L3 mock sample exam CFA level III essay questions 2000

With the above information, portfolio manager Sarah Wheeler prepared the investment policy statement for Taylor shown in Exhibit 13-1... Exhibit 13-1 Robert Taylor Investment Policy Stat

CFA ® Level III

Essay Examination Book

© 2000 Association for Investment Management and Research All rights reserved

FOR AIMR USE ONLY

FOR AIMR USE ONLY

The following list contains the command words used on the Morning Section of

the 2000 Level III examination Candidates may want to refer to this list as they formulate their answers

calculate To ascertain or determine by mathematical processes

compute To determine, especially by mathematical means

contrast To compare in respect to differences

critique To offer a critical review or commentary; to criticize

describe To transmit a mental image, an impression, or an understanding of the

nature and characteristics of

discuss To discourse about through reasoning or argument; to present in detail

evaluate To determine or fix the value of; to determine the significance or worth of,

usually by careful appraisal and study

explain To give the meaning or significance of; to provide an understanding of; to

give the reason for or cause of

justify To prove or show to be valid, sound, or conforming to fact or reason; to

furnish grounds or evidence for

select To choose from a number or group—usually, by fitness, excellence, or

other distinguishing feature

state To express in words

The Morning Section of the 2000 CFA Level III Examination has 21 questions

For grading purposes, the maximum point value for each question is equal to the

number of minutes allocated to that question

Question Topic Minutes

Item Set Book

1–12 Ethical & Professional Standards 36

Questions 13 through 15 relate to Robert Taylor A total of 44 minutes is allocated to these

questions First review the Introduction below and Exhibit 13-1 on page 3 Candidates

should answer these questions in the order presented

Introduction

Robert Taylor, aged 50 and a U.S resident, recently retired and received a $500,000 cash

payment He also obtained $700,000 through the exercise of stock options Both figures are net

of tax Taylor is not entitled to a pension; however, his medical expenses are covered by

insurance paid for by his former employer Taylor is in excellent health and has a normal life expectancy

Taylor’s wife died last year after a long illness, which resulted in devastating medical expenses All their investments, including a home, were liquidated to fully satisfy these medical expenses Taylor has no assets other than the $1,200,000 cash referenced above, and has no debts He plans

to acquire a $300,000 home in three months and insists on paying cash given his recent adverse experience with creditors When presented with investment options, Taylor consistently selects the most conservative alternative

After settling into his new home, Taylor’s living expenses will be $2,000 per month and will rise with inflation He does not plan to work again

Taylor’s father and his wife’s parents died years ago His mother, Renee, is 72 years old and in excellent physical health Her mental health, however, is deteriorating and she has relocated to a long-term care facility Renee’s expenses total $3,500 per month Her monthly income is $1,500 from pensions Her income and expenses will rise with inflation She has no investments or assets of value Taylor, who has no siblings, must cover Renee’s income shortfall

Taylor has one child, Troy Troy and a friend need funds immediately for a start up business First year costs are estimated at $200,000 The partners have no assets and have been unable to obtain outside financing The friend’s family has offered to invest $100,000 in the business in exchange for a minority equity stake if Taylor agrees to invest the same amount

Taylor would like to assist Troy; however, he is concerned about the partners’ ability to succeed, the potential loss of his funds, and whether his assets are sufficient to support his needs and to support Renee He plans to make a decision on this investment very soon If he invests $100,000

in Troy’s business, he insists that this investment be excluded from any investment strategy developed for his remaining funds

With the above information, portfolio manager Sarah Wheeler prepared the investment policy statement for Taylor shown in Exhibit 13-1

Exhibit 13-1 Robert Taylor Investment Policy Statement Return Objective: • Income requirement is $2,000 monthly

• Total return requirement is 2.7% annually ($24,000 / $900,000)

Risk Tolerance: • Substantial asset base and low return requirement provide ample

resources to support an aggressive, growth-oriented portfolio

Time Horizon: • Client is 50 years old, recently retired, and in excellent health

• Time horizon exceeds 20 years

Liquidity Needs: • $300,000 is needed in three months for purchase of home

• Modest additional cash is needed for normal relocation costs

• $100,000 may be needed for possible investment in son’s business

• A normal, ongoing cash reserve level should be established

Tax: • There is little need to defer income

• Mother’s expenses may have an effect

• Client desires to support mother

• Client insists that any investment in son’s business be excluded from long term planning

• Client has strong aversion to debt

QUESTION 13 HAS TWO PARTS FOR A TOTAL OF 20 MINUTES

A Evaluate the appropriateness of Taylor’s investment policy statement in Exhibit 13-1

with regard to the following objectives:

i Return Requirement

ii Risk Tolerance

(12 minutes)

B Evaluate the appropriateness of Taylor’s investment policy statement in Exhibit 13-1

with regard to the following constraints:

i Time Horizon

ii Liquidity Needs

(8 minutes)

QUESTION 14 HAS ONE PART FOR A TOTAL OF 12 MINUTES

After revising the investment policy statement and confirming it with Taylor, Wheeler is now

developing a long-term asset allocation strategy for him Wheeler will use the following revised

information to recommend one of the allocations in Exhibit 14-1:

• Taylor has decided to invest $100,000 in his son’s business but still insists that this

investment be disregarded in making his allocation decision

• Taylor’s total cash flow needs have changed to $4,200 a month

• The available asset base is $800,000

• Wheeler estimates that the inflation rate will be 1 percent next year

• Taylor is determined to maintain the real value of his assets because he plans to set up

a charitable foundation in the future

• Taylor insists on taking no more risk than absolutely necessary to achieve his return

goals

Exhibit 14-1 Potential Long Term Asset Allocation Strategies

Income Growth Very Low Low Moderate High

Select the allocation strategy from Exhibit 14-1 that is most appropriate for Taylor, and justify

your selection with two supporting reasons related to the revised information shown above

(12 minutes)

QUESTION 15 HAS ONE PART FOR A TOTAL OF 12 MINUTES

After five years, Wheeler is reviewing whether Taylor’s investment policy statement is still appropriate for his situation She discovers that:

• Taylor’s expenses have decreased significantly because of the death of his mother

• His net worth has tripled, largely because of profits realized from the sale of his investment

in his son’s business

• Taylor now feels financially secure and plans to invest primarily to provide for future charitable goals

• Taylor believes the only significant change to his cash flow needs during the next few months will be a $100,000 gift to a charity

Wheeler concludes that a revised investment policy statement is needed

Discuss the effect of Taylor’s new circumstances on the following four components of his

investment policy statement Your discussion should focus on the direction and magnitude of

change in each factor rather than on a specific numerical change

i Return Requirement

ii Risk Tolerance

iii Time Horizon

iv Liquidity Needs

(12 minutes)

QUESTION 16 HAS ONE PART FOR A TOTAL OF 12 MINUTES

Wheeler has concluded her work with Taylor and is meeting with Don Sampson, a potential new client Sampson begins the meeting by outlining his investment philosophy as shown in Exhibit 16-1

Exhibit 16-1 Don Sampson’s Investment Philosophy Statement

1 Investments should offer strong return potential but with very limited risk I prefer to

be conservative and to minimize losses, even if I miss out on substantial growth opportunities

2 All non-governmental investments should be in industry-leading and financially

strong companies

3 Income needs should be met entirely through interest income and cash dividends

All equity securities held should pay cash dividends

4 Investment decisions should be based primarily on consensus forecasts of general

economic conditions and company-specific growth

5 If an investment falls below the purchase price, that security should be retained until

it returns to its original cost Conversely, I prefer to take quick profits on successful investments

6 I will direct the purchase of investments, including derivative securities,

periodically These aggressive investments result from personal research and may not prove consistent with my investment policy I have not kept records on the performance of similar past investments, but I have had some “big winners”

Select the statement from Exhibit 16-1 that best illustrates each of the following behavioral

finance concepts Justify your selection

i Mental Accounting

ii Overconfidence (illusion of control)

iii Reference Dependence

Note: Candidates should not select any statement more than once

(12 minutes)

QUESTION 17 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES

Walter Tobler is considering a substantial change in investment strategy for the portfolio he manages His supervisor has raised concerns about the measurement and management of the increased risks to the portfolio that might result from such a change in strategy In response to those concerns, Tobler states:

“Our approach to risk will not change As we have done in the past, we will monitor both variance of security returns and tracking error relative to our benchmark I have looked at additional risk measurement tools, in particular probability of shortfall and expected shortfall, but I believe that these measures do not add value to our process.”

A Describe the calculation of each of the following four measures of risk:

i Variance of security returns

ii Tracking error relative to a benchmark

iii Probability of shortfall

iv Expected shortfall

(8 minutes)

B Discuss one unique weakness for each of the following measures:

i Variance of security returns

ii Probability of shortfall

iii Expected shortfall

correlations are essentially stable These two basic conditions will serve to limit our risk

as we move to invest in new markets.”

C Critique each of Tobler’s two premises, using the template on page 37 State, for each

premise, one unique implication for Tobler’s approach to risk management

Answer Question 17-C in the Template provided on page 37

(8 minutes)

Template for Question 17-C

Premise Critique of Premise Unique Implication of Premise

QUESTION 18 HAS FOUR PARTS FOR A TOTAL OF 16 MINUTES

Janice Delsing, a U.S.-based portfolio manager, manages an $800 million portfolio ($600 million

in stocks and $200 million in bonds) In reaction to anticipated short-term market events, Delsing wishes to adjust the allocation to 50 percent stock and 50 percent bonds through the use of futures Her position will be held only until “the time is right to restore the original asset

allocation.” Delsing determines a financial futures-based asset allocation strategy is appropriate The stock futures index multiplier is 250 and the denomination of the bond futures contract is

$100,000 Other information relevant to a futures-based strategy is given in Exhibit 18-1

Exhibit 18-1 Information for Futures-Based Strategy

Bond portfolio modified duration Bond portfolio yield to maturity Basis Point Value (BPV) of bond futures Stock Index Futures Price

Stock Portfolio Beta

5 years 7%

$97.85

$1378 1.0

A Describe the financial futures-based strategy needed and explain how the strategy allows

Delsing to implement her allocation adjustment No calculations are necessary

(4 minutes)

B Compute the number of each of the following needed to implement Delsing’s asset

allocation strategy:

i Bond futures contracts

ii Stock index futures contracts

One month later, the yield to maturity on comparable bond portfolios has increased by 10 basis points and the stock index has risen by $28

D Calculate the percentage return (from price changes only) for the past month, assuming:

i Delsing executed the 50/50 asset allocation strategy using futures

ii Delsing did not execute the strategy but instead preserved her original long-term

asset allocation

(4 minutes)

QUESTION 19 HAS THREE PARTS FOR A TOTAL OF 20 MINUTES

The Board of Directors of Evergreen Pension Fund asked consultant Whitney Hannah to review two approaches to forecasting economic trends: econometric and consensus

A Discuss whether econometric approaches and consensus approaches to forecasting

economic trends are different or similar with respect to:

i Role of historical data

ii Number of analysts reflected in the forecast

iii Nature of assumptions about future economic relationships

(6 minutes)

B State and discuss whether econometric approaches or consensus approaches to

forecasting economic trends are more likely to be distorted by:

C State and discuss whether econometric approaches or consensus approaches to

forecasting economic trends are more likely to reflect the following strengths:

i Ability to identify turning points in trends

ii Ease of construction

iii Ability to capture multiple market influences

(6 minutes)

QUESTION 20 HAS ONE PART FOR A TOTAL OF 16 MINUTES

Kirby Anderson is reviewing the nature of the data used in constructing two U.S real estate indexes One index, published by the National Association of Real Estate Investment Trusts (NAREIT), measures the performance of equity real estate investment trusts The other index, published by the National Council of Real Estate Investment Fiduciaries (NCREIF), measures the performance of commingled investment funds

Anderson is convinced that the two indexes are comparable in terms of the types of real estate properties, geographic distribution, and market capitalization

Contrast the NAREIT and NCREIF indexes with respect to:

i Source of underlying asset valuation

ii Leverage (gearing) of underlying assets

iii Index returns calculated before or after deduction of investment advisory fees

iv Correlation with broad equity market (e.g., S&P 500 Index)

Answer Question 20 in the Template provided on page 55

(16 minutes)

Template for Question 20

QUESTION 21 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES

James Norwood, a fixed income portfolio manager, was recently hired to manage two U.S Treasury portfolios for HEY Corporation These portfolios, shown in Exhibit 21-1, comprise HEY’s total investments Norwood noticed that although the yields to maturity and modified durations of the two portfolios were similar, the portfolios were structured differently

Exhibit 21-1 Portfolio Characteristics Characteristics Portfolio A Portfolio B

2-year maturity 10-year maturity 30-year maturity

A Select and justify the portfolio in Exhibit 21-1 that will provide the higher return in each

of the following scenarios (assume an initial yield curve that is upward sloping) No calculations are necessary

i An upward parallel shift of 50 basis points in the yield curve

ii A twist in the slope of the yield curve Two-year interest rates rise by 10 basis

points, while 30-year interest rates decline by 10 basis points

(8 minutes)

One year has passed Each investment portfolio now has a total market value of $200 million and

a modified duration of 7.2 HEY’s liabilities now total $180 million and have a modified

duration of 6

B Calculate the effect on HEY’s assets and liabilities if interest rates decline by 100 basis

points (ignore convexity) Show your calculations

(6 minutes)

CFA Level III Examination

2000 Morning Section

IMPORTANT INSTRUCTIONS TO CANDIDATES

1 Write your candidate number in the spaces provided at the top left corner of the front cover

of this Essay Exam book and of the Item Set Exam book

2 Instructions for using the Item Set Exam answer sheet (computer scan sheet):

• Use a No 2 or HB pencil to record your answers on the answer sheet

• Read and sign the pledge at the bottom of your answer sheet Write your exam center code and today’s date on the lines provided in the pledge section

• Write your name in the spaces provided at the top of the answer sheet Darken the ovals that correspond with the letters in your name

• Write your candidate number in the spaces provided at the top of your answer sheet Darken the ovals that correspond with your candidate number

• Select the best answer for each question and darken the oval that corresponds with your answer Only answers recorded on the answer sheet will be graded Any marks you make

in the exam book will not be graded

• Do not make any stray marks on the answer sheet

3 Instructions for using the Essay Exam answer pages:

• Write your answers in blue or black ink on the correct answer pages in the Essay Exam book

• Label each part of your answer (A, B, C, or i, ii, iii, etc.)

• Only answers written on the correct answer pages will be graded You may make marks and notes on the question pages, but these marks will not be graded

• If you use all of the designated answer pages, check the box at the bottom of the last page

of your answer and continue your answer on the unnumbered extra pages at the back of the exam book Label extra pages with the correct question number

DO NOT OPEN THIS EXAM BOOK UNTIL INSTRUCTED TO DO SO BY THE PROCTOR

DO NOT REMOVE ANY EXAM BOOK OR ANSWER SHEET

FROM THE EXAM ROOM

CFA ® Level III

Essay Examination Book

© 2000 Association for Investment Management and Research All rights reserved

FOR AIMR USE ONLY

FOR AIMR USE ONLY

The following list contains the command words used on the Afternoon Section of the 2000

Level III examination Candidates may want to refer to this list as they formulate their answers

calculate To ascertain or determine by mathematical processes

cite To quote by way of evidence, authority, or proof

construct To create by organizing ideas or concepts logically and coherently

critique To offer a critical review or commentary; to criticize

describe To transmit a mental image, an impression, or an understanding of the

nature and characteristics of

determine To come to a decision as the result of investigation or reasoning; to settle

or decide by choice among alternatives or possibilities

diagram To represent by or put into the form of a diagram

discuss To discourse about through reasoning or argument; to present in detail

evaluate To determine or fix the value of; to determine the significance or worth of,

usually by careful appraisal and study

explain To give the meaning or significance of; to provide an understanding of; to

give the reason for or cause of

give To yield or furnish as a product, consequence, or effect; to offer for the

consideration, acceptance or use of another

identify To establish the identity of; to show or prove the sameness of

indicate To point out or point to with more or less exactness; to show or make

known with a fair degree of certainty

justify To prove or show to be valid, sound, or conforming to fact or reason; to

furnish grounds or evidence for

select To choose from a number or group—usually, by fitness, excellence, or

other distinguishing feature

state To express in words

The Afternoon Section of the 2000 CFA Level III Examination has 11 questions For grading

purposes, the maximum point value for each question is equal to the number of minutes

allocated to that question

Question Topic Minutes

22 Portfolio Management / Asset Valuation 28

23 Portfolio Management / Asset Valuation 21