CFA level 3 mock exam 4 level 3 mock 2017

QUESTION 1 HAS FOUR PARTS A, B, C, AND D FOR A TOTAL OF 20 MINUTES Dano Parker works as a portfolio manager at Picasso Investments PICIN, a large and reputable financial advisory firm o

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CFA Level III Mock Exam 4

June, 2017 Revision 1

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FinQuiz.com – 4th Mock Exam 2017 (AM Session)

The morning session of the 2017 Level III CFA Examination has 8 questions For

grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question

Total: 180

QUESTION 1 HAS FOUR PARTS (A, B, C, AND D) FOR A TOTAL OF 20

MINUTES

Dano Parker works as a portfolio manager at Picasso Investments (PICIN), a large and reputable financial advisory firm offering a range of capital management services and investment products to individual and institutional investors Parker has been with the firm for over five years now, and has managed more than fifteen client portfolios As such, PICIN has appointed Parker to appraise the performance of private wealth

portfolios at regular intervals During his appraisals, and also as part of experience, Parker notices that, in many instances, the assumptions of traditional finance with respect

to the behaviors of individuals do not hold true Parker was not sure what effects this might have on optimal portfolio construction by financial market participants To discuss this further, Parker invited David Hulsey, a behavioral financial analyst, to talk about investor behavior in detail During their conversation, Hulsey made the following

comment:

“I believe that investors behave rationally when making investment decisions and try to maximize the expected utility, given their budget constraint When faced with new information, market participants revise expectations consistent with Bayes’ formula Also, investors are risk-averse, demanding more return for each unit of risk.”

Parker disagreed with Hulsey on the basis of the ‘Prospect Theory’, but was not sure how this theory provided an alternative explanation to investor behavior He was, however, convinced that the theory explained apparent deviations in decision making from those explained under the utility theory

A Justify how the prospect theory supports Parker’s notion of an apparent departure

of investor behavior from the behavior of the rational economic man Give three

ways the prospect theory differs from the utility theory

(6 minutes)

After his meeting with Hulsey, Parker proceeded with developing an earnings forecast for Sparkle Fixtures Incorporated (SFI), a US firm famous for its lighting fixtures and

decorative lamps The lighting industry has seen tremendous growth over the past decade due to a rising trend of professional interior designing of homes and offices Historical data of the past 15 years shows earnings growth for SFI at 1.0-1.5% above the GDP growth rate Just recently, however, the firm reported a drop of 5.0% in earnings growth due to a number concerns regarding the supply of raw materials In addition, a few other firms also reported losses for the recent quarter In developing his forecasts, Parker decided to revise his earnings estimate downward for the stock in order to avoid any losses and keep his estimate conservative

B Determine the bias that Parker is most likely subject to while developing earnings

estimate for SFI Give one example where such a bias may result in excessive

trading by financial market participants

(4 minutes)

While reviewing the asset allocation decisions of his clients, and their stated preferences during regular meetings for updating their IPSs, Parker noticed that many portfolios lacked the appropriate amount of diversification, as would be present if investors behaved rationally and took a holistic view of their portfolios Parker was assured that this was due to the presence of behavioral biases

C Give three behavioral explanations for inadequately diversified portfolios State

the bias inherent in each explanation

(6 marks)

Before ending his day, Parker shortlisted five potential stock investments for his portfolio that met his risk and return constraints and had approximately similar risk-return profiles Given his budget constraint, Parker decided to invest in two of the most well-known and established firms amongst those he had shortlisted

D Determine, using behavioral finance, the behavior that guided Parker to select

stocks for his portfolio State the bias leading to such a behavior Justify your

response

(4 marks)

QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS

Renee Russo works as a portfolio manager at Panther Investment Management Firm (PIMF), a financial advisory firm offering portfolio management services to institutional investors, including pension plans, endowments and foundations Pension funds make up the largest portfolio of PIMF’s client base Russo has recently been appointed as the Chief Portfolio Manager (CPM) for the pension fund of Revolutionary Technologies Limited (RTEL), a large, US based firm operating in the electronics and technology industry The firm has been quite profitable over the past five years, as has been the general industry trend Working in association with Dennie Thorpe, the Chief Financial Officer (CFO) of RTEL, Russo compiles the data provided in Exhibit 1

Exhibit 1:

Financial Information of RTEL (Average of the past five years)

Inflation rate:

5.0%

Utilizing the opportunity to work with the CFO of the firm, Russo also accumulates the following facts:

• The projected benefit obligation (PBO) as reported on the current balance sheet, dated 31 December 2013, equals $10 billion

• The duration of the liabilities equals 22 years

• The total value of the firm’s pension assets as of 31 December 2013 equal $13 billion

• The ratio of the retired lives to active lives for the firm equals 0.33

• The correlation between pension plan assets and plan liabilities is close to 0.33, with pension assets invested mostly in growth oriented investments

While talking to Russo about the pension plan’s objectives, Thorpe also states the

following:

“RTEL primary focus is to maintain the funded status of the plan at a level of at least 100% with respect to the PBO The board has decided that a probability of 10% of falling short of meeting this objective is reasonable In addition, the plan’s objectives need to be set so as to minimize the probability of making future contributions to the plan Also, since proficient human resource is a key element of success in this industry, to retain our employees, we keep modifying our plan provisions according to changes in the industry This helps ensure retention of the best possible human resource in the face of

competition.”

Thorpe continues with the following comment:

“To meet our long-term objectives of minimizing contributions, the board has estimated that a return of 2.5% over and above the minimum required return would be appropriate for the fund.”

A Formulate an appropriate risk objective for Revolutionary Technologies

Limited’s (RTEL) pension fund Determine whether RTEL’s ability to take risk

is above-average, average, or below average Give three reasons why the ability may be high, and three reasons why it might be low Use the template on page 8

to answer the question

(8 marks)

B Determine the minimum return requirement for RTEL’s pension fund Formulate an appropriate return objective for the RTEL pension fund

(4 marks)

Ten years have passed, and Russo is still the manager of the RTEL pension fund The following changes have occurred during this time period:

• The ratio of the retired lives to average lives is 0.66

• The industry has seen a large number of new entrants, which has squeezed profit margins for existing firms The overall growth rate of the industry is now

approximately in line with the rate of growth of the general economy

• The firm introduced a provision for early retirement two years ago 10% of employees have opted for this option

• The asset base is now $9 billion with plan liabilities unchanged

For the current month, RTEL made a contribution to the pension plan of $10 million Given the number of retired employees, Russo estimates a cash disbursement of $60 million per month to satisfy obligations

C Determine the current liquidity requirement of the RTEL pension fund Explain

whether the liquidity constraint for the fund has improved, remained stable, or

deteriorated Justify your response with three reasons

(5 marks)

D Formulate the time horizon portion of the IPS of the RTEL pension fund as of

today and ten years ago

(3 marks)

Template for Question 2-D

Reasons (High) Reasons (Low)

QUESTION 3 HAS FIVE PARTS (A, B , C , D, E) FOR A TOTAL OF 19 MARKS

Target Lock Investment Firm (TLIF) operates in the financial services industry of USA TLIF is known for its expertise in managing equity portfolios and growth-oriented stock investments Given the immense success in this area, TLIF’s CEO, Michael Dobson, believes it strategically wise to include the fixed-income asset class to their investment universe Accordingly, he hires Natalie Acosta, a fixed-income analyst and portfolio manager, to introduce the TLIF Debt Fund, a new product, to TLIF’s clients and

prospects To determine which issues to include in the fund, Acosta works with the research department to collect the data presented in Exhibit 1

Exhibit 1:

Spread Data for Three Bond Issues

A Determine the issue that should most likely be purchased given the above

information Give two limitations of the bond selection approach used

(4 marks)

Acosta has considerable experience in constructing trading strategies in the fixed-income market For the current economic state, Dobson predicts the following:

Prediction 1: “The economy appears to be at a business cycle trough given low consumer

demand and low interest rates In the coming six months, the economy will start picking up as demand rises.”

Prediction 2: “The US Treasury bonds term structure is expected to flatten in the near

future In a year or so, economic conditions may lead to an inversion of the

B Construct two trading strategies that would be profitable given that Acosta’s

predictions are accurate Justify your response for each

C Determine two ways in which Acosta can hedge the risk of RLO’s bond holdings

without having to liquidate the position Explain how they could offer protection

from the expected risk factor

meeting with the fixed-income analysts, Acosta was presented the following data:

*The U.S risk free rate is 5.0%

D Assuming that the IRP holds, determine whether the investments in the foreign

bonds should be hedged or not Justify your response

(4 marks)

On further analysis of the data provided to her, Acosta determined that French bonds provided attractive returns to foreign investors Acosta particularly short listed a French bond that had a duration of 8 and provided an annual return of 5.5% A similar bond in Japan offered a return of 2.0% and had a duration of 9

E Determine the spread widening that would cause the additional yield advantage

to a Japanese investor investing in French bonds to be wiped out Show your

calculations

(3 marks)

QUESTION 4 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 39 MARKS

John Devlin is a portfolio manager at All-Mark Associates (AMA), a financial advisory firm that manages portfolios for high net worth individual clients AMA has gained significant acclaim in the financial community, and the core reason for its success is its strategy of appointing a dedicated portfolio manager for each of its clients As such, Devlin has been assigned the task of managing the portfolio of Sean Hart, a private wealth investor that just joined AMA as a client

Hart is a renowned physician and works at a state-owned hospital in Massachusetts, USA His superior technical expertise, professionalism and interpersonal skills, have contributed to his success in the medical community Consequently, after ten years of working as a physician, Hart was offered a distinguished administrative position in his hospital around five years ago Hart is 45 years old and has decided to stay single He is, however, very close to his mother, who lives alone and left her job ten years ago Hart pays her $50,000/year to support her living expenses; he would continue to do so for the coming five years, after which, his mother’s pension disbursements will support her Hart goes to the gym regularly, and has managed to keep himself physically fit and healthy During the course of several meetings with Hart, Devlin accumulated the following facts:

• Hart earns a salary of $200,000/year as a physician, and an additional $50,000 for the administrative duties

• Hart is planning to renovate his home and needs $40,000 in the coming three months for this purpose

• Hart wishes to donate $20,000 next month to a charity that funds the education expenses of orphans

• Hart’s living expenses average $300,000/ year

• Before he passed away, Hart’s father put some money in a trust fund that pays Hart $15,000/year

• The income tax applicable to Hart equals 25% and the gift fund is subject to a 15% tax rate

• Hart’s expenses and salary are expected to increase with inflation

• The risk-free rate is 5% and the inflation rate is 3.0%

With his hard work at the hospital, Hart has managed to accumulate a significant amount

of assets Exhibit 1 displays details about them

*Stock holdings represent investments in stable, value stocks

Ten years after he stops making payments to his mom, Hart wants at least $3,000,000 in investable assets Even though his employer’s stock forms a considerable portion of his investable assets, Hart wants Devlin to carefully analyze the profitability and

appropriateness of the investment He is prepared to liquidate the holding if

circumstances suggested

A Formulate the return objective portion of Hart’s IPS Show your calculations

(10 marks)

B Determine whether Hart’s ability and willingness to take risk are above-average,

average, or below-average Justify your response with three reasons each Use the

template on page 15 to answer this question

(8 marks)

C Formulate the liquidity constraint portion of Hart’s IPS

(5 marks)

After his analysis, Devlin considers the asset allocations given in Exhibit 2 for Hart

Exhibit 2:

Proposed Asset Allocation Alternatives

Data on the Asset Allocations

The risk-free rate is 3.0%

E Determine the asset allocation that is most appropriate for Hart Justify your

response with four reasons For each of the allocations not selected, give one

reason each why they were not appropriate Use the template provided on page 16

to answer the question

(11 marks)

Template for Question 4-B

Above-Below Average

Below average

1

2

3

Template for Question 4-E

Recommended

asset allocation

(circle one)

Four Reasons to support decision

For each of the allocations

not selected, give one reason

each why they were not appropriate

QUESTION 5 HAS THREE PARTS (A , B , C) FOR A TOTAL OF 22 MARKS

Parallel Investments (PARIN) is a capital management firm that offers its advisory services to large, institutional funds like pensions, endowments and foundations The Gems Foundation (TGM) is one of the largest clients of PARIN TGM core objective is

to fund educational institutes that provide free of cost educational services to privileged children between 5-15 years of age

under-The foundation has accumulated a portfolio worth $50 million TGM’s investment policy statement dictates the following:

• TGM’s expenses are expected to rise with the expected rate of inflation of 3.0%

• PARIN estimates that the cost of earning investment returns equals 50bps

• TGM wants the appropriate asset allocation to minimize the probability of the annual portfolio return falling below TGM’s spending rate

• TGM has decided to donate $2,500,000 to a charitable organization in the coming three months This cash outflow is to be excluded from TGM’s investable asset base

• TGM’s board has decided that a worst-case return of -13.5% is acceptable during any 12-month period However, the probability of failing to meet this return level should be minimized to 5.0%

• T-bills offer a rate of 2.5%

Using the information in TGM’s IPS, Ben Spencer, a portfolio manager at PARIN, listed the following asset classes:

Exhibit 1:

Corner Portfolios given PARIN’s Capital Market Expectations

A Determine the asset allocation that would be most appropriate for The Gems

Foundation Justify your selection with three reasons Show your calculations

Find the weights for each asset class in the optimal asset allocation

(12 marks)

Spencer has managed TGM’s portfolio for a number of years now The foundation’s

portfolio is invested in an asset allocation that has a Sharpe ratio of 0.52 Spencer is

considering adding international bonds to the asset mix to improve the risk profile of the portfolio However, he is not sure whether adding another asset class would prove

fruitful International bonds have a predicted Sharpe ratio of 0.45 and a predicted

correlation with TGM’s portfolio of 0.60

B Determine whether TGM should add international bonds to its existing portfolio Justify your response

(4 marks)

Spencer was not sure about the addition of international bonds However, he is convinced that adding emerging market equities to TFM’s portfolio would not only increase the portfolio’s returns but would also decrease the overall risk When Spencer talked about this with Andrew Selle, his colleague, Sell made the following comment:

“You might be right, but I am concerned with the risks associated with investment in such markets.”

To this, Selle replied with the following comment:

“Emerging market equities can serve as a valuable addition to the existing portfolio by improving its risk/return profile Markets are becoming increasingly integrated now, which has served to mitigate some of the concerns of investing in emerging economies.”

C Determine the effect of market integration on the following:

QUESTION 6 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 2O MINUTES

Capital Enhancement Investment Group (CEIG) is a capital management firm in the US that holds a prestigious position amongst similar firms in its industry CEIG has

introduced a number of revolutionary products in the financial industry that combine traditional assets with simultaneous derivative positions to cash on profitable

opportunities To remain competitive in this growing industry, CEIG appointed James Hull, a compliance officer, to implement the Global Investment Performance Standards (GIPS) within the firm Hull has worked with CEIG for over three years now and deems himself fruitful in the proper implementation of the Standards CEIG considers itself amongst the list of GIPS complaint firms, and, in doing so, believes it has gained the trust

of many prospective clients Just recently, the CEO of CEIG hired Darin Hollings, a performance evaluation and presentation expert, to review the firm’s procedures for GIPS compliance During his review, as of January 2011, Hollings noted the following:

• CEIG used trade date accounting to report transactions Assets and liabilities were recognized within a week of entering into a transaction

• When reporting fixed-income securities, interest income earned but not yet

received was also included in their total value For dividend paying equities, dividends not yet paid were not accrued due to their uncertainty

• CEIG has a fiscal year that corresponds to the calendar year Consequently, every portfolio within its composites was valued at the last business day of each year

• When reviewing the frequency of portfolio valuations, Hollings discovered that CEIG valued all portfolios at least monthly

• When presenting net-of-fees returns, CEIG did not accrue investment

management fees, especially performance-based fees

After the review, Hollings met with the CEO and posed the following question:

“In reporting portfolio values, which definition of value do you use?”

The CEO responded with the following comment:

“Last year, we measured and reported all portfolio values at market value However, recently, we have started to use the ‘fair value’ of portfolios for reporting purposes If fair values are not easily obtainable, a best estimate of market value is used.”

A List three ways in which CEIG’s procedures violate the GIPS requirements with

regards to input data Support your answer with proper justifications for each

reason

(6 marks)

After his review, Hollings proceeded with evaluating the performance of the portfolios managed by CEIG’s portfolio managers While doing so, Hollings met with Ricardo Nadu, a portfolio manager who managed a few of the firm’s private wealth accounts Nadu told Hollings that all portfolio managers were required to measure the time-

weighted rates of return that adjusted for external cash flows In addition, returns for longer measurement periods were computed by geometrically linking the monthly

returns Upon further questioning by Hollings, Nadu stated the following:

• Cash and cash equivalents were included in the total return calculations

However, if the cash was not actually invested by the same group of portfolio managers that managed the portfolio, it was excluded from the return calculations

• In addition, returns were always calculated after the deduction of trading

expenses To be conservative and ensure compliance with GIPS, if actual values for such expenses were unavailable, estimated values were used based on

• Withholding taxes were not considered when estimating net of fee returns

• CEIG’s definition of what constituted ‘a large cash flow’ varied with each

composite depending on the nature of the investment strategy

B For each of the facts stated by Nadu, state whether they are in compliance with

the GIPS For each of the procedures not in compliance, determine the changes necessary to make them GIPS compliant Use the template on the following page

to answer the question

Answer Question 6-B in the Template provided on page 23

Hollings knew that his analysis of CEIG would not be complete without assessing the appropriateness of the construction of composites within CEIG Specifically, Hollings analyzed the following actual, fee-paying client portfolios:

Portfolio A The client specifically instructed not to invest more than 10% of the portfolio

value or 115% of the benchmark weight, whichever is greater, in any given economic sector

Portfolio B The client is the CEO of his firm and has holdings in his company’s stock

He has instructed his portfolio manager not to sell any part of this holding, even if capital market conditions stated otherwise.”

Portfolio C More than 60% of the client’s portfolio constitutes holdings in his

grandfather’s firm that has been managed by family over the course of many years Since the holding has a very low cost basis, the client has directed his portfolio manager that it should not be sold.”

C Select the portfolio that is likely to be not included in a composite under the

Global Investment Performance Standards For the portfolio selected, list three

ways in which it can be handled with regards to GIPS compliant composite construction

(4 marks)

Hollings was particularly interested in the firm’s traditional asset class composites, mainly:

The equity portions of the three funds were managed by a group of equity managers at CEIG, whereas the fixed-income portions, along with cash and cash equivalents, were managed by the fixed-income managers Just recently, CEIG created a new composite by the name of “Standard Equity Account Composite” that included only the equity

segments of the above-mentioned composites This was created to ensure proper

performance evaluation of the equity managers of CEIG

D Determine whether the construction of the new composite is in compliance with

the GIPS Support your answer with two reasons

(4 marks)

Template for Question 6-B

with GIPS

Changes (if necessary)

to be in compliance Cash and cash equivalents were included

in the total return calculations However,

if the cash was not actually invested by

the same group of portfolio managers

that managed the portfolio, it was

excluded from the return calculations

Custody fees were not considered direct

trading expenses However, if they were

charged on a per-transaction basis, they

were included in trading expenses

When trading expenses could not be

broken out of bundled fees, gross-of-fee

returns were reduced by the entire

amount of the bundled fee to estimate

returns gross of investment management

fees

In addition, returns were always

calculated after the deduction of trading

expenses To be conservative and ensure

compliance with GIPS, if actual values

for such expenses were unavailable,

estimated values were used based on

historical averages

Withholding taxes were not considered

when estimating net of fee returns

CEIG’s definition of what constituted ‘a

large cash flow’ varied with each

composite depending on the nature of

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 20 MARKS

Jocelyn Mathews works as a portfolio manager at Victor Investment and Capital

Management (VICM) Mathews manages a number of VICM’s private wealth accounts invested in asset classes ranging from equities and fixed-income to alternative

investments Mathews believes strongly in not only the value of research and analysis in proper security selection, but also in the significance of trading and implementation in managing costs Accordingly, he is analyzing the trading costs of his most recent

purchase: 1,000 shares of the stock of Stripes Incorporated He accumulates the following facts for his evaluation:

• The order was placed on last Tuesday, when the shares of Stripes closed at

$59.90/share 500 shares were purchased at a price of $61.05 per share

Commissions and fees were $50

Commissions and fees were $20 Shares of Stripes closed at $61.03 during the same day

market closed at $62.00 per share

Mathews meant to use this data to calculate the implementation shortfall of his trade

A Calculate the total implementation shortfall for the trade in the stock of Stripes

Incorporated Determine the contribution of the various cost components to the total implementation shortfall Show your calculations

(6 marks)

Upon completion of his analysis, Mathews met with is fellow colleagues to share his conclusion They were all intrigued with the impact that trading costs could have on investment results As their discussion continued, each manager presented ways in which they attempted to minimize trading expenses They made the following comments:

Manager A: “I always use extensive competitor and industry data while screening

securities A comprehensive fundamental analysis is a trialed and tested method for selecting superior investments While placing an order, I wait till the price reaches the level I deem fit “

Manager B: “I believe that markets are efficient, and costs to actively managed funds

overweight the benefits of doing so Most of my investments are in indexed funds To minimize the costs of trading, I only trade at regular intervals for rebalancing purposes.”

Manager C: “Just recently, I traded in the stock of Star Industries that I believed was

significantly overvalued They had met fierce opposition from their largest suppliers, which led to the cancellation of a supply contract just a few days ago My trading costs were quite low.”

B Determine which category of traders types would each of the above managers fall

into State the order type that they are most likely to use along with one limitation

for each order type

(6 marks)

After their discussion, Jim McGraw (Manager B) stayed back to talk a little more about rebalancing needs and methodologies When Mathews inquired about the frequency of his rebalancing trades, McGraw stated that he rebalanced his portfolio to target weights

on a semiannual basis; a choice linked to the schedule of his portfolio’s reviews For investment advice from Mathews, McGraw presented him with the following details of his portfolio:

Exhibit 1:

Asset Class Weights (Strategic Asset Allocation)

In addition, McGraw also mentioned that over the course of the previous year, some economic, personal, and financial changes occurred, affecting each of these asset classes Specifically, he pointed out the following:

• Direct transaction costs of trading in domestic bonds increased considerably over the year

• Due to a large down payment to be made for the purchase of a new home, the portfolio experienced a significant cash outflow As such, minimizing tracking risk relative to the benchmark became a prime objective

• The volatility of international bonds increased, maybe due to differing economic changes worldwide Its correlation with domestic equities increased, reflecting less of a diversification benefit

• The correlation of international equities with domestic equities decreased

however, adding to the diversification benefits

• The volatility of international equities increased too, over the same time period

C (i) State the rebalancing method used by McGraw List two ways in which

percentage-of-portfolio rebalancing can mitigate the drawbacks of the rebalancing method used by McGraw

(3 marks)

C (ii) Evaluate the implications of each of the above mentioned changes on the

tolerance bands of the asset classes assuming percentage-of-portfolio rebalancing

was used Use the template on page 27 to answer the question

(5 marks)

Template for Question 7-C (ii)

Band for:

Implications

Direct transaction costs of

trading in domestic bonds

increased considerably over

the year

Domestic bonds

Due to a large down payment

to be made for the purchase

of a new home, the portfolio

experienced a significant

cash outflow As such,

minimizing tracking risk

relative to the benchmark

became a prime objective

International bonds

The volatility of international

bonds increased, maybe due

to differing economic

changes worldwide Its

correlation with domestic

equities increased, reflecting

less of a diversification

benefit

Domestic equities

The correlation of

international equities with

domestic equities decreased

however, adding to the

diversification benefits

Domestic bonds

The volatility of domestic

equities increased too, over

International equities

QUESTION 8 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS

Susanne Karen is an architect who works for a prominent multinational firm in the

industry Karen has managed to accumulate a portfolio worth $10 million with her annual savings The portfolio is invested to track a balanced fund with 50% invested in stocks and 50% in bonds To suitably manage her portfolio, Karen hired Robin Clark, a portfolio manager and investment management expert For estimating the expected performance of Karen’s portfolio, Clark accumulated the information given in Exhibit 1

Exhibit 1:

Annual Expected Return and Risk

The correlation between stocks and bonds is 0.65 During a meeting with Karen, Clark extracted all pertinent information about her financial situation and personal preferences This was then used to construct an appropriate IPS Keeping the objectives, as stipulated

by the IPS, in mind, Clark suggested investing a small portion of her portfolio in

derivatives Specifically, he proposed the following option:

‘A forward contract on the stock of Titan Enterprises with a maturity of 18 months The stock is currently worth $120/share The risk-free rate is 5.5%.”

Clark is convinced that the stock price would rise in the coming year or so, due to a change in the firm’s product strategy He constructed a position for Karen which would take advantage of this expectation

A Determine the 1 percent VAR of Karen’s portfolio before the addition of the

forward contract Express it in the most conservative way

(4 marks)

Nine months have passed since Clark has been managing Karen’s portfolio Titan

Enterprises’ stock is now worth $135/share The stock paid no dividends during this period and is not expected to do so for the coming five years

B Evaluate the credit risk position of Karen in the forward contract Determine the

new price of the forward contract if it were to be marked to market

(4 marks)

After two years, Karen requested Clark to present her with a comprehensive analysis of her portfolios performance Displeased with the results, Karen instructed Clark to look for other investment opportunities Clark stated, that over a year ago, his investment management firm introduced a new fund managed by a team of reputable portfolio

managers and invested in a number of financial sectors The fund managers used their skills and expertise to earn above-average returns for the fund Upon further request, Clark presented Karen with the information given in Exhibit 2

Exhibit 2:

GHE Investment Fund Annual Performance Attribution

(Risk-free asset) Incremental Value Contribution $675,000

Incremental return contribution for allocation

C (i) Determine how much of the total return was attributed to style bias Show

Exhibit 3:

Portfolio Performance Results (Extract)

(%)

Sector Benchmark weight (%)

Portfolio Return (%)

Sector Benchmark Return

D Determine the within sector selection return and the pure sector allocation return

for each of the above mentioned economic sectors Show your calculations Use

the template below to answer the question

(6 marks)

Template for Question 8-D

Pure Sector Allocation

Within Sector Selection Capital Goods

Consumer durables

Technology

FinQuiz.com

CFA Level III Mock Exam 4

June, 2017 Revision 1

Copyright © 2010-2017 FinQuiz.com All rights reserved Copying, reproduction

or redistribution of this material is strictly prohibited info@finquiz.com.

FinQuiz.com – 4th Mock Exam 2017 (AM Session)

The morning session of the 2017 Level III CFA Examination has 8 questions For

grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question

Total: 180

QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MINUTES

Dano Parker works as a portfolio manager at Picasso Investments (PICIN), a large and reputable financial advisory firm offering a range of capital management services and investment products to individual and institutional investors Parker has been with the firm for over five years now, and has managed more than fifteen client portfolios As such, PICIN has appointed Parker to appraise the performance of private wealth

portfolios at regular intervals During his appraisals, and also as part of experience, Parker notices that, in many instances, the assumptions of traditional finance with respect

to the behaviors of individuals do not hold true Parker was not sure what effects this might have on optimal portfolio construction by financial market participants To discuss this further, Parker invited David Hulsey, a behavioral financial analyst, to talk about investor behavior in detail During their conversation, Hulsey made the following

comment:

“I believe that investors behave rationally when making investment decisions and try to maximize the expected utility, given their budget constraint When faced with new information, market participants revise expectations consistent with Bayes’ formula Also, investors are risk-averse, demanding more return for each unit of risk.”

Parker disagreed with Hulsey on the basis of the ‘Prospect Theory’, but was not sure how this theory provided an alternative explanation to investor behavior He was, however, convinced that the theory explained apparent deviations in decision making from those explained under the utility theory

A Justify how the prospect theory supports Parker’s notion of an apparent departure

of investor behavior from the behavior of the rational economic man Give three

ways the prospect theory differs from the utility theory

(6 minutes)

After his meeting with Hulsey, Parker proceeded with developing an earnings forecast for Sparkle Fixtures Incorporated (SFI), a US firm famous for its lighting fixtures and

decorative lamps The lighting industry has seen tremendous growth over the past decade due to a rising trend of professional interior designing of homes and offices Historical data of the past 15 years shows earnings growth for SFI at 1.0-1.5% above the GDP growth rate Just recently, however, the firm reported a drop of 5.0% in earnings growth due to a number concerns regarding the supply of raw materials In addition, a few other firms also reported losses for the recent quarter In developing his forecasts, Parker decided to revise his earnings estimate downward for the stock in order to avoid any losses and keep his estimate conservative

B Determine the bias that Parker is most likely subject to while developing an

earnings estimate for SFI Give one example where such a bias may result in

excessive trading by financial market participants

(4 minutes)

While reviewing the asset allocation decisions of his clients, and their stated preferences during regular meetings for updating their IPSs, Parker noticed that many portfolios lacked the appropriate amount of diversification, as would be present if investors behaved rationally and took a holistic view of their portfolios Parker was assured that this was due to the presence of behavioral biases

C Give three behavioral explanations for inadequately diversified portfolios State

the bias inherent in each explanation

(6 marks)

Before ending his day, Parker shortlisted five potential stock investments for his portfolio that met his risk and return constraints and had approximately similar risk-return profiles Given his budget constraint, Parker decided to invest in two of the most well-known and established firms amongst those he had shortlisted

D Determine, using behavioral finance, the behavior that guided Parker to select

stocks for his portfolio State the bias leading to such a behavior Justify your

response

(4 marks)

Solution for Question 1

A Solution:

Unlike the utility theory, the prospect theory considers how prospects are perceived based

on their ‘framing’, how ‘gains’ and ‘losses’ are evaluated, and how uncertain outcomes are weighted

The three ways in which the prospect theory differs from the utility theory are:

1 The probability-weighting function expresses the fact that people tend to

overreact to small probability events but underreact to mid-sized and large

Parker is most likely subject to the representative bias He is ignoring the base rate

information of an above average earnings growth rate for SFI for so many years and is assuming that the small sample of firms that reported losses is representative of all firms

in the industry Hence, he is guilty of both base-rate neglect and sample-size neglect

Example:

Investors tend to buy a fund immediately following rapid price appreciation

Representativeness causes them to categorize the funds as good investments based on this recent information Similarly, when prices fall, they sell their holdings Moving in and out of investments based on categorizations like these is likely to result in excessive trading

Reference:

C Solution:

The three behavioral explanations are as follows:

1 Illusion of Control bias: Investors tend to hold positions in companies they feel they have some control over, leading them to hold concentrated positions

2 Confirmation bias: FMPs may become convinced of the value of a single stock and tend to ignore negative news about that stock This can lead them to build a large position in the stock and hold poorly diversified portfolios

3 Availability bias: Since this bias leads FMPs to base investment choices on

information that can be easily recalled, their choices would reflect a narrow range

of experience This can lead to overweighing securities and a lack of

diversification

Reference:

CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-d

D Solution:

Parker is most likely engaging in herding behavior by investing in the most popular

investments The regret-aversion bias leads to such a behavior People prefer the stocks

of well-known companies even in the face of equal risk and return characteristics because choosing less familiar stocks is perceived riskier and involves greater personal

responsibility and greater potential for regret

Reference:

CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-c

QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS

Renee Russo works as a portfolio manager at Panther Investment Management Firm (PIMF), a financial advisory firm offering portfolio management services to institutional investors, including pension plans, endowments and foundations Pension funds make up the largest portfolio of PIMF’s client base Russo has recently been appointed as the Chief Portfolio Manager (CPM) for the pension fund of Revolutionary Technologies Limited (RTEL), a large, US based firm operating in the electronics and technology industry The firm has been quite profitable over the past five years, as has been the general industry trend Working in association with Dennie Thorpe, the Chief Financial Officer (CFO) of RTEL, Russo compiles the data provided in Exhibit 1

Exhibit 1:

Financial Information of RTEL (Average of the past five years)

Inflation rate:

5.0%

Utilizing the opportunity to work with the CFO of the firm, Russo also accumulates the following facts:

• The projected benefit obligation (PBO) as reported on the current balance sheet, dated 31 December 2013, equals $10 billion

• The duration of the liabilities equals 22 years

• The total value of the firm’s pension assets as of 31 December 2013 equal $13 billion

• The ratio of the retired lives to active lives for the firm equals 0.33

• The correlation between pension plan assets and plan liabilities is close to 0.33, with pension assets invested mostly in growth oriented investments

While talking to Russo about the pension plan’s objectives, Thorpe also states the

following:

“RTEL primary focus is to maintain the funded status of the plan at a level of at least 100% with respect to the PBO The board has decided that a probability of 10% of falling short of meeting this objective is reasonable In addition, the plan’s objectives need to be set so as to minimize the probability of making future contributions to the plan Also, since proficient human resource is a key element of success in this industry, to retain our employees, we keep modifying our plan provisions according to changes in the industry This helps ensure retention of the best possible human resource in the face of

competition.”

Thorpe continues with the following comment:

“To meet our long-term objectives of minimizing contributions, the board has estimated that a return of 2.5% over and above the minimum required return would be appropriate for the fund.”

A Formulate an appropriate risk objective for Revolutionary Technologies

Limited’s (RTEL) pension fund Determine whether RTEL’s ability to take risk

is above-average, average, or below average Give three reasons why the ability may be high, and three reasons why it might be low Use the template on the

following page to answer the question

(8 marks)

B Determine the minimum return requirement for RTEL’s pension fund Formulate an appropriate return objective for the RTEL pension fund

(4 marks)

Ten years have passed, and Russo is still the manager of the RTEL pension fund The following changes have occurred during this time period:

• The ratio of the retired lives to average lives is 0.66

• The industry has seen a large number of new entrants, which has squeezed profit margins for existing firms The overall growth rate of the industry is now

approximately in line with the rate of growth of the general economy

• The firm introduced a provision for early retirement two years ago 10% of employees have opted for this option

• The asset base is now $9 billion with plan liabilities unchanged

For the current month, RTEL made a contribution to the pension plan of $10 million Given the number of retired employees, Russo estimates a cash disbursement of $60 million per month to satisfy obligations

C Determine the current liquidity requirement of the RTEL pension fund Explain

whether the liquidity constraint for the fund has improved, remained stable, or

deteriorated Justify your response with three reasons

(5 marks)

D Formulate the time horizon portion of the IPS of the RTEL pension fund as of

today and ten years ago

(3 marks)

Solution for Question 2:

1 RTEL’s debt/total assets ratio is less

than the industry average Its profit margins (gross profit margin and net income margin) are higher than the industry average Hence, RTEL has

a greater tolerance for risk

1 A significant amount of pension assets invested in growth oriented investments increases the volatility of the portfolio and decreases the risk tolerance

2 The ratio of retired lives to active

lives is 0.33 implying that active lives are much greater than retired lives This implies a longer time horizon and greater risk tolerance

2 A pension plan that keeps modifying its provisions is likely

to introduce competitive plan features like early retirement or lump-sum distributions This decreases the ability to take risk

3 RTEL has a pension surplus of $3

billion ($13-$10=$3 billion) implying greater risk tolerance

3 A low correlation between pension assets and pension liabilities implies a greater mismatch between them, and a lower ability to take risk

Overall: Ability to take risk is above-average because of:

• Higher financial profitability than the industry average

• No current plan features that would require early disbursements

• Greater number of active lives relative to retired lives

Risk objective:

“The probability that the funded status falls below 100% should be equal to 10% or less

In addition, the portfolio should minimize the probability of making future

contributions.”