A bank funds a securities portfolio with short-term deposits that reprice quarterly. The portfolio is mostly fixed-rate bonds with an average remaining life of 7 years. Market short-term rates rise sharply. What is the most likely effect on the bank's net interest margin?

It narrows because funding costs reset upward before the fixed asset yields can adjust

A client has both a taxable account and a tax-deferred retirement account. She holds an index equity fund with low turnover and a taxable bond fund that pays high ordinary income. Which asset location is generally most tax-efficient?

Bond fund in the tax-deferred account and the equity index fund in the taxable account

An investment committee is deciding where to place active versus passive mandates in a global equity program. It believes that large-capitalization developed-market stocks are priced very efficiently and that small-cap and emerging-market segments are less efficient. Which blend is most consistent with this view?

Passive in large-cap developed markets, with active risk concentrated in small-cap and emerging markets

A government establishes a sovereign wealth fund whose purpose is to cushion the national budget when commodity export prices fall. Withdrawals may be required on short notice. Which investment policy is most consistent with this mandate?

A high liquidity priority, capital preservation focus, and low allocation to illiquid assets

A pension plan wants to raise its effective equity exposure from 55% to 60% for several months without asking its external managers to sell holdings or changing their mandates. Which approach is the most direct?

An equity index futures overlay backed by cash held within the plan

CFA Level III Portfolio Construction Practice Questions

Official outline: CFA Institute Level III exam topics and pathways
Questions on this page: 6
Updated: Nov 3, 2026

Question 1, easy
A bank funds a securities portfolio with short-term deposits that reprice quarterly. The portfolio is mostly fixed-rate bonds with an average remaining life of 7 years. Market short-term rates rise sharply. What is the most likely effect on the bank's net interest margin?
- A.It widens because higher market rates raise the yield on the existing fixed-rate bonds immediately
- B.It narrows because funding costs reset upward before the fixed asset yields can adjust
- C.It widens because the market value of the bonds falls and increases their yield
- D.It is unchanged because deposits and securities both reprice at the same pace
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Correct answer: B. It narrows because funding costs reset upward before the fixed asset yields can adjust
With short-term liabilities funding long fixed-rate assets, liability costs rise before asset income does, compressing the spread. Banks manage this repricing gap through asset-liability matching.
- A. Wrong: coupons on existing fixed-rate bonds do not change when market rates rise.
- B. Correct: short liabilities reprice faster than long fixed assets.
- C. Wrong: a price decline raises yield for new purchasers, not the income on holdings already owned.
- D. Wrong: the stem says deposits reprice quarterly and the bonds are long-dated, so repricing is mismatched.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 2, easy
A client has both a taxable account and a tax-deferred retirement account. She holds an index equity fund with low turnover and a taxable bond fund that pays high ordinary income. Which asset location is generally most tax-efficient?
- A.Both holdings in the taxable account to simplify reporting
- B.Bond fund in the tax-deferred account and the equity index fund in the taxable account
- C.Both holdings in the tax-deferred account to maximize deferral
- D.Equity index fund in the tax-deferred account and bond fund in the taxable account
Show answer and explanationHide answer
Correct answer: B. Bond fund in the tax-deferred account and the equity index fund in the taxable account
Placing income-heavy, tax-inefficient assets in tax-deferred accounts and tax-efficient, low-turnover equity in taxable accounts typically raises after-tax wealth.
- A. Wrong: this wastes the tax-deferred shelter and leaves high ordinary income taxed currently.
- B. Correct: ordinary income is sheltered while equity gains defer and may receive lower rates.
- C. Wrong: it leaves no assets in the taxable account for liquidity and forgoes favorable treatment of equity gains.
- D. Wrong: this exposes high ordinary income to current tax and wastes the shelter on a tax-efficient holding.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 3, medium
An investment committee is deciding where to place active versus passive mandates in a global equity program. It believes that large-capitalization developed-market stocks are priced very efficiently and that small-cap and emerging-market segments are less efficient. Which blend is most consistent with this view?
- A.A fully passive program because the committee's views on efficiency would reduce net alpha after fees
- B.Equal active risk across all segments since expected alpha cannot be predicted by market segment
- C.Active in the large-cap developed segment where information is abundant and passive elsewhere
- D.Passive in large-cap developed markets, with active risk concentrated in small-cap and emerging markets
Show answer and explanationHide answer
Correct answer: D. Passive in large-cap developed markets, with active risk concentrated in small-cap and emerging markets
Active management is most likely to add value net of costs where inefficiency and dispersion exist. Passive exposure is cost-efficient where markets are highly efficient.
- A. Wrong: the committee's view supports active management in some segments, not a blanket passive approach.
- B. Wrong: the stated view implies expected alpha opportunities differ by segment.
- C. Wrong: this reverses the efficiency view stated by the committee.
- D. Correct: allocate active risk to the less efficient segments.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 4, hard
A plan sponsor allocates 50% each to two active managers with tracking errors of 8% and 6% against the same benchmark. Their active returns are uncorrelated. What is the tracking error of the combined portfolio?
- A.10.0%
- B.3.5%
- C.7.0%
- D.5.0%
Show answer and explanationHide answer
Correct answer: D. 5.0%
TE = sqrt(0.5^2 x 8^2 + 0.5^2 x 6^2) = sqrt(16 + 9) = sqrt(25) = 5.0%. Uncorrelated active returns diversify, so TE is below the 7.0% weighted average.
- A. Wrong: this adds the tracking errors without weights or diversification.
- B. Wrong: this halves the average and ignores the required squared terms.
- C. Wrong: this is the simple average of the two tracking errors, which assumes perfect correlation.
- D. Correct: with zero correlation, add weighted variances and take the square root.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 5, medium
A government establishes a sovereign wealth fund whose purpose is to cushion the national budget when commodity export prices fall. Withdrawals may be required on short notice. Which investment policy is most consistent with this mandate?
- A.A multi-generational horizon with a high allocation to private equity and real assets
- B.A concentrated allocation to domestic commodity producers to hedge the export base
- C.A growth objective funded by borrowing against the fund to raise expected return
- D.A high liquidity priority, capital preservation focus, and low allocation to illiquid assets
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Correct answer: D. A high liquidity priority, capital preservation focus, and low allocation to illiquid assets
Stabilization funds must be available when budget revenues drop, so liquidity and capital preservation dominate the policy. Savings funds for future generations can accept illiquidity and a long horizon.
- A. Wrong: this fits a future-generations savings fund, not a stabilization fund.
- B. Wrong: this would raise correlation with the very shock the fund is meant to offset.
- C. Wrong: borrowing raises risk and conflicts with preserving capital for budget support.
- D. Correct: short-notice withdrawals require liquidity and low drawdown risk.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026
Question 6, easy
A pension plan wants to raise its effective equity exposure from 55% to 60% for several months without asking its external managers to sell holdings or changing their mandates. Which approach is the most direct?
- A.A cash-flow matching program that dedicates bond maturities to equity purchases
- B.Hiring a new manager to run an equity portfolio funded by liquidating all bond managers
- C.Directing each manager to sell 5% of fixed income and purchase equities
- D.An equity index futures overlay backed by cash held within the plan
Show answer and explanationHide answer
Correct answer: D. An equity index futures overlay backed by cash held within the plan
A derivatives overlay changes asset class exposure while leaving manager portfolios intact, with low transaction cost and fast implementation.
- A. Wrong: cash-flow matching is a liability-hedging tool, not a way to adjust equity exposure.
- B. Wrong: terminating bond managers is a much larger change than a 5% shift.
- C. Wrong: this disrupts mandates and incurs the trading costs the stem seeks to avoid.
- D. Correct: futures give exposure without disturbing underlying mandates.
- Source: Exam outline: CFA Institute Level III exam topics and pathways, accessed October 2026

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