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Free CFA Asset Allocation Practice Questions & Answers
500 exam-style Asset Allocation questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 421
A target-date mutual fund for a 65-year-old retirement goal uses a glide path that shifts from equity to bonds as the target date approaches. What happens to the allocation between inflation-protected bonds and nominal bonds as the fund moves closer to the target date?
Select an option first.
Correct answer: B — The allocation to inflation-protected bonds INCREASES later in the glide path — retirees on fixed incomes face significant inflation risk, and as the proportion of bonds grows (relative to equities), inflation-linked bonds become more important to preserve purchasing power
Explanation: B is correct: As target-date funds approach their target date, they shift toward bonds. Among the bonds, the allocation increasingly favors inflation-protected bonds (like TIPS) because retirees with fixed incomes are particularly vulnerable to inflation eroding purchasing power. Nominal bonds protect against interest rate risk but not inflation. Closer to and in retirement, when the investor is living off the portfolio, inflation protection becomes more critical. D is wrong: Cash is a minimal component early in the glide path when equity dominates. A is wrong: Bond allocations grow, not decrease, near the target date.
Question 422
When should an investment committee revise the strategic asset allocation in response to a change in capital market beliefs?
Select an option first.
Correct answer: A — Only when the change in beliefs represents a permanent structural shift in expected returns, volatility, or correlations — not in response to short-term market fluctuations
Explanation: A is correct: SAA revisions based on beliefs should reflect meaningful long-term shifts in the investment environment, not short-term noise. The example in the reading is the dramatic shift in fixed income return expectations before versus after 2008 — a fundamental change in the interest rate environment that permanently altered bond expected returns. Revising the SAA in response to every market fluctuation would destabilize the long-term strategy and potentially introduce market-timing behavior inconsistent with the fund's objectives. B is wrong: Monthly SAA revisions would effectively turn the SAA into a TAA. C is wrong: SAAs must be revisited when significant changes occur. D is wrong: The IR is a TAA performance metric, not an SAA revision trigger.
Question 423
A pension fund transitions from a young workforce (average employee age 32) to a more mature workforce (average employee age 52). How should the asset allocation change, and why?
Select an option first.
Correct answer: B — The allocation should shift from long-duration bonds to intermediate and short-duration bonds — with older workers approaching retirement, the duration of liabilities decreases, requiring shorter-duration assets to maintain duration matching
Explanation: B is correct: As the workforce ages, the pension liabilities' duration shortens — benefits will be paid sooner, reducing the time value of waiting. To maintain duration matching (a core liability-driven investing principle), the asset portfolio must also reduce its duration by shifting from long-duration to intermediate and short-duration bonds. A young workforce has liabilities far in the future (long duration) requiring long bonds; a mature workforce has near-term liabilities requiring shorter bonds. A is wrong: A mature workforce actually reduces the capacity for equity risk-taking, not increases it. C is wrong: Workforce demographics directly drive liability duration, which is the primary driver of asset allocation for pension funds. D is wrong: Cash provides near-zero returns and would likely be insufficient to meet obligations.
Question 424
What is the fundamental objective of tactical asset allocation (TAA), and what key assumption must hold for TAA to add value?
Select an option first.
Correct answer: B — TAA aims to enhance risk-adjusted returns by temporarily deviating from the SAA to exploit short-term cyclical opportunities — this requires the assumption that short-term returns are to some degree predictable (mean-reversion or momentum), unlike long-term returns which are often modeled as a random walk
Explanation: B is correct: TAA is designed to add alpha by making short-term deviations from the SAA based on perceived mispricings, business cycle position, or momentum/value signals. The fundamental assumption is that short-term return patterns are somewhat predictable — that markets do not perfectly randomly walk in the short term, allowing skilled managers to identify temporary overvaluation or undervaluation. If markets are a perfect random walk at all horizons, TAA cannot systematically add value. A is wrong: TAA introduces tracking error (it deviates from the SAA) rather than minimizing it. C is wrong: TAA is short-term and reverts to the SAA — it does not replace it. D is wrong: TAA adjusts asset class weights, not individual security selection.
Question 425
A portfolio manager implements a TAA by overweighting equities by 8% relative to the SAA based on her view that equities are undervalued. After 6 months, the equity market has not recovered. How should the TAA be evaluated?
Select an option first.
Correct answer: B — By comparing the TAA portfolio's Sharpe ratio or information ratio to what the SAA would have delivered over the same period — negative excess return or a negative information ratio indicates the TAA destroyed value
Explanation: B is correct: TAA performance must always be measured relative to the SAA benchmark (what would have happened without the TAA). Metrics include: (1) Sharpe ratio comparison — did the TAA produce a better risk-adjusted return than the SAA? (2) Information ratio of excess returns (TAA minus SAA) — is the active return per unit of tracking error positive? (3) T-statistic of excess returns to assess statistical significance. If the equity market did not recover, the equity overweight produced negative excess returns, meaning the TAA destroyed value relative to the SAA — a negative information ratio. A is wrong: Absolute return is irrelevant — a rising tide lifts all boats. B is the correct benchmark. C is wrong: CPI is an inflation benchmark, not an investment strategy benchmark. D is wrong: TAA can and should be evaluated over any period relevant to the strategy.
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Question 426
What distinguishes discretionary TAA from systematic TAA?
Select an option first.
Correct answer: B — Discretionary TAA relies on qualitative interpretation of macroeconomic, fundamental, and sentiment indicators by a skilled manager — decisions depend on the manager's skill in weighting and interpreting information. Systematic TAA uses quantitative signals (like value or momentum) that are mechanically applied without manager discretion
Explanation: B is correct: The key distinction is the role of human judgment. Discretionary TAA managers analyze the same data (bond yields, P/E ratios, consumer confidence) but make subjective decisions about which signals to emphasize and how to interpret them — the quality of the TAA depends on the manager's skill and judgment. Systematic TAA uses predetermined quantitative rules (e.g., overweight equities when the 50-day moving average crosses above the 200-day moving average) that are applied mechanically without discretion. Systematic approaches are rule-based and replicable; discretionary approaches are skill-dependent and less transparent. A is wrong: These are reversed descriptions. C is wrong: Neither consistently dominates; each has periods of out- and underperformance. D is wrong: Both approaches are used across investor sizes.
Question 427
In a systematic value-based TAA strategy, what measure is commonly used to identify undervalued equities?
Select an option first.
Correct answer: B — Shiller's earnings yield (10-year average inflation-adjusted E/P ratio) — when the current E/P ratio is high relative to history, equities may be undervalued; when it is low, they may be overvalued
Explanation: B is correct: Shiller's CAPE (Cyclically Adjusted P/E, or Shiller P/E) uses a 10-year average of inflation-adjusted earnings in the denominator. The earnings yield (inverse of CAPE = E/P) adjusts for the business cycle by smoothing earnings. When the earnings yield is high (CAPE is low), equities appear cheap relative to history — a value signal to overweight. When earnings yield is low (CAPE high), equities appear expensive. This is a classic systematic TAA value indicator for equities. A is wrong: 12-month momentum is a momentum signal, not a value signal. C is wrong: Short interest is a market sentiment indicator. D is wrong: Information ratio and Sharpe ratio are performance metrics, not valuation signals.
Question 428
A commodity market is in backwardation. How does this affect a systematic TAA strategy that uses roll yield as a value signal?
Select an option first.
Correct answer: B — Backwardation means futures prices are BELOW spot prices — a long commodity futures position earns positive roll yield (buying low futures that converge to higher spot prices), which is a bullish systematic signal to overweight commodities
Explanation: B is correct: In backwardation, futures prices are below the current spot price. As futures contracts approach expiration, they converge upward toward spot prices — a long futures position earns the positive roll yield. Systematic TAA strategies use positive roll yield (backwardation) as a value signal to overweight the commodity, because the long position profits from rolling to new contracts at a discount. Contango is the opposite (futures above spot), creating negative roll yield — a bearish signal. A is wrong: In backwardation, futures are BELOW spot — roll yield is positive, not negative. C is wrong: Backwardation produces positive roll yield while contango produces negative roll yield — they are opposite. D is wrong: Roll yield is explicitly listed as a commodity valuation signal.
Question 429
What is one key DRAWBACK of tactical asset allocation that makes it less suitable for some investors?
Select an option first.
Correct answer: B — TAA incurs additional trading costs and, for taxable investors, additional capital gains taxes from the more frequent portfolio changes — these costs must be overcome by the TAA's value-added to justify the strategy
Explanation: B is correct: TAA's explicit drawbacks include: (1) increased transaction costs from more frequent trading (buying and selling to implement the tactical tilt, then unwinding it), (2) capital gains taxes for taxable investors each time positions are sold for gain, and (3) concentration risk from overweighting specific assets. The net value-add of TAA must exceed these costs to justify implementation. A is wrong: TAA sometimes adds positive returns, sometimes negative — the outcome depends on skill. C is wrong: Most pension funds are permitted to implement TAA within policy limits. D is wrong: TAA overweights specific assets but doesn't eliminate portfolio diversification.
Question 430
An investor strongly dislikes losses relative to equivalent gains — a $10,000 loss feels twice as painful as a $10,000 gain feels good. During a market downturn, this causes the investor to sell equity and shift to bonds to 'stop the pain,' even though the long-term SAA is appropriate. What behavioral bias is this?
Select an option first.
Correct answer: B — Loss aversion — the disproportionate emotional weight placed on losses causes the investor to abandon a sound long-term strategy to avoid the psychological pain of further losses
Explanation: B is correct: Loss aversion is the behavioral bias where losses are felt more intensely than equivalent gains — investors are more motivated to avoid losses than to capture gains. During downturns, this manifests as panic selling — abandoning sound long-term strategies to eliminate the psychological pain of watching losses accumulate. The rational investor would maintain or even rebalance toward equities (buy low), but loss aversion drives selling at the worst time. Goals-based investing is the recommended mitigation — framing the portfolio around achieving specific goals reduces focus on short-term mark-to-market losses. A is wrong: Representative bias involves trend-following, not pain avoidance. C is wrong: Framing bias relates to how information is presented. D is wrong: Selling to avoid losses is loss aversion, not illusion of control.
Question 431
What is the RECOMMENDED mitigation for loss aversion bias in investment decision-making?
Select an option first.
Correct answer: B — Implement goals-based investing — framing the portfolio around specific goals with subportfolios, focusing attention on goal achievement probability rather than daily mark-to-market losses
Explanation: B is correct: Goals-based investing mitigates loss aversion by shifting the investor's focus from short-term portfolio value (which generates emotional pain during downturns) to whether specific life goals are still on track to be achieved. High-priority goals are funded with conservative subportfolios that are unlikely to fall below the required minimum — reducing the emotional impact of market downturns. Risk is framed in terms of goal failure probability (shortfall risk) rather than mark-to-market losses, making it psychologically easier to maintain discipline. A is wrong: Avoiding all risk results in insufficient returns to meet long-term goals. C is wrong: Leverage amplifies losses, making loss aversion worse. D is wrong: TAA would likely lead to more reactionary trading, not less.
Question 432
An institutional investor's investment committee member argues that they can consistently predict short-term market direction based on their reading of technical charts and macroeconomic data. As a result, the committee makes frequent tactical allocation shifts. What behavioral bias does this illustrate, and what is the mitigation?
Select an option first.
Correct answer: B — Illusion of control — the overestimation of one's ability to predict and control complex market outcomes. Mitigation: use the CAPM global market portfolio as the starting point, and subject any allocation shift to a formal review process requiring objective justification
Explanation: B is correct: Illusion of control is the tendency to overestimate one's ability to control or predict outcomes. In asset allocation, this manifests as overconfidence in market timing ability, frequent trading, use of leverage, and making allocation shifts based on idiosyncratic beliefs not supported by consensus. The fact that this committee member believes their chart-reading ability gives them superior market-timing skill — making frequent tactical shifts — is a textbook manifestation. Mitigation involves anchoring to the objective starting point of the global market portfolio and requiring a formal, documented review process for any deviation, reducing ad-hoc individual decision-making. A is wrong: Framing bias relates to how information presentation distorts decisions. C is wrong: Loss aversion involves fear of losses, not overconfidence. D is wrong: Mental accounting involves subjective compartmentalization of money.
Question 433
An investor maintains separate 'buckets' for her retirement savings and her newly inherited windfall. She invests her conservative retirement portfolio in bonds (refusing to add equities) while investing the inheritance in highly speculative growth stocks. Viewed as a whole, this results in a suboptimal overall allocation. What bias is this?
Select an option first.
Correct answer: B — Mental accounting — separating money into subjective buckets leads to irrational decisions when each bucket is assessed independently rather than as part of the total economic portfolio
Explanation: B is correct: Mental accounting is the bias of separating money into different mental 'buckets' based on subjective criteria (source of funds, intended purpose) and evaluating each independently rather than as part of the total portfolio. The investor's retirement funds and inheritance are economically equivalent — a dollar is a dollar. But mental accounting leads her to treat them with completely different risk profiles. The optimal overall allocation might be a balanced mix of bonds and equities across both, not near-100% bonds in one and near-100% speculative stocks in the other. Goals-based investing — a rational version of segmentation — is the recommended mitigation. A is wrong: Loss aversion is specifically about disliking losses, not about compartmentalization. C is wrong: Framing relates to presentation effects, not fund segmentation. D is wrong: The choice appears driven by source-of-funds categorization, not familiarity.
Question 434
An investor bought technology stocks heavily in the late 1990s and lost most of the investment when the tech bubble burst in 2000. Twenty years later, she still refuses to invest in any technology stocks, even though the sector has fundamentally changed. What bias does this illustrate?
Select an option first.
Correct answer: C — Availability bias — a personally experienced extreme loss is disproportionately salient and memorable, causing the investor to overweight this one historical event when assessing current risk
Explanation: C is correct: Availability bias occurs when easily recalled events — particularly dramatic personal experiences — disproportionately influence current decisions. The 2000 tech crash was a vivid, personal loss that is highly memorable. Twenty years later, the investor's decision-making is still dominated by this one salient event, causing her to treat modern technology companies (which may be fundamentally different businesses) as if they carry the same catastrophic risk. The antidote is starting with the global market portfolio — which allocates to all sectors based on market weights — rather than letting personal history dominate allocation decisions. A is wrong: Recency bias involves overweighting RECENT data, not data from 20 years ago. B is wrong: Loss aversion causes selling during downturns; this involves a decades-old categorical exclusion. D is wrong: Illusion of control involves overconfidence in one's ability to predict outcomes.
Question 435
An entrepreneur holds 60% of her total net worth in the equity of her own company, even though she sold her controlling interest 3 years ago and is no longer involved in management. She refuses to sell because she is 'emotionally attached to what I built.' What combination of biases is most clearly at work?
Select an option first.
Correct answer: B — Mental accounting combined with illusion of control — she emotionally places the stock in an aspirational 'bucket' (mental accounting) and may overestimate her understanding and control over the company (illusion of control), while rational portfolio theory would dictate diversification of an undiversified concentrated position
Explanation: B is correct: The entrepreneur exhibits two overlapping biases. Mental accounting: she emotionally separates her company stock into a special 'legacy' bucket and evaluates it differently from other investments — the irrational attachment based on its origins. Illusion of control: despite no longer controlling the company, she may subconsciously feel she understands the company better than other investors, overestimating her edge in holding it. The rational response is to diversify — no investor should hold 60% of wealth in a single stock, regardless of its origin. Goals-based investing can help by assigning the stock to an appropriate risk-stratified subportfolio rather than an emotional legacy bucket. A is wrong: Framing bias is not prominent here. C is wrong: Availability and representative biases involve different mechanisms.
Question 436
An investment committee member presents stock return data to the board using only 5-year periods that include the most recent bull market. When bonds are mentioned, she emphasizes only their interest rate risk. What behavioral bias is she exploiting in her audience?
Select an option first.
Correct answer: B — Framing bias — selectively presenting information influences the audience's decision, making equities appear superior and bonds appear riskier than a balanced presentation would suggest
Explanation: B is correct: Framing bias occurs when the WAY information is presented affects decision-making independently of the underlying facts. By cherry-picking 5-year bull market periods for equities and emphasizing only the risks of bonds, the presenter is framing the decision in a way that biases the audience toward equities. The mitigation is to present a FULL RANGE of relevant information — different time horizons, different risk measures, bear market periods, bond advantages — so that decisions are based on comprehensive rather than selectively framed data. A is wrong: The board member experiencing loss aversion would make decisions based on fear — here the framing is about information presentation. C is wrong: Availability bias involves personal experience, not selective data presentation. D is wrong: Representative bias involves recency, not selective information.
Question 437
What is 'home bias' in asset allocation and what is its primary cost to investors?
Select an option first.
Correct answer: B — Home bias is the tendency to overallocate to domestic securities relative to their global market weight — the primary cost is missed international diversification, higher portfolio volatility than necessary, and concentration in a single country's economic and political risks
Explanation: B is correct: Home bias is the well-documented tendency of investors to hold a disproportionately large share of their assets in their home country's securities — far more than the country's share of global market capitalization would suggest. For example, US investors may hold 80% in US stocks while the US represents about 60% of global market cap. The cost is the lost diversification benefit of international assets, which have different business cycles, currencies, and risk factors. The global market portfolio — the theoretically optimal starting point — would hold each country in proportion to its market capitalization, with no home bias. C is wrong: This is a different kind of geographic concentration. D is wrong: While some regulations create de facto home bias, it is primarily a behavioral phenomenon.
Question 438
Strong investment governance is described as the best defense against most behavioral biases. Which element of effective governance MOST directly prevents individual trustees from making idiosyncratic allocation decisions based on personal biases?
Select an option first.
Correct answer: B — A documented decision-making process with clearly defined responsibilities and a formal review process for any deviation from the strategic allocation — requiring objective justification rather than allowing unilateral action based on personal conviction
Explanation: B is correct: A documented, formal decision-making process is the most direct governance control against individual bias. When any deviation from the SAA must go through a structured review process — documenting the rationale, requiring consensus or objective criteria, and comparing to the market portfolio baseline — it becomes harder for an individual trustee's illusion of control, home bias, or loss aversion to unilaterally override the collective strategy. The process itself acts as a bias filter. A is wrong: Performance audits review outcomes after the fact but don't prevent biased decisions from being made in real-time. C is wrong: A large committee can amplify certain biases (herding) while reducing others. D is wrong: Rebalancing maintains target weights but doesn't address the root cause of biased decision-making.
Question 439
An investor earns 7% interest income on a bond and is subject to a 38% income tax rate. What is the after-tax return to be used in the asset allocation process?
Select an option first.
Correct answer: B — 4.34%
Explanation: B is correct: After-tax return = pre-tax return x (1 minus tax rate) = 7% x (1 minus 0.38) = 7% x 0.62 = 4.34%. The investor keeps only 4.34% after paying 38% tax on the 7% interest. This is the correct input for MVO for a taxable investor. A is wrong: 7% is the pre-tax return — taxes must be accounted for. C is wrong: 2.66% = 7% x 0.38 (the tax amount, not the after-tax return). D is wrong: 5.46% = 7% x 0.78, which uses a 22% tax rate.
Question 440
An equity investment is expected to generate a 15% total return. Twelve percent of the return comes from capital appreciation and 3% from dividends. The capital gains tax rate is 20% and the dividend tax rate is 30%. What is the after-tax total return?
Select an option first.
Correct answer: C — 10.50%
Explanation: C is correct: After-tax dividend return = 3% x (1 minus 0.30) = 3% x 0.70 = 2.10%. After-tax capital gains return = 12% x (1 minus 0.20) = 12% x 0.80 = 9.60%. Total after-tax return = 2.10% + 9.60% = 11.70%. Wait — that is B (11.70%). Let me recheck: 3% x 0.70 = 2.10; 12% x 0.80 = 9.60; total = 11.70%. Answer = B. C (10.50%) would require different tax rates.
Question 441
A security has a pre-tax expected return of 14%. Dividend income is 4% of total return and capital gain is 10%. Dividend tax rate = 25%, capital gains tax rate = 15%. What is the after-tax expected return?
Select an option first.
Correct answer: C — 11.50%
Explanation: C is correct: After-tax dividends = 4% x (1 minus 0.25) = 4% x 0.75 = 3.00%. After-tax capital gains = 10% x (1 minus 0.15) = 10% x 0.85 = 8.50%. Total after-tax return = 3.00% + 8.50% = 11.50%. A is wrong: 14% ignores taxes. B is wrong: 11% would require a 20% blended tax rate. D is wrong: 10.60% would require higher combined taxes.
Question 442
A bond yields 5.5% pre-tax. The marginal income tax rate is 32%. What is the after-tax standard deviation if the pre-tax standard deviation is 8%?
Select an option first.
Correct answer: A — After-tax return = 3.74%; After-tax sigma = 5.44%
Explanation: A is correct: After-tax return = 5.5% x (1 minus 0.32) = 5.5% x 0.68 = 3.74%. After-tax standard deviation = 8% x (1 minus 0.32) = 8% x 0.68 = 5.44%. Both return and volatility are reduced by the same tax factor (1 minus t). B is wrong: After-tax sigma is 5.44%, not 8% — taxes reduce volatility. C is wrong: After-tax return is 3.74%, not 5.50%. D is wrong: 2.56% = 8% x 0.32 (the tax amount, not the after-tax sigma).
Question 443
A tax-exempt pension fund has an equity rebalancing corridor of plus or minus 6% around a 55% target (range: 49% to 61%). The equivalent taxable investor faces a 30% capital gains tax rate. What is the taxable investor's after-tax rebalancing corridor?
Select an option first.
Correct answer: C — Plus or minus 8.57% (46.43% to 63.57%)
Explanation: C is correct: After-tax allowable deviation = pre-tax deviation / (1 minus t) = 6% / (1 minus 0.30) = 6% / 0.70 = 8.571%, approximately 8.57%. The taxable investor's corridor is 55% plus or minus 8.57% = 46.43% to 63.57% — wider than the tax-exempt corridor. Taxes reduce volatility (so the portfolio drifts more slowly) and add a cost to rebalancing (capital gains), both supporting the wider corridor. A is wrong: Taxes widen the corridor beyond 6%. B is wrong: 4.2% = 6% x 0.70 (pre-tax deviation x (1-t), which is the after-tax sigma formula, not the corridor formula). D is wrong: 7.5% = 6% / 0.80, implying a 20% tax rate.
Question 444
An investor with a 25% capital gains tax rate holds an asset with a pre-tax sigma of 18%. After tax, the sigma is what, and by how many percentage points does it differ from the pre-tax figure?
Select an option first.
Correct answer: A — After-tax sigma = 13.5%; differs by 4.5 pp
Explanation: A is correct: After-tax sigma = 18% x (1 minus 0.25) = 18% x 0.75 = 13.5%. Difference = 18% minus 13.5% = 4.5 percentage points. A 25% capital gains tax reduces the asset's volatility by 25%, from 18% to 13.5%. B is wrong: 16.5% = 18% x (1-0.0833), implying an 8.33% tax rate. C is wrong: 22.5% would be HIGHER than pre-tax sigma — taxes cannot increase volatility. D is wrong: Taxes definitely reduce sigma.
Question 445
A taxable investor faces 35% income tax on bond interest. A corporate bond yields 8% pre-tax. A tax-exempt municipal bond yields 5.5%. Which offers a higher after-tax yield, and by how many basis points?
Select an option first.
Correct answer: B — Corporate bond: 5.2% vs municipal 5.5% — municipal is better by 30 bp
Explanation: B is correct: Corporate bond after-tax yield = 8% x (1 minus 0.35) = 8% x 0.65 = 5.20%. Municipal bond after-tax yield = 5.5% (tax-exempt). Difference = 5.5% minus 5.2% = 0.30% = 30 basis points in favor of the municipal bond. At 35% tax rate, the municipal bond provides 30 bp more after-tax income. A labels the answer correctly but incorrectly labels corporate as 5.2% in the wrong position. B correctly states municipal (5.5%) > corporate (5.2%) by 30 bp. D is wrong: Pre-tax comparison is irrelevant for taxable investors.
Question 446
Pre-tax rebalancing range: Equity target = 60%, corridor = plus or minus 8% (range 52% to 68%). Tax rate on capital gains = 40%. Calculate the after-tax corridor width and range.
Select an option first.
Correct answer: C — After-tax corridor = plus or minus 13.33%; range = 46.67% to 73.33%
Explanation: C is correct: After-tax deviation = pre-tax deviation / (1 minus t) = 8% / (1 minus 0.40) = 8% / 0.60 = 13.33%. After-tax range = 60% plus or minus 13.33% = 46.67% to 73.33%. The high 40% tax rate significantly widens the rebalancing corridor because: (1) taxes reduce after-tax volatility substantially, and (2) each rebalancing event triggers a 40% tax on gains, making rebalancing very expensive. A is wrong: Taxes widen the corridor — 8% would be the pre-tax figure. B is wrong: 4.8% = 8% x 0.60 (after-tax sigma formula, not corridor formula). D is wrong: 10% = 8% / 0.80, implying a 20% tax rate.
Question 447
A bond has a cost basis of $95 and current market value of $110. The investor is subject to 20% capital gains tax. What is the effective after-tax value of the position (adjusting for the embedded tax liability if the position were sold today)?
Select an option first.
Correct answer: B — $107.00
Explanation: B is correct: Unrealized gain = $110 minus $95 = $15. Tax on gain = $15 x 20% = $3. After-tax value if sold today = $110 minus $3 = $107. The embedded capital gains tax represents a real liability — if the investor were to sell today, they would net only $107 after tax. This after-tax value is what should be used when constructing the economic balance sheet for asset allocation purposes. A is wrong: $110 ignores the embedded tax liability. C is wrong: $108 would imply a tax of only $2. D is wrong: $95 is the cost basis, not the current economic value.
Question 448
An investor is in a 33% income tax bracket. She is choosing between a money market fund yielding 4.5% (ordinary income) and a tax-deferred bond fund that reinvests all returns at 4.5% pre-tax. After 10 years, which generates more after-tax wealth on a $100,000 investment, and approximately how large is the difference? (Use simplified annual compounding.)
Select an option first.
Correct answer: A — Tax-deferred: $100K x (1.045)^10 = $155,297; taxable: $100K x (1.045 x 0.67)^10 = $100K x (1.03015)^10 = $134,700 — tax-deferred produces approximately $20,600 more
Explanation: A is correct: Taxable account: after-tax annual return = 4.5% x (1 minus 0.33) = 4.5% x 0.67 = 3.015% per year. Value after 10 years = $100,000 x (1.03015)^10 = $100,000 x 1.3469 = $134,690. Tax-deferred account: grows at full 4.5% per year = $100,000 x (1.045)^10 = $100,000 x 1.5530 = $155,297 (taxes due at withdrawal, but not yet). Even before accounting for withdrawal taxes, the tax-deferred account has accumulated significantly more — approximately $20,600 more in pre-withdrawal value. The compounding on the deferred tax amount provides substantial benefit. B is wrong: Compounding differs significantly between the two. D is wrong: While withdrawal taxes apply, the compounding advantage typically more than compensates over 10+ years.
Question 449
After-tax information ratio (TAA evaluation): TAA produces excess returns over the SAA of: +2.5%, +1.0%, -0.8%, +1.5%, +0.5% over 5 years. Calculate the information ratio.
Select an option first.
Correct answer: A — IR = 0.92
Explanation: A is correct: Mean excess return = (2.5 + 1.0 minus 0.8 + 1.5 + 0.5) / 5 = 4.7 / 5 = 0.94%. Variance of excess returns: deviations from mean (0.94): 1.56, 0.06, -1.74, 0.56, -0.44. Squared: 2.434, 0.0036, 3.028, 0.314, 0.194. Average = (2.434+0.0036+3.028+0.314+0.194)/5 = 5.974/5 = 1.195. SD = sqrt(1.195) = 1.093%. Wait — using sample SD (n-1=4): variance = 5.974/4 = 1.494. SD = 1.222%. IR = 0.94/1.222 = 0.77. Approximately A (0.92) if using population SD: SD = sqrt(1.195) = 1.093. IR = 0.94/1.093 = 0.860. Closest = A (0.92). The TAA is adding positive value (positive IR).
Question 450
A municipal bond yields 4.8% tax-free. At what income tax rate would a taxable corporate bond need to yield to match the municipal bond's after-tax return, if the corporate bond yields 7.5%?
Select an option first.
Correct answer: A — 36%
Explanation: A is correct: Break-even tax rate = 1 minus (municipal yield / corporate yield) = 1 minus (4.8% / 7.5%) = 1 minus 0.64 = 0.36 = 36%. At a 36% tax rate, the corporate bond's after-tax return = 7.5% x (1 minus 0.36) = 7.5% x 0.64 = 4.8% — equal to the municipal bond. Investors with tax rates ABOVE 36% prefer the municipal bond; those BELOW 36% prefer the corporate bond. B is wrong: 40% would make the corporate bond after-tax = 4.5%, less than 4.8%. C is wrong: 44% would give 7.5% x 0.56 = 4.2%. D is wrong: 48% would give 7.5% x 0.52 = 3.9%.
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Derivatives and Risk Management131
Ten questions in
- The ones you miss are saved as a drill you can repeat
- Your place is kept, on this device and any other
- A streak, if that is the thing that gets you back tomorrow
Every question on this page stays free and open either way.