Risk Management and Investment Management: FRM® Part II

It is 15% of the 2026 Part II exam. 96 learning outcomes across 17 learning modules.

570+ practice questions and 131 formula cards on this topic in the app.

Factor Theory

• Lay out the drivers of asset prices and account for the theory behind risk premiums attached to factors.
• Set out the CAPM together with its underlying assumptions, and show how the model deals with factor risk.
• Show what follows from valuing assets with the CAPM: equilibrium and optimal holdings, factor risk exposure, how diversification gains are handled, and where the model falls short.
• Characterise multifactor models and set them side by side with the CAPM, pointing out similarities and differences.
• Put stochastic discount factors to work in pricing assets, after showing how they are constructed.
• Set out the theory of efficient markets and show the ways in which markets can fail to be efficient.

Factors

• Lay out how value investing is carried out and account for why a value premium might exist.
• Account for the way economy-wide drivers, namely growth, inflation and volatility, shape what assets return and the premiums investors demand for bearing risk.
• Judge the approaches available for reducing volatility risk within a portfolio and outline the difficulties of managing that risk.
• Using Fama-French as the worked example, account for the role that time-varying risk factors play inside a multifactor return model.
• Set value investing against momentum investing, looking at what each tends to earn and how risky each is.

Alpha (and the Low-Risk Anomaly)

• Characterise the low-risk anomaly in asset returns and weigh up the case for it.
• Work out alpha, tracking error, the Sharpe ratio and the information ratio from data, after defining each of these four measures.
• Account for how the choice of benchmark shifts measured alpha and set out what makes a benchmark good for measuring it.
• Set out Grinold's fundamental law of active management with its assumptions and limits, and use it to work out the highest information ratio that can be attained.
• Use a factor regression to build a multifactor benchmark, gauge how sensitive a portfolio is to those factors, and measure alpha relative to the benchmark.
• Show how style analysis can be used to cope with factor exposures that change over time.
• Outline the problems that come up when alphas are measured for strategies with nonlinear payoffs.
• Distinguish the beta anomaly from the volatility anomaly, and examine what the data show for both.
• Lay out the possible explanations offered for the risk anomaly.

Portfolio Construction

• Outline the inputs feeding portfolio construction and explain the difficulties that arise in working with them.
• Weigh up why alphas are refined during implementation and the methods used to do so.
• Set out what neutralization means and the various ways alphas are refined so as to be neutral.
• Show how transaction costs bear on the way a portfolio is constructed.
• Outline practical matters in building portfolios, such as choosing a suitable level of risk aversion, aversion to particular risks, and making sure alphas cover the whole universe properly.
• Explain what revising and rebalancing a portfolio involve, and examine how alpha, risk, trading costs and the investment horizon pull against one another.
• Work out the best no-trade region to use when rebalancing in the presence of transaction costs.
• Judge screens, stratification, linear programming and quadratic programming as ways of building portfolios, noting what each does well and badly.
• Characterise dispersion, account for what causes it, and set out ways to keep its different forms under control.

Portfolio Risk: Analytical Methods

• Specify, compute and set against each other six portfolio VaR figures: individual, undiversified, diversified, incremental, marginal and component.
• Show how correlation affects the risk of a portfolio.
• Use marginal VaR when making decisions about managing a portfolio.
• Account for and compute both the position that minimizes risk and the position that gives the best ratio of expected return to risk.
• Distinguish risk management from portfolio management and show how marginal VaR is put to work in managing portfolios.

VaR and Risk Budgeting in Investment Management

• State what is meant by a risk budget and by risk budgeting.
• Discuss the way that holding period, portfolio turnover and the use of leverage affect how risk is managed by asset managers.
• Lay out how large investors, pension funds for instance, go about investing.
• Outline the challenges of managing risk when money is invested in hedge funds.
• Distinguish six kinds of risk and compare them: sponsor, funding, active management, policy-mix, relative and absolute risk.
• Show how VaR is used to keep watch over risk.
• Show how VaR can inform the drafting of investment guidelines and help make the investment process better.
• Walk through how a risk budget is put together, and compute the allocations of risk to each asset class and to each active manager.

Portfolio Performance Evaluation

• Distinguish a portfolio's time-weighted return from its dollar-weighted return and explain when each is the right one to use.
• Characterise risk-adjusted measures including Sharpe's measure, Treynor's measure, Jensen's measure (Jensen's alpha) and the information ratio, and pinpoint when each fits best.
• Outline what Modigliani-squared and Treynor's measure are used for when comparing two portfolios, and how each is shown on a graph.
• Use the standard error and t-statistic to decide whether a performance measure is statistically significant.
• Characterise what style analysis is.
• Account for why it is hard to gauge the performance of actively managed portfolios.
• Explain how reported performance can be gamed, and why standard performance metrics become unreliable as a result.
• Outline regression and call option model techniques for gauging a fund manager's market timing skill, and work out the return that a manager earns from timing.
• Describe how performance attribution is done and apply it to split results into asset allocation, sector and security selection effects and their combined total.

Hedge Fund Investment Strategies

• Compare the major hedge fund approaches built on equities or on macro views, and explain what returns and risks each one typically carries.
• Set the various arbitrage strategies side by side and outline how convertible arbitrage works.
• Outline how event-driven strategies such as merger arbitrage work and what risks they carry.
• Account for how a distressed securities strategy works and outline the difficulties, risks and factors involved in carrying it out.

Risk, Regulation and Organizational Structure

• Characterise the assorted risks that hedge fund investors face.
• Explain why both what hedge funds do and the extent to which others are exposed to them may heighten systemic risk.
• Give an overview of the different ways regulators try to limit hedge fund related risks.
• Characterise the usual organizational structure of a hedge fund and account for why that structure is chosen.

The Rise and Risks of Private Credit

• Describe private credit, including the usual lenders and borrowers, and contrast it with other forms of lending and with fixed-income securities.
• Explain how private credit has grown and what it returns, and compare its track record of returns against that of other asset classes.
• Characterise and judge the risks and weak points of private credit, and show how it can threaten financial stability.
• Weigh up policy proposals that might reduce the risks that private credit brings.

Private Markets Investing (up to section 3.3.10)

• Account for why investors choose to put money into private markets.
• Outline the structures through which private assets can be held and contrast their features.
• Use and contrast the various ways of measuring private equity performance, outlining the strengths and weaknesses of each.
• Show how investors in private markets come to face different risks and judge how those risks can be measured.
• Characterise co-investing in private markets and weigh up its benefits and drawbacks.
• Explain what investors gain and what obstacles they meet when they reach private markets by way of a pooled vehicle like a private equity or private debt fund.

Performing Due Diligence on Specific Managers and Funds

• Pinpoint why hedge funds have failed in the past.
• Explain what goes into the due diligence procedure that investors follow in appraising a manager.
• Pinpoint the themes and questions that an investor might weigh when assessing a hedge fund manager.
• Characterise the criteria by which a hedge fund's risk management process can be assessed.
• Show how to carry out due diligence on the operational setting of a hedge fund.
• Explain the means of appraising both the fraud risk and the business model risk of a hedge fund.
• Outline what a due diligence questionnaire can contain.

Distress Symptoms and Remedies

• Account for the varied causes of financial distress at firms and pinpoint possible signs that it is occurring.
• Outline the ways firms can fix financial distress at its different stages and account for what each way implies and the difficulties it presents.
• Sum up the legal problems a company may run into during financial distress or while being restructured.

Madoff: A Riot of Red Flags

• Recount how Bernie Madoff's hedge fund came about and outline the strategy it claimed to follow and the performance it reported.
• Spot the traits of Bernie Madoff's hedge fund that acted as red flags, and explain why each one hints at a danger of fraud.

Market-Driven Scenarios: An Approach for Plausible Scenario Construction

• Characterise the market-driven scenario (MDS) approach to building stress test scenarios for investment portfolios and judge its merits.
• Explain the scenario, volatility and correlation z-scores along with the Mahalanobis distance, and how they feed into judging both the plausibility and the size of a scenario.
• Account for the steps in defining and building market-driven scenarios, and outline how the MDS approach is applied in the worked example.
• Outline the challenges and points to bear in mind when putting the market-driven scenario approach into practice.

Liquidity Risk Management

• Explain the recommended ways for an investment fund to control its exposure to liquidity risk.
• Account for the potential difficulties fund managers meet in managing liquidity risk in fixed-income portfolios, data modeling included.
• Characterise and use the different approaches for modeling asset liquidity, among them one for bonds that trade rarely and the t-cost model for working out transaction costs on corporate bonds.
• Name emergency tools that regulators can let funds use when redemption demands are unforeseen, and explain the circumstances in which each is permitted.
• Explain how a fund can handle and model redemption risk, covering the redemption waterfall, modeling of redemption-at-risk, and tuning liquidity so that withdrawals can be met.

Illiquid Assets

• Appraise the defining features of markets that are illiquid.
• Examine the link between imperfections in markets and a lack of liquidity.
• Weigh up how biases affect the returns reported for illiquid assets.
• Account for how returns are unsmoothed and what unsmoothing does.
• Set the premiums paid for bearing illiquidity risk against each other, both across asset categories and within a single category.
• Appraise the consequences of putting illiquid assets into a portfolio, for rebalancing and trading as well as for deciding how large a proportion of them is optimal.

Other topics

• Credit Risk Measurement and Management
• Market Risk Measurement and Management
• Operational Risk and Resilience
• Liquidity and Treasury Risk Measurement and Management
• Current Issues in Financial Markets
• All of FRM Part II