CFM Risk Assessment & Asset Allocation 2 — Questions and Answers
Question 1: A fund manager observes that two assets have a correlation coefficient of -1.0. What does this imply for portfolio construction?
- Perfect diversification is achievable, potentially eliminating all portfolio risk (Correct answer)
- The assets will always generate the same returns
- Diversification provides no benefit since returns move in opposite directions equally
- The portfolio's expected return is zero
Correct answer: Perfect diversification is achievable, potentially eliminating all portfolio risk
A correlation of -1.0 means assets move in perfectly opposite directions, allowing a portfolio to be constructed that eliminates all unsystematic and systematic risk.
Question 2: Which risk measure captures the probability that portfolio losses will exceed a specified threshold over a given time horizon?
- Standard deviation
- Beta
- Value at Risk (VaR) (Correct answer)
- Sharpe ratio
Correct answer: Value at Risk (VaR)
Value at Risk (VaR) quantifies the maximum expected loss at a given confidence level over a specified time period.
Question 3: In mean-variance optimization, the efficient frontier represents portfolios that:
- Maximize return for every level of risk (Correct answer)
- Offer the highest Sharpe ratios only
- Are dominated by at least one other portfolio
- Minimize fees for a given return target
Correct answer: Maximize return for every level of risk
The efficient frontier consists of portfolios that maximize expected return for each level of risk (standard deviation), with no other portfolio offering a better risk-return tradeoff.
Question 4: A portfolio has a beta of 1.4. If the market rises 10%, the portfolio is expected to:
- Rise 14% (Correct answer)
- Rise 10%
- Rise 4%
- Rise 1.4%
Correct answer: Rise 14%
Beta measures systematic risk; a beta of 1.4 means the portfolio is expected to move 1.4 times the market movement, so a 10% market gain implies a 14% portfolio gain.
Question 5: Which asset class has historically exhibited the lowest correlation with US equities, making it most useful for diversification?
- US corporate bonds
- International developed-market equities
- Commodities (Correct answer)
- Real estate investment trusts (REITs)
Correct answer: Commodities
Commodities have historically exhibited low or negative correlation with US equities, providing meaningful diversification benefits in a multi-asset portfolio.
Question 6: Conditional Value at Risk (CVaR), also known as Expected Shortfall, is preferred over VaR because it:
- Is easier to calculate using historical simulation
- Captures the average loss in the tail beyond the VaR threshold (Correct answer)
- Always produces lower risk estimates
- Does not require a confidence level specification
Correct answer: Captures the average loss in the tail beyond the VaR threshold
CVaR measures the expected loss given that the loss exceeds the VaR threshold, capturing tail risk that VaR ignores.
Question 7: A risk-averse investor would prefer which of the following portfolio characteristics, all else equal?
- Higher variance and higher expected return
- Lower variance and same expected return (Correct answer)
- Lower expected return and same variance
- Higher skewness and higher variance
Correct answer: Lower variance and same expected return
Risk-averse investors prefer less uncertainty for a given expected return, so a portfolio with lower variance at the same expected return is strictly preferred.
CFM Risk Assessment & Asset Allocation 2
A fund manager observes that two assets have a correlation coefficient of -1.0.
What does this imply for portfolio construction?