Portfolio Management — CFA Level I practice questions

Rebalancing a portfolio back to target weights MOST often:

1. Forces selling winners and buying losers systematically
2. Maximizes returns by chasing recent momentum trends
3. Eliminates all tracking error against the benchmark
4. Reduces long-run expected returns by transaction costs

Answer: A — Forces selling winners and buying losers systematically

A) Correct — rebalancing is inherently contrarian. B) That is the opposite of rebalancing discipline. C) It controls, but does not eliminate, tracking error. D) Costs exist but are not the primary effect at issue.

An investor needing tuition in 6 months should MOST emphasize:

1. Long-duration corporate bonds for yield pickup
2. Emerging-market debt with above-average yield potential
3. Concentrated single-stock equity for upside exposure
4. Short-duration high-liquidity capital-preservation assets

Answer: D — Short-duration high-liquidity capital-preservation assets

A) Long-duration corporates carry interest-rate and credit risk. B) EM debt combines duration, credit, and currency risk against a 6-month horizon. C) Concentrated equity exposes the goal to idiosyncratic loss. D) Correct — a short, non-negotiable horizon prioritizes principal preservation and liquidity via T-bills or money markets.

Prospect theory as developed by Kahneman and Tversky implies that investors will behave in which of the following characteristic ways?

1. Behave as risk-neutral expected-utility maximizers across both the gain and the loss decision domains of the choice problem
2. Feel losses about twice as intensely as equivalent gains, with an S-shaped subjective value function about a reference point
3. Weight gains and losses symmetrically, so that a $1 realized loss and a $1 realized gain carry equal psychological weight

Answer: B — Feel losses about twice as intensely as equivalent gains, with an S-shaped subjective value function about a reference point

A) Prospect theory is inconsistent with pure risk neutrality. B) Correct — loss aversion and S-shaped valuation. C) Symmetric weighting is exactly what prospect theory rejects.

Concentrated single-stock positions arising from executive compensation carry which of the following combinations of investment risks for the executive holder?

1. Materially lower total volatility than a diversified portfolio because of the executive's superior information advantage on the company overall
2. Idiosyncratic firm-specific risk plus a correlation between the executive's own human capital and the same firm's equity return on its stock
3. Automatic tax efficiency that removes the need to consider exchange funds, collars, prepaid variable forwards, or other hedging structures

Answer: B — Idiosyncratic firm-specific risk plus a correlation between the executive's own human capital and the same firm's equity return on its stock

A) Concentration raises, not reduces, idiosyncratic volatility. B) Correct — firm risk plus human-capital correlation. C) Concentration is not automatically tax-efficient.

The Capital Allocation Line (CAL) shows:

1. All efficient risky-asset portfolios
2. A risk-free asset plus one risky portfolio
3. The minimum-variance risky frontier
4. Only individual stock return points

Answer: B — A risk-free asset plus one risky portfolio

A) Describes the efficient frontier. B) Correct — CAL combines Rf with a single risky portfolio. C) Different curve, ignores Rf entirely. D) Describes plotting single-asset points.

Sharpe ratio:

1. Portfolio return alone measured
2. Portfolio volatility alone measured
3. Total return without any adjustment
4. Excess return per unit of total risk

Answer: D — Excess return per unit of total risk

A) Ignores the risk denominator. B) Ignores the return numerator. C) Ignores both risk and Rf. D) Correct — (Rp − Rf) / sigma, higher is better.

Stress testing in risk management differs from statistical VaR analysis in that stress testing follows which of the following approaches to characterizing tail-risk exposure?

1. Stress testing is intended to replace VaR entirely and to eliminate the need for any probabilistic risk-measurement tool in the risk-manager's overall analytic toolkit
2. Stress testing evaluates portfolio outcomes under specified, often extreme, historical or hypothetical scenarios without assuming a specific probability distribution of losses
3. Stress testing requires the analyst to assume that portfolio returns follow the normal distribution in every relevant test case and every relevant time-horizon scenario

Answer: B — Stress testing evaluates portfolio outcomes under specified, often extreme, historical or hypothetical scenarios without assuming a specific probability distribution of losses

A) Stress testing complements, not replaces, VaR. B) Correct — scenario-based rather than distributional. C) Stress tests do not require normality assumptions.

The Security Market Line (SML) differs from the Capital Market Line (CML) in that the SML:

1. Plots expected return versus total risk (sigma)
2. Plots expected return versus beta for all assets
3. Has a steeper slope than the CML by design
4. Applies only to efficient combinations of assets

Answer: B — Plots expected return versus beta for all assets

A) That describes the CML's x-axis. B) Correct — SML uses beta and covers all securities. C) Slope comparison is not the defining distinction. D) That is the CML's scope, not the SML's.

The historical January effect in U.S. equity markets is best described as which of the following categories of documented empirical anomaly?

1. A currency-arbitrage strategy exploiting persistent price differences for the same currency pair across various foreign-exchange trading venues globally
2. A sector-rotation strategy that reallocates portfolio capital across the cyclical and defensive equity sectors according to macroeconomic signals
3. A calendar anomaly in which small-capitalization U.S. stocks have historically earned abnormal risk-adjusted returns during the month of January

Answer: C — A calendar anomaly in which small-capitalization U.S. stocks have historically earned abnormal risk-adjusted returns during the month of January

A) Currency arbitrage is unrelated to the January effect. B) Sector rotation is a different strategy. C) Correct — the January effect is a documented calendar anomaly.

Scenario analysis in portfolio risk management examines which of the following aspects of portfolio behavior under specified sets of joint risk-factor changes considered together?

1. Only single-variable sensitivities, holding every other risk factor fixed at its central baseline estimate throughout every scenario the risk manager considers in the analysis
2. Only realized past returns of the portfolio over the historical sample, without projecting any forward-looking parameter changes or plausible future macro-financial states
3. The plausible combinations of risk-factor changes across factors, typically grouped as base, bull, and bear narratives, in order to understand portfolio behavior under stress

Answer: C — The plausible combinations of risk-factor changes across factors, typically grouped as base, bull, and bear narratives, in order to understand portfolio behavior under stress

A) Scenario analysis is multi-factor. B) Scenario analysis is forward-looking. C) Correct — coherent multi-factor narratives are the standard approach.

What is the Sortino ratio?

(Portfolio Return − Target Return) / Downside Deviation. Like Sharpe but only penalizes downside volatility, not upside. More appropriate when returns are skewed.

What is systematic risk measured by?

Beta. It cannot be reduced through diversification. Rewarded by the market through higher expected returns per CAPM.

What is a benchmark?

A standard against which portfolio performance is measured. Should be investable, measurable, appropriate, and specified in advance.

What is overconfidence bias?

Overestimating one's ability to predict markets or pick investments. Leads to excessive trading and underperformance.