2004 CFA® Level III Examination FOR AIMR USE ONLY Morning Session – Essay Candidate Number: FOR AIMR USE ONLY _ _ _ _ _ _ _ THIS BOOK IS THE PROPERTY OF: Association for Investment Management and Research® 560 Ray C Hunt Drive Charlottesville VA 22903-0668 USA Tel: 434-951-5499 © 2004 Association for Investment Management and Research All rights reserved 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 10 11 12 13 Topic Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Asset Valuation Asset Valuation Asset Valuation Portfolio Management Portfolio Management Total: Minutes 20 18 18 22 18 16 18 10 11 180 Questions through 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 HAS ONE PART FOR A TOTAL OF 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 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 in the Template provided on page (9 minutes) Answer Question on This Page Template for Question Maclin’s three statements “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 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 QUESTION 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 not want to experience a loss greater than 12 percent in any one year • They 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 ii iii iv Time horizon Liquidity requirements Tax concerns Unique circumstances Note: Your response should not address legal and regulatory factors (8 minutes) QUESTION 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 Asset Class Recommended Allocation Cash 15.0% U.K Corporate Bonds 55.0 U.K Small-capitalization Equities 0.0 U.K Large-capitalization Equities 10.0 U.S Equities* 5.0 Barnett Co Common Stock 15.0 Total Portfolio 100.0 *U.S equity data are in British pound terms A Current Yield 1.0% 4.0 0.0 2.0 1.5 1.0 - Projected Annualized Pre-tax Total Return 1.0% 5.0 11.0 9.0 10.0 16.0 6.7 Expected Standard Deviation 2.5% 11.0 25.0 21.0 20.0 48.0 12.4 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 (6 minutes) After further discussion, Webb and the Maclins agree that any suitable strategic asset allocation will include: • to 10 percent in U.K small-capitalization equities • 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 Asset Class Exhibit 3-2 Louise and Christopher Maclin Asset Class Ranges Allocation Ranges Cash 0% to 3% 5% to 10% 15% to 20% 10% to 20% 30% to 40% 50% to 60% U.S Equities 0% to 5% 10% to 15% 20% to 25% Barnett Co Common Stock 0% to 5% 10% to 15% 20% to 25% U.K Corporate Bonds 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 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 QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES The Glover Scholastic Aid Foundation has received a €20 million global government bond portfolio from a Greek donor This bond portfolio will be held in euros and managed separately from Glover’s existing U.S dollar-denominated assets Although the bond portfolio is currently unhedged, the portfolio manager, Raine Sofia, is investigating various alternatives to hedge the currency risk of the portfolio The bond portfolio’s current allocation and the relevant country performance data are given in Exhibits 9-1 and 9-2 Historical correlations for the currencies being considered by Sofia are given in Exhibit 9-3 Sofia expects that future returns and correlations will be approximately equal to those given in Exhibits 9-2 and 9-3 Exhibit 9-1 Glover Scholastic Aid Foundation Current Allocation Global Government Bond Portfolio Allocation Maturity Country (%) (years) Greece 25 A 40 B 10 10 C 10 D 15 10 Country Greece A B C D Exhibit 9-2 Country Performance Data (in local currency) 5-year 10-year Unhedged Cash Excess Excess Currency Return Bond Bond Return (%) Return Return (%) (%) (%) 2.0 1.5 2.0 1.0 2.0 3.0 –4.0 4.0 0.5 1.0 2.0 3.0 1.0 2.0 –2.0 2.6 1.4 2.4 –3.0 Liquidity of 90-day Currency Forward Contracts Good Good Fair Fair Good Exhibit 9-3 Historical Currency Correlation Table (1998-2003, weekly observations) € Currency A B C D (Greece) € (Greece) 1.00 –0.77 0.45 –0.57 0.77 A 1.00 –0.61 0.56 –0.70 B 1.00 –0.79 0.88 C 1.00 –0.59 D 1.00 A Calculate the expected total annual return (euro-based) of the current bond portfolio if Sofia decides to leave the currency risk unhedged Show your calculations (4 minutes) B Explain, with respect to currency exposure and forward rates, the circumstance in which Sofia should use a currency forward contract to hedge the current bond portfolio’s exposure to a given currency (3 minutes) C Determine which one of the currencies being considered by Sofia would be the best proxy hedge for Country B bonds Justify your response with two reasons (5 minutes) Sofia has been disappointed with the low returns on the current bond portfolio relative to the benchmark—a diversified global bond index—and is exploring general strategies to generate excess returns on the portfolio She has already researched two such strategies: duration management and investing in markets outside the benchmark index D Identify three general strategies (other than duration management and investing in markets outside the benchmark index) that Sofia could use to generate excess returns on the current bond portfolio Give, for each of the three strategies, a potential benefit specific to the current bond portfolio Answer Question 9-D in the Template provided on page 52 (6 minutes) Answer Question on This Page Template for Question 9-D Identify three general strategies (other than duration management and investing in markets outside the benchmark index) that Sofia could use to generate excess returns on the current bond portfolio Give, for each of the three strategies, a potential benefit specific to the current bond portfolio QUESTION 10 HAS TWO PARTS (A, B) FOR A TOTAL OF 16 MINUTES After several years, the Board of Trustees of the Glover Scholastic Aid Foundation has decided to allocate 12 percent of Glover’s total portfolio to international equities The Board is considering three alternative international equity managers: Highlands Investments, Coastal Asset Management, and Valley Advisors Portfolio statistics for Glover’s current total portfolio and each of the three alternative equity managers are given in Exhibit 10-1 Exhibit 10-2 gives portfolio statistics for Glover’s current total portfolio combined with Coastal and Valley, respectively The appropriate risk-free rate of return is 3.82 percent All returns are U.S.-dollar based Exhibit 10-1 Glover Scholastic Aid Foundation Portfolio Statistics Glover’s Coastal Current Highlands Asset Total Investments Management Portfolio Return Prior Years 2.10% –2.60% –3.50% –0.50% - 0.83 0.80 0.87 Expected Return 8.50% 8.50% 9.75% 10.50% Expected Standard Deviation 13.50% 27.00% 18.50% 32.00% - 309.80 162.34 367.20 - 0.85 0.65 0.85 Correlation Prior Years with Current Glover Portfolio Expected Covariance with Current Glover Portfolio Expected Correlation with Current Glover Portfolio Exhibit 10-2 Glover Scholastic Aid Foundation Combined Portfolio Statistics Highlands and Coastal and Glover Portfolio Glover Portfolio Combined Combined Return Prior Years 1.43% Expected Return 8.65% Expected Standard Deviation 13.43% A Valley Advisors Valley and Glover Portfolio Combined 1.79% 8.74% 15.28% Recommend one of the three alternative international equity managers being considered by Glover’s Board of Trustees Justify your response with reference to the portfolio statistics for all three managers (7 minutes) The Board has asked a consultant about possible determinants of the long-term performance of Glover’s international equity investments The consultant makes the following statements: B • “Because Glover’s portfolio has a long-term time horizon, currency risk makes a much larger contribution to total risk than would be the case for an investor with a short-term time horizon.” • “So-called ‘correlation breakdowns’ present Glover with an opportunity to enhance portfolio diversification.” • “Glover can expect to realize superior long-term returns by identifying and investing in international economies that have consistently offered superior performance over time.” Indicate whether each of the consultant’s three statements is correct or incorrect If incorrect, give one reason why the statement is incorrect Answer Question 10-B in the Template provided on page 59 (9 minutes) Answer Question 10 on This Page Template for Question 10-B Consultant’s three statements “Because Glover’s portfolio has a long-term time horizon, currency risk makes a much larger contribution to total risk than would be the case for an investor with a shortterm time horizon.” “So-called ‘correlation breakdowns’ present Glover with an opportunity to enhance portfolio diversification.” “Glover can expect to realize superior long-term returns by identifying and investing in international economies that have consistently offered superior performance over time.” Indicate whether each of the consultant’s three statements is correct or incorrect (circle one for each statement) Correct Incorrect Correct Incorrect Correct Incorrect If incorrect, give one reason why the statement is incorrect QUESTION 11 HAS ONE PART FOR A TOTAL OF 18 MINUTES Several more years have passed, and the Board of Trustees of the Glover Scholastic Aid Foundation has invested in developed international equity markets with reasonable success Recently, the Board discussed adding emerging market equities to the portfolio During the discussion, Board members Mark McDuff and Freda Dorton made statements, shown in Exhibit 11-1, about three aspects—currency risk, segmentation and integration, and volatile markets—of investing in emerging markets McDuff Dorton McDuff Dorton McDuff Dorton Exhibit 11-1 Mark McDuff and Freda Dorton Statements about Three Aspects of Investing in Emerging Markets I Currency Risk For emerging markets, we should expect the local currency movement to be in the opposite direction of the local stock market movement Because of the nature of the correlation of market returns and currencies, we could suffer more in a down market by investing in emerging markets than if we had invested in a developed market II Segmentation and Integration Because of economic linkages, the expected returns of the individual countries should be a function of those countries’ commonly shared risks Market efficiency transcends borders because of the global nature of world economies Local market prices will reflect these efficiencies III Volatile Markets When looking at investing in volatile emerging markets, we will find that standard deviation is a sufficient measure of risk Because emerging markets are often highly volatile, we need to be aware of the possibility of large shocks to returns The distribution of those returns tends to be non-normal Indicate, for each of the three aspects of investing in emerging markets, whether each of the statements made by McDuff and Dorton is correct or incorrect If incorrect, give one reason why the statement is incorrect Answer Question 11 in the Template provided on pages 63, 64, and 65 (18 minutes) Answer Question 11 on This Page Template for Question 11 Indicate, for each of the three aspects of investing in emerging markets, whether each of the statements made by Three aspects McDuff and Dorton is correct or incorrect (circle correct or incorrect for each statement) If incorrect, give one reason why the statement is incorrect Correct McDuff’s statement Incorrect I Currency Risk Correct Dorton’s statement Incorrect Template for Question 11 continued on pages 64 and 65 Answer Question 11 on This Page Template for Question 11 (continued) Indicate, for each of the three aspects of investing in emerging markets, whether each of the statements made by Three aspects McDuff and Dorton is correct or incorrect (circle correct or incorrect for each statement) If incorrect, give one reason why the statement is incorrect Correct McDuff’s statement Incorrect II Segmentation and Integration Correct Dorton’s statement Incorrect Template for Question 11 continued on page 65 Answer Question 11 on This Page Template for Question 11 (continued) Indicate, for each of the three aspects of investing in emerging markets, whether each of the statements made by Three aspects McDuff and Dorton is correct or incorrect (circle correct or incorrect for each statement) Correct McDuff’s statement Incorrect III Volatile Markets Correct Dorton’s statement Incorrect If incorrect, give one reason why the statement is incorrect QUESTION 12 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 10 MINUTES Kenneth Lee, CFA, is evaluating the performance of several asset management firms Dragon International Advisors Ltd (DIAL), a well-known Singapore-based firm, states that its objective is to be a regional specialist in security selection and market allocation DIAL indicates that it seeks to outperform the MSCI Far East Index (MSCI-FEI) by: (1) identifying substantial investment opportunities in undervalued and under-researched securities within the index’s country components, and (2) overweighting/underweighting country components versus the MSCI-FEI DIAL further states that it does not practice active currency management as part of its investment strategy The recent performance of DIAL’s growth equity composite is summarized in Exhibit 12-1 The country components of the composite have average risk relative to their respective country indexes Relevant information for the MSCI-FEI is summarized in Exhibit 12-2 Country Component Hong Kong Japan Singapore Composite Exhibit 12-1 Dragon International Advisors Ltd Growth Equity Composite Rate of Rate of MSCI-FEI Rate Currency Country Return in Return in of Return in Local Contribution Base Weights Local Currency Currency Currency 30% –4.70% –8.70% 4.00% –8.00% 45% 10.40% 2.40% 8.00% 4.00% 25% 15.60% 15.60% 0.00% 7.50% 100% 7.17% 2.37% 4.80% 1.28% Exhibit 12-2 MSCI Far East Index (MSCI-FEI) Rate of Return Rate of Return Country Country Currency in Base in Local Component Weights Contribution Currency Currency Hong Kong Japan Singapore Index 30% 55% 15% 100% –4.00% 12.00% 7.50% 6.53% –8.00% 4.00% 7.50% 0.93% 4.00% 8.00% 0.00% 5.60% Lee has evaluated the contribution of market allocation to the total return of DIAL’s growth equity composite He wants to further evaluate the performance of the composite, especially with respect to DIAL’s statements about security selection and active currency management A Determine the performance of DIAL’s growth equity composite relative to the MSCIFEI in terms of: i ii Base currency Local currency Show your calculations (4 minutes) B Judge whether the contribution of security selection to the total return of DIAL’s growth equity composite is consistent with DIAL’s stated objective regarding security selection Justify your response with one reason (3 minutes) C Judge whether the contribution of currency movements to the total return of DIAL’s growth equity composite is consistent with DIAL’s statement about active currency management Justify your response with one reason (3 minutes) QUESTION 13 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 11 MINUTES Julia Lueck, principal of Dragon International Advisors Ltd (DIAL), has decided that DIAL will comply with the Global Investment Performance Standards (GIPS®) She begins by reviewing all monthly composite calculations to ensure that DIAL has complied with all of the GIPS composite calculation requirements DIAL currently presents its investment performance using a composite, calculated on a monthly basis, for each investment objective DIAL’s growth equity composite consists of four client portfolios that are fully invested in large-capitalization growth equities, as shown in Exhibit 13-1 Client Portfolio A B C D Total A Exhibit 13-1 Dragon International Advisors Ltd Growth Equity Composite Performance Period: December 2003 Beginning Market Ending Market Value Value (Millions of (Millions of Singapore Dollars) Singapore Dollars) 125.0 126.5 220.0 218.0 68.0 69.8 92.0 93.9 505.0 508.2 Monthly Return (%) 1.20 0.91 1.65 1.10 Calculate the GIPS-compliant composite-level return for DIAL’s growth equity composite for December 2003 Show your calculations (3 minutes) Lueck determines that the monthly returns are gross of both management fees and transaction costs B Discuss whether DIAL can present each of the following in compliance with the accountlevel calculation requirements of GIPS: i ii Returns that are gross of management fees Returns that are gross of transaction costs (4 minutes) Lueck has decided that DIAL will obtain an independent third-party verification prior to claiming compliance with GIPS, and has contracted with a local firm to perform a verification of only the growth equity composite C Discuss whether: i ii DIAL may claim compliance with GIPS without independent third-party verification Lueck’s plan to obtain independent verification of only the growth equity composite would comply with GIPS (4 minutes) 2004 CFA® Level III Examination Morning Session – Essay IMPORTANT INSTRUCTIONS TO CANDIDATES Write your candidate number in the spaces provided on the front cover of this 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.) 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 Use only the Texas Instruments BAII Plus, Hewlett Packard 12C or 12C Platinum calculator Use of any other calculator will result in the submission of a Violation Report to AIMR You must stop writing immediately when instructed to so at the conclusion of the examination Violation of any of AIMR’s examination rules will result in AIMR voiding your examination results and may lead to a suspension or termination of your candidacy in the CFA Program DO NOT OPEN THIS EXAMINATION BOOK UNTIL INSTRUCTED TO DO SO BY THE PROCTOR/INVIGILATOR DO NOT REMOVE ANY EXAMINATION MATERIALS FROM THE TESTING ROOM ... (4 minutes) 2004 CFA? ? Level III Examination Morning Session – Essay IMPORTANT INSTRUCTIONS TO CANDIDATES Write your candidate number in the spaces provided on the front cover of this examination... 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...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