Chartered Financial Analyst Level III
Exam Practice Questions And Correct
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1.A CFA Level III candidate is evaluating a client’s investment policy
statement (IPS). Which of the following components is most likely
considered a constraint rather than an objective?
A. Target return requirement
B. Risk tolerance
C. Liquidity requirement
D. Preservation of purchasing power
Answer: C. Liquidity requirement
Liquidity requirements are constraints because they restrict the investment
opportunity set by determining when and how much cash must be
available. Objectives such as return requirements and risk tolerance define
desired outcomes, while liquidity, time horizon, taxes, and legal
considerations are generally classified as constraints.
2. An investment manager is creating an IPS for a high-net-worth
individual. The client states that avoiding any short-term losses is
, more important than achieving a specific return target. Which
behavioral characteristic does this statement most directly represent?
A. High risk capacity
B. Low risk tolerance
C. Long investment horizon
D. High return objective
Answer: B. Low risk tolerance
Risk tolerance reflects an investor’s willingness to accept uncertainty and
potential losses. A preference for avoiding short-term losses indicates a
low willingness to bear risk, regardless of the investor’s financial ability to
do so.
3. A portfolio manager uses historical returns, correlations, and
volatilities to determine the optimal combination of risky assets. This
approach is most closely associated with:
A. Behavioral finance theory
B. Modern portfolio theory
C. Arbitrage pricing theory
D. Capital preservation theory
Answer: B. Modern portfolio theory
Modern portfolio theory uses expected returns, risk measures, and
correlations among assets to construct efficient portfolios that maximize
expected return for a given level of risk.
4. A pension fund has liabilities extending 30 years into the future. The
portfolio manager decides to construct a portfolio whose duration
, closely matches the duration of the liabilities. This strategy is known
as:
A. Active equity management
B. Liability-driven investing
C. Tactical asset allocation
D. Security selection
Answer: B. Liability-driven investing
Liability-driven investing focuses on aligning portfolio characteristics,
especially duration and cash flows, with future obligations to reduce the
risk of failing to meet liabilities.
5. In the CFA Level III portfolio management process, the primary
purpose of an IPS is to:
A. Guarantee investment returns
B. Eliminate portfolio risk
C. Establish investment guidelines and objectives
D. Identify undervalued securities
Answer: C. Establish investment guidelines and objectives
An IPS provides a structured framework describing investor objectives,
constraints, risk preferences, and governance procedures. It guides
portfolio decisions rather than guaranteeing outcomes.
6. A portfolio manager believes that equity markets are temporarily
undervalued and increases the portfolio’s equity allocation above its
strategic target. This decision represents:
, A. Strategic asset allocation
B. Tactical asset allocation
C. Passive management
D. Liability immunization
Answer: B. Tactical asset allocation
Tactical asset allocation involves short-term deviations from strategic
asset allocation to exploit perceived market opportunities or valuation
differences.
7. A foundation requires annual distributions to fund charitable
activities. Which IPS constraint is most directly affected by this
requirement?
A. Tax considerations
B. Liquidity requirements
C. Legal constraints
D. Time horizon
Answer: B. Liquidity requirements
Regular charitable distributions create a need for available cash flows,
making liquidity a primary portfolio constraint.
8. A portfolio manager evaluates whether an active strategy has
generated excess returns after adjusting for systematic risk. Which
measure is most appropriate?
A. Sharpe ratio
B. Information ratio
C. Jensen’s alpha
D. Treynor ratio
Exam Practice Questions And Correct
Answers (Verified Answers) Plus
Rationale 2026 Q&A| Instant Download
1.A CFA Level III candidate is evaluating a client’s investment policy
statement (IPS). Which of the following components is most likely
considered a constraint rather than an objective?
A. Target return requirement
B. Risk tolerance
C. Liquidity requirement
D. Preservation of purchasing power
Answer: C. Liquidity requirement
Liquidity requirements are constraints because they restrict the investment
opportunity set by determining when and how much cash must be
available. Objectives such as return requirements and risk tolerance define
desired outcomes, while liquidity, time horizon, taxes, and legal
considerations are generally classified as constraints.
2. An investment manager is creating an IPS for a high-net-worth
individual. The client states that avoiding any short-term losses is
, more important than achieving a specific return target. Which
behavioral characteristic does this statement most directly represent?
A. High risk capacity
B. Low risk tolerance
C. Long investment horizon
D. High return objective
Answer: B. Low risk tolerance
Risk tolerance reflects an investor’s willingness to accept uncertainty and
potential losses. A preference for avoiding short-term losses indicates a
low willingness to bear risk, regardless of the investor’s financial ability to
do so.
3. A portfolio manager uses historical returns, correlations, and
volatilities to determine the optimal combination of risky assets. This
approach is most closely associated with:
A. Behavioral finance theory
B. Modern portfolio theory
C. Arbitrage pricing theory
D. Capital preservation theory
Answer: B. Modern portfolio theory
Modern portfolio theory uses expected returns, risk measures, and
correlations among assets to construct efficient portfolios that maximize
expected return for a given level of risk.
4. A pension fund has liabilities extending 30 years into the future. The
portfolio manager decides to construct a portfolio whose duration
, closely matches the duration of the liabilities. This strategy is known
as:
A. Active equity management
B. Liability-driven investing
C. Tactical asset allocation
D. Security selection
Answer: B. Liability-driven investing
Liability-driven investing focuses on aligning portfolio characteristics,
especially duration and cash flows, with future obligations to reduce the
risk of failing to meet liabilities.
5. In the CFA Level III portfolio management process, the primary
purpose of an IPS is to:
A. Guarantee investment returns
B. Eliminate portfolio risk
C. Establish investment guidelines and objectives
D. Identify undervalued securities
Answer: C. Establish investment guidelines and objectives
An IPS provides a structured framework describing investor objectives,
constraints, risk preferences, and governance procedures. It guides
portfolio decisions rather than guaranteeing outcomes.
6. A portfolio manager believes that equity markets are temporarily
undervalued and increases the portfolio’s equity allocation above its
strategic target. This decision represents:
, A. Strategic asset allocation
B. Tactical asset allocation
C. Passive management
D. Liability immunization
Answer: B. Tactical asset allocation
Tactical asset allocation involves short-term deviations from strategic
asset allocation to exploit perceived market opportunities or valuation
differences.
7. A foundation requires annual distributions to fund charitable
activities. Which IPS constraint is most directly affected by this
requirement?
A. Tax considerations
B. Liquidity requirements
C. Legal constraints
D. Time horizon
Answer: B. Liquidity requirements
Regular charitable distributions create a need for available cash flows,
making liquidity a primary portfolio constraint.
8. A portfolio manager evaluates whether an active strategy has
generated excess returns after adjusting for systematic risk. Which
measure is most appropriate?
A. Sharpe ratio
B. Information ratio
C. Jensen’s alpha
D. Treynor ratio
