CFA level 3 mock exam 5 level 3 mock 2017

Determine whether an increase in inflation rate, reduction in the sales price of the business, and an increase in the price of the boat will increase, decrease or have no impact on risk

FinQuiz.com

CFA Level III Mock Exam 5

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 – 5th Mock Exam 2017 (AM Session)

The morning session of the 2017 Level III CFA Examination has 12 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question

10 Portfolio Management – Monitoring and Rebalancing 6

Total: 180

QUESTION 1 HAS SIX PARTS (A, B, C, D and E) FOR A TOTAL OF 26

MINUTES

Kyle Lucas is the owner of a privately traded manufacturing concern which is currently worth $15 million and was established twenty-five years ago Lucas is 65 years of age and intends to sell the business three years from today

Lucas has approached portfolio manager Gus Weaver to manage his investment portfolio which is currently worth $8.5 million and is equally allocated to long-term corporate bonds, domestic and international equities, and alternative asset classes In response to a question regarding his investment experience, Lucas states, “I have faced significant financial crises in the past and now always look to avoid making investment choices which hold the potential for disastrous consequences.”

Lucas earns annual business income which is fixed at a pre-tax amount of $100,000 His living expenses are $98,000 in the current year and are expected to increase at the annual rate of inflation of 5% Upon retirement, he will no longer earn business income and his annual living expenses will become constant at $150,000

If Lucas sells his business at its current market price, three years from today, he will be able to meet his retirement living expenses and purchase a boat currently sold at a price

of $1.0 million He has instructed Weaver to exclude the boat purchase from the

investment decision Lucas intends to finance his grandson’s college education as well as purchase residential property for him Total estimated costs will amount to $30 million and will be required fifteen years from today

Lucas is subject to an ordinary income and capital gains tax rate of 25% and 30%

respectively He always maintains an emergency reserve equal to 3 years of his annual business income in addition to his portfolio holdings

A Formulate each of the following constraints for Lucas’ investment policy

statement (IPS):

B Determine whether an increase in inflation rate, reduction in the sales price of the

business, and an increase in the price of the boat will increase, decrease or have

no impact on risk tolerance Justify your choice with one reason

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

(6 minutes)

C State Lucas’s return objective for his IPS

(3 minutes)

D Calculate Lucas’ annual after-tax nominal rate of return for the IPS if his

business is sold at its current market price three years from today Show your

calculations

(6 minutes)

Walker strongly feels that incorporating behavioral considerations in an IPS is essential

to fulfilling the client’s long-term goals To achieve this purpose, he holds a meeting with Lucas to determine his behavioral investor type (BIT) and associated biases by holding a meeting with the client

E Discuss two benefits of including behavioral finance into the IPS

(4 minutes)

Lucas is an avid follower of the stock market and makes investment decisions on behalf

of friends and family members His most recent investment decision involved a $100,000 purchase of French Inc’s stock The decision was influenced by recent media attention on the corporation following a ‘brave’ policy shift towards unconventional production processes promising shorter lead times and a greater focus on organic raw materials as input He further justifies his decisions by stating, “Over the course of industry history, companies who were experimental in setting their policy have been popular amongst investors.”

F Identify the bias demonstrated by Lucas and justify your selection with one

reason

(3 minutes) Answer Question 1-F in the template provided on page 7

Template for Question 1-B

Factor

Impact on Risk Tolerance (Circle the Correct Answer)

Justify Your Choice With

One Reason

Increase in inflation rate

Increase Decrease

No impact

Reduction in sales price of business

Increase Decrease

No impact

Increase in the price of the boat

Increase Decrease

No impact

Template for Question 1-F

Identify the Bias (Circle the

QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES

Carl Segal is an asset advisor at Vector Asset Management Segal is working closely with

a private client, Timothy Allen; aged 45 to ascertain the behavioral investor type (BIT) exhibited by Allen Allen has considerable investment experience and often recommends potential investments for further evaluation to his adviser During a discussion between Segal and Allen, the client shares his investment approach:

“I have devoted a significant amount of time to studying security markets and asset

classes Based on the insight which I have gained over these years, I can comfortably trust my instincts when making investment decisions for myself as well as acquaintances, who have entrusted me with the management of their financial wealth I trust nothing but

my own research and prefer not to let my judgment get influenced by the advice of those who possess little knowledge about wealth planning.”

A Classify Carl’s BIT, determine the risk tolerance, and identify one emotional bias

typically associated with the identified behavioral category

(3 minutes) Answer Question 2-A in the Template provided on page 10

B. Carl participates in the defined contribution (DC) offered by his employer Segal determines that Carl is fifteen years away from retirement Segal would like to compare the client’s current allocation to plan assets with the average allocation held over the past five years Segal also determines that:

• Carl’s annual income sufficiently covers his living expenses

• he is unmarried but finances his brother’s medical care His brother is mentally challenged His salary is not sufficient to cover these expenses

• he has inherited $1.5 million from his deceased father’s estate in the

beginning of the current year He intends to employ these funds for investment purposes

• he has assigned a risk score of 3.1 to the average company stock, in

comparison with 3.6 to domestic stock funds and 4.1 to global stock funds

Exhibit:

Carl’s Allocations to the DC Plan Assets

Average Historical Allocation (2009-2013)

Current Allocation (2014)

(3 minutes)

Template for Question 2-A

Classify Carl’s BIT

(Circle the Correct Choice)

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

Identify One Emotional Bias Typically Associated With the Behavioral Category Passive Preserver (PP)

Active Accumulator (AA)

QUESTION 3 HAS ONE PART FOR A TOTAL OF 3 MINUTES

Mr and Mrs Fairview, aged 65 and 60 respectively, are the owners of a hotel chain which has branches located across the US and has been in establishment for the past thirty years Their business is currently worth $60 million and has appreciated by 10% in the current year leading to an increase in the wealth of its owners The hotel chain is a privately traded concern

The Fairviews are seeking to transfer the business to their daughter, Samantha, but would like to retain ownership rights They have approached Kim Young, a tax advisor, for a solution Under current tax laws a donor’s annual gift exclusions are limited to $13,000 per donee Gifts exceeding this allowance are taxed at a rate of 25% Young discovers that the couple has consumed this allowance and now sets out to devise a wealth transfer strategy which will minimize transfer taxes and retain ownership rights

After considerable evaluation, Young has identified three potential wealth transfer

strategies She would now like to determine the most appropriate strategy

Recommend the most suitable wealth transfer strategy For the choices not selected

provide one reason for their unsuitability

Answer Question 3 in the template provided on page 12

(3 minutes)

Template for Question 3

Recommend the most Suitable Wealth

Transfer Strategy

Provide One Reason for Why the Choices Not Selected are Unsuitable

Corporate Estate Tax Freeze

Family Limited Partnership

Direct Gifting to Samantha

QUESTION 4 HAS SEVEN PARTS (A, B, C, D, E, F, G) FOR A TOTAL OF 35 MINUTES

Yellow Tires (YT) offers a defined benefit pension plan to its employees Sean Martin is managing YT’s investment portfolio and has collected the following details which are relevant for the analysis:

• The plan is fully funded

• The average age of the participants is 38 years

• The active to retired participants ratio is 3:1

• The company has reported strong financial results in the current year

• The discount rate used to determine the present value of future obligations is 8.0%

• The duration of plan liabilities is 22 years

• The sponsor has proposed a return objective of 8.5%

• YT offers a one-for-one inflation indexation via a cost of living allowance

(COLA)

• Future benefits are twice as high relative to accrued benefits and are attributable

to future real wage growth

• YT is considered the inclusion of an early retirement provision

A State YT’s return objective

(2 minutes)

B Identify one purpose which the sponsor may have in stating a return objective of

8.5%

(2 minutes)

D For each of the following scenarios, determine whether risk tolerance will

increase or decrease Explain your choice

Answer 4-D in the Template provided on page 16

(12 minutes)

Based on his findings, Martin constructs a portfolio to be used as an investment

performance benchmark for YT’s policy portfolio The contents of the portfolio include equities, real return bonds, and nominal bonds

Exhibit:

Composition of Investment Benchmark

for YT’s Policy Portfolio

Equities Nominal Bonds Real Rate Bonds

E Determine whether the proposed investment benchmark is appropriate for YT’s

policy portfolio

(3 minutes)

F The plan sponsor suggests that Martin invest in the index portfolio citing that the

constructed portfolio will match the policy portfolio’s liability structure Martin deems a liability relative approach to be more appropriate for the purposes of achieving YT’s investment goals

I Provide two reasons which refute the sponsor’s proposal with respect to

an investment in the liability mimicking portfolio

II Describe how the liability relative approach can be designed to better

achieve satisfactory investment results

(6 minutes)

G YT also maintains an employee stock ownership plan (ESOP) which requires the

employer to contribute 5% of each employee’s salary Employees are also

required to contribute towards the plan The vesting schedule is specified such that each employee will be entitled to stock ownership eight years after the initial participation date

In addition to encouraging ownership of one’s employer, identify an additional purpose behind YT’s offer of an ESOP and discuss one risk associated with participating in the plan

(4 minutes)

Template for Question 4-D

Factor

Impact on Risk

Introduction of an early

retirement provision

Increase in discount rate

Decrease in the allocation of

fund assets to YT stock

Increase in bankruptcy risk

QUESTION 5 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 16 MINUTES

First Bank is a commercial lending institution operating in the U.S Sasha Wilson is the bank’s senior investment officer Wilson would like to implement more stringent risk management measures with respect to the bank’s liabilities and has convened a meeting

to address the following objectives:

Objective 1: Address the possibility of a positive interest rate shock

Objective 2: Minimize the leveraged-adjusted duration gap

Objective 3: Maximize return-on-invested capital

Wilson is analyzing the implications of the recent unexpected rise in interest rates on the bank’s market value of equity

The current structure of the bank’s balance sheet is as follows:

D. First Bank has implemented three policy changes with respect to its loan

portfolio Wilson would like to determine how each policy change will impact the objectives and constraints for the securities portfolio The three policies are as follows:

Policy 1: Expanding lending activities by opening branches in other cities of the

country

Policy 2: Restricting lending to customers with a credit rating of A or higher Policy 3: Increase the holdings of long-term mortgage-backed securities

Explain the impact of each policy change on the bank’s objectives and constraints Your

response should consider each policy in isolation

(6 minutes) Answer Question 5-D in the template provided on page 19

Template for Question 5-D

Expanding lending activities by opening

branches in other cities of the country

Restricting lending to customers with a

credit rating of A of higher

Increase the holdings of long-term

mortgage-backed securities

QUESTION 6 HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES

Samantha Gilbert is the chief investment officer of Home Asset Trust (HAT) which is based in the US HAT runs a top-down global tactical asset allocation (TAA) program which first evaluates the overall asset allocation level followed by individual asset-classes

A Explain two principles underlying a TAA program

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES

Jill Starc is a senior asset manager at RP Financial (RPF), a portfolio management firm Starc oversees the Global Equity Fund I (GEF I) which is being offered by the firm The fund holds global (Canadian, Mexican and British) and domestic U.S equities Foreign currency exposures are currently unhedged The exhibit below illustrates the values of the fund assets, spot exchange rates, and correlations between movements in foreign

currency-asset returns and foreign currency returns

Exhibit GEF I Fund Asset Values, Spot Rates, and Correlations

Last Year (2013)

Current Year (2014) CAD-denominated asset value

Based on a discussion with Singh, Starc determines that hedging the client’s foreign currency risk exposures is essential However, she is yet to establish the degree to which currency risk exposures should be hedged

B Describe two potential considerations which Starc will need to account for when

determining the degree of currency risk exposures to undertake Your answer should focus on Singh’s current portfolio allocation and the information in the exhibit

(6 minutes)

To aid her currency hedging decision, Starc collects necessary details with respect to Singh She will examine each factor independently to determine whether a full currency hedge will be required

Information on Singh:

• Risk averse to portfolio losses

• Has a relatively long time-horizon

• Desire for foreign fixed-income security exposure

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

C For each of the four points collected, determine whether the strategic currency

position of the portfolio should be biased towards a fully hedged currency

management program Consider each factor independently and support each answer with one reason

Answer Question 7-C in the template provided on page 23

(8 minutes)

Template for Question 7-C

Point Collected

Strategic Currency Position Biased Towards a Fully Hedged Currency Management Program?

Circle the Correct Answer

Support Each Answer with One Reason

Risk averse to portfolio

Desire for foreign

fixed-income security exposure

Yes

No

Required to make a down

payment for the purchase of

a home in three month’s

time and pays for her son’s

ongoing medical expenses

Yes

No

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

19 MINUTES

Simon Weaver is an economic analyst working at Time Analytics Weaver covers

developed and emerging markets specializing in bonds and equities

Weaver is making inflation forecasts for Lidon, a country with an emerging market His analysis focuses on two historical periods, 1990-1995 and 1996-2001 The first time period was marked with above average inflation, GDP growth exceeding its target, and

an economy in danger of becoming overheated The cause of the high inflation was a global rise in energy prices triggering cost-push inflation in the country Circumstances changed in the 1996-2001 period when monetary authorities implemented restrictive policy measures to cool down the economy

Based on economic analysis, Weaver projects that Lidon’s economy is once again

expected to overheat due to the rapid supply of money currently being injected by

monetary authorities To calculate the anticipated increase in inflation, Weaver uses the average inflation prevailing over the two time periods, assigning a higher probability to the inflation observed during 1990-1995, as input to his analytical model

A Discuss the bias observed demonstrated by Weaver’s analytical methods

(2 minutes)

B

i Identify the psychological trap which Weaver has fallen into Justify you choice

Answer B-i in the template provided below

ii For the identified bias, discuss two possible measures which can be taken to avoid

this bias

(5 minutes) Template for Question 8-B (i) is provided on page 26

C Three months later Weaver’s inflation forecast materializes The analyst

anticipates Lidon’s central bank will deal with this scenario by tightening the monetary policy and increasing the short-term interest rate to 7.0% from its current level of 6.0%

Recommend which asset class will be a suitable investment choice given Weaver’s expectations For the asset classes not selected, explain why they are inappropriate

Answer Question 9-C in the template provided on page 26

(7 minutes)

D The authorities in Lidon have announced their intention to peg the local currency,

LDN, to the U.S dollar (USD) The market is weary of the strategy’s

effectiveness and expects the LDN to be devalued shortly before Lidon

implements the policy The current interest rate differential between Lidon and U.S sovereign bonds is 4.5%

i. Identify two benefits of maintaining an exchange rate peg

(2 minutes)

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

(3 minutes)

Template for Question 8-B (i)

Identify the Psychological Trap which

Weaver has Fallen Into (Circle the

Correct Answer)

For the Trap Not Selected, Provide

one Reason Why it is Inappropriate

Overconfidence

Confirming evidence

Status Quo

Template for Question 8-C

Select the most suitable asset class given

QUESTION 9 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF

17 MINUTES

Melissa Reed manages the equity allocation of institutional client portfolios at Carter The Smithson Foundation (SF) is Reed’s most recent client During a meeting with the foundation’s chief executive, Reed deems that the portfolio’s equity allocation should be indexed to the Russell 3000 index

Wood-In her conversation with the chief executive concerning the portfolio management

strategy, the latter states, “The chosen passive management strategy should minimize portfolio rebalancing costs and be cost effective in terms of portfolio construction costs.”

A. Select which strategy is most suitable for the passive management of SF

portfolio’s equity allocation Justify your choice Your answer should also

explain why the strategies not selected are unsuitable

(Note: The provided justifications for the three strategies should be distinct.)

Answer Question 9-A in the template provided on page 29

(7 minutes)

Reed is of the opinion that the investment universe of SF’s portfolio should be expanded

to include global equities However, she does not wish to undertake the purchase of individual stocks and so engages in an equity total return swap whereby the SF policy portfolio will receive the return on the MSCI global equity index in exchange for interest payments on U.S Treasury bonds

B Discuss two general advantages of Reed’s global equity allocation strategy

(4 minutes)

Reed also manages the equity portion of Glenn Endowment’s (GE) policy portfolio The

Annualized portfolio return 14.50%

Annualized tracking risk 7.85%

C State one advantage and one disadvantage of the performance evaluation

approach being used by Edgar

(2 minutes)

D State and justify whether GE’s portfolio is invested in accordance with the stated

mandate

(4 minutes)

Template for Question 9-A

Select the most Suitable

Strategy for the

QUESTION 10 HAS ONE PART FOR A TOTAL OF 6 MINUTES

Carl Storm is an institutional portfolio manager at Theta Asset Management Storm works closely with Green Associates, a broker/dealer firm, to execute trades on behalf of client accounts Below are excerpts from her meetings with the chief executives of two of her clients Storm needs to determine which type of order will be submitted to Green Associates based on the details collected

Smithson Corp’s Defined Benefit Pension Fund:

Smithson has placed an order to purchase 100,000 shares of Reliable Corp, a software manufacturer The average day’s volume of the manufacturer’s stock is 400,000 The firm’s purchase decision is based on earnings growth projections generated by the firm’s in-house forecasting model The chief executive has instructed to Storm, “We would not like to reveal the full extent of our purchase order to the market.”

Thornton Endowment Fund:

The chief executive emphasizes on giving brokers free reign to make purchase decisions for the fund’s policy portfolio whenever the market presents a favorable opportunity All trades must be executed within three trading days of placing the order

Determine which order is most suitable for the two clients Explain your choice

Answer Question 10 in the template provided on page 31

(6 minutes)

Template for Question 10

Client

Determine which order is

most suitable for the two

clients (Circle the Correct Answer) Explain your Choice

Best efforts order

Market on open order

QUESTION 11 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 15 MINUTES

Bjore Traders is a shipping company listed on the NYSE The company has divisions operating in several states across the U.S Each divisional manager is responsible for overseeing the risk management of its exposures

A Identify one benefit and one drawback of BT’s risk management system

structure

(2 minutes)

Jacqueline Andrew is the head of risk management at BT’s Idaho division Andrew is preparing a report on the division’s risk exposures in order to determine how to manage them effectively She begins her report by discussing the division’s strategy for risk management:

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

B Does Andrew’s statement reflect efficient risk management practices? Justify

your response

(3 minutes) Answer Question 11-B in the template provided on page 33

The Idaho Division is BT’s only division delivering orders to customers outside the U.S

A portion of its sales are on credit Shipping fuel is procured by paying for 12 months’ fuel in advance using over-the-counter (OTC) prepaid commodity swaps The firm has hedged its foreign currency exposures using currency futures

In the current year, the management is seeking to expand the division’s delivery

destinations and will be purchasing three freight ships from a U.S supplier Funds from the purchase will come from issuing a combination of equities and corporate bonds

C Identify five risk exposures faced by the Idaho division Your answer should

explain each risk exposure by identifying one source

Template for Question 11-B

Andrew’s Statement:

Does Andrew’s Statement Reflect Efficient Risk Management Practices?

(Circle the Correct Option) Justify Your Response

“We manage risk

strategically by avoiding

risk taking in areas in which

we do not have expertise

and hedging only tactically

in areas in which we have

an edge.”

Yes

No

Template for Question 11-C

Identify Five Risk Exposures Faced by

the Idaho Division

Explain Each Risk Exposure with One Identified Source

QUESTION 12 HAS ONE PART FOR A TOTAL OF 5 MINUTES

Capex Asset Management is a U.S based portfolio management firm which has always invested in domestic stocks on behalf of client portfolios Victor Solanki is CAM’s senior most portfolio manager Solanki has allocated €100 million for investing in German stocks with an average beta of 0.75 The spot exchange rate is $0.89 The German interest rate is 4%

Solanki will be hedging both German market risk as well as currency risk for a three month period A three-month futures contract on the German market is priced at

€200,000 and has a beta of 0.60 The three-month forward rate is $0.9560

i Identify the strategy Capex Asset Management will need to undertake for

hedging German local market return

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

your calculations

(5 minutes)

FinQuiz.com

CFA Level III Mock Exam 5

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 – 5th Mock Exam 2017 (AM Session)

The morning session of the 2017 Level III CFA Examination has 12 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question

10 Portfolio Management – Monitoring and Rebalancing 6

Total: 180

QUESTION 1 HAS SIX PARTS (A, B, C, D and E) FOR A TOTAL OF 26

MINUTES

Kyle Lucas is the owner of a privately traded manufacturing concern which is currently worth $15 million and was established twenty-five years ago Lucas is 65 years of age and intends to sell the business three years from today

Lucas has approached portfolio manager Gus Weaver to manage his investment portfolio which is currently worth $8.5 million and is equally allocated to long-term corporate bonds, domestic and international equities, and alternative asset classes In response to a question regarding his investment experience, Lucas states, “I have faced significant financial crises in the past and now always look to avoid making investment choices which hold the potential for disastrous consequences.”

Lucas earns annual business income which is fixed at a pre-tax amount of $100,000 His living expenses are $98,000 in the current year and are expected to increase at the annual rate of inflation of 5% Upon retirement, he will no longer earn business income and his annual living expenses will become constant at $150,000

If Lucas sells his business at its current market price, three years from today, he will be able to meet his retirement living expenses and purchase a boat currently sold at a price

of $1.0 million He has instructed Weaver to exclude the boat purchase from the

investment decision Lucas intends to finance his grandson’s college education as well as purchase residential property for him Total estimated costs will amount to $30 million and will be required fifteen years from today

Lucas is subject to an ordinary income and capital gains tax rate of 25% and 30%

respectively He always maintains an emergency reserve equal to 3 years of his annual business income in addition to his portfolio holdings

A Formulate each of the following constraints for Lucas’ investment policy

statement (IPS):

I Time Horizon

II Unique Circumstances

(4 minutes)

B Determine whether an increase in inflation rate, reduction in the sales price of the

business, and an increase in the price of the boat will increase, decrease or have

no impact on risk tolerance Justify your choice with one reason

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

(6 minutes)

C State Lucas’s return objective for his IPS

(3 minutes)

D Calculate Lucas’ annual after-tax nominal rate of return for the IPS if his

business is sold at its current market price three years from today Show your

calculations

(6 minutes)

Walker strongly feels that incorporating behavioral considerations in an IPS is essential

to fulfilling the client’s long-term goals To achieve this purpose, he holds a meeting with Lucas to determine his behavioral investor type (BIT) and associated biases by holding a meeting with the client

E Discuss two benefits of including behavioral finance into the IPS

(4 minutes)

Lucas is an avid follower of the stock market and makes investment decisions on behalf

of friends and family members His most recent investment decision involved a $100,000 purchase of French Inc’s stock The decision was influenced by recent media attention on the corporation following a ‘brave’ policy shift towards unconventional production processes promising shorter lead times and a greater focus on organic raw materials as

F Identify the bias demonstrated by Lucas and justify your selection with one

reason

(3 minutes) Answer Question 1-F in the template provided on page 7