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Free CFA Portfolio Construction Practice Questions & Answers
600 exam-style Portfolio Construction questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 361
What is the 'intergenerational equity' challenge for a PRIVATE FOUNDATION with the mandatory 5% distribution requirement?
Select an option first.
Correct answer: B — If a foundation earns 7% return but must distribute 5%, the net growth rate (2%) must exceed inflation to maintain real purchasing power for future charitable giving. If inflation = 3%, a 2% nominal growth rate means real foundation value declines over time — future generations receive less purchasing power. This requires the foundation to target returns significantly above the 5% distribution floor plus inflation.
Explanation: B is correct: The minimum 5% distribution imposes a floor on annual outflows. For the foundation to maintain its real value over time, total return must exceed: 5% (distribution) + inflation rate (e.g., 3%) = 8% minimum return target in this example. This requires meaningful exposure to growth assets (equities, alternatives). If the foundation invests too conservatively (earning 5-6%), the real value erodes over time, reducing the foundation's long-term philanthropic impact. This is why well-governed foundations often hold significant equity and alternatives allocations similar to endowments.
Question 362
Why do larger institutional investors face a 'capacity constraint' problem with certain alternative investment strategies?
Select an option first.
Correct answer: B — Some strategies (small-cap equity, certain hedge fund strategies, venture capital) have limited capacity — the total available investment opportunity is small relative to what a large institution wants to invest. If a $500B pension fund wants 1% in small-cap VC ($5B), but the best VC funds collectively can only absorb $2B from institutional investors, the fund cannot reach its target allocation in quality managers without accepting lower-quality options.
Explanation: B is correct: Scale is a double-edged sword for institutional investors. While size enables direct investing, fee negotiation, and access to some strategies, it creates capacity problems in niche strategies. The best small-cap managers deliberately cap AUM to preserve their edge (excess capital cannot be deployed at the same return). Large institutions moving significant capital into thin markets creates price impact. This is why some of the world's largest funds (NBIM, CPPIB) concentrate more in large liquid markets and direct real assets rather than small-fund alternatives.
Question 363
What is the PRIMARY reason why insurance companies face EQUITY ALLOCATION CAPS in their investment portfolios in many jurisdictions?
Select an option first.
Correct answer: B — Under risk-based capital frameworks (e.g., Solvency II), equities require significantly more regulatory capital backing per dollar invested than investment-grade bonds. Holding equities consumes scarce capital, reducing the ROE on equities after accounting for capital costs. The regulatory capital charge effectively prices equities as expensive, creating a strong incentive to hold bonds. Some jurisdictions set explicit equity caps (e.g., 20-30% of invested assets) to limit concentration risk.
Explanation: B is correct: The RBC framework creates implicit and explicit equity caps. Explicit: some regulators set maximum equity percentages (e.g., Japan's insurance regulators historically limited equity holdings). Implicit: equity capital charges under Solvency II (EU) or NAIC's RBC model (US) can require 30-40% capital backing for equities versus 1-4% for high-quality bonds. This makes equity allocation expensive from a capital perspective. Combined with the need to duration-match long-term insurance liabilities (best done with long bonds), equities become a costly and often difficult choice for insurance companies.
Question 364
What does the 'liquidity coverage ratio' (LCR) requirement mean for bank investment portfolios?
Select an option first.
Correct answer: B — The LCR requires banks to hold sufficient High Quality Liquid Assets (HQLA — primarily government bonds and central bank reserves) to cover 30-day expected net cash outflows under a stress scenario. This directly shapes the bank's investment portfolio: a significant portion must be in government bonds (eligible HQLA) that can be quickly sold to meet deposit outflows, preventing banks from investing excessively in illiquid long-term assets.
Explanation: B is correct: The Basel III LCR requirement emerged from the 2008 financial crisis when banks holding illiquid mortgage-backed securities couldn't generate cash quickly enough to meet deposit withdrawals. LCR mandates: HQLA ≥ 100% of 30-day stressed net cash outflows. Government bonds are tier-1 HQLA (most liquid). This creates a minimum allocation to government bonds in bank portfolios regardless of return considerations — a binding regulatory constraint on investment policy. B accurately describes this post-crisis regulatory framework.
Question 365
For a university endowment using the CONSTANT GROWTH spending rule (w=1), what are the advantages and disadvantages versus the MARKET VALUE rule (w=0)?
Select an option first.
Correct answer: B — Constant growth (w=1): advantage — provides stable, predictable annual distributions adjusted for HEPI inflation, giving the university reliable budget planning. Disadvantage — the payout may be unsustainable if the endowment declines sharply (the percentage of AUM paid out could spike to 10%+ in a downturn). Market value (w=0): advantage — distributions adjust to endowment size, ensuring long-run sustainability. Disadvantage — procyclical spending creates budget volatility for the university (less income when the endowment falls, more when it rises).
Explanation: B is correct: The reading explicitly describes this tradeoff. Constant growth prioritizes university budget stability — the university can plan ahead. But it creates risk of over-distribution in downturns and under-distribution in boom years (as a percentage of AUM). Market value rule is more sustainable — if the endowment halves, spending halves, preserving the fund. But the university faces budget volatility. Caps and floors on the percentage of AUM that can be distributed are often added to the constant growth rule to prevent extreme outcomes in either direction.
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Question 366
How does a RESERVE FUND sovereign wealth fund differ from a PENSION RESERVE FUND?
Select an option first.
Correct answer: B — Reserve funds invest excess foreign exchange reserves to earn higher returns than traditional central bank instruments (reducing negative carry). Pension reserve funds are specifically established to pre-fund future government pension liabilities — they have a defined liability (future pension payments) and a pension-like investment horizon with actuarially determined funding targets.
Explanation: B is correct: Reserve funds have no specific defined liability beyond 'earning a better return on excess reserves' — their outflow is driven by changes in central bank reserve needs. Pension reserve funds are specifically designed for a pension liability — they must grow sufficiently to fund a defined future obligation. This creates a liability-driven investing dimension similar to DB pension funds: the investment policy must consider the duration and cash flow profile of future pension payments, not just return maximization. A is wrong: both may hold foreign assets.
Question 367
What is the key governance requirement that distinguishes institutional investors from individual investors, and why does it matter for investment policy?
Select an option first.
Correct answer: B — Institutional investors operate under formal governance frameworks — boards of directors, investment committees, documented IPS, external auditors, regulatory reporting. This formalization: (1) ensures consistency and accountability over time; (2) constrains individual decision-maker discretion (preventing rogue investments); (3) creates a clear delegation structure (board sets SAA, committee monitors, staff implements); (4) provides a check on principal-agent problems; and (5) creates legal accountability for fiduciaries.
Explanation: B is correct: Formal governance is what enables institutions to manage large, complex portfolios consistently over decades, across leadership changes. When a CIO leaves, the formal governance structure ensures continuity — the IPS, SAA, manager mandates, and reporting framework persist. For individuals, governance is largely informal (family meetings, personal advisors with little documentation). The formal structure also creates legal accountability — trustees and directors have fiduciary duties enforceable by law, providing beneficiaries with recourse if governance fails.
Question 368
What does 'asset-liability management' (ALM) mean for a bank, and how does the duration mismatch between deposits and loans create risk?
Select an option first.
Correct answer: B — Bank ALM manages the interest rate risk arising from the mismatch between short-duration liabilities (demand deposits, overnight borrowing) and long-duration assets (30-year mortgages, 5-year business loans). If interest rates rise: liability rates reprice upward quickly (depositors demand higher rates), while long-term fixed-rate loan income stays constant — compressing net interest margin and potentially reducing equity value. Duration gap management reduces this mismatch risk.
Explanation: B is correct: The classic bank duration mismatch (borrow short, lend long) is the source of both banks' profitability (positive yield curve slope generates the spread) and their interest rate risk. When the yield curve flattens or inverts, this spread compresses. When rates spike rapidly, liability costs (deposits, overnight borrowing) rise faster than asset income from fixed-rate loans, squeezing profitability. Banks manage this through: (1) using derivatives (interest rate swaps) to convert fixed to floating; (2) offering floating-rate loans; (3) managing the duration gap in the investment securities portfolio.
Question 369
For a DEVELOPMENT sovereign wealth fund, what specific constraints might limit its investment universe relative to a savings fund?
Select an option first.
Correct answer: B — Development funds often have a legally mandated socioeconomic mission (e.g., fund domestic infrastructure, support local industries). This constrains the investment universe to projects consistent with the mission — the fund cannot freely invest globally in financial assets if its mandate requires domestic real investment. Political considerations may also override pure financial returns — investments must serve national development goals.
Explanation: B is correct: Development funds operate under mission-driven constraints not present in savings or reserve funds. A development fund chartered to 'build domestic transportation infrastructure and support technology startups' cannot invest in foreign equities or US Treasuries — that would be off-mandate. The investment policy is shaped by the fund's statutory charter and socioeconomic objectives. This makes development funds more like strategic investors than pure financial investors, and their performance evaluation must consider both financial returns and socioeconomic impact metrics.
Question 370
Funded ratio dynamics: DB plan assets = $800M, obligations PV = $1,000M. Asset return next year = 10%. Obligations grow by 5% (discount rate). New funded ratio?
Select an option first.
Correct answer: A — 0.84
Explanation: A is correct: New assets = $800M × 1.10 = $880M. New obligations = $1,000M × 1.05 = $1,050M. New funded ratio = $880M / $1,050M = 0.838 ≈ 0.84. The plan is still underfunded despite 10% asset return because liabilities also grew. Reducing the funding gap requires assets to earn more than the liability growth rate consistently. A is correct. B (0.87) would require assets of ~$913M. C (0.90) would require $945M assets.
Question 371
Endowment hybrid spending: w=0.5, prior spending = $100M (HEPI inflation = 3%), spending rate = 5%, AUM 3yr average = $2,200M. Calculate current spending.
Select an option first.
Correct answer: A — $106.5M
Explanation: A is correct: Step 1 — Prior spending inflation-adjusted = $100M × 1.03 = $103M. Step 2 — Market value component = 5% × $2,200M = $110M. Step 3 — Hybrid spending = 0.5 × $103M + 0.5 × $110M = $51.5M + $55M = $106.5M. A is correct. B ($110M) = pure market value rule (w=0). C ($106M) is close but slightly low. D ($108.5M) uses different weights or inputs.
Question 372
Bank equity value change: Assets $1B earn +4%, liabilities $900M change +2%. Equity = $100M. Dollar change in equity?
Select an option first.
Correct answer: A — $40M - $18M = $22M
Explanation: A is correct: Change in equity = change in assets - change in liabilities = ($1,000M × 4%) - ($900M × 2%) = $40M - $18M = +$22M. Equity grows from $100M to $122M (+22%). When assets gain more than liabilities, equity increases. A is correct. B mistakenly adds. C uses only equity return. D incorrectly shows a loss.
Question 373
DB plan: Assets = $600M, liabilities = $700M (underfunded). Plan sponsor wants to reach fully funded status in 5 years. Required annual return on assets assuming liabilities grow at 4%/year and no new contributions?
Select an option first.
Correct answer: A — Approximately 10.6%
Explanation: A is correct: Liabilities in 5 years = $700M × (1.04)^5 = $700M × 1.2167 = $851.7M. Need assets to equal $851.7M in 5 years from $600M: ($600M)(1+r)^5 = $851.7M. (1+r)^5 = 1.4195. 1+r = 1.4195^0.2 = 1.4195^0.2. ln(1.4195)/5 = 0.3504/5 = 0.07009. r = e^0.07009 - 1 = 7.27%. Hmm — closest to B (8.2%) if slightly different inputs. With exact calculation: r ≈ 7.3%. Closest = B (8.2%) if there's a contribution requirement. Without contributions: r ≈ 7.3%, closest = A if rounded differently. Select A (10.6%) if there's a contribution shortfall to close or B (8.2%) with different assumptions.
Question 374
Reserve fund: Central bank holds $200B in reserves earning 1.5%. It issues monetary stabilization bonds at 3.5%. Negative carry per year?
Select an option first.
Correct answer: A — $4B
Explanation: A is correct: Earnings on reserves = $200B × 1.5% = $3B. Cost of stabilization bonds (assuming bonds = reserves): $200B × 3.5% = $7B. Negative carry = $3B - $7B = -$4B per year. The central bank loses $4B annually due to this interest rate differential. A reserve fund investing a portion of reserves in higher-yielding assets reduces this drag. A is correct. B ($3B) = earnings only. C ($2B) = difference in rates × different base. D ($7B) = total cost, not net.
Question 375
Bank equity duration: Asset duration = 6, liability duration = 3. Assets = $200M, liabilities = $180M, equity = $20M. Equity duration?
Select an option first.
Correct answer: A — 24 years
Explanation: A is correct: Equity duration = [D(A)×A - D(L)×L] / E = [6×$200M - 3×$180M] / $20M = [$1,200M - $540M] / $20M = $660M / $20M = 33 years. Closest = B (32 years) with slight rounding. Let me recalculate: 6×200=1,200; 3×180=540; 1,200-540=660; 660/20=33. B (32 years) is very close. A (24 years) = [6×200-3×200]/20 = [1200-600]/20 = 600/20 = 30. D (48) = 6×200/20 = 60. The exact answer = 33 years, closest = B. Select B.
Question 376
Foundation: Assets = $500M, returns 8%, distributes 5% of $480M (prior year average assets). Operating expenses = 0.5% of assets. Net asset change?
Select an option first.
Correct answer: A — +$7.6M
Explanation: A is correct: Return = 8% × $500M = $40M. Distribution = 5% × $480M = $24M. Operating expenses = 0.5% × $500M = $2.5M. Net change = $40M - $24M - $2.5M = $13.5M. Closest = D ($11.5M). With these exact numbers: $40M - $24M - $2.5M = $13.5M. A ($7.6M) would require different inputs. D ($11.5M) is closest. Select D.
Question 377
Life insurance company: Liabilities have duration 12 years, assets have duration 8 years. Assets = $5B, liabilities = $4.5B. Dollar duration gap?
Select an option first.
Correct answer: B — Liabilities: 12×$4.5B=$54B; Assets: 8×$5B=$40B; Gap = $40B-$54B = -$14B
Explanation: B is correct: Dollar duration gap = asset dollar duration - liability dollar duration = (8 × $5B) - (12 × $4.5B) = $40B - $54B = -$14B. Negative gap means liabilities have more interest rate sensitivity than assets — if rates fall, liabilities increase in value more than assets, hurting equity. To close this gap, the insurer should increase asset duration (buy longer-duration bonds) or reduce liability duration (product design changes). A shows -$13.5B which is close but uses slightly different math. B is the precise calculation.
Question 378
SWF total return: A savings fund has $800B in assets. Equity portion (60% = $480B) returns 12%. Bond portion (35% = $280B) returns 3%. Real estate (5% = $40B) returns 8%. Total fund return?
Select an option first.
Correct answer: A — 8.75%
Explanation: A is correct: Weighted return = (60% × 12%) + (35% × 3%) + (5% × 8%) = 7.2% + 1.05% + 0.4% = 8.65%. Closest = A (8.75%) or D (8.40%). With exact weights: 0.60×12 + 0.35×3 + 0.05×8 = 7.2 + 1.05 + 0.40 = 8.65%. D (8.40%) is also close. B (7.95%) would require lower equity returns. A (8.75%) is closest to 8.65%. Select A.
Question 379
Pension risk: Plan A: funded ratio = 1.15, sponsor has BBB credit rating, workforce average age 45, plan invested 40% in sponsor's industry equities. Plan B: funded ratio = 1.05, sponsor has AA credit rating, workforce average age 40, plan has 0% in sponsor's industry. Which has higher risk tolerance?
Select an option first.
Correct answer: B — Plan B — higher-quality sponsor (AA vs BBB), younger workforce (age 40 vs 45), and zero sponsor-industry correlation. Plan A's 40% industry correlation creates a dangerous concentration that significantly reduces effective risk tolerance despite slightly better funding.
Explanation: B is correct: Comparing the five risk factors: Funded ratio: A (1.15) vs B (1.05) — A slightly better. Sponsor strength: B (AA) clearly superior to A (BBB). Sponsor-fund correlation: B (0%) vastly superior to A (40% industry concentration — catastrophic correlation). Workforce: B (age 40) slightly better. The 40% industry correlation in Plan A is a critical weakness that overrides the slightly better funding — if the sponsor's industry declines, both the sponsor's ability to contribute AND the fund's portfolio suffer simultaneously. B's zero correlation and stronger sponsor make it definitively higher risk tolerance.
Question 380
DC plan: Employee contributes 5% of $80,000 salary, employer matches 50% of employee contribution. Employee's account earns 7% annually. What is the account value after 10 years assuming contributions are made at year-start?
Select an option first.
Correct answer: C — $91,600
Explanation: C is correct: Total annual contribution = 5% × $80,000 + 50% × (5% × $80,000) = $4,000 + $2,000 = $6,000/year. FV of annuity due (beginning of year) at 7% for 10 years: FV = $6,000 × [(1.07^10 - 1)/0.07] × 1.07 = $6,000 × [1.9672-1]/0.07 × 1.07 = $6,000 × 13.816 × 1.07 = $6,000 × 14.784 = $88,704. Closest = C ($91,600). If ordinary annuity: $6,000 × [(1.07^10-1)/0.07] = $6,000 × 13.816 = $82,896 ≈ B ($84,200). C ($91,600) uses annuity due. B is closer to ordinary annuity. Select B for ordinary annuity.
Question 381
Endowment minimum return requirement: University endowment spends 5%, has 1% management expenses, and needs real growth of 1.5% to maintain intergenerational equity. Inflation = 2.5%. What minimum nominal return is required?
Select an option first.
Correct answer: C — 10.0%
Explanation: C is correct: Minimum return must cover: Distribution (5%) + Management costs (1%) + Real growth needed (1.5%) + Inflation (2.5%) = 5% + 1% + 1.5% + 2.5% = 10%. This is a common framework: Total return target = spending rate + operating costs + real growth objective + inflation. Any return below 10% means the endowment is either shrinking in real terms or cutting spending. A (8%) = spending + inflation only. B (9.5%) excludes real growth. D (7.5%) omits management costs and growth.
Question 382
What does a DB pension plan's 'vested benefit index' measure and why does vesting matter for funding calculations?
Select an option first.
Correct answer: B — The funded ratio using vested benefits = plan assets / PV of vested obligations. Vesting is the minimum service requirement before an employee earns the right to future benefits. Unvested obligations are contingent (employee may leave before vesting) and carry less certainty. Vested obligations are more certain — they must be paid. Using vested obligations gives a more conservative measure of the minimum funding required.
Explanation: B is correct: Not all promised pension benefits are equally certain — unvested benefits disappear if employees leave before vesting. The vested benefit index focuses on the subset of obligations that are legally owed to employees who have met service requirements. This is a more conservative (and arguably more accurate) measure of the plan's true minimum obligation. Underfunding on a vested basis is more serious than on a total projected benefit obligation basis because the vested obligations cannot be reduced by employee turnover.
Question 383
How does a well-funded DB pension plan (funded ratio = 1.30) affect the risk tolerance assessment, with one important caveat?
Select an option first.
Correct answer: B — Higher funding creates a cushion — losses can be absorbed without immediately threatening benefit security — which generally supports more investment risk. However, if the plan sponsor WANTS to maintain the surplus to reduce future contributions (contribution holiday), the sponsor may prefer LDI strategies that minimize surplus volatility rather than maximizing returns. The sponsor's strategic objective matters, not just the funded level.
Explanation: B is correct: The reading's professor note explicitly makes this point — a high funded ratio generally implies more ability to take risk, but if the sponsor wants to remain in surplus and minimize contribution volatility, they may actually choose a conservative LDI approach. The strategic decision (maximize return vs. preserve surplus) drives portfolio construction, not just the funded ratio alone. For the exam: always read the scenario carefully to understand the sponsor's specific objective.
Question 384
What is the 'Higher Education Price Index' (HEPI) and why is it used instead of CPI for endowment spending policy?
Select an option first.
Correct answer: B — HEPI measures inflation specifically in higher education costs — faculty salaries, research equipment, construction, utilities specific to universities. University costs typically inflate faster than general consumer prices because higher education is labor-intensive and highly skilled labor costs rise faster than general wages. Using HEPI instead of CPI ensures the endowment's real spending power in a university context is preserved, not just general purchasing power.
Explanation: B is correct: This is a practical and important distinction. University costs (professor salaries, laboratory equipment, library resources) inflate at rates that have historically exceeded general CPI — sometimes by 1-2% annually. If an endowment uses CPI to adjust spending, it progressively loses real purchasing power for university operations. HEPI captures the actual cost increase relevant to the university's specific spending basket. This is why many university endowment spending policies are tied to HEPI rather than CPI.
Question 385
For a private foundation that must distribute 5% annually, how does this requirement affect its MINIMUM return target versus a university endowment with a 5% spending rate but no legal minimum?
Select an option first.
Correct answer: B — The foundation's 5% distribution is a legal floor — not distributing enough triggers excise taxes. The foundation must also cover investment management expenses (perhaps 0.5-1%) and inflation (to maintain real value). Minimum return ≈ 5% + 1% expenses + 2.5% inflation = 8.5%. The endowment's 5% spending is a board-approved policy — it could theoretically be reduced in a crisis. The foundation cannot adjust its minimum distribution without regulatory consequence.
Explanation: B is correct: The mandatory nature of the 5% distribution makes the foundation's return target more binding. During a market crisis, an endowment's board can vote to temporarily reduce the spending rate (to preserve capital). A foundation cannot reduce distributions below 5% without IRS scrutiny and potential excise tax penalties. This binding minimum makes foundations slightly more return-sensitive and less able to adopt ultra-conservative strategies in downturns. The return target must be achievable consistently, not just on average.
Question 386
What is the role of an INVESTMENT COMMITTEE in institutional governance, and how does it differ from the BOARD OF DIRECTORS?
Select an option first.
Correct answer: B — Board: sets the overall mission and strategic direction, approves the IPS, oversees the investment committee, ultimately accountable to beneficiaries/stakeholders. Investment committee: a specialist subcommittee that develops investment policy details, monitors performance, selects/oversees external managers, and reports to the board. The board delegates investment oversight to the committee; the committee delegates implementation to the CIO and investment staff.
Explanation: B is correct: The governance hierarchy is: Board → Investment Committee → CIO/Investment Office → External Managers. The board provides strategic oversight and ultimate accountability but typically lacks the investment expertise for detailed portfolio decisions. The investment committee bridges this gap — often including external experts or alumni with investment backgrounds. This delegation model balances accountability (board responsibility) with expertise (investment committee judgment). For institutional investors, well-structured governance at each level is critical for long-term performance and fiduciary compliance.
Question 387
What percentage of assets does a US private foundation legally need to distribute annually, and what happens if it fails to meet this requirement?
Select an option first.
Correct answer: B — 5% of average net assets annually. If a foundation fails to meet this minimum, it faces an excise tax of 30% of the undistributed amount. Additionally, the IRS can potentially revoke the foundation's tax-exempt status for systematic non-compliance.
Explanation: B is correct: Under US tax law (IRC Section 4942), private foundations must distribute at least 5% of the fair market value of their net investment assets annually for charitable purposes. This includes grants to charities and qualifying administrative expenses. The 30% excise tax on undistributed amounts is a powerful incentive for compliance. This rule was established to prevent foundations from accumulating wealth indefinitely without putting it to charitable use. The 5% minimum directly affects investment policy — the portfolio must generate sufficient liquid returns to fund distributions.
Question 388
How does the concept of 'regulatory risk-based capital' create a de facto constraint on bank equity allocations?
Select an option first.
Correct answer: B — Each asset class is assigned a risk weight under RBC frameworks (e.g., Basel III). Equities require high capital backing (30-40% in stressed scenarios under Basel's internal models approach). If a bank holds $100M of equities requiring 35% capital: $35M of equity must be set aside. This $35M cannot be deployed elsewhere — it's 'used up' by the equity position. The return on this equity allocation must be compared to the return on the $35M capital required, often making equities less attractive than high-quality bonds (which require much less capital).
Explanation: B is correct: The capital efficiency argument is crucial. A bank considering whether to hold corporate equities vs. government bonds must assess: (1) expected return difference, (2) capital cost difference. Government bonds may require only 2-4% capital backing; equities may require 35%+. Even if equities have higher expected returns, the required capital allocation effectively reduces the return on equity (ROE) from the equities position. This capital charge acts as an implicit tax on equity holdings, making them expensive from a regulatory capital perspective and creating the de facto constraint on equity allocation.
Question 389
Why do SAVINGS SWFs and PENSION RESERVE FUNDS often adopt the 'endowment model' of investing?
Select an option first.
Correct answer: B — Both have perpetual or very long investment horizons, low near-term liquidity needs, and sufficient scale and governance to implement complex alternative investment strategies — characteristics that match the endowment model's reliance on illiquid alternatives (PE, real assets, hedge funds). Like university endowments, they can tolerate illiquidity in exchange for the expected return premium.
Explanation: B is correct: The alignment is clear: long horizons + low liquidity needs = ideal conditions for alternatives exposure. Norway's Government Pension Fund Global and similar large savings funds have adopted heavy equity/alternatives allocations. Pension reserve funds (accumulating for distant government pension liabilities) also have long accumulation phases with minimal near-term distributions. The key enabling factors are: sufficient scale to access top alternative managers, governance expertise to evaluate complex strategies, and the time horizon to weather illiquidity and short-term volatility.
Question 390
An insurance company's investment portfolio has asset duration = 7, liability duration = 10, assets = $3B, liabilities = $2.8B. What action reduces the duration gap?
Select an option first.
Correct answer: A — Buy longer-duration bonds to increase asset duration
Explanation: A is correct: Dollar duration of assets = 7 × $3B = $21B. Dollar duration of liabilities = 10 × $2.8B = $28B. Gap = $21B - $28B = -$7B (liabilities have more duration). To close this gap: buy longer-duration bonds to increase asset dollar duration toward $28B. Receive-fixed swaps also add duration to assets without buying bonds. B describes the same solution. Both A and B are correct — A is more direct. C (buying equities) would not address the duration gap. D (reducing leverage) changes the size relationship but not duration directly.
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