CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set questions, study session 7, reading 14

Rose knows that capital market expectations are an essential input to formulating a strategic asset allocation since it helps determine the risk and return prospects of various asset cla

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CFA Level III Item-set - Question

Study Session 7 June 2018

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FinQuiz Item-set ID: 12513

Questions 1(12514) through 6(12519) relate to Reading 14

Christine Rose Case Scenario

Christine Rose is a portfolio manager currently in the process of determining an appropriate asset allocation for her $15 million portfolio Rose knows that capital market expectations are an essential input to formulating a strategic asset allocation since it helps determine the risk and return prospects of various asset classes To help her with forming these expectations, Rose hired Laura Quicksilver, an economist with a vast experience of working with portfolio managers Rose is going to use the past five years as a historical benchmark to form her expectations During that period, the central bank planned to reduce interest rates to increase economic growth This policy would have increased inflation to double digit figures, but growth increased without the need to implement the policy When Rose inquired about her views, Quicksilver made the following comment:

Statement 1: “Looking back at the historical prices and returns of bonds we can expect bonds

to earn high returns in excess of the short-term interest rates In addition, using values of private equity indices, I found out that not only do they yield high returns with low risk, but they also have a very low correlation with traditional asset classes Hence, private equity could be a good return enhancement and diversification tool.”

Rose visited Hal Douglas, a portfolio manager and her colleague at the firm, to get his

perspective about the performance of different asset classes Douglas made the following

comment:

Statement 2: “According to my research, there is a high correlation between foreign investment

in the country and stock returns; an increase in foreign direct investment results in

an increase in stock market returns Since I expect FDI in the country to rise, I will increase the weight of stocks in my portfolio.”

Rose disagreed and made the following comment:

Statement 3: “Using an average of the beta of growth stocks over the past seven years, the

expected return for this asset class equals 9.5% However, the actual realized return over the same period was 7.8% Hence, this asset class inadequately rewards risk and its weight should be reduced.”

Rose and Douglas are working together as investment advisers to Justin Collins, a high-net-worth private client of their firm During a telephonic conversation with Rose, Collins expressed his interest in investing in technology stocks due a recent rise in stock prices of large

multinational technology firms in the country Rose told Collins to reconsider his growth

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estimates for such stocks since most analysts following these firms have pessimistic views about their stock prices and expect their growth to fall to single digit figures by the next year

Douglas is trying to determine the asset prices for a few manufacturing firms in which he plans

to invest for the next seven months or so He wants to choose an appropriate tool for setting capital market expectations to short list amongst the firms Rose advised him to use the

discounted cash flow model to set return expectations for the stocks under analysis She also stated that such models give accurate estimates since they use the growth in real GDP as a proxy for stock market growth

Douglas is also trying to assess the sources of historical returns for information technology firms

in the U.S Exhibit 1 shows some of the information Douglas gathered based on his research of past information

Exhibit 1

When Douglas discussed his analysis of historical returns with Rose, she mentioned her current assignment of forming long-term return expectations for Australian stocks Rose has gathered the following statistics:

2.1%

Rose will use her forecasts to make comparisons between Australian stock returns and other developed market equity returns

FinQuiz Question ID: 12514

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most likely correct?

fallen into the status quo trap?

likely incorrect?

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