A trustee holds US large-cap equity, high-yield bonds and listed real estate and regards them as three diversifying asset classes. A risk analysis shows that most of each holding's volatility is explained by equity-market and credit-spread factors that rise together in downturns. What would a factor-based approach conclude?

The portfolio is less diversified than the asset-class labels suggest, with risk concentrated in a common growth factor

A committee proposes adding high-dividend stocks as a separate asset class. The holdings are spread across the domestic large-cap universe and the group has a 0.97 correlation with the broad large-cap index. Which criterion for a useful asset class does the proposal most clearly fail?

Low correlation with the other asset classes in the policy

Lena expects US inflation of 3.0% and euro-area inflation of 1.5% over the next year, and she believes relative purchasing power parity will hold over that horizon. The spot rate is quoted as USD per EUR. What does she forecast for the spot rate?

USD per EUR rises about 1.5%, so the USD depreciates

CFA Level III Asset Allocation Practice Questions

Official outline: CFA Institute Level III exam topics and pathways
Questions on this page: 5
Updated: Nov 3, 2026

Question 1, medium
A trustee holds US large-cap equity, high-yield bonds and listed real estate and regards them as three diversifying asset classes. A risk analysis shows that most of each holding's volatility is explained by equity-market and credit-spread factors that rise together in downturns. What would a factor-based approach conclude?
- A.Diversification is adequate because each holding has a different label, benchmark and manager
- B.The portfolio is less diversified than the asset-class labels suggest, with risk concentrated in a common growth factor
- C.Factors cannot inform allocation because they are not directly investable securities, so asset-class weights remain the working unit
- D.Factor correlations matter for liquidity planning, while asset-class weights remain the best measure of diversification
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Correct answer: B. The portfolio is less diversified than the asset-class labels suggest, with risk concentrated in a common growth factor
Factor-based allocation looks through asset-class labels to underlying risk drivers. Assets loading on the same factor provide little diversification when that factor falls.
- A. Labels do not create diversification; common factor exposure does.
- B. Correct: the holdings share exposure to the same underlying factor.
- C. Factors can be accessed through factor-tilted or long-short strategies and are used in allocation.
- D. Factor correlations bear directly on diversification, not just liquidity.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 2, medium
A committee proposes adding high-dividend stocks as a separate asset class. The holdings are spread across the domestic large-cap universe and the group has a 0.97 correlation with the broad large-cap index. Which criterion for a useful asset class does the proposal most clearly fail?
- A.Sufficient liquidity to hold meaningful positions without moving prices when the portfolio trades
- B.Homogeneity of the securities within the group
- C.Low correlation with the other asset classes in the policy
- D.A long enough return history to estimate risk and return
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Correct answer: C. Low correlation with the other asset classes in the policy
A useful asset class should be diversifying, with low correlation to other classes. A group correlated 0.97 with large-cap equity adds little diversification, so it is better treated as a tilt within equity.
- A. Large-cap dividend stocks are generally liquid, so liquidity is not the problem.
- B. Homogeneity is not the main issue raised by the 0.97 correlation.
- C. Correct: the high correlation shows little diversification benefit.
- D. History length is unrelated to the facts given.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 3, medium
A pension plan begins the year with assets of 900 and a present value of liabilities of 1,000 (EUR millions). Assets return 8.0% and the liabilities grow 5.0% for the year. There are no contributions or benefit payments. What is the funded ratio at year end?
- A.93.0%
- B.90.0%
- C.92.6%
- D.97.2%
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Correct answer: C. 92.6%
Ending assets = 900 x 1.08 = 972. Ending liabilities = 1,000 x 1.05 = 1,050. Funded ratio = 972 / 1,050 = 92.6%. The plan remains underfunded because liabilities grew.
- A. Adds the 3-point return gap to the starting 90.0% ratio, which ignores compounding on different bases.
- B. Reports the starting funded ratio, ignoring that assets and liabilities both changed.
- C. Correct: 972 / 1,050 = 92.6%.
- D. Divides ending assets by the starting liabilities, ignoring liability growth.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 4, easy
Ines evaluates a candidate portfolio with an expected return of 7.0% and a standard deviation of 12.0%. Her risk aversion coefficient is 4, and she uses the mean-variance utility U = E(R) - 0.005 x lambda x variance, with return and standard deviation in percent. What is the portfolio's utility?
- A.6.76
- B.4.12
- C.5.56
- D.9.88
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Correct answer: B. 4.12
Variance is 12.0 squared = 144. Penalty = 0.005 x 4 x 144 = 2.88. Utility = 7.0 - 2.88 = 4.12. Risk aversion of 4 scales the variance penalty.
- A. Uses the standard deviation (12) rather than the variance (144) in the penalty.
- B. Correct: 7.0 - 0.005 x 4 x 144 = 4.12.
- C. Uses 0.01 and ignores risk aversion, giving 7.0 - 1.44.
- D. Adds the risk penalty instead of subtracting it.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 5, medium
Lena expects US inflation of 3.0% and euro-area inflation of 1.5% over the next year, and she believes relative purchasing power parity will hold over that horizon. The spot rate is quoted as USD per EUR. What does she forecast for the spot rate?
- A.USD per EUR rises about 1.5%, so the USD depreciates
- B.USD per EUR falls about 1.5%, so the USD appreciates
- C.USD per EUR rises about 4.5%, so the USD depreciates
- D.USD per EUR is little changed because interest rates would offset the inflation gap
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Correct answer: A. USD per EUR rises about 1.5%, so the USD depreciates
Under relative PPP, the expected percentage change in the domestic-per-foreign spot rate is about domestic inflation minus foreign inflation: 3.0 - 1.5 = +1.5%. The higher-inflation currency (USD) is expected to depreciate.
- A. Correct: +1.5% in USD per EUR means the USD loses value.
- B. Reverses the sign; the currency with higher inflation depreciates, it does not appreciate.
- C. Adds the two inflation rates instead of taking the difference.
- D. Relative PPP is about inflation differentials; interest rate parity is a separate relationship and does not cancel the PPP forecast.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026

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