CFA Level III Mock Exam – Solutions (AM) FinQuiz.com CFA Level III Mock Exam June, 2018 Revision Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) FinQuiz.com – 2nd Mock Exam 2018 (AM Session) Questions Topic Minutes Portfolio Management – Individual Investors 32 Portfolio Management – Behavioral Finance 18 30 Portfolio Management – Institutional Investors Portfolio Management – Individual Investors/Asset Allocation Portfolio Management – Equity Investments Portfolio Management – Fixed-Income Investments 19 Portfolio Management – Risk Management 17 Portfolio Management – Monitoring and Rebalancing Portfolio Management – Performance Evaluation and Attribution 13 Total: FinQuiz.com © 2018- All rights reserved 24 21 180 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 32 MINUTES Michael and Andy Seinfeld are married and live in Minneapolis, Minnesota Michael, 45 years old, is a physician working in the North Memorial Hospital in Minneapolis The Seinfelds have two children; Ryan, a college student in the State University of New York, and Rebecca, a marketing specialist working for a multinational firm, with headquarters in Boston The Seinfelds are in excellent health and have sufficient medical insurance Michael earns a current salary of $150,000 annually which is taxed as income at 25% Andy earns $75,000, and her income is taxed at a rate of 20% Both Michael and Andy expect their salaries to grow at the inflation rate of 3.5% In addition, the Seinfelds are obligated to pay Ryan’s tuition fee, which equals $50,000 per year Ryan expects to specialize in economic studies in a university in Boston, a year from now The admission fee will equal $25,000, which would be paid at the beginning of the next year, and the annual tuition fee will equal that he pays currently—this fee will remain constant till he graduates in about seven years’ time Rebecca is independent and her salary sufficiently covers her living expenses The Seinfelds fully own and live in a well-furnished home in Minneapolis with a current price of $1,800,000 The family also owns a small side business of home furnishing that they plan to sell by next year Michael has received an offer of $5,000,000 for his business, and if he decides to sell, the entire amount will be taxed at a capital gains tax rate of 17% Exhibit displays information about the Seinfelds personal assets as of today Exhibit Stock holdings $950,000 Fixed-Income holdings $850,000 Cash and cash Equivalents $550,000 Real Estate $1,800,000 Michael just hired Jay Peck, a financial advisor and portfolio manager, to manage their personal portfolio During a conversation with Michael, Peck discovered that the average living expenses of the family equal $155,000 a year that will increase at 3.5% annually, the U.S inflation rate Peck also found out that both Michael and Andy (who is currently 43 years old) want to retire in about ten years time after which they want to fulfill their lifelong dream of travelling around the globe They believe that by that time, Ryan would also be independent and earning FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) To make sure that their portfolio allows for the achievement of their goals, Michael often reads financial journals to gain information on what trading strategies would reap the most profit Most of his investments were based on research of several analyst recommendations and market information Andy believes that investing should be done after careful analysis to minimize the probability of the loss of principal Her past experience has shown her that rushing into investments can cause unexpected losses Peck is in the process of developing an appropriate investment policy statement for the Seinfelds A Assuming that the market value of the current portfolio remains unchanged and Michael sells the family business, calculate the after-tax nominal rate of return that is required by the Seinfelds for year Show your calculations (12 minutes) B Prepare the following portions of Seinfelds’ Investment Policy Statement, after the sale of the furnishing business: i ii Risk tolerance Time horizon Answer Question 1-B in the template provided (8 minutes) C Characterize Michael and Andy Seinfeld as cautious, individualistic, methodical, or spontaneous investors Justify your selection with two reasons each Answer Question 1-C in the template provided (4 minutes) FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Five years have passed and Michael and Andy Seinfeld have incomes that just cover their current expenses Their joint after-tax salary equals $350,000 and both their incomes and expenses grow at the inflation rate of 5.0% The Seinfelds current investment portfolio includes stocks, corporate bonds and short-term instruments and has a current market value of $3,500,000 Ryan and Rebecca are each financially independent and earn competitive salaries in their respective fields Both Michael and Andy plan to retire in five years time, after which they want their portfolio to provide sufficient income to cover their expenses Neither of the two has participated in a pension plan Peck has continued to be their financial advisor and the Seinfelds have explained to him that a real after-tax return of 4.5% would be adequate to meet their objectives, while instructing him to take on only those risks with their portfolio that are absolutely necessary to meet their return requirement They also mentioned that they would like to maintain their current standard of living during retirement and have no further goals or objectives The Seinfelds are now taxed at a rate of 30% The U.S inflation rate will continue to be 5.0% even after their retirement D i Prepare the current return objectives portion of the Seinfeld’s IPS ii Assuming the market value of the current portfolio remains unchanged, calculate the after-tax nominal rate of return that will be required by the portfolio during the first year of retirement Show your calculations (8 minutes) FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 1-B Prepare the following portions of Seinfelds’ IPS i Risk tolerance ii Time horizon FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 1-C Circle the type that best describes them Explain your choice with two justifications each Cautious Methodical Andy Individualistic Spontaneous Cautious Methodical Michael Individualistic Spontaneous FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: Current Year Year Inflows Michael’s Salary Andy’s Salary Sale of Company Total Inflows $150,000 $75,000 $225,000 $155,250 $77,625 $5,000,000 $5,232,875 $160,684 $80,342 $241,026 Outflows Income tax: Michael’s Salary (25%) Income tax: Andy’s Salary (20%) Capital gains tax (17%) Admission fee Ryan’s college fee $37,500 $15,000 $50,000 $38,813 $15,525 $850,000 $25,000 $50,000 $40,171 $16,068 $50,000 $155,000 ($257,500) ($32,500) $160,425 ($1,139,763) $4,093,112 $166,040 ($272,279) ($31,253) Living expenses Total expenses Net additions/withdrawals Investable assets: Stock holdings $950,000 Fixed-Income holdings $850,000 Cash and cash Equivalents Current year cash flow $550,000 ($32,500) Year cash flow $4,093,112 Total $6,410,612 Real after tax return = 31,253/6,410,612 = 0.4875% After tax nominal rate of return = 1.004875(1.035) –1 = 4.00% Reference: CFA Level III, Volume 2, Study Session 4, Reading FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) B Solution: Prepare the following portions of Seinfelds’ IPS Ability: Seinfelds have an above average ability to tolerate risk: • • • • • Risk tolerance Long term time horizon Large portfolio value relative to spending needs Sale of the furnishing business will increase wealth and the ability of the portfolio to bear volatility Low return requirement Low liquidity needs Willingness: Seinfelds’ have a below average willingness to tolerate risk as is apparent from: • • • Careful analysis before investing Concern over losing principal, and over excess losses Michael’s approach of investing shows that he analyzes historical databases before making an investment; this shows his conservative nature Overall: Since the willingness to tolerate risk is below average, and because of their apparent preference for lower risk, their overall risk tolerance is below average The Seinfelds have a long-term multistage time horizon Time horizon • • • • Current till next year when Seinfelds sell their business Year 1-8 defined by Ryan’s college tenure Year 8-10, after which Seinfelds will retire Retirement—25 to 30 years based on average life expectancy after retirement Reference: CFA Level III, Volume 2, Study Session 4, Reading FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) C Solution: Circle the type that best describes them Explain your choice with two justifications each Andy is a cautious investor because: • Cautious Methodical Andy • • Individualistic Spontaneous Her past experience makes her averse to unexpected losses She wants to minimize the probability of the loss of principal She makes investments after careful analysis Explanation: Andy dislikes losing money and rushing into investments Due to past experiences, she feels a need of financial security She has a fear of loses which most likely characterizes her as a cautious investor Michael is a methodical investor because: • Cautious Methodical Michael Individualistic Spontaneous • He bases his investment decisions on research and hard facts He intently follows market analysts and new information Explanation: Michael follows analyst recommendations, reads financial journals and undertakes research before making investments Since he relies on hard facts, and hence, most likely does not form emotional attachments to investment positions, he is best characterized as a methodical investor Reference: CFA Level III, Volume 2, Study Session 4, Reading FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 7-C (i) Identify the risk management approaches used by Bretherton in the management of her portfolio Justify your response for each approach Note: Consider each approach independently Bretherton has developed a multifactor model to explain the returns on her portfolio The model includes factors that she believes explain the majority of returns to her portfolio After every six months, she determines the combined effect of the risk factors on her portfolio assuming they move in the most unfavorable way Based on her probability models and expectations, Bretherton determines the worst possible return outcome for her portfolio, one that she expects has some probability of occurring She then compares this return to her threshold return requirement Every year, Bretherton creates scenarios based on certain investment fears she has, and then analyzes how her portfolio would react to such events She knows that such scenarios have an extremely small or maybe even a zero probability of occurring, but she still feels it is necessary to remove any uncertainties FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 7-C(ii) Determine why Fishman might have preferred the use of forwards over futures and options for meeting Orange Enterprises’s risk management objectives Futures Contracts Option Contracts FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: In order to fully hedge the currency risk Fishman will need to go short a euro denominated currency forward contract However, the notional principal cannot be known at the initiation of the contract To be sure about the amount of euros to be delivered (and not base the decision on estimates), Fishman will need to hedge the European equity market risk also To hedge the equity market risk: (0-1.27/1.10)(33,129,502/259,394) = -147.46 contracts To hedge the European market risk, Fishman should go short 147 euro-equity index forwards By hedging this risk, the portfolio would earn the foreign risk free rate: €33,129,502 (1.0467) = €34,676,650 Hence, Fishman should (also) go short the currency forward contract with a notional principal equal to €34,676,650, and the quoted price of $1.1742/€ Reference: CFA Level III, Volume 5, Study Session 15, Reading 28 B Solution: i ii Walters will engage in a mismatched FX swap Walter should increase the size of the hedged position Additional information: Given that the foreign currency value of the assets has changed (increased) and Walters expects the GBP to depreciate, this will imply that she should increase the size of the hedge to more than £2.5 million Walter will increase her hedge exposure to more than 100% to take advantage of a depreciating GBP iii To increase the size of the hedged position (beyond £2.5 million) Walters will need to buy £2.5 million at a spot rate of 1.6621 The forward leg of the swap will involve selling an amount more than £2.5 million forward Forward rate = 1.6621 + (-14/10,000) = 1.6607 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Additional information: Since GBP is the base currency, the spot and forward rates are determined using the bid side of the forward points Reference: CFA Level III, Volume 4, Study Session 9, Reading 19 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) C Solution: Template for Question 7-C (i) Identify the risk management approaches used by Bretherton in the management of her portfolio Justify your response for each approach Note: Consider each approach independently Bretherton has developed a multifactor model to explain the returns on her portfolio The model includes factors that she believes explain the majority of returns to her portfolio After every six months, she determines the combined effect of the risk factors on her portfolio assuming they move in the most unfavorable way Based on her probability models and expectations, Bretherton determines the worst possible return outcome for her portfolio, one that she expects has some probability of occurring She then compares this return to her threshold return requirement Every year, Bretherton creates scenarios based on certain investment fears she has, and then analyzes how her portfolio would react to such events She knows that such scenarios have an extremely small or maybe even a zero probability of occurring, but she still feels it is necessary to remove any uncertainties Bretherton uses the ‘factor push’ approach, since she pushes the risk factors of the model in the most unfavorable way and then works out their combined effect on her portfolio’s value Here, Bretherton uses the ‘worst-case scenario analysis’ approach, since she is examining the worst case for the portfolio that she actually expects to occur given her probability estimates Bretherton is using a scenario analysis approach based on ‘hypothetical events’ Based on her fears, she creates scenarios that have a very small probability of occurring, and perhaps have never happened in the markets before (given that they might have a zero probability of occurring) Reference: CFA Level III, Volume 5, Study Session 14, Reading 27 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 7-C (ii) Determine why Fishman might have preferred the use of forwards over futures and options for meeting Orange Enterprises’s risk management objectives Give one reason each for the other two tools relative to forwards • Futures Contracts • • Option Contracts Forwards are preferred over futures for the risk management of foreign currency, because of the deep liquidity in the forward market relative to futures Futures contracts require margin deposits and the daily settling of gains and losses, which can create administrative problems Forward transactions, mostly, not require margin deposits (since they are customized, they could be constructed anyway) Options require a cash investment at the start, whereas forwards have zero value at initiation meaning that no one invests any money (they are fully leveraged positions) Reference: CFA Level III, Volume 5, Study Session 15, Reading 28 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS TWO PARTS (A, B) FOR A TOTAL OF 13 MINUTES Anthony Reyna is responsible for the implementation of portfolio management decisions made by the research and management department at his investment firm Recently, Reyna was instructed to buy 1,500 shares of W-Tech Corporation, a company specializing in high-tech security equipment In the process of selecting the best broker, Reyna searched the market and decided to select the Chicago Brokers for the execution of the order Reyna ordered Chicago Brokers to buy 1,500 shares of W-Tech stock on Monday, with a benchmark price of $56 On the same day, Chicago Brokers managed to purchase 750 shares at a price of $56.703/share To trade these shares, Reyna had to pay commissions of $55 No more shares were purchased that day, and the stock closed at a price of $55.302/share On Tuesday, 300 more shares were purchased at $57.923/share, and the commissions on the trade were $25 The closing price for the stock that day was $56.201 The remaining shares could not be purchased, and Reyna cancelled the order on Wednesday, the day when W-Tech stock closed at $57.034 Reyna’s employer just launched an investment product that invests in emerging and developing markets, including Brazil, Russia and India Reyna knows that although these markets offer attractive return and diversification opportunities, they also have inherent risks One of the risks is the absence of an established and well-organized market structure, one that encourages secondary trades To examine the quality of Brazil’s capital market, Reyna gathered the following information A The Crossover Clearing House has recently been established to serve as an intermediary to capital market transactions The entity is subject to financial and ethical standards imposed by the Brazilian government B The market offers attractive opportunities to investors who can identify mispricings before others, especially in the small-cap sector Those who act early can earn significant gains Reyna is working with Sam Walter, a portfolio manager, towards setting the appropriate corridor width for asset classes within the Brazilian market The asset classes include Brazilian corporate bonds, Brazilian equities, and Brazilian government bonds Walter has determined the following about the asset c lasses: • • The volatility of Brazilian government bonds and equities has increased over the past few years The correlation of Brazilian equities with Brazilian corporate bonds is higher than their correlation with Brazilian government bonds FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) A Calculate the components of the implementation shortfall for the trade of W-Tech Stock Show your calculations separately for each component (5 minutes) B i Determine whether the Brazilian market information suggests an increase or a decrease in the quality of the Brazilian market Identify the market quality factor that each affect Justify your response with one reason each Note: Consider each point independently Answer Question 8-B (i) in the template provided (4 marks) ii Evaluate the effect of the information Walter gathered, on the optimal corridor width of Brazilian corporate bonds Justify your response with one reason each Note: Use an all-else equal assumption in each case Answer Question 8-B (ii) in the template provided (4 marks) FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 8-B(i) Determine whether the Brazilian market information suggests an increase or a decrease in the quality of the Brazilian market The Crossover Clearing House has recently been established to serve as an intermediary to capital market transactions The entity is subject to financial and ethical standards imposed by the Brazilian government The market offers attractive opportunities to investors who can identify mispricings before others, especially in the small-cap sector Those who act early can earn significant gains FinQuiz.com © 2018- All rights reserved Identify the market quality factor that each affect Justify your response with one reason each CFA Level III Mock Exam – Solutions (AM) Template for Question 8-B (ii) Evaluate the effect of the information Walter gathered, on the optimal corridor width of Brazilian corporate bonds Justify your response with one reason each Note: Use an all-else equal assumption in each case The volatility of Brazilian government bonds and equities has increased over the past few years The correlation of Brazilian equities with Brazilian corporate bonds is higher than their correlation with Brazilian government bonds FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: The components are calculated as follows: Delay • • Monday: 750/1,500[56-56/56] = 0% Tuesday: 300/1,500[(55.302-56)/56] = -0.2493% Realized profit/loss • • Monday: 750/1,500[(56.703-56)/56] = 0.6277% Tuesday: 300/1,500[(57.923-55.302)/56] = 0.93607% Missed trade opportunity cost • 450/1,500[(57.034-56)/56 = 0.5539% Commissions are 55/84,000 + 25/84,000 = 0.0952% Total implementation shortfall = +(-0.2493)+0.6277+0.93607+0.5539+0.0952 = 1.963% Reference: CFA Level III, Volume 6, Study Session 16, Reading 31 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) B Solution: Template for Question 8-B(i) Determine whether the Brazilian market information suggests an increase or a decrease in the quality of the Brazilian market The Crossover Clearing House has recently been established to serve as an intermediary to capital market transactions The entity is subject to financial and ethical standards imposed by the Brazilian government Increase The market offers attractive opportunities to investors who can identify mispricings before others, especially in the small-cap sector Those who act early can earn significant gains Decrease Identify the market quality factor that each affect Justify your response with one reason each This factor increases the ‘assurity of completion’ of trades A clearing house serving as an intermediary will guarantee both sides of a trade and will ensure that the trade is completed The entity is subject to ethical and financial standards, which further assures that the guarantee has strength This factor reduces the ‘liquidity’ of the market by decreasing the market’s ‘resilience’ Since gains can be significant for investors who identify mispricings, the discrepancies between market price and intrinsic value must be large or corrected with a time lag Reference: CFA Level III, Volume 6, Study Session 16, Reading 31 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 8-B(ii) Evaluate the effect of the information Walter gathered, on the optimal corridor width of Brazilian corporate bonds The volatility of Brazilian government bonds and equities has increased over the past few years The correlation of Brazilian equities with Brazilian corporate bonds is higher than their correlation with Brazilian government bonds The corridor should be narrower The corridor should be wider Justify your response with one reason each Note: Use an all-else equal assumption in each case Considering the balance of the portfolio as one asset class, an increase in volatility will cause the optimal corridor to be narrower since this will make large divergences from strategic asset allocation more likely When asset classes move in synch, further divergence from targets is less likely, so the corridor will be wider Reference: CFA Level III, Volume 6, Study Session 16, Reading 32 FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS ONE PART FOR A TOTAL OF MINUTES Hugh Ross is a fixed income analyst at White Stripes Investment Management, a firm that offers bond portfolio management services Ross has managed more than twenty portfolios over the course of his career, some for institutional investors, and others for private wealth clients Recently, Larry Kemp, the chief investment officer at White Stripes, instructed Ross to analyze the performance of a bond portfolio managed by one of his subordinates, Anne Couk While evaluating the portfolio’s performance, Ross calculated the impact of the following on the portfolio’s total return: • • • The sector/quality effect The security selection effect The trading effect A Determine for each of the effects mentioned how Ross might have calculated their impact on the portfolio’s total return Note: No calculations are necessary (6 minutes) FinQuiz.com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question Solution: The sector/quality effect: This is estimated by pricing each security in the portfolio using a discount rate accounting for the average yield premium in its respective category (risk free rate + premium) A gross return is calculated based on this price The external effect and the interest rate management effect are then subtracted from this gross return The security selection effect: For a single security, this is calculating by subtracting the bond’s price, calculated using the discount rate accounting for the yield premium, from the bond’s actual price The difference is calculated in percentage terms The portfolio’s security selection effect is then the market value weighted average of all the individual security selection effects The trading effect: The trading effect is calculated as the total portfolio return minus all the other components: the external effect, the interest rate management effect, the sector/quality effect, and the security selection effect Reference: CFA Level III, Volume 6, Study Session 17, Reading 33 FinQuiz.com © 2018- All rights reserved ... credit for successes and blaming failures on exogenous factors Reference: CFA Level III, Volume2 , Study Session 3, Readings and FinQuiz. com © 2018- All rights reserved CFA Level III Mock Exam – Solutions... her biases should be ‘moderated and adapted’ to Reference: CFA Level III, Volume 2, Study Session 3, Reading FinQuiz. com © 2018- All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION... in providing stable and sustainable spending distributions Reference: CFA Level III, Volume 2, Study Session 6, Reading 13 FinQuiz. com © 2018- All rights reserved CFA Level III Mock Exam – Solutions