Free CFA Level III: Portfolio Management Portfolio Construction Practice Questions

A is correct. Price improvement occurs when a trade executes at a price better than the prevailing quoted price for the customer. For a buy order, this means executing below the ask price, and specifically if below the midquote, the effective spread is narrower than the quoted spread. This represents a genuine cost saving for the investor.

Choice B is incorrect because executing a buy above the ask reflects adverse market impact and represents price deterioration (negative price improvement), not improvement. The buyer paid more than the quoted ask price.

Choice C is incorrect because a sell order executing below the bid reflects slippage and represents price deterioration for the seller, not improvement. Price improvement for a sell would be execution above the midquote.

B is correct. SWFs face complex, interconnected risks across large, globally diversified portfolios that include both public and private assets. Traditional VaR models, which rely on historical correlations and assume normal distributions, may underestimate the probability and impact of extreme tail events. Scenario analysis and stress testing allow SWFs to evaluate the impact of specific adverse scenarios (e.g., commodity price collapses, geopolitical crises) on the entire portfolio, capturing risk interactions that VaR misses.

Choice A is incorrect because SWFs generally have very long (often perpetual) investment horizons, not short ones. While daily monitoring may be used for liquid portfolios, the primary value of stress testing is in understanding long-term structural vulnerabilities.

Choice C is incorrect because SWFs are free to use any risk models they choose. The Santiago Principles address governance and transparency but do not restrict the use of standard quantitative models. Scenario analysis supplements (not replaces) standard quantitative models.

B is correct. Original expected return:
$$E(R_{orig}) = 0.20 \times 13\% + 0.30 \times 7\% + 0.50 \times 9\% = 2.60 + 2.10 + 4.50 = 9.20\%$$ Proposed (PE = 25%, HF = 25%, Eq = 50%):
$$E(R_{new}) = 0.25 \times 13\% + 0.25 \times 7\% + 0.50 \times 9\% = 3.25 + 1.75 + 4.50 = 9.50\%$$ Change: $9.50\% - 9.20\% = +0.30\%$, an increase of 30 basis points. Shifting 5% from the 7% hedge fund allocation to the 13% private equity allocation adds $0.05 \times (13\% - 7\%) = 0.05 \times 6\% = 0.30\%$ to portfolio expected return.
A is incorrect. A decrease of 30 basis points would occur if the reallocation moved weight from private equity to hedge funds (the opposite direction). Shifting from the lower-returning hedge fund allocation to the higher-returning private equity allocation increases expected return.
C is incorrect. While the portfolio weights always sum to 100%, the composition matters enormously for expected return. Changing the weight of a 13% asset versus a 7% asset by 5% produces a measurable difference of 30 basis points — the portfolio's weighted average return is not unchanged by reallocation.