Chapter 3 - Principles of Investment Risk & Return Flashcards
Which of the following best describes the concept of Time Value of Money (TVM)?
a) Money held today and money received in the future have the same value if inflation is low.
b) Future cash flows should always be discounted using the risk-free rate to determine their present value.
c) A sum of money today is worth more than the same sum in the future due to its potential to generate returns.
d) The value of money remains constant over time if interest rates are stable.
Answer: c
Explanation: TVM states that money today has greater value than the same amount in the future because it can be invested and earn returns. This principle applies regardless of inflation or interest rates.
A firm expects to receive £500,000 in five years. Assuming a discount rate of 7% per annum, what is the approximate present value of this future sum?
a) £356,490
b) £410,210
c) £356,130
d) £392,480
Answer: a
Explanation: Present Value (PV) is calculated using the formula:
PV = FV/(1+r)^t
PV = 500,000/(1.07)^5 = 356,490
This shows how discounting adjusts for the time value of money.
An investor has the option to receive £50,000 today or £70,000 in six years. If the investor’s required rate of return is 5% per annum, which option is financially preferable?
a) Taking the £50,000 today is better, as future money is always worth less.
b) Taking the £70,000 in six years is better, as it is a larger sum.
c) Both options are equivalent in value when adjusted for the time value of money.
d) The decision depends on the risk-free rate rather than the investor’s required return.
Answer: b
Explanation: To compare, we discount £70,000 back to present value:
𝑃𝑉 = £70,000 / (1.05)^6 ≈ £52,300
Since £52,300 (discounted value) is greater than £50,000, the future amount is slightly preferable. However, if opportunity costs or risk are considered, taking £50,000 now may still be reasonable.
Which of the following best describes the time value of money (TVM)?
A) Money today is worth the same as money in the future due to inflation adjustments.
B) Money today is worth more than money in the future because of its potential earning capacity.
C) Money today is worth less than money in the future due to risk factors.
D) Money today and in the future have the same value if invested at a risk-free rate
✅ Answer: B
📖 Explanation: The time value of money principle states that a sum of money is worth more today than in the future because it can be invested to generate returns.
If an investor deposits £5,000 in a savings account offering 6% annual compound interest, how much will they have after 8 years?
A) £7,540.20
B) £7,969.24
C) £8,540.60
D) £8,961.40
✅ Answer: B
📖 Explanation: Use the future value formula:
FV = PV × (1 + r)ⁿ
= £5,000 × (1.06)⁸ = £7,969.24
An investment of £10,000 grows to £16,000 in 6 years. What is the approximate annual compound interest rate?
A) 7.9%
B) 8.1%
C) 8.6%
D) 9.2%
✅ Answer: B
📖 Explanation: Use the compound interest formula solved for r:
FV = PV × (1 + r)ⁿ
16,000 = 10,000 × (1 + r)⁶
(1 + r) = (16,000/10,000)^(1/6)
r ≈ 8.1%
What is the present value of £50,000 received in 10 years, assuming a discount rate of 5%?
A) £30,675
B) £33,891
C) £38,610
D) £41,322
✅ Answer: B
📖 Explanation: Use the present value formula:
PV = FV / (1 + r)ⁿ
= 50,000 / (1.05)¹⁰ = £33,891
An investment requires an initial outlay of £20,000 and returns £5,000 per year for 6 years. If the discount rate is 10%, what is the net present value (NPV)?
A) £2,150
B) £2,890
C) £3,415
D) £4,275
✅ Answer: C
📖 Explanation: Use the NPV formula:
NPV = Σ [Cash Flow / (1 + r)ⁿ] - Initial Investment
= £5,000 × [1 - (1.10)⁻⁶] / 0.10 - £20,000
= £3,415
A 10-year bond pays a fixed interest rate of 4% per annum. If inflation is consistently 5% per annum, what is the real rate of return?
A) -1.00%
B) -0.95%
C) 0.96%
D) 1.02%
✅ Answer: B
📖 Explanation: Use the Fisher equation:
Real Rate ≈ (1 + Nominal Rate) / (1 + Inflation Rate) - 1
= (1.04 / 1.05) - 1 ≈ -0.95% (indicating a real loss).
If the inflation rate is 4% per year, how much will a £10,000 product cost in 15 years?
A) £15,231
B) £18,009
C) £18,006
D) £20,121
✅ Answer: B
📖 Explanation: Use the inflation-adjusted future value formula:
FV = PV × (1 + inflation rate)ⁿ
= 10,000 × (1.04)¹⁵ = £18,009
What is the future value of an annuity that pays £2,500 annually for 10 years at an interest rate of 5%?
A) £31,453
B) £32,578
C) £34,719
D) £36,288
✅ Answer: C
📖 Explanation: Use the future value of an annuity formula:
FV = P × [(1 + r)ⁿ - 1] / r
= £2,500 × [(1.05)¹⁰ - 1] / 0.05
= £34,719
If an investment earns 8% per year, how long will it take for it to double in value?
A) 9 years
B) 8.9 years
C) 9.1 years
D) 10.2 years
✅ Answer: A
📖 Explanation: Use the Rule of 72:
Time (years) = 72 / interest rate
= 72 / 8 = 9 years
What is the main reason that future value calculations require compounding?
A) To account for declining purchasing power.
B) To reflect the time value of money and reinvestment of earnings.
C) To ensure cash flows remain constant.
D) To match inflationary adjustments.
✅ Answer: B
📖 Explanation: Future value accounts for reinvestment of returns, compounding interest over time.
A pension fund is expected to grow at an annual rate of 7%. How much should an investor contribute annually for 20 years to accumulate £1,000,000?
A) £18,289
B) £20,503
C) £22,657
D) £24,393
✅ Answer: D
📖 Explanation: Use the future value of an annuity formula:
FV = P × [(1 + r)ⁿ - 1] / r
Solving for P gives £24,393 per year.
If an investor requires a real return of 3% and expects inflation to be 2.5%, what nominal return should they target?
A) 5.62%
B) 5.57%
C) 5.93%
D) 6.05%
✅ Answer: B
📖 Explanation: Using the Fisher equation:
Nominal Rate ≈ (1 + Real Rate) × (1 + Inflation Rate) - 1
= (1.03 × 1.025) - 1 = 5.57%
A company is evaluating a project that requires an investment of £500,000 and generates annual cash flows of £120,000 for 5 years. If the discount rate is 6%, should the company proceed?
A) Yes, because the NPV is positive.
B) Yes, because the IRR exceeds the discount rate.
C) No, because the NPV is negative.
D) No, because the payback period exceeds 5 years.
✅ Answer: A
📖 Explanation: Using NPV formula, the NPV is positive, meaning the investment adds value.
What impact does a higher discount rate have on the present value of future cash flows?
A) Increases the present value.
B) Decreases the present value.
C) Has no effect on the present value.
D) Causes future cash flows to grow at a higher rate.
✅ Answer: B
📖 Explanation: A higher discount rate reduces present value, as future cash flows are discounted more heavily.
If an investor deposits £1,500 monthly into an account earning 5% compounded monthly, how much will they have in 10 years?
A) £193,685
B) £204,122
C) £232,950
D) £238,901
✅ Answer: C
📖 Explanation: Use the future value of an annuity formula for monthly contributions.
What is the main risk of relying solely on the Rule of 72 for estimating investment growth?
A) It only applies to interest rates below 5%.
B) It does not account for inflation.
C) It assumes simple interest instead of compound interest.
D) It becomes inaccurate for very high or low rates.
✅ Answer: D
📖 Explanation: The Rule of 72 is an approximation, and becomes less accurate at extreme interest rates.
If inflation is consistently 3% per year, how much will £5,000 be worth in real terms in 25 years?
A) £2,440
B) £2,890
C) £3,050
D) £3,290
✅ Answer: A
📖 Explanation: Use the inflation-adjusted present value formula:
PV = FV / (1 + inflation rate)ⁿ
= £5,000 / (1.03)²⁵ = £2,440
A company is considering two investments: Project A with a 10% annual return and Project B with a 12% annual return. If inflation is 4%, what is the real rate of return for each?
A) 5.8% for A and 7.7% for B
B) 5.9% for A and 7.7% for B
C) 6.0% for A and 7.6% for B
D) 6.1% for A and 7.8% for B
✅ Answer: A
📖 Explanation: Use the Fisher equation for each:
Real Rate = (1 + Nominal Rate) / (1 + Inflation Rate) - 1
Project A: (1.10 / 1.04) - 1 ≈ 5.8%
Project B: (1.12 / 1.04) - 1 ≈ 7.7%
What happens when interest is compounded continuously rather than annually?
A) The final amount is always twice the principal.
B) The investment grows at an exponentially higher rate.
C) The interest rate becomes less important.
D) The investment’s value decreases over time.
✅ Answer: B
📖 Explanation: Continuous compounding leads to exponential growth, as per the formula:
FV = PV × e^(rt)
If an investor has the option to receive £50,000 today or £75,000 in 10 years, what discount rate would make them indifferent?
A) 3.8%
B) 4.5%
C) 5.2%
D) 6.0%
✅ Answer: C
📖 Explanation: Solve using PV = FV / (1 + r)ⁿ and find r that equates the present values.
What is the primary factor influencing the risk premium required by investors for holding a particular asset?
A) The risk-free rate of return
B) The asset’s correlation with market movements
C) The standard deviation of historical returns
D) The investor’s subjective risk tolerance
✅ Answer: B
📖 Explanation: The risk premium compensates for the systematic risk of an asset, which is measured by its beta (correlation with the market).
Which of the following is an example of an investment carrying only unsystematic risk?
A) A government bond yielding 3%
B) A diversified global equity fund
C) A small technology company’s stock
D) An index-tracking exchange-traded fund (ETF)
✅ Answer: C
📖 Explanation: Unsystematic risk is company-specific. Small tech firms are highly volatile due to individual business risk, unlike diversified or government-backed investments.
Systematic risk is best described as which of the following?
A) Risk that can be reduced through portfolio diversification
B) The impact of a company’s management decisions on its stock performance
C) Risk that affects an entire market or economy and cannot be diversified away
D) The possibility of default on a corporate bond
✅ Answer: C
📖 Explanation: Systematic risk (also known as market risk) includes risks such as inflation, interest rates, and geopolitical events, which affect all investments.
Which event best illustrates systemic risk?
A) The bankruptcy of a small regional bank
B) A corporate fraud scandal at a single company
C) The 2008 global financial crisis
D) A sharp increase in oil prices affecting energy stocks
✅ Answer: C
📖 Explanation: Systemic risk refers to failures that impact the entire financial system, such as the 2008 financial crisis.
What is the main disadvantage of a highly concentrated investment portfolio?
A) It reduces the effect of unsystematic risk
B) It eliminates exposure to systematic risk
C) It increases vulnerability to company or sector-specific shocks
D) It ensures stable returns over the long term
✅ Answer: C
📖 Explanation: A concentrated portfolio exposes investors to unsystematic risk, as it lacks diversification across industries or geographies.
How can diversification reduce risk in an investment portfolio?
A) By increasing exposure to higher-risk assets
B) By eliminating all risk from investments
C) By spreading investments across uncorrelated assets
D) By concentrating capital into high-growth industries
✅ Answer: C
📖 Explanation: Diversification reduces unsystematic risk by investing in uncorrelated assets, ensuring that poor performance in one area does not significantly impact the whole portfolio.
An investor believes they can predict market movements and adjusts their asset allocation frequently. What is this strategy called?
A) Passive investing
B) Market timing
C) Buy and hold
D) Mean reversion
✅ Answer: B
📖 Explanation: Market timing is the practice of actively moving in and out of investments based on perceived market trends, often increasing transaction costs and risk.
Which risk is most likely to impact all assets in an investment portfolio, regardless of diversification?
A) Interest rate risk
B) Liquidity risk
C) Business risk
D) Default risk
✅ Answer: A
📖 Explanation: Interest rate risk is a systematic risk, affecting all asset classes, including equities, bonds, and real estate.
Why do longer investment timescales generally reduce risk?
A) They allow investors to engage in frequent trading
B) They provide more opportunities to exploit short-term market movements
C) They smooth out volatility and increase the probability of positive returns
D) They ensure that investors can avoid economic recessions
✅ Answer: C
📖 Explanation: Over time, market fluctuations tend to balance out, reducing volatility for long-term investors.
How does ESG investing impact risk-adjusted returns?
A) It always improves returns by focusing on ethical companies
B) It reduces exposure to potential regulatory and reputational risks
C) It eliminates the need for traditional risk assessment
D) It ensures all companies in the portfolio are equally sustainable
✅ Answer: B
📖 Explanation: ESG investing can lower risk exposure by avoiding companies with high regulatory, governance, or environmental risks.
What is the main objective of measuring beta in an investment portfolio?
A) To assess the correlation between an asset and overall market risk
B) To determine an asset’s intrinsic value
C) To evaluate liquidity risk in a portfolio
D) To estimate the potential default risk of corporate bonds
✅ Answer: A
📖 Explanation: Beta measures an asset’s sensitivity to market movements, with a beta above 1 indicating higher volatility than the market.
Which of the following factors can lead to concentration risk?
A) Investing in multiple uncorrelated asset classes
B) Holding a portfolio composed primarily of technology stocks
C) Rebalancing a portfolio periodically
D) Allocating assets across various sectors and geographies
✅ Answer: B
📖 Explanation: Holding many assets within the same sector leads to concentration risk, reducing diversification benefits.
What is a key characteristic of unsystematic risk?
A) It can be reduced through diversification
B) It affects all investments equally
C) It is driven by macroeconomic events
D) It cannot be mitigated by hedging
✅ Answer: A
📖 Explanation: Unsystematic risk is company- or industry-specific and can be minimized through diversification.
Which asset class is most affected by systemic risk?
A) Government bonds
B) Equities
C) Real estate
D) Commodities
✅ Answer: B
📖 Explanation: Equities are highly exposed to systemic risk, as they react strongly to economic downturns and financial crises.
Why is market timing difficult to execute successfully?
A) It requires no skill or analysis
B) It involves frequent trading with minimal transaction costs
C) It assumes investors can consistently predict market trends
D) It reduces exposure to systematic risk
✅ Answer: C
📖 Explanation: Timing the market successfully requires consistently accurate predictions, which is extremely difficult due to market efficiency.
Why do some investors allocate capital to ESG investments despite concerns over returns?
A) They are legally required to do so
B) ESG investments guarantee outperformance
C) ESG factors may reduce regulatory, legal, and reputational risks
D) ESG funds only invest in large, stable companies
✅ Answer: C
📖 Explanation: ESG investing can reduce risks related to regulation, governance, and environmental liabilities, making companies more resilient.
Which of the following would best help an investor hedge against systematic risk?
A) Investing in a diverse set of stocks
B) Holding only government bonds
C) Using derivatives such as index options
D) Buying stocks with high expected growth rates
✅ Answer: C
📖 Explanation: Hedging using derivatives (e.g., index puts) can offset losses from broad market declines.
How does high inflation impact the risk premium on equities?
A) It decreases risk premium
B) It increases risk premium
C) It has no effect on risk premium
D) It makes equities a risk-free investment
✅ Answer: B
📖 Explanation: Higher inflation increases economic uncertainty, leading investors to demand a higher risk premium for equities.
What is the key risk in sustainable investing (ESG)?
A) Lack of sufficient regulation
B) Guaranteed underperformance
C) No risk premium considerations
D) No diversification benefits
✅ Answer: A
📖 Explanation: ESG investing is still evolving, and lack of standardization creates uncertainty around regulation and performance measurement.
Which of the following factors increases the risk premium required by investors?
A) Greater market efficiency
B) Reduced liquidity in financial markets
C) Stable macroeconomic conditions
D) Higher central bank intervention
✅ Answer: B
📖 Explanation: Lower liquidity increases risk, requiring higher compensation (risk premium) to attract investors.
What does the variance of an investment’s returns measure?
A) The likelihood of an investment outperforming the market
B) The dispersion of returns around the mean return
C) The total risk of a portfolio, including systematic and unsystematic risk
D) The risk-adjusted return relative to a benchmark
✅ Answer: B
📖 Explanation: Variance measures the dispersion of returns around the average return, indicating the investment’s risk.
Which of the following statements about standard deviation is true?
A) It measures the absolute level of risk in an investment
B) It only considers downside risk
C) It is unaffected by extreme values
D) It is a measure of expected return
✅ Answer: A
📖 Explanation: Standard deviation is a measure of total risk, capturing both upside and downside volatility.
What does a correlation coefficient of -1 between two assets indicate?
A) The assets move perfectly together in the same direction
B) The assets have no relationship in their movements
C) The assets move in completely opposite directions
D) The assets have identical return distributions
✅ Answer: C
📖 Explanation: A correlation coefficient of -1 means perfect inverse movement—when one asset rises, the other falls.
What does total return include?
A) Only price appreciation
B) Only dividends and interest payments
C) Capital gains, dividends, and interest income
D) Only unrealized gains and losses
✅ Answer: C
📖 Explanation: Total return includes all sources of return—capital gains, dividends, and interest.
The Sharpe ratio measures return relative to which type of risk?
A) Systematic risk
B) Unsystematic risk
C) Total risk
D) Credit risk
✅ Answer: C
📖 Explanation: The Sharpe ratio evaluates risk-adjusted return by dividing excess return by total risk (standard deviation).
How does the Sortino ratio improve upon the Sharpe ratio?
A) It only considers downside volatility
B) It adjusts for total risk, not just market risk
C) It measures alpha relative to systematic risk
D) It removes the need for a risk-free rate
✅ Answer: A
📖 Explanation: The Sortino ratio focuses on downside deviation, ignoring upside volatility.
What does the Treynor ratio measure?
A) Return per unit of total risk
B) Return per unit of systematic risk
C) Return per unit of downside risk
D) Return per unit of market timing risk
✅ Answer: B
📖 Explanation: The Treynor ratio divides excess return by beta, measuring return per unit of systematic risk.
What is Jensen’s Alpha primarily used for?
A) Assessing whether a portfolio has outperformed its expected return based on CAPM
B) Measuring excess return per unit of risk
C) Evaluating a portfolio’s correlation with the market
D) Calculating total return over a given period
✅ Answer: A
📖 Explanation: Jensen’s Alpha shows excess return beyond what CAPM predicts, indicating manager skill.
A high information ratio suggests that a portfolio manager has:
A) Generated returns with minimal risk
B) Achieved high returns regardless of risk
C) Delivered consistent returns above the benchmark
D) Matched the market return with low volatility
✅ Answer: C
📖 Explanation: The information ratio measures excess return per unit of active risk, showing consistency in beating the benchmark.
If a portfolio has an R-squared value of 85%, what does this imply?
A) 85% of the portfolio’s movements are explained by its benchmark
B) The portfolio will outperform the market 85% of the time
C) The portfolio is highly diversified
D) The portfolio has no systematic risk
✅ Answer: A
📖 Explanation: R-squared measures how much of a portfolio’s returns are explained by the benchmark.
Which risk measure is most useful for investors concerned with tail risk?
A) Standard deviation
B) Value at Risk (VaR)
C) Beta
D) Treynor ratio
✅ Answer: B
📖 Explanation: Value at Risk (VaR) estimates potential losses in extreme scenarios.
A portfolio with a low R-squared and a high Sharpe ratio suggests:
A) Strong correlation with the market
B) Skilled active management
C) Low systematic risk
D) Poor risk-adjusted returns
✅ Answer: B
📖 Explanation: A low R-squared suggests independence from the market, and high Sharpe indicates strong active management.
What is the primary criticism of using standard deviation as a risk measure?
A) It does not account for systematic risk
B) It considers both upside and downside volatility equally
C) It is not mathematically rigorous
D) It is only useful for short-term investments
✅ Answer: B
📖 Explanation: Standard deviation does not distinguish between good and bad volatility.
The Sortino ratio differs from the Sharpe ratio by using which risk metric?
A) Downside deviation
B) Total return
C) Market beta
D) Value at Risk
✅ Answer: A
📖 Explanation: The Sortino ratio focuses on downside risk, ignoring positive volatility.
What does a negative Jensen’s Alpha indicate?
A) A portfolio is outperforming expectations
B) The portfolio is underperforming its expected return based on CAPM
C) The portfolio is highly volatile
D) The portfolio has a low correlation with the market
✅ Answer: B
📖 Explanation: A negative Jensen’s Alpha means returns are lower than expected given the portfolio’s beta.
What does a higher Sharpe ratio indicate about a portfolio’s performance?
A) It has higher absolute returns compared to peers
B) It has generated higher risk-adjusted returns
C) It has lower market correlation
D) It has less exposure to systematic risk
✅ Answer: B
📖 Explanation: A higher Sharpe ratio means the portfolio has better risk-adjusted returns, meaning it is delivering more return per unit of risk.
Why is the Treynor ratio considered more suitable than the Sharpe ratio for well-diversified portfolios?
A) It accounts for unsystematic risk
B) It only considers systematic risk (beta)
C) It measures maximum drawdown
D) It uses downside deviation instead of standard deviation
✅ Answer: B
📖 Explanation: Since a well-diversified portfolio eliminates unsystematic risk, the Treynor ratio is more relevant because it focuses on systematic risk (beta).
A portfolio manager claims to have generated alpha. Which of the following must be true for this to be correct?
A) The portfolio outperformed its benchmark
B) The portfolio delivered higher risk-adjusted returns than the risk-free rate
C) The portfolio achieved excess returns after adjusting for risk using CAPM
D) The portfolio had a lower Sharpe ratio than its benchmark
✅ Answer: C
📖 Explanation: Alpha refers to excess return after adjusting for the risk level predicted by the Capital Asset Pricing Model (CAPM).
What does a high information ratio suggest?
A) The portfolio has delivered excess return consistently above its benchmark
B) The portfolio has outperformed the risk-free rate
C) The portfolio has high systematic risk
D) The portfolio has a low Sharpe ratio
✅ Answer: A
📖 Explanation: The information ratio measures how much excess return a portfolio generates per unit of active risk, showing consistent outperformance.
If two funds have the same Sharpe ratio but different standard deviations, what does this imply?
A) The funds have different return profiles
B) The fund with lower standard deviation has lower risk-adjusted performance
C) The fund with higher standard deviation must have lower returns
D) Both funds have identical risk-adjusted performance
✅ Answer: D
📖 Explanation: Sharpe ratio already adjusts for standard deviation, meaning both funds have the same risk-adjusted performance, even if their total risk differs.
What does a beta of 1.5 imply about a portfolio’s expected volatility relative to the market?
A) It is 50% more volatile than the market
B) It is 50% less volatile than the market
C) It moves in the opposite direction of the market
D) It is uncorrelated with the market
✅ Answer: A
📖 Explanation: A beta of 1.5 means the portfolio is 50% more volatile than the market, amplifying both gains and losses.
What does an R-squared value of 95% indicate?
A) The portfolio closely tracks the benchmark
B) The portfolio has outperformed 95% of its peers
C) The portfolio has low systematic risk
D) The portfolio is highly diversified
✅ Answer: A
📖 Explanation: R-squared measures the degree of correlation between the portfolio and benchmark, with 95% meaning it tracks very closely.
If a portfolio has a high Sharpe ratio but a negative alpha, what does this suggest?
A) The portfolio has good risk-adjusted returns but underperforms its benchmark
B) The portfolio has taken on excessive risk
C) The portfolio has higher beta than the market
D) The portfolio has no systematic risk
✅ Answer: A
📖 Explanation: Negative alpha means the portfolio is underperforming the expected CAPM return, even if its Sharpe ratio suggests good risk-adjusted performance.
If a fund’s Treynor ratio is lower than that of its benchmark, what does this imply?
A) The fund has lower risk-adjusted return relative to systematic risk
B) The fund has lower overall risk
C) The fund has a higher Sharpe ratio
D) The fund has lower downside deviation
✅ Answer: A
📖 Explanation: A lower Treynor ratio suggests the fund is underperforming the benchmark after adjusting for systematic risk.
How does alternative benchmarking differ from traditional benchmarking?
A) It includes non-financial metrics like ESG factors
B) It only applies to hedge funds
C) It ignores market performance
D) It tracks risk-free rates instead of market indices
✅ Answer: A
📖 Explanation: Alternative benchmarks consider additional factors like ESG performance, absolute return objectives, or custom indices.
Which of the following statements about Jensen’s Alpha is true?
A) It measures how much return a portfolio generates for each unit of risk
B) It evaluates performance against the risk-free rate
C) It is based on excess return relative to expected return under CAPM
D) It is unaffected by market beta
✅ Answer: C
📖 Explanation: Jensen’s Alpha measures excess return relative to CAPM expectations, showing a manager’s ability to outperform.
Why is benchmarking important in investment performance evaluation?
A) It provides a reference point for assessing relative performance
B) It eliminates market risk
C) It adjusts for changes in investor preferences
D) It only applies to passive investing
✅ Answer: A
📖 Explanation: Benchmarking is essential for measuring portfolio performance relative to a standard, whether an index or a custom benchmark.
If a portfolio has an R-squared of 10% with its benchmark, what does this indicate?
A) It has a low correlation with the benchmark
B) It has a high risk-adjusted return
C) It has outperformed its benchmark
D) It has low total risk
✅ Answer: A
📖 Explanation: A low R-squared value means the portfolio does not closely follow the benchmark’s movements.
Why might an investor prefer a portfolio with a high Sortino ratio over a high Sharpe ratio?
A) It penalizes upside volatility less
B) It considers total risk
C) It ignores market beta
D) It is not affected by asset correlation
✅ Answer: A
📖 Explanation: The Sortino ratio only accounts for downside risk, making it more relevant for investors concerned about capital preservation.
What is the key limitation of the Sharpe ratio when comparing funds with different strategies?
A) It does not differentiate between upside and downside volatility
B) It ignores benchmark performance
C) It assumes a risk-free rate of zero
D) It does not consider total return
✅ Answer: A
📖 Explanation: The Sharpe ratio treats all volatility equally, meaning it penalizes positive volatility the same way as negative volatility.
Which of the following best describes the holding period return (HPR) of a two-security portfolio?
A) The sum of individual security returns divided by the number of securities
B) The weighted average return of both securities, adjusted for time
C) The return based on portfolio value appreciation and income received during the period
D) The total return of the higher-performing security over the investment horizon
✅ Answer: C
📖 Explanation: The holding period return (HPR) for a portfolio considers both the capital appreciation and income received over a given period.
Which factor is the most significant in calculating the standard deviation of a portfolio?
A) The standard deviation of each individual asset
B) The number of assets in the portfolio
C) The correlation between asset returns
D) The proportion of risk-free assets in the portfolio
✅ Answer: C
📖 Explanation: Portfolio standard deviation depends heavily on correlation between assets, as diversification can reduce overall risk.
How does the Treynor ratio differ from the Sharpe ratio in evaluating portfolio performance?
A) It uses total risk instead of systematic risk
B) It focuses only on downside risk
C) It evaluates return per unit of systematic risk instead of total risk
D) It ignores the risk-free rate in calculations
✅ Answer: C
📖 Explanation: The Treynor ratio evaluates return per unit of systematic risk (beta), while the Sharpe ratio considers total risk (standard deviation).
A portfolio has an expected return of 8%, a standard deviation of 10%, and a benchmark return of 5%. What is the relative return?
A) 3%
B) 5%
C) 13%
D) 2%
✅ Answer: A
📖 Explanation: Relative return is the difference between the portfolio return and benchmark return, so 8% - 5% = 3%.
In risk-adjusted return measures, what does a high Sortino ratio indicate?
A) The portfolio has high total volatility
B) The portfolio has strong upside potential with minimal downside risk
C) The portfolio has no correlation with the market
D) The portfolio has higher standard deviation than the market
✅ Answer: B
📖 Explanation: The Sortino ratio measures risk-adjusted return but only considers downside deviation, making it more relevant for investors focused on capital protection.
What is the key limitation of using standard deviation as a risk indicator?
A) It does not account for market volatility
B) It does not differentiate between positive and negative volatility
C) It is only applicable to single-asset portfolios
D) It assumes all investments are highly correlated
✅ Answer: B
📖 Explanation: Standard deviation treats all volatility equally, meaning it does not distinguish between favorable and unfavorable fluctuations.
Why is Jensen’s Alpha a better measure of fund manager skill than absolute return?
A) It isolates unsystematic risk from the return calculation
B) It measures risk-adjusted excess return over CAPM expectations
C) It considers correlation with other asset classes
D) It focuses only on total return performance
✅ Answer: B
📖 Explanation: Jensen’s Alpha calculates a manager’s ability to generate returns above what is expected under CAPM, adjusting for risk.
If a portfolio has an R-squared value of 0.92, what does this indicate?
A) The portfolio has very high unsystematic risk
B) The portfolio’s returns are highly correlated with the benchmark
C) The portfolio has poor diversification
D) The portfolio is outperforming the benchmark
✅ Answer: B
📖 Explanation: R-squared measures correlation, and a value of 0.92 means 92% of the portfolio’s movements are explained by benchmark returns.
In a two-asset portfolio, what happens when correlation is -1?
A) The portfolio’s standard deviation is maximized
B) The portfolio experiences no risk reduction
C) The portfolio achieves the lowest possible risk
D) The portfolio returns remain unchanged
✅ Answer: C
📖 Explanation: A correlation of -1 means the assets move perfectly in opposite directions, achieving maximum risk reduction.
What does the Information Ratio measure in portfolio performance?
A) Return per unit of standard deviation
B) Excess return per unit of tracking error
C) The correlation between a portfolio and the market
D) The likelihood of achieving benchmark returns
✅ Answer: B
📖 Explanation: The Information Ratio measures how much excess return a portfolio generates per unit of tracking error.
Why does diversification reduce unsystematic risk?
A) It increases correlation between assets
B) It ensures all investments move in the same direction
C) It spreads risk across multiple uncorrelated assets
D) It eliminates market risk entirely
✅ Answer: C
📖 Explanation: Diversification reduces unsystematic risk by spreading exposure across uncorrelated assets.
What is a limitation of benchmarking using market indices?
A) Indices do not consider risk
B) Indices change too frequently to be reliable
C) Indices do not account for sector rotation
D) Indices are highly subject to selection bias
✅ Answer: A
📖 Explanation: Market indices measure absolute performance but do not consider risk-adjusted returns.
What is the primary assumption behind Modern Portfolio Theory (MPT)?
A) Investors prefer high-risk investments
B) Investors seek to maximize return for a given level of risk
C) All investors have the same risk tolerance
D) Markets are inefficient
✅ Answer: B
📖 Explanation: MPT assumes investors aim to maximize returns while minimizing risk, leading to efficient portfolios.
What does a high Treynor ratio suggest?
A) The portfolio has high correlation with the benchmark
B) The portfolio has delivered high risk-adjusted returns relative to systematic risk
C) The portfolio is concentrated in high-risk assets
D) The portfolio has lower standard deviation than the market
✅ Answer: B
📖 Explanation: Treynor ratio measures excess return per unit of beta, meaning a high value indicates strong performance relative to systematic risk.
Which risk-adjusted return measure is best suited for portfolios with asymmetric risk profiles?
A) Sharpe Ratio
B) Treynor Ratio
C) Sortino Ratio
D) Jensen’s Alpha
✅ Answer: C
📖 Explanation: The Sortino Ratio is best for asymmetric risk profiles, as it only considers downside risk, ignoring upside volatility.
What is the primary function of a benchmark in portfolio management?
A) It sets a minimum return target
B) It measures relative portfolio performance
C) It eliminates unsystematic risk
D) It determines a portfolio’s risk tolerance
✅ Answer: B
📖 Explanation: A benchmark provides a performance comparison to assess how well a portfolio is managed.
What does a negative Jensen’s Alpha indicate?
A) The portfolio outperformed the market
B) The portfolio underperformed given its risk level
C) The portfolio has lower total risk than expected
D) The portfolio follows a passive investment strategy
✅ Answer: B
📖 Explanation: A negative alpha means the portfolio’s actual return is lower than what CAPM predicts.
According to the Efficient Market Hypothesis (EMH), which of the following investment strategies should consistently outperform the market?
A) Fundamental analysis based on earnings forecasts
B) Technical analysis using historical price patterns
C) Passive investing through index funds
D) Momentum investing based on recent trends
✅ Answer: C
📖 Explanation: EMH states that all available information is already reflected in asset prices, making active strategies ineffective in consistently outperforming passive investments.
What is a major criticism of the EMH?
A) It assumes investors act irrationally at all times
B) It does not consider the impact of market anomalies
C) It assumes stock prices always follow a predictable pattern
D) It suggests that arbitrage opportunities are infinite
✅ Answer: B
📖 Explanation: Market anomalies, such as seasonal effects and behavioral biases, challenge EMH by showing persistent inefficiencies in financial markets.
In Modern Portfolio Theory (MPT), what is the purpose of the efficient frontier?
A) To maximize expected return for a given level of risk
B) To identify the risk-free rate in a portfolio
C) To determine the correlation between two assets
D) To minimize portfolio variance at any cost
✅ Answer: A
📖 Explanation: The efficient frontier represents portfolios that provide the highest return for a given level of risk, optimizing the risk-return tradeoff.
What is a key assumption of Modern Portfolio Theory (MPT)?
A) Investors prefer risk over return
B) All investors have identical time horizons
C) Asset returns follow a normal distribution
D) Market inefficiencies create arbitrage opportunities
✅ Answer: C
📖 Explanation: MPT assumes asset returns are normally distributed, which simplifies calculations but does not always hold in real markets.
Why is the Capital Market Line (CML) an important part of CAPM?
A) It represents the tradeoff between systematic and unsystematic risk
B) It shows the expected return of efficient portfolios given a risk-free asset
C) It measures the correlation between beta and alpha
D) It determines the variance of market returns
✅ Answer: B
📖 Explanation: The CML plots the expected return of a portfolio given its risk level, showing the optimal mix of risk-free assets and risky assets.
The CAPM assumes which of the following about investors?
A) They can borrow and lend at different interest rates
B) They hold a diversified portfolio on the efficient frontier
C) They prefer assets with high unsystematic risk
D) They react differently to risk based on behavioral biases
✅ Answer: B
📖 Explanation: CAPM assumes investors hold diversified portfolios, eliminating unsystematic risk, leaving only market (systematic) risk.
In the Arbitrage Pricing Theory (APT), what replaces beta as a risk measure?
A) Single-factor risk exposure
B) A combination of multiple economic factors
C) Market capitalization weighting
D) Volatility-adjusted returns
✅ Answer: B
📖 Explanation: Unlike CAPM, which relies on a single beta, APT incorporates multiple factors that influence asset prices, such as inflation, GDP growth, and interest rates.
Which of the following is a key limitation of CAPM?
A) It overemphasizes the role of unsystematic risk
B) It assumes investors hold only government bonds
C) It relies on historical beta, which may not predict future risk
D) It assumes market prices do not fluctuate
✅ Answer: C
📖 Explanation: CAPM assumes historical beta is stable, but in reality, betas change over time, making risk estimation less reliable.
Which of the following is NOT an assumption of APT?
A) Returns can be explained by multiple economic factors
B) There are no arbitrage opportunities in equilibrium
C) Investors have homogeneous expectations
D) Risk factors have a linear impact on returns
✅ Answer: C
📖 Explanation: Unlike CAPM, APT does not assume homogeneous expectations. Investors may have different views on factor sensitivities.
Why do multifactor models offer an advantage over single-factor models like CAPM?
A) They account for multiple risk drivers beyond market risk
B) They assume investors react randomly to market events
C) They eliminate all types of risk in a portfolio
D) They predict market downturns with certainty
✅ Answer: A
📖 Explanation: Multifactor models improve accuracy by incorporating multiple risk factors, unlike CAPM, which relies on a single market factor.
What does the Security Market Line (SML) represent in CAPM?
A) The risk-return tradeoff for a fully diversified portfolio
B) The relationship between beta and expected return
C) The minimum required return for any investment
D) The maximum possible return an investor can earn
✅ Answer: B
📖 Explanation: The SML shows the linear relationship between systematic risk (beta) and expected return in CAPM.
How does APT differ from CAPM in explaining asset returns?
A) APT allows for multiple risk factors, while CAPM relies on a single factor
B) APT assumes all investors have the same risk tolerance
C) APT ignores market risk, focusing only on individual securities
D) APT requires that investors hold the market portfolio
✅ Answer: A
📖 Explanation: APT incorporates multiple risk factors, whereas CAPM assumes market risk (beta) is the sole determinant of return.
What does R-squared indicate in a multifactor model?
A) The percentage of a stock’s movement explained by the model
B) The future return of a portfolio
C) The amount of leverage used in the portfolio
D) The level of risk-adjusted return in CAPM
✅ Answer: A
📖 Explanation: R-squared measures how well a multifactor model explains stock price movements.
Which factor is most likely to be included in a multifactor pricing model?
A) Expected future dividends
B) Macroeconomic indicators like interest rates
C) Company earnings growth
D) Daily stock volume
✅ Answer: B
📖 Explanation: Multifactor models incorporate macroeconomic indicators, which influence asset prices beyond market risk.
n an efficient market, which of the following is true?
A) No investor can consistently earn excess returns
B) Technical analysis can predict future stock prices
C) Some investors will always outperform due to skill
D) Insider information has no effect on prices
✅ Answer: A
📖 Explanation: In an efficient market, all available information is already reflected in prices, preventing consistent outperformance.
What is a key limitation of Modern Portfolio Theory (MPT)?
A) It assumes risk-free assets do not exist
B) It does not account for investor behavior
C) It only works for fixed-income securities
D) It requires all assets to have zero correlation
✅ Answer: B
📖 Explanation: MPT assumes investors behave rationally, ignoring behavioral finance and emotional decision-making.
What does a high alpha indicate in an APT model?
A) The stock is mispriced relative to risk factors
B) The stock is perfectly correlated with the market
C) The risk-free rate has increased
D) The portfolio is highly diversified
✅ Answer: A
📖 Explanation: Alpha measures excess return beyond what is predicted by risk factors in the APT model.
Which of the following biases best explains why investors hold onto losing stocks for too long?
A) Recency bias
B) Loss aversion
C) Overconfidence bias
D) Hindsight bias
✅ Answer: B
📖 Explanation: Loss aversion describes investors’ tendency to avoid realizing losses by holding onto poor-performing investments longer than rationality dictates.
A retail investor follows the trading decisions of a well-known financial influencer without conducting their own analysis. What behavioural bias is this an example of?
A) Availability bias
B) Herding bias
C) Representativeness bias
D) Endowment effect
✅ Answer: B
📖 Explanation: Herding bias occurs when investors mimic others’ investment choices, often leading to bubbles or crashes.
What is a key limitation of behavioural finance when compared to traditional finance theories?
A) It assumes all investors are perfectly rational
B) It cannot be used to explain anomalies in markets
C) It lacks a unified theory that applies across all investors
D) It ignores emotions when making investment decisions
✅ Answer: C
📖 Explanation: Unlike traditional finance, behavioural finance lacks a single, unified theory, making it more difficult to apply consistently.
What is the primary difference between cognitive biases and emotional biases?
A) Cognitive biases result from logical reasoning errors, while emotional biases stem from feelings and emotions
B) Cognitive biases are exclusive to inexperienced investors, while emotional biases only affect professionals
C) Emotional biases are more predictable than cognitive biases
D) Cognitive biases have no impact on financial decision-making
✅ Answer: A
📖 Explanation: Cognitive biases are errors in logical reasoning, while emotional biases are based on feelings rather than facts.
How does R-squared relate to portfolio diversification?
A) A low R-squared suggests the portfolio is well-diversified and independent from the benchmark
B) A high R-squared indicates a portfolio is uncorrelated with the market
C) A low R-squared means the portfolio has high exposure to market risk
D) R-squared does not affect diversification decisions
✅ Answer: A
📖 Explanation: A low R-squared means a portfolio’s returns are less dependent on market movements, indicating better diversification.
In asset allocation, why is it beneficial to invest in assets with a low correlation?
A) To maximize returns regardless of market conditions
B) To reduce systematic risk without impacting returns
C) To eliminate the need for hedging strategies
D) To increase exposure to volatile assets
✅ Answer: B
📖 Explanation: Low correlation assets help reduce systematic risk, improving the risk-return tradeoff in a portfolio.
Which hedging strategy is most appropriate for an investor holding a well-diversified equity portfolio?
A) Buying put options on individual stocks
B) Short selling individual underperforming stocks
C) Purchasing index put options or volatility hedges
D) Increasing exposure to cyclical stocks
✅ Answer: C
📖 Explanation: Index put options protect a diversified equity portfolio by hedging against market downturns.
Which of the following best describes the primary goal of immunisation in fixed-income investing?
A) To maximise capital appreciation over a short-term period
B) To ensure that reinvestment risk and interest rate risk cancel each other out
C) To create a portfolio with zero credit risk
D) To increase a portfolio’s sensitivity to duration changes
✅ Answer: B
📖 Explanation: Immunisation seeks to balance reinvestment risk and interest rate risk, ensuring a fixed-income portfolio meets future liabilities.
An investor systematically overestimates their ability to predict market movements. This is an example of which bias?
A) Overconfidence bias
B) Confirmation bias
C) Framing bias
D) Regret aversion
✅ Answer: A
📖 Explanation: Overconfidence bias leads investors to overestimate their ability to forecast market trends, often resulting in excessive risk-taking.
If an investor only looks for information that supports their existing beliefs, they are demonstrating which bias?
A) Regret aversion
B) Framing bias
C) Confirmation bias
D) Self-attribution bias
✅ Answer: C
📖 Explanation: Confirmation bias occurs when investors seek out information that confirms their existing views, ignoring contradictory evidence.
Which risk measure best accounts for downside risk specifically?
A) Sharpe Ratio
B) Sortino Ratio
C) Beta
D) R-Squared
✅ Answer: B
📖 Explanation: Sortino Ratio improves on the Sharpe Ratio by only penalising downside volatility, making it more useful for risk management.
Which of the following is NOT a limitation of the CAPM model?
A) It assumes all investors have the same expectations
B) It assumes markets are inefficient
C) It only considers systematic risk
D) It assumes investors can borrow and lend at the risk-free rate
✅ Answer: B
📖 Explanation: CAPM assumes markets are efficient, but it is criticized for oversimplifying risk and ignoring behavioral biases.
If an asset has a beta of 1.5, what does it indicate?
A) The asset is expected to be more volatile than the market
B) The asset moves in the opposite direction of the market
C) The asset is uncorrelated with the market
D) The asset has no systematic risk
✅ Answer: A
📖 Explanation: A beta of 1.5 means the asset is 50% more volatile than the overall market.
What is the main purpose of using alternative asset classes in a diversified portfolio?
A) To maximise short-term capital appreciation
B) To reduce correlation with traditional assets and improve risk-adjusted returns
C) To increase exposure to high-risk investments
D) To guarantee absolute returns in any market condition
✅ Answer: B
📖 Explanation: Alternative assets like commodities, real estate, and hedge funds provide diversification by having low correlation with equities and bonds.
How does the framing effect influence investment decisions?
A) It causes investors to make decisions based on how information is presented rather than its substance
B) It makes investors more likely to react to fundamental analysis than technical analysis
C) It forces investors to trade only in bull markets
D) It increases the probability of insider trading
✅ Answer: A
📖 Explanation: Framing bias causes investors to react differently depending on how choices are presented, even when the underlying information is the same.
Which factor has the biggest impact on portfolio performance over time?
A) Security selection
B) Asset allocation
C) Market timing
D) Trading volume
✅ Answer: B
📖 Explanation: Studies show that asset allocation determines over 90% of a portfolio’s long-term returns, making it more important than security selection or market timing.
Which of the following is NOT a common hedging strategy?
A) Buying put options
B) Short selling stocks
C) Dollar-cost averaging
D) Using futures contracts
✅ Answer: C
📖 Explanation: Dollar-cost averaging is an investment strategy, not a hedging strategy.
What does a low Information Ratio indicate about a portfolio manager’s performance?
A) The manager has generated excess returns with high consistency
B) The manager’s active returns are not worth the additional risk taken
C) The portfolio is well-diversified
D) The manager is outperforming the market significantly
✅ Answer: B
📖 Explanation: A low Information Ratio suggests that the manager’s excess returns are inconsistent relative to the additional risk taken.
What is the purpose of tactical asset allocation?
A) To capitalize on short-term market opportunities while maintaining a strategic allocation
B) To maintain a fixed portfolio allocation regardless of market changes
C) To minimize all investment risks
D) To avoid portfolio rebalancing
✅ Answer: A
📖 Explanation: Tactical asset allocation allows investors to temporarily adjust portfolios to take advantage of short-term opportunities.
What is the primary goal of portfolio immunisation?
A) To increase active trading in bonds
B) To create a self-financing portfolio immune to interest rate changes
C) To maximize bond yields regardless of risk
D) To avoid default risk entirely
✅ Answer: B
📖 Explanation: Immunisation balances interest rate risk and reinvestment risk to ensure future liabilities are met.
Which of the following best describes a key limitation of passive investing?
A) Passive funds tend to underperform active funds in bull markets
B) Passive investing relies heavily on the skill of fund managers
C) Passive strategies lack flexibility and cannot adapt to market inefficiencies
D) Passive investing typically incurs higher transaction costs than active investing
Answer: C) Passive strategies lack flexibility and cannot adapt to market inefficiencies
Explanation: Passive investing follows a benchmark index and does not adjust to market mispricing’s or inefficiencies, whereas active managers can exploit these opportunities.
Which of the following is NOT a characteristic of active management?
A) Higher expense ratios compared to passive strategies
B) Reliance on fundamental and technical analysis
C) Consistently outperforming the market net of fees
D) Frequent trading based on market research and forecasts
Answer: C) Consistently outperforming the market net of fees
Explanation: While active managers attempt to outperform, research shows that most fail to do so after accounting for fees and transaction costs.
The Core/Satellite strategy is designed to achieve which of the following objectives?
A) To minimize tracking error by mirroring a benchmark index
B) To combine cost-efficient passive investments with targeted active strategies
C) To allocate 100% of a portfolio into smart beta strategies
D) To focus exclusively on high-frequency trading strategies
Answer: B) To combine cost-efficient passive investments with targeted active strategies
Explanation: The Core/Satellite approach keeps the core of the portfolio in passive funds for stability, while the satellite portion is actively managed for potential excess returns.
How does Smart Beta differ from traditional passive investing?
A) Smart Beta strategies incorporate fundamental and technical analysis to select stocks
B) Smart Beta uses alternative weighting schemes instead of traditional market capitalization weighting
C) Smart Beta relies solely on AI and machine learning to select investments
D) Smart Beta is an entirely discretionary approach to portfolio management
Answer: B) Smart Beta uses alternative weighting schemes instead of traditional market capitalization weighting
Explanation: Smart Beta applies factors such as value, momentum, or low volatility instead of cap-weighted indices to improve risk-adjusted returns.
Which of the following is a primary risk associated with active market timing strategies?
A) Underestimation of tracking error
B) Over-diversification leading to benchmark-like returns
C) Missing out on major market upswings due to incorrect timing decisions
D) Excessive reliance on high-frequency trading
Answer: C) Missing out on major market upswings due to incorrect timing decisions
Explanation: Market timing strategies often fail due to the difficulty of consistently predicting market movements, leading to poor risk-adjusted returns.
What is the key premise of Smart Alpha strategies?
A) Smart Alpha seeks to maximize exposure to market risk while minimizing portfolio turnover
B) Smart Alpha combines active management insights with factor-based strategies
C) Smart Alpha focuses solely on high-growth stocks in emerging markets
D) Smart Alpha aims to eliminate all systematic risk from portfolios
Answer: B) Smart Alpha combines active management insights with factor-based strategies
Explanation: Smart Alpha blends elements of active management with systematic factor-based investing to achieve enhanced returns.
Which of the following is a common criticism of Smart Beta strategies?
A) They rely too heavily on high-frequency trading techniques
B) They introduce unintended factor exposures that may increase risk
C) They are significantly more expensive than actively managed funds
D) They cannot be used for institutional portfolios
Answer: B) They introduce unintended factor exposures that may increase risk
Explanation: Smart Beta strategies may introduce concentrated factor exposures that can lead to increased volatility or unintended risks.
What differentiates fundamental indexing from traditional market-cap indexing?
A) Fundamental indexing selects stocks based purely on historical volatility
B) Fundamental indexing weighs stocks based on financial metrics like earnings and book value rather than market capitalization
C) Fundamental indexing aims to track market sentiment using technical indicators
D) Fundamental indexing eliminates the need for diversification in portfolio construction
Answer: B) Fundamental indexing weighs stocks based on financial metrics like earnings and book value rather than market capitalization
Explanation: Unlike cap-weighted indices, fundamental indices assign weights based on company fundamentals like earnings, revenue, and book value.
Which of the following is a potential downside of using an active market timing strategy?
A) Low transaction costs
B) Increased tax efficiency
C) Greater exposure to systematic risk
D) High trading costs and tax inefficiencies
Answer: D) High trading costs and tax inefficiencies
Explanation: Active market timing often involves frequent trading, leading to higher transaction costs and potential tax inefficiencies.
In a Core/Satellite portfolio, which asset classes are most commonly included in the core?
A) High-yield bonds and private equity
B) Large-cap index funds and ETFs
C) Venture capital and cryptocurrencies
D) Derivatives and leveraged ETFs
Answer: B) Large-cap index funds and ETFs
Explanation: The core is typically composed of broad, low-cost index funds that provide stability and long-term growth potential.
Which factor is NOT typically considered in Smart Beta strategies?
A) Value
B) Momentum
C) Credit risk
D) Low volatility
Answer: C) Credit risk
Explanation: Smart Beta strategies focus on equity factors like value, momentum, and low volatility rather than credit risk, which is more relevant to fixed-income investing.
Which of the following investment approaches best describes Smart Beta?
A) A purely passive strategy with no factor tilts
B) An active strategy with full discretion over asset allocation
C) A rules-based strategy that seeks to improve risk-adjusted returns by using factors
D) A high-frequency trading strategy designed to capture short-term inefficiencies
Answer: C) A rules-based strategy that seeks to improve risk-adjusted returns by using factors
Explanation: Smart Beta follows a systematic approach to tilting portfolios towards specific investment factors like value or momentum.
How does Smart Alpha differ from traditional active management?
A) Smart Alpha relies purely on fundamental analysis
B) Smart Alpha incorporates systematic factor exposures alongside active insights
C) Smart Alpha eliminates market risk through short selling
D) Smart Alpha is a passive strategy that mimics an index
Answer: B) Smart Alpha incorporates systematic factor exposures alongside active insights
Explanation: Smart Alpha aims to enhance returns by blending factor-based investing with active decision-making.
Why might a passive investment strategy underperform in certain market conditions?
A) It involves frequent trading, increasing transaction costs
B) It lacks the ability to adjust to market inefficiencies or downturns
C) It consistently has higher fees than active management
D) It relies on fundamental analysis rather than market trends
Answer: B) It lacks the ability to adjust to market inefficiencies or downturns
Explanation: Passive strategies track an index and do not adjust based on economic cycles, potentially underperforming in volatile or inefficient markets.
In what situation might an investor favor a Core/Satellite strategy over a fully passive approach?
A) When they seek to avoid all market risk
B) When they want to balance cost efficiency with targeted active exposure
C) When they are only interested in high-frequency trading strategies
D) When they have a very short-term investment horizon
Answer: B) When they want to balance cost efficiency with targeted active exposure
Explanation: Core/Satellite combines passive investing for stability with active management for targeted return enhancement.
