I85PREP
⌘ K
IFoA SP5 study materials
IFoA SP5 study resources

IFoA SP5 practice questions

One question at a time. Build your IFoA SP5 understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Investment and asset management

An investor holds a bond with a modified duration of 6.0 and a convexity of 45. If yields fall by 50 basis points, which estimate of the percentage price change best reflects the combined duration and convexity effect?

  1. Approximately +3.00%
  2. Approximately +3.06% Correct answer.
  3. Approximately +2.94%
  4. Approximately +3.12%

Explanation

The duration effect is -D times the yield change, giving +3.00% for a 50bp fall. The convexity adjustment is 0.5 times convexity times the squared yield change, adding about 0.056%. Combining them gives roughly +3.06%, so the convexity term makes the gain slightly larger than duration alone predicts.

Question 2Investment and asset management

Under modern portfolio theory, the efficient frontier is best described as which set of portfolios?

  1. Portfolios that maximise expected return regardless of risk
  2. Portfolios with the highest correlation between constituents
  3. Portfolios containing only risk-free assets
  4. Portfolios offering the lowest variance for each level of expected return Correct answer.

Explanation

The efficient frontier comprises portfolios that give the maximum expected return for a given level of risk, equivalently the minimum variance for each return level. Portfolios below the frontier are dominated because a better risk-return combination exists.

Question 3Investment and asset management

A UK equity fund reports a beta of 1.4. The expected market return is 8% and the risk-free rate is 3%. Using the CAPM, what is the fund's required return?

  1. 4.2%
  2. 11.2%
  3. 10.0% Correct answer.
  4. 8.0%

Explanation

CAPM gives required return equal to the risk-free rate plus beta times the market risk premium. The premium is 8% minus 3%, equal to 5%, and 1.4 times 5% is 7%, added to 3% gives 10%.

Question 4Investment and asset management

Which statement best describes the role of a custodian in an investment management operation?

  1. Guaranteeing a minimum investment return to the client
  2. Executing derivative hedging decisions on behalf of the manager
  3. Setting the strategic asset allocation for client portfolios
  4. Safekeeping of assets and settlement of trades independent of the investment manager Correct answer.

Explanation

A custodian holds assets in safekeeping, settles transactions and provides independent record-keeping, creating segregation from the investment manager. This independence is a core control in the client asset protection framework.

Question 5Investment and asset management

An asset manager wants to measure the proportion of active return explained by sector allocation versus stock selection. Which attribution approach is most appropriate?

  1. Modified duration analysis
  2. Brinson sector-based attribution Correct answer.
  3. Monte Carlo simulation
  4. Value at risk decomposition

Explanation

Brinson attribution decomposes active return into allocation, selection and interaction effects by comparing portfolio and benchmark weights within sectors. This directly isolates whether sector tilts or stock picking drove relative performance.

Question 6Investment and asset management

A portfolio has an expected return of 12% and a standard deviation of 16%. The risk-free rate is 4%. What is the Sharpe ratio?

  1. 0.25
  2. 2.00
  3. 0.50 Correct answer.
  4. 0.75

Explanation

The Sharpe ratio is excess return divided by standard deviation. Excess return is 12% minus 4%, equal to 8%, and dividing by 16% gives 0.50.

Question 7Investment and asset management

Which feature most distinguishes a defined contribution pension arrangement from a defined benefit arrangement from an investment perspective?

  1. Contributions are always invested in cash equivalents
  2. Assets are never held in pooled funds
  3. Benefits are guaranteed by the scheme actuary
  4. Investment risk is borne by the member rather than the sponsor Correct answer.

Explanation

In defined contribution schemes the member bears investment and longevity risk because the eventual benefit depends on accumulated fund value. In defined benefit schemes the sponsor typically bears investment risk against a promised benefit formula.

Question 8Investment and asset management

An insurance company holds long-dated liabilities and wants to reduce interest rate mismatch risk. Which asset strategy is most directly suited to this objective?

  1. Holding commodities for inflation protection
  2. Purchasing emerging market equity funds
  3. Buying fixed interest bonds matching the liability cash flow timing Correct answer.
  4. Investing in short-dated money market instruments

Explanation

Cash flow matching or duration matching with fixed interest bonds aligns asset cash flows with liability timing, reducing interest rate mismatch. Money market instruments have short duration and leave long liabilities exposed.

Question 9Investment and asset management

A fund's information ratio is calculated as active return divided by which quantity?

  1. Tracking error Correct answer.
  2. Total standard deviation
  3. Maximum drawdown
  4. Beta

Explanation

The information ratio measures active return per unit of active risk, where active risk is the tracking error of returns relative to the benchmark. It therefore rewards consistent outperformance rather than total volatility.

Question 10Investment and asset management

A portfolio manager expects a rise in volatility but is unsure of the direction of the equity market. Which option strategy is most consistent with this view?

  1. Buying a protective put
  2. Selling a cash-secured put
  3. Writing a covered call
  4. Buying a long straddle Correct answer.

Explanation

A long straddle combines a call and a put at the same strike and profits from large moves in either direction, so it benefits from rising volatility. Directional strategies such as covered calls or protective puts depend on a market view.

Question 11Investment and asset management

Which measure of modified duration is correct for a bond trading at a price of 98 with a duration of 5.2 when yields rise by 10 basis points?

  1. Price falls by approximately 0.51% Correct answer.
  2. Price falls by approximately 5.20%
  3. Price rises by approximately 0.51%
  4. Price is unchanged because duration only applies to par bonds

Explanation

The percentage price change is approximately minus modified duration times the yield change. With duration 5.2 and a 0.10% yield rise, the price falls by about 0.52%, close to 0.51% once the price level is considered.

Question 12Investment and asset management

An investment manager is assessing liquidity risk in a corporate bond portfolio. Which combination of factors most directly increases liquidity risk?

  1. Index inclusion and active secondary trading
  2. High credit rating and large issue size
  3. Short maturity and frequent coupon payments
  4. Wide bid-ask spreads and few market makers Correct answer.

Explanation

Liquidity risk rises when the gap between buying and selling prices is wide and dealer coverage is thin, making it costly to trade quickly. Large, highly rated, index-eligible issues with active trading generally trade more liquidly.

Question 13Investment and asset management

A pension scheme uses a liability-driven investment approach and wishes to hedge inflation-linked liabilities. Which instrument is most appropriate?

  1. Sterling corporate floating rate notes
  2. Conventional fixed coupon gilts
  3. Index-linked gilts Correct answer.
  4. UK equity income funds

Explanation

Index-linked gilts provide cash flows linked to realised inflation, matching inflation-linked liability payments. Conventional gilts hedge nominal interest rate risk but leave inflation exposure unhedged.

Question 14Investment and asset management

An analyst compares two funds with identical returns but different tracking errors. Which interpretation is correct?

  1. Both funds must have identical information ratios
  2. The fund with lower tracking error delivered its return with more consistent benchmark-relative positioning Correct answer.
  3. The fund with higher tracking error is necessarily more skilful
  4. Tracking error is irrelevant when total returns are equal

Explanation

Tracking error measures the volatility of active returns, so a lower figure means the fund deviated less from the benchmark to achieve its result. With equal returns, the lower tracking error fund has the higher information ratio.

Question 15Investment and asset management

A fund uses a value at risk model at the 99% confidence level over one day and reports a VaR of GBP 2 million. Which interpretation is most accurate?

  1. Maximum daily loss over the year is GBP 2 million
  2. The expected daily loss is GBP 2 million
  3. Losses are expected to exceed GBP 2 million on about one trading day in a hundred Correct answer.
  4. The fund can never lose more than GBP 2 million in a day

Explanation

A 99% one-day VaR of GBP 2 million means there is a 1% probability that the loss exceeds that amount over one day, assuming the model is correct. It is not a maximum loss and says nothing about the size of losses beyond the threshold.

Question 16Investment and asset management

Which feature of an exchange-traded fund most distinguishes it from a traditional open-ended mutual fund?

  1. Intraday trading on an exchange at prices set by supply and demand Correct answer.
  2. Regulation by a financial conduct authority
  3. Use of a fund manager to select assets
  4. Daily valuation of underlying holdings

Explanation

Exchange-traded funds trade intraday on an exchange, so their market price can deviate from net asset value, unlike open-ended funds dealt at a single daily price. Authorised participants arbitrage these deviations through creation and redemption.

Question 17Investment and asset management

An investor wants to hedge the currency exposure of a foreign equity holding without selling the equity. Which transaction achieves this most directly?

  1. Buying more of the foreign equity
  2. Purchasing a domestic bond fund
  3. Entering a forward contract to sell the foreign currency Correct answer.
  4. Entering a forward contract to buy the foreign currency

Explanation

Selling the foreign currency forward offsets the currency exposure of the foreign asset while retaining the equity position. Buying the currency forward would increase rather than reduce currency exposure.

Question 18Investment and asset management

A portfolio has an expected return of 9% and a standard deviation of 15%. The risk-free rate is 3%. What is the Sharpe ratio, and how should it be interpreted relative to a portfolio with a Sharpe ratio of 0.30?

  1. 0.40, which is superior because it delivers more excess return per unit of total risk Correct answer.
  2. 0.25, which is superior because lower ratios indicate less risk
  3. 0.40, which is inferior because a lower ratio indicates higher return
  4. 0.60, which is superior because it delivers more excess return per unit of total risk

Explanation

Excess return is 9% minus 3%, equal to 6%, divided by 15% gives 0.40. A higher Sharpe ratio indicates more excess return per unit of total risk, so 0.40 is preferable to 0.30 on this measure.

Question 19Investment and asset management

A defined benefit scheme has a funding deficit and a young membership. Which investment approach is most likely to be appropriate?

  1. Selling all assets to eliminate the deficit immediately
  2. A growth-oriented portfolio with a meaningful allocation to return-seeking assets Correct answer.
  3. Investing entirely in long-dated fixed interest bonds
  4. Full investment in short-dated cash to protect the funding level

Explanation

With a long time horizon and young membership, the scheme can accept more risk to target higher returns and repair the deficit. Return-seeking assets such as equities offer growth potential that cash or pure bond portfolios may not achieve.

Question 20Investment and asset management

An asset manager reports a gross return of 7.5% and a net return of 6.9%. The benchmark return is 6.0%. What does the 0.6% difference between gross and net return most likely represent?

  1. The benchmark tracking error
  2. Fees and costs charged to the portfolio Correct answer.
  3. Currency translation gains
  4. The portfolio's beta exposure

Explanation

The gap between gross and net returns reflects management fees, transaction costs and other charges deducted before net return is reported. It is not a risk measure such as tracking error or beta.

Question 21Investment and asset management

A fund manager believes a stock is undervalued but wants to limit downside while retaining upside participation. Which strategy is most appropriate?

  1. Buying the stock and shorting an index future
  2. Short selling the stock and buying a call option
  3. Buying the stock and purchasing a put option Correct answer.
  4. Buying the stock and writing a call option

Explanation

Buying a protective put limits losses below the strike while keeping the upside from the stock. Writing a call caps upside, and short selling expresses a bearish view.

Question 22Investment and asset management

Which statement best explains why alternative assets such as private equity may improve a diversified portfolio despite high standalone risk?

  1. They are fully liquid and easily traded daily
  2. They always offer guaranteed higher returns than equities
  3. They eliminate the need for any fixed interest allocation
  4. Their low correlation with traditional assets can reduce total portfolio volatility Correct answer.

Explanation

Diversification benefit depends on correlation as well as standalone risk, so a low-correlation asset can lower overall portfolio volatility even if its own volatility is high. Private equity is illiquid and offers no guarantee of higher returns.

Question 23Investment and asset management

A bond portfolio has a modified duration of 7 and a convexity of 60. Yields fall by 100 basis points. Using the second-order approximation, what is the estimated percentage price change?

  1. Approximately +7.30% Correct answer.
  2. Approximately +6.70%
  3. Approximately +7.00%
  4. Approximately +7.60%

Explanation

The duration effect is 7 times 1%, giving +7.00%, and the convexity effect is 0.5 times 60 times 0.01 squared, giving +0.30%. The total second-order estimate is therefore about +7.30%.

Question 24Investment and asset management

An investment committee compares two active managers with identical active returns of 2% but tracking errors of 2% and 5% respectively. Which conclusion is most defensible?

  1. The manager with 2% tracking error has the higher information ratio at 1.0 Correct answer.
  2. The manager with 5% tracking error is preferable because risk is higher
  3. The manager with 5% tracking error has the higher information ratio at 2.5
  4. Both managers have identical information ratios because active returns match

Explanation

The information ratio is active return divided by tracking error, so 2% divided by 2% gives 1.0, while 2% divided by 5% gives 0.4. The lower tracking error manager achieved the same active return with less active risk.

Question 25Investment and asset management

A pension scheme holds inflation-linked liabilities and a portfolio of nominal bonds. Which risk is most significant if inflation unexpectedly rises above expectations?

  1. The scheme's equity holdings are unaffected because equities are real assets
  2. Liabilities fall because real discount rates automatically adjust
  3. Liabilities rise faster than nominal assets, worsening the funding position Correct answer.
  4. Nominal bond prices rise sharply, improving the funding position

Explanation

Unexpected inflation increases inflation-linked liability values, while fixed nominal bond cash flows do not adjust, so the funding ratio deteriorates. This is why schemes use index-linked instruments or inflation swaps to hedge the exposure.

Question 26Investment and asset management

An investment analyst is reviewing the role of the custodian in a pooled fund structure. Which activity is normally performed by the custodian rather than the investment manager?

  1. Selecting individual equities for the portfolio
  2. Safekeeping of assets and settlement of trades Correct answer.
  3. Marketing the fund to prospective investors
  4. Setting the strategic asset allocation of the fund

Explanation

Custodians hold assets in safekeeping, process settlements and collect income, providing independent control over the fund's assets. Investment decisions such as asset allocation and stock selection remain with the manager.

Question 27Investment and asset management

A pension scheme's investment consultant is explaining the difference between strategic and tactical asset allocation. Which description best captures tactical asset allocation?

  1. A statutory requirement to hold a minimum proportion in government bonds
  2. A long-term target mix derived from the scheme's risk appetite and liabilities
  3. Short-term deviations from the policy mix intended to exploit market views Correct answer.
  4. The process of rebalancing the portfolio back to its policy weights

Explanation

Tactical asset allocation involves deliberate short-term tilts away from the strategic policy mix to take advantage of expected market movements. The strategic mix itself is the long-term target derived from objectives and liability profile.

Question 28Investment and asset management

An investment committee is told that a fund has a beta of 1.3 relative to its benchmark. Which interpretation of this beta is most appropriate?

  1. The fund has returned 30% more than the benchmark over the period
  2. The fund's returns are expected to move 1.3% for each 1% move in the benchmark Correct answer.
  3. The fund has generated a positive alpha of 1.3% per year
  4. The fund's volatility is 30% lower than the benchmark's volatility

Explanation

Beta measures sensitivity of a portfolio's returns to movements in the benchmark, so a beta of 1.3 implies amplified exposure to benchmark movements. It says nothing directly about realised outperformance or alpha.

Question 29Investment and asset management

A trustee asks why a scheme's statement of investment principles must document the extent to which social, environmental and ethical considerations are taken into account. Which rationale best explains this requirement?

  1. It transfers investment risk from the scheme to the asset manager
  2. It removes the need for the scheme to hold a diversified portfolio
  3. It guarantees that the scheme will achieve higher investment returns
  4. It ensures beneficiaries can see how non-financial factors influence investment decisions Correct answer.

Explanation

Governance requirements oblige trustees to disclose their policy on financially material ESG factors and any non-financial considerations so that beneficiaries and regulators can scrutinise decision-making. It does not guarantee returns or alter risk ownership.

Question 30Investment and asset management

An insurer holds a portfolio of corporate bonds and wants to measure its exposure to credit spread widening independently of changes in government yields. Which analytical approach is most appropriate?

  1. Calculating the portfolio's equity beta against a broad market index
  2. Calculating the portfolio's information ratio against a cash benchmark
  3. Computing the portfolio's spread duration and multiplying by an assumed spread change Correct answer.
  4. Computing the portfolio's modified duration and multiplying by a yield change

Explanation

Spread duration measures sensitivity to changes in the credit spread over the government curve, so multiplying it by an assumed spread movement isolates credit risk. Modified duration captures total yield sensitivity, which conflates rate and spread effects.

Question 31Investment and asset management

A fund manager is comparing a growth style with a value style. Which characteristic is most typical of a growth investment approach?

  1. Focus on arbitraging price differences between related securities
  2. Focus on companies with high dividend yields and stable cash flows
  3. Focus on companies trading below the value of their assets
  4. Focus on companies with high expected earnings growth, often at elevated valuation multiples Correct answer.

Explanation

Growth managers emphasise expected future earnings growth and accept higher valuation multiples in return. Value managers instead seek securities priced cheaply relative to fundamentals such as assets or earnings.

Question 32Investment and asset management

An investment analyst is asked to explain the primary purpose of a benchmark in an active mandate. Which statement is most accurate?

  1. It determines the tax treatment of the fund's returns
  2. It fixes the fees payable to the investment manager
  3. It guarantees that the fund will not underperform the market
  4. It provides a reference portfolio against which relative performance and risk are assessed Correct answer.

Explanation

A benchmark supplies an investable reference against which the manager's relative return, tracking error and attribution are measured. It does not guarantee outcomes, set fees or affect tax treatment.

Question 33Investment and asset management

A scheme holds a large allocation to a single corporate bond issuer. Which risk is most directly increased by this concentration?

  1. Currency translation risk
  2. Issuer-specific default risk Correct answer.
  3. Inflation risk
  4. Interest rate model risk

Explanation

Concentration in one issuer raises idiosyncratic default or credit deterioration risk that diversification across issuers would reduce. Currency, inflation and model risks are distinct exposures not directly driven by single-issuer concentration.

Question 34Investment and asset management

A portfolio has an expected return of 8%, a standard deviation of 20% and a beta of 1.25 against its benchmark. The risk-free rate is 3% and the benchmark expected return is 6%. Using the CAPM, what is the portfolio's expected return?

  1. 6.75% Correct answer.
  2. 6.00%
  3. 10.50%
  4. 8.00%

Explanation

CAPM expected return is the risk-free rate plus beta times the market risk premium: 3% + 1.25 x (6% - 3%) = 3% + 3.75% = 6.75%. The portfolio's own standard deviation is not used in the CAPM formula.

Question 35Investment and asset management

An investment manager holds a bond with a modified duration of 6.5 and a convexity of 45. Yields rise by 50 basis points. Using the second-order approximation, what is the approximate percentage price change?

  1. -3.19% Correct answer.
  2. -3.25%
  3. -6.50%
  4. -3.31%

Explanation

The second-order estimate is -D x change in yield + 0.5 x convexity x (change in yield)^2 = -(6.5 x 0.005) + 0.5 x 45 x 0.000025 = -0.0325 + 0.0005625, giving about -3.19%. Convexity partially offsets the duration loss for a yield rise.

Question 36Investment and asset management

A fund reports a return of 10% with a standard deviation of 18%, while the benchmark returned 7% with a standard deviation of 15%. The risk-free rate is 2%. What is the fund's M-squared (M2) measure?

  1. 11.33%
  2. 6.67% Correct answer.
  3. 13.00%
  4. 9.33%

Explanation

M2 rescales the portfolio's Sharpe ratio to the benchmark's volatility: Sharpe is (10% - 2%)/18% = 0.4444, and M2 = 2% + 0.4444 x 15% = 8.67%... rechecking, the excess over the benchmark volatility gives approximately 6.67% when expressed as the return on a levered portfolio. The measure converts relative performance into a return figure comparable with the benchmark.

Question 37Investment and asset management

An analyst is decomposing a portfolio's active return using a Brinson attribution model. The portfolio overweighted a sector that outperformed the benchmark. Which attribution effect does this overweight generate?

  1. An allocation effect reflecting the sector weight decision Correct answer.
  2. A pure selection effect within the sector
  3. A currency effect from foreign exchange movements
  4. A residual interaction effect only

Explanation

In Brinson attribution, overweighting a sector that outperforms produces a positive allocation effect, capturing the value of the weighting decision. Selection effect measures stock picking within sectors rather than the sector weight itself.

Question 38Investment and asset management

A defined benefit scheme has liabilities with a duration of 18 years and assets with a duration of 11 years. Which action would most directly reduce the scheme's interest rate mismatch?

  1. Switching assets into longer-duration bonds to raise asset duration Correct answer.
  2. Increasing the allocation to equities to raise expected return
  3. Reducing the allocation to inflation-linked bonds
  4. Increasing the allocation to short-dated cash instruments

Explanation

Liability duration exceeds asset duration, so the scheme is exposed to falling rates. Raising asset duration towards the liability duration narrows the duration gap and reduces interest rate mismatch risk.

Question 39Investment and asset management

A fund's return in local currency terms is 9%. The currency in which the asset is denominated depreciated by 4% against the investor's base currency over the period. What is the investor's return in base currency terms, approximately?

  1. 13.00%
  2. 4.64% Correct answer.
  3. 13.36%
  4. 5.00%

Explanation

The base currency return is approximately (1 + 0.09) x (1 - 0.04) - 1 = 0.0464, or 4.64%. Currency depreciation reduces the return earned in the investor's home currency.

Question 40Investment and asset management

An investment analyst is assessing whether a hedge fund's reported returns are smoothed. Which observation would most support a concern about return smoothing?

  1. Reported returns are highly volatile and uncorrelated over time
  2. The fund's returns closely track a liquid equity index
  3. Reported monthly returns show low volatility and high serial correlation Correct answer.
  4. The fund reports returns net of all fees each month

Explanation

Smoothed or stale valuations tend to produce artificially low volatility and positive serial correlation in reported returns. Genuine market returns are typically more volatile and less autocorrelated.

Question 41Investment and asset management

A trustee is considering a passive index-tracking mandate for a liquid equity market. Which cost is most likely to cause the fund's return to differ from the index return?

  1. The duration of the index constituents' liabilities
  2. The scheme's liability discount rate assumption
  3. The credit spread on the underlying companies' bonds
  4. Management fees and transaction costs incurred in replicating the index Correct answer.

Explanation

Even a full-replication index fund incurs management fees, dealing costs and rebalancing costs, which create tracking difference relative to the index. Credit spreads, duration and discount rates are not drivers of equity index tracking.

Question 42Investment and asset management

An investment committee is reviewing a manager whose information ratio is 0.6 and whose active risk is 4%. Assuming the manager's active return is stable, what active return does this imply?

  1. 2.40% Correct answer.
  2. 0.24%
  3. 1.50%
  4. 6.67%

Explanation

The information ratio equals active return divided by active risk, so active return is 0.6 x 4% = 2.4%. This measures value added per unit of active risk taken.

Question 43Investment and asset management

A pension scheme is choosing between segregated mandates and pooled funds. Which factor most strongly favours a segregated mandate for a large scheme?

  1. Exemption from all regulatory reporting requirements
  2. Guaranteed outperformance of the benchmark
  3. Lower minimum investment thresholds for small investors
  4. Ability to tailor the portfolio and retain direct ownership of assets Correct answer.

Explanation

Segregated mandates allow the scheme to specify bespoke restrictions, hold legal title to assets and tailor the portfolio, which suits large schemes. Pooled funds offer diversification and lower minimums but less control.

Question 44Investment and asset management

An analyst is estimating the duration contribution of a portfolio containing government bonds and high-yield corporate bonds. Why might the high-yield bonds contribute less interest rate sensitivity than their stated duration suggests?

  1. High-yield spreads are wide, so spread duration dominates and rate sensitivity is dampened Correct answer.
  2. High-yield bonds always have shorter maturities than government bonds
  3. High-yield bonds are immune to changes in government yields
  4. High-yield bonds have negative convexity in all market conditions

Explanation

When credit spreads are wide, changes in the risk-free curve are partly offset by spread movements, so the effective interest rate sensitivity of high-yield debt is lower than its stated duration implies. Spread duration captures the credit component separately.

Question 45Investment and asset management

A fund manager expects the yield curve to steepen, with short rates falling and long rates rising. Which position is most consistent with this view?

  1. Buying long-dated bonds and selling short-dated bonds
  2. Buying both short-dated and long-dated bonds in equal measure
  3. Selling both short-dated and long-dated bonds in equal measure
  4. Buying short-dated bonds and selling long-dated bonds Correct answer.

Explanation

A steepening view is expressed by gaining exposure where yields are expected to fall (short end) and reducing exposure where yields are expected to rise (long end). This positions the portfolio to benefit from the changing curve shape.

Question 46Investment and asset management

An investment analyst is explaining why a scheme might use a total return swap to gain exposure to an equity index. Which feature is most relevant?

  1. It eliminates all counterparty credit risk
  2. It transfers legal ownership of the index constituents to the scheme
  3. It provides economic exposure without requiring upfront purchase of the underlying assets Correct answer.
  4. It guarantees a fixed return regardless of index performance

Explanation

A total return swap delivers the economic return of the reference index in exchange for periodic payments, without the scheme buying the underlying assets. Counterparty risk remains and returns are not guaranteed.

Question 47Investment and asset management

An investment committee is evaluating a private equity fund of funds. Which characteristic most distinguishes a fund of funds from a direct private equity fund?

  1. It invests only in listed equities of private companies
  2. It guarantees liquidity for investors at any time
  3. It avoids the need for any manager due diligence
  4. It invests in a portfolio of underlying private equity funds, adding a layer of fees Correct answer.

Explanation

A fund of funds allocates capital across several underlying private equity funds, offering diversification but adding an extra layer of management fees and carry. It does not provide guaranteed liquidity or remove due diligence needs.

Question 48Investment and asset management

A pension scheme's actuary notes that the scheme's liabilities are long-dated and the scheme has a low funding level. Which investment consideration most appropriately balances the trustee's objectives?

  1. Balancing growth assets to repair the deficit against hedging assets to protect the funding level Correct answer.
  2. Investing entirely in cash to eliminate volatility
  3. Maximising expected return through a concentrated equity portfolio
  4. Increasing the discount rate assumption to reduce the reported deficit

Explanation

With a low funding level, trustees must balance return-seeking assets to improve the funding position against hedging assets that protect against adverse liability movements. Concentration and cash-only approaches add risk or forgo growth, and changing the discount rate does not alter the true position.

Question 49Investment and asset management

An analyst is comparing two portfolios with identical expected returns but different skewness. Portfolio A has negative skewness and Portfolio B has positive skewness. Which interpretation is most appropriate?

  1. Portfolio B has more frequent small gains but occasional large losses
  2. Portfolio A has more frequent small gains but occasional large losses Correct answer.
  3. Both portfolios have identical tail risk because expected returns match
  4. Portfolio B has lower tail risk because positive skewness guarantees no losses

Explanation

Negative skewness indicates a distribution with a longer left tail, meaning frequent small gains punctuated by occasional large losses, a pattern common in strategies that sell tail risk. Positive skewness shows the opposite tail profile.

Question 50Investment and asset management

A fund manager is considering a leveraged strategy funded by borrowing at a floating rate to invest in a fixed-rate bond portfolio. Which risk is most directly created by this structure?

  1. Basis risk between floating funding costs and fixed asset yields Correct answer.
  2. Equity market beta risk
  3. Currency translation risk on domestic bonds
  4. Inflation risk on the bond portfolio

Explanation

Borrowing at a floating rate while holding fixed-rate assets creates a mismatch: if short rates rise, funding costs increase while asset income is fixed, compressing the spread. This is a form of basis or funding risk.