CFM Risk Assessment & Asset Allocation 5 — Questions and Answers
Question 1: In the context of alternative investments, which risk is most unique to private equity compared to public equities?
- Market risk from broad equity index movements
- Illiquidity risk due to lock-up periods and limited secondary market access (Correct answer)
- Interest rate sensitivity affecting valuation multiples
- Currency risk from international operations
Correct answer: Illiquidity risk due to lock-up periods and limited secondary market access
Private equity investments typically have multi-year lock-up periods with no liquid secondary market, creating illiquidity risk that is fundamentally different from publicly traded equities.
Question 2: An asset allocation model shows a portfolio has a maximum drawdown of -35%. This metric represents:
- The average annual loss over the investment horizon
- The peak-to-trough decline in portfolio value over a specified period (Correct answer)
- The probability of losing more than 35% in any given year
- The standard deviation multiplied by a confidence factor
Correct answer: The peak-to-trough decline in portfolio value over a specified period
Maximum drawdown measures the largest peak-to-trough decline experienced, giving investors insight into the worst historical loss they would have endured.
Question 3: Which scenario best illustrates concentration risk in a portfolio?
- Holding 50 stocks across 10 different sectors with equal weights
- Holding 30% of the portfolio in a single technology stock (Correct answer)
- Investing in both US and international equity index funds
- Diversifying across stocks, bonds, and real estate
Correct answer: Holding 30% of the portfolio in a single technology stock
Concentration risk arises when a disproportionately large allocation to a single position or sector exposes the portfolio to idiosyncratic events that affect that holding.
Question 4: The Capital Market Line (CML) in modern portfolio theory connects the risk-free rate to:
- The minimum variance portfolio on the efficient frontier
- The tangency portfolio, which has the highest Sharpe ratio (Correct answer)
- Any portfolio with a beta greater than 1.0
- The global equity market index only
Correct answer: The tangency portfolio, which has the highest Sharpe ratio
The CML runs from the risk-free rate through the tangency portfolio (optimal risky portfolio), representing all efficient portfolios combining the risk-free asset and the market portfolio.
Question 5: In stress testing a fund's asset allocation, a manager should primarily focus on:
- Average annual returns under normal market conditions
- Portfolio behavior under extreme adverse scenarios, including correlations rising toward 1 (Correct answer)
- The portfolio's Sharpe ratio during bull markets
- Tax efficiency of the allocation under standard tax rules
Correct answer: Portfolio behavior under extreme adverse scenarios, including correlations rising toward 1
Stress testing examines how a portfolio performs under severe conditions, particularly noting that diversification benefits erode when inter-asset correlations spike during crises.
Question 6: A fund manager shifts from a 50/50 stock/bond allocation to 70/30 based on a short-term macroeconomic outlook. This is an example of:
- Strategic asset allocation
- Tactical asset allocation (Correct answer)
- Passive indexing
- Core-satellite investing
Correct answer: Tactical asset allocation
Tactical asset allocation involves temporary deviations from the long-term strategic allocation to exploit shorter-term market opportunities or manage near-term risks.
Question 7: Which of the following best describes the risk-return tradeoff of adding emerging market equities to a developed-market portfolio?
- Lower expected returns with reduced volatility due to government stability
- Higher expected returns with higher volatility, but potential diversification benefits from lower correlation (Correct answer)
- No change in risk or return since global markets are fully integrated
- Guaranteed outperformance due to faster GDP growth in emerging economies
Correct answer: Higher expected returns with higher volatility, but potential diversification benefits from lower correlation
Emerging markets offer higher growth potential and expected returns but come with higher volatility, political risk, and currency risk, with partial diversification benefits when correlations are below 1.
CFM Risk Assessment & Asset Allocation 5
In the context of alternative investments, which risk is most unique to private equity compared to public equities?