21 cards · Stock Market & Investing · answer each one, then read the explanation. Your score tallies below. Looking for Sharpe, Treynor, Sortino, Jensen's alpha & information ratio compared? Read the explainer.
What does the Sharpe ratio measure, and why is a higher Sharpe ratio generally considered better?
AThe Sharpe ratio compares a portfolio's return to the market return (alpha), so a higher Sharpe ratio always means the manager outperformed the benchmark index
BThe Sharpe ratio measures the total return of a portfolio without any adjustment for risk, so a higher number simply means higher absolute returns regardless of the volatility involved
CThe Sharpe ratio measures risk-adjusted return: it equals the portfolio's excess return over the risk-free rate divided by its standard deviation, so a higher ratio means the portfolio earned more return per unit of total risk taken
DThe Sharpe ratio measures only the downside risk of a portfolio, ignoring upside volatility entirely, making it the same as the Sortino ratio
Correct answer: .
The Sharpe ratio, developed by William Sharpe in 1966, equals (portfolio return minus risk-free rate) divided by the portfolio's standard deviation of returns. It measures how much excess return is earned per unit of total risk. A portfolio returning 15% with 20% volatility and a 5% risk-free rate has a Sharpe ratio of 0.50, while one returning 12% with 10% volatility has a Sharpe ratio of 0.70 — the second portfolio is more efficient despite lower absolute returns. The option ignoring risk adjustment describes absolute return, not the Sharpe ratio. The option describing alpha confuses the Sharpe ratio with Jensen's alpha or the information ratio. The option equating it with the Sortino ratio is wrong — the Sortino ratio uses downside deviation rather than total standard deviation, precisely because the Sharpe ratio treats upside and downside volatility equally.
Source: Sharpe, W. (1966), 'Mutual Fund Performance'; CFA Institute, Portfolio Risk and Return
An investor's portfolio has a beta of 1.5 relative to the S&P 500. If the S&P 500 drops 10% in a month, approximately how much would this investor's portfolio be expected to decline, all else equal?
AThe portfolio would be expected to gain 15%, because a high beta means the portfolio moves in the opposite direction of the market
BApproximately 15%, because a beta of 1.5 means the portfolio is expected to move 1.5 times as much as the market — for every 1% market decline, the portfolio declines roughly 1.5%
CApproximately 6.67%, because beta works inversely — a portfolio with beta greater than 1 is actually less sensitive to market moves than the market itself
DExactly 10%, because all equity portfolios move in lockstep with the market regardless of their beta
Correct answer: .
Beta measures a security's or portfolio's systematic risk relative to the market. A beta of 1.5 means the portfolio has historically moved 1.5 times as much as the benchmark in the same direction. If the S&P 500 falls 10%, the portfolio is expected to fall approximately 15% (10% times 1.5). This is an estimate based on historical co-movement, not a guarantee, and idiosyncratic factors can cause the actual decline to differ. The option claiming a lockstep 10% decline describes a beta of exactly 1.0. The option claiming an inverse relationship misunderstands what beta greater than 1 means — it amplifies market moves, not dampens them. The option claiming an opposite-direction move confuses positive beta with negative beta; a negative beta (which is rare) would indeed move opposite to the market.
Source: CFA Institute, Portfolio Risk and Return: Part II; CAPM (Sharpe, 1964; Lintner, 1965)
An analyst calculates that a portfolio's one-day 95% Value at Risk (VaR) is $500,000. What does this figure mean in practical terms?
AThe maximum possible loss on the portfolio in any single trading day is exactly $500,000 under all market conditions, with no possibility of exceeding that amount
BThere is a 95% probability that the portfolio will lose exactly $500,000 on any given day, no more and no less
CThe portfolio will generate at least $500,000 in profit on 95% of trading days, guaranteeing a minimum daily return
DOn 95% of trading days, the portfolio is expected to lose no more than $500,000 — equivalently, there is a 5% chance that the daily loss will exceed $500,000, but VaR says nothing about how large the loss could be in that worst 5% of days
Correct answer: .
Value at Risk is a statistical measure that estimates, with a given confidence level, the maximum expected loss over a specified time horizon under normal market conditions. A one-day 95% VaR of $500,000 means that on 95% of days the portfolio's loss should not exceed $500,000 — but on the remaining 5% of days, losses could be much larger and VaR provides no information about their magnitude. This limitation is well-known and is why metrics like Conditional VaR (Expected Shortfall) were developed. The option claiming $500,000 is the absolute maximum ignores tail risk entirely. The option about guaranteed profit reverses what VaR measures — it is about losses, not gains. The option about losing exactly $500,000 misinterprets the threshold nature of VaR; it is a boundary, not a point estimate.
Source: CFA Institute, Risk Management: An Introduction; JP Morgan RiskMetrics Technical Document (1996)
The Treynor ratio and the Sharpe ratio are both risk-adjusted return measures, but they divide excess return by different risk measures. What does the Treynor ratio use in its denominator instead of standard deviation, and in which situation is the Treynor ratio generally considered the more appropriate metric?
AThe Treynor ratio divides excess return by the portfolio's downside deviation rather than its total standard deviation, making it more appropriate whenever an investor is especially concerned about losses rather than volatility in general
BThe Treynor ratio divides excess return by the same standard deviation used in the Sharpe ratio, so the two measures produce identical rankings for any set of portfolios and neither is more appropriate than the other
CThe Treynor ratio divides excess return by the portfolio's beta, making it more appropriate for evaluating a well-diversified portfolio, since beta captures only systematic risk and assumes unsystematic risk has already been diversified away
DThe Treynor ratio divides the portfolio's total return by the risk-free rate rather than subtracting it, making it more appropriate for comparing portfolios that hold no risk-free assets at all
Correct answer: .
The Treynor ratio equals (portfolio return minus the risk-free rate) divided by the portfolio's beta, rather than by standard deviation as the Sharpe ratio does. Because beta measures only systematic (market) risk, the Treynor ratio implicitly assumes the portfolio is well-diversified and that unsystematic, company-specific risk has already been diversified away, making it most appropriate for judging a single diversified portfolio or a manager's contribution within a larger diversified whole, rather than a concentrated, undiversified holding where idiosyncratic risk still matters. The option describing downside deviation instead confuses the Treynor ratio with the Sortino ratio, which targets loss-averse investors specifically, not diversification. The option claiming both ratios use the same denominator is wrong; using different risk measures is precisely why they can rank portfolios differently, especially when portfolios differ in diversification. The option describing a ratio of total return to the risk-free rate misstates the formula entirely, since both ratios subtract the risk-free rate from the portfolio return in the numerator rather than dividing by it.
Source: CFA Institute, Portfolio Risk and Return: Part II; Treynor, J. (1965), 'How to Rate Management of Investment Funds'
The Sharpe ratio treats upside and downside volatility identically when it computes standard deviation, so a fund with several large positive months looks just as 'risky' as one with equally large negative months. Which alternative risk-adjusted return metric addresses this by dividing excess return only by downside deviation, the variability of returns that fall below a minimum acceptable return, so strong positive swings don't count against the portfolio?
AThe Sortino ratio, which replaces standard deviation with downside deviation in the denominator so only harmful volatility below a chosen threshold return penalizes the portfolio
BThe Treynor ratio, which replaces standard deviation with the portfolio's beta in the denominator, focusing on systematic market risk rather than on the direction of individual returns
CThe information ratio, which divides a portfolio's return in excess of its benchmark by the standard deviation of that excess return, regardless of whether the excess return was positive or negative in any given period
DJensen's alpha, which measures the portfolio's return in excess of what the Capital Asset Pricing Model predicts given its beta, without using any measure of return volatility in its calculation at all
Correct answer: .
The Sortino ratio divides a portfolio's excess return, typically over a minimum acceptable return such as the risk-free rate, by its downside deviation, which is the standard deviation calculated using only returns that fall below that threshold. This means large positive returns, which the Sharpe ratio's symmetric standard deviation would count as 'risk,' don't reduce the Sortino ratio at all, making it a better fit for investors who care specifically about downside loss rather than volatility in general. The option describing the Treynor ratio is wrong because beta measures sensitivity to market-wide moves, not the asymmetry between upside and downside dispersion. The option describing the information ratio is wrong because tracking error measures dispersion of excess return relative to a benchmark, treating deviations above and below that benchmark symmetrically, just like the Sharpe ratio's standard deviation problem this question describes. The option describing Jensen's alpha is wrong because alpha is a single expected-return comparison derived from CAPM, not a ratio built from any volatility measure at all.
Source: Sortino, F. & van der Meer, R. (1991), 'Downside Risk'; CFA Institute, Portfolio Risk and Return: Part II
A portfolio returned 14% over the year. The risk-free rate was 3%, the market portfolio returned 11%, and the portfolio's beta was 1.2. Using the Capital Asset Pricing Model (CAPM) to determine the portfolio's expected return given its systematic risk, what is the portfolio's Jensen's alpha for the year, and what does a positive alpha indicate?
AAlpha equals the portfolio's return minus the market's return, or 14% minus 11% = 3%, indicating the portfolio simply beat its benchmark index by that margin
BAlpha equals the portfolio's return minus the risk-free rate, or 14% minus 3% = 11%, indicating that the entire return should be credited to manager skill since it is measured against a riskless baseline
CAlpha cannot be calculated from the information given, because Jensen's alpha requires the portfolio's total standard deviation rather than its beta
DThe CAPM expected return is 3% + 1.2 x (11% - 3%) = 12.6%; alpha equals the actual return minus this expected return, or 14% - 12.6% = 1.4%, indicating the portfolio earned more than its beta-implied, risk-adjusted expected return
Correct answer: .
Jensen's alpha compares a portfolio's actual return to the return the Capital Asset Pricing Model predicts it should have earned given its systematic risk, beta. The CAPM expected return here is the risk-free rate plus beta times the market risk premium: 3% + 1.2 x (11% - 3%) = 12.6%. Subtracting this from the actual 14% return gives an alpha of 1.4%, meaning the portfolio outperformed what its beta alone would justify, evidence of value added beyond simple compensation for the market risk taken. The option subtracting the market return directly ignores beta and the risk-free rate entirely, describing raw benchmark-relative outperformance rather than CAPM-adjusted alpha. The option subtracting only the risk-free rate describes the numerator used in the Sharpe and Treynor ratios, not alpha, and wrongly attributes the entire excess return to skill without adjusting for the systematic risk taken. The option claiming standard deviation is required is wrong because Jensen's alpha is explicitly a CAPM-based, beta-driven measure, not one built on total volatility.
Source: Jensen, M. (1968), 'The Performance of Mutual Funds in the Period 1945-1964'; CFA Institute, Portfolio Risk and Return: Part II
A portfolio manager benchmarks their fund against the S&P 500. Over the year, the fund's return exceeded the benchmark by 2 percentage points (its active return), while the standard deviation of that excess return over time (its tracking error) was 4%. Which risk-adjusted metric is calculated as active return divided by tracking error, and what does a higher value of this metric indicate?
AThe Sharpe ratio, which divides the fund's return in excess of the risk-free rate by its total standard deviation, and is unrelated to how the fund performs relative to any specific benchmark
BThe information ratio, which divides active return by tracking error, and a higher value indicates the manager generated a benchmark-beating return more consistently per unit of active risk taken relative to the benchmark
CThe Treynor ratio, which divides the fund's return in excess of the risk-free rate by its beta, and measures compensation for systematic market risk rather than for deviating from a specific benchmark
DThe Sortino ratio, which divides the fund's return in excess of a minimum acceptable return by its downside deviation, and ignores the fund's performance relative to any benchmark entirely
Correct answer: .
The information ratio equals a portfolio's active return, its return minus the benchmark's return, divided by tracking error, the standard deviation of that active return over time. A higher information ratio means the manager has generated benchmark-beating returns more consistently, with less variability in that outperformance, indicating more reliable skill rather than a single lucky period. The option describing the Sharpe ratio is wrong because it measures return in excess of the risk-free rate divided by total volatility, with no reference to a specific benchmark at all. The option describing the Treynor ratio is wrong for the same reason, since it uses beta and the risk-free rate, not a benchmark-relative active return and tracking error. The option describing the Sortino ratio is wrong because it substitutes downside deviation for standard deviation but still measures return against a minimum acceptable return threshold, not against a benchmark's actual return.
Source: CFA Institute, Portfolio Risk and Return: Part II; Grinold, R. & Kahn, R., 'Active Portfolio Management'
An investor tracks their portfolio's value over three years. It peaks at $200,000, then falls to a low of $140,000 before eventually recovering above its prior peak. What is this $60,000 (30%) peak-to-trough decline commonly called, and what does this measure capture that standard deviation of returns does not?
AValue at Risk (VaR), a forward-looking, probability-based estimate of a potential future loss threshold, rather than a measurement of a decline that has already actually occurred
BStandard deviation, which is itself the general dispersion of returns around their average and does not specifically isolate the depth of any single sustained decline
CMaximum drawdown, which captures the single largest peak-to-trough decline actually experienced over a period, the real depth of the worst sustained loss, which standard deviation's average dispersion doesn't directly reveal
DBeta, a measure of how sensitive the portfolio's returns are to broad market movements, unrelated to the magnitude of any specific historical decline
Correct answer: .
Maximum drawdown is the largest percentage or dollar decline from a peak to a subsequent trough before a new peak is reached, here $60,000 or 30%. Unlike standard deviation, which averages the dispersion of returns around the mean across an entire period, maximum drawdown isolates the single worst sustained loss an investor would actually have experienced, a figure that matters for real-world concerns like whether an investor could psychologically or financially tolerate holding through such a decline. The option describing VaR is wrong because VaR is a forward-looking probabilistic estimate made in advance, not a backward-looking measurement of an actual realized decline. The option describing standard deviation is wrong because it measures overall variability, not the depth of a specific consecutive decline. The option describing beta is wrong because beta measures sensitivity to market movements, not the magnitude of any particular historical drawdown.
Source: CFA Institute, Risk Management: An Introduction; Investopedia, 'Maximum Drawdown (MDD)'
An investor holds shares of a stock currently worth $100 each and wants to limit potential downside losses while still keeping the ability to profit if the stock rises further, accepting an upfront cost in exchange for that protection. Which options-based hedging strategy involves buying a put option on a stock the investor already owns?
AA covered call, which involves selling a call option against shares already owned, generating upfront income but capping the position's upside rather than protecting its downside
BA short sale, which involves borrowing and selling shares the investor does not own, betting on a price decline rather than hedging an existing long position
CA straddle, which involves buying both a call and a put at the same strike price, a bet on a large price move in either direction rather than a hedge on an existing holding
DA protective put (also called a married put), which involves buying a put option on shares already owned, setting a floor near the strike price on potential losses while preserving unlimited upside, in exchange for the premium paid
Correct answer: .
A protective put pairs a long stock position with a purchased put option on the same stock, which gives the investor the right to sell at the put's strike price. This sets an effective floor on losses, near the strike price minus the premium paid, while leaving unlimited upside intact if the stock rises, at the cost of the premium, functioning like an insurance policy on the position. The option describing a covered call is wrong because selling a call generates income but caps the upside rather than protecting the downside, and doesn't involve buying a put at all. The option describing a short sale is wrong because it is a bet on price decline using borrowed shares, not a hedge layered on an existing long position. The option describing a straddle is wrong because it combines a purchased call and put at the same strike as a bet on volatility or direction, not a hedge specifically tied to shares the investor already owns.
Source: CFA Institute, Derivatives; SEC Investor.gov, 'Options Basics'
A US-based investor buys shares of a European company listed on a European exchange and denominated in euros. Even if the stock's price in euros doesn't move at all, the investor's return measured in US dollars can still turn out positive or negative. What risk does this illustrate, and how can it typically be hedged?
AInterest rate risk, the risk that rising rates reduce the present value of the company's future cash flows, which can be hedged using interest rate swaps
BCurrency (foreign exchange) risk, the risk that movements in the euro/dollar exchange rate affect the investor's home-currency return independent of the stock's local-currency performance, which can be hedged using currency forwards, futures, or currency-hedged fund share classes
CCredit risk, the risk that the company defaults on its obligations, which can be hedged by purchasing credit default swaps referencing the company's debt
DLiquidity risk, the risk that the investor cannot sell the shares quickly without moving the price, which can be hedged by only trading during the exchange's most active hours
Correct answer: .
Because the euro-denominated stock is converted back into US dollars for the investor's actual return, any change in the euro/dollar exchange rate directly affects that dollar return even if the stock's own euro price is unchanged, this is currency (foreign exchange) risk. It can be reduced by hedging the currency exposure directly with currency forwards or futures, or by choosing a currency-hedged version of a fund that holds the same underlying stock. The option describing interest rate risk is wrong because it concerns how rate changes affect the valuation of cash flows, not the currency-conversion mechanic described. The option describing credit risk is wrong because it concerns the issuer's ability to meet obligations, unrelated to exchange-rate movements. The option describing liquidity risk is wrong because it concerns the ability to transact without moving the price, not the effect of currency conversion on returns.
Source: SEC Investor.gov, 'International Investing'; CFA Institute, Currency Management: An Introduction
A mutual fund holds a large position in small, thinly traded corporate bonds. During a period of market stress, many investors simultaneously request redemptions, forcing the fund to sell these bonds quickly to raise cash. Even though the bonds' credit quality hasn't changed, the fund must accept steep price discounts to sell them in time. What risk does this scenario primarily illustrate?
ACredit risk, the risk that a bond issuer fails to make its scheduled interest or principal payments, which is explicitly unchanged in this scenario
BInterest rate risk, the risk that a bond's market price falls when prevailing interest rates rise, which is not the driver of the price discounts described here
CLiquidity risk, the risk that an asset cannot be sold quickly at a fair price, particularly in thinly traded markets or under redemption pressure, forcing a seller to accept a discount unrelated to the asset's underlying credit quality
DSystematic (market) risk, the risk arising from a security's sensitivity to broad market-wide movements, rather than from the specific difficulty of exiting an illiquid position quickly
Correct answer: .
Liquidity risk is the risk that a holder cannot exit a position quickly without accepting an adverse price, which is exactly what happens here: the fund must sell thinly traded bonds fast to meet redemptions and accepts a discount to do so, even though nothing about the bonds' creditworthiness changed. This is a structural risk of holding illiquid assets inside a vehicle that promises investors daily liquidity. The option describing credit risk is wrong because the question explicitly states credit quality is unchanged, and the loss comes from the forced-sale discount, not from default risk. The option describing interest rate risk is wrong because nothing in the scenario ties the price discount to a change in prevailing interest rates. The option describing systematic risk is wrong because the price impact here stems from the specific difficulty of exiting a thinly traded position under time pressure, not from general sensitivity to market-wide moves.
Source: CFA Institute, Risk Management: An Introduction; SEC, 'Liquidity Risk Management Programs for Open-End Funds' (Rule 22e-4)
A financial advisor distinguishes between two related but different concepts when assessing a client's suitable level of investment risk: one is the client's psychological, emotional willingness to endure investment losses and volatility, and the other is the client's objective financial ability to absorb losses without jeopardizing their goals, based on factors like time horizon, income stability, and existing wealth. What are these two concepts called, respectively?
ARisk premium, the extra return investors demand for bearing risk, and the risk-free rate, the return available on an investment with no risk at all
BRisk capacity, meaning the psychological willingness to endure losses, and risk tolerance, meaning the objective financial ability to absorb losses without jeopardizing goals
CSystematic risk, the portion of risk that cannot be diversified away, and unsystematic risk, the portion that diversification can reduce
DRisk tolerance, the psychological willingness to endure losses and volatility, and risk capacity, the objective financial ability to absorb losses without jeopardizing goals
Correct answer: .
Risk tolerance describes an investor's emotional comfort with volatility and potential losses, while risk capacity describes their objective financial ability to withstand losses given concrete factors such as time horizon, income stability, and existing wealth, and the two don't always align. A sound financial plan generally sets portfolio risk based on whichever of the two is more restrictive: for example, a retiree nearing the end of a fixed income stream might feel emotionally comfortable with a volatile portfolio, high risk tolerance, but have little real capacity to absorb a large loss, low risk capacity, in which case capacity should generally constrain the portfolio's risk level. The option describing risk premium and the risk-free rate is wrong because those are pricing concepts unrelated to an individual investor's personal risk profile. The option with the definitions swapped between risk capacity and risk tolerance reverses which concept is psychological and which is financial. The option describing systematic and unsystematic risk is wrong because those describe types of portfolio risk exposure, not investor-specific willingness or ability to bear risk.
Source: CFA Institute, Institutional Investors and Individual Investors; CFP Board, Financial Planning Practice Standards
A risk manager notes that a portfolio's one-day 95% Value at Risk (VaR) is $500,000 — meaning there is a 5% chance daily losses exceed that amount — but is frustrated that VaR says nothing about how large losses could get within that worst 5% of days. Which risk measure addresses this gap by calculating the average loss specifically within that worst-case tail, and is also considered mathematically superior to VaR because it satisfies the subadditivity property (a combined portfolio's risk measure never exceeds the sum of its parts' individual risk measures)?
AStandard deviation, which measures the dispersion of all returns around the mean, including both gains and losses, rather than the magnitude of losses specifically beyond a tail threshold
BThe Sharpe ratio, which divides a portfolio's excess return over the risk-free rate by its standard deviation, a reward-to-risk measure rather than a tail-loss measure
CBeta, which measures a portfolio's sensitivity to broad market movements rather than the size of losses within a specific tail of the loss distribution
DConditional Value at Risk (CVaR), also called Expected Shortfall, which averages the losses that occur beyond the VaR threshold, directly answering how severe the worst-case tail actually is
Correct answer: .
Conditional Value at Risk (CVaR), also known as Expected Shortfall, is calculated as the average of all losses that fall beyond the VaR threshold at a given confidence level, so instead of stopping at a cutoff point it directly measures how bad the worst-case tail actually is. CVaR is also classified as a coherent risk measure because it satisfies subadditivity: the CVaR of a combined portfolio can never exceed the sum of the CVaRs of its individual components, which rewards diversification consistently. Plain VaR lacks this property, meaning VaR can occasionally suggest that diversifying actually increases measured risk, an internally inconsistent result. The option describing standard deviation is wrong because it treats upside and downside dispersion identically and says nothing about losses beyond a specific threshold. The option describing the Sharpe ratio is wrong because it is a reward-to-risk ratio built on overall volatility, not a tail-loss measure. The option describing beta is wrong because it captures sensitivity to broad market moves, not the magnitude of losses within an already-identified tail.
Source: CFA Institute, Measuring and Managing Market Risk; Wikipedia, 'Expected shortfall' (summarizing Artzner et al.'s coherent risk measure criteria)
An investor already owns 100 shares of a stock trading at $60 and expects the price to stay roughly flat or rise only modestly over the next month. To generate extra income from the position, they sell a call option against those shares in exchange for the premium, accepting that their gains will be capped if the stock rises above the option's strike price. Which options strategy does this describe?
AA covered call, selling a call option against stock already owned, which collects premium income but caps the position's upside above the strike price
BA protective put, buying a put option on stock already owned, which sets a floor on losses but requires paying a premium rather than collecting one
CA straddle, buying both a call and a put at the same strike price, a bet on a large price move in either direction rather than an income strategy on an existing holding
DA short sale, borrowing and selling shares the investor does not own, a bet on price decline rather than an income strategy layered on an existing long position
Correct answer: .
A covered call means selling a call option against shares the investor already owns, collecting the option's premium immediately. If the stock stays below the strike price, the investor keeps both the shares and the premium; if it rises above the strike, the investor is obligated to deliver the shares at that strike, keeping the premium but forgoing any gain beyond it. This makes it a favored strategy for an investor who expects flat or modestly rising prices and wants to enhance income rather than maximize upside. The option describing a protective put is the opposite trade entirely: buying (not selling) a put, paying (not collecting) a premium, to protect against losses rather than generate income. The option describing a straddle is wrong because it combines a purchased call and put at the same strike as a bet on a large move in either direction, unrelated to an existing stock holding. The option describing a short sale is wrong because it involves borrowed shares and bets on a price decline, not an income overlay on a position the investor already holds.
Source: CFA Institute, Derivatives; SEC Investor.gov, 'Options Basics'
A portfolio manager discovers that a single technology company makes up 35% of a client's total portfolio value, even though the portfolio holds 40 different stocks spread across many sectors overall. What risk does this one outsized position chiefly expose the client to, regardless of how many other stocks the portfolio holds?
ALiquidity risk, the risk that a position cannot be sold quickly without moving its price, which depends on the stock's trading volume rather than its share of the portfolio
BSystematic risk, the market-wide risk that cannot be diversified away even in a portfolio with no single large position
CConcentration risk, the risk that a disproportionate share of the portfolio sits in one security, sector, or geography, so company-specific bad news can disproportionately hurt the whole portfolio even though many other positions exist
DInterest rate risk, the risk that rising rates reduce the value of fixed-income holdings, unrelated to how portfolio weight is distributed among equities
Correct answer: .
Concentration risk is the vulnerability that arises when a disproportionate share of a portfolio sits in a single security, sector, or geography. Even a portfolio holding 40 different stocks can carry severe concentration risk if one name dominates its value, because adverse company-specific news (an earnings miss, a scandal, a product failure) can drag down the entire portfolio's return far more than the number of distinct holdings would suggest. The fix is typically to cap any single position's weight and rebalance back toward that cap over time. The option describing liquidity risk is wrong because it concerns how easily a position can be traded without moving the price, a function of the stock's own trading volume, not of how large a share it represents of this particular portfolio. The option describing systematic risk is wrong because it describes market-wide risk that persists even without any single large position. The option describing interest rate risk is wrong because it specifically concerns fixed-income valuations, not how equity weight is distributed.
Source: U.S. Bank, 'Ways to Manage Concentration Risk in Your Portfolio'; Wikipedia, 'Concentration risk'
Two financial institutions enter into an over-the-counter (OTC) interest rate swap directly with each other, with no central clearinghouse standing between them. One institution later becomes financially distressed and fails to make its required payments under the swap. What risk does this scenario illustrate, and what mechanism has become the most common way to reduce it across the broader OTC derivatives market?
ACounterparty risk, the risk that the other party to a bilateral contract defaults on its obligations; it is now commonly reduced by routing standardized derivatives through a central clearing counterparty (CCP) that insulates each side from the other's default, together with posting collateral against net exposures
BInterest rate risk, the risk that changes in market interest rates reduce the swap's value, which has nothing to do with whether the counterparty itself can pay
CLiquidity risk, the risk that the swap cannot be unwound quickly at a fair price, unrelated to whether the counterparty defaults on its payments
DCredit spread risk, the risk that widening yield spreads on corporate bonds reduce bond prices, a bond-market risk distinct from a bilateral derivatives contract's default risk
Correct answer: .
Counterparty risk is the risk that the other party to a bilateral over-the-counter contract defaults and cannot honor its obligations, and it is distinct from ordinary credit risk because derivative exposures move with market prices over the life of the contract rather than staying fixed like a loan. The primary mechanism used today to reduce it across the OTC derivatives market is central clearing: a central clearing counterparty (CCP) interposes itself between the two original parties, so each faces the well-capitalized CCP instead of each other, gaining multilateral netting and loss-sharing among clearing members. Posting collateral against net exposures further reduces, though does not eliminate, the loss if a party defaults. The option describing interest rate risk is wrong because it concerns how rate moves affect the swap's valuation, not whether the counterparty itself can pay. The option describing liquidity risk is wrong because it concerns the ability to exit a position, not default by the other party. The option describing credit spread risk is wrong because it is a bond-market pricing risk unrelated to a bilateral derivatives default.
Source: Bank for International Settlements / IMF Global Financial Stability Report, 'Making Over-the-Counter Derivatives Safer: The Role of Central Counterparties'; Duffie & Zhu, 'Does a Central Clearing Counterparty Reduce Counterparty Risk?' (Stanford)
A risk team already calculates its portfolio's Value at Risk (VaR) using several years of historical daily returns. Concerned that VaR, built from relatively ordinary historical data, might understate the portfolio's exposure to a severe but plausible event that has not occurred in that history — such as a sudden interest rate spike striking alongside a sharp equity selloff — the team instead models the portfolio's hypothetical loss under that specific, deliberately extreme combination of market moves. What is this risk-management technique called, and how does it fundamentally differ from VaR's approach?
ABacktesting, which compares a model's past VaR predictions against actual subsequent losses to check the model's accuracy, rather than modeling a hypothetical future scenario
BStress testing (or scenario analysis), which evaluates portfolio losses under a specific, deliberately chosen extreme hypothetical scenario rather than inferring a loss threshold from the statistical distribution of historical returns, letting it capture severe events absent from the historical data VaR relies on
CMonte Carlo simulation of the efficient frontier, which generates many random portfolio-weight combinations to estimate the optimal risk-return trade-off, not a single deliberately chosen adverse scenario
DCalculating the portfolio's beta under the Capital Asset Pricing Model, which measures sensitivity to broad market movements rather than modeling one specific hypothetical extreme event
Correct answer: .
Stress testing, sometimes called scenario analysis, evaluates how a portfolio would perform under a specific, deliberately chosen extreme scenario, such as a named historical crisis or a hypothetical combination of adverse moves, rather than inferring a loss threshold from the statistical distribution of historical returns the way VaR does. Because it does not depend on an event having already occurred in the historical sample, stress testing can surface severe but plausible combinations of market moves that VaR, built from relatively ordinary historical data, would understate or miss entirely; the two techniques are typically used together rather than as substitutes. The option describing backtesting is wrong because that process checks a model's past predictions against what actually happened afterward, it does not model a hypothetical future scenario. The option describing Monte Carlo simulation of the efficient frontier is wrong because that technique searches across random portfolio weightings for an optimal risk-return trade-off, not a single deliberately extreme scenario. The option describing beta under the CAPM is wrong because beta is a single sensitivity figure to broad market movements, not a scenario-specific loss estimate.
Source: CFA Institute, Measuring and Managing Market Risk (Refresher Reading); AnalystPrep, 'Use of Sensitivity and Scenario Risk Measures'
A portfolio manager wants to understand how their portfolio would perform under a hypothetical 2008-style financial crisis, even though no period in the portfolio's own historical return data closely resembles that scenario. Which risk management technique is designed for exactly this kind of forward-looking 'what if' analysis, as distinct from statistical measures like standard deviation or VaR that are derived from the portfolio's own historical return distribution?
ACalculating the portfolio's historical Sharpe ratio over the longest available sample period, extending the look-back window far enough to hopefully include a comparable crisis
BRecomputing Value at Risk at a higher confidence level, such as 99.9% instead of 95%, so the statistical threshold pushes further into the historical tail
CIncreasing the number of holdings in the portfolio to lower its standard deviation, on the assumption that a more diversified portfolio would perform better in any crisis
DStress testing (scenario analysis) — modeling the portfolio's response to a specific hypothetical or historical crisis by applying assumed shocks to relevant risk factors, independent of whether a comparable scenario appears anywhere in the portfolio's own historical return data
Correct answer: .
Stress testing, also called scenario analysis, is built specifically for this purpose: it applies a defined set of hypothetical or historical shocks to the risk factors that drive a portfolio's value — such as equity prices falling sharply, credit spreads widening, and liquidity drying up simultaneously — and reports how the portfolio would respond, regardless of whether anything resembling that combination actually appears in the portfolio's own historical returns. Extending the look-back period for a historical performance ratio only works if a comparable crisis happens to already exist somewhere in that extended sample; it cannot manufacture a scenario that never occurred. Pushing a VaR calculation to a higher confidence level still derives its estimate from the shape of the historical return distribution, so it inherits the same blind spot to genuinely unprecedented shocks. Adding more holdings to reduce standard deviation addresses day-to-day volatility under normal conditions, but diversification benefits often break down during systemic crises when correlations across assets tend to rise together, which is precisely the kind of dynamic stress testing is meant to probe.
Source: CFA Institute curriculum — Risk Management: sensitivity analysis, scenario analysis and stress testing
An investor holds a stock that has risen substantially and wants to protect those gains from a sharp decline without paying the full upfront premium a standalone protective put would cost, and is willing to give up some further upside in exchange. Which options strategy combines buying a put option below the current price with selling a call option above the current price on the same shares, using the premium received from the call to offset the cost of the put?
AA collar — buying an out-of-the-money put for downside protection and simultaneously selling an out-of-the-money call, with the call's premium income reducing or, in a 'zero-cost' version, fully covering the put's premium cost, at the expense of capping the stock's upside above the call's strike
BA straddle — buying both a put and a call at the same strike price, a strategy designed to profit from a large price move in either direction rather than to protect an existing long stock position
CA standalone protective put, where the investor buys a put option and simply accepts its full premium cost as the price of downside protection, with no offsetting option sold
DA covered call written on its own, where the investor sells a call against the stock for income but accepts unlimited downside risk below the stock's current price since no put is purchased
Correct answer: .
A collar combines two option positions around an existing stock holding: an out-of-the-money put purchased for downside protection, and an out-of-the-money call sold against the same shares, whose premium income offsets some or, in a zero-cost structure, all of the put's cost — the tradeoff is that the sold call caps the position's upside at its strike price. A straddle instead buys a put and a call at the same strike without owning the underlying stock, a bet on a large move in either direction rather than a hedge on an existing holding. A standalone protective put does provide the same downside floor but without selling a call to offset its premium, making it costlier to carry than a collar. Selling a covered call by itself generates income but provides no floor under the stock's price at all, leaving the position exposed to the same unlimited downside as holding the shares outright, which is exactly the risk a collar's purchased put is meant to eliminate.
Source: CBOE Options Institute / Options Clearing Corporation investor education — Collar strategy; Britannica Money — 'What Is a Collar Option Strategy?'
A traditional 60/40 stock-bond portfolio allocates 60% of its dollars to equities, but because stocks are typically far more volatile than bonds, equities can end up contributing well over 90% of the portfolio's total risk despite being less than two-thirds of its capital. Which portfolio construction approach instead sizes positions so that each asset class contributes an equal share of the portfolio's overall risk, rather than an equal share of its invested capital?
AStrategic asset allocation, which sets a long-term target mix of asset classes based on an investor's goals and risk tolerance, then rebalances back to those fixed capital weights whenever the portfolio drifts
BRisk parity — sizing each asset class's position so that it contributes an equal share of the portfolio's total risk (commonly measured by volatility) rather than an equal share of invested capital, typically requiring lower-volatility assets like bonds to be leveraged up to match the risk contributed by equities
CTactical asset allocation, which makes short-term, temporary deviations away from a portfolio's long-term target weights based on near-term views about which asset classes look attractively priced
DThe two-fund separation approach, under which every investor's optimal mix of risky assets converges on the same tangency portfolio, with only the split between that portfolio and the risk-free asset differing by investor
Correct answer: .
Risk parity sizes positions so that each asset class contributes an equal share of the portfolio's total risk, typically measured by volatility, rather than an equal share of invested capital — because bonds are usually far less volatile than equities, achieving equal risk contributions commonly requires leveraging the lower-volatility holdings so their dollar-weighted risk matches that of the unlevered equity position. Strategic asset allocation sets and rebalances back to fixed capital-weight targets, which is exactly the equal-capital approach risk parity departs from, since it does nothing to equalize how much risk each asset class actually contributes. Tactical asset allocation describes short-term, temporary tilts away from a long-term target mix based on near-term market views, a timing decision rather than a risk-budgeting framework. The two-fund separation result describes how every investor converges on the same optimal risky portfolio and varies only their split against the risk-free asset — a theoretical result about investor choice, not a method of weighting positions within a multi-asset-class portfolio by their risk contribution.
Source: Qian, E. (2005), 'Risk Parity Portfolios: Efficient Portfolios Through True Diversification', PanAgora Asset Management; CFA Institute curriculum — risk budgeting and risk parity
A portfolio manager holds a large, diversified US equity portfolio and becomes concerned about a near-term market-wide decline, but does not want to sell any of the individual stocks, which would trigger transaction costs and realize capital gains. Which hedging technique lets the manager temporarily reduce the portfolio's overall exposure to market-wide moves without selling any of the underlying holdings?
ASelling stock index futures contracts (such as S&P 500 futures) in a quantity scaled to the portfolio's beta, offsetting gains or losses on the futures position against market-wide moves in the underlying stock holdings without requiring any individual stock to be sold
BBuying additional shares of the same stocks already held, on the reasoning that a larger position in familiar holdings reduces uncertainty about how the portfolio will behave
CShort selling the individual stocks already held in the portfolio, which would close out the existing long positions entirely rather than temporarily offsetting their market exposure
DSwitching the entire portfolio into short-term government bonds, which eliminates market exposure only by liquidating the equity holdings outright rather than hedging them while keeping them intact
Correct answer: .
Selling stock index futures in a quantity sized to the portfolio's beta lets a manager offset the portfolio's sensitivity to broad market moves: if the market falls, losses on the stock holdings are offset by gains on the short futures position, and the hedge can later be removed simply by closing out the futures contracts, all without selling a single underlying share or triggering the transaction costs and realized capital gains that selling would create. Buying more of the same shares increases, rather than reduces, the portfolio's market exposure, since it adds more of the very risk the manager is trying to hedge. Short selling the individual stocks already held would directly offset and close out those long positions, which is economically equivalent to liquidating the portfolio rather than temporarily hedging it while keeping the holdings intact. Moving the entire portfolio into government bonds does reduce market exposure, but only by actually selling the equity holdings, which is precisely the transaction-cost and capital-gains outcome the manager is trying to avoid.
Source: CME Group — 'Equity Index Futures: Hedging Portfolio Market Risk'; CFA Institute curriculum — Risk Management Applications of Forward and Futures Strategies
About Risk, Volatility & Hedging
"Risk" in investing has several distinct, non-interchangeable measures. Standard deviation captures an asset or portfolio's total volatility, both up and down. Beta measures only systematic risk — a security's sensitivity to broad market moves, as used in the Capital Asset Pricing Model (CAPM) to set a required return (the market itself has a beta of 1; a stock with a beta of 1.5 tends to move roughly 50% more than the market in either direction). Value at Risk (VaR) answers a different question: the minimum loss a portfolio would be expected to exceed, with a given probability, over a given time horizon — for example, a 1-day 95% VaR of $1 million means there is a 5% chance of losing at least that much in a single day.
Because these measures capture different things, so do the ratios built on them for judging risk-adjusted returns: the Sharpe ratio divides excess return by standard deviation (total risk), while the Treynor ratio divides it by beta (systematic risk only) and Jensen's alpha measures the return earned above what CAPM would predict for that beta. Hedging tools — options, futures, and plain diversification — reduce one or more of these exposures deliberately, usually at some cost in expected return. The risk-adjusted-return guide computes all four side by side on one portfolio.