Mock exam a afternoon session

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Mock exam a afternoon session

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2018 Level III Mock Exam PM The afternoon session of the 2018 Level III Chartered Financial Analyst Mock ® Examination has 60 questions To best simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item set (vignette and multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam Questions Topic Minutes 1–6 Ethical and Professional Standards 18 7–12 Private Wealth 18 13–18 Private Wealth 18 19–24 Economics 18 25–30 Asset Allocation 18 31–36 Fixed Income 18 37–42 Equity 18 43–48 Alternative Investments 18 49–54 Derivatives 18 55–60 Global Investment Performance Standards Total: 18 180 By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-­registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose © 2017 CFA Institute All rights reserved 2 2018 Level III Mock Exam PM 2018 LEVEL III MOCK EXAM PM CleanTech Research Fund Case Scenario Kim Tang, CFA, is a consultant reviewing a hedge fund, CleanTech Research Fund CleanTech invests in high-­risk and volatile “clean technology” companies CleanTech has adopted the CFA Institute Code of Ethics and Standards of Professional Conduct Tang examines the various forms of advertising used by CleanTech to attract new clients In one of its advertising messages, CleanTech states, “We have a very experienced research team and are proud they are all CFA’s Several of our managers serve as volunteers for CFA Institute CFA Institute recognizes their expertise, and as a result, you can rely on our team for superior performance results.” In reviewing CleanTech’s marketing brochure, Tang reads the following statements: Statement The share prices of companies in the clean technology sector have increased recently because of the growing awareness of climate change issues and the rising cost of energy There are many risks in this sector, some of which include new technology that is unproven Also, the addition or removal of government incentives can make markets dysfunctional Nevertheless, it is our opinion that returns in this area will continue to be above average for several years In fact, our proprietary investment analytics software has determined that investments in green transportation companies are likely to double in value in the next six months based on a multiple factor regression analysis Key risks associated with analytics software include the fact that they rely on historical data and that a set of unknown factors could interfere with the anticipated results We will earn a 200% return over the next year on one of our solar power company investments based on sales projections we prepared, assuming that last year’s generous tax incentives stay in place Statement The CleanTech fund invests in publicly traded and highly liquid companies and is recommended only for investors who are able to assume a high level of risk Last month, we invested in EnergyAlgae, a “green energy” company that partnered with a global energy firm early last year to create oil from algae EnergyAlgae’s market capitalization quadrupled shortly after the partnership was formed Recently, EnergyAlgae also patented a waste plastic-­to-­oil process that produces oil at less than $30 a barrel One of the founders of CleanTech is on the board of EnergyAlgae, and information he gave us on the company’s patent process led us to purchase additional stock in EnergyAlgae before the patent became widely publicized with the release of the company’s semiannual financial report.* (*Information supporting the statements made in this communication is available upon request.) When Tang asks CleanTech’s founders for supporting documents related to their investment in EnergyAlgae, she is told that this information is based on third-­party research from Slar Brokerage (Slar), who maintains all necessary records Tang completes a due diligence exercise on this research and learns that Slar has used sound assumptions and rigor in its analysis of EnergyAlgae In particular, Tang learned that Slar used, at a minimum, the following attributes to form the basis of 2018 Level III Mock Exam PM the recommendation: the company’s past three years of operational history, current stage of the industry’s business cycle, an annual research update, a historical financial analysis, and a one-year earnings forecast Tang also learns that the founders of CleanTech are majority shareholders of Slar, which underwrote the public offering of EnergyAlgae Additionally, CleanTech’s analysts inform Tang that they did not need to look at the quality of Slar’s research because one of their former colleagues recently left CleanTech and established the research department at the brokerage firm In researching EnergyAlgae, Tang finds that potential customers and suppliers of EnergyAlgae are highly skeptical of the claims made regarding the company’s respective products She also contacts several energy companies and is unable to locate anyone who has even heard of EnergyAlgae When Tang reviews CleanTech’s trading activity in EnergyAlgae shares, she finds that CleanTech liquidated its position in EnergyAlgae soon after CleanTech’s portfolio managers presented positive views on EnergyAlgae in a number of media interviews In addition, many of CleanTech’s employees also sold their shares in EnergyAlgae immediately after CleanTech sold its shares of the company The share price of EnergyAlgae dropped dramatically after the stock sales made by CleanTech and its employees CleanTech’s advertising is least likely in violation of the CFA Institute Standards of Professional Conduct with respect to: A expected performance results B managers’ volunteer activities C use of the CFA designation In Statement 1, CleanTech management most likely violated the CFA Institute Standards of Professional Conduct with regard to their comments on: A investment analytics software B clean technology sector returns C solar power company investment In Statement 2, CleanTech most likely violated which of the following Standards of Professional Conduct? A Material Nonpublic Information B Suitability C Misrepresentation To be in compliance with the CFA Institute Standards of Professional Conduct, CleanTech should most likely question the validity of Slar’s research on EnergyAlgae for deficiencies in which of the following areas? A Operational analysis B Earnings projections C Annual research update 5 Tang’s most appropriate course of action concerning the relationship between CleanTech and Slar is to recommend that CleanTech: A communicate relevant information to all clients B explain the ownership structure to all clients C sever the relationship immediately The EnergyAlgae trades are least likely to have violated the CFA Institute Standards of Professional Conduct with regard to: A the adverse and skeptical opinions of EnergyAlgae products 2018 Level III Mock Exam PM B the order in which the shares were traded C share price distortion because of positive media presentations Connor McClelland Case Scenario Conner McClelland is a private client financial consultant with US-­based Edmonstone Wealth Management LLC McClelland has been engaged by Bradley and Reagan Graham to develop a personal wealth management plan Prior to meeting with McClelland, the Grahams filled out a personal profile questionnaire that will be used in developing their wealth management plan Using information from the questionnaire, McClelland prepares Exhibit 1 Exhibit 1  Graham Family: Personal and Financial Information Occupations and Family Structure ■ Bradley is a 50-­year-­old electrical engineer at a major utility company His annual income of $175,000 is projected to increase 3% per year He has a defined-­contribution pension plan and expects to retire at age 65 ■ Reagan is a 48-­year-­old pharmacist with a pharmaceutical company Her annual income of $132,000 is projected to increase 3% per year She has a defined-­contribution pension plan and expects to retire at age 65 Prior to joining the pharmaceutical company, Reagan had a 20-­year career in the US Navy, retiring at the rank of commander ■ The family has two children, ages 10 and Financial Information Checking account $27,000 Taxable investment account 625,000 Residence 525,000 Residential mortgage 285,000 Outstanding balance on a $100,000 home equity line of credit 38,000 Bradley’s defined-­contribution plan (vested; normal retirement age for the plan is 65) 796,000 Cash value of Bradley’s life insurance ($250,000 death benefit) 67,000 Estimated present value of Bradley’s future earnings 2,150,000 Reagan’s defined-­contribution plan (vested; normal retirement age for the plan is 65) 160,000 Present value of Reagan’s military pension (vested; inflation indexed; survivor benefit) 1,320,000 Cash value of Reagan’s life insurance ($250,000 death benefit) 52,000 Estimated present value of Reagan’s future earnings 1,790,000 Estimated present value of the Grahams’ future consumption 3,700,000 Aspirational and Other Goals ■ Cost of four years of university for the two children, with an estimated present value of $350,000 ■ Purchase of a vacation home in the next five years, with an estimated present value of $325,000 ■ Donations to charitable organizations during the next 15 years, with an estimated present value of $400,000 At their initial meeting, Bradley tells McClelland that he recently attended a financial planning seminar conducted by his employer’s human resources department One of the presenters discussed the importance of preparing and understanding the 2018 Level III Mock Exam PM components of an economic balance sheet compared with a traditional balance sheet Bradley was confused by a few of the presenter’s comments and asks McClelland for further clarification The presenter’s comments were as follows: ■■ Real estate can be described as a personal asset, an investment asset, and a mixed asset ■■ Financial capital consists of tangible and intangible assets, including both the vested and unvested portions of an employer pension plan ■■ The value of human capital relative to overall economic wealth is typically higher for an individual in mid-­career with an established earnings record than for an individual in the early stages of his career As McClelland reviews insurance coverage with the Grahams, he explains that there are various ways to manage risk “It depends on the frequency of a risk occurring and the severity of the potential loss For example, consider the following two risks: ■■ An earthquake: This risk seldom occurs but would result in a large financial loss; ■■ Dental cavities: This risk arises frequently, resulting in small financial losses.” McClelland determines that both Bradley’s and Reagan’s life insurance coverage is inadequate Bradley is particularly concerned about the inadequacy of his life insurance and asks McClelland to calculate how much additional insurance he should purchase to cover him until he retires in exactly 15 years and begins to receive his employer pension McClelland prefers to use the human life value method to determine the appropriate level of life insurance coverage Exhibit  contains additional personal and financial information about Bradley Exhibit 2  Bradley Graham: Additional Personal and Financial Information Current annual income; salary and expenses expected to increase 3% per year $175,000 Income and payroll taxes (percentage of annual income) 30% Employer contribution to defined-­contribution plan (percentage of annual income) 5% Annual family expenses attributable to Bradley 20,000 Estimated tax rate on income earned on insurance proceeds 20% Applicable discount rate 4% The Grahams mention that a primary concern is the ability to manage the risks to both their financial and human capital so that they can achieve their financial goals of maintaining a comfortable lifestyle while having sufficient assets to purchase a vacation home, pay for their children’s university education, and fund charitable donations Bradley mentions that he and Reagan have some concern about possibly outliving their assets and that he understands annuities can help protect against this risk He is interested in an annuity that will provide income for as long as one of them is alive The Grahams have average risk tolerance and expect they will be able to adjust their spending in retirement if necessary Using the data in Exhibit 1, the Grahams’ net wealth (in thousands) is closest to: A $2,174 B $2,414 C $2,795 6 2018 Level III Mock Exam PM Which of the presenter’s comments regarding economic and traditional balance sheets is most accurate? A The comment about human capital B The comment about financial capital C The comment about real estate Which of the following risk management techniques is most appropriate for the second risk exposure example provided by McClelland? A Risk retention B Risk reduction C Risk transfer 10 Based on the data in Exhibits and and using the human life value method for determining life insurance needs, the additional amount of life insurance that Bradley should purchase is closest to: A $1,701,345 B $1,547,862 C $1,951,345 11 Risk to which of the following is least likely to compromise the Grahams’ ability to achieve their financial and aspirational goals? A Health B Earnings C Property 12 The type of life annuity that is most consistent with the Grahams’ risk tolerance and retirement spending plans is a: A variable joint life annuity B fixed joint life annuity C variable life annuity with period certain Rhys Jacobs Case Scenario Rhys Jacobs is a 70-­year-­old resident of Sahjong, a small island country off the coast of Australia that caters to high-­net-­worth individuals because of its low tax rates and status as a sought-­after free trade zone Jacobs grew up in Sahjong and is a well-­ respected entrepreneur Jacobs has long put it off but believes that now is the time to finally receive some much-­needed assistance in tax-­efficient wealth accumulation, retirement and estate planning, and other financial matters, so he recently hired Jassica Simson as his tax and financial adviser In preparing for their introductory meeting, Jacobs performs initial research on various tax-­planning strategies available in Sahjong, where the capital gains tax rate is much lower than the income tax rate He finds several strategies that might be appropriate for his investment portfolio and summarizes them as follows: A strategy based on low portfolio turnover whereby assets are held for extended periods A strategy that concentrates on tax-­exempt securities A strategy to restructure his portfolio to focus on annual capital gains versus income generation 2018 Level III Mock Exam PM Jacobs provides materials to Simson, including the following notes he took from a recent financial blog discussing the various tools currently being used in retirement planning: Long-­term market return and historical inflation averages are simple but effective strategies for accurately extrapolating how much wealth will be accumulated after a period of time if one could earn, say, 10% a year The Monte Carlo approach helps an investor get to a straightforward “yes/no” determination on whether a particular retirement income goal can be achieved Given a particular investment strategy, the likelihood of achieving a certain percentage return throughout retirement can be answered with a Monte Carlo simulation Sustainable spending rates in retirement can be approximated without the need for a Monte Carlo simulation by using the notion of ruin probabilities Jacobs asks Simson to evaluate these notes Simson states that she is very much in favor of a long-­term buy-­and-­hold strategy focused on capital appreciation She states that investors often not realize just how much of their investment returns are consumed by taxes, and she provides Jacobs with the data in Exhibit 1 to illustrate the point Exhibit 1  Data Illustrating the Effect of Taxes on Wealth Accumulation Initial investment $250,000 Holding period 25 years Expected annual gain 8% Tax rate on investment returns 10% Turning to retirement planning, Simson confirms that sustainable spending rates in retirement can be approximated without the need for a Monte Carlo simulation by using the notion of ruin probabilities (as developed by Milevsky and Robinson) The analysis incorporates lifespan uncertainty as well as financial market risk After they discuss the method, Jacobs asks her to determine how much he could withdraw annually from a balanced portfolio if he wants to be at least 94% certain that the portfolio will last for the remainder of his life He states that the current value of his (balanced) portfolio is $2 million, made up of 50% income-­producing equities and 50% bonds Simson uses the ruin probabilities in Exhibit 2 as the basis for her calculation of Jacobs’ lifetime sustainable annual withdrawal Exhibit 2  Ruin Probabilities for a Balanced Portfolio: 50% Equity and 50% Bonds Real Annual Spending per $100 of Initial Nest Egg Current Age 70 Hazard Rate, λ (%) $2 (%) $3 (%) $4 (%) $5 (%) $6 (%) $7 (%) $8 (%) $9 (%) $10 (%) 4.75 0.8 2.8 6.3 11.4 17.6 24.7 32.2 39.8 47.2 Assumptions: Portfolio return: arithmetic: 5%; geometric: 4.28%; standard deviation: 12% 2018 Level III Mock Exam PM Jacobs owns a controlling interest in a rapidly growing private firm that explores for and produces oil The firm generates steady cash flow but is considered illiquid Simson explains that Jacobs’ death could create significant inheritance taxes She suggests an insurance policy to help fund any future inheritance taxes and help offset the risk of a tax liability combined with an illiquid asset Jacobs is confused about the use of life insurance and asks Simson to verify the following statements: ■■ The combination of a life insurance policy and a trust is likely to be redundant and unnecessary ■■ Death benefits from a life insurance policy are usually taxable at favorable rates ■■ Premiums paid by the policyholder are typically neither part of the policyholder’s taxable estate at the time of his or her death nor are subject to a gratuitous transfer tax The oil firm that Jacobs controls is headquartered in the island country of Mahjong, located near Sahjong Because of the foreign location of the oil firm, Simson believes there might be opportunities to reduce taxes Simson knows that Sahjong uses the exemption method, whereby it does not impose taxes on income that stems from a foreign country However, Sahjong will soon hold parliamentary elections, and the opposition party is said to favor the deduction method Simson plans to investigate how this possible change might affect Jacobs’ tax liability She compares the tax rates in the two countries in Exhibit 3 Exhibit 3  Comparative Income Tax Rates Country Income tax rate Sahjong Mahjong 10.00% 15.50% 13 Which of the tax-­planning strategies summarized by Jacobs is best described as tax deferral? A Strategy B Strategy C Strategy 14 Which of Jacobs’ notes on retirement planning from the financial blog is most accurate? A Note B Note C Note 15 Based on the data in Exhibit 1 and assuming that all returns are taxed annually, the proportion of the investment’s return that is consumed by taxes is closest to: A 19.9% B 17.0% C 10.0% 16 Based on Exhibit 2 and Jacobs’ stated level of concern for the probability of retirement ruin, the lifetime sustainable annual withdrawal is closest to: A $80,000 B $120,000 C $95,000 2018 Level III Mock Exam PM 17 Which of the statements about life insurance is most appropriate? A The statement about tax treatment of death benefits B The statement about combination of life insurance and trusts C The statement about premiums paid by policyholders 18 If the opposition party wins the election in Sahjong and its tax proposals are passed into law, the tax rate that Jacobs will face on income stemming from Mahjong will be closest to: A 0.0% B 15.5% C 24.0% Brian O’Reilly Case Scenario Brian O’Reilly is a capital markets consultant for the Tennessee Teachers’ Retirement System (TTRS) O’Reilly is meeting with the TTRS board to present his capital market expectations for the next year Board member Kay Durden asks O’Reilly about the possibility that data measurement biases exist in historical data O’Reilly responds: “Some benchmark indexes suffer from survivorship bias For example, the returns of failed or merged companies are dropped from the data series, resulting in an upward bias to reported returns This bias may result in an overly optimistic expectation with respect to future index returns Another bias results from the use of appraisal data in the absence of market transaction data Appraisal values tend to be less volatile than market determined values for identical assets The result is that calculated correlations with other assets tend to be biased upward in absolute value compared with the true correlations, and the true variance of the asset is biased downward.” Board member Arnold Brown asks O’Reilly about the use of high-­frequency (daily) data in developing capital market expectations O’Reilly answers, “Sometimes it is necessary to use daily data to obtain a data series of the desired length High-­ frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce higher correlation estimates.” Board member Harold Melson notes he recently read an article on psychological traps related to making accurate and unbiased forecasts He asks O’Reilly to inform the board about the anchoring trap and the confirming evidence trap O’Reilly offers the following explanation: “The anchoring trap is the tendency for forecasts to be overly influenced by the memory of catastrophic or dramatic past events that are anchored in a person’s memory The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports a preferred viewpoint than to evidence that contradicts it.” The board asks O’Reilly about using a multifactor model to estimate asset returns and covariances among asset returns O’Reilly presents the factor covariance matrix for global equity and global bonds shown in Exhibit 1 and market factor sensitivities and residual risk shown in Exhibit 2 10 2018 Level III Mock Exam PM Exhibit 1  Factor Covariance Matrix Exhibit 2 Global Equity Global Bonds Global equity 0.0225 0.0022 Global bonds 0.0022 0.0025  Market Factor Sensitivities and Residual Risk Sensitivities Global Equity Global Bonds Residual Risk Market 1.2 12.00% Market 0.9 7.00% Market 0.95 1.80% Finally, the board asks about forecasting expected returns for major markets, given that price earnings ratios are not constant over time and that many companies are repurchasing shares instead of increasing cash dividends O’Reilly responds that the Grinold–Kroner model accounts for those factors and then makes the following forecasts for the European equity market: ■■ The dividend yield will be 1.95% ■■ Shares outstanding will decline 1.00% ■■ The long-­term inflation rate will be 1.75% per year ■■ An expansion rate for P/E multiples will be 0.15% per year ■■ The long-­term corporate earnings growth premium will be 1% above GDP growth ■■ GDP growth will be 2.5% per year ■■ The risk-­free rate will be 2.5% 19 With respect to his explanation of survivorship bias, O’Reilly most likely is: A correct B incorrect, because survivorship bias results in a downward bias to reported returns C incorrect, because survivorship bias results in an overly pessimistic view of expected returns 20 With respect to his explanation of appraisal data bias, O’Reilly most likely is: A correct B incorrect, because the true variance of the asset is biased upward C incorrect, because calculated correlations with other assets tend to be biased downward in absolute value 21 With respect to his answer to Brown’s question, O’Reilly most likely is: A incorrect, because high-­frequency data tend to produce lower correlation estimates B correct C incorrect, because high-­frequency data are less sensitive to asynchronism 2018 Level III Mock Exam PM 11 22 Is O’Reilly’s explanation of the anchoring trap most likely correct? A No, because the anchoring trap is the tendency for the mind to give a disproportionate weight to the first information it receives on a topic B Yes C No, because the anchoring trap is the tendency to temper forecasts so that they not appear extreme 23 Given the data in Exhibits and 2, the covariance between Market and Market is closest to: A 0.0225 B 0.0243 C 0.0027 24 Given O’Reilly’s forecasts for the European market, the expected long-­term equity return using the Grinold–Kroner model is closest to: A 7.35% B 6.35% C 8.35% Sabanai Investimentos Case Scenario Marina Campos is a senior portfolio manager for Sabanai Investimentos in Sao Paulo, Brazil Sabanai provides investment management and advisory services for high-­ net-­worth and institutional clients She is assisted by two portfolio analysts, Fabiana Traldi and Pedro Peixaria Campos is meeting with Traldi and Peixaria to discuss the portfolios of three clients The first client is Gilvan Araujo Dias, a high-­net-­worth client who has given Sabanai responsibility for managing his foreign investments, which consist of equity investments in the United Kingdom and Germany His other assets consist of equity and corporate bond investments in Brazil Exhibit 1 summarizes information on Dias’s foreign portfolio holdings and exchange rates Exhibit 1  Gilvan Araujo Dias, Information on Foreign Asset Holdings and Exchange Rates UK Assets German Assets Value in GBP Value in EUR BRL/GBP BRL/EUR 1/1/2013 83,400,000 55,000,000 3.8729 3.0359 1/1/2014 86,000,000 51,000,000 4.1025 3.5142 Date Spot Exchange Rates Dias has asked whether it would be appropriate for him to hedge his foreign currency exposure Campos raises the issue with Traldi and Peixaria Traldi responds, “In the short run, if the correlation between foreign asset returns and foreign currency returns is negative, then there may be a need to hedge all foreign currency exposure Alternatively, one could implement a currency overlay program in which the currency exposure is fully hedged and currency alpha is generated separately This currency overlay strategy will only be successful in adding value to the portfolio if the currency alpha has a high correlation with Brazilian equities and corporate bonds.” The second client, BC Fundos de Pensao (BC), manages pension funds for numerous local companies and has currency exposure to the USD, the EUR, and the GBP BC wants Sabanai to provide guidance on using active currency management strategies 12 2018 Level III Mock Exam PM for the portfolios they manage Peixaria has been assigned this task and has collected information on one-­year yield levels in the United States, United Kingdom, and Eurozone, as well as one-­year implied volatility for various currency pairs extracted from option pricing models This information is provided in Exhibit 2 Exhibit 2  One-­Year Yield Levels and Implied Volatilities Panel A One-­Year Yield Country United States 0.05% United Kingdom 0.40% Eurozone 0.11% Panel B One-­Year Implied Volatility Currency Pair USD/GBP 5.50% GBP/EUR 7.50% USD/EUR 9.50% Peixaria indicates that his research suggests that the USD/EUR currency pair will become more volatile over the near term He recommends that BC implement an options-­based strategy using USD/EUR options to profit from the expected increase in volatility The third client is Fundo Brasil (FB), a Brazilian sovereign wealth fund FB has long equity positions in Australian and Swiss equities Spot and forward market currency information for AUD and CHF is provided in Exhibit 3 FB managers have asked Campos for advice on whether it would be appropriate to hedge the currency exposure with forward contracts in AUD and CHF Campos indicates that she will examine the use of forward contracts to hedge currency exposure Exhibit 3  Spot and Forward Rates for AUD and CHF Current Spot Rate Six-­Month Forward Rate Six-­Month Forecast Spot Rate BRL/AUD 2.1046 2.1523 2.0355 BRL/CHF 2.5309 2.4641 2.5642 Currency Pair 2018 Level III Mock Exam PM Traldi suggests that the use of put options might be a better way to hedge currency exposure Campos responds that there are better options-based strategies that can exploit market views and reduce hedging costs She suggests the following strategies: ■■ ■■ Strategy 1: For AUD exposure, the appropriate strategy is to be long put options at a strike price of 2.1046, short put options with a strike price 2.1006, and short call options with a strike price of 2.1456 Strategy 2: For CHF exposure, the appropriate strategy is to be long put options at a strike price of 2.5309, short put options with a strike price 2.5049, and short call options with a strike price of 2.5669 25 Based on the information provided in Exhibit 1, the domestic currency value of Dias’s foreign investments most likely: A decreased because of changes in the domestic currency value of foreign asset holdings B increased because of changes in the domestic currency value of UK assets but decreased because of changes in the domestic currency value of German assets C increased because of changes in the domestic currency value of foreign asset holdings 26 In her response regarding hedging foreign currency exposure in Dias’s portfolio, Traldi is most likely: A incorrect about the correlations, but correct about the currency overlay program B incorrect about the correlations and the currency overlay program C correct about the correlations and the currency overlay program 27 Based on the information in Exhibit 2, it would be best for Sabanai to implement a carry trade for BC by borrowing in: A USD and investing in GBP B GBP and investing in USD C EUR and investing in GBP 28 In regard to using USD/EUR options, Peixaria is least likely to recommend a strategy to go: A long an equal number of 25-­delta puts and calls B long an equal number of 50-­delta puts and calls C short an equal number of 15-­delta puts and calls 29 Based on the information provided in Exhibit 3, the most appropriate risk neutral strategy is for FB to: A over-­hedge AUD and not hedge CHF B under-­hedge AUD and over-­hedge CHF C under-­hedge CHF and not hedge AUD 30 Is Campos most likely correct that Strategy and Strategy will accomplish the goals of exploiting market views and reducing hedging costs? A No, she is incorrect about reducing hedging costs B No, she is incorrect about exploiting market views C Yes 13 14 2018 Level III Mock Exam PM Beatriz Maestre Case Scenario Beatriz Maestre is a fixed-­income consultant who has been retained by Filipe Ruelas, the CFO of Cávado Produtos Agricolas, SA (Cávado) Cávado is a manufacturer of prepared foods headquartered in Braga, Portugal Ruelas has a number of concerns regarding the firm’s exposure to interest rate movements, particularly with respect to its defined-­benefit pension plan and an outstanding debt it would like to retire In their first face-­to-­face meeting, Ruelas gathers a group of his employees and asks Maestre to explain the methods Cávado uses to manage interest rate risk Maestre starts by discussing the nature of pension fund management She tells the group, “With a defined-­benefit pension fund, the assets are structured to match the expected cash outflows required to meet the liabilities, making it a form of liability-­driven investing (LDI) Pension funds can be difficult to manage, because neither the timing nor the amount of the liabilities is known in advance with certainty With LDI, interest rate risk management efforts focus on changes in the values of the assets because the liabilities, while uncertain, aren’t affected by changes in interest rates.” During the meeting, Maestre presents some information about Cávado’s pension fund, which is primarily invested in corporate bonds with a mixture of investment-­ grade and speculative-­grade issues This information is presented in Exhibit 1 Exhibit 1  Cávado Pension Fund Liabilities and Assets Value Liabilities Assets EUR47.3 million EUR49.8 million Modified Duration 12.6 years 18.4 years Basis Point Value (BPV) EUR59,598 EUR91,632 Ruelas explains that he uses futures contracts on euro-­denominated German government bonds to reduce the duration gap between assets and liabilities However, because the pension fund has only a small surplus and he would like to increase this surplus through active management of the portfolio, he employs a contingent immunization strategy The fund is currently short 254 contracts based on a 10-­year bond with a par value of EUR100,000 and a basis point value (BPV) of EUR97.40 per contract Ruelas tells Maestre he is concerned about the many risks Cávado faces both in managing the pension fund and in managing the derivatives overlay He asks if any risks can be avoided Maestre names a risk that is not faced in managing the portfolio and would be virtually eliminated through careful selection of the type of derivatives used in the overlay Ruelas also tells Maestre that he has considered moving to a passively managed bond portfolio He is not convinced it is worth his or his staff ’s time and effort to try to beat the broad market bond index He is concerned, however, that it may be no less expensive either in time or transaction costs to replicate an index than to actively manage a portfolio Maestre recommends a bond-­indexing strategy As Maestre continues, she discusses an example of a single liability owed by Cávado, a EUR2.3 million balloon payment due to the former CEO of the company in approximately six and a half years as a part of her deferred compensation package Maestre tells the group, “Suppose you wanted to immunize this liability One way to so would be to purchase zero-­coupon bonds with essentially zero credit risk that mature in six-­and-­a-half years and have a face value of EUR2.3 million Unfortunately, no zero-­coupon bonds are available with this maturity Therefore, a portfolio of high-­ quality government bonds with a duration of approximately six-­and-­a-half years could 15 2018 Level III Mock Exam PM be used, although this portfolio might have to be adjusted over time to maintain a matched duration with the liability.” She proposes to select one of the three portfolios shown in Exhibit 2 Exhibit 2  German Euro-­Denominated Government Bond Portfolios Cash Flow Yield Macaulay Duration Convexity Portfolio A Portfolio B Portfolio C 2.18% 2.14% 2.16% 6.50 6.52 6.47 102.64 86.16 129.43 At a second meeting, Ruelas tells Maestre about a EUR22  million bond issue Cávado would like to retire The issue is currently rated A–, and credit spreads for that rating are relatively high Ruelas expects spreads to narrow in the future as the economy improves and as Cávado’s performance for the coming year is factored into markets The bond is closely held by two investment funds, and Ruelas feels they would be willing to sell their bond exposure at a small premium over the market price Ruelas also feels Cávado’s auditors would permit accounting defeasement if Cávado purchased a portfolio of high-­quality government bonds whose cash flow characteristics closely matched the Cávado bonds or if it purchased a portfolio of corporate bonds with similar duration and convexity characteristics and higher yields Maestre recommends a strategy for retiring the bond 31 Is Maestre’s description of pension fund management as a form of LDI most likely correct? A Yes B No, she is incorrect regarding the focus of interest rate risk management C No, she is incorrect regarding the difficulty of managing pension funds 32 Given the futures position entered into by the pension fund, Ruelas most likely believes interest rates will: A fall B rise C remain the same 33 In her response to Ruelas regarding risks, Maestre is most likely referring to: A spread risk B model risk C counterparty credit risk 34 What bond indexing strategy would Maestre least likely recommend? A A stratified sampling approach B An index mutual fund C A synthetic strategy using a total return swap 35 Which of the portfolios described in Exhibit 2 would most likely be recommended by Maestre? A Portfolio A B Portfolio B C Portfolio C 16 2018 Level III Mock Exam PM 36 Which of the following strategies would Maestre most likely recommend for retiring the Cávado bond? A Bond tender offer B Cash flow matching with government bonds C Duration matching with corporate bonds McMorris Asset Management Case Scenario McMorris Asset Management (MCAM) is an investment adviser based in Atlanta, Georgia Tom Morris manages the active equity portfolios Dan McKeen manages the semi-­active equity portfolios and the semi-­active derivatives portfolios They are preparing to meet with Maggie Smith, the chief investment officer of Philaburgh Capital, who is considering hiring MCAM to replace one of its current managers At the meeting, Morris and McKeen discuss MCAM’s investment approaches with Smith and present her with the risk and return characteristics detailed in Exhibit 1 Exhibit 1  Summary Information for MCAM’s Investment Strategies Approaches Active Equity Semi-­active Equity Semi-­active Derivatives Tracking risk 4.90% 3.70% 3.30% Information ratio 0.50% 0.60% 0.70% Expected alpha 2.40% 2.20% 2.30% Smith asks if MCAM’s active equity strategy is long only McKeen responds that MCAM uses market-­neutral long–short strategies for several reasons He indicates that long–short strategies: Reason enhance portfolio performance by increasing the beta Reason generate alpha by identifying undervalued or overvalued securities Reason benefit from events that give rise to price changes, which are more prevalent on the short side than on the long side Smith considers each approach listed in Exhibit  but is uncertain about what would be an optimal investment strategy She makes the following comments about market efficiency: Comment A firm’s stock price does not reflect all publicly available company information, and good research can uncover sound investment opportunities Comment Philaburgh’s mandate is for managers to limit volatility around the benchmark return while providing incremental returns that exceed management costs Smith states, “In order to ensure investment discipline, Philaburgh uses two methods to evaluate an investment manager’s style.” She then reviews the current characteristics of MCAM’s active equity approach using the first method, as presented in Exhibit 2 2018 Level III Mock Exam PM 17 Exhibit 2  Method 1—Portfolio Characteristics for MCAM Active Equity Strategy Based on Current-­Period Data Active Equity Number of stocks Benchmark 50 1,000 Market value $180 billion $4,400 billion Weighted average market capitalization $4.0 billion $4.1 billion Dividend yield 3.00% 2.00% Price/Earnings 8× 12× Smith then selects three benchmarks—value, blend, and growth—in addition to the normal benchmark to assess the manager’s style using the second method, as presented in Exhibit 3 Exhibit 3  Method 2—Return Correlations between MCAM’s Active Equity Approach and Benchmarks Based on 36 Months of Historical Data Coefficient of determination Value Blend Growth 0.39 0.45 0.65 Smith indicates that Philaburgh’s performance measurement is compliant with the Global Investment Performance Standards In considering investment performance, Morris identifies three risks that may prevent MCAM’s active equity approach from generating incremental returns: Risk 1: Overestimating a stock’s earnings per share growth Risk 2: Deciding incorrectly that a stock’s earnings multiple would not contract Risk 3: Misjudging whether a stock’s undervaluation will correct within the investor’s investment horizon Smith concludes by telling Morris that she is impressed by MCAM’s track record in adding alpha in the US stock market However, she believes that the European equity markets are likely to outperform the US equity markets over the next five years She asks whether MCAM can structure a portfolio to capture both opportunities Morris offers to combine his long–short active equity strategy with a EURO STOXX 50 Index strategy 37 Based on Exhibit 1, the approach that is least likely efficient with respect to delivering active returns for a given level of tracking risk is: A semi-­active derivatives B semi-­active equity C active equity 38 McKeen’s response to Smith’s question about MCAM’s active equity style is least likely correct with respect to: A Reason B Reason C Reason 18 2018 Level III Mock Exam PM 39 Smith’s Comment and Comment 2, respectively, are most likely consistent with an investment style that is: A active; active B semi-­active; active C active; semi-­active 40 Based on Exhibits and 3, what can Smith most likely determine about MCAM’s investment style over time? MCAM's style has: A drifted from growth to value B drifted from value to growth C not drifted 41 Which of the risks Morris identifies with respect to MCAM’s active equity strategy is least likely applicable to a growth-­oriented investor? A Risk B Risk C Risk 42 The type of portfolio that Morris recommends to Smith to take advantage of both US and European equity market opportunities is most likely a(n): A completeness fund B core–satellite C alpha and beta separation Faith Wanja Case Scenario Faith Wanja is an asset consultant to many large Kenyan pension funds In response to numerous client inquiries about alternative investment products now being offered in the market to pension funds, she decides to hold a seminar for her clients She believes it is important for her clients to understand the pros and cons of adding alternate investments to their existing portfolios, which are made up of public equity, fixed-­income securities, and direct real estate investments To start off the seminar, Wanja discusses the general characteristics of real estate investment trusts (REITs), private equity, and hedge funds She makes the following statements: Statement Hedge funds have tended to be more heavily regulated than other pooled investments because of their perceived higher risk profiles Statement Successful private equity investments, unlike public equity investments, rely heavily on a portfolio manager’s business skills rather than his or her portfolio management skills Statement REITs act as cash flow conduits for underlying real estate assets Wanja discusses the possible benefits of adding REIT investments to her clients’ portfolios that currently only hold equities and fixed-­income securities She indicates to the seminar participants that two existing private property investment companies (Batian and Lenana) are converting to a REIT structure and will soon be listed on the local securities exchange In Exhibit 1, Wanja shows the audience the projected impact on her clients’ portfolios, as reflected in a client composite, by adding one of the two REITs to a portfolio that had a 50/50 allocation to equities and fixed income 2018 Level III Mock Exam PM 19 Exhibit 1  Forecast Data for Portfolio Returns Client Composite with Traditional 50/50 Equity/ Bond (%) Client Composite with Batian REIT 45/45/10 Equity/ Bond/REIT (%) Client Composite with Lenana REIT 45/45/10 Equity/ Bond/REIT (%) Expected return 15.5 18.3 20.6 Standard deviation of returns 9.8 12.5 18.4 Measure The next topic Wanja discusses is private equity investments She lists the attributes of private equity and the possible benefits of adding private equity to a pension fund as follows: Private equity has low correlations with public equity, so it can greatly contribute to a portfolio’s ability to diversify risks The asset class’s low liquidity generally implies a smaller allocation Small pension funds should invest in a fund-­of-­funds structure to help increase diversification without increasing expenses She tells the audience that private equity management fees are often based on a percentage of the value of the limited partners’ committed funds and tend to stay the same throughout the life of the investment In addition, managers typically receive carried interest of about 20%, which is paid before any limited partner distribution of profits But limited partners sometimes require a clawback provision that mandates if they not achieve the preferred return over the full life of the investment, the manager is required to forfeit carried interest previously earned After Wanja finishes her presentation, she opens the floor to questions An audience member tells Wanja she recently met an investment adviser for high-­net-­worth individuals who stated that she has a tougher job advising high-­net-­worth clients than someone managing funds for institutional investors She asks, “Is this true? I would have thought the level of responsibility would be very similar for both types of clients.” Wanja responds, “Investment advisers have a fiduciary duty to both individual clients and institutional clients, so it is vital to discuss the issue of suitability with both types of client But advisers working with high-­net-­worth clients must recognize that they are more prone to panicking and changing strategies when there are large losses than institutional investors.” Wanja ends the seminar by stating that pension fund managers should consider investing in distressed securities if approved by the pension regulator She states, “Because government security yields remain low, pension funds will need to chase yield, and distressed securities can add value to a portfolio because Sharpe ratios of distressed securities tend to be understated.” She further explains her recommendation by saying, “Credit risk assessments are also often similar across distressed companies because they have similar cash flow problems, so due diligence costs are not very high I should also point out that market risk is not as important as liquidity risk for distressed securities.” 43 Which of Wanja’s statements regarding the new asset classes available in the Kenyan market is least likely correct? A Statement B Statement 20 2018 Level III Mock Exam PM C Statement 44 Based only on the information in Exhibit 1 and a risk-­free rate of 8%, should Wanja most likely recommend a 10% REIT exposure to her clients’ existing portfolios? A Yes, the Batian REIT B No C Yes, the Lenana REIT 45 When discussing the possible benefits of adding private equity to a pension fund, Wanja is most likely correct regarding the: A relationship between liquidity and size of the exposure B ability to diversify portfolio risks C use of a fund-­of-­funds structure 46 Wanja’s explanation of a private equity fund manager’s fees is least likely correct with regards to: A management fees B clawback provisions C carried interest 47 Is Wanja most likely correct when she explains the differences between managing high-­net-­worth client funds and institutional funds? A No, in regard to decision risk B Yes C No, in regard to communication with clients 48 Which of the distressed security characteristics described by Wanja is most likely correct? A Sharpe ratio B Due diligence costs C Market risk Omega Analytics Case Scenario Omega Analytics provides risk management consulting services for institutional and individual clients Rachel Osborne, CFA, is an investment adviser for Omega who works with the firm’s larger accounts She is considering derivative strategies for four separate clients: HMM Foundation, Bob Valentine, Bedford Trust, and Kung Chen HMM Foundation owns 30,000 shares of NASDAQ 100 Index Tracking Stock (QQQQ), which has a current price of $30 per share Osborne believes there is substantial risk of downside price movement in the index over the next six months She recommends HMM use a six-­month collar for the entire position of 30,000 shares as protection against the QQQQ price falling below $27 HMM would maintain the collar strategy until expiration of the put and call options Exhibit 1 provides data on current QQQQ puts and calls expiring in six months Exhibit 1  QQQQ Puts and Calls Expiring in Six Months Option Type Exercise Price ($) Option Premium ($) Call 35 0.80 Put 27 0.95 21 2018 Level III Mock Exam PM Another client, Bob Valentine, believes the prices of large-capitalization stocks will rise slightly, and he wants to profit from this movement using a bull spread strategy Osborne recommends that Valentine use 1/100 Dow Jones Industrial Average (DJX) options expiring in two months The current price of DJX is $91 Exhibit 2 provides current option information for two DJX call options expiring in two months Exhibit 2  DJX Call Options Expiring in Two Months Option Premium ($) Delta 88 4.40 0.75 94 1.00 0.30 Exercise Price ($) Valentine decides to use 100 contracts per position Each contract is equal to 100 shares The Bedford Trust is focused on long-­term growth and invests only in equities The trust has an equity portfolio with a market value of $60 million, of which $20 million is allocated to WTO stock Its trustees are considering a temporary decrease in the allocation to WTO stock in order to diversify into small-­capitalization US stocks Osborne recommends the Russell 2000 Index as an appropriate small-­capitalization index and recommends that Bedford Trust enter into an equity swap on $20 million of WTO stock with the Russell 2000 Kung Chen expects the tracking stock on the SPDR Dow Jones Industrial Average ETF (DIA) to trade within a narrow range around its current price over the near term On the basis of this expectation, he believes a profitable trading opportunity is to initiate a butterfly spread strategy using call options on DIA Osborne suggests using three one-­month call options on the DJIA Chen initiates a butterfly spread using a total of 200 long contracts and 200 short contracts Exhibit 3 illustrates current DJIA call options expiring in one month Exhibit 3  DJIA Call Options Expiring in One Month Exercise Price ($) Option Premium ($) 88 4.20 92 2.00 96 0.50 49 If HMM enters into the collar recommended by Osborne, and the market value of QQQQ is $33 when the options expire, the change in the profit of the collar would be closest to: A $94,500 B $85,500 C $90,000 50 If HMM enters into the collar recommended by Osborne, the maximum profit of the collar at option expiration would be closest to: A $154,500 B $150,000 22 2018 Level III Mock Exam PM C $145,500 51 At expiration of the DJX call options, the maximum potential profit from the bull spread strategy recommended for Valentine is closest to: A $60,000 B $6,000 C $26,000 52 If the price of DJX is $91, the delta of Valentine’s bull spread just before contract expiration, will most likely be in the range of: A 0.00 to 0.20 B 0.40 to 0.60 C 0.80 to 1.00 53 If Bedford Trust implements Osborne’s recommendation regarding WTO, it will least likely experience a cash outflow if the returns on WTO stock and the Russell 2000 Index are: A WTO Return: Positive and Russell 2000 Return: Negative B WTO Return: Negative and Russell 2000 Return: Positive C WTO Return: Zero and Russell 2000 Return: Negative 54 If Chen creates a butterfly spread using the three one-­month call options suggested by Osborne, the maximum potential loss at expiration is closest to: A $7,000 B $3,000 C $27,000 Katherine Ng Case Scenario Katherine Ng, a Global Investment Performance Standards (GIPS) specialist, has been hired as a consultant to assist Rune Managers in becoming a GIPS-­compliant firm Rune is a global asset manager with several divisions around the world that invest in both stock and bond strategies James Arnott, a performance specialist at Rune, is responsible for the project In their first meeting, Ng and Arnott discuss the GIPS standards and the steps Rune will need to take to become compliant Ng recommends starting with the definition of the firm She tells Arnott that how the firm is defined will affect the compliance process and that the standards recommend the firm be defined as broadly as possible Arnott replies that Rune management has been discussing the firm definition, and they want the definition to include all Rune divisions except the European division, Rune Europe Rune Europe has its own strategies and management team that are distinct from the rest of Rune Ng replies that the Rune Europe division should be included in the definition of the firm because the division markets itself as part of Rune Managers Ng then asks about Rune’s policies for the inclusion of portfolios in composites Arnott responds that Rune has the following policies for all composites: Policy All new accounts funded with cash or securities on or before the 10th day of the month are added to the composite at the beginning of the following month Those funded after the 10th day of the month are added at the beginning of the 2nd month after funding, or at the beginning of the calendar month after the proceeds are substantially invested in the appropriate strategy 2018 Level III Mock Exam PM 23 Policy All portfolios are deemed “non-­discretionary” on the date the notice of termination of the management relationship is received and removed from the composite at the end of the month of notification The discussion then moves on to a new composite that Rune is constructing Arnott tells Ng that the marketing department has decided to target domestic Swiss investors and would like to carve out the Swiss portion of international and global accounts for the period of January 2006 through January 2011 and allocate cash to each carved-­out segment to create a Swiss franc (CHF) composite Ng responds that this new composite will comply with the standards, but Rune must disclose the percentage of composite assets that are carve-­outs for each annual period end, as well as the policy used to allocate cash to the carved-­out segments Arnott interjects that the marketing department is looking forward to claiming GIPs compliance in advertisements He is meeting with the marketing department and asks Ng what they need to be aware of regarding the Standards in advertising Ng responds that there are several requirements in the GIPS Advertising Guidelines; specifically, the following must be disclosed in the advertisements: the firm description, composite and benchmark descriptions, and the number of accounts in the composite Arnott and Ng then move on to discuss one of Rune's GIPS-­compliant performance presentations, provided in Exhibit 1 Exhibit 1  Rune Mid-­Capitalization Value Equity Composite (Benchmark: Russell Midcap Value Index) Year Composite Gross Return (%) Composite Net Return (%) Benchmark Return (%) 2006 11.2 10.69 2007 18.92 18.68 Composite 3-­Year Std Dev (%) Number of Portfolios Internal Dispersion (%) Composite % of Firm Assets 12.65 15 0.09 7.1 20.22 19 0.06 7.2 2008 0.07 –0.17 –1.42 22 0.46 6.8 2009 –33.75 –33.95 –38.44 23 0.25 5.5 2010 31.44 31 34.21 26 0.95 5.9 2011 22.09 21.73 24.75 25 0.21 6.9 22.83 Rune Managers claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards Rune Managers has not been independently verified Notes: Rune Managers is an investment manager registered with the US SEC Rune Managers has divisions in Europe, Asia, and the United States that invest in various equity and bond strategies The Rune Mid-­Capitalization Equity Composite includes all institutional portfolios that invest in mid-­capitalization US equities, with the goal of providing long-­term capital growth and steady income from dividends by investing in low price-­to-­earnings, undervalued securities A complete list and description of Rune Managers’ composites, as well as policies for valuing portfolios and preparing compliant presentations, are available upon request The composite was created on 30 November 2005 Leverage, derivatives, and short positions are not used by this strategy Performance is expressed in US dollars The returns include the reinvestment of all income Gross-­of-­fees returns are presented before management and custodial fees but after all trading expenses Net-­of-­fees returns are calculated by deducting the actual fees of the accounts from the gross composite return The management fee schedule is as follows: 0.80% on the first $10 million, 0.55% on the next $40 million, 0.40% on assets greater than $50 million This presentation is not required to conform to any laws or regulations that conflict with the GIPS standards (continued) 24 2018 Level III Mock Exam PM Exhibit 1  (Continued) Internal dispersion is calculated using the asset-­weighted standard deviation of annual gross returns of those portfolios that were included in the composite for the entire year 10 The three-­year annualized standard deviation measures the variability of the composite and the benchmark returns during the preceding 36-­month period The standard deviation is not presented for 2006 through 2010 because monthly composite and benchmark returns were not available, and it is not required for periods prior to 2011 55 In their discussion of the Rune Europe division, which of the following is most likely correct? A Ng’s analysis, because of how the division markets itself B Arnott’s analysis, because of how the strategies are run C Arnott’s analysis, because of how the division is managed 56 Which policy on the inclusion of portfolios in composites is most likely compliant with the GIPS standards? A Policy B Policy C Policy and Policy 57 In the discussion of carve-­outs, Ng is least likely correct in her statement regarding the: A disclosure of the cash allocation policy B compliance of the composite C disclosure of the percentage of composite assets 58 In the discussion of the GIPS Advertising Guidelines, Ng is most likely correct in her statement regarding the disclosure of: A composite description B number of accounts in the composite C firm description 59 Regarding the disclosures contained in the notes to Exhibit 1, the notes most likely required are: A 1, and B 2, and C 6, and 60 Regarding Exhibit 1, which item is least likely an error in the presentation? A Composite percentage of firm assets B Note C Three-­year standard deviation ... A 7.35% B 6.35% C 8.35% Sabanai Investimentos Case Scenario Marina Campos is a senior portfolio manager for Sabanai Investimentos in Sao Paulo, Brazil Sabanai provides investment management and... returns Another bias results from the use of appraisal data in the absence of market transaction data Appraisal values tend to be less volatile than market determined values for identical assets... opportunities is most likely a( n): A completeness fund B core–satellite C alpha and beta separation Faith Wanja Case Scenario Faith Wanja is an asset consultant to many large Kenyan pension funds In response

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