Answer: nonsystematic variance.

## Explanation The information ratio is calculated as: **Information Ratio = Jensen's Alpha / Tracking Error** Where: - **Jensen's Alpha** is the excess return of a portfolio over its expected return based on the Capital Asset Pricing Model (CAPM) - **Tracking Error** is the standard deviation of the portfolio's excess returns relative to its benchmark Tracking error represents the **nonsystematic risk** or **idiosyncratic risk** of the portfolio. This is the risk that is specific to the portfolio manager's investment decisions and not related to overall market movements. ### Key Points: 1. **Total variance** includes both systematic (market) risk and nonsystematic (idiosyncratic) risk 2. **Systematic variance** is the portion of risk that cannot be diversified away (market risk) 3. **Nonsystematic variance** is the portion of risk that can be eliminated through diversification (idiosyncratic risk) Since the information ratio measures a portfolio manager's ability to generate excess returns relative to a benchmark, it uses tracking error (nonsystematic risk) in the denominator to assess the consistency of the manager's outperformance. **Correct Answer: C - nonsystematic variance**

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