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Financial Risk Manager Handbook + Test Bank: FRM Part I / Part II, 6th Edition by Philippe Jorion

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Chapter 29

Portfolio Risk Management*

We now turn to risk management in the context of the portfolio management process. Investors assume risk because they expect to be compensated for it in the form of higher returns. The real issue is how to balance risk against expected return. This trade-off is the subject of portfolio management. This requires formal risk measurement, however.

In recent years, institutional investors have placed a much sharper focus on the total risk of their portfolio. This has led to the widespread use of risk budgeting. The process starts with a broad portfolio allocation into asset classes that reflects the best trade-off between risk and return. Once a total risk budget is decided upon, this can be allocated to various asset classes and managers. Thus, risk budgeting reflects a top-down view of the total portfolio risk.

At the end of the investment process, it is important to assess whether realized returns were in line with the risks assumed. The purpose of performance evaluation methods is to decompose the investment performance into various components. The goal is to identify whether the active manager really adds value. Part of the returns generally represents general market factors, also called “beta bets”; the remainder represents true value added, or “alpha bets.” The purpose of this chapter is to present risk and performance evaluation tools used in the investment management industry. Section 29.1 gives a brief introduction to institutional investors. ...

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