2019 CFA level 3 qbank r 20 21 asset allocation with real world c currency management answers

Study Session 10, Module 21.4, LOS 21.f Related Material SchweserNotes - Book 3 Question #2 of 24 Currency trading based on economic fundamentals would be most likely to sell a currency

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Question #1 of 24

A U.S.-based investor has purchased a 15,000,000 peso o ce building in Mexico He has hedged his investment by selling forward futures at $0.1098/peso Two months later, the futures exchange rate has fallen to $0.0921/peso The investor's net change in the futures position is:

A) $265,500.00

B) ($265,500.00)

C) $1,647,000.00

Explanation

The realized gain on the futures position is:

V0(-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500 (Study Session 10, Module 21.4, LOS 21.f)

Related Material

SchweserNotes - Book 3

Currency trading based on economic fundamentals would be most likely to sell a currency forward if the country issuing the currency is experiencing:

A) declining levels of relative risk in the economy.

B) rising relative in ation.

C) increasing real rates of return.

Explanation

Higher relative in ation is associated with declining value of the currency and would tend to encourage sale of the currency by the manager The other two factors are associated with currency appreciation

(Study Session 10, Module 21.3, LOS 21.d)

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Jane Simms manages a German portfolio denominated in the EUR and decides to use an option collar to reduce her downside risk exposure to the Mexican peso (MXP) while retaining some potential upside Which of the following strategies will accomplish her objective?

A) Buy an OTM call on the EUR and sell an OTM put on the EUR.

B) Buy an OTM put on the MXP and sell an in-the-money call on the MXP.

C) Buy an OTM put on the MXP and sell an OTM put on the MXP with a lower strike

price

Explanation

The collar Simms describes requires buying OTM puts and selling OTM calls on the MXP However, this is directly equivalent to buying OTM calls on the EUR and selling OTM puts on the EUR Note that selling an in-the-money call on the MXP removes all portfolio upside and will not meet her objectives

(Study Session 10, Module 21.5, LOS 21.g)

The Howarth School Foundation (HSF) has historically provided 30% of the annual operating costs of running the Howarth Law school Recent changes in government funding mean that previously fully funded scholarships will now only be 40% funded and that HSF must provide more support to the school Based on this information, HSF will most likely:

A) Increase the allocation to zero-coupon bonds to increase duration.

B) Increase the allocation to riskier timber and farmland to generate higher expected

return and cover the required out ows

C) Decrease the allocation to private equity in order in increase the liquidity of the

portfolio

Explanation

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The school is becoming more dependent on the foundation, decreasing the ability to take risk and increasing liquidity demands for payouts to the school Shifting to more liquid

investments makes sense Higher duration is not relevant and is probably riskier plus zero-coupons provide no regular cash ow Higher return may seem logical but taking more risk to get it is not appropriate when ability to take risk has declined Plus land is an illiquid asset (Study Session 10, Module 20.2, LOS 20.c)

Which scenario would most likely lead a portfolio manager to buy a foreign currency in the forward market?

A) A portfolio that is overweighted in assets denominated in that currency.

B) An active manager implementing a carry trade when the currency being bought as

the higher relative yield

C) An active currency manager who is underweighted in assets denominated in that

currency

Explanation

No manager views were indicated in the question; lacking views, an active manager should take a neutral exposure to the currency Being underweighted in the assets would produce

an underweighting in the currency which is corrected by buying the currency forward The other two answers are incorrect Being overweighted would lead to selling the currency forward A carry trade would buy the higher yield currency in the spot, not forward, market (Study Session 10, Module 21.4, LOS 21.e)

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Dan Vustings, 51, is a senior account executive at an advertising agency in San Francisco He currently has su cient capital in his two investment portfolios to retire in 14 years His capital

is evenly split between a taxable portfolio which he uses to fund current consumption goals and a tax-deferred retirement account Vustings received advice from an investment manager last year who suggested the following asset allocation:

High-yield bonds 15%

High dividend yield equities 50%

High growth equities 35%

Vustings has the same allocation in both the taxable and the retirement account Which of the following allocations would be most likely to improve the e ciency of the portfolios, ignoring rebalancing or withdrawal penalties?

A) Increase the allocation to high-yield bonds in the retirement account, and increase

the allocation to high growth equity investments in the taxable account

B) Increase the allocation to high-dividend yield equities in the taxable account, and

increase the allocation to high growth equities in the retirement account

C) Increase the allocation to high-yield bonds in the taxable account, and increase the

allocation to high growth equities in the retirement account

Explanation

Assets subject to the highest rates of tax should be rst allocated to tax advantaged

accounts Interest on high yield bonds is typically taxed at a higher rate than dividend income which in turn is taxed at a higher rate than capital gains Vustings should therefore allocate high-yield bonds rst to the retirement account, and leave the high growth equity in the taxable account

(Study Session 10, Module 20.1, LOS 20.b)

Which of the following portfolios would most likely follow a passive currency hedging strategy?

A) One with a shorter time horizon and higher liquidity needs.

B) One very concerned with minimizing regret and higher allocation to equity

investments

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C) One with more con dence in the portfolio manager and high income needs.

Explanation

The following will shift the portfolio towards more passive currency management:

A short time horizon for portfolio objectives

High risk aversion

Lack of concern with regret at missing opportunities to add value through discretionary currency management

High short-term income and liquidity needs

Signi cant foreign currency bond exposure

Low hedging costs

Clients who doubt the bene ts of discretionary management

(Study Session 10, Module 21.1, LOS 21.c)

A U.S investor who holds a £2,000,000 investment wishes to hedge the portfolio against

currency risk The investor should:

A) buy £2,000,000 worth of futures for U.S dollars.

B) sell $2,000,000 worth of futures for British pounds.

C) sell £2,000,000 worth of futures for U.S dollars.

Explanation

The investor should sell £2,000,000 worth of futures contracts for U.S dollars This will o set the existing long position in pound-denominated assets In so doing, the investor has

e ectively xed the exchange rate for pounds into dollars for the duration of the futures contract

(Study Session 10, Module 21.1, LOS 21.b)

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The basis risk in a currency hedge is most likely highest in a:

A) cross hedge.

B) minimum-variance hedge ratio.

C) direct hedge.

Explanation

A Basis risk exists when movement in the hedge currency is not matched by movement in the hedging vehicle A direct hedge will short forwards on the currency to be hedged and basis risk will therefore be low A cross hedge can range from lower to higher basis risk depending

on what is used as the hedging vehicle The MVHR depends on regressing past asset returns and currency movement to calculate a hedge ratio that would had minimized past volatility of returns to the domestic investor in a foreign asset It is exposed to changing correlation and likely to have the highest basis risk

(Study Session 10, Module 21.6, LOS 21.h)

Kevin Collison has several di erent places where he has assets in which he manages as

separate accounts such as his checking account which he uses for short term cash and

emergency needs, his 401(k) account for retirement, and his children's college fund In his 401(k) he owns a small cap stock in a company which makes catheters to be used in

experimental cancer treatment in which the catheter is used to deliver cancer killing drugs to hard to reach tumors in the body The stock has recently taken a downturn in price due to the FDA not approving their most recent catheter As a result of the downturn in price, Collison purchases more of the stock in hopes of recouping his losses at some future time Collison's management of his portfolio is indicative of:

A) money illusion and fear of regret.

B) mental accounting and loss aversion.

C) asset allocation and pyramiding.

Explanation

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Collison is exhibiting mental accounting by having separate accounts for his assets which he manages each account separately for a speci c purpose and does not manage his assets as a complete portfolio for asset allocation purposes He is also exhibiting loss aversion by not accepting the loss on the stock which is also leading to risk seeking behavior by buying more

of the losing stock

(Study Session 10, Module 20.3, LOS 20.e)

The cost to hedge a long position in the EUR is reduced by:

A) forward euro exchange rates are below the spot exchange rates.

B) lower relative interest rates in the euro zone.

C) negative roll yield.

Explanation

A long position in the euro is hedged by selling the euro forward Positive roll yield is a reduction in hedging cost Positive roll yield for the seller of the euro occurs if the forward exchange rate for the euro is above the spot exchange rate This will occur if euro zone interest rates are relatively low

(Study Session 10, Module 21.4, LOS 21.f)

Goals based investing is most directly useful to counter:

A) loss aversion.

B) illusion of control.

C) representativeness.

Explanation

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The answer is loss aversion based speci cally on what the reading says You have taken at least 2 CFA exams and know such picky questions are unusual Exhibit good judgement, give your best guess, and move on

(Study Session 10, Module 20.3, LOS 20.e)

Which of the following statements regarding hedging of emerging market currencies is least accurate?

A) Hedging costs for managers who buy emerging market currencies are increased by

the relatively high interest rates in emerging markets

B) Hedging cost varies with normally large bid/asked spreads followed by infrequent

periods of even higher spreads

C) Tail risk and contagion both refer to relatively infrequent events that increase the

di culty of hedging emerging market currencies

Explanation

The relatively high interest rates of emerging market economies leads to an inverted pricing curve with forward prices of the emerging market currencies below their spot prices This raises hedging cost for sellers of the currency, not buyers; sellers receive negative roll yield while buyers receive positive roll yield EM currencies do have relatively high bid/asked spreads which increase in periods of crisis Contagion and tail risk refer to infrequent events Contagion refers to all EM currencies tending to decline together in periods of crisis, and tail risk to the downside in those periods of crisis being large in relation to typical upside

movement in the currencies

(Study Session 10, Module 21.6, LOS 21.i)

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A European investor holds a diversi ed portfolio From the euro perspective the portfolio is weighted 60% and 40% in U.S and U.K investments

Additional information:

Assets:

Returns measured in foreign currency:

Returns measured from investor's perspective:

Standard deviation of asset's returns measured in foreign currency:

Stand deviation of the foreign currency's returns:

The correlation between the foreign-currency asset's returns and returns on the foreign currency are 0.81 and 0.67 respectively for the U.S and U.K assets Compute the standard deviation of returns for the investor in the U.K assets

A) 7.8%.

B) 60.9%.

C) 7.5%.

Explanation

It depends on the standard deviation of the asset returns measured in the foreign currency, the standard deviation of the currency's returns, and the correlation between these two sources of returns

Variance = (1.02)(3.52) + (1.02)(4.72) + 2(1.0)(1.0)(0.67)(3.5)(4.7) = 56.38

Standard deviation = 7.5%

(Study Session 10, Module 21.1, LOS 21.a)

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A Djiboutian (DJF) investor holds an international portfolio with beginning investments of USD 1,253,000 and EUR 2,347,800 Measured in the foreign currencies these investments appreciate 5% and depreciate 7% respectively

Additional information:

Beginning Spot

Exchange Rate Beginning Forward Exchange Rate Ending Spot Exchange Rate

DJF/USD 179.54 DJF/USD 185.67 DJF/USD 192.85

EUR/DJF 0.00416 EUR/DJF 0.00413 EUR/DJF 0.00421

The ending value of the EUR investment is closest to:

A) EUR 2,200,000.

B) EUR 2,500,000.

C) DJF 575,000.

Explanation

The ending value in EUR

is: EUR 2,347,800 × 93 = EUR 2,183,454

The ending value in DJF

is:

EUR 2,183,454 / (EUR/DJF 0.00421) = DJF 518,635,154

(Study Session 10, Module 21.1, LOS 21.a)

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The strategic asset allocation, current allocation, and upper and lower policy limits for a

retirement portfolio are shown in the table below

Asset Class Current Weight SAA Upper Limit Lower Limit

The portfolio manager takes a discretionary approach to tactical asset allocation She follows various indicators that she believes are useful in evaluating speci c asset classes Her current observations and interpretations are:

Equity brokers have reported that margin borrowing levels increased dramatically over the last two months and now sit at their highest levels for 15 months, a bearish sign Real estate indexes have started to rise suggesting the market may be 'heating up', a bullish sign

Indications from the federal reserve are that interest rates will rise several times in the next 12 months, a clearly obvious sign

Which of the following tactical allocation shifts is the manager most likely to make?

A) Increase the weighting to real estate.

B) Decrease the weighting to xed income.

C) Increase the weighting to domestic equity.

Explanation

She is bullish on RE and RE is at the bottom of her range; she should increase the allocation if possible Admittedly RE is a less liquid asset She is bearish on equity and would not want to increase the weight Increasing interest rates is bearish for bonds, but she is already at the bottom of the range Avoid convoluted arguments that to change one weight she must do something else as well That is not a direct answer to the question, was not asked, and we'd

be guessing what that other action is She may already have some cash assets

(Study Session 10, Module 20.2, LOS 20.d)

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