CFA Level I Portfolio Construction practice questions
25 exam-style questions from across Portfolio Construction, which is 8–12% of the Level I exam (roughly 14–22 of the 180 questions). Pick an answer to see whether you were right, why each option is right or wrong, and the lesson to go back to.
Module 1 Portfolio Risk and Return: Part I
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1Over long historical periods in major markets, which asset class has most likely shown the highest standard deviation of annual returns?
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The answer is C.
A. Bonds sit in the middle of the ladder. Their volatility comes from interest rate risk and is well below that of stocks.
B. Large company stocks are volatile, but they sit one rung below small company stocks. This is the default equity answer. The trap
C. Small company stocks combined the highest average return with the highest volatility, the top rung of the risk–return ladder.
From the lesson How the major asset classes compare on return and risk
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2Using U = E(r) − 0.5Aσ², an investor with A = 3 is choosing between portfolio X (expected return 7%, σ 10%), portfolio Y (10%, 18%) and portfolio Z (13%, 25%). The investor most likely chooses:
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The answer is A.
A. U(X) = 0.07 − 1.5 × 0.0100 = 0.0550. It is the highest of the three.
B. U(Y) = 0.10 − 1.5 × 0.0324 = 0.0514. Lower than X.
C. U(Z) = 0.13 − 1.5 × 0.0625 = 0.0363. Z has the highest return, which is the risk-neutral choice, but the variance penalty takes it to last place. The trap
On your calculator- 0.07−(1.5×0.1x²)= 0.055
- 0.1−(1.5×0.18x²)= 0.0514
- 0.13−(1.5×0.25x²)= 0.03625
x² square
- 0.1ENTER×1.5×CHS0.07+ 0.055
- 0.18ENTER×1.5×CHS0.1+ 0.0514
- 0.25ENTER×1.5×CHS0.13+ 0.03625
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
From the lesson Risk aversion, utility and indifference curves
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3A portfolio is 50% in asset A (standard deviation 18%) and 50% in asset B (standard deviation 12%). The correlation between the two assets is 0.25. The portfolio’s standard deviation is closest to:
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The answer is B.
A. Drops the covariance term: √(0.0081 + 0.0036) = 10.82%. The trap
B. σp² = 0.25 × 0.0324 + 0.25 × 0.0144 + 2 × 0.5 × 0.5 × 0.25 × 0.18 × 0.12 = 0.0081 + 0.0036 + 0.0027 = 0.0144, so σp = 12.00%.
C. The weighted average of the two σs, 0.5 × 18 + 0.5 × 12. It is right only when the correlation is +1.
On your calculator- 0.5x²×0.18x²+(0.5x²×0.12x²)+(2×0.5×0.5×0.25×0.18×0.12)=√x 0.12
x² square · √x square root
- 0.5ENTER×0.18ENTER××0.5ENTER×0.12ENTER××+2ENTER0.5×0.5×0.25×0.18×0.12×+g√x 0.12
ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root
From the lesson Portfolio variance, covariance and correlation
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4A portfolio lies on the minimum-variance frontier, below and to the right of the global minimum-variance portfolio. It is best described as:
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The answer is B.
A. Minimum variance for its return is not enough. Below the GMV there is a portfolio on the upper branch with the same risk and more return. The trap
B. On the lower branch, a portfolio directly above has the same risk and a higher return, so this one is dominated.
C. The optimal risky portfolio is a point on the upper (efficient) branch, found in the next lesson. It cannot lie below the GMV.
From the lesson The efficient frontier and the global minimum-variance portfolio
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5The risk-free rate is 4%. A risky portfolio has an expected return of 12% and a standard deviation of 16%. An investor on the capital allocation line who wants a standard deviation of 20% will have an expected return closest to:
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The answer is B.
A. Assumes no one can hold more than 100% in the risky portfolio, so the return stays at the portfolio’s 12%.
B. The weight in the risky portfolio is 20 ÷ 16 = 1.25 (borrow 25% at 4%). E = 4% + 1.25 × (12% − 4%) = 14.00%, or 1.25 × 12% − 0.25 × 4%.
C. Scales the whole 12% by 1.25 and forgets the cost of the borrowing. The trap
On your calculator- 20÷16= 1.25
- ×(12−4)+4= 14
- 20ENTER16÷ 1.25
- 12ENTER4−×4+ 14
ENTER enter (on the HP, puts the number on the stack)
From the lesson The capital allocation line and the optimal portfolio
Module 2 Portfolio Risk and Return: Part II (CAPM and Performance Measures)
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6The risk-free rate is 3%, the market's expected return is 9% and its standard deviation is 15%. A portfolio on the capital market line with a standard deviation of 9% has an expected return closest to:
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The answer is B.
A. Takes 0.6 × 9%, which forgets that the other 40% of wealth earns the risk-free rate. The trap
B. The weight in the market is 9 ÷ 15 = 0.6. E = 3% + 0.6 × (9% − 3%) = 6.60%.
C. Adds the risk-free rate to 0.6 × 9%, so the market return is treated as the premium.
On your calculator- 9÷15=×6+3= 6.6
- 9ENTER15÷6×3+ 6.6
ENTER enter (on the HP, puts the number on the stack)
From the lesson The capital market line
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7According to capital market theory, an investor should expect to be compensated for bearing:
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The answer is B.
A. Total risk includes nonsystematic risk, which can be diversified away at little cost and so earns nothing extra. The trap
B. Only market-wide risk cannot be diversified away, so only it carries a premium.
C. Nonsystematic risk is the part that is diversified away. It earns no premium.
From the lesson Systematic vs nonsystematic risk and return-generating models
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8A stock's correlation with the market is 0.45. The stock's standard deviation is 32% and the market's is 16%. The stock's beta is closest to:
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The answer is B.
A. Inverts the ratio of standard deviations: 0.45 × 16 ÷ 32 = 0.225.
B. β = ρ × σi ÷ σm = 0.45 × 32 ÷ 16 = 0.90.
C. Ignores the correlation and uses σi ÷ σm = 2.00. The trap
On your calculator- 0.45×32÷16= 0.9
- 0.45ENTER32×16÷ 0.9
ENTER enter (on the HP, puts the number on the stack)
From the lesson How to calculate and interpret beta
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9The risk-free rate is 2.0%, the expected market return is 7.5% and a stock's beta is 1.4. The stock's CAPM expected return is closest to:
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The answer is A.
A. E = 2.0% + 1.4 × (7.5% − 2.0%) = 2.0% + 7.7% = 9.70%.
B. Takes 1.4 × 7.5% and ignores the risk-free rate.
C. Adds 2.0% to 1.4 × 7.5%, so the market return is used as the premium. The trap
On your calculator- 7.5−2=×1.4+2= 9.7
- 7.5ENTER2−1.4×2+ 9.7
ENTER enter (on the HP, puts the number on the stack)
From the lesson The CAPM and the security market line
Module 3 Portfolio Management: An Overview
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10An equally weighted portfolio has a standard deviation of 13.8%. The average standard deviation of its individual holdings is 23.0%. The diversification ratio is closest to:
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The answer is B.
A. That is 1 − 0.60, the share of risk removed, not the ratio. The trap
B. Portfolio σ ÷ average single-holding σ = 13.8 ÷ 23.0 = 0.60.
C. Inverts the ratio: 23.0 ÷ 13.8.
On your calculator- 13.8÷23= 0.6
- 13.8ENTER23÷ 0.6
ENTER enter (on the HP, puts the number on the stack)
From the lesson Why invest through a portfolio
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11Preparing the investment policy statement is part of the:
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The answer is A.
A. The IPS records the client's objectives, constraints and benchmark, and is the output of the planning step.
B. Execution uses the IPS to build the portfolio. It does not write it. The trap
C. Feedback compares results with the IPS, but the IPS exists before that.
From the lesson The three steps of the portfolio management process
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12Which institution most likely has the lowest liquidity needs?
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The answer is C.
A. A bank must be ready to repay deposits, so its liquidity need is the highest.
B. Insurers must be ready to pay claims, so their liquidity needs are high. The trap
C. An endowment has a perpetual life and spends only a modest share of its assets each year, so liquidity needs are low.
From the lesson Types of investors, and DB vs DC pension plans
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13An open-end fund has assets of USD 84 million, liabilities of USD 4 million and 3.2 million shares outstanding. An investor who invests USD 500,000 will receive closest to:
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The answer is B.
A. Ignores the liabilities: 84 ÷ 3.2 = 26.25, and 500,000 ÷ 26.25 = 19,048. The trap
B. NAV = (84 − 4) ÷ 3.2 = USD 25.00. Shares = 500,000 ÷ 25.00 = 20,000.
C. Divides the investment by the shares outstanding (500,000 ÷ 3.2) instead of by NAV per share.
On your calculator- 84−4=÷3.2= 25
- 500000÷25= 20000
- 84ENTER4−3.2÷ 25
- 500000ENTER25÷ 20000
ENTER enter (on the HP, puts the number on the stack)
From the lesson Mutual funds, ETFs and other pooled investment products
Module 4 Basics of Portfolio Planning and Construction
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14A statement that 'the portfolio may not use derivatives except to hedge currency exposure' most likely belongs in the IPS section on:
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The answer is C.
A. Objectives state the return and risk the client wants, not the tools a manager may use.
B. Constraints describe the client's circumstances (liquidity, horizon, taxes, law, unique needs), not the tools allowed. The trap
C. Guidelines say how policy is executed, such as whether leverage or derivatives may be used.
From the lesson The investment policy statement (IPS)
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15A retiree has a EUR 2,400,000 portfolio and needs EUR 90,000 a year for spending. Inflation is expected to be 2.0%. The return needed to fund spending and preserve the portfolio's real value is closest to:
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The answer is C.
A. Ignores inflation: 90,000 ÷ 2,400,000 = 3.75%.
B. Adds the spending rate and inflation (3.75% + 2.0%) instead of compounding. The trap
C. Spending rate = 3.75%. (1.0375)(1.02) − 1 = 5.825%, about 5.83%.
On your calculator- 90000÷2400000+1=×1.02−1= 0.05825
- 90000ENTER2400000÷1+1.02×1− 0.05825
ENTER enter (on the HP, puts the number on the stack)
From the lesson Risk and return objectives: willingness vs ability to take risk
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16A client must settle a GBP 180,000 inheritance tax bill from the portfolio in eight months. This fact is most relevant to the IPS constraint of:
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The answer is A.
A. A known cash outflow on a known date is a liquidity requirement. The money must be in liquid, low-risk assets by then.
B. The overall horizon may be long. The bill is a dated cash need, not the horizon.
C. The bill comes from tax, but the constraint it creates for the portfolio is a cash need. Tax concerns relate to how returns are taxed. The trap
From the lesson IPS constraints: liquidity, time horizon, taxes, legal and unique circumstances
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17When specifying asset classes for a strategic asset allocation, assets within one asset class should most likely have:
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The answer is A.
A. An asset class should be homogeneous: similar risk and return and relatively high correlations inside the class.
B. Low correlation is wanted between asset classes, not inside one. The trap
C. Classes should diversify one another, but a correlation of −1 is not required (or realistic).
From the lesson Asset classes, strategic asset allocation and portfolio construction
Module 5 The Behavioral Biases of Individuals
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18Compared with emotional biases, cognitive errors are most likely:
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The answer is A.
A. Cognitive errors stem from faulty reasoning, so information, education and advice can reduce them.
B. This describes emotional biases, which come from impulse and intuition. The trap
C. Adapting is the usual response to emotional biases. Cognitive errors are moderated.
From the lesson Cognitive errors vs emotional biases
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19An analyst keeps a buy rating and leaves earnings forecasts almost unchanged after a company announces the loss of its largest customer. The analyst most likely shows:
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The answer is A.
A. Slow updating of a prior view after material new information is the tell of conservatism.
B. Availability would show up as judging likelihood by what is easy to recall, such as recent headlines. The trap
C. Hindsight is seeing past events as predictable. Nothing here looks back on an outcome.
From the lesson Cognitive errors: belief perseverance and information processing
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20An investor sells shares that have risen 15% to "lock in the gain" but keeps shares that have fallen 30%, waiting for them to recover. This most likely reflects:
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The answer is A.
A. Selling winners early and holding losers to avoid realizing a loss is the disposition effect, the practical form of loss aversion.
B. Overconfidence is unwarranted faith in own ability. Nothing in the vignette points to it. The trap
C. Self-control is giving up long-term goals for short-term satisfaction, such as spending instead of saving.
From the lesson Emotional biases: loss aversion, overconfidence and four more
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21Investors who extrapolate recent strong returns into the future, helping winners keep rising, most likely show:
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The answer is A.
A. Recalling recent events vividly and giving them undue weight, so that a rise is extrapolated, is the recency effect, a form of availability bias.
B. Endowment is valuing what one owns more. It does not explain extrapolating returns.
C. Conservatism is slow updating of beliefs after new information. The vignette describes extrapolating recent returns, which is the recency effect. The trap
From the lesson How biases show up in markets: momentum, bubbles and value
Module 6 Introduction to Risk Management
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22Risk governance is best described as:
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The answer is B.
A. Measuring exposures is risk identification and measurement, carried out by the risk function under governance direction. The trap
B. Governance, normally the board, defines goals and risk tolerance and provides oversight across the whole enterprise.
C. Insurance is one way of modifying risk (risk transfer). It is an action taken within the framework, not governance.
From the lesson Risk governance, risk tolerance and risk budgeting
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23A fund's derivatives counterparty defaults after the fund has made its payment but before the counterparty's own payment arrives on the same day. This is best described as:
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The answer is B.
A. Liquidity risk is the price concession needed to sell an asset. No asset is being sold here. The trap
B. The loss comes from paying before receiving around a default. The root source is the timing of the payment process, which is settlement risk.
C. Model risk is a valuation error from an inappropriate model. The models are not the problem here.
From the lesson Financial and non-financial risks, and how they interact
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24A bank reports a 5% one-day VaR of GBP 2 million. This most likely means:
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The answer is B.
A. VaR is a minimum loss on the bad days, not a ceiling. The maximum loss is the whole portfolio. The trap
B. A 5% VaR is the loss that is expected to be reached or exceeded on about 5% of days, roughly one day in twenty.
C. VaR is not an average. The average loss beyond VaR is CVaR.
From the lesson Measuring risk: probability, VaR, CVaR and sensitivities
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25A bakery chain buys wheat futures to lock in the price of next year's flour. This is best described as:
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The answer is B.
A. Risk transfer is passing a risk to another party, usually through insurance. Derivatives are not called transfer in the curriculum. The trap
B. Derivatives change the distribution of outcomes, here fixing the flour price. That is risk shifting.
C. The chain still needs flour and still carries the business. The price risk is changed, not avoided.
From the lesson Modifying risk: prevention, acceptance, transfer and shifting
Keep going
Study the topic module by module in the Portfolio Construction lessons, look up a word in the Level I glossary, or run a timed practice set that tracks your score by topic.