CFM Investment Analysis & Portfolio Management 5 — Questions and Answers
Question 1: In a scenario where an investor expects equity markets to decline significantly, which portfolio adjustment is most appropriate?
- Increase equity duration
- Shift allocation toward defensive sectors and increase cash holdings (Correct answer)
- Add leverage to amplify potential gains
- Concentrate holdings in cyclical stocks
Correct answer: Shift allocation toward defensive sectors and increase cash holdings
Moving to defensive sectors (utilities, consumer staples) and cash reduces downside exposure during anticipated market declines.
Question 2: What is the primary limitation of using historical standard deviation as a risk measure for a portfolio?
- It is too difficult to calculate
- It assumes returns are normally distributed and may underestimate tail risks (Correct answer)
- It does not account for dividend income
- It overestimates risk for low-volatility assets
Correct answer: It assumes returns are normally distributed and may underestimate tail risks
Standard deviation assumes normally distributed returns, which may understate the probability of extreme losses (fat tails) observed in real markets.
Question 3: A company's free cash flow to equity (FCFE) is $5 per share, shares grow at 3%, and investors require a 9% return. What is the estimated stock value?
- $55.56
- $62.50
- $83.33 (Correct answer)
- $100.00
Correct answer: $83.33
FCFE model: V = FCFE / (r − g) = $5 / (0.09 − 0.03) = $5 / 0.06 = $83.33.
Question 4: Which factor best explains why small-cap stocks historically earn a premium return according to the Fama-French three-factor model?
- Small-cap stocks have lower transaction costs
- Small-cap stocks carry greater risk (SMB factor) that commands a return premium (Correct answer)
- Small-cap stocks are more liquid than large-caps
- Small-cap stocks have lower earnings volatility
Correct answer: Small-cap stocks carry greater risk (SMB factor) that commands a return premium
The Fama-French model includes the SMB (Small Minus Big) factor, which captures the return premium associated with the higher risk of small-cap stocks.
Question 5: A CFM manager is constructing a liability-driven investment (LDI) strategy for a pension fund. What is the primary objective?
- Maximizing total portfolio return
- Matching or exceeding the growth of the fund's liabilities (Correct answer)
- Minimizing portfolio volatility regardless of liabilities
- Maximizing dividend income
Correct answer: Matching or exceeding the growth of the fund's liabilities
LDI strategies align asset characteristics (especially duration) with the pension fund's liabilities to reduce surplus risk.
Question 6: Which of the following best describes momentum investing?
- Buying undervalued stocks with low P/B ratios
- Investing in securities that have shown strong recent price performance expecting continuation (Correct answer)
- Focusing on companies with high dividend yields
- Selecting stocks based on discounted cash flow models
Correct answer: Investing in securities that have shown strong recent price performance expecting continuation
Momentum investing buys securities with strong recent performance, betting that trends persist over the short to medium term.
Question 7: When performing a scenario analysis on a bond portfolio, a manager tests the impact of a parallel yield curve shift of +200 bps. This technique primarily assesses which type of risk?
- Credit risk
- Interest rate risk (Correct answer)
- Liquidity risk
- Currency risk
Correct answer: Interest rate risk
A parallel yield curve shift scenario directly tests the portfolio's sensitivity to interest rate changes across all maturities.
CFM Investment Analysis & Portfolio Management 5
In a scenario where an investor expects equity markets to decline significantly, which portfolio adjustment is most appropriate?