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Ans Question Bank Lv2

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Question #1 of 4 Question ID: 1210767

ETF ownership costs are least likely to be increased by:

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.

(Study Session 16, Module 43.2, LOS 43.f)

Question #2 of 4 Question ID: 1210766

When an ETF trades on the primary market, this is most likely to refer to a trade that happens:

A) over-the-counter.

B) between APs and issuers.

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).

(Study Session 16, Module 43.1, LOS 43.b)

Question #3 of 4 Question ID: 1210768

Exchange-traded notes (ETNs) are similar to exchange traded funds (ETFs), in that they both:

A) are subject to total default by the issuer.

B) hold underlying securities.

C) use the creation/redemption process.

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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.

(Study Session 16, Module 43.3, LOS 43.g)

Question #4 of 4 Question ID: 1210765

It would be most accurate to state that ETF shares can be created or redeemed by:

A) accredited investors (i.e. quali ed investors) only.

B) anyone, including individual investors using a brokerage account.

C) a special group of institutional investors (APs) only.

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.

(Study Session 16, Module 43.1, LOS 43.a)

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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)?

A) A large number of assets are available to investors.

B) The priced factors risks can be hedged without taking short positions in any
portfolios.

C) Asset returns are described by a k-factor model.

Explanation

APT does not prohibit short positions.

(Study Session 16, Module 44.1, LOS 44.a)

Question #2 of 33 Question ID: 1210789

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.

RStone = 0.11 + 1.0FInt + 1.2FUn + εStone

RRock = 0.13 + 0.8FInt + 3.5FUn + εRock

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:

Table 1: Expected versus Actual Interest Rates and Unemployment Rates

Company-speci c returns
Actual Expected
surprises

Interest Rate 0.053 0.051 0.0

Unemployment
0.072 0.068 0.0
Rate

What is the portfolio's sensitivity to interest rate surprises?

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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.

(Study Session 16, Module 44.2, LOS 44.d)

Question #3 of 33 Question ID: 1210790

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.

RStone = 0.11 + 1.0FInt + 1.2FUn + εStone

RRock = 0.13 + 0.8FInt + 3.5FUn + εRock

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:

Table 1: Expected versus Actual Interest Rates and Unemployment Rates

Company-speci c returns
Actual Expected
surprises

Interest Rate 0.053 0.051 0.0

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:

Ri = ai+ bi,1FInt + bi,2FUn + εi

where:

Ri = the return on stock i

ai = the expected return on stock i

bi,1 = the factor sensitivity of stock i to unexpected changes in interest rates

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%

(Study Session 16, Module 44.2, LOS 44.d)

Question #4 of 33 Question ID: 1210774

Which of the following does NOT describe the arbitrage pricing theory (APT)?

A) It is an equilibrium-pricing model like the CAPM.

B) There are assumed to be at least ve factors that explain asset returns.

C) It requires a weaker set of assumptions than the CAPM to derive.

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.

(Study Session 16, Module 44.1, LOS 44.a)

Question #5 of 33 Question ID: 1210779

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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:

Portfolio Expected Return Beta

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?

Portfolio X Portfolio Y Portfolio Z

A) 25% 50% 25%

B) 50% 12% 38%

C) 100% 0% 0%

Explanation

Portfolio Weights
Expected Return Beta
X Y Z

25% 50% 25% 13.00% 1.13

50% 12% 38% 10.96% 1.00

100% 0% 0% 12.00% 1.00

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).

(Study Session 16, Module 44.1, LOS 44.b)

Question #6 of 33 Question ID: 1210796

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:

A) 30% short position in the in ation tracking portfolio.

B) 30% long position in the in ation factor portfolio.

C) 30% short position in the in ation factor portfolio.

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.

(Study Session 16, Module 44.3, LOS 44.f)

Question #7 of 33 Question ID: 1210787

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

returns. She decides to use the following factors in her model:

Changes in payout ratios.

Credit rating changes.

Companies' position in the business cycle.

Management tenure and quali cations.

Which of the following factors is least appropriate for Vista's factor model?

A) Management tenure and quali cations.

B) Changes in payout ratios.

C) Companies’ position in the business cycle.

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.

(Study Session 16, Module 44.2, LOS 44.d)

Question #8 of 33 Question ID: 1210781

Given a three-factor arbitrage pricing theory APT model, what is the expected return on the

Freedom Fund?

The factor risk premiums to factors 1, 2, and 3 are 10%, 7% and 6%, respectively.

The Freedom Fund has sensitivities to the factors 1, 2, and 3 of 1.0, 2.0 and 0.0,
respectively.

The risk-free rate is 6.0%.

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A) 30.0%.

B) 33.0%.

C) 24.0%.

Explanation

The expected return on the Freedom Fund is 6% + (10.0%)(1.0) + (7.0%)(2.0) + (6.0%)(0.0) =


30.0%.

(Study Session 16, Module 44.1, LOS 44.c)

Question #9 of 33 Question ID: 1210786

Identify the most accurate statement regarding multifactor models from among the following.

A) Macroeconomic factor models include explanatory variables such as the business


cycle, interest rates, and in ation, and fundamental factor models include
l i bl h i d h i i i
B) Macroeconomic factor models include explanatory variables such as real GDP growth
and the price-to-earnings ratio and fundamental factor models include explanatory
i bl h i d di i
C) Macroeconomic factor models include explanatory variables such as rm size and the
price-to-earnings ratio and fundamental factor models include explanatory variables
h lG h d di i
Explanation

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.

(Study Session 16, Module 44.2, LOS 44.d)

Question #10 of 33 Question ID: 1210773

The Arbitrage Pricing Theory (APT) has all of the following characteristics EXCEPT it:

A) assumes that asset returns are described by a factor model.

B) is an equilibrium pricing model.

C) assumes that arbitrage opportunities are available to investors.

Explanation

The APT assumes that no arbitrage opportunities are available to investors.

(Study Session 16, Module 44.1, LOS 44.a)

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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:

Risk Free Factor Risk


Rate Premium

A) 2.50% 3.00%

B) 3.00% 2.00%

C) 2.00% 3.00%

Explanation

Expected return = risk free rate + factor sensitivity x risk premium

For portfolio A: 0.044 = Rf + 0.8λ Hence Rf = 0.044 – 0.8λ

Substituting Rf = (0.04 – 0.8λ) for portfolio B, 0.053 = (0.044 – 0.8λ) + 1.1λ

λ = 0.03 or 3% and Rf = 2%.

(Study Session 16, Module 44.1, LOS 44.c)

Question #12 of 33 Question ID: 1210800

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.

(Study Session 16, Module 44.3, LOS 44.g)

Question #13 of 33 Question ID: 1210775

One of the assumptions of the arbitrage pricing theory (APT) is that there are no arbitrage
opportunities available. An arbitrage opportunity is:

A) a portfolio with factor exposures that sum to one.

B) a factor portfolio with a positive expected risk premium.

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.

(Study Session 16, Module 44.1, LOS 44.a)

Question #14 of 33 Question ID: 1210782

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:

RPort = 0.03 + 0.02(−1.2) + 0.03(0.80) = 3.0%

(Study Session 16, Module 44.1, LOS 44.c)

Question #15 of 33 Question ID: 1210780

Given a three-factor arbitrage pricing theory (APT) model, what is the expected return on the
Premium Dividend Yield Fund?

The factor risk premiums to factors 1, 2 and 3 are 8%, 12% and 5%, respectively.
The fund has sensitivities to the factors 1, 2, and 3 of 2.0, 1.0 and 1.0, respectively.

The risk-free rate is 3.0%.

A) 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%.

(Study Session 16, Module 44.1, LOS 44.c)

Question #16 of 33 Question ID: 1210791

Janice Barefoot, CFA, has managed a portfolio where she used the Dow Jones Industrial Average

(DJIA) as a benchmark. In the past two years the average monthly return on her portfolio has
been higher than that of the DJIA. To get a measure of active return per unit of active risk

Barefoot should compute the:

A) information ratio, which is the standard deviation of the 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.

(Study Session 16, Module 44.3, LOS 44.e)

Question #17 of 33 Question ID: 1210788

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.

RStone = 0.11 + 1.0FInt + 1.2FUn + εStone

RRock = 0.13 + 0.8FInt + 3.5FUn + εRock

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:

Table 1: Expected versus Actual Interest Rates and Unemployment Rates

Company-speci c returns
Actual Expected
surprises

Interest Rate 0.053 0.051 0.0

Unemployment
0.072 0.068 0.0
Rate

What is the expected return for Stonebrook in the absence of surprises?

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%.

(Study Session 16, Module 44.2, LOS 44.d)

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Question #18 of 33 Question ID: 1210801

In the context of multi-factor models, investors with lower-than-average exposure to recession


risk (e.g. those without labor income) can earn a risk premium for holding dimensions of risk

unrelated to market movements by creating equity portfolios with:

A) greater-than-average market risk exposure.

B) greater-than-average exposure to the recession risk factor.

C) less-than-average exposure to the recession risk factor.

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.

(Study Session 16, Module 44.3, LOS 44.g)

Question #19 of 33 Question ID: 1210777

Arbitrage pricing models assume which risk is priced?

A) Both systematic and unsystematic.

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.

(Study Session 16, Module 44.1, LOS 44.a)

Question #20 of 33 Question ID: 1210793

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.

(Study Session 16, Module 44.3, LOS 44.f)

Question #21 of 33 Question ID: 1210772

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.

C) Asset returns are described by a K factor model.

Explanation

The APT makes no assumption about a market portfolio.

(Study Session 16, Module 44.1, LOS 44.a)

Question #22 of 33 Question ID: 1210776

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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.

E(Ri) = Rf + f1 Bi,1 + f2 Bi,2 + f3 Bi,3. where: f1 =3.0%, f2 = −40.0%, and f3 =50.0%.

Beta estimates for Growth and Value funds for a three factor model

Factor 1 Factor 2 Factor 3

Betas for Growth 0.5 0.7 1.2

Betas for Value 0.2 1.8 0.6

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%

(Study Session 16, Module 44.1, LOS 44.a)

Question #23 of 33 Question ID: 1210785

The macroeconomic factor models for the returns on Omni, Inc., (OM) and Garbo Manufacturing
(GAR) are:

ROM = 20.0% +1.0(FGDP) + 1.4(FQS) + εOM

RGAR = 15.0% +0.5(FGDP) + 0.8 (FQS) + εGAR

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:

RP = [(0.6)(20.0%) + (0.4)(15.0%)] = 18%

(Study Session 16, Module 44.2, LOS 44.d)

Question #24 of 33 Question ID: 1210784

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:

A) statistical factor model.

B) macroeconomic factor model.

C) fundamental factor model.

Explanation

Macroeconomic factor models use unexpected changes (surprises) in macroeconomic variables


as the factors to explain asset returns. One example of a factor in this type of model is the
unexpected change in gross domestic product (GDP) growth. In fundamental factor models, the
factors are characteristics of the stock or the company that have been shown to a ect asset
returns, such as book-to-market or price-to-earnings ratios. A statistical factor model identi es
the portfolios that best explain the historical cross-sectional returns or covariances among
assets. The returns on these portfolios represent the factors.

(Study Session 16, Module 44.2, LOS 44.d)

Question #25 of 33 Question ID: 1210770

Which of the following is an equilibrium-pricing model?

A) Fundamental factor model.

B) The arbitrage pricing theory (APT).

C) Macroeconomic factor model.

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.

(Study Session 16, Module 44.1, LOS 44.a)

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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:

A) negative and positive respectively.

B) both positive.

C) positive and negative respectively.

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.

(Study Session 16, Module 44.3, LOS 44.f)

Question #27 of 33 Question ID: 1210794

A tracking portfolio is a portfolio with:

A) a speci c set of factor sensitivities designed to replicate the factor exposures of a


benchmark index.

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.

(Study Session 16, Module 44.3, LOS 44.f)

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Question #28 of 33 Question ID: 1210795

A common strategy in bond portfolio management is enhanced indexing by matching primary


risk factors. This strategy could be implemented by forming:

A) a portfolio with factor sensitivities equal to that of the index.

B) a portfolio with asset portfolio weights equal to that of the index.

C) a portfolio with factor sensitivities that sum to one.

Explanation

Enhanced indexing by matching primary risk factors could be implemented by creating a


tracking portfolio with the same factor sensitivities as the index but with a di erent set of
bonds. Then any di erences in performance between the portfolio and the benchmark index
will be the result of bond selection ability and not from di erent exposures to macroeconomic
factors like GDP, in ation, and interest rates.

(Study Session 16, Module 44.3, LOS 44.f)

Question #29 of 33 Question ID: 1210792

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.

(Study Session 16, Module 44.3, LOS 44.f)

Question #30 of 33 Question ID: 1210799

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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

portfolio with a speci c set of factor sensitivities to the Russell 2000.

Did Torres correctly describe tracking and factor portfolios?

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.

(Study Session 16, Module 44.3, LOS 44.f)

Question #31 of 33 Question ID: 1210771

Which of the following is not an assumption of the arbitrage pricing theory (APT)?

A) Security returns are normally distributed.

B) The market contains enough stocks so that unsystematic risk can be diversi ed away.

C) Returns on assets can be described by a multi-factor process.

Explanation

APT does not require that security returns be normally distributed.

(Study Session 16, Module 44.1, LOS 44.a)

Question #32 of 33 Question ID: 1210798

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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:

A) negative and positive respectively.

B) both positive.

C) positive and negative respectively.

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.

(Study Session 16, Module 44.3, LOS 44.f)

Question #33 of 33 Question ID: 1210778

Diversi cation can reduce:

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.

(Study Session 16, Module 44.1, LOS 44.a)

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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

Grieve's breadth assuming independent bets = 10 × 12 = 120


−−
− −−−
Information ratio assuming independent bets = IC√BR = 0.20 × √120 = 2.19

If the bets are correlated, BR =

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

% reduction = 1 − 0.30/2.19 = 86.4%

(Study Session 17, Module 47.4, LOS 47.f)

Question #2 of 28 Question ID: 1210862

When choosing an active manager, an investor with a high level of risk aversion:

A) will choose the manager with the highest information ratio.

B) will choose the manager with the highest active return.

C) will choose a manager with the lowest active risk.

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).

(Study Session 17, Module 47.3, LOS 47.d)

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Question #3 of 28 Question ID: 1210851

Which of the following statements is least accurate?

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.

C) A closet index fund has a low Sharpe ratio.

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.

(Study Session 17, Module 47.2, LOS 47.b)

Question #4 of 28 Question ID: 1210857

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

(Study Session 17, Module 47.3, LOS 47.c)

Question #5 of 28 Question ID: 1210861

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%

B) The information coe cient will fall by approximately 50%

C) The information ratio will fall by approximately 30%

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

With quarterly predictions IR = IC × 160½ = 12.65 (IC)

With semi-annual forecasts IR = IC × 80½ = 8.94 (IC)

8.94IC / 12.65IC = 0.701

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.

(Study Session 17, Module 47.3, LOS 47.c)

Question #6 of 28 Question ID: 1210853

Which of the following terms is the ex-ante risk weighted correlation between forecasted active

returns and actual active returns?

A) Breadth

B) Transfer Coe cient

C) Information Coe cient

Explanation

Information coe cient is the ex-ante correlation between forecasted active returns and actual
active returns. It captures the skill of the manager.

(Study Session 17, Module 47.3, LOS 47.c)

Question #7 of 28 Question ID: 1210848

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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%.

The maximum possible Sharpe ratio of a portfolio consisting of Zeta fund and the benchmark

portfolio is closest to:

A) 0.55

B) 0.5

C) 0.4

Explanation

SRP = [SRB2 + IR2]1/2 = [0.352 + 0.202]1/2 = 0.4031

(Study Session 17, Module 47.2, LOS 47.b)

Question #8 of 28 Question ID: 1210868

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

two managers is most accurate?

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.

Grenkin 0.75 = IC × 4½ IC = 0.75/2 = 0.375

Fontina 0.75 = IC × 200½ IC = 0.75/14.14 = 0.053

(Note: Calculations are not required)

(Study Session 17, Module 47.4, LOS 47.e)

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Question #9 of 28 Question ID: 1210854

Which of the following is correct for an unconstrained active portfolio?

A) TC>1

B) TC<1

C) TC=1

Explanation

TC=1 if the active portfolio has no constraints.

(Study Session 17, Module 47.3, LOS 47.c)

Question #10 of 28 Question ID: 1210847

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 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

Information Ratio = active return / active risk = 1.6% / 8% = 0.2


IR 0.2
Optimal level of active risk = σ A
= σB = (10.5) = 6%
SRB 0.35

Active risk of Zeta fund = 8%

Weight of Zeta fund = 6% / 8% = 0.75

Weight of benchmark = 0.25

(Study Session 17, Module 47.2, LOS 47.b)

Question #11 of 28 Question ID: 1210845

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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)

Industrials 30% 40% 11% 12%

Financials 50% 30% 6% 5%

Utilities 20% 30% 14% 12%

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)

Industrials 30% 40% 12% -10% -1.20%

Financials 50% 30% 5% 20% 1.00%

Utilities 20% 30% 12% -10% -1.20%

(Study Session 17, Module 47.1, LOS 47.a)

Question #12 of 28 Question ID: 1210856

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%

(Study Session 17, Module 47.3, LOS 47.c)

Question #13 of 28 Question ID: 1210855

Which of the following terms is the number of independent bets per year made by an active
manager?

A) Information Coe cient

B) Breadth

C) Transfer Coe cient

Explanation

Breadth is the number of independent bets (based on unique information) made per year by
the active manager.

(Study Session 17, Module 47.3, LOS 47.c)

Question #14 of 28 Question ID: 1210863

Alisa Darent is evaluating several active portfolio managers with the same style and benchmark
portfolio.

Manager Active return Active risk

Alfred 3.00% 12.00%

Brad 2.20% 11.00%

Charles 2.00% 10.50%

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.

IR (Alfred) = 3/12 = 0.25

IR(Brad) = 2.2/11 = 0.20

IR(Charles) = 2.0/10.50 = 0.19

Expected active return = E(RA) = IR x σA =0.25 x 11 = 2.75%.

Expected return = E(RB) + E(RA) = 11% + 2.75% = 13.75%

(Study Session 17, Module 47.3, LOS 47.d)

Question #15 of 28 Question ID: 1210869

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

Sector E (R) σ Weight

Industrial 12.00% 13.0% 80%

Utility 5.2% 2.5% 20%

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

Combined active risk = σC = [σI2 -2σIσUrIU+ σU2]1/2

= [0.132 + 0.0252 – 2 (0.13)(0.025)(-0.20)]1/2 = 0.1372 or 13.72%

Annualized active risk = 0.1372 x (4)1/2 = 0.2744 or 24.44%

−−

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:

(0.55)(0.1372) + (0.45)(-0.1372) = 0.0137 or 1.37% per quarter.

Annual active return = 1.37% x 4 = 5.48%.

(Study Session 17, Module 47.4, LOS 47.e)

Question #16 of 28 Question ID: 1210850

Which of the following statements is least accurate?

A) The information ratio of a constrained active portfolio is una ected by


aggressiveness of the active weights.

B) Sharpe ratio of a portfolio consisting of a combination of benchmark and actively


managed portfolio with positive active return will be higher than the Sharpe ratio of
h b h k
C) Unlike Sharpe ratio, information ratio is a ected due to addition of cash or leverage.

Explanation

Information ratio of an unconstrained active portfolio is una ected by aggressiveness of the


active weights. Sharpe ratio is una ected by addition of cash or leverage but information ratio
would be. A portfolio consisting of a combination of benchmark and an actively managed
portfolio is calculated as:

SRP2 = SRB2 + IR2

If the active return is positive, IR>0 and SRP>SRB.

(Study Session 17, Module 47.2, LOS 47.b)

Question #17 of 28 Question ID: 1210852

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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?

A) Transfer Coe cient

B) Breadth

C) Information Coe cient

Explanation

Transfer coe cient = TC = CORR (μi/σi, Δ wiσi)

(Study Session 17, Module 47.3, LOS 47.c)

Question #18 of 28 Question ID: 1210864

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%.

(Study Session 17, Module 47.4, LOS 47.e)

Question #19 of 28 Question ID: 1210865

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Jon Gamlin is comparing a market timing strategy with a stock selection strategy. He draws the

following two conclusions for unconstrained active managers:

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

updating the forecast semi-annually

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

updates his assessments semi-annually

Regarding Gamlin's conclusions:

A) Only conclusion 1 is correct.

B) Neither conclusion is correct.

C) Only conclusion 2 is correct.

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

(Study Session 17, Module 47.4, LOS 47.e)

Question #20 of 28 Question ID: 1210860

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?

A) The information ratio will decrease

B) The information ratio will remain constant

C) The information ratio will increase

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.

(Study Session 17, Module 47.3, LOS 47.c)

Question #21 of 28 Question ID: 1210867

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

Sector E (R) σ Weight

Industrial 12.00% 13.0% 80%


Utility 5.2% 2.5% 20%

The annualized active risk of Gri th's strategy is closest to:

A) 27.44%

B) 10.90%

C) 13.72%

Explanation

Combined active risk = σC = [σI2 -2σIσUrIU+ σU2]1/2

= [0.132 + 0.0252 – 2 (0.13)(0.025)(-0.20)]1/2 = 0.1372 or 13.72%

Annualized active risk = 0.1372 x (4)1/2 = 0.2744 or 27.44%

(Study Session 17, Module 47.4, LOS 47.e)

Question #22 of 28 Question ID: 1210858

Which of the following is correct for a constrained active portfolio?

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.

(Study Session 17, Module 47.3, LOS 47.c)

Question #23 of 28 Question ID: 1210844

Susan Thomas is evaluating the holdings of Primus fund. Based on the information below, the
estimated active return is closest to:

Portfolio Benchmark ReturnE

Security (i) Weight (wPi) Weight (wBi) (Ri)

X 30% 40% 11.20%

y 15% 25% 4.25%

z 55% 35% 14.00%

Total 100% 100%

A) 0.44%

B) 1.77%

C) 1.26%

Explanation

Portfolio return = RP = ∑(wPi) x E(Ri) = 11.70%

Benchmark return = RB = ∑(wBi) x E(Ri) = 10.44%

Active return = RP - RB = 11.70% – 10.44% = 1.26

(Study Session 17, Module 47.1, LOS 47.a)

Question #24 of 28 Question ID: 1210870

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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.

How many of Fox's statements are correct:

A) Only one statement is correct.

B) Neither statement is correct.

C) Both statements are correct.

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.

(Study Session 17, Module 47.4, LOS 47.f)

Question #25 of 28 Question ID: 1210849

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

Information ratio (IR) = 1.6% /8% = 0.2


IR 0.2
Optimal level of active risk = σ A
= σB = (10.5) = 6%
SRB 0.35

Active risk of Zeta fund = 8%

Weight of Zeta fund = 6% / 8% = 0.75

Weight of benchmark = 0.25

(Study Session 17, Module 47.2, LOS 47.b)

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Question #26 of 28 Question ID: 1210866

Which of the following statements regarding the information ratio of an unconstrained portfolio

is most likely correct?

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

Market timer: 0.20 = IC × 12½ IC = 0.20 / 3.464 IC = 0.058

Selector: 0.20 = IC × 40½ IC = 0.20 / 6.325 IC = 0.032

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.

(Study Session 17, Module 47.4, LOS 47.e)

Question #27 of 28 Question ID: 1210846

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)

Industrials 30% 40% 11% 12%

Financials 50% 30% 6% 5%

Utilities 20% 30% 14% 12%

The expected active return for Optimal is closest to:

A) -0.44%

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B) – 0.80%

C) – 1.40%

Explanation

Portfolio return = RP = ∑(wPi) x E(RPi) = 9.10%

Benchmark return = RB = ∑(wBi) x E(RBi) = 9.90%

Active return = RP - RB = 9.10% – 9.90% = -0.80%

(Study Session 17, Module 47.1, LOS 47.a)

Question #28 of 28 Question ID: 1210859

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:

σ*A =(IR / SBB)σB = (0.441 / 0.40)(0.12) = 13.23%

(Study Session 17, Module 47.3, LOS 47.c)

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