Level III 2018 IFT mock exams sample

2018 Level III Mocks 2018 CFA® Exam Prep IFT Mock Exams Level III Document Version: 1.5 Publish Date: May 13, 2018 Errata information can be found at: https://goo.gl/UVXdAv This document should be used in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analystđ are trademarks owned by CFA Institute â IFT All rights reserved 2018 Level III Mocks Table of Contents Exam Morning Session Exam Afternoon Session 60 Exam Morning Session 88 Exam Afternoon Session 140 Exam Morning Session 165 Exam Afternoon Session 205 Exam Morning Session Solutions 228 Exam Afternoon Session Solutions 262 Exam Morning Session Solutions 276 Exam Afternoon Session Solutions 302 Exam Morning Session Solutions 314 Exam Afternoon Session Solutions 336 © IFT All rights reserved 2018 Level III Mocks Exam Morning Session Exam Morning Session Questions Topic Minutes Portfolio Management – Behavioral 10 Portfolio Management – Individual 25 Portfolio Management – Individual 15 Portfolio Management – Institutional 17 Portfolio Management – Institutional 18 Portfolio Management – Individual 18 Portfolio Management – Economics 15 Portfolio Management – Fixed Income 14 Portfolio Management – Equity 17 10 Portfolio Management – Risk Management 12 11 Portfolio Management – Trading, Monitoring, and Rebalancing 19 Total: 180 Start time: 9:00 AM End time: 12:00 PM © IFT All rights reserved 2018 Level III Mocks Exam Morning Session QUESTION HAS THREE PARTS (A, B, & C) FOR A TOTAL OF 10 MINUTES An advisor for Freans Capital Management is working with a new client, Tom Braidwood Prior to meeting with him, the advisor asks Braidwood a series of diagnostic questions to determine whether he may have any of the following investment behavioral biases: • Loss aversion • Endowment • Regret aversion • Illusion of control • Overconfidence • Framing Sample diagnostic questions are shown in Exhibit Exhibit Freans Capital Management Sample Diagnostic Questions If you are offered two free lottery tickets, would you select your own numbers or have a machine it? At what price are you willing to sell off your investment holdings that you received as inheritance? How you generally attribute the success of your decisions? A Identify the behavioral bias that each diagnostic question in Exhibit is most likely to reveal Note: Each diagnostic question is designed to reveal a different bias ANSWER QUESTION 1-A IN THE TEMPLATE PROVIDED (3 Minutes) Tom Braidwood informs his advisor that he has always been willing to take a small chance of losing up to percent of the portfolio annually He says that he can accept any asset classes to meet his financial goals if the following constraint is considered “Expected return – 1.645 × Expected standard deviation ≥ –7%.” After listening to him, the advisor concludes that he is actually striving for a mean- variance efficient portfolio © IFT All rights reserved 2018 Level III Mocks Exam Morning Session Braidwood tells the advisor that his previous Wealth Advisor, Andy, made following statements to him Statement 1: It is always recommended to know the historical performance of the CEO of the company before investing in a company Based on this belief, you should own shares of Frio Industries as Frio’s CEO used to run APCO’s operations and he did a wonderful job there Statement 2: Global Equity Funds have increased 1.5 – 2.0 times the historical average over the past two years Based on this information, I expect global equity funds to face a reversal in near future As a result, it is preferred to reallocate funds from equities to fixed-rate portfolio assets B Comment on the conclusion made by the Advisor regarding Braidwood’s portfolio preference (2 Minutes) C Select the behavioral finance concept (availability, confirmation, framing, gambler’s fallacy, representativeness, overconfidence, hot hand fallacy) best exhibited in each of Andy’s two statements Justify your response with one reason ANSWER QUESTION 1-C IN THE TEMPLATE PROVIDED (5 Minutes) © IFT All rights reserved 2018 Level III Mocks Exam Morning Session Answer Question on This Page 1-A Identify the behavioral bias that each diagnostic question in Exhibit is most likely to reveal Note: Each diagnostic question is designed to reveal a different bias Diagnostic Question Identify the behavioral bias that each diagnostic question in Exhibit is most likely to reveal (circle one) If you are offered two free lottery tickets You may either select your own numbers or have a machine it What would you do? How would you describe your emotional attachment to possessions or investment holdings? © IFT All rights reserved • Loss aversion • Endowment • Regret aversion • Illusion of control • Overconfidence • Framing • Loss aversion • Endowment • Regret aversion • Illusion of control • Overconfidence • Framing 2018 Level III Mocks Exam Morning Session How you generally attribute the success of your decisions? • Loss aversion • Endowment • Regret aversion • Illusion of control • Overconfidence • Framing 1-B Comment on the conclusion made by the Advisor regarding Braidwood’s portfolio preference 1-C Select the behavioral finance concept (availability, confirmation, framing, gambler’s fallacy, representativeness, overconfidence, hot hand fallacy) best exhibited in each of Andy’s two statements Justify your response with one reason Andy’s statement © IFT All rights reserved Select the behavioral finance concept best exhibited in each of Advisor’s two statements Note: No behavioral finance concept can be used more than once (circle one) Justification 2018 Level III Mocks Exam Morning Session It is always recommended to know the historical track record of the CEO of the company before investing in a company Based on this belief, you should own shares of Frio Industries as Frio’s CEO was previously in charge of APCO’s operations where he did a wonderful job Global Equity Funds have increased 1.5 – 2.0 times the historical average over the past two years Based on this information, I expect global equity funds to face a reversal in near future As a result, it is preferred to reallocate funds from equities to fixed-rate portfolio assets â IFT All rights reserved ã Availability • Confirmation • Framing • Gambler’s fallacy • Representativeness • Overconfidence • Hot hand fallacy • Availability • Confirmation • Framing • Gambler’s fallacy • Representativeness • Overconfidence • Hot hand fallacy 2018 Level III Mocks Exam Morning Session QUESTION HAS FOUR PARTS (A, B, C, & D) FOR A TOTAL OF 25 MINUTES Robert and Mary Puentes are meeting with John Mesa, CFA, their long-time advisor, to discuss financial planning issues Robert and Mary Puentes, both age 50, live in U.S Robert is retired He ran an advertising company which he recently sold off The Puentes will rely on their investment portfolio to meet future expenses in excess of Robert’s retirement income Mary is not employed Puentes will receive retirement payments of USD 110,000 per year for his lifetime from the business he sold The retirement payments are not indexed for future inflation and are fully taxable as ordinary income The Puentes’ total living expenses last year were USD 200,000, and they are expected to grow each year at the inflation rate The tax rate on ordinary income and all investment returns is 30% The inflation rate is expected to be 3% per year The Puentes live in a house with a market value of USD 1,250,000, mortgage-free They have a taxable investment portfolio with a current market value of USD 5,500,000 The Puentes’ plan to purchase a second home worth approximately USD 1,150,000 to be used for holidays, in around five years’ time Their goals are to grow the asset base of the portfolio over time to maintain its after-tax purchasing power and to establish and maintain a cash reserve of USD 200,000 Upon his death, Robert wishes to provide for his wife, but intends to donate the majority of his assets to charity John has gathered following information about the Puentes to determine their personality types i.e cautious, methodical, spontaneous, or individualist A summary of this information is presented below • Robert often reads the CEO’s statement about the company in annual reports while analyzing stocks rather than doing a detailed analysis • Robert prefers riskier stocks, and sometimes trades excessively so as not to miss an investment trend • Mary is less concerned with market sentiment or analysts’ recommendations of stocks • Mary’s investment decisions are made based on detailed analysis and investment research • Mary follows a very disciplined approach to stock selection and she is always on the quest for new information The Puentes live in a community property regime The community property regime entitles © IFT All rights reserved 2018 Level III Mocks Exam Morning Session a surviving spouse to receive one-half of the community property after the first spouse’s death Only 15% of Robert’s assets are community property Exhibit summarizes gift and inheritance tax rates applicable to the Puentes Family Exhibit Gift and Inheritance Tax Rates Tax Type Tax Rate Spousal inheritance tax 25% Spousal gift tax 30% Non-spousal inheritance tax 50% Non-spousal gift tax 30% Note: All taxes are due immediately at the time of the transfer and are paid for by the recipient Robert feels that Mary’s legal entitlement under the community property rules will not be sufficient to meet her financial needs John estimates that if Robert were to die today, Mary would need to inherit USD 750,000 net of any taxes to meet her needs A Determine the Puentes’ nominal after-tax required rate of return for the coming year Show your calculations (10 minutes) B Characterize the Puentes’ as below-average, average, or above-average in their ability to take risk Justify your response with two reasons based on the Puentes’ specific circumstances ANSWER QUESTION 2-B IN THE TEMPLATE PROVIDED (6 minutes) C Select the investor personality type for: i Robert ii Mary Justify each selection with one fact from the information about the Puentes’ provided in vignette ANSWER QUESTION 2-C IN THE TEMPLATE PROVIDED (4 minutes) © IFT All rights reserved 10 2018 Level III Mocks Exam Morning Session A Using a goal-based planning framework (i.e., personal, market, and aspirational risk buckets), identify the significant risk(s) that Weaver is currently facing (3 minutes) B Select the monetization strategy that will most likely achieve all of Weaver’s objectives Identify, for each strategy not selected, one objective it fails to achieve ANSWER QUESTION 3-B IN THE TEMPLATE PROVIDED (4 minutes) Weaver’s brother, Mattios, is also Kyle Lucas’ client Mattios recently retired from DigitalTime, Inc., a technology company where he experienced a long and successful tenure as a senior executive During his 30-year career with DigitalTime Mattios received a considerable portion of his compensation in the form of employee stock options Lucas recommended Mattios to hedge the risk of his employee stock options using an option-based cash less collar The underlying stock increases by $5 million above the strike price of the call options while the hedge is in place During his career, Mattios accumulated one million shares of a company named Lakson Inc These shares are currently valued at USD 30 million and represent the majority of his wealth These shares not pay a dividend Lucas notes that Mattios’ Lakson shares have a very low cost basis The jurisdiction in which Mattios resides levies capital gains taxes only on the sale or disposal of a security Therefore, any outright sales of shares would result in significant long-term capital gains which would be taxed at 30% Lucas suggests to Mattios to consider tax-free stock swap to diversify his concentrated position in Lakson’s stocks Tax–free swap would involve $35 million in Maple shares in exchange for all of Lakson’s shares, with no cash consideration The tax cost basis that Mattios has in Lakson shares, essentially zero, would become his tax cost basis in Maple shares transferred to the Maple shares If Mattios accepts a tax-free stock swap, he is able to sell the Maple shares short against the box He would realize 95% of the value of the Maple shares with no limitations on the use of proceeds The after-tax cost to access the proceeds would be locked in at 15 bps per year Mattios would be able to keep the position in place indefinitely Mattios asks Lucas about cashless collar strategy as it sounds easier to implement Lucas determines that the pairs of options shown in Exhibit are available, all with the same expiration dates Lakson’s share price is currently USD 30.00 © IFT All rights reserved 16 2018 Level III Mocks Exam Morning Session Exhibit Strike Prices of Available Lakson Options (in USD) Option Pair Put Call A 32.50 32.50 B 27.50 33.50 C 33.50 27.50 C Describe the mismatch in character that potentially affects Mattios with regard to use of option-based collar for hedging his employee stock options (2 minutes) D Determine the value of the tax-free stock swap offer with a short sale against the box and with immediate sale of the Maple shares Show your calculations (3 minutes) E Identify which option pair is most likely to create a cashless collar position for Mattios Justify your response Note: No calculations are required (3 minutes) © IFT All rights reserved 17 2018 Level III Mocks Exam Morning Session Answer Question on This Page 3-A Using a goal-based planning framework (i.e., personal, market, and aspirational risk buckets), identify the significant risk(s) that Weaver is currently facing 3-B Select the monetization strategy that will most likely achieve all of Weaver’s objectives Identify, for each strategy not selected, one objective it fails to achieve Select the monetization strategy that will most likely achieve all of Weaver’s objectives (circle one) i Full sale to the senior management team in a management buyout; Identify, for each strategy not selected, one objective it fails to achieve ii Full sale to the Family or Next Generation; iii Partial sale through an initial public offering; © IFT All rights reserved 18 2018 Level III Mocks Exam Morning Session 3-C Describe the mismatch in character that potentially affects Mattios with regard to use of option-based collar for hedging his employee stock options 3-D Determine the value of the tax-free stock swap offer with a short sale against the box and with immediate sale of the Maple shares Show your calculations 3-E Identify which option pair is most likely to create a cashless collar position for Mattios Justify your response Note: No calculations are required © IFT All rights reserved 19 2018 Level III Mocks Exam Morning Session QUESTION HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES Link Bank is a commercial bank operating in the U.S The Bank’s Board of Directors (the “Board”) is responsible for formulating and implementing investment policies The Board delegates authority for making specific investments to the Bank’s officers (“Management”) that are consistent with this IPS The Board has appointed an Investment Committee (the “Committee”) who is responsible for monitoring and reviewing all investment decisions for compliance with the IPS and with federal and state regulations The Committee also recommends changes to IPS to the Board when appropriate The Committee, in its last meeting, discussed the following different scenarios with respect to its loan portfolio and requested the Management to apprise the Committee in next meeting the effect of each of the suggested changes on the bank’s investment objectives, constraints, or risk-taking ability I The Bank has decided to restrict lending to customers with a credit rating of A or higher although the Bank’s overall risk tolerance is unchanged II The Bank decides to increase the holdings of long-term mortgage-backed securities III The target average maturity of loans is decreased, with overall risk tolerance unchanged IV Fewer opportunities exist for expanding net interest margins with low risk in Link Bank’s loan portfolio than in its securities portfolio The Chairman of the Bank’s ALCO Committee, Mr Samuel Miller, is analyzing the implications of the recent unexpected fall in interest rates on the bank’s market value of equity The current structure of the bank’s balance sheet is as follows: • Market value of Assets: $ 150 MN • Market Value of Liabilities: $ 170 MN • Duration of Assets: 7.5 • Duration of Liabilities: 4.5 Mr Miller states to other member that besides earning a positive return on invested capital, we should maximize the duration of Bank’s Equity A Explain the impact of each of the scenarios on the bank’s objectives and constraints, or risk-taking ability Your response should consider each policy in isolation ANSWER QUESTION 4-A IN THE TEMPLATE PROVIDED (4 minutes) © IFT All rights reserved 20 2018 Level III Mocks Exam Morning Session B Discuss one implication of a negative interest rate shock on the bank’s balance sheet (3 minutes) C Determine the course of action that should most likely be taken if the duration of Bank’s Equity is lower than desired (2 minutes) D Determine whether Link Bank has below-average, average, or above average ability to take risk regarding their securities portfolio Justify your response ANSWER QUESTION 4-D IN THE TEMPLATE PROVIDED (2 minutes) E Formulate each of the following constraints for Link Bank’s IPS: i time horizon ii liquidity iii tax concerns (6 minutes) © IFT All rights reserved 21 2018 Level III Mocks Exam Morning Session Answer Question on This Page 4-A Explain the impact of each of the scenarios on the bank’s objectives and constraints, or risk-taking ability Your response should consider each policy in isolation Scenario Evaluate the Impact of the scenario on the Bank’s Objectives and Constraints, or risk-taking ability Consider each Policy in Isolation I The Bank has decided to restrict lending to customers with a credit rating of A or higher although the Bank’s overall risk tolerance is unchanged II The Bank decides to increase the holdings of long-term mortgage-backed securities III The target average maturity of loans is decreased, with overall risk tolerance unchanged IV Fewer opportunities exist for expanding net interest margins with low risk in Link Bank’s loan portfolio than in its securities portfolio © IFT All rights reserved 22 2018 Level III Mocks Exam Morning Session 4-B Discuss one implication of a negative interest rate shock on the bank’s balance sheet 4-C Determine the course of action that should most likely be taken if the duration of Bank’s Equity is lower than desired 4-D Determine whether Link Bank has below-average, average, or above average ability to take risk regarding their securities portfolio Justify your response Ability to take risk: Circle one Below-average © IFT All rights reserved Average 23 Above-average 2018 Level III Mocks Exam Morning Session 4-E Formulate each of the following constraints for Link Bank’s IPS: I time horizon II liquidity III tax concerns © IFT All rights reserved 24 2018 Level III Mocks Exam Morning Session QUESTION HAS FOUR PARTS (A, B, C, D, E) FOR A TOTAL OF 18 MINUTES Theo Radcliff is Head of Finance at Network Solutions (NS) NS is solely responsible for funding its Defined Benefit (DB) plan by making annual contributions Management of NS asks Radcliff to compare NS’s DB plan against the DB plan of its two main competitors, Tyler Technologies (TT) and Munis Support (MS) He summarizes financial data and plan characteristics for the three companies NS TT MS Sales 21,000,000 38,000,000 29,500,000 Profit margin 29% 35% 35% Projected benefit obligations 23,500,000 34,000,000 27,600,000 Long term debt-to-capital ratio 47% 43% 53% Provision allowing lump-sum distribution YES YES NO Provision allowing early retirement NO YES NO Proportion of active lives 43% 28% 64% Plan funded status Deficit Surplus Surplus A Determine which company’s pension plan has the highest risk tolerance based on: i Financial position ii Plan features (4 minutes) Magnus Capital Management provides asset management services to a diverse pool of clients Among its clientele is the endowment associated with University of Brussels (UB) • Endowment currently has a planned time horizon till 2035 • All returns on the investments made by endowment are tax exempt • UB currently receives enough funds from the endowment to meet its spending needs and in recent years it has actually had a budget surplus • UB’s board is confident that it could raise funds through donor contributions, if necessary Magnus Capital Management also manages a large fund for Hassler Insurance Corp (HIC), a © IFT All rights reserved 25 2018 Level III Mocks Exam Morning Session non-life insurance company • The timing and amount of claims by HIC’s clients are uncertain but HIC has a policy of settling all its liabilities within a span of years • Return requirement for HIC is calculated every year based on its forecast for expected claims, capital market expectations and the MV of its portfolios B Compare the following components of IPS for HIC and UB’s endowment: i Risk tolerance ii Liquidity requirement (4 minutes) Safeway International (SI), a US based company, operates a DB pension plan for its employees It is a financially health, fast growing trading company with a higher percentage of active lives than retired lives Currently SI’s DB pension plan is in surplus SI’s management wants to maintain the plan’s funded status (pension surplus) relative to plan liabilities without making additional contributions to the plan SI hires a pension consultant who presents to the board the asset liability management approaches to portfolio construction C Explain why the asset liability management approach is appropriate for achieving SI’s objective related to its DB pension plan (4 minutes) SI hired the pension consultant on a permanent basis After a year, the consultant must explain to the board of directors why the surplus declined in a year when the actual investment return was 150 basis points more than the long-term objective stated by the board Information regarding SI’s defined-benefit pension plan is provided below Asset Class Actual & Target Allocation (%) 50 26 Weighted Prior-Year Total Return (%) 5.83 0.65 Equities US Treasury Bills & intermediate bonds US 10 Year bonds 24 5.52%* Total 100 12.00 *Income element 9.0%, price gain element 14.0% Total return = 23.0% © IFT All rights reserved 26 2018 Level III Mocks Exam Morning Session Surplus Duration of liabilities Actuarial return assumption SI board’s long-term total return objective USD 1.5 million 10 years 9.00% 10.50% Currently SI’s DB plan equities include: domestic equities and emerging market equities SI plan to discount its liabilities at the market interest rate for bonds with the same duration SI’s risk objectives include a limitation on volatility of surplus Currently SI’s DB plan has the following asset classes: real rate bonds, domestic equities, emerging market equities, nominal bonds, hedge funds D Explain how the plan surplus declined in a given year despite an actual return in excess of the board’s stated objective Justify with two reasons (4 minutes) E Recommend an investment time horizon (short-term or long-term) appropriate for the investment policy of SI’s pension plan Support with one reason (2 minutes) © IFT All rights reserved 27 2018 Level III Mocks Exam Morning Session Answer Question on This Page 5-A Determine which company’s pension plan has the highest risk tolerance based on: i Financial position ii Plan features 5-B Compare the following components of IPS for HIC and UB’s endowment: i Risk tolerance ii Liquidity requirement © IFT All rights reserved 28 2018 Level III Mocks Exam Morning Session 5-C Explain why the asset liability management approach is appropriate for achieving SI’s objective related to its DB pension plan 5-D Explain how the plan surplus declined in a given year despite an actual return in excess of the board’s stated objective Justify with two reasons 5-E Recommend an investment horizon (short-term or long-term) appropriate for the investment policy of SI’s pension plan Support with one reason © IFT All rights reserved 29 2018 Level III Mocks Exam Morning Session QUESTION HAS FIVE PARTS (A, B, C, D, & E) FOR A TOTAL OF 18 MINUTES Kasia Robert is a wealth adviser for individuals She works at Three Stars Wealth Advisory Firm Robert’s first meeting of the day is with David Nicholls, age 58 years, and plans on retiring in years Nicholls’ annual wage is currently $35,000 and is expected to grow 2.5% per year The risk-free rate is 3.5% Nicholls works in a job with a moderate degree of occupational risk; therefore, we assume a risk adjustment based on occupational income volatility of 3% There is a 99% probability that Nicholls’ survives the first year, a 98% probability that he survives the second year In the afternoon, Robert has a meeting with her other clients, Peter Elam and Darek Dorman Elam is 35 years old and works for capital market newsletter He is largely financially independent and his income is increasing rapidly Dorman, age 45, is a dentist and works in a local hospital Dorman is a single parent of a child who lives independently He is discussing estate planning with Robert His major concern is immediate liquidity to his child after his death Robert recommends Dorman to use a life insurance policy that provides a range of investment options Dorman selects a policy and asks Roberts to calculate the Surrender Cost Index (per $1,000 of face value, per year), using a life expectancy of 25 years and a discount rate of 6% Exhibit provides information about Dorman’s policy Exhibit Dorman’s Life Insurance Policy Face value $100,000 Annual premium (paid at beginning of the year) Policy dividends anticipated per year (paid at end of the year) Cash value protected at the end of 20 years $10,000 $2,500 $50,000 A Calculate the present value of Nicholls’ human capital? (2 Minutes) B Identify the financial stage of the life cycle of Peter Elam Justify your response with two reasons State the appropriate financial advice for him (5 Minutes) C Identify whether income volatility adjustment of Peter Elam’s human capital would be © IFT All rights reserved 30 ... ii Full sale to the Family or Next Generation; iii Partial sale through an initial public offering; © IFT All rights reserved 15 2018 Level III Mocks Exam Morning Session A Using a goal-based... ii Full sale to the Family or Next Generation; iii Partial sale through an initial public offering; © IFT All rights reserved 18 2018 Level III Mocks Exam Morning Session 3-C Describe the mismatch... constraints for Link Bank’s IPS: i time horizon ii liquidity iii tax concerns (6 minutes) © IFT All rights reserved 21 2018 Level III Mocks Exam Morning Session Answer Question on This Page 4-A