CFA Level III Mock Exam – Solutions (PM) 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 (PM) FinQuiz.com – 4th Mock Exam 2018 (PM Session) Questions Topic Minutes 1-6 Ethical and Professional Standards 18 7-12 Ethical and Professional Standards 18 13-18 Economic Analysis 18 19-24 Economic Analysis 18 25-30 Risk Management Application of Derivatives 18 31-36 Risk Management Application of Derivatives 18 37-42 Equity Portfolio Management 18 43-48 Fixed-Income Portfolio Management 18 49-54 Alternative Investments 18 55-60 Alternative Investments 18 Total FinQuiz.com © 2018 - All rights reserved 180 CFA Level III Mock Exam – Solutions (PM) Questions through relate to Ethical & Professional Standards A&J Case Scenario Matt Beckner is a chemical engineer who works for an oil exploration firm in Ohio, USA Beckner is 55 years old and has an investment portfolio worth $75,000 consisting of stocks, bonds and T-bills In the past, Beckner has been managing his portfolio himself However, he now believes that getting professional expertise and financial advice for his portfolio’s management would be prudent Consequently, he selects Alfred & Jack Associates (A&J) to be his capital management firm During his visit at the firm, Beckner meets Robin Flynn, an investment analyst at A&J As part an introductory presentation to Beckner, Flynn presents him with the performance of a number of A&J’s internally managed funds Beckner observes that many of these funds, especially the ones that relied on complex derivative strategies, lacked an associated benchmark presentation In addition, when presenting the value of the firm’s real estate investments, Flynn states that independent, third party valuations were used since fair values were not easily available He provides Beckner with a list of third party firms that were hired Beckner notices that in the past two years, A&J switched among ten firms for obtaining valuations for their real estate investments While presenting to Beckner, Flynn also displays a list of the funds that the firm offered its clients and prospects Beckner discovers that the firm offered a total of fifteen funds ranging from completely conservative, to very aggressive The presentation then makes the following comment: “A&J has achieved excellent returns for its investors The Aggressive Growth Fund, for example, has had returns that exceeded its peer group benchmark by more than 12% for the past fifteen years.” Beckner was satisfied with the performance history of A&J’s funds He now wanted to know about the procedures and methods used by the managers at the firm for stock picking In seeking such information, Beckner approaches Gina Melton, the chief portfolio manager at A&J Melton tells Beckner that A&J paid a firm that served as an intermediary in connecting analysts and investors with market experts Many of these experts have followed a single industry for over five to seven years, and are thus, privy to much of the industry’s internal workings Melton adds that A&J uses the insights of such experts in making investment choices He then makes the following comment: FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) “Whenever a portfolio manager is uncertain about the appropriate course of action with respect to a specific client, the manager makes the decision as if it were affecting him/her If in doubt, the manager discloses the matter to the client and obtains client approval.” Beckner then asks Melton about the trading procedures at A&J and the related policies in place Melton states that many a times they get unsolicited trade requests from clients that are unsuitable for them In such cases, the manager updates the client’s investment policy statements so that he or she can clearly understand the potential effect of the requested trade on his or her current goals After meeting with several other portfolio managers and employees at the firm, Beckner is satisfied with his decision to opt for A&J to manager his portfolio Before his departure, Melton provides Beckner with the ID of his facebook account that she maintained only for professional purposes She states that this makes it easier for her to separate her personal contacts from her professional ones In Flynn’s presentation, which of the following is most likely a red flag with regards to a violation of the CFA Institute Standards of Professional Conduct? A The lack of benchmarks B The third party valuations C Both the lack of benchmarks and the third party valuations Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS-a,b The Standards not require that a benchmark always be provided in order to comply Some investment strategies may not lend themselves to displaying an appropriate benchmark because of the complexity or diversity of the investments included As long as DIM states this fact and discloses the reasons behind not using a benchmark, it is in compliance DIM has switched among a lot of service providers, hence, the valuations most likely lack consistency Also, switching amongst service providers may indicate that DIM is trying to get the highest valuations for its real estate investments (shopping for the highest valuations) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) In his comment about The Aggressive Growth Fund, has Flynn most likely violated the CFA Institute Standards of Professional Conduct? A Yes B No, since Flynn is allowed to state outperformance as long as it is correct C No, since Flynn has stated a fact and used a sufficiently long time horizon to justify its accuracy Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c Flynn is most likely misleading Beckner by citing the performance of the sole fund that achieved such results Flynn should present the past performance of all the funds of A&J If all of the funds outperformed their benchmarks, only then can he assert that the firm is achieving ‘excellent returns’ In using the services of the intermediary firm, A&J has most likely: A not violated any Standards B violated the Standards, since it is requesting or acting on confidential information C violated the Standard, since the compensation provided may result in a conflict of interest Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c Firms are allowed to use the insights of industry experts, as long as they are not requesting or acting on confidential information received from these external experts FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) With regards to Melton’s comment, are the managers at A&J most likely in compliance with the CFA Institute Standards of Professional Conduct? A Yes B No, since clients are not financial experts and decisions should not be based on their approval C No, since managers are required to seek approval from their compliance department first Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c If a member or candidate is uncertain about the appropriate course of action with respect to a client, he/she should consider what he/she would demand if the member or candidate were the client If in doubt, a member or candidate should disclose the questionable matter in writing to the client and obtain client approval With regards to the handling of unsolicited trade requests, to be in compliance with the Standards, portfolio managers should adopt A&Js policy: A under no circumstances B only for clients agreeing with the policy C only for trades that have a material impact on the portfolio Correct Answer: C Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c If the unsolicited request is expected to have a material impact on the portfolio, the member or candidate should update the investment policy statement so that the client can fully understand the potential effect of the requested trade on his goals and risk levels FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) If Melton decides to leave A&J and join another firm, to be in compliance with the CFA Institute Standards of Professional Conduct, before leaving she should most likely: A delete her professional facebook account or transfer it B keep her facebook accounts since they are her property C keep her facebook accounts only if A&J approves of it Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c The professional account would be considered part of the firm’s assets, thus requiring members or candidates to transfer or delete the accounts as directed by their firm’s policies and procedures FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions through 12 relate to Ethical & Professional Standards DIM Case Scenario Delta Investment Management (DIM) is a capital management firm in New York, USA DIM initiated its operations as a small firm comprising of only a few portfolio managers With hard work and disciplined efforts, DIM has managed to increase its investable asset base considerably To ensure that asset managers within the firm fulfill their ethical responsibilities with respect to the management of client assets, Brad Lowman, the CEO of DIM is considering compliance with the Asset Manager Code of Professional Conduct Lowman plans to work in alliance with a team of ethical experts headed by Thomas Hahn to research the procedures within DIM and determine the ones that need to be altered for assuring compliance At their first meeting, Lowman makes the following comment: “As part of holding clients’ interest paramount, at DIM, we have established policies that guide portfolio managers with regards to the acceptance of gifts from clients Our policy limits the acceptance of cash gifts by specifying the amount per time period per vendor Usually the items accepted are of minimal value.” He continued with the following comment: “Also, to preserve independence and objectivity, the managers at DIM are not allowed to maintain multiple business relationships with a client as it can result in significant conflicts of interests.” As their discussion continued, Lowman mentioned that DIM offered certain financial products that were made available only to certain qualifying clients Also, additional services were provided to only those clients who expressed an interest in getting them and paid additional fees In addition, managers at DIM engaged in ‘tag-along’ arrangements with certain clients for whom the opportunity was suitable Hahn was interested in knowing about the financial products offered by DIM One such product, The International Growth Investment Fund, particularly caught his attention The Fund earned a return of more than 18% last year, which was very impressive given the performance of similar funds On further research, Hahn discovered that the Manager of the fund would occasionally diverge slightly from the stated strategy to take advantage of changing financial circumstances This was disclosed to clients in the course of normal client reporting FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) When researching the policies regarding the allocation of initial public offerings, Hahn was surprised to learn that the firm allowed employees to participate in IPOs for their personal accounts In justifying this policy, Lowman stated that all employees who wished to invest in IPOs for their personal accounts needed to seek prior approval and were not allowed to forerun client trades In addition, employees were required to provide the compliance officer with copies of trade confirmations each quarter, along with a statement of personal holdings As Lowman talked about the various risks faced by Managers at DIM, Hahn inquired a little further about the risk management processes at DIM Lowman stated that all risk management activities were outsourced because a separate risk management firm was not cost-effective or feasible Hahn was confused how the managers at DIM ensured that risk management complemented the investment management processes at DIM instead of competing with it Before the meeting concluded, Hahn scrutinized the performances of DIM’s private wealth accounts Hahn noticed that when presenting the performance of their accounts, portfolio managers at DIM disclosed the actual management fees, incentive fees, and other costs charged to them However, since future trading expenses, including commissions and bid/ask spreads were uncertain, estimated or expected expenses were not disclosed to prospective clients The firm did, however, mention in all presentations to prospects, that fees and other costs would be assessed to investors With respect to the comments made by Lowman, are DIM’s policies regarding the acceptance of gifts and multiple business relationships most likely in compliance with the Asset Manager Code of Professional Conduct? A No B Yes C Only with respect to multiple business relationships Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Best practice under the Asset Manager Code of Professional Conduct prohibits the acceptance of any cash gifts However, the Code does not preclude Managers from maintaining multiple business relationships with a client as long as potential conflicts of interest are managed and disclosed In offering additional services and products to only a few clients, and engaging in tag-along arrangements, has DIM violated the Asset Manager Code of Professional Conduct? A Yes B Only with respect to tag-along arrangements and not with respect to additional services and financial products C No, as long as the arrangements are disclosed and made available to all clients and opportunities are fairly allocated Correct Answer: C Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c Clients may pay for a higher level of service, or certain services and products may be made available only to certain qualifying clients These practices are permitted as long as they are disclosed and made available to all clients The Code does not prevent Managers to engage in secondary investment opportunities, like tag-along arrangements, with certain clients as long as such opportunities are fairly allocated among similarly situated clients for whom the opportunity is suitable With regards to the International Growth Investment Fund, DIM has most likely: A violated the Asset Manager Code of Professional Conduct B not violated the Asset Manager Code of Professional Conduct C not violated the Asset Manager Code of Professional Conduct, only if the divergence occurs less than twice a year Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions 43 through 48 relate to Fixed Income Portfolio management Amy Wulfing Case Scenario Amy Wulfing is a portfolio analyst who manages a fifteen million dollar fixed-income portfolio invested in US-based corporate bonds Wulfing manages credit risk separately from interest rate risk and uses the Z-spread as a close approximation of the credit spread of a security Wulfing is currently evaluating the attractiveness of four corporate bonds each with a different credit rating Exhibits and display relevant information for all the four bonds Exhibit 1: Expected Credit Loss Expected recovery rate Expected probability of default Yield Bond A 60% 0.55% 4.5% Bond B 45% 1.38% 5.7% Bond C 25% 5.77% 9.5% Bond D 35% 2.90% 6.4% Exhibit 2: Bond Characteristics Spread Duration Z-Spread (today) Z-spread (at the end of the holding period) Holding period Bond A 2.5% 2.75% months Bond B 2.7% 3.00% months Bond C 4.4% 4.90% months Bond D 3.5% 3.70% months Wulfing derives the following conclusions from her appraisal of the corporate bonds: Conclusion 1: “The evaluation of spread risk and credit migration risk will bear more importance in the assessment of Bond A than the assessment of Bond C.” Conclusion 2: “If interest rates rise in the near future, Bond C is likely to experience the highest % change in its price.” FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Conclusion 3: “If default losses are expected to be low, and credit spreads to be relatively tight, Bond C’s interest rate sensitivity is likely to increase.” Wulfing is planning to construct a portfolio composed of bonds that span a broad range of the credit spectrum The ratings of the bonds will vary from Aaa to Caa2 In addition, the portfolio’s mandate will emphasize a focus on long-term returns, so only intermediate to long-term bonds will be a part of the asset allocation To accurately assess the credit quality of this portfolio, Wulfing will use the following approaches: The arithmetical weighting of each credit rating category assigned A market-value weighted OAS of each of the component bond’s individual OAS Even though this portfolio would include only domestic bonds, Wulfing is evaluating the possibilities of expanding the investment universe to include international bonds After a comprehensive analysis, Wulfing has shortlisted European Corporates as a plausible option Using these bonds, Wulfing develops the following two investment strategies: Strategy 1: Buying credit securities in the European market and selling credit securities in the US market Strategy 2: Borrowing in the euro market and investing in the US market Wulfing bases these strategies on the following market expectations: Expectation 1: “Euro interest rates are expected to fall and US interest rates are expected to rise.” Expectation 2: “Euro bond prices are expected to rise more than the rise in US bond prices.” Expectation 3: “The euro/dollar exchange rate is expected to fall.” Wulfing is also using the G-spread to estimate the price change of a bond issued by The Eon Group (TEG) The bond has an interest rate of 6.94% and a duration of 8.0 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) 43 Which bond is most likely to experience the greatest credit loss? A Bond A B Bond B C Bond D Correct Answer: B Reference: CFA Level III, Volume 4, Study Session 11, Reading 24 Excess Returns: Bond A: (2.5×0.25)-(0.25×3) – (0.25×0.55×40%) = -0.18% Bond B: (2.7×0.5)-(0.3×4) – (0.5×1.38×55%) = -0.2295% Bond D: (3.5×0.5)-(0.20×5) – (0.5×2.90×65%) = -0.1925% 44 Which of the following conclusion(s) is (are) most accurate? A Conclusion only B Conclusions and only C Conclusions 1, and Correct Answer: B Reference: CFA Level III, Volume 4, Study Session 11, Reading 24 Unlike Bond A, Bond C is a high-yield bond, with a low recovery rate and a greater spread duration For such bonds, credit risk is utmost importance On the other hand, for high quality bonds, spread risk, interest rate risk and downgrade risk are more important High yield bonds have a lower empirical duration Hence, if interest rates change, Bond C is likely to experience a relatively less % price change When default losses are low and credit spreads are relatively tight, high yield bonds behave more like investment-grade bonds, and show greater interest rate sensitivity FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) 45 Wulfing’s suggested methods of assessing the credit quality of the bond portfolio are most likely to: A Overestimate credit quality B Underestimate credit quality C One method will overestimate credit quality, whereas the other will underestimate it Correct Answer: A Reference: CFA Level III, Volume 4, Study Session 11, Reading 24 Using an arithmetic weighting would overestimate credit quality Using OAS to measure long-term bonds would also likely overestimate credit quality because it would not consider credit spread volatility which is much higher for longer term bonds 46 Which of the following market expectations are most likely to affect Strategy negatively? A Expectations and only B Expectation and only C Expectations 1, and Correct Answer: C Reference: CFA Level III, Volume 4, Study Session 11, Reading 24 Strategy is a carry trade The carry trade will be adversely affected if the US dollar depreciated relative to the euro, if the yield curve does not remain stable or if US bond prices not rise as much Hence, all three expectations are to negatively affect Strategy FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) 47 Which of the following market expectations are most likely to affect Strategy positively? A Expectation only B Expectations and only C Expectations 1, and Correct Answer: C Reference: CFA Level III, Volume 4, Study Session 11, Reading 24 If euro rates fall, bond prices will rise If US rates rise, selling US credit securities will be profitable For the same reason, expectation will benefit strategy The euro is expected to strengthen so buying credit securities there will benefit an investor 48 What advantage would Wulfing gain, if instead of the G-spread, she uses the Ispread to measure the price change of the TEG bond? A The I-spread more accurately reflects supply and demand B The swap curve is less disjointed than the government bond curve C The I-spread more accurately represents a credit risk-free rate Correct Answer: B Reference: CFA Level III, Volume 4, Study Session 11, Reading 24 Option B is correct The other two options are incorrect FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions 49 through 54 relate to Alternative Investments Connon Carey Case Scenario Connon Carey is a wealthy entrepreneur who holds an investment portfolio worth ten million US dollars Carey’s portfolio is invested in US stocks, US corporate bonds, and T-bills During a recent meeting with Kasey Kreft, his portfolio manager, Carey informed her about an expected influx of $100,000 in cash in the coming six months Keeping the probability of receiving this inflow in mind, Kreft recommended Carey to invest a certain portion of his portfolio in alternative investments She presented the following options: Equity market neutral hedge funds Systematic managed futures Hedged equity hedge funds Event driven hedge funds Fixed-income arbitrage Carey agreed with the suggestion to add alternative investments to his portfolio but was still contemplating which investment would be most appropriate for him, given his circumstances He was particularly interested in hedge funds but was also concerned with the issues in selecting and using hedge fund indices Kreft shared his concern, and stated that survivorship bias was often raised as a major concern for investors in hedge funds However, she added that such a bias could be reduced by conducting superior due diligence In addition, Kreft mentioned the following additional concerns related to the creation of hedge fund indices: • • • Age effects make it difficult to compare the performance of hedge funds However, as the time horizon increases, age effects generally decrease in importance Lack of security trading leads to the stale price bias which causes volatility to be understated and measured correlations to be lower than expected Value-weighted indices overweigh the performance of the best-performing hedge funds over a given time period As their discussion on hedge funds continued, Carey mentioned the difficulties in appraising the performance of a hedge fund investment Kreft stated that the most extensively used measure for hedge fund appraisal has been the Sharpe Ratio However, she added that such a ratio could easily be gamed In trying to further elucidate her point, Kreft presented the following examples: FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Example 1: Many hedge funds take on excessive amounts of exposure to a specific risk factor to improve the mean or standard deviation of a particular investment Example 2: A hedge fund can enter a total return swap where it pays the best and worst returns for its benchmark index each year, and the counterparty pays a fixed cash flow Example 3: Many FOFs combine funds in such a way that reduces negative skewness For example, global macro funds with high volatility and kurtosis are often combined with equity market-neutral funds that tend to act as volatility and kurtosis reducers When the discussion concluded, Kreft altered Carey’s portfolio’s asset allocation by investing 10% of the portfolio in hedge funds While reviewing his portfolio’s revised asset allocation, Carey instructed Kreft to diversify his alternative investments by including another asset class Kreft advised Carey to invest in distressed securities, given the economic forecasts and expected long-term financial trends Carey agreed, though he stated some conditions as expressed in the following comment: “I not want to take on an influential position by becoming the target’s major creditor or by owning most of its stock In addition, I would like to gain certain protection under either scenario: the target’s prospects worsening, or the target’s prospects improving.” Carey then posed the following question: “Which risk should I be least worried about when investing in distressed securities?” 49 In order to achieve maximum diversification, which of the following fund options presented by Kreft should Carey least likely invest in? A hedged equity and event driven hedge funds B fixed-income arbitrage and systematic managed futures C systematic managed futures and event driven hedge funds Correct Answer: A FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-p The hedge fund groups whose strategies call for eliminating stock or bond market risk e.g equity market neutral and fixed income arbitrage, have low correlations with stock or bond indices Also, systematic managed futures are sensitive to different return factors from equities and bonds Hedged equity and event driven hedge funds tend to have high correlations with equity and are considered more of return-enhancers 50 To minimize the concern of survivorship bias, Carey should least likely invest in: A Currency funds B Hedged equity C Funds of funds Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-p Survivorship bias is higher is minor for event-driven strategies, is higher for hedged equity, and is considerable for currency funds If the FOFs have screened funds, survivorship bias may be reduced significantly 51 Kreft is most accurate with respect to which of the following concerns regarding hedge funds? A Age effects and value-weighting effect only B Stale price bias and value-weighting effect only C Age effects, stale price bias and value-weighting effect Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-p FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Kreft is inaccurate with respect to the stale price bias Stale prices can cause measured standard deviations to be over- or understated, depending on the time period being studied The other two concerns are correct 52 Which of the examples given by Kreft least likely represents a gaming of the Sharpe ratio? A Example B Example C Example Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-s Combining global macro funds with equity market-neutral strategies is an example of smart hedge fund selection that may be able to reduce the problem of negative skewness The other two are examples of gaming the Sharpe Ratio 53 Given Carey’s conditions as presented in his comment, the most appropriate distressed investment strategy for him would be: A private Equity B prepackaged Bankruptcy C distressed Debt Arbitrage Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-u Distressed debt arbitrage would be most suitable since it does not involve corporate activism In addition, if the company’s prospects improve, the portfolio manager hopes that debt will appreciate at a higher rate than the equity If the company’s prospects worsen, the value of the company’s debt and equity should decline, but the manager hopes that the equity (in which the fund has a short position) will decline to a greater degree FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) 54 The most appropriate response to Carey’s question is: A event risk B market risk C market liquidity risk Correct Answer: B Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-v For a distressed securities strategy, the economy, interest rates, and the state of equity markets are not as important as the liquidity risks and event risk FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions 55 through 60 relate to Alternative Investments Ted Smith Case Scenario Ted Smith, a portfolio manager and research analyst, owns and operates an investment management firm in the U.S Smith’s firm specializes and deals mainly in the more traditional asset classes, that is, stocks and bonds However, recently, Smith hired a group of financial managers who were experts in managing funds in non-traditional asset classes; ones that had risk and return characteristics very different from those of stock and bond investments This branch of Smith’s firm attracted many high-net worth private wealth clients as well as institutional funds Martha Long is the head of this department and is contemplating investment in a small private firm for a large pension fund Long estimates the market value of the firm’s equity to be $800 million After careful deliberation, Long determines that an investment representing 5.0% of the firm’s equity is appropriate for the pension fund A minority interest discount and a marketability discount relating to the investment have been estimated to equal 25% and 20% respectively After making the investment, Long met with Bruce Will, the head of the pension fund’s board Will was not completely satisfied with the idea of investing in alternative investments To mitigate his concerns, Long presented him with the information given in Exhibit Exhibit 1: Correlation of Alternative Investments with Traditional Asset Classes Private Stocks NCREIF NAREIT Bonds Equity Stocks 1.0 Private Equity -0.12 1.0 NCREIF -0.09 0.35 1.0 NAREIT 0.45 0.55 0.53 1.0 Bonds 0.23 0.05 0.13 0.19 FinQuiz.com © 2018 - All rights reserved 1.0 CFA Level III Mock Exam – Solutions (PM) After studying the figures, Will got convinced about the benefits of investing in more non-traditional asset classes He asked Long to provide him with the details of commodity investments and their risk and return characteristics Since Will showed an interest in commodities, Long attempted to explain to him the return components to a commodity index using the data provided in Exhibits and Exhibit 2: Commodity Futures Contract Maturity Futures Price (May) Futures Price (July) Change in Spot Price Convenience Yield August $150.55 $151.60 $0.60 15% September $147.90 $149.00 $0.60 22% Exhibit 3: Commodity Index Return Components (to a long position) Year Collateral Yield Roll Return Spot Return 1980 7.5% 11.0% 5.5% 2010 8.5% -11.0% 36.0% Will was still confused about the factors contributing to commodity returns While talking to Long about it, he stated the following: “I have heard that physical commodities are exposed to event risk How true is that?” Will’s query made Long ponder over the effect of the unique characteristics of this asset class on the -returns earned in the commodity markets FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) 55 The value of the equity investment of the pension fund in the private equity firm is closest to: A $22 million B $24 million C $20 million Correct Answer: B Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-h (0.05×800 million) = $40 million Minority interest discount: $40 million (0.25) = $10 million Marketable minority interest: 40-10 = $30 million Marketability discount: $30 (0.20) = $6 million Nonmarketable minority interest: 30-6 = $24 million 56 Which of the values given in the correlation matrix seems most inaccurate? The correlation between: A stocks and NAREIT B NCREIF and NAREIT C private equity and stocks Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-h The correlation between private equity and public equity (stocks) is expected to be positive, since all types of businesses have some exposure to economic and industry conditions Also, VC has public equity markets as one main exit route, so returns to VC fund investors would be expected to be higher when public equity market values are advancing A negative correlation seems inaccurate FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) 57.Given the data in Exhibit 2, the roll return is most likely: A positive, but is likely to decrease B negative, but is likely to increase C positive, and is likely to increase Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-n The roll returns are positive since the change in the futures prices is greater than the change in the spot prices : e.g August: 151.60-150.55 = 1.05-0.60 = 0.45 (roll return) A rising convenience yield should lead to futures market conditions offering higher roll returns Since convenience yield is rising, roll return is likely to rise 58 The most appropriate response to Will’s question is that physical commodities are exposed to: A positive event risk B negative event risk C event risk only with respect to changes in the business cycle Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-n Most of the socks with respect to physical commodities tend to be events that reduce the current supply and cause prices to rise; thus, physical commodities have positive event risk 59 For the year 2010, the data in Exhibit least likely implies that the: A market is in contango B market supply is less than the market demand C convenience yield has followed an increasing trend FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-n Roll returns are negative, which means that the market is in contango Decreasing roll returns are indicative of a falling trend of convenience yields Spot returns have increased, implying rising spot prices (for a long position) This can be because of demand being greater than supply 60 The existence of real options in the commodity market will most likely result in: A a downward-sloping term structure of futures prices B an upward-sloping term structure of futures prices C commodities being an excellent inflation hedge Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 13, Reading 24, LOS-o The existence of real options causes futures prices to be lower than current spot prices This results in a downward –sloping term structure of futures prices FinQuiz.com © 2018 - All rights reserved ...CFA Level III Mock Exam – Solutions (PM) FinQuiz. com – 4th Mock Exam 2018 (PM Session) Questions Topic Minutes 1-6 Ethical and Professional Standards 18 7-12 Ethical and Professional Standards... relationships Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c FinQuiz. com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Best practice... a year Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 1, Reading 4, LOS-b, c FinQuiz. com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (PM) The Code offers