Reading 58 - Residual Risk and Return

Question 1

Define what alpha (residual return) is ……

**Critical Concept**

Answer 1

The return of a portfolio in excess of its benchmark (adjusted for risk difference between the portfolio and benchmark)

***i.e. excess risk adjusted return

Question 2

What does ex-ante mean?

Answer 2

looking forward

Question 3

What does ex-post mean?

Answer 3

looking backward

Question 4

What is an ex-post alpha?

Answer 4

alpha measured after actual results become available.

Question 5

What is an ex-ante alpha?

Answer 5

is a forward-looking forecast of residual return

Question 6

In general terms, what is the information ratio?

Answer 6

Is a ratio of (annualized) residual return to (annualized) residual risk.

**Information Ratio increases with the time horizon due to how it is calculated**

Question 7

How is the information ratio calculated?

**Critical Concept**

Answer 7

**The notion of success is captured and quantified by the IR. The IR says how good you think you are***

Question 8

Who do you calculate the residual return (α_p)?

Answer 8

αp = IR * ω_p

IR = Information Ratio

ω_p = residual risk

Question 9

A manager can achieve an expected residual return of 2% with a residual risk of 5%. Compute the expected residual return given a risk tolerance of 8% for residual risk…

Answer 9

Step1: manager’s information ratio = 2% /5% = 0.4

Step2: residual risk target = 8%

Step3: expected residual return = (0.4)8% = 3.2%

Question 10

What is a residual frontier?

Answer 10

a plot of residual return versus risk for a given information ratio

**which are “opportunities available to the active manager”

Question 11

What is the alpha and residual risk of the benchmark portfolio

Answer 11

0 for both

Question 12

Since the information ratio can be viewed as a budget constraint, what is the only way a manager can increase their active return?

**Critical Concept**

Answer 12

By increasing residual risk

a = IR * w

Question 13

What is the ultimate objective of active management?

Answer 13

To maximize value added from residual return

aka certainty equivalent return

Question 14

Define what Value Added is ….

**Critical Concept**

Answer 14

It measures the tradeoff between active return and active risk

Question 15

What is the formula to calculate Value Added if given the residual return?

**Critical Concept**

Answer 15

**** Return and risk figures should be in % form, not decimal**

Question 16

Jackie Schroff is a value manager with First Partners. Schroff estimates that he can generate residual return of 3% annually. Schroff’s residual risk is 6.5%

Compute the value added for:

A. An aggresive investor (0.05 risk aversion)

B. Moderately risk averse investor (0.10)

C. Conservative investor (0.15)

Answer 16

Question 17

What is the formula to derive the implied level of risk aversion when given information ratio and optimal level of residual risk?

**Critical Concept**

Answer 17

Question 18

How can Value Added (VA) be calculated if given the information ratio and level of risk aversion?

**Critical Concept**

Answer 18

Question 19

How can Value Added (VA) be calculated if given the information ratio and the optimal level of residual risk?

**Critical Concept**

Answer 19

w* = optimal level of residual risk

Question 20

Explain the relationship between the value added amount and IR and the risk aversion…….

Answer 20

Value added increase with information ratio regardless of the risk aversion.

Question 21

How do you calculate Value Added when given the follow pieces of information?

**Critical Concept**

Answer 21

Formula was incorrect

is equation 9 on page 213

Question 22

What does the parameter ⋋ refer to?

Answer 22

it measures the aversion to residual risk (ie risk aversion)

Question 23

What is the equation for the optimal level of residual risk which maxImizes value added?

Answer 23