IMC Portfolio Management — Questions and Answers
Question 1: According to Modern Portfolio Theory (MPT), what is the primary benefit of diversification?
- It eliminates all investment risk
- It reduces unsystematic (specific) risk without necessarily reducing expected return (Correct answer)
- It guarantees a minimum level of return
- It increases the portfolio's exposure to market risk
Correct answer: It reduces unsystematic (specific) risk without necessarily reducing expected return
MPT demonstrates that by combining assets with less than perfect positive correlation, investors can reduce unsystematic (company-specific) risk. Systematic (market) risk cannot be diversified away. The efficient frontier shows optimal risk-return combinations achievable through diversification.
Question 2: The Capital Asset Pricing Model (CAPM) is expressed as E(Ri) = Rf + βi(E(Rm) - Rf). What does the term βi represent?
- The risk-free rate of return
- The sensitivity of the asset's return to movements in the overall market (Correct answer)
- The expected return of the market portfolio
- The unsystematic risk of the asset
Correct answer: The sensitivity of the asset's return to movements in the overall market
Beta (β) measures the systematic risk of an asset relative to the market. A beta of 1 means the asset moves in line with the market; greater than 1 indicates higher sensitivity to market movements; less than 1 indicates lower sensitivity. Beta only captures systematic risk.
Question 3: An investor with a 'balanced' risk profile would most likely hold which of the following asset allocations?
- 100% equities
- 100% cash deposits
- A mix of equities, bonds, property and some cash (Correct answer)
- 100% high-yield bonds
Correct answer: A mix of equities, bonds, property and some cash
A balanced investor typically accepts moderate risk for moderate return potential. The appropriate allocation includes a diversified mix across asset classes — equities for growth, bonds for income and stability, property for diversification, and cash for liquidity. The exact proportions depend on individual circumstances.
Question 4: What is 'rebalancing' in the context of portfolio management?
- Completely changing the investment strategy
- Adjusting portfolio holdings to restore the original target asset allocation (Correct answer)
- Selling all assets and moving to cash
- Increasing leverage in the portfolio
Correct answer: Adjusting portfolio holdings to restore the original target asset allocation
Rebalancing involves buying and selling assets to bring the portfolio back to its target allocation after market movements have caused drift. For example, if equities have outperformed and now represent 70% of a portfolio with a 60% target, the manager would sell equities and buy other assets to restore the 60/40 split.
Question 5: Which performance measure adjusts returns for total risk using standard deviation?
- The Treynor ratio
- The Sharpe ratio (Correct answer)
- Jensen's alpha
- The information ratio
Correct answer: The Sharpe ratio
The Sharpe ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation of Portfolio. It measures risk-adjusted return using total risk (standard deviation) rather than just systematic risk. A higher Sharpe ratio indicates better return per unit of total risk taken.
Question 6: What is the key advantage of a passive (index-tracking) investment strategy compared to active management?
- It always outperforms the benchmark
- It typically has lower management fees and transaction costs (Correct answer)
- It provides guaranteed returns
- It eliminates market risk entirely
Correct answer: It typically has lower management fees and transaction costs
Passive strategies aim to replicate the performance of a benchmark index rather than beat it. Because they require less research and less frequent trading, they typically charge lower management fees and incur fewer transaction costs. However, they will also capture the full downside of market falls.
IMC Portfolio Management
According to Modern Portfolio Theory (MPT), what is the primary benefit of diversification?