1.

Elizabeth Ngobeni is a newly hired performance attribution analyst at an investment

consulting firm. Maria Mabaso is a senior research analyst at the firm and Ngobeni's
supervisor. Mabaso quizzes Ngobeni on her fundamental knowledge of factor models and
asks her to describe the arbitrage pricing theory (APT). Ngobeni responds by stating the
key underlying assumptions of APT:

Assumption 1:No arbitrage opportunities exist among well-diversified portfolios.

Assumption 2:Investors are able to form portfolios that are free of factor risk but
still subject to asset-specific risk.
Assumption 3:APT describes asset returns through the three factors of portfolio
beta, value, and market capitalization.

Ngobeni continues by comparing the Carhart model to CAPM and APT:

Comparison 1:The Carhart model is an APT model.

Comparison 2:The Carhart model is a multifactor extension of CAPM.
Comparison 3:Persistent market anomalies that are difficult to explain in a CAPM
framework are systematic risk factors in the Carhart model.

Mabaso then provides a statistical one-factor model, shown in Exhibit 1, that describes the
expected return for three equal dollar-weighted portfolios, along with their associated
expected returns and factor sensitivity. She asks Ngobeni to test for an arbitrage
opportunity with these three portfolios.

Mabaso shifts the discussion to the pros and cons of statistical fixed-income factor models,
and then to the potential benefits of factor models in strategic portfolio decision-making.
Ngobeni adds that in strategic portfolio decisions, multifactor models help investors to:

Comment
Develop more efficient, better diversified portfolios
1:
Comment
Allocate to risks in which investors have a comparative advantage
2:
Comment Develop market timing models between the market portfolio and a risk-free
3: asset to adjust risk exposure
 Question 1 of 6

Which of Ngobeni's assumptions regarding APT is correct?

a. Only Assumption 1
b. Only Assumption 2
c. Only Assumption 3

2. Question 2 of 6

Which of Ngobeni's comparisons are correct?

a. Comparison 1 and Comparison 2 only

b. Comparison 2 and Comparison 3 only
c. Comparison 1, Comparison 2, and Comparison 3

3. Question 3 of 6

Ngobeni uses APT to test for an arbitrage opportunity with the portfolios described in Exhibit
1. Which of the following is her best conclusion? An arbitrage opportunity:

a. is not possible.
b. is possible, by buying 100% of Portfolio B and shorting 100% of Portfolio A.
c. is possible, by buying 50% of Portfolio A and 50% of Portfolio B and shorting 100% of
Portfolio C.

4. Question 4 of 6

Which of the following best describes a potential weakness of statistical factor models?
Statistical factor models:

a. may lack meaningful economic explanation.

b. use observed company and stock attributes as factor betas.
c. require the prior identification of all factors that potentially impact security returns.

5. Question 5 of 6

Which of the following best describe examples of statistical fixed income factors?

a. Duration, credit, and currency

b. Real yields, momentum, and carry
c. Economic growth, inflation, and interest rates
6. Question 6 of 6

Which of Ngobeni's comments on strategic portfolio decisions are correct?

a. Comment 1 and Comment 2 only

b. Comment 2 and Comment 3 only
c. Comment 1, Comment 2, and Comment 3
7. Bob Jones is a senior research analyst for a United States university endowment. Jones is
considering hiring a new US equity manager for a portion of the endowment's equity
allocation. The new manager describes his investing style as a "multi-cap, go anywhere"
manager.

Jones analyzes the manager's performance over the past year using the Carhart four-factor
model relative to a market-capitalization weighted benchmark index based on the 500
largest US-listed stocks. The manager's security selection contributed −0.10% to his overall
return for this period. The factor sensitivities and returns are presented in Exhibit 1:

Jones then compares the new manager's historical performance with the endowment's
existing active equity managers using the same benchmark. This information is presented
in Exhibit 2:

Jones discusses the results presented in Exhibit 1 and Exhibit 2 with Jennifer Williams, a
junior research analyst at the endowment. Williams makes the following comments:

Comment 1:By squaring active risk, the various sources of a portfolio's active risk
components can be separated.
Comment 2:The components of active risk are systematic risk and residual risk.
Comment 3:The benchmark selection for the new manager may not be appropriate.

Williams believes that instead of hiring the new manager, the endowment would be better off
investing in an alternative index product. The bases for her belief are that alternative
 indexes:

Basis 1:capture systematic alpha exposures

Basis 2:cost less than traditional active managers
Basis 3:use a mechanical, rules-based process

Question 1 of 6

Based on Exhibit 1 and relative to the benchmark, the new US equity manager's investment
style biases are best described as:

a. large-capitalization, value.
b. small-capitalization, value.
c. small-capitalization, growth.

8. Question 2 of 6

Based on Exhibit 1, the new manager's active return from factor tilts is closest to:

a. 0.37%
b. 0.62%
c. 0.72%

9. Question 3 of 6

Based on Exhibit 2 and using the information ratio, which manager has demonstrated the
most investment skill?

a. Manager 1
b. Manager 2
c. New Manager

10. Question 4 of 6

Which of Williams's comments regarding active risk is (are) correct?

a. Only Comment 1
b. Only Comment 2
c. Both Comment 1 and Comment 2
11. Question 5 of 6

Based on Exhibits 1 and 2, which of the following is the most appropriate basis for
Williams's Comment 3?

a. Factor returns and tracking error

b. Factor exposures and factor returns
c. Factor exposures and tracking error

12. Question 6 of 6

Which of Williams's bases for her belief that the endowment should invest in an alternative
index product are correct?

a. Basis 1 and Basis 2

b. Basis 2 and Basis 3
c. Basis 1, Basis 2, and Basis 3
13. Ronald Jones, CFA, is a junior analyst at a buy-side firm. Jones has been tasked with
evaluating the three domestic equity funds that are used to construct the firm's model client
equity portfolio. Jones compares the funds to the model portfolio's broadly diversified
domestic equity benchmark.

The model portfolio equally weights each fund, and Jones has developed the following
fundamental single-factor model based on arbitrage pricing theory (APT).

Jones then constructs a four-factor APT model for Fund A using a 2% risk-free rate, which is
presented in Exhibit 2.

Jones also creates a new three-factor model for the firm's domestic bond fund (DBF) based
on industrial production, inflation, and corporate credit spreads. Corporate credit spreads
are calculated by comparing the yields on a broad-based corporate bond index to the five-
year government benchmark on a monthly basis. The portion of the return not explained by
the model was 0.5%. The details of the DBF model are presented in Exhibit 3, and the
previous month's model inputs are shown in Exhibit 4.
 Question 1 of 6

Based on the information provided and Exhibit 1, if an APT arbitrage opportunity did exist
between the model equity portfolio and the benchmark index, which of the following is least
likely responsible for this outcome?

a. The portfolios are not well-diversified.

b. The universe of suitable investable assets is too limited.
c. The factor model does not accurately describe asset returns.

14. Question 2 of 6

Based on the information provided and Exhibit 1, the arbitrage opportunity between the
model equity portfolio and the benchmark index is best described as:

a. no arbitrage opportunity exists.

b. shorting the benchmark and using the proceeds to buy the portfolio.
c. shorting the portfolio and using the proceeds to buy the benchmark.

15. Question 3 of 6

Assuming Jones' model in Exhibit 2 is a Carhart four-factor model, it most likely incorporates
factor risk premiums that would be considered:

a. pure factors.
b. statistical factors.
c. market anomalies under CAPM.
16. Question 4 of 6

Based on the information provided and Exhibit 2, and assuming the APT assumptions hold,
the expected return for Fund A based on APT is closest to:

a. 5.30%
b. 7.30%
c. 9.30%

17. Question 5 of 6

The three-factor model presented in Exhibits 3 and 4 is best described as a:

a. statistical factor model.

b. fundamental factor model.
c. macroeconomic factor model.

18. Question 6 of 6

Based on the information provided in Exhibits 3 and 4, the return on the domestic bond fund
in the previous month is closest to:

a. 0.72%
b. 1.92%
c. 2.42%
19. Elif Yildiz is an equity portfolio manager at a corporate pension plan. The plan invests in
multiple equity funds, each managed by a different manager. Yildiz is conducting a search
for a new equity manager who would diversify the existing mix of purely fundamental,
bottom-up managers.

Yildiz instructs Anushka Patel, a research analyst at the plan, to prepare information on
three new managers who invest predominately with a top-down macro approach, minimizing
stock selection risk. This information is presented in Exhibit 1:

Yildiz then reviews last year's factor sensitivity and return information for the Value Fund,
one of the current equity funds used by the plan. Yildiz notes the benchmark for the Value
Fund is appropriate. This information is presented in Exhibit 2:

Yildiz expects the equity momentum factor to outperform over the near term and is
concerned about the pension plan's active exposure to this factor. She asks Patel to identify
three factor portfolios that could be added to the plan to hedge the momentum risk
exposure. These portfolios are presented in Exhibit 3:
Yildiz then considers the plan's asset allocation mix. The plan uses a two-factor
macroeconomic model to assist in asset allocation weighting decisions. Based on the plan's
diversified asset allocation approach, the weighted average factor risk premium for the
portfolio is 2.5%. The portion of the return not explained by the two-factor macroeconomic
model is 0.5%. Information for the last year is presented in Exhibit 4:

Patel then reminds Yildiz of the multiple risk dimensions that must be considered when
arriving at an asset allocation policy. Patel makes the following statement regarding the
pension plan:

"The plan is sponsored by a highly leveraged cyclical company whose revenue

and profitability are very sensitive to economic fluctuations. The plan's
participants are relatively young compared with many other plans in the same
industry."

Question 1 of 6

Based on Exhibit 1, the manager who most closely aligns with Yildiz's desired investment
profile is:

a. Manager A.
b. Manager B.
c. Manager C.
20. Question 2 of 6

Based on Exhibit 1, the manager with the greatest information ratio is:

a. Manager A.
b. Manager B.
c. Manager C.

21. Question 3 of 6

Based on Exhibit 2, the active return for the Value Fund is closest to:

a. −0.32%
b. 0.43%
c. 1.07%

22. Question 4 of 6

Based on Exhibit 3, to hedge the plan's momentum factor exposure, it is most appropriate to
use a long position in:

a. Portfolio A.
b. Portfolio B.
c. Portfolio C.

23. Question 5 of 6

Based on the information provided on the macroeconomic factor model and Exhibit 4, the
plan's expected return last year was closest to:

a. 4.7%
b. 8.0%
c. 9.7%

24. Question 6 of 6

Based on Patel's statement, the pension plan most likely has a comparative advantage in
bearing which type of risk?

a. Inflation
b. Liquidity
c. Business cycle