L3 mock sample exam CFA level III essay questions 2011

Level III Page The Morning Session of the 2011 Level III CFA® Examination has 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 Portfolio Management – Individual/Behavioral Portfolio Management – Individual Portfolio Management – Institutional Portfolio Management – Economics Portfolio Management – Asset Allocation Portfolio Management – Fixed Income Portfolio Management – Equity Investments Portfolio Management – Risk Management Portfolio Management – Performance Evaluation 15 23 26 23 20 19 22 16 16 Total: 180 Page Level III THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED Level III Page Questions and relate to the Becker family A total of 38 minutes is allocated to these questions Candidates should answer these questions in the order presented QUESTION HAS TWO PARTS (A, B) FOR A TOTAL OF 15 MINUTES Robert Becker, age 75, retired years ago from the building products business that he founded After his business, Buildco, went public in the 1990’s, he remained as CEO and continued to hold shares in the company After his wife’s death, Becker hires Emily Frost, a portfolio manager and trust specialist, to help with his estate planning Becker establishes a revocable trust and an irrevocable trust Income, realized capital gains, and estate assets (at death) are all taxed at a flat 20% rate For the revocable trust, the cost basis of investments increases to the market value on the date of Becker’s death, and the assets are subject to estate taxes For the irrevocable trust, the cost basis of investments does not change, and the assets are not subject to estate taxes Currently, the two trusts each have 2.0 million U.S dollars (USD) of their assets in Buildco shares, with a cost basis of USD 200,000 each All Buildco shares have unrealized capital gains Becker has the following two immediate objectives as part of his estate planning: A Objective 1: Sell USD 1.0 million of Buildco shares while minimizing total taxes Objective 2: Put additional assets into a trust to protect those assets from potential future legal claims against Becker Determine which trust (irrevocable, revocable, or both equally) is more appropriate for each objective: i ii Objective Objective Justify your response with one reason for each objective Note: Consider each objective independently Answer Question 1-A in the Template provided on page (6 minutes) Page Level III Frost meets with Becker to compare their views on investing Four discussions from that meeting are shown in Exhibit Exhibit Selected Discussions from Becker – Frost Meeting Discussion Speaker Discussion Number Becker: The first thing you might notice about my investment style is that I favor growth investments over income-producing assets Frost: I don’t think that is the right approach Equities might deliver higher long-term returns However, for a trust portfolio, I prefer that the client knows the size and timing of the cash flows he will be receiving That’s what an investor gets with bonds Frost: I notice you hold a significant position in Rolling Mix Cement shares Becker: Rolling Mix Cement’s CEO used to run the western operations for Buildco He did a wonderful job for us, so I think Rolling Mix shares are great to own Frost: I was looking at the mutual funds in your portfolio and can see that you purchased an equal amount across four mutual funds Becker: I think that mutual fund family offers four great products So I bought all of them: an EAFE large-cap fund, a U.S growth fund, a U.S smallcap fund, and a U.S corporate bond fund Frost: I notice you have many portfolio positions where the current values have been below cost for awhile Becker: Investing requires patience You have to give things time to work out B Identify the discussion in which one of the participants best illustrates each of the following behavioral biases: i ii iii representativeness frame dependence aversion to ambiguity Justify each response with one reason Note: Consider each bias independently Use each discussion only once Answer Question 1-B in the Template provided on page (9 minutes) Level III Page Answer Question on This Page Template for Question 1-A Note: Consider each objective independently Determine which trust (irrevocable, revocable, or both Justify your response with one reason for each Objective equally) is more objective appropriate for each objective (circle one) irrevocable Sell USD 1.0 million of Buildco shares while minimizing total taxes revocable both equally Put additional assets into a trust to protect those assets from potential future legal claims against Becker irrevocable revocable both equally Page Level III Answer Question on This Page Template for Question 1-B Note: Consider each bias independently Use each discussion only once Identify the discussion in which one of the participants best illustrates each of Behavioral bias Justify each response with one reason the following behavioral biases (circle the discussion number from Exhibit 1) i representativeness ii frame dependence iii aversion to ambiguity Page Level III THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED Level III Page Questions and relate to the Becker family A total of 38 minutes is allocated to these questions Candidates should answer these questions in the order presented QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 23 MINUTES Five years have passed Robert Becker recently died and left his estate to his only child, Michael Michael and his wife are both 50 years old and have no children Michael expects to receive his after-tax inheritance of 8.0 million U.S dollars (USD) at the end of this year The Beckers both plan to retire at that time, and are meeting with Emily Frost to help them establish an investment plan The Beckers currently not have an investment portfolio and they own a home valued at USD 3.7 million At the end of this year, the Beckers’ outstanding debt will be USD 3.5 million (home mortgage) and USD 150,000 (consumer debts) The Beckers will pay off their mortgage and their consumer debts soon after the inheritance is received The Beckers currently have a combined after-tax salary of USD 475,000, current-year living expenses of USD 250,000, plus annual mortgage payments (principal + interest) of USD 225,000 Michael’s company pension will pay him USD 48,000 after-tax next year, and then payments will grow at the rate of inflation, which is expected to be 3% annually His employer will continue to pay all of the Beckers’ medical costs until death Both the pension and health benefits will continue to accrue to Becker’s wife, if he dies first The Beckers expect their living expenses will also continue to grow at the rate of inflation until one of them dies At that time, they expect the survivor’s living expenses will decrease to 75% of their combined expenses, and then continue to grow at the rate of inflation The Beckers intend to fund their living expenses with Michael’s pension and investment income generated from their investable assets, which not include their home The Beckers consider their investment base to be large, and want their portfolio to be invested conservatively They want to maintain the real value of their investable assets over time, and plan to leave their estate to charity All income and realized capital gains are taxed at 20% A Calculate the after-tax nominal rate of return required for the Beckers’ first year of retirement Show your calculations (8 minutes) B Discuss two factors specific to the Beckers’ situation that decrease their risk tolerance (4 minutes) Page 10 C Level III Formulate each of the following constraints for the Beckers’ investment policy statement (IPS): i ii liquidity time horizon (4 minutes) Several years later, the Beckers again meet with Frost Their investable portfolio is now valued at USD 7.0 million The Beckers state that their primary goal is to maintain their current living standard as long as they live The Beckers also want to leave a charitable gift of at least USD 5.0 million from their investable assets after they have both died However, they are not willing to risk running out of money in their old age to achieve this secondary goal The Beckers agree with Frost to assume a 25-year time horizon Frost produces Monte Carlo simulations for the Beckers using two portfolios with different asset allocations The simulations use a long series of historical index data for each asset class in the two portfolios The resulting distributions of terminal values are shown in Exhibit All terminal values are after expected taxes and spending needs have been met Exhibit Monte Carlo Simulation Results Projected Portfolio Terminal Values at 25 Years Terminal Values (USD thousands) Percentile Portfolio A Portfolio B D 95th 17,808 35,814 90 th 11,916 21,729 75 th 9,192 14,454 50 th 4,896 8,813 25 th 2,154 5,016 10th 294 5th 39 i Determine, based on the Monte Carlo simulations, which portfolio (A or B) will better allow the Beckers to achieve their goals Justify your response with one reason related to risk ii Discuss two improvements Frost could make in her Monte Carlo simulations (7 minutes) Page 16 Level III QUESTION HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 26 MINUTES Stacy Bergen is a consultant for the endowments of two American universities – Weymount University (WU) and Slate University (SU) WU is a private university with annual operating expenses of 150.0 million U.S dollars (USD) WU has an endowment currently valued at USD 750.0 million Bergen gathers the following information about WU and its endowment: A • The WU endowment’s primary goal is to maintain the real value of its assets over the long term • The WU endowment’s secondary goal is to continue to fund 25% of WU’s annual operating expenses, by means of its spending rule ○ Tuition and grants fund the remainder of the annual operating expenses ○ As a private institution, WU receives no government financial support • The WU endowment: ○ uses a simple spending rule with a 5% annual spending rate based on the endowment’s beginning-of-year market value ○ receives private donations and uses these donations, in part, for its liquidity needs ○ evaluates its investment managers based on the endowment’s three-year average annual return ○ forecasts the inflation rate of WU’s operating expenses to be equal to the growth rate of the Higher Education Price Index (HEPI), which is expected to be 4% annually ○ has an annual 0.55% management expense rate i Formulate the return objective for the WU endowment ii Calculate the required return for the WU endowment Show your calculations (4 minutes) B Determine how a change in each of the following factors, holding all else constant, affects the risk tolerance (increases, decreases, does not change) for the WU endowment: i ii private donations expected inflation Justify each response with one reason Note: Consider each factor independently Answer Question 3-B in the Template provided on page 20 (6 minutes) ... representativeness ii frame dependence iii aversion to ambiguity Page Level III THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED Level III Page Questions and relate to the...Page Level III THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED Level III Page Questions and relate to the Becker family... Justify each response with one reason Page 24 Level III THIS PAGE INTENTIONALLY LEFT BLANK ANY MARKS MADE ON THIS PAGE WILL NOT BE GRADED Level III Page 25 QUESTION HAS FIVE PARTS (A, B, C, D,