L3 mock sample exam CFA level III essay questions 2006

Answer Question 1-B in the Template provided on page 7.. Answer Question 1-C in the Template provided on page 8.. Answer Question 1 on This Page Template for Question 1-B Identify two f

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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 Topic Minutes

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QUESTION 1 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 1

Exhibit 1 Rodolfo Serra: Personal Assets

(all amounts in €)

Cash savings 4,000,000Growth equity portfolio* 40,000,000Commercial 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

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 4 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

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A i Formulate the return objective in Serra’s investment policy statement

ii 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

iii 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 7

(6 minutes)

C Formulate each of the following constraints in Serra’s investment policy statement:

i Liquidity requirement

ii Time horizon

Support each response with one reason based on Serra’s specific circumstances

Answer Question 1-C in the Template provided on page 8

(6 minutes)

D Determine which one action taken by Serra best illustrates each of the following

psychological biases:

i Snake-bite effect

ii House-money effect

iii 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

(9 minutes)

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Answer Question 1 on This Page

Template for Question 1-B

Identify two factors in Serra’s personal situation that increase his ability to take risk

Judge, considering all factors, whether Serra has below-average, average, or above-average

ability to take risk (circle one)

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Template for Question 1-C

Constraint Formulate each of the following constraints in Serra’s investment policy statement

Support each response with one reason based on Serra’s specific circumstances

i Liquidity

requirement

ii Time

horizon

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Template for Question 1-D

to take risk, or has

no effect on Serra’s willingness to take

risk (circle one)

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Questions 2 and 3 relate to Lucinda Kennedy A total of 18 minutes is allocated to these

questions Candidates should answer these questions in the order presented

QUESTION 2 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 1 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 1 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 5

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

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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 2 Bulloch explains Exhibit 2 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 2 Monte Carlo Simulation Results Projected Portfolio Terminal Values at 20 Years

Terminal Values ($ thousands)*

* 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)

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QUESTION 3 HAS ONE PART FOR A TOTAL OF 6 MINUTES

After determining the appropriate asset allocation to meet Lucinda Kennedy’s needs, Richard Bulloch, CFA, invests a portion of Kennedy’s assets in two fixed income investment funds

Trinity Index Fund – a passively managed portfolio of global bonds designed to track the Lehman Brothers® Global Aggregate Bond (LGAB) Index using a pure bond indexing strategy The management fee is 15 basis points annually

Montego Global Bond Fund – an actively managed portfolio of global bonds designed to outperform the LGAB net of fees The management fee is 50 basis points annually

Six months after investing in these funds, Kennedy and Bulloch review the performance data shown in Exhibit 1

Exhibit 1 Total Returns on Index and Funds

Return

LGAB Index 3.21%

Trinity Index Fund* 3.66%

Montego Global Bond Fund* 3.02%

* Net of Fees

Kennedy makes the following statements regarding her fixed income investments:

1 “The Trinity Index Fund is being managed well.”

2 “I expected that, as an active manager, Montego would outperform the index;

therefore, the fund should be sold.”

Determine whether you agree or disagree with each of Kennedy’s statements Justify your

response with one reason for each statement

Note: Each justification can only be used once

Answer Question 3 in the Template provided on page 21

(6 minutes)

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Template for Question 3

Statement

Determine whether you agree or

disagree with each

of Kennedy’s statements (circle one)

Justify your response with one reason for

each statement

Note: Each justification can only be used

once

1 “The Trinity Index

Fund is being managed

well.”

Agree

Disagree

2 “I expected that, as an

active manager, Montego

would outperform the

index; therefore, the fund

should be sold.”

Agree

Disagree

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Questions 4 and 5 relate to American Cruise Lines A total of 34 minutes is allocated to

these questions Candidates should answer these questions in the order presented

QUESTION 4 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 24 MINUTES

American Cruise Lines (ACL) is a leading global cruise ship company with few major

competitors and a market capitalization of $10 billion The assets of the ACL Defined Benefit Pension Plan (ACLP) have a current market value of $100 million Using a 5 percent discount rate (the current yield to maturity on a long-term U.S Treasury bond), ACLP’s actuary

calculates the value of its Projected Benefit Obligation to be approximately $100 million with a duration of 15 years ACLP has an early retirement feature which includes annuity and lump-sum pay-out options for long-term employees over 50 years old Few employees are currently planning to retire early ACLP is directed and managed by an independent investment

committee that is subject to a fiduciary obligation to act in the best interests of its beneficiaries

ACLP’s investment committee has recruited Emily Wilson, CFA, to manage ACLP’s investment portfolio Wilson conducts research on ACL and concludes the company is financially sound with a stable workforce Compared to the averages for the cruise industry, ACL has a lower debt/equity ratio and a higher return on equity

Wilson prepares Exhibit 1 which summarizes the workforce characteristics of ACL and the cruise industry

Exhibit 1 Comparison of ACL and the Cruise Industry

Average

Average age of active employees 33 years old 40 years old

Active long-term employees over age 50 14% 17%

Active employees/Retired employees 85% /15% 90% /10%

Wilson meets separately with ACLP’s investment committee and with ACL’s President John Johnson to listen to their ideas on ACLP’s investments

Investment Committee: “Our investment objective is to build a pension surplus in ACLP by

setting a return objective that is 200 basis points above ACLP’s minimum required return We have determined that this investment objective is consistent with ACLP’s current risk tolerance.”

Johnson: “In today’s environment, ACLP should be able to produce

returns of at least 10 percent per year

In addition, according to industry analysts, the increasing popularity of cruises should translate into increased growth and profitability for the cruise industry over the next 10 to 15 years

The investment committee should increase ACLP’s investment

in cruise industry equities from its current level of 10 percent to

at least 15 percent of plan assets.”

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Wilson’s first task is to draft an ACLP investment policy statement (IPS) to present to its

investment committee

A Formulate the return objective of an IPS for the American Cruise Line’s Defined Benefit

Pension Plan (ACLP) Show your calculation

(3 minutes)

B Indicate whether ACLP has a below-average, average, or above-average ability to take

risk compared with the average for the cruise industry with respect to each of the

following risk factors:

i Sponsor financial status and profitability

ii Workforce age

iii Retired employees

Justify each response with one reason

Answer Question 4-B in the Template provided on page 29

(9 minutes)

C Indicate whether each of the following factors increases, leaves unchanged, or decreases

ACLP’s ability to take risk:

i Sponsor (ACL) and pension fund (ACLP) common risk exposures

ii Retirement plan features

Answer Question 4-C in the Template provided on page 30

(6 minutes)

D Formulate each of the following constraints in ACLP’s investment policy statement:

i Liquidity requirement

ii Time horizon

Note: Your answer should specifically address ACLP’s circumstances

Answer Question 4-D in the Template provided on page 31

(6 minutes)

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Template for Question 4-B

Risk factor

Indicate whether ACLP has a below-average, average, or above- average ability to take risk compared with the average for the cruise industry with respect to

each of the following risk

factors (circle one)

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Template for Question 4-C

Factor

Indicate whether each

of the following factors increases, leaves unchanged, or decreases ACLP’s ability to take risk (circle one)

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Template for Question 4-D

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QUESTION 5 HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES

Several years have passed American Cruise Line’s Defined Benefit Pension Plan (ACLP) now

has $200 million in assets and has a funding surplus due to the successful execution of the

policies adopted by ACLP’s investment committee

American Cruise Lines (ACL) has experienced a decline in sales related to a sustained downturn

in travel The company is now faced with material restructuring expenses As part of the

restructuring, ACLP will be required to make lump-sum payments averaging $200,000 to each of

100 retiring employees over the next 12 months

Because of these changes and considering current market conditions, the investment committee

adopts the following policy objectives:

• a return requirement of 8.5 percent

• a shortfall risk objective of –8.0 percent Shortfall risk is defined as the portfolio

expected return minus two standard deviations

• match assets and liabilities in the short and long term

• reduce exposure to equities highly correlated with the plan sponsor

Emily Wilson, CFA, is instructed to reassess the portfolio’s asset allocation and recommend any

necessary changes Wilson’s analysis results in the asset allocation alternatives shown in

Exhibit 1

Exhibit 1 Alternative Asset Allocations and Return/Risk Measures

Portfolio Allocations (%) Asset Class

Expected total return 9.25 9.06 8.59 9.04 9.07

Expected standard deviation 8.43 8.83 7.83 8.19 8.57

Wilson notes that all the portfolios have an expected return that meets the policy objectives of

ACLP She is considering other reasons for making her selection

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