FIA Portfolio Theory & Asset Management 2 — Questions and Answers
Question 1: In the Capital Market Line (CML), what does the y-intercept represent?
- The risk-free rate of return (Correct answer)
- The market portfolio return
- The Sharpe ratio
- The equity risk premium
Correct answer: The risk-free rate of return
The CML's y-intercept is the risk-free rate, which is the return earned when taking zero risk.
Question 2: Which performance measure divides excess return by the portfolio's beta rather than its standard deviation?
- Sharpe ratio
- Treynor ratio (Correct answer)
- Jensen's alpha
- Information ratio
Correct answer: Treynor ratio
The Treynor ratio uses beta (systematic risk) as the denominator, unlike the Sharpe ratio which uses total standard deviation.
Question 3: A portfolio has an expected return of 12%, a standard deviation of 18%, and the risk-free rate is 3%. What is its Sharpe ratio?
- 0.50 (Correct answer)
- 0.67
- 0.75
- 1.00
Correct answer: 0.50
Sharpe ratio = (12% - 3%) / 18% = 9% / 18% = 0.50.
Question 4: What is the primary purpose of the efficient frontier in modern portfolio theory?
- To identify portfolios that maximize return for each level of risk (Correct answer)
- To calculate individual stock betas
- To determine the risk-free rate
- To measure market capitalization of assets
Correct answer: To identify portfolios that maximize return for each level of risk
The efficient frontier identifies the set of portfolios offering maximum expected return for a given level of risk.
Question 5: When two assets have a correlation coefficient of -1.0, what is achievable through portfolio construction?
- Maximum diversification benefit only
- Complete elimination of systematic risk
- Complete elimination of portfolio risk (Correct answer)
- Reduction of beta to zero
Correct answer: Complete elimination of portfolio risk
Perfect negative correlation (-1.0) allows construction of a portfolio with zero variance at the appropriate weights.
Question 6: In the context of asset management, what does 'tracking error' measure?
- The portfolio's absolute return
- The standard deviation of returns relative to a benchmark (Correct answer)
- The beta of the portfolio
- The Sharpe ratio minus the benchmark Sharpe ratio
Correct answer: The standard deviation of returns relative to a benchmark
Tracking error is the standard deviation of the difference between portfolio returns and benchmark returns.
Question 7: Which of the following best describes a 'passive' investment strategy?
- Selecting stocks based on fundamental analysis
- Replicating the composition of a market index (Correct answer)
- Rotating between sectors based on economic cycles
- Using leverage to amplify market returns
Correct answer: Replicating the composition of a market index
Passive strategies seek to replicate an index's performance rather than outperform through active selection.
FIA Portfolio Theory & Asset Management 2
In the Capital Market Line (CML), what does the y-intercept represent?