Portfolio management I

Question 1

Evidence of risk aversion is best illustrated by a risk–return relationship that is ?

Answer 1

Positive
Explanation: Historical data over long periods of time indicate that there exists a positive risk–return relationship, which is a reflection of an investor’s risk aversion.

Question 2

When considering a portfolio that is optimal for one investor, a second investor with a higher risk aversion would most likely:
A. expect a higher variance for the portfolio.

B. derive a lower utility from the portfolio.

C. have a lower return expectation for the portfolio.

Answer 2

B is Correct. Utility has two terms: the expected return and a negative term based on the portfolio risk weighted by risk aversion. For an identical portfolio, the investor with a higher risk aversion (A) would calculate a lower utility (U). U=E(r) −1/2 * Aσ

Question 3

With respect to risk-averse investors, a risk-free asset will generate a numerical utility that is

the same for all individuals.

positive for risk-averse investors.

equal to zero for risk seeking investors.

Answer 3

the same for all individuals.

Question 4

With respect to an investor’s utility function expressed as: U=E(r)−12Aσ2
, which of the following values for the measure for risk aversion has the least amount of risk aversion?

−4.
0.
4.

Answer 4

-4

Question 5

With respect to the mean–variance portfolio theory, the capital allocation line, CAL, is the combination of the risk-free asset and a portfolio of all:

risky assets.
equity securities.
feasible investments.

Answer 5

risky assets.

The CAL is the combination of the risk-free asset with zero risk and the portfolio of all risky assets that provides for the set of feasible investments. Allowing for borrowing at the risk-free rate and investing in the portfolio of all risky assets provides for attainable portfolios that dominate risky assets below the CAL

Question 6

Two individual investors with different levels of risk aversion will have optimal portfolios that are:

below the capital allocation line.
on the capital allocation line.
above the capital allocation line.

Answer 6

The CAL represents the set of all feasible investments. Each investor’s indifference curve determines the optimal combination of the risk-free asset and the portfolio of all risky assets, which must lie on the CAL.

Question 7

The CAL represents the set of all

Answer 7

feasible investments

Question 8

What is beta of By definition, a short-term US Treasury bill ?

Answer 8

By definition, a short-term US Treasury bill has zero risk. Therefore, its beta is zero.

Question 9

Portfolios are most likely to provide:

risk reduction.

risk elimination.

downside protection.

Answer 9

A is correct. Combining assets into a portfolio should reduce the portfolio’s volatility. However, the portfolio approach does not necessarily provide downside protection or eliminate all risk.

Question 10

Which of the following biases least likely relates to the mental discomfort that occurs when new information conflicts with a set of initial beliefs?

A. Confirmation bias

B. Representativeness bias

C. Anchoring and adjustment bias

Answer 10

Belief perseverance biases relate to cognitive dissonance, the mental discomfort when an investor is given new information that conflicts with prior beliefs. Biases in this category include:

Conservatism bias
Confirmation bias
Representativeness bias
Illusion of control bias
Hindsight bias
Anchoring and adjustment bias is a type of processing error bias.

Question 11

un Park, CFA, works at a hedge fund. Most of Park’s colleagues are also CFA charterholders. At an event with recent university graduates, Park comments, “Most CFA charterholders work at hedge funds.” Park’s remark exhibits which behavioral bias?
A Availability

B Conservatism

C Framing

Answer 11

A is correct. Park is extrapolating his observation based on a narrow range of experience (working at a hedge fund that employs many CFA charterholders) to the entire population of CFA charterholders. Using a narrow range of experience is a form of availability bias.

Question 12

Which of the following is not a goal of risk management?

A.Measuring risk exposures
B.Minimizing exposure to risk
C.Defining the level of risk appetite

Answer 12

B is correct. The definition of risk management includes both defining the level of risk desired and measuring the level of risk taken. Risk management means taking risks actively and in the best, most value-added way possible and is not about minimizing risks.

Question 13

Which element of a risk management framework sets the overall context for risk management in an organization?

Governance
Risk infrastructure
Policies and processes

Answer 13

A is correct. Governance is the element of the risk management framework that is the top-level foundation for risk management. Although policies, procedures, and infrastructure are necessary to implement a risk management framework, it is governance that provides the overall context for an organization’s risk management

Question 14

Which element of risk management makes up the analytical component of the process?

Communication
Risk governance
Risk identification and measurement

Answer 14

C is correct. Risk identification and measurement is the quantitative part of the process. It involves identifying the risks and summarizing their potential quantitative impact. Communication and risk governance are largely qualitative.

Question 15

Which element of risk management involves action when risk exposures are found to be out of line with risk tolerance?

Risk governance
Risk identification and measurement
Risk monitoring, mitigation, and management

Answer 15

C is correct. Risk monitoring, mitigation, and management require recognizing and taking action when these (risk exposure and risk tolerance) are not in line, as shown in the middle of Exhibit 1. Risk governance involves setting the risk tolerance. Risk identification and measurement involves identifying and measuring the risk exposures.

Question 16

Which of the following is not consistent with a risk-budgeting approach to portfolio management?

Limiting the beta of the portfolio to 0.75
Allocating investments by their amount of underlying risk sources or factors
Limiting the amount of money available to be spent on hedging strategies by each portfolio manager

Answer 16

C is correct. Risk budgeting is any means of allocating a portfolio by some risk characteristics of the investments. This approach could be a strict limit on beta or some other risk measure or an approach that uses risk classes or factors to allocate investments. Risk budgeting does not require nor prohibit hedging, although hedging is available as an implementation tool to support risk budgeting and overall risk governance.

Question 17

Who would be the least appropriate for controlling the risk management function in a large organization?

Chief risk officer
Chief financial officer
Risk management committee

Answer 17

B is correct. A chief risk officer or a risk management committee is an individual or group that specializes in risk management. A chief financial officer may have considerable knowledge of risk management, may supervise a CRO, and would likely have some involvement in a risk management committee, but a CFO has broader responsibilities and cannot provide the specialization and attention to risk management that is necessary in a large organization.

Question 18

Which of the following best describes a financial risk?

The risk of an increase in interest rates.
The risk that regulations will make a transaction illegal.
The risk of an individual trading without limits or controls.

Answer 18

A is correct because this risk arises from the financial markets.

Question 19

Which of the following is not an example of model risk?

Assuming the tails of a returns distribution are thin when they are, in fact, fat.
Using standard deviation to measure risk when the returns distribution is asymmetric.
Using the one-year risk-free rate to discount the face value of a one-year government bond.

Answer 19

C is correct. The risk-free rate is generally the appropriate rate to use in discounting government bonds. Although government bonds are generally default free, their returns are certainly risky. Assuming a returns distribution has thin tails when it does not and assuming symmetry in an asymmetric distribution are both forms of model risk.

Question 20

The risks that individuals face based on mortality create which of the following problems?

The risk of loss of income to their families.
Covariance risk associated with their human capital and their investment portfolios.
The interacting effects of solvency risk and the risk of being taken advantage of by an unscrupulous financial adviser.

Answer 20

A is correct. The uncertainty about death creates two risks: mortality risk and longevity risk. The mortality risk (risk of dying relatively young) is manifested by a termination of the income stream generated by the person. In contrast, longevity risk is the risk of outliving one’s financial resources.

Question 21

The best definition of value at risk is:

the expected loss if a counterparty defaults.
the maximum loss an organization would expect to incur over a holding period.
the minimum loss expected over a holding period a certain percentage of the time.

Answer 21

C is correct. VaR measures a minimum loss expected over a holding period a certain percentage of the time. It is not an expected loss, nor does it reflect the maximum possible loss, which is the entire equity of the organization.

Question 22

Which of the following are methods commonly used to supplement VaR to measure the risk of extreme events?

Standard deviation
Loss given default
Scenario analysis and stress testing

Answer 22

C is correct. Scenario analysis and stress testing both examine the performance of a portfolio subject to extreme events. The other two answers are metrics used in portfolio analysis but are not typically associated with extreme events.

Question 23

Which of the following is a true statement about insurable risks?

Insurable risks are less costly.
Insurable risks have smaller loss limits.
Insurable risks are typically diversifiable by the insurer.

Answer 23

C is correct. Insurance works by pooling risks. It is not necessarily less costly than derivatives nor does it have lower loss limits.

Question 24

Which of the following performance measures is consistent with the CAPM?

M^2.
Sharpe ratio.
Jensen’s alpha.

Answer 24

C is correct. Jensen’s alpha adjusts for systematic risk, and M^2 and the Sharpe Ratio adjust for total risk.

Question 25

Which of the following performance measures does not require the measure to be compared to another value?

Sharpe ratio.
Treynor ratio.
Jensen’s alpha.

Answer 25

C is correct. The sign of Jensen’s alpha indicates whether or not the portfolio has outperformed the market. If alpha is positive, the portfolio has outperformed the market; if alpha is negative, the portfolio has underperformed the market.

Question 26

Which of the following performance measures is most appropriate for an investor who is not fully diversified?

M2.
Treynor ratio.
Jensen’s alpha.

Answer 26

A is the correct. M2 adjusts for risk using standard deviation (i.e., total risk).

Question 27

The portfolio of a risk-free asset and a risky asset has a better risk-return tradeoff than investing in only one asset type because the correlation between the risk-free asset and the risky asset is equal to:

−1.0.
0.0.
1.0.

Answer 27

B is correct. A portfolio of the risk-free asset and a risky asset or a portfolio of risky assets can result in a better risk-return tradeoff than an investment in only one type of an asset, because the risk-free asset has zero correlation with the risky asset.

Question 28

With respect to capital market theory, an investor’s optimal portfolio is the combination of a risk-free asset and a risky asset with the highest:

expected return.
indifference curve.
capital allocation line slope.

Answer 28

B is correct. Investors will have different optimal portfolios depending on their indifference curves. The optimal portfolio for each investor is the one with highest utility; that is, where the CAL is tangent to the individual investor’s highest possible indifference curve.

Question 29

Which of the following statements most accurately defines the market portfolio in capital market theory? The market portfolio consists of all:

risky assets.
tradable assets.
investable assets.

Answer 29

A is correct. The market includes all risky assets, or anything that has value; however, not all assets are tradable, and not all tradable assets are investable.

Question 30

With respect to the pricing of risk in capital market theory, which of the following statements is most accurate?

All risk is priced.
Systematic risk is priced.
Nonsystematic risk is priced.

Answer 30

B is correct. Only systematic risk is priced. Investors do not receive any return for accepting nonsystematic or diversifiable risk.

Question 31

A return-generating model that provides an estimate of the expected return of a security based on such factors as earnings growth and cash flow generation is best described as a

Answer 31

fundamental factor

Question 32

With respect to the capital asset pricing model, the market risk premium is:

less than the excess market return.

equal to the excess market return.

greater than the excess market return.

Answer 32

B is correct. In the CAPM, the market risk premium is the difference between the return on the market and the risk-free rate, which is the same as the return in excess of the market return.

Question 33

With respect to capital market theory, which of the following assumptions allows for the existence of the market portfolio? All investors:

are price takers.

have homogeneous expectations.

plan for the same, single holding period.

Answer 33

B is correct. The homogeneous expectations assumption means that all investors analyze securities in the same way and are rational. That is, they use the same probability distributions, use the same inputs for future cash flows, and arrive at the same valuations. Because their valuation of all assets is identical, they will generate the same optimal risky portfolio, which is the market portfolio.

Question 34

Which of the following portfolio performance measures are the most appropriate for an investor who holds a fully diversified portfolio?

Sharpe ratio and Treynor ratio.

Treynor ratio and Jensen’s alpha.

M-Squared and Sharpe ratio.

Answer 34

Correct. For an investor who holds a fully diversified portfolio, the Treynor ratio and Jensen’s alpha are the appropriate portfolio performance measures. They are appropriate because in a fully diversified portfolio, only systematic risk matters; both these metrics measure performance relative to beta or systematic risk.

Question 35

Portfolio managers, who are maximizing risk-adjusted returns, will seek to invest less in securities with:

lower values for nonsystematic variance.

values of nonsystematic variance equal to 0.

higher values for
nonsystematic variance.

Answer 35

C is correct. Since managers are concerned with maximizing risk-adjusted returns, securities with greater nonsystematic risk should be given less weight in the portfolio.

Question 36

Which of the following is the best reason for an investor to be concerned with the composition of a portfolio?

Risk reduction.
Downside risk protection.
Avoidance of investment disasters.

Answer 36

A is correct. Combining assets into a portfolio should reduce the portfolio’s volatility. The portfolio approach does not necessarily provide downside protection or guarantee that the portfolio always will avoid losses

Question 37

With respect to the formation of portfolios, which of the following statements is most accurate?

Portfolios affect risk less than returns.

Portfolios affect risk more than returns.

Portfolios affect risk and returns equally.

Answer 37

B is correct. As illustrated in the reading, portfolios reduce risk more than they increase returns.

Question 38

In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset classes should generally be:

equal to correlations among asset classes.
lower than correlations among asset classes.
higher than correlations among asset classes.

Answer 38

C is correct. As the reading states, “an asset class should contain homogeneous assets… paired correlations of securities would be high within an asset class, but should be lower versus securities in other asset classes.”

Question 39

In a strategic asset allocation, assets within a specific asset class are least likely to have:

low paired correlations.

low correlations with other asset classes.

similar risk and return expectations.

Answer 39

A is Correct. In a strategic asset allocation, assets within a specific asset class have high paired correlations and low correlations with other asset classes.

Question 40

Returns on asset classes are best described as being a function of:

the failure of arbitrage.

exposure to the idiosyncratic risks of those asset classes.

exposure to sets of systematic factors relevant to those asset classes.

Answer 40

C is correct. Strategic asset allocation depends on several principles. As stated in the reading, “One principle is that a portfolio’s systematic risk accounts for most of its change in value over the long run.” A second principle is that, “the returns to groups of like assets… predictably reflect exposures to certain sets of systematic factors.” This latter principle establishes that returns on asset classes primarily reflect the systematic risks of the classes.

Question 41

A portfolio manager decides to temporarily invest more of a portfolio in equities than the investment policy statement prescribes because he expects equities will generate a higher return than other asset classes. This decision is most likely an example of:

rebalancing.

tactical asset allocation.

strategic asset allocation.

Answer 41

B is Correct. Tactical asset allocation is the decision to deliberately deviate from the policy exposures to systematic risk factors with the intent to add value based on forecasts of the near-term returns of those asset classes.

Question 42

Which of the following best describes activities that are supported by a risk management infrastructure?

Risk tolerance, budgeting, and reporting

Risk tolerance, measurement, and monitoring

Risk identification, measurement, and monitoring

Answer 42

C is correct. Risk infrastructure refers to the people and systems required to track risk exposures and perform most of the quantitative risk analysis to allow an assessment of the organization’s risk profile. The risk management infrastructure identifies, measures, and monitors risks (among other things).

Question 43

The top level of a risk management system most likely is:

risk governance.

strategic analysis or integration.

defined policies or procedures.

Answer 43

Correct. Normally a role of the board of directors of a company, risk governance is where goals and responsibilities are defined and top-level decisions (such as determining the company’s risk tolerance) are made.

Question 44

Once an enterprise’s risk tolerance is determined, the role of risk management is to:

analyze risk drivers.

align risk exposures with risk appetite.

identify the extent to which the enterprise is willing to fail in meeting its objectives.

Answer 44

B is correct. When risk tolerance has been determined, the risk framework should be geared toward measuring, managing, and complying with the risk tolerance, or

aligning risk exposure with risk tolerance.

The risk tolerance decision begins by looking at what shortfalls within an organization would cause it to fail to achieve some critical goals and what are the organization’s risk drivers.

Question 45

Q. Which factor should most affect a company’s ability to tolerate risk?

A stable market environment

The beliefs of the individual board members

The ability to dynamically respond to adverse events

Answer 45

C is correct. If a company has the ability to adapt quickly to adverse events may allow for a higher risk tolerance. There are other factors, such as beliefs of board members and a stable market environment, which may but should not affect risk tolerance.

Question 46

Among other things, an organization’s risk tolerance should most likely reflect its:

perception of market stability.

size.

competitive position.

Answer 46

C is Correct. An organization with a strong competitive position can recover from losses more easily than one with a weaker competitive position. Therefore an organization’s risk tolerance should reflect its competitive position. An organization’s size does not define the risk sources it faces or the relative losses it can absorb, so it should not be reflected in its risk tolerance. Neither the risk sources affecting an organization nor the size of the losses an organization can absorb are a function of its perception of market stability.

Question 47

Which of the following institutions will on average have the greatest need for liquidity?

Banks.
Investment companies.
Non-life insurance companies.

Answer 47

A is correct. The excess reserves invested by banks need to be relatively liquid. Although investment companies and non-life insurance companies have high liquidity needs, the liquidity need for banks is on average the greatest

Question 48

Which of the following institutional investors will most likely have the longest time horizon?

Defined benefit plan.
University endowment.
Life insurance company.

Answer 48

B is correct. Most foundations and endowments are established with the intent of having perpetual lives. Although defined benefit plans and life insurance companies have portfolios with a long time horizon, they are not perpetual.

Question 49

Q. A defined benefit plan with a large number of retirees is likely to have a high need for:

income.
liquidity.
insurance.

Answer 49

A is correct. Income is necessary to meet the cash flow obligation to retirees. Although defined benefit plans have a need for income, the need for liquidity typically is quite low. A retiree may need life insurance; however, a defined benefit plan does not need insurance.

Question 50

Which of the following types of investment clients most likely have the lowest liquidity needs?

Insurance companies

Banks

Endowments and foundations

Answer 50

C is Correct. A typical investment objective of an endowment or a foundation is to maintain the real capital value of the fund while generating income to fund the objectives of the institution. Liquidity needs are typically rather low.

Question 51

Which of the following is most likely a feature of a defined-contribution pension plan? The

employer accepts the investment risk.

employer provides a specified retirement benefit.

employee accepts the investment risk.

Answer 51

C is Correct. In a defined-contribution pension plan, the employee accepts the investment risk and is responsible for ensuring that the plan contains enough funds to meet retirement needs.

Question 52

Which of the following types of institutions is most likely to have a long investment time horizon and a higher level of risk tolerance?

An endowment

An insurance company

A bank

Answer 52

A. Correct. Endowments have a long investment time horizon and a high level of risk tolerance.

Incorrect. Insurance companies have a short investment time horizon and a low level of risk tolerance.

Incorrect. Banks have a short investment time horizon and a low level of risk tolerance

Question 53

Which of the following institutional investors is most likely to have a low tolerance for investment risk and relatively high liquidity needs?

Insurance company

Defined-benefit pension plan

Charitable foundation

Answer 53

A. Correct. Insurance companies need to be relatively conservative and liquid, given the necessity of paying claims when due.

Incorrect. Defined-benefit pension plans tend to have quite high risk tolerances and quite low liquidity needs.

Incorrect. Endowments/foundations typically have high risk tolerances and quite low liquidity needs.

Question 54

What is the risk tolerance and liquidity needs of Defined-benefit pension plans and Endowments/foundations ?

Answer 54

Defined-benefit pension plans tend to have quite high risk tolerances and quite low liquidity needs.

Endowments/foundations typically have high risk tolerances and quite low liquidity needs.

Question 55

Which of the following financial products is least likely to have a capital gain distribution?

Exchange traded funds.
Open-end mutual funds.
Closed-end mutual funds.

Answer 55

A is correct. Exchange traded funds do not have capital gain distributions. If an investor sells shares of an ETF (or open-end mutual fund or closed-end mutual fund), the investor may have a capital gain or loss on the shares sold; however, the gain (or loss) from the sale is not a distribution.

Question 56

Which of the following pooled investments is most likely characterized by a few large investments?

Hedge funds.
Buyout funds.
Venture capital funds.

Answer 56

B is correct. Buyout funds or private equity firms make only a few large investments in private companies with the intent of selling the restructured companies in three to five years. Venture capital funds also have a short time horizon; however, these funds consist of many small investments in companies with the expectation that only a few will have a large payoff (and that most will fail).

Question 57

Which of the following is least likely true for a separately managed account (SMA) compared with a mutual fund?

Assets are directly owned by the individual.

The minimum investment required to open a SMA is lower than that of a mutual fund.

Transactions can be tailored to the specific tax needs of the investor.

Answer 57

Incorrect. SMA assets are directly owned by the individual. The investor has control over which assets are bought and sold as well as the timing of the transactions.

Correct. The minimum investment required to open a separately managed account is usually much higher than that to open a mutual fund.

Incorrect. SMA transactions can be tailored to the specific tax needs of the investor.

Question 58

A key difference between a wrap account and a mutual fund is that wrap accounts:

have assets that are owned directly by the individual.

cannot be tailored to the tax needs of a client.

have a lower required minimum investment

Answer 58

Correct. The key difference between a wrap account and a mutual fund is that in a wrap account, the assets are owned directly by the individual.

Incorrect. Wrap accounts can be tailored to the tax needs of a client.

Incorrect. Wrap accounts have higher required minimum investments.

Question 59

Which of the following best describes the underlying rationale for a written investment policy statement (IPS)?

A written IPS communicates a plan for trying to achieve investment success.
A written IPS provides investment managers with a ready defense against client lawsuits.
A written IPS allows investment managers to instruct clients about the proper use and purpose of investments.

Answer 59

A is correct. A written IPS is best seen as a communication instrument allowing clients and portfolio managers to mutually establish investment objectives and constraints.

Question 60

The section of the investment policy statement (IPS) that provides information about how policy may be executed, including restrictions and exclusions, is best described as the:

Investment Objectives.
Investment Guidelines.
Statement of Duties and Responsibilities.

Answer 60

B is correct. The major components of an IPS are listed in Section 2 of the reading. Investment Guidelines are described as the section that provides information about how policy may be executed, including restrictions on the permissible use of leverage and derivatives and on specific types of assets excluded from investment, if any. Statement of Duties and Responsibilities “detail[s] the duties and responsibilities of the client, the custodian of the client’s assets, the investment managers, and so forth.” Investment Objectives is “a section explaining the client’s objectives in investing.”

Question 61

Which of the following typical topics in an investment policy statement (IPS) is most closely linked to the client’s “distinctive needs”?

Procedures.
Investment Guidelines.
Statement of Duties and Responsibilities.

Answer 61

B is correct. According to the reading, “The sections of an IPS that are most closely linked to the client’s distinctive needs are those dealing with investment objectives and constraints.” Investment Guidelines “[provide] information about how policy may be executed, including investment constraints.” Procedures “[detail] the steps to be taken to keep the IPS current and the procedures to follow to respond to various contingencies.” Statement of Duties and Responsibilities “detail[s] the duties and responsibilities of the client, the custodian of the client’s assets, the investment managers, and so forth.”

Question 62

The strategic asset allocation and portfolio rebalancing policy are most likely addressed in which section of an investment policy statement?

Appendices

Investment objectives

Procedures

Answer 62

orrect. Information related to strategic asset allocation and portfolio rebalancing policy would be placed in the appendices of an investment policy statement.

Incorrect. This section contains information on the client’s objectives when investing.

Incorrect. This section contains information on the steps to take to keep the investment policy statement current and the procedures to follow to respond to various contingencies.

Question 63

Risk assessment questionnaires for investment management clients are most useful in measuring:

value at risk.
ability to take risk.
willingness to take risk.

Answer 63

C is correct. Risk attitude is a subjective factor and measuring risk attitude is difficult. Oftentimes, investment managers use psychometric questionnaires, such as those developed by Grable and Joo (2004), to assess a client’s willingness to take risk.

Question 64

In preparing an investment policy statement, which of the following is most difficult to quantify?

Time horizon.
Ability to accept risk.
Willingness to accept risk.

Answer 64

C is correct. Measuring willingness to take risk (risk tolerance, risk aversion) is an exercise in applied psychology. Instruments attempting to measure risk attitudes exist, but they are clearly less objective than measurements of ability to take risk. Ability to take risk is based on relatively objective traits such as expected income, time horizon, and existing wealth relative to liabilities.

Question 65

Which strategy would best mitigate or prevent endowment bias?

Actively seeking out information that challenges existing beliefs
When new information is presented, asking “How does this information change my forecast?”
Asking “Would you buy this security today at the current price?”

Answer 65

C is correct. Endowment bias refers to people attributing additional, unwarranted value to things they possess versus things they do not. This bias is evident in FMPs that systematically and materially overvalue securities in their portfolio versus securities not in their portfolio. The question “Would you buy this security today at the current price?” turns the investor’s attention to assessing the reasonableness of the current price as a buy price rather than solely as a selling price.

Question 66

Jun Park, CFA, works at a hedge fund. Most of Park’s colleagues are also CFA charterholders. At an event with recent university graduates, Park comments, “Most CFA charterholders work at hedge funds.” Park’s remark exhibits which behavioral bias?

Availability
Conservatism
Framing

Answer 66

A is correct. Park is extrapolating his observation based on a narrow range of experience (working at a hedge fund that employs many CFA charterholders) to the entire population of CFA charterholders. Using a narrow range of experience is a form of availability bias.

Question 67

In the 1980s, Japan was viewed by many FMPs as the model economy. Although its growth began to decelerate sharply by 1990, it was not until the mid to late 1990s that FMPs’ GDP forecasts were consistently achieved. By taking several years to adapt their forecasts to the lower growth environment, FMPs exhibited which behavioral bias?

Mental accounting
Overconfidence
Conservatism

Answer 67

C is correct. Conservatism bias results in maintain or only slowly updating views and forecasts despite the presence of new information. FMPs in the 1990s were reluctant to update forecasts, despite materially different new information for several years.

Question 68

Which of the following is a likely consequence of mental accounting

Concentrated portfolio positions
Forgone opportunities to reduce risk by combining assets with low correlations
Excessive trading

Answer 68

B is correct. The most common consequence of mental accounting is neglecting opportunities to reduce risk by combining assets with low correlations, because each account’s asset allocation is examined discretely. Offsetting positions across accounts, or an overall inefficient allocation with respect to risk, can lead to suboptimal aggregate performance.

Question 69

Which strategy should be used or recommended for mental accounting ?

Keep written records of investment decisions.

Ask questions such as, “Is the decision the result of focusing on a net gain or net loss position?”

Aggregate all accounts and portfolios into a single spreadsheet.

Answer 69

C is correct. Aggregating mental accounts is a logical strategy to combat mental accounting. It is the opposite of disaggregating money into separate accounts.

Question 70

The halo effect, which may be evident in FMP’s assessments of a company with a history of high revenue growth, is a form of which behavioral bias?

Endowment
Representativeness
Regret aversion

Answer 70

B is correct. Representativeness refers to the tendency to adopt a view or forecast based on individual information or a small sample, as well to use simple classifications. The halo effect is an example of representativeness, because FMPs extend an overall favorable evaluation to an investment (e.g., a “good company”) based on one or few characteristics (e.g., a “visionary CEO”)

Question 71

Investment managers incentivized or accountable for short-term performance by current and prospective clients is a potentially rational explanation for which of the following?

Home bias
Bubbles
Value stocks outperforming growth stocks

Answer 71

B is correct. Investment managers’ incentives—or perhaps more accurately, their perception of their incentives—for short-term performance were named as considerations in the technology and real estate bubbles. Not participating in the bubble presented certain FMPs with commercial or career risk.

Question 72

Momentum, can be partly explained by the following behavioral biases except:

availability.
home bias.
regret.

Answer 72

B is correct. Home bias refers to FMPs preferentially investing in domestic securities, likely reflecting perceived relative informational advantages, a greater feeling of comfort with the access to company executives that proximity brings (either personal or through a local brokerage), or a psychological desire to invest in a local community. Momentum, on the other hand, has been documented in a range of markets around the world, in a time-dependent manner, and reflects some FMPs’ availability bias, manifested as a belief that stocks will continue to rise because recently they have only risen, as well as regret aversion by those who invest in past winners because they regret not investing in them in the past.

Question 73

All of the following are reasons that the historical outperformance of value stocks versus growth stocks may not be anomalous except:

Abnormal returns represent compensation for risk exposures, such as the heightened risk of value stocks to suffer distress during downturns.

Companies with strong historical growth rates are viewed as good investments, with higher expected returns than risk characteristics merit.

The deviation disappears by incorporating a three-factor asset pricing model.

Answer 73

B is correct. This choice describes the halo effect, which does offer a behavioral explanation for the poor performance of growth stocks versus value stocks. Growth stocks are mispriced relative to their risk characteristics, because FMPs focusing on just a few properties, such as a high historical revenue growth rate, while neglecting other characteristics.

Question 74

Risk management in the case of individuals is best described as concerned with:

hedging risk exposures.
maximizing utility while bearing a tolerable level of risk.
maximizing utility while avoiding exposure to undesirable risks.

Answer 74

B is correct. For individuals, risk management concerns maximizing utility while taking risk consistent with individual’s level of risk tolerance.

Question 75

Which of the following may be controlled by an investor?

Risk
Raw returns
Risk-adjusted returns

Answer 75

A is correct. Many decision makers focus on return, which is not something that is easily controlled, as opposed to risk, or exposure to risk, which may actually be managed or controlled

Question 76

The process of risk management includes:

minimizing risk.
maximizing returns.
defining and measuring risks being taken.

Answer 76

C is correct. Risks need to be defined and measured so as to be consistent with the organization’s chosen level of risk tolerance and target for returns or other outcomes.

Question 77

Risk management is most likely the process by which an organization:

minimizes its exposure to potential losses.

adjusts its risk to a predetermined level.

maximizes its risk-adjusted return.

Answer 77

B is Correct. An organization with a strong competitive position can recover from losses more easily than one with a weaker competitive position. Therefore, an organization’s risk tolerance should reflect its competitive position. An organization’s size does not define the risk sources it faces or the relative losses it can absorb, so it should not be reflected in its risk tolerance. Neither the risk sources affecting an organization nor the size of the losses an organization can absorb are a function of its perception of market stability.

Question 78

Risk governance:

aligns risk management activities with the goals of the overall enterprise.
defines the qualitative assessment and evaluation of potential sources of risk in an organization.
delegates responsibility for risk management to all levels of the organization’s hierarchy.

Answer 78

A is correct. Risk governance is the top-down process that defines risk tolerance, provides risk oversight and guidance to align risk with enterprise goals.

Question 79

Effective risk governance in an enterprise provides guidance on all of the following except:

unacceptable risks.
worst losses that may be tolerated.
specific methods to mitigate risk for each subsidiary in the enterprise.

Answer 79

C is correct. Risk governance is not about specifying methods to mitigate risk at the business line level. Rather, it is about establishing an appropriate level of risk for the entire enterprise. Specifics of dealing with risk fall under risk management and the risk infrastructure framework.

Question 80

A firm’s risk management committee would be expected to do all of the following except:

approving the governing body’s proposed risk policies.
deliberating the governing body’s risk policies at the operational level.
providing top decision-makers with a forum for considering risk management issues.

Answer 80

A is correct. The risk management committee is a part of the risk governance structure at the operational level—as such, it does not approve the governing body’s policies.

Question 81

A good risk governance process would most likely:

provide guidance on the size of the largest acceptable loss for the organization.

provide different risk targets for each unit within the organization.

be a bottom-up process that reflects the current risk exposures of all parts of the organization.

Answer 81

Correct. A quality risk governance process takes a top-down approach and is charged with risk oversight for the entire organization. It should operate on an enterprise-wise basis rather than viewing each unit in isolation. It will determine the organization’s risk tolerance and provide a sense of the maximum loss the organization can absorb.

Incorrect. A good risk governance process looks at the enterprise as a whole rather than viewing individual units in isolation.

Incorrect. A risk governance process is a top-down process.

Question 82

A top-down process that offers guidance and directs activities that seek to maximize the value of an enterprise is most likely an element of:

risk governance.

risk infrastructure.

risk monitoring and mitigation.

Answer 82

Solution
Correct. Risk governance is the top-down process and guidance that directs risk management activities to align with and support the overall enterprise.

Incorrect. Risk infrastructure refers to the people and systems required to track risk exposures and to perform quantitative risk analysis to allow assessment of a risk profile.

Incorrect. Active risk monitoring and mitigation requires pulling together risk governance, identification, measurement, infrastructure, policies, and procedures and continually reevaluating in the face of changing risk exposures and risk drivers.

Question 83

Which of the following is the correct sequence of events for risk governance and management that focuses on the entire enterprise? Establishing:

risk tolerance, then risk budgeting, and then risk exposures.
risk exposures, then risk tolerance, and then risk budgeting.
risk budgeting, then risk exposures, and then risk tolerance.

Answer 83

A is correct. In establishing a risk management system, determining risk tolerance must happen before specific risks can be accepted or reduced. Risk tolerance defines the appetite for risk. Risk budgeting determine how or where the risk is taken and quantifies the tolerable risk by specific metrics. Risk exposures can then be measured and compared against the acceptable risk.

Question 84

Risk budgeting includes all of the following except:

determining the target return.
quantifying tolerable risk by specific metrics.
allocating a portfolio by some risk characteristics of the investments.

Answer 84

A is correct. Risk budgeting does not include determining the target return. Risk budgeting quantifies and allocates the tolerable risk by specific metrics.

Question 85

A benefit of risk budgeting is that it:

considers risk tradeoffs.
establishes a firm’s risk tolerance.
reduces uncertainty facing the firm.

Answer 85

A is correct. The process of risk budgeting forces the firm to consider risk tradeoffs. As a result, the firm should choose to invest where the return per unit of risk is the highest.

Question 86

A major benefit of employing a risk budgeting process is that it most likely:

allows the organization to determine its enterprise risk tolerance.

forces risk tradeoffs across the organization.

eliminates the need for hedging within the organization.

Answer 86

Correct. Adding a risk budgeting process causes the organization to consider how its total risk tolerance will be allocated across its subsidiaries. Either the total current risks the subsidiaries are engaging in will exceed the risk tolerance and subsidiaries will have to compete for risk by demonstrating highest returns per unit of risk or the total current risks will be less than the risk tolerance and a search will be underway for the subsidiaries that can best utilize the remaining risk budget. The risk tolerance is determined and then sets the risk budget, rather than being determined by it. Hedging can be a part of risk budgeting if hedging produces the superior risk adjusted returns.

Question 87

Can hedging be part of risk budgeting ?

Answer 87

Hedging can be a part of risk budgeting if hedging produces the superior risk adjusted returns.

Question 88

Risk budgeting most likely:

limits the cost of hedging a portfolio.

can be defined by a measure such as beta or scenario loss.

focuses on the appetite for risk and what exposures are acceptable.

Answer 88

Incorrect. Limiting the amount invested for hedging purposes is not a result of a market-benchmarked choice of risk intensity.

Correct. Risk budgeting quantifies and allocates the tolerable risk according to specific metrics. A risk budget can be multidimensional or a simple, one-dimensional risk measure, such as standard deviation, beta, value at risk, or scenario loss, among others.

Incorrect. Risk tolerance focuses on the appetite for risk.

Question 89

Which of the following risks is best described as a financial risk?

Credit
Solvency
Operational

Answer 89

A is correct. A financial risk originates from the financial markets. Credit risk is one of three financial risks identified in the reading: Credit risk is the chance of loss due to an outside party defaulting on an obligation. Solvency risk depends at least in part on factors internal to the organization and operational risk is an internal risk arising from the people and processes within the organization.

Question 90

Liquidity risk is most associated with:

the probability of default.
a widening bid–ask spread.
a poorly functioning market.

Answer 90

B is correct. Liquidity risk is also called transaction cost risk. When the bid–ask spread widens, purchase and sale transactions become increasingly costly. The risk arises from the uncertainty of the spread.

Question 91

An example of a non-financial risk is:

market risk.
liquidity risk.
settlement risk.

Answer 91

C is correct. Settlement risk is related to default risk but deals with the timing of payments rather than the risk of default.

Question 92

Which of the following pairs of risks are most closely related?

Model risk and tail risk

Liquidity risk and operational risk

Credit risk and solvency risk

Answer 92

Correct. Model risk is the risk of using the wrong model to analyze an investment or the risk of using the right model for the analysis but using it incorrectly. Tail risk, although it involves unlikely but substantial losses, typically results from using inappropriate modeling assumptions such as assuming that returns are normally distributed. Credit risk involves the risk of a borrower not repaying you, whereas solvency risk is the risk of you running out of the money needed to pay your obligations. Liquidity risk is the risk that the future transaction price for an investment will be different than expected, whereas operational risk includes a wide range of potential problems occurring within an organization’s personnel and systems.

Incorrect. Liquidity risk is the risk that the future transaction price for an investment will be different than expected, whereas operational risk includes a wide range of potential problems occurring within an organization’s personnel and systems.

Incorrect. Credit risk involves the risk of a borrower not repaying you, whereas solvency risk is the risk of you running out of the money needed to pay your obligations.