Level III SS & Item Set Quiz Solution (12 questions, 36 minutes) Jane Grant Case Study A is correct Since her business activity of designing clothes is not related to her investing activities at Global Assets, it does not pose any conflict of interest Hence, such a business activity need not be disclosed to her employer and clients A is correct Standard III (C) Suitability does not appear to have been violated because the fund is characterized as a high-risk investment and it is clearly stated that MiraclePro is also a highrisk investment Jane’s statement that the fund benefited from the doubling of market capitalization for MiraclePro last year is a violation of Standard I (C) Misrepresentation because the fund had only recently invested in the stock so did not benefit from the large move in the stock’s price Standard II (A) Material Nonpublic Information has also been violated by the board member who shared material nonpublic information with the fund and by the fund because it acted on the information C is correct The commission arrangement with OneLife is acceptable but needs to be disclosed C is correct Standard IV (B) Addition Compensation Arrangements is not violated Holding a competition to encourage sales is unlikely to cause a conflict of interest with the employer’s interests In order to win the award, sales representatives might be too eager to sell and could lose sight of what is best for the customer Hence, Standard III (A) Loyalty, Prudence and Care and Standard III (C) Suitability might be violated C is correct The fund management business will comply with the Code if it makes full disclosure to clients regarding any possible conflicts of interest B is correct because the Code calls for the Manager to maximize client portfolio value by seeking best execution for all client transactions If trades only go through one stockbroker, best execution cannot be assured Daniel Strife Case Study C is correct Stating that by having CFA charterholders the firm can guarantee returns is a violation of Standard I(C) Standard VII (B) is also in violation as Bob clearly exaggerates the implications of being a member or candidate of the CFA program Relating to that same standard, Bob has incorrectly identified Anton as a CFA candidate because he has not as yet enrolled in the next examination of the CFA program A is correct Daniel conforms to the requirements of Standard IV (B) as his lecturing activities has no direct relation to his work at Dyne Clearly this does not create a conflict with the employer’s interest and therefore there is no need for Daniel to obtain written permission from Dyne for his activities Bob is also not in violation of Standard II (Integrity of Capital Markets) as the Code and Standards only provide guidance for recommended procedures dealing with firewall elements The Code and Standards concede that the breath of these recommendation procedures would vary depending on the firm’s size and the type of services offered At a minimum, formal procedures relating to interdepartmental communications and the investigation of violators should be observed The code also concedes that while it is a best Copyright © IFT All rights reserved www.ift.world Page Level III SS & Item Set Quiz Solution (12 questions, 36 minutes) practice to have physical separation of departments, practical limitations must be considered A is correct According to Standard VII (B), candidates who are registered for a specific examination may refer to their participation in the CFA program as candidates However, this should be done in a manner which does not imply that a candidate has achieved some form of partial designation or cite an expected completion date for the CFA program Hence statements such as “CFA Level III candidate” and “CFA expected 2013” after ones name would be inappropriate 10 A is correct Bob is justified in asking Daniel to remove the econometric model from the report on Davidson Docks as it is not a critical component of the report’s analysis and recommendation, which is based on a top down approach and a comparison of the current relative pricing of the stock It is clear that Daniel has followed the recommended procedure for analysis and recommendation used in the past reports of Dyne and has supplemented his analysis with the econometrics model Hence the standard of Diligence and Reasonable basis has been satisfied Standard III (B) states that members and candidates must deal fairly and objectively with all clients when providing investment analysis Daniel has complied with this standard by emailing his report to all clients and thus achieving public dissemination The distribution of hard copies of his report to large clients suggests that the firm offers different levels of service which is allowed under the standards so long as this fact is disclosed to all clients 11 B is correct By stating that the source of the research is the Daily Mirror Newspaper, Paul has not followed the recommend procedures outlined in Standard I (C), Misrepresentation The research has in fact been produced by the Ministry of Tourism and is simply reported by the daily newspaper Hence the industry must be cited as a source Daniel is not in violation of Standard V (B) by presenting only a summary of his findings during the presentation Once an analyst has completed the analysis process in accordance with due diligence and reasonable basis, the member or candidate is free to decide the structure of a presentation/report and include those elements which he/she feels are important to the analysis Paul is also not in breach of the standards by not including Daniel’s name in the presentation as research done on behalf of a firm is the property of the firm 12 B is correct Bob violated the standard regarding loyalty to employer by sharing the firm’s model templates with his students without the express permission of the firm Although Daniel built the model from scratch, all work done on behalf of Dyne is the property of Dyne and by presenting Daniel with the tablet PC, Bob grants him permission to access the files on the server for his own use Bob has also violated the standard relating to preservation of confidentiality by sharing the details of the client’s portfolio with his students The standard is applicable even though the client is a former client and that the information is used purely for educational purposes as it represents a breach of the investment advisors’ fiduciary duty towards the client The responsibility of maintaining records generally falls within the purview of the firm rather than with individuals and hence Bob has not violated any requirements relating to this standard Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (12 questions, 36 minutes) Katherine Hult Case Study A is correct Conservatism bias is when an individual maintains his or her prior views by inadequately incorporating new information Mrs Wentworth believes international stocks are risky even when she is presented with new information proving that they are not Availability bias is not correct because it relates to making investment decisions based on specific events/investments that are easily recalled Mrs Wentworth does not hold this belief due to a specific event or investment B is correct Jack takes credit for successful startups but blames the failed startups on external conditions This is an example of self-attribution bias A is correct Henry doesn’t want to make a change in his portfolio, preferring to maintain it at the existing level, signaling presence of a status quo bias In addition, he’s attached to his portfolio because he inherited it from his parents This is an example of endowment bias C is correct Mental accounting bias does result in a higher risk profile but it is because total risk and correlation between assets is not considered and not because higher returns are pursued Options A and C are a consequence of mental accounting bias B is the correct answer Bounded rationality is when the assumption of perfect information is relaxed and an investor makes a decision based on available information They then use heuristics to analyze the information to arrive at a satisfactory, but not necessarily optimal, decision A is correct Friendly followers have low to moderate risk tolerance and suffer from cognitive errors They tend to overestimate their risk tolerance and want to be in the most popular investments with little regard to market conditions or how the investment fits into her overall long-term investment plan Options B and C are not correct An independent individualist does her own research and is often a contrarian while an active accumulator has high risk tolerance and is aggressive, both of which does not suit Kristie Matthews Dave Daisuke Case Study A is correct Mr Porter exhibits overconfidence bias by believing that he is smarter than everyone Overconfidence bias is a bias in which people demonstrate unwarranted faith their own reasoning and cognitive abilities C is correct Mrs Crawley does not demonstrate a mental accounting bias which is an information processing bias, in which people group their assets into numerous non-fungible mental accounts She exhibits loss aversion bias by continuing to keep securities showing losses in her portfolio and regretaversion bias in which people avoid making decisions for fear that it may cause regret later B is correct Miss Dukakis does not demonstrate the Confirmation bias which is a belief perseverance bias in which people notice what confirms their belief and ignore which contradicts their belief She has illusion of self control bias by believing she can control or influence outcomes since she knows about the technological sector and hindsight bias as she Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (12 questions, 36 minutes) sees past events as having been predictable 10 A is correct A is a consequence of representativeness bias, B is a consequence of mental accounting bias whereas C is a result of framing bias 11 C is correct Adaptive Market Hypothesis is when individuals act in their own self-interest make mistakes, and learn and adapt It is a revised version of EMH 12 A is correct Anchoring bias is an information processing bias which influences the way people estimate probabilities They envision a certain initial default number and then adjust up or down in this case the price of $420, to reflect subsequent information and analysis Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (6 questions, 18 minutes) C is correct The Smiths need USD 90,000 every year (USD 80,000 living expenses and USD 10,000 donation to charity) These will need to be fully funded from their investment portfolio Their investment portfolio consists of USD 600,000 gratuity, USD 350,000 350,000 in stocks and cash savings of USD 300,000 Their home is not included Therefore, total investable assets equal USD 1,250,000 Required return from the portfolio is USD 90,000/USD 1,250,000 = 7.2% Inflation rate is 6% so the total nominal required return retu is 7.2% + 6% = 13.2% B is correct Even though the he Smiths have a large asset base compared to their annual living expenses and their liquidity requirements are low, they have no post retirement employment income All their living expenses will need to be funded from their investment portfolio Since they want to gift an amount of USD 1,000,000 to their daughter, they will also need to maintain the real value of their portfolio Hence, the Smiths have an average risk taking ability A is correct The donations are part of their required return and not pose any specific restrictions or limitations on the portfolio They should therefore be included under the Liquidity constraint of the IPS The USD 1,000,000 1,000,000 gift and desire to give their house to cha charity are special instructions that should be listed under unique circumstances A is correct Tax exempt assets are not appropriate for tax deferred accounts In a Flat and Heavy Tax Regime, interest income is exempt Dividends and capital gains are taxe taxed at ordinary rates and are therefore, not the best choices for taxable accounts B is correct Mr and Mrs Smith’s joint survival probabilities are equal to the sum of their individual probabilities less the product of their individual probabilities, calculated calculated as follows: p(joint survival) = p(Mr Smith survives) + p(Mrs Smith survives) – p(Mr Smith survives) x p(Mrs Smith survives) For Year 3, the probability is: p(joint survival) = 0.7667 + 0.9105 – (0.7667 x 0.9105) = 0.9791 A is correct The capitalized value of their core capital spending needs equals the product of the joint probability of survival and the real spending need for each year discount using the real Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (6 questions, 18 minutes) risk-free rate The real risk-free free rate is calculated as follows: follo Real risk-free free rate = [(1 + Nominal risk-free risk rate) / (1 + Inflation rate) – 1] = (1.09/1.06 – 1) = 2.83% Expected spending is calculated by multiplying annual spending by their joint probabilities Discounted value = Expected spending / (1 + real risk-free rate)t Year Annual Spending 90,000 90,000 90,000 90,000 90,000 Total Expected Spending 89,618 89,089 88,119 87,183 85,597 Discounted Value 87,152 84,253 81,042 77,974 74,449 404,870 Mr and Mrs Smith have core capital spending needs of USD 404,870 for the next five years Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (6 questions, 18 minutes) B is correct Calculation is shown below: Spending rule = Spending rate [(MVt-1+ MVt-2+ MVt-3)/3] = 5% [(1350000 + 1300000 + 1100000)/3] = USD 62,500 C is correct Endowments should maintain their long-term purchasing power in inflation-adjusted terms and should provide stable and sustainable spending distributions/flow of income to operations Hence endowments generally use a total return approach in calculating the minimum return requirement The minimum return requirement is: the spending rate (5%) + inflation (6.5%) + administration fees (0.5%) = 12.0% For a more precise calculation the multiplicative approach can be used: 1.05 x 1.065 x 1.005 – = 12.38% A is correct An underfunded plan has less ability to take risk because of a funding shortfall The sponsor should make contributions to the pension plan; however, the ability to make contributions depends on the financial strength and profitability of the sponsor A is correct Changes in the retirees’ savings rate have no impact on the company’s pension liability C is correct A young growing workforce entails smaller liquidity requirement and longer duration of pension liabilities as opposed to an older, declining workforce Option A and B result in higher liquidity requirement because of the need to distribute benefit payments to the retirees B is correct Endowments are more able to take risk compared to non-life insurance companies Insurance companies are generally subject to higher regulation Hence, options A and C are inaccurate statements Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (6 questions, questions 18 minutes) B is correct During periods of falling inflation or deflation 1) the buying power of coupon income increases and 2) interest rates decline Hence bonds generally well The link between inflation and equity returns is complex Equity returns will depen depend on the specific industry/company and the stage of the economic lifecycle Deflation reduces the value of investments financed with debt, such as real estate, because leverage magnifies losses Of the three options, bonds are the best C is correct Early rly upswing is characterized by rising short-term short term interest rates and flat or slightly rising bond yields Late upswing is characterized by both increasing short-term short term and long long-term rates In the initial recovery phase, we can observe low or falling short-term short erm rates, and bond yields bottoming B is correct An analysis of the weighted percentage changes of the economic indicators shown in the table shows that China will be expected to achieve a higher economic growth rate (12%) relative to India (9.6%) over the next year if current trends are sustained While the negative % change for miscellaneous GDP factors should be explored further, it does not mean that there should be no investment in China or India One explanation for the negative % change could be a large amount of imports (relative to exports) of goods and supplies required to maintain the current pace of the economy of China and India C is correct According to the Grinold-Kroner Grinold model, the expected long-term term market equity return is equal to thee sum of the: 1) expected income return (dividend yield minus the percentage change in the number of shares outstanding), 2) expected nominal earnings growth return (expected long-term term inflation rate plus expected real total earnings growth rate), and 3) expected repricing return (per per period percentage change in P/E multiples) In this case: E(Re) = [1.45 – (– 0.90)] + [2.00 + 4.00] + 0.20 = 2.35 + 6.00 + 0.20 = 8.55% A is correct Data for alternative investments without liquid public markets tend to ov overly smooth return variations because they are often appraisal-based appraisal based rather than transaction transaction-based This smoothing underestimates risk and the magnitudes of correlation values B is correct Finn believes the impact of the drought will not necessarily continue in the future A time-period period bias occurs when particular relationships or sensitivities only occur during a particular period of time Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (16 questions, 48 minutes) Chris Raymond Case Scenario A is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Allocation, Section 4, LOS.b Raymond’s economic net worth is closest to $1,090,000 An economic balance sheet includes conventional financial assets and liabilities, as well as extended portfolio assets and liabilities that are relevant in making asset allocation decisions The economic balance sheet for Raymond is shown in the following exhibit Assets Financial Assets Equity investments $650,000 Fixed income $250,000 investments Real estate $300,000 Liabilities and Net Worth Financial Liabilities Mortgage debt $165,000 Extended Assets Human capital Extended Liabilities PV of consumption Overseas vacation expense Gift to niece Total Economic Liabilities $845,000 $170,000 $300,000 $1,480,000 Economic Net Worth $1,090,000 Total Economic Assets $1,370,000 $2,570,000 Economic net worth is equal to total economic assets minus total economic liabilities ($2,570,000 – $1,480,000 = $1,090,000) A is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Allocation, Section 4, LOS.b Raymond’s equity portfolio is heavily concentrated in energy sector stocks (75% of the equity portfolio) Raymond works in energy sector, i.e at RE If the energy sector faces an economic downturn, both his investments and his human capital are likely to be adversely affected Therefore, his investment in energy stocks should be reviewed and his equity portfolio diversified further For example, investing more of his financial capital into sectors like health care or telecommunications, could offer diversification and help him better manage the overall risks of his investment portfolio C is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (16 questions, 48 minutes) Allocation, Section 5.3, LOS.e In order to effectively specify asset classes for the purpose of asset allocation, assets within an asset class should be relatively homogeneous and have similar attributes Since U.S equities form a major part of world equities, so the specification does not meet the criterion that asset classes should be mutually exclusive The specification of the equity asset class also includes real estate This definition results in a non-homogeneous asset class C is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Allocation, Section 5.3, LOS.f Fact is incorrect: Risk factors are associated with non-diversifiable (i.e systematic) risk Fact is incorrect: To achieve exposure to inflation, one can go long on nominal Treasuries and gp short on inflation-linked bonds B is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Allocation, Section 6.3, LOS c,d,g Portfolio best meets Raymond’s goal for overseas vacation The estimated present value of the Raymond’s expected vacation expense is $170,000 Given that the goal has short time horizon (to be incurred within next year) and Raymond has a very strong desire to achieve this goal, Portfolio 2, which stresses liquidity and stability, is most appropriate to meet Raymond’s short-term goal A is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Allocation, Section 6.3, LOS c,d,g Portfolio best meets Raymond’s goal to fund gift payment in 25 years In present value terms, the gift is valued at $300,000, with Raymond desiring a high probability of achieving this goal Although slightly more conservative than the 75/25 global equity/bond mix, Portfolio has a greater growth emphasis compared with Portfolios and Therefore, Portfolio is best for funding gift payment given the goal’s long-term horizon and Raymond’s desire for a high probability of achieving it C is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Allocation, Section 8.2, LOS j Using the cost–benefit approach, lower transaction costs for an asset class imply narrower rebalancing ranges Daniel’s recommendation for a narrower rebalancing range for global Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (16 questions, 48 minutes) The most conservative mix for the surplus efficient frontier consists mostly of the US corporate bond index (the hedging asset) because it results in the lowest volatility of surplus In contrast, the most conservative mix for the asset-only efficient frontier consists chiefly of cash 14 C is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 17, Principles of Asset Allocation, Section 2.6, LOS.e US large growth contributes the highest risk to the portfolio in absolute terms as it has the highest ACTR as calculated below Asset Class Weight Beta Expected return US Large Value 30% 1.276 6.30% US Large Growth 30% 2.294 6.76% US Bonds 40% -0.176 5% MCTR (Asset beta relative to portfolio × Portfolio standard deviation) 1.276*6.7 % = 8.55% 2.294 * 6.7% = 15.37% 0.176*6.7 % = -1.18 ACTR (Asset weight in portfolio × MCTR) 30%*8.55% = 2.56% 30% * 15.3698% = 4.61% 40% * 1.1792 = 0.47 6.7% Ratio of Excess return Percentage to contributio MCTR n to total = standard (Expect deviation = ed ACTR / return Total risk – Riskfree rate)/M CTR 38% 0.44 69% 0.28 -7% -2.12 100% 15 B is correct Reference: CFA Level III, Volume III, Study Session 8, Reading 17, Principles of Asset Allocation, Section 2.6, LOS.e An asset allocation is optimal when the ratio of excess return (over the risk-free rate) to MCTR is the same for all assets, which in this case is not the same Hence, asset allocation is not optimal 16 A is correct Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (16 questions, 48 minutes) Reference: CFA Level III, Volume III, Study Session 8, Reading 17, Principles of Asset Allocation, Section 6, LOS.o Increased transaction costs point to widening the tolerance band for domestic fixed income; increasing correlation also point to widening it The overall effect is widening of tolerance band Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (6 questions, 18 minutes) B is correct The firm is long in ARS and hence must sell it forward against the USD, which means buying USD, base currency in the ARS/USD quote The offer side of the market must be used The all-in rate one month ago would have been 8.6439 + ( 895/10,000) = 8.7334 C is correct To rebalance the hedge, the firm must reduce the size of the hedge, as the foreign investment went down in ARS value Selling forward is incorrect because it will increase the size of the hedge B is correct To implement the hedge Bernstein & Goldberg must sell ARS forward against the USD or equivalently buy USD (the base currency in the P/B quote) against ARS The base currency is selling forward at a premium, and all else equal its price would “roll down the curve” as contract maturity approached Settling the contract is selling USD spot at lower prices, hence defining a negative roll yield A is correct Expected domestic currency return for the Australian asset is: RDC = (1+ RFC)(1 + RFX) -1 = (1.05)(1.04) – = 9.2% Expected domestic currency return for the German asset is: RDC = (1+ RFC)(1 + RFX) -1 = (1.03)(1.04) – = 7.12% Expected domestic-currency return for the portfolio = 0.5*0.092 + 0.5*0.0712 = 8.16 B is correct RFX is a random variable as it is not known in advance The RFC term is constant and known in advance as the T-Bill rate Using the statistical rule (kX) = k(X) where X is a random variable and k is a constant and the fact that the correlation between the random variable and constant is zero we concluded that only the risk on the currency side is relevant The firm does not need to consider the correlation between the exchange rate movements and the foreign currency asset returns The expected risk of the domestic currency return for the Australian asset is (1.05) x 8% = 8.4% The expected risk of the domestic currency return for the German asset = (1.03) x 6% = 6.2% 2(RDC) = (0.5)2 (8.4%)2 + (0.5)2(6.2%)2 + 2(0.5)(8.4%)(0.50(6.2%)(0.5) = 0.004027 (RDC) = 0.063 = 6.3% C is correct A disadvantage of the fundamental-weighted index is that it reflects the creator’s view of valuation which may not be correct It would not serve as a valid benchmark for investors preferring a large-cap or growth emphasis since it’s tilted towards small-cap value stocks Copyright © IFT All rights reserved www.ift.world Page Level III SS 10 Item Set Quiz Solution (6 questions, 18 minutes) B is correct The total expected return is calculated as: Total expected return = Rolling yield + E(Change in price based on investor’s yield and yield spread view) – E(Credit losses) + E(Currency gains or losses) Rolling yield = Yield income + Rolldown return Yield income Annual coupon payment/Current bond price + Rolldown (𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝐸𝑛𝑑−𝑜𝑓−ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 − 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 ) 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 return = Rolling yield + E(Change in price based on investor’s yield and yield spread view) Yield income + Rolldown return [–MD × ΔYield] + [1/2 × Convexity × (Yield)2] – E(Credit losses) + E(Currency gains or losses) = Total expected return $2.50/$97.50 = 2.564% (97.68 − 97.50 97.50 = 0.1846% 2.56% + 0.18% = 2.74% [−4.72 × 0.0020] + [ × 0.20 × (0.0020)2 ] Given = −0.94396% -0.10% Given 0.78% 2.48% Section 5.1 LO.d Introduction to Fixed-Income Portfolio Management C is correct The domestic bond portfolio’s return objective is to track the benchmark Its risk factors (duration, credit risk etc.) are to closely match the benchmark Small deviations in sector weights are allowed, and tracking error should be close to zero These features are typical of pure indexing Section 3.2.1 LO.b Introduction to Fixed-Income Portfolio Management A is correct The IC committee is recommending that the domestic bond portfolio’s return objective is to a modest outperformance relative to the benchmark Its allowing mismatches in sector or quality risk factors, but duration is to closely match the benchmark Small deviations in sector weights are allowed, and tracking error should be less than 50bps per year These features are typical of enhanced indexing Section 3.2.2 LO.b Introduction to Fixed-Income Portfolio Management A is correct Inflation-indexed bonds (Alternative 2) provide inflation protection for the interest income and the principal because they pay a return that is linked to an index of consumer prices and adjusting for inflation The purchase of fixed-coupon bonds as suggested in Alternative provides no protection against inflation for either interest or principal Alternative is however superior to Alternative in providing better diversification because of lower correlation Section Copyright © IFT All rights reserved www.ift.world Page Level III SS 10 Item Set Quiz Solution (6 questions, 18 minutes) LO.a Introduction to Fixed-Income Portfolio Management B is correct Cash flow matching is an immunization approach which is the simplest as it requires no assumptions and matches a liability stream and a stream of cash inflows This approach, unlike duration matching attempts to ensure that all future liability payouts are matched precisely by cash flows from bonds Rebalancing is not required but often necessary Approach is correctly stated Section 3.1 LO.b Introduction to Fixed-Income Portfolio Management A is correct The optimal strategy for PWEPF is the sale of 100% of Bond A, because it is considered by Dunford to be overvalued PWEPF is a tax-exempt client, therefore tax considerations are not relevant Section LO.f Introduction to Fixed-Income Portfolio Management Copyright © IFT All rights reserved www.ift.world Page Level III SS11 Item Set Quiz Solution (6 questions, 18 minutes) C is correct High-yield bonds are more sensitive to credit risk than interest rate risk as compared to investment-grade bonds This is because there is typically negative correlation between risk-free rates and credit spreads When risk-free rates rise (economy is on a growth trend) they tend to generate smaller changes in corporate bond yields and have a more reduced effect on securities with high credit risk and large credit spreads—that is, bonds with comparatively large credit spreads have less sensitivity to interest rate changes than bonds with smaller credit spreads Because investment-grade corporate bonds have meaningful interest rate sensitivity, investment-grade portfolio managers focus on portfolio durations and yield curve exposures as compared to high-yield portfolio managers Section 2.3 LO.a Fixed-Income Active Management: Credit Strategies B is correct The G-spread is the spread over an actual or interpolated government bond whereas the I-spread, also an interpolated spread, and similar to the G-spread uses swap rates instead of government yields Both spreads are used for estimating yields and prices of option-free bonds If the market perceives credit risk in either a country’s government bonds or its banks, then yields on government bonds or interbank rates will not be a useful representation of the risk-free rate and thus G-spread and I-spread will not be helpful Section 3.1 LO.b Fixed-Income Active Management: Credit Strategies A is correct The Britta Industries’ bond is trading at 103, significantly above the price at which it can be called, therefore there is a high probability of the bond being called on the next call date The bond’s OAS of 295 bps is lower than its G-spread, I-spread, or Z-spread because of the call option on the bond The difference between the OAS and the other spread measures implies that the value of the call option is about 65 bps The option-adjusted spread is the best measure of for bonds with embedded options compared with the other spread measures because it reflects the value of the embedded option Section 3.1 LO.b Fixed-Income Active Management: Credit Strategies C is correct For issuers with different credit-related risk, an investor has to decide if the additional spread is sufficient to compensate for the additional credit risk taken Therefore when comparing issuers with different credit-related risks one of the important considerations is the historical default rate information based on credit rating categories Section 4.1 LO.c FixedIncome Active Management: Credit Strategies Fixed-Income Active Management: Credit Strategies B is correct Bond Y has a higher credit spread relative to the other bonds Therefore, Ali should investigate the cause(s) of this difference before including it in the relative value analysis The higher coupon and lower credit rating suggest that it is riskier than the other bonds Bond Y may be subordinated in the company’s capital structure Bond Y’s smaller issue size suggests that the bond may be less liquid than the company’s other bonds Finally, its higher price of 110 means perhaps a larger loss in the event of default Given these features, it seems unsuitable to include Bond Y in the relative value analysis Section 4.1.2.-4.1.4 LO.c C is correct Spread sensitivity is the widening of credit spreads due to large withdrawals by investors from credit funds Spread sensitivity can be measured as the spread widening (in basis points) divided by the percentage outflow from high-yield funds (funds withdrawn divided by Copyright © IFT All rights reserved www.ift.world Page Level III SS11 Item Set Quiz Solution (6 questions, 18 minutes) assets under management) A decrease in the spread sensitivity to fund outflows would likely indicate an increase in liquidity A & B will decrease liquidity Section 5.1 LO.e Fixed-Income Active Management: Credit Strategies Copyright © IFT All rights reserved www.ift.world Page SS 11 Itemset et Quiz Solution (6 Questions, 18 minutes) A is correct because a large portion of the portfolio is invested in a manager who is expected to match the portfolio’s benchmark (zero alpha, zero tracking error), forming the core of the portfolio A is correct because the expected alpha of the portfolio is: (150/200 x 0%) + (30 (30/200 x 1.75%) + (20/200 x 2.50%) = 0.5125% which is greater than 0.50% 0.50% The expected tracking error is: [(150/200 x 2 0.5 0%) + (30/200 x 2.50%) + (20/200 x 3.75%) ] = 0.53% which is less than 0.75% B is correct A portable alpha strategy seeks an alpha return on top of systematic risk exposures In this case an investment in the Russell 1000 represents the systematic (beta) risk exposure The clientt will look for alpha returns from the market-neutral market long-short short strategy with UK equities A is correct because valuation-level level sell disciplines are rule driven A is correct because “misfit” active return is equal to the return of the manager’s normal benchmark minus the return of the investor’s benchmark 0.6% = 12.1% - 11.5%, where 12.1% is the return on the S&P 500 and 11.5% is the return on the MSCI U.S Index C is correct Full replication can be accomplished inexpensively This is because ause there are only a few stocks,, and all components of S&P 500 are very liquid The other two approaches will be more expensive in comparison Copyright © IFT All rights reserved www.ift.world Page Level III SS 13 Item Set Quiz Solution (6 questions, 18 minutes) C is correct The Sharpe ratio is probably not applicable to hedge funds because it assumes the returns are normally distributed and not serially correlated Another problem is that the Sharpe ratio is a stand-alone measure and does not consider the diversification that the hedge fund can add to a portfolio A is correct Direct investment in real estate is relatively illiquid The transaction costs are high compared to to indirect investments in real estate (REITs) and the correlation with stocks is lower C is correct The high water mark is a specified net asset value level that a fund must exceed before performance/incentive fees are paid to the hedge fund manager Once the first incentive fee has been paid, the highest month end NAV establishes a high water mark A is correct The incentive fee applies to the difference between the ending period net asset value and the net assets at the high water mark, not to the entire amount under management Five years is an exceedingly long lock-up period during which investors will not be able to withdraw any funds C is correct Survivorship bias and backfill bias can both cause historical returns to be overstated as managers can choose to report only returns of successful funds Stale price bias arises from infrequent trading and can cause measured standard deviation to be over or understated, depending on the time period being studied B is correct Value weighting may result in a particular index taking on the return characteristics of the best performing hedge funds in a particular time period The second statement is incorrect as the transaction costs make it difficult to rebalance an equally weighted index Copyright © IFT All rights reserved www.ift.world Page Level III SS 14 Item Set Quiz Solution (6 questions, 18 minutes) C is correct Enterprise level risk estimates allow a company to recognize the offsetting nature of distinct exposures that an enterprise might assume in its day to day operations In ERM, an organization is able to consider each risk factor to which it is exposed to, both in isolation and in terms of any interplay among them ERM is a feature of centralized risk management systems only B is correct Interest rate risk is considered a financial risk whereas model and settlement risk are a source of non-financial risk B is correct Value at risk (VAR) is an estimate of the loss (in money terms) that we expect to be exceeded with a given level of probability over a specified time period Therefore, it measures a minimum loss That is why the correct interpretation is that there is a 5% chance that the portfolio will lose at least €14 million B is correct The correlation between both investment strategies is low which will create a diversification benefit Therefore, the combined VAR of the two strategies should be lower than the sum of VARs of individual desks (€16 million) B is correct VAR often underestimates the magnitude and frequency of the worst returns, although this problem often derives from erroneous assumptions and models Limitation and are correct C is correct When the mark-to-market value is positive to FFS, the counter party needs to make the payment Copyright © IFT All rights reserved www.ift.world Page Level III SS 15 Item Set Quiz Solution (6 Questions, 18 minutes) A is correct Jerry is correct about covered calls and protective puts C is correct Collar strategy, which is a directional strategy; that is, its performance is dependent on the direction of the movement of the underlying (in this instance, the S&P 500 Index) The performance of butterfly spread strategy and straddle strategy are based on the expected volatility of the S&P 500 Index B is correct because the total value of the portfolio is USD 60 million and the 35% target allocation to bonds would be USD 21 million, but the current allocation is USD 30 million or USD million more In order to correct this, the equivalent of USD million in bonds with duration of 4.50 must be sold using bond futures and then converted to equity exposure with a 1.15 beta using stock futures The number of bond futures contracts to be sold (shorted) is Nbf = (MDURT – MDURB)/MDURf x (B/ fB) Where, MDURT is the target modified duration (0.25 for cash), MDURB is the current bond portfolio duration (4.50), MDURf is the modified duration of the futures contract (6.50), B is the value of the bonds being converted to cash (USD million), fB is the price of one bond futures contract (USD 450,000) Therefore, the number of contracts is: Nbf = (0.25 – 4.50)/6.50 x (9,000,000/450,000) = -13.076 or sell 13 bond futures contracts B is correct because the total value of the portfolio is USD 60 million and the 65% target allocation to equity would be USD 39 million, but the current allocation is USD 30 million or USD million less In order to correct this, the equivalent of USD million in bonds with duration of 4.50 must be sold using bond futures (converted to synthetic cash) and then converted to equity exposure with a 1.15 beta using stock futures The number of equity futures contracts to be bought is: Nsf = (βT – βB)/ βf x (S/ fS) Where, βT is the target beta (1.15), βS is the beta of the synthetic cash position (0), βf is the beta of the futures contract (1.05), S is the value of the stock being created from the synthetic cash position (USD million), fS is the price of one equity futures contract (USD 150,000) Therefore, the number of contracts is: Nsf = (1.15 – 0)/1.05 x (9,000,000/150,000) = 65.71 or buy 66 equity contracts B is correct B is correct because a pay-fixed (receive-floating) position in an interest rate swap is similar to issuing a fixed-rate bond and buying a floating-rate bond with the proceeds The Copyright © IFT All rights reserved www.ift.world Page Level III SS 15 Item Set Quiz Solution (6 Questions, 18 minutes) duration of the fixed-rate bond is approximately 75% of the maturity, and the swap is short this duration The duration of the floating-rate bond is approximately half its repricing frequency, and the swap is long this duration Therefore, the duration of the 3-year swap with semi-annual payments is (0.5 × 0.5) – (0.75 × 3) = –2.00 B is correct Statement I is correct Statement II is incorrect Given that the original swap is pay fixed receive floating he should enter into a receiver swaption Copyright © IFT All rights reserved www.ift.world Page Level III SS 16 Item Set Quiz Solution (6 Questions, 18 minutes) C is correct The CPPI strategy dynamically provides a floor to the portfolio value, consistent with Kate’s objectives In addition, when equities are trading up, CPPI will buy equities, constant mix will sell equities and buy-and-hold will make no transactions The greater investment in equities with CPPI allows Kate to minimize exposure to risk-free securities in rising equity markets, consistent with her objectives C is correct The trade is not urgent Harriet has six months to liquidate the Habib Mills position Habib Mills shares are held by institutions and crossing networks mainly serve institutional investors Anonymity is important since, the shares to be liquidated represent 150% of Habib Mill’s average daily volume B is correct Harriet is anticipating that the press conference scheduled for the next day will diminish the value of the information she currently possesses As such, she must buy the shares quickly A market order is appropriate because it emphasizes the immediacy of execution In addition, the market for D-Link Systems stock is liquid and can absorb a large order without a significant price impact A market order will be less obvious and disguise her trading intentions A is Correct Missed trade opportunity cost reflects the difference between the trade cancellation price and the original benchmark price based on the amount of the order that was not filled, or: % unfilled × (difference between new closing price and benchmark price/ benchmark price) = 14,000/20,000 × ((15.25 – 15.00)/15.00 ) = 0.70 × 0.016667 = 0011667 or 1.1667% or 117 basis points B is correct CHC is unsuitable because urgency to complete trade is high making VWAP unsuitable For ACM, the size of the order represents a high percentage of the average daily volume and the VWAP algorithm would not have high likelihood of success A is correct Implementation shortfall is best suited to trades that are urgent CHC has a high urgency to trade and the order size is a small proportion of the average daily volume ADI’s trade size is a large proportion of the average daily volume and hence, implementation shortfall will not be suitable for the trade Both CMI and ADI have higher volumes towards end of the day which would make front-loaded implementation shortfall strategies less suitable In addition, CMI has a low urgency to trade which makes implementation shortfall less suitable Copyright © IFT All rights reserved www.ift.world Page Level III SS 17 Item Set Quiz Solution (6 Questions, 18 minutes) B is correct Pure energy sector allocation = [(0.0850 - 0.0750) x (3.50% - 2.50%)] = 0.01% This shows that the decision to overweight a sector that performed better than the overall benchmark resulted in a positive contribution to portfolio performance A is correct Agriculture sector within-sector allocation return = 1350 x (1.50% - 1.25%) = +0.03375% The positive contribution shows that Jonathan’s portfolio held agriculture stocks that performed better than the agriculture stocks contained in the sector benchmark C is correct Pharmaceutical sector allocation/selection interaction return = [(0.18 - 0.21) x (3.50% - 3.25%)] = - 0.0075% The negative contribution is a result of underweighting the portfolio in the pharmaceutical sector when the fund performed better than the sector benchmark A is correct Calculate rates of return for each sub-period as shown below: Sub-period (days 1-11) Return 1= [($ 1,200,000 - $ 50,000) - $ 1,100,000] / $ 1,100,000 = 0.0455 Sub-period (days 12-17) Return = [($ 1,270,000 - $ 20,000) - $ 1,200,000] / $ 1,200,000 = 0.0417 Sub-period (days 18-30) Return = ($1,300,000 - $ 1,270,000) / $ 1,270,000 = 0.0236 Compounding the returns together to calculate an overall time-weighted rate of return: TWRR = (1 + 0.0455)(1 + 0.0417)(1 + 0.0236) - = 0.1148 = 11.48% A is correct A median manager benchmark fails all the tests of benchmark validity except for being measurable C is correct Sharpe Ratio for Juncker = (2.5 – 0.3)/1.2 = 1.83 Sharpe Ratio for benchmark = (2.6 – 0.3)/1.4 = 1.64 Hence Juncker portfolio has a higher Sharpe Ratio indicating a superior-risk adjusted performance relative to the benchmark portfolio Treynor Measure for Juncker = Treynor Measure for Benchmark = (2.5 – 0.3)/0.8 = 2.75 (2.6 – 0.3)/0.8 = 2.88 The Juncker portfolio has a lower Treynor Measure indicating an inferior risk-adjusted performance The Sharpe Ratio and Treynor Measure offer conflicting conclusions about the performance of the Juncker portfolio relative to the benchmark portfolio Copyright © IFT All rights reserved www.ift.world Page Level III SS 18 Item Set Solution B is correct GIPS standards require the use of fair value for portfolio valuations A is correct If local laws or regulations related to valuation conflict with the GIPS, firms are required to follow the local laws or regulations and disclose the conflict C is correct Standard 2.A.4 states that all returns must be calculated after the deduction of the actual trading expenses incurred during the period Estimated trading expenses are not permitted C is correct Standard 3.A l states that all actual fee-paying discretionary portfolios must be included in at least one composite Although non-fee-paying discretionary portfolios may be included in a composite (with appropriate disclosures), nondiscretionary portfolios must not be included in a firm's composites B is correct According to Standard 3.A.1, a client may place significant constraints on the manager; for instance, the investment policy statement (IPS) may specify limits on sectors, credit ratings, durations, et cetera Furthermore, there may be total restrictions on certain transactions, such as the purchase of "unethical" or foreign investments, or the sale of specified stocks These restrictions not automatically remove the discretionary nature of the portfolio C is correct Standard 5.A.4 states that returns of portfolios and composites for periods of less than one year must not be annualized Copyright © IFT All rights reserved www.ift.world Page ...Level III SS & Item Set Quiz Solution (12 questions, 36 minutes) practice to have physical separation of departments, practical limitations... rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (16 questions, 48 minutes) Chris Raymond Case Scenario A is correct Reference: CFA Level III, Volume III, Study Session 8, Reading... correct Reference: CFA Level III, Volume III, Study Session 8, Reading 16, Introduction to Asset Copyright © IFT All rights reserved www.ift.world Page Level III SS Item Set Quiz Solution (16 questions,