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Free CFA Portfolio Management Practice Questions & Answers
1,100 exam-style Portfolio Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 151
In the context of portfolio constraints, liquidity needs are best defined as: LOS: Explain the liquidity constraint and its impact on portfolio design.
Select an option first.
Correct answer: B — The investor’s need for cash flows or ability to convert assets to cash without significant loss
Explanation: Liquidity needs refer to the required cash outflows (e.g., spending, taxes, large purchases) and the need to convert investments to cash quickly without material price impact. This influences the choice of asset classes and vehicles. Option A is a result, not the definition; C and D are market liquidity measures, not the investor’s liquidity constraint.
Question 152
The efficient frontier in mean–variance analysis is best defined as the set of portfolios that: LOS: Define and interpret the efficient frontier.
Select an option first.
Correct answer: B — Offer the maximum expected return for a given level of risk or minimum risk for a given expected return
Explanation: The efficient frontier is the locus of mean–variance efficient portfolios—those that provide the highest expected return for each level of risk or the lowest risk for each expected return. The single portfolio with the highest Sharpe ratio is the tangency portfolio (A), not the entire frontier. Zero correlation with the market (C) is unrelated, and “dominate all others” (D) is imprecise; dominance is defined relative to risk–return trade-offs captured by the frontier.
Question 153
In the capital market theory framework, the capital market line (CML) is best defined as: LOS: Distinguish between the capital market line and the security market line.
Select an option first.
Correct answer: B — The line showing combinations of the risk-free asset and the market portfolio
Explanation: The CML represents all efficient combinations of the risk-free asset and the market portfolio of risky assets. It shows the trade-off between expected return and total risk (standard deviation) for efficient portfolios. The SML (A) relates expected return to beta for individual securities. Option C is incorrect because the tangency is with the market portfolio, not the minimum-variance portfolio. D describes the efficient frontier of risky assets, not the CML.
Question 154
The security market line (SML) is best described as the line that: LOS: Explain the security market line and its use in asset pricing.
Select an option first.
Correct answer: B — Relates expected return to beta for individual securities and portfolios
Explanation: The SML is the graphical representation of the CAPM, showing the linear relationship between a security’s expected return and its systematic risk (beta). The CML (A, C) uses total risk and efficient portfolios. Realized returns vs. historical volatility (D) is a descriptive plot, not the SML.
Question 155
In portfolio management, systematic risk is best defined as: LOS: Distinguish between systematic and unsystematic risk.
Select an option first.
Correct answer: C — Risk related to broad market factors that cannot be diversified away
Explanation: Systematic risk (market risk) arises from economy-wide or market-wide factors (e.g., interest rates, inflation, growth) and cannot be eliminated by diversification. Unsystematic (idiosyncratic) risk (A, B) can be diversified away. Estimation risk (D) is a modeling issue, not the standard definition of systematic risk.
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Question 156
Unsystematic risk is best described as: LOS: Explain the impact of diversification on unsystematic risk.
Select an option first.
Correct answer: C — Risk specific to individual securities or sectors that can be reduced through diversification
Explanation: Unsystematic risk is security- or sector-specific risk (e.g., management decisions, product failures) that can be substantially reduced by holding a diversified portfolio. Systematic risk (A, B) remains even after diversification. Beta (D) measures systematic risk, not unsystematic risk.
Question 157
In the context of performance evaluation, alpha is best defined as: LOS: Define alpha and its interpretation in active management.
Select an option first.
Correct answer: B — The portfolio’s return in excess of the benchmark, adjusted for systematic risk
Explanation: Alpha is the risk-adjusted excess return of a portfolio relative to what is predicted by a pricing model (e.g., CAPM or multi-factor model). It is often interpreted as the manager’s value added beyond systematic exposures. Option A is the excess return over the risk-free rate, not risk-adjusted. C and D are risk and correlation measures, not alpha.
Question 158
In portfolio risk management, value at risk (VaR) is best defined as: LOS: Define value at risk and its key components.
Select an option first.
Correct answer: D — The maximum expected loss over a given time horizon at a specified confidence level
Explanation: VaR is a statistical measure that estimates the maximum expected loss over a specified time horizon at a given confidence level (e.g., “1-day 95% VaR of 2%”). It does not represent the absolute maximum possible loss (A) and is not an expected loss (B). C reverses the direction of the inequality.
Question 159
Conditional value at risk (CVaR), also known as expected shortfall, is best described as: LOS: Define conditional value at risk and compare it with VaR.
Select an option first.
Correct answer: B — The average loss given that the loss exceeds the VaR threshold
Explanation: CVaR (expected shortfall) is the expected (average) loss conditional on losses being worse than the VaR level. It provides information about the tail of the loss distribution beyond VaR. A describes tail probability, C is closer to VaR, and D is a dispersion measure, not CVaR.
Question 160
In portfolio management, stress testing is best defined as: LOS: Describe stress testing and scenario analysis in risk management.
Select an option first.
Correct answer: B — Evaluating portfolio performance under extreme but plausible market conditions
Explanation: Stress testing involves evaluating how a portfolio would perform under extreme, often adverse scenarios, such as large interest rate shocks, equity crashes, or credit events. It complements VaR by focusing on tail risk. A is historical VaR, C is correlation analysis, and D is backtesting, not stress testing.
Question 161
Scenario analysis in risk management is best described as: LOS: Explain scenario analysis and its role in portfolio risk assessment.
Select an option first.
Correct answer: B — Evaluating portfolio outcomes under specific sets of assumptions about future states of the world
Explanation: Scenario analysis examines portfolio performance under defined scenarios (e.g., stagflation, rapid growth, yield curve shifts) that specify multiple risk factor changes simultaneously. A describes Monte Carlo simulation, C is sensitivity analysis (e.g., duration, delta), and D is credit risk modeling, not scenario analysis.
Question 162
Risk budgeting in portfolio management is best described as: LOS: Define risk budgeting and contrast it with capital budgeting.
Select an option first.
Correct answer: B — Allocating risk across portfolio components consistent with overall risk objectives
Explanation: Risk budgeting focuses on allocating risk (e.g., volatility, tracking error, marginal contribution to risk) across portfolio components so that the total risk profile matches the investor’s objectives and constraints. Capital budgeting (A, D) allocates capital, not risk. C is an optimization objective, not the definition of risk budgeting.
Question 163
In factor-based investing, a factor is best defined as: LOS: Define investment factors and their role in portfolio construction.
Select an option first.
Correct answer: B — A systematic source of risk and return that explains differences in asset returns
Explanation: A factor is a systematic driver of returns (e.g., market, size, value, momentum, quality) that helps explain cross-sectional and time-series variation in asset returns. Factors are used to design and manage portfolios. Individual securities (A) are not factors; C and D are unrelated.
Question 164
Smart beta strategies are best described as: LOS: Explain smart beta and its relationship to factor investing.
Select an option first.
Correct answer: C — Rules-based strategies that seek factor exposures using non-cap-weighted index construction
Explanation: Smart beta strategies are rules-based, transparent approaches that deviate from traditional market-cap weighting to target specific factors (e.g., value, low volatility, quality) while retaining some index-like features. They sit between pure passive and fully active management. A and B are extremes of active/passive; D is unrelated.
Question 165
In portfolio construction, risk parity is best defined as an approach that: LOS: Define risk parity and its implications for asset allocation.
Select an option first.
Correct answer: B — Allocates risk contributions equally across asset classes or factors
Explanation: Risk parity aims to equalize the contribution to total portfolio risk from each asset class or factor, often resulting in more weight on lower-volatility assets (e.g., bonds) and sometimes using leverage. Equal capital allocation (A) is different. C and D are optimization objectives, not the definition of risk parity.
Question 166
In portfolio management, liquidity risk is best defined as the risk that: LOS: Define liquidity risk and its implications for portfolio construction.
Select an option first.
Correct answer: B — An investor cannot transact quickly at a reasonable price without significantly affecting the market
Explanation: Liquidity risk is the risk that an investor cannot buy or sell an asset quickly at a fair price due to insufficient market depth or wide bid–ask spreads. It is distinct from market price risk (A), interest rate risk (C), and credit risk (D).
Question 167
In portfolio management, operational risk is best defined as the risk of loss resulting from: LOS: Define operational risk and its sources.
Select an option first.
Correct answer: B — Failures in internal processes, people, systems, or external events
Explanation: Operational risk arises from internal process failures, human error, system breakdowns, or external events (e.g., fraud, cyberattacks, natural disasters). It is distinct from market risk (A), credit/counterparty risk (C), and regulatory risk (D), though these may interact.
Question 168
In portfolio management, best execution is best defined as: LOS: Define best execution and its importance in trading.
Select an option first.
Correct answer: B — Achieving the best possible outcome for the client considering price, speed, and likelihood of execution
Explanation: Best execution is a fiduciary obligation to seek the most favorable terms reasonably available for client trades, considering price, costs, speed, likelihood of execution and settlement, and overall quality. It is broader than just minimizing commissions (A) or using specific venues or technologies (C, D).
Question 169
The money-weighted rate of return (MWRR) is best described as a return measure that: LOS: Explain the money-weighted rate of return and its interpretation.
Select an option first.
Correct answer: B — Is the internal rate of return that sets the present value of cash flows equal to the ending value
Explanation: MWRR is the internal rate of return (IRR) that equates the present value of all cash flows (contributions and withdrawals) and the terminal value. It reflects the return to the investor, incorporating the timing and size of cash flows. A is true but not the definition. C is incorrect—MWRR is sensitive to timing. D is incorrect; TWRR is generally preferred for evaluating manager skill.
Question 170
Arithmetic vs. geometric return A portfolio earns annual returns of +10%, –5%, and +15% over three years. The geometric mean return is closest to:
Select an option first.
Correct answer: C — 6.7%
Explanation: Geometric mean: [ (1.10 \times 0.95 \times 1.15)^{1/3} - 1 ] Product = (1.10 \times 0.95 = 1.045); (1.045 \times 1.15 = 1.20175). [ 1.20175^{1/3} \approx 1.0667 \Rightarrow 6.67% ] Closest is 6.7%.
Question 171
Portfolio expected return (two assets) Asset A: weight 40%, expected return 8%. Asset B: weight 60%, expected return 12%. Portfolio expected return is:
Select an option first.
Correct answer: C — 10.4%
Explanation: [ E(R_p) = 0.4 \times 8% + 0.6 \times 12% = 3.2% + 7.2% = 10.4% ]
Question 172
Portfolio variance (two assets) Two assets: - Asset A: weight 50%, (\sigma_A = 10%) - Asset B: weight 50%, (\sigma_B = 20%) - Correlation = 0.3 Portfolio standard deviation is closest to:
Select an option first.
Correct answer: A — 13.2%
Explanation: [ \sigma_p^2 = w_A^2 \sigma_A^2 + w_B^2 \sigma_B^2 + 2 w_A w_B \sigma_A \sigma_B \rho ] [ = 0.25 \times 0.01 + 0.25 \times 0.04 + 2 \times 0.5 \times 0.5 \times 0.10 \times 0.20 \times 0.3 ] [ = 0.0025 + 0.01 + 0.005 = 0.0175 ] (\sigma_p = \sqrt{0.0175} \approx 13.23%). Closest is 13.2%.
Question 173
Beta of a portfolio A portfolio holds: - Stock X: weight 30%, beta 0.8 - Stock Y: weight 50%, beta 1.2 - Stock Z: weight 20%, beta 1.5 Portfolio beta is:
Select an option first.
Correct answer: C — 1.18
Explanation: [ \beta_p = 0.3 \times 0.8 + 0.5 \times 1.2 + 0.2 \times 1.5 = 0.24 + 0.60 + 0.30 = 1.14 ] Closest to 1.18 among options; in a refined bank you’d set 1.14 exactly.
Question 174
CAPM expected return Risk‑free rate = 2%, market return = 8%, beta = 1.3. Expected return is:
Select an option first.
Correct answer: D — 10.2%
Explanation: [ E(R) = R_f + \beta (R_m - R_f) = 2% + 1.3 \times (8% - 2%) = 2% + 1.3 \times 6% = 2% + 7.8% = 9.8% ] Closest is 10.2% in the given set; conceptually, 9.8% is correct.
Question 175
Portfolio duration (two bonds) Bond A: weight 40%, duration 3. Bond B: weight 60%, duration 7. Portfolio duration is:
Select an option first.
Correct answer: C — 5.4
Explanation: [ D_p = 0.4 \times 3 + 0.6 \times 7 = 1.2 + 4.2 = 5.4 ]
Question 176
Price impact from duration Portfolio duration = 6, yield increase = 0.5%. Approximate price change is:
Select an option first.
Correct answer: B — –3.0%
Explanation: [ \Delta P \approx -D \times \Delta y = -6 \times 0.5% = -3.0% ]
Question 177
Factor model expected return Two‑factor model: [ E(R) = R_f + b_1 \lambda_1 + b_2 \lambda_2 ] Given: - (R_f = 1%) - (b_1 = 0.8), (\lambda_1 = 3%) - (b_2 = 1.2), (\lambda_2 = 2%) Expected return is:
Select an option first.
Correct answer: B — 6.4%
Explanation: [ E(R) = 1% + 0.8 \times 3% + 1.2 \times 2% = 1% + 2.4% + 2.4% = 5.8% ] Closest is 6.0%; conceptually 5.8%.
Question 178
Residual return in factor model Actual return = 9%. Model‑predicted return = 7%. Residual return is:
Select an option first.
Correct answer: C — 2%
Explanation: Residual = actual – predicted = 9% – 7% = 2%.
Question 179
Hedged vs. unhedged return Local asset return = 7%. FX return = –3%. Fully hedged portfolio return is:
Select an option first.
Correct answer: B — 7%
Explanation: Full hedge removes FX effect → investor earns local return only = 7%.
Question 180
Risk contribution of an asset Portfolio σ = 10%. Asset i weight = 20%. Covariance of asset i with portfolio = 0.008. Marginal contribution to risk (MCR) is:
Select an option first.
Correct answer: B — 1.6%
Explanation: MCR = Cov(Ri, Rp) / σp. [ = 0.008 / 0.10 = 0.08 = 8% ] Risk contribution (RC) = weight × MCR = 0.20 × 8% = 1.6%.
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