Free CFA Level III: Portfolio Management Practice Questions

A is correct. The appraisal ratio is calculated as the portfolio's alpha (the return earned beyond what is explained by systematic risk exposure) divided by the portfolio's unsystematic (residual or idiosyncratic) risk. It measures the manager's ability to generate abnormal returns per unit of diversifiable risk taken.

B is incorrect because the total return divided by total volatility describes a variant of the return-to-volatility ratio. The Sharpe ratio uses excess return (over the risk-free rate) divided by total standard deviation.

C is incorrect because the excess return over the risk-free rate divided by beta describes the Treynor ratio, which measures risk-adjusted performance per unit of systematic risk, not the appraisal ratio.

B is correct. A covered call is primarily a yield enhancement (income) strategy. The writer earns premium income in exchange for capping the upside at the strike price. It works best when the writer expects the stock to remain flat or rise slightly, as the premium provides additional return above the stock's performance.

A is incorrect. Covered calls are conservative, not speculative. The strategy limits upside, making it unsuitable for maximizing capital gains. Speculative strategies would involve buying options or taking leveraged positions.

C is incorrect. Covered calls do not eliminate downside risk. The short call provides only limited downside protection (equal to the premium received). Below the breakeven point ($S_0 - c_0$), the position incurs losses.

A is correct. The Fundamental Law of Active Management shows that IR = IC x sqrt(BR). To increase active return (IR x tracking error) without increasing tracking error, the manager must increase the information ratio. This can be achieved by improving the information coefficient (forecasting skill) through better research, data, or analytical methods.
B is incorrect because increasing position sizes in high-conviction holdings would increase tracking error along with expected active return.
C is incorrect because concentrating the portfolio reduces breadth and increases idiosyncratic risk (tracking error), which does not maintain constant tracking error.