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 – 3rd Mock Exam 2018 (AM Session) The morning session of the 2018 Level III CFA Examination has 10 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question Questions Topic Minutes Portfolio Management – Individual Investor 34 Portfolio Management – Institutional Investors 26 Portfolio Management – Economics 15 Portfolio Management – Asset Allocation 18 Portfolio Management – Fixed-Income Investments Portfolio Management – Equity Investments 18 Portfolio Management – Alternative Investments Portfolio Management – Risk Management Portfolio Management – Execution, Monitoring and Rebalancing Portfolio Management –Performance Evaluation 21 10 21 Total: FinQuiz.com © 2018 - All rights reserved 180 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 34 MINUTES Forrest Wiltkinson is a professional player for the New Horizon cricket club who, along with a sizeable salary from his career, has also done well with his many venture capital investments Mr Wiltkinson grew up in a poor family and still lives well within his means despite his sizeable wealth Forrest will play one more year and then plans on devoting the rest of his life to charitable causes At the end of the year he will sell his primary residence for an estimated $500,000 (after taxes) so he can travel more freely His philanthropic pursuits and life as a professional athlete has taken him around the globe and he is disheartened by the working conditions prevalent in some regions Going forward, he makes a commitment not to invest in tobacco or gambling companies or those with human rights violations He is 34 years old now and has an investment portfolio of $40 million His annual salary is $5 million and pays taxes of 40% on all income and 15% on capital gains For planning purposes, his portfolio manager tells him that he can expect a 7.5% after-tax nominal return in his investments over the next year Living expenses amount to about $750,000 per year and rise with the general rate of inflation around 2.5% per year A i Formulate the return objective for Forrest’s investment policy statement ii Calculate the after-tax nominal rate of return that is required during his first year of retirement Show your Calculations (12 minutes) B i Identify two factors from Forrest’s profile that increases his ability to take risks ii Identify two factors from Forrest’s profile that increases his willingness to take risks iii Describe Forrest’s overall risk tolerance (8 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) C Formulate each of the following constraints in Forrest’s investment policy statement and support with one reason from the profile i Liquidity requirement ii Time horizon iii Unique circumstances Answer Question 1-C in the Template provided on page (6 minutes) Ten years have passed and instead of retiring to charitable causes, Mr Wiltkinson has become a successful private equity fund manager He has grown accustomed to the flashy and expensive lifestyle and wants to be able to maintain it into his eventual retirement Though his investable assets have increased, his expenses have also increased and the required return on his portfolio to meet retirement goals has increased to percent D i Identify three factors that affect Forrest’s risk tolerance and identify whether ability or willingness to tolerate risk is increased or decreased (8 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 1-C Constraint Formulate each of the following constraints in Forrest’s investment policy statement and support with one reason from the profile i Liquidity ii Time Horizon iii Unique Circumstances FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: i The return objective is to earn an after-tax nominal return sufficient enough to maintain the real value of assets and pay for annual spending needs beginning at the age of 35 years old To this, the portfolio must earn a 4.18% after-tax nominal rate of return Current Year Next Year Inflows Salary Growth in Investment Portfolio (after tax) Total $5,000,000 3,000,000 $8,000,000 Outflows Income tax (40%) Expenses Total $2,000,000 750,000 $2,750,000 $768,750 $768,750 Net $5,250,000 $(768,750) Investment Portfolio Sale of primary residence Net inflows from year Total Investable Assets at Retirement Outflows during first year of retirement Required after-tax real rate of return Add: Inflation Required after-tax nominal rate of return * Growth in Investment Portfolio $40,000,000 * 7.5% * Income tax $5,000,000 * 40% Reference: CFA Level III, Volume 2, Study Session 4, Reading FinQuiz.com © 2018 - All rights reserved $40,000,000 $500,000 $5,250,000 $45,750,000 $(768,750) 1.68% 2.50% 4.18% CFA Level III Mock Exam – Solutions (AM) B Solution: i The size of the portfolio at retirement ($45.75 million) is large relative to spending needs If the portfolio were to experience sub-required returns, spending could be reduced or the client could seek additional income ii The client enjoys the ‘thrill’ of investing and is presumably willing to accept higher levels of risk for that emotion The client’s willingness to fund venture capital investments denotes a higher willingness for risk iii With an above average ability and willingness for risk, Mr Wiltkinson’s overall risk tolerance is above average Reference: CFA Level III, Volume 2, Study Session 4, Reading C Solution: Template for Question 1-C Constraint Formulate each of the following constraints in Forrest’s investment policy statement and support with one reason from the profile i Liquidity The client will have annual expenses of $768,750 beginning the first year of retirement and increasing each year at 2.5% with inflation ii Time Horizon The client's time horizon is two-staged and long-term The first stage is one-year to retirement The second stage is +45 years through retirement iii Unique Circumstances The client does not want to invest in companies engaged in tobacco or gambling or with a record of human rights violations Reference: CFA Level III, Volume 2, Study Session 4, Reading FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) D Solution: 1) Ability to tolerate risk is increased with the addition of income and successful career 2) Willingness to tolerate risk is increased with the desire to maintain new, more expensive lifestyle 3) Ability to tolerate risk is decreased by need for higher return on assets Reference: CFA Level III, Volume 2, Study Session 4, Reading FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS TWO PARTS (A, B) FOR A TOTAL OF 26 MINUTES Riva Manufacturing makes park benches and road signs for markets in North America The company did well over the last few years, benefiting from significant government stimulus dollars into road and infrastructure projects Recently however, the company has returned to operating losses, a trend that was developing before stimulus measures The company has offered a defined benefit plan for employees and calculates benefits by number of years service and compensation at time of retirement Benefits for the plan are not indexed to inflation and the pension fund is currently operating with a surplus The board has recently decided to shift employee retirement options to a defined contribution plan and has closed the defined benefit plan to new members Because of this, the plan will experience an increase in the proportion of inactive members relative to active members The board is worried about the future burden the plan may place on the company and would like to achieve an excess return over the discount rate to minimize contributions while still maintaining the plan surplus The total return objective for 2012 is the same as last year but the nominal discount rate for calculating PBO has been reduced to 6.5% Other data for the plan is shown in the table below Riva Manufacturing Defined Benefit Plan 2011 Projected Benefit Obligation (PBO) $37,458 Pension Assets $97,458 Plan Surplus or Deficit $60,000 Payments and Distributions Average Duration of Liabilities $850 10 years Discount Rate 7.5% Excess Return Target 1.5% Figures in millions of dollars A State the return objective for the pension and calculate the excess return target for 2012 Show your calculations (6 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) B Identify five factors that affect the plan’s ability to take risk Determine whether each factor increases or decreases the plan’s ability to take risk and support your response with one reason Answer Question 2-B in the Template provided on page 11 (20 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) B(i) Portfolio volatility: 9.7218%(0) + 90.2782%(22) = 19.8612% Asset Class Marginal Contribution to Risk= Beta × (portfolio vol) Beta 8.9375 0.45 6.55419 0.33 35.5515 1.79 37.3390 1.88 21.8473 1.10 US bonds Global ex US bonds Global REITS Emerging market equities US equities Reference: CFA Level III, Volume 3, Study Session 8, Reading 17 (ii) To find out whether the asset allocation is optimal with regards to risk-budgeting, we would have to find the ratio of excess return to MCTR for each asset class This should equal the Sharpe ratio of the tangency portfolio, i.e 0.50 Ratio of excess return to MCTR (Exp return – Rf)/MCTR Asset Class Weight MCTR % Beta Expected Return % Rf + β(RmRf) US bonds 45% 8.9375 0.45 5.75 0.25 Global ex US bonds 25% 6.55419 0.33 5.15 0.25 Global REITS 5% 35.5515 1.79 12.45 0.25 Emerging market equities 10% 37.3390 1.88 12.9 0.25 US equities 15% 21.8473 1.10 9.0 0.25 Even though the MCTR is the same for all asset classes but it does not match the Sharpe ratio of the tangency portfolio (Portfolio 4)=0.50 Hence, this is not an optimal allocation from a risk budgeting perspective Reference: CFA Level III, Volume 3, Study Session 8, Reading 17 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS ONE PART (A) FOR A TOTAL OF MARKS Karen Anne Gray has been managing the ‘Quart Fixed-Income Fund’ for her investment firm for the past two years The fund is fully invested in four major sectors of the US fixed-income market and has followed a relatively passive investment strategy during its recent past Owing to current economic developments in the country, Gray expects a bull market in bonds over the next phase of the business cycle Since the fund is fully invested and Gray does not want to alter the fund’s basic composition, she plans to use derivatives to increase the fund’s duration Presently, the fund has a market value of $15 million with a duration of Gray wishes to increase the duration by 1.5 points To so, she has accumulated the following data: § § § Price value of basis point of a 10-year Treasury note futures contract is $77 Bonds that can be purchased and financed have a duration of A 20-year swap has an effective PVBP of 0.143 for the fixed side and 0.0030 for the floating side Gray is attempting to construct an appropriate strategy to achieve the desired duration However, she is also concerned with the risks inherent in each of the viable options present A State and describe three strategies that can alter the portfolio’s duration to the desired level Show your calculations for each strategy Mention one risk for each of the stated strategies (9 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question The PVBP of the current portfolio is: $15 million × 7/10,000 = $10,500 Duration is to be increased to 8.5 or: $15 million ×8.5/10,000 = $12,750 $2,250 PVBP needs to be added without changing the fund’s composition Strategy 1: Use the 10-year futures contract Number of contracts required: $2,250/$77 = 29.220779 Buy 29 futures contracts Risk: A futures contract lacks a well-defined duration since a new futures contract has no market value The PVBP captures approximates the money volatility added to the portfolio by the contract Strategy 2: Leverage can be used to increase the duration Value of the bonds required: $2,250/4 = 562.50 ×10,000 = $5.625 million An additional amount of bonds worth $5.625 with a duration of can be bought to increase the duration to 8.5 Risk: Leverage adds interest rate risk because it increases the portfolio’s sensitivity to changes in rates It also amplifies both credit risk and liquidity risk Strategy 3: Use the 20-year swap, that has a net effective PVBP of: 0.143 - 0.0030 = 0.140, or $1,400 PVBP Amount in swaps to be added: $2,250/$1,400 = $1.607143 million in swaps Risk: Curve risk is inherent in the selection process of a swap A different swap may add the same dollar volatility for a parallel shift in the yield curve but different exposures to changes in the curvature of the YC Hence, the manager has to make sure he is adding an appropriate swap given his expectations of the changes in the yield curve Reference: CFA Level III, Volume 4, Study Session 11, Reading23 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES Rudolf Dithers is the Director for the H James University endowment and is interested in market efficiencies and biases He first examines the various weighting schemes employed in index creation, specifically indexes that are price-weighted, value-weighted, and equal-weighted The endowment has historically favored mutual funds as a way to gain broad exposure at a low cost With the increasing popularity of exchange traded funds, Dithers would like to identify any advantages or disadvantages for a report to the investment committee A Identify one bias within each of the three index weighting schemes studied (6 minutes) A Identify two advantages and one disadvantage of exchange traded funds over mutual funds (6 minutes) Mr Dithers is now studying the performance of two managers with allocations from the endowment Fred Wilma, manager of the Siri Fund, covers 400 stocks and has been able to achieve an information coefficient of 0.05 Jan Barnle, manager of the Pirius Fund, has attained an information coefficient of 0.07 while covering only 150 stocks B Calculate the information ratio for each manager Show your calculations (6 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: Price-Weighted indexes have a greater impact from higher priced stocks than lowerpriced stocks Also, the price of a stock is arbitrary and changes with repurchases and splits Value-Weighted indexes have a greater impact from those companies with higher market capitalization versus smaller companies This will also mean that the index is biased to overvalued stocks Equal-Weighted indexes are biased to small-cap stocks because they are given the same weight as large caps even though they have less liquidity and are more numerous Reference: CFA Level III, Volume 4, Study Session 12, Reading 25 B Solution: The advantages of ETFs over mutual funds are: • • • • Constant pricing and trading throughout the day Lower expenses because shareholder record-keeping is not required Tax efficiency Lower long-term costs due to lower management fees and redemption fees The disadvantage of ETF over mutual funds is higher license fees paid to index providers Reference: CFA Level III, Volume 4, Study Session 12, Reading 25 C Solution: The information ratio for each manager is: Wilma: 0.05(4001/2) = 1.00 Barnle: 0.07(1501/2) = 0.86 Reference: CFA Level III, Volume 4, Study Session 12, Reading 25 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS TWO PARTS (A, B) FOR A TOTAL OF MINUTES A U.S based portfolio management firm maintains a global equity fund This year Raul Gibbons, the fund’s manager, is considering the addition of South Korean equities to the fund The purchase will be undertaken in three month’s time and the firm has hedged its exposure to the USD/KRW using at-the-money (ATM) options After undertaking the hedge, Gibbons believes there is further potential to reduce hedging costs He would like to select a strategy which maximizes upside potential while maintaining downside protection Gibbons proposes four alternative strategies for achieving his return enhancement/ cost reduction motive Proposal 1: Short position in 25-delta put options Proposal 2: Long position in a 25-delta risk reversal Proposal 3: Short position in ATM call options Proposal 4: Digital options A Identify the existing ATM option position held by the firm Explain your choice (3 minutes) B Identify the proposal most suitable for achieving the Gibbons’ objectives For each proposal not selected, discuss one reason why it is inappropriate (6 minutes) Answer Question 7-B in the Template provided on page 25 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 7-B Identify the most suitable proposal for achieving Gibbons’ objectives For each proposal not selected, discuss one reason why it is inappropriate Proposal Proposal Proposal Proposal FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: The firm is long ATM USD/KRW call options The firm would like to purchase the KRW and therefore will have a long exposure to the KRW The firm will need to protect itself against an appreciation of the KRW To hedge this exposure, the firm will purchase ATM call options Reference: CFA Level III, Volume 5, Study Session 9, Reading 19 B Solution: Template for Question 7-B Identify the most suitable proposal for achieving Gibbons’ objectives Writing OTM put options increases downside risk; the firm will not be protected against an appreciating KRW Proposal Proposal22 Proposal Proposal Proposal For each proposal not selected, discuss one reason why it is inappropriate Buying out-of-the-money (OTM) call options will reduce the cost of hedging and continue to protect the firm against an appreciating KRW Selling OTM put options will bring in option premium and reduce the net cost of hedging Shorting ATM call options will increase the exposure to the USD contrary to Gibbons’ objectives Digital options cost more than plain vanilla options and are more appropriate for active management rather than as hedging tools FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Reference: CFA Level III, Volume 5, Study Session 9, Reading 19 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 21 MINUTES As part of a foreign exchange hedging strategy, a U.S portfolio manager enters into a 6month forward contract to deliver CAD1,000,000 for dollars The current 6-month forward rate is $1.8095/CAD Three months into the contract, the spot rate is $1.8038/CAD, the U.S interest rate is 5.5%, and the foreign rate is 5.0% A Calculate the value and direction of any credit risk (6 minutes) The manager also holds a portfolio of two stocks, Omnicrom and Fissure Semi The expected returns for the two stocks are 9% for Omnicrom and 13% for Fissure Semi and their standard deviations are 18% and 21%, respectively The correlation of returns between the two assets is 0.5 B Calculate the 5% (analytical) value at risk of a $100,000 portfolio invested 75% in Omnicrom and 25% in Fissure Semi Show your calculations (9 minutes) C List one advantage and two disadvantages of analytical VAR for estimating risk (6 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: = 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 − (1 + 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑖) (1 + 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑖)3 = $1,809,500 $1,803,800 − (1.055)?/A (1.05)?/A =$3,509 Since the manager has sold CAD for dollars and the dollar has appreciated, the manager would be better off in the contract than in the spot market The manager has the credit risk Reference: CFA Level III, Volume 5, Study Session 14, Reading 27 B Solution: Expected Returnportfolio = 75(0.09) + 0.25(0.13) = 0.10 Variance portfolio = (0.75)2 (0.18)2+(0.25)2(0.21)2+2(0.75)(0.25)(0.18)(0.21)(0.50) = 0.02807 Standard Deviation portfolio = 0.02807 ½ = 0.1675 VAR = $100,000(0.10 – 1.65(0.1675)) = –$17,637 Reference: CFA Level III, Volume 5, Study Session 14, Reading 27 C Solution: Acceptable answers (advantages): • Easy to calculate and understand • Allows modeling the correlation of risks • Applicable to different time periods Acceptable answers (disadvantages): • Assumption of normal distribution • Difficulty of estimating correlations for large portfolios • No indication of size of potential losses on tail risk Reference: CFA Level III, Volume 5, Study Session 14, Reading 27 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 21 MINUTES Iowa Pork Processors (IPP) closes Wednesday at $20 per share, a 52-week low but on low volume Mark Epps, a portfolio manager, thinks the shares could see a rebound over the next few days and decides to place a limit order for 1,000 shares at $19.95 The shares not fall to $19.95 during the day, so the order expires unfilled The stock closes at $20.05 that day On Friday, Epps revises the order to a limit at $20.06 The order is partially filled that day and 800 shares are bought at $20.06 The commission for the order is $18 and the stock closes at $20.09 with the remaining order of 200 shares cancelled A Calculate the gain or loss on the both the paper and real portfolio Show your calculations (3 minutes) B Calculate the four components of implementation costs: explicit costs, realized profit/loss, delay costs, missed trade opportunity costs Show your calculations (12 minutes) C Calculate the total implementation costs Show your calculations (6 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: • • The gain on the paper portfolio is the terminal value of the paper portfolio ($20.09×1,000) minus the initial investment ($20.00×1,000) or $90 The gain on the real portfolio is the terminal value of the actual portfolio (800×$20.09) minus the initial investment including commissions ((800×$20.06)+$18) or $6 Reference: CFA Level III, Volume 6, Study Session 16, Reading 31 B Solution: • • • • Explicit costs equals commission divided by paper portfolio investment ($18/$20,000) or 0.09% Realized profit or loss equals the execution price minus the previous day’s closing divided by the benchmark price and multiplied by proportion filled (($20.06 – $20.05)/$20.00)×(800/1,000) or 0.04% Delay costs equal the closing price the day before minus the benchmark price and divided by the benchmark price then multiplied by proportion filled (($20.05 – $20.00)/$20.0)×(800/1,000) or 0.20% Missed trade opportunity costs equal the difference between the final price and the benchmark price divided by the benchmark price and multiplied by proportion unfilled (($20.09 – $20.00/)$20.00)×(200/1,000) or 0.09% Reference: CFA Level III, Volume 6, Study Session 16, Reading 31 C Solution: • Total implementation costs are the sum of the four components (0.09%+0.04%+0.20%+0.09%) or the difference between the paper gain and the real portfolio gain divided by the paper portfolio investment (($90 – $6)/$20,000) or 0.42% Reference: CFA Level III, Volume 6, Study Session 16, Reading 31 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION 10 HAS THREE PARTS (A, B, C) FOR A TOTAL OF MINUTES Shown below is the attribution analysis for a portfolio manager at the Wellgarden Funds Sector Consumer Staples Financials Utilities Portfolio Weight (%) Sector Benchmark Weight (%) Portfolio Return (%) Sector Benchmark Return (%) 7.72 13.42 22.01 3.55 1.66 3.21 3.32 1.1 3.18 8.38 15.48 17.89 Overall Benchmark Return = 2.32% A Calculate the within-sector return for the financials sector Show your calculations (3 points) B Calculate the pure-sector allocation return for the consumer staples sector Show your calculations (3 points) C Calculate the allocation/selection interaction return for the utilities sector Show your calculations (3 points) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Solution for Question 10 A Solution: = 0.1342×(1.66% – 1.10%)= +0.0752% Reference: CFA Level III, Volume 6, Study Session 17, Reading 33 B Solution: =(0.0838 – 0.0772)×(3.32% – 2.32%)= 0.0066% Reference: CFA Level III, Volume 6, Study Session 17, Reading 33 C Solution: = (0.1789 – 0.2201)×(3.21% – 3.18%)= –0.0012% Reference: CFA Level III, Volume 6, Study Session 17, Reading 33 FinQuiz.com © 2018 - All rights reserved ... relative to total assets and increases ability to take risk Reference: CFA Level III, Volume 2, Study Session 6, Reading 13 FinQuiz. com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions... options and are more appropriate for active management rather than as hedging tools FinQuiz. com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Reference: CFA Level III, Volume. .. Reference: CFA Level III, Volume 6, Study Session 17, Reading 33 C Solution: = (0.1789 – 0.2201)×(3.21% – 3.18%)= –0.0012% Reference: CFA Level III, Volume 6, Study Session 17, Reading 33 FinQuiz. com