CFA® Level III Essay Examination Book FOR AIMR USE ONLY 2000 Morning Section Candidate Number: FOR AIMR USE ONLY _ _ _ _ _ _ THIS BOOK IS THE PROPERTY OF: Association for Investment Management and Research Post Office Box 3668 Charlottesville VA 22903-0668 USA Tel: 804-951-5499 © 2000 Association for Investment Management and Research All rights reserved 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 Item Set Book 1–12 Essay Book 13 14 15 16 17 18 19 20 21 Topic Minutes Ethical & Professional Standards 36 Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Economics Asset Valuation Asset Valuation 20 12 12 12 22 16 20 16 14 Total: 180 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 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 Return Objective: • • Risk Tolerance: • Time Horizon: Liquidity Needs: Tax: Legal and Regulatory: Unusual Circumstances: • • • • • • • • • • • • Exhibit 13-1 Robert Taylor Investment Policy Statement Income requirement is $2,000 monthly Total return requirement is 2.7% annually ($24,000 / $900,000) Substantial asset base and low return requirement provide ample resources to support an aggressive, growth-oriented portfolio Client is 50 years old, recently retired, and in excellent health Time horizon exceeds 20 years $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 There is little need to defer income Mother’s expenses may have an effect No special considerations exist 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 ii Return Requirement 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 ii Time Horizon 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 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 Allocation Allocation Allocation B A C Asset Class Weighting Stocks 20% 40% 60% Bonds 75% 55% 35% Cash 5% 5% 5% Expected Annual Return 6.7% 7.5% 8.2% Standard Deviation 9.0% 11.5% 15.3% Potential for Asset Growth Very Low Low Moderate Income Growth Very Low Low Moderate Current Income High High Low Stability Very High High Moderate Allocation D 80% 15% 5% 9.1% 19.0% High High Very Low Low 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 ii iii iv Return Requirement Risk Tolerance Time Horizon 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 Number Statement 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 All non-governmental investments should be in industry-leading and financially strong companies Income needs should be met entirely through interest income and cash dividends All equity securities held should pay cash dividends Investment decisions should be based primarily on consensus forecasts of general economic conditions and company-specific growth 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 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 ii iii Mental Accounting Overconfidence (illusion of control) 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 not add value to our process.” A Describe the calculation of each of the following four measures of risk: i ii iii iv Variance of security returns Tracking error relative to a benchmark Probability of shortfall Expected shortfall (8 minutes) B Discuss one unique weakness for each of the following measures: i ii iii Variance of security returns Probability of shortfall Expected shortfall (6 minutes) In response to further questions about whether his risk management system really captures the riskiness inherent in financial markets, Tobler replies: “Fortunately, our entire approach to risk management is based on two well-supported premises: Financial market returns are normally distributed, and financial market 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 24-B QUESTION 25 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES A stock currently sells for $77.50 Call options on the stock have an exercise price of $75 and sell for $7.75, and put options have an exercise price of $75 and sell for $4 These options will expire in three months The threemonth U.S Treasury bill annualized yield is percent There are no transaction costs and no restrictions against using the proceeds from the short sale of any security A A synthetic Treasury bill can be constructed by investing in a combination of the securities identified above i ii Identify the three transactions needed to construct a synthetic Treasury bill Calculate the synthetic Treasury bill’s annualized yield (4 minutes) B An arbitrage strategy can be constructed with 75 actual and 100 synthetic Treasury bills, producing a face amount of $750,000 i ii State the arbitrage strategy Calculate the immediate incoming net cash flow (4 minutes) C Determine the net cash flow of the arbitrage strategy at the six-month expiration date if the stock price at expiration is $80 (Ignore any cash flows stemming from the original arbitrage profit.) (4 minutes) QUESTION 26 HAS ONE PART FOR A TOTAL OF MINUTES Duffy Chow, a principal at Portable Alpha Consulting, has a client who wishes to capture excess equity returns from small capitalization U.S stocks while simultaneously establishing exposure to the large capitalization U.S equity market Chow has determined that the Russell 2000 Index and the S&P 500 Index are the appropriate small capitalization and large capitalization benchmarks, respectively Chow proposes the following two strategies: Strategy One: • • • Hire an equity manager who has consistently outperformed the Russell 2000 Index Buy the same dollar amount of Russell 2000 futures exposure Sell short the same dollar amount of S&P 500 futures exposure Strategy Two: • • Hire a market neutral (i.e., long/short) small capitalization manager Buy the same dollar amount of S&P 500 futures exposure Indicate whether or not each strategy should achieve the client’s objectives, and justify your response Answer Question 26 in the Template on page 31 (6 minutes) Template for Question 26 Should Achieve Strategy Client’s Objectives (Circle One) One Yes No Two Yes No Justification QUESTION 27 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES Dinah Kees, the chief financial officer of Murphy Corporation, is reviewing a performance measurement report for Murphy’s defined benefit pension plan She notes that Arctic Asset Management (Arctic), a large capitalization U.S equity value manager, has significantly underperformed the S&P 500 for the year to date and past one- and three-year periods Exhibit 27-1 identifies factors that are included in the performance measurement report Exhibit 27-1 Performance Measurement Factors Arctic’s portfolio return S&P 500 index return Salomon World ex-U.S index return Russell 1000 Value index return Russell 2000 Growth index return Risk-free rate of return A P M E B X R Construct a formula, using factors from Exhibit 27-1, that measures the contribution of style to Arctic’s relative performance (3 minutes) B Construct a formula, using factors from Exhibit 27-1, that measures the contribution of stock selection to Arctic’s relative performance (3 minutes) C Discuss one advantage and one limitation of using return-based style analysis to identify unintended style bets in portfolio construction (6 minutes) QUESTION 28 HAS ONE PART FOR A TOTAL OF 18 MINUTES The following sequence of events describes a stock trade of TRP, Incorporated: • • • • 10:00 a.m — A portfolio manager gives the following order to a trader: SELL 50,000 shares TRP (market price $43.00) 10:30 a.m — The trade desk places the order with a broker (market price $41.00) 10:31 a.m — The broker executes the sale of 50,000 TRP shares at $40.25; commission is $0.05 per share Three days later — The market price of TRP closes at $38.00 Answer Question 28 by completing the blank boxes in the Template on page 41 (18 minutes) Template for Question 28 (Provide answers only in the blank boxes.) Identify the trading cost Commission Price Impact Describe the trading costs Explain how the trading costs are measured Explicit fee charged Provided for listed trades by a broker for services Cost of immediate execution Timing Cost of failing to find liquidity Total Cost of Trade Three-day return for unexecuted shares (cancelled trades) Sum of the costs Calculate the trading costs (per share) $0.05 QUESTION 29 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES Trustees of the Pallor Corp pension plan ask consultant Donald Millip to comment on the validity and appropriateness of using the performance of a median manager as a benchmark Millip states the following: • • • A Median manager benchmarks are statistically unbiased measures of performance over long periods of time Median manager benchmarks are unambiguous and are therefore easily replicated by managers wishing to adopt a passive/indexed approach Median manager benchmarks are not appropriate in all circumstances because the median manager universe encompasses many investment styles Indicate whether each of Millip’s statements is correct or incorrect If incorrect, justify your answer by referring to one characteristic of a valid benchmark Answer Question 29-A in the Template provided on page 45 (6 minutes) A trustee asks Millip to comment on the advantages and disadvantages of Value at Risk (VAR) as a risk management methodology Millip states the following: • • • B VAR provides managers with information on the risk characteristics of the total portfolio because VAR can measure risk on a comparable basis across asset classes VAR analyses are typically quite accurate because the model inputs are easy to determine VAR results are not dependent on past market conditions being representative of the future Indicate whether each of Millip’s statements is correct or incorrect If incorrect, justify your conclusion by citing one reason Answer Question 29-B in the Template provided on page 47 (6 minutes) Template for Question 29-A Statement: Correct or Median manager Incorrect benchmarks are … (Circle One) … statistically unbiased measures of performance over long periods of time Correct Incorrect … unambiguous and are therefore easily replicated by managers wishing to adopt a passive/indexed approach Correct Incorrect … not appropriate in all circumstances because the median manager universe encompasses many investment styles Correct Incorrect If Incorrect, Justify with One Characteristic of Valid Benchmark Template for Question 29-B Correct or Statement Incorrect (Circle One) VAR provides managers with information on the risk characteristics of the total portfolio because VAR can measure risk on a comparable basis across asset classes VAR analyses are typically quite accurate because the model inputs are easy to determine Correct Incorrect Correct Incorrect VAR results are not dependent on past market conditions being representative of the future Correct Incorrect If Incorrect, Justify with One Reason QUESTION 30 HAS ONE PART FOR A TOTAL OF 15 MINUTES Dayne Investment Managers, in existence since 1988, has created the performance presentation shown in Exhibit 30-1 Dayne believes that this presentation complies with the Global Investment Performance Standards (GIPS) Exhibit 30-1 Dayne Investment Managers, LLP Equity Composite January 1, 1995, through December 31, 1999 Year Total Return (percent) Number of Portfolios Composite Dispersion (percent) Total Assets at End of Period Percentage of Firm Assets Total Firm Assets 1995 11.0 20 1.5 123 45 273 1996 8.3 24 3.0 187 46 407 1997 5.4 33 4.4 222 56 396 1998 13.1 51 1.2 289 64 452 1999 15.6 65 2.9 355 62 572 Dayne has calculated the returns in this presentation in accordance with the Global Investment Performance Standards (GIPS) Cite five reasons why the presentation is not in compliance with GIPS Your answer should only be based on any errors or omissions in the presentation itself (15 minutes) QUESTION 31 HAS ONE PART FOR A TOTAL OF 12 MINUTES Benjamin Sparks is a consultant to Regal, Incorporated, a large U.S corporation Regal’s chief financial officer is considering adding bonds from other countries to Regal’s fixed income portfolio In a presentation to the CFO, Sparks makes the following statements: Forward currency exchange rates are poor predictors of future spot exchange rates The presence of a significant non-government bond market in developed countries provides opportunities to enhance returns through sector selection Investing in bond markets in countries outside the target international index can enhance returns, but also dramatically increases the risk in the portfolio Duration management is equally challenging for U.S bond portfolios and for portfolios containing bonds from several developed markets Indicate whether each statement is correct or incorrect If incorrect, justify your conclusion by citing one reason Answer Question 31 in the Template provided on page 57 (12 minutes) Template for Question 31 Statement Forward currency exchange rates are poor predictors of future spot exchange rates Correct or Incorrect (Circle One) Correct Incorrect The presence of a significant non-government bond market in developed countries provides opportunities to enhance returns through sector selection Investing in bond markets in countries outside the target international index can enhance returns, but also dramatically increases the risk in the portfolio Duration management is equally challenging for U.S bond portfolios and for portfolios containing bonds from several developed markets Correct Incorrect Correct Incorrect Correct Incorrect If Incorrect, Justify With One Reason QUESTION 32 HAS FOUR PARTS FOR A TOTAL OF 22 MINUTES Carol Harrod is the investment officer for a $100 million U.S pension fund The fixed income portion of the portfolio is actively managed, and a substantial portion of the fund’s large capitalization U.S equity portfolio is indexed and managed by Webb Street Advisors Harrod has been impressed with the investment results of Webb Street’s equity index strategy and is considering asking Webb Street to index a portion of the actively managed fixed income portfolio A Describe two advantages and two disadvantages of bond indexing relative to active bond management (8 minutes) Webb Street manages indexed bond portfolios that are constructed using two different methods Webb Street has stated that the source of tracking error is different for each method B Discuss how an indexed portfolio is constructed under each of the following methods: i ii Stratified sampling Optimization (4 minutes) C Describe the main source of tracking error for each of the following methods: i ii Stratified sampling Optimization (4 minutes) Harrod believes that an indexed bond portfolio should have less tracking error than an indexed equity portfolio D Indicate whether Harrod’s belief is correct or incorrect Give two reasons to support your position (6 minutes) CFA Level III Examination 2000 Afternoon Section IMPORTANT INSTRUCTIONS TO CANDIDATES Write your candidate number in the spaces provided at the top left corner of the front cover of this exam book Write your answers in blue or black ink on the correct answer pages in the 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 THIS EXAM BOOK FROM THE EXAM ROOM ... 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... minutes) CFA Level III Examination 2000 Morning Section IMPORTANT INSTRUCTIONS TO CANDIDATES Write your candidate number in the spaces provided at the top left corner of the front cover of this Essay. .. PROCTOR DO NOT REMOVE ANY EXAM BOOK OR ANSWER SHEET FROM THE EXAM ROOM CFA? ? Level III Essay Examination Book FOR AIMR USE ONLY 2000 Afternoon Section Candidate Number: FOR AIMR USE ONLY _ _