AAMS Risk, Return & Investment Performance 4 — Questions and Answers
Question 1: Which of the following best describes 'reinvestment risk'?
- The risk that a bond issuer will default before maturity
- The risk that interest payments will be reinvested at lower rates (Correct answer)
- The risk of losing principal due to market price declines
- The risk that inflation will erode real returns
Correct answer: The risk that interest payments will be reinvested at lower rates
Reinvestment risk is the chance that future cash flows (coupons or dividends) must be reinvested at a lower rate than originally anticipated.
Question 2: An AAMS candidate reviews two portfolios: Portfolio X (return 12%, std dev 15%) and Portfolio Y (return 10%, std dev 9%). The risk-free rate is 3%. Which portfolio has the superior Sharpe ratio?
- Portfolio X with 0.60
- Portfolio Y with 0.78 (Correct answer)
- Both are equal
- Cannot determine without beta
Correct answer: Portfolio Y with 0.78
Sharpe X = (12−3)/15 = 0.60; Sharpe Y = (10−3)/9 = 0.78; Portfolio Y offers better risk-adjusted returns.
Question 3: Convexity in fixed income investing is best described as:
- A measure of a bond's credit quality relative to peers
- The curvature in the price-yield relationship that benefits bond prices (Correct answer)
- The sensitivity of a bond's coupon to changes in interest rates
- A risk measure for equity portfolios with nonlinear payoffs
Correct answer: The curvature in the price-yield relationship that benefits bond prices
Convexity captures the curvature of the price-yield curve, meaning bond prices rise more than duration predicts when rates fall and fall less when rates rise.
Question 4: An investor holds an undiversified portfolio of one stock. The relevant risk measure for this investor is:
- Beta only
- Total risk (standard deviation) (Correct answer)
- Tracking error
- Downside deviation
Correct answer: Total risk (standard deviation)
For an undiversified investor, total risk (standard deviation) is the relevant measure because unsystematic risk has not been eliminated.
Question 5: Time-weighted return (TWR) is preferred over money-weighted return (MWR) for evaluating investment managers because:
- TWR accounts for the timing and size of client cash flows
- TWR eliminates the effect of client-controlled cash flows on performance (Correct answer)
- TWR is always higher than MWR in rising markets
- TWR penalizes managers for underperformance relative to a benchmark
Correct answer: TWR eliminates the effect of client-controlled cash flows on performance
TWR removes the impact of external cash flows (controlled by clients, not managers), providing a fair measure of manager skill.
Question 6: Which of the following scenarios illustrates 'sequence of returns risk'?
- A retiree earns 7% average annual return but experiences large losses early in retirement (Correct answer)
- An investor's portfolio earns below-average returns due to high inflation
- A bond investor faces rising interest rates immediately after purchase
- A growth stock investor loses value when the sector rotates to value stocks
Correct answer: A retiree earns 7% average annual return but experiences large losses early in retirement
Sequence of returns risk occurs when poor early returns during withdrawals permanently reduce the portfolio's ability to recover, even if long-term averages are favorable.
Question 7: The Fama-French three-factor model expands on CAPM by adding which two additional factors?
- Momentum and profitability
- Size and value (book-to-market ratio) (Correct answer)
- Liquidity and credit risk
- Inflation and GDP growth
Correct answer: Size and value (book-to-market ratio)
Fama and French added a size factor (SMB: small minus big) and a value factor (HML: high minus low book-to-market) to CAPM's single market factor.
AAMS Risk, Return & Investment Performance 4
Which of the following best describes 'reinvestment risk'?