L3 mock sample exam CFA level III essay questions 2004

During an initial discussion of the Maclins’ financial plans, Christopher Maclin makes the following statements to the Maclins’ financial advisor, Grant Webb: • “I have used the Internet

2004 CFA ® Level III Examination

Morning Session – Essay

© 2004 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 Session of

the 2004 CFA Level III examination Candidates may want to refer to this list as they formulate their answers

Calculate: To ascertain or determine by mathematical processes

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 in 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

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

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

Recommend: To bring forward as being fit or worthy; to indicate as being one’s choice for

something or as otherwise having one’s approval or support

Show: To set forth in a statement, account, or description; to make evident or clear

Support: To provide with verification, corroboration, or substantiation

The Morning Session of the 2004 CFA Level III Examination has 13 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 Louise and Christopher Maclin A total of 72 minutes is

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

presented

QUESTION 1 HAS ONE PART FOR A TOTAL OF 9 MINUTES

Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment

in the metropolitan area During an initial discussion of the Maclins’ financial plans, Christopher Maclin makes the following statements to the Maclins’ financial advisor, Grant Webb:

• “I have used the Internet extensively to research the outlook for the housing

market over the next five years, and I believe now is the best time to buy a house.”

• “I do not want to sell any bond in my portfolio for a lower price than I paid for the

bond.”

• “I will not sell any of my company stock because I know my company and I

believe it has excellent prospects for the future.”

Identify the behavioral finance concept most directly exhibited in each of Maclin’s three

statements Explain how each behavioral finance concept is affecting Maclin’s investment

decision-making

Answer Question 1 in the Template provided on page 3

(9 minutes)

Answer Question 1 on This Page

Template for Question 1

Maclin’s three

statements

Identify the behavioral

finance concept most

directly exhibited in

each of Maclin’s three

statements

Explain how each behavioral finance

concept is affecting Maclin’s investment

decision-making

“I have used the Internet

extensively to research the

outlook for the housing

market over the next five

years, and I believe now is

the best time to buy a

house.”

“I do not want to sell any

bond in my portfolio for a

lower price than I paid for

the bond.”

“I will not sell any of my

company stock because I

know my company and I

believe it has excellent

prospects for the future.”

QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 20 MINUTES

Christopher Maclin, aged 40, is a supervisor at Barnett Co and earns an annual salary of £80,000 before taxes Louise Maclin, aged 38, stays home to care for their newborn twins She recently inherited £900,000 (after wealth-transfer taxes) in cash from her father’s estate In addition, the Maclins have accumulated the following assets (current market value):

• £5,000 in cash

• £160,000 in stocks and bonds

• £220,000 in Barnett common stock

The value of their holdings in Barnett stock has appreciated substantially as a result of the

company’s growth in sales and profits during the past ten years Christopher Maclin is confident that the company and its stock will continue to perform well

The Maclins need £30,000 for a down payment on the purchase of a house and plan to make a

£20,000 non-tax deductible donation to a local charity in memory of Louise Maclin’s father The Maclins’ annual living expenses are £74,000 After-tax salary increases will offset any future increases in their living expenses

During their discussions with Grant Webb, the Maclins express concern about achieving their educational goals for their children and their own retirement goals The Maclins tell Webb:

• They want to have sufficient funds to retire in 18 years when their children begin

their four years of university education

• They have been unhappy with the portfolio volatility they have experienced in

recent years and they do not want to experience a loss greater than 12 percent in any one year

• They do not want to invest in alcohol and tobacco stocks

• They will not have any additional children

After their discussions, Webb calculates that in 18 years the Maclins will need £2 million to meet their educational and retirement goals Webb suggests that their portfolio be structured to limit shortfall risk (defined as expected total return minus two standard deviations) to no lower than a negative 12 percent return in any one year Maclin’s salary and all capital gains and investment income are taxed at 40 percent and no tax-sheltering strategies are available Webb’s next step is

to formulate an investment policy statement for the Maclins

A i Formulate the risk objective of an investment policy statement for the Maclins

ii Formulate the return objective of an investment policy statement for the Maclins

Calculate the pre-tax rate of return that is required to achieve this objective Show your calculations

(12 minutes)

B Formulate the constraints portion of an investment policy statement for the Maclins,

addressing each of the following:

i Time horizon

ii Liquidity requirements

iii Tax concerns

iv Unique circumstances

Note: Your response should not address legal and regulatory factors

(8 minutes)

QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES

Louise and Christopher Maclin have purchased their house and made the donation to the local

charity Now that an investment policy statement has been prepared for the Maclins, Grant

Webb recommends that they consider the strategic asset allocation described in Exhibit 3-1

Exhibit 3-1 Louise and Christopher Maclin Recommended Strategic Asset Allocation

Allocation

Current Yield

Projected Annualized Pre-tax Total Return

Expected Standard Deviation

Cash 15.0% 1.0% 1.0% 2.5% U.K Corporate Bonds 55.0 4.0 5.0 11.0

U.K Small-capitalization Equities 0.0 0.0 11.0 25.0

U.K Large-capitalization Equities 10.0 2.0 9.0 21.0

U.S Equities* 5.0 1.5 10.0 20.0 Barnett Co Common Stock 15.0 1.0 16.0 48.0

Total Portfolio 100.0 - 6.7 12.4

*U.S equity data are in British pound terms

A Identify two aspects of the recommended asset allocation in Exhibit 3-1 that are

inconsistent with the Maclins’ investment objectives and constraints Support each of

your responses with one reason

Answer Question 3-A in the Template provided on page 15

• 10 to 15 percent in U.K large-capitalization equities

For the remainder of the portfolio, Webb is considering the asset class ranges described in

Exhibit 3-2

Exhibit 3-2 Louise and Christopher Maclin Asset Class Ranges

B Recommend the most appropriate allocation range for each of the asset classes in Exhibit

3-2 Justify each appropriate allocation range with one reason based on the Maclins’

investment objectives and constraints

Note: No calculations are required

Answer Question 3-B in the Template provided on page 16

(12 minutes)

Answer Question 3 on This Page

Template for Question 3-A

Identify two aspects of the

recommended asset allocation in

Exhibit 3-1 that are inconsistent with

the Maclins’ investment objectives

and constraints

Support each of your responses with one reason

1

2

Answer Question 3 on This Page

Template for Question 3-B

Note: No calculations are required

Asset Class

Recommend the most

appropriate allocation range for

each of the asset

classes in Exhibit 3-2

(circle one for each

asset class)

Justify each appropriate allocation range with one

reason based on the Maclins’ investment objectives

QUESTION 4 HAS TWO PARTS (A, B) FOR A TOTAL OF 7 MINUTES

Louise and Christopher Maclin are considering the rebalancing implications of two possible strategic asset allocation scenarios Grant Webb outlines a rebalancing methodology that sets upper and lower limits for the weights of each asset class based on the same fixed percentage bands for each asset class The portfolio will be rebalanced to the target allocations whenever the weight of an asset class violates the fixed percentage limits Webb also describes an alternate rebalancing methodology, based on standard deviation, in which each asset class is rebalanced when the weight for the asset class exceeds the number of standard deviations set for all asset classes

A Discuss why a rebalancing methodology based on fixed percentage bands may result in

excessive transaction costs in each of the following strategic asset allocation scenarios:

i The Maclins hold a small allocation (less than 5 percent) to an emerging market

equities fund

ii The Maclins hold a sizable allocation to a hedge fund that has experienced a

persistently very low correlation with the other assets in the portfolio

(4 minutes)

Webb is concerned about the negative effect of realized capital gains on the Maclins’ portfolio

B Determine, given Webb’s concern about realized capital gains, whether a rebalancing

methodology based on standard deviation is likely to be more or less appropriate than a

rebalancing methodology based on fixed percentage bands Justify your response with

one reason

(3 minutes)

QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES

Christopher Maclin, after reading an article in a business publication, expresses concern to Grant Webb that the U.S equity market is overvalued, especially when measured on a market value to book value basis Maclin is particularly concerned about the U.S technology and service

sectors Webb states that Tobin’s Q theory adjusts for possible distortions in market value to book value relationships; he also indicates, however, that the theory may not be appropriate for valuing technology and service sectors

A i Describe one adjustment that Tobin’s Q theory makes to address distortions in

market value to book value relationships

ii Describe one weakness of applying Tobin’s Q theory to technology and service

sectors

(6 minutes)

Webb explains to Maclin that equity market values can be compared to Gross Domestic Product (GDP) to determine whether a market is overvalued Webb states that while the ratio of market value of equity to GDP is currently high, he is not sure about the usefulness of the ratio given deleveraging activity in the U.S market and the fact that an increasing number of U.S firms are becoming public companies

B Explain how the usefulness of the ratio of market value of equity to GDP is likely to be

affected by:

i Deleveraging activity in a market

ii An increasing number of firms in a market becoming public companies

(6 minutes)

Webb indicates to Maclin that the Fed model can be used to forecast equity returns He tells Maclin, however, that he expects continued low interest rates and very low inflation in the U.S economy, and that such an economic scenario may have implications for the effectiveness of the Fed model

C i Explain how the Fed model identifies an overvalued equity market

ii Determine, in the economic scenario that Webb expects, whether the Fed model

is likely to be effective in identifying whether the equity market is overvalued or

undervalued Justify your response with one reason

(6 minutes)

Questions 6 through 11 relate to the Hale Health Foundation and the Glover Scholastic Aid

Foundation A total of 87 minutes is allocated to these questions Candidates should answer

these questions in the order presented

QUESTION 6 HAS TWO PARTS (A, B) FOR A TOTAL OF 22 MINUTES

The Hale Health Foundation is a company-sponsored U.S foundation with the sole mission of supporting the Graceville Clinic Over the past five years, Hale has contributed 75-80 percent of the Clinic’s operating budget Health care costs have grown at 1 percent above the annual rate of inflation, and this trend is expected to continue

This year, Hale estimates that its spending budget for the Clinic will be $11 million Hale’s management expenses average 0.40 percent of assets In addition to the ongoing spending budget, Hale is funding a new facility for the Clinic, which will require a final outlay of

$4 million within six months

Hale was founded five years ago by Nord Pharmaceuticals with a gift consisting of Nord

company stock and a 100 percent ownership interest in a privately-held computer consulting business Nord has contributed $2 million annually to Hale since the initial gift However, Nord has faced increasing capital expenditures and recently announced that it will be unable to make additional contributions to Hale The computer consulting business is expected to generate $1.25 million of pre-tax income this year; pre-tax income will grow with little volatility at the annual inflation rate, which is expected to be 1.5 percent for the foreseeable future The corporate tax rate is 20 percent

The following information relates to Hale’s Board of Trustees:

• The Board has diversified the portfolio over time so that Nord common equity

now comprises a small proportion of the overall portfolio The Board has expressed a desire to sell the computer consulting business because it requires an excessive amount of oversight by Hale’s Board and management Excluding the computer consulting business, Hale’s portfolio has a market value of $200 million

• The Board is concerned about the uncertainty of the exact dollar amount of

required spending during the year Historically, the Board has designated a portion of the portfolio to serve as a reserve of approximately 15 percent of its spending budget for the Clinic to ensure that Hale’s annual spending goals will be met

• The Board is aware of the market risk/return tradeoff and is willing to accept the

risk necessary to support Hale’s long-term growth orientation With respect to return on investable assets, the Trustees have agreed that a shortfall risk limit (defined as expected total return minus two standard deviations) of –14 percent in any one year is acceptable

Sarah Cole, an executive of Nord, has recently been appointed Trustee of Hale, with

responsibility for formulating a new investment policy statement to guide Hale’s investing activities

A i Formulate the risk objective of an investment policy statement for Hale

ii Formulate the return objective of an investment policy statement for Hale

Calculate the rate of return that is required to achieve this objective Show your

calculations

(12 minutes)

B Formulate the constraints portion of an investment policy statement for Hale, addressing

each of the following:

i Time horizon

ii Liquidity requirements

iii Tax concerns

iv Legal and regulatory factors

v Unique circumstances

(10 minutes)

QUESTION 7 HAS ONE PART FOR A TOTAL OF 7 MINUTES

The Hale Health Foundation has made the $4 million facility payment Sarah Cole is

considering the most appropriate strategic asset allocation for the Hale portfolio, given Hale’s investment objectives and constraints

A consultant has developed five alternative portfolios for Cole to consider, as shown in Exhibit 7-1

Exhibit 7-1 Hale Health Foundation Strategic Asset Allocation Five Alternative Portfolios

Alternative Portfolios Asset Allocation Percentages

(%) Asset Class

A B C D E

Cash Equivalents 1 2 4 3 6 U.S Intermediate-term Bonds 20 23 10 15 15 U.S High-yield Corporate Bonds 16 25 20 25 25

U.S Equities 35 35 20 30 24 Non-U.S Equities 13 5 25 15 15 Real Estate Investment Trusts 15 10 21 12 15 Total 100 100 100 100 100

Alternative Portfolios Portfolio Measures

A B C D E

Expected Annual Total Return (%) 8.42 7.59 8.77 8.13 7.90 Expected Standard Deviation (%) 11.18 10.31 11.54 10.85 10.28

Recommend the one alternative portfolio in Exhibit 7-1 that is the most appropriate strategic

asset allocation for the Hale portfolio Justify your response with three reasons Show your

calculations

(7 minutes)