Absolute risk, also referred to as asset risk, is the possibility of a dollar loss over the horizon, and its rate of return is Rₐₛₛₑₜ. On the other hand, relative risk is the dollar difference between the fund return and that of the amount invested in the benchmark. The tracking error is the appropriate return for this risk, given by E = Rₐₛₛₑₜ − Rᵇ. This choice accurately differentiates between absolute risk and relative risk by correctly defining each term and their implications in financial risk management.

Choice A is incorrect. Absolute risk does not refer to the possibility of loss caused by an insufficient cover to the liabilities of the fund. Instead, it refers to the potential for a dollar loss over a certain period. Similarly, relative risk does not pertain to where surplus ultimately applies but rather refers to the dollar difference between the return of a fund and that invested in a benchmark.

Choice B is incorrect. Absolute risk does not arise from yearly changes in contributions to pension funds; it pertains more broadly to potential losses over time. Relative risk, on the other hand, doesn't stem from fluctuations in financial earnings of plan sponsors but rather from differences between returns on investments and benchmarks.

Choice D is incorrect. Absolute risk isn't about base currency loss regarding any benchmark selected by a fund; it's about possible losses over time irrespective of any benchmark comparison. Relative risk isn't about summing up profits or losses from active managers concerning baseline; instead, it's about comparing returns against those achieved by investing in benchmarks.

Things to Remember

• Absolute risk is the risk of a loss occurring over a certain time horizon, typically measured in dollar terms.
• Relative risk is the difference in returns between a fund and its benchmark, often measured by tracking error.
• Tracking error is the standard deviation of the difference between the portfolio return and the benchmark return.
• Absolute risk is more concerned with the potential for losses, while relative risk focuses on how a fund performs compared to a benchmark.
• A common measure of relative risk is the Sharpe ratio, which considers both risk and return in comparing a fund to its benchmark.