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 – Solutions (AM) FinQuiz.com – 6th Mock Exam 2017 (AM Session) The morning session of the 2017 Level III CFA Examination has 11 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question Questions 10 11 Topic Minutes Portfolio Management – Individual Portfolio Management – Individual Portfolio Management – Individual Portfolio Management – Individual Portfolio Management – Institutional Portfolio Management – Economics Portfolio Management – Equity Investments Portfolio Management – Fixed Income Portfolio Management – Risk Management Portfolio Management – Derivatives Portfolio Management – Monitoring and Rebalancing 31 12 18 22 24 12 16 14 10 12 Total: FinQuiz.com © 2017 - All rights reserved 180 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 31 MINUTES Cynthia McCollum, CFA, is a portfolio manager at Western Brookes, an asset advisory firm Hart has been asked to construct an investment portfolio for Mona Hart, a senior manager at a manufacturing enterprise McCollum collects the following information on Hart: • • • • • • Hart is 52 years old and is the divorced mother of two sons, aged and 12 respectively Her living expenses are protected against inflation and amount to $350,000 per annum Her annual salary offsets her living expenses on an inflation-adjusted basis without leaving any funds for saving purposes Her salary is expected to grow at the annual inflation rate of 4% The inflation rate is expected to remain the same for the indefinite future She expects her living expenses to reduce by 20% upon her retirement, which is ten years from today She is taxed at a rate of 35% on all income, dividends and capital gains She has recently received $3 million from her deceased father’s estate which she wishes to employ for investment purposes During McCollum’s meeting with Hart, the client makes two statements which the manager feels are essential to incorporate in the decision making process Statement 1: “My past experience with a venture capital fund investment was unpleasant Long lock-up periods and high losses meant that my funds were tied up in a poorly performing asset class for quite some time I would request refraining from all types of alternative asset classes.” Statement 2: “I would not like my investment portfolio to decline by more than 15% in nominal terms in any given year and will be satisfied with an annual pretax real return of 2.5%.” A Formulate the return objective of an investment policy statement for Hart Calculate the after-tax nominal return requirement to achieve this objective assuming that the inheritance is invested in accordance with the stated before-tax real rate of return Show your calculations (6 minutes) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) B Formulate the risk objective for Hart’s investment portfolio (5 minutes) C Construct the constraints section of the investment policy statement Your answer should address: i ii iii taxes liquidity time horizon (6 minutes) D i Determine the behavioral trait exhibited by Hart according to the principles of behavioral finance Justify your response (3 minutes) ii Considering both her statements, determine three consequences of Hart’s personality type (3 minutes) McCollum proposes four alternative strategic allocations for Hart’s investment portfolio in the exhibit on next page: FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Cash and equivalents Corporate bonds Large-cap US stocks Small-cap US stocks International stocks Venture capital Total Exhibit: Proposed Strategic Allocations for Hart’s Investment Portfolio Allocation A B C (%) (%) (%) 15 12 55 20 15 12 25 25 10 30 28 20 20 10 100 100 100 Expected nominal after-tax return (%) Expected standard deviation (%) Sharpe ratio 7.4 9.4 0.574 11.5 14.8 0.642 8.4 10.5 0.609 D (%) 20 50 15 35 100 10.9 12.8 0.695 E Determine which allocation is most suitable for satisfying Hart’s investment objectives Justify your response with four reasons (8 minutes) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12 MINUTES The Trust Department of Granton Advisory oversees the portfolios of high net-worth private clients Sean McEwen is the department’s senior trust officer who is responsible for overseeing the accounts of five clients In the current year McEwen will be changing his investment approach and base his investment decisions on the psychographic characteristics of investors He will be applying the following models to make classify investors: i ii Barnewall Two-Way Model Bailard, Biehl, and Kaiser (BB&K) Five-Way Model A Discuss one use and one limitation of classifying investors into personality types (2 minutes) Model ‘i’ will be used to classify Sigmund Castro, one of McEwen’s clients Castro is a chief executive officer of a steel manufacturing concern owning a minority stake in the firm Castro has been responsible for the company’s stock price doubling in just less than five years His experimentation with corporate strategy has been the sole reason for the company’s success and growth in his financial wealth B Applying Model ‘I’ to classify Castro, determine: i ii the appropriate classification category and his risk tolerance relative to need for security (2 minutes) Four of McEwen’s clients have varying degrees of investment experience He will be using Model ‘ii’ to classify these clients based on excerpts obtained from client interviews Jill Marc: “The reason for becoming a stock broker is that I am confident in my intuition However, it is imperative that all my investment decisions be supported by well-reasoned economic analysis.” Stephen Dale: “I have spent many years building a solid asset base Having started with almost nothing, I cannot bear losing it to irrational decision-making.” FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Arnold Peterson: “I have to admit that there is a certain thrill to taking on risks especially when the outcome is uncertain.” Kevin Singh: “I am the most enthusiastic amongst my fellow colleagues when it comes to making investment decisions While I like to form opinions, I prefer screening my ideas by asking for assistance from an experienced individual and opting for those which are most suitable from a risk and return perspective.” C Classify each of the four clients according to Model ‘ii’ Justify your classification Answer Question 2-C in the template provided 0n page (8 minutes) FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Template for Question 2-C Classify Each of the Four Clients According to Model ‘ii’ Excerpt Justify Your Classification Marc: “The reason for becoming a stock broker is that I am confident in my intuition However, it is imperative that all my investment decisions be supported by well-reasoned economic analysis.” Dale: “I have spent many years building a solid asset base Having started with almost nothing, I cannot bear losing it to irrational decisionmaking.” Peterson: “I have to admit that there is a certain thrill to taking on risks especially when the outcome is uncertain.” FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) Singh: “I am the most enthusiastic amongst my fellow colleagues when it comes to making investment decisions While I like to form opinions, I prefer screening my ideas by asking for assistance from an experienced individual and opting for those which are most suitable from a risk and return perspective.” FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) QUESTION HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES The Walkers reside in Gratina, a country with an emerging market and currency pegged to the US dollar The couple is seeking a professional to advise them on how to transfer their $50 million investment portfolio to their daughter, Cynthia, in a tax-efficient manner They have come to Abdul Rasool, CFA, who is a tax advisor, for a solution After analyzing the couple’s portfolio, Rasool determines that stocks and bonds comprising the portfolio earn a pre-tax return of 8% and 6% respectively The asset classes are held in the proportion 80 stocks/20 bonds He also determines that the couple has an expected life expectancy of 20 years Rasool devises two alternative wealth transfer strategies both of which account for the fact that bequests are taxed at a rate of 50% Cynthia pays a marginal tax rate of 30% Current tax laws permit tax-free transfer of up to $25 million The first strategy will involve gifting the portfolio to Cynthia A Determine the after-tax value of the portfolio if the first strategy is executed Your answer should discuss whether this strategy should be recommended based on the change in the value of the investment over the investment horizon Show your calculations (6 minutes) The second strategy involves placing bonds in Cynthia’s investment account while retaining equities in the couple’s investment account Rasool proceeds with this strategy by making the necessary allocations Immediately after doing so, Rasool realizes that placing equities in Cynthia’s account will be more advantageous from a tax perspective He now sets out to determine the adjustments will be required to the investment accounts to ensure the post-tax weights are kept constant B Determine the magnitude of adjustments which Rasool will need to make to the investment accounts to ensure that the original allocation is maintained Show your calculations (12 minutes) FinQuiz.com © 2017 - All rights reserved 10 CFA Level III Mock Exam – Solutions (AM) Template for Question 6-D Determine which of the following factors supports a price decline (Circle the Answer (s)) Justify Your Response Long-term, real dividend growth Required return on equity Dividends paid FinQuiz.com © 2017 - All rights reserved 19 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 12 MINUTES Hailey Bronso is surgeon running his own medical practice He is seeking to hire an equity manager for his $1 million portfolio He prepares an equity manager questionnaire and sends it out to various investment management firms Based on the results collected, Bronso attempts to narrow his selection to firms employing the top-down forecasting approach, with a historical record of achieving excess returns relative to their benchmarks, and delegating responsibility within the organization for asset allocation and research in an appropriate manner A Identify the sections of the equity management questionnaire Bronso should pay attention to when: I II III selecting investment management firms which use the top-down forecasting approach determining the investment management firm’s capability of generating an excess returns relative to the benchmark determining how responsibility is delegated within the organization (3 minutes) After considerable research, Bronso engages North Advisory Bronso’s investment will be made in a fund with a quoted base fee rate of 0.50% of beginning AUM plus 30% of performance in excess of the Russell 3000 index B Discuss two relative strengths and two relative weaknesses of adopting a performance-fee based structure Answer Question 7-B in the template provided on page 22 (4 minutes) FinQuiz.com © 2017 - All rights reserved 20 CFA Level III Mock Exam – Solutions (AM) While Bronso enjoys a certain level of risk taking, he has expressed his desire of placing a limit on the investment manager’s ability to take risk C Identify a feature which can alleviate Bronso’s concern with respect to risktaking (1 minute) Four years later, Bronso evaluates the performance of North Advisory’s equity fund relative to the benchmark index, Russell 3,000 equity index The fund is subject to a high water mark Exhibit: Performance of the North Advisory Equity Fund Relative to the Benchmark Index Russell 3,000 Ending Net Beginning Net Index Value Asset Value* Year Asset Value (in (in Millions) (in Millions) Millions) $10.0 $13.0 $12.0 $13.0 $9.5 $11.5 $9.5 $11.0 $11.7 $11.0 $11.9 $11.2 *Gross of investment management fees D-i Determine the value of the high water-mark, gross of investment management fees, at the end of the third year D-ii Determine the amount of fees which will be received by North Advisory in the fourth year, Show your calculations (4 minutes) FinQuiz.com © 2017 - All rights reserved 21 CFA Level III Mock Exam – Solutions (AM) Template for Question 7-B Discuss two relative strengths and two relative weaknesses of adopting a performance-fee based structure Strengths: Weaknesses: FinQuiz.com © 2017 - All rights reserved 22 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS THREE PARTS (A, B, C) FOR A TOTAL OF 16 MINUTES AR Manufacturing offers a defined benefit pension plan The average age of participants covered by the plan is 35 years To finance the fund’s liabilities, the chief investment officer (CIO) has constructed a portfolio of three bond issues The duration of the portfolio has been set such that it matches that of the average liability structure Exhibit presents the initial duration of the bond portfolio from the time it was first constructed Exhibit 1: Initial Duration and Dollar Duration of Bond Portfolio Market price ($ per 100 of par Yield (%) Duration value) Issuer Holmes Inc 99.85 4.113 5.6 Theta plc 97.30 4.506 6.2 Lakehouse Corp 105.67 8.327 9.0 Dollar duration $1,083,213.705 One year after constructing the portfolio, the yield curve shifts upwards thereby decreasing the market prices of the bonds Exhibit presents the new prices of the three issues The CIO is seeking to rebalance the portfolio such that the original dollar duration is maintained Exhibit 2: Revised Duration and Dollar Duration of Bond Portfolio Market price ($ per 100 of par Issuer value) Duration Yield (%) Holmes Inc 98.30 3.420 6.6 Theta plc 96.42 3.988 7.2 Lakehouse Corp 100.05 7.589 10.0 Dollar duration $929,768.515 FinQuiz.com © 2017 - All rights reserved 23 CFA Level III Mock Exam – Solutions (AM) A Determine the cash required to rebalance the portfolio (2 minutes) Rather than investing in each of the three bond issues, the CIO devises an alternative strategy for rebalancing the portfolio, which involves selling the Lakehouse Corp issue and investing the proceeds equally in the remaining issues The par value of the Lakehouse Corp bond is $7.56 million B Determine the total par value required to maintain the hedge Show your calculations (8 minutes) The CIO recommends constructing a multiple asset portfolio to immunize the pension plan’s liability stream He attempts to determine the conditions which will be required to assure this immunization strategy (presented below): The duration of the portfolio should equal to the average age of the participants, 35 The portfolio should contain an asset with a duration equal to or less than the duration of the shortest duration liability The portfolio must be constructed to incorporate parallel and non-parallel yield curve shifts C Determine which of the stated conditions is correct Justify your response Answer Question 8-C in the template provided on page 25 (6 minutes) FinQuiz.com © 2017 - All rights reserved 24 CFA Level III Mock Exam – Solutions (AM) Template for Question 8-C Determine whether the stated condition is correct (Circle the Correct Answer) Condition The duration of the portfolio should equal to the average age of the participants, 35 Justify Your Response Correct Incorrect The portfolio should contain an asset with a duration equal to or less than the duration of the shortest duration liability The portfolio must be constructed to incorporate parallel and non-parallel yield curve shifts Correct Incorrect Correct Incorrect FinQuiz.com © 2017 - All rights reserved 25 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 14 MINUTES Twain Advisory (TA) is a U.S based firm providing brokerage and investment banking services TA manages two funds, a global equity fund and a fixed income fund The equity fund comprises highly volatile emerging market equities of two countries, Yip and Wilter, and is currently valued at $25 million The expected returns, standard deviation, correlations and weights assigned to the two stocks in the fund are summarized in the exhibit below Bolton Drew, TA’s senior most risk manager, is evaluating the loss potential of the fund in a given week He will be using a 5% probability level for the analysis Exhibit: Risk and Return Data Concerning the Global Equity Fund Yip Equities Percent invested (%) 45 Expected annual return (%) 18 Standard deviation (%) 28 Correlation - 0.15 Wilter Equities 55 25 40 A Calculate the weekly value added risk (VAR) using the analytical method and interpret your results Show your calculations Assume there are 52 weeks in a typical trading year (4 minutes) B Determine whether the analytical method is appropriate for measuring the global equity fund’s minimum potential loss Justify your answer Your answer should focus on the characteristics of the fund Answer Question 9-B in the Template provided on page 28 (4 minutes) FinQuiz.com © 2017 - All rights reserved 26 CFA Level III Mock Exam – Solutions (AM) TA’s fixed income fund includes a $10 million allocation to callable bonds Drew will again be using VAR for measuring the risk exposure associated with this allocation He is attempting to determine the probability level which should be used for estimating daily VAR His choices include a probability level of 1%, 5% or 10% C Determine which probability level is most appropriate for the allocation Justify your choice Answer Question 9-C in the Template provided on page 29 (3 minutes) TA manages the policy portfolio of Freight Inc’s defined benefit pension plan which presently reports a surplus of $600,000 The present value of the plan’s liabilities is equal to $1.5 million Based on his analysis of the fund’s risk exposures, Drew concludes, ‘Since the plan sponsor is required to fund liabilities, whose value is exposed to interest rate risk and other risks, any calculated VAR measure will be interpreted as the probability of the policy portfolio’s value falling by a minimum amount of $1.5 million.’ D Evaluate the accuracy of Drew’s conclusion Explain your answer (3 minutes) FinQuiz.com © 2017 - All rights reserved 27 CFA Level III Mock Exam – Solutions (AM) Template for Question 9-B Determine whether the analytical method is appropriate for measuring the global equity fund’s minimum potential loss (Circle the correct answer) Justify Your Answer Appropriate Inappropriate FinQuiz.com © 2017 - All rights reserved 28 CFA Level III Mock Exam – Solutions (AM) Template for Question 9-C Determine which probability level is most appropriate for the allocation (Circle the correct choice) Justify Your Answer 1% 5% 10% FinQuiz.com © 2017 - All rights reserved 29 CFA Level III Mock Exam – Solutions (AM) QUESTION 10 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 10 MINUTES Meredith Stone is a fixed-income analyst at Rust Inc The firm issued $50 million face value worth of callable bonds ten years ago which pay an annual fixed rate of 9.2% The bond issue has a remaining maturity of six years Stone does not anticipate any further decline in interest rates for at least two years and decides to eliminate the call feature, which is not exercisable for another two years, by using a European payer swaption Rust Inc is paying a credit spread of 300 basis points over the LIBOR rate on the bond issue The relevant floating rate is LIBOR A Determine the transaction which Stone will undertake to synthetically remove the call feature (2 minutes) Two years later, the swaption expires and the relevant market swap fixed rate is 5.0% Stone decides to terminate the swap by entering into a swap at the prevailing market rate and with a maturity equal to that remaining on the original swap The floating rate is equal to LIBOR B Calculate the Rust Inc.’s annual effective payment/receipt on the transaction Your answer should include a discussion on the payoffs on the original and new swap as well as payments to bondholders Show your calculations (7 minutes) Rust Inc has puttable bonds in its fixed-income portfolio In response to the unanticipated decline in market swap rates, the firm would like to remove the embedded put features C Determine how Rust Inc can synthetically remove the embedded put features (1 minute) FinQuiz.com © 2017 - All rights reserved 30 CFA Level III Mock Exam – Solutions (AM) QUESTION 11 HAS ONE PART FOR A TOTAL OF 12 MINUTES Irwin Smith is an asset advisor serving ACE Advisors, a portfolio management firm operating in Kenya Smith is reviewing the asset allocation of one of his client’s investment portfolios (Exhibit) in an attempt to determine whether any modifications are necessary in light of three projections made by the firm’s economic analyst: The projections made by ACE’s economic analyst are as follows: Projection 1: “In response to a rapidly expanding economy, the central bank is expected to tighten the monetary policy to bring inflation under control.” Projection 2: “Given the central bank’s reputation to respond slowly to changes in economic conditions, a rapidly expanding economy can be the sole cause of an unanticipated surge in inflation.” Projection 3: “A recession is the only consequence if the economy is not taken care of.” Exhibit: Asset Allocation of Smith’s Investment Portfolio Equities 49% Long-term bonds 22% Short-term bonds 15% Private equity 10% Cash and cash equivalents 4% Total 100% For each projection, determine whether allocation to the mentioned asset classes should be increased, reduced or held constant Explain your answer considering each projection in isolation Answer Question 11 in the template provided on page 32 (12 minutes) FinQuiz.com © 2017 - All rights reserved 31 CFA Level III Mock Exam – Solutions (AM) Template for Question 11 Projection “In response to a rapidly expanding economy, the central bank is expected to tighten the monetary policy to bring inflation under control.” Asset Class For Each Asset Class, Determine Whether the Allocation Should Be Increased, Reduced or Held Constant Explain Your Answer Option 1: Stocks Option 2: Bonds “Given the central bank’s reputation to respond slowly to changes in economic conditions, a rapidly expanding economy can be the sole cause for an unanticipated surge in inflation.” Option 1: Stocks Option 2: Bonds FinQuiz.com © 2017 - All rights reserved 32 CFA Level III Mock Exam – Solutions (AM) Option 1: Short-term bonds “A recession is the only consequence if the economy is not taken care of.” Option 2: Long-term Bonds FinQuiz.com © 2017 - All rights reserved 33 ...CFA Level III Mock Exam – Solutions (AM) FinQuiz. com – 6th Mock Exam 2017 (AM Session) The morning session of the 2017 Level III CFA Examination... Derivatives Portfolio Management – Monitoring and Rebalancing 31 12 18 22 24 12 16 14 10 12 Total: FinQuiz. com © 2017 - All rights reserved 180 CFA Level III Mock Exam – Solutions (AM) QUESTION HAS... in accordance with the stated before-tax real rate of return Show your calculations (6 minutes) FinQuiz. com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) B Formulate the