2013 level III sample exam version 1

2013 Level III Sample Exam Version Jacaranda Asset Management Case Scenario Most financial services regulatory bodies in East Africa are moving toward risk-based supervision models Miriam Bukenya, CFA, is the head of compliance at Jacaranda Asset Management, a manager of both retail and institutional portfolios She is currently revising the company's compliance policies to address risk in all areas of the business and is checking different aspects of the firm to ensure that it will be able to meet new risk-based supervision regulations when they become effective in six months' time The firm recently adopted the CFA Institute Code of Ethics and Standards of Professional Conduct as its own Code and Standards While reviewing Jacaranda's compliance manual, Bukenya realizes it needs a few changes to comply with the new risk-based regulations To ensure she uses best practice, she consults with Luc Remmy, CFA, the head of compliance at her former employer, Mercury Advisory Services Remmy, who now runs an independent consulting firm, e-mails Bukenya the compliance manual he uses for his own firm While reviewing the compliance manual, Bukenya notices that many sections look familiar She finds a statement in the document indicating that it is for the "sole use of Mercury Advisory Services." When questioned, Remmy states that he used only the table of contents of Mercury's document and none of the other content in the document to develop his compliance manual Bukenya looks at the marketing materials Jacaranda uses to communicate to existing and prospective clients to ensure that everything mentioned in the material is factual and complies with the CFA Standards of Professional Conduct The following statements are examined: Statement 1: Jacaranda looks for investments offering intrinsic value through a topdown approach including a review of forecasts of economic and industry performance We evaluate historical and projected company financials, perform extensive financial ratio analysis, conduct management interviews, and determine target prices using a variety of valuation models Statement 2: Jacaranda may, at times, hire outside advisers to manage real estate holdings on behalf of clients These advisers have the necessary expertise to manage property assets Statement 3: Jacaranda has four CFA charterholders among its senior management Their participation in the CFA examination program has enhanced their investment management skills All of these managers passed the three exams in the shortest time possible The new risk-based regulations also require accurate and complete performance presentations, with all discretionary accounts included in at least one composite Bukenya believes Jacaranda's performance presentation policy meets these new requirements as well as the CFA Institute Code of Ethics and Standards of Professional Conduct since Jacaranda's single composite includes all current and terminated client accounts and presentations include this statement: "Detailed information regarding the performance presentation is available upon request." While Jacaranda does not currently comply with GIPS Standards, she encourages the firm to so within the next few years Bukenya then reviews Jacaranda's record-keeping policy Currently, the policy requires retention of hard copies of all supporting documentation for investment recommendations and decisions made during the last five years This policy meets the new risk-based regulations Client meeting minutes and communication logs are kept electronically and backed up on a remote server Fund managers and research analysts are responsible for maintaining their own personal notes and research models This policy also applies to Jacaranda's independent research contractor, Mathew Ochieng, who (for security reasons) does not have access to the company's server Ochieng, who undertakes research only for Jacaranda, sends his research reports to the Head of Research, who then archives the electronic copies While reviewing Jacaranda's counterparty risk policy, Bukenya discovers that trader Jackson Gatera recently convinced the back office to override controls designed to prevent overexposure to specific stockbrokers This was in violation of company rules The rules state that if the trading allocation to a specific broker is breached, trading through that broker must be suspended until the exposure drops to within the exposure limits The Counterparty Risk Committee predetermines these limits The new risk-based regulations also require companies to gather client information as part of "Know Your Client" and anti-money-laundering processes Bukenya creates a confidentiality policy restricting access to existing and prospective client information The information is available only to personnel who are authorized by the existing or prospective client The one exception is if the client or prospective client is thought to be conducting illegal activities In this circumstance, the information can be released without authorization if the information is demanded through a court order or other legal requirement Which of the following CFA Institute Standards of Professional Conduct did Remmy least likely violate? A Loyalty B Misrepresentation C Responsibilities of Supervisors Which marketing statement should Bukenya most likely revise to conform to the CFA Institute Code of Ethics and Standards of Professional Conduct? A Statement B Statement C Statement 3 Does Jacaranda's performance presentation policy most likely meet recommended procedures for complying with CFA Institute Code of Ethics and Standards of Professional Conduct? A Yes B No, because of the structure of the composite C No, because it is not in compliance with GIPS standards Jacaranda's record-keeping policy is most likely in violation of CFA Institute Standard V (C) Record Retention regarding the: A retention time frame B keeping of hard and electronic copies C retention of personal notes and research models 5 In response to Gatera's actions, Bukenya should least likely recommend which of the following actions to prevent violations of the CFA Institute Code of Ethics and Standards of Professional Conduct? A Investigate further B Increase supervision of Gatera C Report Gatera to CFA Institute Does Bukenya's confidentiality policy most likely violate CFA Institute Standard III (E) Preservation of Confidentiality? A No B Yes, regarding client status C Yes, regarding type of information Ptolemy Foundation Case Scenario The Ptolemy Foundation was established to provide financial assistance for research and education in the field of astronomy Tom Fiske, the foundation's chief investment officer, and his staff of three analysts employ a top-down process that begins with an economic forecast, assignment of asset class weights, and select ion of appropriate index funds The team meets once a week to discuss a variety of topics ranging from economic modeling to economic outlook, portfolio performance, and investment opportunities, including those in emerging markets At the start of the meeting, Fiske ash the analyst s, Len Tuoc, Kim Spenser, and Pier Poulsen, to describe and justify their different approaches to economic forecasting They reply: Tuoc: "I prefer econometric modeling Robust models built with detailed regression analysis can help predict recessions well because the established relationships among the variables seldom change." Spenser: "I like the economic indicators approach For example, the composite of leading economic indicators is based upon an analysis of its forecasting usefulness in past cycles They are intuitive, simple to construct, require only a limited number of variables, and third-party versions are also available." Poulsen: "The checklist approach is my choice This straightforward approach considers the widest range of data Using simple statistical methods like time-series analysis, an analyst can quickly assess which measures are extreme This approach relies less on subjectivity and is less timeconsuming." The team then discusses what the long-term growth path for U.S GDP should be in the aftermath of exogenous shocks due to the financial crises that began in 2008 They examine several reports from outside sources and develop a consensus view of 10year annual growth expectations for the items in Exhibit After a review of the portfolio and his discussion with the investment team, Fiske determines a need to increase U.S large-cap equities He prefers to forecast the average annual return for U.S large-cap equities over the next 10 years using the Grinold-Kroner model and the data in Exhibit The analysts think that adding to U.S Treasuries would fit portfolio objectives but they are concerned that the Federal Reserve is likely to raise the feel funds rate soon They assemble the data in Exhibit in order to use the Taylor rule to help predict the Fed's next move with respect to interest rates To assess the attractiveness of emerging market equities, Fiske suggests that they use the data in Exhibit and determine the expected return of small-cap emerging market equities using the Singer-Terhaar approach Finally, upon examining the data pertaining to the European equity markets, the investment team believes there are attractive investment opportunities in selected countries Specifically, they compare the recent economic data with long-term average trends in three different countries (Exhibit 5) 7 Regarding the approaches to economic forecasting, the statement by which analyst is most accurate? A Tuoc B Spenser C Poulsen Using the data in Exhibit and the simplest approach to analyze aggregate trend growth for U.S GDP, the most likely estimate for the 10-year annual GDP growth (in %) is: A 3.0 B 3.5 C 3.6 Using the data in Exhibit and Fiske's preferred approach, the estimated expected annual return (in %) for U.S large-cap equities over the next 10 years is closest to: A 5.6 B 7.6 C 8.4 10 Using the data in Exhibit and the investment team's approach to predict the Fed's next move, the new fed funds rate (in %) will most likely be: A 2.1 B 2.6 C 2.9 11 Using the data in Exhibit and Fiske's suggested approach, the forecast of the expected return (in %) for small-cap emerging market equities is closest to: A 8.94 B 9.54 C 9.85 12 Among the three countries examined by the investment team, which is in the most attractive phase of the business cycle for equity returns? A Spain B Ireland C Hungary Sophia Doulton Case Scenario Sophia Doulton, CFA, owns Doulton Investments, LLC, an asset management firm She is preparing for a meeting with Jorge Thompson, a new client At an earlier meeting, Thompson provided information about his current portfolio holdings and the investment policy statement (IPS) created for him by his previous investment adviser Thompson has stated that he is generally happy with the IPS but left the previous adviser because of high fees and poor investment returns He asked Doulton to review the JPS and let him know if changes are warranted Thompson's current IPS includes the strategic asset allocation shown in Exhibit Doulton's long-term and short-term return expectations for each asset class are included The IPS allows for asset allocations that diverge from its strategic allocations based on the following rules and reasoning: Rule 1: The portfolio should always overweight emerging market equities because most long-term forecasts show high expected returns for this asset class relative to the others Rule 2: The asset manager may make tactical allocations to asset classes not included in the strategic asset allocation because the portfolio manager has discretion to pursue excess returns wherever they are available Rule 3: The total allocation to bonds (U.S and non-U.S.) should never be less than 35% because Thompson views the bond allocation as being his retirement portfolio and does not want too much risk taken with that money Doulton is considering two additional asset classes that could be added to Thompson's strategic asset allocation Information about the current portfolio and these two asset classes is found in Exhibit Thompson's previous investment adviser used a single-period mean-variance approach to determine his optimal strategic asset allocation Doulton is concerned about this because most of the portfolio's returns are taxable and are subject to a variety of marginal rates, depending on the type and length of the investment Furthermore, Thompson's income over the next 10 years will likely result in substantial additional contributions to the portfolio Doulton plans to recommend a different approach to optimization for Thompson Thompson does not currently hedge any of the currency risk in his strategic portfolio, which contains a 40% foreign asset exposure He asks Doulton to estimate the impact of currency risk on that part of his portfolio Doulton estimates the standard deviation of Thompson's foreign assets in local currency terms to be 22%, the standard deviation of the exchange rate is 12%, and the correlation between foreign asset returns in local currency and exchange rate movements is 0.4 13 Based on Doulton's return expectations provided in Exhibit 1, she would most likely implement which of these tactical asset allocation adjustments relative to the strategic asset allocations? 14 Which of the asset allocation rules in Thompson's IPS is least appropriate? A Rule B Rule C Rule 15 The tactical asset allocation rules in Thompson's IPS suggest which of these behavioral influences? A Fear of regret B Los aversion C Mental accounting 16 Using the information provided in Exhibits and 2, Doulton should most likely recommend adding which new asset class(es) to Thompson's strategic asset allocation? A New asset class #1 B New asset class #2 C Both new asset classes 17 Which approach to optimization would be most appropriate for Doulton to recommend to Thompson? A Black-Litterman B Monte Carlo simulation C Resampled efficient frontier 18 The contribution of currency risk to the risk of Thompson's foreign assets is closest to: A 1.44% B 3.06% C 6.97% Rioja Case Scenario Andres Rioja is the treasurer of Empresas Crianza His duties have recently been expanded to include oversight of the firm's pension fund Given his limited experience in overseeing investments, he is relying on an outside consultant Rioja prepares a number of questions for his first meeting with the consultant, Manolo Priorat of Consulta Jerez Priorat starts the meeting by summarizing the status of the defined-benefit pension plan to Rioja and makes the following statement: "The pension liability has duration of 14 and a present value of 54 billion The liabilities are discounted using the spot rate on high-quality long-term corporate bonds The existing asset portfolio covers 87.5% of these liabilities and is invested entirely in fixed-income assets The plan assets have fallen short of the pension liabilities over the past five years because their durations are not properly matched I am concerned that Crianza has selected the wrong benchmark for the pension plan The current benchmark is a weighted average of the benchmarks for the various strategies employed in the investment of pension assets I believe the appropriate benchmark should be the liability itself." Priorat and Rioja review the fixed-income funds in which the pension assets are currently invested Portfolio managers have been given the mandate to meet or exceed their respective benchmarks based on their investment styles Details of the various portfolios are provided in Exhibit Rioja updates Priorat on Crianza's current plans for the pension plan Rioja states, "Crianza will make a $500 million contribution to fully fund the plan and invest the funds in Treasury STRIPs In addition, we would like to completely reallocate pension investments away from the fund that presents the greatest contingent claim risk and into the Long Corporate Bond Fund." Rioja then asks Priorat, "I would like to understand the risk profile of each index benchmark we have assigned to the portfolio managers What measures are available to this?" Priorat responds, "There are several key measures that come to mind Effective duration measures the sensitivity of the index's price to a relatively small parallel shift in interest rates For large nonparallel changes in interest rates, a convexity adjustment is used to improve the accuracy of the index's estimated price change Key rate duration measures the effect of shifts in key points along the yield curve Key rate durations are particularly useful for determining the relative attractiveness of various portfolio strategies, such as bullet strategies versus barbell strategies Spread duration describes how a non-Treasury security's price will change as a result of the widening or narrowing of the spread contribution." Rioja then asks about the rationale for active managers to secondary market trades Priorat responds, "Secondary market trades should be evaluated in a total return framework The exception is the yield or spread pickup trade, which should be evaluated in the context of additional yield Credit-upside trades provide an opportunity for managers to capitalize on unexpected upgrades Curve-adjustment trades are yet another example of investors expressing their interest rate views in the credit markets in anticipation of interest rate changes." Finally, Priorat offers further explanation of how active managers can acid value He notes, "Structural analysis of corporate bonds is an important part of active management Credit bullets in conjunct ion with long-end Treasury structures are used in a barbell strategy Callable bonds provide a spread premium that can be valuable to an investor during periods of rising interest rate volatility Put structures will provide investors with some protection in the event interest rates rise sharply but not if the issuer has an unexpected credit event." 19 Is Priorat's statement regarding selecting a benchmark for the pension plan most likely correct? A Yes B No, because the current benchmark is appropriate to measure each strategy's performance C No, because Crianza should select a high-quality, long-term corporate bond index as the benchmark 20 For which portfolio in Exhibit is a sampling approach most likely to be used in an attempt to match the primary index risk factors? A Treasury STRIPs B Mortgage (MBS) Fund C Emerging Market Bond Fund 21 If Rioja rebalances the portfolio as he proposes in his statement to Priorat, the dollar duration of the assets relative to the dollar duration of the liabilities is most likely to: A fall well short B be far exceeded C be nearly matched 22 In Priorat's response to Rioja regarding the explanation of key measures of an index's profile, he is most likely correct regarding: A spread duration and incorrect regarding effective duration B key rate duration and incorrect regarding convexity adjustment C convexity adjustment and incorrect regarding key rate duration 23 Regarding evaluating secondary market trades, Priorat is least likely correct with respect to: A Credit-up side trades B Curve-adjustment trades C Yield/spread pickup trades 24 Priorat is most likely correct regarding which structural trade? A Bullets B Putables C Callables Apollo Bank Case Scenario Apollo Bank and Mercury Bank are commercial banking institutions considering a merger The head of Apollo's risk committee, Alan Armstrong, is meeting with Mercury's CEO, Neil Shephard, to discuss risk management practices for their respective firms and for the prospective merged firm Shephard shares Mercury's risk management philosophy: "We think risk management is an ongoing process We follow a conservative management style, and in all of our businesses, our risk policy is to adjust risk levels so that risk exposures remain within certain ranges Our risk governance entails a firmwide, enterprise risk management approach where risk factors are considered both in isolation and in relation to each other." Shephard continues with a discussion of the portfolio's sources of risk: "For example, our investment portfolio includes publicly traded large-cap and small-cap domestic stocks and global bonds Our bonds are denominated in various currencies and have both fixed and floating rates We use over-the-counter derivatives to hedge risk related to interest rates, foreign currency, adverse security price movements, and payment default." Shephard asks Armstrong to describe how Apollo manages credit exposure related to its over-the-counter derivatives activity Armstrong makes the following comments: Comment 1: Swap, option, and forward payments are netted Each of these derivatives has bilateral credit risk Comment 2: Market value updates received from counterparties are used to measure credit risk Comment 3: Cross-default provisions are negotiated into all agreements to reduce credit risk Shephard turns his attention to the loan portfolio He asks Armstrong, "To which industries does Apollo have substantial loan exposure?" Armstrong indicates Apollo has three industry-specific lending units and shows him the data contained in Exhibit Armstrong then states, "At Apollo, in addition to VAR, we use an additional risk measure that is an extension of VAR This supplemental metric provides a measure of our expected loss in excess of VAR." Armstrong concludes the discussion by commenting, "Ultimately, our success as a merged company will depend, in part, on measuring the total amount of risk we are taking Within our risk management framework, we can use scenario analysis to estimate total losses under normal market conditions and then stress our models to estimate total losses under extreme market conditions.t 25 Is Mercury's risk management philosophy likely consistent with the practical application of the process of risk management? A Yes B No, because of Mercury’s risk policy C No, because of Mercury’s risk governance 26 Mercury's investment portfolio most likely has the greatest net exposure to which source of risk: A credit risk B market risk C liquidity risk 27 Which of Armstrong's comments regarding Apollo's credit management for its over-the-counter derivatives activity is least likely correct? A Comment B Comment C Comment 28 Based on the information in Exhibit and assuming Mercury uses the Analytical Method for calculating value at risk, which of Mercury's industryspecific lending units most likely has the lowest annual VAR? A Energy B Technology C Media & Entertainment 29 Which extension of VAR is most likely used by Apollo? A Cash flow at risk B Tail value at risk C Incremental value at risk 30 Are Armstrong's concluding comments about measuring total risk most likely correct? A Yes B No, because he is incorrect about stressing models C No, because he is incorrect about scenario analysis  ... to predict the Fed''s next move, the new fed funds rate (in %) will most likely be: A 2 .1 B 2.6 C 2.9 11 Using the data in Exhibit and Fiske''s suggested approach, the forecast of the expected... exchange rate is 12 %, and the correlation between foreign asset returns in local currency and exchange rate movements is 0.4 13 Based on Doulton''s return expectations provided in Exhibit 1, she would... Black-Litterman B Monte Carlo simulation C Resampled efficient frontier 18 The contribution of currency risk to the risk of Thompson''s foreign assets is closest to: A 1. 44% B 3.06% C 6.97% Rioja Case Scenario