Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Information Ratio (IR) measure?

1. Excess return per unit of risk

2. Total portfolio return

3. Market volatility

4. Cost of investment

The correct answer is: Excess return per unit of risk

The Information Ratio measures the excess return generated by an investment portfolio relative to a benchmark, specifically on a risk-adjusted basis. It is calculated by taking the portfolio's excess return (the return of the portfolio minus the return of the benchmark) and dividing it by the tracking error, which is the standard deviation of the differences between the portfolio returns and the benchmark returns. This ratio provides valuable insight into how effectively a portfolio manager is delivering returns above the benchmark while managing the associated risks. A higher Information Ratio indicates that a portfolio is providing better returns for each unit of risk taken, making it an essential tool for evaluating the performance of active investment strategies. The other options do not accurately describe what the Information Ratio measures. Total portfolio return is a broader concept that does not consider risk on a relative basis to a benchmark. Market volatility refers to the fluctuations in the price of securities over time, typically measured by standard deviation or beta, and does not directly relate to excess returns. The cost of investment pertains to the expenses incurred in purchasing or managing an investment, which is unrelated to measuring performance versus a benchmark. Thus, the Information Ratio specifically captures the efficiency of generating excess returns relative to risk, making it a crucial metric in investment analysis.