Level III of CFA Program Mock Exam 3 June, 2019 Revision 1 [PDF]

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FinQuiz.com Level III of CFA Program Mock Exam 3 June, 2019 Revision 1

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CFA Level III Mock Exam 3 – Solutions (AM)

FinQuiz.com – 3rd Mock Exam 2019 (AM Session) The morning session of the 2019 Level III Examination has 12 questions. For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question. Questions Topic

Minutes

1

Portfolio Management – Individual

26

2

Portfolio Management – Individual

10

3

Portfolio Management – Individual

3

4

Portfolio Management – Institutional

18

5

Portfolio Management – Institutional

16

6

Portfolio Management – Asset Allocation

10

7

Portfolio Management – Asset Allocation

18

8

Portfolio Management – Economics

19

9

Portfolio Management – Equity Investments

17

10

Portfolio Management – Monitoring and Rebalancing

6

11 12

Portfolio Management – Risk Management Portfolio Management – Derivatives

15 5

13

Portfolio Management – Asset Allocation

17 Total:

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180

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 1 HAS SIX PARTS (A, B, C, D and E) FOR A TOTAL OF 26 MINUTES Kyle Lucas is the owner of a small privately traded manufacturing concern which is currently worth $12 million and was established twenty-five years ago. Lucas is 65 years of age and intends to sell the business two years from today. Lucas has approached portfolio manager Gus Weaver to manage his investment portfolio which is currently worth $8.5 million and is equally allocated to long-term corporate bonds, domestic and international equities, and alternative asset classes. In response to a question regarding his investment experience, Lucas states, “I have faced significant financial crises in the past and now always look to avoid making investment choices which hold the potential for disastrous consequences.” Lucas earns annual business income which is fixed at a pre-tax amount of $100,000. His living expenses are $98,000 in the current year and are expected to increase at the annual rate of inflation of 5%. Upon retirement, he will no longer earn business income and his annual living expenses will become constant at $150,000. If Lucas sells his business at its expected market price, two years from today, he will be able to purchase his dream house for $8 million and a boat currently sold at a price of $1.0 million and will donate the remaining amount to a local charity. He has instructed Weaver to exclude the sale of his business from the investment decision. Lucas intends to finance his grandson’s college education as well as purchase residential property for him. Total estimated costs will amount to $30 million and will be required fifteen years from today. Lucas is subject to an ordinary income and capital gains tax rate of 25% and 30% respectively. He always maintains an emergency reserve equal to 3 years of his annual business income in addition to his portfolio holdings. A. Formulate each of the following constraints for Lucas’ investment policy statement (IPS): I. II.

Time Horizon Unique Circumstances (4 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

B. Determine whether an increase in inflation rate, reduction in the sales price of the business, and an increase in the price of his dream house will increase, decrease or have no impact on risk tolerance. Justify your choice with one reason. Answer Question 1-B in the template provided at the end of Question 1. (6 minutes) C. State Lucas’s return objective for his IPS. (3 minutes) D. Calculate Lucas’ annual after-tax nominal rate of return for the IPS if his business is sold at its current market price two years from today. Show your calculations. (6 minutes) Walker strongly feels that incorporating behavioral considerations in an IPS is essential to fulfilling the client’s long-term goals. To achieve this purpose, he holds a meeting with Lucas to determine his behavioral investor type (BIT) and associated biases by holding a meeting with the client. E. Discuss two benefits of including behavioral finance into the IPS. (4 minutes) Lucas is an avid follower of the stock market and makes investment decisions on behalf of friends and family members. His most recent investment decision involved a $100,000 purchase of French Inc.’s stock. The decision was influenced by recent media attention on the corporation following a ‘brave’ policy shift towards unconventional production processes promising shorter lead times and a greater focus on organic raw materials as input. He further justifies his decisions by stating, “Over the course of industry history, companies who were experimental in setting their policy have been popular amongst investors.”

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CFA Level III Mock Exam 3 – Solutions (AM)

F. Identify the bias demonstrated by Lucas and justify your selection with one reason. (3 minutes) Answer Question 1-F in the template provided at the end of Question 1.

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 1-B Impact on Risk Tolerance (Circle the Correct Answer)

Factor

Justify Your Choice With One Reason

Increase Increase in inflation rate

Decrease No impact

Increase Reduction in sales price of business

Decrease No impact

Increase Increase in the price of his dream house

Decrease No impact

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 1-F Identify the Bias (Circle the Correct Choice)

Justify Your Choice with One Reason

Regret Aversion

Overconfidence

Availability Bias

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 1: A Solution: I.

Time Horizon: Lucas has a time horizon comprising of three stages. Stage 1: Present to sale of business or retirement – 2 years Stage 2: Retirement to the funding of his grandson’s college education and home purchase – 15 years Stage 3: Stage 2 onwards

II.

Unique Circumstances: Lucas’ ownership suggests a large concentrated position. Weaver will need to consider diversifying the position and accordingly devise a strategy. It is important that Weaver consider a number of factors including Lucas’ loyalty to the position and his willingness to reduce his holding in the business prior to the date of sale.

Reference: CFA Level III, Volume 2, Study Session 5, Reading 10, LOS h

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CFA Level III Mock Exam 3 – Solutions (AM)

B Solution:

Factor

Impact on Risk Tolerance (Circle the Correct Answer)

Increase Increase in inflation rate

Decrease Decrease s No impact

Increase Reduction in sales price of business

Decrease

No impact

Increase Increase in the price of his dream house

Decrease

No impact No impact

Justify your choice with one reason An increase in the inflation rate will increase the shortfall between business income and living expenses which is expected to equal $27,900 [($100,000 × 0.75)– ($98,000 × 1.05)] in the following year and increase annually thereafter. Given that Lucas’ living expenses after retirement are not dependent on the sale of the business, therefore reduction in this source of funds will not impact his ability to tolerate risk. Lucas has expressly stated that the sale of the business or any purchase from that amount should not be included in the investment process. Therefore, a change in the price of the his dream house should not affect his risk tolerance.

Reference: CFA Level III, Volume 2, Study Session 5, Reading 10, LOS g

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CFA Level III Mock Exam 3 – Solutions (AM)

C Solution: Lucas needs to generate sufficient income to fund his living expenses on an inflationadjusted basis, provide for his retirement spending needs and grow his portfolio to finance his grandson’s college education and the purchase of residential property. Reference: CFA Level III, Volume 2, Study Session 5, Reading 10, LOS g D Solution:

Inflows Annual business income Sale of business [$15,000,000 × (1 – 0.3)]

Current

Year 1

Year 2

$100,000

$100,000

$100,000

-

-

-

Outflows Living expenses* $98,000 $102,900 Tax on salary ($100,000 × 0.25) $25,000 $25,000 Net inflows/(outflows) ($23,000) ($27,900) * expected to increase at the annual rate of inflation of 5% Investable Asset Base at the beginning of Year 3:

Cash flow – Year 2 Portfolio assets Cash reserve (3 × $100,000) Total

$108,045 $25,000 ($33,045)

Current ($33,045) $8,500,000 $300,000 $8,766,955

PV = - 8,766,955 N = 12 years FV = 30,000,000 PMT = - 150,000 I/Y = 9.771% The after-tax nominal required rate of return is 9.771% Reference: CFA Level III, Volume 2, Study Session 5, Reading 10, LOS g

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CFA Level III Mock Exam 3 – Solutions (AM)

E Solution: The benefits of incorporating behavioral finance in the IPS include: •

Formulating financial goals: While defining financial goals is a critical phase of the investment process, advisers must understand the psychology and emotions involved in the decisions underlying the goals. Behavioral finance will help advisors determine why investors set certain goals.

•

Maintaining a consistent approach: Behavioral finance helps to add professionalism and structure to relationship between a wealth advisor and his or her clients allowing them to deliver relevant investment advice.

•

Investing as the client expects: Behavioral finance allows advisors to better understand their clients’ expectations so that they are in a better position to satisfy them.

•

Ensuring mutual benefits: By incorporating behavioral finance into the investment process, managers will be in a better position to satisfy clients and improve their own practice and work life. Clients will feel that their managers better understand them as well as their financial objectives. Therefore, a stronger bond can be developed between the two.

Reference: CFA Level III, Volume 2, Study Session 4, Reading 9, LOS b

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CFA Level III Mock Exam 3 – Solutions (AM)

F Solution: Identify the Bias (Circle the Correct Choice)

Regret Aversion

Overconfidence

Availability AvailabilityBias

Bias

Justify Your Choice With One Reason Lucas is exhibiting availability bias because he is overestimating the success probability of the investment decision based on information most readily available. The availability bias can be classified as retrievability and categorization as he focuses on recent information (media attention) as well as uses a narrow search set (historical policy changes by industry participants), respectively.

Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS c

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES Carl Segal is an asset advisor at Vector Asset Management. Segal is working closely with a private client, Timothy Allen; aged 45 to ascertain the behavioral investor type (BIT) exhibited by Allen. Allen has considerable investment experience and often recommends potential investments for further evaluation to his adviser. During a discussion between Segal and Allen, the client shares his investment approach: “I have devoted a significant amount of time to studying security markets and asset classes. Based on the insight which I have gained over these years, I can comfortably trust my instincts when making investment decisions for myself as well as acquaintances, who have entrusted me with the management of their financial wealth. I trust nothing but my own research and prefer not to let my judgment get influenced by the advice of those who possess little knowledge about wealth planning.” A. Classify Carl’s BIT, determine the risk tolerance, and identify one emotional bias typically associated with the identified behavioral category. (3 minutes) Answer Question 2-A in the Template provided at the end of Question 2. B. Carl participates in the defined contribution (DC) offered by his employer. Segal determines that Carl is fifteen years away from retirement. Segal would like to compare the client’s current allocation to plan assets with the average allocation held over the past five years. Segal also determines that: • • •

•

Carl’s annual income sufficiently covers his living expenses. he is unmarried but finances his brother’s medical care. His brother is mentally challenged. His salary is not sufficient to cover these expenses. he has inherited $1.5 million from his deceased father’s estate in the beginning of the current year. He intends to employ these funds for investment purposes. he has assigned a risk score of 3.1 to the average company stock, in comparison with 3.6 to domestic stock funds and 4.1 to global stock funds.

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CFA Level III Mock Exam 3 – Solutions (AM)

Exhibit: Carl’s Allocations to the DC Plan Assets Average Historical Allocation (2009-2013) Stocks – Corporate stock 36% Stocks – Domestic Non-corporate stocks 6 Stocks – Global stocks 3 Fixed Income 45 Short-term income 10 Total 100% I.

Current Allocation (2014) 34% 7 4 48 9 100%

Using the data collected by Segal, explain one bias exhibited by Carl in his portfolio selection decisions with respect to the DC plan. Support your response with two reasons. (4 minutes)

II.

Based on Segal’s findings, he intends to employ an autopilot strategy to align Carl’s allocations with his circumstances. Explain how such a strategy would affect the current allocation. (3 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 2-A

Classify Carl’s BIT (Circle the Correct Choice)

Determine Risk Tolerance Associated With the Behavioral Category (Circle the correct choice)

Passive Preserver (PP)

Low

Active Accumulator (AA)

Low to Medium

Friendly Follower (FF)

Medium to High

Independent Individualist (II)

High

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Identify One Emotional Bias Typically Associated With the Behavioral Category

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CFA Level III Mock Exam 3 – Solutions (AM)

Solution for Question 2. A Solution.

Classify Carl’s BIT (Circle the Correct Choice)

Determine risk tolerance associated with the behavioral category (Circle the correct choice)

Identify one emotional bias typically associated with the behavioral category Possible answers include:

Passive Preserver (PP)

Low Overconfidence

Active Accumulator (AA)

Low to Medium

Friendly Follower (FF)

Medium to to High Medium High

Independent Independent Individualist (II)

High

Individualist (II)

Self-attribution

Reference: CFA Level III, Volume 2, Study Session 4, Reading 9, LOS b

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CFA Level III Mock Exam 3 – Solutions (AM)

B – (i) Solution: Bias 1: Carl demonstrates inertia and default by maintaining the composition of his current allocations at the average level observed over the previous five years. A decomposition of his holdings reveals that the allocation to: • • •

fixed income has only increase by 3% short-term income has decrease by 1% stocks has decreased [(34% + 7% + 4%) – (36% + 6% + 4%) =-1]

The receipt of inheritance should increase Carl’s risk tolerance which should be reflected by an increase in the allocation to stocks as opposed to an allocation with a higher proportion of less risky (fixed income and short-term income) securities. By keeping the allocation constant despite the change in financial circumstances and risk tolerance, the client demonstrates inertia. Bias 2: Carl also demonstrates familiarity. His allocation to corporate stock outweighs that to domestic non-corporate and global stocks (34% vs. 7% and 4% respectively). Furthermore, his allocation to domestic stocks his higher relative to global stocks (7% and 4% respectively) which lead to a confirmation of this bias. Bias 3: Carl demonstrates overconfidence in their estimate of company performance. He has assigned the lowest risk score to his employer’s stock. This enthusiasm for own company stocks stems from overconfidence as well as familiarity bias. Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS c B–(ii) Solution: Following the receipt of the inheritance, Carl’s risk tolerance will increase, and an autopilot strategy should increase his equity allocation which is currently lower than the allocation to the less risky fixed income and short-term income combined (45% vs. 55% respectively). Furthermore, his long-term horizon (fifteen years) dictates a higher allocation to risky securities such as equities. The autopilot strategy would also diversify the equity allocation and reduce the high concentration in own company stock. Reference: CFA Level III, Volume 2, Study Session 4, Reading 9

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 3 HAS ONE PART FOR A TOTAL OF 3 MINUTES Mr. and Mrs. Fairview, aged 65 and 60 respectively, are the owners of a hotel chain which has branches located across the US and has been in establishment for the past thirty years. Their business is currently worth $60 million and has appreciated by 10% in the current year leading to an increase in the wealth of its owners. The hotel chain is a privately traded concern. The Fairviews are seeking to transfer the business to their daughter, Samantha, but would like to retain ownership rights. They have approached Kim Young, a tax advisor, for a solution. Under current tax laws a donor’s annual gift exclusions are limited to $13,000 per donee. Gifts exceeding this allowance are taxed at a rate of 25%. Young discovers that the couple has consumed this allowance and now sets out to devise a wealth transfer strategy which will minimize transfer taxes and retain ownership rights. After considerable evaluation, Young has identified three potential wealth transfer strategies. She would now like to determine the most appropriate strategy. Recommend the most suitable wealth transfer strategy. For the choices not selected provide one reason for their unsuitability. Answer Question 3 in the template provided at the end of Question 3. (3 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 3 Recommend the most Suitable Wealth Transfer Strategy

Provide One Reason for Why the Choices Not Selected are Unsuitable

Corporate Estate Tax Freeze

Family Limited Partnership

Direct Gifting to Samantha

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CFA Level III Mock Exam 3 – Solutions (AM)

Solution for Question 3. Recommend the most Suitable Wealth Transfer Strategy

Corporate Estate Tax Freeze

Provide One Reason for Why the Choices Not Selected are Unsuitable Corporate estate tax freezes are suitable wealth transfer strategies before the concentrated position has appreciated significantly. The position has increased by 10% in the current year and before the Fairviews approach Young. Therefore, this is not a suitable wealth transfer strategy.

Family Limited Partnership

Family Limited Partnership

Direct Gifting to the Samantha

Reason 1: The Fairviews have already utilized their combined gift tax allowance of $26 million ($13 million per donee or donor) and so any further gifting would trigger the 25% gift tax. Reason 2: Direct gifting would require the Fairviews to give up their ownership rights which they do not want to do.

Reference: CFA Level III, Volume 2, Study Session 6, Reading 13, LOS g

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 4 HAS SEVEN PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES Yellow Tires (YT) offers a defined benefit pension plan to its employees. Sean Martin is managing YT’s investment portfolio and has collected the following details which are relevant for the analysis: • • • • • • • • • •

The plan is fully funded The average age of the participants is 38 years The active to retired participants ratio is 3:1 The company has reported strong financial results in the current year. The discount rate used to determine the present value of future obligations is 8.0%. The duration of plan liabilities is 22 years The sponsor has proposed a return objective of 8.5% YT offers a one-for-one inflation indexation via a cost of living allowance (COLA) Future benefits are twice as high relative to accrued benefits and are attributable to future real wage growth. YT is considered the inclusion of an early retirement provision

A. State YT’s return objective. (2 minutes)

B. Identify one purpose which the sponsor may have in stating a return objective of 8.5%. (2 minutes)

C. Characterize each of the following components for YT’s IPS: I. II. III.

risk tolerance liquidity time horizon (6 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

D. For each of the following scenarios, determine whether risk tolerance will increase or decrease. Explain your choice. Answer 4-D in the Template provided at the end of Question 4. (8 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 4-D

Factor

Impact on Risk Tolerance

Explain Your Choice

Introduction of an early retirement provision

Increase in discount rate

Increase in the allocation of fund assets to YT stock

Increase in bankruptcy risk

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 4. A Solution: YT is required to achieve a minimum return equal to the discount rate used to determine the present value of fund liabilities, 8.0%. Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS b B Solution: Possible purposes behind a higher desired return (8.5%) include: • •

To minimize YT’s future pension contribution and/or To generate pension income.

Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS b C Solution: I.

Risk tolerance: YT’s risk tolerance can be described as being above average due to the following reasons: • • • •

the plan is fully funded participants are relatively young the positive operating results generated by the sponsor the greater the proportion of active lives relate to retired lives

II.

Liquidity: YT’s liquidity requirements are low as evidenced by the low number of retired lives and an absence of early retirement provisions.

III.

Time horizon: The time horizon can be characterized as long-term with multiple stages. YT’s workforce is young with an average age of 38 years and the duration of its liabilities is 20 years.

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CFA Level III Mock Exam 3 – Solutions (AM)

Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS b D Solution: Template for Question 4 D. Impact on Risk Tolerance

Factor Introduction of an early retirement provision

Decrease

Increase in discount rate

Increase

Decrease in the allocation of fund assets to YT stock

Increase

Increase in bankruptcy risk

Decrease

Explain Your Choice An early retirement provision will reduce the duration of plan liabilities, resulting in a lower risk tolerance. A higher discount rate will reduce the present value of plan liabilities and the funded status will most likely change from fully funded to a surplus. The sponsor stock is highly correlated with its operating results. A lower allocation will reduce the correlation between the performance of plan assets and that of the sponsor and increase risk tolerance. An increase in the degree of bankruptcy risk may increase financial obligations and may jeopardize YT’s going concern status and/or weaken its financial status.

Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS c

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 5 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 16 MINUTES First Bank is a commercial lending institution operating in the U.S. Sasha Wilson is the bank’s senior investment officer. Wilson would like to implement more stringent risk management measures with respect to the bank’s liabilities and has convened a meeting to address the following objectives: Objective 1: Address the possibility of a positive interest rate shock Objective 2: Minimize the leveraged-adjusted duration gap Objective 3: Maximize return-on-invested capital Wilson is analyzing the implications of the recent unexpected rise in interest rates on the bank’s market value of equity. The current structure of the bank’s balance sheet is as follows:

Duration Assets Loans Fixed assets Cash Total

7.4 4.5 0.0 6.2*

Exhibit: First Bank’s Balance Sheet Market value ($ millions) Duration Liabilities 65 31 Time 3.0 deposits 4 Demand 3.5 deposits 100 3.2*

Market value ($ millions)

60 40 100

*Represents weighted average duration A. Discuss one implication of a positive interest rate shock on the bank’s balance sheet. (2 minutes) B. Determine what course of action should most likely be taken to achieve Objective 2. (2 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

C.. Formulate the following constraints for First Bank’s IPS: I. II. III.

time horizon liquidity unique circumstances (6 minutes)

D. First Bank has implemented three policy changes with respect to its loan portfolio. Wilson would like to determine how each policy change will impact the objectives and constraints for the securities portfolio. The three policies are as follows: Policy 1: Expanding lending activities by opening branches in other cities of the country. Policy 2: Restricting lending to customers with a credit rating of A or higher. Policy 3: Increase the holdings of long-term mortgage-backed securities. Explain the impact of each policy change on the bank’s objectives and constraints. Your response should consider each policy in isolation. (6 minutes) Answer Question 5-D in the template provided at the end of Question 5.

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 5-D

Policy Change

Evaluate the Impact of the Policy Change on the Bank’s Objectives and Constraints. Consider each Policy in Isolation

Expanding lending activities by opening branches in other cities of the country

Restricting lending to customers with a credit rating of A of higher

Increase the holdings of long-term mortgage-backed securities

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 5: A Solution. A positive interest rate shock will reduce the market value of the company’s equity. Although the market values of assets and liabilities will both decline in response to an increase in interest rates, the decline in the value of assets will be greater due to a higher weighted average duration. Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS m B Solution. Given that the weighted average duration of the assets exceeds that of liabilities, the most suitable course of action would be reduce the duration of the securities portfolio by purchasing shorter maturity securities. Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS m C Solution. I.

II. III.

Time horizon: A bank’s liability structure tends to have a shorter overall maturity than its loan portfolio. The time horizon of the securities portfolio is therefore of an intermediate term. Liquidity: Requirements for liquidity are determined by net outflows of deposits as well as demand for loans. Unique circumstances: There are no unique circumstances.

Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS k

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CFA Level III Mock Exam 3 – Solutions (AM)

D Solution: Template for Question 5-D

Policy Change

Expanding lending activities by opening branches in other cities of the country

Restricting lending to customers with a credit rating of A of higher

Increase the holdings of long-term mortgage-backed securities

Evaluate the Impact of the Policy Change on the Bank’s Objectives and Constraints. Consider each Policy in Isolation • Diversification of the loan pool will reduce the risk of the loan portfolio • Risk objective of the securities portfolio can be increased • Credit risk of the asset portfolio is decreased • Risk objective of the securities portfolio can be increased • Increases the need for liquidity in the securities portfolio • Duration of assets is increased • Securities portfolio will need to be used reduce overall duration.

Reference: CFA Level III, Volume 2, Study Session 7, Reading 15, LOS m

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 6 HAS TWO PARTS (A & B) FOR A TOTAL OF 10 MINUTES Becky Sands established the “Sands & Steel Financial Firm (S&S)” with her classmate and colleague, Linda Steels, around five years ago. S&S is a financial consultancy firm that assists institutional clients in managing their investment portfolios. Often, the firm works in coordination with an already established, internal financial team of the clients they deal with. Over the course of its business, S&S has built a client base of more than twenty regular and loyal institutional funds. A few days ago, the firm landed consultancy of three additional funds totaling a net worth of approximately 300 million US dollars. Sands appointed three of the firm’s most seasoned portfolio managers to meet with the board of directors of each of the concerned institutions. After their initial meeting with the clients, Sands met with the managers to inquire about strategic issues relating to the respective investment strategies and constraints of each of the clients. The managers presented Sands with the following key summarized information: §

Insurance fund: The portfolio is overfunded and offers life insurance policies to individual clients. It incorporates a very low risk premium in the discount rate used to find the present value of its liabilities. The discount rate is primarily determined by regulatory authorities and then adjusted downward to reflect the conservative nature of the fund’s policy. The board wishes to reduce the need of any additional contribution over the next year and also, to significantly decrease the risk of not being able to pay next year’s liabilities.

§

Pension Fund: The present value of the pension fund’s liabilities equals $550 million whereas the fund’s assets equal $475 million. The fund’s board of directors has instructed S&S to maintain a surplus volatility of not more than 8% per year. The fund has an established risk aversion score of 6.5. The focus has primarily been on the systematic risk of the asset mix and how it relates to that of the portfolio of liabilities. The board has directed S&S to achieve a return of 13% over the next year, while ensuring that the risk objective is not violated.

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CFA Level III Mock Exam 3 – Solutions (AM)

§

A hospital endowment: The endowment has sporadic spending needs due to an erratic influx of patients at irregular intervals. The fund’s board of directors wants to ensure that enough capital is available at the time liabilities are due. They want to minimize tail risk and ensure that worst-case outcomes are properly incorporated when constructing a strategic asset allocation. As such, their main goal is to minimize the probability of not being able to make future contributions and to keep the 1% VAR at the desired level.

A. For each of the above funds, determine the most appropriate way to account for liabilities. Justify your response for each fund with three reasons each. (6 minutes) Sands selects the following strategic asset allocation for the insurance fund based on mean variance optimization: Exhibit 1: Asset Class Ranges Asset Class

Strategic Target

Cost-Benefit Ranges

Corporate Bonds

65%

62%-67%

Domestic Equity

20%

17%-23%

International Equity

10%

6%-15%

International Real Estate

5%

4%-6%

The research analysts at S&S provide Sands with the following information about the different asset classes: §

§

§ §

A rising trend in US stock prices has been observed for the past three years, which is expected to continue. Since the overall market is also expected to rise, the US stocks will have a correlation between 0.80-0.85 with the rest of the asset classes. Trading stocks in the international market is exceedingly challenging due to a lack of a properly functional financial market in many countries. However, the presence of derivatives on international stocks makes it easy to synthetically create the desired positions. US fixed-income has historically shown little diversion from its base values over the past 25 years. Taxes on interest income are expected to be lower than taxes on dividend income.

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CFA Level III Mock Exam 3 – Solutions (AM)

§ §

The insurance fund has a conservative approach to investing and thus wants to keep exposure to volatile asset classes to a minimum. International equity, although illiquid, offers significant diversification benefits.

B. For the cost-benefit ranges given, state the asset class for which the range is most inconsistent. Justify your response with four reasons. (4 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

SOLUTION: Part A. Insurance Fund: Most suitable approach is the ‘hedging/return seeking approach’ Reasons: 1. It has a conservative (risk-averse) policy for which hedging is appropriate. 2. It is an overfunded plan that will allow the surplus to be invested in a returnseeking portfolio (the basic two portfolio approach can easily be used). 3. The focus is on a single period, and also on the ability to reduce the risk of not being able to meet liabilities. Hedging the liabilities will help ensure that. Pension Fund: Most suitable approach is the ‘surplus optimization using MVO’. Reasons: 1. The plan is underfunded. 2. Focus is on a single period—return should be met over the next year—and also on surplus volatility. 3. Emphasis is on systematic risk, which is what the correlation between assets and liabilities is based on, the main focus of MVO. Hospital Endowment: Most suitable approach is the ‘Integrated Asset-Liability Approach’. Reasons: 1. The multi-period model works best in incorporating the probability of not being able to make future contributions. 2. Since spending needs are sporadic, it is best to manage assets along with liabilities in an integrated approach so that best compromise decisions can be made. 3. Worst-case scenarios and tail risk can best be managed using an integrated approach. It can incorporate multiple assumptions and constraints. Reference: CFA Level III, Volume 3, Study Session 9, Reading 19

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CFA Level III Mock Exam 3 – Solutions (AM)

Part B. The cost-benefit range seems most inconsistent for domestic equity. Justification: 1. A momentum of trend in US stock prices is expected to continue. This warrants a wider rebalancing range (the range is only slightly higher than that for fixed income). 2. The correlation of US stocks with the rest of the portfolio is significantly high, again meriting a wider range. 3. Even though international stocks are illiquid, the presence of derivatives can make synthetic rebalancing possible and reduces the need to widen the range (relative to domestic stocks). This indicates that the difference in the range of domestic and international stocks should not be as high. International stocks also have a lower correlation with the rest of the portfolio (offer diversification) meriting a tighter balance than that of domestic stocks. 4. Unlike domestic stocks, US fixed-income has shown mean reversion and has lower taxes than those on dividend income. This indicates that the rebalancing range of fixed-income should be reasonably lower than that of domestic stocks. Yet, the difference is only of 1%. Reference: CFA Level III, Volume 3, Study Session 9, Reading 19

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES Jill Starc is a senior asset manager at RP Financial (RPF), a portfolio management firm. Starc oversees the Global Equity Fund I (GEF I) which is being offered by the firm. The fund holds global (Canadian, Mexican and British) and domestic U.S. equities. Foreign currency exposures are currently unhedged. The exhibit below illustrates the values of the fund assets, spot exchange rates, and correlations between movements in foreign currency-asset returns and foreign currency returns. Exhibit GEF I Fund Asset Values, Spot Rates, and Correlations Last Year (2013) CAD-denominated asset value in CAD millions MXN-denominated asset value in MXN millions GBP-denominated asset value in GBP millions USD-denominated asset value in USD millions CAD/USD spot rate USD/MXN spot rate GBP/USD spot rate p(RCAD,RCAD/USD) p(RMXN,RMXN/USD) p(RGBP,RGBP/USD)

100

Current Year (2014) 150

80

70

230

300

500

450

0.7900 15.2420 1.4754

0.8100 15.0050 1.5000

+ 0.7 - 0.3 + 0.2

Gracy Singh is one of Starc’s clients. Singh’s investment portfolio comprises solely of the securities held in the GEF I fund. Her allocation to CAD-, MXN-, GBP- and USDdenominated equities is 30%, 40%, 25% and 5% respectively. A. Calculate the domestic currency return on Singh’s portfolio. Show your calculations. (4 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Based on a discussion with Singh, Starc determines that hedging the client’s foreign currency risk exposures is essential. However, she is yet to establish the degree to which currency risk exposures should be hedged. B. Describe two potential considerations which Starc will need to account for when determining the degree of currency risk exposures to undertake. Your answer should focus on Singh’s current portfolio allocation and the information in the exhibit. (6 minutes) To aid her currency hedging decision, Starc collects necessary details with respect to Singh. She will examine each factor independently to determine whether a full currency hedge will be required. Information on Singh: • • • •

Risk averse to portfolio losses Has a relatively long time-horizon Desire for foreign fixed-income security exposure Required to make a down payment for the purchase of a home in three month’s time and pays for her son’s ongoing medical expenses.

C. For each of the four points collected, determine whether the strategic currency position of the portfolio should be biased towards a fully hedged currency management program. Consider each factor independently and support each answer with one reason. Answer Question 7-C in the template provided at the end of Question 7. (8 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 7-C Strategic Currency Position Biased Towards a Fully Hedged Currency Management Program? Circle the Correct Answer.

Point Collected

Support Each Answer with One Reason

Yes Risk averse to portfolio losses

No

Yes Has a relatively long timehorizon

No

Yes Desire for foreign fixedincome security exposure

No

Required to make a down payment for the purchase of a home in three month’s time and pays for her son’s ongoing medical expenses

Yes No

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 7 A Solution. Domestic currency return (RDC) =

or 10.42% Reference: CFA Level III, Volume 4, Study Session 10, Reading 21, LOS a B Solution. Marks will be awarded for any two of the three points discussed. 1. Diversification Considerations: Starc will need to consider the asset composition of the foreign-currency asset portfolio. •

•

Foreign currency asset returns of MXN-denominated assets have a negative correlation with foreign currency returns; some MXN FX exposure may help portfolio diversification and reduce domestic-currency return risk, σ(RDC). The other two correlations are positive and so Starc should consider a lower degree of active currency exposure to the CAD and GBP relative to the MXN.

2. Trading Cost Considerations: Maintaining a 100% hedge results in no currency risk exposure but is costly to maintain especially if a large number of rebalancing trades are required increasing the frequency of payments based on the bid-ask spread. 3. Opportunity Cost of the Hedge: To be 100% hedged requires forgoing the possibility and favorable foreign currency rate moves. A less than 100% hedge ratio may be desirable to minimize regret. Reference: CFA Level III, Volume 4, Study Session 10, Reading 21, LOS b

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CFA Level III Mock Exam 3 – Solutions (AM)

C Solution. Template for Question 7-C Strategic Currency Position Biased Towards a Fully Hedged Currency Management Program? Point Collected Circle the Correct Answer.

Risk averse to portfolio losses

Yes Yes

Desire for foreign fixed-income security exposure

Required to make a down payment for the purchase of a home in three month’s time and pays for her son’s ongoing medical expenses

Risk aversion will reduce the propensity to assume active currency risk exposure.

No

Yes Has a relatively long time-horizon

Support Each Answer with One Reason

No No

Yes

Yes

No

Yes Yes No

In the long-run, currencies tend to mean revert and so currency risk is lower in the long run. Adding unhedged foreign currency returns will not significantly affect long-run portfolio returns. The currency risk exposure of fixed income securities will provide little diversification benefits to the portfolio and so currency risk should be hedged. Further explanation: The correlation between foreign currency returns and foreign currency asset returns tends to be greater for fixed-income portfolios as bonds and currencies react strongly to exchange rates. Therefore, Singh has significant immediate liquidity needs and so she would like to reduce the risk of liquidating foreign-currency assets as disadvantageous exchange rates.

Reference: CFA Level III, Volume 4, Study Session 10, Reading 21, LOS c

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 8 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 19 MINUTES Simon Weaver is an economic analyst working at Time Analytics. Weaver covers developed and emerging markets specializing in bonds and equities. Weaver is making inflation forecasts for Lidon, a country with an emerging market. His analysis focuses on two historical periods, 1990-1995 and 1996-2001. The first time period was marked with above average inflation, GDP growth exceeding its target, and an economy in danger of becoming overheated. The cause of the high inflation was a global rise in energy prices triggering cost-push inflation in the country. Circumstances changed in the 1996-2001 period when monetary authorities implemented restrictive policy measures to cool down the economy. Based on economic analysis, Weaver projects that Lidon’s economy is once again expected to overheat due to the rapid supply of money currently being injected by monetary authorities. To calculate the anticipated increase in inflation, Weaver uses the average inflation prevailing over the two time periods, assigning a higher probability to the inflation observed during 1990-1995, as input to his analytical model. A. Discuss the bias observed demonstrated by Weaver’s analytical methods. (2 minutes) B. i.

Identify the psychological trap which Weaver has fallen into. Justify you choice. Answer B-i in the template provided below.

ii.

For the identified bias, discuss two possible measures which can be taken to avoid this bias. (5 minutes)

Template for Question 8-B (i) is provided at the end of Question 8.

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CFA Level III Mock Exam 3 – Solutions (AM)

C. Three months later Weaver’s inflation forecast materializes. The analyst anticipates Lidon’s central bank will deal with this scenario by tightening the monetary policy and increasing the short-term interest rate to 7.0% from its current level of 6.0%. Recommend which asset class will be a suitable investment choice given Weaver’s expectations. For the asset classes not selected, explain why they are inappropriate. Answer Question 8-C in the template provided at the end of Question 8. (7 minutes) D. The authorities in Lidon have announced their intention to peg the local currency, LDN, to the U.S. dollar (USD). The market is weary of the strategy’s effectiveness and expects the LDN to be devalued shortly before Lidon implements the policy. The current interest rate differential between Lidon and U.S. sovereign bonds is 4.5%. i.

Identify two benefits of maintaining an exchange rate peg. (2 minutes)

ii.

Determine whether the change in interest rate differential will be positive, negative or neutral based on the information provided on the market’s views concerning the exchange rate peg. Justify you answer. (3 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 8-B (i) Identify the Psychological Trap which Weaver has Fallen Into (Circle the Correct Answer)

For the Trap Not Selected, Provide one Reason Why it is Inappropriate.

Overconfidence

Confirming evidence

Status Quo

Template for Question 8-C Select the most suitable asset class given Weaver’s expectations

Explain why the choices not selected are inappropriate

Stocks

Cash

7.5% Mortgage-backed securities

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 8. A Solution. Weaver has introduced time period bias while developing inflation forecasts. His forecast is heavily influenced by the inflation observed in the 1990-2005 time period. His analysis is not appropriate given that the underlying cause of inflation is not cost push. His forecast for inflation would have differed if he had given both time periods the same or relatively similar emphasis. Reference: CFA Level III, Volume 3, Study Session 10, Reading 21, LOS b B-(i) Solution: Identify the Psychological Trap which Weaver has Fallen Into (Circle the Correct Answer)

Justify Your Selection

Overconfidence

Confirming Confirming evidence evidence

He is assigning greater weight to the time period when inflation was high; he emphasizes on data which supports his point of view concerning future inflation.

Status Quo

Reference: CFA Level III, Volume 3, Study Session 10, Reading 21, LOS b

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CFA Level III Mock Exam 3 – Solutions (AM)

B-ii Solution: Possible measures include: • • •

Examining all evidence with equal rigor Enlisting an independent individual to argue your preferred conclusion or decision Being honest about your motives.

Reference: CFA Level III, Volume 3, Study Session 10, Reading 21, LOS b C Solution: Select the most suitable asset class given Weaver’s expectations

Equities

Explain why the choices not selected are inappropriate There are signs of inflation moving out of equilibrium as demonstrated by the expectation that the central bank will act to slow down the economy. Equity securities will not be an appropriate investment choice in this scenario.

Cash Cash

7.5% Mortgage-backed securities

Despite the predicted increase in short-term rates, they will continue to remain below the 7.5% mortgage rate. Therefore, borrowers will continue to exercise their prepayment option which will result in lower cash flows and lower reinvestment income for security holders.

Reference: CFA Level III, Volume 3, Study Session 10, Reading 21, LOS g

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CFA Level III Mock Exam 3 – Solutions (AM)

D-(i) Solution. Domestic businesses have some reassurance that exchange rates will not fluctuate wildly. By pegging its exchange rate, a pegged country often hopes to control inflation. Reference: CFA Level III, Volume 3, Study Session 7, Reading 18, LOS l D-(ii) Solution The interest rate differential will widen with the LDN rate being higher relative to the US rate as: • •

investors will demand a substantial interest rate differential because they see the peg policy as being unsustainable. the LDN is expected to be devalued before Lidon pegs its currency.

Reference: CFA Level III, Volume 3, Study Session 10, Reading 21, LOS l

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46

CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 9 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES Melissa Reed manages the equity allocation of institutional client portfolios at WoodCarter. The Smithson Foundation (SF) is Reed’s most recent client. During a meeting with the foundation’s chief executive, Reed deems that the portfolio’s equity allocation should be indexed to the Russell 3000 index. In her conversation with the chief executive concerning the portfolio management strategy, the latter states, “The chosen passive management strategy should minimize portfolio rebalancing costs and be cost effective in terms of portfolio construction costs.” A. Select which strategy is most suitable for the passive management of SF portfolio’s equity allocation. Justify your choice. Your answer should also explain why the strategies not selected are unsuitable. (Note: The provided justifications for the three strategies should be distinct.) Answer Question 9-A in the Template provided at the end of Question 9. (7 minutes) Reed is of the opinion that the investment universe of SF’s portfolio should be expanded to include global equities. However, she does not wish to undertake the purchase of individual stocks and so engages in an equity index swap whereby the SF policy portfolio will receive the return on the MSCI global equity index in exchange for interest payments on U.S. Treasury bonds. B. Discuss two usual motivations for Reed’s global equity swap strategy. (4 minutes) Reed also manages the equity portion of Glenn Endowment’s (GE) policy portfolio. The fund’s prospectus identifies the investment mandate as “active large-cap exposure with a growth bias.” Reed’s manager, Carl Edgar, evaluates his subordinate’s performance using a returnsbased style analysis and employs four benchmarks – Russell 1000 Value Index, Russell 1000 Growth Index, Russell 2000 Growth Index, and Russell 2000 Value Index. The results of the performance evaluation are summarized below.

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CFA Level III Mock Exam 3 – Solutions (AM)

Exhibit: Results of Edgar’s Returns-Based Style Analysis Factor Weights Russell 1000 Value 0.45 Russell 1000 Growth 0.25 Russell 2000 Value 0.20 Russell 2000 Growth 0.10 Annualized portfolio return Annualized tracking risk Error term

14.50% 7.85% 9.58%

C. State one advantage and one disadvantage of the performance evaluation approach being used by Edgar. (2 minutes) D. State and justify whether GE’s portfolio is invested in accordance with the stated mandate. (4 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 9-A Select the most Suitable Strategy for the Passive Management of SF’s Portfolio

Justify Your Response with One Reason.

Full Replication

Stratified Sampling

Optimization

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 9. A Solution. Select the most Suitable Strategy for the Passive Management of SF’s Portfolio Full Replication

Stratified Sampling Stratified

Sampling

Optimization

Justify Your Response with One Reason.

Possible answers: • The full replication approach is more suitable when the index stocks are less than 1,000. • Portfolio rebalancing costs reduce the return of the portfolio relative to that of the benchmark index. Explanation: • Suitable when the benchmark comprises a large number of stocks (> 1,000) • Cost-effective; managers can construct portfolio which replicates the benchmark index exposure without having to purchase all of the stocks in the index. Optimization requires periodic trading to keep the portfolio’s risk exposures in line with the benchmark generating portfolio rebalancing costs.

Reference: CFA Level III, Volume 4, Study Session 12, Reading 27, LOS d

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CFA Level III Mock Exam 3 – Solutions (AM)

B Solution. Typical motivations for using equity index swaps are given below: Efficient asset allocation: Equity swaps can be used to efficiently effect a change in asset allocation. A manager can use swaps to rebalance portfolios to the strategic asset allocation and incur rebalancing costs which are lower than having to trade the underlying securities. Tax savings: One prime motivation for using equity swaps is to avoid high taxes on the full return amount from an equity investment under circumstances where tax laws are favorable. Equity swap applications are motivated by differences in the tax treatment of shareholders domiciled in different countries. Other motivations may include gaining synthetic exposure to index returns, adding leverage or hedging a portfolio etc. Reference: CFA Level III, Volume 4, Study Session 12, Reading 27, LOS c C Solution. Possible advantages include: • • • • • • • •

Characterizes the entire portfolio Facilitates comparisons of portfolios Aggregates the effect of the investment process Different models usually give broadly similar results and portfolio characterizations Clear theoretical basis for portfolio categorization Requires minimal information Can be executed quickly Cost effective

Possible disadvantages include: • •

May be ineffective in characterizing current style Error in specifying indices in the model may lead to inaccurate conclusions

Reference: CFA Level III, Volume 4, Study Session 13, Reading 28, LOS i FinQuiz.com © 2019 - All rights reserved.

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CFA Level III Mock Exam 3 – Solutions (AM)

D Solution: The fraction of the portfolio explained by the manager’s security selection ability is 9.58% indicating that the portfolio is indeed being managed actively. A closer look at the benchmark weights reveals that Reed has drifted from her stated investment style. His factor weight of .70 (0.45 + 0.25) on large-cap stocks exceeds his weight of 0.30 (0.20 + 0.10) on small-cap stocks. However, his allocation to small-cap stocks is not insignificant. In addition, his factor weight of 0.45 on large-cap value stocks exceeds his factor weight of 0.25 on large-cap growth stocks. GE’s portfolio appears to be an actively managed large- and small-cap market-oriented portfolio with a value bias. Reference: CFA Level III, Volume 4, Study Session 12, Reading 28, LOS d

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 10 HAS ONE PART FOR A TOTAL OF 6 MINUTES Carl Storm is an institutional portfolio manager at Theta Asset Management. Storm works closely with Green Associates, a broker/dealer firm, to execute trades on behalf of client accounts. Below are excerpts from her meetings with the chief executives of two of her clients. Storm needs to determine which type of order will be submitted to Green Associates based on the details collected. Smithson Corp’s Defined Benefit Pension Fund: Smithson has placed an order to purchase 100,000 shares of Reliable Corp, a software manufacturer. The average day’s volume of the manufacturer’s stock is 400,000. The firm’s purchase decision is based on earnings growth projections generated by the firm’s in-house forecasting model. The chief executive has instructed to Storm, “We would not like to reveal the full extent of our purchase order to the market.” Thornton Endowment Fund: The chief executive emphasizes on giving brokers free reign to make purchase decisions for the fund’s policy portfolio whenever the market presents a favorable opportunity. All trades must be executed within three trading days of placing the order. Determine which order is most suitable for the two clients. Explain your choice. Answer Question 10 in the template provided at the end of Question 10. (6 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 10

Client

Determine which order is most suitable for the two clients (Circle the Correct Answer)

Explain your Choice

Reserve order

Smithson Corp’s Defined Benefit Pension Fund

Market-not-held order

Market on open order

Participate order

Thornton Endowment Fund

Best efforts order

Market on open order

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CFA Level III Mock Exam 3 – Solutions (AM)

Solution for Question 10

Client

Determine which order is most suitable for the two clients (Circle the Correct Answer)

Reserve order Reserve order Smithson Corp’s Defined Benefit Pension Fund

Market-not-held order

Market on open order

Participate order Thornton Endowment Fund

Best efforts order order Best efforts

Market on open order

Explain your Choice Reserve orders are suitable for those traders who place an order which represents a substantial fraction of the average daily trading volume, but do not wish to display the full size of their orders. Smithson’s order represents 40% (100,000/400,000) of the stock’s trading volume in a day which is significant and the chief executive has expressed his desire to conceal a portion of the order.

Best efforts orders are suitable for those clients who are willing to give their broker/agent full discretion to work the order only when the broker judges the market to be favorable. Based on the chief executive’s demands, this order is most suitable for the client.

Reference: CFA Level III, Volume 6, Study Session 18, Reading 35, LOS d

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 11 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 15 MINUTES Bjore Traders is a shipping company listed on the NYSE. The company has divisions operating in several states across the U.S. Each divisional manager is responsible for overseeing the risk management of its exposures. A. Identify one benefit and one drawback of BT’s risk management system structure. (2 minutes) Jacqueline Andrew is the head of risk management at BT’s Idaho division. Andrew is preparing a report on the division’s risk exposures in order to determine how to manage them effectively. She begins her report by discussing the division’s strategy for risk management: Statement: “We manage risk strategically by avoiding risk taking in areas in which we do not have expertise and hedging only tactically in areas in which we have an edge.” B. Does Andrew’s statement reflect efficient risk management practices? Justify your response. (3 minutes) Answer Question 11-B in the template provided at the end of Question 11. The Idaho Division is BT’s only division delivering orders to customers outside the U.S. A portion of its sales are on credit. Shipping fuel is procured by paying for 12 months’ fuel in advance using over-the-counter (OTC) prepaid commodity swaps. The firm has hedged its foreign currency exposures using currency futures. In the current year, the management is seeking to expand the division’s delivery destinations and will be purchasing three freight ships from a U.S. supplier. Funds from the purchase will come from issuing a combination of equities and corporate bonds. C. Identify five risk exposures faced by the Idaho division. Your answer should explain each risk exposure by identifying one source. Answer Question 11-C in the Template provided at the end of Question 311. (10 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 11-B Does Andrew’s Statement Reflect Efficient Risk Management Practices? (Circle the Correct Option)

Andrew’s Statement: “We manage risk strategically by avoiding risk taking in areas in which we do not have expertise and hedging only tactically in areas in which we have an edge.”

Justify Your Response

Yes No

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CFA Level III Mock Exam 3 – Solutions (AM)

Template for Question 11-C Identify Five Risk Exposures Faced by the Idaho Division

Explain Each Risk Exposure with One Identified Source

1.

2.

3.

4.

5.

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CFA Level III Mock Exam 3 – Solutions (AM)

Solutions for Question 11. A Solution. BT has a decentralized risk management system as each division is responsible for managing its own risk exposures. Advantage: People who are most familiar with the risk will be managing exposures. Disadvantage (Marks will be awarded for any one of the following disadvantages identified): • •

Does not permit economies of scale Does not allow a company to recognize the offsetting nature of distinct exposures that an enterprise may assume in its day-to-day operations.

Reference: CFA Level III, Volume 5, Study Session 16, Reading 31, LOS d B Solution: Does Andrew’s Statement Reflect Efficient Risk Management Practices? (Circle the Correct Option)

Andrew’s Statement:

“We manage risk strategically by avoiding risk taking in areas in which we do not have expertise and hedging only tactically in areas in which we have an edge.”

Yes

No No

Justify Your Answer: Although the tactical hedging of areas in which the entity has comparative advantage is an efficient strategy, the division should hedge risks in areas in which they have no expertise. Efficient risk management involves adjusting levels of risk to appropriate levels and not necessarily eliminating risks.

Reference CFA Level III, Volume 5, Study Session 16, Reading 31, LOS a

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CFA Level III Mock Exam 3 – Solutions (AM)

C Solution: Identify Five Risk Exposures Faced by the Idaho Division

1. Credit risk

2. Commodity risk

3. Settlement risk

Explain Each Risk Exposure with One Identified Source

Possible sources of credit risk include: • Credit risk arises from credit sales • Credit risk arises from prepaid swaps as the dealer may not fulfill his side of the agreement by either delaying or failing to deliver the shipment of fuel to the division.

Potential sources of commodity risk include: • The company has exposure in fuel • The company has exposure in shipments to customers

Settlements on the swap can expose the division to settlement risk. The division has prepaid for fuel which it may not receive.

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CFA Level III Mock Exam 3 – Solutions (AM)

4. Equity market risk

5. Liquidity risk

6. Interest rate risk

The success of its expansion operations will be affected by the price it receives from issuing shares.

The division is exposed to the risk that securities may not be bought or sold as quickly to finance the freights purchase.

Potential sources of interest rate risk include: • The division is financing the purchase of freights by issuing corporate bonds. • A portion of sales are offered on credit terms.

Reference: CFA Level III, Volume 5, Study Session 16, Reading 31, LOS d

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 12 HAS ONE PART FOR A TOTAL OF 5 MINUTES Capex Asset Management is a U.S. based portfolio management firm which has always invested in domestic stocks on behalf of client portfolios. Victor Solanki is CAM’s senior most portfolio manager. Solanki has allocated €100 million for investing in German stocks with an average beta of 0.75. The spot exchange rate is $0.89. The German interest rate is 4%. Solanki will be hedging both German market risk as well as currency risk for a three month period. A three-month futures contract on the German market is priced at €200,000 and has a beta of 0.60. The three-month forward rate is $0.9560. i.

Identify the strategy Capex Asset Management will need to undertake for hedging German local market return.

ii.

Calculate the hedged portfolio return. Use a ‘n/360’ days convention and show your calculations.

(5 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Question 12 Solution: i.

Capex Asset Management will need to sell futures contracts to hedge the German local market return. Explanation: Capex has a long exposure to the German equity market. A fall in return will generate losses for its investment portfolio. Therefore, to hedge against potential losses the company will need to sell futures contracts.

ii.

The portfolio is hedged for local market risk and therefore it will grow to a value of €101,000 = €100,000[1 + (0.04 × 90/360)]. Capex can hedge this amount using a currency forward contract with a notional principal of €101,000. With the portfolio hedged for currency risk, the dollars received at contract expiration will equal to $96,556 (€101,000 × $0.9560). Based on the original portfolio value of $89,000 (€100,000 × $0.89), the hedged portfolio return is equal to 8.49% ($96,556/$89,000 – 1).

Reference: CFA Level III, Volume 5, Study Session 17, Reading 32, LOS f

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CFA Level III Mock Exam 3 – Solutions (AM)

QUESTION 13 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 17 MINUTES. Steven Blair, CFA, has been contracted to help Betty Davis put together an Investor Policy Statement and a strategic allocation for her $2.5 million in assets. The funds are currently allocated to the asset classes established by a previous advisor Money Market Instruments U.S. Large Cap Fund U.S. Corporate Bonds U.S. Treasuries S&P500 Fund

20% 20% 20% 20% 20%

They begin to discuss the asset classes and recommendations in their first meeting. Steven tells Betty that the previous advisor did not correctly specify the asset classes. He also recommends treasury-inflation protected securities as a separate asset class from the nominal bonds currently in the portfolio and provides the table below as evidence. Historical Correlation of Returns TIPS Corporates Asset Class Treasury Inflation Protected Securities 1.00 U.S. Corporate Bonds 0.85 1.00 U.S. Treasuries 0.71 0.80

Treasuries

1.00

A. Support Stevens recommendation to add TIPS with two reasons (2 minutes) B. Describe three errors that were made in the specification of asset classes (6 minutes) Steven has experience developing strategic asset allocations using traditional mean variance optimization with unadjusted historical returns, variances and covariances. To construct a strategic allocation for Betty, he is interested in using other approaches like Black-Litterman and Monte Carlo simulation. C. Identify one advantage and one limitation for each of the approaches listed in the case (Mean-Variance, Black-Litterman, and Monte Carlo) (9 minutes)

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CFA Level III Mock Exam 3 – Solutions (AM)

Solution for Question 4 A Solution: TIPS are a homogenous asset class (they are correlated with themselves). They also provide important protection against inflation, which is not provided in nominal bonds. Reference: CFA Level III, Volume 3, Study Session 9, Reading 19. B Solution: 1)

The asset classes listed do not make up a preponderance of global investable wealth, no international investments are listed.

2)

Asset classes should be mutually exclusive or have no overlap. The U.S. large cap and the S&P500 fund will overlap significantly.

3)

Asset classes should be diversifying for risk control. The U.S. corporate bonds and Treasuries are highly correlated and it is assumed that the U.S. large cap and S&P500 funds will also be highly correlated.

Reference: CFA Level III, Volume 3, Study Session 9, Reading 19. C Solution: Mean-Variance: Advantage is that it identifies portfolios with the highest expected return at each level of risk, though it is limited in the number and nature of estimates can overwhelm the analyst. Black-Litterman: Advantage is that it provides portfolios that are well-diversified and a stable efficient frontier, though it is limited in that it relies on historical returns and variances. Monte Carlo: Advantage is that it can be used to generate a distribution of probabilities, though its limitation is the complexity of the approach. Reference: CFA Level III, Volume 3, Study Session 9, Reading 19. FinQuiz.com © 2019 - All rights reserved.

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