CFM Risk Assessment & Asset Allocation 4 — Questions and Answers
Question 1: Tail risk hedging strategies are typically implemented using:
- Long equity futures to amplify upside
- Out-of-the-money put options on broad market indices (Correct answer)
- Treasury Inflation-Protected Securities (TIPS)
- High-yield bond positions
Correct answer: Out-of-the-money put options on broad market indices
Out-of-the-money put options provide payoffs during large market downturns, making them a cost-effective tool for hedging against tail risk events.
Question 2: Factor-based asset allocation (smart beta) differs from traditional cap-weighted indexing by:
- Weighting securities by their market capitalization
- Systematically overweighting stocks with targeted risk/return characteristics (Correct answer)
- Selecting only government bonds for fixed income exposure
- Using active stock-picking based on analyst recommendations
Correct answer: Systematically overweighting stocks with targeted risk/return characteristics
Smart beta strategies tilt portfolios toward factors such as value, momentum, quality, or low volatility, seeking to capture systematic risk premia beyond market beta.
Question 3: A portfolio manager wants to reduce duration risk without selling bonds. The most efficient instrument to achieve this is:
- Equity index futures
- Interest rate swaps (pay fixed, receive floating) (Correct answer)
- Currency forward contracts
- Commodity futures
Correct answer: Interest rate swaps (pay fixed, receive floating)
An interest rate swap where the manager pays fixed and receives floating converts fixed-rate bond exposure to floating-rate, effectively reducing interest rate duration.
Question 4: Which of the following is an example of systematic (market) risk that cannot be diversified away?
- A key executive leaves a portfolio company
- A factory fire disrupts one company's operations
- A Federal Reserve rate hike affects all bond prices (Correct answer)
- A product recall hurts one consumer goods company
Correct answer: A Federal Reserve rate hike affects all bond prices
Systematic risk affects all market participants simultaneously; a Federal Reserve rate hike impacts all bonds and equities, and no amount of diversification eliminates this exposure.
Question 5: The risk budgeting approach to asset allocation assigns capital based on:
- Equal dollar weights across all asset classes
- The contribution of each asset to total portfolio risk (Correct answer)
- The expected return of each asset class
- Historical average returns over the past decade
Correct answer: The contribution of each asset to total portfolio risk
Risk budgeting allocates portfolio weights so that each asset class contributes a pre-specified share of total portfolio risk, rather than allocating equal capital.
Question 6: When a fund manager uses Monte Carlo simulation for risk assessment, the primary advantage over historical simulation is that it:
- Relies entirely on actual past market data
- Can generate scenarios not observed in history, including extreme tail events (Correct answer)
- Eliminates model risk from the analysis
- Requires no assumptions about return distributions
Correct answer: Can generate scenarios not observed in history, including extreme tail events
Monte Carlo simulation generates thousands of hypothetical return paths using assumed distributions, capturing scenarios beyond what has been observed historically.
Question 7: Rebalancing frequency in a strategic asset allocation policy primarily involves a trade-off between:
- Return maximization and fee minimization
- Risk control precision and transaction costs (Correct answer)
- Benchmark tracking error and alpha generation
- Liquidity needs and credit risk
Correct answer: Risk control precision and transaction costs
More frequent rebalancing keeps the portfolio closer to its target risk profile but incurs higher transaction costs; less frequent rebalancing reduces costs but allows drift from intended risk.
CFM Risk Assessment & Asset Allocation 4
Tail risk hedging strategies are typically implemented using: