FIA Portfolio Theory & Asset Management 5 — Questions and Answers
Question 1: What does the 'two-fund separation theorem' state in portfolio theory?
- Every investor needs exactly two advisors for optimal results
- All investors can hold an optimal portfolio using any combination of the risk-free asset and the market portfolio (Correct answer)
- Portfolios should be split equally between stocks and bonds
- Two assets are sufficient to eliminate all portfolio risk
Correct answer: All investors can hold an optimal portfolio using any combination of the risk-free asset and the market portfolio
The two-fund separation theorem states that any efficient portfolio is a combination of the risk-free asset and the tangency (market) portfolio.
Question 2: Which of the following best defines 'duration' in fixed income portfolio management?
- The time until a bond matures
- The weighted average time to receive a bond's cash flows, measuring interest rate sensitivity (Correct answer)
- The coupon payment frequency of a bond
- The credit rating transition period
Correct answer: The weighted average time to receive a bond's cash flows, measuring interest rate sensitivity
Duration is the weighted average time to receive cash flows and also measures how much a bond's price changes for a 1% change in interest rates.
Question 3: A pension fund with long-term liabilities should generally prefer assets with what characteristic?
- Short duration to minimize interest rate risk
- Long duration to match liability duration (Correct answer)
- High correlation with equity markets
- Maximum liquidity at all times
Correct answer: Long duration to match liability duration
Matching long-duration assets to long-duration liabilities reduces the fund's net interest rate exposure.
Question 4: In multi-factor models, what does the Fama-French three-factor model add to the market factor?
- Momentum and volatility factors
- Size (SMB) and value (HML) factors (Correct answer)
- Quality and profitability factors
- Currency and commodity factors
Correct answer: Size (SMB) and value (HML) factors
The Fama-French model adds SMB (small minus big, a size factor) and HML (high minus low, a value factor) to the market return factor.
Question 5: What is the primary difference between systematic and active risk in portfolio management?
- Systematic risk is diversifiable; active risk is not
- Active risk arises from deviations from the benchmark; systematic risk comes from market exposure (Correct answer)
- Systematic risk affects individual securities; active risk affects the whole portfolio
- Active risk is measured by beta; systematic risk is measured by tracking error
Correct answer: Active risk arises from deviations from the benchmark; systematic risk comes from market exposure
Systematic (market) risk stems from overall market exposure, while active risk (tracking error) results from deviations from the benchmark.
Question 6: Which concept explains why adding a security with high individual risk can reduce overall portfolio risk?
- The law of large numbers applied to returns
- Low or negative correlation with existing portfolio holdings (Correct answer)
- Higher expected returns compensating for higher risk
- The substitution effect in asset pricing
Correct answer: Low or negative correlation with existing portfolio holdings
Even a high-risk security reduces portfolio risk if it has low or negative correlation with existing holdings, providing diversification benefits.
Question 7: What does 'reversion to the mean' imply for active portfolio managers using a contrarian strategy?
- Assets that underperform tend to continue underperforming
- Assets that deviate significantly from historical averages tend to return toward those averages (Correct answer)
- Mean returns are the highest achievable in efficient markets
- Portfolio beta always reverts to 1.0 over time
Correct answer: Assets that deviate significantly from historical averages tend to return toward those averages
Mean reversion suggests that extreme performance (up or down) tends to moderate over time, supporting contrarian investment approaches.
FIA Portfolio Theory & Asset Management 5
What does the 'two-fund separation theorem' state in portfolio theory?