Optimal Active Risk

CFA Level II Portfolio Management
#1

Hi- Can someone please help me understand what is the intuition behind the optimal active risk formula? Std dev(A)* = (IR/SRb)* std dev(b) Can’t seem to wrap my head aroud it.

#2

Do you want understanding, or do you want intuition?

The understanding takes a half-dozen steps:

  1. Compute the optimal amount of active return
  2. Compute the benchmark’s excess return (over the risk-free rate)
  3. Compute the optimal portfolio’s excess return (over the risk-free rate)
  4. Compute the optimal portfolio’s standard deviation of returns
  5. Compute the optimal portfolio’s Sharpe ratio
  6. Compute the percentage of active portfolio in the optimal portfolio

As with all optimization problems, it becomes a matter of calculus.

The intuition is easier: know the formula.

#3

Thanks for the explanation. I wanted to know, what are we trying to achieve here. Is there something prior to knowing the steps in your answer ( intuition: that I am looking for). Can you help with some analogy that could help understand what are we trying to achieve when we are finding optimal active risk.