CFA Level III Pathway: Portfolio Management Practice Questions
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- CFA Institute Level III exam topics and pathways
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- 7
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- Nov 3, 2026
Over five months, an index fund's returns minus its benchmark's returns were +0.20%, -0.20%, +0.20%, -0.20% and 0.00%. Using the sample standard deviation of these monthly active returns and annualizing, what is the fund's tracking error?
- A.0.20%
- B.2.40%
- C.0.62%
- D.0.69%
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Correct answer: D. 0.69%
Mean active return is 0. Sum of squared deviations is 0.04x4 = 0.16 (in %-squared); sample variance = 0.16/4 = 0.04, so monthly TE = 0.20%. Annualized TE = 0.20% x sqrt(12) = 0.69%.
- A. 0.20% is the monthly figure and has not been annualized.
- B. Multiplying by 12 instead of the square root of 12 overstates tracking error.
- C. 0.62% results from dividing by n (population SD of 0.179%) instead of n-1 before annualizing.
- D. Right: 0.20% x 3.4641 = 0.69%.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
A portfolio manager holds 150 illiquid corporate bonds and wants to reduce credit-spread exposure for the next quarter without selling the bonds. Which action is most appropriate, and what risk does it leave?
- A.Sell protection on a CDS index, leaving basis risk because index constituents differ from the holdings
- B.Buy protection on a CDS index, leaving basis risk because index constituents differ from the holdings
- C.Sell Treasury futures, leaving no residual risk because spread risk is fully offset
- D.Enter a total return swap receiving a corporate bond index, leaving some tracking risk
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Correct answer: B. Buy protection on a CDS index, leaving basis risk because index constituents differ from the holdings
Buying CDS index protection gains when credit spreads widen, offsetting spread losses on the bond portfolio at lower transaction cost than selling illiquid bonds. The hedge is imperfect because the index's names, maturities and spreads differ from the holdings.
- A. Selling protection adds credit exposure rather than reducing it.
- B. Right: it is a short credit position that offsets spread exposure, with basis risk.
- C. Treasury futures hedge interest rate duration, not credit spread.
- D. Receiving a bond index return increases credit exposure.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Two portfolios have equal modified duration of 6.0. The barbell has convexity of 80 and the bullet has convexity of 45. Yields move by a large amount in a parallel shift. Ignoring yield differences, which statement is correct?
- A.The bullet outperforms because its lower convexity limits losses when yields rise sharply
- B.They perform the same because duration alone determines price change
- C.The barbell outperforms only when yields rise, because convexity benefits losses but not gains
- D.The barbell outperforms for a large move either way because higher convexity adds gain or cushions loss
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Correct answer: D. The barbell outperforms for a large move either way because higher convexity adds gain or cushions loss
Duration estimates price changes for small moves; convexity captures curvature. At equal duration, the higher-convexity barbell gains more when yields fall and loses less when yields rise, so it outperforms for large parallel shifts, other things equal.
- A. Lower convexity gives less cushion, not more.
- B. Equal duration matches only the first-order change; the second-order term still differs.
- C. Convexity adds value to price changes in both directions, not just for yield increases.
- D. Right: positive convexity helps in both directions, and more of it helps more.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
A bond portfolio has a key rate duration of 1.20 at the 5-year point versus 0.70 for its benchmark; all other key rate durations are equal. The 5-year par yield falls by 10 bps and no other key rate moves. What is the approximate return of the portfolio relative to the benchmark?
- A.+0.05%
- B.-0.05%
- C.+0.12%
- D.+0.50%
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Correct answer: A. +0.05%
Relative return is approximately -(1.20 - 0.70) x change in 5-year yield = -0.50 x (-0.10%) = +0.05%. The portfolio is overweight that key rate, so it gains when the 5-year yield falls.
- A. Right: a 0.50 duration overweight times a 0.10% yield drop yields +0.05%.
- B. The sign is wrong; an overweight benefits from a yield decline.
- C. 0.12% applies the full portfolio key rate duration (1.20 x 0.10%) rather than the active difference.
- D. 0.50% treats 10 bps as 1%.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
A trader must buy an amount equal to 15% of average daily volume in a mid-cap stock. The portfolio manager's signal is expected to decay within hours. Which statement about the cost trade-off is most accurate?
- A.Slower trading lowers both market impact and opportunity cost, so patience is preferred
- B.Market impact does not depend on order size relative to volume, so only the quoted spread matters for cost
- C.Faster trading raises market impact but cuts timing risk, so a short-lived signal justifies urgency
- D.A passive limit order eliminates timing risk because the execution price is fixed in advance
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Correct answer: C. Faster trading raises market impact but cuts timing risk, so a short-lived signal justifies urgency
Trading faster demands liquidity and increases market impact; trading slowly reduces impact but exposes the order to adverse price drift and, with decaying alpha, opportunity cost. A fast-decaying signal shifts the optimum toward quicker execution.
- A. Slower trading raises opportunity and drift cost when the signal is short-lived.
- B. Impact rises with participation rate and order size relative to volume.
- C. Right: the trade-off between impact and timing risk favors urgency when alpha decays quickly.
- D. A limit order fixes price but not whether it fills, so non-execution risk remains.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
A manager is considering a 5-year zero-coupon bond yielding 3.00% (annual compounding). The 4-year zero-coupon yield is 2.50%. Assuming the yield curve is unchanged one year from now, what is the approximate total return over the year?
- A.3.00%
- B.2.50%
- C.5.02%
- D.5.50%
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Correct answer: C. 5.02%
Price now = 100/1.03^5 = 86.26. In one year the bond is a 4-year zero priced at 100/1.025^4 = 90.60. Return = 90.60/86.26 - 1 = 5.02%, which is 3.00% accretion plus about 2.02% rolldown.
- A. 3.00% captures the bond's yield but ignores rolldown.
- B. 2.50% is the yield of the shorter bond, not a return measure.
- C. Right: price rises from 86.26 to 90.60 as the bond rolls down the upward-sloping curve.
- D. 5.50% adds the two yields together.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
A manager routes a large block order to a dark pool instead of displaying it on a lit exchange. Which pair best describes the main advantage and main drawback of this choice?
- A.Guaranteed full execution at the midpoint; higher commissions than exchanges
- B.Greater pre-trade transparency for price discovery; wider quoted spreads
- C.Less information leakage and market impact; uncertain execution and possible adverse selection
- D.Faster execution against displayed quotes; greater market impact
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Correct answer: C. Less information leakage and market impact; uncertain execution and possible adverse selection
Dark pools do not display orders pre-trade, which reduces signaling and impact for large orders. Drawbacks are no guarantee of a fill and the chance that fills occur when the price is about to move against the order (adverse selection).
- A. Execution is not guaranteed in a dark pool, and midpoint pricing does not ensure full fills.
- B. Dark pools have less, not more, pre-trade transparency.
- C. Right: hidden orders limit leakage but fills are uncertain and may be adversely selected.
- D. Dark pools offer no displayed quotes to trade against.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
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