WMS Investment Strategies and Portfolio Management 3 — Questions and Answers
Question 1: What does the efficient frontier represent in Modern Portfolio Theory?
- The set of portfolios with the highest return for any given level of risk (Correct answer)
- The single portfolio with the maximum Sharpe ratio
- The minimum variance portfolio across all asset classes
- The set of portfolios with zero correlation between holdings
Correct answer: The set of portfolios with the highest return for any given level of risk
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk.
Question 2: Which alternative investment strategy profits from pricing discrepancies between a target company's stock and the acquirer's stock during a merger?
- Long/short equity
- Merger arbitrage (Correct answer)
- Convertible arbitrage
- Global macro
Correct answer: Merger arbitrage
Merger arbitrage (risk arbitrage) exploits the spread between the target's current price and the announced acquisition price.
Question 3: A growth investor screening for companies would prioritize which metric above others?
- High dividend yield
- Low price-to-book ratio
- High earnings growth rate (Correct answer)
- Low price-to-earnings ratio
Correct answer: High earnings growth rate
Growth investors seek companies with above-average earnings growth potential, often accepting higher valuations in exchange for expected future appreciation.
Question 4: What is the primary risk associated with investing in callable bonds compared to non-callable bonds?
- Credit risk increases when interest rates rise
- Reinvestment risk increases when interest rates fall (Correct answer)
- Liquidity risk is higher due to infrequent trading
- Currency risk is elevated for domestic issuers
Correct answer: Reinvestment risk increases when interest rates fall
When rates fall, issuers call bonds and investors must reinvest proceeds at lower prevailing rates, creating reinvestment risk.
Question 5: In the context of factor investing, which factor captures the tendency of recent winners to continue outperforming?
- Value factor
- Size factor
- Momentum factor (Correct answer)
- Quality factor
Correct answer: Momentum factor
The momentum factor reflects the observed tendency of assets that have performed well recently to continue performing well in the near term.
Question 6: Which portfolio construction technique uses optimization to find the weights that minimize portfolio variance for a given expected return?
- Black-Litterman model
- Mean-variance optimization (Correct answer)
- Risk parity allocation
- Equal weighting
Correct answer: Mean-variance optimization
Mean-variance optimization, introduced by Markowitz, finds the portfolio weights that minimize variance (risk) for each level of expected return.
Question 7: An investor uses a put option on their equity portfolio to protect against downside risk. This strategy is best described as:
- Covered call writing
- Protective put strategy (Correct answer)
- Collar strategy
- Cash-secured put writing
Correct answer: Protective put strategy
A protective put involves purchasing a put option on an existing long position to limit potential losses below the strike price.
WMS Investment Strategies and Portfolio Management 3
What does the efficient frontier represent in Modern Portfolio Theory?