Free CFA Level III: Private Wealth Practice Questions

A is correct. The appraisal ratio is calculated as the portfolio's alpha (the return earned beyond what is explained by systematic risk exposure) divided by the portfolio's unsystematic (residual or idiosyncratic) risk. It measures the manager's ability to generate abnormal returns per unit of diversifiable risk taken.

B is incorrect because the total return divided by total volatility describes a variant of the return-to-volatility ratio. The Sharpe ratio uses excess return (over the risk-free rate) divided by total standard deviation.

C is incorrect because the excess return over the risk-free rate divided by beta describes the Treynor ratio, which measures risk-adjusted performance per unit of systematic risk, not the appraisal ratio.

B is correct. A covered call is primarily a yield enhancement (income) strategy. The writer earns premium income in exchange for capping the upside at the strike price. It works best when the writer expects the stock to remain flat or rise slightly, as the premium provides additional return above the stock's performance.

A is incorrect. Covered calls are conservative, not speculative. The strategy limits upside, making it unsuitable for maximizing capital gains. Speculative strategies would involve buying options or taking leveraged positions.

C is incorrect. Covered calls do not eliminate downside risk. The short call provides only limited downside protection (equal to the premium received). Below the breakeven point ($S_0 - c_0$), the position incurs losses.

A is correct. The Sortino ratio uses downside deviation in the denominator while the Sharpe ratio uses total standard deviation. When the Sortino ratio exceeds the Sharpe ratio, it indicates that downside deviation is less than total standard deviation (assuming the same numerator, which differs slightly by MAR vs. risk-free rate). This occurs when returns are positively skewed — there is more upside variation than downside variation, meaning the total standard deviation captures upside volatility that is not penalized by the Sortino ratio.

B is incorrect because if the distribution were negatively skewed (more downside variation), the downside deviation would be relatively larger, making the Sortino ratio lower than (or closer to) the Sharpe ratio, not higher.

C is incorrect because the Sortino and Sharpe ratios measure different things and commonly differ. The Sharpe ratio uses total standard deviation (both upside and downside) while the Sortino ratio uses only downside deviation. They will be equal only when the return distribution is perfectly symmetric around the MAR/risk-free rate.