CFA Portfolio Management & Construction 2 — Questions and Answers
Question 1: An investor has a portfolio with expected return of 10% and standard deviation of 15%. The risk-free rate is 3%. What is the Sharpe ratio?
- 0.47 (Correct answer)
- 0.67
- 0.87
- 1.07
Correct answer: 0.47
Sharpe ratio = (10% - 3%) / 15% = 7/15 ≈ 0.467.
Question 2: Which of the following best describes the 'core-satellite' portfolio construction approach?
- All assets are actively managed for alpha generation
- A passive index core is supplemented by smaller active or alternative positions (Correct answer)
- Satellites are risk-free assets used to reduce volatility
- The core consists of international equities and satellites of domestic bonds
Correct answer: A passive index core is supplemented by smaller active or alternative positions
Core-satellite combines a low-cost passive core (broad market exposure) with satellite positions seeking alpha or diversification.
Question 3: When constructing a portfolio, the 'information ratio' measures:
- Total return divided by total risk
- Active return divided by tracking error (Correct answer)
- Alpha divided by beta
- Excess return divided by standard deviation
Correct answer: Active return divided by tracking error
The information ratio = active return (portfolio return minus benchmark return) divided by tracking error.
Question 4: A pension fund has a liability duration of 12 years. To implement liability-driven investing (LDI), the fund should:
- Minimize the portfolio duration to 0
- Match the portfolio duration to the liability duration of 12 years (Correct answer)
- Maximize equity exposure for higher returns
- Hold only short-term Treasury bills
Correct answer: Match the portfolio duration to the liability duration of 12 years
LDI aims to immunize liability risk by matching the duration of assets to the duration of liabilities.
Question 5: Which rebalancing strategy involves selling assets that have risen above their target weight and buying those below?
- Buy-and-hold
- Tactical asset allocation
- Calendar rebalancing
- Threshold rebalancing (Correct answer)
Correct answer: Threshold rebalancing
Threshold (or percentage-of-portfolio) rebalancing triggers trades when any asset class deviates from its target by a set percentage.
Question 6: In mean-variance optimization, the efficient frontier represents portfolios that:
- Maximize return regardless of risk
- Minimize risk for a given level of expected return (Correct answer)
- Have the highest Sharpe ratio only
- Exclude all risky assets
Correct answer: Minimize risk for a given level of expected return
The efficient frontier consists of portfolios offering the maximum expected return for each level of risk (minimum variance for each return level).
Question 7: Which of the following is a major limitation of mean-variance optimization in practice?
- It requires no input assumptions
- It is highly sensitive to small changes in expected return inputs (Correct answer)
- It always produces well-diversified portfolios
- It cannot handle more than 10 assets
Correct answer: It is highly sensitive to small changes in expected return inputs
MVO is known for input sensitivity — small changes in expected returns can lead to dramatically different optimal portfolios.
CFA Portfolio Management & Construction 2
An investor has a portfolio with expected return of 10% and standard deviation of 15%.
The risk-free rate is 3%.
What is the Sharpe ratio?