Level III 2018 IFT mock exams sample

Prior to meeting with him, the advisor asks Braidwood a series of diagnostic questions to determine whether he may have any of the following investment behavioral biases: Freans Capital

2018 CFA® Exam Prep

IFT Mock Exams

Level III

Document Version: 1.5

Publish Date: May 13, 2018

Errata information can be found at: https://goo.gl/UVXdAv

This document should be used in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered

Financial Analyst® are trademarks owned by CFA Institute

Table of Contents

Exam 1 Morning Session 3

Exam 1 Afternoon Session 60

Exam 2 Morning Session 88

Exam 2 Afternoon Session 140

Exam 3 Morning Session 165

Exam 3 Afternoon Session 205

Exam 1 Morning Session Solutions 228

Exam 1 Afternoon Session Solutions 262

Exam 2 Morning Session Solutions 276

Exam 2 Afternoon Session Solutions 302

Exam 3 Morning Session Solutions 314

Exam 3 Afternoon Session Solutions 336

Exam 1 Morning Session

11 Portfolio Management – Trading, Monitoring, and

Total: 180

Start time: 9:00 AM

End time: 12:00 PM

QUESTION 1 HAS THREE PARTS (A, B, & C) FOR A TOTAL OF 10 MINUTES

An advisor for Freans Capital Management is working with a new client, Tom Braidwood Prior to meeting with him, the advisor asks Braidwood a series of diagnostic questions to determine whether he may have any of the following investment behavioral biases:

Freans Capital Management

Sample Diagnostic Questions

1 If you are offered two free lottery tickets, would you select your own numbers or have a machine do it?

2 At what price are you willing to sell off your investment holdings that you received as inheritance?

3 How do you generally attribute the success of your decisions?

A Identify the behavioral bias that each diagnostic question in Exhibit 1 is most likely to reveal

Note: Each diagnostic question is designed to reveal a different bias

ANSWER QUESTION 1-A IN THE TEMPLATE PROVIDED

(3 Minutes)

Tom Braidwood informs his advisor that he has always been willing to take a small chance of losing up to 7 percent of the portfolio annually He says that he can accept any asset classes

to meet his financial goals if the following constraint is considered

“Expected return – 1.645 × Expected standard deviation ≥ –7%.”

After listening to him, the advisor concludes that he is actually striving for a mean- variance efficient portfolio

Braidwood tells the advisor that his previous Wealth Advisor, Andy, made following

statements to him

Statement 1: It is always recommended to know the historical performance of the CEO of

the company before investing in a company Based on this belief, you should own shares of Frio Industries as Frio’s CEO used to run APCO’s operations and he did a wonderful job there

Statement 2: Global Equity Funds have increased 1.5 – 2.0 times the historical average over

the past two years Based on this information, I expect global equity funds to face a reversal

in near future As a result, it is preferred to reallocate funds from equities to fixed-rate portfolio assets

B Comment on the conclusion made by the Advisor regarding Braidwood’s portfolio preference

(2 Minutes)

C Select the behavioral finance concept (availability, confirmation, framing, gambler’s

fallacy, representativeness, overconfidence, hot hand fallacy) best exhibited in each of

Andy’s two statements Justify your response with one reason

ANSWER QUESTION 1-C IN THE TEMPLATE PROVIDED

(5 Minutes)

Answer Question 1 on This Page

1-A Identify the behavioral bias that each diagnostic question in Exhibit 1 is most likely to reveal

Note: Each diagnostic question is designed to reveal a different bias

Diagnostic Question Identify the behavioral bias that each

diagnostic question in Exhibit 1 is most

likely to reveal

(circle one)

1 If you are offered two free lottery

tickets You may either select your own

numbers or have a machine do it What

would you do?

2 How would you describe your

emotional attachment to possessions or

3 How do you generally attribute the

success of your decisions? • Loss aversion

1-C Select the behavioral finance concept (availability, confirmation, framing, gambler’s

fallacy, representativeness, overconfidence, hot hand fallacy) best exhibited in each of Andy’s

two statements Justify your response with one reason

Andy’s statement Select the behavioral

finance concept best exhibited in each of

Advisor’s two statements

Note: No behavioral finance concept can be used more than once

(circle one)

Justification

1 It is always recommended

to know the historical

track record of the CEO of

the company before

investing in a company

Based on this belief, you

should own shares of Frio

Industries as Frio’s CEO

was previously in charge

• Hot hand fallacy

2 Global Equity Funds have

increased 1.5 – 2.0 times

the historical average

over the past two years

Based on this

information, I expect

global equity funds to face

a reversal in near future

QUESTION 2 HAS FOUR PARTS (A, B, C, & D) FOR A TOTAL OF 25 MINUTES

Robert and Mary Puentes are meeting with John Mesa, CFA, their long-time advisor, to

discuss financial planning issues Robert and Mary Puentes, both age 50, live in U.S Robert is retired He ran an advertising company which he recently sold off The Puentes will rely on their investment portfolio to meet future expenses in excess of Robert’s retirement income Mary is not employed Puentes will receive retirement payments of USD 110,000 per year for his lifetime from the business he sold The retirement payments are not indexed for future inflation and are fully taxable as ordinary income

The Puentes’ total living expenses last year were USD 200,000, and they are expected to grow each year at the inflation rate The tax rate on ordinary income and all investment returns is 30% The inflation rate is expected to be 3% per year

The Puentes live in a house with a market value of USD 1,250,000, mortgage-free They have

a taxable investment portfolio with a current market value of USD 5,500,000 The Puentes’ plan to purchase a second home worth approximately USD 1,150,000 to be used for holidays,

in around five years’ time

Their goals are to grow the asset base of the portfolio over time to maintain its after-tax purchasing power and to establish and maintain a cash reserve of USD 200,000 Upon his death, Robert wishes to provide for his wife, but intends to donate the majority of his assets

to charity

John has gathered following information about the Puentes to determine their personality types i.e cautious, methodical, spontaneous, or individualist

A summary of this information is presented below

• Robert often reads the CEO’s statement about the company in annual reports while analyzing stocks rather than doing a detailed analysis

• Robert prefers riskier stocks, and sometimes trades excessively so as not to miss an investment trend

• Mary is less concerned with market sentiment or analysts’ recommendations of stocks

• Mary’s investment decisions are made based on detailed analysis and investment research

• Mary follows a very disciplined approach to stock selection and she is always on the quest for new information

The Puentes live in a community property regime The community property regime entitles

a surviving spouse to receive one-half of the community property after the first spouse’s death Only 15% of Robert’s assets are community property Exhibit 1 summarizes gift and inheritance tax rates applicable to the Puentes Family

Exhibit 1

Gift and Inheritance Tax Rates

Spousal inheritance tax 25%

Non-spousal inheritance tax 50%

Non-spousal gift tax 30%

Note: All taxes are due immediately at the time of the transfer and are paid for by the

recipient

Robert feels that Mary’s legal entitlement under the community property rules will not be sufficient to meet her financial needs John estimates that if Robert were to die today, Mary would need to inherit USD 750,000 net of any taxes to meet her needs

A Determine the Puentes’ nominal after-tax required rate of return for the coming year Show your calculations

D Calculate the minimum bequest (in USD) from Robert’s estate to Mary in order to meet her spending needs and taxes Show your calculations

(5 minutes)

Answer Question 2 on This Page

2-A Determine the Puentes’ nominal after-tax required rate of return for the coming year Show your calculations

2-B Characterize the Puentes’ as below-average, average, or above-average in their ability

to take risk Justify your response with two reasons based on the Puentes’ specific

Justify your response with two reasons

based on the Puentes’ specific circumstances

Select the investor

personality type for i Robert and ii Mary

(circle one for each)

Justify each selection with

one fact from the

information about the Puentes’

presented in vignette

i Robert

Cautious Methodical Spontaneous Individualist

ii Mary

Cautious Methodical Spontaneous Individualist

2-D Calculate the minimum bequest (in USD) from Robert’s estate to Mary in order to meet her spending needs and taxes Show your calculations

QUESTION 3 HAS FOUR PARTS (A, B, C, & D) FOR A TOTAL OF 15 MINUTES

Gus Weaver is the owner of a privately traded manufacturing concern which is currently worth $25 million and was established twenty-five years ago Weaver is 65 years of age and has approached his financial advisor, Kyle Lucas, to discuss his goals and investment

portfolio Weaver’s is concerned about minimizing the downside risk and wants to maintain

a minimum net worth of $5 million at all times Exhibit 1 shows Weaver other assets details

Exhibit 1

“Personal” Risk Bucket “Market” Risk Bucket

“Aspirational” Risk Bucket

Lucas thinks that current asset allocation seems very aggressive for someone his age Lucas suggests Weaver to consider diversifying his current portfolio by selling a portion of his family business Weaver agrees to Lucas’ suggestion but requests him to consider following near term objectives while deciding for monetization strategies

• Maximize the amount of cash up front at the time of sale;

• Remain actively involved in the company for near future;

• Retain some upside exposure to the value of the business;

Weaver presents the following three potential monetization strategies:

i Full sale to the senior management team in a management buyout;

ii Full sale to the Family or Next Generation;

iii Partial sale through an initial public offering;

A Using a goal-based planning framework (i.e., personal, market, and aspirational risk buckets), identify the significant risk(s) that Weaver is currently facing

Weaver’s brother, Mattios, is also Kyle Lucas’ client Mattios recently retired from

DigitalTime, Inc., a technology company where he experienced a long and successful tenure

as a senior executive During his 30-year career with DigitalTime Mattios received a

considerable portion of his compensation in the form of employee stock options Lucas recommended Mattios to hedge the risk of his employee stock options using an option-based cash less collar The underlying stock increases by $5 million above the strike price of the call options while the hedge is in place

During his career, Mattios accumulated one million shares of a company named Lakson Inc These shares are currently valued at USD 30 million and represent the majority of his

wealth These shares do not pay a dividend Lucas notes that Mattios’ Lakson shares have a very low cost basis The jurisdiction in which Mattios resides levies capital gains taxes only

on the sale or disposal of a security Therefore, any outright sales of shares would result in significant long-term capital gains which would be taxed at 30%

Lucas suggests to Mattios to consider tax-free stock swap to diversify his concentrated position in Lakson’s stocks Tax–free swap would involve $35 million in Maple shares in exchange for all of Lakson’s shares, with no cash consideration The tax cost basis that

Mattios has in Lakson shares, essentially zero, would become his tax cost basis in Maple shares transferred to the Maple shares If Mattios accepts a tax-free stock swap, he is able to sell the Maple shares short against the box He would realize 95% of the value of the Maple shares with no limitations on the use of proceeds The after-tax cost to access the proceeds would be locked in at 15 bps per year Mattios would be able to keep the position in place indefinitely

Mattios asks Lucas about cashless collar strategy as it sounds easier to implement Lucas determines that the pairs of options shown in Exhibit 2 are available, all with the same

expiration dates Lakson’s share price is currently USD 30.00

Exhibit 2

Strike Prices of Available Lakson Options (in USD)

E Identify which option pair is most likely to create a cashless collar position for Mattios

Justify your response

Note: No calculations are required

(3 minutes)

Answer Question 3 on This Page

3-A Using a goal-based planning framework (i.e., personal, market, and aspirational risk buckets), identify the significant risk(s) that Weaver is currently facing

3-B Select the monetization strategy that will most likely achieve all of Weaver’s objectives Identify, for each strategy not selected, one objective it fails to achieve

Select the monetization strategy that

will most likely achieve all of Weaver’s

objectives

(circle one)

Identify, for each strategy not selected, one objective it fails to achieve

i Full sale to the senior management

team in a management buyout;

ii Full sale to the Family or Next

Generation;

iii Partial sale through an initial public

offering;

3-C Describe the mismatch in character that potentially affects Mattios with regard to use

of option-based collar for hedging his employee stock options

3-D Determine the value of the tax-free stock swap offer with a short sale against the box and with immediate sale of the Maple shares Show your calculations

3-E Identify which option pair is most likely to create a cashless collar position for Mattios Justify your response

Note: No calculations are required

QUESTION 4 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES

Link Bank is a commercial bank operating in the U.S The Bank’s Board of Directors (the

“Board”) is responsible for formulating and implementing investment policies The Board delegates authority for making specific investments to the Bank’s officers (“Management”) that are consistent with this IPS The Board has appointed an Investment Committee (the

“Committee”) who is responsible for monitoring and reviewing all investment decisions for compliance with the IPS and with federal and state regulations The Committee also

recommends changes to IPS to the Board when appropriate

The Committee, in its last meeting, discussed the following different scenarios with respect

to its loan portfolio and requested the Management to apprise the Committee in next

meeting the effect of each of the suggested changes on the bank’s investment objectives, constraints, or risk-taking ability

I The Bank has decided to restrict lending to customers with a credit rating of A or higher although the Bank’s overall risk tolerance is unchanged

II The Bank decides to increase the holdings of long-term mortgage-backed securities III The target average maturity of loans is decreased, with overall risk tolerance

unchanged

IV Fewer opportunities exist for expanding net interest margins with low risk in Link Bank’s loan portfolio than in its securities portfolio

The Chairman of the Bank’s ALCO Committee, Mr Samuel Miller, is analyzing the

implications of the recent unexpected fall in interest rates on the bank’s market value of equity

The current structure of the bank’s balance sheet is as follows:

• Market value of Assets: $ 150 MN

• Market Value of Liabilities: $ 170 MN

• Duration of Assets: 7.5

• Duration of Liabilities: 4.5

Mr Miller states to other member that besides earning a positive return on invested capital,

we should maximize the duration of Bank’s Equity

A Explain the impact of each of the scenarios on the bank’s objectives and constraints, or

risk-taking ability Your response should consider each policy in isolation

ANSWER QUESTION 4-A IN THE TEMPLATE PROVIDED

(4 minutes)