Practice exams for the 2010 CFA exam

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LEVEL 3 PRACTICE EXAMS — VOLUME 2

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PPN; 4550-0150

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Disclaimer: The Schweser Notes should be used onjunction with the original readings as sec forth by

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HOW TO USE THE LEVEL 3 PRACTICE EXAMS

This volume contains three full-length Schweser practice exams Answers to all item set questions contain full explanations, and since the goal for the morning session of the Level 3 exam is writing complete answers without consuming unnecessary time, essay questions have two answers—a For the Exam answer to help you practice writing short, correct answers for the exam, and a Discussion answer, which fully explains the concept

behind the question and answer

I recommend that you save the Practice Exams for as late in the season as possible A

good strategy is to take one exam in each of the three weeks prior to the exam (two pet week, if you have both practice exam volumes) Plan ahead; actually schedule the exam and take the entire exam in two, 3-hour sittings on the scheduled day Do your best to mimic actual exam conditions For example, time yourself, have someone work on a computer in the same room, and for distractions, have that person leave the room occasionally, turn the temperature in the room up and-down, and talk to him- or herself Remember, no matter how challenging we make our Practice Exams, the actual exam— and the exam experience, for that matter-—will be different because you and everyone €lse in the room will be nervous and fidgety with the pressures of the day Also, mainly due to nerves and the exam experience, your perception will be that the actual exam was

much more difficult than our practice exams or even old CFA Exam questions you have

studied

The morning session of your exam (3 hours and 50% of the exam) will be entirely constructed response essay questions The afternoon session (3 hours and 50%) will be 10 selected response item sets, each worth 18 points You can expect any topic (eg, portfolio management, derivatives, GIPS®) to be tested in either format The Level 3 topic area weights, as presented on the CFA Instirute® Web site, are shown in Figure i

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Topic Area Level 3 Weight

| Ethical and Professional Standards 10% ! Quantitative Methods 0% Economics 0% Financial Reporting and Analysis 0% Corporate Finance 0% Equity Investments 5-15% Fixed Income 10-20% Derivatives 5-15% Alternative Investments 5~15% Portfolio Management and Wealth Planning | 45-55%

* Note: These weights are intended to guide the curriculum and exam development processes Actual exam weights may vary slightly from year to year Please note that some topics are combined for testing purposes

Figure 2 shows the topic areas by study session When you compare Figure 2 to

Figure 1, the topic area weights in Figure 1 might appear a little confusing You might

have noticed that in Figure 2, Study Session 7 is titled Economic Concepts for Asset Valuation in Portfolio Management Then, you see that the weight for Economics in

Figure 1 is zero As explained to me by a representative of CFA Institute, this is because Economics is tested as part of Portfolio Management In fact, Study Sessions 3 through

18 all fall under the umbrella of Portfolio Management Just how the individual topics

will be combined and tested is somewhat of an unknown, so your focus is exactly the same as that for prior years’ candidates—you must learn the entire Level 3 curriculum

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Figure 2: 2010 Level 3 Topic Areas by Study Session Study Senin Topic Area Tisle 1 Ethics and Standards Ị Code of Ethics and Professional Standards 2 Ethics and Standards | Ethical and Professional Standards in Practice

3._| Portfolio Management | Behavioral Finance

| 4 | Portfolio Management | Private Wealth Management

Porcfolio Management | Portfolio Management for Institutional Investors | 6 | Portfolio Management | Capital Market Expectations in Portfolio Management

7 | Porefolio Management | Economic Concepts for Asset Valuation in Portfolio Management 8 | Portfolio Management | Asser Allocation

9 | Portfolio Management | Management of Passive and Active Fixed Income Portfolios 10 | Portfolio Management | Portfolio Management of Global Bonds and Fixed Income Derivatives 11 } Portfolio Management | Equity Portfolio Management | 12 | Portfolio Management | Equity Portfolio Management 13 | Portfolio Management | Alternative Investments for Portfolio Management 14 | Portfolio Management | Risk Management 15 | Portfolio Management | Risk Management Applications of Derivatives 16 | Portfolio Management | Execution ef Portfolio Decisions; Monitoring and Rebalancing 17 | Portfolio Management | Performance Evaluation and Attribution 18 | Portfolio Management | Global Investment Performance Standards

Do not underestimate Level 3 A long-standing rumor is that Level 2 has the hardest curriculum and exam, and Level 3 has the most enjoyable curriculum—it’s almost easy reading However, this does not mean you should take the Level 3 exam lightly At levels 1 and 2, all you had to do was search your mental data base for the answer At Level 3, you must know the entire curriculum well enough to integrate the topics

and construct an answer In other words, the vast proportion of your exam will require thinking and piecing together what you know

Write effective answers to the essay questions To be effective, the answer must be concise, yet fully address the question: CFA Institute’s guidelineanswers for old exam

questions ate “petfectlanswers” (i.e), th® one yOu Would write ifyou had endughxime)/

Also CFA Institute typicallyygives you much more answer space.on the exam than you need You should not feel that you are expected to fill all the answer space provided Your responses should be concise yet complete and most importantly, address the command

words This way, there can be no doubt that you are addressing the question

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thought, either yours or theirs! That is, they are not allowed to read anything into your

answer, so you must write exactly what you want to say Also, organize your work and think before you write If the graders can’t find or decipher your work, you will receive

no credit Also d, be sure to use the late fo answer if one is provided

For the Exam answers To help make these exams a true learning experience, there are

two answers for every constructed response essay question The first answer is labeled For the Exam These short, to-the-point answers would be awarded full credit on the exam

The second answer is labeled Discussion This is more of an explanation of the concept, which should help you fully understand why you were correct or incorrect

Be prepared It should go without saying that you should get plenty of sleep the night before the exam Bring all necessary items (including food) with you, and arrive early

enough at the test site to get a decent parking space and a seat in the exam room that feels “right” to you In fact, I recommend thoroughly checking out the site before exam day Important! Be sure to read the CFA Institute guidelines for test day, which can be

found on the CFA Institute Web site Also, remember to answer every question, even if it means guessing Graders can only award points; they cannot deduct points for wrong

answers

My thanks to the Schweser Level 3 team I would like to thank all of my colleagues at

Schweser, especially my content specialist Kurt Schuldes, CFA; Kristen Hutchins, Lead

Editor; Jessica Benrud, Editorial Assistant; and Julie Welscher, Lead Editor for their

incredible work ethic and commitment to quality Schweser would net be the company itis, nor could we provide the quality products you see, without ail the Schweser content

and editing professionals Best regards,

Bruce Kallman

Dr Bruce Kuhlman, Ph.D., CFA, CAIA

VP and Level 3 Manager

Kaplan Schweser

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2010 PRACTICE EXAM ANSWERS AND EXPLANATIONS ARE ONLINE AT WWW.SCHWESER.COM

Answers and explanations for self-grading all practice exam essays and item sets are included at the end of this book Explanations and calculations for the item sets are also available online at schweser.com They also contain embedded links to supporting curriculum material for the relevant Learning Outcome Statements In addition, you can access Performance Tracker, a tool that will provide you with exam diagnostics to target your review effort and allow you to compare your scores to those of other candidates

USE YOUR SCHWESER ONLINE ACCESS ACCOUNT

You should have received an email with login information for Online Access This is your login to view “What Every Level 3 Candidate Should Know” and volumes in the Schweser Library, to use the Schweser Study Planner and Performance Tracker, and (if you purchased any package) to get your questions answered during Instructor-Led Office Hours Simply log in at www.schweser.com and select Online Access to use any of these features You can access practice exam answers and explanations with the Practice Exams Vol 2 left-hand ment item Ifyou need password help, go to www.schweser.com/password or use the

Password Help link that appears if your login is unsuccessful

PRACTICE EXAM ONLINE FEATURES AT A GLANCE

Answer Explanations

Our answer format contains explanations to help you understand why one answer is the best of all the choices When using Performance Tracker, you can choose to get detailed explanations for only those item set questions you missed or for ail item set questions Links to Curriculum

Within the answer explanations, we have embedded links to the relevant content for review This can include multiple Learning Outcome Statements, concepts, definitions, or formulas

Exam Diagnostics

When you access Performance Tracker, you can request a breakdown of your overall score on the afternoon session of any exam You can even get the LOS references for questions you answered incorrectly to facilitate your review efforts

Performance Comparison

Log in today and enjoy the benefits of the Schweser Library, Office Hours", the Schweser Study Planner, expanded Practi¢e Exam item set answers, and /Pétformance Tracker, “Included with either the Essential or Premiam Solution

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PRACTICE EXAM {1 SCORE SHEET MORNING SESSION AFTERNOON SESSION | T T

7 Maximum | Your Approximate : Maximum | Your Approximate

Question Points Score Question Points Score 1A 4 13 18 1B 3 | 14 18 2A 6 | 1 18 2B 2 ] | r 16 18 1 2C 2 | 17 18 16 [ag | as 4 9 19 18 5A 9 20 18 5B 6 | 21 18 i 6A 6 | 2 18 6B 4 | Total 180 | 6C 6 6D 9 7A 6 7B 2

BA 19 Certain Passing Score: 252 of 360 (70%)

m 2 Probable Passing Score: 234

8C 9 Please note that we write these exams to be

9A 6 as representative of Level 3 exam questions

as possible However, due to the relaxed

3B 6 conditions that most candidates apply when

9C 2 they “take” these exams (i.e., “I’m getting a

little tired, I think I'll go to the refrigerator

104 2 and get a snack”), you should adjust your score

10B 3 downward by 10-15% to get a more accurate

10C 3 measure of the score you would have received

on exam day Also, you must be honest with

10D 4 yourself for your score on this exam to have

1A 9 any meaning Don't assume, for example,

that ifyour answer is close, the graders will be:

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PRACTICE Exam 1 MORNING SESSION

Questions 1, 2, and 3 relate to Joe and Sara Finnegan A total of 43 minutes is allocated to these questions Candidates should answer these questions in the order presented

Joe and Sara Finnegan are both 62 years old and live in Kerrvilie, Texas They are retired and have a combined investable net worth of $2 million, the bulk of which was inherited from Sara’s father’s estate Included in their total wealth is Joe’s $500,000 defined-contribution retirement plan that is managed separately in a 401(k) retirement plan Joe makes the investment decisions

for his 401(k) plan, but Sara makes the investmént decisions for their other

portfolio Joe will not begin withdrawing funds from his retirement plan until

he reaches age 70

The Finnegans have no children, but they have agreed to pay the nursing home expenses for Joe’s 86-year-old father, who is in very poor health These expenses are projected to be $130,000 per year, and are expected to last for at least three years The Finnegans home in Kerrville is valued at $750,000 The Finnegans do not have a mortgage on their home They enjoy traveling around the world and project living expenses to total $115,000 per year The Finnegans’ entire income is generated from their portfolio and is taxed at 15% The Finnegans would like to exclude inflation from any and all projections related to their account, so that they can evaluate their position based on current dollar amounts

Mr Finnegan’s 401(k) plan is administered by a loca] bank trust department The trust department offers its clients a range of portfolio allocations from aggressive to conservative as shown in Exhibit 1 Without regard for asset class characteristics or his own risk and return objectives, Mr Finnegan has

selected a portfolio that is equally weighted in each asset class and instructed his trust manager to rebalance the portfolio at the end of each year to maintain the equal weighting Mr Finnegansis concerned about.potential losses in his accountibutprefers not to make any investment @ecisions beyond maintaining his initial allocation

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Exhibit 1: Alternative Portfolios

Current Aggressive Conservative

Asset Class Yield Asset Mix Asset Mix

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QUESTION 1 HAS TWO PARTS FOR A TOTAL OF 7 MINUTES

A Identify and explain two behavioral characteristics that are evident in Joe Finnegan’s allocation of his 401(k) retirement account

(4 minutes)

B Based solely on the way in which he designed his 401(k) investment portfolio, select the investor personality type most likely exhibited by Joe and justify your selection with two reasons

(3 minutes)

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Morning Session

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QUESTION 2 HAS THREE PARTS FOR A TOTAL OF 20 MINUTES

The local bank trust department also custodies the Finnegans’ taxable $1.5 million inheritance account, but for this account Sara Finnegan directs all the trades Sara expresses her social priorities through her financial investments She deliberately excludes tobacco, defense, oil and gas, and chemical

companies from her universe of potential investments and she is obsessed with tax minimization Sara’s portfolio allocation is shown in Exhibit 2

Exhibit 2: Finnegan’s Portfolio 7 a ¬ | Expected | Expected

Investments Weight & ost Current Curren ự Capital Standard asts rice \ Appreciation | Deviation Cash [1% | 10% | 0% 1% mm _ 1 [Fond Bond | 50% 12.401 81240 Ì 5.0% x.= 5% 7 - T 1 Domestic Equity | yo, ' 18.501 s22.00! 4,0 | - 12% 13% Income ị i | Ị | Individual domestic | I | | stocks: | { Solar Power | 7% $10.00 | $35.00 | 0.0% 35% 40% _| Biotech Inc T7% $30.00] $13.00 | 0.0% 30% 36% | The Drug | 0, 9 9 | Company 7% $73.00 | $80.00 | 2.0% ị 20% 28% | Chip Design 71% $58.00 | $20.00 | 1.0% | 22% 22% | Conglomerate Inc 7% $28.00 | $70.00 | 4.0% 10% 13% [ { International Stock Fund 10% „ $14.00 | $30.00 | 3.0% | ° 8% 6 18%

Sara is also passionate about animals Her activism has led the Finnegans to become involved with the Spay Neuter Action Project (SNAP), and it is their intention to bequest the stock of Conglomerate Inc to the organization

They also hope to use the growth in the portfolio’s assets to make additional contributions of similar size as often as possible

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A From the information provided, indicate one item that would affect Sara’s

ability to tolerate risk and one item that would affect her willingness to

tolerate risk and explain each with one reason

Answer Question 2A in the template provided

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Morning Session

B In the template provided, formulate the constraints portion of an investment policy statement for Sara, addressing each of the following

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Exam | Morning Session

Describe the tax consequences if the Finnegans make an immediate

charitable bequest of their Conglomerate Inc holdings to SNAP

i Determine how the Finnegans will most likely be allowed to value the donation

ii, Determine how the donation would most likely be treated on their personal federal tax return

(2 minutes)

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QUESTION 3 HAS ONE PART FORA TOTAL OF 16 MINUTES

Using the data provided in Question 2, Exhibit 2, recommend the most appropriate asset allocation adjustmenis for the Finnegans’ $1.5 million portfolio to meet their goal of funding charities and Joe’s father’s nursing home care Sara has indicated that she does not want to alter her current allocation to the international stock fund Indicate how the allocation to each asset class listed below should be changed from the current allocation, and justify your responses Your answer should address the risk-adjusted returns of the non-cash asset categories

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QUESTION 4 HAS ONE PART FORA TOTAL OF 9 MINUTES

Martina Edwards is retiring and stepping down from her position as portfolio

manager at the Huron Foundation, which funds undergraduate and graduate

environmental science research She is currently training her replacement, Greg Matlock, who previously worked as the portfolio manager for the defined benefit pension plan of a large corporation

During training, Edwards tries to relate the role of a foundation portfolio manager to the role of a portfolio manager for a defined benefit pension plan by making the following statements:

“The objectives and constraints for defined benefit pension plans and foundations are very similar Since, unless specifically directed otherwise,

the lives of both are infinite, for example, their primary return objective is

to cover the effects of inflation and thereby preserve the purchasing power

of the investment portfolio.”

“Huron Foundation does not need to be concerned about the correlation between the plan sponsor financial performance and performance of the portfolio For defined benefit plans, however, this is a significant concern.” “Payouts are typically based on the quality of the funding applications and proposals received each year, so Huron’s liquidity needs tend to fluctuate over time Since they are based on reasonably easily determined pension obligations, however, the liquidity needs of defined benefit pension plans

do not fluctuate.”

Determine whether you agree or disagree with each statement made by Edwards }f you disagree, support your decision with one reason related to portfolio management Note supporting your opinion by simply reversing an

incorrect statement will receive no credit

Answer Question 4 in the template provided

(9 minutes)

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Morning Session Page 20 Template for Question 4 Determine

whether you agree| If you disagree, support

Statement or disagree with your opinion with one

made by Edwards each statement (circle one)

reason related to portfolio management

“The objectives and

constraints for defined benefit pension plans and foundations are very similar Since, unless

specifically directed otherwise,

the lives of both are infinite, for example, their primary return objective is to cover the effects of inflation and thereby preserve the purchasing power of the investment portfolio.”

Agree Disagree

“Huron Foundation does not need to be concerned about the correlation between the plan sponsor financial performance and performance of the portfolio For defined benefit plans, however, this is | a significant concern.”

Agree Disagree

“Payouts are typically based on the quality of the funding applications and proposals

received each year, so Huron’s liquidity needs tend to fluctuate over time Since they are based on reasonably easily determined pension obligations, however, the liquidity needs of defined benefit pension plans do not

| fluctuate.” |

Agree

Disagree

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Exam 1 Morning Session

QUESTION 5 HAS TWO PARTS FORA TOTAL OF 15 MINUTES

Jacque Claude is an analyst for Lafayette Portfolio Managers, a French firm

Lafayette provides investment advice regarding stocks and bonds for wealthy

individuals Claude is discussing the characteristics of international investments

before a group of clients, during which he makes the following comments:

“Although withholding taxes are frequently assessed by foreign governments on dividends and interest, the presence of domestic tax credits means that they are no longer a significant obstacle to international investing.”

“T would recommend that the return on a stock be compared to global sector benchmarks, because industry factors have increased in importance for explaining stock returns In fact, I believe that diversifying across borders is no ionger necessary as long as the investor has adequate industry

representation.”

“Differing governmental monetary and fiscal policies cause bond market correlations to be low, often lower than that between equity markets Asa result, adding global bonds to global equity portfolios can improve

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Morning Session Page 22 Template for Question 5A Comment Correct or incorrect? (circle one) Explanation, if incorrect “Although withholding taxes are frequently assessed by foreign governments on

dividends and interest, the presence of domestic tax credits means that they are no longer a significant obstacle to international investing.” Correct Incorrect

“I would recommend that the return on a stock be compared to global sector benchmarks because industry factors have increased in importance for explaining stock returns In fact, I believe that diversifying across borders is no longer ‘necessary as long as the

‘investor has adequate industry representation.” Correct Incorrect “Differing governmental monetary and fiscal policies cause bond market correlations to be low, often lower than that between global equity markets As a

result, adding global bonds to global equity portfolios can improve the performance ofa

global efficient frontier,

especially for lower risk | portfolios.”

Correct Incorrect

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Claude is examining the risk and returns for an investment in a Japanese stock and has collected the following statistics

+ The return on the stock in yen was 12%

+ The yen has appreciated by 5% relative to the euro * The standard deviation of stock returns was 29%

+ The standard deviation of the yen-euro exchange rate was 14% + _ The correlation between the stock returns and the yen is 0.30

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Morning Session

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QUESTION 6 HAS FOUR PARTS FOR A TOTAL OF 25 MINUTES

In 1955, David Peebles, founder of the successful California-based Peebles

Winery, established the Tokay Endowment to fund research on producing globally

competitive California wine grapes Since Peebles’s initial contribution of $1 million, the fund has grown to its $75 million current value

Peebles’s grandson, Vincent Scavuzzo, a graduate of a globally recognized private

business school and holder of the CFA Charter, was recently given responsibility for managing the endowment’s portfolio He believes the endowment’s asset mix,

currently 60% equities ($45 million) and 40% bonds ($30 million), needs to be updated to include alternative investments He has gathered the historical data

in Exhibits 1 and 2 on the Tokay portfolio, managed futures, hedge funds, and buyout funds (a furm of private equity) He is suggesting the fund invest 10% of total assets in managed futures by selling a portion of the bonds held

Exhibit 1: Returns and Standard Deviation for the Most Recent 10-Year Period Annualized Return Standard Deviation Tokay equities 9.8% 14.9% Tokay bonds 6.9% 4.3% Buyout funds 13.9% 15.2% Hedge funds 14.6% 10.1% Managed futures 12.5% 11.9% Risk-free asset 3.0% — Exhibit 2: Correlations for the Most Recent 10-Year Period

Tokay Tokay Buyout Hedge Managed

Equities Bonds Funds Funds Futures Tokay equities 1.00 Tokay bonds 0.37 1.00 Buyout funds 0.86 0.28 1.00 Hedge funds 0.85 0.10 0.45 1.00 Managed futures -0.12 0.10 -0.04 ~0.14 1.00

Mario Rudd, a'trusted friend and financial analyst, offers Scavuzzo some advice: “I agree that adding alternatives to your portfolio will improve its return performance from a risk-adjusted perspective If 1 was making the decision,

however, I would invest in hedge funds instead of managed futures Their

historical Sharpe ratios have been consistently higher than those of managed futures.”

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A In the template provided, discuss six major due diligence criteria that the

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Morning Session

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B Using the data in Exhibits 1 and 2, determine whether you agree with

Rudd’s recommendation and support your decision with one reason

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Morning Session

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Tom Amato is an analyst for Orthogonal Research and specializes in commodities markets Amato is discussing the pricing of commodities in the spot and futures

markets and makes the following comments:

“To derive the futures contract price using the cost of carry model, an

investor would add the periodic financing and storage costs to the spot

rate For assets that have a convenience yield, the convenience yield would then be subtracted to obtain the no arbitrage price for a futures contract.” “The financing and storage costs for corn are substantial and can be greater

than the convenience yield, and futures contracts save the investor the

cost of holding spot corn Therefore, considering both long term contracts of two to three years as well as short term contracts of a few months, the futures price curve will be continually upward sloping.”

A State whether or not each of these comments is correct If incorrect, explain why Answer Questien 7A in the template provided (6 minutes) Amato is examining the following futures prices for crude oil, gasoline, and heating oil

One-month crude oil futures price $70.29 per barrel! Two-month gasoline futures price $1.7500 per gallon

Two-month heating oil futures price $1.8200 per gallon

'There are 42 gallons of crude oil in a barrel

B Calculate the value of a 5-3-2 crack spread (2 minutes)

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Template for Question 7A Comment Is the statement correct or incorrect? (circle one) If incorrect, explain why

“To derive the futures contract price using the

cost of carry model,

an investor would add

the periodic financing and storage costs to the spot rate From this, the convenience yield would be subtracted to obtain the no arbitrage price for a

futures contract.”

Correct

Incorrect

“The financing and

storage costs for corn are

substantial and are greater than the convenience yield Futures contracts

save the investor the

costs of holding the spot Therefore, using short-

term contracts of a few

months to long-term

contracts of two to three years, the futures price

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Morning Session

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QUESTION 8 HAS THREE PARTS FOR A TOTAL OF 32 MINUTES

Johan and Andrea Kraus are both 85 years old Their current annual spending rate is €125,000, and they anticipate that the real rate of spending will grow at 3% annually Their current portfolio contains €600,000 of cash equivalents, a €300,000 position in a diversified bond fund, and a €300,000 position in a

diversified equity fund

The Krauses have decided that they would like to gift a substantial portion of their wealth, so they are going to meet with financial planner, Jens Schultz, CFA, to update their investment policy statement Schultz has constructed the mortality table in Exhibit | for the Krauses given a three-year planning horizon

Exhibit 1: Mortality Table

Years Johan Andrea

Age | Prob | Age | Prob 86 | 0.8882 | 86 | 0.9171 1 2 87 |0.7645 | 87 | 0.8244 3 §8 | 0.6277] 88 [0.7208

Schultz plans on computing the Kraus’s core capital and excess capital based

on the probabilities in Exhibit 1 He estimates inflation will be 2%, and the real risk-free rate is 4%

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Morning Session

Schultz believes the Krauses have not been taking advantage of available methods to avoid double taxation on their U.S income He has determined that the

appropriate tax rates are 40% in the United States and 45% in Germany Schultz estimates the Krauses will receive income of $60,000 from their U.S assets next year

B In the template provided, indicate the most likely tax jurisdiction claimed on the Krauses’ income by the United States and by Germany (4 minutes) Template for Question 8B Tax Jurisdiction Country (circle one) Source Jurisdiction United States Residence Jurisdiction 1 Source Jurisdiction Germany Residence Jurisdiction

Cc Determine the Kraus’s total income tax liability on the income

received from U.S assets under the credit method, the exemption

method, and the deduction method

Answer Question 8C in the template provided Show your calculations (9 minutes)

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Morning Session

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QUESTION 9 HAS THREE PARTS FOR A TOTAL OF 14 MINUTES Helen Baker, CFA, invests in distressed securities Specifically, she creates an

arbitrage position by shorting the underlying company equity and purchasing a long position in the company’s distressed debt Baker’s strategy is to capitalize

on her knowledge of, and patience for, particular situations To this end, she takes

advantage of creditors who want to liquidate securities of companies that are in

or near bankruptcy In addition, Baker exploits the fact that distressed companies

lack adequate research coverage Baker buys the distressed debt for 50 cents or less on the dollar

A i, Explain the distressed debt arbitrage strategy most likely utilized by Baker

ii Assuming the company’s prospects improve, explain how the strategy

will perform with respect to prices of the stocks and bonds as well as

coupon interest and dividends paid and/or received (6 minutes)

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B Describe the following three sources of risk in distressed debt investing, and comment on the relative importance of each

i Event risk

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Morning Session

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Heather Ramberg, a consultant to the board of directors of Reins Foundation

has been asked to analyze and recommend an asset allocation for Reins

Ramberg has read Reins’s investment policy statement and found the

following information: Return objective: 8.5%

Risk objective: Maximum standard deviation 10%

To analyze the appropriate asset allocation, Ramberg produced data on the 5 corner portfolios shown in Exhibit 1

Exhibit 1: Data on Five Corner Portfolios Ị Expected [ Portfolio Weights, in % | + Expected

Corner Return Standard| Sharpe us Foreien | Global US Portfolio} (%) Deviation, Ratio 8 “ Fonte , B 4Ì Rea]

A Select the two adjacent corner portfolios to be used in finding the most appropriate strategic asset allocation for Reins’s portfolio, assuming that short selling or other borrowing (margin) is not allowed

(2 minutes)

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B

Determine the most appropriate combination (percentage weights of the final combination) of the two corner portfolios selected in Part A

@ minutes)

Assuming the two corner portfolios have been combined according to the weights in Part B, determine the percentage of the final combination that will be invested in foreign equities

(3 minutes)

Using data from Exhibit 1 and assuming that short selling (leverage) is permitted: (1) determine which comer portfolio or portfolios would most likely be selected and provide one reason to support your selection; and (2) describe, without calculations, the most likely

portfolio allocation (i.e., weights of the assets that are combined)

(4 minutes)

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Morning Session

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Nick Richards is a pension consultant and is asked to evaluate the following

portfolios:

Portfolio 1 is highly concentrated, with five stocks representing 75% of the total portfolio

Portfolio 2 is highly diversified with over 400 stocks, none of which

represents more than 1% of the total portfolio

Portfolio 3 is a diversified portfolio of 70 stocks, with the top ten names

representing 30% of the total portfolio

The following investment results were recorded during 2008: A Portfolio 1 Portfolio 2 Portfolio 3 S&P 500 Retum 42.0% 25.0% 16.0% 20.0% Standard deviation 1.20 0.40 0.20 0.50 Beta 1.80 1.20 0.50 1.00 Risk-free rate: 6%

Compute the Sharpe, Treynor, and Jensen measures for each portfolio

Answer Queétion 11A in the template provided

B

(9 minutes)

Identify which portfolio had the best risk-adjusted performance in 2008 Justify your selection with Avo supporting arguments

(3 minutes)

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“Template for Question 11A

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Page 40

Beaver Dam Lumber (BDL) is one of the largest lumber companies in the

United States, and the Beaver Dam Lumber Defined Benefit Pension Plan (BDLP) currently has a funding surplus Slumping building starts in both the

residential and commercial sectors, however, have led to declining sales In response, BDL has offered early retirement to some employees, and the BDLP

investment committee has decided to restructure the plan’s portfolio more

conservatively

As a result of the early retirement offer, BDLP will have to make lump-sum

payments totaling $20,000,000 over the next year The BDLP investment committee has met and adopted a required return objective for their portfolio

of 8.5% with a minimum acceptable return of -8.0%, coinciding with a Roy’s

Safety First ratio of 2.0

The BDLP investment committee instructs Stephen Shamley, CFA, to evaluate the plan’s $200,090,000 portfolio allocation and recommend changes

Shamley presents the five alternative allocations shown in Exhibit 1 for the committee’s consideration Exhibit 1: Alternative Asset Allocations and Return/Risk Measures ¬ Allocations (%) _| A B Cc D E

Cash & equivalents 5 5 10 4 10

Global fixed income 35 30 30 40 35

Domestic fixed income 15 5 5 20 10

US equities 30 30 30 16 35

| Non-US equities 15 15 3 20 10

Lumber industry equities 0 15 12 0 0

| Risk and Return (%)

Expected total return 8.65 | 9.25 | 9.06 | 8.29 | 9.04 Expected standard deviation 853 8.43 | 8.83 | 8.35 | 8.1 9 |

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