CFA Program Level III — constructed-response practice for the last charter exam

Compared to a calendar-based rebalancing policy (e.g., rebalance every quarter regardless of drift), a percentage-of-portfolio corridor policy (e.g., rebalance whenever an asset class drifts more than 5% from target) is MOST likely to:

1. Trigger rebalancing trades more responsively during periods of high market volatility, since large drifts can occur well before the next scheduled calendar date
2. Guarantee lower total transaction costs than calendar rebalancing in every market environment
3. Eliminate tracking error relative to the strategic policy portfolio entirely
4. Require the same number of trades per year regardless of market conditions

Answer: A — Trigger rebalancing trades more responsively during periods of high market volatility, since large drifts can occur well before the next scheduled calendar date

A) Correct — corridor-based rebalancing is triggered by drift magnitude, so in volatile markets it can fire multiple times before a calendar date would have, keeping weights closer to target when it matters most. B) Whether corridor rebalancing costs less depends on realized volatility and corridor width; in especially volatile periods it can trigger more frequent, and thus costlier, trading than a fixed calendar schedule. C) No rebalancing policy eliminates tracking error entirely; corridors merely bound how far weights can drift before a trade is triggered. D) The number of corridor-triggered trades varies with market volatility, unlike a fixed calendar schedule.

A glide path for a target-date fund typically becomes more conservative over time because:

1. As the target date approaches, the investor's remaining time horizon and risk capacity shrink, so the fund shifts weight from equities toward fixed income and cash
2. Target-date fund providers are contractually required to raise their expense ratios each year as assets mature
3. Equity return volatility mechanically declines as any fund nears a fixed calendar date
4. Bonds have historically outperformed equities in the five years immediately preceding a typical retirement date

Answer: A — As the target date approaches, the investor's remaining time horizon and risk capacity shrink, so the fund shifts weight from equities toward fixed income and cash

A) Correct — a shortening time horizon reduces the investor's capacity to recover from a drawdown before the funds are needed, so the glide path systematically de-risks by trimming equity and adding fixed income as the target date nears. B) There is no such fee-escalation mandate; glide-path de-risking is a risk-management rule, not a fee mechanism. C) Equity volatility does not fall simply because a calendar date approaches — the change in allocation reflects the investor's shrinking risk capacity, not a change in the equity market's own volatility. D) Bond returns are not systematically higher than equity returns near retirement; the shift toward bonds is driven by risk reduction, not a return forecast.

A 47-year-old tenured university professor with $1.2M in financial assets, stable inflation-adjusted salary, defined-benefit pension expected at 65, and a 20-year horizon to retirement asks how her bond-like human capital should affect her strategic asset allocation. The MOST appropriate recommendation is:

1. Short-term market-view deviations
2. Reaction to recent performance
3. Long-term policy from IPS and CME
4. Whichever fund has lowest fee

Answer: C — Long-term policy from IPS and CME

A) That describes tactical asset allocation (TAA). B) Chasing performance violates strategic discipline. C) Correct — SAA is the long-run policy portfolio grounded in IPS constraints and capital-market expectations. D) Fee-only selection is not an allocation method.

Conditional Value-at-Risk (CVaR or Expected Shortfall) is preferred over VaR for tail-risk-sensitive allocations because:

1. Same figure as VaR itself in the standard framework
2. Median of the loss tail in the standard framework
3. Maximum loss in the tail in the standard framework
4. Average loss conditional on exceeding VaR

Answer: D — Average loss conditional on exceeding VaR

A) ES exceeds VaR by construction. B) Mean, not median. C) Max isn't well-defined for continuous distributions. D) Correct — Expected shortfall (CVaR) is the mean of losses beyond VaR; coherent risk measure.

An insurance company's fixed-income portfolio is benchmarked using a custom liability-based index rather than a standard market-value-weighted bond index. The PRIMARY reason for this choice is that a standard market index:

1. Always has a shorter duration than any insurance liability schedule, making it unusable for any comparison
2. Cannot legally be used as a benchmark by regulated insurance companies under any circumstance
3. May not reflect the specific duration, cash-flow timing, and risk profile of the insurer's actual liabilities
4. Provides a higher yield than any liability-based index, making performance comparisons misleadingly favorable

Answer: C — May not reflect the specific duration, cash-flow timing, and risk profile of the insurer's actual liabilities

A) Market-value-weighted indices vary widely in duration depending on composition; the issue isn't a universal duration mismatch but that any given standard index may not match the specific liability profile. B) There is no blanket legal prohibition on insurers using standard market indices; some do, though many prefer custom liability-based benchmarks for asset-liability management purposes. C) Correct — A liability-based custom index is constructed to mirror the insurer's own liability duration and cash-flow schedule, which a generic market-value-weighted index is not designed to do. D) Yield levels between the two types of indices are not systematically ordered in one direction; the concern is representativeness of the liability profile, not yield magnitude.

A US insurer purchases a portfolio of long-dated Japanese-yen-denominated corporate bonds to match a block of yen-denominated liabilities from its Japan operations, and wants to hedge the currency and interest-rate mismatch versus its US-dollar general account reporting currency using a single instrument over the life of the bonds. The MOST appropriate instrument is:

1. A rolling series of 1-month FX forward contracts, renewed monthly for the life of the bonds
2. An interest-rate swap in yen only, exchanging fixed for floating yen cash flows, with no cross-currency exchange of principal
3. Selling the Japanese bonds and reinvesting in equivalent US-dollar-denominated corporate bonds of similar credit quality
4. A cross-currency interest-rate swap exchanging yen fixed (or floating) cash flows and principal for US-dollar fixed (or floating) cash flows and principal over the life of the bonds

Answer: D — A cross-currency interest-rate swap exchanging yen fixed (or floating) cash flows and principal for US-dollar fixed (or floating) cash flows and principal over the life of the bonds

A) A rolling series of short-dated forwards can approximate a hedge but introduces rollover (basis and liquidity) risk and requires ongoing active management rather than the single, life-of-bond instrument the scenario calls for. B) A single-currency interest-rate swap manages yen interest-rate risk only; it does nothing to address the USD/JPY currency mismatch central to this scenario. C) Selling the yen bonds also unwinds the deliberate currency and cash-flow match against the insurer's yen-denominated Japan liabilities, defeating the original purpose of holding the yen bonds rather than hedging them. D) Correct — a cross-currency interest-rate swap exchanges both principal and interest cash flows in the two currencies over the life of the underlying bonds, directly addressing both the currency mismatch and the interest-rate profile in a single instrument spanning the full holding period.

A pension plan's equity allocation is managed passively via full replication of a broad domestic index, except for a small satellite sleeve run by a high-conviction concentrated manager. This 'core-satellite' structure is MOST likely chosen to:

1. Eliminate all tracking error at the total-plan level by using a fully passive core
2. Guarantee that the satellite manager outperforms net of fees over any single year
3. Control overall active risk and cost while retaining targeted exposure to a manager believed to have genuine skill
4. Replace the need for an investment policy statement governing the equity allocation

Answer: C — Control overall active risk and cost while retaining targeted exposure to a manager believed to have genuine skill

A) The satellite sleeve, by design, introduces tracking error at the total-plan level; the passive core alone would eliminate it, but the structure as a whole does not. B) No structure guarantees manager outperformance in any given year; core-satellite is a risk-budgeting choice, not a performance guarantee. C) Correct — Core-satellite combines a low-cost, low-tracking-error passive core with a smaller, higher-conviction active satellite, controlling total active risk and fees while still pursuing alpha from managers believed to add value. D) The IPS still governs the overall allocation, including sizing and monitoring of both the core and satellite sleeves.

A 'cash and carry' equity strategy involves:

1. Selling the underlying stock or index basket short while simultaneously buying a futures or forward contract on it, hoping the spot price falls faster than the futures price
2. Borrowing shares to short the underlying index while holding no offsetting futures or forward position
3. Holding only a long futures position without any position in the underlying spot instrument
4. Simultaneously buying the underlying stock (or index basket) and selling a future/forward contract against it, capturing the arbitrage spread between the futures price and the spot price plus the cost of carry (financing minus dividends)

Answer: D — Simultaneously buying the underlying stock (or index basket) and selling a future/forward contract against it, capturing the arbitrage spread between the futures price and the spot price plus the cost of carry (financing minus dividends)

A) This reverses both legs of a true cash-and-carry — it describes a short-spot/long-futures reverse arbitrage, not the strategy named in the question. B) Cash and carry specifically requires an offsetting futures/forward leg; an unhedged short with no futures position is simply a naked short, not an arbitrage strategy. C) Holding only the futures leg with no underlying position is a directional bet, not the market-neutral cash-and-carry structure. D) Correct — cash and carry buys the underlying asset (financed at the risk-free/repo rate) and simultaneously sells it forward, locking in the difference between the forward price and the spot price plus net cost of carry as a low-risk arbitrage profit when the futures is priced above fair value.

A portfolio manager needs to execute a large, urgent order in a stock reacting to unexpected news, prioritizing speed over minimizing market impact. The NEXT most appropriate execution strategy is

1. An aggressive implementation-shortfall algorithm that front-loads execution
2. A passive VWAP algorithm spread evenly over the full trading day
3. A dark-pool-only strategy that waits for the day's volume-weighted price
4. A limit order placed at the prior day's closing price and left unattended

Answer: A — An aggressive implementation-shortfall algorithm that front-loads execution

A) Correct — when urgency dominates and opportunity cost outweighs market-impact concerns, an aggressive, front-loaded implementation-shortfall strategy minimizes the risk of missing the move. B) A VWAP schedule spreads execution over the day, appropriate for low-urgency orders, not fast-moving news. C) Dark pools may not fill quickly enough during a fast-moving, urgent situation. D) A passive limit order risks non-execution while the price runs away.

A manager positions the portfolio to profit from a flattening yield curve by going long long-maturity bonds and short short-maturity bonds relative to the benchmark. This is an example of:

1. Cash flow matching
2. A yield-curve positioning (flattener) strategy
3. A bullet strategy targeting a single maturity point
4. A credit-spread strategy targeting issuer-specific risk

Answer: B — A yield-curve positioning (flattener) strategy

A) Cash flow matching funds specific liability payments and has nothing to do with curve-shape views. B) Correct — going long the long end and short the short end relative to benchmark is a classic flattener trade on the yield curve's shape. C) A bullet describes maturity concentration, not a relative long/short curve position. D) This trade targets Treasury curve shape, not issuer credit risk.

A performance attribution report shows a fund's allocation effect was strongly positive while its selection effect was slightly negative. This MOST LIKELY means the manager

1. Picked stocks within sectors that outperformed their sector benchmarks, but weighted sectors poorly
2. Weighted sectors well relative to the benchmark, but picked stocks within those sectors that underperformed their sector benchmarks
3. Added no value at either the sector or security level
4. Matched the benchmark's sector weights exactly while selecting superior stocks

Answer: B — Weighted sectors well relative to the benchmark, but picked stocks within those sectors that underperformed their sector benchmarks

A) Reverses the pattern — this would produce negative allocation and positive selection. B) Correct — a positive allocation effect reflects good sector-weighting decisions, while a negative selection effect reflects security picks that lagged their own sector benchmarks. C) Contradicted by the strongly positive allocation effect. D) Matching benchmark weights exactly would produce a zero, not positive, allocation effect.

A trader evaluates execution against VWAP. A key LIMITATION of VWAP as a benchmark is:

1. Time-weighted average price of quotes
2. Volume-adjusted midquote at close
3. Volatility-weighted average per bar
4. Volume-weighted average price of trades

Answer: D — Volume-weighted average price of trades

A) That's TWAP, different benchmark. B) Not a standard trading benchmark. C) Not a standard trading benchmark. D) Correct — VWAP weights each trade by executed volume across the day.

A behavioral 'overconfidence' bias in an individual investor typically manifests as:

1. Encourage more frequent trading in the standard framework
2. Use probabilistic framing and structural limits
3. Defer entirely to client judgment in the standard framework
4. Avoid all pushback with client in the standard framework

Answer: B — Use probabilistic framing and structural limits

A) Trading more amplifies the bias, not mitigates it. B) Correct — Overconfidence is best mitigated by base-rate evidence and position-size defaults. C) Deferring reinforces the overconfident bias. D) Passive acceptance fails the advisor duty to correct.

Tax-loss harvesting can MOST appropriately be implemented in a taxable account while maintaining market exposure by:

1. Realized losses always convert to credit
2. Only allowed in retirement accounts
3. Increases annual tax bill by design
4. Realize losses to offset gains

Answer: D — Realize losses to offset gains

A) Credit vs. offset are different mechanisms. B) Not restricted to retirement accounts. C) Reverses the intended effect. D) Correct — TLH offsets capital gains and up to $3,000 of ordinary income, subject to wash sale rules.

A high-net-worth client in the top tax bracket holds a taxable brokerage account with several positions showing unrealized losses alongside positions with large unrealized gains accumulated over many years. A tax-loss harvesting program applied to this account will MOST DIRECTLY

1. Eliminate all capital gains tax owed on the appreciated positions permanently
2. Realize losses to offset realized gains and up to $3,000 of ordinary income annually, while maintaining market exposure through a similar (not substantially identical) replacement security
3. Require the client to hold cash for 30 days after every harvested sale to remain compliant
4. Increase the cost basis of the appreciated positions to reduce future gains

Answer: B — Realize losses to offset realized gains and up to $3,000 of ordinary income annually, while maintaining market exposure through a similar (not substantially identical) replacement security

A) Harvesting offsets gains realized in the current or future periods; it doesn't permanently eliminate tax on the appreciated core positions unless they are also sold. B) Correct — harvested losses offset realized capital gains dollar-for-dollar and up to $3,000 of ordinary income per year (with carryforward), while a similar replacement security preserves the portfolio's market exposure. C) The 30-day rule (wash-sale) restricts repurchasing the SAME or substantially identical security, not holding cash — a similar-but-not-identical replacement can be bought immediately. D) Harvesting affects the basis of the sold lot, not unrelated appreciated positions.

A commercial property generates stabilized net operating income (NOI) of $4,000,000, and recently sold comparable properties in the same submarket have transacted at a 5% capitalization rate. Using direct capitalization, the MOST appropriate estimate of this property's value is:

1. $4,000,000, since a 5% cap rate implies NOI and value are approximately equal in a stabilized market
2. $80,000,000, calculated as NOI divided by the capitalization rate ($4,000,000 / 0.05)
3. $200,000, calculated as NOI multiplied by the capitalization rate ($4,000,000 x 0.05)
4. $4,200,000, calculated by adding the capitalization rate as a percentage markup to NOI ($4,000,000 x 1.05)

Answer: B — $80,000,000, calculated as NOI divided by the capitalization rate ($4,000,000 / 0.05)

B) Correct — direct capitalization values income property as NOI divided by the market capitalization rate: $4,000,000 / 0.05 = $80,000,000. A) This confuses the cap rate concept with a 1:1 relationship between NOI and value; a 5% cap rate implies value is a multiple (20x) of NOI, not equal to it. C) This inverts the formula, multiplying instead of dividing, and produces an economically meaningless figure far below NOI itself. D) This treats the cap rate as an addition to NOI rather than a discount rate applied through division, another direction/procedure error.

A private real estate allocation is appraised quarterly, while the public REIT proxy is marked daily. In a rapidly falling market, the private allocation will appear:

1. More volatile than the public REIT proxy over the same period
2. Identical in both return and volatility to the public REIT proxy
3. Less volatile, with declines that lag and understate the public proxy's fall
4. Immediately and fully repriced to reflect the public market decline

Answer: C — Less volatile, with declines that lag and understate the public proxy's fall

A) Appraisal-based, infrequently updated valuations produce smoothed reported returns, so volatility appears lower, not higher. B) Appraisal lag and differing pricing mechanisms mean the two series diverge, especially in fast-moving markets. C) Correct — Quarterly appraisals lag real-time price discovery, so private real estate values are smoothed and adjust with a delay, understating both the speed and magnitude of a rapid decline that the daily-marked REIT proxy captures immediately. D) Full, immediate repricing describes a mark-to-market instrument like the public REIT, not an appraisal-based private allocation.

An infrastructure fund invests in long-life regulated utility assets. The PRIMARY portfolio role is:

1. Providing stable, often inflation-linked cash flows with bond-like, long-duration characteristics
2. Providing high-beta exposure to short-term economic growth surprises
3. Providing tax-loss-harvesting opportunities through frequent turnover
4. Providing currency-hedged exposure to emerging-market technology equities

Answer: A — Providing stable, often inflation-linked cash flows with bond-like, long-duration characteristics

A) Correct — Regulated infrastructure typically generates contracted or regulated, often inflation-linked, cash flows with long-duration, bond-like characteristics that diversify a portfolio and hedge liabilities. B) Regulated utility infrastructure is valued precisely because it has low sensitivity to short-term economic cycles, not high beta to them. C) Infrastructure funds are long-hold, low-turnover vehicles; frequent trading for tax purposes is inconsistent with the asset class. D) This describes an unrelated equity strategy, not the defining role of regulated infrastructure assets.

A sell-side analyst attends an expert-network call in which a former employee of a public company inadvertently discloses unreleased quarterly revenue figures. The analyst recognizes the information is material and nonpublic. Under Standard II(A), Material Nonpublic Information, the analyst's FIRST obligation is to:

1. Refrain from trading on or further disseminating the information, and encourage the source to report it to the issuer's investor relations or legal department
2. Trade immediately on behalf of the firm's proprietary book before the information becomes public
3. Share the information only with the firm's most senior portfolio managers, since Standard II(A) permits internal distribution among decision-makers
4. Publish a research note referencing the figures as 'channel checks,' without revealing the direct source, to legitimately inform clients

Answer: A — Refrain from trading on or further disseminating the information, and encourage the source to report it to the issuer's investor relations or legal department

A) Correct — upon recognizing MNPI, the member must not trade or disseminate it and should encourage disclosure through proper channels (issuer's IR/legal) or public dissemination. B) Trading on MNPI is a direct violation, regardless of urgency. C) Standard II(A) does not create an internal 'decision-maker' exception; disseminating MNPI even internally to inform trading decisions is prohibited. D) Laundering MNPI through vague sourcing language ('channel checks') does not cure the underlying violation of using material nonpublic information.

A firm presents 5-year performance for its 'Global Equity' composite but excludes one portfolio whose mandate was terminated mid-period after losses. Under GIPS, this exclusion is:

1. Permitted, since terminated portfolios may always be removed retroactively from history
2. Not permitted, because terminated portfolios must remain in the composite's historical returns through their last full period under management
3. Permitted only if the client consents in writing to the exclusion
4. Irrelevant to GIPS compliance, since composite membership rules apply only to active accounts

Answer: B — Not permitted, because terminated portfolios must remain in the composite's historical returns through their last full period under management

A) GIPS specifically prohibits retroactively removing terminated portfolios from historical composite performance to prevent survivorship-bias manipulation. B) Correct — GIPS requires that terminated portfolios remain in the historical record of the composite through the last full measurement period they were managed, so results cannot be cleaned up after the fact. C) Client consent does not override the GIPS requirement; the standard governs firm-level presentation, not a private waiver. D) GIPS composite construction explicitly addresses how terminated, as well as active, portfolios must be treated historically.

A wealth manager's compensation includes a higher commission for recommending an in-house structured product versus a comparable third-party alternative. All else being suitable and equal, which of the following is REQUIRED, and which is merely encouraged, under Standard VI(A), Disclosure of Conflicts?

1. Required: refusing to ever sell the in-house product; Encouraged: nothing further is needed
2. Required: matching the in-house product's commission to the third-party product before any sale; Encouraged: nothing further is needed
3. Required: obtaining written client consent only if the in-house product underperforms; Encouraged: verbal disclosure at account opening
4. Required: full and fair disclosure of the compensation conflict to the client before the recommendation; Encouraged (but not required): additionally disclosing the general magnitude/structure of the compensation differential

Answer: D — Required: full and fair disclosure of the compensation conflict to the client before the recommendation; Encouraged (but not required): additionally disclosing the general magnitude/structure of the compensation differential

A) Standard VI(A) does not prohibit selling proprietary products outright; it requires disclosure of the conflict, not avoidance. B) Nothing in the Standard requires equalizing compensation between products. C) Disclosure obligations aren't contingent on subsequent underperformance, and informal verbal-only disclosure at an unrelated point in time doesn't satisfy the requirement. D) Correct — the Standard requires clear, prominent disclosure of the conflict before the recommendation; providing further detail on the compensation structure is good practice but not mandated to the same degree.

Compared to Levels I and II, the Level III exam places its PRIMARY emphasis on:

1. Testing isolated formula recall across all ten topic areas equally
2. Testing asset valuation techniques in isolation from client circumstances
3. Ranking candidates solely on speed of computation under timed conditions
4. Constructing and justifying portfolio recommendations via vignette-based constructed-response and item-set questions

Answer: D — Constructing and justifying portfolio recommendations via vignette-based constructed-response and item-set questions

A) Formula recall in isolation is more characteristic of Level I's breadth-first testing style. B) Valuation in isolation from a client's circumstances describes Level II's item-set focus. C) Speed of computation is not the exam's stated emphasis at any level. D) Correct — Level III integrates prior material into applied portfolio construction, requiring candidates to justify recommendations for specific client and institutional contexts.

An endowment with a perpetual time horizon and a 4-5% annual spending policy should construct its strategic asset allocation to PRIMARILY target:

1. The lowest-volatility return achievable regardless of spending needs
2. A return equal to the risk-free rate plus the spending rate only
3. A long-run nominal return sufficient to cover spending, inflation, and investment costs
4. Matching the duration of a fixed-income liability schedule

Answer: C — A long-run nominal return sufficient to cover spending, inflation, and investment costs

A) Minimizing volatility while ignoring the payout requirement risks eroding real corpus over time. B) Omits inflation, the key erosion factor for a perpetual spending stream. C) Correct — perpetual-horizon spending institutions need total return >= spending + inflation + costs to preserve real purchasing power. D) LDI-style duration matching applies to institutions with fixed liability schedules, not an endowment's open-ended, growing spending need.

A defined-contribution (DC) plan's PRIMARY governance challenge, compared to a DB plan, is:

1. Managing the plan's funded status and projected benefit obligation
2. Setting the actuarial discount rate used to value plan liabilities
3. Negotiating benefit formulas with labor representatives
4. Ensuring participants — who bear investment decision-making and risk — receive suitable defaults, education, and a well-designed fund menu

Answer: D — Ensuring participants — who bear investment decision-making and risk — receive suitable defaults, education, and a well-designed fund menu

A) Funded status and PBO are DB, not DC, concepts — a DC plan has no pooled benefit obligation. B) DC plans have no actuarial liability requiring a discount rate. C) Benefit-formula negotiation applies to DB plans. D) Correct — because DC participants individually bear investment risk and decision-making, the sponsor's primary fiduciary/governance challenge is designing defaults, education, and fund menus that support suitable outcomes.

What is anchoring and adjustment bias, and how does it typically affect valuation estimates?

The tendency to rely too heavily on an initial reference point (anchor) and adjust insufficiently away from it when forming subsequent judgments, skewing valuation estimates toward the anchor.

What is a 'completion portfolio' and why is it used with a multi-manager equity lineup?

An overlay/completion portfolio corrects unintended aggregate factor, sector, or style tilts that arise when combining multiple active managers, restoring the intended overall policy exposure.

In a contingent immunization mandate, what event defines the trigger for switching from active management to full immunization, and why is a single quarter of benchmark-relative underperformance not sufficient on its own?

The trigger is exhaustion of the safety margin — the portfolio value falling to the present value of the liability discounted at the minimum acceptable rate of return — not a single period's relative performance, because the strategy is monitored via the cushion level over time, and a portfolio can underperform its benchmark in one quarter while the safety margin remains largely intact.

What risk does the absence of a most-favored-nation (MFN) clause create when some hedge fund investors hold preferential side letters?

Investors without side letters may face worse liquidity terms and higher effective costs than favored investors, and in a redemption run, favored investors with better terms may exit first, leaving remaining investors with a more adversely selected, illiquid portfolio.

Why does a completion portfolio typically offset the aggregate tilts of a fund's specialist managers rather than reinforce them?

It is deliberately constructed to counteract whatever unintended sector, factor, or country biases emerge when the specialist managers' holdings are combined, taking the opposite position on those aggregate tilts so the fund's total equity exposure realigns with its policy benchmark rather than reflecting unplanned concentration.

Treynor ratio?

(Return - RFR) / beta. Like Sharpe but for systematic risk only.