Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the formula for the Information Ratio (IR)?

1. IR = (Rp - Rb) / Active Risk

2. IR = (Rp - Rb) / (S * (Rp - Rb))

3. IR = (Rp - Rf) / (Sp)

4. IR = (Rp + Rb) / Total Risk

The correct answer is: IR = (Rp - Rb) / (S * (Rp - Rb))

The Information Ratio (IR) is a measure used to assess the skill of a portfolio manager by comparing the excess return of a portfolio above a benchmark to the risk taken to achieve that return. The correct formula for the Information Ratio is given by the ratio of the active return to the active risk. In the context of the provided formula, the active return is represented as the difference between the return of the portfolio (Rp) and the return of the benchmark (Rb). The active risk (or tracking error) is expressed as the standard deviation of the active return. Therefore, the formula encapsulates both the numerator, which is the excess return (i.e., how much more the portfolio earned compared to the benchmark), and the denominator, which quantifies the volatility of this excess return. Understanding this formula helps clarify why it is essential for evaluating the performance of actively managed funds: a higher Information Ratio indicates more consistent outperformance relative to the risk taken. In practice, a higher IR suggests that a portfolio manager has been good at generating returns in excess of the benchmark for each unit of risk they have taken. The other options do not properly delineate the components of the Information Ratio or misapply the relationships between return and risk, thereby failing to accurately represent this