L3 mock sample exam CFA level III essay questions 2006

Page The Morning Session of the 2006 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 Asset Valuation Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Asset Valuation Asset Valuation Portfolio Management Portfolio Management Total: Minutes 34 12 24 10 12 15 14 17 15 12 180 2006 Page THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED 2006 Page QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 34 MINUTES Rodolfo Serra is a professional soccer player with FA Milan, a leading soccer team in Italy’s Serie A league He has been well paid over his career including an initial, one-time signing bonus of €2 million, which he immediately invested in a start-up company designing training equipment This aggressive venture eventually went bankrupt At 34 years old, Serra is now at his professional peak with an annual pre-tax salary of €5 million: €4 million paid throughout the year and a €1 million year-end bonus His salary is taxed at 40 percent Since the beginning of his career Serra has managed his own investments He has had mixed results in his growth equity portfolio One of his worst performing equity holdings is B&K, an investment he initially made three years ago On several occasions, in reaction to an extended decline in B&K’s share price, Serra used a portion of his year-end bonus to acquire additional shares in an effort to lower his average cost per share He avoids the technology sector after incurring severe investment losses in the late 1990’s The remainder of his growth equity portfolio has performed satisfactorily He also has commercial real estate investments that are expected to be cash-flow neutral this year A summary of his personal assets is shown in Exhibit Exhibit Rodolfo Serra: Personal Assets (all amounts in €) Cash savings 4,000,000 Growth equity portfolio* 40,000,000 Commercial real estate investments 14,000,000 * All dividends are reinvested Serra expects the annual after-tax interest income on his cash savings to be €100,000 at the end of the year Serra will retire from professional soccer one year from now at the age of 35 He will pay cash for a personal home costing €4.5 million when he receives his year-end bonus Having grown up in poverty, Serra recently established a children’s welfare foundation He will legally gift all his commercial real estate investments to the foundation upon his retirement After retirement, Serra intends to volunteer all of his time to the foundation and does not expect to receive any compensation from other sources Serra has been divorced for two years and has a 7-year-old son who lives with his mother in Italy He makes annual family support payments amounting to €800,000 The annual family support payments will stop when his son reaches age 18 Serra’s living expenses are expected to be €1.2 million this year Both family support payments and living expenses will grow at an average annual inflation rate of percent All income net of expenses is currently reinvested in his growth equity portfolio Serra has expressed his desire to maintain the real value of his portfolio during retirement, which is expected to last a minimum of 40 years Serra recently hired a portfolio manager, Patrick Schneider, CFA, who expects the after-tax nominal annual return for growth equity to be 8.5 percent 2006 Page A i ii Formulate the return objective in Serra’s investment policy statement Calculate the after-tax nominal rate of return that is required during his first year of retirement Show your calculations Note: Assume there are no tax benefits or tax liabilities related to Serra’s gifting commercial real estate, or paying family support and living expenses (13 minutes) B i ii iii Identify two factors in Serra’s personal situation that increase his ability to take risk Identify two factors in Serra’s personal situation that decrease his ability to take risk Judge, considering all factors, whether Serra has below-average, average, or above-average ability to take risk Answer Question 1-B in the Template provided on page (6 minutes) C Formulate each of the following constraints in Serra’s investment policy statement: i ii Liquidity requirement Time horizon Support each response with one reason based on Serra’s specific circumstances Answer Question 1-C in the Template provided on page (6 minutes) D Determine which one action taken by Serra best illustrates each of the following psychological biases: i ii iii Snake-bite effect House-money effect Trying-to-break-even effect Conclude whether each psychological bias indicates Serra is more willing to take risk, less willing to take risk, or has no effect on Serra’s willingness to take risk Answer Question 1-D in the Template provided on page (9 minutes) 2006 Page Answer Question on This Page Template for Question 1-B Identify two factors in Serra’s personal situation that increase his ability to take risk Identify two factors in Serra’s personal situation that decrease his ability to take risk Judge, considering all factors, whether Serra has below-average, average, or above-average ability to take risk (circle one) Below-average Average Above-average 2006 Page Answer Question on This Page Template for Question 1-C Constraint i Liquidity requirement ii Time horizon 2006 Formulate each of the following constraints in Serra’s investment policy statement Support each response with one reason based on Serra’s specific circumstances Page Answer Question on This Page Template for Question 1-D Psychological Determine which one action taken by Serra best Bias illustrates each of the following psychological biases Conclude whether each psychological bias indicates Serra is more willing to take risk, less willing to take risk, or has no effect on Serra’s willingness to take risk (circle one) More willing i Snake-bite effect Less willing No effect More willing ii Housemoney effect Less willing No effect More willing iii Trying-tobreak-even effect Less willing No effect 2006 Page 14 THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED 2006 Page 15 Questions and relate to Lucinda Kennedy A total of 18 minutes is allocated to these questions Candidates should answer these questions in the order presented QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12 MINUTES Lucinda Kennedy, a 65-year-old retiree, has accumulated investment assets of $3 million and has a life expectancy of 20 years Kennedy meets with Richard Bulloch, CFA, to develop an asset allocation that will provide for her retirement spending needs Her needs are significant and it would be very difficult to reduce her spending Kennedy informs Bulloch that her biggest fear is outliving her assets because she has no other sources of income Kennedy and Bulloch agree to use a life expectancy of 20 years for planning purposes Bulloch presents Kennedy with three alternative portfolio allocations shown in Exhibit Kennedy believes that a conservative allocation will provide the safety she needs However, she wonders whether a more aggressive allocation to increase the value of the portfolio would be better over the long term Exhibit Alternative Portfolio Allocations (%) Asset Class Conservative Moderate Aggressive U.S equities 10 30 40 Non-U.S equities 10 30 40 Global fixed income 60 30 15 Cash equivalents 20 10 Bulloch states: “Given your circumstances, an asset-liability management approach to strategic asset allocation is more appropriate than an asset-only approach.” A Explain two advantages of using an asset-liability management approach in Kennedy’s situation (4 minutes) Bulloch decides to use Monte Carlo simulation to determine the most appropriate asset allocation for Kennedy’s portfolio B Explain two ways that Monte Carlo simulation differs from mean-variance analysis in a multi-period setting (4 minutes) 2006 Page 16 Bulloch prepares a Monte Carlo simulation using his capital markets expectations The likely outcomes for the conservative, moderate, and aggressive portfolio allocations are shown in Exhibit Bulloch explains Exhibit to Kennedy Using the conservative allocation as an example, there is a 75 percent probability that the terminal value will be less than or equal to $986,000 and a 25 percent probability that the terminal value will be greater than $986,000 Exhibit Monte Carlo Simulation Results Projected Portfolio Terminal Values at 20 Years Terminal Values ($ thousands)* Percentile Conservative Moderate Aggressive th 95 1,701 5,936 11,938 90th 1,313 3,972 7,243 th 75 986 3,064 4,818 50th 621 1,632 2,271 th 25 343 718 777 th 10 98 5th 13 * After Kennedy’s retirement spending needs have been met C Recommend the most appropriate portfolio allocation for Kennedy based upon the results of the Monte Carlo simulation Justify your response with one reason (4 minutes) 2006 ... effect More willing iii Trying-tobreak-even effect Less willing No effect 2006 Page 14 THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED 2006 Page 15 Questions and relate... the fund should be sold.” Agree Disagree 2006 Page 24 THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED 2006 Page 25 Questions and relate to American Cruise Lines... recently hired a portfolio manager, Patrick Schneider, CFA, who expects the after-tax nominal annual return for growth equity to be 8.5 percent 2006 Page A i ii Formulate the return objective in