Investment & Portfolio Management Interview Questions

Modern Portfolio Theory (MPT) is a framework for constructing a portfolio of assets that aims to maximize return for a given level of risk, or minimize risk for a given level of return. MPT uses diversification to reduce portfolio risk. It assumes that investors are risk-averse and that asset returns are normally distributed. In practice, MPT is applied by selecting a mix of assets that optimize the portfolio’s risk-return tradeoff, typically using a variance-covariance matrix to calculate the efficient frontier.

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between a security's expected return and its risk, as measured by beta. The formula is: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate). The assumptions of CAPM include: markets are efficient, there are no transaction costs, all investors are rational and risk-averse, and all investors have the same time horizon and access to the same information.

Beta measures the sensitivity of a stock’s returns relative to the overall market's returns. It is calculated through regression analysis, where the stock’s return is regressed against the return of the market index. The slope of the regression line represents the stock’s beta. A beta of 1 indicates the stock moves in line with the market, while a beta greater than 1 indicates higher volatility, and a beta less than 1 indicates lower volatility than the market.

Alpha represents the excess return of an investment relative to its expected return, given its level of risk (beta). A positive alpha indicates the investment outperformed the market, while a negative alpha suggests underperformance. Beta, on the other hand, measures the volatility or systematic risk of a security compared to the market as a whole. While alpha focuses on performance, beta focuses on risk.

An efficient frontier is a graphical representation of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of return. To construct it, you first need to calculate the expected returns, variances, and covariances of each asset in the portfolio. Using optimization techniques, you combine assets in various proportions to create a portfolio that lies on the efficient frontier, ensuring maximum diversification and risk-return optimization.

The Treynor ratio is a measure of the risk-adjusted return of an investment portfolio, calculated as: (Portfolio Return - Risk-Free Rate) ÷ Portfolio Beta. It evaluates how much excess return the portfolio generates for each unit of market risk (beta). A higher Treynor ratio indicates better risk-adjusted performance, making it useful for comparing portfolios with different levels of systematic risk.

The Black-Scholes model is a mathematical model used to calculate the theoretical price of options. It takes into account factors like the stock price, strike price, time to maturity, risk-free interest rate, and the volatility of the underlying asset. The model assumes no dividends are paid and that markets are efficient. It is widely used in pricing European-style options and helps determine whether an option is undervalued or overvalued in the market.

Risk-adjusted performance of a mutual fund is evaluated using ratios like the Sharpe ratio, Treynor ratio, and Jensen’s alpha. The Sharpe ratio is calculated by dividing the fund’s excess return over the risk-free rate by its standard deviation, measuring total risk. The Treynor ratio divides the excess return by the fund’s beta, measuring systematic risk. Jensen’s alpha compares the fund’s actual return to its expected return based on its beta, assessing manager skill.

Diversification is the practice of spreading investments across different assets or asset classes to reduce overall portfolio risk. By holding a mix of investments with low correlations to each other, investors can minimize the impact of poor performance from any single asset. Diversification reduces unsystematic risk, which is specific to individual assets, while systematic risk, driven by market movements, cannot be eliminated through diversification.

When building a fixed-income portfolio, key considerations include the duration, credit quality, yield curve, and interest rate risk. Investors must assess the duration of bonds to understand interest rate sensitivity. Credit quality influences the risk of default, and the yield curve helps identify investment opportunities based on interest rate expectations. The portfolio should balance risk and return by diversifying across bond types, such as government, corporate, and municipal bonds.