CFA 2018 level 3 schweser practice exam v2 exam 2 mornings

Determine the Smythes' willingness to take risk and justify your answer with two reasons based on their situation.. 4 minutes Answer / Comment: QUESTION 2 HAS THREE PARTS FOR A TOTAL OF

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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

(3 minutes) Answer / Comment:

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

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

for the coming year

(6 minutes)

D Determine the Smythes' liquidity needs and time horizon

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

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

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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

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

Answer Question 2-B in the template provided.

(11 minutes) Template for Question 2-B

Investment Policy Statement for Matrix Corporation

Risk

Return

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

Answer Question 2-C in the template provided.

(10 minutes) Template for Question 2-C

Constraints Time Horizon

Liquidity

Legal/Regulatory

Taxes

Unique

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

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A Compute the surplus and the (money) duration gap measured in BPV for this set of assets and liabilities

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

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

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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

Estimated world

Estimated emerging

market return 3 + 1.1(8) + 1 = 12.80%

4 + 1.3(5) + 1 =

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

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

(4 minutes)

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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

A rated government

Average equity

market total return 9.5%

Past 12 months:

Average dividend

Average real

C

i Calculate the historical equity risk premium and use it to calculate the appropriate equity discount rate based on current bond market conditions

(2 minutes)

ii Calculate the equity risk premium and the appropriate expected equity return based on Grinold-Kroner assuming a 1% reduction in shares outstanding

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

Consumer confidence index 0 -0.1 +1.1 +2.5

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Inventory, % change -1% 1.1% 3.4% 9.3%

30 - 1 year government bond yield 1.1% 2.7% 2.5% 0.1%

D Determine, based on business cycle analysis, whether the outlook for the equity market is favorable or unfavorable and support your conclusion with 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 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

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 Discuss one disadvantage and one advantage of holdings-based style analysis over returns-based style analysis

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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

(7 minutes)

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

QUESTION 6 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 22 MINUTES

Fred Norton is a portfolio manager for U.S.-based clients at GJA Management His firm uses a module approach to portfolio construction Each module is derived through mean-variance optimization Consensus asset class return estimates are derived from reverse optimization The Black-Litterman methodology is then applied to add value through selective adjustment of asset class return estimates The firm will only accept clients where this approach is suitable Two levels of service are offered:

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 Tier 1 is for (mostly smaller) clients where a single module is suitable for the client's total portfolio

 Tier 2 is for more complex situations where a custom blend of modules is used to meet objectives

Norton is working on several client portfolios and has determined six modules are potentially relevant The modules are shown in Exhibit 1 All data is nominal and after-tax

Exhibit 1: Module Sub-Portfolios

Expected return 2.8% 5.2% 6.8% 8.9% 10.2% 12.4%

Standard deviation 4.9% 6.4% 7.8% 11.3% 15.6% 24.2%

Sharpe ratio* 0.265 0.578 0.679 0.655 0.558 0.450

Weighing to U.S

small-cap stocks 4.82% 12.60% 20.15% 23.75% 17.98% 5.76%

*The risk-free rate is 1.5%

Norton is preparing to meet with Julian Brandon, a 32-year old lawyer in public practice Brandon

is recently divorced, has no dependents, and comes to GJA with an $850,000 portfolio Norton has concluded that Brandon has moderate risk tolerance (quantified as a risk aversion coefficient

of 3) Norton has further determined that one of three modules is suitable for Brandon-Gamma, Delta, or Epsilon

A Determine which one module (Gamma, Delta, or Epsilon) will maximize Brandon's risk-adjusted expected return (utility) and justify your answer

Before implementing the decision from part A, Brandon advises Norton that he has one more critical goal Brandon plans to withdraw $50,000 from the portfolio in one year to purchase a boat Brandon will reinvest all return earned into the portfolio and wants the value of the portfolio after the withdrawal in one year to still be at least $850,000 Norton agrees to revise the plan to include these additional considerations Norton again determines Gamma, Delta, or Epsilon is the optimal module, only one module will be used, and the data in Exhibit 1 is relevant

B Based on the data in Exhibit 1, calculate the amount that should be invested in U.S small-cap stock to maximize the probability the portfolio value will still be at least $850,000 in one year and after the withdrawal Show your calculations

(4 minutes)

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Answer / Comment:

Norton has a larger client, Henry Simpson, which requires a 9% after-tax return to cover

spending needs and to maintain real value Norton is now considering all six modules and would use them in two potential strategies:

1 Use the risk-free asset and one module to reach the 9% return objective

2 Use a blend of two modules to meet the return objective He will not use the risk-free asset

He is treating the modules as corner portfolios which means a simple weighted average calculation based on two modules is appropriate

C Assuming Norton will consider all six modules:

i State which one module Norton will use and compute the percentage allocation to that module if he uses the risk-free asset and one module

ii State which two modules Norton will use and compute the percentage allocation to each module if he will not use the risk-free asset

Norton's boss has asked him to consider applying their module approach to goals-based asset allocation (GBAA) In GBAA, a specific module will be used to meet a specific client goal based

on the time horizon and urgency of the goal Norton has the GJA risk analytics team to compute real (nominal return less expected inflation) returns for each of the modules over a variety of time horizons and required probabilities of success This analysis is presented in Exhibit 2:

Exhibit 2: Model Portfolio Annualized Minimum Real Returns

Required success 95% −1.25% 0.37% 1.24% 1.52% 0.58% −1.69%

85% −0.31% 1.60% 2.74% 3.70% 3.59% 2.97%

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