IMC Portfolio Management Principles 3 — Questions and Answers
Question 1: What is 'drawdown' as a risk measure?
- The act of withdrawing cash from a portfolio
- The peak-to-trough decline in portfolio value over a specified period, measuring the magnitude of losses (Correct answer)
- The management fee deducted from a fund
- The reduction in bond duration as maturity approaches
Correct answer: The peak-to-trough decline in portfolio value over a specified period, measuring the magnitude of losses
Maximum drawdown measures the largest peak-to-trough decline in a portfolio's value before a new peak is reached. It provides investors with an understanding of the worst loss they could have experienced over a period, and is used to assess downside risk.
Question 2: What is 'scenario analysis' in portfolio risk management?
- Analysis of past portfolio performance
- Evaluating how a portfolio would perform under specific hypothetical or historical market conditions or events (Correct answer)
- Analysis of individual security scenarios
- A comparison of different fund manager scenarios
Correct answer: Evaluating how a portfolio would perform under specific hypothetical or historical market conditions or events
Scenario analysis assesses portfolio performance under specific hypothetical scenarios (e.g., a 2008-style financial crisis, a sharp rise in rates, a Brexit-type event). It helps identify vulnerabilities not captured by standard statistical risk measures.
Question 3: What is 'stress testing' in investment risk management?
- Testing portfolio managers under pressure
- Applying extreme adverse market conditions to a portfolio to assess potential losses under severe but plausible scenarios (Correct answer)
- Testing the technical infrastructure of trading systems
- Regulatory compliance testing
Correct answer: Applying extreme adverse market conditions to a portfolio to assess potential losses under severe but plausible scenarios
Stress testing evaluates a portfolio under extreme market conditions (severe equity crashes, liquidity crises, extreme rate movements) to identify vulnerabilities. It is required by regulators and is an important risk management tool alongside standard statistical measures.
Question 4: What is 'Value at Risk' (VaR)?
- The maximum profit achievable from a portfolio in normal conditions
- A statistical measure of the maximum expected loss over a given time period at a given confidence level under normal market conditions (Correct answer)
- The current market value of a portfolio's assets
- The minimum acceptable return for a client
Correct answer: A statistical measure of the maximum expected loss over a given time period at a given confidence level under normal market conditions
VaR is a statistical risk measure. A 95% one-day VaR of £1 million means there is a 5% probability of losing more than £1 million in a single day under normal market conditions. It provides a single-number summary of market risk.
Question 5: What is 'performance attribution' in fund management?
- Attributing performance records to individual fund managers for career purposes
- Analysing the sources of a portfolio's outperformance or underperformance relative to its benchmark, broken down by asset allocation and stock selection (Correct answer)
- Calculating the performance fee due to a manager
- Attribution of tax liability on investment returns
Correct answer: Analysing the sources of a portfolio's outperformance or underperformance relative to its benchmark, broken down by asset allocation and stock selection
Performance attribution decomposes a portfolio's active return (alpha) into contributions from asset allocation decisions (overweighting/underweighting sectors or geographies) and stock selection (choosing outperforming/underperforming securities within sectors).
Question 6: In investment management, what is 'fiduciary duty'?
- A duty to maximise fees for the firm
- A legal and ethical obligation to act in the best interests of the client, putting their interests ahead of the manager's own (Correct answer)
- A duty to comply with all regulations
- A duty to report all trades to the regulator
Correct answer: A legal and ethical obligation to act in the best interests of the client, putting their interests ahead of the manager's own
Fiduciary duty is the highest standard of care in investment management, requiring the manager to act solely in the best interests of the client. It encompasses loyalty (no conflicts of interest) and prudence (exercising professional care and skill).
IMC Portfolio Management Principles 3
What is 'drawdown' as a risk measure?