Level III Guidelines Answers 2018 [PDF]

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CFA Institute Chartered Financial Analyst® Examination

2018 Essay Mock Exam Guideline Answers

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2018 Level III Guideline Answers Morning Session - Page 1 of 47

LEVEL III Question: #1 Topic: Equity Minutes: 20 Reading References: #26 − “Introduction to Equity Portfolio Management,” James Clunie, and James Alan Finnegan #27 − “Passive Equity Investing,” David M. Smith and Kevin Yousif #28 − “Active Equity Investing: Strategies,” Bing Li, Yin Luo, and Pranay Gupta #29 − “Active Equity Investing: Portfolio Construction,” Jacques Lussier and Marc Reinganum

LOS: #26: The candidate should be able to: a. describe the roles of equities in the overall portfolio; b. describe how an equity manager’s investment universe can be segmented; c. describe the types of income and costs associated with owning and managing an equity portfolio and their potential effects on portfolio performance; d. describe the potential benefits of shareholder engagement and the role an equity manager might play in shareholder engagement; e. describe rationales for equity investment across the passive–active spectrum. #27: The candidate should be able to: a. discuss considerations in choosing a benchmark for a passively managed equity portfolio; b. compare passive factor-based strategies to market-capitalization-weighted indexing; c. compare different approaches to passive equity investing; d. compare the full replication, stratified sampling, and optimization approaches for the construction of passively managed equity portfolios; e. discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios; f. explain sources of return and risk to a passively managed equity portfolio. #28: The candidate should be able to: a. compare fundamental and quantitative approaches to active management; b. analyze bottom-up active strategies, including their rationale and associated processes; c. analyze top-down active strategies, including their rationale and associated processes; d. analyze factor-based active strategies, including their rationale and associated processes; e. analyze activist strategies, including their rationale and associated processes; f. describe active strategies based on statistical arbitrage and market microstructure; g. describe how fundamental active investment strategies are created; h. describe how quantitative active investment strategies are created; i. discuss equity investment style classifications.

2018 Level III Guideline Answers Morning Session - Page 2 of 47

LEVEL III Question: Topic: Minutes:

#1 Equity 20

#29: The candidate should be able to: a. describe elements of a manager’s investment philosophy that influence the portfolio construction process; b. discuss approaches for constructing actively managed equity portfolios; c. distinguish between Active Share and active risk and discuss how each measure relates to a manager’s investment strategy; d. discuss the application of risk budgeting concepts in portfolio construction; e. discuss risk measures that are incorporated in equity portfolio construction and describe how limits set on these measures affect portfolio construction; f. discuss how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions; g. evaluate the efficiency of a portfolio structure given its investment mandate; h. discuss the long-only, long extension, long/short, and equitized market-neutral approaches to equity portfolio construction, including their risks, costs, and effects on potential alphas.

2018 Level III Guideline Answers Morning Session - Page 3 of 47

Answer Question 1-A on This Page

Justify, with three reasons based only on Välimaa’s notes, why the use of the passive investment approach is appropriate for the Fund’s portfolio. The passive investment approach is appropriate for the Fund’s portfolio for the following three reasons: • • •

The passive approach typically has low turnover and generates lower capital gains relative to active strategies. Since the Fund is taxed on investment income, the passive approach would likely result in lower taxes. The Fund’s investment committee members believe that equity markets are highly efficient, suggesting that a manager’s ability to generate alpha may be limited. An efficient market with limited alpha generation potential supports the use of the passive investment approach. The Fund’s investment committee mandates that the portfolio shall have minimum tracking risk. The passive approach provides low tracking risk relative to an active approach. In particular, indexing has the goal of minimizing tracking error, subject to realistic portfolio constraints.

2018 Level III Guideline Answers Morning Session - Page 4 of 47

Answer Question 1-B on This Page

Determine, from the three methods that Välimaa is considering, the most appropriate method for constructing the equity portfolio. (circle one) Full replication

Stratified sampling

Optimization

Justify your response. The value of the Fund’s equity portfolio is EUR 150 million and is large enough to follow a full replication approach of the FTSE Eurotop 100 Index. The constituents of this index are the top 100 large capitalization European equities, which are likely liquid and available for trading. The full replication approach requires owning each of the securities in the benchmark portfolio. Tracking error is likely to remain low since the number of constituents in this index is not large. Stratified sampling is less appropriate since it does not track the index as closely as full replication, which would result in higher tracking error relative to full replication. The board prefers not to use sophisticated algorithms that are difficult to understand, making the optimization approach less appropriate.

2018 Level III Guideline Answers Morning Session - Page 5 of 47

Answer Question 1-C on This Page

Determine, based solely on the memo’s content, the previous manager’s two approaches to portfolio construction. (circle one from each group)

Top-down

Justify each response.

The previous manager used a growth at a reasonable price (GARP) investment approach to identify attractively-priced stocks and emphasized understanding firm-specific factors such as corporate governance and management quality. The GARP approach with these attributes indicates a bottom-up approach. A manager following a bottom-up approach develops an understanding of the environment by first evaluating the risk and return characteristics of individual securities. The ability to identify companies with strong or weak fundamentals depends on the analyst’s in-depth knowledge of each company’s industry, product lines, business plan, management abilities, and financial strength.

Bottom-up

Systematic

The previous manager’s consideration of firm specific factors, such as ESG attributes and management quality, indicate a discretionary approach. Further, managers who use discretionary strategies can result in concentrated portfolios, reflecting the depth of the managers’ insights on company characteristics and the competitive landscape. Discretionary strategies search for active returns by building a greater depth of understanding of a firm’s governance, business model, and competitive landscape, through the development of better factor proxies or through successful timing strategies. A discretionary manager is also likely to integrate nonfinancial variables to the equation, such as the quality of management, the competitive landscape, and the pricing power of the firm.

Discretionary

2018 Level III Guideline Answers Morning Session - Page 6 of 47

Answer Question 1-D on This Page

Determine, based solely on the memo’s content, whether the former manager’s portfolio would most likely be characterized as having high or low: (circle one from each group)

Low

Justify each response.

The previous manager generally held a concentrated portfolio of less than 60 stocks, which was significantly less than the number of stocks in the benchmark. A concentrated portfolio tends to have high active risk (typically 8-12% or higher). Active risk, which is driven by the differences between the security weights in the portfolio and the security weights in the benchmark, increases when a portfolio becomes more uncorrelated with its benchmark.

i. Active risk

High

Low

Given the relatively small number of stocks (less than 60) held in the previous manager’s portfolio and lack of diversification, the former manager exhibited characteristics of a concentrated stock picker. A concentrated portfolio tends to have high Active Share, typically above 0.90.

ii. Active Share

High

2018 Level III Guideline Answers Morning Session - Page 7 of 47

Question: #2 Topic: Economics Minutes: 15 Reading References: #14 – Capital Market Expectations by John P. Calverley, Alan M. Meder, CPA, CFA, Brian D. Singer, CFA, and Renato Staub, PhD LOS: #14: The candidate should be able to: a. discuss the role of, and a framework for, capital market expectations in the portfolio management process; b. discuss challenges in developing capital market forecasts; c. demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models; d. explain the use of survey and panel methods and judgment in setting capital market expectations; e. discuss the inventory and business cycles and the effects that consumer and business spending and monetary and fiscal policy have on the business cycle; f. discuss the effects that the phases of the business cycle have on short-term/long-term capital market returns; g. explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns; h. demonstrate the use of the Taylor rule to predict central bank behavior; i. interpret the shape of the yield curve as an economic predictor and discuss the relationship between the yield curve and fiscal and monetary policy; j. identify and interpret the components of economic growth trends and demonstrate the application of economic growth trend analysis to the formulation of capital market expectations; k. explain how exogenous shocks may affect economic growth trends; l. identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies; m. discuss the risks faced by investors in emerging-market securities and the country risk analysis techniques used to evaluate emerging market economies; n. compare the major approaches to economic forecasting; o. demonstrate the use of economic information in forecasting asset class returns; p. explain how economic and competitive factors can affect investment markets, sectors, and specific securities; q. discuss the relative advantages and limitations of the major approaches to forecasting exchange rates; r. recommend and justify changes in the component weights of a global investment portfolio based on trends and expected changes in macroeconomic factors.

2018 Level III Guideline Answers Morning Session - Page 8 of 47

Answer Question 2-A on This Page

Calculate the risk premium for Edonia equities using the Singer-Terhaar approach. Show your calculations. The risk premium on the Edonia equities is 6.1%, which is calculated in three steps. Step 1: Risk premium of Edonia equities under full integration (RPEE, full int)  RPM   + i = 30% × .50 × .28 = 4.2%  σM 

RPEE, full int = σ EE ρ EE , M  where,

σEE = standard deviation of returns of Edonia equities (given as 30%) ρEE,M = correlation of Edonia equity returns to GIM portfolio (given as 0.50)

RPM/σM = Sharpe ratio of the GIM portfolio (given as 0.28) i = illiquidity premium (not required for a developed market)

Step 2: Risk premium of Edonia equities under full segmentation (RPEE, full seg)  RPM   + i = 30% × .28 = 8.4%  σM 

RPEE, full seg = σ EE  where,

σEE = standard deviation of returns of Edonia equities (given as 30%) RPM/σM = Sharpe ratio of the GIM portfolio (given as 0.28) i = illiquidity premium (not required for a developed market)

Step 3: Risk premium of Edonia equities (RPEE) RP EE = δ RP EE, full int + (1 − δ ) RP EE,full seg = 0.55×4.2% + (1– 0.55)×8.4% = 6 .1%

where,

RPEE, full int = Risk premium of Edonia equities under full integration (4.2%) RPEE, full seg = Risk premium of Edonia equities under full segmentation (8.4%) δ = degree of integration with GIM (given as 0.55)

2018 Level III Guideline Answers Morning Session - Page 9 of 47

Answer Question 2-B on This Page

Determine the most likely combined effect of Lyon’s updated estimates on the risk premium for Edonia equities using the Grinold-Kroner model. (circle one) decrease

no change

increase

Justify your response with two reasons. (Note: No calculations are required.) With her updates, Lyon expects the percent change in P/E ratio, or repricing return, for Edonia equities to be lower than her previous estimate. Based on the Grinold-Kroner model, the repricing return is additive, so a lower repricing return would lower the expected rate of return on equity, and hence the expected equity risk premium, all else equal. Lyon also expects the percent change in shares outstanding to increase compared to her previous estimate. Based on the Grinold-Kroner model, when the percent change in number of shares outstanding increases, the expected rate of return on equity decreases, and hence the equity risk premium, all else equal. Both indicators will cause a decrease in the expected return on equity, and hence the equity risk premium.

2018 Level III Guideline Answers Morning Session - Page 10 of 47

Answer Question 2-C on This Page

Support Lyon’s inflation forecast with two reasons.

Factors that are consistent with higher inflation expectations are as follows. •

Consumer Confidence Index: Rising consumer optimism suggests that near-term consumer spending will increase. Consumer spending represents a sizeable portion of GDP in many developed countries and is an important business cycle factor. Consumer confidence survey data are watched closely as indicators of whether consumers are more likely to buy more goods, driving up prices. When consumer confidence is rising, inflation is more likely to increase.

•

Inventory/Sales Ratio: The inventory/sales ratio has been trending down and is expected to continue to decline. When the inventory/sales ratio declines, the economy is likely to be stronger as businesses try to rebuild inventory. A strong economy often leads to higher inflation.

•

Output gap: The output gap is defined as the difference between actual GDP and potential GDP scaled by potential GDP. Exhibit 3 shows that output gap has been closing and is expected to become positive as a proportion of potential GDP, and therefore spare capacity of the economy is forecast to decline. This implies higher inflationary pressure.

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Question: #3 Topic: Institutional IPS Minutes: 16 Reading References: #13 - Managing Institutional Investor Portfolios by R. Charles Tschampion, CFA, Laurence B. Siegel, Dean J. Takahashi, and John L. Maginn, CFA LOS: #13: The candidate should be able to: a. contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and disadvantages of each from the perspectives of the employee and the employer; b. discuss investment objectives and constraints for defined-benefit plans; c. evaluate pension fund risk tolerance when risk is considered from the perspective of the plan surplus, 2) sponsor financial status and profitability, 3) sponsor and pension fund common risk exposures, 4) plan features, and 5) workforce characteristics; d. prepare an investment policy statement for a defined-benefit plan; e. evaluate the risk management considerations in investing pension plan assets; f. prepare an investment policy statement for a participant directed defined-contribution plan; g. discuss hybrid pension plans (e.g., cash balance plans) and employee stock ownership plans; h. distinguish among various types of foundations, with respect to their description, purpose, and source of funds; i. compare the investment objectives and constraints of foundations, endowments, insurance companies, and banks; j. discuss the factors that determine investment policy for pension funds, foundation endowments, life and non-life insurance companies, and banks; k. prepare an investment policy statement for a foundation, an endowment, an insurance company, and a bank; l. contrast investment companies, commodity pools, and hedge funds to other types of institutional investors; m. compare the asset/liability management needs of pension funds, foundations, endowments, insurance companies, and banks; n. compare the investment objectives and constraints of institutional investors given relevant data, such as o. descriptions of their financial circumstances and attitudes toward risk.

2018 Level III Guideline Answers Morning Session - Page 12 of 47

Answer Question 3-A on This Page

Determine, based on the forecasts, the maximum spending rate that will allow the Foundation to maintain the real value of the current portfolio. Show your calculations. The maximum spending rate that will allow the Foundation to preserve the portfolio’s real value is calculated using the following formula. Expected nominal return that preserves real value of portfolio = (1 + spending rate) × (1 + inflation) × (1 + management fee) – 1 Rearranging terms to solve for the spending rate and using the expected nominal return for the nominal return level, we can calculate the maximum feasible spending rate. Spending rate = (1 + expected nominal return) / [(1 + inflation) x (1 + management fee)] – 1 Spending rate = (1 + 7.0%) / [(1 + 1.5%) × (1 + 0.33%)] – 1 Spending rate = 0.0507 = 5.1% An additive formulation can also be used. expected nominal return = spending rate + inflation + management fee Rearranging terms to solve for the spending rate: Spending rate = expected nominal return – inflation – management fee Spending rate = 7.0% – 1.5% – 0.33% Spending rate = 5.17% = 5.2%

2018 Level III Guideline Answers Morning Session - Page 13 of 47

Answer Question 3-B on This Page

Discuss, for each of the following, two factors for the Foundation that contribute to a: (Note: Restating case facts without additional support will not receive credit.) • • •

The Foundation is the sole source of funding for the local youth centers and the high degree of reliance decreases its ability to suffer losses. The Foundation is not expected to receive new donations and therefore fully relies on its investment portfolio returns to cover the operating budget and required spending distribution. The Foundation has a high spending requirement relative to its average return.

i. low ability to take risk.

• •

The long-time horizon of the Foundation, indicated by the Foundation’s stated desire to operate long into the future, increases the ability to take risk as it gives the Foundation ample time to recoup short-term investment losses While the youth centers depend on the Foundation’s distributions for their funding, this is not a defined liability of the Foundation; it is simply a goal. Similarly, the tax-exempt status, while also a goal, is also not a legally defined requirement. Because neither of these are binding requirements for the Foundation, it has a higher ability to take risk.

ii. high ability to take risk.

2018 Level III Guideline Answers Morning Session - Page 14 of 47

Answer Question 3-C on This Page

Determine, as a result of the new spending requirement policy, the most likely change in the Foundation’s cash reserve. (circle one) lower

no change

higher

Justify your response. A foundation’s cash reserve should include both anticipated and unanticipated needs for cash. The new spending requirement policy effectively forces the Foundation to increase its cash reserve. With the new policy, monthly asset values will be used instead of a beginning of year value, so the distribution amount is unknown at the start of the year. The potential for unanticipated cash needs increases, making higher cash reserves necessary.

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Question: #4 Topic: Behavioral Minutes: 15 Reading References: #6 – The Behavioral Biases of Individuals by Michael M. Pompian, CFA LOS: #6: The candidate should be able to: a. distinguish between cognitive errors and emotional biases; b. discuss commonly recognized behavioral biases and their implications for financial decision making; c. identify and evaluate an individual’s behavioral biases; d. evaluate how behavioral biases affect investment policy and asset allocation decisions e. and recommend approaches to mitigate their effects.

2018 Level III Guideline Answers Morning Session - Page 16 of 47

Answer Question 4-A on This Page

Support Beech’s conclusion with two reasons.

Overconfidence bias occurs when people demonstrate unwarranted faith in their own abilities. Richard exhibits this in two ways: •

Richard’s belief that his outperformance would continue despite not outperforming in the past indicates overconfidence. This is an example of overconfidence bias that occurs when the probabilities assigned to outcomes are too high because individuals are too certain of their judgments.

•

Richard maintains a poorly diversified portfolio, with 50% of total assets held in 5 companies, versus the more diversified mutual fund and index funds. When estimating the future value of a stock, investors with overconfidence bias will incorporate too little variation – using a narrower range of expected payoffs and a lower standard deviation of returns – than justified based on historical results and fundamental analysis. Such an investor may underestimate the risks, particularly downside risks, and consequently hold a poorly diversified portfolio.

2018 Level III Guideline Answers Morning Session - Page 17 of 47

Answer Question 4-B on This Page

Adult Child

Determine, based on their potential bias, whether each of the following will most likely hold or sell their shares of Alphadog. (circle one)

hold

Justify each response.

Sara’s representativeness bias is a belief perseverance bias in which people tend to classify new information based on past experiences and classifications. Her bias will lead her to overweight the new information of missed earnings and lowered guidance, viewing this new information as representative of a long-term trend for the company. She will therefore most likely sell her shares.

i. Sara

sell

hold

Patrick’s conservatism bias is a belief perseverance bias in which people maintain their prior views, inadequately incorporating new information. As a result, Patrick is likely to be slow to update his view or forecast, even when presented with the new information regarding missed earnings and lowered guidance. Underweighting the importance of this new information, and not using it to update his forecast, will most likely lead him to hold his shares.

ii. Patrick

sell

2018 Level III Guideline Answers Morning Session - Page 18 of 47

Answer Question 4-C on This Page

Determine the most likely amount by which the asset class weights of Sara’s two portfolios will differ. (circle one) less than +/− 10%

equal to +/− 10%

Justify your response.

greater than +/− 10%

The decision to moderate or adapt to a client’s behavioral biases depends on two factors: the standard of living risk / level of wealth (high or low) and the type of bias (emotional or cognitive). Sara, with a high standard of living risk, is at risk of failing to achieve her goals, so her behaviorally modified portfolio should be closer to a mean-variance optimized portfolio. In addition, because her bias is cognitive (representativeness), better information can help to correct it (i.e., moderating the bias is more likely to be successful). As such, with the appropriate education, Sara should be able to adjust her behavior and tolerate a portfolio that more closely matches a rational (mean-variance optimized) allocation. This would lead Sara to have a portfolio with less than a + / − 10% difference in her asset class weights to the rational allocation.

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Question: #5 Topic: Individual Private Wealth Minutes: 19 Reading References: #12 − “Estate Planning in a Global Context,” Stephen M. Horan, CFA, CIPM, and Thomas R. Robinson, CFA) LOS: #12: The candidate should be able to:

a. discuss the purpose of estate planning and explain the basic concepts of domestic estate planning, including estates, wills, and probate; b. explain the two principal forms of wealth transfer taxes and discuss effects of important non-tax issues, such as legal system, forced heirship, and marital property regime; c. determine a family’s core capital and excess capital, based on mortality probabilities and Monte Carlo analysis; d. evaluate the relative after-tax value of lifetime gifts and testamentary bequests; e. explain the estate planning benefit of making lifetime gifts when gift taxes are paid by the donor, rather than the recipient; f. evaluate the after-tax benefits of basic estate planning strategies, including generation skipping, spousal exemptions, valuation discounts, and charitable gifts; g. explain the basic structure of a trust and discuss the differences between revocable and irrevocable trusts; h. explain how life insurance can be a tax-efficient means of wealth transfer; i. discuss the two principal systems (source jurisdiction and residence jurisdiction) for establishing a country’s tax jurisdiction; j. discuss the possible income and estate tax consequences of foreign situated assets and foreign-sourced income; k. evaluate a client’s tax liability under each of three basic methods (credit, exemption, and deduction) that a country may use to provide relief from double taxation; l. discuss how increasing international transparency and information exchange among tax authorities affect international estate planning.

2018 Level III Guideline Answers Morning Session - Page 20 of 47

Answer Question 5-A on This Page

Determine the minimum amount (in EUR) that Bert should be entitled to before estate taxes if Emma were to die today. Show your calculations. The Gondos’ total estate is EUR 16 million. Bert is entitled to the greater of: • •

One-half of the increase in the value of the total estate during the marriage under community property: (EUR 16 million – EUR 6 million) x 0.50 = EUR 5 million, or One-third of the total estate under forced heirship: EUR 16 million / 3 = EUR 5.33 million

Therefore, the minimum amount Bert is entitled to, before considering estate taxes, if Emma were to die today, is the greater of his share under community property and forced heirship, which is EUR 5.33 million.

2018 Level III Guideline Answers Morning Session - Page 21 of 47

Answer Question 5-B on This Page

Determine the minimum amount (in EUR) that each child should receive if Emma were to die today. Show your calculations. The Gondos’ three children are collectively entitled to one-third of the total estate under forced heirship. Assuming Emma were to die today, the estate tax is computed as: Estate value Less: Statutory Allowance Excess Tax rate Estate Tax

EUR 16,000,000 EUR 500,000 EUR 15,500,000 40% EUR 6,200,000

The value of the total estate, on an after-tax basis, is EUR 16,000,000 – EUR 6,200,000 = EUR 9,800,000. The three children are collectively entitled to one-third of the EUR 9.8 million which equals EUR 3,266,667 (EUR 9,800,000/3). Each child would receive EUR 1,088,889 (EUR 3,266,667)/3.

2018 Level III Guideline Answers Morning Session - Page 22 of 47

Answer Question 5-C on This Page Justify, with two reasons, why tax considerations favor the Gondos making annual gifts to Erica. Tax considerations favor the Gordon making annual gifts for the following reasons: • By making annual gifts of EUR 30,000 over the next five years, the Gondos and Erica can avoid paying gift taxes. • Since Erica’s income tax rate is lower than that of the Gondos and her pre-tax investment returns are assumed to be the same as that of the Gondos, the future after-tax value of any gifted amount will be greater than if this amount stayed in the Gondos’ estate. • The value of the Gondos’ taxable estate is lowered as a result of the annual gifts. Since it is assumed that Erica’s estate will not be subject to estate tax, the gifts further reduce any future estate taxes for the Gondos.

2018 Level III Guideline Answers Morning Session - Page 23 of 47

Answer Question 5-D on This Page

Discuss two benefits, specific to the Gondos’ circumstances, of Bert purchasing the life insurance policy. Life insurance can be used as a planning tool in which the policy holder transfers assets (via premiums) to an insurer. The insurer has a contractual obligation to pay death benefit proceeds to the beneficiaries named in the policy. The purchase of a life insurance policy on himself would provide Bert and his family with the following two benefits: • •

Upon Bert’s death, the death benefit proceeds could be used to pay estate taxes. Having the insurance policy proceeds addresses Bert’s concerns about a potential lack of liquidity to pay estate taxes upon his death, and for possibly having to sell shares of the family-owned business. The payment of insurance premiums would serve to reduce the value of the estate, which would result in lower future estate taxes, particularly since death benefit proceeds paid to life insurance beneficiaries are tax exempt.

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Answer Question 5-E on This Page Discuss two benefits, specific to the Gondos’ circumstances, of establishing a trust. A trust is an arrangement created by a settlor or grantor, in this case, the Gondos, who transfers assets to a trustee. The trustee holds and manages the assets for the benefit of the beneficiaries (Emma and the three children). In a revocable trust arrangement, the settlor retains the right to rescind the trust relationship and regain title to the trust assets. Under these circumstances, the settlor’s revocation power makes the trust assets vulnerable to the reach of creditors having claims against the settlor. An irrevocable trust structure generally provides greater asset protection from claims coming from outside of the family against a settlor than a revocable trust. The establishment of an irrevocable trust would provide the Gondos with the following three benefits: • Protection of the assets within the trust from claims outside the family, such as potential creditors. Bert wants to secure a financial future for Emma and their three children and worries about claims coming from outside of the family. • Avoids disputes within the family (among his wife and three children). • Transfer of assets to his wife and children without the potential publicity associated with probate. Bert prefers to keep family’s financial affairs private.

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Question: #6 Topic: Individual IPS Minutes: 21 Reading References: #8 – Managing Individual Investor Portfolios by James W. Bronson, CFA, Matthew H. Scanlan, CFA, and Jan R. Squires, DBA, CFA LOS: #8: The candidate should be able to: a. discuss how source of wealth, measure of wealth, and stage of life affect an individual investors’ risk tolerance; b. explain the role of situational and psychological profiling in understanding an individual investor’s attitude toward risk; c. explain the influence of investor psychology on risk tolerance and investment choices; d. explain potential benefits, for both clients and investment advisers, of having a formal investment policy statement; e. explain the process involved in creating an investment policy statement; f. distinguish between required return and desired return and explain how these affect the individual investor’s investment policy; g. explain how to set risk and return objectives for individual investor portfolios; h. discuss the effects that ability and willingness to take risk have on risk tolerance; i. discuss the major constraint categories included in an individual investor’s investment policy statement; j. prepare and justify an investment policy statement for an individual investor; k. determine the strategic asset allocation that is most appropriate for an individual investor’s specific investment objectives and constraints; l. compare Monte Carlo and traditional deterministic approaches to retirement planning and explain the advantages of a Monte Carlo approach.

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Answer Question 6-A on This Page

Determine, given the Hidalgos’ funding goal for the next year, the maximum amount (in ORP) that can be donated immediately. Show your calculations. (Note: Assume that annual income and expenses are end-of-year cash flows.) The Hidalgos’ funding goal for next year is to both meet next year’s net cash needs and maintain the after-tax, real size of their post-donation portfolio. The maximum donation they can make today that will satisfy this funding goal is ORP 535,455. •

Calculate next year’s net cash needs: Inflow: Ordinary income × (1 + inflation rate) × (1 – tax rate) = 250,000 × (1 + 3.0%) × (1 – 25%) = 193,125 Outflow: Living expenses × (1 + inflation rate) = 280,000 × (1 + 3.0%) = 288,400 Next year’s net cash needs: Outflow – Inflow: 288,400 – 193,125 = 95,275

•

Calculate the minimum size of the portfolio (min Portfolio) that can meet next year’s net cash needs using the expected real after-tax return (2.75%): min Portfolio × net expected return = next year’s net cash needs min Portfolio × 0.0275 = 95,275 min Portfolio = 3,464,545 = 95,275 / 0.0275

•

Calculate the maximum donation (max Donation) that can be made today based on the difference between the existing portfolio size and the minimum portfolio size that can meet next year’s net cash needs: max Donation = existing Portfolio – min Portfolio max Donation = 4,000,000 – 3,464,545 max Donation = 535,455

2018 Level III Guideline Answers Morning Session - Page 27 of 47

Answer Question 6-B on This Page

Identify, for each of the following, two factors for the Hidalgos that contribute to a: • • • •

The Hidalgos have a concentrated equity position. This is likely to make their portfolio more volatile, thus would reduce their ability to take risk in the remaining portfolio. The donation to the research organization will reduce the size of the investment portfolio. A smaller portfolio puts more pressure on remaining assets to produce the same cash flow. They have a liquidity need from the portfolio because their living expenses exceed their income. Juan’s recent disability would prevent him from working which reduces future human capital.

i. low ability to take risk.

• • • •

The Hidalgos have ten years remaining before Mariana plans to retire. This is a long-time horizon, giving the portfolio time to recover from an unexpected drop in value. Mariana’s pension will be able to cover at least some of their expenses in retirement. This reduces the minimum return required from the investment portfolio to support them in retirement. Their income and expenses are expected to remain stable, growing at the expected inflation rate. This leads to a stable shortfall which will be reevaluated at retirement. Even though the Hidalgos’ home is excluded from their investment portfolio, it remains an asset that could be utilized if necessary, particularly since it is mortgage-free.

ii. high ability to take risk.

2018 Level III Guideline Answers Morning Session - Page 28 of 47

Answer Question 6-C on This Page

Demonstrate whether the portfolio meets the Hidalgos’: Show your calculations. i. return objective.

The recommended portfolio meets the return objective. The recommended portfolio’s real after-tax rate of return of 5.6% is greater than the 4.5% return objective. Calculation of real after-tax rate of return: Pre-tax nominal rate of return x (1 – tax rate) – inflation rate 12.8% × (1 – 25%) – 4% = 5.6% Alternative answer: The recommended portfolio’s pre-tax nominal rate of return of 12.8% is greater than the 11.3% return objective. Calculation of minimum pre-tax nominal rate of return objective: (4.5% real after tax required rate of return + 4% inflation) ÷ (1 – 25% tax rate) 8.5% ÷ 0.75 = 11.3%

ii. risk objective. The recommended portfolio meets risk objective. The recommended portfolio shortfall risk of 13.6% is less than the 14% risk objective. Calculation of shortfall risk: Pre-tax nominal rate of return – (2 × standard deviation) 12.8% – (2 × 13.2%) = –13.6% iii. liquidity constraint. The recommended portfolio cash of ORP 336,000 (ORP 4,200,000 × 8%) is greater than the ORP 250,000 to ORP 300,000 range for the liquidity constraint.

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Question: Topic: Minutes:

#7 Fixed Income 20

Reading References: #22 – “Introduction to Fixed-Income Portfolio Management,” Bernd Hanke, PhD, CFA and Brian J. Henderson, PhD, CFA #23 − “Liability-Driven and Index-Based Strategies,” James F. Adams, PhD, CFA, and Donald J. Smith, PhD, CFA #24 − “Yield Curve Strategies,” Robert W. Kopprasch, PhD, CFA, and Steven V. Mann, PhD

LOS: #22: The candidate should be able to: a. discuss roles of fixed-income securities in portfolios; b. describe how fixed-income mandates may be classified and compare features of the mandates; c. describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management; d. describe and interpret a model for fixed-income returns; e. discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios; f. discuss differences in managing fixed-income portfolios for taxable and tax exempt investors #23: The candidate should be able to: a. describe liability-driven investing; b. evaluate strategies for managing a single liability; c. compare strategies for a single liability and for multiple liabilities, including alternative means of implementation; d. evaluate liability-based strategies under various interest rate scenarios and select a strategy to achieve a portfolio’s objectives; e. explain risks associated with managing a portfolio against a liability structure; f. discuss bond indexes and the challenges of managing a fixed-income portfolio to mimic the characteristics of a bond index; g. compare alternative methods for establishing bond market exposure passively; h. discuss criteria for selecting a benchmark and justify the selection of a benchmark; i. describe construction, benefits, limitations, and risk-return characteristics of a laddered bond portfolio. #24: The candidate should be able to: a. describe major types of yield curve strategies; b. explain how to execute a carry trade; c. explain why and how a fixed-income portfolio manager might choose to alter portfolio convexity; d. formulate a portfolio positioning strategy given forward interest rates and an interest rate view; e. explain how derivatives may be used to implement yield curve strategies; f. evaluate a portfolio’s sensitivity to a change in curve slope using key rate durations of the portfolio and its benchmark; g. discuss inter-market curve strategies; h. construct a duration-neutral government bond portfolio to profit from a change in yield curve curvature; i. evaluate the expected return and risks of a yield curve strategy.

2018 Level III Guideline Answers Morning Session - Page 30 of 47

Answer Question 7-A on This Page

Determine which portfolio in Exhibit 1 would best immunize the future liability. (circle one) Portfolio A

Portfolio B

Portfolio C

Justify your response. The characteristics of a bond portfolio structured to immunize a single liability are that it (1) has an initial market value that equals or exceeds the present value of the liability; (2) has a portfolio Macaulay duration that matches the liability’s due date; and (3) minimizes the portfolio convexity statistic. Portfolio A is the most appropriate portfolio to immunize the future liability. Since all three portfolios have approximately equal cash flow yields, we can use the following three criteria to select the best portfolio for the immunization: 1. Market Value: The immunizing portfolio’s initial market value must equal or exceed the present value of the liability. Portfolio A’s initial market value of USD 92,339,315 exceeds the outflow’s present value of USD 92,221,521. Portfolio B is not appropriate because its market value of USD 92,101,324 is less than the present value of the future outflow. 2. Macaulay Duration: The immunizing portfolio’s Macaulay duration must closely match the due date of the single liability outflow. Portfolio A’s Macaulay duration of 9.998 closely matches the ten-year horizon of the outflow. Portfolio C is not appropriate because its Macaulay duration of 9.537 is furthest away from the investment horizon of ten years. 3. Convexity: For given levels of Macaulay duration and cash flow yield, smaller convexity is preferable to minimize structural risk. Minimizing convexity is the same as minimizing dispersion when considering portfolios with similar Macaulay durations and cash flow yields. Reducing a portfolio’s dispersion reduces its structural risk—the risk that yield curve twists and non-parallel shifts create duration gaps between the immunization portfolio and the liability outflow. Although Portfolio C has the lowest convexity at 108.969, its Macaulay duration does not closely match the outflow time horizon. Of the remaining two portfolios, Portfolio A has the lower convexity at 119.079; this lower convexity will minimize structural risk.

2018 Level III Guideline Answers Morning Session - Page 31 of 47

Answer Question 7-B on This Page

Determine whether Zerbe should take a long or short position in the futures contracts. (circle one) Long

Short

Calculate the number of futures contracts required to close the duration gap. To determine the number of futures contracts required to close the duration gap, compute the money durations for the liability and the immunization portfolio: money duration = modified duration × market value liability money duration = 8.867 × USD 91,732,436 = USD 813,391,510 immunization portfolio money duration = 9.107 × USD 92,749,570 = USD 844,670,334 The basis point values (BPVs) can then be calculated for the liability and the immunization portfolio: BPV = money duration × 1 bp = money duration × 0.0001 liability BPV = USD 813,391,510 × 0.0001 = USD 81,339 immunization portfolio BPV = USD 844,670,334 × 0.0001 = USD 84,467 Calculate the number of futures contracts using the BPVs: Nf = Nf =

liability BPV – immunization portfolio BPV futures BPV USD 81,339 – USD 84,467 = –43.86 USD 71.32

Nf ≈ 44 futures contracts

Since the money duration of the liability is less than that of the immunizing portfolio, Zerbe should short 44 futures contracts to close the duration gap.

2018 Level III Guideline Answers Morning Session - Page 32 of 47

Answer Question 7-C on This Page

Determine the portfolio in Exhibit 3 that is most appropriate for Oswayo, given Zerbe’s yield curve forecast. (circle one) Portfolio 1

Portfolio 2

Portfolio 3

Justify your response. (Note: No calculations are required.) The most appropriate portfolio is Portfolio 2. Barbell portfolios—combining securities concentrated in short and long maturities, as in Portfolio 2—are typically used to take advantage of a flattening yield curve. Zerbe expects the yield curve to flatten, with the twist pinned at the 10-year yield. That means the 10-year yield will remain unchanged, while the 2-year and 5-year yields will increase, and the 30-year yield will decrease. Although all three portfolios have similar modified durations, and therefore approximately the same change in value for a parallel shift in the yield curve, the impact of Zerbe’s forecasted yield curve flattening will be most advantageous for the barbell (Portfolio 2) and least advantageous for the bullet (Portfolio 1), with the ladder (Portfolio 3) in the middle. The only yield that falls, thereby creating a price increase, is that of the 30-year bond. Portfolio 2 benefits most from the drop in the 30-year yield, while Portfolio 3 benefits less because of its smaller allocation to the 30-year bond, and Portfolio 1 doesn’t benefit at all because it doesn’t hold any of the 30-year bond. For Portfolio 2, even though the 2-year and 30-year yields change by the same absolute magnitude, the price impact on the 30-year bond will be much larger than on the 2-year because the duration of the 30-year bond is much larger than that of the 2year bond. Since the forecasted twist is pinned at the 10-year yield, the 10-year yield will not change; therefore, there is no price impact on Portfolio 1 from this forecasted curve twist. Portfolio 3 will underperform Portfolio 2 for this yield curve flattening, as it holds a smaller position in the 30-year bond, giving it less price increase than Portfolio 2. Portfolio 3 also holds a larger position in the 5-year bond, which will cause some price decrease with the increase in the 5-year yield.

2018 Level III Guideline Answers Morning Session - Page 33 of 47

Answer Question 7-D on This Page

Calculate the expected return on the fixed-income portion of Oswayo’s portfolio invested in Country X for the next year. Show your calculations. The expected return on the fixed-income portion of Oswayo’s portfolio invested in Country X for the next year is calculated as: E(R)

≈ yield income + rolldown return + E(change in price based on investor’s views of yields and yield spreads) – E(credit losses) + E(currency gains or losses)

The E(change in price based on investor’s views of yields and yield spreads) term is equal to 0% since Zerbe expects the yield curve and yield spreads in Country X to be unchanged over the year. Because Zerbe fully hedges currency risk the expected gains or losses from currency, E(currency gains or losses), is also 0%.

Return Component Yield income

+ Rolldown return

Formula

Annual coupon payment ÷ Current bond price (Bond priceend of horizon – Bond pricebeginning of horizon) ÷ Bond pricebeginning of horizon

= Rolling yield + E(change in price based on Zerbe’s views of yields and yield spreads) – E(credit losses) + E(currency gains or losses) = Total Expected Return

Portfolio Performance

4.15 / 95.55 = 4.34%

(96.12 – 95.55) / 95.55) = 0.60%

Yield income + Rolldown return N/A Given N/A

2018 Level III Guideline Answers Morning Session - Page 34 of 47

4.34% + 0.60% = 4.94% 0% –0.12% 0% = 4.82%

Question: #8 Topic: Risk Management Minutes: 21 Reading References: #28 – Risk Management Applications of Forward and Futures Strategies by Don M. Chance, PhD, CFA #29 – Risk Management Applications of Option Strategies by Don M. Chance, PhD, CFA LOS: #28: The candidate should be able to: a. demonstrate the use of equity futures contracts to achieve a target beta for a stock portfolio and calculate and interpret the number of futures contracts required; b. construct a synthetic stock index fund using cash and stock index futures (equitizing cash); c. explain the use of stock index futures to convert a long stock position into synthetic cash; d. demonstrate the use of equity and bond futures to adjust the allocation of a portfolio between equity and debt; e. demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class; f. explain exchange rate risk and demonstrate the use of forward contracts to reduce the risk associated with a future receipt or payment in a foreign currency; g. explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss feasible strategies for managing such risk. #29: The candidate should be able to: a. compare the use of covered calls and protective puts to manage risk exposure to individual securities; b. calculate and interpret the value at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and general shape of the graph for the following option strategies: bull spread, bear spread, butterfly spread, collar, straddle, box spread; c. calculate the effective annual rate for a given interest rate outcome when a borrower (lender) manages the risk of an anticipated loan using an interest rate call (put) option; d. calculate the payoffs for a series of interest rate outcomes when a floating rate loan is combined with 1) an interest rate cap, 2) an interest rate floor, or 3) an interest rate collar; e. explain why and how a dealer delta hedges an option position, why delta changes, and how the dealer adjusts to maintain the delta hedge; f. interpret the gamma of a delta-hedged portfolio and explain how gamma changes as in-the-money and out-of-themoney options move toward expiration.

2018 Level III Guideline Answers Morning Session - Page 35 of 47

Answer Question 8-A on This Page

Calculate, to achieve Yang’s reallocation, the number of: Show your calculations. i. financial sector index futures contracts to sell.

Convert CVA 10 million of financial equities to cash using futures contracts:

Where,

𝛽𝛽𝑇𝑇 − 𝛽𝛽𝐹𝐹 𝑆𝑆𝑓𝑓 0 − 1.04 𝐶𝐶𝐶𝐶𝐶𝐶 10,000,000 𝑁𝑁𝐹𝐹𝐹𝐹 = � �� � = � �� � = −144.00 𝛽𝛽𝐹𝐹𝐹𝐹 𝑓𝑓𝐹𝐹 0.92 𝐶𝐶𝐶𝐶𝐶𝐶 78,500

NFf = number of financial futures contracts βT = target beta (zero for cash) βF = beta of financial sector equities in portfolio βFf = beta of financial sector index futures Sf = market value of financial equity involved in transaction fF = price of financial sector index futures contract

 sell 144 financial futures contracts

ii. energy sector index futures contracts to buy. Convert CVA 10 million of cash to energy equities using futures contracts:

Where,

𝛽𝛽𝐸𝐸 − 𝛽𝛽𝑇𝑇 𝑆𝑆𝑒𝑒 1.21 − 0.00 𝐶𝐶𝐶𝐶𝐶𝐶 10,000,000 𝑁𝑁𝐸𝐸𝐸𝐸 = � �� � = � �� � = 176.00 𝛽𝛽𝐸𝐸𝐸𝐸 𝑓𝑓𝐸𝐸 1.10 𝐶𝐶𝐶𝐶𝐶𝐶 62,500

NEf = number of energy futures contracts βE = desired beta of portfolio of energy sector equities βT = beta of cash to be converted βEf = beta of energy sector index futures Se = market value of energy equity involved in transaction fE = price of energy sector index futures contract

 Buy 176 energy futures contracts

2018 Level III Guideline Answers Morning Session - Page 36 of 47

Answer Question 8-B on This Page

Calculate the value (in CVA) of the portfolio in 12 months if Yang uses Strategy 1 to completely hedge the client’s portfolio over the next 12 months. Show your calculations. If Yang hedges the foreign market return and the exchange rate movement, she can expect to earn the domestic risk-free rate. The original value of the USD 50,000,000 portfolio expressed in the domestic currency is: USD 50,000,000 x spot rate (CVA/USD) = USD 50,000,000 x CVA 12.00 = CVA 600,000,000 If the domestic risk-free rate is earned, the value of the portfolio in one year is: CVA 600,000,000 x (1+rd) = CVA 600,000,000 x 1.0353 = CVA 621,180,000 Alternative answer Because the one-year forward rate is consistent with prevailing risk-free rates, covered interest rate parity holds so we have: 𝐹𝐹 (1 + 𝑟𝑟𝑑𝑑 ) = � � (1 + 𝑟𝑟𝑓𝑓 ) 𝑆𝑆

Where rd = the domestic (Covina) risk-free rate rf = the foreign (U.S.) risk-free rate F = the one-year forward exchange rate quoted as CVA/USD S = the spot rate quoted as CVA/USD

An equivalent approach involves using the above expression for (1+rd): CVA 600,000,000 x [CVA 12.18 / CVA 12.00] x (1.02) = CVA 621,180,000

2018 Level III Guideline Answers Morning Session - Page 37 of 47

Answer Question 8-C on This Page

Explain why it is not possible to completely hedge the value (in CVA) of the portfolio over the next 12 months using Strategy 2. To completely hedge the US equity portfolio value in CVA, the risk of fluctuations in the value of the US equity portfolio must be hedged. Yang cannot know the actual US equity return over the next 12 months. Therefore, Yang would not know at the beginning of the 12 months the number of USD to sell forward. This might lead to either over-hedging or under-hedging, depending on the change in the USD value of the portfolio.

2018 Level III Guideline Answers Morning Session - Page 38 of 47

Answer Question 8-D on This Page

Calculate the effective interest paid (in CVA) on 15 December 2017. Show your calculations. Effective interest can be calculated in currency units or as an effective rate.

Currency units: Effective interest is equal to interest on the floating rate loan minus the interest payoff on the caplet. Effective interest = Loan amount × (Libor on previous reset date + loan spread) × (days in settlement period / 360) – Notional value of cap × Max (0, Libor on previous reset date – exercise rate) × (days in settlement period / 360) The effective interest on the loan equals then: CVA 120,000,000 × [(2.45% + 1.80%) × (183/360)] – CVA 120,000,000 × [(2.45% – 2.25%) × (183/360)] = CVA 2,592,500 – CVA 122,000 = CVA 2,470,500 Effective rate: Effective rate = [(Loan amount + effective interest paid)] / Loan amount](360/days in settlement period) – 1.0 Effective rate = [(CVA 120,000,000 + CVA 2,470,500)) / CVA 120,000,000]360/183 – 1.0 = 4.09%

2018 Level III Guideline Answers Morning Session - Page 39 of 47

Question: #9 Topic: Asset Allocation Minutes: 15 Reading References: #19. “ Principles of Asset Allocation,” Jean L.P. Brunel, CFA, Thomas M. Idzorek, CFA, and John M. Mulvey, PhD LOS: #19: The candidate should be able to: a. describe and critique the use of mean-variance optimization in asset allocation; b. recommend and justify an asset allocation using mean-variance optimization; c. interpret and critique an asset allocation in relation to an investor’s economic balance sheet; d. discuss asset class liquidity considerations in asset allocation; e. explain absolute and relative risk budgets and their use in determining and implementing an asset allocation; f. describe how client needs and preferences regarding investment risks can be incorporated into asset allocation; g. discuss the use of Monte Carlo simulation and scenario analysis to evaluate the robustness of an asset allocation; h. describe the use of investment factors in constructing and analyzing an asset allocation; i. recommend and justify an asset allocation based on the global market portfolio; j. describe and evaluate characteristics of liabilities that are relevant to asset allocation; k. discuss approaches to liability-relative asset allocation; l. recommend and justify a liability-relative asset allocation; m. recommend and justify an asset allocation using a goals-based approach; n. describe and critique heuristic and other approaches to asset allocation; o. discuss factors affecting rebalancing policy.

2018 Level III Guideline Answers Morning Session - Page 40 of 47

Answer Question 9-A on This Page

Determine which portfolio Sarzi should recommend to Robson based solely on expected utility. (circle one) Portfolio A

Portfolio B Justify your response.

Based solely on expected utility, Sarzi should recommend Portfolio B since it results in higher expected utility. The expected utility for each portfolio is calculated as follows:

Where Um Rm λ 2 𝜎𝜎𝑚𝑚

Um = E(Rm) – 0.005λσ2m

= the investor’s expected utility for asset mix (allocation) m = return for asset mix (allocation) m = the investor’s risk aversion coefficient = the expected variance of return for asset mix (allocation m)

The expected utility of Portfolio A is: UA = 8% – 0.005 (5) (14%)2 = 3.1%

The expected utility of Portfolio B is: UB = 6% – 0.005 (5) (10%)2 = 3.5% = 3.5%

2018 Level III Guideline Answers Morning Session - Page 41 of 47

Answer Question 9-B on This Page

Determine which asset allocation would be most appropriate for the pension fund given Sarzi’s recommendation. (circle one) Allocation 1

Allocation 2

Allocation 3

Justify your response. The pension fund currently has a surplus of USD 2 billion (USD 10 billion – USD 8 billion) where USD 8 billion is the present value of the fund’s liabilities. To adopt a hedging/return-seeking portfolio approach, the board would first hedge the liabilities by allocating an amount equal to the present value of the fund’s liabilities, USD 8 billion, to a hedging portfolio. The hedging portfolio must include assets whose returns are driven by the same factors that drive the returns of the liabilities, which in this case are the index-linked government bonds. So, the board should allocate 80% (USD 8 billion / USD 10 billion) of the fund’s assets to index-linked government bonds. The residual USD 2 billion surplus would then be invested into a return-seeking portfolio. Allocation 2 is the most appropriate asset allocation for the fund because it allocates 80% of the fund’s assets to index-linked government bonds, and the remaining 20% of fund assets in a return-seeking portfolio consisting of corporate bonds and equities.

2018 Level III Guideline Answers Morning Session - Page 42 of 47

Answer Question 9-C on This Page

Construct the overall goals-based asset allocation for the Rozeers given their two goals and Sarzi’s suggestion for investing any excess capital. (insert the percentage of total assets to be invested in each module) Module A

Module B

Module C

25.7%

46.0%

28.3%

Show your calculations. The appropriate goals-based allocation for the Rozeers is as follows: Goal 1

Goal 2

Surplus

Horizon (years)

10

25

N/A

Prob. of success

85%

75%

N/A

Selected module

B

C

A

5.0%

6.9%

N/A

USD 4.60

USD 2.83

USD 2.57

46.0%

28.3%

Discount rate Dollars invested (USD millions) As a % of total

25.7%

Goal 1 has a time horizon of 10 years and a required probability of success of 85%. As a result, Module B should be chosen because its 5.0% expected return is higher than the expected returns of all the other modules. The present value of Goal 1, discounted using the 5.0% expected return, is calculated as: N = 10, FV = –USD 7,500,000, I/Y = 5.0%; PV = USD 4,604,349 (or USD 4.60 million) So, approximately 46.0% of the total assets of USD 10 million (= USD 4.60 million / USD 10.00 million) should be allocated to Module B. For Goal 2, which has a time horizon of 25 years and a required probability of success of 75%, Module C should be chosen because its 6.9% expected return is higher than the expected returns of all the other modules. The present value of Goal 2, discounted using the 6.9% expected return, is calculated as: N = 25, FV = –USD 15,000,000, I/Y = 6.9%; PV = USD 2,829,102 (or USD 2.83 million) So, approximately 28.3% of the total assets of USD 10 million (= USD 2.83 million / USD 10.00 million) should be allocated to Module C. Finally, the surplus of USD 2,566,549 (= USD 10,000,000 – USD 4,604,349 – USD 2,829,102), representing 25.7% (= USD 2.57 million / USD 10.00 million), should be invested in Module A following Sarzi’s suggestion.

2018 Level III Guideline Answers Morning Session - Page 43 of 47

Question: #10 Topic: Trading, Monitoring, Rebalancing Minutes: 18 Reading References: #31 - Execution of Portfolio Decisions by Ananth Madhavan, PhD, Jack L. Treynor, and Wayne H. Wagner #32 - Monitoring and Rebalancing by Robert D. Arnott, Terence E. Burns, CFA, Lisa Plaxco, CFA, and Philip Moore LOS: #31: The candidate should be able to: a. compare market orders with limit orders, including the price and execution uncertainty of each; b. calculate and interpret the effective spread of a market order and contrast it to the quoted bid–ask spread as a measure of trading cost; c. compare alternative market structures and their relative advantages; d. explain the criteria of market quality and evaluate the quality of a market when given a description of its characteristics; e. explain the components of execution costs, including explicit and implicit costs, and evaluate a trade in terms of these costs; f. calculate and discuss implementation shortfall as a measure of transaction costs; g. contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs; h. explain the use of econometric methods in pretrade analysis to estimate implicit transaction costs; i. discuss the major types of traders, based on their motivation to trade, time versus price preferences, and preferred order types; j. describe the suitable uses of major trading tactics, evaluate their relative costs, advantages, and weaknesses, and recommend a trading tactic when given a description of the investor’s motivation to trade, the size of the trade, and key market characteristics; k. explain the motivation for algorithmic trading and discuss the basic classes of algorithmic trading strategies; l. discuss the factors that typically determine the selection of a specific algorithmic trading strategy, including order size, average daily trading volume, bid–ask spread, and the urgency of the order; m. explain the meaning and criteria of best execution; n. evaluate a firm’s investment and trading procedures, including processes, disclosures, and record keeping, with respect to best execution; o. discuss the role of ethics in trading. #32: The candidate should be able to: a. discuss a fiduciary’s responsibilities in monitoring an investment portfolio; b. discuss the monitoring of investor circumstances, market/economic conditions, and portfolio holdings and explain the effects that changes in each of these areas can have on the investor’s portfolio; c. recommend and justify revisions to an investor’s investment policy statement and strategic asset allocation, given a change in investor circumstances; d. discuss the benefits and costs of rebalancing a portfolio to the investor’s strategic asset allocation; e. contrast calendar rebalancing to percentage-of-portfolio rebalancing; f. discuss the key determinants of the optimal corridor width of an asset class in a percentage-of-portfolio rebalancing program; g. compare the benefits of rebalancing an asset class to its target portfolio weight versus rebalancing the asset class to stay within its allowed range; h. explain the performance consequences in up, down, and flat markets of 1) rebalancing to a constant mix of equities and bills, 2) buying and holding equities, and 3) constant proportion portfolio insurance (CPPI); i. distinguish among linear, concave, and convex rebalancing strategies; j. judge the appropriateness of constant mix, buy-and-hold, and CPPI rebalancing strategies when given an investor’s risk tolerance and asset return expectations.

2018 Level III Guideline Answers Morning Session - Page 44 of 47

Answer Question 10-A on This Page

Support Kinloch’s conclusions regarding corridor widths for: i. equities.

The report forecasts an increase in correlation between equities and fixed income. In a portfolio that has increased correlation among asset classes, there is less chance of an asset class diverting from its target weight. As an asset class increases in value, the other asset class will likely increase in value. Therefore, reduce the chance of divergence. This supports widening the corridor width. The report also forecasts that transaction costs for equity executions will decrease. If transaction costs decrease, the costs of more frequent rebalancing decrease and the performance needed to compensate for the transaction costs is lower. This supports a narrower corridor width. In addition, the forecasted increase in volatility for commodities would also support having a narrower corridor width for equities, for similar reasons. All asset classes’ volatilities would affect the optimal corridor in this multi-asset case. Forecasts that support opposite actions do not permit a definitive conclusion to be drawn with respect to the equity corridor width, making Kinloch’s conclusion correct.

ii. commodities. The analyst report forecasts that volatility for the commodities will increase. In a volatile market, being off target can lead to greater potential losses as further divergence from the strategic asset allocation becomes more likely. This supports Kinloch’s conclusion of a narrower corridor width for commodities.

2018 Level III Guideline Answers Morning Session - Page 45 of 47

Answer Question 10-B on This Page

Calculate the implementation shortfall (in bps) of the SJTL order at the close of trading on 5 June. Show your calculations. The implementation shortfall is the difference between the return on the paper portfolio and the actual (real) portfolio return. The return on the paper portfolio assumes that the trade was fully executed at its benchmark price. The return on the paper portfolio is: (11.25 − 11.10) × 30,000 = GBP 4,500 (where 11.25 is the closing price of the stock and 11.10 is the benchmark price when the order was given). The cost of the actual portfolio is the cost of the individual legs plus any execution fees: (15,000 × 11.12) + (10,000 × 11.14) + (25,000 × 0.02) = GBP 278,700 The value of the actual portfolio is: (25,000 × 11.25) = GBP 281,250

Therefore, the return on the actual portfolio is the difference between its cost and value: 281,250 − 278,700 = GBP 2,550 This makes the implementation shortfall equal 4,500 – 2,550 = GBP 1,950 The value of the paper portfolio at initiation is 30,000 × 11.10 = GBP 333,000

In relation to the paper portfolio this equates to a shortfall of 1,950/333,000 = 0.00586 = 59 bps Alternate approach: Implementation shortfall can also be broken down into commission cost plus three components. The first component is delay costs or slippage which equals the cost of not trading shares over a day the order is outstanding. The second component is realized profit and loss for the trades executed. The third component is missed trade opportunity cost. Adding the commission cost plus all the components equals the implementation shortfall.

2018 Level III Guideline Answers Morning Session - Page 46 of 47

Answer Question 10-C on This Page

Equity

Determine which trading strategy is most appropriate for: (circle one)

VWAP

i. HRET.

Justify each response.

An opportunistic participation strategy uses passive trading and takes advantage of trading opportunities when they become available. Due to the large ratio of order size to average daily volume (70%), Kinloch would apply a strategy that looks to take advantage of liquidity, when it is present. Urgency is not an issue for this trade as the HRET results have already been released and were in line with expectations, thus VWAP and implementation strategies are less appropriate.

IS

opportunistic

VWAP

ii. WPGS.

The case states that Kinloch wants to complete the trade before WPGS financial results come out. This implies a degree of urgency which supports the use of an implementation shortfall. The implementation shortfall algorithm is a frontloaded strategy that can be adjusted to aggressively execute an order when the order has a high urgency. Either VWAP or opportunistic strategies would be less appropriate as the longer the trade takes to execute, the greater the chance of increased opportunity costs.

IS

opportunistic

2018 Level III Guideline Answers Morning Session - Page 47 of 47