L3 mock sample exam CFA level III essay questions 1999

Cases in Portfolio Management Session 22 • create a formal investment policy statement for an investor.. Question 1, including Guideline Answer, 1996 CFA Level III Examination AIMR Purpo

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Level III: Question 1

Topic: Individual Investor Policy Statements

Reading References:

1 “Individual Investors,” Ch 3, Ronald W Kaiser, Managing Investment Portfolios: A

Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham

and Lamont, 1990)

2 Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd, (AIMR, 1990)

3 Questions 1 and 2, including Guideline Answers, 1995 Level III Examination (AIMR)

Purpose:

To test the candidate’s ability to develop a long-term investment policy statement for a family withchanging resources and return needs over time Specific tax and unique circumstances are includedfor consideration

LOS: The candidate should be able to

“Individual Investors” (Session 13)

• analyze the objectives and constraints of a particular individual investor and use the investor’spsychological characteristics, position in the life-cycle, long-term goals and particular

constraints (such as liquidity, taxes, gifts and estate planning) to formulate appropriate

investment policies for the investor;

• create a set of portfolio policies that is based on a multi-asset, total return approach to individualinvesting

Cases in Portfolio Management (Session 22)

• create a formal investment policy statement for an investor

1995 CFA Level III Examination (Session 22)

• prepare an investment policy statement that clearly states the investment objectives and

i Return Objective The Muellers’ return objective should be a total return approach that is a

combination of capital appreciation and capital preservation After retirement, they will needapproximately $75,000 (adjusted for inflation) annually to maintain their current standard ofliving Given their limited needs and asset base, preserving their financial position on an

inflation-adjusted basis may be a sufficient objective However, their long life expectancy andundetermined retirement needs lead to the likely need for some growth of assets over time, atleast to counter any effects of inflation

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Although the Muellers wish to exclude the future trust distribution from their current planning,that distribution will substantially increase their capital base and dramatically alter the returnobjective of their future investment policy statement, primarily by reducing their needed returnlevel.

ii Risk Tolerance The Muellers are in the middle stage of their investor life cycle Their

relationship of income to expenses, total financial resources, and long time horizon give themthe ability to assume at least an average, if not an above average, level of risk in their

investments However, their stated preference of “minimal volatility” investments apparentlyindicates a below average willingness to assume risk The large realized losses incurred inprevious investments may be a contributing factor to their desire for safety Also, their need forcontinuing cash outflow to meet their daughter’s college expenses may temporarily and slightlyreduce their ability to take risk

Two other issues affect the Muellers’ ability to take risk First, the holding of Andrea’s companystock represents a large percentage of the Muellers’ total investable assets and thus is an

important risk factor for their portfolio Reducing the size of this holding or otherwise reducingthe risk associated with a single large holding should be a priority for the Muellers Second, thefuture trust distribution will substantially increase their capital base and therefore increase theirability to assume risk However, the larger capital base would reduce their need for higherreturns, and the corresponding higher risk levels

Constraints:

iii Time Horizon Overall, the Mueller’s ages and long life expectancies indicate a long time

horizon However, they face a multi-stage time horizon because of their changing cash flow andresource circumstances Their time horizon can be viewed as three distinct stages: the next fiveyears (some assets, negative cash flow because of their daughter’s college expenses), the

following five years (some assets, positive cash flow), and beyond ten years (increased assetsfrom a sizable trust distribution, decreased income because they plan to retire)

iv Liquidity The Muellers need both immediate liquidity and ongoing funds over the next five

years They need to have $50,000 available now for the contribution to the college’s endowmentfund Alternatively, they may be able to contribute $50,000 of Andrea’s low cost basis stock tomeet the endowment obligation In addition, they expect the regular annual college expenses toexceed their normal annual savings (combined incomes minus usual living expenses) by

approximately $15,000 for each of the next five years This relatively low cash flow

requirement of 2.7 percent ($15,000/$550,000 asset base after $50,000 contribution) can besubstantially met through income generation from their portfolio, further reducing the need forsizable cash reserves Once their daughter has completed college, their liquidity needs should beminimal until retirement because their income more than adequately covers their living

expenses

v Taxes The Muellers are subject to a 30 percent marginal tax rate for ordinary income and a 20

percent rate for realized capital gains The difference in the rates makes investment returns inthe form of capital gains preferable to equivalent amounts of taxable dividends and interest

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While taxes on capital gains would normally be a concern to investors with low cost basis stock,this is not a major concern for the Muellers because they have a tax loss carry forward of

$100,000 The Muellers can offset up to $100,000 in realized gains with the available tax losscarry forward without experiencing any cash outflow or any reduction in asset base

vi Unique Circumstances The large holding of the low-basis stock in Andrea’s company, a

“technology firm with a highly uncertain future,” is a key factor to be included in the evaluation

of the risk level of the Mueller’s portfolio and the future management of their assets In

particular, the family should systematically reduce the size of the investment in this single stock.Because of the existence of the tax loss carry forward, the stock position can be reduced by atleast 50 percent (perhaps more depending on the exact cost basis of the stock) without reducingthe asset base to pay a tax obligation

In addition, the trust distribution in 10 years presents special circumstances for the Muellers,although they prefer to ignore these future assets in their current planning The trust will providesignificant assets to help meet their long term return needs and objectives Any long-term

investment policy for the family must consider this circumstance and any recommended

investment strategy will need to be adjusted before the distribution takes place

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Topic: Investment Policy Statements

Reading references:

1 “Developing an Investment Policy Statement,” including Appendix, Ch 5, The Management

of Investment Decisions, Donald B Trone, William R Allbright and Phillip R Taylor

LOS: The candidate should be able to:

“Developing an Investment Policy Statement” (Session 12)

• explain why creating an investment policy statement is good discipline, virtually indispensable,and also sometimes legally required

• discuss the overall portfolio management process leading to the asset allocation decision,

including the stage devoted to investor information requirements (i.e., objectives and

constraints) and the stage devoted to analyzing capital market expectations

Guideline Answer:

A potential benefit of using a written investment policy statement that contradicts each of the

comments is:

• A policy statement identifies the pertinent investment objectives and constraints Clearly

identified objectives and constraints help an investor, and investment manager, to focus onappropriate investment strategies among the universe of possible strategies The result should be

an optimal balance between return seeking and risk taking and an increased probability ofsuccess in achieving investment goals

• An investment policy statement provides a long-term plan for an investor and a basis for makingdisciplined investment decisions over time The absence of a policy statement reduces decisionmaking to an individual event basis and often leads to chasing short-term opportunities that maynot contribute to, or may even take away from, reaching long-term goals The presence of apolicy encourages all parties to maintain their focus on the long-term nature of the investmentprocess, especially during turbulent times

• A written policy statement can provide continuity from current manager(s) to future ones In theMueller’s case, this could contribute to meeting long-term goals if they decide in the future tohire an investment manager or if the control of their assets passes to their daughter or othersacting on their behalf A well thought out policy will evolve over time but likely will not besubject to a complete overhaul because of a change in managers Similarly, a policy statementcan enhance communication between an investment manager and client by clarifying issues ofimportance and concerns to either party Improved communication, in turn, increases the

likelihood that the investment manager will faithfully implement the agreed-upon plan

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Topic: Asset Allocation

1 “Asset Allocation,” Ch 7, William F Sharpe, Managing Investment Portfolios: A Dynamic

Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham &

Lamont, 1990), pp 7-1 through 7-27

3 Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR)

4 Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR)

Purpose:

To test the candidate’s knowledge of asset allocation issues by using a common example of

investors, who have built up a collection of assets over time, seeking advice from a portfoliomanager on the strengths and weaknesses of their portfolio asset allocation

“Asset Allocation” (Session 12)

• formulate major steps in the asset allocation process

• recommend and justify a general asset allocation that would be appropriate for an investor

• recommend an asset allocation and justify the recommendation;

• justify the use of specific asset classes and relate the asset allocation to the investment policystatement

• recommend and justify an asset allocation and clearly state any assumptions, especially the risktolerance of the client, that contributed to the recommendation

The Muellers’ portfolio can be evaluated in terms of the following criteria:

i Preference for “Minimal Volatility.” The volatility of the Muellers’ portfolio is likely to be

much greater than minimal The asset allocation of 95 percent stocks and 5 percent bondsindicates that substantial fluctuations in asset value will likely occur over time The assetallocation’s volatility is exacerbated by the fact that the beta coefficient of 90 percent of theportfolio (i.e., the four growth stock allocations) is substantially greater than 1.0 Thus theallocation to stocks should be reduced, as should the proportion of growth stocks or higher betaissues Furthermore, the 5 percent allocation to bonds is in a long-term zero coupon bond fundthat will be highly volatile in response to long-term interest rate changes; this bond allocatonshould be exchanged for one with lower volatility (perhaps shorter maturity, higher gradeissues)

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ii Equity Diversification The most obvious equity diversification issue is the concentration of 35

percent of the portfolio in the high beta small cap stock of Andrea’s company, a company with ahighly uncertain future A substantial portion of the stock can and should be sold, which can bedone free or largely free of tax liability because of the available tax loss carry forward Anotherissue is the 90 percent concentration in high beta growth stocks, which contradicts the Muellers’preference for minimal volatility investments The same is true of the portfolio’s 45 percentallocation to higher volatility small cap stocks Finally, the entire portfolio is concentrated in thedomestic market Diversification away from Andrea’s company’s stock, into more value stocks,into more larger cap stocks, and into at least some international stocks is warranted

iii Asset Allocation (including cash flow needs) The portfolio has a large equity weighting that

appears to be much too aggressive given the Muellers’ financial situation and objectives Theirbelow average risk tolerance and limited growth objectives indicate that a more conservative,balanced allocation is more appropriate The Muellers are not invested in any asset class otherthan stocks and the small bond fund holding A reduction in equity investments, especiallygrowth and small cap equities, and an increase in debt investments is warranted to produce moreconsistent and desired results over a complete market cycle

In addition, the Muellers have no cash reserve or holdings of short-term high grade debt assets

In the very near future, the Muellers will need $50,000 (up front payment) and at least part of

$40,000 (first year’s tuition and living expenses) for their daughter’s college education, as well

as some reserve against normal expenses In addition, they expect to have negative cash floweach year their daughter is in college, which should lead them to increase their cash reserves.The current portfolio is likely to produce a low level of income because of the large weighting

in growth stocks and because the only bond holding is a long-term zero coupon fund Also, themarketability of Andrea’s company stock is unknown and could present a liquidity problem if itneeds to be sold quickly After their immediate cash needs are met, the Muellers will need amodest, ongoing allocation to cash equivalents

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Topic: Tax/Mutual Fund Issues

1 “Mutual Fund Misclassification: Evidence Based on Style Analysis,” Dan DiBartolomeo

and Erik Witkowski, Financial Analysts Journal (AIMR, September/October 1997)

2 “Tax Considerations in Investing,” Ch 8, Robert H Jeffrey, The Portable MBA in

Investment, Peter L Bernstein, ed (John Wiley & Sons, 1995)

Purpose:

To test the candidate’s understanding of how tax and mutual fund considerations affect investmentreturns and investment strategies

“Mutual Fund Misclassification: Evidence Based on Style Analysis” (Session 11)

• discuss why a mutual fund could be misclassified in regard to its investment guidelines

“Tax Considerations in Investing” (Session 13)

• explain the importance of taxation on investment policy and discuss taxes as an investmentexpense;

• differentiate capital gains and dividends and compare the taxation of each;

• analyze the impact of turnover on the portfolio when taxes are considered and calculate theeffect of turnover at a given tax rate;

• analyze the profile of an individual investor, discuss the impact of spending requirements onoverall investment performance, discuss the probability of realizing capital gains taxes, anddiscuss the benefits of deferring capital gains taxes;

• discuss the advantages and disadvantages of realizing losses

A Compared to the Superior Growth and Income Fund, the Exceptional Growth and Income Fund

is more consistent with the Muellers’ goal with regard to both the return volatility and theexpected one-year after-tax return

i Return Volatility The Exceptional Fund has had a substantially lower beta than the Superior

Fund Based on the betas, Exceptional has been slightly less volatile than the overall marketwhile Superior has been considerably more volatile than average Exceptional has alsoexhibited more consistent performance in the past, producing a lower return in up marketsand a higher return in down markets

ii Expected One-Year After-Tax Return (assuming all turnover resulted in gains) The

Exceptional Fund’s expected one-year after-tax return is 9.73 percent and the SuperiorFund’s comparable return is 9.50 percent Each fund’s gross (pre-tax) total return is

composed of the fund’s capital appreciation and dividend yield The gross appreciation rate

is the expected realized capital gains (estimated by the fund’s turnover rate) taxed at theclient’s capital gains tax rate (20% in the case of the Muellers) The gross dividend return is

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reduced by the client’s applicable ordinary income tax rate (30% for the Muellers) Theexpected after-tax return can be estimated by:

= taxed capital gain + taxed dividend yield + non-taxed capital gain

OR

= [(total return – yield) × (turnover rate) × (1 – capital gains tax rate)]

+ [yield × (1 – income tax rate)] + [(total return – yield) × (1 – turnover rate)]

OR

= (total return – yield) × (1 – turnover rate × capital gains tax rate)

+ [yield × (1 – income tax rate)]

= total return – (yield × ordinary tax rate) – [(total return – yield) × turnover × capital

gains tax rate]

The Exceptional Fund’s expected after-tax return is:

be exchanged for monies that would otherwise be paid to the taxing authority, creating

additional “cash in the bank” The greatest tax benefit and addition to portfolio value is likely tooccur if losses are realized whenever they are available rather than waiting until the end of a taxyear to sell any losers Obviously, realizing losses can add to the value of a portfolio only aslong as the tax benefit is greater than the trading costs that are incurred Otherwise, realizing taxlosses does have a negative effect on portfolio value

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Topic: Investment Policy Statement

1 “Asset Allocation,” Ch 7, pp 7-1 through 7-27, William F Sharpe, Managing Investment

Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds.

(Warren, Gorham & Lamont, 1990)

3 Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR)

4 Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR)

Purpose:

To test the candidate’s ability to select appropriate asset allocation strategies for various clients’objectives and constraints

“Asset Allocation” (Session 12)

• formulate major steps in the asset allocation process

• recommend and justify a general asset allocation that would be appropriate for an investor

• recommend an asset allocation and justify the recommendation;

• justify the use of specific asset classes and relate the asset allocation to the investment policystatement

• recommend and justify an asset allocation and clearly state any assumptions, especially

regarding the risk tolerance of the client, that contributed to the recommendation

A Personal Portfolio

Portfolio A is the most appropriate portfolio for the Muellers Because their pension income willnot cover their annual expenditures, the shortfall will not likely be met by the return on theirinvestments so the 10 percent cash reserve is appropriate As the portfolio depletes over time, itmay be prudent to allocate more than 10 percent to cash equivalents The income deficit will bemet each year via a combination of investment return and principal invasion

Now that their daughter is financially independent, the Mueller’s sole objective for their

personal portfolio is to provide for their living expenses Their willingness and need to take onrisk is fairly low Clearly, there is no need to expose the Muellers to the possibility of a largeloss Also, their time horizon has been shortened considerably because of their health situation.Therefore, a 70 percent allocation to intermediate term high grade fixed income securities iswarranted

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The income deficit will rise each year as the Muellers’ expenses rise with inflation but theirpension income need remains constant The conservative 20 percent allocation to equitiesshould provide diversification benefits and some protection against unanticipated inflation overthe expected maximum 10-year time horizon.

Portfolio B, the second best portfolio, has no cash reserves so the Mueller’s liquidity needswould not be met Also, although it has a higher expected return, Portfolio B’s asset allocationresults in a somewhat higher standard deviation of returns than Portfolio A

Portfolios C and D offer higher expected returns but at markedly higher levels of risk and withrelatively lower levels of current income The Mueller’s large income requirements and low risktolerance preclude the use of Portfolios C and D

B Trust Distribution Portfolio

Portfolio B is the most appropriate portfolio for the trust assets Portfolio B’s expected return of5.8 percent exceeds the required return of 5.4 percent, and the required return would actuallydecline if the surviving spouse lives longer than five years The time horizon for the portfolio isrelatively short, ranging from a minimum of five years to a maximum of 10 years The

Mueller’s sole objective for these funds is to provide adequate funds for the building addition.Growth requirements for the portfolio are modest and the Mueller’s willingness to take on risk

is low The portfolio would be unlikely to achieve its objective if large, even short term, losseswere absorbed during the minimum five year time horizon Except for taxes, no principal orincome disbursements are expected for at least five years; therefore, only a minimal or evenzero cash reserve is required Accordingly, an allocation of 40 percent to equities to providesome growth and 60 percent to intermediate fixed income to provide stability and capital

preservation is appropriate

There is no second best portfolio Portfolio A’s cash level is higher than necessary and theportfolio’s expected return is insufficient to achieve the $2,600,000 value within the minimum5-year time horizon Portfolio C has an expected return sufficient to achieve the $2,600,000value in five years but it has a higher cash level than is necessary and, more importantly, it has astandard deviation of returns that is too high given the low risk tolerance of the trust portfolio.Portfolio D has a high enough return and the appropriate cash level but a clearly excessive risk(standard deviation) level Portfolios C and D share the flaw of having excessive equity

allocations that fail to recognize the relatively short time horizon and that generate risk levelsthat are much higher than necessary or warranted

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Reading Reference:

1 “Using Interest Rate Futures in Portfolio Management,” Concepts and Applications (Board

of Trade of the City of Chicago, 1988)

2 “Interest Rate Futures: Refinements,” Futures, Options and Swaps, 2nd edition, Ch 6,

Robert W Kolb (Blackwell 1997)

Purpose

To test the candidate’s ability to apply an understanding of interest rate futures to the adjustment offixed income portfolio duration; evaluate the use of futures to accomplish duration adjustment; anddemonstrate an understanding that this use of futures has not addressed immunization risk

“Using Interest Rate Futures in Portfolio Management” (Session 17)

• create, design, and evaluate a duration-increasing or -decreasing strategy using bond futures;

• appraise the advantages and disadvantages of using financial futures for asset allocation

“Interest Rate Futures: Refinements” (Session 17)

• compare and contrast the various hedging strategies or models that can be used when hedgingwith T-bond futures, including computations involved in the various methodologies;

• compare and contrast a cross-hedge and a perfect hedge, including computing the number of

futures contracts and providing an ex post evaluation indicating the distinctions between the two

strategies

Guideline Answer

A Futures are an efficient, low-cost tool that can be used to alter the risk and return characteristics

of an entire portfolio with less disruption than using conventional methods There may also beboth institutional constraints and unfavorable tax consequences that prevent a portfolio managersuch as Klein from liquidating the entire portfolio Because Treasury bonds and Treasury bondfutures have a very high correlation, the futures approach allows one to effectively create atemporary fully liquidated position without disturbing the portfolio Futures can be sold againstthe portfolio to replicate the price response of the portfolio with the desired duration In

addition, there are cost advantages of using futures contracts including lower execution costs(bid-ask spread), speed and ease of executions (time required), and the higher

marketability/liquidity of futures contracts The bond sale strategy may well be disadvantageous

on all counts Shortening the duration by liquidating the bond portfolio would be more costly,time consuming, and disruptive to the portfolio, with possible adverse tax implications as well

In Klein’s case, there may be more bonds to sell than futures contracts, because many bonds inthe portfolio could be in denominations as low as $1,000 Also, the bond sales would invokeliquidity problems not encountered by the bond and futures strategy

B The value of the futures contract is 94-05 (i.e., 94 5/32 % of $100,000), which translates into0.9415625 × $100,000 = $94,156.25

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Using the information given, there are at least two ways, modified duration (MD) or basis pointvalue (BPV), to calculate the number of contracts.

Using modified duration,

Target Change in Value using MD

= Change in Value using MD hedge + Change in Value using MD portfolio

= (MD hedge × change in yield × Value hedge) +

(MD portfolio × change in yield × Value portfolio)

= (MD per futures × change in yield × N × contract value) +

(MD portfolio × change in yield × Value portfolio)where N = the number of futures contracts

Because the target MD is zero, then:

N = – (MD portfolio × Value portfolio) / (MD per futures × contract value) = – (10 × $100,000,000) / (8 × $94,156.25)

= – 1328 (exact answer –1327.58) or short 1328 contracts

Using basis point value,

BPV target = BPV portfolio – BPV hedge

BPV target = BPV portfolio – (N × BPV per futures)

and N = (BPV target – BPV portfolio) / BPV per futures

Because the target BPV is zero, then:

N = ($0 – $100,000) / $75.32 = –1328 (exact answer –1327.67) or short 1328 contracts

Klein is selling the contracts as indicated by the negative value of contracts The difference inthe two exact answers is due to rounding the BPV number to the nearest cent

C Because the newly modified portfolio has approximately a zero modified duration and basispoint value, the value of this portfolio would remain relatively constant for small parallelchanges in rates With an interest rate increase, the bond portfolio’s immediate market valuewould decline, but the positive cash flow from the Treasury bond futures contracts would offsetthis loss As shown in part B, either modified duration or basis point value can be used tocompute the change in value

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Change in Value using MD = MD × change in yield × value, or

Change in Value using BPV = BPV × BP change

i The $100,000 BPV for the portfolio means that the portfolio value will decrease (increase)

by $100,000 for each basis point increase (decrease) A 10 basis point increase in interestrates would mean a $1,000,000 decline (or loss) in the market value of the original portfolio

Change in Value = MD × change in yield × value

Differences from exactly $1,000,000 are due to rounding the number of contracts

iii The change in value of the hedged portfolio is the sum of the change in value of the originalportfolio and the cash flow from the hedge (futures) position or,

Newly-hedged portfolio change = –$1,000,000 + 1,000,316 ≈ $0 (using MD)

= –$1,000,000 + 1,000,249 ≈ $0 (using BPV)

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D Klein’s hedging strategy might not fully protect the portfolio against interest rate risk for severalreasons First, immunization risk would remain even after execution of the strategy, because ofthe possibility of non-parallel shifts in the yield curve If the yield curve shifts in a non-parallelfashion, the modified portfolio is not immunized against interest rate risk because the originalbond portfolio and T-Bond futures exist at different points on the yield curve and hence facedifferent interest rate changes If the curve became steeper, for example, then the market valueloss on the original bond portfolio would be accompanied by a less-than-compensating marketvalue gain on the futures position Second, the volatility of the yield between the T-bond futuresand the government bond portfolio may not be one-to-one Hence a yield beta adjustment may

be needed Third, basis risk also exists between T-bond futures and spot T-bonds, so that therewould still be risk even if the government portfolio held only T-bonds Fourth, this may still be

a cross-hedge, because the government bonds in the portfolio may not be the same as the

cheapest-to-deliver bond Fifth, the duration will change as time passes, so risk will arise unlesscontinual rebalancing takes place Sixth, because fractional futures contacts cannot be sold, theduration may not be able to be set exactly to zero

E The correct strategy would be to short (write or sell) call options and go long (buy) put options.The short call position would create a negative cash flow if rates were to decline but the longput position would create a positive cash flow if rates were to increase This fully hedges theportfolio The call and put options should have the same exercise price and expiration date andthe appropriate notional amounts The following diagram illustrates this strategy:

Question 6 - Short Call/Long Put at Expiration

Underlying Value

Short Call Long Put

Long Put+Short Call=Short Futures

Short Call

Long Put

Combined Position of Long Put and Short Call

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“Interest Rate Futures: Refinements” (Session 17)

• create a synthetic floating-rate (fixed-rate) loan from a fixed-rate (floating-rate) loan, includingcomputing the number of Eurodollar futures required;

• compare and contrast “strip” and “stack” hedges, including computing the number of futurescontracts required

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N = (value of spot position) / (value of futures position)

= ($100,000,000) / ($981,750)

where value of futures position = $1,000,000 × [1 – (0.073 / 4)]

≈ 102 contracts

Therefore on September 20, Johnson would sell 100 (or 102) December Eurodollar futures

contracts at the 7.3 percent yield The implied LIBOR rate in December is 7.3 percent as

indicated by the December Eurofutures discount yield of 7.3 percent Thus a borrowing rate of9.3 percent (7.3 percent + 200 basis points) can be locked in if the hedge is correctly

Combining the cash flow from the hedge with the cash flow from the loan results in a net

outflow of $2,325,000, which translates into an annual rate of 9.3 percent:

= ($2,325,000 × 4) / $100,000,000 = 0.093

This is precisely the implied borrowing rate that Johnson locked in on September 20 Regardless

of the LIBOR rate on December 20, the net cash outflow will be $2,325,000, which translatesinto an annualized rate of 9.3 percent Consequently, the floating rate liability has been

converted to a fixed rate liability in the sense that the interest rate uncertainty associated withthe March 20 payment (using the December 20 contract) has been removed as of September 20

B In a strip hedge, Johnson would sell 100 December futures (for the March payment), 100 Marchfutures (for the June payment), and 100 June futures (for the September payment) The objective

is to hedge each interest rate payment separately using the appropriate number of contracts Theproblem is the same as in Part A except here three cash flows are subject to rising rates and astrip of futures is used to hedge this interest rate risk This problem is simplified somewhatbecause the cash flow mismatch between the futures and the loan payment is ignored

Therefore, in order to hedge each cash flow, Johnson simply sells 100 contracts for each

payment The strip hedge transforms the floating rate loan into a strip of fixed rate payments Aswas done in Part A, the fixed rates are found by adding 200 basis points to the implied forwardLIBOR rate indicated by the discount yield of the three different Eurodollar futures contracts.The fixed payments will be equal when the LIBOR term structure is flat for the first year

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Topic: Economic Inputs and Portfolio Management

“Is Purchasing Power Parity a Useful Guide to the Dollar?” Craig S Hakkio, Economic Review

(Federal Reserve Bank of Kansas City, Third Quarter 1992)

Purpose:

To test the candidate’s ability to compare and contrast absolute PPP and relative PPP and evaluatethe extent to which PPP is useful in forecasting exchange rate movements

“Is Purchasing Power Parity a Useful Guide to the Dollar?” (Session 6)

• contrast the performance of relative purchasing power parity (PPP) as a guide in forecastingshort-term movements and as a guide in forecasting long-term movements in foreign exchangerates;

• appraise the usefulness of PPP in forming expectations about future movements in exchangerates and in making judgments about managing portfolio exposure to currency risks

A Purchasing power parity (PPP) is a measure of a currency’s equilibrium value (the exchange

rate to which the currency moves over time) In PPP equilibrium, any asset or service purchasedwith a certain amount of currency in one country will cost the same in any other country, afterconversion into the base currency PPP is grounded in the law of one price, which states that, inthe absence of transport costs and trade impediments, identical goods should cost the sameacross all countries and currencies

Absolute PPP states that exchange rates depend on differences in absolute price levels in

different countries Under absolute PPP, exchange rates move to equalize the prices of identicalmarket baskets in different countries That is, the exchange rate between two currencies willtend to rise or fall toward the ratio of the two countries’ overall price levels

Relative PPP states that exchange rates depend on differences in inflation rates in different

countries Under relative PPP, exchange rates move to offset inflation differentials in differentcountries That is, the exchange rate between two currencies will tend to rise or fall at a rateequal to the difference between the two countries’ inflation rates

Because relative PPP extends directly from absolute PPP, relative PPP holds if absolute PPPholds But relative PPP may hold even if absolute PPP does not Although the exchange rate isnot likely to strictly equal the ratio of foreign and domestic price levels, as absolute PPP

requires, the exchange rate may be proportional to the ratio If the proportion is fixed, a lessrestrictive condition than precise equality, relative PPP holds Thus, relative PPP is more likely

to hold than absolute PPP

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Both absolute and relative PPP are subject to criticism Absolute PPP is criticized because thelaw of one price does not always hold and because price levels in different countries are

calculated using different price indexes Relative PPP is criticized because different theories ofexchange rate determination can generate non-PPP equilibrium rates and because price levelsadjust at different speeds than exchange rates

B For several reasons, PPP has limited usefulness in predicting short-term foreign exchange ratemovements First, because exchange rates change rapidly while price levels adjust more slowly,deviations from PPP are likely to disappear only over longer periods of time as prices adjust.Second, evidence suggests that:

• market exchange rates and PPP rates do not tend to move together from month to month;

• the time required for exchange rates to equal their PPP rates ranges from several months toseveral years;

• trade and capital flows create long-run pressures toward PPP, but observed exchange ratesoften show large and prolonged deviations from PPP levels;

• only when deviations from PPP are unusually large is it likely that exchange rates will movetoward their PPP rates in the short run;

• major political and economic events can dominate short-run exchange rate movements;

• explicit government intervention can cause exchange rates to deviate from PPP levels

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Topic: Global Markets/Instruments and Analysis of Alternative Investments

1 Emerging Stock Markets: Risk, Return, and Performance, Christopher B Barry, John W.

Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997)

2 “Does Venture Make Sense for the Institutional Investor? Part I,” David F Swensen,

Investing in Venture Capital (ICFA, 1989)

Purpose:

To test the candidate’s ability to compare the strengths and weaknesses of two different but relatedasset sub-classes

Emerging Stock Markets (Session 7)

• discuss the potential benefits from investing in emerging markets;

• summarize the problems or constraints facing the emerging market investor;

• comment on the historical performance of emerging equity markets;

• discuss the risks involved in investing in emerging markets;

• discuss performance comparisons between indexes of investable securities and indexes of allsecurities in emerging markets

“Does Venture Make Sense for the Institutional Investor? Part I” (Session 11)

• describe the distinguishing characteristics of the private equity asset class;

• determine how the inclusion of private equity might enhance the opportunity set of a multi-assetportfolio, leading to a more efficient portfolio

A The potential benefits resulting from overweighting in both emerging market equities andventure capital include the following:

• Higher Expected Returns Over certain past time periods, both of these asset classes

experienced favorable returns relative to other asset classes It is entirely possible thatexpected returns for both will be higher than those for other asset classes

• Low Correlation with Other Asset Classes Likewise, over certain past periods, both of theseasset classes’ returns had low correlations with other asset classes, resulting in reducedportfolio risk Similar low correlations and risk-reduction effects may be forecast for thefuture

• Increased Portfolio Efficiency If both of these asset classes have higher expected returnsand/or lower expected correlations relative to other asset classes, their inclusion in portfoliosmay shift those portfolios to a higher efficient frontier

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B The potential problems resulting from overweighting in both emerging market equities andventure capital include the following:

• Illiquidity Both of these asset classes may have less liquidity than other asset classes That

is, it may not be possible to sell either at fair value in a short period of time

• Long Time Horizon Requirement Both of these asset classes may require investors to adopt

a long time horizon, primarily because of the high volatility each of these asset classesexhibits

• High Transaction Costs Both asset classes are likely to have high transaction costs, in theform of timing, market impact, opportunity costs, and large bid-ask spreads

• High Information Costs Both asset classes are likely to have high information costs,

especially relative to U.S equities and bonds that feature easy and cheap access to massivequantities of data

• Low Expected Returns Forecast returns for both asset classes may, in fact, be lower thanthose for other asset classes, regardless of past return experience

• High Future Return Volatility Both asset classes may have high return volatility that is notoffset by prospective low correlation effects, with the net result that portfolio risk mayactually increase as a result of including these asset classes in portfolios

• Higher Future Correlations, Especially in Down Markets Even though return correlations

of both asset classes with other asset classes have been low in the past, they may be forecast

to be higher in the future, especially in down markets The result will be a much lower riskreduction benefit to the portfolio

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Topic: Ethical and Professional Standards

1 Standards of Practice Handbook, 7th Edition (AIMR, 1996), pp 53-59.

2 “Avoiding Legal Problems in the Decade of Retribution,” Karl A Groskaufmanis,

Corporate Financial Decision Making and Equity Analysis (AIMR, 1995)

3 “Managing Ethics from the Top Down,” Saul W Gellerman, Sloan Management Review

(Sloan Management Review Association, Winter 1989)

4 “Compliance Guidelines: Introduction,” Michael S Caccese, Good Ethics; The Essential

Element of a Firm’s Success (AIMR 1994)

Purpose:

To test the candidate’s understanding of the methods used to create and maintain an ethical

environment in an investment firm

“Avoiding Legal Problems in the Decade of Retribution” (Session 3)

• discuss specific steps to create and apply an effective compliance policy in anticipation ofpotential scrutiny

“Managing Ethics from the Top Down” (Session 3)

• discuss issues related to management’s responsibility for creating and sustaining an ethicalenvironment and minimizing conditions that foster unethical acts (such as unusually largerewards or severe punishments);

• explain how management can take explicit steps to ensure that employees do not risk

commission of an unethical act

“Compliance Guidelines: Introduction” (Session 4)

• explain the steps to be taken in designing an effective compliance program for investmentorganizations

Any of the following additional specific actions would contribute to implementation of an effectivecompliance policy:

• minimize exposure to conditions/conflicts that induce misconduct;

• provide incentives (rewards) for good behavior;

• clearly delineate sanctions for misconduct;

• designate a compliance officer;

• provide ethics training;

• establish disclosure mechanisms (e.g., “whistle blowing”);

• review employee conduct;

• resolve compliance concerns promptly;

• keep codes of ethics and compliance programs current to reflect changes in the firm and theindustry

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Topic: Ethical and Professional Standards

1 Standards of Practice Handbook, 7th Edition (AIMR, 1996), pp 83-93.

2 Establishing a Proxy Voting Policy for Professional Investors, (AIMR, 1992)

3 “Tore & Associates,” Douglas R Hughes, Standards of Practice Casebook (AIMR, 1996)

Purpose:

To test the candidate’s understanding of the firm’s responsibility under AIMR Standards for proxyvoting

“Establishing a Proxy Voting Policy for Professional Investors” (Session 3)

• construct a written policy on proxy voting

“Tore & Associates” (Session 4)

• demonstrate the appropriate responsive actions and show adequate compliance procedures foreach of the violations of the Code and Standards

A Because FIA has discretionary authority to manage fund assets, its approach can be critiqued onthe following grounds:

• FIA has a fiduciary duty to vote all proxies associated with the assets; the firm cannot refuse

to exercise its fiduciary duty because it is too expensive or too time consuming

• FIA should have a firm-wide policy on proxy voting so that decisions are not left up toindividual managers

• FIA’s policy must require portfolio managers to vote proxies in a way that will maximizethe economic value of plan holdings

B To ensure adherence to an adequate proxy voting policy, FIA should adopt the following

specific procedures:

• designate a policy-making body or individual to implement a proxy policy;

• provide a review mechanism that will monitor the proxy voting process on a regular basis;

• identify, when appropriate, preferences of clients regarding proxy voting issues;

• consider applying internal financial ratios or other criteria (for evaluating corporate

performance) to proxy decisions;

• develop adequate record-keeping procedures;

• educate and train staff regarding proxy voting policies;

• adequately disclose proxy voting procedures to clients

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