CFA 2018 level 3 schweser practice exam v1 exam 1 mornings

Joe makes the investment decisions for his 401k plan, but Sara makes the investment decisions for their other portfolio.. Finnegan selected a portfolio that is equally weighted in each a

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QUESTION 1 HAS 4 PARTS (A, B, C, D) FOR A TOTAL OF 15 MINUTES

Joe and Sara Finnegan are both 62 years old and live in Kerrville, Texas They are retired and have a combined investable net worth of $2 million, the bulk of which was inherited from Sara's father's estate Included in their total wealth is Joe's $500,000 defined-contribution retirement plan that is managed separately in a 401(k) retirement plan Joe makes the investment decisions for his 401(k) plan, but Sara makes the investment decisions for their other portfolio The

Finnegans home in Kerrville is valued at $750,000 The Finnegans do not have a mortgage on their home

Mr Finnegan's 401(k) plan is administered by a local bank trust department The trust

department offers its clients a range of portfolio allocations from aggressive to conservative as shown in Exhibit 1 Without regard for asset class characteristics or his own risk and return objectives, Mr Finnegan selected a portfolio that is equally weighted in each asset class and has made no changes to the portfolio allocation or to the allocation of new deposits to the plan portfolio Mr Finnegan is primarily concerned about potential losses in his account and prefers not to make investment decisions He is often fearful and anxious about what may happen in his portfolio

Exhibit 1: Alternative Portfolios

Yield

Aggressive Asset Mix

Conservative Asset Mix

Domestic Equity Stocks-Income 4.0% 40% 15%

Alternative Investments 2.0% 25% 5%

A Identify and support your identification of two behavioral characteristics that are evident in Joe Finnegan's allocation of his 401(k) retirement account Make your identification from the following list: myopic loss aversion, conservatism, 1/n diversification, home bias, status-quo bias, and reference dependence

(4 minutes) Answer / Comment:

B Based solely on his 401(k) investment portfolio, select the investor behavioral type (BIT) most likely exhibited by Joe and justify your selection with one reason

(3 minutes) Answer Question 1B in the template provided

Template for Question 1B

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Behavioral

Type

(circle one)

Justification

Adventurer

Individualist

Guardian

After several years, the Finnegans become dissatisfied with managing their own portfolio and approach Tim Smith in the bank trust department for advice Smith conducts detailed interviews with the Finnegans and identifies three sets of goals with varying priority He uses a client

questionnaire and determines that their biases are mainly emotional Because of their lack of investment success, he concludes that meeting their primary goals will be difficult He then develops both a goals-based investment plan and one based on traditional financial concepts

C Explain both how Smith would structure a goals-based investment plan for the Finnegans and the advantage of such a plan for them

D Explain one reason Smith would and one reason Smith would not deviate from the traditional plan asset allocations Each reason must be based directly on the information provided regarding the Finnegans

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ANSWER QUESTIONS 2 AND 3 IN ORDER

QUESTION 2 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES

Lachlan Martin and his wife Chloe are both 50 years old, have no children, and live in Sydney, Australia Lachlan's father, Liam Martin, recently died and left his entire estate to Lachlan

Lachlan expects to receive his after-tax inheritance of 9.0 million Australian dollars (AUD) in one year The Martins both plan to retire at that time, and are meeting with Zoe White to help them establish an investment plan

The Martins currently own a home valued at AUD 3.9 million, do not have a portfolio of investable assets, and do not consider their home as part of their investable assets In one year, the

Martins' outstanding debt will be AUD 3.7 million (home mortgage) and AUD 160,000 (other debts) The Martins will pay off their mortgage and their other debts once the inheritance is received

The Martins currently have a combined after-tax salary of AUD 500,000, current-year living expenses of AUD 263,000, plus annual mortgage payments (principal + interest) of AUD

237,000 Lachlan's company will pay him an after-tax pension of AUD 51,000 starting in one year when he retires, with the payments increasing by the rate of inflation, which is expected to be 3% annually His employer will continue to pay all of the Martins' medical costs until death Both the pension and health benefits will continue to accrue to Lachlan's wife, if he dies first The Martins 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 Martins intend to fund their living expenses during retirement with Lachlan's pension and the investment income generated from the assets invested in from the inheritance The Martins consider their investment base to be large given the inheritance, want their portfolio to be

invested conservatively, and want to maintain the real value of their investable assets over time They plan to leave any assets left in their estate to charity All income and realized capital gains are taxed at 25% The assumed annual effective tax rate is 20%

A Calculate the before-tax nominal rate of return required for the Martins' first year of

retirement Show your calculations Do not assume any tax effects related to the mortgage

B Discuss two factors that decrease and one factor that increases the Martins' risk tolerance

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C Formulate each of the following constraints for the Martins' investment policy statement

(IPS):

i Liquidity

ii Time horizon

QUESTION 3 HAS SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 21 MINUTES

The Martins have approached Steve Perry, a charterholder, for asset allocation advice The Martins have read about the benefits of diversification and how it will allow them to take less risk but earn a higher return They bring in articles on three investments that they have seen regularly discussed in the press and want to know if they will help the portfolio return The portfolio is currently invested in domestic (Australian) stocks and bonds Perry agrees to look into it and get back to them

As a first step, Perry compiles the following historical data:

Deviation E(R)

Correlation to Existing Portfolio

Sharpe Ratio

Current Portfolio 7.8% 6.5% 1.0

Additions:

International Equity 12.5% 8.7% 0.4 0.50

Real Estate 6.4% 7.1% 0.1 0.72

Managed Futures 13.9% 9.2% -0.2 0.48

Risk-free rate 2.5%

Using the data in the table, Perry decides to examine how return to risk would be affected if he adds one of the new asset classes He will liquidate existing assets so the characteristics

(expected return, standard deviation, and correlations) for that portion of the existing portfolio are unaffected

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A Compute the Sharpe ratio if the Martins reallocate their existing portfolio The reallocated portfolio would be 90% of the existing portfolio assets and 10% international equity Show your calculations

B State which proposed asset class's Sharpe ratio, based on the historical data, is most likely overstated and explain why

C State which Sharpe ratio, based on the historical data, is least likely to persist in the future and explain why

Before meeting with the Martins, Perry asks his assistant to review the characteristics of a valid asset class and the issues of adding international assets The assistant gathers the following data

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Correlation:

Asset Class: Within Asset Class To Other Asset Classes

Asset class "Z" 0.91 0.33

Global includes domestic and international

D Determine whether it is more likely international bond or equity currency exposure should be hedged and support your answer with one reason

E Explain how contagion can be a problem if emerging market securities are added to the Martins' portfolio and what tool Perry would use to manage the problem

Perry also asks the assistant to analyze the effect on the Martins' portfolio of adding French stocks to the portfolio if the currency risk is hedged or not hedged, based on the following assumptions:

Stock market from the French investor

perspective:

Return: 12% Standard deviation:

29%

Risk-free rates:

French: 2% Australian: 5%

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Standard deviation of the EUR: 14%

Expected change in value of the EUR: +2%

Correlation of French stock and EUR return: 0.30

F Compute the return and standard deviation of a currency hedged and unhedged investment in the French stocks for the Martins There are four items to calculate Approximate calculations are acceptable

QUESTION 4 HAS ONE PART FOR A TOTAL OF 8 MINUTES

Martina Edwards is retiring and stepping down from her position as portfolio manager at the Huron Foundation, which funds undergraduate and graduate environmental science research She is currently training her replacement, Greg Matlock, who previously worked as the portfolio manager for the defined benefit pension plan of a large corporation

During training, Edwards makes the following statements to compare a typical foundation to a typical defined benefit plan:

1 Both have perpetual time horizons

2 Both should consider the effects of future inflation on return by compounding (or adding) real return and inflation to determine nominal return needs

3 Foundations consider the correlation between return and dependence of the recipient on distributions DB plans consider correlation of return and plan sponsor business results In both cases, high correlation reduces risk tolerance

4 Both have high needs for cash equivalents to fund large payouts

Determine whether you agree or disagree with each statement made by Edwards Support your decision Note: supporting your opinion by simply reversing an incorrect statement will receive no credit.

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QUESTION 5 HAS SEVEN (A, B, C, D, E, F, G) PARTS FOR A TOTAL OF 25 MINUTES

Vincent Scavuzzo is a CFA charterholder and was recently hired as a director of high net worth clients for an investment firm One of his goals is to move the firm into alternative investments In preparation for this move, the firm's board has raised several issues he must address

A Explain why the firm will need legal and tax advisors to invest in private equity and other partnerships when this is not needed for existing stock and bond portfolios

B State whether direct real estate or REITs will be more expensive to invest in Support your decision with one reason it will be more expensive for the firm and one reason it will be more expensive for clients

C State whether direct real estate or REITs should provide the largest diversification benefit and explain why Do not base your answer on return data for any specific historical time period

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D Explain decision risk and whether it is a more serious problem for private equity (PE) or for commodity futures contracts

E Discuss how venture capital (VC) and buyout funds (BO) differ in regard to using leverage, riskiness of the underlying securities, consistency of returns, and cash flow pattern to the

investors over the life of the fund

F Explain what vintage year means and the implication for selecting private equity benchmarks

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G State whether zinc or wheat futures are more likely to have positive correlation with changes

in future inflation and explain why

QUESTION 6 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES

Jens Gustave is a senior portfolio manager with BAM Asset Management He is reviewing the manager asset allocation for the High Grove Foundation, one of BAM's larger accounts The foundation has carved out a 10% allocation, which employs aggressive techniques to enhance returns Gustave has gathered data on three equity sub-managers to be employed and collected the following data

P/E 15.2 18.4 22.8 18.5

Dividend Yield 4.7% 3.1% 1.5% 3.2%

Carl Johnson is a new board member for High Grove and also a money manager Johnson has contacted Gustave and proposed an allocation between manager A and C of 100% and 100% with a 100% short position in B to fund the allocation Manager B allows short positions in their fund

Johnson says that the alpha of the equity sub-managers in this strategy can (1) be transported to other asset classes and (2) transporting alpha would be desirable during periods of poor relative equity performance Gustave has promised to consider the idea and get back to Johnson before the next board meeting

A Calculate the true information ratio for the allocation proposal Show your work

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B Identify the approach being proposed and support your identification

C State and explain whether each of Johnson's statements are correct or incorrect "The alpha

of the equity sub-managers in this strategy can be (1) transported to other asset classes and (2) transporting alpha would be desirable during periods of poor relative equity performance." Treat each statement in isolation and be specific to the Foundation's situation

Gustave later has his staff gather additional information on Manager A and C From this he concludes A invests in inefficient small-cap value stocks while C invests in efficient large-cap growth stocks Despite this, he believes they both have an equal number of unique investment insights

D Determine which manager (A or C) most likely has better information content in their

decisions Support your conclusion with two reasons based on the information provided

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QUESTION 7 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 23 MINUTES

Johan and Andrea Kraus are both 85 years old They estimate they will need $128,750 to

support their lifestyle this year After this year, they want to increase their real spending amount

by 3% per year Their current portfolio contains $600,000 of cash equivalents, a $300,000

position in a diversified bond fund, and a $300,000 position in a diversified equity fund

The Krauses have decided that they would like to gift a substantial portion of their wealth, so they are going to meet with financial planner, Jens Schultz, CFA, to update their investment policy statement Schultz has constructed the mortality table in Exhibit 1 for the Krauses given a three-year planning horizon

Exhibit 1: Mortality Table

Age Prob Age Prob

1 86 0.8882 86 0.9171

2 87 0.7644 87 0.8244

3 88 0.6277 88 0.7208

Schultz plans on computing the Kraus's core capital and excess capital based on the

probabilities in Exhibit 1 He estimates inflation will be 2% The real and nominal risk-free rates are 4% and 6.08%

A Compute the core capital required for year 2 based on the information provided Show your work

B Schultz has decided that Monte Carlo simulation (MCS) is more appropriate and determines

$450,000 of core capital is required Explain three advantages of MCS over using mortality tables

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