AAMS Risk, Return & Investment Performance 3 — Questions and Answers
Question 1: Which type of risk is eliminated through diversification across many asset classes?
- Systematic risk
- Market risk
- Unsystematic risk (Correct answer)
- Interest rate risk
Correct answer: Unsystematic risk
Unsystematic (idiosyncratic) risk is company- or industry-specific and can be diversified away, unlike systematic risk.
Question 2: An investment has an arithmetic mean return of 10% and a geometric mean return of 9.5%. What explains the difference?
- Compounding effect of volatility (Correct answer)
- Tax drag on returns
- Currency exchange losses
- Transaction cost impact
Correct answer: Compounding effect of volatility
Volatility causes the geometric mean to be lower than the arithmetic mean; higher variance widens the gap.
Question 3: A client wants to maximize return for a given level of risk. According to Modern Portfolio Theory, the client should select a portfolio on which boundary?
- Capital market line
- Security market line
- Efficient frontier (Correct answer)
- Characteristic line
Correct answer: Efficient frontier
The efficient frontier represents portfolios offering the highest expected return for each level of portfolio risk.
Question 4: Which risk measure expresses the maximum expected loss over a given time period at a specified confidence level?
- Standard deviation
- Beta
- Value at Risk (VaR) (Correct answer)
- Coefficient of variation
Correct answer: Value at Risk (VaR)
VaR quantifies the maximum potential loss over a defined period at a given confidence level (e.g., 95% or 99%).
Question 5: The Capital Asset Pricing Model (CAPM) assumes which of the following?
- Investors have different time horizons
- Markets are inefficient and prices lag information
- All investors can borrow and lend at the risk-free rate (Correct answer)
- Transaction costs vary by investor size
Correct answer: All investors can borrow and lend at the risk-free rate
CAPM assumes investors can borrow and lend unlimited amounts at the risk-free rate, among other simplifying assumptions.
Question 6: Which of the following is an example of a 'real' rate of return calculation?
- 10% nominal return minus 3% inflation = 7% real return (approximate) (Correct answer)
- 10% nominal return plus 3% inflation = 13% combined return
- 10% nominal return divided by market beta = 5% adjusted return
- 10% nominal return minus 2% management fee = 8% net return
Correct answer: 10% nominal return minus 3% inflation = 7% real return (approximate)
The approximate real return = nominal return − inflation rate; the exact Fisher formula refines this calculation.
Question 7: A portfolio manager consistently earns 2% above benchmark after adjusting for risk. This excess return is known as:
- Tracking error
- Alpha (Correct answer)
- Information ratio
- Risk premium
Correct answer: Alpha
Alpha represents the risk-adjusted excess return generated by a portfolio manager above the expected return from CAPM or a benchmark.
AAMS Risk, Return & Investment Performance 3
Which type of risk is eliminated through diversification across many asset classes?