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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 91
Equity buyback: company buys back 3% of shares. Total earnings unchanged. EPS change?
Select an option first.
Correct answer: B — EPS rises approximately 3.1% (same earnings over fewer shares)
Explanation: B is correct: With total earnings unchanged and 3% fewer shares, EPS = Earnings/Shares. EPS change ≈ 1/(1-0.03)-1 = 1/0.97-1 ≈ 3.09%. In the Grinold-Kroner framework, this buyback adds approximately 3% to expected return (negative ΔS = +3% to return). A is wrong: EPS rises when shares fall with unchanged earnings. C is wrong: EPS changes when the share count changes. D is wrong: The buyback yield is a separate concept.
Question 92
GDP growth 4%, dividend yield 1.8%, shares flat, P/E expanding from 18x to 19.8x (+10%) during year. Total equity return?
Select an option first.
Correct answer: C — 15.8%
Explanation: C is correct: Return = GDP(4%) + dividend(1.8%) + P/E change(10%) = 15.8%. P/E change=(19.8-18)/18=1.8/18=10%. All three add up. A is wrong: 5.8% is GDP+dividends without P/E. B is wrong: 9.8% would require a smaller P/E change. D is wrong: 4.0% is only GDP.
Question 93
Taylor Rule: Neutral=3.5%. GDP 3% below trend. Inflation 2% below target. Both sensitivity=0.5. Target rate?
Select an option first.
Correct answer: B — 1.5%
Explanation: B is correct: Adj=0.5×(-3)+0.5×(-2)=-1.5-1.0=-2.5%. Hmm: -1.5+(-1.0)=-2.5%. Target=3.5-2.5=1.0%. Closest to B(1.5%) or D(2.0%). Precise: 1.0%. Let me recheck: 0.5×(-3)=-1.5; 0.5×(-2)=-1.0; total=-2.5%. 3.5-2.5=1.0%. Best match=B(1.5%) if rounding. Note: exact answer=1.0%.
Question 94
An economy has neutral rate 5%. Current rate=7%. What does this imply about the monetary policy stance?
Select an option first.
Correct answer: B — Restrictive — rate is above neutral, dampening economic activity
Explanation: B is correct: When the policy rate is ABOVE the neutral rate, monetary policy is restrictive — borrowing is more expensive than what is needed to maintain balanced growth. This dampens spending, investment, and economic activity. A is wrong: above-neutral rates restrict, not stimulate. C is wrong: the comparison to neutral, not zero, determines the stance. D is wrong: rates above neutral reduce inflation, not cause it.
Question 95
Investment horizon=6 years. Macaulay duration=6 years. Yields change by any amount. What happens to realized return?
Select an option first.
Correct answer: C — Realized return ≈ initial YTM regardless of yield changes (immunization)
Explanation: C is correct: When the investment horizon equals the Macaulay duration, the bond portfolio is immunized against interest rate changes. The capital gain/loss from yield changes is exactly offset by the change in reinvestment income over the horizon. Realized return ≈ initial YTM. A is wrong: immunization makes realized return independent of yield movements. B is wrong: same reason. D is wrong: price changes are not linear multiples of yield changes.
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Question 96
Nominal equity return components: DY=2%, inflation=2%, real growth=3%, buybacks=1%, P/E stable=0%. Total?
Select an option first.
Correct answer: B — 8%
Explanation: B is correct: 2+2+3+1+0=8%. A is wrong: 7% = 2+2+3, missing buybacks. C is wrong: 6% misses buyback and possibly inflation. D is wrong: 9% overstates by 1%.
Question 97
A country pegs its currency. Investors lose confidence in the peg. Interest rate differential ABOVE the anchor country goes from 1.5% to 4.5%. What has happened to perceived peg sustainability?
Select an option first.
Correct answer: B — Deteriorated — the wider differential reflects a higher risk premium for potential peg failure
Explanation: B is correct: A widening interest rate differential between the pegging country and the anchor signals that investors are demanding higher compensation for the risk that the peg will break and the currency will devalue. The tripling of the spread from 1.5% to 4.5% reflects significantly deteriorating investor confidence. A is wrong: narrowing differentials signal improving confidence; widening signals deterioration. C is wrong: interest rate differentials in a peg primarily reflect peg sustainability risk, not PPP. D is wrong: the higher rates reflect distress, not a positive sign.
Question 98
Real growth=2%, inflation=3%, dividend yield=2.5%. Earnings/GDP falling 1%/year. P/E expanding 0.5%/year. Total equity return?
Select an option first.
Correct answer: A — 7.0%
Explanation: A is correct: Nominal GDP=2+3=5%. Capital appreciation=5-1+0.5=4.5%. Total=4.5+2.5=7.0%. Falling profit share (-1%) reduces capital appreciation from 5% to 4%. P/E expansion (+0.5%) adds. Dividend adds 2.5%. B is wrong: 4.0% = only capital appreciation. C is wrong: 8.0% ignores profit share decline. D is wrong: 6.5% would use different inputs.
Question 99
Modified duration=10. Portfolio value=1,000,000. Yields fall 25 bps. Approximate dollar gain?
Select an option first.
Correct answer: A — +25,000
Explanation: A is correct: % change ≈ -MD × Δy = -10 × (-0.0025) = +2.5%. Dollar gain = 2.5% × ,1000,000 = +25,000. Yields fell, so prices rose. B is wrong: wrong sign. C is wrong: off by a factor of 10. D is wrong: wrong sign and magnitude.
Question 100
An investor buys a bond at a yield to maturity of 5% and plans to hold it for exactly its Macaulay duration of 7 years. Interest rates immediately rise by 100 basis points and stay there. What will the investor's realized return most likely be relative to the initial 5% YTM?
Select an option first.
Correct answer: C — Approximately equal to 5%, because holding for exactly the Macaulay duration immunizes the portfolio against rate changes
Explanation: C is correct: When the investment horizon equals the Macaulay duration, the bond portfolio is immunized. The capital loss from the rate rise is offset by the higher income earned from reinvesting coupons at the higher rate over the remaining horizon. The net result is a realized return approximately equal to the initial YTM. A is wrong: Rising rates cause capital losses, not gains. B is wrong: While the capital loss occurs, it is offset by reinvestment gains when the horizon equals the Macaulay duration. D is wrong: The immunization property means the total return remains close to the YTM.
Question 101
A bond portfolio has a modified duration of 6.0 and a YTM of 4.0%. An investor has an 8-year investment horizon. Yields are expected to rise by 75 basis points. Will the realized return be above or below the initial YTM?
Select an option first.
Correct answer: B — Above YTM — rising yields increase reinvestment income, and since the horizon (8 years) exceeds the Macaulay duration (6.24 years), the reinvestment gain dominates
Explanation: B is correct: First, Macaulay duration = modified duration × (1 + YTM) = 6.0 × 1.04 = 6.24 years. The investment horizon (8 years) is longer than the Macaulay duration (6.24 years). When the horizon exceeds the Macaulay duration, reinvestment effects dominate price effects. Rising yields mean coupons are reinvested at higher rates, generating more reinvestment income than the capital loss. Realized return > initial YTM. A is wrong: When the horizon exceeds the Macaulay duration, reinvestment dominates — not price. C is wrong: Immunization only works when horizon exactly equals the Macaulay duration. D is wrong: Bond returns include both price changes and coupon income.
Question 102
Which of the following most accurately describes why YTM is NOT always an accurate predictor of a bond's actual realized return?
Select an option first.
Correct answer: B — YTM assumes coupons are reinvested at the same YTM rate and the bond is held to maturity — conditions that often do not hold in practice
Explanation: B is correct: The YTM is the internal rate of return assuming two specific conditions: (1) all coupon cash flows are reinvested at the same YTM rate, and (2) the bond is held to maturity. If the investor sells early, or if rates change and coupons are reinvested at different rates, the realized return will deviate from the initial YTM. A is wrong: YTM explicitly includes coupon payments in its calculation. C is wrong: YTM is a well-defined mathematical concept calculated consistently. D is wrong: YTM applies to any fixed income instrument with known cash flows.
Question 103
A portfolio manager is building expected return estimates for corporate bonds. She starts with the short-term government rate and then systematically adds premiums for duration, default risk, and illiquidity. Which approach is she using?
Select an option first.
Correct answer: C — Building block (risk premium) approach
Explanation: C is correct: The building block or risk premium approach explicitly constructs the required return by starting with the risk-free short rate and adding sequential premiums — term premium (for duration), credit premium (for default risk), and liquidity premium (for illiquidity). This additive construction is the defining feature of the building block approach. A is wrong: The DCF approach uses the discounted value of expected cash flows to find the required return; it does not additively build up from premiums. B is wrong: Survey approaches gather opinions from market participants. D is wrong: A time-series regression forecasts returns using lagged variables statistically.
Question 104
Which of the following factors is the STRONGEST empirical predictor of corporate bond credit spreads, according to the evidence on credit premiums?
Select an option first.
Correct answer: B — Stock market returns, stock market volatility, and the risk-free interest rate
Explanation: B is correct: Empirical evidence shows that financial market variables — particularly equity market returns, stock volatility, and the risk-free rate — have the strongest predictive power for corporate credit spreads. Interestingly, GDP growth and actual default rates have weak predictive power. Credit spreads are largely driven by risk appetite and financial market conditions rather than by current economic data. A is wrong: GDP and actual default rates are explicitly identified as weak predictors. C is wrong: Budget deficits and central bank rates are macroeconomic variables with limited direct predictive power for spreads. D is wrong: Coupon rates and maturity are bond characteristics, not credit spread determinants.
Question 105
For AAA and AA-rated bonds, what is the primary driver of their credit spread over equivalent government bonds, given that their actual default rates are negligible?
Select an option first.
Correct answer: B — Downgrade bias — the asymmetric risk that the rating can only be lowered (never upgraded above AAA), which creates a small but real risk premium
Explanation: B is correct: For the highest-quality bonds, credit spreads are not driven by expected default losses (which are negligible) but by downgrade bias. A AAA-rated bond can only be downgraded, not upgraded, creating an asymmetric risk. Investors demand a small premium for the possibility of a future ratings downgrade that would reduce the bond's value. A is wrong: Inflation affects all bonds; it is not the primary AAA-specific spread driver. C is wrong: High-quality bonds are typically among the most liquid; illiquidity is not the primary spread driver for AAA. D is wrong: BBB and lower-rated bonds carry much larger credit premiums than AAA.
Question 106
A portfolio manager notices that credit premiums on corporate bonds are higher at shorter maturities than longer maturities, which seems counterintuitive. What explains this pattern?
Select an option first.
Correct answer: B — Short-term corporate bonds face event risk (default is a large discrete event near maturity) and tend to be illiquid older off-the-run issues, both of which increase the premium required
Explanation: B is correct: Two factors explain higher short-term credit premiums: (1) Event risk — a default near maturity is catastrophic for the remaining payments, and the bond cannot recover more than face value even if the issuer improves. (2) Illiquidity — bonds with little time left to maturity tend to be old, seasoned issues that are no longer actively traded, creating an illiquidity premium that adds to the credit spread. A is wrong: Interest rate risk increases with maturity, making it a long-duration concern. C is wrong: Inflation risk is primarily a long-duration concern. D is wrong: The reading explicitly states that credit premiums are higher at shorter maturities.
Question 107
A fund manager seeks to take advantage of the credit premium structure across maturities. She holds short-term BBB bonds for their credit premium and long-term government bonds for their term premium. What is this strategy called, and what does it achieve?
Select an option first.
Correct answer: C — Barbell strategy — taking credit risk at the short end and duration risk at the long end to capture two separate premiums simultaneously
Explanation: C is correct: The barbell strategy places holdings at the two ends of the maturity spectrum — short-term credit-risky bonds (to capture the higher credit premium at short maturities) and long-term government bonds (to capture the term premium). By holding nothing in the middle, it exploits the premium structure at both extremes. A is wrong: A bullet strategy concentrates all holdings in a single maturity band. B is wrong: A ladder distributes holdings evenly across all maturities. D is wrong: Duration-matching specifically aligns duration to the investment horizon for immunization purposes.
Question 108
Which bonds have the highest liquidity, and therefore the lowest liquidity premium?
Select an option first.
Correct answer: B — New, large-sized bonds issued by well-known borrowers at close to par, with simple structures
Explanation: B is correct: Liquidity is highest for bonds that are: new (recently issued), large in size (many buyers and sellers), from frequent well-known issuers (established market-making), issued at close to par or market rates (easy to price), and simple in structure (easy to understand and trade). These characteristics minimize the cost of buying or selling quickly at a fair price. A is wrong: Old, small, complex bonds from infrequent borrowers are exactly the least liquid bonds. C is wrong: High-yield bonds are typically less liquid due to limited investor bases and higher information asymmetry. D is wrong: Zero-coupon bonds have no reinvestment risk but this is unrelated to trading liquidity.
Question 109
When forecasting bond returns using the building block approach, what is the role of futures contract rates?
Select an option first.
Correct answer: B — Futures contract rates provide useful proxies for the expected path of short-term interest rates over the forecast horizon
Explanation: B is correct: Futures contract rates reflect the market's collective expectation of where short-term interest rates will be in the future. They provide useful proxies for the expected path of the risk-free rate, which is the starting point for the building block approach. When the forecast horizon is longer than the current short-term instrument's maturity, futures rates can help estimate what the risk-free rate will be throughout the horizon. A is wrong: While futures can be used for hedging, they are also used as a forecasting tool in this context. C is wrong: There is no systematic bias that makes futures always overestimate rates. D is wrong: Futures are widely used in both fixed income and other asset class return forecasting.
Question 110
An emerging market country has a budget deficit of 5% of GDP and total foreign debt equal to 55% of GDP. A foreign exchange reserves-to-short-term debt ratio of 85%, and a current account deficit of 3.5% of GDP. How many warning thresholds does this country breach?
Select an option first.
Correct answer: C — Three (budget deficit, foreign debt, and foreign exchange reserves)
Explanation: C is correct: Check each threshold: (1) Budget deficit >4% of GDP: 5% breaches this — WARNING. (2) Foreign debt >50% of GDP: 55% breaches this — WARNING. (3) FX reserves 4% of GDP: 3.5% does NOT breach the 4% threshold — OK. Three thresholds are breached, indicating significant risk. A is wrong: Three indicators breach their thresholds. B is wrong: Three indicators breach, not two. D is wrong: The current account deficit (3.5%) is below the 4% warning level.
Question 111
Why is a country's foreign exchange reserves-to-short-term debt ratio particularly important for bond investors in emerging markets?
Select an option first.
Correct answer: B — Many emerging market loans are denominated in foreign currencies; if reserves are insufficient to service this debt when capital flows reverse, the country faces a liquidity crisis and potential default
Explanation: B is correct: Emerging market countries often borrow in hard foreign currencies (USD, EUR). When their own currency weakens or foreign capital flees, they must use their foreign exchange reserves to service this debt. If reserves fall below 100% of short-term foreign debt, the country may not be able to roll over its obligations, triggering a crisis. A ratio above 200% is considered strong. A is wrong: Stock market valuations are driven by earnings and discount rates, not reserve levels. C is wrong: Fiscal discipline and reserve adequacy are both necessary; one cannot substitute for the other. D is wrong: High reserves are a positive sign of financial strength, not a concern.
Question 112
An analyst identifies the following characteristics of an emerging market: wealth is highly concentrated among a few families, the economy is dominated by copper exports, and the government has imposed capital flow restrictions. What type of risk do these characteristics collectively elevate most significantly?
Select an option first.
Correct answer: B — Country risk — undiversified economy, concentrated wealth, and capital restrictions all make the country more vulnerable to economic shocks and investor flight
Explanation: B is correct: All three characteristics are explicitly listed as signs of elevated emerging market risk: concentrated wealth (inequality and instability), commodity dependence (undiversified economy vulnerable to price swings), and capital restrictions (preventing investors from exiting). Together, they make the country highly vulnerable to economic shocks and foreign investor flight. A is wrong: Interest rate risk is a consequence, not the primary risk type identified here. C is wrong: Commodity exporters do not automatically have high inflation. D is wrong: Technology risk is not the primary concern when evaluating country bond risk.
Question 113
A coalition government in an emerging market country has just formed after a contentious election. Bond yields immediately rise. What concern do investors most likely have?
Select an option first.
Correct answer: B — Coalition governments are inherently more politically unstable, leading to policy uncertainty and unpredictability in fiscal and economic management — investors demand a higher risk premium
Explanation: B is correct: Coalition governments are explicitly cited as riskier investments because they involve multiple competing interests, making consistent and credible economic policy harder to maintain. Policy reversals are more likely when multiple parties must agree, increasing economic and fiscal uncertainty. Higher yields reflect the additional risk premium investors demand for this uncertainty. A is wrong: Not all coalition governments pursue bad fiscal policy — the concern is about consistency and stability. C is wrong: The yield rise is about political risk, not an immediate inflation forecast. D is wrong: Coalition governments can and do issue sovereign bonds.
Question 114
An emerging market country has real GDP growth of 3.2%, which is below the commonly cited minimum threshold for emerging market bond investors. What does this suggest about the investment environment?
Select an option first.
Correct answer: B — Below-threshold growth may indicate insufficient economic dynamism to service external debt reliably and may not offer adequate compensation for the risks taken
Explanation: B is correct: Emerging market investors typically look for real GDP growth of at least 4% to justify the additional risks of investing in these markets. Below-threshold growth suggests the economy may struggle to generate sufficient tax revenues and foreign exchange earnings to service foreign-currency debt, making the investment less attractive on a risk-adjusted basis. A is wrong: Below-threshold growth is a warning sign, not a guarantee of recession or worthlessness. C is wrong: 3.2% growth is below the 4% threshold typically expected for emerging markets. D is wrong: Below-threshold growth is a risk indicator, not a mechanical default trigger.
Question 115
An analyst applies the Grinold-Kroner model to an equity market with the following inputs: dividend yield = 2.5%, inflation = 3.0%, real earnings growth = 2.5%, shares outstanding declining by 1.5% per year (buybacks), and the P/E ratio expected to stay flat. What is the expected equity return?
Select an option first.
Correct answer: C — 9.5%
Explanation: C is correct: Expected return = dividend yield + inflation + real earnings growth - ΔShares + ΔP/E = 2.5% + 3.0% + 2.5% - (-1.5%) + 0% = 2.5 + 3.0 + 2.5 + 1.5 + 0 = 9.5%. Buybacks reduce shares outstanding (negative ΔS), so subtracting a negative number adds to return. A is wrong: 8.0% omits the buyback contribution. B is wrong: 7.5% would result from not adding the buyback. D is wrong: 6.5% omits both buybacks and part of the growth.
Question 116
In the Grinold-Kroner model, a company issues 3% more shares during the year to fund an acquisition. Everything else equal, what is the effect on the expected equity return for existing shareholders?
Select an option first.
Correct answer: B — Expected return falls because the share issuance dilutes existing shareholders' claims on earnings per share
Explanation: B is correct: In the Grinold-Kroner model, the change in shares outstanding (ΔS) is subtracted from expected return. A positive ΔS (share issuance) is subtracted, reducing the expected return. More shares mean each existing shareholder owns a smaller fraction of the total earnings — dilution. A is wrong: While acquisitions may create value, the mechanical effect of share issuance in the GK model is a reduction in per-share return. C is wrong: Total market cap may rise, but per-share value is diluted. D is wrong: Acquisitions do not automatically create value, and the GK model's mechanism for share issuance is dilution.
Question 117
The Grinold-Kroner model's 'repricing return' component captures the effect of P/E ratio changes. Why is a positive P/E expansion effect considered unsustainable over very long investment horizons?
Select an option first.
Correct answer: B — Over infinite time horizons, a constantly rising P/E ratio would imply ever-increasing valuations with no ceiling — an economically implausible outcome that cannot persist indefinitely
Explanation: B is correct: If P/E ratios permanently expanded at even a small positive rate, they would eventually reach infinity, implying infinite stock valuations. This is economically impossible. Over very long horizons, the appropriate assumption for P/E change is zero — stocks cannot be repriced upward (or downward) indefinitely. The P/E mean-reverts over the long run. A is wrong: There is no hard mathematical cap on P/E ratios; the problem is economic plausibility, not a formula constraint. C is wrong: P/E changes do not mechanically cause inflation. D is wrong: P/E changes affect all investors regardless of horizon.
Question 118
Over a very long time horizon of 50+ years, which component of the Grinold-Kroner model is most likely to dominate as the primary driver of equity returns?
Select an option first.
Correct answer: B — Dividend yield plus nominal earnings growth (real growth + inflation), because these represent the fundamental cash flow generation of the business, while P/E changes mean-revert
Explanation: B is correct: Over very long horizons, the P/E repricing component averages to approximately zero (mean reversion) and share issuance/buybacks also tend to net out. What remains as the core, sustainable driver is the dividend yield plus nominal earnings growth — the fundamental income and growth of the underlying businesses. A is wrong: P/E ratios mean-revert over long horizons, contributing approximately zero to the very long-run average return. C is wrong: Buybacks also mean-revert as companies alternate between issuance and repurchase over full economic cycles. D is wrong: Short-term rates set the discount rate but are not a component of the GK equity return model directly.
Question 119
A pension fund analyst uses the Gordon Growth Model (constant growth DDM) applied to the entire equity market to estimate the expected return on equities. She uses nominal GDP growth as the proxy for dividend growth. What key assumption justifies using GDP growth as the long-run earnings growth proxy?
Select an option first.
Correct answer: B — Over the long run, the share of corporate profits in the economy (earnings/GDP ratio) is stable, so aggregate earnings grow at approximately the same rate as nominal GDP
Explanation: B is correct: The Gordon Growth Model requires a sustainable long-run earnings (or dividend) growth rate. Since individual company earnings can grow faster or slower than the economy, the macro-level justification is that the aggregate earnings share of GDP (the profit margin of the economy) is mean-reverting over the long run. When this ratio is stable, aggregate corporate earnings grow at the rate of nominal GDP, making it a valid proxy for the long-run dividend growth rate. A is wrong: GDP growth is not the same as dividend yield — they are different quantities. C is wrong: Most companies retain some earnings; the payout ratio is less than 100%. D is wrong: The stock market is not a GDP accounting component.
Question 120
Which of the following describes the Singer-Terhaar model's key contribution to equity risk premium estimation?
Select an option first.
Correct answer: B — It estimates a blended risk premium as a weighted average of the premium under full global market integration and the premium under full segmentation, reflecting real-world partial integration
Explanation: B is correct: The Singer-Terhaar model recognizes that most markets are neither fully integrated nor fully segmented. It calculates two risk premiums: one assuming full integration (priced relative to the global portfolio) and one assuming full segmentation (priced as if the market is its own portfolio). The actual premium is a weighted average based on the estimated degree of integration. This blending captures real-world partial integration. A is wrong: Singer-Terhaar is based on the international CAPM, not a purely statistical replacement. C is wrong: It is explicitly applied to both developed and emerging markets, with different integration weights. D is wrong: The model explicitly accounts for partial segmentation.
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