Free CFA Level III Practice Questions with Answers

Correct answer: D. A denominator effect has pushed private equity over target and tightened liquidity; slow new commitments and plan liquidity for capital calls rather than force sales

When liquid assets fall, illiquid holdings with lagged valuations form a larger share of the total. Illiquidity makes quick rebalancing costly, so managers adjust commitments and liquidity plans.

• A. Forced secondary sales usually occur at steep discounts and are not required by an overweight.
• B. Lagged appraisals understate the decline, so the overweight is real in economic terms.
• C. Relative drift from a market fall is not evidence of outperformance.
• D. Correct: manage the overweight through pacing and liquidity planning.

Correct answer: C. USD 4.36 million

Spending = 0.70 x (4.00 x 1.02) + 0.30 x (0.05 x 100.00) = 0.70 x 4.08 + 0.30 x 5.00 = 2.856 + 1.50 = 4.356, or USD 4.36 million.

• A. Wrong: this is prior spending grown by inflation only, ignoring the market value component.
• B. Wrong: this is the simple percentage-of-market-value rule and ignores smoothing.
• C. Correct: weighted combination of inflated prior spending and rate-based spending.
• D. Wrong: the 70% and 30% weights are reversed.

Correct answer: A. 6.4

Treynor ratio = (portfolio return - risk-free rate) / beta = (11.0 - 3.0) / 1.25 = 6.4. Treynor suits a sleeve of a diversified portfolio because it uses systematic risk.

• A. Correct: 8.0 / 1.25 = 6.4.
• B. Ignores the risk-free rate (11.0 / 1.25).
• C. Reports the excess return without dividing by beta.
• D. Multiplies excess return by beta (8.0 x 1.25).

Correct answer: C. 4.10

A pay-fixed swap has a duration equal to -(fixed leg duration - floating leg duration) = -(5.00 - 0.25) = -4.75. Dollar duration: (6.0 x 100) + (-4.75 x 40) = 600 - 190 = 410. Divide by the 100 million portfolio value: 4.10.

• A. Uses -5.0 for the swap and ignores the floating leg's duration.
• B. Adds the swap's duration contribution instead of subtracting it, as if the swap were receive-fixed.
• C. Correct: swap duration of -4.75 applied to the 40% notional and added to the portfolio.
• D. Reports only the swap's contribution to the portfolio, not the combined duration.

Correct answer: A. Yes, because the asset owner must include all discretionary portfolios in at least one composite

For asset owners the fee-paying test is not applicable: the plan is the owner of the assets, so GIPS requires all of its discretionary portfolios to be in at least one composite. Asset owners can claim compliance and follow the requirements adapted for them.

• A. Correct: all discretionary portfolios are in a composite.
• B. The fee-paying criterion applies to investment firms, not asset owners.
• C. Asset owners can claim compliance and must construct composites.
• D. Inclusion is a construction requirement and does not depend on a sponsor request.

Correct answer: C. 0.40

Full fundamental law: IR = TC x IC x sqrt(BR) = 0.80 x 0.05 x sqrt(100) = 0.80 x 0.05 x 10 = 0.40. The transfer coefficient scales how fully the signals reach the portfolio, and breadth enters through its square root.

• A. 0.50 ignores the transfer coefficient (0.05 x 10).
• B. 4.00 uses breadth instead of its square root.
• C. Right: 0.80 x 0.05 x 10 = 0.40.
• D. 0.04 omits breadth and keeps only TC x IC.

Correct answer: C. $16.0M

LPs get $100M capital and $20M preferred return. The catch-up x satisfies x = 20% x (20 + x), so x = $5M. Remaining $55M splits 80/20, giving the GP $11M. Total carry = 5 + 11 = $16M, which is 20% of the $80M profit.

• A. $12M is 20% of profit above the hurdle only ($60M), as if there were no catch-up.
• B. $11M counts only the post-catch-up split and omits the catch-up.
• C. Right: with a full catch-up the GP ends with 20% of total profit, $16M.
• D. $20M mistakes the preferred return amount for the GP's carry.

Correct answer: C. Fund it with low-risk, liability-matching assets sized for a very high probability of success

Goals-based allocation assigns each goal its own sub-portfolio and required probability of success. Essential, non-negotiable goals need low-risk, liability-matched assets; aspirational goals can take more risk and accept a lower probability of success.

• A. Sacrifices certainty for an essential need; a market drawdown could leave the goal unfunded.
• B. Goals-based allocation separates goals by importance and time horizon rather than blending them.
• C. Correct. Essential goals get conservative assets and a high required probability of funding.
• D. Priority runs the other way: essential goals are funded first with the highest certainty.

Correct answer: A. 7.0%

Grinold-Kroner: E(R) = dividend yield - %change in shares + inflation + real earnings growth + %change in P/E. A falling share count raises per-share growth, so net buybacks add to return: 2.0 + 1.0 + 2.0 + 2.5 - 0.5 = 7.0%.

• A. Correct: 2.0 + 1.0 + 2.0 + 2.5 - 0.5 = 7.0%.
• B. Subtracts the 1.0% repurchase yield instead of adding it; the formula subtracts the change in share count, which is negative here.
• C. Leaves out the P/E repricing term, which gives 2.0 + 1.0 + 2.0 + 2.5 = 7.5%.
• D. Adds the 0.5% repricing term instead of subtracting it, treating P/E contraction as expansion.

Correct answer: C. 10.0%

Return on equity = (150 x 8% - 50 x 4%) / 100 = (12 - 2) / 100 = 10.0%. Leverage adds (8% - 4%) x 0.5 = 2% to the unlevered 8%.

• A. Wrong: this ignores interest on the borrowed funds.
• B. Wrong: this ignores leverage entirely.
• C. Correct: gross gain less interest, divided by equity.
• D. Wrong: interest is added rather than subtracted.

Correct answer: D. 0.20%

Brinson-Fachler allocation = (portfolio weight - benchmark weight) x (sector benchmark return - total benchmark return) = (0.40 - 0.30)(8.0 - 6.0) = 0.20%.

• A. Multiplies by the sector return alone (as in the Brinson-Hood-Beebower version), ignoring the total benchmark return.
• B. Multiplies the weight difference by the total benchmark return, using the wrong return.
• C. Reverses the sign of the weight difference or excess return.
• D. Correct: 0.10 x 2.0% = 0.20%.

Correct answer: C. USD 37.00

A covered call lowers the cost basis by the premium received. Breakeven = stock purchase price minus call premium = 40.00 - 3.00 = USD 37.00. Below that price the stock loss exceeds the premium cushion; the maximum gain is capped at 45.00 - 40.00 + 3.00 = USD 8.00.

• A. Adds the premium to the cost, which is the breakeven logic for a long option, not a short call.
• B. Ignores the premium entirely; the stock must fall below the purchase price before the investor loses, but the premium provides a cushion.
• C. Correct: breakeven equals purchase price less the premium received.
• D. Subtracts the premium from the strike rather than from the purchase price.

Correct answer: A. Responsibilities of Supervisors

Supervisors must make reasonable efforts to detect and prevent violations, which includes adequate compliance procedures and appropriate follow-up when problems are found. A verbal warning with no review procedure does not meet that duty. The inflated figures are Dev's violation.

• A. Correct: she failed to put in place and enforce procedures.
• B. Nothing suggests Laura herself acted dishonestly.
• C. Performance misstatement was Dev's act, not Laura's.
• D. No duty to her employer or clients was breached by loyalty failure; the issue is oversight.

Correct answer: A. Add position and risk constraints and shrink the return forecasts toward benchmark-implied values

Mean-variance optimizers act as error maximizers: they overweight assets whose inputs are overestimated. Constraints and shrinkage of forecasts toward equilibrium or benchmark-implied returns stabilize weights and improve out-of-sample results.

• A. Right: constraints and shrinkage limit sensitivity of the weights to input errors.
• B. Removing constraints increases extreme positions and instability.
• C. Sample means are noisy estimates and are themselves a major source of instability.
• D. A smaller universe raises concentration and sacrifices diversification.

Correct answer: B. Greenfield assets are built from scratch and carry construction and ramp-up risk, while brownfield assets are operating

Greenfield projects require construction and ramp-up before generating revenue, which brings completion, cost overrun and demand risks and typically higher required returns. Brownfield assets are existing, operating assets with more predictable cash flows.

• A. Greenfield assets do not yet have established cash flows.
• B. Right: construction and ramp-up risk distinguishes greenfield from operating brownfield assets.
• C. Brownfield assets are existing; greenfield are the ones under construction.
• D. Existing assets still need maintenance and capital spending.

Correct answer: D. 80,000 USD

Gain = 500,000 - 100,000 = 400,000; tax if sold = 20% x 400,000 = 80,000 USD. Donating appreciated shares directly avoids that tax, so the charity receives 500,000 rather than 420,000.

• A. Applies the 20% rate to the full 500,000 value instead of the 400,000 gain.
• B. Applies the 20% rate to the 100,000 basis instead of the gain.
• C. This is the size of the gain, not the tax on it.
• D. Correct. The 20% tax on the 400,000 gain is avoided.

Correct answer: C. 5.67%

Taxable-equivalent yield = tax-exempt yield / (1 - tax rate) = 3.4% / 0.60 = 5.67%. A taxable bond must yield more than 5.67% to beat the municipal after tax.

• A. Multiplies by (1 - tax rate), which gives an after-tax figure for a taxable bond, not an equivalent yield.
• B. Multiplies by (1 + tax rate), which is not how tax-equivalence is computed.
• C. Correct: 3.4 / 0.60 = 5.67%.
• D. Ignores the tax rate; the yields are not comparable without adjustment.

Correct answer: B. Constant mix, because it sells after rises and buys after declines

Constant mix is concave: it rebalances against the trend and profits from mean reversion in range-bound markets. CPPI follows the trend and loses in whipsaws; buy-and-hold has a linear payoff.

• A. Wrong: constant mix underperforms in strong trends; this reasoning contradicts its concave payoff.
• B. Correct: constant mix sells high and buys low in reversing markets.
• C. Wrong: buy-and-hold has a linear payoff, not a convex one.
• D. Wrong: CPPI buys after rises and sells after falls and underperforms in oscillation.

Correct answer: B. The time-weighted return, because it removes the effect of cash flows timing that the manager does not control

Time-weighted returns are unaffected by the size and timing of external cash flows, so they isolate manager performance. Money-weighted returns capture the client's experience, including timing decisions.

• A. The manager has no control over client contributions, so IRR does not measure skill.
• B. Correct: the time-weighted return isolates the manager from client cash flow timing.
• C. An arithmetic average does not weight by assets and does not adjust for cash flows.
• D. The measures differ whenever cash flows interact with return patterns, regardless of sign.

Correct answer: D. Sell protection on an investment-grade CDS index

Selling protection on an index creates unfunded credit exposure similar to owning the basket: the seller earns the spread and bears default losses. Buying protection reduces exposure. Paying the index total return in a swap also reduces exposure.

• A. Buying protection hedges credit risk and does the opposite of what is wanted.
• B. A single-name hedge does not create diversified exposure and shorts credit.
• C. Paying the index return gives up credit exposure.
• D. Correct: the protection seller takes diversified credit risk.

Correct answer: A. No violation, provided she did not solicit during employment or use firm records

Employees may make arrangements to depart and set up a competing business so long as they do not breach their duties during employment: no soliciting clients, no using the employer's time, resources or records. Contacting clients after leaving, using information she remembers, is generally permitted, unless a contract limits it.

• A. Correct: planning on personal time without firm resources is allowed.
• B. Mere preparation on her own time is not a breach.
• C. No consent is required to contact clients after employment ends, absent a legal restriction.
• D. Notifying clients before leaving would itself risk soliciting while employed.

Correct answer: A. Authorized participants redeem in kind, so low-basis securities leave the fund unsold

ETFs use in-kind creation and redemption with authorized participants. Delivering appreciated low-basis shares out of the fund removes embedded gains without a taxable sale, which is why ETF capital gain distributions are generally smaller than those of index mutual funds.

• A. Right: in-kind redemptions purge low-basis lots without triggering realized gains inside the fund.
• B. Portfolio size is not the mechanism; many ETFs hold as many securities as index mutual funds.
• C. Prices only approximately track NAV, and the creation/redemption process is exactly what keeps them close.
• D. Lending income does not offset realized capital gains distributions.

Correct answer: D. $10.00M

Effective gross income = $1,000,000 x 0.95 = $950,000. NOI = $950,000 - $350,000 = $600,000. Value = NOI / cap rate = $600,000 / 0.06 = $10.00M.

• A. $15.83M capitalizes effective gross income, ignoring operating expenses.
• B. $16.67M capitalizes potential gross income, ignoring vacancy and expenses.
• C. $5.83M capitalizes operating expenses.
• D. Right: $600,000 NOI capitalized at 6.0% is $10.00M.

Correct answer: D. Set it by capacity, the lower measure, and explain why tolerance can never be fully used

Risk tolerance is willingness; risk capacity is ability to bear loss without failing goals. With little non-portfolio income and a need to spend most assets on essentials, capacity is low, so the policy follows the lower measure. The adviser should document the discussion.

• A. A drawdown could jeopardize essential spending; capacity is a binding constraint, not just advice.
• B. Averaging lets high willingness offset low ability; a shortfall in essential funding is not offset by comfort with risk.
• C. Waiting for losses to test capacity exposes essential spending to the very risk the policy should avoid.
• D. Correct. When willingness exceeds ability, the more conservative measure governs.

Correct answer: D. 4.05%

Building-block bond return: E(R) is about YTM + rolldown return + expected price change from yield and spread changes - expected credit losses. Here: 4.20 + 0.30 + 0 - 0.45 = 4.05%.

• A. Adds expected credit losses instead of subtracting them.
• B. Omits expected credit losses entirely, giving 4.20 + 0.30 = 4.50%.
• C. Omits the rolldown return and still deducts credit losses, giving 4.20 - 0.45 = 3.75%.
• D. Correct: 4.20 + 0.30 - 0.45 = 4.05%.