CFA Level III practice questions

How to use these questions

These original questions are written for practice and do not reproduce CFA Institute material. They illustrate how to move from a case fact to a recommendation or calculation. Level III practice needs both response formats: linked multiple-choice questions and constructed responses. The exam has 11 sets of each type, with 20 scored sets and two trial sets. You cannot identify trial sets during the exam, so treat every set seriously.

For a constructed response, read the command word and requested number of points first. If asked to recommend one action and justify it with two reasons, provide one action and two distinct case-based reasons. For an item set, answer each question from the case and its own stem. A detail that matters to one question may be irrelevant to another.

Question 1: choose a liability hedge

A pension plan has a large fixed liability due in 12 years. Its funded status is sensitive to falling long-term rates. The sponsor can use government bonds or a receive-fixed interest-rate swap. The plan already holds short-duration bonds for near-term benefit payments. Which change most directly reduces the liability interest-rate sensitivity without using the cash reserved for near-term payments?

1. Sell the short-duration bonds and hold the proceeds in cash.
2. Add a receive-fixed swap position that increases the duration of the liability-hedging portfolio.
3. Replace the long-term liability benchmark with a short-term cash benchmark.

Answer: B. A receive-fixed swap generally gains value when rates fall and can add duration exposure without requiring the plan to sell short-duration assets earmarked for liquidity. A confuses duration hedging with cash management. C changes the benchmark label but does not change the liability or portfolio risk. A may increase the mismatch and leaves the plan more exposed to falling rates.

Question 2: write a concise recommendation

A family has a near-term home purchase and a separate 20-year education goal. Its equity portfolio has fallen sharply. The case states that the purchase funds are held in equities, the purchase date cannot move, and the family has sufficient cash for six months of expenses. The prompt asks for one change to reduce the risk that the home purchase must be delayed, with one justification.

Sample constructed response: Move the amount required for the near-term purchase into cash or short-duration high-quality fixed income. The purchase date is fixed, so a further equity decline could leave the family short when the funds are needed.

This answer gives one action and ties the reason to a stated constraint. A generic sentence such as “diversify the portfolio” does not identify what to change or why. Recommending that the family sell all equities would go beyond the question and could damage the long-horizon education objective. The emergency reserve does not make the purchase portfolio safe; those funds serve different purposes.

Question 3: calculate a required return

A foundation expects to spend 4.0% of assets next year. It estimates inflation at 2.5% and annual investment expenses at 0.4%. Assume the spending rate is stated as a percentage of current assets and that the foundation wants to preserve purchasing power. Estimate the required nominal return using the common additive approximation.

Answer: 6.9%. Add spending, inflation, and expenses: 4.0% + 2.5% + 0.4% = 6.9%. The approximation ignores the small interaction among rates. A 6.5% answer omits expenses. A 4.0% answer funds spending but does not maintain real value after inflation.

Question 4: evaluate manager performance

A manager returns 8.0% while the policy benchmark returns 6.0%. The portfolio held a larger allocation to a high-performing asset class than the benchmark. Within that asset class, the manager underperformed its market index. Which statement is best supported?

1. The manager added value through security selection in that asset class.
2. The portfolio return can reflect a favorable allocation effect even though selection within the asset class detracted.
3. The manager total return proves the benchmark is inappropriate.

Answer: B. Allocation and selection are separate sources of active return. Overweighting a strong asset class can help the total portfolio even when the manager within-class result is weak. A reverses the stated comparison. C requires evidence about the benchmark suitability, not just a return difference.

Question 5: distinguish risk capacity from willingness

An investor says she is comfortable with equity volatility. Her planned retirement begins in two years, most wealth is in one employer stock, and she has no other income source. Which fact most clearly limits her ability to take additional portfolio risk?

1. Her stated comfort with volatility.
2. The short time until withdrawals and concentration of wealth in employer stock.
3. Her willingness to hold equities for a long time.

Answer: B. Capacity depends on financial circumstances and the ability to absorb losses without impairing goals. Her stated comfort informs willingness, but it cannot remove the short horizon or concentration risk. C describes willingness and conflicts with the imminent withdrawals.

How to review a set

For each miss, write the case clue, the decision it supports, and the step you skipped. In Question 4, the clue is the overweight to a strong asset class and the weaker within-class result. The decision is to separate allocation from selection. In Question 2, the fixed purchase date makes liquidity the binding constraint. This short chain is more useful than copying a full solution.

Review correct guesses too. If you chose the right answer because one alternative sounded familiar, solve a new version with different facts. Change one fact at a time: make the purchase date flexible, shorten the liability duration, or change the source of active return. Explain what changes in your recommendation.

Practice written responses

Before typing, count what the prompt requests. A recommendation with two justifications needs three logical pieces. Use one sentence for the action and a separate sentence for each reason when that makes the mapping clear. For a calculation, identify the formula and units, then provide the requested value. If the answer field requests only a number, do not add a paragraph that risks obscuring it.

A useful self-review asks whether every sentence answers the command, uses a case fact, and adds a distinct point. Delete background theory that does not support the answer. If the prompt asks for a weakness, naming an attractive feature is not a substitute. If it asks for two risks, repeating the same risk in different words does not create a second point.

A timed practice routine

The two exam sessions are each 132 minutes. A set worth 12 points represents roughly 12 minutes at an even pace, though case length and response demands vary. Use that as a planning reference, not a command to abandon a difficult set at exactly 12 minutes. Practice reading the case efficiently, answering direct questions, and marking a time-consuming calculation for return.

Mix formats in practice. If you spend all week on multiple choice, your written answers may be vague under time pressure. If you only write essays, you may miss efficient case interpretation in the item sets. A balanced session can contain one short case, one written response, a calculation, and a review of why each distractor fails.

A closer application

For constructed response, use a three-part scratch routine: command, decision, supporting fact. If a task says “recommend and justify,” the response should contain both a recommendation and a reason tied to the vignette. A sentence defining the relevant concept without applying it is incomplete. If it says “calculate,” show the inputs and result; if it says “identify,” do not spend time on a long essay. Original practice prompt: A foundation expects a large grant payment in 18 months, has a limited tolerance for short-term losses, and holds a portfolio with a long-term spending objective. The committee asks whether it should commit a portion of the near-term reserve to an illiquid strategy. A focused response would recognize that the near-term liability and limited loss capacity constrain the reserve allocation. It would recommend preserving sufficient liquid assets and explain that the long horizon of the broader portfolio does not remove the reserve’s timing need. It should not invent a specific return or allocation percentage absent from the case. For an item-set style question, read the vignette once for mandate, horizon, constraints, and current position. On the question pass, return to the exact fact that controls the answer. Do not carry a conclusion from one question into another if the second asks a different risk or implementation issue. Practice identifying which details are relevant and which are background. When reviewing, rewrite weak answers in the requested form. Turn a paragraph of background into a direct recommendation plus one case-specific justification. For a calculation, check that units and period match. For an item set, explain why the tempting alternative conflicts with a stated constraint. This feedback is more useful than marking only the correct option.