FinQuiz.com CFA Level III Mock Exam June, 2017 Revision Copyright © 2010-2017 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com CFA Level III Mock Exam – Questions (AM) FinQuiz.com – 4th Mock Exam 2017 (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 © 2017 - All rights reserved 20 180 CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, AND D) FOR A TOTAL OF 20 MINUTES Dano Parker works as a portfolio manager at Picasso Investments (PICIN), a large and reputable financial advisory firm offering a range of capital management services and investment products to individual and institutional investors Parker has been with the firm for over five years now, and has managed more than fifteen client portfolios As such, PICIN has appointed Parker to appraise the performance of private wealth portfolios at regular intervals During his appraisals, and also as part of experience, Parker notices that, in many instances, the assumptions of traditional finance with respect to the behaviors of individuals not hold true Parker was not sure what effects this might have on optimal portfolio construction by financial market participants To discuss this further, Parker invited David Hulsey, a behavioral financial analyst, to talk about investor behavior in detail During their conversation, Hulsey made the following comment: “I believe that investors behave rationally when making investment decisions and try to maximize the expected utility, given their budget constraint When faced with new information, market participants revise expectations consistent with Bayes’ formula Also, investors are risk-averse, demanding more return for each unit of risk.” Parker disagreed with Hulsey on the basis of the ‘Prospect Theory’, but was not sure how this theory provided an alternative explanation to investor behavior He was, however, convinced that the theory explained apparent deviations in decision making from those explained under the utility theory A Justify how the prospect theory supports Parker’s notion of an apparent departure of investor behavior from the behavior of the rational economic man Give three ways the prospect theory differs from the utility theory (6 minutes) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) After his meeting with Hulsey, Parker proceeded with developing an earnings forecast for Sparkle Fixtures Incorporated (SFI), a US firm famous for its lighting fixtures and decorative lamps The lighting industry has seen tremendous growth over the past decade due to a rising trend of professional interior designing of homes and offices Historical data of the past 15 years shows earnings growth for SFI at 1.0-1.5% above the GDP growth rate Just recently, however, the firm reported a drop of 5.0% in earnings growth due to a number concerns regarding the supply of raw materials In addition, a few other firms also reported losses for the recent quarter In developing his forecasts, Parker decided to revise his earnings estimate downward for the stock in order to avoid any losses and keep his estimate conservative B Determine the bias that Parker is most likely subject to while developing earnings estimate for SFI Give one example where such a bias may result in excessive trading by financial market participants (4 minutes) While reviewing the asset allocation decisions of his clients, and their stated preferences during regular meetings for updating their IPSs, Parker noticed that many portfolios lacked the appropriate amount of diversification, as would be present if investors behaved rationally and took a holistic view of their portfolios Parker was assured that this was due to the presence of behavioral biases C Give three behavioral explanations for inadequately diversified portfolios State the bias inherent in each explanation (6 marks) Before ending his day, Parker shortlisted five potential stock investments for his portfolio that met his risk and return constraints and had approximately similar risk-return profiles Given his budget constraint, Parker decided to invest in two of the most well-known and established firms amongst those he had shortlisted D Determine, using behavioral finance, the behavior that guided Parker to select stocks for his portfolio State the bias leading to such a behavior Justify your response (4 marks) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS Renee Russo works as a portfolio manager at Panther Investment Management Firm (PIMF), a financial advisory firm offering portfolio management services to institutional investors, including pension plans, endowments and foundations Pension funds make up the largest portfolio of PIMF’s client base Russo has recently been appointed as the Chief Portfolio Manager (CPM) for the pension fund of Revolutionary Technologies Limited (RTEL), a large, US based firm operating in the electronics and technology industry The firm has been quite profitable over the past five years, as has been the general industry trend Working in association with Dennie Thorpe, the Chief Financial Officer (CFO) of RTEL, Russo compiles the data provided in Exhibit Exhibit 1: Financial Information of RTEL (Average of the past five years) RTEL Industry Average Debt/Total Assets 35% 55% Net Income/Sales 22% 19% Expected Gross Profit Margin 45% 47% Russo’s team at PIMF presents her with the data in Exhibit Exhibit 2: Economic Data Duration 25 year, US Treasury bonds 16 years 35 year, US Treasury bonds 22 years Interest Rate 7.5% 8.5% Inflation rate: 5.0% FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) Utilizing the opportunity to work with the CFO of the firm, Russo also accumulates the following facts: • • • • • The projected benefit obligation (PBO) as reported on the current balance sheet, dated 31 December 2013, equals $10 billion The duration of the liabilities equals 22 years The total value of the firm’s pension assets as of 31 December 2013 equal $13 billion The ratio of the retired lives to active lives for the firm equals 0.33 The correlation between pension plan assets and plan liabilities is close to 0.33, with pension assets invested mostly in growth oriented investments While talking to Russo about the pension plan’s objectives, Thorpe also states the following: “RTEL primary focus is to maintain the funded status of the plan at a level of at least 100% with respect to the PBO The board has decided that a probability of 10% of falling short of meeting this objective is reasonable In addition, the plan’s objectives need to be set so as to minimize the probability of making future contributions to the plan Also, since proficient human resource is a key element of success in this industry, to retain our employees, we keep modifying our plan provisions according to changes in the industry This helps ensure retention of the best possible human resource in the face of competition.” Thorpe continues with the following comment: “To meet our long-term objectives of minimizing contributions, the board has estimated that a return of 2.5% over and above the minimum required return would be appropriate for the fund.” A Formulate an appropriate risk objective for Revolutionary Technologies Limited’s (RTEL) pension fund Determine whether RTEL’s ability to take risk is above-average, average, or below average Give three reasons why the ability may be high, and three reasons why it might be low Use the template on page to answer the question (8 marks) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) B Determine the minimum return requirement for RTEL’s pension fund Formulate an appropriate return objective for the RTEL pension fund (4 marks) Ten years have passed, and Russo is still the manager of the RTEL pension fund The following changes have occurred during this time period: • • • • The ratio of the retired lives to average lives is 0.66 The industry has seen a large number of new entrants, which has squeezed profit margins for existing firms The overall growth rate of the industry is now approximately in line with the rate of growth of the general economy The firm introduced a provision for early retirement two years ago 10% of employees have opted for this option The asset base is now $9 billion with plan liabilities unchanged For the current month, RTEL made a contribution to the pension plan of $10 million Given the number of retired employees, Russo estimates a cash disbursement of $60 million per month to satisfy obligations C Determine the current liquidity requirement of the RTEL pension fund Explain whether the liquidity constraint for the fund has improved, remained stable, or deteriorated Justify your response with three reasons (5 marks) D Formulate the time horizon portion of the IPS of the RTEL pension fund as of today and ten years ago (3 marks) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) Template for Question 2-D Reasons (High) Ability to take risk Reasons (Low) 1 2 3 FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) QUESTION HAS FIVE PARTS (A, B , C , D, E) FOR A TOTAL OF 19 MARKS Target Lock Investment Firm (TLIF) operates in the financial services industry of USA TLIF is known for its expertise in managing equity portfolios and growth-oriented stock investments Given the immense success in this area, TLIF’s CEO, Michael Dobson, believes it strategically wise to include the fixed-income asset class to their investment universe Accordingly, he hires Natalie Acosta, a fixed-income analyst and portfolio manager, to introduce the TLIF Debt Fund, a new product, to TLIF’s clients and prospects To determine which issues to include in the fund, Acosta works with the research department to collect the data presented in Exhibit Exhibit 1: Spread Data for Three Bond Issues Issue Current Spread Standard Deviation of Spread Mean Spread over the past year TYS Co 220 bps 57 bps 165 bps RLO Firm 260 bps 45 bps 215 bps Ace Inc 200 bps 30 bps 165 bps A Determine the issue that should most likely be purchased given the above information Give two limitations of the bond selection approach used (4 marks) Acosta has considerable experience in constructing trading strategies in the fixed-income market For the current economic state, Dobson predicts the following: Prediction 1: “The economy appears to be at a business cycle trough given low consumer demand and low interest rates In the coming six months, the economy will start picking up as demand rises.” Prediction 2: “The US Treasury bonds term structure is expected to flatten in the near future In a year or so, economic conditions may lead to an inversion of the term structure for government bonds.” FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) B Construct two trading strategies that would be profitable given that Acosta’s predictions are accurate Justify your response for each (4 marks) A year after the launch of the TLIF Debt Fund, Acosta reviews the performance of the fund to determine any portfolio rebalancing that might be needed The fund had invested in 10,000 bonds of RLO Firm, each with a par value of $1,000 Acosta is concerned with the possibility of a rating downgrade that could seriously affect the fund’s return Given her strong opinion about the possibility of an adverse event, Acosta decides to liquidate the holdings in RLO Firm’s bond issues C Determine two ways in which Acosta can hedge the risk of RLO’s bond holdings without having to liquidate the position Explain how they could offer protection from the expected risk factor (4 marks) Five years later, the TLIF Debt Fund has managed to establish a place amongst the highest rated fixed-income funds in the area Last year, Acosta decided to include international bonds in the asset-mix and consequently, had hired a team of portfolio managers for the management of international bond investments As such, the fund has considerable holdings in French bonds, UK bonds and Japanese bonds In a recent meeting with the fixed-income analysts, Acosta was presented the following data: Exhibit 2: Annual Interest Rate Data Japan Germany UK Short-term interest rates 2.0% 4.5% 6.5% Currency appreciation relative to the dollar 3.5% 0.35% -0.40% *The U.S risk free rate is 5.0% D Assuming that the IRP holds, determine whether the investments in the foreign bonds should be hedged or not Justify your response (4 marks) FinQuiz.com © 2017 - All rights reserved 10 CFA Level III Mock Exam – Questions (AM) Template for Question 4-E Recommended asset allocation (circle one) Allocation Four Reasons to support decision For each of the allocations not selected, give one reason each why they were not appropriate i ii A B C iii D FinQuiz.com © 2017 - All rights reserved 16 CFA Level III Mock Exam – Questions (AM) QUESTION HAS THREE PARTS (A , B , C) FOR A TOTAL OF 22 MARKS Parallel Investments (PARIN) is a capital management firm that offers its advisory services to large, institutional funds like pensions, endowments and foundations The Gems Foundation (TGM) is one of the largest clients of PARIN TGM core objective is to fund educational institutes that provide free of cost educational services to underprivileged children between 5-15 years of age The foundation has accumulated a portfolio worth $50 million TGM’s investment policy statement dictates the following: • • • • • • • • TGM has an annual spending requirement of $2,375,000 TGM’s expenses are expected to rise with the expected rate of inflation of 3.0% PARIN estimates that the cost of earning investment returns equals 50bps TGM wants the appropriate asset allocation to minimize the probability of the annual portfolio return falling below TGM’s spending rate TGM has decided to donate $2,500,000 to a charitable organization in the coming three months This cash outflow is to be excluded from TGM’s investable asset base TGM’s board has decided that a worst-case return of -13.5% is acceptable during any 12-month period However, the probability of failing to meet this return level should be minimized to 5.0% T-bills offer a rate of 2.5% The maximum acceptable standard deviation to TGM’s board is 17.0% Using the information in TGM’s IPS, Ben Spencer, a portfolio manager at PARIN, shortlisted the following asset classes: U.S Equities International equities Corporate bonds Government bonds Real Estate Using these asset classes, Spencer determined five possible asset allocations given his capital market expectations These are displayed in Exhibits and FinQuiz.com © 2017 - All rights reserved 17 CFA Level III Mock Exam – Questions (AM) Exhibit 1: Corner Portfolios given PARIN’s Capital Market Expectations Corner Portfolio Expected Return Standard Deviation Sharpe Ratio A 9.90% 16.66% 0.517 B 8.71% 13.20% 0.650 C 7.50% 13.00% 0.635 D 6.24% 7.8% 0.612 E 5.50% 6.5% 0.600 Exhibit 2: Asset Allocations Corner Portfolio Asset Class Asset Class Asset Class Asset Class Asset Class A 50% 30% 10% 0% 10% B 30% 20% 15% 25% 10% C 40% 20% 10% 25% 5% D 20% 50% 10% 10% 10% E 35% 25% 30% 0% 10% A Determine the asset allocation that would be most appropriate for The Gems Foundation Justify your selection with three reasons Show your calculations Find the weights for each asset class in the optimal asset allocation (12 marks) Spencer has managed TGM’s portfolio for a number of years now The foundation’s portfolio is invested in an asset allocation that has a Sharpe ratio of 0.52 Spencer is considering adding international bonds to the asset mix to improve the risk profile of the portfolio However, he is not sure whether adding another asset class would prove fruitful International bonds have a predicted Sharpe ratio of 0.45 and a predicted correlation with TGM’s portfolio of 0.60 FinQuiz.com © 2017 - All rights reserved 18 CFA Level III Mock Exam – Questions (AM) B Determine whether TGM should add international bonds to its existing portfolio Justify your response (4 marks) Spencer was not sure about the addition of international bonds However, he is convinced that adding emerging market equities to TFM’s portfolio would not only increase the portfolio’s returns but would also decrease the overall risk When Spencer talked about this with Andrew Selle, his colleague, Sell made the following comment: “You might be right, but I am concerned with the risks associated with investment in such markets.” To this, Selle replied with the following comment: “Emerging market equities can serve as a valuable addition to the existing portfolio by improving its risk/return profile Markets are becoming increasingly integrated now, which has served to mitigate some of the concerns of investing in emerging economies.” C Determine the effect of market integration on the following: • • • Equity prices Expected return Return volatility Justify your response for each of the above (6 marks) FinQuiz.com © 2017 - All rights reserved 19 CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 2O MINUTES Capital Enhancement Investment Group (CEIG) is a capital management firm in the US that holds a prestigious position amongst similar firms in its industry CEIG has introduced a number of revolutionary products in the financial industry that combine traditional assets with simultaneous derivative positions to cash on profitable opportunities To remain competitive in this growing industry, CEIG appointed James Hull, a compliance officer, to implement the Global Investment Performance Standards (GIPS) within the firm Hull has worked with CEIG for over three years now and deems himself fruitful in the proper implementation of the Standards CEIG considers itself amongst the list of GIPS complaint firms, and, in doing so, believes it has gained the trust of many prospective clients Just recently, the CEO of CEIG hired Darin Hollings, a performance evaluation and presentation expert, to review the firm’s procedures for GIPS compliance During his review, as of January 2011, Hollings noted the following: • • • • • CEIG used trade date accounting to report transactions Assets and liabilities were recognized within a week of entering into a transaction When reporting fixed-income securities, interest income earned but not yet received was also included in their total value For dividend paying equities, dividends not yet paid were not accrued due to their uncertainty CEIG has a fiscal year that corresponds to the calendar year Consequently, every portfolio within its composites was valued at the last business day of each year When reviewing the frequency of portfolio valuations, Hollings discovered that CEIG valued all portfolios at least monthly When presenting net-of-fees returns, CEIG did not accrue investment management fees, especially performance-based fees After the review, Hollings met with the CEO and posed the following question: “In reporting portfolio values, which definition of value you use?” The CEO responded with the following comment: “Last year, we measured and reported all portfolio values at market value However, recently, we have started to use the ‘fair value’ of portfolios for reporting purposes If fair values are not easily obtainable, a best estimate of market value is used.” FinQuiz.com © 2017 - All rights reserved 20 CFA Level III Mock Exam – Questions (AM) A List three ways in which CEIG’s procedures violate the GIPS requirements with regards to input data Support your answer with proper justifications for each reason (6 marks) After his review, Hollings proceeded with evaluating the performance of the portfolios managed by CEIG’s portfolio managers While doing so, Hollings met with Ricardo Nadu, a portfolio manager who managed a few of the firm’s private wealth accounts Nadu told Hollings that all portfolio managers were required to measure the timeweighted rates of return that adjusted for external cash flows In addition, returns for longer measurement periods were computed by geometrically linking the monthly returns Upon further questioning by Hollings, Nadu stated the following: • • • • • • Cash and cash equivalents were included in the total return calculations However, if the cash was not actually invested by the same group of portfolio managers that managed the portfolio, it was excluded from the return calculations In addition, returns were always calculated after the deduction of trading expenses To be conservative and ensure compliance with GIPS, if actual values for such expenses were unavailable, estimated values were used based on historical averages Custody fees were not considered direct trading expenses However, if they were charged on a per-transaction basis, they were included in trading expenses When trading expenses could not be broken out of bundled fees, gross-of-fee returns were reduced by the entire amount of the bundled fee to estimate returns gross of investment management fees Withholding taxes were not considered when estimating net of fee returns CEIG’s definition of what constituted ‘a large cash flow’ varied with each composite depending on the nature of the investment strategy B For each of the facts stated by Nadu, state whether they are in compliance with the GIPS For each of the procedures not in compliance, determine the changes necessary to make them GIPS compliant Use the template on the following page to answer the question Answer Question 6-B in the Template provided on page 23 (6 marks) FinQuiz.com © 2017 - All rights reserved 21 CFA Level III Mock Exam – Questions (AM) Hollings knew that his analysis of CEIG would not be complete without assessing the appropriateness of the construction of composites within CEIG Specifically, Hollings analyzed the following actual, fee-paying client portfolios: Portfolio A The client specifically instructed not to invest more than 10% of the portfolio value or 115% of the benchmark weight, whichever is greater, in any given economic sector Portfolio B The client is the CEO of his firm and has holdings in his company’s stock He has instructed his portfolio manager not to sell any part of this holding, even if capital market conditions stated otherwise.” Portfolio C More than 60% of the client’s portfolio constitutes holdings in his grandfather’s firm that has been managed by family over the course of many years Since the holding has a very low cost basis, the client has directed his portfolio manager that it should not be sold.” C Select the portfolio that is likely to be not included in a composite under the Global Investment Performance Standards For the portfolio selected, list three ways in which it can be handled with regards to GIPS compliant composite construction (4 marks) Hollings was particularly interested in the firm’s traditional asset class composites, mainly: Balanced Fund Composite (50% equities, 50% fixed income) Growth Fund Composite (70% equities, 30% fixed income) Income Fund Composite (30% fixed income, 70% equities) The equity portions of the three funds were managed by a group of equity managers at CEIG, whereas the fixed-income portions, along with cash and cash equivalents, were managed by the fixed-income managers Just recently, CEIG created a new composite by the name of “Standard Equity Account Composite” that included only the equity segments of the above-mentioned composites This was created to ensure proper performance evaluation of the equity managers of CEIG D Determine whether the construction of the new composite is in compliance with the GIPS Support your answer with two reasons (4 marks) FinQuiz.com © 2017 - All rights reserved 22 CFA Level III Mock Exam – Questions (AM) Template for Question 6-B Procedures Compliance Changes (if necessary) with GIPS to be in compliance Cash and cash equivalents were included in the total return calculations However, if the cash was not actually invested by the same group of portfolio managers that managed the portfolio, it was excluded from the return calculations Custody fees were not considered direct trading expenses However, if they were charged on a per-transaction basis, they were included in trading expenses When trading expenses could not be broken out of bundled fees, gross-of-fee returns were reduced by the entire amount of the bundled fee to estimate returns gross of investment management fees In addition, returns were always calculated after the deduction of trading expenses To be conservative and ensure compliance with GIPS, if actual values for such expenses were unavailable, estimated values were used based on historical averages Withholding taxes were not considered when estimating net of fee returns CEIG’s definition of what constituted ‘a large cash flow’ varied with each composite depending on the nature of the investment strategy FinQuiz.com © 2017 - All rights reserved 23 CFA Level III Mock Exam – Questions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 20 MARKS Jocelyn Mathews works as a portfolio manager at Victor Investment and Capital Management (VICM) Mathews manages a number of VICM’s private wealth accounts invested in asset classes ranging from equities and fixed-income to alternative investments Mathews believes strongly in not only the value of research and analysis in proper security selection, but also in the significance of trading and implementation in managing costs Accordingly, he is analyzing the trading costs of his most recent purchase: 1,000 shares of the stock of Stripes Incorporated He accumulates the following facts for his evaluation: • • • • The benchmark price was $60.00/share The order was placed on last Tuesday, when the shares of Stripes closed at $59.90/share 500 shares were purchased at a price of $61.05 per share Commissions and fees were $50 On Wednesday, 200 more shares were purchased at $62.05 per share Commissions and fees were $20 Shares of Stripes closed at $61.03 during the same day On Thursday, no more shares were purchased and the order was canceled The market closed at $62.00 per share Mathews meant to use this data to calculate the implementation shortfall of his trade A Calculate the total implementation shortfall for the trade in the stock of Stripes Incorporated Determine the contribution of the various cost components to the total implementation shortfall Show your calculations (6 marks) Upon completion of his analysis, Mathews met with is fellow colleagues to share his conclusion They were all intrigued with the impact that trading costs could have on investment results As their discussion continued, each manager presented ways in which they attempted to minimize trading expenses They made the following comments: Manager A: “I always use extensive competitor and industry data while screening securities A comprehensive fundamental analysis is a trialed and tested method for selecting superior investments While placing an order, I wait till the price reaches the level I deem fit “ FinQuiz.com © 2017 - All rights reserved 24 CFA Level III Mock Exam – Questions (AM) Manager B: “I believe that markets are efficient, and costs to actively managed funds overweight the benefits of doing so Most of my investments are in indexed funds To minimize the costs of trading, I only trade at regular intervals for rebalancing purposes.” Manager C: “Just recently, I traded in the stock of Star Industries that I believed was significantly overvalued They had met fierce opposition from their largest suppliers, which led to the cancellation of a supply contract just a few days ago My trading costs were quite low.” B Determine which category of traders types would each of the above managers fall into State the order type that they are most likely to use along with one limitation for each order type (6 marks) After their discussion, Jim McGraw (Manager B) stayed back to talk a little more about rebalancing needs and methodologies When Mathews inquired about the frequency of his rebalancing trades, McGraw stated that he rebalanced his portfolio to target weights on a semiannual basis; a choice linked to the schedule of his portfolio’s reviews For investment advice from Mathews, McGraw presented him with the following details of his portfolio: Exhibit 1: Asset Class Weights (Strategic Asset Allocation) Asset Class Weights Domestic bonds 25% International bonds 15% Domestic Equities 40% International Equities 20% FinQuiz.com © 2017 - All rights reserved 25 CFA Level III Mock Exam – Questions (AM) In addition, McGraw also mentioned that over the course of the previous year, some economic, personal, and financial changes occurred, affecting each of these asset classes Specifically, he pointed out the following: • • • • • Direct transaction costs of trading in domestic bonds increased considerably over the year Due to a large down payment to be made for the purchase of a new home, the portfolio experienced a significant cash outflow As such, minimizing tracking risk relative to the benchmark became a prime objective The volatility of international bonds increased, maybe due to differing economic changes worldwide Its correlation with domestic equities increased, reflecting less of a diversification benefit The correlation of international equities with domestic equities decreased however, adding to the diversification benefits The volatility of international equities increased too, over the same time period C (i) State the rebalancing method used by McGraw List two ways in which percentage-of-portfolio rebalancing can mitigate the drawbacks of the rebalancing method used by McGraw (3 marks) C (ii) Evaluate the implications of each of the above mentioned changes on the tolerance bands of the asset classes assuming percentage-of-portfolio rebalancing was used Use the template on page 27 to answer the question (5 marks) FinQuiz.com © 2017 - All rights reserved 26 CFA Level III Mock Exam – Questions (AM) Template for Question 7-C (ii) Changes Direct transaction costs of trading in domestic bonds increased considerably over the year Due to a large down payment to be made for the purchase of a new home, the portfolio experienced a significant cash outflow As such, minimizing tracking risk relative to the benchmark became a prime objective Tolerance Band for: Domestic bonds Implications International bonds The volatility of international Domestic equities 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 Domestic bonds The volatility of domestic equities increased too, over the same time period International equities *Consider each in isolation FinQuiz.com © 2017 - All rights reserved 27 CFA Level III Mock Exam – Questions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS Susanne Karen is an architect who works for a prominent multinational firm in the industry Karen has managed to accumulate a portfolio worth $10 million with her annual savings The portfolio is invested to track a balanced fund with 50% invested in stocks and 50% in bonds To suitably manage her portfolio, Karen hired Robin Clark, a portfolio manager and investment management expert For estimating the expected performance of Karen’s portfolio, Clark accumulated the information given in Exhibit Exhibit 1: Annual Expected Return and Risk Asset Class Standard Deviation Return Stocks 22% 15% Bonds 9% 6% The correlation between stocks and bonds is 0.65 During a meeting with Karen, Clark extracted all pertinent information about her financial situation and personal preferences This was then used to construct an appropriate IPS Keeping the objectives, as stipulated by the IPS, in mind, Clark suggested investing a small portion of her portfolio in derivatives Specifically, he proposed the following option: ‘A forward contract on the stock of Titan Enterprises with a maturity of 18 months The stock is currently worth $120/share The risk-free rate is 5.5%.” Clark is convinced that the stock price would rise in the coming year or so, due to a change in the firm’s product strategy He constructed a position for Karen which would take advantage of this expectation A Determine the percent VAR of Karen’s portfolio before the addition of the forward contract Express it in the most conservative way (4 marks) Nine months have passed since Clark has been managing Karen’s portfolio Titan Enterprises’ stock is now worth $135/share The stock paid no dividends during this period and is not expected to so for the coming five years FinQuiz.com © 2017 - All rights reserved 28 CFA Level III Mock Exam – Questions (AM) B Evaluate the credit risk position of Karen in the forward contract Determine the new price of the forward contract if it were to be marked to market (4 marks) After two years, Karen requested Clark to present her with a comprehensive analysis of her portfolios performance Displeased with the results, Karen instructed Clark to look for other investment opportunities Clark stated, that over a year ago, his investment management firm introduced a new fund managed by a team of reputable portfolio managers and invested in a number of financial sectors The fund managers used their skills and expertise to earn above-average returns for the fund Upon further request, Clark presented Karen with the information given in Exhibit Exhibit 2: GHE Investment Fund Annual Performance Attribution Beginning Value $150,000,000 Net Contributions $850,000 (Risk-free asset) Incremental Value Contribution $675,000 Fund value (asset category) $165,500,000 Fund Value (benchmarks) $165,900,000 Incremental return contribution for allocation effects 0% Total fund return 11.05% C (i) Determine how much of the total return was attributed to style bias Show your calculations (4 marks) C (ii) Determine how much value active stock selection added to the fund (2 marks) Karen was greatly impressed with the fund’s performance Convinced with the superior stock picking ability of managers at the firm, she decided to give Clark more discretion in making investment decisions for her portfolio After six months, Karen’s portfolio earned an unexpectedly higher return than its benchmark To confirm the results, Karen requested the details given in Exhibit FinQuiz.com © 2017 - All rights reserved 29 CFA Level III Mock Exam – Questions (AM) Exhibit 3: Portfolio Performance Results (Extract) Sector Portfolio Weight Portfolio Return Benchmark (%) (%) weight (%) 8.9 8.0 -0.55 Sector Benchmark Return -0.67 Consumer durables 7.5 8.5 0.30 -0.40 Technology 12.0 10.5 3.95 2.90 Economic Sector Capital Goods The total portfolio earned a return of 2.12% whereas the total benchmark return was 0.70% D Determine the within sector selection return and the pure sector allocation return for each of the above mentioned economic sectors Show your calculations Use the template below to answer the question (6 marks) Template for Question 8-D Pure Sector Allocation Within Sector Selection Capital Goods Consumer durables Technology FinQuiz.com © 2017 - All rights reserved 30 ... ago (3 marks) FinQuiz. com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) Template for Question 2-D Reasons (High) Ability to take risk Reasons (Low) 1 2 3 FinQuiz. com ©... Trading and Rebalancing Portfolio Management – Risk Management & Performance Evaluation 20 Total: FinQuiz. com © 2017 - All rights reserved 20 180 CFA Level III Mock Exam – Questions (AM) QUESTION... rational economic man Give three ways the prospect theory differs from the utility theory (6 minutes) FinQuiz. com © 2017 - All rights reserved CFA Level III Mock Exam – Questions (AM) After his meeting