Table of Contents
CFA Level 2 – Portfolio Management, Session 18 – Reading 63
(Practice Questions, Sample Questions)
1. Gemini Investment Management Company (GIMC) assumes markets will remain at equilibrium indefinitely. GIMC defines security analysis as the examination of factors affecting the value of individual securities. GIMC defines asset allocation as the examination of factors affecting the optimal allocation of assets to the market portfolio and to the risk-free asset. Given GIMC’s assumption that markets are at equilibrium indefinitely, indicate whether GIMC should place significant or insignificant emphasis on security selection and asset allocation.
A)Insignificant emphasis on asset allocation only.
B)Insignificant emphasis on both.
C)Insignificant emphasis on security selection only (Explanation: When markets are at equilibrium, all asset prices will equal their fair values. Assets are neither undervalued nor overvalued. Therefore, if GIMC believes markets will remain at equilibrium indefinitely, then they should place very little, if any, emphasis on security selection. In contrast, active portfolio management is needed to determine the appropriate allocation of the client’s investment between the market portfolio and the risk free asset. Active portfolio management is needed to forecast the expected returns and risk for the market portfolio and to forecast the return on the risk-free asset. GIMC should allocate large percentages to the market portfolio for highly risk tolerant clients and high percentages to the risk-free asset for highly risk averse clients. Significant effort must be expended to determine the appropriate mix of assets for the client)
2. When markets are at equilibrium, all asset:
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A)alphas will equal zero. (Explanation: When markets are at equilibrium, forecast returns equal equilibrium expected returns. The stock’s alpha is defined as the difference between the analyst’s forecast return for the stock and the stock’s equilibrium expected return. Therefore, when markets are at equilibrium, all alphas will equal zero.)
B)betas will equal zero.
C)alphas will be positive
3. Intelligent Investors Inc. (III) manages $10 billion in assets using active portfolio management. III believes that security prices often stray from their equilibrium values. Elizabeth Adams and Rajendra Rao work as analysts at III. Adams states that III should overweight all positive alpha stocks. An overweight is defined as an allocation in excess of the asset’s relative market value weight. Rao states that III should allocate assets to maximize the portfolio Sharpe ratio.
Regarding these statements:
A)only Adams is correct.
B)both are correct. (Explanation: Adams’ statement is correct. If markets are in disequilibrium, asset prices will deviate from their fair values. An asset’s alpha equals the difference between the analyst’s forecast return for an asset and its required return. Positive alpha assets should be overweighted. Note that a neutral weight for III equals the asset’s relative market value weight, which is how assets are allocated with the “market” portfolio. Rao’s statement is correct too. Allocations should provide investments with the maximum Sharpe ratio defined as the portfolio’s expected excess return, E(Rp) minus RF, divided by the portfolio’s standard deviation)
C)only Rao is correct
4. An asset’s alpha returns are returns earned in addition to the asset’s:
A)ex ante returns.
B)projected returns.
C) required returns (Explanation: Alpha returns are returns beyond the required return expected on an asset given its level of risk)
5. Expected returns beyond required returns are referred to as an asset’s:
A) alpha. (Explanation: Alpha returns are returns beyond the required return expected on an asset given its level of risk)
B)beta.
C)ex ante returns
6. MPT Associates selects optimal portfolios using the Treynor-Black model. Randall Morgan and Charles Alverson, research associates at MPT, debate the assumptions of the model. Morgan states that the model assumes that large numbers of assets are mispriced. Alverson states that the model places high importance on diversification.
Regarding these statements:
A)only Alverson is incorrect.
B)both are incorrect.
C) only Morgan is incorrect (Explanation: The Treynor-Black model combines modern portfolio theory and market inefficiency. The model is based on the premise that markets are nearly efficient, implying that the number of mispriced assets is small. Therefore, Morgan’s statement is not correct. In contrast, Alverson’s statement is correct. The Treynor-Black model incorporates active security selection within an optimally diversified portfolio context. Therefore, the model places large value on the importance of diversification)
7. Amanda Keene, CFA, works for an investment firm that employs the Treynor-Black portfolio optimization model. Keene predicts that the market index return will move higher next year as markets move closer to equilibrium. Keene advises a client, whose risk aversion will remain unchanged next year. Using the Treynor-Black framework, Keene should make which of the following changes in her client’s allocations, with respect to the percentage of actively managed and passively managed portfolios, noting that the remaining percentage is allocated to cash?
A)Decrease both portfolios.
B)Decrease only passively managed portfolios.
C) Decrease only actively managed portfolios (Explanation: The client’s risk aversion will remain unchanged next year, which suggests that the percentage allocated to cash will not change. A higher market return suggests greater weight should be placed on the passively managed portfolio, especially in light of Keene’s prediction that markets will move closer to equilibrium. Less emphasis is placed on active management as markets move toward equilibrium (alphas move closer to zero))
8. Collette Gallant, CFA, employs the capital asset pricing model (CAPM) to determine the required returns for stocks. Gallant works for Trey-Black Inc. (TBI) which uses the Treynor-Black model for portfolio optimization. Gallant is deciding whether to include stock ABZ in the TBI’s actively managed portfolio. She forecasts that the ABZ stock return will be 15% next year. TBI provides Gallant with the following information.
Expected return on the S&P500 stock market index = 15%.
1-year Treasury bill rate = 5%.
ABZ stock beta = 1.25.
TBI determines that Gallant’s forecast ability has been very poor. TBI also finds that the average alpha across stocks in their actively managed portfolio equals 1%. Determine if Trey-Black’s allocation to ABZ in its actively managed portfolio should be an above or below average, long or short position
Magnitude
Position
A)
Below average
Long
B)
Below average
Short
C)
Above average
Short
(Explanation: (B) According to the Treynor-Black model, the actively-managed portfolio takes long positions in positive alpha stocks and short positions in negative alpha stocks. The alpha is defined as the difference between the analyst’s forecast return for the stock and its required return. As stated in the question, the required return for stock ABZ is calculated using the CAPM:
E(R) = RF + βm) – RF] = 0.05 + 1.25[0.15 – 0.05] = 0.175 = 17.5%.
Gallant’s forecast return (15%) is less than the required return (17.5%):
alpha = 0.15 – 0.175 = −0.025 = −2.5%.
Therefore, Gallant’s predicted alpha is much higher in absolute magnitude than the average alpha (1%), which would suggest an above-average short position if Gallant’s forecasting ability is reliable. However, TBI has determined that Gallant’s forecast ability is poor. Therefore, her forecast alpha will be adjusted severely toward zero to account for her poor forecast ability. The end result is that only a small short position will be taken in ABZ)
9. Frederick Kurzonkowski, CFA, employs the Treynor-Black portfolio optimization model at his firm, TBP, where he serves as portfolio manager. TBP recently decided against holding short positions in their portfolios. Kurzonkowski is asked to determine the most likely result of the short-sale prohibition on the weights allocated to the long positions in the active portfolio, and to the alpha on the active portfolio. Kurzonkowski should make the following predictions about the effects of the prohibition on short sales on the actively managed portfolio:
Allocation to long positions
Alpha
A)
Increases
Decreases
B)
Decreases
Increases
C)
Decreases
Decreases
(Explanation: (C) The prohibition on short sales removes the negative weights within the actively managed portfolio, along with the leverage that the short positions offer to the long positions. When short sales are allowed, more than 100% can be allocated to the long positions. When short sales are not allowed, only 100% can be allocated to the long positions. Therefore, the prohibition on short sales causes the weights to the long positions within the actively managed portfolio to fall. The alpha also is expected to fall: smaller weight is now assigned to positive alpha stocks, and there are no negative weights to assign to negative alpha stocks)
10. Gemini Investment Management Company (GIMC) assumes markets will remain at equilibrium indefinitely. GIMC defines security analysis as the examination of factors affecting the value of individual securities. GIMC defines asset allocation as the examination of factors affecting the optimal allocation of assets to the market portfolio and to the risk-free asset. Given GIMC’s assumption that markets are at equilibrium indefinitely, indicate whether GIMC should place significant or insignificant emphasis on security selection and asset allocation.
A)Insignificant emphasis on asset allocation only.
B)Insignificant emphasis on security selection only. (Explanation: When markets are at equilibrium, all asset prices will equal their fair values. Assets are neither undervalued nor overvalued. Therefore, if GIMC believes markets will remain at equilibrium indefinitely, then they should place very little, if any, emphasis on security selection. In contrast, active portfolio management is needed to determine the appropriate allocation of the client’s investment between the market portfolio and the risk free asset. Active portfolio management is needed to forecast the expected returns and risk for the market portfolio and to forecast the return on the risk-free asset. GIMC should allocate large percentages to the market portfolio for highly risk tolerant clients and high percentages to the risk-free asset for highly risk averse clients. Significant effort must be expended to determine the appropriate mix of assets for the client.)
C)Insignificant emphasis on both
