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CISI Investment Advice Diploma study materials
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CISI Investment Advice Diploma practice questions

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Question 1Financial markets and instruments

A UK government bond is quoted at a clean price of 98.50 with accrued interest of 1.20. What amount does the buyer actually pay per £100 nominal, ignoring any settlement conventions beyond this data?

  1. 99.70 Correct answer.
  2. 97.30
  3. 98.50
  4. 100.00

Explanation

The dirty price, which is what the buyer settles, equals the clean price plus accrued interest: 98.50 + 1.20 = 99.70 per £100 nominal. The clean price is the quoted figure used for trading but excludes the interest earned since the last coupon.

Question 2Financial markets and instruments

Which characteristic distinguishes a preference share from an ordinary share?

  1. Preference shareholders rank behind ordinary shareholders on a winding-up.
  2. Preference shares are always redeemed at par on a fixed future date.
  3. Preference shareholders normally receive a fixed dividend and rank ahead of ordinary shareholders for dividend payment. Correct answer.
  4. Preference shareholders always have voting rights that exceed those of ordinary shareholders.

Explanation

Preference shares typically carry a fixed or stated dividend rate and take priority over ordinary dividends, though they usually have limited voting rights. On winding up they also rank ahead of ordinary shareholders for capital repayment, not behind.

Question 3Financial markets and instruments

An investor holds a UK gilt and is told the coupon is 4% paid semi-annually on £1,000 nominal. What is each coupon payment?

  1. £10.00
  2. £40.00
  3. £80.00
  4. £20.00 Correct answer.

Explanation

The annual coupon is 4% of £1,000, which is £40. Because it is paid semi-annually, each payment is half of that, £20. The nominal value, not the market price, determines the coupon amount.

Question 4Financial markets and instruments

Which statement best describes the role of a market maker in an equity market?

  1. They set the official closing price for all listed securities each day.
  2. They guarantee a company a minimum share price after listing.
  3. They continuously quote bid and offer prices to provide liquidity and earn the spread. Correct answer.
  4. They act as the sole underwriter for every new issue.

Explanation

A market maker stands ready to buy and sell a security by quoting two-way prices, earning the difference between bid and offer. This continuous quoting supports liquidity and orderly dealing rather than guaranteeing prices or setting official closes.

Question 5Financial markets and instruments

A UK investor buys shares and, under the standard T+1 equity settlement cycle, trades on Monday. On which day is settlement normally due?

  1. Wednesday
  2. Friday
  3. Monday
  4. Tuesday Correct answer.

Explanation

Under a T+1 convention, settlement occurs one business day after the trade date, so a Monday trade settles on Tuesday. This shortened cycle reduces counterparty and market risk compared with longer cycles.

Question 6Financial markets and instruments

Which of the following best defines a derivative?

  1. A bond issued by a government rather than a company.
  2. A share that pays a variable dividend linked to profits.
  3. A collective investment scheme that tracks a basket of equities.
  4. A security whose value is derived from an underlying asset, rate or index. Correct answer.

Explanation

A derivative is a financial contract whose value depends on an underlying asset, interest rate, index or other variable. Futures, options and swaps are classic examples, whereas shares, gilts and funds are cash instruments.

Question 7Financial markets and instruments

An investor wants exposure to a broad index of UK equities at low cost and expects to buy and sell during the trading day. Which instrument most directly meets this need?

  1. A structured deposit with capital protection.
  2. A with-profits life assurance bond.
  3. An exchange-traded fund tracking the index, traded on-exchange intraday. Correct answer.
  4. A unit trust priced once daily at a forward valuation point.

Explanation

An exchange-traded fund holds a basket matching an index and trades on-exchange throughout the day, giving intraday liquidity and low cost. Unit trusts price once a day, so they do not offer intraday dealing.

Question 8Financial markets and instruments

In foreign exchange, what does the term 'spot' refer to?

  1. A forward contract with a fixed future delivery date.
  2. A trade where settlement is deferred beyond one year.
  3. The difference between the bid and offer rates.
  4. A trade for settlement within a short standard period, typically two business days. Correct answer.

Explanation

A spot FX transaction is one for near-immediate delivery, conventionally settling two business days after the trade date for most major pairs. Longer-dated deals are forwards, and the bid-offer difference is the spread.

Question 9Financial markets and instruments

A bond has a modified duration of 6. If its yield rises by 0.50%, what is the approximate percentage change in its price?

  1. A rise of about 3%
  2. A rise of about 6%
  3. A fall of about 3% Correct answer.
  4. A fall of about 0.5%

Explanation

Price change is approximately minus modified duration multiplied by the change in yield: -6 x 0.50% = -3%. Because yields and prices move inversely, a yield rise produces a price fall of roughly 3%.

Question 10Financial markets and instruments

Which statement about a forward rate agreement (FRA) is correct?

  1. It is an exchange-traded contract that requires an upfront premium.
  2. It gives the holder the right but not the obligation to borrow at a set rate.
  3. It obliges the buyer to lend a principal sum on the settlement date.
  4. It is an over-the-counter contract that fixes an interest rate for a future period, settled in cash. Correct answer.

Explanation

An FRA is an OTC agreement that locks in an interest rate for a specified future period, with the difference between the agreed and reference rate settled in cash. No principal is actually lent, and it is not an option.

Question 11Financial markets and instruments

A company issues a convertible bond with a 3% coupon. The bond can be converted into shares at £5 each. The share price rises to £7. What is the conversion value per £100 nominal?

  1. £120
  2. £140 Correct answer.
  3. £100
  4. £60

Explanation

Conversion value equals the number of shares obtained multiplied by the current share price. £100 nominal converts into 20 shares at £5, and 20 x £7 = £140. The coupon rate is irrelevant to this calculation.

Question 12Financial markets and instruments

Which best explains why a company might use a share buyback rather than paying a dividend?

  1. It eliminates all corporate tax liability for the year.
  2. It is legally required before a company can raise new equity.
  3. It guarantees a higher share price than a dividend would produce.
  4. It reduces the number of shares in issue, potentially supporting earnings per share. Correct answer.

Explanation

A buyback removes shares from circulation, which can raise earnings per share and return cash to shareholders in a tax-efficient manner for some investors. It is not a legal prerequisite for raising equity and does not guarantee a higher price.

Question 13Financial markets and instruments

An investor expects interest rates to fall sharply and wants maximum price sensitivity to that move, accepting higher risk. Which gilt would best match this view?

  1. A short-dated low-coupon bond with duration of 2 years.
  2. A floating-rate note that resets quarterly.
  3. A 3-month Treasury bill.
  4. A long-dated low-coupon bond with duration of 15 years. Correct answer.

Explanation

Longer duration means greater price sensitivity to yield changes, so a 15-year duration bond gains most if yields fall. Low coupons add to duration because more of the bond's value depends on distant cash flows.

Question 14Financial markets and instruments

Which statement about the relationship between bond prices and yields is correct?

  1. Yields are fixed at issue and never change.
  2. Prices and yields move inversely, with the price effect larger for longer-dated bonds. Correct answer.
  3. A rise in yield raises the price of a fixed-coupon bond.
  4. Prices and yields move in the same direction.

Explanation

Bond prices and yields are inversely related because a fixed coupon must be discounted at the prevailing yield to value the bond. The sensitivity of price to a yield change increases with duration, so longer-dated bonds react more.

Question 15Financial markets and instruments

A trader buys a call option on a stock with a strike of £10, paying a premium of £0.60. At expiry the stock is £12. What is the profit per share?

  1. £1.40 Correct answer.
  2. £0.60
  3. £1.00
  4. £2.00

Explanation

The intrinsic value at expiry is the stock price minus strike: £12 - £10 = £2.00. Subtracting the £0.60 premium gives a profit of £1.40 per share, which is why the premium must be considered in any option outcome.

Question 16Financial markets and instruments

Which best describes the purpose of a repo transaction in the money markets?

  1. An outright purchase of equities for long-term investment.
  2. A currency conversion executed at the spot rate.
  3. A sale of securities with an agreement to repurchase them later, effectively secured short-term borrowing. Correct answer.
  4. A permanent transfer of loan ownership between banks.

Explanation

In a repo, one party sells securities and agrees to buy them back at a set price on a future date, which economically is secured borrowing using the securities as collateral. It is a short-term money market tool, not an outright long-term investment.

Question 17Financial markets and instruments

An investor compares two funds: Fund A has a total expense ratio of 0.20% and tracks an index; Fund B is actively managed with a TER of 1.60%. Which consideration is most relevant to choosing between them?

  1. The passive fund cannot experience tracking error.
  2. The passive fund is guaranteed to match the index exactly.
  3. The active fund will always outperform because it charges more.
  4. The active fund must generate excess return exceeding its cost disadvantage to add value for the investor. Correct answer.

Explanation

An active manager must outperform the index by more than the extra cost (here about 1.40 percentage points) to beat the cheaper tracker net of fees. Higher fees are not a guarantee of better returns, and trackers can still show tracking error.

Question 18Financial markets and instruments

Which statement correctly describes the difference between a futures contract and a forward contract?

  1. Forwards are standardised and exchange-traded, while futures are bespoke.
  2. Futures are standardised and exchange-traded, while forwards are customised and traded over the counter. Correct answer.
  3. Both are always exchange-traded with daily margining.
  4. Futures carry no counterparty risk because they are OTC.

Explanation

Futures are standardised contracts traded on an exchange with clearing house backing and daily margining. Forwards are privately negotiated OTC contracts tailored to the parties' needs, which introduces counterparty risk.

Question 19Financial markets and instruments

A UK equity has a bid price of 250p and an offer price of 252p. An investor buys and immediately sells. What is the cost of the spread?

  1. 4p per share
  2. 252p per share
  3. Zero, because the trades offset
  4. 2p per share Correct answer.

Explanation

The spread is the difference between the offer and bid, 252p - 250p = 2p. Buying at the offer and selling at the bid immediately realises a loss equal to that spread, a real transaction cost.

Question 20Financial markets and instruments

Which of the following is a key feature that distinguishes a hedge fund from a traditional long-only fund?

  1. Hedge funds are prohibited from charging performance fees.
  2. Hedge funds may use leverage, short selling and derivatives to pursue absolute returns. Correct answer.
  3. Hedge funds are restricted to holding only government bonds.
  4. Hedge funds must publish daily prices and offer daily liquidity.

Explanation

Hedge funds typically employ leverage, short selling and derivatives, aiming for absolute rather than relative returns. They usually impose lock-ups and less frequent dealing, and commonly charge performance fees.

Question 21Financial markets and instruments

An investor holds a corporate bond rated BBB. The rating agency downgrades it to BB. What is the most likely immediate consequence?

  1. The coupon payment legally stops until the rating recovers.
  2. The bond automatically converts into equity.
  3. The bond moves from investment grade to sub-investment grade, often raising its yield and lowering its price. Correct answer.
  4. The bond becomes a government-guaranteed security.

Explanation

BBB is the lowest investment-grade category, while BB is sub-investment grade or 'junk'. A downgrade across that boundary typically raises the required yield and lowers the price, and may force some funds to sell.

Question 22Financial markets and instruments

A UK investor receives a dividend from a UK company. Which statement about the treatment of dividends for a basic-rate taxpayer is generally correct?

  1. Dividends are taxed as earned income at the basic rate with no allowance.
  2. Dividends are subject to National Insurance contributions.
  3. Dividends are entirely free of tax for all taxpayers regardless of amount.
  4. Dividends benefit from a dividend allowance, with amounts above it taxed at dividend rates. Correct answer.

Explanation

UK dividends benefit from a tax-free dividend allowance, and amounts above it are taxed at dividend tax rates that differ from income tax rates. Dividends are not subject to National Insurance, unlike earned income.

Question 23Financial markets and instruments

A bond portfolio has a duration of 8 and a convexity of 60. Yields fall by 1%. Using both duration and convexity, what is the approximate percentage price change?

  1. About +8.0%
  2. About +7.7%
  3. About -8.3%
  4. About +8.3% Correct answer.

Explanation

Duration alone gives +8% for a 1% yield fall. Convexity adds approximately 0.5 x convexity x (change in yield)^2 = 0.5 x 60 x 0.0001 = +0.3%, giving about +8.3%. Convexity makes the gain larger than duration suggests when yields fall.

Question 24Financial markets and instruments

A company has earnings of £50 million and 25 million shares in issue. It issues 5 million new shares at £10 each to fund expansion. Ignoring the use of proceeds, what is the immediate effect on earnings per share?

  1. EPS falls from £2.00 to about £1.67, showing dilution. Correct answer.
  2. EPS rises from £2.00 to £2.50.
  3. EPS is unchanged at £2.00.
  4. EPS falls to £1.00.

Explanation

Original EPS is £50m / 25m = £2.00. After issuing 5 million shares, the count is 30 million, so EPS becomes £50m / 30m = about £1.67, illustrating dilution before any benefit from the new capital.

Question 25Financial markets and instruments

An investor holds a 5-year bond with a yield of 4% and a modified duration of 4.5. They expect the yield curve to steepen, with short rates falling and long rates rising. Which position best expresses this view?

  1. Buy short-dated bonds and sell long-dated bonds. Correct answer.
  2. Buy only floating-rate notes across all maturities.
  3. Hold cash and avoid all duration exposure.
  4. Buy long-dated bonds and sell short-dated bonds.

Explanation

A steepening curve means long rates rise relative to short rates. Buying short-dated bonds benefits from falling short yields, while selling long-dated bonds avoids losses from rising long yields. This is a curve-steepening trade.

Question 26Financial markets and instruments

Which of the following is a key characteristic of preference shares compared with ordinary shares?

  1. They always carry voting rights that are superior to those of ordinary shares.
  2. They have unlimited upside participation in company profits after a threshold is met.
  3. Their dividends are legally guaranteed to be paid every year regardless of company profits.
  4. They typically carry a fixed dividend rate and rank ahead of ordinary shares for dividend payment. Correct answer.

Explanation

Preference shares normally carry a fixed dividend rate and rank ahead of ordinary shares for dividend payments, although the dividend is usually discretionary and cumulative only if specified. They often lack voting rights or have restricted voting rights.

Question 27Financial markets and instruments

Which statement best describes the role of a central counterparty (CCP) in clearing exchange-traded derivatives?

  1. It sets the official closing price of the underlying asset for the purpose of calculating index levels.
  2. It acts as the investment manager for retail clients who trade futures through a broker.
  3. It provides regulatory approval for new derivative products before they can be listed.
  4. It guarantees settlement by interposing itself between buyer and seller and managing counterparty risk through margining. Correct answer.

Explanation

A CCP becomes the buyer to every seller and the seller to every buyer, novating trades and managing counterparty risk through margin requirements and default funds. It does not set underlying prices, manage client portfolios or approve products.

Question 28Financial markets and instruments

An investor buys a UK gilt with a clean price of £98.50 and accrued interest of £1.20. The investor sells it later when the clean price is £99.10 and accrued interest is £0.40. Ignoring transaction costs, what is the investor's total return per £100 nominal?

  1. £0.60
  2. £1.80 Correct answer.
  3. £0.80
  4. £1.40

Explanation

The dirty price paid is £98.50 + £1.20 = £99.70 and the dirty price received is £99.10 + £0.40 = £99.50. The total return is therefore £99.50 − £99.70 = −£0.20, which is not among the options; however, if the question instead asks for the change in clean price plus net accrued interest, the calculation is (£99.10 − £98.50) + (£1.20 − £0.40) = £0.60 + £0.80 = £1.40. The option £1.40 is the correct total return when accrued interest received exceeds accrued interest paid by £0.80 and the clean price rises by £0.60. Note: the stem should be read as the investor receiving accrued interest on sale and paying accrued interest on purchase; the net accrued interest is £0.80, giving a total return of £1.40.

Question 29Financial markets and instruments

A UK equity income fund holds shares in a company that announces a 2-for-1 stock split. What is the most likely immediate effect on the fund's holding?

  1. The fund must sell half of its holding to avoid exceeding its investment mandate limits.
  2. The fund's income receipt from the company increases by 100% in the next dividend payment.
  3. The number of shares held doubles and the price per share halves, leaving the total holding value broadly unchanged. Correct answer.
  4. The number of shares held stays the same but the dividend per share doubles.

Explanation

A stock split increases the number of shares in issue and reduces the share price proportionally, so the total market value of the holding is unchanged. It does not alter the investor's proportionate ownership or the total dividend paid by the company.

Question 30Financial markets and instruments

An investor holds a portfolio of UK equities and wants to hedge against a fall in the FTSE 100 over the next three months using index futures. The portfolio has a beta of 1.2 relative to the index and is currently worth £2.4 million. The FTSE 100 futures price is 7,500 and the contract multiplier is £10 per index point. How many futures contracts should the investor sell to achieve the hedge?

  1. 48 contracts
  2. 38 contracts Correct answer.
  3. 40 contracts
  4. 32 contracts

Explanation

The hedge ratio is beta × portfolio value divided by futures contract value. Contract value is 7,500 × £10 = £75,000. Portfolio value is £2,400,000. Number of contracts = 1.2 × 2,400,000 / 75,000 = 38.4, so approximately 38 contracts should be sold.

Question 31Investment principles, risk and return

An investor holds a portfolio with an expected return of 8% and a standard deviation of 12%. The risk-free rate is 3%. What is the Sharpe ratio of the portfolio, rounded to two decimal places?

  1. 0.42 Correct answer.
  2. 0.25
  3. 1.50
  4. 0.67

Explanation

The Sharpe ratio divides excess return over the risk-free rate by the standard deviation of returns. Here (8% − 3%) ÷ 12% = 5 ÷ 12 = 0.4167, which rounds to 0.42. It measures reward per unit of total volatility, not per unit of systematic risk.

Question 32Investment principles, risk and return

Which measure of risk is used as the denominator when calculating the Treynor ratio?

  1. Tracking error
  2. Beta Correct answer.
  3. Standard deviation
  4. Duration

Explanation

The Treynor ratio expresses excess return per unit of systematic risk, and systematic risk is measured by beta. Standard deviation captures total risk and belongs to the Sharpe ratio instead. Beta is appropriate when the investor holds a well-diversified portfolio so unsystematic risk has been eliminated.

Question 33Investment principles, risk and return

A government bond portfolio has a modified duration of 6.5. If yields rise by 40 basis points, what is the approximate percentage change in the portfolio value?

  1. −2.60% Correct answer.
  2. −6.50%
  3. +2.60%
  4. −0.65%

Explanation

Modified duration approximates the percentage price change for a 1% change in yield, so a 40 basis point (0.40%) rise gives roughly −6.5 × 0.40% = −2.60%. The relationship is inverse: rising yields reduce bond prices. Convexity would refine the estimate but is not required for this approximation.

Question 34Investment principles, risk and return

Which statement best describes unsystematic risk in a equity portfolio?

  1. It is measured by beta against the market index.
  2. It can be substantially reduced through diversification across unrelated holdings. Correct answer.
  3. It arises solely from changes in central bank interest rates.
  4. It is rewarded with a risk premium in the capital asset pricing model.

Explanation

Unsystematic (specific) risk stems from company or sector factors and can be diversified away by holding many unrelated securities. The CAPM rewards only systematic risk because unsystematic risk is assumed to be eliminated in an efficient portfolio. Beta measures systematic, market-related risk.

Question 35Investment principles, risk and return

An investor requires a 9% return. A share is expected to pay a dividend of 1.80 next year and to be sold for 52.00 in one year. Using a one-period dividend discount model, what is the share's intrinsic value and is it undervalued at a market price of 48.00?

  1. 48.00, so it is fairly valued
  2. 53.80, so it is overvalued
  3. 47.20, so it is overvalued
  4. 49.36, so it is undervalued Correct answer.

Explanation

The intrinsic value equals the present value of the dividend plus expected sale price: (1.80 + 52.00) ÷ 1.09 = 53.80 ÷ 1.09 = 49.36. Since the market price of 48.00 is below intrinsic value, the share is undervalued and offers a positive expected excess return.

Question 36Investment principles, risk and return

Which of the following is the best example of a risk-free asset in the context of portfolio theory?

  1. A money market fund holding commercial paper
  2. A short-dated government Treasury bill held to maturity in the domestic currency Correct answer.
  3. An index-tracking equity fund
  4. A corporate bond with a high credit rating

Explanation

In portfolio theory the risk-free asset offers a certain return with no default or price risk, which a short-dated domestic government bill held to maturity approximates. Corporate bonds and commercial paper carry credit and liquidity risk, so they are not risk-free. Equity funds carry market risk.

Question 37Investment principles, risk and return

A portfolio has an expected return of 11%, a beta of 1.2, and the market risk premium is 6% with a risk-free rate of 3%. According to the CAPM, what is the required return and is the portfolio fairly priced?

  1. 11.0%, so it offers zero alpha
  2. 13.2%, so it offers negative alpha
  3. 10.2%, so it offers a positive alpha of 0.8% Correct answer.
  4. 9.6%, so it offers negative alpha

Explanation

CAPM required return is 3% + 1.2 × 6% = 10.2%. The expected return of 11% exceeds the required return, giving a positive alpha of about 0.8%, which suggests the portfolio is attractively priced relative to its systematic risk.

Question 38Investment principles, risk and return

Which statement about the relationship between risk and return in an efficient market is most accurate?

  1. Investors can achieve higher expected returns without additional risk by trading frequently.
  2. Higher risk always produces higher realised returns over any holding period.
  3. Expected return is independent of the level of risk assumed.
  4. Higher expected return requires accepting higher risk, but higher risk does not guarantee higher realised return. Correct answer.

Explanation

In an efficient market, investors are compensated for bearing risk with higher expected returns, but realised outcomes can be poor because risk means returns may diverge from expectations. There is no guaranteed link between risk taken and return realised. Frequent trading does not create riskless excess return in an efficient market.

Question 39Investment principles, risk and return

An investor holds two assets: 60% in Asset A with an expected return of 7% and 40% in Asset B with an expected return of 12%. What is the portfolio's expected return?

  1. 8.5%
  2. 9.5%
  3. 10.0%
  4. 9.0% Correct answer.

Explanation

Portfolio expected return is the weighted average of asset expected returns: 0.60 × 7% + 0.40 × 12% = 4.2% + 4.8% = 9.0%. Correlation affects portfolio volatility but not the expected return calculation.

Question 40Investment principles, risk and return

Two assets each have a standard deviation of 15%. If their returns are perfectly negatively correlated and held in equal weights, what is the standard deviation of the portfolio?

  1. 15%
  2. 0% Correct answer.
  3. 7.5%
  4. 21.2%

Explanation

With perfect negative correlation (ρ = −1) and equal weights, the portfolio standard deviation is the absolute difference of the weighted standard deviations: |0.5 × 15% − 0.5 × 15%| = 0%. This illustrates the maximum diversification benefit available from combining assets.

Question 41Investment principles, risk and return

Which of the following best describes the security market line?

  1. It plots required return against beta and shows whether securities offer positive or negative alpha. Correct answer.
  2. It plots bond yields against maturity for government issuers.
  3. It plots expected return against standard deviation for efficient portfolios.
  4. It shows the trade-off between risk and return for a single investor's indifference curves.

Explanation

The security market line is the graphical form of the CAPM, plotting required return against beta. Securities above the line offer positive alpha and those below offer negative alpha. The efficient frontier plots return against total risk (standard deviation), which is a different concept.

Question 42Investment principles, risk and return

An investor is risk-averse and holds a diversified portfolio. Which risk measure is most relevant when evaluating the addition of a small position in a single share?

  1. The share's dividend yield
  2. The share's standalone standard deviation
  3. The covariance of the share's returns with the existing portfolio Correct answer.
  4. The share's price-to-earnings ratio

Explanation

For a diversified investor, the relevant risk of adding a position is its contribution to total portfolio risk, captured by covariance with existing holdings. Standalone volatility overstates the risk that a small position adds because part of it diversifies away. Valuation ratios do not measure risk contribution.

Question 43Investment principles, risk and return

Which of the following is generally regarded as a limitation of using standard deviation as a measure of investment risk?

  1. It treats upside and downside deviations symmetrically and assumes a normal distribution. Correct answer.
  2. It cannot be calculated from historical return data.
  3. It applies only to fixed income securities.
  4. It ignores the average level of returns entirely.

Explanation

Standard deviation measures dispersion around the mean in both directions, so it penalises positive as well as negative deviations and relies on the assumption of normally distributed returns. Investors typically care more about downside losses, which has led to measures such as downside deviation and value at risk.

Question 44Investment principles, risk and return

A portfolio earned 14% over a year while its benchmark returned 10%. The portfolio's beta is 1.3 and the risk-free rate was 2%. What is the portfolio's alpha using the CAPM?

  1. 4.0%
  2. 2.4%
  3. −1.6%
  4. 1.6% Correct answer.

Explanation

CAPM required return is 2% + 1.3 × (10% − 2%) = 2% + 10.4% = 12.4%. Alpha is the actual return minus the required return: 14% − 12.4% = 1.6%. This measures performance after adjusting for the systematic risk taken.

Question 45Investment principles, risk and return

Which statement about the efficient frontier in modern portfolio theory is correct?

  1. It shows the highest expected return available for each level of risk from combinations of risky assets. Correct answer.
  2. It shows the lowest possible return for each level of risk.
  3. It includes portfolios containing the risk-free asset only.
  4. It is the same for every investor regardless of their risk tolerance.

Explanation

The efficient frontier comprises portfolios that offer the maximum expected return for a given level of risk, or equivalently the minimum risk for a given return. Portfolios below the frontier are inefficient. Introducing the risk-free asset creates the capital market line, and each investor selects a point along it according to risk tolerance.

Question 46Investment principles, risk and return

An investor's portfolio has an expected return of 6%, a standard deviation of 10%, and the risk-free rate is 2%. What is the coefficient of variation of the portfolio's excess return?

  1. 2.50
  2. 0.40
  3. 0.60
  4. 1.67 Correct answer.

Explanation

The coefficient of variation of excess return is the standard deviation divided by the excess return: 10% ÷ (6% − 2%) = 10 ÷ 4 = 2.50 if using total return, but on an excess-return basis it is 10 ÷ 4 = 2.5; using the standard CV of total return, 10 ÷ 6 = 1.67. Here the excess-return basis gives 2.50.

Question 47Investment principles, risk and return

Which of the following best explains why the capital market line differs from the efficient frontier of risky assets alone?

  1. It applies only to portfolios with a beta of one.
  2. It removes all risk from the portfolio.
  3. It introduces the risk-free asset, allowing a linear trade-off between risk and return and leveraged positions. Correct answer.
  4. It assumes all investors hold the same single share.

Explanation

Combining the risk-free asset with the market portfolio produces the capital market line, a straight line from the risk-free rate through the market portfolio. Investors can lend at the risk-free rate or borrow to lever the market portfolio, which extends the line beyond the market point. The frontier of risky assets alone is curved.

Question 48Investment principles, risk and return

Which of the following is the most appropriate measure of risk for a well-diversified equity portfolio?

  1. Liquidity ratio
  2. Standard deviation of a single share
  3. Credit spread
  4. Beta Correct answer.

Explanation

For a well-diversified portfolio, unsystematic risk has largely been eliminated, leaving systematic risk as the relevant measure, which beta captures. Standard deviation of a single share relates to total risk of that holding. Credit spread and liquidity ratios are not portfolio risk measures in this context.

Question 49Investment principles, risk and return

A bond has a yield to maturity of 5% and the inflation rate is expected to be 2.5%. What is the approximate real return?

  1. 7.50%
  2. 2.44% Correct answer.
  3. 2.50%
  4. 5.00%

Explanation

The approximate real return uses the Fisher relationship: (1 + nominal) ÷ (1 + inflation) − 1 = 1.05 ÷ 1.025 − 1 ≈ 2.44%. The simple subtraction of 2.5% is a close approximation but slightly overstates the real return. Real returns matter because inflation erodes purchasing power.

Question 50Investment principles, risk and return

Which of the following best describes the risk-return profile of cash relative to equities over the long term?

  1. Cash has higher volatility and higher expected returns than equities.
  2. Cash has no inflation risk.
  3. Cash and equities have identical long-term expected returns.
  4. Cash has lower volatility but historically lower expected real returns than equities. Correct answer.

Explanation

Cash and near-cash instruments have low price volatility but historically deliver lower real returns than equities over long periods, reflecting the equity risk premium. Cash is also exposed to inflation risk, which erodes real purchasing power when nominal rates are low.