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 – 5th Mock Exam 2018 (AM Session) The morning session of the 2018 Level III CFA Examination has 12 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question Questions Topic Minutes Portfolio Management – Individual 26 Portfolio Management – Individual 10 Portfolio Management – Individual Portfolio Management – Institutional 18 Portfolio Management – Institutional 16 Portfolio Management – Asset Allocation 10 Portfolio Management – Asset Allocation 18 Portfolio Management – Economics 19 Portfolio Management – Equity Investments 17 10 Portfolio Management – Monitoring and Rebalancing 11 12 Portfolio Management – Risk Management Portfolio Management – Derivatives 15 13 Portfolio Management – Asset Allocation 17 Total: FinQuiz.com © 2018 - All rights reserved 180 CFA Level III Mock Exam – Questions (AM) QUESTION HAS SIX PARTS (A, B, C, D and E) FOR A TOTAL OF 26 MINUTES Kyle Lucas is the owner of a small privately traded manufacturing concern which is currently worth $12 million and was established twenty-five years ago Lucas is 65 years of age and intends to sell the business two years from today Lucas has approached portfolio manager Gus Weaver to manage his investment portfolio which is currently worth $8.5 million and is equally allocated to long-term corporate bonds, domestic and international equities, and alternative asset classes In response to a question regarding his investment experience, Lucas states, “I have faced significant financial crises in the past and now always look to avoid making investment choices which hold the potential for disastrous consequences.” Lucas earns annual business income which is fixed at a pre-tax amount of $100,000 His living expenses are $98,000 in the current year and are expected to increase at the annual rate of inflation of 5% Upon retirement, he will no longer earn business income and his annual living expenses will become constant at $150,000 If Lucas sells his business at its expected market price, two years from today, he will be able to purchase his dream house for $8 million and a boat currently sold at a price of $1.0 million and will donate the remaining amount to a local charity He has instructed Weaver to exclude the sale of his business from the investment decision Lucas intends to finance his grandson’s college education as well as purchase residential property for him Total estimated costs will amount to $30 million and will be required fifteen years from today Lucas is subject to an ordinary income and capital gains tax rate of 25% and 30% respectively He always maintains an emergency reserve equal to years of his annual business income in addition to his portfolio holdings A Formulate each of the following constraints for Lucas’ investment policy statement (IPS): I II Time Horizon Unique Circumstances (4 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) B Determine whether an increase in inflation rate, reduction in the sales price of the business, and an increase in the price of his dream house will increase, decrease or have no impact on risk tolerance Justify your choice with one reason Answer Question 1-B in the template provided on page (6 minutes) C State Lucas’s return objective for his IPS (3 minutes) D Calculate Lucas’ annual after-tax nominal rate of return for the IPS if his business is sold at its current market price two years from today Show your calculations (6 minutes) Walker strongly feels that incorporating behavioral considerations in an IPS is essential to fulfilling the client’s long-term goals To achieve this purpose, he holds a meeting with Lucas to determine his behavioral investor type (BIT) and associated biases by holding a meeting with the client E Discuss two benefits of including behavioral finance into the IPS (4 minutes) Lucas is an avid follower of the stock market and makes investment decisions on behalf of friends and family members His most recent investment decision involved a $100,000 purchase of French Inc’s stock The decision was influenced by recent media attention on the corporation following a ‘brave’ policy shift towards unconventional production processes promising shorter lead times and a greater focus on organic raw materials as input He further justifies his decisions by stating, “Over the course of industry history, companies who were experimental in setting their policy have been popular amongst investors.” FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) F Identify the bias demonstrated by Lucas and justify your selection with one reason (3 minutes) Answer Question 1-F in the template provided on page FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Template for Question 1-B Impact on Risk Tolerance (Circle the Correct Answer) Factor Justify Your Choice With One Reason Increase Increase in inflation rate Decrease No impact Increase Reduction in sales price of business Decrease No impact Increase Increase in the price of his dream house Decrease No impact FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Template for Question 1-F Identify the Bias (Circle the Correct Choice) Justify Your Choice with One Reason Regret Aversion Overconfidence Availability Bias FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) QUESTION HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES Carl Segal is an asset advisor at Vector Asset Management Segal is working closely with a private client, Timothy Allen; aged 45 to ascertain the behavioral investor type (BIT) exhibited by Allen Allen has considerable investment experience and often recommends potential investments for further evaluation to his adviser During a discussion between Segal and Allen, the client shares his investment approach: “I have devoted a significant amount of time to studying security markets and asset classes Based on the insight which I have gained over these years, I can comfortably trust my instincts when making investment decisions for myself as well as acquaintances, who have entrusted me with the management of their financial wealth I trust nothing but my own research and prefer not to let my judgment get influenced by the advice of those who possess little knowledge about wealth planning.” A Classify Carl’s BIT, determine the risk tolerance, and identify one emotional bias typically associated with the identified behavioral category (3 minutes) Answer Question 2-A in the Template provided on page 10 B Carl participates in the defined contribution (DC) offered by his employer Segal determines that Carl is fifteen years away from retirement Segal would like to compare the client’s current allocation to plan assets with the average allocation held over the past five years Segal also determines that: • • • • Carl’s annual income sufficiently covers his living expenses he is unmarried but finances his brother’s medical care His brother is mentally challenged His salary is not sufficient to cover these expenses he has inherited $1.5 million from his deceased father’s estate in the beginning of the current year He intends to employ these funds for investment purposes he has assigned a risk score of 3.1 to the average company stock, in comparison with 3.6 to domestic stock funds and 4.1 to global stock funds FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Exhibit: Carl’s Allocations to the DC Plan Assets Average Historical Allocation (2009-2013) Stocks – Corporate stock 36% Stocks – Domestic Non-corporate stocks Stocks – Global stocks Fixed Income 45 Short-term income 10 Total 100% I Current Allocation (2014) 34% 48 100% Using the data collected by Segal, explain one bias exhibited by Carl in his portfolio selection decisions with respect to the DC plan Support your response with two reasons (4 minutes) II Based on Segal’s findings, he intends to employ an autopilot strategy to align Carl’s allocations with his circumstances Explain how such a strategy would affect the current allocation (3 minutes) FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Questions (AM) Template for Question 2-A Classify Carl’s BIT (Circle the Correct Choice) Determine Risk Tolerance Associated With the Behavioral Category (Circle the correct choice) Passive Preserver (PP) Low Active Accumulator (AA) Low to Medium Friendly Follower (FF) Medium to High Independent Individualist (II) High FinQuiz.com © 2018 - All rights reserved Identify One Emotional Bias Typically Associated With the Behavioral Category 10 CFA Level III Mock Exam – Questions (AM) Based on a discussion with Singh, Starc determines that hedging the client’s foreign currency risk exposures is essential However, she is yet to establish the degree to which currency risk exposures should be hedged B Describe two potential considerations which Starc will need to account for when determining the degree of currency risk exposures to undertake Your answer should focus on Singh’s current portfolio allocation and the information in the exhibit (6 minutes) To aid her currency hedging decision, Starc collects necessary details with respect to Singh She will examine each factor independently to determine whether a full currency hedge will be required Information on Singh: • • • • Risk averse to portfolio losses Has a relatively long time-horizon Desire for foreign fixed-income security exposure Required to make a down payment for the purchase of a home in three month’s time and pays for her son’s ongoing medical expenses C For each of the four points collected, determine whether the strategic currency position of the portfolio should be biased towards a fully hedged currency management program Consider each factor independently and support each answer with one reason Answer Question 7-C in the template provided on page 23 (8 minutes) FinQuiz.com © 2018 - All rights reserved 22 CFA Level III Mock Exam – Questions (AM) Template for Question 7-C Strategic Currency Position Biased Towards a Fully Hedged Currency Management Program? Circle the Correct Answer Point Collected Support Each Answer with One Reason Yes Risk averse to portfolio losses No Yes Has a relatively long timehorizon No Yes Desire for foreign fixedincome security exposure No Required to make a down payment for the purchase of a home in three month’s time and pays for her son’s ongoing medical expenses Yes No FinQuiz.com © 2018 - All rights reserved 23 CFA Level III Mock Exam – Questions (AM) QUESTION HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 19 MINUTES Simon Weaver is an economic analyst working at Time Analytics Weaver covers developed and emerging markets specializing in bonds and equities Weaver is making inflation forecasts for Lidon, a country with an emerging market His analysis focuses on two historical periods, 1990-1995 and 1996-2001 The first time period was marked with above average inflation, GDP growth exceeding its target, and an economy in danger of becoming overheated The cause of the high inflation was a global rise in energy prices triggering cost-push inflation in the country Circumstances changed in the 1996-2001 period when monetary authorities implemented restrictive policy measures to cool down the economy Based on economic analysis, Weaver projects that Lidon’s economy is once again expected to overheat due to the rapid supply of money currently being injected by monetary authorities To calculate the anticipated increase in inflation, Weaver uses the average inflation prevailing over the two time periods, assigning a higher probability to the inflation observed during 1990-1995, as input to his analytical model A Discuss the bias observed demonstrated by Weaver’s analytical methods (2 minutes) B i Identify the psychological trap which Weaver has fallen into Justify you choice Answer B-i in the template provided below ii For the identified bias, discuss two possible measures which can be taken to avoid this bias (5 minutes) Template for Question 8-B (i) is provided on page 26 FinQuiz.com © 2018 - All rights reserved 24 CFA Level III Mock Exam – Questions (AM) C Three months later Weaver’s inflation forecast materializes The analyst anticipates Lidon’s central bank will deal with this scenario by tightening the monetary policy and increasing the short-term interest rate to 7.0% from its current level of 6.0% Recommend which asset class will be a suitable investment choice given Weaver’s expectations For the asset classes not selected, explain why they are inappropriate Answer Question 9-C in the template provided on page 26 (7 minutes) D The authorities in Lidon have announced their intention to peg the local currency, LDN, to the U.S dollar (USD) The market is weary of the strategy’s effectiveness and expects the LDN to be devalued shortly before Lidon implements the policy The current interest rate differential between Lidon and U.S sovereign bonds is 4.5% i Identify two benefits of maintaining an exchange rate peg (2 minutes) ii Determine whether the change in interest rate differential will be positive, negative or neutral based on the information provided on the market’s views concerning the exchange rate peg Justify you answer (3 minutes) FinQuiz.com © 2018 - All rights reserved 25 CFA Level III Mock Exam – Questions (AM) Template for Question 8-B (i) Identify the Psychological Trap which Weaver has Fallen Into (Circle the Correct Answer) For the Trap Not Selected, Provide one Reason Why it is Inappropriate Overconfidence Confirming evidence Status Quo Template for Question 8-C Select the most suitable asset class given Weaver’s expectations Explain why the choices not selected are inappropriate Stocks Cash 7.5% Mortgage-backed securities FinQuiz.com © 2018 - All rights reserved 26 CFA Level III Mock Exam – Questions (AM) QUESTION HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES Melissa Reed manages the equity allocation of institutional client portfolios at WoodCarter The Smithson Foundation (SF) is Reed’s most recent client During a meeting with the foundation’s chief executive, Reed deems that the portfolio’s equity allocation should be indexed to the Russell 3000 index In her conversation with the chief executive concerning the portfolio management strategy, the latter states, “The chosen passive management strategy should minimize portfolio rebalancing costs and be cost effective in terms of portfolio construction costs.” A Select which strategy is most suitable for the passive management of SF portfolio’s equity allocation Justify your choice Your answer should also explain why the strategies not selected are unsuitable (Note: The provided justifications for the three strategies should be distinct.) Answer Question 9-A in the template provided on page 29 (7 minutes) Reed is of the opinion that the investment universe of SF’s portfolio should be expanded to include global equities However, she does not wish to undertake the purchase of individual stocks and so engages in an equity total return swap whereby the SF policy portfolio will receive the return on the MSCI global equity index in exchange for interest payments on U.S Treasury bonds B Discuss two general advantages of Reed’s global equity allocation strategy (4 minutes) Reed also manages the equity portion of Glenn Endowment’s (GE) policy portfolio The fund’s prospectus identifies the investment mandate as “active large-cap exposure with a growth bias.” Reed’s manager, Carl Edgar, evaluates his subordinate’s performance using a returnsbased style analysis and employs four benchmarks – Russell 1000 Value Index, Russell 1000 Growth Index, Russell 2000 Growth Index, and Russell 2000 Value Index The results of the performance evaluation are summarized below FinQuiz.com © 2018 - All rights reserved 27 CFA Level III Mock Exam – Questions (AM) Exhibit: Results of Edgar’s Returns-Based Style Analysis Factor Weights Russell 1000 Value 0.45 Russell 1000 Growth 0.25 Russell 2000 Value 0.20 Russell 2000 Growth 0.10 Annualized portfolio return Annualized tracking risk Error term 14.50% 7.85% 9.58% C State one advantage and one disadvantage of the performance evaluation approach being used by Edgar (2 minutes) D State and justify whether GE’s portfolio is invested in accordance with the stated mandate (4 minutes) FinQuiz.com © 2018 - All rights reserved 28 CFA Level III Mock Exam – Questions (AM) Template for Question 9-A Select the most Suitable Strategy for the Passive Management of SF’s Portfolio Justify Your Response with One Reason Full Replication Stratified Sampling Optimization FinQuiz.com © 2018 - All rights reserved 29 CFA Level III Mock Exam – Questions (AM) QUESTION 10 HAS ONE PART FOR A TOTAL OF MINUTES Carl Storm is an institutional portfolio manager at Theta Asset Management Storm works closely with Green Associates, a broker/dealer firm, to execute trades on behalf of client accounts Below are excerpts from her meetings with the chief executives of two of her clients Storm needs to determine which type of order will be submitted to Green Associates based on the details collected Smithson Corp’s Defined Benefit Pension Fund: Smithson has placed an order to purchase 100,000 shares of Reliable Corp, a software manufacturer The average day’s volume of the manufacturer’s stock is 400,000 The firm’s purchase decision is based on earnings growth projections generated by the firm’s in-house forecasting model The chief executive has instructed to Storm, “We would not like to reveal the full extent of our purchase order to the market.” Thornton Endowment Fund: The chief executive emphasizes on giving brokers free reign to make purchase decisions for the fund’s policy portfolio whenever the market presents a favorable opportunity All trades must be executed within three trading days of placing the order Determine which order is most suitable for the two clients Explain your choice Answer Question 10 in the template provided on page 31 (6 minutes) FinQuiz.com © 2018 - All rights reserved 30 CFA Level III Mock Exam – Questions (AM) Template for Question 10 Client Determine which order is most suitable for the two clients (Circle the Correct Answer) Explain your Choice Reserve order Smithson Corp’s Defined Benefit Pension Fund Market-not-held order Market on open order Participate order Thornton Endowment Fund Best efforts order Market on open order FinQuiz.com © 2018 - All rights reserved 31 CFA Level III Mock Exam – Questions (AM) QUESTION 11 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 15 MINUTES Bjore Traders is a shipping company listed on the NYSE The company has divisions operating in several states across the U.S Each divisional manager is responsible for overseeing the risk management of its exposures A Identify one benefit and one drawback of BT’s risk management system structure (2 minutes) Jacqueline Andrew is the head of risk management at BT’s Idaho division Andrew is preparing a report on the division’s risk exposures in order to determine how to manage them effectively She begins her report by discussing the division’s strategy for risk management: Statement: “We manage risk strategically by avoiding risk taking in areas in which we not have expertise and hedging only tactically in areas in which we have an edge.” B Does Andrew’s statement reflect efficient risk management practices? Justify your response (3 minutes) Answer Question 11-B in the template provided on page 33 The Idaho Division is BT’s only division delivering orders to customers outside the U.S A portion of its sales are on credit Shipping fuel is procured by paying for 12 months’ fuel in advance using over-the-counter (OTC) prepaid commodity swaps The firm has hedged its foreign currency exposures using currency futures In the current year, the management is seeking to expand the division’s delivery destinations and will be purchasing three freight ships from a U.S supplier Funds from the purchase will come from issuing a combination of equities and corporate bonds C Identify five risk exposures faced by the Idaho division Your answer should explain each risk exposure by identifying one source Answer Question 11-C in the Template provided on page 34 (10 minutes) FinQuiz.com © 2018 - All rights reserved 32 CFA Level III Mock Exam – Questions (AM) Template for Question 11-B Does Andrew’s Statement Reflect Efficient Risk Management Practices? (Circle the Correct Option) Andrew’s Statement: “We manage risk strategically by avoiding risk taking in areas in which we not have expertise and hedging only tactically in areas in which we have an edge.” Justify Your Response Yes No FinQuiz.com © 2018 - All rights reserved 33 CFA Level III Mock Exam – Questions (AM) Template for Question 11-C Identify Five Risk Exposures Faced by the Idaho Division Explain Each Risk Exposure with One Identified Source FinQuiz.com © 2018 - All rights reserved 34 CFA Level III Mock Exam – Questions (AM) QUESTION 12 HAS ONE PART FOR A TOTAL OF MINUTES Capex Asset Management is a U.S based portfolio management firm which has always invested in domestic stocks on behalf of client portfolios Victor Solanki is CAM’s senior most portfolio manager Solanki has allocated €100 million for investing in German stocks with an average beta of 0.75 The spot exchange rate is $0.89 The German interest rate is 4% Solanki will be hedging both German market risk as well as currency risk for a three month period A three-month futures contract on the German market is priced at €200,000 and has a beta of 0.60 The three-month forward rate is $0.9560 i Identify the strategy Capex Asset Management will need to undertake for hedging German local market return ii Calculate the hedged portfolio return Use a ‘n/360’ days convention and show your calculations (5 minutes) FinQuiz.com © 2018 - All rights reserved 35 CFA Level III Mock Exam – Questions (AM) QUESTION 13 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 17 MINUTES Steven Blair, CFA, has been contracted to help Betty Davis put together an Investor Policy Statement and a strategic allocation for her $2.5 million in assets The funds are currently allocated to the asset classes established by a previous advisor Money Market Instruments U.S Large Cap Fund U.S Corporate Bonds U.S Treasuries S&P500 Fund 20% 20% 20% 20% 20% They begin to discuss the asset classes and recommendations in their first meeting Steven tells Betty that the previous advisor did not correctly specify the asset classes He also recommends treasury-inflation protected securities as a separate asset class from the nominal bonds currently in the portfolio and provides the table below as evidence Historical Correlation of Returns TIPS Corporates Asset Class Treasury Inflation Protected Securities 1.00 U.S Corporate Bonds 0.85 1.00 U.S Treasuries 0.71 0.80 Treasuries 1.00 A Support Stevens recommendation to add TIPS with two reasons (2 minutes) B Describe three errors that were made in the specification of asset classes (6 minutes) Steven has experience developing strategic asset allocations using traditional mean variance optimization with unadjusted historical returns, variances and covariances To construct a strategic allocation for Betty, he is interested in using other approaches like Black-Litterman and Monte Carlo simulation C Identify one advantage and one limitation for each of the approaches listed in the case (Mean-Variance, Black-Litterman, and Monte Carlo) (9 minutes) FinQuiz.com © 2018 - All rights reserved 36 ...CFA Level III Mock Exam – Questions (AM) FinQuiz. com – 5th Mock Exam 2018 (AM Session) The morning session of the 2018 Level III CFA Examination has 12 questions... the following components for YT’s IPS: I II III risk tolerance liquidity time horizon (6 minutes) FinQuiz. com © 2018 - All rights reserved 13 CFA Level III Mock Exam – Questions (AM) D For each... Objective (2 minutes) FinQuiz. com © 2018 - All rights reserved 15 CFA Level III Mock Exam – Questions (AM) C Formulate the following constraints for First Bank’s IPS: I II III time horizon liquidity