CFA Portfolio Management 1 — Questions and Answers
Question 1: In Modern Portfolio Theory (MPT), the efficient frontier represents:
- Portfolios with the highest return regardless of risk
- The set of portfolios offering the maximum return for each level of risk, or minimum risk for each level of return (Correct answer)
- Only the minimum variance portfolio
- Portfolios composed entirely of risk-free assets
Correct answer: The set of portfolios offering the maximum return for each level of risk, or minimum risk for each level of return
The efficient frontier is the set of optimal portfolios that provide the highest expected return for a given level of risk or the lowest risk for a given expected return.
Question 2: The Capital Market Line (CML) differs from the Security Market Line (SML) in that the CML:
- Uses beta as its measure of risk, while the SML uses standard deviation
- Uses total risk (standard deviation) as its risk measure, while the SML uses systematic risk (beta) (Correct answer)
- Applies to individual securities, while the SML applies only to portfolios
- Is only relevant for bonds, while the SML applies to equities
Correct answer: Uses total risk (standard deviation) as its risk measure, while the SML uses systematic risk (beta)
The CML applies to efficient portfolios and uses standard deviation (total risk), while the SML applies to any asset using beta (systematic risk).
Question 3: An investor's Investment Policy Statement (IPS) must include which of the following?
- Specific stock picks recommended by the manager
- Return objectives and risk tolerance of the client (Correct answer)
- The manager's personal investment philosophy
- Historical market performance benchmarks
Correct answer: Return objectives and risk tolerance of the client
An IPS must document the client's return objectives, risk tolerance, time horizon, liquidity needs, tax situation, legal constraints, and unique preferences.
Question 4: Strategic asset allocation (SAA) is BEST described as:
- Short-term tactical shifts based on market forecasts
- Long-term target allocations across asset classes based on the investor's IPS (Correct answer)
- The selection of individual securities within each asset class
- Daily rebalancing to maintain target weights
Correct answer: Long-term target allocations across asset classes based on the investor's IPS
SAA establishes long-term target weights for asset classes (equities, bonds, alternatives) aligned with the investor's objectives and risk tolerance, serving as the portfolio's policy benchmark.
Question 5: The Sharpe ratio measures:
- Excess return per unit of systematic risk (beta)
- Excess return per unit of total risk (standard deviation) (Correct answer)
- Absolute return relative to the risk-free rate
- Portfolio return divided by portfolio volatility without adjusting for risk-free rate
Correct answer: Excess return per unit of total risk (standard deviation)
Sharpe ratio = (Portfolio return – Risk-free rate) / Portfolio standard deviation; it measures risk-adjusted excess return using total risk.
Question 6: Which of the following is a characteristic of a liability-driven investment (LDI) strategy, as used by pension funds?
- Maximizing portfolio return without regard to liabilities
- Matching asset duration and cash flows to the duration and timing of liabilities (Correct answer)
- Investing only in equities for long-term growth
- Minimizing portfolio volatility regardless of liability structure
Correct answer: Matching asset duration and cash flows to the duration and timing of liabilities
LDI strategies align the asset portfolio's duration and cash flows with the pension fund's liabilities to minimize the funding surplus/deficit volatility.
CFA Portfolio Management 1
In Modern Portfolio Theory (MPT), the efficient frontier represents: