L3 mock sample exam CFA level III essay questions 2001

Template for Question 1-B Select which of the three asset allocations in Exhibit 1-4 is most appropriate for Acme’s pension plan Check One Current Graham Michael... Glenn Rose is an

2001 CFA ® Level III Examination

Morning Section - Essay

© 2001 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 2001 Level III examination Candidates may want to refer to this list as they formulate their answers

Critique: To offer a critical review or commentary

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

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

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

the reason for or cause of

Formulate: To put into a systematized statement or expression; to prepare according to a

formula

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

consideration, acceptance, or use of another

Indicate: To point out or point to with more or less exactness; to show or make known

with a fair degree of certainty

Judge: To form an opinion about through careful weighing of evidence and testing of

premises

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 2001 CFA Level III Examination has 12 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

Questions 1 through 5 relate to the pension plan of Acme Industries A total of 80 minutes

is allocated to these questions Candidates should answer these questions in the order

presented

QUESTION 1 HAS TWO PARTS FOR A TOTAL OF 28 MINUTES

Angus Walker, CFA, is reviewing the defined benefit pension plan of Acme Industries Based in London, Acme has operations in North America, Japan, and several European countries Next month, the retirement age for full benefits under the plan will be lowered from age 60 to age 55 The median age of Acme’s workforce is 49 years Walker is responsible for the pension plan’s investment policy and strategic asset allocation decisions The goals of the plan include

achieving a minimum expected return of 8.4 percent with expected standard deviation no greater than 16.0 percent

Walker is evaluating the current asset allocation (Exhibit 1-1) and selected financial information for the company (Exhibit 1-2)

Exhibit 1-1 Acme Pension Plan Current Asset Allocation

U.K Bonds42%

Cash5%

U.K Large Capitalization Equities30%

U.K Small Capitalization Equities13%

International Equities (MSCI World ex-U.K.)10%

Exhibit 1-2 Acme Industries Selected Financial Information

Return Requirement Plan’s objective is to outperform

the relevant benchmark return by

a substantial margin

Plan’s objective is to match the relevant benchmark return

Risk Tolerance Plan has a high risk tolerance

because of the long-term nature

of the plan and its liabilities

Plan has a low risk tolerance because of its limited ability to assume substantial risk

Time Horizon Plan has a very long time horizon

because of the plan’s infinite life

Plan has a shorter time horizon than in the past because of plan demographics

Liquidity Plan needs moderate level of

liquidity to fund monthly benefit payments

Plan has minimal liquidity needs

A Determine, for each of the following components, whether IPS X or IPS Y has the

appropriate language for the pension plan of Acme Industries Justify each response

with one reason

To assist Walker, Acme has hired two pension consultants, Lucy Graham and Robert Michael

Graham believes that the pension fund must be invested to reflect a low risk tolerance, but

Michael believes the pension fund must be invested to achieve the highest possible returns The

fund’s current asset allocation and the allocations recommended by Graham and Michael are

shown in Exhibit 1-4

Exhibit 1-4 Asset Allocations (in %)

Expected Portfolio Volatility

(Standard Deviation in %)

16.1 12.8 21.1

B Select which of the three asset allocations in Exhibit 1-4 is most appropriate for Acme’s

pension plan Explain how your selection meets each of the following objectives or

constraints for the plan:

iii Liquidity

(12 minutes) Answer Question 1-B in the Template provided on page 8

Template for Question 1-A

Component

Determine whether IPS X or IPS Y has appropriate language (Circle One)

Justify with one reason

Return

Requirement

IPS X IPS Y

Risk

Tolerance

IPS X IPS Y

Template continued on next page

Template for Question 1-A (continued)

Component

Determine whether IPS X or IPS Y has appropriate language (Circle One)

Justify with one reason

Time Horizon

IPS X IPS Y

Liquidity

IPS X IPS Y

Template for Question 1-B

Select which of the three asset allocations in Exhibit 1-4 is most appropriate for Acme’s pension plan (Check One)

Current
Graham
Michael

QUESTION 2 HAS ONE PART FOR A TOTAL OF 9 MINUTES

Michael has developed an economic forecast for presentation to the Board of Trustees of Acme’s defined benefit pension plan He projects that U.K inflation will be substantially higher over the next three years than the Board’s current forecast

Michael recommends that the Board immediately take the following actions based on his

3 Initiate a program to protect the financial strength of the pension plan from the effects

of U.K inflation by indexing benefits paid by the plan

State whether each recommended action is correct or incorrect Justify each of your responses

with one reason

Answer Question 2 in the Template provided on page 11

(9 minutes)

Template for Question 2

Action

State whether each recommended action is Correct or Incorrect (Circle One)

Justify with one reason

QUESTION 3 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES

Glenn Rose is an equity portfolio manager for Acme’s pension plan; the portfolio he manages for Acme is currently invested 100 percent in domestic securities The Board of Trustees has urged Rose to investigate aggressively pursuing global investments Rose is deciding whether or not to add international equity securities to the portfolio

Rose has identified an international emerging market and an international developed market for possible investment He is reviewing Exhibits 3-1 and 3-2, which contain forecasts of expected 5-year performance characteristics for the domestic market and the two international markets under two different scenarios

Rose has decided to pursue one of three possible investment strategies:

1 100 percent domestic (his current portfolio)

2 50 percent domestic market and 50 percent international developed market

3 50 percent domestic market and 50 percent international emerging market

He has decided that he will not hedge any foreign exchange exposure

Exhibit 3-1 Scenario I Forecasted 5-Year Data (in Domestic Currency)

Domestic Market International Emerging

Market

International Developed Market

Expected Correlation Matrix

Domestic Market

International Emerging Market

International Developed Market

Using only the information in Exhibit 3-1,

A Determine which one of the three strategies Rose should pursue if Scenario I is accurate

Justify your response with two reasons No calculations are required

(5 minutes)

Exhibit 3-2 Scenario II Forecasted 5-Year Data (in Domestic Currency)

Domestic Market International Emerging

Market

International Developed Market

Expected Correlation Matrix

Domestic Market

International Emerging Market

International Developed Market

Using only the information in Exhibit 3-2,

B Determine which one of the three strategies Rose should pursue if Scenario II is

accurate Justify your response with two reasons No calculations are required

(5 minutes)

QUESTION 4 HAS TWO PARTS FOR A TOTAL OF 18 MINUTES

During the annual review of Acme’s pension plan, several Trustees questioned Graham about various aspects of performance measurement and risk assessment

In particular, one Trustee asked about the appropriateness of using each of the following

benchmarks:

• market index

• benchmark normal portfolio

• median of the manager universe

A Explain two different weaknesses of using each of the three benchmarks to measure the

performance of a portfolio

Note: Your response must contain a total of six different weaknesses

Answer Question 4-A in the Template provided on pages 21 and 22

(6 minutes)

Another Trustee asked how to distinguish among the following performance measures:

• the Sharpe ratio

• the Treynor measure

• Jensen’s alpha

B i Describe how each of the three performance measures is calculated

ii State whether each measure assumes that the relevant risk is systematic,

unsystematic, or total Explain how each measure relates excess return and the

relevant risk

(12 minutes)

Template for Question 4-A

Benchmark Explain two different weaknesses of using each of the benchmarks to

measure the performance of a portfolio

Template for Question 4-A (continued)

Benchmark Explain two different weaknesses of using each of the benchmarks to

measure the performance of a portfolio

1

Median of the

manager universe

2

QUESTION 5 HAS TWO PARTS FOR A TOTAL OF 15 MINUTES

Edmondson Capital Management is one of the investment managers for the Acme pension fund

portfolio Edmondson is based in the U.K and has prepared a draft Performance Report (Exhibit

5-1) about one of its products for distribution to current and potential clients

Exhibit 5-1 Edmondson Capital Management Performance Results: Balanced Composite January 1, 1990 through December 31, 2000

Composite Dispersion (%)

Total Assets

at End of Period (£ millions)

Percentage

of Firm Assets (%)

Total Firm Assets (£ millions)

Edmondson has prepared and presented this report in compliance with the Global Investment Performance Standards™

(GIPS™) Edmondson is an independent investment management firm that is not affiliated with any parent organization

Independent Verifiers, Ltd has reviewed the Performance Report in Exhibit 5-1 and has

recommended that the following notes, among others, should be included in a GIPS compliant

statement:

1 All balanced accounts over £1.0 million are included in the composite at the beginning of the

first full quarter under management

2 The balanced composite is denominated in pounds (£) and asset-weighted as of the end of the

period

3 The year 1995 is not in compliance with GIPS

A State whether or not each of the Notes 1 through 3 meets the disclosure and calculation

requirements for a performance report to be GIPS compliant Explain why each note

does or does not meet the disclosure and calculation requirements

Answer Question 5-A in the Template provided on page 29

(6 minutes)

Edmondson has now brought the year 1995 into compliance with GIPS and also claims

compliance with the AIMR Performance Presentation Standards™ (AIMR-PPS™) Edmondson manages accounts for high net worth individuals Several of Edmondson’s clients have special instructions concerning the management of their assets The managing directors of Edmondson are uncertain about including these portfolios in Edmondson’s balanced composite

• Client X has given Edmondson a portfolio of £25 million to manage For tax reasons, Client X has requested that Edmondson not realize any profits (capital gains) on existing assets in the portfolio

• Client Y has given Edmondson a portfolio of £50 million to manage and instructed Edmondson to overlay a tactical asset allocation strategy This tactical asset

allocation portion now equals 25 percent of the total market value of the original portfolio

• Client Z has given Edmondson a portfolio of £10 million with discretion to leverage the account The client restricts margin to 50 percent of the market value of the portfolio Edmondson subsequently leverages the account to £13 million

B Determine whether each of these client portfolios should be included in Edmondson’s

balanced composite to ensure that Edmondson’s performance presentation report is

prepared in compliance with AIMR-PPS Justify each response with one reason

Indicate, for each of the portfolios included, the pound (£) amount that should be

included in the composite calculation

Answer Question 5-B in the Template provided on page 31

(9 minutes)

Template for Question 5-A

Note

State whether each note meets requirements (Circle One)

Explain why each note does or does not meet requirements

Template for Question 5-B

Client

Determine

whether

client portfolio

Questions 6 – 9 relate to James Stephenson A total of 61 minutes is allocated to these

questions Candidates should answer these questions in the order presented

QUESTION 6 HAS ONE PART FOR A TOTAL OF 6 MINUTES

James Stephenson has accumulated a substantial investment portfolio without any clear term strategy in mind His current investment advisor recommends that he develop an investment policy for his portfolio Stephenson solicits advice from several friends with experience in the financial markets Their advice includes:

long-
My investment firm, based on its experience with investors, has standard

policy statements in five categories You would be better served to adopt

one of these standard policy statements instead of spending time

developing a policy based on your individual circumstances

Developing a long-term policy can be unwise given the fluctuations of the

market You want your investment advisor to react to changing conditions

and not be limited by a set policy

Because your investment advisor will retire in the next year or two, it

would be inappropriate to commit to an investment policy before you

solicit the input of your new advisor

State whether you agree or disagree with each of the above comments Justify each of your

conclusions with one reason

Answer Question 6 in the Template provided on page 35

(6 minutes)

Template for Question 6

Comment

State Agree or Disagree (Circle One)

Justify with one reason

My investment firm, based

on its experience with

investors, has standard

policy statements in five

categories You would be

better served to adopt one

of these standard policy

statements instead of

spending time developing

a policy based on your

individual circumstances

Agree

Disagree

Developing a long-term

policy can be unwise

given the fluctuations of

the market You want your

investment advisor to

react to changing

conditions and not be

limited by a set policy

Agree

Disagree

Because your investment

advisor will retire in the

next year or two, it would

be inappropriate to

commit to an investment

policy before you solicit

the input of your new

advisor

Agree

Disagree