IAR Portfolio Management 1 — Questions and Answers
Question 1: According to Modern Portfolio Theory (MPT), what is the primary benefit of diversification?
- It eliminates all investment risk from a portfolio
- It reduces unsystematic risk without proportionally reducing expected return (Correct answer)
- It guarantees returns above the risk-free rate
- It increases the beta of the overall portfolio
Correct answer: It reduces unsystematic risk without proportionally reducing expected return
MPT shows that combining assets with low correlations reduces unsystematic (company-specific) risk while maintaining expected return, improving the risk-return trade-off.
Question 2: The efficient frontier in Modern Portfolio Theory represents portfolios that:
- Offer the highest possible return regardless of risk
- Have zero systematic risk
- Maximize expected return for a given level of risk (Correct answer)
- Are guaranteed to outperform the market index
Correct answer: Maximize expected return for a given level of risk
The efficient frontier consists of portfolios that offer the highest expected return for each level of risk (standard deviation), representing optimal diversification.
Question 3: An investment adviser is determining strategic asset allocation for a client. Which factor is MOST important in this decision?
- Current market valuations of equity indices
- The client's investment time horizon and risk tolerance (Correct answer)
- The historical performance of individual securities
- Short-term interest rate forecasts
Correct answer: The client's investment time horizon and risk tolerance
Strategic asset allocation is a long-term framework driven primarily by the client's time horizon and risk tolerance, which determine the appropriate mix of asset classes.
Question 4: Which of the following BEST describes systematic risk?
- Risk specific to a single company that can be eliminated through diversification
- Risk arising from poor internal controls within a firm
- Market-wide risk that affects all securities and cannot be diversified away (Correct answer)
- The risk that a bond issuer will default on its obligations
Correct answer: Market-wide risk that affects all securities and cannot be diversified away
Systematic risk (market risk) stems from macroeconomic factors affecting all investments, such as interest rate changes or recessions, and cannot be eliminated through diversification.
Question 5: A portfolio has a beta of 1.4. If the market rises 10%, what is the expected portfolio return based on beta alone?
- 10%
- 14% (Correct answer)
- 1.4%
- 8.6%
Correct answer: 14%
Beta measures sensitivity to market movements; a beta of 1.4 means the portfolio is expected to move 1.4 times the market return, so 1.4 × 10% = 14%.
Question 6: What does the Sharpe ratio measure?
- A portfolio's total return relative to its benchmark
- Excess return per unit of total risk (standard deviation) (Correct answer)
- Excess return per unit of systematic risk (beta)
- The correlation between a portfolio and the market index
Correct answer: Excess return per unit of total risk (standard deviation)
The Sharpe ratio calculates (portfolio return – risk-free rate) / standard deviation, measuring how much excess return is earned per unit of total risk.
Question 7: An adviser rebalances a client's portfolio back to its target allocation annually. What is the PRIMARY purpose of rebalancing?
- To increase the portfolio's expected return each year
- To restore the intended risk-return profile that market drift has altered (Correct answer)
- To minimize capital gains taxes on appreciated positions
- To replace underperforming managers with better ones
Correct answer: To restore the intended risk-return profile that market drift has altered
Market movements cause asset class weights to drift from targets, changing the portfolio's risk profile; rebalancing restores the original risk-return alignment consistent with client objectives.
IAR Portfolio Management 1
According to Modern Portfolio Theory (MPT), what is the primary benefit of diversification?