CIMA Portfolio Theory and Construction 3 — Questions and Answers
Question 1: The Capital Market Line (CML) differs from the Security Market Line (SML) in that the CML:
- Uses beta as the risk measure instead of standard deviation
- Applies only to individual securities, not portfolios
- Plots expected return against total risk for efficient portfolios (Correct answer)
- Identifies undervalued securities relative to systematic risk
Correct answer: Plots expected return against total risk for efficient portfolios
The CML plots expected return versus total standard deviation for efficient (fully diversified) portfolios, while the SML uses beta for all assets.
Question 2: A portfolio's tracking error is best defined as:
- The difference between gross and net portfolio returns
- The standard deviation of the portfolio's returns minus the benchmark returns (Correct answer)
- The average absolute deviation of monthly returns from the benchmark
- Beta multiplied by the benchmark's standard deviation
Correct answer: The standard deviation of the portfolio's returns minus the benchmark returns
Tracking error is the standard deviation of active returns (portfolio return minus benchmark return) over a period.
Question 3: Under the Black-Litterman model, when an investor expresses no views, the optimal portfolio weights converge to:
- Equal weights across all assets
- The minimum variance portfolio weights
- Market-capitalization weights implied by equilibrium (Correct answer)
- Weights proportional to each asset's Sharpe ratio
Correct answer: Market-capitalization weights implied by equilibrium
With no investor views, the Black-Litterman model reverts to equilibrium (market-cap weighted) expected returns implied by reverse optimization.
Question 4: Which rebalancing strategy involves buying assets that have declined and selling those that have risen to restore target weights?
- Momentum rebalancing
- Calendar rebalancing
- Percentage-of-portfolio rebalancing (Correct answer)
- Buy-and-hold rebalancing
Correct answer: Percentage-of-portfolio rebalancing
Percentage-of-portfolio (or threshold) rebalancing triggers trades whenever an asset drifts beyond a set band from its target weight, inherently acting contra-trend.
Question 5: An investor's utility function is U = E(r) − 0.5 × A × σ². If A = 4 and two portfolios have the same expected return, the investor will prefer the one with:
- Higher standard deviation
- Lower standard deviation (Correct answer)
- Higher beta
- Higher skewness
Correct answer: Lower standard deviation
A positive risk-aversion coefficient A means higher variance reduces utility, so the investor prefers the lower-variance portfolio.
Question 6: Which of the following is a limitation of using historical covariances in mean-variance optimization?
- Historical covariances are always positive, limiting diversification
- Estimation error in covariances can lead to concentrated or unstable portfolios (Correct answer)
- Historical data overstates future correlation during market crises
- Covariances cannot be computed for more than 10 assets simultaneously
Correct answer: Estimation error in covariances can lead to concentrated or unstable portfolios
Mean-variance optimizers can amplify estimation errors in covariance inputs, producing extreme, unstable portfolio weights.
Question 7: A portfolio constructed to maximize return for a given level of tracking error relative to a benchmark is called a(n):
- Absolute return portfolio
- Information ratio-optimized portfolio (Correct answer)
- Enhanced indexing portfolio
- Core-satellite portfolio
Correct answer: Information ratio-optimized portfolio
Maximizing the information ratio (active return / tracking error) is the objective of active portfolio construction that constrains tracking error.
CIMA Portfolio Theory and Construction 3
The Capital Market Line (CML) differs from the Security Market Line (SML) in that the CML: