L3 mock sample exam CFA level III essay questions 2001

2001 CFA® Level III Examination FOR AIMR USE ONLY Morning Section - Essay 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 © 2001 Association for Investment Management and Research All rights reserved 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 10 11 12 Topic Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Asset Valuation Asset Valuation Total: Minutes 28 10 18 15 20 12 23 12 18 180 Questions through 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 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 International Equities (MSCI World ex-U.K.) 10% U.K Small Capitalization Equities 13% U.K Large Capitalization Equities 30% U.K Bonds 42% Cash 5% Exhibit 1-2 Acme Industries Selected Financial Information (in millions) Acme Industries Total Assets Pension Plan Data: Plan Assets Plan Liabilities £16,000 £6,040 £9,850 There is an ongoing debate within Acme Industries about the pension plan’s investment policy statement (IPS) Two investment policy statements under consideration are shown in Exhibit 1-3 Return Requirement Exhibit 1-3 Investment Policy Statements IPS X IPS Y Plan’s objective is to outperform Plan’s objective is to match the the relevant benchmark return by relevant benchmark return a substantial margin 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 i ii iii iv Return Requirement Risk Tolerance Time Horizon Liquidity Note: Some components of IPS X may be appropriate, while other components of IPS Y may be appropriate Answer Question 1-A in the Template provided on pages and (16 minutes) 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 %) U.K Large Capitalization Equities U.K Small Capitalization Equities International Equities (MSCI World ex-U.K.) U.K Bonds Cash Total Expected Portfolio Return (%) Expected Portfolio Volatility (Standard Deviation in %) B Current 30 13 10 42 100 Graham 20 10 52 10 100 Michael 40 20 18 17 100 9.1 16.1 8.2 12.8 10.6 21.1 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: i ii iii Return Requirement Risk Tolerance Liquidity (12 minutes) Answer Question 1-B in the Template provided on page Template for Question 1-A Determine whether IPS X or Component IPS Y has appropriate language (Circle One) IPS X Return Requirement IPS Y IPS X Risk Tolerance IPS Y Template continued on next page Justify with one reason Template for Question 1-A (continued) Determine whether IPS X or Component IPS Y has appropriate language (Circle One) IPS X Time Horizon IPS Y IPS X Liquidity IPS Y Justify with one reason 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 Objective or Constraint Return Requirement Risk Tolerance Liquidity Graham Michael Explain how your selection meets each of the following objectives or constraints for the plan QUESTION HAS ONE PART FOR A TOTAL OF 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 forecast: Revise the investment policy statement of the pension plan to take into account a change in the forecast for inflation in the U.K Reallocate pension assets from domestic (U.K.) to international equities because he also expects inflation in the U.K to be higher than in other countries 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 in the Template provided on page 11 (9 minutes) Template for Question Comment 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 Agree or Disagree (Circle One) Agree Disagree Agree Disagree Agree Disagree Justify with one reason QUESTION HAS TWO PARTS FOR A TOTAL OF 20 MINUTES Stephenson, age 55 and single, is a surgeon Stephenson has accumulated a $2.0 million investment portfolio that has a large concentration in small capitalization U.S equities Over the past five years, the portfolio has averaged 20 percent annual total return on investment His newly hired financial advisor, Caroline Coppa, has compiled the following notes from her meetings with Stephenson: Stephenson hopes that, over the long term, his investment portfolio will continue to earn 20 percent annually For the remainder of this year, he would like to earn a return greater than the percent yield to maturity currently available from short-term government notes When asked about his risk tolerance, he described it as “average.” He was surprised when informed that U.S small cap portfolios have historically experienced extremely high volatility He does not expect to retire before age 70 His current income is more than sufficient to meet his expenses Upon retirement, he plans to sell his surgical practice and use the proceeds to purchase an annuity to cover his post-retirement cash flow needs He could not state any additional long-term goals or needs Both his income and realized capital gains are taxed at a 30 percent rate No pertinent legal or regulatory issues apply He has no pension or retirement plan but does have sufficient health insurance for post-retirement needs Stephenson asks Coppa to draft an investment policy statement based on their initial meetings A Formulate the following elements of Stephenson’s investment policy statement and justify your response for each element with two arguments: i ii Return Requirement Risk Tolerance (12 minutes) B Formulate the following elements of Stephenson’s investment policy statement and justify your response for each element with two arguments: i ii Liquidity Time Horizon (8 minutes) QUESTION HAS ONE PART FOR A TOTAL OF 12 MINUTES Stephenson’s current portfolio of $2.0 million is invested as shown in Exhibit 8-1 Exhibit 8-1 Summary of Stephenson’s Current Portfolio Percent Expected Annual Standard Value of Total Annual Return Deviation Short Term Bonds $200,000 10% 4.6% 1.6% Domestic Large Cap Equities $600,000 30% 12.4% 19.5% Domestic Small Cap Equities $1,200,000 60% 16.0% 29.9% Total Portfolio $2,000,000 100% 13.8% 23.1% Stephenson soon expects to receive an additional $2.0 million and plans to invest the entire amount in an index fund that best complements the current portfolio Coppa is evaluating the four index funds shown in Exhibit 8-2 for their ability to produce a portfolio that will meet the following two criteria relative to the current portfolio: • • maintain or enhance expected return maintain or reduce volatility Each fund is invested in an asset class that is not substantially represented in the current portfolio Index Fund Fund A Fund B Fund C Fund D Exhibit 8-2 Index Fund Characteristics Expected Expected Annual Annual Return Standard Deviation 15% 25% 11% 22% 16% 25% 14% 22% Correlation of Returns with Current Portfolio +0.80 +0.60 +0.90 +0.65 State which fund Coppa should recommend to Stephenson Justify your choice by describing how your chosen fund best meets both of Stephenson’s criteria No calculations are required (12 minutes) QUESTION HAS TWO PARTS FOR A TOTAL OF 23 MINUTES Twenty years later, Stephenson is meeting with his new financial advisor, Jennifer Bolger Bolger is evaluating whether Stephenson’s investment policy remains appropriate for his circumstances A • Stephenson is now age 75 and retired His spending requirements are expected to increase with the rate of general inflation, which is expected to average 3.0 percent annually • Stephenson estimates his current expenses at $150,000 annually An annuity, purchased with the proceeds from the sale of his surgical practice, provides $20,000 of this amount The annuity is adjusted for inflation annually using a national price index • Because of poor investment performance and a high level of spending, Stephenson’s asset base has declined to $1,200,000 exclusive of the value of the annuity • Stephenson sold all of his small-cap investments last year and invested the proceeds in domestic bonds • Because his past international equity investments have performed poorly, Stephenson has serious doubts about whether his portfolio should contain international equities • Stephenson plans to donate $50,000 to a charity in three months Discuss how each of the following components of Stephenson’s investment policy statement should now reflect the changes in his circumstances i ii iii iv Return Objective Risk Tolerance Liquidity Needs Time Horizon Note: Your discussion should focus on, but not be limited to, the direction and magnitude of change in each component rather than on a specific numeric change (8 minutes) Stephenson’s current investment portfolio is summarized in Exhibit 9-1 Exhibit 9-1 Stephenson’s Current Investment Portfolio Current Expected Allocation Return Cash Equivalents 2% 5% Fixed Income 75% 7% Domestic Equities 10% 10% International Equities 3% 12% Domestic Real Estate 10% 10% B Standard Deviation 3% 8% 16% 22% 18% State, given Stephenson’s changed circumstances, whether the current allocation to each asset class should be lower, the same, or higher Justify your response with one reason for each asset class No calculations are required i ii iii iv v Cash Equivalents Fixed Income Domestic Equities International Equities Domestic Real Estate Note: Your response should be based only on Stephenson’s changed circumstances and the information in Exhibit 9-1 Answer Question 9-B in the Template provided on page 58 (15 minutes) Template for Question 9-B State whether Asset Class allocation and should be Current Lower, Allocation Same, or Higher (Circle One) Cash Equivalents 2% Fixed Income 75% Domestic Equities 10% International Equities 3% Domestic Real Estate 10% Lower Same Higher Lower Same Higher Lower Same Higher Lower Same Higher Lower Same Higher Justify your response with one reason Questions 10 through 12 relate to Monty Frost A total of 39 minutes is allocated to these questions Candidates should answer these questions in the order presented QUESTION 10 HAS ONE PART FOR A TOTAL OF 12 MINUTES Monty Frost’s tax-deferred retirement account is invested entirely in equity securities Because the international portion of his portfolio has performed poorly in the past, he has reduced his international equity exposure to percent Frost’s investment advisor has recommended an increased international equity exposure Frost responds with the following comments: • Based on past poor performance, I want to sell all my remaining international equity securities once their market prices rise to equal their original cost • Most diversified international portfolios have had disappointing results over the past five years During that time, however, the market in Country XYZ has outperformed all other markets, even our own If I increase my international equity exposure, I would prefer that the entire exposure consist of securities from Country XYZ • International investments are inherently more risky Therefore, I prefer to purchase any international equity securities in my “speculative” account, my best chance at becoming rich I not want them in my retirement account, which has to protect me from poverty in my old age Frost’s advisor is familiar with behavioral finance concepts but prefers a traditional or standard finance approach (Modern Portfolio Theory) to investments Indicate the behavioral finance concept that Frost most directly exhibits in each of his three comments Explain how each of Frost’s comments can be countered using one standard finance argument Answer Question 10 in the Template provided on pages 61 and 62 (12 minutes) Template for Question 10 Comment Indicate the behavioral concept Based on past poor performance, I want to sell all my remaining international equity securities once their market prices rise to equal their original cost Most diversified international portfolios have had disappointing results over the past five years During that time, however, the market in Country XYZ has outperformed all other markets, even our own If I increase my international equity exposure, I would prefer that the entire exposure consist of securities from Country XYZ Template continued on next page Explain how comment can be countered using one standard finance argument Template for Question 10 (continued) Comment International investments are inherently more risky Therefore, I prefer to purchase any international equity securities in my “speculative” account, my best chance at becoming rich I not want them in my retirement account, which has to protect me from poverty in my old age Indicate the behavioral concept Explain how comment can be countered using one standard finance argument QUESTION 11 HAS ONE PART FOR A TOTAL OF MINUTES Frost inherited an apartment building He initially intended to keep the building, but his attorney suggested that Frost consider selling the building and buying some undeveloped land on the edge of the city The owner of the land had planned to clear it and build a new shopping mall but now is being forced to sell the land at a price below its appraised value Both the apartment building and the land when developed would have the same correlation of returns with Frost’s original portfolio Frost’s attorney made the following comments: The high occupancy rate of your apartment building exceeds the occupancy rate of comparable local apartment buildings As a result, the apartments will not have much potential for price appreciation Although the undeveloped land investment will not provide immediate cash flow, its long-term potential for price appreciation is significant because you can develop a shopping mall there If you prefer not to invest directly in real estate, equity real estate investment trust (EREIT) shares would allow you to diversify across different geographic sectors of the real estate market and would be more liquid than the other alternatives Critique each of the three comments Ignore tax and leverage considerations (9 minutes) QUESTION 12 HAS THREE PARTS FOR A TOTAL OF 18 MINUTES A few weeks later, Frost spoke with Dawn Adoni, a wealthy individual who had heard about Frost’s inheritance Adoni told Frost, “You should sell that apartment building and invest in hedge funds I invested in three types of hedge funds—a quantitative long/short fund, an arbitrage/relative value fund, and a fund of funds—and made a lot of money last year.” To evaluate Adoni’s advice, Frost decided to analyze each of the three funds Adoni mentioned with respect to the fund’s: • • • underlying assumption investment strategy potential downside exposure Frost’s conclusions are presented in Exhibit 12-1 Exhibit 12-1 Frost’s Hedge Fund Conclusions A B Conclusions about Conclusions about Underlying Investment Strategy Assumption C Conclusions about Potential Downside Exposure Quantitative Long/Short Fund Security mispricings exist that can be identified by analyzing the business prospects of issuers within an industry Analyze and backtest historical business data to identify persistent opportunities for unusual returns Exposure to events that have a similar effect on the prices of securities in each of two closely related industries Arbitrage/Relative Value Fund Mispricings exist between closely related securities that are not related to the business prospects of the issuers Mispricings in currencies, bonds, or equities can be found by analyzing global macroeconomic events Invest in a number of hedge funds to gain returns from each identified mispricing Exposure to events that have a different effect on the prices of each of two closely related securities Exposure to systematic risk across hedge fund sector (specific risk diversified away) Hedge Fund Fund of Funds Take positions based on manager’s expectations concerning global macroeconomic events Judge whether each of Frost’s conclusions is correct or incorrect If incorrect, give one reason why the conclusion is incorrect Answer Question 12-A, 12-B, and 12-C in the Templates provided on pages 69, 70, and 71 (18 minutes) Template for Question 12-A A Judge whether Conclusions about each conclusion Underlying is Correct or Assumption Incorrect (Circle One) Quantitative Long/Short Fund Security mispricings exist that can be identified by analyzing the business prospects of issuers within an industry Correct Incorrect Arbitrage/Relative Value Fund Mispricings exist between closely related securities that are not related to the business prospects of the issuers Correct Incorrect Fund of Funds Mispricings in currencies, bonds, or equities can be found by analyzing global macroeconomic events Correct Incorrect If incorrect, give one reason Template for Question 12-B B Judge whether Conclusions about each conclusion Investment is Correct or Strategy Incorrect (Circle One) Quantitative Long/Short Fund Analyze and backtest historical business data to identify persistent opportunities for unusual returns Correct Incorrect Arbitrage/Relative Value Fund Invest in a number of hedge funds to gain returns from each identified mispricing Correct Incorrect Fund of Funds Take positions based on manager’s expectations concerning global macroeconomic events Correct Incorrect If incorrect, give one reason Template for Question 12-C C Judge whether Conclusions about each conclusion Potential is Correct or Downside Incorrect Exposure (Circle One) Quantitative Long/Short Fund Exposure to events that have a similar effect on the prices of securities in each of two closely related industries Correct Incorrect Arbitrage/Relative Value Fund Exposure to events that have a different effect on the prices of each of two closely related securities Correct Incorrect Fund of Funds Exposure to systematic risk across hedge fund sector (specific risk diversified away) Correct Incorrect If incorrect, give one reason 2001 CFA Level III Examination Morning Section – Essay IMPORTANT INSTRUCTIONS TO CANDIDATES Write your candidate number in the spaces provided on the front cover of this Essay examination book Complete and sign the pledge attached to the front cover of this examination book Your examination will not be graded unless the pledge is signed The pledge will be detached prior to grading Write your answers in blue or black ink on the designated answer pages in the examination book Label each part of your answer (A, B, C, D or i, ii, iii, etc.) Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C calculator All other calculators will be confiscated and a report will be submitted to AIMR 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 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 examination book Label extra pages with the correct question number You must stop writing immediately when instructed to so at the conclusion of the examination Violations of any of AIMR's examination rules will result in AIMR voiding your examination results and may lead to a suspension or termination of candidacy in the CFA Program DO NOT OPEN THIS EXAMINATION BOOK UNTIL INSTRUCTED TO DO SO BY THE PROCTOR DO NOT REMOVE ANY EXAMINATION MATERIALS FROM THE EXAMINATION ROOM ... reason 2001 CFA Level III Examination Morning Section – Essay IMPORTANT INSTRUCTIONS TO CANDIDATES Write your candidate number in the spaces provided on the front cover of this Essay examination... 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...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: