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 – Questions (AM) FinQuiz.com – 4th Mock Exam 2018 (AM Session) The morning session of the 2017 Level III CFA Examination has questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question Questions Topic Minutes Portfolio Management – Behavioral Finance 20 Portfolio Management – Institutional Investors 20 Portfolio Management – Fixed Income Investments 19 Portfolio Management – Individual-Asset Allocation 39 Portfolio Management – Asset Allocation 22 Portfolio Management – GIPS 20 Portfolio Management – Trading and Rebalancing Portfolio Management – Risk Management & Performance Evaluation 20 Total: FinQuiz.com © 2018 - All rights reserved 20 180 CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, AND D) FOR A TOTAL OF 20 MINUTES Dano Parker works as a portfolio manager at Picasso Investments (PICIN), a large and reputable financial advisory firm offering a range of capital management services and investment products to individual and institutional investors Parker has been with the firm for over five years now, and has managed more than fifteen client portfolios As such, PICIN has appointed Parker to appraise the performance of private wealth portfolios at regular intervals During his appraisals, and also as part of experience, Parker notices that, in many instances, the assumptions of traditional finance with respect to the behaviors of individuals not hold true Parker was not sure what effects this might have on optimal portfolio construction by financial market participants To discuss this further, Parker invited David Hulsey, a behavioral financial analyst, to talk about investor behavior in detail During their conversation, Hulsey made the following comment: “I believe that investors behave rationally when making investment decisions and try to maximize the expected utility, given their budget constraint When faced with new information, market participants revise expectations consistent with Bayes’ formula Also, investors are risk-averse, demanding more return for each unit of risk.” Parker disagreed with Hulsey on the basis of the ‘Prospect Theory’, but was not sure how this theory provided an alternative explanation to investor behavior He was, however, convinced that the theory explained apparent deviations in decision making from those explained under the utility theory A Justify how the prospect theory supports Parker’s notion of an apparent departure of investor behavior from the behavior of the rational economic man Give three ways the prospect theory differs from the utility theory (6 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) After his meeting with Hulsey, Parker proceeded with developing an earnings forecast for Sparkle Fixtures Incorporated (SFI), a US firm famous for its lighting fixtures and decorative lamps The lighting industry has seen tremendous growth over the past decade due to a rising trend of professional interior designing of homes and offices Historical data of the past 15 years shows earnings growth for SFI at 1.0-1.5% above the GDP growth rate Just recently, however, the firm reported a drop of 5.0% in earnings growth due to a number concerns regarding the supply of raw materials In addition, a few other firms also reported losses for the recent quarter In developing his forecasts, Parker decided to revise his earnings estimate downward for the stock in order to avoid any losses and keep his estimate conservative B Determine the bias that Parker is most likely subject to while developing earnings estimate for SFI Give one example where such a bias may result in excessive trading by financial market participants (4 minutes) While reviewing the asset allocation decisions of his clients, and their stated preferences during regular meetings for updating their IPSs, Parker noticed that many portfolios lacked the appropriate amount of diversification, as would be present if investors behaved rationally and took a holistic view of their portfolios Parker was assured that this was due to the presence of behavioral biases C Give three behavioral explanations for inadequately diversified portfolios State the bias inherent in each explanation (6 marks) Before ending his day, Parker shortlisted five potential stock investments for his portfolio that met his risk and return constraints and had approximately similar risk-return profiles Given his budget constraint, Parker decided to invest in two of the most well-known and established firms amongst those he had shortlisted D Determine, using behavioral finance, the behavior that guided Parker to select stocks for his portfolio State the bias leading to such a behavior Justify your response (4 marks) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS Renee Russo works as a portfolio manager at Panther Investment Management Firm (PIMF), a financial advisory firm offering portfolio management services to institutional investors, including pension plans, endowments and foundations Pension funds make up the largest portfolio of PIMF’s client base Russo has recently been appointed as the Chief Portfolio Manager (CPM) for the pension fund of Revolutionary Technologies Limited (RTEL), a large, US based firm operating in the electronics and technology industry The firm has been quite profitable over the past five years, as has been the general industry trend Working in association with Dennie Thorpe, the Chief Financial Officer (CFO) of RTEL, Russo compiles the data provided in Exhibit Exhibit 1: Financial Information of RTEL (Average of the past five years) RTEL Industry Average Debt/Total Assets 35% 55% Net Income/Sales 22% 19% Expected Gross Profit Margin 45% 47% Russo’s team at PIMF presents her with the data in Exhibit Exhibit 2: Economic Data Duration 25 year, US Treasury bonds 16 years 35 year, US Treasury bonds 22 years Interest Rate 7.5% 8.5% Inflation rate: 5.0% FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Utilizing the opportunity to work with the CFO of the firm, Russo also accumulates the following facts: • • • • • The projected benefit obligation (PBO) as reported on the current balance sheet, dated 31 December 2013, equals $10 billion The duration of the liabilities equals 22 years The total value of the firm’s pension assets as of 31 December 2013 equal $13 billion The ratio of the retired lives to active lives for the firm equals 0.33 The correlation between pension plan assets and plan liabilities is close to 0.33, with pension assets invested mostly in growth oriented investments While talking to Russo about the pension plan’s objectives, Thorpe also states the following: “RTEL primary focus is to maintain the funded status of the plan at a level of at least 100% with respect to the PBO The board has decided that a probability of 10% of falling short of meeting this objective is reasonable In addition, the plan’s objectives need to be set so as to minimize the probability of making future contributions to the plan Also, since proficient human resource is a key element of success in this industry, to retain our employees, we keep modifying our plan provisions according to changes in the industry This helps ensure retention of the best possible human resource in the face of competition.” Thorpe continues with the following comment: “To meet our long-term objectives of minimizing contributions, the board has estimated that a return of 2.5% over and above the minimum required return would be appropriate for the fund.” A Formulate an appropriate risk objective for Revolutionary Technologies Limited’s (RTEL) pension fund Determine whether RTEL’s ability to take risk is above-average, average, or below average Give three reasons why the ability may be high, and three reasons why it might be low Use the template on page to answer the question (8 marks) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) B Determine the minimum return requirement for RTEL’s pension fund Formulate an appropriate return objective for the RTEL pension fund (4 marks) Ten years have passed, and Russo is still the manager of the RTEL pension fund The following changes have occurred during this time period: • • • • The ratio of the retired lives to average lives is 0.66 The industry has seen a large number of new entrants, which has squeezed profit margins for existing firms The overall growth rate of the industry is now approximately in line with the rate of growth of the general economy The firm introduced a provision for early retirement two years ago 10% of employees have opted for this option The asset base is now $9 billion with plan liabilities unchanged For the current month, RTEL made a contribution to the pension plan of $10 million Given the number of retired employees, Russo estimates a cash disbursement of $60 million per month to satisfy obligations C Determine the current liquidity requirement of the RTEL pension fund Explain whether the liquidity constraint for the fund has improved, remained stable, or deteriorated Justify your response with three reasons (5 marks) D Formulate the time horizon portion of the IPS of the RTEL pension fund as of today and ten years ago (3 marks) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Template for Question 2-D Reasons (High) Ability to take risk Reasons (Low) 1 2 3 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) QUESTION HAS THREE PARTS (A, B AND C) FOR A TOTAL OF 19 MARKS David Channing is a 45-year-old computer engineer who owns an established small software house in the United States Channing has saved $2 million from his business and has invested part of it in an investment portfolio managed by Shawn Murphy of Murphy Financial Associates (MFA) Exhibit displays the composition of his current portfolio Exhibit 1: Current Asset Allocation Asset Category Percentage Allocation International Equities 15% Domestic Equities 55% Corporate bonds 20% Real estate 10% Channing is responsible for the medical expenses of his parents that amount to approximately $40,000 per year His business profits sufficiently cover his living expenses, and also allow for a contribution to his savings Channing now plans to invest some of these savings in a fixed-income security that would complement his existing portfolio He wishes to cash out of the investment in a year, at which time he hopes to earn a reasonable return from his outlay For this purpose, Channing meets with Murphy to discuss available options for investment Murphy presents him with data on four bonds Exhibit displays this data Exhibit 2: Bond Investments Bond Yield Z-spread Spread Duration Credit Rating A 2.75% 1.50% A2 B 4.00% 3.50% Ba1 C 5.75% 2.00% Baa3 D 8.00% 2.75% B3 To comprehensively present the risk inherent in each option, Murphy provides Channing with estimated annual default rates and recovery rates data for each bond Exhibit provides this information based on empirical analysis Murphy also states that he expects spreads to narrow by almost 75bps over the holding period since he believes the economy to pick up in the short-term FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Credit Rating Exhibit 3: Default and Recovery Data Average Annual Default Rate Recovery Rate A2 0.33% 70% Baa3 1.00% 60% Ba1 1.90% 55% B3 4.98% 40% About 75% of Channing’s current fixed-income allocation is in investment grade corporate bonds with a minimum rating of A3, some of which are floating-rate bonds The remaining is invested in high-yield corporates with almost the same seniority ranking in their respective issuers’ capital structures Channing’s current IPS gives him a risk aversion score of with no other special concerns State the bond that Channing should purchase based on a relative value analysis considering only the data given about the four bonds in isolation Show your calculations (9 minutes) Recommend a bond that is most suitable for Channing Justify your response with three reasons (5 marks) State which risk is most inherent in Channing’s current fixed-income allocation consisting of floating-rate bonds and high-yield bonds Justify an appropriate measure of risk for each category (5 marks) FinQuiz.com © 2018 - All rights reserved 10 CFA Level III Mock Exam – Questions (AM) Template for Question 4-E Recommended asset allocation (circle one) Allocation Four Reasons to support decision For each of the allocations not selected, give one reason each why they were not appropriate i ii A B C iii D FinQuiz.com © 2018 - All rights reserved 15 CFA Level III Mock Exam – Questions (AM) QUESTION HAS THREE PARTS (A, B, AND C) PARTS FOR A TOTAL OF 22 MARKS James Preston, 48, is a renowned professor of English literature, philosophy and sociology at a State university in Massachusetts, USA Preston is a single parent to two children; Alyssa and Justin Alyssa is 19 years old who has just graduated from college and is planning to join a four-year bachelors program in anthropology Justin, who is 28 years old, has completed his education and works for Clark & Peers Software Developers, a well-established software house in the US Alyssa’s academic program is estimated to cost her $450,000 in total and Preston has agreed to contribute 75% of this amount as assistance, with the rest being taken as a student loan by her Although Justin is financially independent, he has requested Preston to help him make a down payment of $40,000 of a town home he plans to buy in two years that is very close to his workplace Preston feels a strong need to support his children in whatever way he can Preston has written a book on philosophy that is used as a textbook for first year college students With the help of his published book and some additional savings, Preston has managed to accumulate a portfolio worth $15 million The present value of his earnings as a professor is estimated to total $12 million Preston’s current residence is worth $800,000 with around $2 million in mortgage loans Other than the mortgage, Preston has no other debt or liabilities As a tribute to his late wife, Miranda Preston, James wishes to make a contribution, worth $3 million, in ten years to a school for underprivileged children In addition, he wishes to leave $15 million as a bequest to his children at the time of his death Preston’s living expenses average $80,000 per year that he needs to meet for his estimated life expectancy of 25 years Preston has hired Robert Stanton, a portfolio manager and research analyst, to manage his financial assets and liabilities While setting Preston’s investment policy statement, Stanton determined the following probabilities of success for Preston’s stated goals: § § § Extremely high need corresponds to a 95% probability of success A want corresponds to an 85% probability of success A wish corresponds to moderate required probability of achieving and a 75% chance A(i) State and describe four goals for Preston’s IPS (4 minutes) A(ii) Present Preston’s economic balance sheet, detailing the components of his assets and liabilities, and his total net worth (6 minutes) FinQuiz.com © 2018 - All rights reserved 16 CFA Level III Mock Exam – Questions (AM) To determine the appropriate asset allocation for Preston, Stanton requests the investment department of his firm to provide him with a set of pre-optimized, sub-portfolio modules The department provides Stanton with details presented in Exhibit In addition, Stanton also requests data on expected returns of each module for a given time-frame and probability of success A Expected Return Expected volatility Exhibit 1: Pre-optimized Portfolios B C D E 5.0% 5.5% 6.7% 7.8% 8.6% 2.4% 4.9% 6.2% 8.0% 11.5% Exhibit 2: Annualized Minimum Expected Returns years Time Horizon 95% 1.7% 1.0% 0.8% 0.2% -2.1% 85% 2.2% 3.1% 3.3% 2.9% 1.0% 75% 3.3% 3.5% 4.3% 4.5% 4.2% Time Horizon 95% 10 years 2.0% 2.3% 2.2% 1.8% -0.9% 85% 3.3% 3.6% 4.0% 3.9% 3.8% 75% 3.5% 4.5% 5.5% 6.0% 6.2% Time Horizon 95% 20 years 3.5%% 3.6% 4.2% 4.7% 4.4% 85% 3.8% 4.1% 5.0% 5.5% 5.7% 75% 4.0% 4.7% 5.8% 6.1% 6.9% Time Horizon 95% 25 years 3.2% 3.5% 4.5% 4.9% 5.1% 85% 3.6% 4.2% 4.7% 5.5% 5.9% 75% 3.9% 4.7% 5.9% 6.6% 7.1% FinQuiz.com © 2018 - All rights reserved 17 CFA Level III Mock Exam – Questions (AM) B Considering that only Preston’s financial assets are investable, determine the amount of money that needs to be allocated to each goal in absolute terms as well as relative to the total assets State if any further goals can be met with the portfolio (6 minutes) Once Stanton selected the optimal sub-portfolios for Preston, he worked towards deriving an overall asset allocation The detailed compositions of the sub-portfolios with respect to five major areas of investment are given below: Cash Investment grade bonds Exhibit 3: Sub-Portfolio Composition A B C 65% 15% 5% High-yield bonds Developed equities D 3.2% E 2.6% 30% 40% 20% 5% 5% 30% 25% 30% 10% 15% 20% 33.8% 50% 30% 28% 37.4% Emerging market equities At a final meeting with Preston, Stanton stated that even though goals were properly articulated, and money was allocated to each goal, there is a high chance that the portfolio would fall short of meeting the goals Hence, a surplus fund is always necessary to act as a buffer in case things no turn out as anticipated C.(i) Derive the overall goal-based asset allocation for Preston Justify your response C(ii) State whether Stanton’s comment about a surplus is accurate using empirical evidence (6 minutes) FinQuiz.com © 2018 - All rights reserved 18 CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 2O MINUTES Capital Enhancement Investment Group (CEIG) is a capital management firm in the US that holds a prestigious position amongst similar firms in its industry CEIG has introduced a number of revolutionary products in the financial industry that combine traditional assets with simultaneous derivative positions to cash on profitable opportunities To remain competitive in this growing industry, CEIG appointed James Hull, a compliance officer, to implement the Global Investment Performance Standards (GIPS) within the firm Hull has worked with CEIG for over three years now and deems himself fruitful in the proper implementation of the Standards CEIG considers itself amongst the list of GIPS complaint firms, and, in doing so, believes it has gained the trust of many prospective clients Just recently, the CEO of CEIG hired Darin Hollings, a performance evaluation and presentation expert, to review the firm’s procedures for GIPS compliance During his review, as of January 2011, Hollings noted the following: • • • • • CEIG used trade date accounting to report transactions Assets and liabilities were recognized within a week of entering into a transaction When reporting fixed-income securities, interest income earned but not yet received was also included in their total value For dividend paying equities, dividends not yet paid were not accrued due to their uncertainty CEIG has a fiscal year that corresponds to the calendar year Consequently, every portfolio within its composites was valued at the last business day of each year When reviewing the frequency of portfolio valuations, Hollings discovered that CEIG valued all portfolios at least monthly When presenting net-of-fees returns, CEIG did not accrue investment management fees, especially performance-based fees After the review, Hollings met with the CEO and posed the following question: “In reporting portfolio values, which definition of value you use?” The CEO responded with the following comment: “Last year, we measured and reported all portfolio values at market value However, recently, we have started to use the ‘fair value’ of portfolios for reporting purposes If fair values are not easily obtainable, a best estimate of market value is used.” FinQuiz.com © 2018 - All rights reserved 19 CFA Level III Mock Exam – Questions (AM) A List three ways in which CEIG’s procedures violate the GIPS requirements with regards to input data Support your answer with proper justifications for each reason (6 marks) After his review, Hollings proceeded with evaluating the performance of the portfolios managed by CEIG’s portfolio managers While doing so, Hollings met with Ricardo Nadu, a portfolio manager who managed a few of the firm’s private wealth accounts Nadu told Hollings that all portfolio managers were required to measure the timeweighted rates of return that adjusted for external cash flows In addition, returns for longer measurement periods were computed by geometrically linking the monthly returns Upon further questioning by Hollings, Nadu stated the following: • • • • • • Cash and cash equivalents were included in the total return calculations However, if the cash was not actually invested by the same group of portfolio managers that managed the portfolio, it was excluded from the return calculations In addition, returns were always calculated after the deduction of trading expenses To be conservative and ensure compliance with GIPS, if actual values for such expenses were unavailable, estimated values were used based on historical averages Custody fees were not considered direct trading expenses However, if they were charged on a per-transaction basis, they were included in trading expenses When trading expenses could not be broken out of bundled fees, gross-of-fee returns were reduced by the entire amount of the bundled fee to estimate returns gross of investment management fees Withholding taxes were not considered when estimating net of fee returns CEIG’s definition of what constituted ‘a large cash flow’ varied with each composite depending on the nature of the investment strategy B For each of the facts stated by Nadu, state whether they are in compliance with the GIPS For each of the procedures not in compliance, determine the changes necessary to make them GIPS compliant Use the template on the following page to answer the question Answer Question 6-B in the Template provided on page 23 (6 marks) FinQuiz.com © 2018 - All rights reserved 20 CFA Level III Mock Exam – Questions (AM) Hollings knew that his analysis of CEIG would not be complete without assessing the appropriateness of the construction of composites within CEIG Specifically, Hollings analyzed the following actual, fee-paying client portfolios: Portfolio A The client specifically instructed not to invest more than 10% of the portfolio value or 115% of the benchmark weight, whichever is greater, in any given economic sector Portfolio B The client is the CEO of his firm and has holdings in his company’s stock He has instructed his portfolio manager not to sell any part of this holding, even if capital market conditions stated otherwise.” Portfolio C More than 60% of the client’s portfolio constitutes holdings in his grandfather’s firm that has been managed by family over the course of many years Since the holding has a very low cost basis, the client has directed his portfolio manager that it should not be sold.” C Select the portfolio that is likely to be not included in a composite under the Global Investment Performance Standards For the portfolio selected, list three ways in which it can be handled with regards to GIPS compliant composite construction (4 marks) Hollings was particularly interested in the firm’s traditional asset class composites, mainly: Balanced Fund Composite (50% equities, 50% fixed income) Growth Fund Composite (70% equities, 30% fixed income) Income Fund Composite (30% fixed income, 70% equities) The equity portions of the three funds were managed by a group of equity managers at CEIG, whereas the fixed-income portions, along with cash and cash equivalents, were managed by the fixed-income managers Just recently, CEIG created a new composite by the name of “Standard Equity Account Composite” that included only the equity segments of the above-mentioned composites This was created to ensure proper performance evaluation of the equity managers of CEIG D Determine whether the construction of the new composite is in compliance with the GIPS Support your answer with two reasons (4 marks) FinQuiz.com © 2018 - All rights reserved 21 CFA Level III Mock Exam – Questions (AM) Template for Question 6-B Procedures Compliance Changes (if necessary) with GIPS to be in compliance Cash and cash equivalents were included in the total return calculations However, if the cash was not actually invested by the same group of portfolio managers that managed the portfolio, it was excluded from the return calculations Custody fees were not considered direct trading expenses However, if they were charged on a per-transaction basis, they were included in trading expenses When trading expenses could not be broken out of bundled fees, gross-of-fee returns were reduced by the entire amount of the bundled fee to estimate returns gross of investment management fees In addition, returns were always calculated after the deduction of trading expenses To be conservative and ensure compliance with GIPS, if actual values for such expenses were unavailable, estimated values were used based on historical averages Withholding taxes were not considered when estimating net of fee returns CEIG’s definition of what constituted ‘a large cash flow’ varied with each composite depending on the nature of the investment strategy FinQuiz.com © 2018 - All rights reserved 22 CFA Level III Mock Exam – Questions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 20 MARKS Jocelyn Mathews works as a portfolio manager at Victor Investment and Capital Management (VICM) Mathews manages a number of VICM’s private wealth accounts invested in asset classes ranging from equities and fixed-income to alternative investments Mathews believes strongly in not only the value of research and analysis in proper security selection, but also in the significance of trading and implementation in managing costs Accordingly, he is analyzing the trading costs of his most recent purchase: 1,000 shares of the stock of Stripes Incorporated He accumulates the following facts for his evaluation: • • • • The benchmark price was $60.00/share The order was placed on last Tuesday, when the shares of Stripes closed at $59.90/share 500 shares were purchased at a price of $61.05 per share Commissions and fees were $50 On Wednesday, 200 more shares were purchased at $62.05 per share Commissions and fees were $20 Shares of Stripes closed at $61.03 during the same day On Thursday, no more shares were purchased and the order was canceled The market closed at $62.00 per share Mathews meant to use this data to calculate the implementation shortfall of his trade A Calculate the total implementation shortfall for the trade in the stock of Stripes Incorporated Determine the contribution of the various cost components to the total implementation shortfall Show your calculations (6 marks) Upon completion of his analysis, Mathews met with is fellow colleagues to share his conclusion They were all intrigued with the impact that trading costs could have on investment results As their discussion continued, each manager presented ways in which they attempted to minimize trading expenses They made the following comments: Manager A: “I always use extensive competitor and industry data while screening securities A comprehensive fundamental analysis is a trialed and tested method for selecting superior investments While placing an order, I wait till the price reaches the level I deem fit “ FinQuiz.com © 2018 - All rights reserved 23 CFA Level III Mock Exam – Questions (AM) Manager B: “I believe that markets are efficient, and costs to actively managed funds overweight the benefits of doing so Most of my investments are in indexed funds To minimize the costs of trading, I only trade at regular intervals for rebalancing purposes.” Manager C: “Just recently, I traded in the stock of Star Industries that I believed was significantly overvalued They had met fierce opposition from their largest suppliers, which led to the cancellation of a supply contract just a few days ago My trading costs were quite low.” B Determine which category of traders types would each of the above managers fall into State the order type that they are most likely to use along with one limitation for each order type (6 marks) After their discussion, Jim McGraw (Manager B) stayed back to talk a little more about rebalancing needs and methodologies When Mathews inquired about the frequency of his rebalancing trades, McGraw stated that he rebalanced his portfolio to target weights on a semiannual basis; a choice linked to the schedule of his portfolio’s reviews For investment advice from Mathews, McGraw presented him with the following details of his portfolio: Exhibit 1: Asset Class Weights (Strategic Asset Allocation) Asset Class Weights Domestic bonds 25% International bonds 15% Domestic Equities 40% International Equities 20% FinQuiz.com © 2018 - All rights reserved 24 CFA Level III Mock Exam – Questions (AM) In addition, McGraw also mentioned that over the course of the previous year, some economic, personal, and financial changes occurred, affecting each of these asset classes Specifically, he pointed out the following: • • • • • Direct transaction costs of trading in domestic bonds increased considerably over the year Due to a large down payment to be made for the purchase of a new home, the portfolio experienced a significant cash outflow As such, minimizing tracking risk relative to the benchmark became a prime objective The volatility of international bonds increased, maybe due to differing economic changes worldwide Its correlation with domestic equities increased, reflecting less of a diversification benefit The correlation of international equities with domestic equities decreased however, adding to the diversification benefits The volatility of international equities increased too, over the same time period C (i) State the rebalancing method used by McGraw List two ways in which percentage-of-portfolio rebalancing can mitigate the drawbacks of the rebalancing method used by McGraw (3 marks) C (ii) Evaluate the implications of each of the above mentioned changes on the tolerance bands of the asset classes assuming percentage-of-portfolio rebalancing was used Use the template on page 27 to answer the question (5 marks) FinQuiz.com © 2018 - All rights reserved 25 CFA Level III Mock Exam – Questions (AM) Template for Question 7-C (ii) Changes Direct transaction costs of trading in domestic bonds increased considerably over the year Due to a large down payment to be made for the purchase of a new home, the portfolio experienced a significant cash outflow As such, minimizing tracking risk relative to the benchmark became a prime objective Tolerance Band for: Domestic bonds Implications International bonds The volatility of international Domestic bonds increased, maybe due equities to differing economic changes worldwide Its correlation with domestic equities increased, reflecting less of a diversification benefit The correlation of international equities with domestic equities decreased however, adding to the diversification benefits Domestic bonds The volatility of domestic equities increased too, over the same time period International equities *Consider each in isolation FinQuiz.com © 2018 - All rights reserved 26 CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS Susanne Karen is an architect who works for a prominent multinational firm in the industry Karen has managed to accumulate a portfolio worth $10 million with her annual savings The portfolio is invested to track a balanced fund with 50% invested in stocks and 50% in bonds To suitably manage her portfolio, Karen hired Robin Clark, a portfolio manager and investment management expert For estimating the expected performance of Karen’s portfolio, Clark accumulated the information given in Exhibit Exhibit 1: Annual Expected Return and Risk Asset Class Standard Deviation Return Stocks 22% 15% Bonds 9% 6% The correlation between stocks and bonds is 0.65 During a meeting with Karen, Clark extracted all pertinent information about her financial situation and personal preferences This was then used to construct an appropriate IPS Keeping the objectives, as stipulated by the IPS, in mind, Clark suggested investing a small portion of her portfolio in derivatives Specifically, he proposed the following option: ‘A forward contract on the stock of Titan Enterprises with a maturity of 18 months The stock is currently worth $120/share The risk-free rate is 5.5%.” Clark is convinced that the stock price would rise in the coming year or so, due to a change in the firm’s product strategy He constructed a position for Karen which would take advantage of this expectation A Determine the percent VAR of Karen’s portfolio before the addition of the forward contract Express it in the most conservative way (4 marks) Nine months have passed since Clark has been managing Karen’s portfolio Titan Enterprises’ stock is now worth $135/share The stock paid no dividends during this period and is not expected to so for the coming five years FinQuiz.com © 2018 - All rights reserved 27 CFA Level III Mock Exam – Questions (AM) B Evaluate the credit risk position of Karen in the forward contract Determine the new price of the forward contract if it were to be marked to market (4 marks) After two years, Karen requested Clark to present her with a comprehensive analysis of her portfolios performance Displeased with the results, Karen instructed Clark to look for other investment opportunities Clark stated, that over a year ago, his investment management firm introduced a new fund managed by a team of reputable portfolio managers and invested in a number of financial sectors The fund managers used their skills and expertise to earn above-average returns for the fund Upon further request, Clark presented Karen with the information given in Exhibit Exhibit 2: GHE Investment Fund Annual Performance Attribution Beginning Value $150,000,000 Net Contributions $850,000 (Risk-free asset) Incremental Value Contribution $675,000 Fund value (asset category) $165,500,000 Fund Value (benchmarks) $165,900,000 Incremental return contribution for allocation effects 0% Total fund return 11.05% C (i) Determine how much of the total return was attributed to style bias Show your calculations (4 marks) C (ii) Determine how much value active stock selection added to the fund (2 marks) Karen was greatly impressed with the fund’s performance Convinced with the superior stock picking ability of managers at the firm, she decided to give Clark more discretion in making investment decisions for her portfolio After six months, Karen’s portfolio earned an unexpectedly higher return than its benchmark To confirm the results, Karen requested the details given in Exhibit FinQuiz.com © 2018 - All rights reserved 28 CFA Level III Mock Exam – Questions (AM) Exhibit 3: Portfolio Performance Results (Extract) Sector Portfolio Weight Portfolio Return Benchmark (%) (%) weight (%) 8.9 8.0 -0.55 Sector Benchmark Return -0.67 Consumer durables 7.5 8.5 0.30 -0.40 Technology 12.0 10.5 3.95 2.90 Economic Sector Capital Goods The total portfolio earned a return of 2.12% whereas the total benchmark return was 0.70% D Determine the within sector selection return and the pure sector allocation return for each of the above mentioned economic sectors Show your calculations Use the template below to answer the question (6 marks) Template for Question 8-D Pure Sector Allocation Within Sector Selection Capital Goods Consumer durables Technology FinQuiz.com © 2018 - All rights reserved 29 ... why they were not appropriate i ii A B C iii D FinQuiz. com © 2018 - All rights reserved 15 CFA Level III Mock Exam – Questions (AM) QUESTION HAS THREE PARTS (A, B, AND C) PARTS FOR A TOTAL OF 22...CFA Level III Mock Exam – Questions (AM) FinQuiz. com – 4th Mock Exam 2018 (AM Session) The morning session of the 2017 Level III CFA Examination has questions For... price reaches the level I deem fit “ FinQuiz. com © 2018 - All rights reserved 23 CFA Level III Mock Exam – Questions (AM) Manager B: “I believe that markets are efficient, and costs to actively