CFA level 3 mock exam 2 level 3 mock 2017

Assuming that the market value of the current portfolio remains unchanged and Michael sells the family business, calculate the after-tax nominal rate of return that is required by the Se

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CFA Level III Mock Exam 2

June, 2017 Revision 1

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FinQuiz.com – 2nd Mock Exam 2017 (AM Session)

1 Portfolio Management – Individual Investors 32

2 Portfolio Management – Behavioral Finance 18

3 Portfolio Management – Institutional Investors 30

4 Portfolio Management – Individual Investors/Asset

5 Portfolio Management – Equity Investments 21

6 Portfolio Management – Fixed-Income Investments 19

7 Portfolio Management – Risk Management 17

8 Portfolio Management – Monitoring and Rebalancing 13

9 Portfolio Management – Performance Evaluation and

Total: 180

QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 32 MINUTES

Michael and Andy Seinfeld are married and live in Minneapolis, Minnesota Michael, 45 years old, is a physician working in the North Memorial Hospital in Minneapolis The Seinfelds have two children; Ryan, a college student in the State University of New York, and Rebecca, a marketing specialist working for a multinational firm, with headquarters

in Boston The Seinfelds are in excellent health and have sufficient medical insurance Michael earns a current salary of $150,000 annually which is taxed as income at 25% Andy earns $75,000, and her income is taxed at a rate of 20% Both Michael and Andy expect their salaries to grow at the inflation rate of 3.5% In addition, the Seinfelds are obligated to pay Ryan’s tuition fee, which equals $50,000 per year Ryan expects to specialize in economic studies in a university in Boston, a year from now The admission fee will equal $25,000, which would be paid at the beginning of the next year, and the annual tuition fee will equal that he pays currently—this fee will remain constant till he graduates in about seven years’ time Rebecca is independent and her salary sufficiently covers her living expenses The Seinfelds fully own and live in a well furnished home in Minneapolis with a current price of $1,800,000

The family also owns a small side business of home furnishing that they plan to sell by next year Michael has received an offer of $5,000,000 for his business, and if he decides

to sell, the entire amount will be taxed at a capital gains tax rate of 17% Exhibit 1

displays information about the Seinfelds personal assets as of today

Exhibit 1

Fixed-Income holdings $850,000 Cash and cash Equivalents $550,000

Michael just hired Jay Peck, a financial advisor and portfolio manager, to manage their personal portfolio During a conversation with Michael, Peck discovered that the average living expenses of the family equal $155,000 a year that will increase at 3.5% annually, the U.S inflation rate Peck also found out that both Michael and Andy (who is currently

43 years old) want to retire in about ten years time after which they want to fulfill their lifelong dream of travelling around the globe They believe that by that time, Ryan would also be independent and earning

To make sure that their portfolio allows for the achievement of their goals, Michael often reads financial journals to gain information on what trading strategies would reap the

most profit Most of his investments were based on research of several analyst

recommendations and market information Andy believes that investing should be done after careful analysis to minimize the probability of the loss of principal Her past

experience has shown her that rushing into investments can cause unexpected losses Peck is in the process of developing an appropriate investment policy statement for the Seinfelds

A Assuming that the market value of the current portfolio remains unchanged and

Michael sells the family business, calculate the after-tax nominal rate of return that is required by the Seinfelds for year 2 Show your calculations

(12 minutes)

B Prepare the following portions of Seinfelds’ Investment Policy Statement, after

the sale of the furnishing business:

i Risk tolerance

ii Time horizon

Answer Question 1-B in the template provided on page 6

(8 minutes)

C Characterize Michael and Andy Seinfeld as cautious, individualistic, methodical,

or spontaneous investors Justify your selection with two reasons each

Answer Question 1-C in the template provided on page 7

(4 minutes)

Five years have passed and Michael and Andy Seinfeld have incomes that just cover their current expenses Their joint after-tax salary equals $350,000 and both their incomes and expenses grow at the inflation rate of 5.0% The Seinfelds current investment portfolio includes stocks, corporate bonds and short-term instruments and has a current market value of $3,500,000 Ryan and Rebecca are each financially independent and earn

competitive salaries in their respective fields Both Michael and Andy plan to retire in five years time, after which they want their portfolio to provide sufficient income to cover their expenses Neither of the two has participated in a pension plan Peck has continued

to be their financial advisor and the Seinfelds have explained to him that a real after-tax return of 4.5% would be adequate to meet their objectives, while instructing him to take

on only those risks with their portfolio that are absolutely necessary to meet their return

of living during retirement and have no further goals or objectives The Seinfelds are now taxed at a rate of 30% The U.S inflation rate will continue to be 5.0% even after their retirement

D i Prepare the current return objectives portion of the Seinfeld’s IPS

ii Assuming the market value of the current portfolio remains unchanged,

calculate the after-tax nominal rate of return that will be required by the portfolio during the first year of retirement Show your calculations

(8 minutes)

Template for Question 1-B

Prepare the following portions of Seinfelds’ IPS

i Risk

tolerance

ii Time

horizon

Template for Question 1-C

Circle the type that best describes them

Explain your choice with two justifications each

Andy

Cautious Methodical Individualistic Spontaneous

Michael

Cautious Methodical Individualistic Spontaneous

QUESTION 2 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES

Secure Capital Investments (SCI) is a financial advisory firm headed by Lucy Appleby, the firm’s chief portfolio manager and head of the advisory department Appleby has been introducing a number of new concepts and techniques toward an improved

management of clients’ capital One such change has been the application of behavioral finance in the development of clients’ investment policy statements, and in implementing portfolio investment strategies During a conversation with a member of the portfolio management team, Appleby mentioned the following client behaviors reflecting

deviations from perfect rationality:

Client A: “I regularly follow the recommendations of the most successful analysts in

the field to ensure that the right decisions are made Popular investments are likely to return positive returns since everyone must be investing in them for a reason.”

Client B: “These last few years, my portfolio experienced a number of ups and

downs Most of my gains resulted from my accurate prediction for the telecommunications sector However, last year my portfolio’s value dropped by 15%, primarily due to the unanticipated turn of economic events in Canada and Europe.”

A Identify the biases inherent in each of the above statements Give one reason each for their existence

Answer Question 2-A in the template provided on page 10

(4 minutes)

Appleby is currently managing the investment portfolio for Chris Moss, a civil engineer working as a consultant for a number of construction companies in the U.S He is 50 years old, is not married, and has no children Moss earns a salary of $175,000 annually and has living expenses well within his annual income (net of tax) However, Moss spends a considerable amount on travelling and entertainment, and so, frequently spends more than his net income Due to a comprehensive retirement savings and investment plan at his firm, Moss has managed to accumulate a portfolio worth $2,500,000, invested mostly in international and domestic equities Over the past few years the equity

allocation of his portfolio had an 18% annual return, primarily due to some successful bets made by him on oil stocks Appleby noticed that Moss’s equity allocation is

concentrated in the stocks of a few oil companies In addition, Moss frequently traded in and out of investments based on his predictions since he believes they have helped him

earn high returns in the past Appleby also observed an investment in the stock of Lions Enterprises (LEN) that had been performing poorly for the past two years When he recommended liquidating the investment, Moss stated that he would hold it for another year until the stock price reaches his purchase price When Appleby asked him about his retirement goals, Moss mentioned that he would not like to compromise his current spending for future consumption He believed in ‘living in the present’

B i Identify three biases that Moss is most likely subject to Justify your response

for each bias

(6 minutes)

ii Determine whether to adapt to, moderate, or adapt to and moderate Moss’s

biases Justify your response

(4 minutes)

Roger Wong is a financial advisor at SCI Wong has been assigned the responsibility to work with Jasmine Arcus, a 35-year old successful entrepreneur who owns a fashion boutique in Chicago, USA Arcus has an investment portfolio worth $5,000,000 that is invested 55% is stocks, and 45% in bonds She manages to make an annual profit from her boutique that comfortably covers her living expenses and also contributes to her savings Arcus is convinced about the future prospects of the U.S automobile sector and has invested 25% of her equity allocation in automobile stocks When Wong suggested diversifying part of the holding due to a deterioration of the industry’s fundamentals, Arcus disagreed, and stated that his predictive model validated the industry’s positive outlook Arcus also mentioned that most of the companies within the auto industry had high P/E multiples which confirmed that her investment in the industry is of good value When Wong asked her how she gathered the information about the P/E multiples, Arcus mentioned that she read in most of the best selling financial journals about how high P/E multiples for companies within the industry prove that their stocks have growth potential and can yield high returns for investors

C Determine whether to adapt to, moderate, or adapt to and moderate Arcus’s

biases Justify your response

(4 minutes)

Template for Question 2-A

Client Statements Identify the biases inherent

in the statements

Give one reason each for why they might exist

“I regularly follow the

recommendations of the most

successful analysts in the

field to ensure that the right

decisions are made Popular

investments are likely to

return positive returns since

everyone must be investing in

them for a reason.”

“These last few years, my

portfolio experienced a

number of ups and downs

Most of my gains resulted

from my accurate prediction

for the telecommunications

sector However, last year my

portfolio’s value dropped by

15%, primarily due to the

unanticipated turn of

economic events in Canada

and Europe.”

QUESTION 3 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 30

MINUTES

Charlotte Browning is a portfolio manager at Get Right Investments (GRI), an asset management firm providing portfolio management services to institutional investors Browning has currently been assigned the task of managing the investment portfolio of an independent foundation The Towers Foundation (TTF) was formed by the Towers

family and is headed by Mark Towers, the sole decision maker for the institute Mark Towers is a large industrialist in the U.S and has made significant donations to the

foundation for the purpose of aiding educational activities in the country The investment portfolio for TTF is worth $85 million and is entirely responsible to give funding for, and make grants to, numerous independent educational programs for 3-4 years Towers’s objective is to preserve the purchasing power of its corpus, and to maintain a minimum level of spending at 5.0% of the 12-month average asset value in a year, which a

requirement in order to be tax exempt In addition, during a meeting with Browning, Towers instructed him to maintain 15% of the annual grant-making and spending budget

in cash, as a reserve for contingencies Browning has determined that expenses associated with the management of the foundation’s assets will equal 1.23%, and that the U.S inflation rate will equal 4.5% The U.S Internal Revenue Service does not allow for carry-forwards and carry-backs for foundations TTF does not use a smoothing rule to determine the level of spending in a given year

During her regular lunch break at office, Browning met Denise Petcher, her colleague, and a portfolio manager at GRI Petcher is responsible for the management of the

investment portfolio of the Shining Star Endowment (SSE), an endowment owned and established by a nonprofit institution, operating in the health care industry The

endowment was established to provide budgetary support for the Medical Care Hospital (MCH), established in Chicago, USA The endowment is worth $45 million, composed of

$25 million of a restricted fund to support the procurement of medical equipment, and

$20 million for unrestricted use SSE receives donations from its sponsor organization, and its annual spending comprises of 25% of the hospital’s overall revenues About 55%

of the endowment is invested in domestic stocks of the health care industry, and 35% is invested in bonds The sponsoring nonprofit institution has established the endowment to permanently fund the Medical Care Hospital Exhibit 1 displays some information about SSE MCH has recently taken a loan worth $25 million to expand its operations to other states of the country

Exhibit 1

Expected annual inflation as determined by the CPI 4.5%

Last year’s inflation rate as determined by the CPI 2.55%

Last year’s beginning market value $37.5 million

Last year’s ending market value $44.75 million

SSE uses a smoothing rule that determines the spending level in a year well before the endowment market value at the beginning of the fiscal year becomes known In addition, Medical Care Hospital’s inflation rate has averaged 1.2% above the economy in general The investment management expenses equal 0.10% Due to the increase in the growth of patients under 12 years of age, SSE is expected to pay $10 million at the end of the coming six months for the construction of a medical facility with accommodation for more than 200 patients Petcher determined that the endowment’s smoothed spending rate for the past few years has been 4.0%

A Calculate the return objective for:

i The Towers Foundation, and

ii Shining Star Endowment

Show your calculations

(8 minutes)

B Prepare the liquidity constraint portion of the investment policy statement of:

i The Towers Foundation, and

ii Shining Star Endowment

(6 minutes)

C i Identify two factors that increase the Towers Foundation’s ability to

Note: Each factor can be used only once

Answer Question 3-C in the template provided on page 14

(8 minutes)

D Calculate the dollar spending amount for Shining Star Endowment for the

coming year based on the smoothing rule Show your calculations

(4 minutes)

After a meeting with Browning, Petcher met Simon Jones, the head of the research department at Get Right Investments Jones has worked with a number of institutional clients and has played an active role in determining appropriate asset allocations for them During a conversation with Petcher, Jones made the following comments:

Statement 1: “Since most endowments have to meet spending needs of the beneficiary

institution, their portfolios should invest significantly in high-yielding, high quality fixed-income securities that typically make their promised nominal payments on time, according to a predetermined schedule.” Statement 2: “The presence of a cash reserve in a foundation, as a percentage of its

annual grant making budget, can sometimes create a year-end rush of grants paid by the foundation during an ‘up year’ for markets, and overspending during a ‘down’ year.”

E Determine whether each statement is correct or incorrect, and give one reason

each for your selection

Answer Question 3-E in the template provided on page 15

(4 minutes)

Template for Question 3-C

Institution Identify two factors that increase the institution’s ability to

Template for Question 3-E

Determine whether each

of the statements is

correct or incorrect

Give one reason each

for your selection

“Since most endowments have

to meet spending needs of the

beneficiary institution, their

portfolios should invest

significantly in high-yielding,

high quality fixed-income

securities that typically make

their promised nominal

payments on time according to a

predetermined schedule.”

The presence of a cash reserve in

a foundation can sometimes

create a year-end rush of grants

paid by the foundation during an

‘up year’ for markets and

overspending during a ‘down’

year.”

QUESTION 4 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 24 MINUTES

Gwyneth Larson is a successful lawyer living in Boston, USA Larson works as a

consultant for multinational corporations and manages to make around $200,000

annually, net of tax Larson did not marry and lives in a home worth $1,800,000 for which all mortgage payments have been made After working as a lawyer for the past twenty years, Larson, at 48 years of age, has finally decided to retire, and spend the rest

of her years visiting her family and travelling To manage her investment portfolio, Larson hired Adam Wood, a financial analyst and portfolio manager at a reputable investment management firm in the U.S When talking to Larson, Adam noted the

following information:

• Larson is in good medical condition and has medical insurance

• Since Larson has not been working for a specific employer, she is not entitled to receive a pension

• After three months, Larson plans to travel to Europe and has estimated that it would cost her $80,000

• Larson’s investment portfolio worth $2 million is invested 60% in domestic and international stocks, and 30% in bonds The rest is invested in cash

• After retiring, Larson’s living expenses will equal $95,000 a year and will rise with inflation

• To help support child education in the country, Larson will make a $65,000 donation, payable now, to ‘The Light’, a public service organization engaged in promoting education in the less developed areas of the U.S

• In addition to the investment portfolio, Larson just received $800,000 from a family trust Larson has asked Adam to exclude this inflow when determining an appropriate asset allocation and required return for her

• Larson wants to maintain at least 5% of her investment portfolio in cash

• Larson’s risk aversion score is 3 She has expressed that her strategic asset allocation should minimize the probability of falling short of her required return and wants to maximize the risk adjusted expected return from the portfolio

• Larson wants to invest a maximum of 20% of her portfolio in emerging market equities

• The risk free rate is 3.5% and the inflation rate is expected to be 1.5% next year Adam has shortlisted the following asset allocations for Larson

Exhibit 1 Proposed Strategic Asset Allocations for Gwyneth Larson

Treasury bills and notes 15% 15% 10% 5% 0%

Intermediate and long-term

Expected standard deviation 25% 17.5% 10.3% 27% 29%

A Determine the most appropriate portfolio for Larson, assuming she retires

immediately State, for each portfolio not selected, one reason why it is not the

to transfer wealth to Graham, Hayes discovered that the relevant tax for bequests is 45%

in Canada However, he determined that gifts made prior to the age of 75 are subject to only 65% of the normal estate tax Hayes pays a 35% tax rate on investment income and will be responsible to pay the gift tax in case he decides to gift his estate prior to death Graham falls in a low income tax bracket, and hence pays a tax rate of 25% on

investment income Woods has determined that Hayes’s assets will earn an 8.0% return over the next 15 years

B Determine whether it is appropriate for Hayes to gift the assets or bequeath them

as part of his estate Justify your response

(3 minutes)

Graham knows that the appropriate asset allocation for his portfolio also depends on his human capital He works for the sales department at a large utility company, with his compensation based on the amount of sales he makes to retail stores in his allotted region Graham has no contractual relationship with his company regarding his employment tenure In addition, Graham has indicated a strong desire to leave an estate to his children

C Determine whether Graham’s human capital and bequest desire increase or decrease his demand for life insurance Justify your response with one reason

each

Answer Question 4-C in the template provided on page 20

(7 minutes)

Template for Question 4-A

Determine the most

appropriate portfolio for

Larson

(circle one)

State, for each portfolio not selected, one reason why it

is not the most appropriate

Template for Question 4-C

Determine whether

Graham’s human capital

and bequest desire increase

or decrease his demand for

QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 21 MINUTES

Thomas McGrath is 46 years old and lives in Germany McGrath started a clothing line for women around ten years ago The business achieved high success and the demand for his clothing increased manifold over the years McGrath has managed to recently launch his personal designer wear by the name of ‘Exquisite Fashion’ that covers designs for both men and women McGrath owns several boutiques in the country and has a total net worth of around €50 million Even though he has taken several risks to grow his business

to its current level, McGrath has always remained a conservative investor and has tried to take minimum amounts of debt He now wishes to invest some of his money in the stock market, and for this, has hired Martin Allen, the chief portfolio manager at Allen

Investment Advisors McGrath believes that active management of funds is a way too risky strategy, and that given the costs of trading, administrative expenses and

management fees, average active investors generally underperform market indices over time Therefore, during an introductory meeting with Allen, McGrath instructed him to passively manage his investment portfolio by indexing it to a comprehensive equity benchmark index Allen stated the following categories of indexed portfolios to choose from:

• Euro-equity Index Mutual Fund with more than 20 shareholders

• Questa Investor Right ETF indexed to a broad based local equity market index

• Indexed Equity Shares managed as pooled accounts

• Euro-equity Index Futures

Since McGrath wants to invest indefinitely and may use his portfolio for hedging his business risks, he wants to minimize costs as measured by the fund’s expense ratio, as well as the costs associated with cash drag McGrath is not sure which indexed portfolio

to invest in; the one that would be most suitable to meet his objectives

Allen considers McGrath as having an above average ability to tolerate risk, since he has

a well-established business, has minimum liabilities and a long-term time horizon Allen has tried to convince him during several client meetings to take some risk with his capital and has explained how he could generate higher returns if he relaxed his stringent rules with regards to risk-taking McGrath has finally agreed to manage part of his assets using

an active management approach and has hired Melissa Wells for this purpose Wells will manage €5 million for McGrath and is instructed to invest in domestic equities only To evaluate Wells past performance, Allen has gathered the following information

Exhibit 1 Wells Portfolio Analysis (1)

Portfolio Market Benchmark

Weighted average market cap €16 billion €22 billion

Exhibit 2 Wells Portfolio Analysis (2) Sector Portfolio Market Benchmark

As part of his evaluation process, Allen met with Wells to ask her how well she

performed in the past Wells stated that her age old belief that value stocks outperform the market in general finally paid off last year She made the following comment:

“Last year, not only did value stocks outperform the market as a whole, my superior stock picking skill also added to my portfolio’s outperformance relative to the market.”

To confirm Wells’s statement, Allen requested her to provide him with some facts about her portfolio’s performance Allen gathered the following information:

• The Euro-zone Value Stock Index earned a return of 18% during the past year

• The Euro-zone Market Stock Index earned a return of 15% during the past year

• During the same period, Well’s portfolio earned a return of 21%

• Wells active risk computed with respect to the Euro-zone Market Stock Index is 6.7% annually

• Wells misfit risk is 5.5% annually

A Determine which indexed portfolio would be most suitable to meet McGrath’s objectives Determine for each indexed portfolio not selected, one reason why it

is not appropriate

Answer Question 5-A in the template provided on page 24

(6 minutes)

B i Determine the investment style followed by Wells in the management

of her portfolio Justify your response with four reasons

Answer Question 5-B(i) in the template provided on page 25

(7 minutes)

ii Determine the major risk factor faced by investors following the

investment style identified in part (i)

(2 minutes)

C Determine whether Wells comment about her portfolio’s performance is correct Justify your response

(6 minutes)

Template for Question 5-A

Circle the indexed portfolio that

would be most suitable to meet

McGrath’s objectives

Determine for each indexed portfolio not

selected, one reason why it is not appropriate

Euro-equity Index Mutual Fund with

more than 20 shareholders

Questa Investor Right ETF indexed

to a broad based local equity market

Template for Question 5-B(i)

QUESTION 6 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 19 MINUTES

Meredith Dubin is a fixed income analyst managing a bond portfolio for Empire

Enterprise’s pension fund worth $55 million Dubin follows an asset/liability

management approach when constructing and rebalancing the portfolio, so as to minimize the volatility of the surplus An ALM approach also helps keep the probability of falling short of meeting the pension liabilities within the allowable range of 10%-12% (the shortfall risk objective) Recently Dubin established positions in three bonds in equal par amounts of $1 million each Exhibit 1 displays information about the three bonds

Exhibit 1 Initial Market Value and Duration of the Three-Bond Portfolio

Security Price Market Value Duration

Bond A 108.586 $1,753,193 5.951

Bond C 102.103 $1,032,375 5.308 Dubin knows that changes in interest rates, and even just the passage of time, can cause the duration of the portfolio to change, leading to an increased risk of a duration

mismatch between pension assets and pension liabilities To minimize this risk, Dubin regularly rebalances the portfolio to keep it at the desired level of duration During her regular verification process, a year after she had established these positions, Dubin

determined that due to changes in the yield curve, the portfolio’s interest rate sensitivity had deviated significantly from the original duration As part of her rebalancing process, Dubin used Bond A as a controlling position, and invested an additional $997,394 in market value of the bond After the yield curve change, the duration of the bond had decreased to 4.903 The market value of the bond, before the additional investment, and after the change, was $1,235,940

Mathew Mason is the chief investment officer at Empire Enterprise, and heads the board

of the pension committee at the firm During a meeting with Dubin, Mason stated that he would like to match the asset flows from the portfolio to the pension liabilities as they come due He told Mason that since EE exports its products to Canada and Japan, it receives cash at irregular time periods In order to reduce the cost of funding the

liabilities, Mason wants to use these cash flows to satisfy pension payments as they come due, regardless of whether the inflows occur before, or after the payment date In

addition, he stated that EE would like to minimize the risk of non-parallel shifts in the yield curve at least at the short end of the curve, while keeping costs low

A Determine the new dollar duration of the three-bond portfolio, after the interest rate change, but before Dubin’s rebalancing transaction Show your calculations

(4 minutes)

B Determine the strategies that would be most appropriate to achieve Mason’s

objectives related to cash flow use and minimization of the risk associated with

non-parallel yield curve changes Consider each objective independently Justify

your response with one reason each

Answer Question 6-B in the template provided on page 29

(4 minutes)

After a few years of managing the pension portfolio for Empire Enterprise, Dubin

successfully managed to improve the funded status of the plan, and increased the surplus

to $10 million Since the plan was overfunded, Mason allowed Dubin to actively manage part of the portfolio in order to generate greater returns As part of his bond selection process, Dubin established that the U.S economy was currently in the early expansion phase and was headed towards the peak of the economic business cycle He forecasted that the growth rate of the economy would increase, as would liquidity in capital markets

In addition, based on his research, Dubin believes that the auto sector would benefit the most from the expansion of the economy as the credit spreads in the sector will tighten the most After his analysis, Dubin made the following comment to Mason:

“I believe that given the outlook of the U.S economy, the Victor Corporation’s issue will

be upgraded from its current BB+ rating to a BBB- or BBB rating based on its strong credit fundamentals Therefore, I recommend investing in the company’s bond issue.”

C i Name three relative value methodologies that would prove profitable

given that Dubin’s forecast of the U.S economic state is accurate

Explain how these strategies will be implemented

Answer Question 6-C(i) in the template provided on page 30

(6 minutes)

ii Identify the strategy mentioned by Dubin in his statement to Mason Explain the primary risk faced by investors who follow this strategy

(2 minutes)

Mason has identified a lucrative investment opportunity that would cost him $25 million and is expected to earn a return of 12.5% The investment is in the bond issue of Entirety Industrials, a well-established multinational firm selling industrial equipment to the auto-industry in the U.S The issue has a duration of 5.5 During scenario analysis, Mason determined that the probability of interest rates falling in the future is much higher than the probability of them rising Hence, Mason wants to utilize leverage in order to benefit from the expected interest rate decline Mason will borrow 60% of the investment amount needed and the borrowed funds will have a duration of 3.7

D Determine how using leverage can help Mason achieve his objective Show your

calculations

(3 minutes)

Template for Question 6-B

Objectives

Determine the strategies that

would be most appropriate to

achieve Mason’s objectives

Consider each objective

independently

Justify your response with

one reason each

Cash flow use

Minimization of the

risk associated with

non-parallel yield

curve shifts

Template for Question 6-C(i)

Name three relative value

methodologies that would

prove profitable given that

Dubin’s forecast of the U.S

economic state is accurate

Explain how these strategies will be implemented

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 17 MINUTES

Total Asset Management is an investment firm in the U.S that invests funds for high worth private wealth clients TAM specializes in excess return and risk management strategies involving traditional asset classes as well as alternative investments and

net-derivatives Recently, the firm launched the “Global Equity Fund’, an investment vehicle that invests in foreign markets Marc Fishman is part of the portfolio management team for the fund, and is responsible for managing investments made in the euro-zone The high growth in the region, development in the services sector, and the removal of barriers

to foreign capital inflow has caused Fishman to believe that the euro market would be an attractive inclusion to the Global Equity Fund Based on his research, Marc has

determined that a $39,550,000 investment in an equity portfolio of European stocks with

a beta of 1.27 would be appropriate The fund will make this investment for a year, starting from 31 January 2009, till 31 January 2010 TAM, however, does not yet

specialize in currency risk management In addition, Fishman is uncertain about the future movements in the pound-dollar exchange rate For these reasons, Fishman wants to fully hedge the currency risk associated with the investment and not base his hedge on estimates or uncertain expectations For this purpose, Marc approached a currency risk dealer, who gave him the following quotes:

• A stock index futures contract on a euro-denominated index trades at €259,394 and has a beta of 1.10

• A currency forward contract based on the $/€ exchange rate has a price of $1.1742/€

In addition, Fishman determined that the euro-zone risk free rate is 4.67% and the dollar risk free rate is 2.95% Both these rates are annually compounded rates Also, the current spot exchange rate is $1.1938

A Determine and explain the hedging strategy that Fishman should implement to achieve his objective Show your calculations

(5 minutes)

A year has passed, and the Global Equity Fund has performed well TAM’s upper

management has decided to continue the fund and expand its scope to include stocks from other regions as well Jeff Glave, an international portfolio manager, has been assigned the task of investing part of the fund’s assets in British stocks Glave allocates

£2.5 million to British stocks and assigns Matha Walters, an independent currency

specialist, to devise a solution for hedging currency exposure Walters establishes a month short forward position equal to the amount of the investment Two months later the market value of the GBP denominated assets increases to £2.8 million and Walters

two-expects the GBP to depreciate Walters informs Glave that she intends to rebalance and rollover the forward position using a foreign currency (FX) swap

The USD/GBP spot rate and the three-month forward points (scaled by 10,000) at the time of the rollover is 1.6621/1.6639 and -14/-12 respectively

B Determine:

i the type of FX swap used to rebalance the hedged position and

ii whether the size of the hedged position should be increased, decreased, or remain constant

(2 minutes)

iii Determine the rates at which the spot and forward legs of the FX swap are

transacted Show your calculations

(2 minutes)

(4 minutes)

Melissa Bretherton is part of the research management team at Total Asset Management, and is analyzing the performance of her equity portfolio under different possible

scenarios As part of her research, Bretherton executes the following analysis:

• Bretherton has developed a multifactor model to explain the returns on her portfolio The model includes factors that she believes explain the majority of returns to her portfolio After every six months, she determines the combined effect of the risk factors on her portfolio assuming they move in the most unfavorable way

• Based on her probability models and expectations, Bretherton determines the worst possible return outcome for her portfolio, one that she expects has some probability of occurring She then compares this return to her threshold return requirement

• Every year, Bretherton creates scenarios based on certain investment fears she has, and then analyzes how her portfolio would react to such events She knows that such scenarios have an extremely small or maybe even a zero probability of occurring, but she still feels it is necessary to remove any uncertainties

Bretherton has worked with Fishman on several assignments, for the past many years Recently, Fishman took the task of managing an institutional fund worth $10 million owned by Orange Enterprises (OE) OE has instructed Fishman to use the funds provided

to manage the risk of their foreign transactions, and the risk of their bond portfolio Marc has decided to use forward contracts to meet OE’s objectives related to risk management

C i Identify the risk management approaches used by Bretherton in the

management of her portfolio Justify your response for each approach

Answer Question 7-C (i) in the template provided on page 34

Note: Consider each approach independently

(6 minutes)

ii Determine why Fishman might have preferred the use of forwards over

futures and options for meeting Orange Enterprises’s risk management objectives

Answer Question 7-C (ii) in the template provided on page 35

(2 minutes)

Template for Question 7-C(i)

Identify the risk management approaches used

by Bretherton in the management of her

portfolio Justify your response for each

approach

Note: Consider each approach independently

Bretherton has developed a

multifactor model to explain the

returns on her portfolio The model

includes factors that she believes

explain the majority of returns to

her portfolio After every six

months, she determines the

combined effect of the risk factors

on her portfolio assuming they

move in the most unfavorable way

Based on her probability models

and expectations, Bretherton

determines the worst possible return

outcome for her portfolio, one that

she expects has some probability of

occurring She then compares this

return to her threshold return

requirement

Every year, Bretherton creates

scenarios based on certain

investment fears she has, and then

analyzes how her portfolio would

react to such events She knows that

such scenarios have an extremely

small or maybe even a zero

probability of occurring, but she

still feels it is necessary to remove

any uncertainties

Template for Question 7-C(ii)

Determine why Fishman might have preferred the use of

forwards over futures and options for meeting Orange

Enterprises’s risk management objectives

Futures Contracts

Option Contracts

QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 13 MINUTES

Anthony Reyna is responsible for the implementation of portfolio management decisions made by the research and management department at his investment firm Recently, Reyna was instructed to buy 1,500 shares of W-Tech Corporation, a company

specializing in high-tech security equipment In the process of selecting the best broker, Reyna searched the market and decided to select the Chicago Brokers for the execution of the order Reyna ordered Chicago Brokers to buy 1,500 shares of W-Tech stock on Monday, with a benchmark price of $56 On the same day, Chicago Brokers managed to purchase 750 shares at a price of $56.703/share To trade these shares, Reyna had to pay commissions of $55 No more shares were purchased that day, and the stock closed at a price of $55.302/share On Tuesday, 300 more shares were purchased at $57.923/share, and the commissions on the trade were $25 The closing price for the stock that day was

$56.201 The remaining shares could not be purchased, and Reyna cancelled the order on Wednesday, the day when W-Tech stock closed at $57.034

Reyna’s employer just launched an investment product that invests in emerging and developing markets, including Brazil, Russia and India Reyna knows that although these markets offer attractive return and diversification opportunities, they also have inherent risks One of the risks is the absence of an established and well-organized market

structure, one that encourages secondary trades To examine the quality of Brazil’s

capital market, Reyna gathered the following information

A The Crossover Clearing House has recently been established to serve as an

intermediary to capital market transactions The entity is subject to financial and ethical standards imposed by the Brazilian government

B The market offers attractive opportunities to investors who can identify

mispricings before others, especially in the small-cap sector Those who act early can earn significant gains

Reyna is working with Sam Walter, a portfolio manager, towards setting the appropriate corridor width for asset classes within the Brazilian market The asset classes include Brazilian corporate bonds, Brazilian equities, and Brazilian government bonds Walter has determined the following about the asset c lasses:

• The volatility of Brazilian government bonds and equities has increased over the past few years

• The correlation of Brazilian equities with Brazilian corporate bonds is higher than their correlation with Brazilian government bonds

A Calculate the components of the implementation shortfall for the trade of W-Tech Stock Show your calculations separately for each component

(5 minutes)

B i Determine whether the Brazilian market information suggests an

increase or a decrease in the quality of the Brazilian market Identify

the market quality factor that each affect Justify your response with

one reason each

Note: Consider each point independently

Answer Question 8-B (i) in the template provided on page 38

(4 minutes)

ii Evaluate the effect of the information Walter gathered, on the optimal corridor width of Brazilian corporate bonds Justify your response with

one reason each

Note: Use an all-else equal assumption in each case

Answer Question 8-B (ii) in the template provided on page 39

(4 minutes)

Template for Question 8-B(i)

Determine whether the

Brazilian market information suggests an

increase or a decrease in

the quality of the Brazilian market

Identify the market

quality factor that each

affect Justify your

response with one reason each

The Crossover Clearing

House has recently been

established to serve as an

intermediary to capital market

transactions The entity is

subject to financial and ethical

standards imposed by the

Brazilian government

The market offers attractive

opportunities to investors who

can identify mispricings

before others, especially in

the small-cap sector Those

who act early can earn

significant gains

Template for Question 8-B(ii)

Evaluate the effect

of the information Walter gathered, on the optimal corridor width of Brazilian corporate bonds

Justify your response

with one reason each

Note: Use an all-else

equal assumption in each case

The volatility of Brazilian

government bonds and

equities has increased over

the past few years

The correlation of Brazilian

equities with Brazilian

corporate bonds is higher than

their correlation with

Brazilian government bonds

QUESTION 9 HAS ONE PART FOR A TOTAL OF 6 MINUTES

Hugh Ross is a fixed income analyst at White Stripes Investment Management, a firm that offers bond portfolio management services Ross has managed more than twenty portfolios over the course of his career, some for institutional investors, and others for private wealth clients Recently, Larry Kemp, the chief investment officer at White Stripes, instructed Ross to analyze the performance of a bond portfolio managed by one

of his subordinates, Anne Couk While evaluating the portfolio’s performance, Ross calculated the impact of the following on the portfolio’s total return:

• The sector/quality effect

• The security selection effect

• The trading effect

A Determine for each of the effects mentioned how Ross might have calculated

their impact on the portfolio’s total return

Note: No calculations are necessary

(6 minutes)