2019 mock exam a afternoon session with solutions pdf

Asset Manager Code of Professional Conduct LOS b General Principles of Conduct 2 Which of the following anti- money- laundering laws must Athena currently comply with to be consistent w

T he afternoon session of the 2019 Level III Chartered Financial Analyst® Mock Examination has 60 questions To best simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam.

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2019 LEVEL III MOCK EXAM PM

Athena Investment Services Case Scenario

Caitlyn Wilson, CFA, recently started her own asset management company, Athena Investment Services The board of directors of Athena adopted both the CFA Institute Code of Ethics and Standards of Practice (Code and Standards) and the CFA Institute Asset Manager Code of Professional Conduct (Asset Manager Code) to institution- alize ethical behavior within the firm The board also implemented half- yearly staff performance reviews, including an assessment of each manager’s ability to ensure their department’s compliance with the both the Code and Standards and the Asset Manager Code.

Six months into the first financial year, Wilson meets with all of the managers

to assess each department’s compliance Wilson asks the compliance officer, Mark Zefferman, CFA, to make an opening statement to set the right tone for the meeting Zefferman states,

“At a minimum, we are responsible for implementing procedures ing the general principles embedded in the six components of the Asset Manager Code As stated below, we must:

address-Statement 1 Act with skill, competence, and diligence while

exhib-iting independence and objectivity when giving ment advice,

invest-Statement 2 Put our clients’ interests above the firm’s when

appro-priate and act in a professional and ethical manner at all times, and

Statement 3 Communicate with our clients in a timely and non-

misleading manner and obey all rules governing capital markets.”

Zefferman adds,

“With regard to the last statement, please be aware that we must ment the new anti- money- laundering regulations introduced by our local regulator, effective the first quarter of next year I have analyzed the new regulations and have found that all of the local requirements are part of regulations recently introduced in Europe, where only a few of our clients reside When we start taking on new clients based in Singapore in the second half of next year, we will also need to follow that country’s anti- money- laundering regulations The local anti- money- laundering legislation appears to be embedded in the Singapore regulations as well.”

imple-Wilson continues, “I would like each of you to explain how the implementation

of the Asset Manager Code within your department is being supervised Let us start with Shenal Mehta, our client service manager.”

Mehta states,

“With respect to the Asset Manager Code relating to client services, we have ensured that we enforce the following policies: All disclosures are accurate and complete, and our calculations are shown, no matter how complicated

We also ensure that the client sees some sort of communication from us when they request it and that the marketing material sent to clients is checked by the compliance department for accuracy and completeness.”

Anders Peterson, CFA, chief investment officer, states,

“In addition to what Mehta has said, I have the following comments:

Comment 1 On occasion, we are able to acquire securities we expect

will be particularly strong performers, such as subscribed initial public offerings In order to ensure that all clients are treated fairly, each client portfolio

over-is given the same number of shares.

Comment 2 Any communication with clients is kept confidential

and is only accessible by authorized personnel.

Comment 3 A gift and entertainment policy is in place to help ensure

our managers and analysts keep their independence and objectivity.”

Richard Gilchrist, head of portfolio administration, then adds, “Our portfolio

policies call for all assets to be valued at fair market prices using third- party pricing

services When a security price is not available from the service, a committee whose

members have experience in valuing illiquid assets uses the hierarchy dictated by

Global Investment Performance Standards (GIPS) to determine values.”

Wilson concludes the meeting by mentioning that Athena must do even more to

ensure its clients continue to have faith in Athena’s ability to protect and grow their

assets She recommends they disclose their risk management practices, which

iden-tify, measure, and manage the various risk aspects of the business to clients and the

regulator She adds, “In addition, we need to create a business continuity plan covering

data backup and recovery, alternate trading systems if the primary system fails, and

methods to communicate to employees, critical vendors, and suppliers in case of an

emergency that could disrupt normal business functions.”

1 Which of Zefferman’s opening statements is inconsistent with the Asset

Manager Code of Professional Conduct?

A Statement 1

B Statement 3

C Statement 2

C is correct Zefferman states that the firm is responsible for putting clients’ interests

above the firm’s when appropriate The General Principles of Conduct embedded in the

six components of the Asset Manager Code state that managers have the responsibility

of acting for the benefit of clients The code does not stipulate that this responsibility is

applicable only when appropriate

A is incorrect because the principles reflected in the statement are correct

B is incorrect because the principles reflected in the statement are correct

Asset Manager Code of Professional Conduct

LOS b

General Principles of Conduct

2 Which of the following anti- money- laundering laws must Athena currently

comply with to be consistent with the CFA Institute Standards of Professional

Conduct?

A Local

B Singaporean

C European

C is correct Zefferman, as a CFA charterholder, will be responsible for ensuring that Athena complies with the stricter anti- money- laundering laws of Europe, where some of its clients reside, as per Standard I(A)–Knowledge of the Law Europe’s new laws, which encompass and exceed the local anti- money- laundering regulations, are already in place; therefore, these are the regulations that must be currently followed

A is incorrect because Zefferman will be responsible for implementing the more strict laws of Europe that are currently in place

B is incorrect because Zefferman will be responsible for implementing the more strict laws of Europe that are currently in place

Guidance for Standards I–VIILOS b

Standard I(A)–Knowledge of the Law

3 Which of Mehta’s client service policies is consistent with the Asset Manager

Code of Professional Conduct?

A Types of disclosures

B Communication timing

C Marketing material reviews

C is correct Section D, Risk Management, Compliance, and Support, of the Asset Manager Code states that portfolio information provided to clients should be reviewed by an independent third party The compliance department would be considered an inde-pendent third party because compliance is not involved with compiling or presenting the information to clients According to Section F, Disclosures, disclosures should be truthful, accurate, complete, and understandable It is unlikely that clients would easily understand complicated calculations Section F, Disclosures, also calls for communications with clients to be on an ongoing and timely basis Communication with clients only when they ask for it would not be consistent with the Asset Manager Code It is recommended that communication be at least on a quarterly basis

A is incorrect because according to Section F, Disclosures, disclosures should be truthful, accurate, complete, and understandable It is unlikely that clients would easily understand complicated calculations

B is incorrect because Section F, Disclosures, calls for communications with clients to be

on an ongoing and timely basis Annual communication would not be considered timely

Asset Manager Code of Professional ConductLOS c

Section A, Loyalty to Clients; Section D, Risk Management, Compliance, and Support; Section F, Disclosures

4 Which of Peterson’s comments is inconsistent with the Asset Manager Code of

Professional Conduct?

A Comment 1

B Comment 3

C Comment 2

A is correct Section B(6)(b), Investment Process and Actions, requires clients to be treated

equitably, not equally Clients have different investment objectives and risk tolerances,

so treating clients equally would be inconsistent with the Asset Manager Code

B is incorrect because the policy is consistent with the Asset Manager Code

C is incorrect because the policy is consistent with the Asset Manager Code

Asset Manager Code of Professional Conduct

LOS c

Section A, Loyalty to Clients; Section B, Investment Process and Actions

5 Are Gilchrist’s comments regarding portfolio valuation consistent with the

Asset Manager Code of Professional Conduct?

A Yes.

B No, with regard to third- party pricing services.

C No, with regard to the process used to price illiquid securities.

A is correct Section E, Performance and Valuation, of the Asset Manager Code calls for

the use of fair market values sourced by third parties when available, and when such

third- party prices are not available, the code calls for the use of “good faith” methods

to determine fair value Athena’s policy appears consistent with this requirement In

terms of client reporting, monthly valuation reports would be consistent with the call

for timely reporting

B is incorrect because Gilchrist’s valuation methodology using fair value and third-

party valuers is consistent with the Asset Manager Code

C is incorrect because Gilchrist’s monthly valuation reports to clients would be

con-sidered consistent with the Asset Manager Code

Asset Manager Code of Professional Conduct

LOS c

Section E, Performance and Valuation; Section F, Disclosures

6 Are Wilson’s closing remarks consistent with recommended practices and

procedures designed to prevent violations of the Asset Manager Code of

Professional Conduct?

A No, with regard to the business continuity plan.

B No, with regard to disclosure of the firm’s risk management process.

C Yes.

A is correct At a minimum, Section D, Risk Management, Compliance, and Support, of

the Asset Manager Code recommends that a business continuity plan include plans for

contacting and communicating with clients during a period of extended disruption

Wilson’s continuity plan includes no such strategy Wilson’s recommendation for

disclos-ing the firm’s risk management process to both clients and regulators goes beyond the

code recommendation, which is to disclose the risk management process only to clients

B is incorrect because Wilson’s recommendation for disclosing the firm’s risk ment process goes beyond the Code recommendations to disclose the risk management process to just clients, not to regulators Wilson recommends they disclose to both.

manage-C is incorrect because Wilson’s recommendation regarding the business continuity plan did not include the recommended action of having a plan to contact and commu-nicate with clients during a period of extended disruption

Asset Manager Code of Professional ConductLOS d

Section D, Risk Management, Compliance, and Support; Appendix 6, Recommendations and Guidance

Emerald Private Bank Case Scenario

Laura Davidson is a financial advisory partner with Emerald Private Bank (Emerald) Emerald is based in Dublin, Ireland, and manages money on behalf of high- net- worth individual investors, foundations, and endowments Davidson works in Emerald’s private wealth group (PWG) This group is tasked with meeting clients, developing financial plans, and implementing recommendations from Emerald’s investment committee The PWG meets weekly to review new client relationships and to discuss the most appropriate approach for working with each client Emerald believes there are significant benefits to incorporating behavioral finance as part of their client assessment process and has recently made changes to this effect During preparation for the weekly PWG meeting, Davidson reviews the financial holdings of three new clients along with their risk assessment questionnaires Her observations are sum- marized in Exhibit 1.

Exhibit 1 Client Assessment Highlights

Client Assessment Notes

Kyra Conner Conner is a mid- level executive at a publicly traded technology

com-pany Approximately 80 percent of her defined- contribution plan is invested in her own company’s stock Conner focuses on short- term performance and is not comfortable with change Her assessment indicates she is not comfortable taking excessive risks

Michael Donnelly Donnelly recently sold a large publishing firm that he founded 20 years ago Although he has substantial assets, he spends at a rate

that does not appear to be sustainable He has a very high risk tolerance and enjoys chasing high- risk investments recommended

by friends He is strong willed and questions the benefits of portfolio diversification

Alan O’Driscoll O’Driscoll is a retired biotechnology executive His investment portfolio is comprised of a variety of mutual funds and stocks he has

acquired over the years based on recommendations from friends and colleagues He tends to be drawn to the latest, popular investment themes He is indicated as a moderate risk taker

During the meeting, fellow adviser Liam Roche makes the following observation based on the information in Exhibit 1: “Mr Donnelly should respond favorably to education focused on how the investment program affects financial security, retire- ment planning, and future generations However, Ms Connor and Mr O'Driscoll will respond better to education on portfolio metrics, such as the Sharpe Ratio.”

Amanda Kelly is an investment strategist and a member of Emerald’s investment

committee Kelly sits in on the PWG meeting to provide an update on the firm's

investment themes and positioning Emerald has developed a multifactor macro

model to forecast such variables as GDP growth and interest rate movements At the

meeting, Kelly provides detailed information about the macro model, including many

statistics on how the factors have performed using both in- sample and out- of- sample

backtesting The model appears to have had a good track record of predicting changes

in the macro environment over time.

As part of her investment update, Kelly notes that the macro model predicts that

interest rates in Europe are going to revert to their historical averages over the next

three years and that this move will start within the next six to nine months Davidson

asks Kelly if recent unprecedented monetary policy actions by the Bank of England

and European Central Bank have affected the reliability of the model Kelly responds

that because the macro model incorporates more than 100 different variables, central

bank policies are accurately accounted for.

Later that day, Kelly attends Emerald’s weekly investment committee meeting

Kelly brings up Davidson's concerns regarding how central bank activity may affect

the accuracy of their macro model Emerald's chief investment officer (C IO), who

chairs the meeting, dismisses Davidson's concerns as uninformed The rest of the

committee members agree The C IO t hen s uggests u pdating t heir s tock s election

model to incorporate a price momentum factor Kelly states that she is concerned that

momentum will not be effective across all sectors The CIO counters that because a

number of behavioral biases support the persistence of price momentum, they would

be foolish not to incorporate this factor After a brief discussion, the other committee

members agree with the CIO, and momentum is added to the stock selection model.

Following the meeting, Kelly is frustrated and writes an email to the CIO with

suggestions she believes will improve the dynamics of the investment committee in

the future Her recommendations include the following:

1 Spending more time analyzing prior committee decisions

2 Structuring the committee to ensure a higher level of common skills and

A improving Emerald’s client retention metrics.

B reducing portfolio risk.

C closer adherence to client expectations.

B is correct Incorporating behavioral finance does not have a direct impact on portfolio

risk In some cases, this approach will help encourage a reduction in portfolio risk, but

it may also help other clients to take on more risk as appropriate Investing as the client

expects and improvements to client retention metrics are both benefits of incorporating

behavioral finance

A is incorrect Improving the advisory practice is a likely benefit of incorporating

behavioral finance

C is incorrect Investing as the client expects is a likely benefit of incorporating behavioral finance.

Behavioral Finance and Investment ProcessesLOS b

be appropriate for this client

B is incorrect O’Driscoll is a cognitive investor, so focusing on metrics such as the Sharpe ratio would be appropriate for this client

C is incorrect Donnelly is an emotional investor, and this approach is appropriate

Behavioral Finance and Investment ProcessesLOS b

A is incorrect Independent individualists have a medium to high risk tolerance whereas Donnelly has a very high risk tolerance While some of the traits are similar, active accumulator more closely describes this client

B is incorrect Friendly followers have a low to medium risk tolerance whereas Donnelly has a very high risk tolerance

Behavioral Finance and Investment ProcessesLOS a

Section 2

10 In Kelly’s response to Davidson, she is most likely exhibiting:

A gambler’s fallacy.

B self- attribution bias.

C illusion of control bias.

C is correct The illusion of control bias can be encouraged by complex models The

illusion of control can lead to analysts being overly confident when forecasting complex

patterns, such as future interest rate movements

B is incorrect With self- attribution bias, analysts take personal credit for successes

and attribute failures to external factors outside of their control There is no evidence

that Kelly is suffering from this bias

A is incorrect The gambler’s fallacy is a misunderstanding of probabilities in which

analysts wrongly project reversal to a long- term mean This bias is caused by a faulty

understanding of random events and expecting patterns to repeat While Kelly is

expecting rates to increase to historical averages, she is basing this on output from the

macro- model

Behavioral Finance and Investment Processes

LOS e

Section 5

11 Which of the following biases least likely provides behavioral support for the

factor being added to the stock selection model?

A Framing

B Hindsight

C Availability

A is correct Framing bias is a type of cognitive error in which a person answers a question

differently based on the way in which it is asked This behavior is unlikely to explain the

persistence of momentum Regret is a type of hindsight bias that can result in investors

purchasing securities after a significant run- up in price because of a fear of not

partici-pating This bias could explain momentum With availability bias, also referred to as the

recency effect, the tendency to recall recent events more vividly can result in investors

extrapolating recent price gains into the future This bias could also explain momentum

B is incorrect Regret is a type of hindsight bias that can result in investors purchasing

securities after a significant run- up in price due to fear of not participating This could

explain momentum

C is incorrect With availability bias, also referred to as the recency effect, the tendency

to recall recent events more vividly can result in investors extrapolating recent price

gains into the future This could explain momentum

Behavioral Finance and Investment Processes

A is correct It is recommended that investment committees be composed of people with differing skills and experiences, not similar as Kelly has suggested Decision makers are most likely to learn to control harmful behavioral biases when they have repeated attempts at decision making and there is good quality feedback on prior outcomes The investment committee chair should actively encourage alternative opinions so that all perspectives are covered Asking for individual views prior to discussion can help mitigate the impact of group thinking.

B is incorrect Individuals may moderate their own views in a committee setting to fit with consensus The chair should actively encourage alternate opinions so that all per-spectives are covered Asking for individual views prior to discussion can help mitigate the impact of group thinking

C is incorrect It is recommended that investment committees are comprised of people with differing skills and backgrounds, not similar as Kelly has suggested

Behavioral Finance and Investment ProcessesLOS f

Section 8.6

Geri Buylak Case Scenario

Geri Buylak, a financial advisor, is preparing for a meeting with Kasey McLoughlin, the recent widow of,

Bryn McLoughlin, a resident of the country of Weshvia From her files of the McLoughlin family, Buylak notes the following which she thinks might be relevant

in the meeting:

■ Kasey was Bryn’s second wife.

■ Bryn has been the sole provider for his grandson Paulo for the past 20 years; Paulo was orphaned at the age of three and initially lived with Bryn and his first wife.

Mainly as a result of the stress arising from the disabilities and medical lems that Paulo developed, Bryn’s first marriage ended in divorce within one year Two years later, it was determined that Paulo would be better off living in

prob-a privprob-ate cprob-are fprob-acility in the sunny wprob-arm climprob-ate of Izlprob-andiprob-a where he continues

sim-■ Buylak was appointed as the investment advisor for the trust.

■ Bryn and Kasey were married two years after Bryn’s divorce.

Buylak had been faxed a copy of Bryn’s will and in combination with other mation she had available made the following notes:

infor-■ Two years ago, Bryn disposed of his very successful construction company and invested the proceeds in two overseas distribution centers The first property is located in the country of Landlochen and at the time of his death it was jointly owned with Kasey with the right of survivorship For the second of these prop- erties Bryn’s will named Paolo as the beneficiary of the property – the property

is located in Izlandia where he resides.

■ Kasey was named the beneficiary of Bryn’s taxable account and two tax

advan-taged retirement accounts.

■

■ Weshvia, Izlandia and Landlochen all use the euro, and none of the three tax

regimes impose any tax consequences on spousal transfers either before or after

death.

As they begin their meeting, Kasey first asks Buylak if any of the provisions of the

life insurance policy or dispositions of the investment properties might be challenged

in the probate process

Kasey mentions to Buylak that she is aware that a large part of her wealth now

depends on the investment property in Landlochen and asks Buylak what cash flow

would be available to her annually after taxes from its lease income and what after-

tax cash proceeds might she obtain if the property was sold when the current lease

expires Buylak had been prepared for these questions and her responses were based

on the following:

■

■ The investment real estate property in Landlochen had a cost basis of

€2,900,000, a present market value of €3,000,000, and it produces income of

€450,000 (pre- tax) annually through a lease agreement that expires in five years.

By this time, the property will have been owned for seven years.

■

■ After reviewing several reports analyzing Landlochen real estate values, Buylak

estimates that the property could be sold at the termination of the lease for 30%

above its present market value.

■

■ The tax structure in Landlochen differs from Kasey’s home country Weshvia as

shown in Exhibit 1 Fortunately, there is a provision for some relief from double

taxation Weshvia allows use of the deduction method with regard to income

taxes and the credit method toward capital gains.

Exhibit 1 Tax Rates on Investment Property relevant to Kasey McLoughlin

Country Type of Real Estate Property

• Wealth Tax 1.5% of cost basis,

accu-mulated annually and paid at the time of sale

None

• Income Tax 35% of annual income 25% of annual income

• Capital Gains 20% at time of sale 25% at time of sale

Applies to location Locally operating within

borders Owned by residents any-where in the world

Based on her calculations for the cash flows from the Landlochen investment

property, Buylak recommends that the three inherited investment accounts be held

for the next 12 years with all earnings and gains reinvested In anticipation of another

after- tax cash flow question, she estimates the accrual equivalent after- tax rate of

return on the portfolio of combined accounts over the next 12- year period using the

information in Exhibit 2.

Exhibit 2

A Kasey McLoughlin’s Inherited Investment Portfolio

Taxable Tax Deferred Tax Exempt

Expected rate of annual pre- tax return: 12.0% 7.5% 11.0%

B Tax Treatment of Investment Income in Weshvia

Taxable Accounts Total returns are taxed at 28% annuallyTax Deferred Accounts Distributions are taxed at 40%, with deferral allowed for a

maximum of 12 years at which time a full distribution is required

Bryn’s father died about a year after Bryn, creating additional life insurance ceeds paid to Paolo’s trust from the second policy In considering how investments

pro-in the trust portfolio should be changed, Buylak first reviews the trust’s Investment Policy Statement (IPS) and notes the following objectives and constraints:

Expected real after- tax total return 3.9 4.2 3.9

All portfolios meet the IPSs liquidity constraintRisk- free return: 4.0%

13 If Paolo had predeceased Bryn, the life insurance proceeds would most likely

have been paid to:

A Bryn.

B Kasey.

C the University of Izlandia.

C is correct The trust was irrevocable so neither Bryn (while alive) nor his wife would

have a claim on any of its assets including the life insurance policy or its proceeds Had

Paolo predeceased Bryn, the proceeds of the life insurance policy would have been paid

to the remainderman on Bryn’s death, i.e., to the University of Izlandia

A and B are incorrect The trust was irrevocable so neither Bryn (while alive) nor his

wife had a claim on its assets including the life insurance property

Estate Planning in a Global Context

A Izlandia distribution center.

B proceeds of the life insurance.

C Landlochen distribution center.

A is correct Probate is the legal process to confirm the validity of the will so that

exec-utors, heirs, and other interested parties can rely on its authenticity Only the Izlandia

distribution center changes ownership through a provision of the will Joint ownership

with right of survivorship automatically transfers to the surviving joint owner (Kasey)

Death benefit proceeds under a life insurance contract pass directly to policy beneficiaries

outside the probate process

B is incorrect Probate only deals with property that remains in the estate: Death

benefit proceeds under a life insurance contract pass directly to policy beneficiaries

outside the probate process

C is incorrect Probate only deals with property that remains in the estate: Joint

own-ership with right of survivorship includes a provision to transfer the deceased share [of

the Landlochen distribution center] to the surviving joint owner (Kasey)

Estate Planning in a Global Context

LOS a, h

Sections 2.1 and 5.3

15 Using Exhibit 1, the annual amount of after- tax cash flow that Kasey will earn

on the Landlochen property lease is closest to:

A €175,875.

B €219,375.

C €292,500.

B is correct In each year, the tax rate under the deduction method will be:

TResidence + TSource(1 – TResidence)

which here is (0.25) + 0.35(1 – 0.25) = 0.5125

This is the combined tax rate net of tax relief via the deduction method

Kasey’s after- tax annual cash flow is €450,000 × (1 – 0.5125) = €219,375

A is incorrect The mistake is in including the annual wealth tax in annual cash flow; it is

not payable until the end of the five- year period: 219,375 – (0.015 × 2,900,000) = 175,875

C is incorrect The mistake is applying the credit method, which uses the higher tax

rate alone: 450,000 × (1 – 0.35) = 292,500

Estate Planning in a Global ContextLOS i, k

Section 6.3.1

16 If Buylak’s expectations about the Landlochen investment property are

real-ized, using Exhibit 1, the after- tax net cash proceeds that Kasey will receive on

disposal of the property at the expiration of the lease is closest to:

Calculation of total taxes

Plus: Capital Gains Tax from Landlochen (3,900,000 – 2,900,000) – 0.20 200,000Plus: Capital Gains Tax from Weshvia of 0.25

The two- step calculation of capital gains tax under the credit method is equivalent to:

TCredit Method = Max(TSource, TResidence) = Max(20%, 25%) = 25%, Giving a capital gains tax of (3,900,000 – 2,900,000) – 0.25 = €250,000

C is incorrect It calculates the capital gain on the difference between current market value (3,000,000) instead of the original cost (2.9 million) and the 3,900,000

A is incorrect It omits the gains tax credit from the residence country Applies the

full 0.25 capital gains rate from Weshvia thereby skipping the credit for Landlochen

17 Using Exhibit 2, the accrual equivalent after tax annual return that Buylak

cal-culates for Kasey’s investment portfolio is closest to:

A 7.35%.

B 7.45%.

C 7.58%.

A is correct Calculate ending value after taxes at the end of 12 years

Accrual Equivalent Annual Return % = 100% × [(Ending Value/Beginning

Accrual Equivalent After- Tax Annual Return = (4,873,900/2,080,000)1/12 – 1 = 0.0735 = 7.35%

B is incorrect It takes a weighted average of the after- tax return rates where the weights come from the values in each account type This method is an invalid short- cut {(1,200/2,080) × [12 × (1 – 0.28)]} + [(700/2,080) × 7.50 × (1 – 0.40)] +

Tax

Accrual Equivalent Annual Return = (4,996,192/2,080,000)1/12 – 1= 0.0758 = 7.58%

Taxes and Private Wealth Management in a Global Context

LOS d

Sections 3.3 and 4.0

18 Of the portfolios presented in Exhibit 3, the choice that is most consistent with

the trust’s IPS is:

con-in Exhibit 3 Both portfolio X and Z have the same expected real after- tax total returns and portfolio Z has the highest Sharpe ratio but Z does not meet the worse- case return constraint Portfolio Y has the highest real after- tax return but the lowest Sharpe ratio and does not meet the worse- case return constraint

Annual Portfolio Statistics from three potential portfolio allocations

Expected real after- tax total return 3.9 4.2 3.9

X (%) Y (%) Z (%)

Worst- case return = Downside risk = Expected nominal total return – 2 standard deviations

For example, for portfolio X: 10.6 – (2 × 9.67) = –8.74

All portfolios meet the IPSs liquidity constraint

B is incorrect Portfolio Y has the highest nominal and real after- tax returns, but has

both a lower Sharpe ratio and does not meet the worst- case return constraint

C is incorrect Portfolio X and Z have the same real after- tax returns and the same

Sharpe ratio, but portfolio Z violates the worst- case return constraint making X the best

choice

Managing Individual Investor Portfolios

LOS k

Section 5

Emily Ronan Case Scenario

Emily Ronan provides economic analysis of developing countries in her role at CZT

Partners For the country of Antegria, she models gross domestic product (GDP) by

regressing the percentage change in GDP (%ΔGDP) against the percentage changes

in capital stock (%ΔK) and labor (%ΔL) during the previous 10 years using quarterly

data Ronan assumes a Cobb–Douglas production function with constant returns to

scale (see Exhibit 1).

Exhibit 1 Regression for %ΔGDP

Based on the regression output, Ronan compares the effects of a 4% increase in

capital stock, a 10% increase in labor, and the Solow residual on GDP growth.

Ronan runs a similar regression for Bangalla, another country in the region, which

projects %ΔGDP to be 7.2% during the next 12 months Turning to Bangalla’s equity

market, the EQXX, a composite index that represents the country’s equity market, she

projects its short- term dividend growth rate to be the same as the expected %ΔGDP.

Ronan notes that the 7.2% expected short- term dividend growth rate for the EQXX

substantially exceeds both its historical average dividend growth rate and its long-

term sustainable dividend growth rate, as shown in Exhibit 2 Using her short- term

dividend growth rate assumption, Ronan applies an H- model (assuming a 30- year

time horizon) to determine the appropriate intrinsic value for the EQXX.

(Continued)

Exhibit 2 EQXX Equity Index Data

30- year future sustainable EQXX dividend growth

Historical average dividend growth rate 6.22%

Note: All rates shown are inflation adjusted.

* This information is provided from a consensus of multiple analysts’ forecasts

Given that the region tends to suffer frequent periods of currency instability and that most of the firms are state controlled, Ronan discusses with her co- workers Curtis Chadwick and Earl Johns the relative merits of using the H- model and another suggested model, the Gordon model They make the following comments:

Chadwick: A Gordon growth model analysis would produce a nominal rate, which

would be more stable than a real rate

Johns: The currency instability should not affect the results from using either

the H- model or the Gordon growth model

Ronan: I am still concerned about the state- controlled firms having an

incen-tive to overstate productivity, which could affect both models

Chadwick then shares with his co- workers an analysis he is performing on the equity market for a more developed country, Brungaria Ronan suggests using the Fed model

to determine whether Brungaria’s equity market is correctly valued Chadwick ers the Fed model after collecting the economic and market data shown in Exhibit 3.

consid-Exhibit 3 Brungaria Economic and Market Data

Long- term government treasury yield 4.67%

Short- term government treasury yield 2.93%

Justified forward earnings yield 4.35%

Chadwick is concerned that Brungaria might not be developed enough for the

Fed model to apply, so he uses a market- level version of an “equity q” to evaluate the Brungarian equity market He calculates the equity q to be 0.775 using asset book val-

ues and current market data He then discusses his calculation with Ronan and Johns:Ronan: The equity q tends to react quickly to changes in the market and can

be very volatile

Johns: Chadwick’s calculation may be overstated because the replacement

costs for the assets may be higher than their book values

Chadwick: Although the measure may be overstated, the equity q is lower than

1.0 in either case, implying that the market is overvalued

19 The constant returns to scale assumption for the Cobb–Douglas production

function is most likely violated in the regression results in Exhibit 1 because the:

A intercept and coefficients for %ΔK and %ΔL sum to greater than one.

B coefficients for %ΔK and %ΔL sum to greater than one.

C intercept is less than one.

B is correct For the constant returns to scale assumption to be valid, the coefficients

for %ΔK and %ΔL must sum to one That is, a given percentage increase in capital stock

and labor input must result in an equal percentage increase in output Because the

coefficients for %ΔK and %ΔL sum to greater than one, the constant returns to scale

L L

≈ + α + − ( 1 α )

where Y is GDP, A is total factor productivity (TFP), K is capital, and L is labor.

Consequently, regressing the percentage change in GDP (%ΔGDP = ΔY/Y) against the

percentage changes in capital stock (%ΔK = ΔK/K) and labor (%ΔL = ΔL/L) means TFP is

the intercept for the regression, β1 = α, and β2 = (1 – α):

%ΔGDP = intercept + β1 × %ΔK + β2 × %ΔL

A is incorrect The sum of the intercept and the coefficients for %ΔK and %ΔL can sum

to more than one and be consistent with the assumption of constant returns to scale as

long as the coefficients for %ΔK and %ΔL sum to one.

C is incorrect The intercept being less than one does not violate the constant returns

to scale assumption

Equity Market Valuation

LOS a, b

Section 2.1

20 Based on Ronan’s assumptions about the growth in capital stock and labor input

as well as the regression output in Exhibit 1, which Cobb–Douglas production

function input most likely has the greatest effect on %ΔGDP?

A Total factor productivity

B Labor

C Capital stock

A is correct Based on the regression in Exhibit 1 and the assumed percentage changes

in capital stock (4%) and labor (10%) inputs, the Cobb–Douglas production results in an

expected growth in GDP of 14.9% as follows:

Growth in Total Factor Productivity

Growth in Capital Stock × Output Elasticity of Capital

Growth in Labor Input

× Output Elasticity of Labor

%∆GDP 0.082 4% × 0.725 = 0.029 10% × 0.382 = 0.0382

The greatest effect on %∆GDP arises from TFP

The Cobb–Douglas function can be expressed as

L L

≈ + α + − ( 1 α )

where Y is GDP, A is total factor productivity (TFP), K is capital, and L is labor.

Consequently, regressing the percentage change in GDP (%ΔGDP = ΔY/Y) against the percentage changes in capital stock (%ΔK = ΔK/K) and labor (%ΔL = ΔL/L) means TFP is

the intercept for the regression, β1 = α, and β2 = (1 – α):

%ΔGDP = intercept + β1 × %ΔK + β2 × %ΔL

C is incorrect The %∆GDP resulting from the %∆K (capital stock) is the regression

coefficient multiplied by 4%: 0.029 = 0.725 × 0.04 and is lower than 0.08 It may be selected because it has the highest regression coefficient

B is incorrect The %∆GDP resulting from the %∆L (labor) is the regression coefficient

multiplied by 10%: 0.0382 = 0.382 × 0.10 and is lower than 0.08 It may be selected because

it has the highest percentage change (10%)

Equity Market ValuationLOS b

Section 2.1

21 Compared with Ronan’s H- model estimation of the EQXX index, using her

assumptions and the data in Exhibit 2, the current index level is most likely:

V0 = estimated value of the indexFrom Exhibit 2:

D0 = current dividend = 40.32

r = inflation- adjusted discount rate = 12.16%

gL = future sustainable dividend growth rate = 3.95%

Her assumptions:

gS = initial dividend growth rate = 7.20%

N = length of time for sustainable dividend growth rate to emerge = 30

B is incorrect It uses (1 + g S ) in the bracketed term instead of (1 + g L) This will produce

an index level that is equal to the current index level, which incorrectly implies that the current index level is appropriate

C is incorrect It uses g S in the denominator of the first term instead of g L This will

produce an index level above the current index level, which incorrectly implies that the

current index level is too low

22 In their discussion of the relative merits of the H- model and Gordon model,

who provides the most accurate comment?

A Ronan

B Johns

C Chadwick

A is correct Ronan’s concern about an incentive to overstate productivity at the firm

level is a legitimate problem when estimating the H- model and the Gordon model The

models depend on firm- level data that is collected and aggregated to determine the

index’s sustainable growth rate

C is incorrect Chadwick is incorrect because real rates tend to be more stable than

nominal rates

B is incorrect Johns is incorrect because frequent periods of currency instability

would invalidate the data used in the models

Equity Market Valuation

C is correct The Fed model hypothesizes that, in equilibrium, the yield on long- term

treasury securities should equal the forward earnings yield In this case, the Fed model

considers the equity market to be undervalued because the forward earnings yield

(5.25%) exceeds the long- term government treasury yield (4.67%)

A is incorrect It uses short- term plus inflation, equaling forward earnings yield, so

based on the Fed model, the Brungaria equity market is fairly valued

B is incorrect It uses the justified forward earnings yield instead of forward earnings

yield, so based on the Fed model, the Brungaria equity market is under- valued

Equity Market Valuation

LOS g

Section 4.1

24 Who made the most accurate statement concerning the equity q for Brungaria’s

equity market?

A Johns

B Chadwick

C Ronan

A is correct Johns’ statement is the most accurate Given his assertion that the

replace-ment value of assets may be higher than their book values, the equity q calculated by

Chadwick may be overestimated because he used the book value of assets instead of the replacement value of assets in the calculation’s denominator

B is incorrect Chadwick is incorrect An equity q below one indicates that the market

is under- valued

C is incorrect Ronan is incorrect The equity q can persist at high and low levels for

extended periods of time

Equity Market ValuationLOS f

Section 4.2

HNW Worldwide Case Scenario

HNW Worldwide Inc (HNW) is a wealth management company located in Chicago that specializes in very- high- and ultra- high- net worth clients Pierre Fournier, a currency specialist at the company, is reviewing the file of a long- time client, Alex Testa, an American Testa is a former engineer in the plastics industry who has been very successful in identifying potential takeover candidates during the consolidation

of the plastics and packaging industry that has been occurring since about 2001

As US opportunities declined in the plastics industry, Testa began to consider eign investments In the fall of 2008, he acquired a position in a South African plastics processor Although the foreign currency return on the investment was impressive, his domestic return was substantially negative because of the foreign currency change against the US dollar.

for-Testa’s association with HNW began in 2009 as he was about to undertake a position in a Spanish packaging company Fournier used Testa’s description of his investment process to develop an investment policy statement (IPS) for him, which included the following objectives and constraints:

■ The anticipated positions would not have any associated income or liquidity

requirements.

■

■ The cost of any hedging strategies used should be minimized and not materially

affect the otherwise unhedged asset return.

In regard to the anticipated currency movements related to the Spanish packaging

company investment, Fournier told Testa that HNW was forecasting that the euro

was likely to appreciate against the US dollar in the next six months

Testa agreed with HNW’s assessment of the future course of the USD/EUR

exchange rate His conclusion was derived from assessing various analysts’ reports

and was centered on the following three reasons:

1 real interest rates were higher in euro- based countries,

2 the potential default of several euro- based countries from their excessive debt

loads would lead to strong support measures from the IMF and the European

Central Bank, and

3 the US balance of trade deficit with euro- based countries had continued to

decline in the past several years and was expected to continue to decline

The Spanish investment involved Testa acquiring 200,000 shares of a packaging

company at EUR90 per share He decided to fully hedge the position with a six-

month USD/EUR forward contract Details of the euro hedge at initiation and three

months later are provided in Exhibit 1 Three months after the purchase, the shares

had increased to EUR100 each, but Testa, believing that a still higher price was likely,

maintained the position He also indicated that he did not anticipate having to roll the

hedge forward at its maturity Both he and Fournier believed that further appreciation

of the euro was quite likely, and the increase in the notional size of the position was

hedged using currency options They based their choices on the information provided

in Exhibit 2

Exhibit 1 2009 Spot and Forward USD/EUR Quotes (Bid- Offer) and

Annualized Libor Rates

Maturity At Initiation Three Months Later At Maturity

In 2014, Testa notified Fournier that he anticipated taking a position in a plastics

producer located in India Fournier warned him that the Indian rupee (INR) was a

restricted currency and that currency management would not be as simple as in the

other transactions handled previously Fournier said that non- deliverable forwards

(NDFs) on the rupee were available, as they were for the currencies of other developing

countries When asked how non- deliverable forwards differed from the contracts they

had used in the past, Fournier responded:

■

■ NDFs are cash settled in the non- controlled currency of the currency pair,

25 In terms of the objectives and constraints that were incorporated into Testa’s

IPS, the one that best explains the initial euro exposure of the Spanish

invest-ment in 2009 is the one related to his:

A is incorrect Testa is not overly risk averse; his main focus is on the return generated from his investment process

C is incorrect Testa’s investment program did not impose any liquidity or income needs on the position

Currency Management: An IntroductionLOS c

Section 4.5

26 Which of Testa’s reasons for the future course of the USD/EUR exchange rate in

2009 is most consistent with HNW’s assessment?