CPT Portfolio Diversification Strategies 2 — Questions and Answers
Question 1: Which metric measures the degree to which two assets move together, ranging from -1 to +1?
- Beta coefficient
- Correlation coefficient (Correct answer)
- Sharpe ratio
- Standard deviation
Correct answer: Correlation coefficient
The correlation coefficient quantifies the linear relationship between two assets, with -1 indicating perfect negative correlation and +1 indicating perfect positive correlation.
Question 2: An investor holds only domestic large-cap stocks. Which diversification step would most reduce country-specific risk?
- Adding small-cap domestic stocks
- Adding international equities (Correct answer)
- Adding domestic corporate bonds
- Increasing cash holdings
Correct answer: Adding international equities
Adding international equities introduces exposure to different economic cycles and political environments, reducing country-specific (sovereign) risk.
Question 3: What is the primary purpose of rebalancing a diversified portfolio?
- To maximize short-term returns
- To restore the portfolio to its target asset allocation (Correct answer)
- To eliminate all losing positions
- To increase exposure to the best-performing asset class
Correct answer: To restore the portfolio to its target asset allocation
Rebalancing restores a portfolio to its intended risk profile after market movements cause asset class weights to drift from targets.
Question 4: Which portfolio construction approach weights assets inversely to their volatility?
- Equal-weight portfolio
- Market-cap weighted portfolio
- Risk parity portfolio (Correct answer)
- Factor-tilt portfolio
Correct answer: Risk parity portfolio
Risk parity allocates more capital to lower-volatility assets so each asset contributes equally to overall portfolio risk.
Question 5: An investor adds Treasury bonds to an equity portfolio. The primary diversification benefit comes from bonds':
- Higher expected return than equities
- Positive correlation with equities during recessions
- Tendency to appreciate when equities fall sharply (Correct answer)
- Higher liquidity than equities
Correct answer: Tendency to appreciate when equities fall sharply
Treasuries typically exhibit negative or low correlation with equities during market downturns, providing a cushion when stocks decline.
Question 6: Which of the following best describes 'over-diversification'?
- Holding assets with correlation greater than 0.9
- Holding so many positions that marginal risk reduction becomes negligible while costs increase (Correct answer)
- Allocating more than 20% to a single sector
- Investing in both stocks and bonds simultaneously
Correct answer: Holding so many positions that marginal risk reduction becomes negligible while costs increase
Over-diversification occurs when adding more holdings provides virtually no additional risk reduction but raises transaction costs and monitoring complexity.
Question 7: In a portfolio context, 'concentration risk' refers to:
- Excessive exposure to a single security, sector, or geography (Correct answer)
- The risk that cash holdings will lose purchasing power
- Volatility caused by frequent trading
- The danger of holding too many uncorrelated assets
Correct answer: Excessive exposure to a single security, sector, or geography
Concentration risk arises when a portfolio is over-weighted in one area, making its performance heavily dependent on that single source of return.
CPT Portfolio Diversification Strategies 2
Which metric measures the degree to which two assets move together, ranging from -1 to +1?