Financial Risk Manager Part 2
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The equity mutual fund's risk audit committee is reviewing a portfolio construction approach proposed by a recently appointed portfolio manager, who has been allocated capital to manage. Although the fund typically grants its managers the flexibility to select and implement appropriate portfolio construction methods, it requires that the chosen strategy satisfies the core risk control objectives set by the company. From the following options, which portfolio construction technique correctly aligns with and effectively manages risk in this context?
The equity mutual fund's risk audit committee is reviewing a portfolio construction approach proposed by a recently appointed portfolio manager, who has been allocated capital to manage. Although the fund typically grants its managers the flexibility to select and implement appropriate portfolio construction methods, it requires that the chosen strategy satisfies the core risk control objectives set by the company. From the following options, which portfolio construction technique correctly aligns with and effectively manages risk in this context?
Explanation:
The correct answer is A. Quadratic programming allows for risk control through parameter estimation but generally requires many more inputs estimated from market data than other portfolio construction techniques require. Quadratic programming is a powerful process that involves estimating volatilities and pair-wise correlations between all assets in a portfolio. However, due to the large number of inputs and the imperfect nature of most market data, it can introduce the potential for noise and poor calibration. The other options are incorrect because the screening technique does not necessarily provide superior risk control and can lead to fragmented risk control, stratification does not allow for overweighting or underweighting specific categories but rather matches the benchmark weighting, and linear programming does not necessarily select the portfolio with the lowest level of active risk but aims to improve on stratification by introducing more dimensions of risk control.