CFA 2018 level 3 schweser practice exam v2 exam 2 morning answers

Grading Guide Answer for Question 1-B Higher ability:  At age 40 and 39, they have a long time horizon.. Grading Guide Answer for Question 2-B Investment Policy Statement for Matrix Cor

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QUESTION 1 HAS FIVE PARTS FOR A TOTAL OF 21 MINUTES

Barney Smythe, 40, and his wife Heather, 39, are considering what to do with a recent windfall they received after the untimely death of Heather's mother The windfall is estimated to be

$2,500,000 (after taxes) Barney is currently a supervising mechanic at a local luxury car

dealership and has a salary of $48,750 annually Heather has been a stay-at-home mom since she was injured The Smythes have two children, Lenny, 12, and Buford, 10 By design, the Smythes owe no debt and pay their expenses on a monthly basis Family expenses last year amounted to approximately $150,000

In addition to the inheritance they will receive, the Smythes have an additional $1,250,000 in cash equivalents The savings are what remain from a large settlement the Smythes received when Heather was injured on the job five years ago Barney and Heather have approached Net Worth Enhancers, PC, for assistance in managing their portfolio The Smythes made the

following statements at a recent client discovery meeting:

 "One of our goals at this stage in our lives is to pay for the college education of our children

We would like both of them to go to Heather's alma mater, which is a prestigious liberal arts institution."

 "We expect our annual expenses to increase at the general rate of inflation of 2%."

 "We want to retire at 65 and be able to live comfortably, but not extravagantly."

 "We are taxed at 25% on both income and capital gains."

 "We believe our portfolio should never suffer an annual loss of more than 5% In addition, we

do not want to invest in any individual investment or security that is too risky."

 "We do not foresee any unusual expenses over the short term As always, we would like to have enough cash on hand for emergencies."

A Determine the Smythes' willingness to take risk and justify your answer with two reasons based on their situation

Grading Guide

Answer for Question 1-A

Their willingness is low

 They have passive wealth from inheritance and an injury settlement, suggesting they have not been willing to take investment risk

 They indicate low willingness to take risk with statements about avoiding risky securities or not losing more than 5%

 They are adverse to any debt

Candidate discussion

1 point for low and 1 point each for two reasons

(Study Session 4, LOS 8.g, i)

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(Study session 5, LOS 12.j, l)

B Justify with one reason each why the Smythes' have higher and lower ability to take risk based on their situation

Grading Guide

Answer for Question 1-B

Higher ability:

 At age 40 and 39, they have a long time horizon

 They have substantial portfolio assets of $3.75 million versus needs

 The portfolio distributions will need to keep up with inflation

2 points each for one reason supporting higher and one supporting lower

C State the Smythes' return objective(s) and calculate the required after-tax nominal return

for the coming year

Grading Guide

Answer for Question 1-C

 Supplement living expenses

 Pay for the children's college education

 Retire at age 65

Investable asset base: $3.75 million

Need from the portfolio:

Last year's living expenses increased for inflation

150,000 (1.02) = 153,000 Less AT salary of: 48,750 (1 - 0.25) = 36,563

AT real return: 116,437 / 3,750,000 = 3.1%

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+ future inflation (2%) for AT nominal return of 5.1%

Candidate discussion:

C 2 points for stating the three things they want 1 point each for correctly calculating the base and need for the coming year; plus 1 point each setting up the real return calculation and then adding future inflation of 2% Note that inflating last year's need to determine how much money is required this year is a completely separate issue from adding inflation to the

distribution (real) return in order to maintain the real value of the portfolio going forward (Study Session 4, LOS 8.g, i)

D Determine the Smythes' liquidity needs and time horizon

Grading Guide

Answer for Question 1-D

Liquidity:

 They want an unspecified emergency reserve, approximately 6 to 12 months of living

expenses depending on the situation

 Cover annual distribution needs

Time horizon: Overall long given their ages

 Now until retirement in roughly 25 years and then in retirement

 An additional stage could be while the children are in school The oldest child is 12

Liquidity: 1 point each for stating the need to meet ongoing distributions and the desire for a cash reserve Six months of living expenses would be roughly $75,000 No specific number can be determined for the cash reserve, so no number or any reasonably similar value to that in the suggested solution is acceptable

Time horizon: 1 point for dividing time horizon into before and after retirement, plus 1 point for the children's college years

E Justify whether the Smythes most likely have high or low needs for life insurance and

annuities at this time Consider each insurance product separately

Grading Guide

Answer for Question 1-E

Life insurance needs are modest (low) The Smythes' have relatively little human capital to insure given Barney's modest salary, especially when compared to their financial capital

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They currently have little need for annuities because they do not plan to retire for 25 years

2 points each for the two issues In both cases, you must conclude lower and support why it is lower Recall that insurance is a risk sharing and management tool which, in aggregate, reduces the user's total wealth It will not fix this couple's financial issues They have little human capital

to insure so there is little need for life insurance The shortfall between spending and salary is not going to be solved by life insurance Any need for annuities is far in the future

QUESTION 2 HAS THREE PARTS FOR A TOTAL OF 27 MINUTES

Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping Matrix sponsors a traditional defined benefit pension plan Plan assets are valued

at $5.5 billion, while recent declines in interest rates have caused plan liabilities to balloon to $8.3 billion Average employee age at Matrix is 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1:1 Joe Elliot, Matrix's CFO, has made the following statement about the current state of the pension plan

"Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in our long history, but I am sure these low rates are temporary I have looked at the charts and estimated the probability of higher interest rates at more than 90% Given the

expected improvement in interest rate levels, plan liabilities will again come back into line with our historical position Our investment policy will therefore be to invest plan assets in aggressive equity securities This investment exposure will bring our plan to an over-funded status, which will allow us to use pension income to bolster our profitability."

A Critique Elliot's statement with respect to investing Matrix's plan assets by addressing the following three points:

i The behavioral fallacy Elliot is most likely exhibiting is: illusion of control, myopic loss

aversion, or sample size neglect

ii Plan risk and return objectives

iii Using pension plan income to bolster firm profitability

Grading Guide

i Elliot has a very limited set of data on which he based all his conclusions He only looked at some charts; this is most directly sample size neglect If he thought he personally controlled

or influenced future returns, that would be illusion of control Myopic loss aversion refers to systematic underpricing of equities if investors over-focus on their short-term risk, which is not a prediction they will do well in a higher interest rate environment

ii The return objective is excessive Assets should be invested for the benefit of plan

participants and underfunding addressed through contributions, not through taking higher risk

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iii The investment of plan assets for the stated purpose of bolstering profitability is

inappropriate, and is a violation of Elliot's fiduciary responsibilities to invest for the benefit of plan participants, not the sponsoring company

A 2 points for each critique of Elliot's statement

(Study Session 3, LOS 6.b, c)

B Based on the information provided, formulate a return objective and a risk objective for the Matrix Corporation pension plan (No calculations required.)

Grading Guide

Investment Policy Statement for Matrix Corporation

Objectives Risk tolerance is below average:

• The plan is underfunded at $8.3 billion to $5.5 billion of liabilities to assets

• The age of active employees is high

• The ratio of active to retired lives is low

Return objective: To earn the discount rate used in computing the present value of liabilities A modest increment above this might be acceptable but the bulk of the underfunding should be addressed by plan contributions

Candidate discussion

6 points for the risk objective and 5 points for the return objective Given the high point score, a good technique is to support your answer with specific facts from the case

C Based on the information provided, formulate an appropriate constraints section for the investment policy statement for the pension fund

Grading Guide

Time horizon Time horizon is short given the older age of the workforce (57.5 years) and

the low ratio of active to retired lives Both indicate significant outflows from the portfolio

Liquidity Liquidity requirements are high given the low ratio of active to retired lives

and older workforce

Legal/Regulatory A pension plan has significant legal and regulatory requirements with a

fiduciary duty to plan participants, ERISA generally applies in the United States

Taxes Pension plans in the United States are normally tax exempt

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2 points for each constraint

QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 10 MINUTES

Lewis Atkins has been asked to construct and manage a portfolio of fixed-income bonds to fund multiple debt liabilities of a large corporation The liabilities have a market value of $24,465,120 and a modified duration of 6.12 Atkins buys a portfolio of U.S Treasury notes with a market value of $25,875,724 and a modified duration of 4.27

1 point each for correctly calculating the surplus, BPV of assets, and BPV of liabilities

The CFA text includes examples where BPV of the liabilities exceeds that of the assets and just calls the difference the duration gap It provides no formula and does not assign a + or − sign to the gap Rather than fixate on + or −, we recommend you explicitly note whether asset or liability BPV is larger That is the key issue in subsequent strategy decisions

(Study Session 10, LOS 22.a, c, d)

Atkins has deliberately built the portfolio to have a higher market value than the liabilities to provide a cushion against losses He will use T-Note futures to control the duration gap but has been given authority to over or under hedge and is allowed a net hedged duration gap between +1,250 and -$1,250 If the surplus evaporates, however, he must revert to a pure 100% hedged strategy of a zero duration gap

B State the name given to the type of strategy being adopted by

Atkins Describeone advantage and one disadvantage of such a strategy, compared to the 100% hedged strategy

Grading Guide

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For the advantage and disadvantage of CI, it needs to be clear you focused on higher or lower return versus immunization (duration matching) It is also true that CI has a floor rate of return; you revert to immunization before the surplus becomes negative That does not directly address the question asked, so no credit for discussing a floor rate of return on the downside Also notice

we are still drawing no inference from what a + or - duration gap means What is clear is that Atkins can set asset BPV above or below liability BPV by $1,250

(Study Session 10, LOS 22.a, c, d)

Ten-year T-Note futures contracts are quoted at 127.84375, and Atkins estimates that each contract has a BPV of 85.38 Atkins takes a long position in 32 futures contracts to adjust his duration gap

C Determine Atkins' view on interest rates based on his position in the T-note futures

and justify your determination

Grading Guide

 He bought contracts, increasing his asset BPV by: 85.38 per contract × 32 ≈ $2,732

 Making his asset BPV: 11,049 + 2,732 = $13,781

 The liability BPV is still higher, at $14,973

 He must be predicting rates will increase and his asset value will decline less than his liability value

This question depends on your problem solving skills If you have no idea how to solve a

question, skip it and come back later The insight is to see if Atkins set asset BPV above or below liability BPV and then reason through what interest rate forecast that implies

It must be clear to the grader (1) how you determined BPV of assets is still below that of liabilities after the contracts are purchased, and (2) that you used this to infer he expects rates to increase (Study Session 10, LOS 22.a, c, d)

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QUESTION 4 HAS FIVE PARTS FOR A TOTAL OF 28 MINUTES

William Barkley and David McFalls are economists for Irvington Advisors, a U.S.-based firm Irvington provides independent economic and investment advice to portfolio managers, research analysts, and others

Barkley has compiled the following data for equity returns in an emerging market:

Normal conditions, 80% probability

High volatility conditions, 20% probability

Unconditioned expectations, 80/20 average

A McFalls points out that there is a problem in Barkley's analysis McFalls calculates the

expected unconditioned return estimate as 3.20 + 1.14(5.40) + 1 = 10.36% Explain how

systematic and unsystematic risk are reflected in Barkley's analysis Comment on the

implications of this issue

Grading Guide

Systematic risk is related to beta Alpha is related to unsystematic risk Barkley computed the true unconditional return of 9.94% by conditioning his estimated returns to the condition of the market and then probability weighting his results rather than just using an average beta

Candidate discussion: 2 points each for correctly discussing alpha as unsystematic and beta

as systematic risk 1 point for indicating Barkley was correct to condition his estimated return to market conditions

B Barkley has found it difficult to gather data on alternative investments for emerging markets He has been able to estimate an initial value 10 years ago and a current value He is confident in both numbers, and he assumes income returns are evenly distributed throughout

the 10-year period Explain how smoothing and regime change could affect his expected

return and risk estimates derived from the data

Grading Guide

Smoothing will cause him to underestimate risk because he has only a beginning and ending point but no idea of the true volatility between the two time points Applying a constant average income return will only further smooth out the perception of risk

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Regime change is a problem because he does not know if there were fundamental changes that caused risk and return to be much different in one portion of the 10-year period from another portion For instance, there could be a change in government policy that caused returns in the first half to be high but in the second half to be low Risk could also have changed

Candidate discussion: 2 points each for the discussion of smoothing and regime change For

2 points some illustration or elaboration related to the case facts is required

McFalls has gathered the following data for another emerging market He has selected time periods for historical data he believes are relevant to future conditions

Conditions

Expected Conditions

i The historical risk premium was: 9.5 - 6.8 = 2.7%

Using the current bond yield, this is an equity discount rate of 2.7 + 4.8 = 7.5%

Candidate discussion: 1 point for each correct calculation

ii GK is a variation on yield plus growth as the expected return The 1% reduction in shares outstanding is stock repurchase, and it supplements the dividend yield of 1.7% Growth is real plus expected inflation The expected decline in P/E is a downward revaluation, which reduces expected return

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1.7 + 1.0 + 4.1 + 3.3 - [(13.2 - 13.5) / 13.5] = 10.1% - 2.2% = 7.9%

Making the equity risk premium: 7.9 - 4.8 = 3.1%

Candidate discussion: 1 point to set up the GK calculation and 1 point each for the two correct numbers requested

McFalls sees the variations in estimated equity return produced by various models as an

opportunity and decides to use business cycle analysis to gage the relative attractiveness of the equity market He gathers economic data for the last four years with year 4 the oldest data and year 1 the most recent

Unfavorable outlook for equity (or very late in the recovery for equities, which means returns are likely to decline)

 Inflation is rising, which indicates the central bank will reduce monetary growth and increase short-term interest rates, slowing real growth

 Consumer confidence has been increasing, indicating the economy is late in the economic cycle

 Inventories are increasing, which is likely to lead business to slow production, reducing economic growth

 The yield curve is dramatically flattening, which suggests the central bank is restricting monetary growth to slow the economy

 Unemployment has fallen suggesting the economy is late in the economic cycle

Candidate discussion: 2 points for unfavorable and 2 points each for three reasons

Barkley and McFalls are discussing alternative approaches to forecasting markets and exchange rate movements

Statement 1: Barkley states that if interest rates in country A exceed those in country B by 3% and real rates in both countries are equal, then the currency of country B is likely to appreciate

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Statement 2: McFalls states that under those same conditions, the currency of country A should appreciate

Statement 3: Both agree that countries with higher real growth, inflation, and savings deficits have an incentive to maintain the value of their currency

E State and explain why each statement is most likely consistent with the purchasing power parity (PPP), relative economic strength (RES), or savings-investment imbalances (SII) approach

to forecast exchange rate movements Each statement must have a different label, and each label must be used only once

Grading Guide

Answer for Question 4-E

Statement 1-PPP With the same real rates, A will have 3% higher inflation, and PPP predicts a 3% decline in currency A (i.e., B will appreciate)

Statement 3-SII With a savings deficit, a country must maintain the value of its currency to continue to attract foreign capital

Statement 2-RES By elimination, this can be RES The higher rates and inflation could reflect strong economic growth that will attract capital, resulting in an increasing currency value

Candidate discussion: 1 point each for three correct matches and for each correct supporting statement Note, that it was easier to evaluate statement 1 and 3 before statement 2 because 2

is very vague

QUESTION 5 HAS THREE PARTS FOR A TOTAL OF 23 MINUTES

Aaron Bell, a portfolio manager, is focusing his attention on investment style, and whether style should be a factor in investment decision making Bell decides to play it safe and investigate how

he can use different instruments related to style indices or indexing strategies to see if he can add value to his customers' portfolios

A Explain holdings-based style analysis Discussone disadvantage and one advantage of holdings-based style analysis over returns-based style analysis

Grading Guide

Holdings-based style analysis (HB) examines the portfolio, classifying securities based on

characteristics such as capitalization, value, growth, industry, etc

 Disadvantage: Subjective classification of categories

 Advantage over returns-based: Detects style drift faster

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B Explain returns-based style analysis Reproduce the general form of the regression

equation used for returns-based style analysis, including any constraints, and

label each component of the equation Discuss one disadvantage and one advantage of

returns-based style analysis over holdings-based style analysis

Grading Guide

Regress portfolio returns against style indices' returns:

RP = b0 + b1I1 + b2I2 + b3I3 + b4I4 + + bnIn + e

R2 = degree to which the model explains portfolio returns

bi = portfolio sensitivity to index i

RP = portfolio returns

Ii = returns on index i

e = returns to active management

n = number of indices used

Historical portfolio returns are regressed against various indices to find weightings of the indices (the equation"s coefficients) that would have produced the closest tracking to the actual portfolio returns For example, a 0.30 coefficient to large cap growth stocks indicates a 30% weight to large cap growth The weights (coefficients) must sum to 1.0

Disadvantage: Determining number of and which indices to use

Advantage over HB: Doesn"t require looking at portfolio holdings

7 points possible: 2 points for writing the equation; 1 point for labeling the inputs; 2 points for describing the approach; 1 point for disadvantage; 1 point for advantage over HB

(Study Session 12, LOS 25.f, i)

C Bell is considering indexing strategies and a colleague has suggested three alternatives: full replication; stratified sampling; and optimization Explaineach along with the conditions under which each would be appropriate to use and provide one disadvantage for each

Grading Guide

Full replication is simple in concept; all assets in the index are owned and weighted as in the index It should produce a low tracking error

 Appropriate if the index securities are liquid and reasonable in number

 But otherwise it could be very costly to implement

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