CIMA Risk and Performance Measurement 3 — Questions and Answers
Question 1: Which of the following is a limitation of using historical VaR as a risk measure?
- It accounts for fat tails in return distributions
- It assumes future returns will follow historical patterns (Correct answer)
- It captures non-linear risk in options portfolios
- It requires only two parameters to calculate
Correct answer: It assumes future returns will follow historical patterns
Historical VaR assumes that past return distributions are representative of future risk, which may not hold during regime changes or market crises.
Question 2: What does a negative Jensen's alpha indicate?
- The portfolio outperformed on a risk-adjusted basis
- The portfolio underperformed relative to its CAPM-expected return (Correct answer)
- The portfolio had lower volatility than the market
- The portfolio's beta exceeded 1.0
Correct answer: The portfolio underperformed relative to its CAPM-expected return
Negative Jensen's alpha means the portfolio earned less than what the CAPM predicted given its level of systematic risk, indicating underperformance.
Question 3: When using Monte Carlo simulation for VaR, which of the following is a key advantage over historical simulation?
- It uses only actual historical data
- It can model complex instruments and generate scenarios not seen historically (Correct answer)
- It requires no assumptions about return distributions
- It is computationally simpler
Correct answer: It can model complex instruments and generate scenarios not seen historically
Monte Carlo simulation can generate a vast range of hypothetical scenarios based on specified distributions, including events not present in historical data.
Question 4: Tracking error is best described as:
- The correlation between a portfolio and its benchmark
- The standard deviation of the portfolio's active returns relative to the benchmark (Correct answer)
- The absolute difference between portfolio and benchmark returns
- The portfolio's beta minus 1.0
Correct answer: The standard deviation of the portfolio's active returns relative to the benchmark
Tracking error measures the volatility of the difference between the portfolio's returns and the benchmark's returns, quantifying active risk.
Question 5: Which of the following correctly describes the Information Ratio?
- Active return divided by total portfolio volatility
- Active return divided by tracking error (Correct answer)
- Portfolio return divided by benchmark return
- Excess return divided by beta
Correct answer: Active return divided by tracking error
The Information Ratio equals active return (portfolio return minus benchmark return) divided by tracking error, measuring risk-adjusted active performance.
Question 6: A manager wants to stress test a portfolio for a potential 25% equity market decline. This is an example of:
- Historical simulation
- Scenario analysis (Correct answer)
- Parametric VaR
- Factor-model attribution
Correct answer: Scenario analysis
Scenario analysis involves defining specific hypothetical adverse events (like a 25% equity decline) to evaluate portfolio sensitivity to extreme conditions.
Question 7: Which concept explains why adding a low-correlation asset to a portfolio can reduce total portfolio volatility?
- Systematic risk concentration
- Diversification benefit (Correct answer)
- Leverage effect
- Mean reversion
Correct answer: Diversification benefit
Diversification reduces portfolio volatility when assets are not perfectly correlated, as losses in one asset may be offset by gains in another.
CIMA Risk and Performance Measurement 3
Which of the following is a limitation of using historical VaR as a risk measure?