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 CFA Level III Mock Exam – Solutions (PM) FinQuiz.com –2nd Mock Exam 2018 (PM Session) Questions Topic Minutes 1-12 Ethical and Professional Standards 36 13-18 Alternative Investments 18 19-24 Risk Management 18 25-30 Risk Management Application of Derivatives 18 31-36 Equity Investments 18 37-42 Fixed Income 18 43-48 Monitoring and Rebalancing 18 49-54 Risk Application of Swap Strategies 18 55-60 Global Investment Performance Standards 18 Total 180 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions through relate to Ethical and Professional Standards Wilshire Investment Case Scenario Wilshire Investment (WI) is a U.S based investment management firm providing wealth management services to institutional clients The firm primarily invests in traditional asset classes such as equity and fixed income Holme’s Trust Foundation (HTF) is WI’s institutional client Its portfolio is being managed by Tony Monroe Monroe is evaluating commodity futures in Rigea, an Eastern European country, for HTF’s investment portfolio WI does not have expertise with commodity futures Therefore, Monroe has made arrangements with an external portfolio manager, Raul Davis Under the arrangement Davis and WI will share any commissions generated In addition to their agreement, Davis has invited Monroe to Rigea As a signal of good gesture, Davis’s firm has offered Monroe to pay for commercial transport and hotel accommodation Monroe has declined the hotel accommodation offered but has not responded to the transport offer Jean Lowe is a research analyst serving WI’s research wing Lowe is currently analyzing hedge funds in Rigea Monroe has asked Lowe to avoid hedge funds in Rigea because he believes they will not generate attractive returns Lowe remains convinced that the hedge funds are attractive investment opportunities After thorough research and analysis, Lowe recommends the assets class and compels Monroe to invest his clients’ funds Six months later, the investment generates a strong alpha Prior to serving WI, Monroe served another portfolio management firm at which he was extremely popular In order to generate the same level of popularity at WI, Monroe decides to contact a fellow portfolio manager at his previous workplace to provide contact details of clients who are no longer invested with the firm The firm continues to store client details on its database After his successful yet uncertain venture into hedge funds, Monroe contemplates increasing client portfolio allocations to modern alternative investment classes, particularly buyout funds and venture capital funds In describing the new investment opportunity to his clients, he states: FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Statement: “Buyout fund investments are virtually risk-free as the associated funds are established companies; the latter category is highly risky but will generate substantial returns if the associated venture survives.” Octavia Richards, CFA, is a broker serving East End Brokers (EEB) On behalf of EEB, she is forming an arrangement whereby any requested research will be directed to EEB in exchange for providing new clients to Monroe The commission charged by Richards is higher than average; however, he believes doing business through Richards will allow WI to gain access to investment funds with very high investment requirements and improve client accounts’ results as well as meet their investment needs He intends to disclose the arrangement to clients if successful Curious about the success of the hedge fund, Monroe decides to investigate the source of the outperformance During his analysis and discussions with local analysts, Monroe comes to the conclusion that the fund may be victim to survivorship bias He presses fund management who refuse to provide any information on the matter In response to the commercial transport offer made by Davis’s firm, Monroe’s best course of action would be to: A accept the offer without any disclosure to his supervisor B accept the offer with disclosure to his supervisor C decline the offer Correct Answer: C Reference: CFA Level III, Volume 1, Study Session 1, Reading Standard I (B) Independence and Objectivity requires members and candidates to avoid gifts, benefits, and compensation arrangements that compromise their own or another’s independence and objectivity Best practice dictates that members and candidates use commercial transportation rather than accept paid travel arrangements from an outside company Should commercial transportation be unavailable, members and candidates may accept modest travel arrangements Given that commercial transportation is available, Monroe’s best course of action would be to decline the offer FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) By issuing the research report, has Lowe violated any Standards of Professional Conduct? A No B Yes, she has violated IV (A) Loyalty by not respecting Monroe’s instructions C Yes, she has violated VI (A) Disclosure of conflicts by failing to disclose the difference in opinion Correct Answer: A Reference: CFA Level III, Volume 1,Study Session 1, Reading Lowe has not violated any standards by issuing the research report Standard I (B) requires analysts to engage in thorough, independent and unbiased analysis Furthermore, analysts should ensure that the research reflects their independent and objective judgment Given that there are no conflicts of interest, Lowe is not required to provide any disclosures; standard VI (A) has not been violated By requesting access to client records, has Monroe violated any Standards of Professional Conduct? A No B Yes, he has violated IV (A) Loyalty C Yes, he has violated III (E) Preservation of Confidentiality Correct Answer: B Reference: CFA Level III, Volume 1,Study Session 1, Reading Standard IV (A) Loyalty requires members and candidates to act for the benefit of their employer and not divulge confidential information, amongst other actions Departing employees must not engage in the misappropriation of clients or client lists without their employer’s consent By requesting access to client records, which continues to remain stored in the firm’s database, Monroe has violated the loyalty standard Even if the clients are no longer invested with the firm, Monroe is in violation of this standard as the records are a property of the firm FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) In describing the proposed investment classes to his clients, Monroe has most likely violated: A I (C) Misrepresentation B III (D) Performance Presentation C V (B) Communication with Clients and Prospective Clients Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading Standard I (C) Misrepresentation requires members and candidates to not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities The standard prohibits members and candidates from guaranteeing a rate of return on volatile investments Monroe has violated this standard by disclosing to clients that buyout funds are risk-free Although these funds are less risky in contrast to venture capital funds, they cannot be classified as risk-free Standard III (D) Performance Presentation requires members and candidates to make reasonable efforts to ensure investment performance information is fair, accurate, and complete Given that Monroe is not presenting investment performance to his clients, he is not in violation of this standard Standard V (B) Communication with Clients and Prospective Clients requires members and candidates to disclose the basic format and general process of the investment process used to select securities; use reasonable judgment in identifying which factors are important to their investment analysis, recommendations, or actions; and distinguish between fact and opinion is the presentation of investment analysis and recommendation Monroe is not in violation of this standard By undertaking the brokerage arrangement with EEB and Richards, Monroe has: A violated standard III (A) Loyalty, Prudence and Care B violated standard III (C) Suitability C not violated any Standards of Professional Conduct FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading Standard III (A) Loyalty, Prudence and Care requires members and candidates to act with reasonable care and exercise prudent judgment Members and candidates have a duty of loyalty to their clients and must act for their benefit and place their interests before their own By paying high commissions, Monroe will gain access to investment opportunities not otherwise available In this regard, he has not violated the standards However, by failing to disclose the arrangement to client accounts, he is in violation Standard III (C) Suitability requires members and candidates to determine the suitability of an investment to the client’s financial situation Given that the investment opportunity will help improve account performance, he is not in violation of this standard Based on Monroe’s suspicions regarding the hedge fund, his best course of action would be to: A consult his supervisor B consult WI’s whistleblowing policy C discontinue his investment arrangement with the hedge fund Correct Answer: A Reference: CFA Level III, Volume 1,Study Session 1, Reading Monroe’s best course of action would be to consult his supervisor Given that the hedge fund has engaged in performance misrepresentation (by artificially inflating performance), Monroe should consult WI’s whistleblowing policies if consultation with the supervisor is unsuccessful In an extreme scenario, Monroe may consider discontinuing his investment arrangement with the hedge fund FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions through 12 relate to Ethical and Professional Standards Alliance Limited Case Scenario Alliance Limited (AL) is an asset advisory firm situated in Chicago, providing investment advisory services to private wealth clients To improve its standing in the national market, senior officer Ali Reza has recommended AL adopt the CFA Institute Asset Manager Code He has drafted compliance policies in three different areas which will assist the firm in gaining compliance Personal Trading: Any employee intending to trade a security on AL’s watch list must seek prior approval from the compliance officer if the trade exceeds the $1,000 limit Backup records: To ensure the safety of account information, all pertinent information will be stored on a backup computer system in electronic form only The system will be located in AL’s headquarters; an offsite system is currently not within the firm’s budget Fee Disclosures: All managers are encouraged to disclose all actual gross- and net-offees performance results as well as an itemization of charges The procedure used to determine contingent fees must be disclosed upon request After drafting the policies, Reza engages in a discussion with AL’s senior portfolio manager, Rob Martin Martin manages the account of Martha Flower, a wealthy real estate developer who is operating in Florida Martin has long suspected Flower of embezzling her clients’ funds After thorough investigation, Martin is now certain and fears a substantial portion of her portfolio may be funded with these funds He is uncertain of what action to take Sylvia Bath, CFA, a portfolio manager serving AL, manages the investment account of Peter Blake Blake is one year away from retirement and will depend entirely on his retirement income to provide for his modest lifestyle His investment portfolio has a current equity allocation of 10%, comprising entirely of domestic large-cap value stocks, with the remainder in fixed income securities Due to the current cyclicality of the U.S economy and to protect her client’s portfolio, Bath has decided to sell the value stocks and purchase large-cap growth stocks in the same proportion Since this action was taken to protect Blake’s portfolio, she does not believe informing Blake was necessary FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Later that evening, Bath receives an invitation to attend a charitable event from Blake Among the invitees include professionals from the investment industry Believing that the event will provide the opportunity to bring more business to AL, she accepts the invitation after informing her supervisor in writing At the event, the attendees engage in various activities for cash prizes Blake wins two cash prizes worth $50 each, which she intends to disclose to her supervisor The following day Bath has been asked to review the performance record and resume of Ramos Davis, a candidate applying for the position of computer systems technician Davis was fired from Cappa Inc., a large investment bank, after being wrongly accused of negligent supervision of the bank’s backup computer system, which subsequently led to its destruction in a site fire Which of the following policies is most likely consistent with both the required and recommended standards of the CFA Institute Asset Manager Code? The policy concerning: A Personal trading only B Backup records only C neither personal trading nor backup records Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 2, Reading The policy concerning Backup records is consistent with the Asset Manager Code while that concerning Personal trading is not The CFA Institute Asset Manager Code recommends that employers place restricted securities on a restricted or watch list Any employees wishing to trade securities should be required to seek prior approval However the Code does not specify a dollar amount The CFA Institute Manager Code requires each firm to establish a disaster recovery system; the size, nature and complexity of which depends on the size of the organization Managers should consider having adequate backup records, preferably offsite, for all account information Given that an offsite system is not within AL’s budget, an on-site system is consistent with the Code’s recommendations Furthermore, storing account information in electronic form is consistent with the Code FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Which of the following statements is most likely correct with respect to the Fee Disclosures policy? A The procedure used to determine contingent fees must be disclosed regardless of client request B Managers should be encouraged to disclose either gross- or net-of-fees results but not both C The policy is in compliance with the required and recommended standards of the Asset Manager Code Correct Answer: A Reference: CFA Level III, Volume 1,Study Session 2, Reading With respect to fee disclosures, Managers should disclose both gross- and net-offees returns Managers are required to disclose the procedures for determining contingent fees regardless of client request In order to adhere with the requirements and recommendations of the Asset Manager Code, Martin’s best course of action with respect to his knowledge on Flower’s activities is to: A inform his supervisor B inform local authorities C keep any information gained during the investigation confidential Correct Answer: A Reference: CFA Level III, Volume 1,Study Session 2, Reading A Manager’s duty to keep client information confidential does not override his/her duty to report illegal activities concerning client accounts to the appropriate authorities Because he is not completely certain of whether Flower’s portfolio is funded using the stolen funds, Martin’s best course of action would be to inform his supervisor Together, they can determine the best course of action FinQuiz.com © 2018 - All rights reserved 10 CFA Level III Mock Exam – Solutions (PM) Question 2: Is it correct to state that the buy-and-hold strategy is consistent with a risk tolerance which has a positive relation to wealth at all levels of stock return? Task B: Optimal Corridor Width For this task, Pena compiles volatility, return, transaction cost, and correlation data on the three asset classes held in Smith’s (Exhibit 1) portfolio Exhibit Expected Return, Volatility, Transaction Cost, and Correlation Data Asset Class Domestic Equity Domestic Bonds Commodities Volatility Expected (Annualized Transaction Correlation with the Return Standard Costs rest of the portfolio (Annualized) Deviation) 12.5% 14.2% 0.20% 0.25 7.8 11.8 0.45 0.18 11.3 11.9 0.19 0.09 Mildred Jones, CFA, is AWM’s Human Resource Manager She has recently implemented a policy which mandates firing any underperforming managers Some managers have complained that the policy is too stringent and has resulted in the company losing promising managers which have underperformed due to uncontrollable external factors 43 Considering economic forecasts and Lawrence’s requirements, which of the following rebalancing strategies is most appropriate for Lawrence’s portfolio? A CPPI B Buy-and-hold C Constant-mix Correct Answer: A Reference: CFA Level III, Volume 6, Study Session 16, Reading 32 FinQuiz.com © 2018 - All rights reserved 41 CFA Level III Mock Exam – Solutions (PM) The most appropriate rebalancing strategy for Lawrence is CPPI Her risk tolerance is above average; her home purchase is being easily met with the inheritance as well as insurance proceeds and her liquidity needs are minimal In fact, her ability to tolerate risk has increased with the inheritance Furthermore her desire for increasing equity exposure during positive economic conditions and for protection during economic downturns makes this strategy appropriate for the client In conclusion, the CPPI strategy will generate the best performance for the portfolio in the forecasted upwards trending market 44 Assuming expectations are realized, Lawrence’s revised stock/cash allocation under a buy-and-hold strategy is closest to: A 53.5/46.5 B 55.0/45.0 C 56.2/43.8 Correct Answer: C Reference: CFA Level III, Volume 6,Study Session 16, Reading 32 Current stock value = $2,000,000 × 0.55 = $1,100,000 Current cash value = $2,000,000 × 0.45 = $900,000 Portfolio return = Percent in stocks × Return on stocks = 0.55 × 5% = 2.75% New portfolio value = $2,000,000 × 1.0275 = $2,055,000 New stock value = $1,100,000 × 1.05 = $1,155,000 Revised stock allocation = 1,155,000/2,055,000 = 56.2% Revised cash allocation = 900,000/2,055,000 = 43.8% 45 The most appropriate responses to Wise’s questions are: Question A No B No C Yes Question No Yes No FinQuiz.com © 2018 - All rights reserved 42 CFA Level III Mock Exam – Solutions (PM) Correct Answer: C Reference: CFA Level III, Volume 6,Study Session 16, Reading 32 The response to Question is a yes and to Question is a no For the constant mix strategy, the relationship between portfolio and stock returns is concave On the other hand, the CPPI strategy is convex The graphical representations of these strategies are mirror images of each other For the buy-and-hold strategy, the investor’s risk tolerance is positively related to wealth and stock returns However, the risk tolerance is zero if stock returns or value declines to zero 46 Based only on the transaction cost and volatility information presented in Exhibit 1, which asset classes will have the narrowest corridor width? A Commodities B Domestic bonds C Domestic equity Correct Answer: C Reference: CFA Level III, Volume 6,Study Session 16, Reading 32 Domestic equity should have the narrowest corridor width because it has the highest volatility (14.2%) and second lowest transaction costs (0.2%) A given percentage move away from a highly volatile asset class is more harmful for the portfolio because it has a greater chance of a further large move away from the target The more expensive it is to trade an asset, the wider the corridor should be so that the marginal costs of rebalancing at least equal the marginal benefits and viceversa Although the transaction costs of domestic equity are higher relative to commodities, the impact of higher volatility associated with the former asset class is more harmful for the portfolio and dictates a relatively narrow corridor FinQuiz.com © 2018 - All rights reserved 43 CFA Level III Mock Exam – Solutions (PM) 47 Considering the correlation data in isolation, Pena will conclude that the asset class with the narrowest corridor width is: A Commodities B Domestic bonds C Domestic equity Correct Answer: A Reference: CFA Level III, Volume 6,Study Session 16, Reading 32 Commodities have the lowest correlation with the rest of the portfolio (0.09) relative to domestic bonds (0.18) and domestic equity (0.25) Therefore, it should have the narrowest corridor width as chances of further divergences from target allocations become less likely 48 Jones’ policy characterizes a (n): A Type I error B Type II error C adequate manager continuation policy Correct Answer: B Reference: CFA Level III, Volume 6,Study Session 17, Reading 33 Jones’ policy characterizes a Type II error Her policy is resulting in skilled managers being fired from AWM even though the underperformance may not be in their control This represents an inadequate manager continuation policy FinQuiz.com © 2018 - All rights reserved 44 CFA Level III Mock Exam – Solutions (PM) Questions 49 through 54 relate to Risk Application of Swap Strategies TSM Derivatives Trading (TSMDT) Case Scenario TSM Derivatives Trading (TSMDT) is a derivatives trading group situated in London, U.K Amongst the derivative contracts it executes, the group locates interest rate, equity, and commodity swap counterparties by acting as a dealer to parties seeking to hedge their positions In addition to solely offering dealership services, the group routinely undertakes the dual role of derivatives dealer for and acts as swap counterparty to its customers for an additional fee Kyote Inc is one of TSMDT’s customers Kyote Inc is a wholesale manufacturer producing cornmeal and other corn-based edible products For the purposes of producing these products, the manufacturer regularly purchases raw corn Kyote Inc.’s finished products are distributed to retailers to be further sold to individual retail customers To secure the purchase price of raw corn, Kyote Inc plans to enter into a derivative contract TSMDT’s senior derivatives trader, Josef Silos, recommends the manufacturer enter into a three year commodity swap contract on corn The 1-year, 2-year, and 3-year corn forward prices are £125, £150, and £165, respectively The 1-year, 2-year, and 3year interest rates are 7.5%, 8.0%, and 9.5%, respectively During an initial meeting with Kyote Inc.’s head of risk management, Silos makes the following statements: Statement 1: “Entering into the commodity swap contract on corn will give your firm (Kyote Inc.) a position equivalent to three forward contracts Statement 2: “Another way to look at it is, by entering into the commodity swap contract, your firm will effectively be making a 2-year loan to TSMDT.” Statement 3: “The benefit of entering into a commodity swap contract is that your firm’s counterparty credit risk becomes virtually non-existent.” The head of risk management responds to Silos’ statements by asking the following two questions Question 1: Question 2: “If forward prices and interest rates change following contract initiation, will it have an impact on the value of our firm’s swap contract?” “If, in the future, our demand for corn needs to be increased (decreased) to accommodate an unexpected demand rise (fall) for cornmeal and we are met with seasonally high corn prices, is there a way to accommodate corn price and demand changes when pricing commodity corn swap contracts?” FinQuiz.com © 2018 - All rights reserved 45 CFA Level III Mock Exam – Solutions (PM) 49 If Kyote Inc decides to enter into the three-year commodity swap contract on corn, it will most likely: A make a fixed payment and receive a floating payment on the swap B make a floating payment and receive a fixed payment on the swap C make a fixed payment on the swap only Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 15, Reading 30 Since Kyote Inc is a regular purchase of raw corn the manufacturer will be hurt by corn price rises and by volatile corn prices Thus the manufacturer will enter into a commodity swap contract where it will pay the fixed swap price and receive the floating spot price 50 The effective unit price on the 3-year swap is closest to: A £119.51/bushel B £145.56/bushel C £165.55/bushel Correct Answer: B Reference: CFA Level III, Volume 5, Study Session 15, Reading 30 The effective swap price on the three-year corn commodity swap is £145.56/bushel This is calculated as follows: • Firstly, the present value of the cost per bushel is calculated: 125 150 165 + + = 370.5528 (1.075) (1.08) (1.095)3 The swap price per bushel is then obtained by solving: x x x + + = 370.5528 1.075 (1.08 ) (1.095)3 x = £145.5562 ≈ £145.56 FinQuiz.com © 2018 - All rights reserved 46 CFA Level III Mock Exam – Solutions (PM) 51 TSMDT has entered into a three-year swap contract with Kyote Inc as a dealer and swap counterparty Assuming TSMDT hedge corn price risk on the swap contract by entering into three forward contracts, the derivative group’s net cash flow position on the swap and forward contract in the second year is closest to: A – £4.44 B + £4.44 C + £15.55 Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 15, Reading 30 Since Kayote Inc is paying fixed and receiving floating on the swap, the dealer is in a position opposite to the manufacturer (i.e receiving fixed and paying floating) Because the dealer is paying floating, the dealer is exposed to the risk of an increase in corn prices and consequentially having to make greater £ sterling floating payments In order to hedge this corn price risk, the dealer should enter into three forward contracts by undertaking a long position, one contract for each year of the swap The payoffs received under the swap are depicted in column whereas the payoffs received under the forward contracts are depicted in column with the aggregate net cash flow position in column Year Net Swap Payment Long Forwards Net Position S1 − £145.5562* S1 − £125 + 20.5562 S1 – £145.5562 S1 – £150 − 4.4438 S1 – £145.5562 S1 – £165 * See the solution to previous question − 19.4438 52 In context of the statements made by Silos to Kyote Inc.’s head of risk management, which of the following statements is most likely incorrect? A All three statements B and only C only Correct Answer: B Reference: CFA Level III, Volume 5, Study Session 15, Reading 30 FinQuiz.com © 2018 - All rights reserved 47 CFA Level III Mock Exam – Solutions (PM) Statement 1: From the prospective of Kyote In (the corn buyer), entering into a commodity swap contract is equivalent to entering into three forward contracts plus an agreement to lend money at the implied forward rate Thus statement fails to correctly equate swaps to forward contracts and a lending contract Statement 2: By entering into the swap, Kyote Inc is effectively lending TSMDT (the counterparty) money for two years beginning in a year’s time Thus statement correctly states this fact Statement 3: A commodity swap which calls for physical delivery exposes the buyer of the prepaid swap to credit risk should the counterparty fail to deliver the commodity A commodity swap which calls for financial settlement has an initial credit risk of zero as either party does not pay anything to enter into the swap However during the life of the swap, credit risk may go back and forth between the swap buyer and seller as the value of the swap changes Thus, irrespective of Kyote Inc.’s mode of settlement, which has not been mentioned in the case, a commodity swap will entail credit risk for the manufacturer Statement incorrectly asserts the fact that commodity swaps facilitate an elimination of credit risk 53 The most appropriate response to the risk management head’s first question is: A there will be no impact on the value of the swap contract B the value of the swap contract will change, increase or decrease, only in response to a change in corn forward prices C the value of the swap contract will change, increase or decrease, in response to a change in the value of either of the two variables, corn forward prices and forward interest rates Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 15, Reading 30 When a commodity buyer enters into a commodity swap, its market value is zero However, once the swap is struck its market value no longer remains zero: • • as forward prices for the commodity (in this case, corn) and interest rates change; due to implicit borrowing and lending (which changes the value of the swap despite forward prices and interest rates remaining constant) FinQuiz.com © 2018 - All rights reserved 48 CFA Level III Mock Exam – Solutions (PM) 54 The most appropriate response to the question is: A Yes B No, commodity swap contracts may only accommodate forward price changes C No, commodity swap contracts may not be able to accommodate either variable commodity demand or forward prices Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 15, Reading 30 Swaps can take into account the tendency of commodity prices to exhibit seasonality That is, the swap can take into account circumstances where a commodity’s demand and its price are seasonally varying This is done by including a varying price and quantity component in the swap agreement FinQuiz.com © 2018 - All rights reserved 49 CFA Level III Mock Exam – Solutions (PM) Questions 55 through 60 relate to Global Investment Performance Standards Brooks Wealth Management Case Scenario Brooks Wealth Management (BWM) is an asset advisory firm situated in Brooklyn, New York BWM manages the accounts of individual clients Its subsidiary, Thuraiya Associates, handles institutional client accounts Each firm has its own team of portfolio managers, trading desks, and marketing staff Managers from both departments base their investment decisions on research reports issued by a centralized in-house research department Access to this department is shared BWM is currently in the process of seeking compliance with the Global Investment Performance Standards (GIPS) Three of its policies are believed to comply with the requirements of these standards Large External Cash Flows: Portfolios belonging to the developed market equity composite are revalued when capital equal to 10% of the fair value is contributed or withdrawn Portfolios belonging to the emerging market equity composite are revalued when capital equal to 30% of the fair value is contributed or withdrawn This policy is documented Portfolio Valuation: The beginning value of investments is measured at cost Subsequent to initial recognition, investments are valued at fair value Valuation Frequency: Due to the illiquid nature of emerging market investments, portfolios belonging to the emerging market equity composite are revalued semiannually Liquid investments are revalued on the last day of the calendar month James Marco, BWM’s client, has requested BWM to demonstrate how his account’s performance is calculated in accordance with the GIPS standards Dmitri Solvang, CFA, Marco’s portfolio manager, compiles relevant portfolio information (Exhibit 1) FinQuiz.com © 2018 - All rights reserved 50 CFA Level III Mock Exam – Solutions (PM) Exhibit Marco’s Portfolio Activity for the Month of January, 2011 (in $) January (Beginning value) 180,000 External cash flows: 12 January + 4,500 27 January ─ 3,450 Value on 12 January* 197,500 Value on 27 January* 220,000 January 31, 2010 (Ending value) 222,000 *Portfolio values include the relevant cash flows When presenting performance to clients, Solvang believes it is necessary to report internal dispersion of returns earned by individual portfolios in the composite Such information will enable users to evaluate how consistently the firm was able to achieve its strategy across individual portfolios To measure internal dispersion, BWM reports an annual VAR for all measured portfolios on an annual basis Gene Davis is another client of BWM Her contract with the firm expires on August 31, 2011 Unsatisfied with her account’s performance, she instructs her portfolio manager to cease trading and liquidate her holdings with immediate effect on August 12 Her account’s performance is calculated on a monthly basis 55 Which of the following entities meets the definition of a firm as outlined by the GIPS standards? A both entities B BWM only C Thuraiya Associates only Correct Answer: A Reference: CFA Level III, Volume 6, Study Session 18, Reading 34 FinQuiz.com © 2018 - All rights reserved 51 CFA Level III Mock Exam – Solutions (PM) In order to comply with the GIPS standards, a firm must be an investment management firm, subsidiary or department held out to clients as a distinct business entity A distinct business entity is defined as a “unit, division, department or office that is organizationally and functionally segregated from other units, divisions, departments or offices and that retains discretion over the assets it manages and that should have autonomy over the investment decisionmaking process.” BWM and Thuraiya Associates are functionally and organizationally distinct entities Even if they share access to the research division, investment decisions are made independently by the two entities 56 BWM’s Large External Cash Flows policy most likely satisfies the requirements of the GIPS standards with respect to: A both composites B the developed market equity composite only C the emerging market equity composite only Correct Answer: A Reference: CFA Level III, Volume 6, Study Session 18, Reading 34 The standards state that for periods beginning on or after January 2010, portfolios must be valued on the date of all large external cash flows (I.1.A.3-4) and that firms must define large cash flows for each composite to determine when the portfolios in the composite are valued The standards require firms to define portfolio- or composite-specific amounts or percentages that constitute large external cash flows By defining what constitutes ‘large external cash flows’ and valuing portfolios in the two composites accordingly, BWM’s large external cash flows policy satisfies this requirement with respect to both composites FinQuiz.com © 2018 - All rights reserved 52 CFA Level III Mock Exam – Solutions (PM) 57 Do BWM’s policies concerning portfolio valuation and valuation frequency, respectively, satisfy the requirements of the GIPS standards? Portfolio Valuation A No B No C Yes Valuation Frequency No Yes No Correct Answer: C Reference: CFA Level III, Volume 6,Study Session 18, Reading 34 The use of fair value represents a method consistent with the GIPS standards Although the standards prohibit the use of cost for valuation purposes, cost is applicable to performance measurement as long as it reflects an investment’s beginning value (I.1.A.2) By recording the beginning value of investments at cost and subsequent value at fair value, BWM’s portfolio valuation policy satisfies the standard’s requirements For periods prior to January 1, 2001 portfolios must be valued at least quarterly; for periods beginning on or after January 1, 2001 portfolios must be valued at least monthly; and for periods on or after January 1, 2010 portfolios must valued on the last date of each calendar or business month (II.1.A.3-4) Although BWM’s valuation frequency policy is consistent with these requirements with respect to liquid investments, its semi-annual valuation policy is not 58 The true time-weighted rate of return on Marco’s portfolio is closest to: A 13.1% B 18.6% C 22.4% Correct Answer: C Reference: CFA Level III, Volume 6,Study Session 18, Reading 34 FinQuiz.com © 2018 - All rights reserved 53 CFA Level III Mock Exam – Solutions (PM) The true time-weighted rate of return is calculated by chain linking the returns at each cash flow date Return Period = (197,500 – 4,500) – 180,000/180,000 = 7.22% Return Period = [(220,000 – (– 3,450)] – 197,500/197,500 = 13.14% Return Period = (222,000 – 220,000)/220,000 = 0.91% Time-weighted rate of return = (1.0722)(1.1314)(1.0091) – = 22.41% 59 Does BWM’s internal dispersion policy satisfy the GIPS standards? A Yes B No, firms are required to report VAR on a monthly basis C No, VAR is not an acceptable measure of internal dispersion Correct Answer: C Reference: CFA Level III, Volume 6,Study Session 18, Reading 34 The standards mandate reporting for each annual period a measure of internal dispersion of the returns earned by individual portfolios in the composite (I.5.A.1.i) The GIPS Glossary contains several acceptable methods such as high/low, range, and the equal-weighted or asset-weighted standard deviation of portfolio returns Using VAR as a measure for internal dispersion of portfolio returns is inconsistent with these acceptable methods 60 In order to comply with the requirements of the standards, BWM’s best course of action with respect to Davis’s account at a minimum, is to: A retain her performance record up to July 31, 2011 B retain her performance record up to August 12, 2011 C transfer her performance record to her new asset advisor Correct Answer: A Reference: CFA Level III, Volume 6,Study Session 18, Reading 34 FinQuiz.com © 2018 - All rights reserved 54 CFA Level III Mock Exam – Solutions (PM) The GIPS standards require firms to include a portfolio’s historical performance in the composite up to the last full measurement period that the portfolio was under management (I.3.A.6) Given that BWM calculates Davis’s account performance on a monthly basis, it must at a minimum, retain her performance record up to July 31, 2011 FinQuiz.com © 2018 - All rights reserved 55 ... CFA Level III Mock Exam – Solutions (PM) Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading Standard III (A) Loyalty, Prudence and Care requires members and candidates... with EEB and Richards, Monroe has: A violated standard III (A) Loyalty, Prudence and Care B violated standard III (C) Suitability C not violated any Standards of Professional Conduct FinQuiz. com... Answer: C Reference: CFA Level III, Volume 1, Study Session 1, Reading Standard I (B) Independence and Objectivity requires members and candidates to avoid gifts, benefits, and compensation arrangements