Volume II behavioral finance, individual investors, and institutional InvestorsCFA level 3CFA finquiz Level3Mock2018Version5JuneAMSolutions

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 – 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 – Solutions (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 – Solutions (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 (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 – Solutions (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 FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (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 – Solutions (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 – Solutions (AM) Solutions for Question 1: A Solution: I Time Horizon: Lucas has a time horizon comprising of three stages Stage 1: Present to sale of business or retirement – years Stage 2: Retirement to the funding of his grandson’s college education and home purchase – 15 years Stage 3: Stage onwards II Unique Circumstances: Lucas’ ownership suggests a large concentrated position Weaver will need to consider diversifying the position and accordingly devise a strategy It is important that Weaver consider a number of factors including Lucas’ loyalty to the position and his willingness to reduce his holding in the business prior to the date of sale Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS h FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) B Solution: Factor Impact on Risk Tolerance (Circle the Correct Answer) Increase Increase in inflation rate Decrease Decrease s No impact Increase Reduction in sales price of business Decrease No impact Increase Increase in the price of his dream house Decrease No impact No impact Justify your choice with one reason An increase in the inflation rate will increase the shortfall between business income and living expenses which is expected to equal $27,900 [($100,000 × 0.75)– ($98,000 × 1.05)] in the following year and increase annually thereafter Given that Lucas’ living expenses after retirement are not dependent on the sale of the business, therefore reduction in this source of funds will not impact his ability to tolerate risk Lucas has expressly stated that the sale of the business or any purchase from that amount should not be included in the investment process Therefore, a change in the price of the his dream house should not affect his risk tolerance Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS g FinQuiz.com © 2018 - All rights reserved CFA Level III Mock Exam – Solutions (AM) C Solution: Lucas needs to generate sufficient income to fund his living expenses on an inflationadjusted basis, provide for his retirement spending needs and grow his portfolio to finance his grandson’s college education and the purchase of residential property Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS g D Solution: Inflows Annual business income Sale of business [$15,000,000 × (1 – 0.3)] Current Year Year $100,000 $100,000 $100,000 - - - Outflows Living expenses* $98,000 $102,900 Tax on salary ($100,000 × 0.25) $25,000 $25,000 Net inflows/(outflows) ($23,000) ($27,900) * expected to increase at the annual rate of inflation of 5% Investable Asset Base at the beginning of Year 3: Cash flow – Year Portfolio assets Cash reserve (3 × $100,000) Total $108,045 $25,000 ($33,045) Current ($33,045) $8,500,000 $300,000 $8,766,955 PV = - 8,766,955 N = 12 years FV = 30,000,000 PMT = - 150,000 I/Y = 9.771% The after-tax nominal required rate of return is 9.771% Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS g FinQuiz.com © 2018 - All rights reserved 10 CFA Level III Mock Exam – Solutions (AM) Solutions for Question A Solution Select the most Suitable Strategy for the Passive Management of SF’s Portfolio Full Replication Stratified Sampling Stratified Sampling Optimization Justify Your Response with One Reason Possible answers: • The full replication approach is more suitable when the index stocks are less than 1,000 • Portfolio rebalancing costs reduce the return of the portfolio relative to that of the benchmark index Explanation: • Suitable when the benchmark comprises a large number of stocks (> 1,000) • Cost-effective; managers can construct portfolio which replicates the benchmark index exposure without having to purchase all of the stocks in the index Optimization requires periodic trading to keep the portfolio’s risk exposures in line with the benchmark generating portfolio rebalancing costs Reference: CFA Level III, Volume 4, Study Session 12, Reading 25, LOS e B Solution Tax savings: Total return equity swaps provide significant tax-saving opportunities particularly if the counterparty, to which the swap payment is due, holds the underlying equities more tax-efficiently Equity swap applications are motivated by differences in the tax treatment of shareholders domiciled in different countries Efficient asset allocation: Equity swaps can be used to efficiently effect a change in asset allocation A manager can use swaps to rebalance portfolios to the strategic asset allocation and incur rebalancing costs which are lower than having to trade the underlying securities FinQuiz.com © 2018 - All rights reserved 50 CFA Level III Mock Exam – Solutions (AM) Reference: CFA Level III, Volume 4, Study Session 12, Reading 25, LOS e C Solution Possible advantages include: • • • • • • • • Characterizes the entire portfolio Facilitates comparisons of portfolios Aggregates the effect of the investment process Different models usually give broadly similar results and portfolio characterizations Clear theoretical basis for portfolio categorization Requires minimal information Can be executed quickly Cost effective Possible disadvantages include: • • May be ineffective in characterizing current style Error in specifying indices in the model may lead to inaccurate conclusions Reference: CFA Level III, Volume 4, Study Session 12, Reading 25, LOS i D Solution: The fraction of the portfolio explained by the manager’s security selection ability is 9.58% indicating that the portfolio is indeed being managed actively A closer look at the benchmark weights reveals that Reed has drifted from her stated investment style His factor weight of 70 (0.45 + 0.25) on large-cap stocks exceeds his weight of 0.30 (0.20 + 0.10) on small-cap stocks However, his allocation to small-cap stocks is not insignificant In addition, his factor weight of 0.45 on large-cap value stocks exceeds his factor weight of 0.25 on large-cap growth stocks GE’s portfolio appears to be an actively managed large- and small-cap market-oriented portfolio with a value bias Reference: CFA Level III, Volume 4, Study Session 12, Reading 25, LOS i FinQuiz.com © 2018 - All rights reserved 51 CFA Level III Mock Exam – Solutions (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 (6 minutes) FinQuiz.com © 2018 - All rights reserved 52 CFA Level III Mock Exam – Solutions (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 53 CFA Level III Mock Exam – Solutions (AM) Solution for Question 10 Client Determine which order is most suitable for the two clients (Circle the Correct Answer) Reserve order 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 order Best efforts Market on open order FinQuiz.com © 2018 - All rights reserved Explain your Choice Reserve orders are suitable for those traders who place an order which represents a substantial fraction of the average daily trading volume, but not wish to display the full size of their orders Smithson’s order represents 40% (100,000/400,000) of the stock’s trading volume in a day which is significant and the chief executive has expressed his desire to conceal a portion of the order Best efforts orders are suitable for those clients who are willing to give their broker/agent full discretion to work the order only when the broker judges the market to be favorable Based on the chief executive’s demands, this order is most suitable for the client 54 CFA Level III Mock Exam – Solutions (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 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 (10 minutes) FinQuiz.com © 2018 - All rights reserved 55 CFA Level III Mock Exam – Solutions (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 56 CFA Level III Mock Exam – Solutions (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 57 CFA Level III Mock Exam – Solutions (AM) Solutions for Question 11 A Solution BT has a decentralized risk management system as each division is responsible for managing its own risk exposures Advantage: People who are most familiar with the risk will be managing exposures Disadvantage (Marks will be awarded for any one of the following disadvantages identified): • • Does not permit economies of scale Does not allow a company to recognize the offsetting nature of distinct exposures that an enterprise may assume in its day-to-day operations Reference: CFA Level III, Volume 5, Study Session 14, Reading 27, LOS d B Solution: 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.” Yes No No Justify Your Answer: Although the tactical hedging of areas in which the entity has comparative advantage is an efficient strategy, the division should hedge risks in areas in which they have no expertise Efficient risk management involves adjusting levels of risk to appropriate levels and not necessarily eliminating risks Reference CFA Level III, Volume 5, Study Session 14, Reading 27, LOS a FinQuiz.com © 2018 - All rights reserved 58 CFA Level III Mock Exam – Solutions (AM) C Solution: Identify Five Risk Exposures Faced by the Idaho Division Credit risk Commodity risk Settlement risk Explain Each Risk Exposure with One Identified Source Possible sources of credit risk include: • Credit risk arises from credit sales • Credit risk arises from prepaid swaps as the dealer may not fulfill his side of the agreement by either delaying or failing to deliver the shipment of fuel to the division Potential sources of commodity risk include: • The company has exposure in fuel • The company has exposure in shipments to customers Settlements on the swap can expose the division to settlement risk The division has prepaid for fuel which it may not receive FinQuiz.com © 2018 - All rights reserved 59 CFA Level III Mock Exam – Solutions (AM) Equity market risk Liquidity risk Interest rate risk The success of its expansion operations will be affected by the price it receives from issuing shares The division is exposed to the risk that securities may not be bought or sold as quickly to finance the freights purchase Potential sources of interest rate risk include: • The division is financing the purchase of freights by issuing corporate bonds • A portion of sales are offered on credit terms Reference: CFA Level III, Volume 5, Study Session 14, Reading 27, LOS d FinQuiz.com © 2018 - All rights reserved 60 CFA Level III Mock Exam – Solutions (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 61 CFA Level III Mock Exam – Solutions (AM) Question 12 Solution: i Capex Asset Management will need to sell futures contracts to hedge the German local market return Explanation: Capex has a long exposure to the German equity market A fall in return will generate losses for its investment portfolio Therefore, to hedge against potential losses the company will need to sell futures contracts ii The portfolio is hedged for local market risk and therefore it will grow to a value of €101,000 = €100,000[1 + (0.04 × 90/360)] Capex can hedge this amount using a currency forward contract with a notional principal of €101,000 With the portfolio hedged for currency risk, the dollars received at contract expiration will equal to $96,556 (€101,000 × $0.9560) Based on the original portfolio value of $89,000 (€100,000 × $0.89), the hedged portfolio return is equal to 8.49% ($96,556/$89,000 – 1) Reference: CFA Level III, Volume 5, Study Session 15, Reading 28, LOS f FinQuiz.com © 2018 - All rights reserved 62 CFA Level III Mock Exam – Solutions (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 63 CFA Level III Mock Exam – Solutions (AM) Solution for Question A Solution: TIPS are a homogenous asset class (they are correlated with themselves) They also provide important protection against inflation, which is not provided in nominal bonds Reference: CFA Level III, Volume 3, Study Session 8, Reading 17 B Solution: 1) The asset classes listed not make up a preponderance of global investable wealth, no international investments are listed 2) Asset classes should be mutually exclusive or have no overlap The U.S large cap and the S&P500 fund will overlap significantly 3) Asset classes should be diversifying for risk control The U.S corporate bonds and Treasuries are highly correlated and it is assumed that the U.S large cap and S&P500 funds will also be highly correlated Reference: CFA Level III, Volume 3, Study Session 8, Reading 17 C Solution: Mean-Variance: Advantage is that it identifies portfolios with the highest expected return at each level of risk, though it is limited in the number and nature of estimates can overwhelm the analyst Black-Litterman: Advantage is that it provides portfolios that are well-diversified and a stable efficient frontier, though it is limited in that it relies on historical returns and variances Monte Carlo: Advantage is that it can be used to generate a distribution of probabilities, though its limitation is the complexity of the approach Reference: CFA Level III, Volume 3, Study Session 8, Reading 17 FinQuiz.com © 2018 - All rights reserved 64 ... CFA Level III, Volume 2, Study Session 4, Reading 8, LOS g FinQuiz. com © 2018 - All rights reserved 10 CFA Level III Mock Exam – Solutions (AM) E Solution: The benefits of incorporating behavioral. .. age of 38 years and the duration of its liabilities is 20 years FinQuiz. com © 2018 - All rights reserved 24 CFA Level III Mock Exam – Solutions (AM) Reference: CFA Level III, Volume 2, Study... Status Quo Reference: CFA Level III, Volume 3, Study Session 7, Reading 19, LOS b FinQuiz. com © 2018 - All rights reserved 44 CFA Level III Mock Exam – Solutions (AM) B -ii Solution: Possible measures