Ans Question Bank Lv2
Ans Question Bank Lv2
Ans Question Bank Lv2
A) security lending.
B) portfolio turnover.
C) bid–ask spreads.
Explanation
The main components of ETF cost are the fund management fee, tracking error, portfolio
turnover, trading costs (including commissions, bid–ask spreads, and premiums/discounts),
taxable gains/losses, and security lending. These costs generally reduce returns, with the
exception of security lending, which can be considered a "negative" cost as it generates
additional income that o sets fund expenses. Security lending for an ETF typically means
loaning a portion of portfolio holdings to short sellers.
When an ETF trades on the primary market, this is most likely to refer to a trade that happens:
A) over-the-counter.
C) on an exchange.
Explanation
ETFs trade on both the primary market (directly between issuers and APs) and on the
secondary markets (over-the-counter or exchange-based trades, like listed equity).
Exchange-traded notes (ETNs) are similar to exchange traded funds (ETFs), in that they both:
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Explanation
Both ETFs and ETNs use the creation/redemption process. Some ETFs may lend securities or
use swaps, exposing the fund to some level of default risk. However ETNs are unsecured,
unsubordinated debt notes and thus an ETN's theoretical counterparty risk is 100% in the event
of a default by the underwriting bank. Unlike ETFs, ETNs do not hold the underlying securities.
It would be most accurate to state that ETF shares can be created or redeemed by:
Explanation
The only investors who can create or redeem new ETF shares are a special group of
institutional investors called authorized participants. ETFs' creation/redemption mechanism
allows for the continuous creation and redemption of ETF shares.
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Question #1 of 33 Question ID: 1210769
Which of the following is NOT an assumption necessary to derive the arbitrage pricing theory
(APT)?
B) The priced factors risks can be hedged without taking short positions in any
portfolios.
Explanation
Assume you are considering forming a common stock portfolio consisting of 25% Stonebrook
Corporation (Stone) and 75% Rockway Corporation (Rock). As expressed in the two-factor returns
models presented below, both of these stocks' returns are a ected by two common factors:
surprises in interest rates and surprises in the unemployment rate.
Assume that at the beginning of the year, interest rates were expected to be 5.1% and
unemployment was expected to be 6.8%. Further, assume that at the end of the year, interest
rates were actually 5.3%, the actual unemployment rate was 7.2%, and there were no company-
speci c surprises in returns. This information is summarized in Table 1 below:
Company-speci c returns
Actual Expected
surprises
Unemployment
0.072 0.068 0.0
Rate
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A) 0.25.
B) 0.85.
C) 0.95.
Explanation
The portfolio composition is 25% Stonebrook and 75% Rockway. The interest rate sensitivities
for Stonebrook and Rockway are 1.0 and 0.8, respectively. Thus, the portfolio's sensitivity to
interest rate surprises is: (0.25)(1.0) + (0.75)(0.8) = 0.85.
Assume you are considering forming a common stock portfolio consisting of 25% Stonebrook
Corporation (Stone) and 75% Rockway Corporation (Rock). As expressed in the two-factor returns
models presented below, both of these stocks' returns are a ected by two common factors:
Assume that at the beginning of the year, interest rates were expected to be 5.1% and
unemployment was expected to be 6.8%. Further, assume that at the end of the year, interest
rates were actually 5.3%, the actual unemployment rate was 7.2%, and there were no company-
Company-speci c returns
Actual Expected
surprises
Unemployment
0.072 0.068 0.0
Rate
What is the predicted return for Stonebrook if the return unexplained by the model was -1%?
A) 1.40%.
B) 10.68%.
C) 12.00%
Explanation
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The actual return uses the unemployment and interest rate surprises as follows:
The returns for a stock that are correlated with surprises in interest rates and unemployment
rates can be expressed using a two-factor model as:
where:
FInt = unexpected changes in interest rates (the interest factor) = .053 − .051 = .002
bi,2 = the factor sensitivity of stock i to unexpected changes in the unemployment rate
FUn = unexpected changes in the unemployment rate (the unemployment rate factor)
= .072 − .068 = .004
εi = a mean-zero error term that represents the part of asset i's return not explained
by the two factors.
Thus the actual return is: 0.11 + (1.0)(0.002) + (1.2)(0.004) – 0.01 = 0.1068 or 10.68%
Which of the following does NOT describe the arbitrage pricing theory (APT)?
Explanation
APT is a k-factor model, in which the number of factors, k, is assumed to be a lot smaller than
the number of assets; no speci c number of factors is assumed.
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Michael Paul, a portfolio manager, is screening potential investments and suspects that an
arbitrage opportunity may be available. The three portfolios that meet his screening criteria are
detailed below:
X 12% 1.0
Y 16% 1.3
Z 8% 0.9
Which of the following portfolio combinations produces the highest return while maintaining a
beta of 1.00?
C) 100% 0% 0%
Explanation
Portfolio Weights
Expected Return Beta
X Y Z
Portfolio weights of 25%, 50%, and 25% yield the highest return, but at a beta of 1.13. Investing
100% in Portfolio X yields the highest return for this risk level (i.e., beta = 1.00).
The Real Value Fund is designed to have zero exposure to in ation. However its current in ation
factor sensitivity is 0.30. To correct for this, the portfolio manager should take a:
Explanation
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To hedge in ation, the fund should take a 30% short position in the in ation factor portfolio.
This short position will fully o set the fund's positive exposure to in ation. Tracking portfolios
are typically used for active asset selection and have multiple factor exposures which would
prevent them from adequately hedging the in ation exposure of the fund.
Summer Vista decides to develop a fundamental factor model. She establishes a proxy for the
market portfolio, and then considers the importance of various factors in determining stock
Which of the following factors is least appropriate for Vista's factor model?
Explanation
Fundamental factors are factors measured by characteristics of the companies themselves, like
price-to-earnings (P/E) ratios or growth rates. Macroeconomic factors are economic in uences
on security returns. A company's position in the business cycle is dependent on the cycle itself,
and cannot be accurately measured by looking at a company's fundamentals – business cycle is
a macroeconomic factor. Payout ratios and management tenure are pieces of company-speci c
data suitable for use in a fundamental factor model.
Given a three-factor arbitrage pricing theory APT model, what is the expected return on the
Freedom Fund?
The factor risk premiums to factors 1, 2, and 3 are 10%, 7% and 6%, respectively.
The Freedom Fund has sensitivities to the factors 1, 2, and 3 of 1.0, 2.0 and 0.0,
respectively.
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A) 30.0%.
B) 33.0%.
C) 24.0%.
Explanation
Identify the most accurate statement regarding multifactor models from among the following.
Macroeconomic factor models include multiple risk factors such as the business cycle, interest
rates, and in ation. Fundamental factor models include speci c characteristics of the securities
themselves such as rm size and the price-to-earnings ratio.
The Arbitrage Pricing Theory (APT) has all of the following characteristics EXCEPT it:
Explanation
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Question #11 of 33 Question ID: 1210783
Portfolios A and B have an expected return of 4.4% and 5.3% respectively. Assume that a one-
factor APT model is appropriate and the factor sensitivities of portfolios A and B are 0.8 and 1.1
respectively. The risk-free rate and factor risk premium are closest to:
A) 2.50% 3.00%
B) 3.00% 2.00%
C) 2.00% 3.00%
Explanation
A portfolio manager uses a two-factor model to manage her portfolio. The two factors are
con dence risk and time-horizon risk. If she wants to bet on an unexpected increase in the
con dence risk factor (which has a positive risk premium), but hedge away her exposure to time-
horizon risk (which has a negative risk premium), she should create a portfolio with a sensitivity
of:
A) −1.0 to the con dence risk factor and 1.0 to the time-horizon factor.
B) 1.0 to the con dence risk factor and -1.0 to the time-horizon factor.
C) 1.0 to the con dence risk factor and 0.0 to the time-horizon factor.
Explanation
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She wants to create a con dence risk factor portfolio, which has a sensitivity of 1.0 to the
con dence risk factor and 0.0 to the time horizon factor. Because the risk premium on the
con dence risk factor is positive, an unexpected increase in this factor will increase the returns
on her portfolio. The exposure to the time-horizon risk factor has been hedged away, because
the sensitivity to that factor is zero.
One of the assumptions of the arbitrage pricing theory (APT) is that there are no arbitrage
opportunities available. An arbitrage opportunity is:
C) an investment that has an expected positive net cash ow but requires no initial
investment.
Explanation
One of the three assumptions of the APT is that there are no arbitrage opportunities available
to investors among these well-diversi ed portfolios. An arbitrage opportunity is an investment
that has an expected positive net cash ow but requires no initial investment.
All factor portfolios will have positive risk premiums equal to the factor price for that factor. An
arbitrage opportunity does not necessarily require a return equal to the risk-free rate, and the
factor exposures for an arbitrage portfolio are all equal to zero.
Assume you are attempting to estimate the equilibrium expected return for a portfolio using a
two-factor arbitrage pricing theory (APT) model. Assume that you have estimated the risk
premium for factor 1 to be 0.02, and the risk premium for factor 2 to be 0.03. The sensitivity of
the portfolio to factor 1 is –1.2 and the portfolios sensitivity to factor 2 is 0.80. Given a risk free
rate equal to 0.03, what is the expected return for the asset?
A) 2.4%.
B) 5.0%.
C) 3.0%.
Explanation
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The general form of the two-factor APT model is: E(RPort) = RF = λ1β1 + λ2β2, where the λ's are
the factor risk premiums and the β's are the portfolio's factor sensitivities. Substituting the
appropriate values, we have:
Given a three-factor arbitrage pricing theory (APT) model, what is the expected return on the
Premium Dividend Yield Fund?
The factor risk premiums to factors 1, 2 and 3 are 8%, 12% and 5%, respectively.
The fund has sensitivities to the factors 1, 2, and 3 of 2.0, 1.0 and 1.0, respectively.
A) 50.0%.
B) 33.0%.
C) 36.0%.
Explanation
The expected return on the Premium Dividend Yield Fund is 3% + (8.0%)(2.0) + (12.0%)(1.0) +
(5.0%)(1.0) = 36.0%.
Janice Barefoot, CFA, has managed a portfolio where she used the Dow Jones Industrial Average
(DJIA) as a benchmark. In the past two years the average monthly return on her portfolio has
been higher than that of the DJIA. To get a measure of active return per unit of active risk
A) information ratio, which is the standard deviation of the di erences between the
portfolio and benchmark returns divided by the average of those di erences.
B) Sharpe ratio, which is the standard deviation of the di erences between the portfolio
and benchmark returns divided into the average of those di erences.
C) information ratio, which is the average excess portfolio return over the benchmark
divided by the standard deviation of the di erences between the portfolio and
b h k
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Explanation
The information ratio is the measure of active return per unit of active risk. If we let X =
(monthly portfolio return − the benchmark return), then the information ratio = (the average of
X / the standard deviation of X). It is similar to the Sharpe ratio, which de nes the random
variable Y as Y = (monthly portfolio return − the risk-free rate). The Sharpe ratio = (the average
of Y / the standard deviation of the portfolio return) = the standard deviation of Y if the risk-
free rate is constant.
Assume you are considering forming a common stock portfolio consisting of 25% Stonebrook
Corporation (Stone) and 75% Rockway Corporation (Rock). As expressed in the two-factor returns
models presented below, both of these stocks' returns are a ected by two common factors:
surprises in interest rates and surprises in the unemployment rate.
Assume that at the beginning of the year, interest rates were expected to be 5.1% and
unemployment was expected to be 6.8%. Further, assume that at the end of the year, interest
rates were actually 5.3%, the actual unemployment rate was 7.2%, and there were no company-
speci c surprises in returns. This information is summarized in Table 1 below:
Company-speci c returns
Actual Expected
surprises
Unemployment
0.072 0.068 0.0
Rate
A) 13.0%.
B) 11.0%.
C) 13.2%.
Explanation
The expected return for Stonebrook is simply the intercept return (ai) of 0.11, or = 11.0%.
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Question #18 of 33 Question ID: 1210801
Explanation
Multifactor models allow us to capture other dimensions of risk besides overall market risk.
Investors with unique circumstances di erent than the average investor may want to hold
portfolios tilted away from the market portfolio in order to hedge or speculate on factors like
recession risk, interest rate risk or in ation risk. An investor with lower-than-average exposure
to recession risk can earn a premium by creating greater-than-average exposure to the
recession risk factor. In e ect, he earns a risk premium determined by the average investor by
taking on a risk he doesn't care about as much as the average investor does.
B) Systematic.
C) Unsystematic.
Explanation
Unsystematic risk can be diversi ed away. Thus, arbitrage pricing re ects only systematic risk.
It is assumed that the portfolio manager will take steps to diversify and reduce risk.
A portfolio with a factor sensitivity of one to a particular factor in a multi-factor model and zero to
all other factors is called a(n):
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A) arbitrage portfolio.
B) factor portfolio.
C) tracking portfolio.
Explanation
A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to
all other factors. An arbitrage portfolio is a portfolio with factor sensitivities of zero to all
factors, positive expected net cash ow, and an initial investment of zero. A tracking portfolio is
a portfolio with a speci c set of factor sensitivities designed to replicate the factor exposures of
a benchmark index.
Which of the following is NOT an underlying assumption of the arbitrage pricing theory (APT)?
A) There are a su cient number of assets for investors to create diversi ed portfolios in
which rm-speci c risk is eliminated.
B) A market portfolio exists that contains all risky assets and is mean-variance e cient.
Explanation
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Marcie Deiner is an investment manager with G&G Investment Corporation. She works with a
variety of clients who di er in terms of experience, risk aversion and wealth. Deiner recently
attended a seminar on multifactor analysis. Among other things, the seminar taught how the
assumptions concerning the Arbitrage Pricing Theory (APT) model are di erent from those of the
Capital Asset Pricing Model (CAPM). One of the examples used in the seminar is below.
Beta estimates for Growth and Value funds for a three factor model
For the model used as an example in the seminar, if the T-bill rate is 3.5%, what are the expected
returns for the Growth and Value Funds?
E(RGrowth) E(RValue)
A) 3.1% −3.16%
B) 37.0% −37.9%
C) 33.5% −41.4%
Explanation
E(RGrowth)= 0.035 + 0.03(0.5) − 0.4(0.7) + 0.5(1.2) = 0.035 + 0.015 − 0.28 + 0.6 = 0.37 or 37.0%
E(RValue)= 0.035 + 0.03(0.2) − 0.4(1.8) + 0.5(0.6) = 0.035 + 0.006 − 0.72 + 0.30 = −0.379 or −37.9%
The macroeconomic factor models for the returns on Omni, Inc., (OM) and Garbo Manufacturing
(GAR) are:
What is the expected return on a portfolio invested 60% in Omni and 40% in Garbo?
A) 20.96%.
B) 18.0%.
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C) 19.96%.
Explanation
In the macroeconomic model, the intercept is the expected return. The expected return of the
portfolio is the weighted average of the expected return of the 2 stocks:
A multi-factor model that uses unexpected changes (surprises) in macroeconomic variables (e.g.,
in ation and gross domestic product) as the factors to explain asset returns is called a:
Explanation
Explanation
The APT is an equilibrium-pricing model; multi-factor models are "ad-hoc," meaning the factors
in these models are not derived directly from an equilibrium theory. Rather they are identi ed
empirically by looking for macroeconomic variables that best t the data.
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Question #26 of 33 Question ID: 1210797
Janice Barefoot, CFA, has been managing a portfolio for a client who has asked Barefoot to use
the Dow Jones Industrial Average (DJIA) as a benchmark. In her rst year Barefoot managed the
portfolio by choosing 29 of the 30 DJIA stocks. She selected a non-DJIA stock in the same industry
as the omitted stock to replace that stock. Compared to the DJIA, Barefoot has placed a higher
weight on the nancial stocks and a lower weight on the other stocks still in the portfolio. Over
that year, the non-DJIA stock in the portfolio had a negative return while the omitted DJIA stock
had a positive return. The portfolio managed by Barefoot outperformed the DJIA. Based on this
we can say that the return from factor tilts and asset selection were:
B) both positive.
Explanation
Since the replacement of the asset obviously had a negative e ect, the tilting towards nancial
stocks must have been positive to not only compensate for the loss but produce a portfolio
return greater than the DJIA.
B) a factor sensitivity of one to a particular factor in a multi-factor model and zero to all
other factors.
C) factor sensitivities of zero to all factors, positive expected net cash ow, and an initial
investment of zero.
Explanation
A tracking portfolio is a portfolio with a speci c set of factor sensitivities designed to replicate
the factor exposures of a benchmark index. A factor portfolio is a portfolio with a factor
sensitivity of one to a particular factor and zero to all other factors. An arbitrage portfolio is a
portfolio with factor sensitivities of zero to all factors, positive expected net cash ow, and an
initial investment of zero.
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Question #28 of 33 Question ID: 1210795
Explanation
A portfolio with a speci c set of factor sensitivities designed to replicate the factor exposures of a
benchmark index is called a:
A) tracking portfolio.
B) arbitrage portfolio.
C) factor portfolio.
Explanation
A tracking portfolio is a portfolio with a speci c set of factor sensitivities designed to replicate
the factor exposures of a benchmark index. A factor portfolio is a portfolio with a factor
sensitivity of one to a particular factor and zero to all other factors. An arbitrage portfolio is a
portfolio with factor sensitivities of zero to all factors, positive expected net cash ow, and an
initial investment of zero.
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Rob Tanner, portfolio manager at Alpha Inc. meets his old college friend Del Torres for lunch.
Torres excitedly tells Tanner about his latest work with tracking and factor portfolios. Torres says
he has developed a tracking portfolio to aid in speculating on oil prices and is working on a factor
Tracking Factor
A) No No
B) No Yes
C) Yes No
Explanation
Torres reversed the concepts and is thus incorrect on both counts. A factor portfolio is a
portfolio with a factor sensitivity of 1 to a particular factor and zero to all other factors. It
represents a pure bet on one factor, and can be used for speculation or hedging purposes. A
tracking portfolio is a portfolio with a speci c set of factor sensitivities. Tracking portfolios are
often designed to replicate the factor exposures of a benchmark index like the Russell 2000.
Which of the following is not an assumption of the arbitrage pricing theory (APT)?
B) The market contains enough stocks so that unsystematic risk can be diversi ed away.
Explanation
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Janice Barefoot, CFA, has been managing a portfolio for a client who has asked Barefoot to use
the Dow Jones Industrial Average (DJIA) as a benchmark. In her second year, Barefoot used 29 of
the 30 DJIA stocks. She selected a non-DJIA stock in the same industry as the omitted DJIA stock to
replace that stock. Compared to the DJIA, Barefoot placed a lower weight on the communication
stocks and a higher weight on the other stocks still in the portfolio. Over that year, the non-DJIA
stock in the portfolio had a positive and higher return than the omitted DJIA stock. The
communication stocks had a negative return while all of the other stocks had a positive return.
The portfolio managed by Barefoot outperformed the DJIA. Based on this we can say that the
return from factor tilts and asset selection were:
B) both positive.
Explanation
Since the communications stocks had a negative return while all the other stocks had a positive
return, Barefoot's underweighting of those stocks produced a positive tilt return. Since the
asset chosen to replace the DJIA stock outperformed the omitted stock, the asset selection
return was positive.
A) systematic risk.
B) unsystematic risk.
C) macroeconomic risks.
Explanation
Systematic risk re ects factors that have a general e ect on the security markets as a whole,
and cannot be diversi ed away. Macroeconomic risk comes in many forms, and it is usually
considered systematic risk. Unsystematic risk can be reduced through diversi cation.
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Question #1 of 28 Question ID: 1210871
Pamela Grieve claims that her information coe cient is 0.20 on monthly bets on 10 stocks in the
healthcare industry. Assuming unconstrained optimization, the reduction in her information ratio
if her bets have a correlation coe cient of 0.45 as opposed to being truly independent is closest
to:
A) 45%
B) 86%
C) 22%
Explanation
N 120
= = 2.19
1+(N−1)r 1+(120−1)0.45
−−
− −−−−
New information ratio assuming correlated bets IC√BR = 0.20 × √2.20 = 0.30
When choosing an active manager, an investor with a high level of risk aversion:
Explanation
Value added is independent of the level of risk aversion. All investors will choose the manager
with the highest information ratio. Those with higher levels of risk aversion will implement the
strategy less aggressively (i.e., invest a larger proportion in the benchmark portfolio).
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Question #3 of 28 Question ID: 1210851
A) Investors can take active risk that is suitable for them by investing in a combination of
actively managed portfolio and benchmark portfolio.
B) The Sharpe ratio of a portfolio is una ected by addition of cash or leverage in the
portfolio.
Explanation
A closet index fund will have Sharpe ratio close to the benchmark's Sharpe ratio. The Sharpe
ratio is for a portfolio is indeed una ected by addition of cash or leverage to the portfolio.
However, information ratio does change as we add cash or leverage to the actively managed
portfolio. Investors can combine benchmark portfolio and active portfolio to obtain optimal
level of active risk for them.
An active manager has an information coe cient of 0.05 and makes 36 independent bets per
year. What is the manager's information ratio given a transfer coe cient of 0.75?
A) 1.35
B) 0.45
C) 0.23
Explanation
Information ratio =
−−
− −−
IR = (TC) IC√BR = (0.75) (0.05) √36 = 0.225
An active manager currently covers 40 stocks and makes a forecast for each of them every
quarter. Next year he intends to cover the same stocks but only once every 6 months. Assuming
the manager's skill, measured in terms of the correlation of each forecast with actual returns
doesn't change, which of the following statements is most accurate?
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A) The information ratio will fall by approximately 50%
Explanation
−−
−
Information ratio (IR) = IC × √BR
Hence a reduction in the breadth from 160 (40 × 4) to 80 (40 × 2) will cause an approximate
30% drop in the IR
Hence the Information Ratio will fall by approximately 30%. Note that full calculation is not
required. Given that IR changes with the square root of breadth, a 50% drop in breadth must
cause a less than 50% drop in IR. Note that it does not matter if the portfolio is constrained or
unconstrained.
Which of the following terms is the ex-ante risk weighted correlation between forecasted active
A) Breadth
Explanation
Information coe cient is the ex-ante correlation between forecasted active returns and actual
active returns. It captures the skill of the manager.
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Zeta fund has active return and active risk of 1.6% and 8% respectively. Benchmark portfolio has
The maximum possible Sharpe ratio of a portfolio consisting of Zeta fund and the benchmark
A) 0.55
B) 0.5
C) 0.4
Explanation
Tom Grenkin is a market timer with an information ratio of 0.75. He makes a prediction of the
movement in the market each quarter. Jane Fortina is a stock selector who follows 50 companies
and revises her assessment each quarter. She also has an information ratio of 0.75. Assuming
both managers have unconstrained portfolios, which of the following statements regarding the
A) As Grenkin makes fewer bets per year, he requires a higher information coe cient
on each bet than Fortina to achieve the same information ratio.
B) As both managers have the same information ratio, they must also have the same
information coe cient.
C) As Fortina’s strategy has a much larger breadth, she must have a larger information
coe cient than Grenkin.
Explanation
−−
−
(IR) = IC × √BR
As a stock selector, Fortina makes many more bets per period and has a much larger breadth.
She therefore requires a lower information coe cient than Grenkin to achieve the same
information ratio. Grenkin requires a higher coe cient.
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Question #9 of 28 Question ID: 1210854
A) TC>1
B) TC<1
C) TC=1
Explanation
Zeta fund has active return and active risk of 1.6% and 8% respectively. Benchmark portfolio has
What is the weight of benchmark portfolio in a portfolio consisting of Zeta fund and the
benchmark portfolio assuming that the portfolio is constructed to have optimal active risk?
A) 0.1667
B) 0.2
C) 0.25
Explanation
∗
IR 0.2
Optimal level of active risk = σ A
= σB = (10.5) = 6%
SRB 0.35
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Helen Wilde is trying to estimate the active return of Optimal fund. A comparison of Optimal's
holdings and that of the benchmark are shown below:
Optimal Benchmark
Optimal Benchmark
Asset Class Return
(i) Return
Weight (wPi) Weight (wBi)
E(RPi) E(RBi)
The expected active return due to asset allocation for Optimal is closest to:
A) -0.44%
B) – 1.40%
C) – 0.86%
Explanation
Active
Portfolio Benchmark
Benchmark Return (Δwi)
Asset Class Return
(i) Weight (E(RBi))
Weight (wBi) Weight
(wPi) E(RBi)
(Δwi)
An active manager has an information coe cient of 0.08, transfer coe cient of 0.50, and makes
100 independent bets per year. What is the expected active return for an active risk constraint of
5%?
A) 1.8%
B) 2.0%
C) 2.4%
Explanation
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−−
− −−−
E (RA ) = (TC) IC√BR σA = (0.50) (0.08) √100 (0.05) = 0.02 or 2%
Which of the following terms is the number of independent bets per year made by an active
manager?
B) Breadth
Explanation
Breadth is the number of independent bets (based on unique information) made per year by
the active manager.
Alisa Darent is evaluating several active portfolio managers with the same style and benchmark
portfolio.
Benchmark return is expected to be 11%. What will be the maximum expected return for Darent's
portfolio assuming that she wants to limit her active risk to 11%?
A) 2.75%
B) 2.20%
C) 13.75%
Explanation
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Darent will select the manager with the highest information ratio – or Alfred.
Charles Gri th makes quarterly bets between stocks of industrial and utility sectors. The
historical correlation between the returns of the two sectors is -0.20 and Gri th's bets have been
correct 55% of the time. Further information is as below:
Benchmark
The expected annualized active return of Gri th's sector rotation strategy is closest to:
A) 13.72%
B) 10.64%
C) 5.48%
Explanation
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IC = 2(0.55) – 1 = 0.10
−−
−
Annualized active return = IC x √BR x σA = 0.10 x (4)1/2 x 0.2744 = 0.0548 or 5.48%
Alternatively,
Active return from this strategy using a probability weighted average (given Gri th makes
correct calls 55% of time) of combined risk is:
Explanation
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Which of the following terms is the cross-sectional correlation between forecasted active returns
and actual active weights adjusted for risk?
B) Breadth
Explanation
Charles Gri th makes quarterly bets between stocks of industrial and utility sectors. Gri th's
strategy has an annualized active risk of 18%. Based on the information below, If Gri th wants to
limit his active risk to 6%, what is the allocation to Utility sector when Gri th is bullish about
Industrial stocks?
Benchmark
Sector Weight
Industrial 80%
Utility 20%
A) -13%
B) 14%
C) 5%
Explanation
If active risk is limited to 6%, the deviation from the benchmark weights of 80% and 20% is
limited to 6%/18% or 33%. Hence when Gri th is bullish about industrials, the weight to that
sector will be 80% + 33% or 113% and the weight to utility sector will be 20% - 33% or -13%.
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Jon Gamlin is comparing a market timing strategy with a stock selection strategy. He draws the
Conclusion 1
To achieve the same information ratio, a market timer making weekly forecasts on the movement
of the market needs to have a higher skill level than a stock selector following 25 stocks and
Conclusion 2
A specialist following only 4 stocks who revises his forecast 100 times per year will achieve the
same information ratio as a stock selector with the same skill level who follows 50 stocks and
Explanation
In conclusion 1, the market timer has a breadth of 52 and the stock selector 50. In order to
achieve the same information ratio, the stock selector would need to make up for the lower
breadth with a higher information coe cient.
In conclusion 2, the specialist has a breadth of 400 and the selector 100. If they have the same
skill level, the specialist with the larger breadth will have a higher information ratio
An active manager expects his information coe cient to drop from 0.08 to 0.02 in the coming
period due to extremely volatile and unpredictable markets. As a response he intends to increase
his breadth by a factor of 4. Which of the following statements is most accurately describes the
impact on the information ratio?
Explanation
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−−
−
Information ratio (IR) = IC × √BR
If breadth is increased by a factor of 4, this would increase the information ratio by a factor of
2. As the information coe cient is decreasing by a factor of 4, the information ratio will
decrease.
Charles Gri th makes quarterly bets between stocks of industrial and utility sectors. The
historical correlation between the returns of the two sectors is -0.20.Further information is as
below:
Benchmark
A) 27.44%
B) 10.90%
C) 13.72%
Explanation
A) TC=1
B) TC>1
C) TC<1
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Explanation
When we impose constraints on portfolios, the actual active weights (Δwi) will di er from
optimal active weights (Δwi*) and TC<1.
Susan Thomas is evaluating the holdings of Primus fund. Based on the information below, the
estimated active return is closest to:
A) 0.44%
B) 1.77%
C) 1.26%
Explanation
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An active manager makes quarterly bets on the stocks in the Russell 2000 index and uses the
index as the benchmark. The manager claims a modest IC of 0.02 using a stock screening model.
Sam Fox, CFA makes the following two statements:
I. The bets on the 2000 stocks in the index is not independent as the screens by de nition
introduce dependency in the decision process.
II. The quarterly bets are likely to be independent.
Explanation
Fox is correct that screens (e.g., minimum dividend yield) would pass stocks with similar
attributes and hence would introduce dependency in the decision making process. Fox is
incorrect that the decisions over time are independent. Those stocks that pass the screen in
one quarter are probably more likely to pass the same screen in the next quarter and hence
the decisions are not truly independent.
Zeta fund has active return and active risk of 1.6% and 8% respectively. Benchmark portfolio has
a Sharpe ratio of 0.35 and standard deviation of benchmark returns is 10.5%.
What is the level of active risk that an investor would need to take to maximize the Sharpe ratio of
a portfolio consisting of Zeta fund and the benchmark portfolio?
A) 8%
B) 7%
C) 6%
Explanation
∗
IR 0.2
Optimal level of active risk = σ A
= σB = (10.5) = 6%
SRB 0.35
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Question #26 of 28 Question ID: 1210866
Which of the following statements regarding the information ratio of an unconstrained portfolio
A) A market timer who uses independent information to make predictions about market
movements on a monthly basis and has an information ratio of 0.20 must have an
i f i i l h k l ih h i f i i
B) A market timer who uses independent information to make predictions about market
movements on a monthly basis and has an information ratio of 0.20 must have an
i f i i l k l ih h i f i i h
C) A market timer who uses independent information to make predictions about market
movements on a monthly basis and has an information ratio of 0.20 must have an
i f i i hi h h k l ih h i f i i
Explanation
−−
−
Unconstrained Information ratio (IR) = IC × √BR
The market timer has a lower breadth. In order to achieve the same information ratio he must
have a higher information coe cient. Note calculations not required.
Helen Wilde is trying to estimate the active return of Optimal fund. A comparison of Optimal's
holdings and that of the benchmark are shown below:
Optimal Benchmark
Optimal Benchmark
Asset Class Return
(i) Return
Weight (wPi) Weight (wBi)
E(RPi) E(RBi)
A) -0.44%
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B) – 0.80%
C) – 1.40%
Explanation
An active manager has an information coe cient of 0.07, transfer coe cient of 0.90, and makes
49 independent bets per year. Benchmark portfolio has a Sharpe ratio of 0.40 and standard
deviation of benchmark returns is 12%. The optimal amount of active risk is closest to:
A) 8%
B) 14%
C) 6%
Explanation
−−
− −−
IR = ( TC ) IC √BR = ( 0.90 ) ( 0.07 ) √49 = 0.441
For a constrained portfolio, the optimal level of residual risk can be computed as:
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