Free CFA Level III: Private Markets Asset Allocation Practice Questions

C is correct.

Risk budgeting treats risk as a scarce resource and allocates it purposefully across asset classes, strategies, or factors. Each asset class receives a "risk budget" representing its allowed contribution to total portfolio risk. This approach ensures that risk is deployed where it is most likely to be compensated. For example, an investor might allocate 60% of the total risk budget to equities, 20% to credit, and 20% to alternatives, reflecting the expected risk-return tradeoff in each area.

B is correct. The expected return is the weight of each asset class multiplied by its expected return, summed across the portfolio. Under Policy 2: $0.30 \times 7.0\% = 2.10\%$ (Domestic Equity), $0.35 \times 5.0\% = 1.75\%$ (Long Corporate Bonds), $0.20 \times 3.8\% = 0.76\%$ (Intermediate Treasuries), $0.10 \times 6.5\% = 0.65\%$ (Hedge Funds), and $0.05 \times 7.5\% = 0.375\%$ (Infrastructure). Summing: $2.10 + 1.75 + 0.76 + 0.65 + 0.375 = 5.635\%$, or 5.64%. This exceeds the plan's 5.50% return requirement, so the de-risked Policy 2 still meets the actuarial discount rate.

A is correct. Cascadia's plan is frozen and 92% funded, so the dominant objective is protecting funded status rather than maximizing return. Policy 2 increases the liability-hedging sleeve, lifting the hedging ratio from 29.3% to 40.7% and moving it toward the 60% target. Better matching of asset duration to the 14.5-year liability reduces the mismatch driving surplus volatility, which is the appropriate posture for an inactive, closed plan. The trade-off is a modest decline in expected return, but at 5.64% Policy 2 still exceeds the 5.50% requirement, so de-risking does not sacrifice the ability to meet the discount rate.