic factor exposure available more cheaply
C. A backtesting error
D. Survivorship bias in the benchmark

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B. Return attributable to a known factor is beta, not alpha, and can be obtained through cheaper systematic implementations.

Reading: Risk and Investment Management — Factor Theory

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