Mock exam a afternoon session (with solutions)

B is incorrect because Standard IIIC–Suitability does not appear to have been violated because the fund is characterized as a high- risk investment and it is clearly stated that EnergyAl

T he afternoon session of the 2018 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.

to any website, emailing, distributing and/or reprinting the mock exam for any purpose

© 2017 CFA Institute All rights reserved

2018 LEVEL III MOCK EXAM PM

CleanTech Research Fund Case Scenario

Kim Tang, CFA, is a consultant reviewing a hedge fund, CleanTech Research Fund CleanTech invests in high- risk and volatile “clean technology” companies CleanTech has adopted the CFA Institute Code of Ethics and Standards of Professional Conduct Tang examines the various forms of advertising used by CleanTech to attract new clients In one of its advertising messages, CleanTech states, “We have a very experienced research team and are proud they are all CFA’s Several of our managers serve as volunteers for CFA Institute CFA Institute recognizes their expertise, and

as a result, you can rely on our team for superior performance results.”

In reviewing CleanTech’s marketing brochure, Tang reads the following statements: Statement 1 The share prices of companies in the clean technology sector

have increased recently because of the growing awareness of mate change issues and the rising cost of energy There are many risks in this sector, some of which include new technology that is unproven Also, the addition or removal of government incen- tives can make markets dysfunctional Nevertheless, it is our opinion that returns in this area will continue to be above average for several years In fact, our proprietary investment analytics software has determined that investments in green transportation companies are likely to double in value in the next six months based on a multiple factor regression analysis Key risks associ- ated with analytics software include the fact that they rely on his- torical data and that a set of unknown factors could interfere with the anticipated results We will earn a 200% return over the next year on one of our solar power company investments based on sales projections we prepared, assuming that last year’s generous tax incentives stay in place.

cli-Statement 2 The CleanTech fund invests in publicly traded and highly

liq-uid companies and is recommended only for investors who are able to assume a high level of risk Last month, we invested in EnergyAlgae, a “green energy” company that partnered with

a global energy firm early last year to create oil from algae EnergyAlgae’s market capitalization quadrupled shortly after the partnership was formed Recently, EnergyAlgae also pat- ented a waste plastic- to- oil process that produces oil at less than

$30 a barrel One of the founders of CleanTech is on the board

of EnergyAlgae, and information he gave us on the company’s patent process led us to purchase additional stock in EnergyAlgae before the patent became widely publicized with the release of the company’s semiannual financial report.* (*Information sup- porting the statements made in this communication is available upon request.)

When Tang asks CleanTech’s founders for supporting documents related to their investment in EnergyAlgae, she is told that this information is based on third- party research from Slar Brokerage (Slar), who maintains all necessary records Tang completes a due diligence exercise on this research and learns that Slar has used sound assumptions and rigor in its analysis of EnergyAlgae In particular, Tang learned that Slar used, at a minimum, the following attributes to form the basis of

the recommendation: the company’s past three years of operational history, current

stage of the industry’s business cycle, an annual research update, a historical financial

analysis, and a one- year earnings forecast.

Tang also learns that the founders of CleanTech are majority shareholders of

Slar, which underwrote the public offering of EnergyAlgae Additionally, CleanTech’s

analysts inform Tang that they did not need to look at the quality of Slar’s research

because one of their former colleagues recently left CleanTech and established the

research department at the brokerage firm.

In researching EnergyAlgae, Tang finds that potential customers and suppliers of

EnergyAlgae are highly skeptical of the claims made regarding the company’s respective

products She also contacts several energy companies and is unable to locate anyone

who has even heard of EnergyAlgae When Tang reviews CleanTech’s trading activity

in EnergyAlgae shares, she finds that CleanTech liquidated its position in EnergyAlgae

soon after CleanTech’s portfolio managers presented positive views on EnergyAlgae

in a number of media interviews In addition, many of CleanTech’s employees also

sold their shares in EnergyAlgae immediately after CleanTech sold its shares of the

company The share price of EnergyAlgae dropped dramatically after the stock sales

made by CleanTech and its employees.

1 CleanTech’s advertising is least likely in violation of the CFA Institute Standards

of Professional Conduct with respect to:

A expected performance results.

B managers’ volunteer activities.

C use of the CFA designation.

B is correct Disclosure of the managers’ involvement with CFA Institute is not a violation

of Standard VII(A)–Conduct as Members and Candidates in the CFA Program, because it

does not reveal any confidential information But the CFA designation must always be

used as an adjective In this situation, the designation has not been used as an adjective,

thus the statement is in violation of Standard VII(B)–Reference to CFA Institute, the CFA

Designation, and the CFA Program (i.e., the statement should read “the entire research

team is made up of CFA charterholders,” rather than “they are all CFA’s”) Members must

not exaggerate the meaning or implications of membership in CFA Institute or holding

the CFA designation, which Tang does, violating Standard VII(B)

A is incorrect because members must not exaggerate the meaning or implications of

membership in CFA Institute or holding the CFA designation Statements that overstate

the competency of an individual or imply that superior performance can be expected

from someone with the CFA designation are not allowed under the Standard

C is incorrect because the CFA designation must always be used as an adjective, i.e.,

“the entire research team is made up of CFA charterholders.”

Guidance for Standards I–VII

LOS a

Standard VII(A)–Conduct as Members and Candidates in the CFA Program; Standard VII(B)–Reference

to CFA Institute, the CFA Designation, and the CFA Program

2 In Statement 1, CleanTech management most likely violated the CFA Institute

Standards of Professional Conduct with regard to their comments on:

A investment analytics software.

B clean technology sector returns.

C solar power company investment.

C is correct The performance return claim is a violation of Standard V(B)–Communication with Clients and Prospective Clients, which requires opinion to be separated from fact

In addition, Standard I(C)–Misrepresentation prohibits members and candidates from guaranteeing clients any specific return on volatile investments In the case of complex analyses, such as proprietary investment analytics software used by CleanTech, analysts must clearly separate fact from statistical conjecture and should identify the known limitations of an analysis, which has been done

A is incorrect because the investment software has determined investment returns on green transportation companies based on a multiple factor regression analysis, so there

is diligence and reasonable basis for the opinion as required by Standard V(A)–Diligence and Reasonable Basis In addition, disclosure of key risks associated with such software has been provided

B is incorrect because Standard V(B)–Communication with Clients and Prospective Clients, which requires a balanced discussion of how this investment would perform should tax incentives change or be eliminated completely, has been addressed

Guidance for Standards I–VIILOS a

Standard V(B)–Communication with Clients and Prospective Clients; Standard I(C)–Misrepresentation

3 In Statement 2, CleanTech most likely violated which of the following Standards

in the stock, so it did not benefit from the large move in the stock’s price

B is incorrect because Standard III(C)–Suitability does not appear to have been violated because the fund is characterized as a high- risk investment and it is clearly stated that EnergyAlgae is also a high- risk investment

C is incorrect because CleanTech’s statement that the hedge fund benefited from the increase in share value for EnergyAlgae last year is a violation of Standard  I(C)–Misrepresentation because the fund had only just recently invested in the stock, so it did not benefit from the large move in the stock’s price

Guidance for Standards I–VIILOS a

Standard II(A)–Material Nonpublic Information; Standard I(C)–Misrepresentation

4 To be in compliance with the CFA Institute Standards of Professional Conduct,

CleanTech should most likely question the validity of Slar’s research on

EnergyAlgae for deficiencies in which of the following areas?

A Operational analysis

B Earnings projections

C Annual research update

C is correct A reasonable and diligent effort was not made when the analysis on

EnergyAlgae was updated on only an annual basis because the information on the

com-pany could change materially in such a high- risk industry, a violation of Standard V(A)–

Diligence and Reasonable Basis In addition, when the company reports financial results

on a semiannual basis, an annual update to a research report would not be timely

A and B are incorrect because the earnings projections along with the operational

analysis are components of a reasonable and diligent effort Third- party research may

be relied upon only when a reasonable and diligent effort has been made to determine

the research is sound, which in this case appears to have been performed

Guidance for Standards I–VII

LOS b

Standard V(A)–Diligence and Reasonable Basis

5 Tang’s most appropriate course of action concerning the relationship between

CleanTech and Slar is to recommend that CleanTech:

A communicate relevant information to all clients.

B explain the ownership structure to all clients.

C sever the relationship immediately.

A is correct According to Standard  I(B)–Independence and Objectivity, full and fair

disclosure of all matters that could reasonably be expected to impair independence

and objectivity must be made to all clients In this case, the controlling position in the

broker held by the founders of CleanTech, as well as the fact that Slar has underwritten

two stocks the hedge fund holds and whose recommendations the fund relied on to

make these investments, must be disclosed to all clients so they are better able to judge

motives and possible biases for themselves

C is incorrect because the controlling position in the broker as well as the fact that this

firm has underwritten two stocks the hedge fund holds and whose recommendations

the fund relied upon to make these investments must be disclosed to all clients so they

may be better able to judge motives and possible biases for themselves according to

Standard VI(A)–Disclosure of Conflicts; however, there is no requirement the position

be eliminated

B is incorrect because all clients should be made aware of the ownership structure

along with other relevant information as required by Standard V(B)–Communication with

Clients and Prospective Clients, and there should not be selective disclosure of just one

piece of relevant information concerning the arrangement

Guidance for Standards I–VII

LOS b

Standard I(B)–Independence and Objectivity

6 The EnergyAlgae trades are least likely to have violated the CFA Institute

Standards of Professional Conduct with regard to:

A the adverse and skeptical opinions of EnergyAlgae products.

B the order in which the shares were traded.

C share price distortion because of positive media presentations.

B is correct The hedge fund had priority in trading the stock ahead of employees The hedge fund is effectively the client But it does not alleviate the stock price manipulation that was engaged in by the fund and its employees, a violation of Standard II(B)–Market Manipulation In addition, there does not appear to be an adequate basis for recom-mending the stock (i.e., negative information on the company’s products from potential customers and suppliers), a violation of Standard V(A)–Diligence and Reasonable Basis

A is incorrect because there does not appear to be an adequate basis for mending the two stocks in violation of Standard V(A)–Diligence and Reasonable Basis

recom-C is incorrect because both the hedge fund and its employees have engaged in tices that distort prices in violation of Standard II(B)–Market Manipulation This appears

prac-to be a classic “pump and dump” fraud where worthless sprac-tock is promoted prac-to the public and once it reaches a certain price level the insiders who helped boost the share price sell off their shares, leaving other investors holding stock that has little or no value

Guidance for Standards I–VIILOS a

Standard II(B)–Market Manipulation, Standard V(A)–Diligence and Reasonable Basis

Connor McClelland Case Scenario

Conner McClelland is a private client financial consultant with US- based Edmonstone Wealth Management LLC McClelland has been engaged by Bradley and Reagan Graham to develop a personal wealth management plan Prior to meeting with McClelland, the Grahams filled out a personal profile questionnaire that will be used

in developing their wealth management plan Using information from the naire, McClelland prepares Exhibit 1.

question-Exhibit 1 Graham Family: Personal and Financial Information

Occupations and Family Structure

■ Bradley is a 50- year- old electrical engineer at a major utility company His annual income of $175,000 is projected toincrease 3% per year He has a defined- contribution pension plan and expects to retire at age 65

■ Reagan is a 48- year- old pharmacist with a pharmaceutical company Her annual income of $132,000 is projected to

increase 3% per year She has a defined- contribution pension plan and expects to retire at age 65 Prior to joining thepharmaceutical company, Reagan had a 20- year career in the US Navy, retiring at the rank of commander

■ The family has two children, ages 10 and 8

Outstanding balance on a $100,000 home equity line of credit 38,000

Bradley’s defined- contribution plan (vested; normal retirement age for the plan is 65) 796,000

Cash value of Bradley’s life insurance ($250,000 death benefit) 67,000

Financial Information

Reagan’s defined- contribution plan (vested; normal retirement age for the plan is 65) 160,000

Present value of Reagan’s military pension (vested; inflation indexed; survivor benefit) 1,320,000

Cash value of Reagan’s life insurance ($250,000 death benefit) 52,000

Estimated present value of the Grahams’ future consumption 3,700,000

Aspirational and Other Goals

■Donations to charitable organizations during the next 15 years, with an estimated present value of $400,000

At their initial meeting, Bradley tells McClelland that he recently attended a

financial planning seminar conducted by his employer’s human resources department

One of the presenters discussed the importance of preparing and understanding the

components of an economic balance sheet compared with a traditional balance sheet

Bradley was confused by a few of the presenter’s comments and asks McClelland for

further clarification The presenter’s comments were as follows:

■

■ Real estate can be described as a personal asset, an investment asset, and a

mixed asset.

■

■ Financial capital consists of tangible and intangible assets, including both the

vested and unvested portions of an employer pension plan.

■

■ The value of human capital relative to overall economic wealth is typically

higher for an individual in mid- career with an established earnings record than

for an individual in the early stages of his career.

As McClelland reviews insurance coverage with the Grahams, he explains that

there are various ways to manage risk “It depends on the frequency of a risk occurring

and the severity of the potential loss For example, consider the following two risks:

■

■ An earthquake: This risk seldom occurs but would result in a large financial

loss;

■

■ Dental cavities: This risk arises frequently, resulting in small financial losses.”

McClelland determines that both Bradley’s and Reagan’s life insurance coverage is

inadequate Bradley is particularly concerned about the inadequacy of his life insurance

and asks McClelland to calculate how much additional insurance he should purchase

to cover him until he retires in exactly 15 years and begins to receive his employer

pension McClelland prefers to use the human life value method to determine the

appropriate level of life insurance coverage Exhibit 2 contains additional personal

and financial information about Bradley.

Exhibit 1 (Continued)

Exhibit 2 Bradley Graham: Additional Personal and Financial Information

Current annual income; salary and expenses expected to increase 3% per

The Grahams mention that a primary concern is the ability to manage the risks to both their financial and human capital so that they can achieve their financial goals of maintaining a comfortable lifestyle while having sufficient assets to purchase a vacation home, pay for their children’s university education, and fund charitable donations Bradley mentions that he and Reagan have some concern about possibly outliving their assets and that he understands annuities can help protect against this risk He is interested in an annuity that will provide income for as long as one of them is alive The Grahams have average risk tolerance and expect they will be able to adjust their spending in retirement if necessary.

7 Using the data in Exhibit 1, the Grahams’ net wealth (in thousands) is closest to:

Checking account $27 Residential mortgage $285 Taxable investment

account 625 Home equity line of credit – outstanding balance 38

Cash value of life ance (combined Bradley and Reagan)

insur-119 University education for

bined Bradley and Reagan) 956 Total Liabilities $5,098

Military pension (Reagan) 1,320

Assets Liabilities

Total Assets $7,512 Total Liabilities and Net

A is incorrect Human capital was not included in assets and lifetime consumption

was not included in liabilities: [(7,512 – 3,940) – (5,098 – 3,700)] = 3,572 – 1,398 = 2,174

C is incorrect The death benefit rather than the cash value of life insurance was

included in the calculation of assets: (7,512 + 250 + 250 – 119) – 5,098 = 7,893 – 5,098 =

2,795

Risk Management for Individuals

LOS d

Section 3.3

8 Which of the presenter’s comments regarding economic and traditional balance

sheets is most accurate?

A The comment about human capital

B The comment about financial capital

C The comment about real estate

C is correct Personal assets are consumed, whereas investment assets are held for the

potential to increase in value and fund future consumption Some assets, such as real

estate, can be described as “mixed assets” because they can act as both personal assets

(shelter) and investment assets (to help fund retirement)

B is incorrect Financial capital includes the tangible and intangible assets (outside

of human capital) owned by an individual or household Financial capital would include

the vested portion but not the unvested portion of an employer pension plan

A is incorrect The economic wealth of an individual changes throughout their lifetime,

as do the underlying assets that make up that wealth The total economic wealth of

younger individuals is typically dominated by the value of their human capital because

younger individuals have not had as much time to save and accumulate financial wealth

As individuals grow older, they are likely to save some of their earnings and will

accu-mulate financial capital

Risk Management for Individuals

LOS a, b

Sections 2.2 and 3.3.2

9 Which of the following risk management techniques is most appropriate for the

second risk exposure example provided by McClelland?

A Risk retention

B Risk reduction

C Risk transfer

(Continued)

B is correct A risk with the loss characteristics of high frequency of occurrence and low severity of loss, such as dental cavities, is best managed through risk reduction—for example, through proper dental hygiene A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, is best managed through risk transfer A risk with the loss characteristics

of low frequency of occurrence and low severity of loss is best managed through risk retention, such as not purchasing an extended warranty on an infrequently used and relatively inexpensive item

A is incorrect A risk with the loss characteristics of low frequency of occurrence and low severity of loss would be best managed through risk retention, such as not pur-chasing an extended warranty on an infrequently used and relatively inexpensive item

C is incorrect A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, would be best managed through risk transfer

Risk Management for IndividualsLOS j

Section 5.1

10 Based on the data in Exhibits 1 and 2 and using the human life value method

for determining life insurance needs, the additional amount of life insurance

that Bradley should purchase is closest to:

1 Calculate the pretax income needed to be replacedBradley’s annual income (before taxes) $175,000Less: income and payroll taxes at 30% ($175,000 × 30%) = 52,500

Less: family expenses attributable to Bradley 20,000Net annual income after expenses attributable to Bradley 102,500Plus: non- taxable employer contribution to defined- contribution

Calculate the adjusted rate (i):

i = [(1 + Discount rate)/(1 + Growth rate)] – 1

 = [(1 + 0.04)/(1 + 0.03)] – 1

 = (1.04/1.03) – 1

 = 1.0097 – 1

 = 0.0097 = 0.97%

3 Determine the total amount of life insurance needed by calculating the present

value of an annuity due in advance

$139,063 × PVAADV(15 years, 0.97%) = $1,951,345

[Inputs on financial calculator (HP- 12C): Mode:

B is incorrect The employer contribution to the defined- contribution retirement plan

was not included in Step 1 of the calculation

C is incorrect The current $250,000 life insurance coverage was not deducted from

the calculation of the total life insurance needed

Risk Management for Individuals

LOS j

Sections 4.1.4.4, 4.1.5, and 5.2.2

11 Risk to which of the following is least likely to compromise the Grahams’ ability

to achieve their financial and aspirational goals?

A Health

B Earnings

C Property

C is correct Because property is a financial asset, property risk is normally considered

to be associated with a potential loss of financial capital, whereas earnings and health

risk can affect both financial and human capital Although the value of the Grahams’

residence is significant, it is a minor portion of the family’s overall financial and human

capital Thus, property risk is least likely to adversely affect the Grahams’ ability to maintain

their lifestyle, purchase a vacation home, pay for their children’s university education,

and fund charitable donations

A is incorrect Health risk is the risk and implication associated with illness or injury

Even with insurance, direct financial costs associated with illness or injury may include

coinsurance, copayments, and deductibles Health factors also typically have an impact

on life, disability, and long- term care insurance premiums Health risks also have

implica-tions for human capital and financial capital For example, if a worker becomes disabled,

he or she may be unable to work while health expenses are incurred, resulting in a loss

to both current assets and future earnings

B is incorrect Earnings risk is the risk associated with an individual’s earning tial Given that there are 15/17 years before retirement, this is a significant risk for them Earnings can be impacted by death, health issues, unemployment, and underemploy-ment The loss of earnings reduces human capital by reducing the present value of future expected labor income and financial capital because assets will be needed to make up for any loss of income.

poten-Risk Management for IndividualsLOS e

Section 3.4

12 The type of life annuity that is most consistent with the Grahams’ risk tolerance

and retirement spending plans is a:

A variable joint life annuity.

B fixed joint life annuity.

C variable life annuity with period certain.

A is correct A variable joint life annuity is most appropriate The Grahams have istics that are compatible with variable annuities—average risk tolerance and the ability

character-to adjust their spending in retirement—enabling them character-to select a variable annuity for which payment is linked to a risky portfolio of assets The joint life feature will provide payments until both of them are no longer living

B is incorrect While the joint life feature would provide payments until both of the Grahams are no longer living, a fixed annuity would lock them into a constant income stream that is guaranteed not to change

C is incorrect The life annuity with period certain feature provides payment for the life

of the annuitant and is guaranteed for a minimum number of years If Bradley purchased

a variable life annuity with period certain policy with a 10- year guarantee and he died after 6 years, Reagan would receive payments for only 4 more years as the beneficiary If Bradley died after the guaranteed minimum, say at 12 years, Reagan would not receive any more payments

Risk Management for IndividualsLOS i

Sections 4.7.3 and 4.7.4

Rhys Jacobs Case Scenario

Rhys Jacobs is a 70- year- old resident of Sahjong, a small island country off the coast

of Australia that caters to high- net- worth individuals because of its low tax rates and status as a sought- after free trade zone Jacobs grew up in Sahjong and is a well- respected entrepreneur.

Jacobs has long put it off but believes that now is the time to finally receive some much- needed assistance in tax- efficient wealth accumulation, retirement and estate planning, and other financial matters, so he recently hired Jassica Simson as his tax and financial adviser.

In preparing for their introductory meeting, Jacobs performs initial research on

various tax- planning strategies available in Sahjong, where the capital gains tax rate

is much lower than the income tax rate He finds several strategies that might b e

appropriate for his investment portfolio and summarizes them as follows:

1 A strategy based on low portfolio turnover whereby assets are held for extended

periods

2 A strategy that concentrates on tax- exempt securities

3 A strategy to restructure his portfolio to focus on annual capital gains versus

income generation

Jacobs provides materials to Simson, including the following notes he took from

a recent financial blog discussing the various tools currently being used in retirement

planning:

1 Long- term market return and historical inflation averages are simple but

effec-tive strategies for accurately extrapolating how much wealth will be

accumu-lated after a period of time if one could earn, say, 10% a year.

2 The Monte Carlo approach helps an investor get to a straightforward “yes/no”

determination on whether a particular retirement income goal can be achieved.

3 Given a particular investment strategy, the likelihood of achieving a certain

percentage return throughout retirement can be answered with a Monte Carlo

simulation.

4 Sustainable spending rates in retirement can be approximated without the need

for a Monte Carlo simulation by using the notion of ruin probabilities.

Jacobs asks Simson to evaluate these notes.

Simson states that she is very much in favor of a long- term buy- and- hold strategy

focused on capital appreciation She states that investors often do not realize just how

much of their investment returns are consumed by taxes, and she provides Jacobs with

the data in Exhibit 1 to illustrate the point.

Exhibit 1 Data Illustrating the Effect of Taxes on Wealth

Accumulation

Tax rate on investment returns 10%

Turning to retirement planning, Simson confirms that sustainable spending rates

in retirement can be approximated without the need for a Monte Carlo simulation

by using the notion of ruin probabilities (as developed by Milevsky and Robinson)

The analysis incorporates lifespan uncertainty as well as financial market risk After

they discuss the method, Jacobs asks her to determine how much he could withdraw

annually from a balanced portfolio if he wants to be at least 94% certain that the

portfolio will last for the remainder of his life He states that the current value of his

(balanced) portfolio is $2 million, made up of 50% income- producing equities and 50%

bonds Simson uses the ruin probabilities in Exhibit 2 as the basis for her calculation

of Jacobs’ lifetime sustainable annual withdrawal.

Exhibit 2 Ruin Probabilities for a Balanced Portfolio: 50% Equity and 50% Bonds

Real Annual Spending per $100 of Initial Nest Egg Current

Age Hazard Rate, λ (%) $2 (%) $3 (%) $4 (%) $5 (%) $6 (%) $7 (%) $8 (%) $9 (%) $10 (%)

Assumptions: Portfolio return: arithmetic: 5%; geometric: 4.28%; standard deviation: 12%

Jacobs owns a controlling interest in a rapidly growing private firm that explores for and produces oil The firm generates steady cash flow but is considered illiquid Simson explains that Jacobs’ death could create significant inheritance taxes She suggests an insurance policy to help fund any future inheritance taxes and help offset the risk of a tax liability combined with an illiquid asset Jacobs is confused about the use of life insurance and asks Simson to verify the following statements:

policyhold-The oil firm that Jacobs controls is headquartered in the island country of Mahjong, located near Sahjong Because of the foreign location of the oil firm, Simson believes there might be opportunities to reduce taxes.

Simson knows that Sahjong uses the exemption method, whereby it does not impose taxes on income that stems from a foreign country However, Sahjong will soon hold parliamentary elections, and the opposition party is said to favor the deduction method Simson plans to investigate how this possible change might affect Jacobs’ tax liability She compares the tax rates in the two countries in Exhibit 3.

Exhibit 3 Comparative Income Tax Rates

13 Which of the tax- planning strategies summarized by Jacobs is best described as

C is incorrect Strategy 3 is a tax reduction strategy because the tax rate on the capital

gains is lower than the income tax rate

Managing Individual Investor Portfolios

A is correct Note 3 is most accurate Monte Carlo simulation provides a probability

distribution of outcomes, not simply a yes/no answer In this context, the discussion of

the investment strategy with a likelihood of achieving a certain return is an accurate

description of the results of a Monte Carlo simulation Merely using long- term averages

for capital market returns or inflation assumptions oversimplifies their variability and

leads to the clearly unrealistic implication of linear wealth accumulation

B is incorrect because getting to a yes/no decision is also oversimplified and

repre-sentative of a deterministic approach, which is opposite to the Monte Carlo process that

emphasizes probability distributions

C is incorrect because this description simply uses long- term market returns and

aver-ages It is too simplified and suggests a linear approach to personal retirement planning

and does not convey the notation of variance (or likelihood) of the value

Managing Individual Investor Portfolios

15 Based on the data in Exhibit 1 and assuming that all returns are taxed annually,

the proportion of the investment’s return that is consumed by taxes is closest to:

Accumulated Value Calculation

Investment gain $1,712,119 – $250,000 $1,462,119Investment gain consumed by

C is incorrect because it taxes the gain at the end

Ignoring taxes $250,000 × [1 + 0.08]25 $1,712,119Investment gain $1,712,119 – $250,000 $1,462,119

16 Based on Exhibit 2 and Jacobs’ stated level of concern for the probability of

retirement ruin, the lifetime sustainable annual withdrawal is closest to:

A $80,000.

B $120,000.

C $95,000.

A is correct If Jacobs wants to be 94% certain that his portfolio will last, he can tolerate

a 6% failure rate A spending rate of $4 per $100 of assets has a ruin probability of 6.3%, which is close to the stated failure rate of 6% (Exhibit 2) Therefore, he can withdraw just under 4% from the balanced portfolio, or 0.04 × $2,000,000 = $80,000

B is incorrect because it incorrectly equates $6 per $100 of assets with the 6% failure rate In this case, the calculation is 0.06% × $2,000,000 = $120,000

C is incorrect because it incorrectly assumes the hazard rate of 4.75% is the failure rate In this case, the calculation is 4.75% × $2,000,000 = $95,000

Estate Planning in a Global ContextLOS c

Section 3.2

17 Which of the statements about life insurance is most appropriate?

A The statement about tax treatment of death benefits.

B The statement about combination of life insurance and trusts.

C The statement about premiums paid by policyholders.

C is correct Premiums paid by the policyholder are not considered part of the holder’s estate at the time of death

policy-A is incorrect because death benefits are tax exempt in most jurisdictions.

B is incorrect because combining life insurance and trust management can be a

powerful retirement planning strategy

Estate Planning in a Global Context

LOS h

Section 5.3

18 If the opposition party wins the election in Sahjong and its tax proposals are

passed into law, the tax rate that Jacobs will face on income stemming from

Mahjong will be closest to:

A is incorrect because it assumes the exemption method, but from the perspective

of Sahjong, not Mahjong, where the residence country (Sahjong) imposes no tax on

foreign- sourced income

B is incorrect because the tax rate would 15.5% under the exemption method (income

from Mahjong would be taxed at the source rate, or Mahjong’s tax rate): TExemption Method

= TSource

Estate Planning in a Global Context

LOS k

Section 6.3.1

Brian O’Reilly Case Scenario

Brian O’Reilly is a capital markets consultant for the Tennessee Teachers’ Retirement

System (TTRS) O’Reilly is meeting with the TTRS board to present his capital market

expectations for the next year Board member Kay Durden asks O’Reilly about the

possibility that data measurement biases exist in historical data O’Reilly responds:

“Some benchmark indexes suffer from survivorship bias For example, the

returns of failed or merged companies are dropped from the data series,

resulting in an upward bias to reported returns This bias may result in an

overly optimistic expectation with respect to future index returns Another

bias results from the use of appraisal data in the absence of market

transac-tion data Appraisal values tend to be less volatile than market determined

values for identical assets The result is that calculated correlations with

other assets tend to be biased upward in absolute value compared with the

true correlations, and the true variance of the asset is biased downward.”

Board member Arnold Brown asks O’Reilly about the use of high- frequency (daily) data in developing capital market expectations O’Reilly answers, “Sometimes

it is necessary to use daily data to obtain a data series of the desired length High- frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce higher correlation estimates.”

Board member Harold Melson notes he recently read an article on psychological traps related to making accurate and unbiased forecasts He asks O’Reilly to inform the board about the anchoring trap and the confirming evidence trap O’Reilly offers the following explanation:

“The anchoring trap is the tendency for forecasts to be overly influenced

by the memory of catastrophic or dramatic past events that are anchored

in a person’s memory The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports a preferred viewpoint than to evidence that contradicts it.”

The board asks O’Reilly about using a multifactor model to estimate asset returns and covariances among asset returns O’Reilly presents the factor covariance matrix for global equity and global bonds shown in Exhibit 1 and market factor sensitivities and residual risk shown in Exhibit 2.

Exhibit 1 Factor Covariance Matrix

Global Equity Global Bonds

Exhibit 2 Market Factor Sensitivities and Residual Risk

Sensitivities Global Equity Global Bonds Residual Risk

■ GDP growth will be 2.5% per year.

■

■ The risk- free rate will be 2.5%.

19 With respect to his explanation of survivorship bias, O’Reilly most likely is:

A is correct O’Reilly's explanation of survivorship bias is correct

B is incorrect Survivorship bias is likely to be overly optimistic, therefore an upward

B incorrect, because the true variance of the asset is biased upward.

C incorrect, because calculated correlations with other assets tend to be

biased downward in absolute value.

C is correct O’Reilly’s explanation of appraisal data bias is incorrect because calculated

correlations with other assets tend to be smaller in absolute value compared with the

true correlations O’Reilly is correct in that appraisal values tend to be less volatile than

market- determined values for identical assets, and the true variance (and standard

deviation) of the asset is biased downward

A is incorrect O’Reilly’s comment regarding calculated correlations is incorrect

B is incorrect O’Reilly’s comment regarding true variance is accurate

Capital Market Expectations

LOS b

Section 2.2.2

21 With respect to his answer to Brown’s question, O’Reilly most likely is:

A incorrect, because high- frequency data tend to produce lower correlation

estimates.

B correct.

C incorrect, because high- frequency data are less sensitive to asynchronism.

A is correct O’Reilly’s answer is incorrect with respect to correlation estimates High- frequency data are more sensitive to asynchronism across variables and, as a result, tend

to produce lower correlation estimates

B is incorrect Although O’Reilly’s statement regarding sensitivity to asynchronism is correct, his statement regarding correlations is incorrect

C is incorrect High- frequency data are more sensitive to asynchronism across variables

Capital Market ExpectationsLOS b

Section 2.2.3

22 Is O’Reilly’s explanation of the anchoring trap most likely correct?

A No, because the anchoring trap is the tendency for the mind to give a

dis-proportionate weight to the first information it receives on a topic.

B Yes.

C No, because the anchoring trap is the tendency to temper forecasts so that

they do not appear extreme.

A is correct O’Reilly’s explanation of the anchoring trap is incorrect The anchoring trap

is the tendency of the mind to give disproportionate weight to the first information it receives on a topic Initial impressions, estimates, or data anchor subsequent thoughts and judgments

B is incorrect O’Reilly’s statement regarding the anchoring trap is incorrect This is a description of the recallability trap

C is incorrect Although O’Reilly’s statement regarding the anchoring trap is incorrect, this is a description of the prudence trap

The Behavioral Finance PerspectiveLOS c

Section 3.2.1Capital Market ExpectationsLOS b

Section 2.2.8

23 Given the data in Exhibits 1 and 2, the covariance between Market 1 and

Market 2 is closest to:

C is incorrect It incorrectly uses variance for global bonds (0.0025) instead of global

24 Given O’Reilly’s forecasts for the European market, the expected long- term

equity return using the Grinold–Kroner model is closest to:

E(Re) = expected rate of return on equity

D/P = expected dividend yield

ΔS = expected percent change in number of shares outstanding

i = expected inflation rate

g = expected real total earnings growth rate

ΔPE = Per period percent change in the P/E multiplier

According to the Grinold–Kroner model, the expected long- term developed market

equity return is equal to the sum of the: 1) expected income return (dividend yield minus

the percentage change in the number of shares outstanding), 2) expected nominal

earn-ings growth return (long- term inflation rate plus long- term corporate earnearn-ings growth

rate), and 3) repricing return (expansion rate for P/E multiples) In this case:

Sabanai Investimentos Case Scenario

Marina Campos is a senior portfolio manager for Sabanai Investimentos in Sao Paulo, Brazil Sabanai provides investment management and advisory services for high- net- worth and institutional clients She is assisted by two portfolio analysts, Fabiana Traldi and Pedro Peixaria Campos is meeting with Traldi and Peixaria to discuss the portfolios of three clients.

The first client is Gilvan Araujo Dias, a high- net- worth client who has given Sabanai responsibility for managing his foreign investments, which consist of equity investments in the United Kingdom and Germany His other assets consist of equity and corporate bond investments in Brazil Exhibit 1 summarizes information on Dias’s foreign portfolio holdings and exchange rates.

Exhibit 1 Gilvan Araujo Dias, Information on Foreign Asset Holdings and

Exchange Rates

UK Assets German Assets Spot Exchange Rates

Dias has asked whether it would be appropriate for him to hedge his foreign rency exposure Campos raises the issue with Traldi and Peixaria Traldi responds, “In the short run, if the correlation between foreign asset returns and foreign currency returns is negative, then there may be a need to hedge all foreign currency exposure Alternatively, one could implement a currency overlay program in which the currency exposure is fully hedged and currency alpha is generated separately This currency overlay strategy will only be successful in adding value to the portfolio if the currency alpha has a high correlation with Brazilian equities and corporate bonds.”

cur-The second client, BC Fundos de Pensao (BC), manages pension funds for numerous local companies and has currency exposure to the USD, the EUR, and the GBP BC wants Sabanai to provide guidance on using active currency management strategies for the portfolios they manage Peixaria has been assigned this task and has collected information on one- year yield levels in the United States, United Kingdom, and Eurozone, as well as one- year implied volatility for various currency pairs extracted from option pricing models This information is provided in Exhibit 2.

Exhibit 2 One- Year Yield Levels and Implied Volatilities

Peixaria indicates that his research suggests that the USD/EUR currency pair will

become more volatile over the near term He recommends that BC implement an

options- based strategy using USD/EUR options to profit from the expected increase

in volatility.

The third client is Fundo do Brasil (FB), a Brazilian sovereign wealth fund FB

has long equity positions in Australian and Swiss equities Spot and forward market

currency information for AUD and CHF is provided in Exhibit 3 FB managers have

asked Campos for advice on whether it would be appropriate to hedge the currency

exposure with forward contracts in AUD and CHF Campos indicates that she will

examine the use of forward contracts to hedge currency exposure.

Exhibit 3 Spot and Forward Rates for AUD and CHF

Currency Pair Current Spot Rate Forward Rate Six- Month Six- Month Forecast Spot Rate

Traldi suggests that the use of put options might be a better way to hedge currency

exposure Campos responds that there are better options- based strategies that can

exploit market views and reduce hedging costs She suggests the following strategies:

■

■ Strategy 1: For AUD exposure, the appropriate strategy is to be long put

options at a strike price of 2.1046, short put options with a strike price 2.1006,

and short call options with a strike price of 2.1456.

■

■ Strategy 2: For CHF exposure, the appropriate strategy is to be long put

options at a strike price of 2.5309, short put options with a strike price 2.5049,

and short call options with a strike price of 2.5669.

25 Based on the information provided in Exhibit 1, the domestic currency value of

Dias’s foreign investments most likely:

A decreased because of changes in the domestic currency value of foreign

asset holdings.

B increased because of changes in the domestic currency value of UK assets

but decreased because of changes in the domestic currency value of German

assets.

C increased because of changes in the domestic currency value of foreign asset

holdings.

Exhibit 2 (Continued)