L3 mock sample exam CFA level III guideline answers 2000

Question 1 and 2, including Guideline Answers, 1995 CFA Level III Examination LOS: The candidate should be able to “Individual Investors” Session 8 • create an asset allocation policy

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LEVEL III, QUESTION 13

Topic: Portfolio Management

Minutes: 20

Reading References:

1 “Individual Investors,” Ch 3, Ronald W Kaiser, Managing Investment Portfolios: A

Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren,

Gorham & Lamont, 1990)

2 Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd (AIMR,

1990)

A “Introduction”

B “The Allen Family (A)”: Case p 15, Guideline Answers p 58

C “The Allen Family (B)”: Case p 18, Guideline Answers p 62

3 Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination

(AIMR)

4 Question 1, including Guideline Answer, 1997 CFA Level III Examination (AIMR)

5 Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR)

Purpose:

To test the candidate’s ability to evaluate an investment policy statement for an individual with changing resources and return needs over time and to address specific liquidity and income needs and unique circumstances

LOS: The candidate should be able to

“Individual Investors” (Session 8)

• analyze the objectives and constraints of an individual investor and use this information to formulate an appropriate investment policy by taking into consideration the investor’s

psychological characteristics, positions in the life cycle, long-term goals, liquidity

constraints, taxes, gifts, and estate planning

“Cases in Portfolio Management” (Session 8)

• apply the readings in this Study Session to create an investment policy statement for an individual investor

“Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8)

• prepare an investment policy statement that clearly states the investment objectives and constraints for an individual investor;

• justify all recommendations and statements included in an investment policy statement;

• criticize an investment policy statement and identify key investment constraints and

objectives not included in the statement

“Question 1, including Guideline Answer, 1997 CFA Level III Examination” (Session 8)

• analyze the objectives and constraints of an individual investor and formulate an appropriate set of investment policies, taking into consideration the investor’s psychological

characteristics, position in the life cycle, and long term goals;

• criticize an investment policy and determine the appropriateness of the policy given the client’s goals and constraints

“Question 1, including Guideline Answer, 1997 CFA Level III Examination” (Session 8)

• prepare and justify a well-organized investment policy statement;

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• criticize an investment policy statement and judge whether the policy statement will meet the

stated goal of the client

Guideline Answer:

• Although Wheeler accurately indicates Taylor’s personal income requirement, she

does not recognize the need to support Renee

• Wheeler does not indicate the need to protect Taylor’s purchasing power by

increasing income by at least the rate of inflation over time

• Wheeler does not indicate the impact of income taxes on the return requirement

• Wheeler calculates required return based on assets of $900,000, appropriately

excluding Taylor’s imminent $300,000 liquidity need (house purchase) from

investable funds However, Taylor may invest $100,000 in his son’s business If he

does, Taylor insists this asset be excluded from his plan In that eventuality, Taylor’s

asset base for purposes of Wheeler’s analysis would be $800,000

• Assuming a $900,000 capital base, Wheeler’s total return estimate of 2.7 percent is

lower than the actual required after-tax real return of 5.3 percent ($48,000 /

$900,000)

ii The risk tolerance section of the IPS is inappropriate

• Wheeler fails to consider Taylor’s willingness to assume risk as exemplified by his

aversion to loss, his consistent preference for conservative investments, his adverse

experience with creditors, and his desire not to work again

• Wheeler fails to consider Taylor’s ability to assume risk, which is based on Taylor’s

recent life changes, the size of his capital base, high personal expenses versus income,

and expenses related to his mother’s care

• Wheeler’s policy statement implies that Taylor has a greater willingness and ability to

accept volatility (higher risk tolerance) than is actually the case Based on Taylor’s

need for an after-tax return of 5.3 percent, a balanced approach with both a fixed

income and growth component is more appropriate than an aggressive growth

strategy

• Wheeler accurately addresses the long-term time horizon based only on Taylor’s age

and life expectancy

• Wheeler fails to consider that Taylor’s investment time horizon is multi-staged

• Stage one represents the life expectancy of Renee, during which time Taylor will

supplement her income

• Stage two begins at Renee’s death, concluding Taylor’s need to supplement her

income, and ends with Taylor’s death

ii The liquidity section of the IPS is appropriate because Wheeler fully discloses all

potential liquidity needs

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Minutes: 12

1 “Individual Investors,” Ch 3, Ronald W Kaiser, Managing Investment Portfolios: A

Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren,

2 Question 1 and 2, including Guideline Answers, 1995 CFA Level III Examination

• create an asset allocation policy for an individual investor that is based on a multi-asset, total return approach

“Question 1 and 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8)

• recommend and justify an asset allocation

“Question 1, including Guideline Answers, 1996 CFA Level III Examination” (Session 8)

• recommend and justify an asset allocation and clearly state any assumptions made that contributed to the recommendation, especially the risk tolerance of the client

Allocation B is most appropriate for Taylor Taylor’s nominal annual return requirement is 6.3%

based upon his cash flow (income) needs ($50,400 annually) to be generated from a current asset base of $800,000 After adjusting for expected annual inflation of 1%, the real return

requirement becomes 7.3% That is, to have $808,000 ($800,000 × 1.01), the portfolio must generate $58,400 ($50,400 + $8,000) in the first year, and $58,400 / $800,000 = 7.3%

Allocation B meets Taylor’s minimum return requirement Of the possible allocations that provide the required minimum real return, Allocation B also has the lowest standard deviation of returns (i.e least volatility risk), and by far the best Sharpe ratio In addition, Allocation B offers a balance of high current income and stability with moderate growth prospects

Allocation A has the lowest standard deviation and best Sharpe ratio, but does not meet the minimum return requirement, when inflation is included in that requirement Allocation A also has very low growth prospects

Allocation C meets the minimum return requirement and has moderate growth prospects but has

a higher risk level (standard deviation) and a lower Sharpe ratio, and less potential for stability than Allocation B

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Allocation D also meets the minimum return requirement and has high growth prospects but has the highest standard deviation and lowest Sharpe ratio of the allocations that provide the required minimum real return

Thus, of the three allocations meeting the minimum return requirement, Allocation B presents the lowest level of risk as indicated by its lower expected standard deviation Given Taylor’s stated desire to assume “no more risk than absolutely necessary” to achieve his return goals, Allocation B is the appropriate selection

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Minutes: 12

Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald

L Tuttle, eds (Warren, Gorham & Lamont, 1990)

A “Individual Investors,” Ch 3, Ronald W Kaiser

B “Monitoring and Rebalancing the Portfolio,” Ch 13, pp 13-4 through 13-8, Robert D

Arnott and Robert M Lovell Jr

Purpose:

To test the candidate’s ability to assess how changing client circumstances and preferences affect ongoing investment policies

• analyze the objectives and constraints of an individual investor and use this information to formulate an appropriate investment policy by taking into consideration the investor’s

psychological characteristics, positions in the life cycle, long-term goals, liquidity

constraints, taxes, gifts, and estate planning

“Monitoring and Rebalancing the Portfolio” (Session 10)

• determine whether changed asset risk and return conditions require a portfolio to be

i Return Requirement Taylor’s asset base is now three times its original level, while his cash

flow needs have dropped substantially His annual return requirement has therefore dropped considerably; for example, if his cash flow needs have declined by 50% and his asset base has tripled, then his minimum nominal return requirement has fallen to one-sixth of its previous level, and his real return requirement has also decreased commensurately

ii Risk Tolerance Taylor’s willingness to assume risk has apparently risen substantially, given

his new feelings of financial security His plan to reorient his investments to provide for future charitable goals may further indicate his willingness to assume additional risk in his portfolio

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Taylor’s ability to assume risk, which was already average to above average, has likely risen

materially as well, because his asset base has grown and his cash flow needs have decreased The increases in both his willingness and ability to assume risk point to a resulting

substantial increase in his overall risk tolerance

iii Time Horizon Taylor is now five years older and his time horizon is shorter, though still

long term Moreover, his time horizon previously was composed of two stages: his mother’s lifetime, when his expenses and cash flow needs were higher, followed upon her death by his remaining lifetime Now, the appropriate horizon is one stage (his lifetime) with lower cash flow needs

iv Liquidity Needs Taylor’s ongoing liquidity needs are largely unchanged and remain

relatively low, with the exception of his possible cash charitable contribution The size ($100,000) of this potential gift and its near term horizon is material enough to create the need for a somewhat larger than usual cash reserve

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Minutes: 12

1 “The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium

Phenomenon for Investment Decision Making (AIMR, 1990)

2 “Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing

Worldwide VI (AIMR, 1996)

3 “Behavioral Finance versus Standard Finance,” Meir Statman, Behavioral Finance and

Decision Theory in Investment Management (AIMR, 1995)

Purpose:

To test the candidate’s ability to identify and discuss major tenets of behavioral finance in the context of observed irrational investor behavior

“The Psychology of Risk” (Session 10)

• contrast the assumptions of rational investment decision-making with observed investor behaviors, including loss aversion, reference dependence, asset segregation, mental

accounting, and biased expectations

“Behavioral Risk: Anecdotes and Disturbing Evidence” (Session 10)

• discuss potential systematic overconfidence in analysts’ forecasts and the associated

implications, particularly for asset allocation and portfolio construction;

• appraise how prospect theory can be used to explain how investors treat losses differently than gains

“Behavioral Finance versus Standard Finance” (Session 10)

• contrast the standard view of human investor behavior with a behavioral finance framework;

• describe how the components of prospect theory, cognitive errors, self control, and regret explain phenomena such as investor preference for cash dividends, preference for the stocks

of good companies, and the disposition to sell winners too early and to hold losers too long;

• show how the proliferation of new financial products, particularly derivatives, can be

explained in terms of behavioral finance;

• appraise how models of investor behavior complicate the development of rational investment policy statements and determination of asset allocations

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i Mental accounting is best illustrated by Statement #3

Sampson’s requirement that his income needs be met via interest income and stock dividends

is an example of mental accounting Mental accounting holds that investors segregate funds into mental accounts (e.g., dividends and capital gains), maintain a set of separate mental accounts, and do not combine outcomes; a loss in one account is treated separately from a loss in another account Mental accounting leads to an investor preference for dividends over capital gains and to an inability or failure to consider total return

ii Overconfidence (illusion of control) is best illustrated by Statement #6

Sampson’s desire to select investments that are inconsistent with his overall strategy

indicates overconfidence Overconfident individuals often exhibit risk-seeking behavior People are also more confident in the validity of their conclusions than is justified by their success rate Causes of overconfidence include the illusion of control, self-enhancement tendencies, insensitivity to predictive accuracy, and misconceptions of chance processes

iii Reference dependence is best illustrated by Statement #5

Sampson’s desire to retain poor performing investments and to take quick profits on

successful investments suggests reference dependence Reference dependence holds that investment decisions are critically dependent on the decision-maker’s reference point; in this case the reference point is the original purchase price Alternatives are evaluated not in terms

of final outcomes but rather in terms of gains and losses relative to this reference point Thus, preferences are susceptible to manipulation simply by changing the reference point

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Minutes: 22

1 “Alternative Measures of Risk,” Roger G Clarke, Investment Management, Peter L

Bernstein and Aswath Damodaran, eds (Wiley, 1998)

2 “Global Risk Management: Are We Missing the Point?” Richard Bookstaber, The

Journal of Portfolio Management (Institutional Investor, Spring 1997)

3 “Indexing,” Ch 18, Bond Markets, Analysis and Strategies, 3rd edition, Frank J Fabozzi

(Prentice Hall, 1996)

Purpose:

To test the candidate’s understanding of the different aspects of risk measurement and risk management in a complex portfolio management environment

“Alternative Measures of Risk” (Session 12)

• evaluate circumstances in which variance or standard deviation may fail to capture some dimensions of risk;

• contrast tracking error, beta, and standard deviation as measures of risk;

• appraise and evaluate the probability of shortfall and expected shortfall as risk measures

“Global Risk Management: Are We Missing the Point?” (Session12)

• evaluate the implications of fat tails for risk managers;

• contrast variance and correlation measures of financial markets during financial crisis with those during normal market environments

“Indexing” (Session 6)

• appraise tracking error, implementation problems, and enhanced indexing in the context of

formulating indexing strategies

A i The population variance of a probability distribution is calculated by squaring the

deviation of each occurrence from the mean and multiplying each squared value by its associated probability The sum of these values is equal to the variance of the

distribution, and the square root of the variance is referred to as the standard deviation The sample variance is calculated as the sum of squared deviations from the mean

divided by the number of observations minus one

ii Tracking error relative to a benchmark can be viewed as a modification of variance or standard deviation In that context, tracking error can be defined as the standard deviation

of the difference in returns between the investment and a specified benchmark or target position; in formula terms, tracking error is the standard deviation of:

∆R = R – B

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where ∆R = all differential returns, R = all investment returns,

B = the benchmark return

Alternatively, tracking error for a managed portfolio can be calculated simply as the difference between the performance of that portfolio and the performance of a benchmark index

iii Probability of shortfall is the chance that the return from an investment may fall below some benchmark or reference return; in formula terms, probability of shortfall is:

Probability (R < B) where R = investment return, B = benchmark or reference return The benchmark or reference may be set at zero or any other minimum acceptable return Shortfall probability is most easily shown as a probability distribution If the benchmark return represents a risky asset or index return, the probability distribution represents the distribution of tracking error relative to the index rather than the distribution of total or

absolute return

iv Expected shortfall is the difference between an investment’s actual return and the

benchmark return over the range of returns where a shortfall occurs; in formula terms, expected shortfall is:

probability of shortfall alone

B i The variance (or standard deviation) of security returns has three unique weaknesses as a

risk measure:

• Deviations above and below the mean return are given weights equal to their

respective probability of occurring Yet, given the same probability of occurrence, most investors are more displeased with (averse to) negative deviations than they are pleased with positive deviations of the same magnitude In other words, if two

investments have the same absolute deviations about the mean (same standard

deviation), but one has more negative returns, investors often view the distribution with the lower mean as more risky Standard deviation as a measure of risk tends to

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be more meaningful and useful when the probability distribution of returns is

symmetric If one distribution is skewed to one side or the other, while another distribution is symmetric around the mean, both might have the same standard

deviation but be perceived as having quite different risk Investors tend to prefer more likely but smaller losses versus less likely but larger losses Asymmetric shapes

of probability distributions distort the conclusions that come from using variance as the only measure of risk

• The Taylor series expansion (the mathematical model used to understand expected utility) is only approximately true in the neighborhood of the expansion point (the mean return) and not in the neighborhood where investors’ questions about risk usually lie Investors are often concerned about downside returns in a region where the Taylor series expansion is known to be less accurate

• The use of variance as the only measure of risk assumes the distribution of returns is normal In that case, the Taylor series estimation of expected utility shows that the expected utility is dependent on only the mean and variance terms and not on higher order terms such as skewness and kurtosis When returns are not normally distributed, the higher order terms are nonzero and overlooking this fact can distort the

assessment of risk

ii Although probability of shortfall gives the probability that an undesirable event might occur, it gives no hint as to how severe that undesirable event might be if it occurs For example, a 10% chance of losing 20% and a 10% chance of losing 100% would be

ranked equally by this risk measurement tool, even though most investors would clearly

be more averse to the latter than to the former

iii Expected shortfall fails to differentiate between a large probability of a small shortfall and a small probability of a large shortfall, treating both cases identically This is a problem to the extent that investors view the consequences of large losses per unit

differently from small losses For example, a 10% chance of losing 50% and a 50% chance of losing 10% would be ranked equally by this risk measurement tool

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of options or non-linear trading strategies, for example, or simply because of the inherent

characteristics of the asset itself)

Empirical evidence seems to show that large moves have a much higher probability of occurring than would be suggested by a normal distribution This is what

is meant by the statement “markets have fat tails.” In other words, there are events that occur infrequently (outliers, in a normal distribution), but that have a dramatic effect on risk exposure

Overlooking the fact that return profiles are often asymmetric can significantly distort the assessment of risk Particularly in cases where variance is used as the primary measure of risk, the asymmetric shape

of the probability distribution can lead

to seriously misleading conclusions Tobler's analysis does not take “fat tails” into account, and therefore is vulnerable to materially

underestimating major risks

increases, particularly in times of crisis It is during such times that increases in correlation are not desired by the portfolio manager, because the benefits of

diversification in terms of spreading risk are weakened by increasing correlations

The expected return of a portfolio is a weighted average of the individual expected returns The variance of the portfolio as a whole, however,

contains a cross-product term that can either increase or decrease the

portfolio variance depending on how the securities move relative to each other (i.e their correlation) Changes

in the correlation between the equities composing a portfolio can

dramatically and unexpectedly change the overall variance of the portfolio Correlations are especially unpredictable during major market moves, i.e., during times when overall volatility is markedly higher

Unstable correlations have major implications for the assessment of risk, which Tobler ignores at his peril

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Minutes: 16

1 “Option Payoffs and Option Strategies,” Ch 11, pp 373–383, Futures,Options & Swaps,

2nd edition, Robert W Kolb (Blackwell, 1997)

2 “Using Interest Rate Futures in Portfolio Management,” Concepts and Applications

(Board of Trade of the City of Chicago, 1988)

Purpose:

To test the candidate’s understanding of how, when, and why to use financial futures to adjust asset allocations

“Option Payoffs and Option Strategies” (Session 13)

• compare and contrast a hedging strategy that uses put options with a strategy that uses index futures

“Using Interest Rate Futures in Portfolio Management” (Session 13)

• evaluate the advantages and disadvantages of using financial futures for asset allocation purposes;

• construct, formulate, and evaluate an asset allocation strategy using stock index futures and bond futures

A Delsing should sell stock index futures contracts and buy bond futures contracts This

strategy is justified because buying the bond futures and selling the stock index futures provides the same exposure as buying the bonds and selling the stocks This strategy assumes high correlations between the movements of the bond futures and bond portfolio as well as the stock index futures and the stock portfolio

B The correct number of contracts in each case is:

i 5 × $200,000,000 × 0.0001 = $100,000, and $100,000 / 97.85 = 1022 contracts

ii $200,000,000 / ($1,378 × 250) = 581 contracts

C i The advantages of using financial futures for asset allocation are:

• execution speed in terms of lower transaction time

• execution efficiency in terms of lower market impact and brokerage fees

• less disruption of external manager’s performance

• less reallocation of funds among managers

• no direct cost to establishing the hedge

• high liquidity of index futures

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The disadvantage of using financial futures for asset allocation is:

• exposure of portfolio to basis risk or tracking error

ii The advantages of using index put options for asset allocation are:

• less disruption of external manager’s performance

• less reallocation of funds among managers

The disadvantages of using index put options for asset allocation are:

• the cost of the index put options, which must be borne regardless of the subsequent stock index movement, i.e., significant up-front cost/cash needed to satisfy premium

• need for frequent rebalancing as delta changes with price of underlying asset

• basis risk or tracking error

D The stock return is: $28 / $1,378 = 2% (or 2.03%)

The bond return is: –Dmod × (basis point change / 100) = –5 × (10 / 100) = –0.5%

where: Dmod = modified duration

i For a 50/50 allocation, the capital gain return is:

(0.5 × 2%) + (0.5 × –0.5%) = 0.75% (or 0.765%)

ii For a 75/25 allocation, the capital gain return is:

(0.75 × 2%) + (0.25 × –0.5%) = 1.375% (or 1.3975%)

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Topic: Economics

Minutes: 20

1 “The Nature of Effective Forecasts,” David B Bostian, Jr., Improving the Investment

Decision Process—Better Use of Economic Inputs in Securities Analysis and Portfolio Management (AIMR, 1992)

2 “Using Economic Models,” Avery B Shenfeld, Economic Analysis for Investment

Professionals (AIMR, 1997)

Purpose:

To test the candidate’s understanding of alternate approaches to economic forecasting and the pitfalls involved in using economic models to predict future events

“The Nature of Effective Forecasts” (Session 4)

• criticize, compare, and evaluate alternative economic forecasting methods;

• evaluate the pitfalls in economic forecasting

“Using Economic Models” (Session 4)

• compare and contrast different approaches to economic forecasting

A i The two approaches are similar with respect to role of historical data Both forecasting

approaches use historical data to establish statistical relationships used in the different models and by different analysts Both assume to some degree that the past can be used to predict the future, or at least that the past provides norms against which the present and future can be assessed

ii The two approaches are different with respect to the number of analysts reflected in the forecast In general, there are typically many more analysts included in the consensus approach than in an econometric approach, which can be and often is the product of only one analyst or a small group of researchers

iii The two approaches are similar with respect to nature of assumptions about future

economic relationships Both methodologies may use the same assumptions for future economic relationships, and in both cases the underlying assumptions may be as difficult

to formulate and justify as the relationships being specified

B i Consensus approaches are more likely to be distorted by group think; in fact, consensus

forecasting may tend to reinforce group think Group think deals with the human

tendency to want to feel comfortable People tend to gravitate towards a consensus view; because it is a view shared by many, it represents a “safe,” comfortable, and generally low-exposure/low-risk position

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ii Consensus approaches are more likely to be distorted by the inability to test sensitivity Analysts are unable to manipulate the consensus data provided to them It is typical to receive the consensus forecast for upcoming economic releases and not have the ability to perform any form of sensitivity analysis on that consensus; in other words, it is often difficult to answer the question “What may be wrong with this view?” with respect to a consensus view

iii Econometric approaches are more likely to be distorted by simultaneity Simultaneity arises when the analyst is trying to measure the influence of one variable on another when that second variable also influences the first one Consensus approaches may

embed distortions created by simultaneous relationships, but simultaneity is more likely

to impart direct and systematic distortions to econometric approaches Given that

econometric models are complex mathematical structures, the interaction of variables is a concern when using that model and those variables to posit a statistical relationship

iv Econometric approaches are more likely to be distorted by data mining, which is testing multiple models with the same data until the desired result is obtained Almost by

definition, econometric approaches that are based on many complex mathematical

relationships are subject to questionable manipulation by eager analysts Econometric models are always subject to the risk of questionable results that arise from the process of trying to isolate one variable or relationship from among many

C i Econometric approaches, because they are much more intricate in nature, can pick

turning points in the economy or data series missed by consensus approaches An

econometric model can create a picture of the economy, which in turn influences other equations that give predictions of such variables as interest rates or GDP It also provides the forecaster with an opportunity to consider the exercise from a number of different frames of reference Consensus forecasts will pick turning points only if enough

participants in the consensus do so

ii Consensus approaches are easy to construct, typically representing a simple polling of analysts Numerous surveys of economists’ opinions and forecasts are available in

business publications and from commercial services Econometric models are complex to design, often difficult to implement, and expensive to maintain

iii Econometric approaches can incorporate as many market influences as the forecaster believes may be important Such models can be designed to try to capture the

complexities of the economy in general and specific economic sectors and can be

modified readily to accommodate changing conditions Because consensus forecasts are adopted as a finished product, the end user typically has no way of determining how many or few market influences are reflected in the forecasts

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Topic: Asset Valuation

Minutes: 16

“Real Estate Investment Performance and Portfolio Considerations,” Ch 21, pp 682–687 and

699–705, Real Estate Finance and Investments, 10th edition, William B Brueggeman and

Jeffrey D Fisher (Irwin, 1997)

Purpose:

To test the candidate’s understanding of the differences in the calculation of real estate

performance indexes

“Real Estate Investment Performance and Portfolio Considerations” (Session 7)

• compare and contrast types of real estate return indexes;

• appraise the shortcomings of the real estate indexes

Characteristic NAREIT Index NCREIF Index

i Source of underlying asset

valuation

Security prices, as represented

by REIT shares traded on an exchange*

Appraisal estimates, that may include a smoothing bias*

ii Leverage (gearing) of

underlying assets

iii Index returns calculated

before or after deduction of

investment advisory fees

Index returns calculated after deduction of fees

Index returns calculated before deduction of fees

iv Correlation with broad

equity market (e.g., S&P 500

Index)

Positive and relatively high (e.g., empirical studies have presented correlation value exceeding +0.60)

Relatively low to negative (e.g., empirical studies have presented negative correlation value near zero)

*Analysts have at least two sources for real estate return information The first is security prices (exchange-traded) as represented by real estate investment trust (REIT) shares The second is estimates of value on individual properties owned by pension fund sponsors The primary difference between these data is that the first is based on trading of real estate-backed securities and the second is based on appraisal estimates of individual properties

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Topic: Asset Valuation

Minutes: 14

Bond Markets, Analysis and Strategies, 3rd edition, Frank J Fabozzi (Prentice Hall, 1996)

A “Active Bond Portfolio Management Strategies,” Ch 17

B “Liability Funding Strategies,” Ch 19

Purpose:

To test the candidate’s understanding of the effect of changing yield curves on the performance

of similar duration bond portfolios and of the effect on an institution’s balance sheet from a mismatch in asset liability duration

“Active Bond Portfolio Management Strategies” (Session 6)

• prepare a bullet-and-barbell analysis to specify appropriate strategies for various changes in the shape of the yield curve;

• compare a barbell strategy to a bullet strategy under various types of yield curve (term structure) shifts;

• recommend and justify the appropriate active bond portfolio strategy under different

expected yield curve scenarios, various interest rate expectations, changing yield spreads, different OAS strategies, and different security selection criteria

“Liability Funding Strategies” (Session 6)

• discriminate between economic and accounting surplus

A i A parallel shift in the yield curve refers to a shift in interest rates in which the basis point

change in yield is the same for all maturities Portfolio A is structured as a bullet

portfolio with the entire portfolio in an intermediate-term security For a parallel yield curve shift involving a relatively small number of basis points, the bullet structure of Portfolio A will outperform the barbell structure of Portfolio B, because the value of the single intermediate-term security Portfolio A, which has shorter duration, will decrease less than will the value of the short- and long-term security Portfolio B

ii A twist in the yield curve refers to a nonparallel shift in interest rates in which the basis point change in yield is not the same for all maturities In this case, the twist describes a flattening yield curve because the yield spread between long- and short-term rates has decreased Portfolio B is structured as a barbell portfolio with half the portfolio in a short-term security and half in a long-term security When the yield curve twists, the twist will affect Portfolio B favorably, with the price increase of the long-maturity bond outweighing the price decrease of the short-maturity bond Thus the barbell structure of Portfolio B will outperform the bullet structure of Portfolio A when the yield curve twists

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B The surplus, or difference between the market value of HEY’s assets and the market value (or

present value) of HEY’s liabilities, is $20 million The duration of the assets and liabilities

determines how their values respond to changes in interest rates The net effect on the

balance sheet depends on the relative interest rate sensitivity of the assets compared to that of

the liabilities Because HEY’s liabilities now have a duration of 6.0 and HEY’s investment

portfolios now have a duration of 7.2, HEY has an asset/liability mismatch and interest rate

movements will affect the balance sheet

If interest rates decline by 100 basis points, the higher duration of the investment portfolios

suggests that they will increase in value more than the liabilities will increase in value

Assuming that the two portfolios together have a total market value of $200 million, HEY’s

surplus will increase by $3,600,000, to $23,600,000

The calculations are as follows:

7.2% × $200,000,000 = $14,400,000 growth in assets

6.0% × $180,000,000 = $10,800,000 growth in liabilities

$ 3,600,000 increase in surplus

Market value of assets = $200,000,000 + $14,400,000 = $214,400,000

Market value of liabilities = $180,000,000 + $10,800,000 = $190,800,000

Assuming that the two portfolios together have a total market value of $400 million, the

surplus calculations are as follows:

7.2% × $400,000,000 = $28,800,000 growth in assets

6.0% × $180,000,000 = $10,800,000 growth in liabilities

$18,000,000 increase in surplus Market value of assets = $400,000,000 + $28,800,000 = $428,800,000

Market value of liabilities = $180,000,000 + $10,800,000 = $190,800,000

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Topic: Portfolio Management / Asset Valuation

Minutes: 28

1 “Determination of Portfolio Policies: Institutional Investors,” Ch 4, Keith P

Ambachtsheer, John L Maginn, and Jay Vawter, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren,

2 “Pension Investing and Corporate Risk Management,” Robert A Haugen, Managing

Institutional Assets, Frank J Fabozzi, ed (Harper Collins, 1990)

3 “Twenty Years of International Equity Investing,” Richard O Michaud, Gary L

Bergstrom, Ronald D Frashure, and Brian K Wolahan, The Journal of Portfolio

Management (Institutional Investor, Fall 1996)

Purpose:

To test the candidate’s understanding of defined benefit pension plans and implications of investment policies

“Determination of Portfolio Policies: Institutional Investors” (Session 9)

• appraise and contrast the factors that affect the investment policies of pension funds,

endowment funds, insurance companies, and commercial banks

“Pension Investing and Corporate Risk Management” (Session 9)

• appraise the investment policy implications, especially for risk management, of the

relationship between the financial condition of a corporate pension fund and the corporation itself;

• evaluate the effect a corporate pension fund investment policy may have on plan surplus, the corporation’s valuation, and its constituents

“Twenty Years of International Equity Investing” (Session 5)

• discuss the issues facing international equity investors;

• discuss patterns of global equity returns and global market correlations across different market environments

A i Concentrating the pension assets in such a fashion subjects plan beneficiaries to an

extraordinarily high level of risk because of the high correlation between the market values of the portfolio and LSC

ii By concentrating the pension assets heavily in technology and Internet companies, Donovan has increased the risk profile of the company LightSpeed now has the prospect

of possibly having to provide additional funding to the pension plan at a time when the company’s own cash flow and/or earnings position may be weakened A more prudent approach would be to invest in assets with market values that are expected to be less highly correlated with the company’s market value, so in the event additional funding for

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the pension plan becomes necessary it will be less likely to occur when the company is in

a weakened financial position

B i The IPS drafted by Jeffries and the Investment Committee correctly identifies that the

return requirement should be total return, with a need for inflation protection, that is sufficient to fund the plan’s long-term obligations

ii The IPS fails to address the pension plan’s risk tolerance—one of the two main objectives

of a complete investment policy statement—and fails to highlight the potential risk to the beneficiaries and the company should the current high-risk strategy not achieve its return goal

iii The IPS correctly addresses the time horizon constraint by stating that the assets are term in nature, both because of the young work force and the normal long-term nature of pension investing

long-iv The IPS fails to address the liquidity constraint; although liquidity is a minimal concern

in this case, the IPS should so state

C Portfolio C is the only appropriate choice

Diversification of Assets: Portfolio C is well diversified across all asset classes Portfolio C

has minimal IPO/Tech exposure and only 34 percent of the portfolio exposed to riskier asset classes in total (IPO/Tech, small capitalization growth, and venture capital) Portfolio C has the largest exposure (35%) to large capitalization stocks, and provides reasonable levels of international and corporate bond exposure Portfolio A has relatively large cash reserves, no international exposure, and 56 percent of the portfolio allocated to the riskier asset classes (concentrated IPO/Tech, small capitalization, and venture capital assets) Such assets are likely to be relatively highly correlated to each other, to share high risk/high volatility

characteristics, and therefore to not provide as diversified a portfolio as Portfolio C or as may appear at first glance Although Portfolio B has similar international exposure to C, it has 55 percent of the portfolio allocated to riskier asset classes (IPO/Tech, small capitalization growth and venture capital) The Current Portfolio has a 50 percent concentration in the IPO/Tech Fund asset class alone and an 85 percent concentration in the riskier asset

classes(IPO/Tech, small capitalization growth, and venture capital assets) in total, which makes it inferior to Portfolio C on a diversification basis

Correlation with Plan Sponsor’s Business: Portfolio C has the lowest exposure to the

IPO/Tech assets, which may be highly correlated with the plan sponsor’s underlying

business, thereby exposing both the company and the plan beneficiaries to excessive risk in the event of a sharp downturn in the company’s business

Risk/Return Tradeoff: Portfolio C has a Sharpe ratio that is lower than, but in line with, those

of Portfolios A and B, but is better diversified across asset classes and substantially less volatile The Current Portfolio has the worst Sharpe Ratio among the portfolios Although Portfolio C has the lowest expected return, it also has the lowest risk as measured by standard deviation Return per unit of risk is highest for Portfolio C The coefficient of variation (standard deviation divided by expected rate of return) is also best (lowest) for Portfolio C

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