Level III AM Session Guideline Answers - FINAL (Revised Feb 18) [PDF]

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Question 1 (23 minutes total) Question 1, Part A (5 minutes) i. The Moores rely on John’s income, which was USD 165,000 last year and is expected to increase by 5% in nominal terms for the coming year. 165,000 x 1.05 = 173,250 This income is taxed at a flat rate of 20%, so the amount of net income available to the Moores on an after-tax basis is: 173,250 x (1 – 20%) = 138,600 The Moore’s will continue to save USD 2,000 of after-tax income per month, which reduces the amount of after-tax income available to cover living expenses as follows: 138,600 – (2,000 x 12) = 114,600 Note that, because the Moores are net savers, living expenses are equal to the amount of after-tax income that is not allocated to savings. ii. The Moores have no liquidity requirement for the coming year. The USD 200,000 transfer to an irrevocable trust for the benefit of their son has already been executed. Moores are net savers, which means that they will not need to draw upon funds from their retirement account over the next twelve months. Note that the Moores’ living expenses and their contributions to their retirement account are not included in the calculation of their liquidity requirement. . Allocation: ✓ 1 point for correctly calculating gross income for the coming year ✓ 1 point for correctly calculating net after-tax income for the coming year ✓ 1 point for correctly calculating living expenses for the coming year ✓ 2 points for providing the correct liquidity requirement for the coming year

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Question 1, Part B (5 minutes) Number of periods = 65 – 50 = 15 years x 12 months/year = 180 months Periodic savings = USD 2,000/month Investable asset base = (700,000 – 200,000) = USD 500,000 Target portfolio value = USD 2,000,000 Using financial calculator: N = 180 PV = -500,000 PMT = -2,000 FV = 2,000,000 CPT I/Y Required annualized rate of return = 0.56486% x 12 = 6.78% Allocation: ✓ 1 point for calculating the number of years until retirement ✓ 1 point for calculating the investable asset base ✓ 1 point for calculating the number of years until retirement ✓ 2 points for calculating the required rate of return Commentary on Question: The rate of return required to achieve the target portfolio value is calculated based on the current portfolio value and the monthly saving of USD 2,000. The current value of the portfolio is equal to the current amount invested minus the amount transferred to the irrevocable trust. Note that the value of their home is not included in the investable asset base because they intend to live in it for the remainder of their lives.

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Question 1, Part C (6 minutes) The following factors increase the Moores’ ability to take investment risk: • Demonstrated ability to save for retirement despite variable income • Long-term time horizon • Lisa Moore can return to the paid workforce if necessary • No plans to leave an estate or make additional lifetime gifts • No dependents • Ability to borrow against the value of their home The following factors decrease the Moores’ ability to take investment risk: • John’s income is uncertain • Neither has accumulated pension benefits Allocation: ✓ 2 points for correctly identifying a factor that increases ability to take investment risk (maximum of 4) ✓ 2 points for correctly identifying a factor that decreases ability to take investment risk

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Question 1, Part D (3 minutes) Template for Question 1-D Determine the personality type (Cautious, Individualist, Methodical, Spontaneous) that Muller would most likely classify John Moore into. (circle one)

Cautious

Individualist

Justify your response with one reason.

John Moore’s personality type is that of a “methodical investor” because: • he bases his decisions on the “hard facts” and does analysis of the facts; • he does not involve emotion while making investment decisions; and • he is a relatively conservative, risk-averse investor.

Methodical

Spontaneous

Allocation: ✓ 1 point for correctly identifying the personality type ✓ 2 points for providing a correct justification Commentary on Question: Cautious investors generally do not take risks, which may be a result of their financial position or various life experiences. Methodical investors base their decisions on the “hard facts” and do analysis of the facts. They do not involve emotion while making investment decisions. They are more risk averse. Spontaneous investors constantly readjust their portfolio, allocations and holdings. They are more risk averse and fear negative results with every new development in the marketplace. Individualist investors have a self-assured approach to investing. They gain information from a variety of sources and are not averse to putting in efforts needed to reconcile conflicting data from their trusted sources. They place great importance on hard work and insight. Because they are confident in their ability to meet their financial objectives over the long-term, they are willing to take more investment risk. www.adaptprep.com

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Question 1, Part E (4 minutes) Two options available to the Moores are: • Allocate a greater share of their portfolio to asset classes with higher expected returns • Borrow against the value of their home and invest the proceeds Allocation: ✓ 2 points for correctly identifying each option (maximum 4) Commentary on Question: The Moores are subject to several constraints. Neither has the ability and/or willingness to increase their current income and it is not possible to reduce their expected living expenses during retirement. With no new contributions from work income and no change in the expected cost of the annuities that they intend to purchase in order to cover their future living expenses, the most obvious option that will allow John to retire as planned in five years is to increase the expected return on their portfolio assets. This will require a greater allocation to higher-risk, higher-expected-return asset classes. Additionally, while the Moores are unwilling to sell their home, they could borrow against its value and invest the proceeds.

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Question 2 (15 minutes total) Question 2, Part A (4 minutes) The Schmidts’ portfolio began the year with a value of EUR 14,350,000 and appreciates in value by 9.60% for a total pre-tax gain of: 14,350,000 x 9.60% = 1,377,600 The following taxes are paid: Source of income Pre-tax gain (EUR) Dividends 452,100 Interest 525,000 Realized capital gains 284,200 Total

Tax rate 30% 20% 30%

Taxes paid (EUR) 135,600 105,000 85,260 325,890

The after-tax return is calculated as follows: 1,377,600 – 325,890 = 1,051,710 The percentage return on an after-tax basis is calculated as follows: 1,051,710 / 14,350,000 = 7.33% Allocation: ✓ 1 point for calculating the total pre-tax gain ✓ 1 point for calculating total taxes paid ✓ 1 point for calculating the after-tax return in currency terms ✓ 1 point for calculating the percentage return on an after-tax basis

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Question 2, Part B (3 minutes) LaFrenz’s portfolio consists of the following: • EUR 5,640,000 of bonds in a taxable account, which will be taxed at a rate of 35% upon being withdrawn. • EUR 7,130,000 of equities in a tax-exempt account that can be withdrawn without triggering a tax liability. The after-tax asset allocation is: Asset Bonds in taxable account Equities in tax-exempt account Total

After-tax value (EUR) 5,640,000 x (1 – 35%) = 3,666,000 7,130,000 10,796,000

Allocation (%) 33.96% 66.04% 100.00%

Allocation: ✓ 1 point for correctly calculating the after-tax value of bonds in tax-deferred account ✓ 1 point for correctly calculating the after-tax value of equities in tax-exempt account ✓ 1 point for correctly calculating the after-tax asset allocations Question 2, Part C (3 minutes) LaFrenz’s decision to allocate bonds to the taxable account and equities in the tax-exempt account indicates that interest income is taxed at a lower rate than dividend income and realized capital gains. This is confirmed by Johnson’s belief that this is the most tax-efficient allocation. Allocation: ✓ 2 points each for identifying interest income as being taxed at a lower rate than dividend income and realized capital gains ✓ 1 point for noting Johnson’s opinion on the tax efficiency of this allocation as a justification Commentary on Question: When allocating assets among taxable and tax-exempt accounts, it is most efficient to hold assets that provide tax-advantaged sources of income in taxable accounts.

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Question 2, Part D (5 minutes) In the absence of any taxes, the future value of Tand’s asset would be: 3,575,000 x (1.07)12 = 8,051,585 In this scenario, the gain on this investment would be: 8,051,585 – 3,575,000 = 4,476,585 With a 1.5% wealth tax applied annually, the after-tax future value of Tand’s asset is: 3,575,000 [(1.07)(1 – 1.5%)]12 = 6,716,084 In this scenario, the gain on this investment would be: 6,716,084 – 3,575,000 = 3,141,084 The amount of the gain consumed by the wealth tax is calculated as: 4,476,585 – 3,141,084 = 1,335,501 The proportion of the gain consumed by the wealth tax is calculated as: 1,335,501 / 4,476,585 = 29.8% Allocation: ✓ 2 points for correctly calculating the gain in the absence of taxes ✓ 2 points for correctly calculating the gain after the wealth tax is applied ✓ 1 point for correctly calculating the proportion of the gain consumed by the wealth tax

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Question 3 (13 minutes total) Question 3, Part A (5 minutes) The expected return on Bosphorian equities is 10.29%. This answer can be arrived at by following these steps: Step 1) Calculate GIM Sharpe ratio: 𝑆𝑅𝐺𝐼𝑀 =

𝐸(𝑅𝑀 ) − 𝑅𝐹 𝜎𝑀

where 𝑆𝑅𝐺𝐼𝑀 = GIM Sharpe ratio 𝐸(𝑅𝑀 ) = expected return on GIM 𝑅𝐹 = risk-free rate 𝜎𝑀 = standard deviation of GIM returns In this example, 𝐸(𝑅𝑀 ) − 𝑅𝐹 7.9% − 3.1% 𝑆𝑅𝐺𝐼𝑀 = = = 0.30 𝜎𝑀 16.0% Step 2) Calculate the Bosphorian equity risk premium under the assumption of perfect integration with GIM. 𝑅𝑃𝑖 = [(𝜎𝑖 )(𝜌𝑖,𝑀 )(𝑆𝑅𝐺𝐼𝑀 )] + 𝐼𝑙𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 where RP𝑖 = risk premium for asset class i 𝜎𝑖 = standard deviation of returns on asset class i 𝜌𝑖,𝑀 = correlation 𝑆𝑅𝐺𝐼𝑀 = GIM Sharpe ratio In this example, 𝑅𝑃𝑖 = [(23.1%)(0.68)(0.30)] + 1.7% = 6.41% Step 3) Calculate the Bosphorian equity risk premium under the assumption of perfect segregation from GIM. 𝑅𝑃𝑖 = [(𝜎𝑖 )(𝑆𝑅𝐺𝐼𝑀 )] + 𝐼𝑙𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 In this example, 𝑅𝑃𝑖 = [(23.1%)(0.30)] + 1.7% = 8.63% Step 4) Calculate the weighted-average Bosphorian equity risk premium based on degree of integration with GIM. 𝑅𝑃𝑖 = [(6.41%)(0.65)] + [(8.63%)(1 − 0.65)] = 7.19%

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Step 5) Add the risk-free rate to arrive at the expected return on Bosphorian equities. 𝐸(𝑅𝑖 ) = 𝑅𝑃𝑖 + 𝑅𝐹 = 7.19% + 3.1% = 10.29% Allocation: ✓ 1 point for calculating the GIM Sharpe ratio ✓ 1 point for calculating the risk premium of markets assuming full integration ✓ 1 point for calculating the risk premium of markets assuming full segmentation ✓ 1 point for calculating the weighted-average equity risk premium ✓ 1 point for calculating the portfolio return Question 3, Part B (3 minutes) The Rumländian economy is expected to grow below its long-term trend rate. This can be determined by analyzing the Taylor rule: 𝑅𝑜𝑝𝑡𝑖𝑚𝑎𝑙 = 𝑅𝑛𝑒𝑢𝑡𝑟𝑎𝑙 + [0.5 ( 𝐺𝐷𝑃𝑔𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 − 𝐺𝐷𝑃𝑔𝑡𝑟𝑒𝑛𝑑 )] + [0.5 ( 𝐼𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 − 𝐼𝑡𝑎𝑟𝑔𝑒𝑡 )] where, 𝑅𝑜𝑝𝑡𝑖𝑚𝑎𝑙 = target short-term interest rate (policy rate) 𝑅𝑛𝑒𝑢𝑡𝑎𝑙 = policy rate if GDP growth was on trend and inflation was forecasted to be on target 𝐺𝐷𝑃𝑔𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = expected GDP growth rate 𝐺𝐷𝑃𝑔𝑡𝑟𝑒𝑛𝑑 = long-term trend GDP growth rate 𝐼𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = expected inflation rate 𝐼𝑡𝑎𝑟𝑔𝑒𝑡 = target inflation rate In this example, inflation is at the target rate and is expected to remain at this level. For the Rumländian central bank to set its policy rate below the natural rate, it must be that GDP growth is forecast to be below its long-term trend rate. Allocation: ✓ 1 point for noting that the GDP growth rate is expected to be below its long-term trend ✓ 2 points for correctly explaining the parameters of the Taylor rule that support this conclusion

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Question 3, Part C (5 minutes) The Rumländian yield curve is most likely moderately steep. This is the result of a combination of tight fiscal policy and loose monetary policy. The Rumländian government has adopted a policy of reducing the budget deficit as a percentage of GDP (tight fiscal policy) and the central bank has set its policy rate below the natural rate (loose monetary policy). The curve is moderately steep (as opposed to flat) because the steepening effect of monetary policy trumps the inverting effect of tight fiscal policy. Allocation: ✓ 1 point for correctly identifying the most likely shape of the yield curve ✓ 2 points for correctly describing the country’s fiscal policy ✓ 2 points for correctly describing the country’s monetary policy Commentary on Question: The following table gives the policy mix and the shape of yield curve. Policy Mix and The Yield Curve

Monetary Policy

Loose

Fiscal Policy Loose Yield curve steep

Tight

Yield curve flat

Tight Yield curve moderately steep Yield curve inverted

If the fiscal and monetary policies are both tight, then the situation is unambiguous and the economy is certain to slow. This leads to an inverted yield curve. On the other hand, if the fiscal and monetary policies are both expansionary, then the economy can be expected to grow. This leads to a steep yield curve.

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Question 4 (20 minutes total) Question 4, Part A (12 minutes) i. The basis point value (BPV) for a fixed-income portfolio is the sum of the basis point values of its component bonds. BPV is calculated as follows: BPV = (Market value of bond) x (Bond duration) x 0.0001 In this example, the portfolio’s BPV at the end of the period is calculated as follows: End of Year Security

Price

Bond A Bond B Bond C Total

103.40 98.66 100.70

Modified Market Value Duration (KWR) 5.59 103,400,000 2.70 98,660,000 3.50 100,700,000

Basis Point Value (KWR) 57,801 26,638 35,245 119,684

ii. In this example, the portfolio’s BPV at the beginning of the period is calculated as follows:

Security Bond A Bond B Bond C Total

Beginning of Year Modified Price Duration 102.34 6.19 99.56 3.51 101.28 4.24

Market Value (KWR) 102,340,000 99,560,000 101,280,000

Basis Point Value (KWR) 63,348 34,946 42,943 141,237

iii. In accordance with Lee’s IPS, the money duration of her portfolio must be reset to its level from the beginning of the year. To accomplish this using futures contracts, it is first necessary to calculate the basis point value for the cheapest-to-deliver bond (BPVCTD): 𝐵𝑃𝑉𝐶𝑇𝐷 = 96,875 × 5.05 × 0.0001 = 48.92 The basis point value of the futures contract (BPVf) can then be calculated as follows: 𝐵𝑃𝑉𝑓 ≈

𝐵𝑃𝑉𝐶𝑇𝐷 48.92 ≈ ≈ 53.62 𝐶𝐹𝐶𝑇𝐷 0.9123

Note that CFCTD is the conversion factor for the CTD bond.

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The number of futures contracts (Nf) required to reestablish a target money duration is calculated as follows:

𝑁𝑓 =

𝐵𝑃𝑉𝑇 − 𝐵𝑃𝑉𝑃 141,237 − 119,684 = = 401.96 𝐵𝑃𝑉𝑓 53.62

Note that BPVT is the target basis point value and BPVP is the portfolio’s current basis point value. Because partial contracts cannot be used, Cho will need to purchase 402 futures contracts. Allocation: ✓ 1 point for correctly stating the formula for basis point value ✓ 3 points for correctly calculating the portfolio’s basis point value a year ago ✓ 3 points for correctly calculating the portfolio’s basis point value today ✓ 2 points for correctly calculating the basis point value of the CTD bond ✓ 2 points for correctly calculating the number of futures contracts required ✓ 1 point for correctly providing the rounded number of futures contracts required Question 4, Part B (8 minutes) To execute a cash flow matching strategy, the first step is to calculate the face value of bonds with the longest duration required to offset the final cash flow. To make a payment of KRW 81 million in four years, Kim will need to hold 4-year, 3.90% coupon bonds with a face value of: 81,000,000 = 77,959,577 1.039 Given the KRW 10,000 minimum size constraint, the face value of 4-year bonds required is KRW 77,960,000. Note that the coupon payment and repayment of principal at the end of Year 4 will be 77,960,000 x 1.039 = 81,000,440. Purchasing 4-year bonds with a face value of 77,960,000 will provide the following annual coupon payments: 77,960,000 x 0.039 = 3,040,440. At the end of Year 3, Kim must pay KRW 64 million. However, this amount will be partially offset by the KRW 3,040,440 coupon payment from the 4-year bond. The face value of 3-year bonds required is: 64,000,000 − 3,040,440 = 58,898,126 1.035 Again, due to the minimum size constraint, this rounds to KRW 58,900,000 for the face value of 3-year bonds required. The annual coupon payments from these bonds total KRW 2,061,500.

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The face value of 2-year bonds required is: 35,000,000 − 3,040,440 − 2,061,500 = 29,225,865 1.023 This rounds to a face value of KRW 29,230,000, which provide annual coupon payments of KRW 672,290. Finally, the face value of 1-year bonds required is: 50,000,000 − 3,040,440 − 2,061,500 − 672,290 = 43,401,148 1.019 This rounds to a face value of KRW 43,400,000, which provide a single coupon payment of KRW 824,600. Allocation: ✓ 2 points for correctly calculating the face value of 4-year bonds required ✓ 2 points for correctly calculating the face value of 3-year bonds required ✓ 2 points for correctly calculating the face value of 2-year bonds required ✓ 2 points for correctly calculating the face value of 1-year bonds required

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Question 5 (22 minutes total) Question 5, Part A (4 minutes) i. Lockhart has exhibited loss aversion bias by continuing to hold stocks that are trading below their purchase prices rather than recognizing a loss despite the opportunity to replace these stocks with ones that offer higher expected risk-adjusted returns. ii. Lockhart exhibits illusion of control bias by refusing to reduce his exposure to the large, concentrated position in his employer’s stock. Allocation: ✓ 2 points for correctly explaining how Lockhart has exhibited each bias (maximum 4) Question 5, Part B (4 minutes) Based on Lockhart’s current tax constraints, the optimal corridor widths are +/-6% for equities and +/-4% for fixed income. In the absence of any tax considerations, these corridor widths would be narrower because untaxed returns are more volatile than taxable returns on the same assets. Because volatility is inversely related to optimal corridor width, higher volatility tax-free returns would result in lower rebalancing ranges. Allocation: ✓ 2 points for correctly noting that the optimal corridor widths would be narrower ✓ 2 points for citing higher volatility of returns as the justification Question 5, Part C (4 minutes) Based only on expected utility, Lockhart should select Portfolio A because it offers the highest risk-adjusted expected return. Expected utility is calculated as follows: Um = E(Rm) – 0.005RAσ2m where Um = expected utility of asset mix m E(Rm) = expected return of asset mix m RA = investor’s risk aversion σ2m = variance of return of asset mix m The expected utilities of the portfolios shown in Exhibit 1 are: Portfolio A: 8.5% - (0.005)(5)(15.1%)2 = 2.80% Portfolio B: 8.8% - (0.005)(5)(15.8%)2 = 2.56% Portfolio C: 9.2% - (0.005)(5)(17.0%)2 = 1.98%

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Note that E(Rm) and σ2m are expressed as percentages rather than as decimals in the calculation. Portfolio A is chosen because it offers the highest expected utility given the investor’s level of risk aversion. Allocation: ✓ 1 point each for each correct calculation of utility-adjusted expected returns (maximum 3) ✓ 1 point for providing a justification of Portfolio A as the best allocation based on this metric Question 5, Part D (4 minutes) Based only on the safety-first criterion, Lockhart should select Portfolio C because it maximizes the safety-first ratio and has the lowest probability of falling below his stated minimum acceptable return of 4.5%. The safety-first ratio is calculated as follows: 𝑆𝐹𝑅𝑎𝑡𝑖𝑜 =

𝐸(𝑅𝑝 ) − 𝑀𝐴𝑅 𝜎𝑝

where SFRatio = safety-first ratio E(Rp) = expected return of the portfolio MAR = minimum acceptable return σp = standard deviation of portfolio returns The safety-first ratios of the portfolios shown in Exhibit 1 are: Portfolio A: (8.5% - 4.5%)/15.1% = 0.265 Portfolio B: (8.8% - 4.5%)/15.8% = 0.272 Portfolio C: (9.2% - 4.5%)/17.0% = 0.276 Portfolio C is chosen because it offers the highest safety-first ratio given Lockhart’s minimum acceptable return. Allocation: ✓ 1 point each for each correct calculation of Roy’s safety-first ratio (maximum 3) ✓ 1 point for providing a justification of Portfolio C as the best allocation based on this metric

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Question 5, Part E (6 minutes) Economic net worth is the value of extended portfolio assets net of his extended portfolio liabilities. For Lockhart these inputs can be summarized on a pre-tax basis as follows: Extended portfolio assets Equity – DM stock Equity – Other Fixed Income Human capital Home (gross) Total

Extended portfolio liabilities 200,000 Mortgage 210,000 PV of future spending 300,000 PV of son’s education 925,000 800,000 2,435,000

200,000 1,250,000 225,000

1,675,000

Lockhart’s economic net worth is 2,435,000 – 1,675,000 = 760,000 Allocation: ✓ 2 points for correctly calculating Lockhart’s total economic assets ✓ 2 points for correctly calculating Lockhart’s total economic liabilities ✓ 2 points for correctly calculating Lockhart’s economic net worth

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Question 6 (17 minutes total) Question 6, Part A (6 minutes) Template for Question 6-A Identify two factors related to the characteristics of Partko’s workforce that indicate the Plan’s ability to take risk is below the automotive parts industry average. 1. Ratio of active to inactive participants

2. Average age of participants

Justify each response with one reason

A larger proportion of inactive lives reduces a definedbenefit pension plan’s ability to take risk by increasing the liquidity requirement as there are more participants collecting benefits relative to the number of active participants who are contributing new funds. The Plan’s ratio of active lives to inactive lives (0.75) is below the industry average (0.86). The ability of a defined-benefit pension plan to take risk decreases as the average age of its participants increases because the duration of liabilities decreases and must be offset by holding shorter duration assets. The Plan’s average age (53) is higher than the industry average (48)

Allocation: ✓ 1 point for correctly identifying a factor relating to Partko’s workforce characteristics (maximum 2) ✓ 2 points for providing an accurate justification for this factor indicating an ability to take risk that is below the industry average (maximum 4) Commentary on Question: The Plan’s below-average ability to take risk is also indicated by other factors, such as: • the provision for a partial lump-sum payment, which is not common in the industry • the sponsor’s below-average operating margin and above-average debt-to-assets ratio However, these factors are not related to workforce characteristics. Other factors (higher funded status and lower correlation between asset returns and sponsor’s operating profits) indicate an above-average ability to take risk if considered in isolation.

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Question 6, Part B (3 minutes) There are two indicators that the Plan has an above-average risk tolerance relative to its peers. It has a higher funded status than its peers. Compared to plans in a deficit position relative to the present value of their liabilities (the average status of plans in this industry), Partko’s fullyfunded plan is better positioned to absorb the greater potential losses associated with risker investments. The correlation between the Plan’s returns and its sponsor’s profitability is lower than the industry average. This increases ability to take risk because it is more likely that the sponsor will have the funds required to make additional contributions in the event that the Plan experiences poor returns and its funded status falls into a deficit position. Allocation: ✓ 1 point for correctly identifying a factor indicating above-average risk tolerance ✓ 2 points for providing an accurate justification for this factor indicating an ability to take risk that is below the industry average

Question 6, Part C (4 minutes) Cash balance plans are like defined-benefit plans in that the sponsor is still largely (if not entirely) responsible for bearing investment risk. Cash balance plans are like defined-contribution plans in that participants receive individual account statements with information on accumulated value, contributions, and earnings credits. Cash balance plans may also be like defined-contribution plans to the extent that employees bear any investment risk, however, the sponsor retains most (if not all) of this risk. Allocation: ✓ 2 points for identifying a characteristic shared with defined-benefit plans ✓ 2 points for identifying a characteristic shared with defined-contribution plans Question 6, Part D (4 minutes) Cash balance plans are typically provided as a result of a defined-benefit plan being terminated and converted into a hybrid plan. Such plans have been criticized for providing existing participants with lower benefits than they would have received if their existing defined-benefit plan had not been converted. Partko could mitigate its exposure to this potential criticism by “grandfathering” the Plan’s current participants – giving them the option to continue with the existing defined-benefit plan rather than requiring them to participate in the new cash balance plan. Allocation: ✓ 2 points for identifying a criticism of cash balance plans ✓ 2 points for identifying a measure to mitigate Partko’s exposure to this potential criticism

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Question 7 (15 minutes total) Question 7, Part A (4 minutes) A mandate requiring the Foundation to maintain a concentrated position of KC common stock (42% of total asset value) limits its ability to hold a diversified portfolio and creates significant unsystematic risk exposure. One action that trustees could take to mitigate this disadvantage while still complying with the mandate is to enter a derivative contract such as a swap agreement that exchanges the returns on the concentrated position of KC shares for the returns on a diversified portfolio. Allocation: ✓ 2 points for discussing limited ability to diversify as a disadvantage ✓ 2 points for identifying a swap agreement (or similar derivative contract as a possible action to mitigate the effects of this mandate Question 7, Part B (3 minutes) The components of the Foundation’s nominal required return are: • 5.2% annual spending requirement • 0.45% management expense rate • 2.1% expected inflation Nominal required return can be calculated using one of the following methods: Additive method Multiplicative method

5.2% + 0.45% + 2.1% = 7.75% (1 + 0.052) x (1 + 0.0045) x (1 + 0.021) – 1 = 7.89%

Allocation: ✓ 2 points for correctly identifying the components of nominal required return ✓ 1 point for correctly calculating nominal required return using one of two acceptable methods Commentary on Question: The additive method of calculating required return produces an approximate estimate, but does not account for the effect of compounding over multiple periods. The multiplicative method is more precise because it does account for this effect. Either method appears to be acceptable for exam purposes.

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Question 7, Part C (4 minutes) The Foundation has a single-stage, long-term investment time horizon. There are two appropriate justifications: • The Foundation does not have a spend down mandate • Trustees plan to maintain the 5.2% spending rate Allocation: ✓ 1 point for correctly identifying the time horizon as single-stage ✓ 1 point for correctly identifying the time horizon as long-term ✓ 2 points for providing an appropriate justification Question 7, Part D (4 minutes) The Foundation’s liquidity requirement for the coming year is the sum of its spending and management expenses, which are both based on the year-end value of portfolio assets, less sponsor contributions. Specifically: Spending Management expenses Sponsor contribution

9,564 million x 0.052 = 497,328,000 9,564 million x 0.0045 = 43,038,000 145 million x (1.052) = 152,540,000

497,328,000 + 43,038,000 – 152,540,000 = JPY 387,826,000 Allocation: ✓ 1 point for correctly identifying the components of the Foundation’s liquidity requirement ✓ 2 points for calculating the correct values of these components ✓ 1 point for correctly calculating the Foundation’s liquidity requirement Commentary on Question: Note that the sponsor contribution was JPY 145 million last year and grew by the real spending rate of 5.2%.

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Question 8 (20 minutes total) Question 8, Part A (3 minutes) Manager C is following the passive investment approach. A returns-based analysis reveals that, with a style fit score of 100%, none of Manager C’s returns are attributable to selection – the portion of return that is unexplained by style. Allocation: ✓ 1 point for correctly identifying the investment approach as passive ✓ 2 points for using a returns-based approach as justification (citing style fit) Commentary on Question: In a passive investment approach, the investor does not try to adjust his expectations by making changes in the securities holdings. The investor tries to mimic any index to get the same returns as that of the index. Returns-based analysis is conducted using historical return data. The portion of a manager’s returns attributable to active selections is calculated as (1 – style fit score). Question 8, Part B (3 minutes) The CAC 40 index, which represents the performance of the broad asset class of French equities, is an inappropriate benchmark for Manager B, who appears to be pursuing a valuing investing style characterized by stock with low P/E and P/B ratios, high dividend yields, and low expected EPS growth. It would be more appropriate to assess Manager B’s performance relative to a style index composed of value stocks. Allocation: ✓ 1 point for noting that the CAC 40 is a broad market index ✓ 1 point for noting that Manager B is pursuing a value investing style ✓ 1 point for recommending a value style index as a more appropriate benchmark

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Question 8, Part C (6 minutes) i. The risks associated with a growth investing style are: - Expected earnings growth may not materialize - A contracting P/E ratio can compound the losses associated with lower-than-expected earnings ii. The main risk of a market-oriented investing style is that investors may pay higher fees for active management, while earning returns that are not significantly higher (and possibly lower) than the returns that could have been earned by following a passive indexing strategy. These returns must be compared on a net-of-fees basis. iii. The risks associated with a value investing style are: - There may be valid reasons for a stock to be trading at an apparently attractive price multiple - Even if stocks are mispriced, it is not possible to know when their prices will adjust to be reflective of intrinsic value Allocation: ✓ 2 points for correctly identifying one risk associated with each investment style (no more than one risk per style, maximum 6 points total)

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Question 8, Part D (4 minutes) The active return and tracking risk for AM’s EUR 700 million domestic equity portfolio are calculated as follows: Portfolio active return 200

100

400

= (700) × (2.2%) + (700) × (1.7%) + (700) × (0.0%) = 0.87% Portfolio tracking risk 0.5

200 2 100 2 400 2 = [( ) × (5.2%)2 + ( ) × (4.4%)2 + ( ) × (0%)2 ] 700 700 700

= 1.61%

Allocation: ✓ 2 points for correctly calculating active return ✓ 2 points for correctly calculating tracking risk Commentary on Question: Active return is the return of a portfolio above the benchmark returns. Active returns for a portfolio are calculated as the weighted average of the managers’ active returns for all the managers weighted by the assets under management. Active risk is the standard deviation of the difference in the portfolio and benchmark returns over time. When all its sources of active return are assumed to be uncorrelated, a portfolio’s active risk is calculated as the square root of the weighted average of the squared managers’ active risk for all the managers, weighted by the squared assets under management.

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Question 8, Part E (4 minutes) The potential disadvantages investors face when a manager drifts away from his or her stated style are: - Investors are no longer getting their desired level of systematic risk exposure - Managers who drift away from their stated style may be trading securities about which they lack sufficient expertise Allocation: ✓ 2 points for correctly identifying each potential disadvantage (maximum 4)

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Question 9 (18 minutes total) Question 9, Part A (4 minutes) Schiff’s recommendation of a wider corridor for domestic equities relative to non-domestic equities is supported by the following: • Returns for domestic equities have a higher correlation with portfolio returns • Returns for domestic equities are less volatile • The volatility of other asset classes in the portfolio is slightly higher for domestic equities because non-domestic equities are relatively more volatile Allocation: ✓ 2 points for each correct reason cited as justification (maximum 4) Commentary on Question: Transaction costs are lower for domestic equities compared to non-domestic equities, which would support a relatively narrower corridor width.

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Question 9, Part B (5 minutes) Template for Question 9-B Determine the development that would most likely cause Schiff to recommend a change in Valke’s SAA. (circle one)

Development 1

Development 2

Explain, for each development not chosen, why it would not justify a change to the SAA. While an unexpected interest rate rise might justify a change in tactical asset allocation based on changes in short-term capital market expectations, the Swiss central bank’s actions are consistent with its long-standing policy and there is no reason to believe that long-term capital market expectations, which determine SAA, have been altered. Although the proportion of Valke’s portfolio represented by domestic bonds has breached the lower bound of that asset class’ corridor, the appropriate response is to rebalance the portfolio back to target weights. This is not a reason to alter Valke’s SAA.

Development 3

Allocation: ✓ 1 point for selecting the correct development ✓ 2 points for each correct explanation for why a development that wasn’t chosen would justify a change to SAA (maximum 4 points)

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Question 9, Part C (6 minutes) Template for Question 9-C Note: The same characteristic cannot be used for both responses. Recommend the most appropriate trade execution tactic – crossing network, implementation shortfall, or Justify your response with one characteristic of the Order volume-weighted average price proposed trade. (VWAP) – for each of the following orders: (circle one) i. Buy ABC 1. The urgency to complete the trade is low. shares crossing network 2. The order size represents a relatively large proportion of average daily trading volume. implementation shortfall

volume-weighted average price (VWAP)

ii. Buy KLM shares

1. The urgency to complete the trade is high. crossing network

2. The order size represents a relatively small proportion of average daily trading volume.

implementation shortfall

volume-weighted average price (VWAP)

Allocation: ✓ 1 point for recommending the correct trade execution tactic (maximum 2) ✓ 2 points for providing an appropriate justification (maximum 4)

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Question 9, Part D (3 minutes) The unrealized profit/loss component of implementation shortfall, also known as missed opportunity trading cost, is calculated as follows: 𝑃𝑐 − 𝑃𝑏 % 𝑜𝑓 𝑜𝑟𝑑𝑒𝑟 𝑢𝑛𝑓𝑖𝑙𝑙𝑒𝑑 × ( ) 𝑃𝑏 where 𝑃𝑐 = cancellation price 𝑃𝑏 = original benchmark price In this example, (

18,000 − 7,200 5.68 − 5.63 )×( ) = 0.005328, 𝑜𝑟 53 𝑏𝑎𝑠𝑖𝑠 𝑝𝑜𝑖𝑛𝑡𝑠 18,000 5.63

Allocation: ✓ 1 point for recognizing that unrealized profit/loss is missed opportunity trading cost (MOTC) ✓ 1 point for correctly identifying the formula for calculating MOTC ✓ 1 point for correctly calculating MOTC in bps Commentary on Question: Implementation shortfall is the difference between the money return on the “paper” portfolio in which positions are established at the price when the trade decision is made (the decision price), and the portfolio’s actual return. There are four components of implementation shortfall: 1. Explicit costs, which include commissions, taxes, and fees 2. Realized profit/loss – price movement from decision price to execution price for the portion of the trade executed on the day it is placed 3. Slippage / delay – change in price over the day an order is placed when the order is not executed that day 4. Missed trade opportunity cost – price difference between trade cancellation price and original benchmark price, based on amount of order not filled

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Question 10 (17 minutes total) Question 10, Part A (12 minutes) Template for Question 10-A Note: Two biases are required for each client but there are three possible answers i. Identify two behavioral biases Justify each identified bias with one example from the information provided. exhibited by Sherman. 1. Confirmation bias Sherman ignores evidence that contradicts his view that now is a good time to purchase the shares of the Canadian retailers that will be selling Sunny Farms’ products. 2. Availability bias

Sherman’s narrow range of experience has limited his investment opportunity set and resulted in an insufficiently diversified portfolio in which retailers are significantly overweighted.

3. Representativeness bias

Sherman is confident that his investments in the shares of Canadian retailers will be successful because he has “never been disappointed” with similar investments in the shares of US retailers that carry Sunny Farms’ products and he expects this trend to continue.

ii. Identify two behavioral biases exhibited by Warner. 1. Endowment bias

Justify each identified bias with one example from the information provided. Warner will not sell her Rivaldi Corp. shares based on a sense of loyalty to her family, despite acknowledging that this is not how she would allocate an equivalent amount of cash.

2. Status quo bias

Warner claims that she cannot remember the last time she rebalanced or even checked the value of her portfolio.

3. Mental accounting bias

Warner has mentally allocated the shares that she has inherited from her grandfather to fund the purchase of “something special” when she retires.

Allocation: ✓ 1 point for correctly identifying a behavioral bias (maximum 2 per client) ✓ 2 points for providing a correct justification from the information provided (maximum 4 points per client)

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Question 10, Part B (5 minutes) Template for Question 10-B Note: Two justifications are required but there are three possible answers Identify the behavioral investment type (Active Accumulator, Friendly Follower, Justify your response with one reason related to his behavioral biases and one Independent Individualist, Passive reason related to his investment approach. Preserver) that Schnetzer would most likely classify Sherman into. 1. Sherman’s exhibits confirmation bias, availability bias, and representativeness bias, which are all cognitive, not emotional, in nature and typically observed in Independent Individualists. Active Accumulator

Friendly Follower

Independent Individualist

2. Sherman has risked his own capital to create wealth and prefers to be in control of both his business and his investments. Additionally, equities represent a significant proportion of his wealth. All of this indicates that Sherman is an active investor with an above-average level of risk tolerance, which is consistent with the profile of an Independent Individualist.

Passive Preserver

Allocation: ✓ 1 point for correctly identifying Sherman’s behavioral investor type ✓ 2 points for providing a correct justification (maximum 4)

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