Volume II behavioral finance, individual investors, and institutional InvestorsCFA level 3CFA finquiz Level3Mock2018Version4JuneAMSolutions

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 (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 – Solutions (AM) QUESTION HAS FOUR PARTS (A, B, C, 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 – Solutions (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 an 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 – Solutions (AM) Solution for Question A Solution: Unlike the utility theory, the prospect theory considers how prospects are perceived based on their ‘framing’, how ‘gains’ and ‘losses’ are evaluated, and how uncertain outcomes are weighted The three ways in which the prospect theory differs from the utility theory are: The probability-weighting function expresses the fact that people tend to overreact to small probability events but underreact to mid-sized and large probabilities The value function is asymmetric, implying that there is a bigger impact of losses than of gains People are not risk-averse but rather are loss-averse The value function is reference dependent Same situations may evoke different preferences merely due to the framing effect Reference: CFA Level III, Volume 2, Study Session 3, Reading 5, LOS-b B Solution: Parker is most likely subject to the representative bias He is ignoring the base rate information of an above average earnings growth rate for SFI for so many years and is assuming that the small sample of firms that reported losses is representative of all firms in the industry Hence, he is guilty of both base-rate neglect and sample-size neglect Example: Investors tend to buy a fund immediately following rapid price appreciation Representativeness causes them to categorize the funds as good investments based on this recent information Similarly, when prices fall, they sell their holdings Moving in and out of investments based on categorizations like these is likely to result in excessive trading Reference: CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-c FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) C Solution: The three behavioral explanations are as follows: Illusion of Control bias: Investors tend to hold positions in companies they feel they have some control over, leading them to hold concentrated positions Confirmation bias: FMPs may become convinced of the value of a single stock and tend to ignore negative news about that stock This can lead them to build a large position in the stock and hold poorly diversified portfolios Availability bias: Since this bias leads FMPs to base investment choices on information that can be easily recalled, their choices would reflect a narrow range of experience This can lead to overweighing securities and a lack of diversification Reference: CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-d D Solution: Parker is most likely engaging in herding behavior by investing in the most popular investments The regret-aversion bias leads to such a behavior People prefer the stocks of well-known companies even in the face of equal risk and return characteristics because choosing less familiar stocks is perceived riskier and involves greater personal responsibility and greater potential for regret Reference: CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-c FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (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 – Solutions (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 the following page to answer the question (8 marks) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (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 – Solutions (AM) Solution for Question 2: A Solution: Reasons (High) Ability to take risk Reasons (Low) RTEL’s debt/total assets ratio is less A significant amount of pension than the industry average Its profit assets invested in growth margins (gross profit margin and net oriented investments increases income margin) are higher than the the volatility of the portfolio and industry average Hence, RTEL has decreases the risk tolerance a greater tolerance for risk The ratio of retired lives to active lives is 0.33 implying that active lives are much greater than retired lives This implies a longer time horizon and greater risk tolerance RTEL has a pension surplus of $3 billion ($13-$10=$3 billion) implying greater risk tolerance A pension plan that keeps modifying its provisions is likely to introduce competitive plan features like early retirement or lump-sum distributions This decreases the ability to take risk A low correlation between pension assets and pension liabilities implies a greater mismatch between them, and a lower ability to take risk Overall: Ability to take risk is above-average because of: • • • • • High surplus Higher financial profitability than the industry average No current plan features that would require early disbursements Greater number of active lives relative to retired lives Long time horizon Risk objective: “The probability that the funded status falls below 100% should be equal to 10% or less In addition, the portfolio should minimize the probability of making future contributions.” FinQuiz.com © 2018 - All rights reserved 10 CFA Level III Mock Exam – Solutions (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 33 CFA Level III Mock Exam – Solutions (AM) Solution for Question 6: A Solution: Three ways in which CEIG’s procedures violate the GIPS requirements with regards to input data are: Although CEIG used trade date accounting, assets and liabilities are to be recognized within three days of entering into a transaction (not a week) CEIG did not accrue dividends not yet paid GIPS standards recommend that dividends be accrued as of the ex-dividend date CEIG valued all portfolios at least monthly However, for periods beginning on or after January 2010, portfolios must be valued: a On the date of all large cash flows as defined by the firm for each composite; and b As of each calendar month-end or the last business day of each month Reference: CFA Level III, Volume 6, Study Session 18, Reading 34, LOS-c B Solution: Procedures 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 pertransaction basis, they were included in trading expenses Compliance Changes (if necessary) to be with GIPS in compliance Not in Cash and cash equivalents compliance need to be included in the total return calculation even if the cash is not actually invested by the same person or group Not in compliance Custody fees are not to be considered direct trading expenses, even when they are charged on a pertransaction basis FinQuiz.com © 2018 - All rights reserved 34 CFA Level III Mock Exam – Solutions (AM) 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 compliance 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 Not in compliance The GIPS standards require that returns be calculated after the deduction of actual, not estimated, trading expenses So actual values should be used Not in compliance Withholding taxes that cannot be recovered should be deducted when calculating returns CEIG’s definition of what constituted ‘a large cash flow’ varied with each composite depending on the nature of the investment strategy In compliance Reference: CFA Level III, Volume 6, Study Session 18, Reading 34, LOS-d FinQuiz.com © 2018 - All rights reserved 35 CFA Level III Mock Exam – Solutions (AM) C Solution: Since all portfolios are actual, fee-paying, the portfolio that is non-discretionary should not be included in any composite Portfolio C is likely to be considered nondiscretionary This is because 60% of the portfolio’s value is not to be sold or managed according to the portfolio manager’s intended strategy 60% is considered a significant amount The portfolio can be handled in the following three ways to be GIPS compliant: The entire portfolio should be considered non-discretionary and removed from the firm’s composites The individual assets over which the manager has no discretion should be removed and the remaining assets could be added to a composite A materiality threshold could be stated in the policy, enabling the manager to consider a portfolio discretionary if the non-discretionary assets consist of less than a certain percentage of portfolio assets Reference: CFA Level III, Volume 6, Study Session 18, Reading 34, LOS-f D Solution: The GIPS Standards state, that for periods beginning on or after January 2010, a carveout must not be included in a composite unless it is managed separately with its own cash balance The construction of the new composite is not in compliance with GIPS because: • In this case, it seems that the cash is pooled and is invested for the balanced funds as a whole The equity segments are not managed with their own cash balances • The equity segments not seem to be managed separately from their fixedincome counterparts (i.e without keeping them in consideration) Reference: CFA Level III, Volume 6, Study Session 18, Reading 34, LOS-i FinQuiz.com © 2018 - All rights reserved 36 CFA Level III Mock Exam – Solutions (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 37 CFA Level III Mock Exam – Solutions (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 38 CFA Level III Mock Exam – Solutions (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 the following page to answer the question (5 marks) FinQuiz.com © 2018 - All rights reserved 39 CFA Level III Mock Exam – Solutions (AM) Solution for Question 7: A Solution: Cost of paper portfolio: 1,000(60) = $60,000 Value on Thursday close: 1,000(62) = $62,000 Net value: 2,000 Real portfolio value on Thursday close: 700(62) = $43,400 Cost of real portfolio: 500(61.05) = 30,525+50 = $30,575 200(62.05) = 12,410+20 =$12,430 Total: $43,005 Net value: 43,400-43,005 = $395 Implementation shortfall: 2,000-395=$1,605 Cost components: • • • • • Delay: Tuesday: 500/1000 [60-60/60] = 0% Wednesday: 200/1000[59.90-60/60] = -0.0333% Realized profit and loss: Tuesday: 500/1000 [ 61.05-60/60] =0.875% Wednesday: 200/1000 [62.05-59.90/60]=0.716667% Missed trade opportunity cost: 300/1000 [62.00-60/60] =1.00% Commissions: $50 + $20 = $70 In percentage Commission = 70/60,000 = 0.1167% Reference: CFA Level III, Volume 6, Study Session 16, Reading 31, LOS-g FinQuiz.com © 2018 - All rights reserved 40 CFA Level III Mock Exam – Solutions (AM) B Solution: Manager A is a value-oriented trader since he/she only trades when the price moves into his/her value range Value-oriented traders use limit orders One disadvantage of the limit order is that it may fail to execute Manager B is a passive trader since he seeks liquidity in his rebalancing transactions and is concerned with minimizing costs They are likely to use portfolio trades or limit orders One disadvantage of such trades is the uncertainty of completion within a given time frame Manager C is an information-motivated trader since he is used a significant piece of information to trade urgently Such traders are likely to trade with dealers or market orders Limitations include high potential for market impact and information leakage Reference: CFA Level III, Volume 6, Study Session 16, Reading 31, LOS-j C (i) & (ii) Solution: C (i) McGraw uses the calendar rebalancing method since he balances his portfolio on a periodic basis (semiannually) The percentage of portfolio rebalancing mitigates the following drawbacks of calendar rebalancing: Percentage of portfolio rebalancing can exercise tighter control on divergences from target proportions since it sets upper and lower limits for an asset class weightage (corridor) Percentage of portfolio rebalancing is directly related to market performance (the trigger depends on asset class market values) C (ii) Changes Direct transaction costs of trading in domestic bonds increased considerably over the year Tolerance Band for: Domestic bonds Implications Higher transaction costs, wider tolerance band FinQuiz.com © 2018 - All rights reserved 41 CFA Level III Mock Exam – Solutions (AM) 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 International bonds Lower risk tolerance, narrower tolerance band 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 Increased volatility, narrower tolerance band Increased correlation with international bonds, wider tolerance band Effect: Inconclusive The correlation of international equities with domestic equities decreased however, adding to the diversification benefits Domestic bonds No effect on the tolerance band of domestic bonds The volatility of domestic equities increased too, over the same time period International equities Higher volatility, narrower the tolerance band *Consider each in isolation Reference: CFA Level III, Volume 6, Study Session 16, Reading 32, LOS-f FinQuiz.com © 2018 - All rights reserved 42 CFA Level III Mock Exam – Solutions (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 43 CFA Level III Mock Exam – Solutions (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 44 CFA Level III Mock Exam – Solutions (AM) Economic Sector Capital Goods 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 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 on page number—to answer the question (6 marks) FinQuiz.com © 2018 - All rights reserved 45 CFA Level III Mock Exam – Solutions (AM) Solution for Question 8: A Solution: Portfolio’s expected return: 0.50(0.15)+0.50(0.06) = 10.50% Portfolio’s standard deviation: (0.5)2 (0.22)2 +(0.5)2(0.09)2 + 2(0.65)(0.5)(0.5)(0.22)(0.09) = 0.020560 P = √0.0205650 = 0.143388 VAR = 0.1050-2.33(0.143388) = -0.2291 $10,000,000(0.2291) = $2.291 million “The VAR for the portfolio is $2.291 million for one year with a probability of 0.01 This means there is a 1% chance that the portfolio will lose at least $2.291 million in a year.” Reference: CFA Level III, Volume 1, Study Session 14, Reading 27, LOS-e B Solution: Forward price was: 120(1.055)1.5 = $130.03490 Current value of contract: 135-130.03490/(1.055)9/12 = $10.0833 Since Karen must have taken the long position to benefit from a rise in price, the contract is positive to Karen and she faces a credit risk of $10.0833 New forward price: 135 (1.055)9/12 = $140.53 Reference: CFA Level III, Volume 1, Study Session 14, Reading 27, LOS-i C Solution: (i) Total fund value at net contribution level: $150,850,000 Total return at asset category level: [165,500,000/150,850,000]-1= 9.71% Total return at benchmark level: [165,900,000/150,850,000]-1 = 9.9768% Style bias: 9.9768%-9.71% = 0.267% FinQuiz.com © 2018 - All rights reserved 46 CFA Level III Mock Exam – Solutions (AM) (ii) Since allocation effects are 0%, the total return less the return at the benchmark level will give us the return to active managers (the incremental return at the investment manager level) This is 11.05%-9.9768 = 1.0732% Reference: CFA Level III, Volume 6, Study Session 17, Reading 33, LOS-l D Solution: Capital Goods Consumer durables Technology Pure Sector Allocation (8.9-8.0)(-0.67-0.70) = -1.23% (7.5-8.5)(-0.400.70)=1.1% (12.0-10.5)(2.900.70)=3.3% Within Sector Selection 8.0[(-0.55-(0.67)]=0.96% 8.5((0.30-(0.40))=5.95% 10.5(3.95-2.90) = 11.025% Reference: CFA Level III, Volume 6, Study Session 17, Reading 33, LOS-l, m FinQuiz.com © 2018 - All rights reserved 47 ... Reference: CFA Level III, Volume 2, Study Session 6, Reading 13, LOS-d FinQuiz. com © 2018 - All rights reserved 12 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B AND C) FOR... $154,625 and would be sufficient to accumulate $3,000,000 in 15 years FinQuiz. com © 2018 - All rights reserved 20 CFA Level III Mock Exam – Solutions (AM) Reference: CFA Level III, Volume 2,... Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS-j FinQuiz. com © 2018 - All rights reserved 23 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B, AND C) PARTS