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) Solutions for Question A Solution Hart’s salary covers her living expenses during her employment term Her return objective should be solely towards saving for her retirement given that her salary is not sufficient to generate savings Hart should focus on preserving the purchasing power of her portfolio by ensuring growth of her financial wealth at the annual rate of inflation each year until retirement McCollum also needs to incorporate the fact that Hart’s living expenses will be reduced by 20% upon retirement To maintain her stated retirement lifestyle she must accumulate $414,468.40 [$350,000 × 0.8 × (1.04)10] in annual inflation-adjusted income over the next ten years If she employs the inheritance amount and is able to earn an after-tax nominal return of 5.69% = [1+ 0.025(1 – 0.35)] × [1.04] – 1, Hart will be able to accumulate $5,217,473.28 ($3,000,000 × 1.056910) Therefore to generate $414,468.40 on $5,217,473.28, a return of 7.94% is needed Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS g B Solution Hart’s overall risk tolerance can be characterized as average to below average This is due to a below average willingness and above average ability: • • Ability to tolerate risk is above average as Hart has a long-term horizon, minimal demands on portfolio liquidity, and she has received $3 million in inheritance Willingness to tolerate risk is below average based on her two statements She dislikes portfolio losses and wants to limit the decline in portfolio value to 15% Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS g FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) C Solution i ii iii Time horizon: Hart’s time horizon can be described as long-term, multi-stage The first stage ends with her retirement and is ten years long The length of the second stage depends on her life expectancy and will most likely be long-term given that she is in excellent health Liquidity: Given that Hart’s current living expenses are covered by her salary, her requirement for liquidity is minimal Taxes: Hart’s salary will be taxed at a rate of 35% per annum Other than this, she has no taxable concerns which demand her attention Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS i D Solution i ii Based on the principles of behavioral finance, Hart’s first statement demonstrates that she holds biased expectations This is because she is overestimating the private equity (venture capital) investment’s representativeness as an alternative asset class Other alternative investments such as commodity investments not require long lock-up periods and are not associated with start-up losses which are otherwise typical of venture capital funds Hart is a cautious investor as both her statements highlight her aversion to portfolio losses and desire to avoid an asset class with a high loss potential Consequences of this personality type include: • • • Missing out on investment opportunities because of over analysis or fear of taking investment action Portfolios with low turnover Portfolios with low volatility Reference: CFA Level III, Volume 2, Study Session 4, Reading 8, LOS b FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (AM) E Solution Allocation C is the most appropriate Marks will be rewarded for any four of the five reasons presented: • • • • • Out of the four allocations, Allocation C includes a higher allocation to equities which is necessary given Hart’s requirement to preserve the purchasing power of her portfolio and grow her portfolio at the rate of inflation Allocation A has included a much higher allocation to corporate bonds than required Although Allocations B and C propose similar holdings of total equity, 75% and 73% respectively, B is inappropriate because it includes a prohibited alternative asset class – direct real estate Allocation C has a Sharpe ratio higher than Allocation A which does not contain a prohibited asset class Allocation D has the highest Sharpe ratio followed by Allocation B; however, both allocations are inappropriate as they include the prohibited asset class The expected nominal return exceeds the after-tax nominal return requirement of 7.94% The worst-case return, portfolio return which is two standard deviations below the mean, is – 12.6% [8.4% - 2(10.5%)] and is higher than the stated – 15% Reference: CFA Level III, Volume 3, Study Session 8, Reading 17, LOS r 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 10 CFA Level III Mock Exam – Solutions (AM) C Solution 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 Correct 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 Correct Incorrect Correct Incorrect Incorrect Justify Your Response To immunize a stream of liabilities, it is necessary for the portfolio duration to match the weighted average of the liability duration The average age of the plan participants, 35, represents the weighted average liability duration A condition of multiple liability immunization is that the distribution of durations of individual portfolio assets must have a wider range than the distribution of the liabilities The three conditions of multiple liability immunization assure immunization against parallel shifts only Reference: CFA Level III, Volume 4, Study Session 10, Reading 20, LOS l FinQuiz.com © 2017 - All rights reserved 45 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 46 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 47 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 48 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 49 CFA Level III Mock Exam – Solutions (AM) Question Solutions A Solution Firstly, the fund’s expected annual return and standard deviation will need to be calculated Equity fund’s expected annual return = 0.45(18%) + 0.55(25%) = 21.85% Weekly expected return = 0.2185/52 = 0.004202 Equity fund’s standard deviation = [(0.45)2(0.28)2 + (0.55)2(0.40)2 + 2(0.45)(0.55)(0.28)(0.40)(- 0.15)]0.5 = 0.236559 Weekly expected standard deviation = 0.236559/(52)0.5 = 0.032805 Weekly VAR = 0.004202 – 1.65(0.032805) = - 0.049926 Given the fund value of $25 million, the weekly VAR is $25,000,000 × 0.049926 = $1,248,150 Interpretation: The weekly VAR figure is interpreted as a 5% probability that a portfolio will lose at least $1,248,150 in a single week Reference: CFA Level III, Volume 5, Study Session 14, Reading 25, LOS f FinQuiz.com © 2017 - All rights reserved 50 CFA Level III Mock Exam – Solutions (AM) B Solution Determine whether the analytical method is appropriate for measuring the global equity fund’s minimum potential loss (Circle the correct answer) Justify Your Answer Based on the facts presented, the return distribution of the fund is extremely volatile Therefore, it would not be uncommon for the return distribution to be characterized by fat tails (Expected market declines which are larger than predicted by a normal distribution) Appropriate Inappropriate Inappropriate Using a VAR measure which assumes a normal distribution, such as the analytical method, will understate the magnitude and frequency of large losses associated with the volatile return distribution of fund equities Reference: CFA Level III, Volume 5, Study Session 14, Reading 25, LOS f FinQuiz.com © 2017 - All rights reserved 51 CFA Level III Mock Exam – Solutions (AM) C Solution Determine which probability level is most appropriate for the allocation (Circle the correct choice) 1% 1% 5% 10% Justify Your Answer For portfolios with optionality risks, such as the callable bond allocation in TA’s fixed income fund, a more conservative probability threshold is more appropriate This would correspond to a 1% probability level Lowering the probability will capture the losses in the tails of the asset class return distribution Reference: CFA Level III, Volume 5, Study Session 14, Reading 25, LOS e D Solution Drew is incorrect with respect to his conclusion VAR methodologies should be applied to the surplus and neither the assets nor liabilities; this is because increasing the amount of surplus will increase the fund’s ability to take risks (assuming all else is held constant) It is precisely this risk position that VAR is designed to measure Therefore, VAR methodologies will treat the liabilities as a portfolio of short securities and calculate VAR on the net position Reference: CFA Level III, Volume 5, Study Session 14, Reading 25, LOS f FinQuiz.com © 2017 - All rights reserved 52 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 53 CFA Level III Mock Exam – Solutions (AM) Question 10 Solutions A Solution To remove the call feature, Stone should sell a × annual-paying receiver swaption with a fixed rate of 6.2% (9.2% - 3.0%) Reference: CFA Level III, Volume 5, Study Session 15, Reading 28, LOS h B Solution Given that the market rate on the underlying swap has declined, the original callable bond issue will be called and the option embedded in the receiver swaption exercised The original callable issue will be called and a new bond issued Interest payments of $4,000,000 = $50,000,000(0.05 + 0.03) will be made annually for the next four years Rust Inc is required to annually pay $3,100,000 ($50,000,000 × 0.062) and receive LIBOR on the original swap To offset the original swap, Rust Inc will need to buy a receiver swaption at a rate of 5.0% Rust Inc will annually pay LIBOR and receive $2,500,000 ($50,000,000 × 0.05) on the new swap The LIBOR payments will cancel out and Rust Inc will effectively be paying an amount of $4,600,000 ($4,000,000 + $3,100,000 - $2,500,000) or an effective rate of 9.2% ($4,600,000/$50,000,000) which is equal to that of a noncallable bond Reference: CFA Level III, Volume 5, Study Session 15, Reading 28, LOS h C Solution Removing the put feature will require an instrument which is identical to put options in terms of payoffs Therefore, Rust Inc will need to buy payer swaptions to synthetically remove the embedded put feature Reference: CFA Level III, Volume 5, Study Session 15, Reading 28, LOS h FinQuiz.com © 2017 - All rights reserved 54 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 55 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 56 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 57 CFA Level III Mock Exam – Solutions (AM) Question 11 Solution Projection “In response to a rapidly expanding economy, the central bank is expected to tighten the monetary policy to bring inflation under control.” “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.” Asset Class For Each Asset Class, Indicate Whether the Allocation Should Be Increased, Reduced or Held Constant in Light of the Projection Option 1: Stocks Decreased Option 2: Bonds Increased Option 1: Stocks Decreased Option 2: Bonds Decreased Explain Your Selection A restrictive monetary policy will put an upward pressure on bond yields favoring an investment in this asset class However, the discount rate is increased which will put a downward pressure of stock prices When inflation rises beyond expectations, real bond investors face a cut in real yields As nominal yields rise to counteract this loss, bond prices fall Therefore, the bond allocation should be reduced to minimize losses The equity allocation should be reduced as unanticipated inflation will reduce the real earnings of businesses which in turn can cause investors to sell FinQuiz.com © 2017 - All rights reserved 58 CFA Level III Mock Exam – Solutions (AM) their holdings An increase in the number of shares being sold will lead to a drop in share price “A recession is the only consequence if the economy is not taken care of.” Option 1: Short-term bonds Option 2: Long-term Bonds Decrease Increase During a recession, the yield curve slopes steeply upwards as the premium on long-term bonds exceeds that of short-term bonds In such a scenario, an investor should look to increasing allocation to long-term bonds and reduce allocation to short-term bonds as the yield premium on the former will be higher due to the countercyclical nature of the premium on longterm bonds On the other hand, shortterm yields tend to be procyclical because central banks lower short-term term rates to stimulate the economy during recession reducing the yield for investors in this asset class Reference: CFA Level III, Volume 6, Study Session 16, Reading 30, LOS b FinQuiz.com © 2017 - All rights reserved 59 ...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