CFA 2018 level 3 schweser practice exam v1 exam 1 morning answers

Candidate discussion: 2 points for guardian and 1 point for one reason supporting the classification.. The Martins consider their investment base to be large given the inheritance, want

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QUESTION 1 HAS 4 PARTS (A, B, C, D) FOR A TOTAL OF 15 MINUTES.

Joe and Sara Finnegan are both 62 years old and live in Kerrville, Texas They are retired and have a combined investable net worth of $2 million, the bulk of which was inherited from Sara's father's estate Included in their total wealth is Joe's $500,000 defined-contribution retirement plan that is managed separately in a 401(k) retirement plan Joe makes the investment decisions for his 401(k) plan, but Sara makes the investment decisions for their other portfolio The

Finnegans home in Kerrville is valued at $750,000 The Finnegans do not have a mortgage on their home

Mr Finnegan's 401(k) plan is administered by a local bank trust department The trust

department offers its clients a range of portfolio allocations from aggressive to conservative as shown in Exhibit 1 Without regard for asset class characteristics or his own risk and return objectives, Mr Finnegan selected a portfolio that is equally weighted in each asset class and has made no changes to the portfolio allocation or to the allocation of new deposits to the plan

portfolio Mr Finnegan is primarily concerned about potential losses in his account and prefers not to make investment decisions He is often fearful and anxious about what may happen in his portfolio

Exhibit 1: Alternative Portfolios

Yield

Aggressive Asset Mix

Conservative Asset Mix

Domestic Equity Stocks-Income 4.0% 40% 15%

SGrading Guide

Answer for Question 1-A

1/n diversification: Joe divides his assets equally among all available alternatives

Status quo bias: Joe has made no changes to his portfolio

Candidate discussion:

Joe may show loss aversion, but that is not the same thing as myopic loss aversion Myopic loss aversion is a macro issue when large numbers of investors under-allocate to stocks, keeping their prices low and biasing upward their return premium Joe is not showing conservatism because that is a cognitive error when an initially rational view is formed but then retained without further consideration as new information comes in Joe made an initial, uninformed, and not well-thought-out decision that he does not change It is conceivable he has some of these other biases, but we know he exhibited the two selected, so other selections will receive no credit 1 point each for a correct identification and 1 point for supporting it

(Study Session 3, LOS 7.c)

B Based solely on his 401(k) investment portfolio, select the investor behavioral type (BIT) most

likely exhibited by Joe and justify your selection with one reason

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 Joe is cautious and wants to protect his assets

Candidate discussion: 2 points for guardian and 1 point for one reason supporting the

classification

(Study Session 3, LOS 7.a)

After several years, the Finnegans become dissatisfied with managing their own portfolio and approach Tim Smith in the bank trust department for advice Smith conducts detailed interviews with the Finnegans and identifies three sets of goals with varying priority He uses a client

questionnaire and determines that their biases are mainly emotional Because of their lack of investment success, he concludes that meeting their primary goals will be difficult He then develops both a goals-based investment plan and one based on traditional financial concepts

C Explain both how Smith would structure a goals-based investment plan for the Finnegans and the advantage of such a plan for them

Grading Guide

Answer for Question 1-C

Structure the plan in three layers, one for each priority level of goals The highest priority goals would be funded with lower risk assets, the lowest priority with higher risk assets, and the middle priority with medium risk assets

The advantage to the client is to see how high priority goals are less likely to be endangered by market declines and, thus, help the client stick with the investment plan during stressful market periods

Candidate discussion: 1 point for covering the 3 layers and 1 point for the risk characteristics in each layer 2 points for conveying that the client is more likely to stay with such a plan and, thus, come out ahead in the long run

D Explain one reason Smith would and one reason Smith would not deviate from the traditional plan asset allocations Each reason must be based directly on the information provided regarding the Finnegans

Grading Guide

D

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 Deviate because their biases are mainly emotional and that will make convincing them to change difficult

 Do not deviate because there is high standard of living risk Their assets are small enough that meeting primary goals will be difficult Therefore, they cannot afford to deviate from traditional finance efficiency

Candidate discussion: 1 point each for identifying the two relevant pieces of information and 1 point each for why one supports less and one more deviation from traditional efficiency

ANSWER QUESTIONS 2 AND 3 IN ORDER.

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

Lachlan Martin and his wife Chloe are both 50 years old, have no children, and live in Sydney, Australia Lachlan's father, Liam Martin, recently died and left his entire estate to Lachlan

Lachlan expects to receive his after-tax inheritance of 9.0 million Australian dollars (AUD) in one year The Martins both plan to retire at that time, and are meeting with Zoe White to help them establish an investment plan

The Martins currently own a home valued at AUD 3.9 million, do not have a portfolio of investable assets, and do not consider their home as part of their investable assets In one year, the

Martins' outstanding debt will be AUD 3.7 million (home mortgage) and AUD 160,000 (other debts) The Martins will pay off their mortgage and their other debts once the inheritance is received

The Martins currently have a combined after-tax salary of AUD 500,000, current-year living expenses of AUD 263,000, plus annual mortgage payments (principal + interest) of AUD

237,000 Lachlan's company will pay him an after-tax pension of AUD 51,000 starting in one year when he retires, with the payments increasing by the rate of inflation, which is expected to be 3% annually His employer will continue to pay all of the Martins' medical costs until death Both the pension and health benefits will continue to accrue to Lachlan's wife, if he dies first The Martins expect their living expenses will also continue to grow at the rate of inflation until one of them dies At that time, they expect the survivor's living expenses will decrease to 75% of their

combined expenses and then continue to grow at the rate of inflation

The Martins intend to fund their living expenses during retirement with Lachlan's pension and the investment income generated from the assets invested in from the inheritance The Martins consider their investment base to be large given the inheritance, want their portfolio to be

invested conservatively, and want to maintain the real value of their investable assets over time They plan to leave any assets left in their estate to charity All income and realized capital gains are taxed at 25% The assumed annual effective tax rate is 20%

A Calculate the before-tax nominal rate of return required for the Martins' first year of

retirement Show your calculations Do not assume any tax effects related to the mortgage

Grading Guide

Retirement starts in one year: first year cash flow needs:

Lachlan's After-Tax Company Pension AUD 51,000

Living expenses (263,000 × 1.03 inflation) -270,890

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Year 1 net required after-tax cash flow AUD -219,890

Net Investable Assets

Investable asset base (beginning Year 1) AUD 5,140,000

Return Objective

Year 1 after-tax required cash flow AUD -219,890

Divided by investable asset base AUD 5,140,000

Equals after-tax nominal rate of return 7.28%

Before tax nominal return: 7.28 / (1 - 0.2) = 9.10%

 Retirement starts in one year and all the figures given are in one year except the 263,000; remember to increase it for inflation

 An effective annual tax rate considers the effects of deferring some taxes and is the pertinent annual tax rate to apply

 You may notice we did not display an in/outflow analysis in this solution We actually did one, but there was no reason to show it Go check the case facts and determine the salary inflow versus living expense and mortgage outflow You should not need a calculator

 Exam answers for individuals have been accepted using either addition or geometric

compounding, only show one method Addition is preferred for individuals

(Study Session 4, LOS 8.f, h, i)

B Discuss two factors that decrease and one factor that increases the Martins' risk tolerance

Grading Guide

Answer for Question 2-B

Factors that decrease the Martins' risk tolerance:

 Retired with no additional income from working to replace any investment shortfalls

 Small pension relative to living expenses and must depend primarily on their investment portfolio

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 Large amount of living expenses relative to investable assets making them less able to tolerate volatility and negative short-term returns

 They want their portfolio invested conservatively-an indication of low willingness to bear risk

 Inherited wealth (passive source of wealth), may indicate a reduced willingness to take risk Factors that increase risk tolerance:

 They plan to leave their estate to charity; if this is a lower priority goal, they could spend the principal on living expenses if needed

 They consider their investment base to be large, which increases willingness to bear risk

 They have a long time horizon, which gives the portfolio time to recover from market losses

Candidate discussion: Only discuss the requested two items that decrease and one that increases risk tolerance 2 points each for two factors that decrease risk tolerance, and 2 points for one factor that increases risk tolerance

C Formulate each of the following constraints for the Martins' investment policy statement

o AUD 219,890 ongoing living expenses

o Expect an AUD 9 million after-tax inheritance in one year

ii Time horizon is long-term (they are age 50):

o One year until retirement

o Retired when both spouses are alive

o After one spouse dies and expenses drop 25%

Candidate discussion:

 Listing the debt payoff items is essential for full credit Listing the inheritance is

recommended

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 Past exam answers are inconsistent in discussing a need for ongoing distributions under liquidity It needs to be discussed and analyzed under return, and to be safe you can list it under liquidity as well

 It is not necessary to call the next year a stage as the portfolio investment does not start until retirement in one year, two stages and only listing the second two is also full credit

 The discussion of pre- and post-death of one spouse is unusual This case provided

specific information, so ignoring the information will reduce the score

QUESTION 3 HAS SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 21 MINUTES

The Martins have approached Steve Perry, a charterholder, for asset allocation advice The Martins have read about the benefits of diversification and how it will allow them to take less risk but earn a higher return They bring in articles on three investments that they have seen regularly discussed in the press and want to know if they will help the portfolio return The portfolio is currently invested in domestic (Australian) stocks and bonds Perry agrees to look into it and get back to them

As a first step, Perry compiles the following historical data:

Deviation E(R)

Correlation to Existing Portfolio

Sharpe Ratio

Grading Guide

E(R) = 0.10(8.7) + 0.90(6.5) = 6.72%

σ2 = (0.102 × 12.52) + (0.902 × 7.82) + (2 × 0.10 × 0.90 × 12.5 × 7.8 × 0.4) = 1.5625 + 49.2804 + 7.0200 = 57.8629

σ = 7.61

Sharpe = (6.72 - 2.5) / 7.61 = 0.55

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Candidate discussion: 1 point for the correct E(R), 2 points for the correct standard deviation, and 1point for setting up a correct Sharpe ratio calculation

Remember how to and be prepared to compute return and standard deviation of a portfolio of two assets as well as a Sharpe ratio

B State which proposed asset class's Sharpe ratio, based on the historical data, is most

likely overstated and explain why

Grading Guide

Real estate is an illiquid security and the price data is subject to infrequent pricing and

smoothing This lowers the reported standard deviation and increases the reported Sharpe ratio Real estate Sharpe is the most likely to be overstated

Candidate discussion: 1 point for real estate For a 2-point explanation, it must be clear the candidate refers to infrequent pricing/smoothing of prices and this lowers the reported standard deviation If only one issue is included, only 1 point The other asset classes are based primarily

on liquid traded securities and are unacceptable answers

(Study Session 13, LOS 26.d, f, g)

C State which Sharpe ratio, based on the historical data, is least likely to persist in the future and explain why

Grading Guide

Managed futures are not really an asset class, but they reflect the skill of the manager They are the least likely to exhibit persistent return characteristics so their Sharpe ratio is the least likely to persist

Candidate discussion: 1 point for managed futures For a 2-point explanation, it must be clear the candidate refers to manager skill issues and/or the lack of persistence in return parameters Referring to the generally shorter history of data for managed futures is not as good an

explanation and receives only 1 point

(Study Session 13, LOS 26.d, t)

Before meeting with the Martins, Perry asks his assistant to review the characteristics of a valid asset class and the issues of adding international assets The assistant gathers the following data

Global includes domestic and international

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D Determine whether it is more likely international bond or equity currency exposure should be hedged and support your answer with one reason

Grading Guide

Answer for Question 3-D

Hedge the international bond currency exposure

Bonds are less volatile than equity, making the currency volatility relatively a greater source of risk of bonds (i.e., foreign currency would be a smaller contributor to return volatility for the Martins in foreign equity than in foreign bonds)

Alterative reason: The correlation of foreign bond return to foreign currency is more positive than the correlation between foreign equity and foreign currency The + correlation contributes to volatility for the investor in the foreign market and makes currency hedging more important in foreign bonds

Candidate discussion: 1 point for foreign bonds and 2 points for either explanation

(Study Session 9, LOS 19.b)

E Explain how contagion can be a problem if emerging market securities are added to the Martins' portfolio and what tool Perry would use to manage the problem

Grading Guide

Answer for Question 3-E

Contagion refers to the observation that in crisis periods of market decline, correlations between markets move upward towards +1 and the benefits of diversification are not present

The tool used is conditional correlation matrices One set of correlations is for normal conditions and another higher set is for crisis conditions

Candidate discussion: 1 point for explaining that correlations increase in declines, 1 for the effect on portfolios, and 1 for using conditional correlation matrices If the candidate says the conditional matrices solve the problem, the last point is not awarded They can be used to

quantify the issue or jointly optimize, but do not solve the underlying problem of convergence and loss of diversification

(Source: Study Session 9, LOS 19.i)

Perry also asks the assistant to analyze the effect on the Martins' portfolio of adding French stocks to the portfolio if the currency risk is hedged or not hedged, based on the following

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Standard deviation of the EUR: 14%

Expected change in value of the EUR: +2%

Correlation of French stock and EUR return: 0.30

F Compute the return and standard deviation of a currency hedged and unhedged investment in the French stocks for the Martins There are four items to calculate Approximate calculations are acceptable

Grading Guide

Answer for Question 3-F

Unhedged return: 12 + 2 = 14%

Hedged return: 12 + 5 - 2 = 15%

Hedged currency standard deviation: 29%

Unhedged currency standard deviation:

Variance is: 12(0.292) + 12(0.142) + 2(1)(1)(0.3)(0.29)(0.14) = 0.1281

Making standard deviation: 0.3579 = 35.79%

Candidate discussion: 1 point each for the first three calculations and 2 points for the last Return is approximately RFC + RFX RFC is given as 12% The projected unhedged RFX is given as a 2% change in value of the EUR This is 12 + 2 = 14% With hedging, RFX is determined by IRP; lose the rf of the currency sold forward (the EUR, so -2%) and gain the rf of the currency

purchased forward (the AUD, so +5%) This is 12 - 2 + 5 = 15% With hedging, the standard deviation of RFX is 0, and the unhedged standard deviation of the investment is the standard deviation of RFC, which is given as 29% With currency unhedged, the standard deviation of

RFX (given as 14%) is used in the standard variance formula, recognizing that the weights for both

RFC and RFX are 1.0 when investing in a foreign asset

(Study Session 9, LOS 19.f)

QUESTION 4 HAS ONE PART FOR A TOTAL OF 8 MINUTES

Martina Edwards is retiring and stepping down from her position as portfolio manager at the Huron Foundation, which funds undergraduate and graduate environmental science research She is currently training her replacement, Greg Matlock, who previously worked as the portfolio manager for the defined benefit pension plan of a large corporation

During training, Edwards makes the following statements to compare a typical foundation to a typical defined benefit plan:

1 Both have perpetual time horizons

2 Both should consider the effects of future inflation on return by compounding (or adding) real return and inflation to determine nominal return needs

3 Foundations consider the correlation between return and dependence of the recipient on distributions DB plans consider correlation of return and plan sponsor business results In both cases, high correlation reduces risk tolerance

4 Both have high needs for cash equivalents to fund large payouts

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Determine whether you agree or disagree with each statement made by Edwards Support your decision Note: supporting your opinion by simply reversing an incorrect statement will receive no

credit

Grading Guide

Answer for Question 4

Disagree-Statement 1 DB plan time horizons are primarily determined by the duration of the liabilities and are not perpetual (They may be legally perpetual, but that is irrelevant to the IPS.) Disagree-Statement 2 For DB plans, future inflation may only apply to some liabilities, not all Or, inflation is already incorporated in the actuary's determination of future and PV of liabilities of DB plans Inflation is not a component of return for the DB manager to consider in the way it is done for foundations

Agree-Statement 3 The correlations are relevant to both If the receiving foundation is highly dependent on portfolio distributions, it reduces risk tolerance So, if low returns correlated with increased needs, portfolio risk tolerance would need to be lower For DB plans, the high

correlation described reduces risk tolerance to avoid contribution requirements increasing when business results are poor

Disagree-Statement 4 The need to hold cash equivalents and fund payouts varies for both

Candidate discussion: 1 point for each correct determination and 1 point for the explanation if the decision is correct

(Study Session 6, LOS 13 b, c, i)

QUESTION 5 HAS SEVEN (A, B, C, D, E, F, G) PARTS FOR A TOTAL OF 25 MINUTES

Vincent Scavuzzo is a CFA charterholder and was recently hired as a director of high net worth clients for an investment firm One of his goals is to move the firm into alternative investments In preparation for this move, the firm's board has raised several issues he must address

A Explain why the firm will need legal and tax advisors to invest in private equity and other partnerships when this is not needed for existing stock and bond portfolios

Grading Guide

These investments use a limited partnership (or similar) structure Each partnership can differ, so

it is essential to review the document for legal or tax implications One common stock is legally like another common stock, but one partnership may not be the same as another in legal or tax details

Candidate discussion: 3 points for discussing the unique structure details of each partnership contract

(Study Session 13, LOS 26.b, d, g, i, k, l, m, n)

B State whether direct real estate or REITs will be more expensive to invest in Support your decision with one reason it will be more expensive for the firm and one reason it will be more expensive for clients

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Grading Guide

Direct RE will be more expensive:

 For the firm: each property is unique and information is generally not publically available, so the property must be thoroughly researched prior to any recommendation (Or property must

be physically managed and maintained, which will involve time and expense)

 For the client: investment management fees are generally higher (or commission and other transaction costs are generally higher)

Candidate discussion: 1 point for direct, 2 points each for the two reasons One must relate to the firm and one the client

C State whether direct real estate or REITs should provide the largest diversification benefit and explain why Do not base your answer on return data for any specific historical time period

Grading Guide

Direct RE: It should provide lower correlation to other portfolio assets and more diversification benefit (Or REITs provide less diversification benefit because they behave partially like stock They are in fact stock in publically traded shares of companies that invest in real estate.)

Candidate discussion: 1 point for direct RE and 2 points for one reason

D Explain decision risk and whether it is a more serious problem for private equity (PE) or for commodity futures contracts

Grading Guide

Answer for Question 5-D

Decision risk refers to investors investing in securities they do not really understand and then exiting the strategy at an inopportune time and at high cost It is higher for PE

Or PE is generally illiquid and has a multiyear time horizon The investor may be unable to exit and then assert they never understood the risks In contrast, commodity futures are both liquid, have low transaction costs, and have short expiration dates Being able to exit lowers the

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E Discuss how venture capital (VC) and buyout funds (BO) differ in regard to using leverage, riskiness of the underlying securities, consistency of returns, and cash flow pattern to the

investors over the life of the fund

Grading Guide

E

 BO funds often use leverage and VC do not

 Underlying VC investments are more risky

 BO fund returns are typically more consistent

 BO funds generally begin to return cash to investors sooner and complete their liquidation in

a shorter period

Candidate discussion: 1 point each, for the four issues

F Explain what vintage year means and the implication for selecting private equity benchmarks

Grading Guide

Answer for Question 5-F

Vintage year is the year in which initial investments are made The initial economic conditions generally have a significant effect on subsequent returns and, therefore, the benchmark should have the same vintage year as the investment

Candidate discussion: 1 point for explaining vintage year and 2 points for the discussion For a 2-point discussion, it must be clear the benchmark must have the same vintage year

G State whether zinc or wheat futures are more likely to have positive correlation with changes

in future inflation and explain why

Grading Guide

Answer for Question 5-G

Commodities that are storable and affected by the level of economic activity, such as industrial metals which includes zinc, are positively related to unexpected changes in inflation and found to

be a good hedge against inflation

Candidate discussion: 1 point for zinc and 3 points for the explanation

QUESTION 6 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES

Jens Gustave is a senior portfolio manager with BAM Asset Management He is reviewing the manager asset allocation for the High Grove Foundation, one of BAM's larger accounts The foundation has carved out a 10% allocation, which employs aggressive techniques to enhance

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