CFA Level 1 - Portfolio Management Session 18 - Reading 60

CFA Level 1 - Portfolio Management Session 18 - Reading 60 (Notes, Practice Questions, Sample Questions) 1. Mean-variance analysis assumes that investor preferences depend on all of the following EXCEPT: A)correlations among asset returns. B)skewness of the distribution of asset returns. C)expected asset returns Explanation: B) Mean-variance analysis assumes that investors only need to know expected returns, variances, and covariances in order create optimal portfolios. The skewness of the distribution of expected returns can be ignored 2. One of the assumptions of mean-variance analysis is that all investors are risk-averse, which means they: A)are not willing to make risky investments. B)prefer less risk to more for any given level of volatility. C)prefer less risk to more for any given level of expected return Explanation: C) In mean-variance analysis we assume that all investors are risk averse, which means they prefer less risk to more for any given level of expected return (NOT for any given level of volatility.) It does NOT mean that they are unwilling to take on any risk 3. What are the expected return and expected standard deviation for the two-asset portfolio described as: Expected Return/Correlation Variance Weight E(R1) = 10% Var(1) = 9% w1 = 30% E(R2) = 15% Var(2) = 25% w2 = 70% r1,2 = 0.4 E(Rport) σport A) 10.5% 15.58% B) 13.5% 39.47% C) 11.5% 3.95% Explanation: B) E(Rport) = w1E(R1) + w2E(R2) = (0.3)(10.0) + (0.7)(15.0) = 13.5% σport = [(w1)2(σ1)2 + (w2)2(σ2)2 + 2w1w2σ1σ2ρ1,2]1/2 = [(0.3)2(0.09) + (0.7)2(0.25) + 2(0.3)(0.7)(0.3)(0.5)(0.4)]1/2 = 39.47% 4.1 Allen Marko, CFA, is analyzing the diversification benefits available from investing in three equity funds. He is basing his analysis on monthly returns for the three funds and an appropriate market index over the past twenty years. He feels that there is no reason that the past performance should not carry forward into the future. Treasury bills currently pay 5%. Table 1: Expected Returns, Variances, and Covariance for Funds A, B, &C Equity Fund A Equity Fund B Equity Fund C Average Return 12% 9% 8% Variance 0.0256 0.0196 0.0172 Correlation of A & B is 0.50 Correlation of A & C is 0.38 Correlation of B & C is 0.85 Marko has also obtained information about a fourth fund, Fund D. He does not have any information regarding the covariance of Fund D with Funds A, B, and C. The average return and variance for fund D are 10% and 0.018, respectively. The beta of Fund D is 0.714. Based on this data, what is the expected return of a portfolio that is made up of 60% of Fund A, 30% of Fund B, and 10% of Fund C? A) 10.2 % B) 10.7 % C) 11.4 % Explanation: B) Expected return for the portfolio = (0.6)(0.12) + (0.3)(0.09) +(0.1)(0.08)= 0.107 or 10.7%. 4.2 Which of the following is closest to the standard deviation of a portfolio that is made up of 60% of Fund A, 30% of Fund B, and 10% of Fund C? A) 14.840 % B) 2.205% C) 13.062 % Explanation: C) Standard deviation of a three asset portfolio: σportfolio = [(0.6)2(0.0256) + (0.3)2(0.0196) + (0.1)2(0.0172) + 2(0.60)(0.30)(0.50)(0.16)(0.14) + 2(0.60)(0.10)(0.38)(0.16)(0.13)+ 2(0.3)(0.1)(0.85)(0.14)(0.13)]0.5 = [0.017062]1/2 = 0.13062 or 13.062% 4.3 With respect to the relative efficiencies of the Funds, which of the following is most accurate? A) Fund B is inefficient relative to Fund D B) No determination is possible C) Fund B and D are both inefficient. Explanation: A) To be inefficient, the return must be lower while the variance is higher. The only case where that relationship exists is with respect to Fund B and D 4.4 If Marko had to choose to form a portfolio using only T-bills and one of the four funds, which should he choose? A) Fund A. B) Fund B. C) Fund D. Explanation: A) The easiest way to approach this question is to calculate the Sharpe ratio for each fund and choose the one with the highest ratio. The highest Sharpe ratio reflects the highest excess return for a given level of risk. The Sharpe ratios are as follows: [p=30, 2, left]Fund A = (12 − 5) / 16.00 = 0.44[/p][p=30, 2, left]Fund B = (9 − 5) / 14.00 = 0.29[/p][p=30, 2, left]Fund D = (10 − 5) / 13.42 = 0.37[/p] Fund A has the highest Sharpe ratio and therefore would be the best one to combine with T-bills. An alternative way to answer the question can be seen by combining Fund A with T-bills in a portfolio to get an average/expected return equal to each of the other portfolios and computing the variance for each of those portfolios. Then compare the variance of the portfolio composed of A and the T-bills to the corresponding variance of the other asset. To find the appropriate weights for the portfolio to earn the return of Fund B, solve for W in the following equation: 9% = W × 12% + (1 − W) × 5%. The solution is W = 0.5714. 0.5714 in Fund A and 0.429 in T-bills has a variance equal to (0.5714)(0.5714)(0.0256) = 0.00836. Applying the same procedure to Fund D gives W = 0.80 0.80 in Fund D and 0.20 in T-bills has a variance equal to (0.80)(0.80)(0.018) = 0.01152. Thus, a CAL formed with Fund A can dominate the CAL of each of the other three portfolios. 4.5 Which of the following statements regarding the graph of return vs. risk for all possible portfolio combinations consisting of Funds A, B, and C is least accurate? A)Combinations of Fund A, B, and C will dominate all other combinations of portfolios that have a lower return for the same level of risk B)If the objective of the portfolio manager is to minimize risk the optimal portfolio must lie on the curved line below the minimum-variance portfolio C)If the objective of the portfolio manager is to maximize return the optimal portfolio must lie on the curved line above the minimum-variance portfolio Explanation: B) The curved line below the minimum-variance portfolio represents all portfolio combinations that are dominated by other portfolio combinations. Based on the efficient frontier created by these two funds higher returns at the same level of risk can be achieved above the minimum-variance portfolio 4.6 The beta of Fund A is 1.2, the expected return of T-bills is 5% and the standard deviation for the market is 13%. What is the covariance between the market portfolio and Fund A? A) 0.020 B) 0.081 C) 0.156 Explanation: A) The beta for fund A is equal to the covariance of fund A and the market divided by the variance of the market. Therefore, 1.2 = COV(A,Market) / (0.13)2 Solving for COV(A,Market) = (1.2)(0.13)2 = 0.0203 5. Given the following information, what is the expected return on the portfolio of the two funds? The Washington Fund The Jefferson Fund Expected Return 30% 36% Variance 0.0576 0.1024 Investment $2,000,000 $6,000,000 Correlation 0.40 A) 33.0 % B) 34.5 % C) 31.5 % Explanation: B) First calculate the portfolio weights on each fund: WWash = $2 million/$8 million = 0.25 WJeff = $6 million/$8 million = 0.75 The expected portfolio return is the weighted average of the funds' expected returns: E(RP) = (0.25)(30%) + (0.75)(36%) = 34.5% 6. Which of the following statements about multifactor models is CORRECT? A)The multifactor model is a cross-sectional equilibrium pricing model that explains variation across assets. B)The intercept term in a macroeconomic factor model is the risk-free rate. C)The multifactor model is a time-series regression that explains variation in one asset. Explanation: C) The multifactor model is a time-series regression that explains variation in one asset. APT is a cross-sectional equilibrium pricing model that explains variation across assets. The intercept term in a macroeconomic factor model is the asset's expected return 7. Given a three-factor arbitrage pricing theory APT model, what is the expected return on the Freedom Fund? The factor risk premiums to factors 1, 2, and 3 are 10%, 7% and 6%, respectively. The Freedom Fund has sensitivities to the factors 1, 2, and 3 of 1.0, 2.0 and 0.0, respectively. The risk-free rate is 6.0%. A)30.0%. B)33.0%. C)24.0%. Explanation: A) The expected return on the Freedom Fund is 6% + (10.0%)(1.0) + (7.0%)(2.0) + (6.0%)(0.0) = 30.0% 8. Given a three-factor arbitrage pricing theory (APT) model, what is the expected return on the Premium Dividend Yield Fund? The factor risk premiums to factors 1, 2 and 3 are 8%, 12% and 5%, respectively. The fund has sensitivities to the factors 1, 2, and 3 of 2.0, 1.0 and 1.0, respectively. The risk-free rate is 3.0%. A)33.0%. B)50.0%. C)36.0%. Explanation: C) The expected return on the Premium Dividend Yield Fund is 3% + (8.0%)(2.0) + (12.0%)(1.0) + (5.0%)(1.0) = 36.0% 9. Which of the following assumptions is NOT necessary to derive the APT? A)The factor portfolios are efficient. B)Investors can create diversified portfolios with no firm-specific risk. C)A factor model describes asset returns Explanation: A) The APT is an equilibrium model that assumes that investors can create diversified portfolios and that a factor model describes asset returns. It does NOT require that factor portfolios (nor, as in the capital asset pricing model [CAPM], the market portfolio) be efficient. In effect, the APT assumes investors simply like more money to less, while the CAPM assumes they care about expected return and standard deviation and invest in efficient portfolios. The APT makes no reference to mean-variance analysis or assumptions about efficient portfolios. This weaker set of assumptions is an advantage of the APT over the CAPM 10. Which of the following is NOT an underlying assumption of the arbitrage pricing theory (APT)? A)Asset returns are described by a K factor model. B)There are a sufficient number of assets for investors to create diversified portfolios in which firm-specific risk is eliminated. C)A market portfolio exists that contains all risky assets and is mean-variance efficient Explanation: C) The APT makes no assumption about a market portfolio 11. The factor risk premium on factor j in the arbitrage pricing theory (APT) can be interpreted as the: A)sensitivity of the market portfolio to factor j. B)expected return investors require on a factor portfolio for factor j. C)expected risk premium investors require on a factor portfolio for factor j. Explanation: C) We can interpret the APT factor risk premiums similar to the way we interpret the market risk premium in the CAPM. Each factor price is the expected risk premium (extra expected return minus the risk-free rate) investors require for a portfolio with a sensitivity of one (βp,j =1) to that factor and a sensitivity of zero to all the other factors (a factor portfolio) 12. The Arbitrage Pricing Theory (APT) has all of the following characteristics EXCEPT it: A)assumes that arbitrage opportunities are available to investors. B)is an equilibrium pricing model. C)assumes that asset returns are described by a factor model. Explanation: A) The APT assumes that no arbitrage opportunities are available to investors 13. Which of the following is an equilibrium-pricing model? A)Macroeconomic factor model. B)Fundamental factor model. C)The arbitrage pricing theory (APT) Explanation: C) The APT is an equilibrium-pricing model; multi-factor models are “ad-hoc,” meaning the factors in these models are not derived directly from an equilibrium theory. Rather they are identified empirically by looking for macroeconomic variables that best fit the data 14. the arbitrage pricing theory (APT) holds, it determines: A)factor sensitivities in a multi-factor model. B)the factor prices in a multi-factor model. C)the intercept term in a multi-factor model Explanation: C) One way to think about the relationship between the APT and multi-factor models is to recognize that the intercept term in a multi-factor model is the asset’s expected return; the APT is an expected return model that tells us what that intercept should be 15. One of the assumptions of the arbitrage pricing theory (APT) is that there are no arbitrage opportunities available. An arbitrage opportunity is: A)an investment that has an expected positive net cash flow but requires no initial investment. B)a factor portfolio with a positive expected risk premium. C)a portfolio with factor exposures that sum to one Explanation: A) One of the three assumptions of the APT is that there are no arbitrage opportunities available to investors among these well-diversified portfolios. An arbitrage opportunity is an investment that has an expected positive net cash flow but requires no initial investment. All factor portfolios will have positive risk premiums equal to the factor price for that factor. An arbitrage opportunity does not necessarily require a return equal to the risk-free rate, and the factor exposures for an arbitrage portfolio are all equal to zero 16. Which of the following statements regarding the arbitrage pricing theory (APT) as compared to the capital asset pricing model (CAPM) is least accurate? APT: A)does not require that one of the risk factors is the market portfolio; unlike the CAPM. B)is often times thought of as a special case of the CAPM. C)has fewer assumptions than CAPM Explanation: B) The CAPM is often times thought of as a special case of the APT since CAPM has only one factor, the market portfolio 17. An arbitrage pricing theory (APT) model has the following characteristics: The risk free rate is 3.8%. Factor risk premiums are: A.(7%) B.(4%) C.(2%) D.(10%) Assume Silver Linings Fund has the following sensitivities to the factors: Sensitivity to A is 0.5. Sensitivity to B is 1.2. Sensitivity to C is 2.1. Sensitivity to D is 0.2. The expected return on the Silver Linings Fund is: A)14.5%. B)18.3%. C)20.1%. Explanation: B) E(R) = 3.8 + (0.5 × 7) + (1.2 × 4) + (2.1 × 2) + (0.2 × 10) = 18.3 18. Gold Horizon, an investment firm, utilizes a three-factor APT model for its Unique & Rich (U&R) fund. The risk-free rate equals 4%. Using the table below, determine U&R’s expected return U&R factor beta Factor risk premium GNPFacto r 1.75 0.020 Inflation Factor 1.5 0.015 Investor Confidence Factor 1.25 0.013 A)7.38% B)11.38% C)4.49% Explanation: B) E(RU&R) = 0.04 + 1.75(0.02) + 1.5(0.015) + 1.25(0.013) E(RU&R) = 0.04 + 0.035 + 0.0225 + 0.01625 E(RU&R) = 11.375% ≈ 11.38% 19.1 Jose Morales has been investing for years, mostly using index funds. But because he is not satisfied with his returns, he decides to meet with Bill Smale, a financial adviser with Big Gains Asset Management.Morales lays out his concerns about active management: ● “Mutual funds average returns below their benchmarks.” ● “All the buying and selling makes for less-efficient markets.” ● “Expenses are higher with active management.” ● “Analyst forecasts are often wrong.” In an effort to win Morales’ business, Smale explains the benefits of active management, starting with the fact that market efficiency is a prime concern of active managers because efficient markets make active management possible. He then explains that active management allows for better protection against systematic risk, and that Big Gains uses multifactor models to adjust investment strategies to account for economic changes. Lastly, Smale tells Morales how Big Gains Asset Management has pledged never to reveal clients’ personal information to third parties. Morales seems willing to listen, so Smale explains Big Gains’ management strategy, which involves a modified version of the Capital Asset Pricing Model (CAPM) using the Dow Jones Total Market Index. He raves about this valuation model, citing its ability to project future alphas, determine true market betas of individual stocks, create an accurate picture of the market portfolio, and provide an alternative for calculated covariances in the charting of the Markowitz Efficient Frontier. After an hour of verbal sparring with Smale, Morales is not yet convinced of the wisdom of active management. He turns to Tobin Capital, calling Susan Worthan, a college friend who works as an analyst in the equity department. Tobin Capital uses the arbitrage pricing theory (APT) to value stocks. Worthan explains that APT offers several benefits relative to the CAPM, most notably its dependence on fewer and less restrictive assumptions. After listening to Worthan’s explanation of the APT, Morales asked her how the theory dealt with mispriced stocks, drawing a table with the following data to illustrate his question: Stock Curre Est. Price in Correlation nt 1 Year with S&P 500 Price $45 $51 0.57 Xavier Flocking Yaris Yarn $6 $6.75 Zimmer $167 $181 Autos 0.40 0.89 Standard Deviation of Returns 17% Beta 7% 10.5% 1.21 0.34 1.68 After seeing Morales’ stock example, Worthan tells him that he still does not understand APT and tries to explain how the theory deals with mispriced stocks. Which of the following statements is most accurate? Under APT: A)any mispricings will be immediately rectified. B)mispricings cannot occur, and there is no arbitrage opportunity. C) the calculation of unsystematic risk is so accurate that mispricings are rare. Explanation: A) Arbitrage pricing theory holds that any arbitrage opportunities will be exploited immediately, making the mispricing disappear 19.2 Which of the following is least likely an assumption of the market model? A)The expected value of the error term is zero. B)Unsystematic risk can be diversified away. C)The firm-specific surprises are uncorrelated across assets. Explanation: B) The assumption that unsystematic risk can be diversified away is an assumption of the arbitrage pricing theory. 19.3 Smale best makes his point about the superiority of active management with his mention of: A)multifactor models. B)systematic risk C)market efficiency Explanation: A) Systematic risk cannot be diversified away, and there is no dependable evidence that active management can help control it. Active managers attempt to capitalize on inefficiencies in the market, and a truly efficient market would eliminate the need for active management. However, multifactor models are a useful tool for active managers, and a high-quality model may indeed represent a competitive advantage over a passive manager 19.4 Which assumption is required by both the CAPM and the APT? A)There are no transaction costs B)All investors have the same return expectations C)Asset prices are not discounted for unsystematic risk. Explanation: C) The assumptions that all investors have the same expectations and that there are no transaction costs are specific to CAPM, not APT. However, both models assume that unsystematic risk can be diversified away, and has a risk premium of zero. 19.5 Which of Morales’ arguments against active management is least accurate? A)“Mutual funds average returns below their benchmarks.” B)“Expenses are higher with active management.” C)“All the buying and selling makes for less-efficient markets.” Explanation: C) When little money is actively managed, asset prices begin to deviate from fair values. Active management exploits inefficiencies and drives prices back toward equilibrium. Both remaining arguments are valid. 19.6 Assuming Morales’ numbers are correct, portfolio allocation of 65% of one stock and 35% of a second would allow arbitrage profits to be closest to: A)0.29% B)0.90% C)0% Explanation: B) A portfolio containing 65% Xavier Flocking and 35% Zimmer Auto would have a weighted average beta of (65% × 1.68) + (35% × 0.34) = 1.21, which is the same as the beta of Yaris Yarn. The weighted average return of the combined portfolio is 11.6%, versus a 12.5% return for Yaris Yarn. Buying Yaris Yarn and selling the Xavier/Zimmer portfolio would earn an estimated 0.9% without investing any capital or taking on any systematic risk. 20. A portfolio with a factor sensitivity of one to a particular factor in a multi-factor model and zero to all other factors is called a(n): A)tracking portfolio. B)factor portfolio. C)arbitrage portfolio. Explanation: B) A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to all other factors. An arbitrage portfolio is a portfolio with factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero. A tracking portfolio is a portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index 21. A portfolio manager uses a two-factor model to manage her portfolio. The two factors are confidence risk and time-horizon risk. If she wants to bet on an unexpected increase in the confidence risk factor (which has a positive risk premium), but hedge away her exposure to time-horizon risk (which has a negative risk premium), she should create a portfolio with a sensitivity of: A)1.0 to the confidence risk factor and 0.0 to the time-horizon factor. B)1.0 to the confidence risk factor and -1.0 to the time-horizon factor. C)−1.0 to the confidence risk factor and 1.0 to the time-horizon factor. Explanation: A) She wants to create a confidence risk factor portfolio, which has a sensitivity of 1.0 to the confidence risk factor and 0.0 to the time horizon factor. Because the risk premium on the confidence risk factor is positive, an unexpected increase in this factor will increase the returns on her portfolio. The exposure to the time-horizon risk factor has been hedged away, because the sensitivity to that factor is zero 22. Janice Barefoot, CFA, has been managing a portfolio for a client who has asked Barefoot to use the Dow Jones Industrial Average (DJIA) as a benchmark. In her second year, Barefoot used 29 of the 30 DJIA stocks. She selected a non-DJIA stock in the same industry as the omitted DJIA stock to replace that stock. Compared to the DJIA, Barefoot placed a lower weight on the communication stocks and a higher weight on the other stocks still in the portfolio. Over that year, the non-DJIA stock in the portfolio had a positive and higher return than the omitted DJIA stock. The communication stocks had a negative return while all of the other stocks had a positive return. The portfolio managed by Barefoot outperformed the DJIA. Based on this we can say that the return from factor tilts and asset selection were: A)both positive. B)negative and positive respectively. C)positive and negative respectively Explanation: A) Since the communications stocks had a negative return while all the other stocks had a positive return, Barefoot’s underweighting of those stocks produced a positive tilt return. Since the asset chosen to replace the DJIA stock outperformed the omitted stock, the asset selection return was positive 23. A common strategy in bond portfolio management is enhanced indexing by matching primary risk factors. This strategy could be implemented by forming: A)a portfolio with factor sensitivities that sum to one. B)a portfolio with factor sensitivities equal to that of the index. C)a portfolio with asset portfolio weights equal to that of the index Explanation: B) Enhanced indexing by matching primary risk factors could be implemented by creating a tracking portfolio with the same factor sensitivities as the index but with a different set of bonds. Then any differences in performance between the portfolio and the benchmark index will be the result of bond selection ability and not from different exposures to macroeconomic factors like GDP, inflation, and interest rates 24. A portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index is called a: A)tracking portfolio. B)factor portfolio. C)arbitrage portfolio. Explanation: A) A tracking portfolio is a portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index. A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to all other factors. An arbitrage portfolio is a portfolio with factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero 25. Janice Barefoot, CFA, has been managing a portfolio for a client who has asked Barefoot to use the Dow Jones Industrial Average (DJIA) as a benchmark. In her first year Barefoot managed the portfolio by choosing 29 of the 30 DJIA stocks. She selected a non-DJIA stock in the same industry as the omitted stock to replace that stock. Compared to the DJIA, Barefoot has placed a higher weight on the financial stocks and a lower weight on the other stocks still in the portfolio. Over that year, the non-DJIA stock in the portfolio had a negative return while the omitted DJIA stock had a positive return. The portfolio managed by Barefoot outperformed the DJIA. Based on this we can say that the return from factor tilts and asset selection were: A)negative and positive respectively. B)both positive. C)positive and negative respectively. Explanation: C) Since the replacement of the asset obviously had a negative effect, the tilting towards financial stocks must have been positive to not only compensate for the loss but produce a portfolio return greater than the DJIA 26. Janice Barefoot, CFA, has managed a portfolio where she used the Dow Jones Industrial Average (DJIA) as a benchmark. In the past two years the average monthly return on her portfolio has been higher than that of the DJIA. To get a measure of active return per unit of active risk Barefoot should compute the: A)information ratio, which is the standard deviation of the differences between the portfolio and benchmark returns divided by the average of those differences. B)Sharpe ratio, which is the standard deviation of the differences between the portfolio and benchmark returns divided into the average of those differences. C)information ratio, which is the standard deviation of the differences between the portfolio and benchmark returns divided into the average of those differences. Explanation: C) The information ratio is the measure of active return per unit of active risk. If we let X = (monthly portfolio return − the benchmark return), then the information ratio = (the average of X / the standard deviation of X). It is similar to the Sharpe ratio, which defines the random variable Y as Y = (monthly portfolio return − the risk-free rate). The Sharpe ratio = (the average of Y / the standard deviation of the portfolio return) = the standard deviation of Y if the risk-free rate is constant 27. A tracking portfolio is a portfolio with: A)factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero. B)a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index. C)a factor sensitivity of one to a particular factor in a multi-factor model and zero to all other factors Explanation: B) A tracking portfolio is a portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index. A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to all other factors. An arbitrage portfolio is a portfolio with factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero 28. A factor portfolio is a portfolio with: A)a factor sensitivity of one to a particular factor in a multi-factor model and zero to all other factors. B)a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index. C)factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero Explanation: A) A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to all other factors. An arbitrage portfolio is a portfolio with factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero. A tracking portfolio is a portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index 29. Sidney Peterson is starting a new fund that is designed to have the same factor exposures as the Dow Jones Industrial Average, but seeks to outperform the index by at least 2% annually thorough superior stock selection. To achieve this, the fund would most likely use a: A)tracking portfolio. B)bottom-up strategy. C)pure factor portfolio. Explanation: A) Tracking portfolios are typically used for active asset selection. A pure factor portfolio would be used to increase or decrease exposure to one specific factor, such as GNP. A bottom-up strategy is unsuitable because it solely focuses on a firm’s characteristics and fails to properly invest in the same industries as the index 30. The Real Value Fund is designed to have zero exposure to inflation. However its current inflation factor sensitivity is 0.30. To correct for this, the portfolio manager should take a: A)30% short position in the inflation tracking portfolio. B)30% long position in the inflation factor portfolio. C)30% short position in the inflation factor portfolio. Explanation: C) To hedge inflation, the fund should take a 30% short position in the inflation factor portfolio. This short position will fully offset the fund’s positive exposure to inflation. Tracking portfolios are typically used for active asset selection and have multiple factor exposures which would prevent them from adequately hedging the inflation exposure of the fund 31. An analyst is constructing a portfolio for a new client. A portfolio which uses multifactor models to create a portfolio with an exposure to only one type of risk is: A)an efficient portfolio. B)a tracking portfolio. C)a factor portfolio Explanation: C) A factor portfolio is established to create exposure to a specific risk (i.e. inflation) 32. An analyst is constructing a portfolio for a new client. A portfolio which has factor exposures matched to those of a benchmark is: A)an arbitrage portfolio. B)a tracking portfolio. C)an efficient portfolio. Explanation: B) A tracking portfolio has factor exposures matched to those of a benchmark 33. Which of the following is an implication of the capital asset pricing model for investor’s portfolio decisions? A)Less risk-averse investors will hold less of a broadly based index and more of the risk-free asset. B)All investors will hold some combination of a broadly based market index and the risk-free asset. C)Less risk-averse investors will overweight high-beta stocks relative to the market portfolio Explanation: B) The CAPM suggests that all investors should hold some combination of the market portfolio and the risk-free asset. Less risk-averse investors will hold more of the market portfolio (and move farther up the CML) and more risk-averse investors will hold more of the risk-free asset (and move farther down the CML) 34. In the context of multi-factor models, investors with lower-than-average exposure to recession risk (e.g. those without labor income) can earn a risk premium for holding dimensions of risk unrelated to market movements by creating equity portfolios with: A)greater-than-average exposure to the recession risk factor. B)greater-than-average market risk exposure. C)less-than-average exposure to the recession risk factor. Explanation: A) Multifactor models allow us to capture other dimensions of risk besides overall market risk. Investors with unique circumstances different than the average investor may want to hold portfolios tilted away from the market portfolio in order to hedge or speculate on factors like recession risk, interest rate risk or inflation risk. An investor with lower-than-average exposure to recession risk can earn a premium by creating greater-than-average exposure to the recession risk factor. In effect, he earns a risk premium determined by the average investor by taking on a risk he doesn’t care about as much as the average investor does 35. Which of the following models is NOT consistent with the concept that investors can earn an additional risk premium for holding dimensions of risk unrelated to market movements? A)The capital asset pricing model (CAPM). B)The arbitrage pricing theory. C)Macroeconomic multi-factor models. Explanation: A) The CAPM suggests that security returns can be captured in a one-factor (market) model. Multifactor models allow us to capture other dimensions of risk besides overall market risk. Investors with unique circumstances that differ from the average investor may want to hold portfolios tilted away from the market portfolio in order to hedge or speculate on factors like recession risk, interest rate risk or inflation risk. In doing so they are able to earn a substantial premium for holding dimensions of risk unrelated to market movements 36. Which of the following statements regarding the arbitrage pricing theory (APT) and the capital asset pricing model (CAPM) is least accurate? APT: A)does not identify its risk factors. B)requires fewer assumptions than CAPM. C)and CAPM assume all investors hold the market portfolio. Explanation: C) CAPM assumes that all investors hold the market portfolio, APT does not make this assumption