CFE CFE Investment & Portfolio Management 1 — Questions and Answers
Question 1: Which investment principle states that higher potential returns are associated with higher levels of risk?
- Diversification principle
- Risk-return tradeoff (Correct answer)
- Efficient market hypothesis
- Capital preservation rule
Correct answer: Risk-return tradeoff
The risk-return tradeoff is a fundamental investment concept stating that the potential return on an investment increases proportionally with an increase in risk.
Question 2: What does the Sharpe Ratio measure in portfolio management?
- Total portfolio value
- Risk-adjusted return relative to a risk-free rate (Correct answer)
- Portfolio liquidity
- Dividend yield percentage
Correct answer: Risk-adjusted return relative to a risk-free rate
The Sharpe Ratio measures the excess return per unit of risk, calculated as (portfolio return minus risk-free rate) divided by portfolio standard deviation.
Question 3: Which type of risk can be eliminated through portfolio diversification?
- Systematic risk
- Market risk
- Unsystematic (idiosyncratic) risk (Correct answer)
- Interest rate risk
Correct answer: Unsystematic (idiosyncratic) risk
Unsystematic risk, also called idiosyncratic or specific risk, is company-specific and can be reduced or eliminated by holding a diversified portfolio.
Question 4: A financial examiner reviews a bank's investment portfolio and finds heavy concentration in a single sector. This primarily violates which best practice?
- Liquidity matching
- Diversification (Correct answer)
- Duration alignment
- Yield maximization
Correct answer: Diversification
Concentration in a single sector violates diversification best practices, which require spreading investments to reduce exposure to any one area.
Question 5: What is the primary purpose of an Investment Policy Statement (IPS) in a financial institution?
- To maximize short-term trading profits
- To document investment objectives, guidelines, and constraints (Correct answer)
- To report portfolio performance to regulators
- To establish employee compensation benchmarks
Correct answer: To document investment objectives, guidelines, and constraints
An IPS documents an institution's investment objectives, risk tolerance, time horizon, and constraints to guide portfolio management decisions.
Question 6: Which bond characteristic measures its sensitivity to changes in interest rates?
- Coupon rate
- Duration (Correct answer)
- Credit spread
- Yield to maturity
Correct answer: Duration
Duration measures a bond's price sensitivity to interest rate changes; a higher duration means greater price volatility when rates shift.
CFE CFE Investment & Portfolio Management 1
Which investment principle states that higher potential returns are associated with higher levels of risk?