2019 CFA level 3 qbank r 20 21 asset allocation with real world c currency management answers

Question #1 of 24 A U.S.-based investor has purchased a 15,000,000 peso o ce building in Mexico He has hedged his investment by selling forward futures at $0.1098/peso Two months later, the futures exchange rate has fallen to $0.0921/peso The investor's net change in the futures position is: A) $265,500.00 B) ($265,500.00) in C) $1,647,000.00 The realized gain on the futures position is: en tre Explanation V0(-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500 bo ok c (Study Session 10, Module 21.4, LOS 21.f) Related Material m SchweserNotes - Book o Question #2 of 24 w w Currency trading based on economic fundamentals would be most likely to sell a currency forward if the country issuing the currency is experiencing: w A) declining levels of relative risk in the economy B) rising relative in ation C) increasing real rates of return Explanation Higher relative in ation is associated with declining value of the currency and would tend to encourage sale of the currency by the manager The other two factors are associated with currency appreciation (Study Session 10, Module 21.3, LOS 21.d) Related Material SchweserNotes - Book Question #3 of 24 Jane Simms manages a German portfolio denominated in the EUR and decides to use an option collar to reduce her downside risk exposure to the Mexican peso (MXP) while retaining some potential upside Which of the following strategies will accomplish her objective? A) Buy an OTM call on the EUR and sell an OTM put on the EUR B) Buy an OTM put on the MXP and sell an in-the-money call on the MXP C) Buy an OTM put on the MXP and sell an OTM put on the MXP with a lower strike in price en tre Explanation The collar Simms describes requires buying OTM puts and selling OTM calls on the MXP However, this is directly equivalent to buying OTM calls on the EUR and selling OTM puts on the EUR Note that selling an in-the-money call on the MXP removes all portfolio upside and will not meet her objectives bo ok c (Study Session 10, Module 21.5, LOS 21.g) Related Material m SchweserNotes - Book w w o Question #4 of 24 The Howarth School Foundation (HSF) has historically provided 30% of the annual operating costs of running the Howarth Law school Recent changes in government funding mean that w previously fully funded scholarships will now only be 40% funded and that HSF must provide more support to the school Based on this information, HSF will most likely: A) Increase the allocation to zero-coupon bonds to increase duration B) Increase the allocation to riskier timber and farmland to generate higher expected return and cover the required out ows C) Decrease the allocation to private equity in order in increase the liquidity of the portfolio Explanation The school is becoming more dependent on the foundation, decreasing the ability to take risk and increasing liquidity demands for payouts to the school Shifting to more liquid investments makes sense Higher duration is not relevant and is probably riskier plus zerocoupons provide no regular cash ow Higher return may seem logical but taking more risk to get it is not appropriate when ability to take risk has declined Plus land is an illiquid asset (Study Session 10, Module 20.2, LOS 20.c) Related Material SchweserNotes - Book in Question #5 of 24 en tre Which scenario would most likely lead a portfolio manager to buy a foreign currency in the forward market? A) A portfolio that is overweighted in assets denominated in that currency the higher relative yield bo ok c B) An active manager implementing a carry trade when the currency being bought as C) An active currency manager who is underweighted in assets denominated in that currency m Explanation w w o No manager views were indicated in the question; lacking views, an active manager should take a neutral exposure to the currency Being underweighted in the assets would produce an underweighting in the currency which is corrected by buying the currency forward The other two answers are incorrect Being overweighted would lead to selling the currency forward A carry trade would buy the higher yield currency in the spot, not forward, market w (Study Session 10, Module 21.4, LOS 21.e) Related Material SchweserNotes - Book Question #6 of 24 Dan Vustings, 51, is a senior account executive at an advertising agency in San Francisco He currently has su cient capital in his two investment portfolios to retire in 14 years His capital is evenly split between a taxable portfolio which he uses to fund current consumption goals and a tax-deferred retirement account Vustings received advice from an investment manager last year who suggested the following asset allocation: High-yield bonds 15% High dividend yield equities 50% High growth equities 35% Vustings has the same allocation in both the taxable and the retirement account Which of the in following allocations would be most likely to improve the e ciency of the portfolios, ignoring rebalancing or withdrawal penalties? en tre A) Increase the allocation to high-yield bonds in the retirement account, and increase the allocation to high growth equity investments in the taxable account B) Increase the allocation to high-dividend yield equities in the taxable account, and bo ok c increase the allocation to high growth equities in the retirement account C) Increase the allocation to high-yield bonds in the taxable account, and increase the allocation to high growth equities in the retirement account Explanation w w o m Assets subject to the highest rates of tax should be rst allocated to tax advantaged accounts Interest on high yield bonds is typically taxed at a higher rate than dividend income which in turn is taxed at a higher rate than capital gains Vustings should therefore allocate high-yield bonds rst to the retirement account, and leave the high growth equity in the taxable account (Study Session 10, Module 20.1, LOS 20.b) w Related Material SchweserNotes - Book Question #7 of 24 Which of the following portfolios would most likely follow a passive currency hedging strategy? A) One with a shorter time horizon and higher liquidity needs B) One very concerned with minimizing regret and higher allocation to equity investments C) One with more dence in the portfolio manager and high income needs Explanation The following will shift the portfolio towards more passive currency management: A short time horizon for portfolio objectives High risk aversion Lack of concern with regret at missing opportunities to add value through discretionary currency management High short-term income and liquidity needs Signi cant foreign currency bond exposure Low hedging costs Clients who doubt the bene ts of discretionary management in (Study Session 10, Module 21.1, LOS 21.c) Related Material bo ok c Question #8 of 24 en tre SchweserNotes - Book A U.S investor who holds a £2,000,000 investment wishes to hedge the portfolio against currency risk The investor should: m A) buy £2,000,000 worth of futures for U.S dollars .o B) sell $2,000,000 worth of futures for British pounds w w C) sell £2,000,000 worth of futures for U.S dollars Explanation w The investor should sell £2,000,000 worth of futures contracts for U.S dollars This will o set the existing long position in pound-denominated assets In so doing, the investor has e ectively xed the exchange rate for pounds into dollars for the duration of the futures contract (Study Session 10, Module 21.1, LOS 21.b) Related Material SchweserNotes - Book Question #9 of 24 The basis risk in a currency hedge is most likely highest in a: A) cross hedge B) minimum-variance hedge ratio C) direct hedge Explanation Related Material Question #10 of 24 bo ok c SchweserNotes - Book en tre (Study Session 10, Module 21.6, LOS 21.h) in A Basis risk exists when movement in the hedge currency is not matched by movement in the hedging vehicle A direct hedge will short forwards on the currency to be hedged and basis risk will therefore be low A cross hedge can range from lower to higher basis risk depending on what is used as the hedging vehicle The MVHR depends on regressing past asset returns and currency movement to calculate a hedge ratio that would had minimized past volatility of returns to the domestic investor in a foreign asset It is exposed to changing correlation and likely to have the highest basis risk Kevin Collison has several di erent places where he has assets in which he manages as m separate accounts such as his checking account which he uses for short term cash and o emergency needs, his 401(k) account for retirement, and his children's college fund In his w w 401(k) he owns a small cap stock in a company which makes catheters to be used in experimental cancer treatment in which the catheter is used to deliver cancer killing drugs to hard to reach tumors in the body The stock has recently taken a downturn in price due to the w FDA not approving their most recent catheter As a result of the downturn in price, Collison purchases more of the stock in hopes of recouping his losses at some future time Collison's management of his portfolio is indicative of: A) money illusion and fear of regret B) mental accounting and loss aversion C) asset allocation and pyramiding Explanation Collison is exhibiting mental accounting by having separate accounts for his assets which he manages each account separately for a speci c purpose and does not manage his assets as a complete portfolio for asset allocation purposes He is also exhibiting loss aversion by not accepting the loss on the stock which is also leading to risk seeking behavior by buying more of the losing stock (Study Session 10, Module 20.3, LOS 20.e) Related Material Question #11 of 24 en tre The cost to hedge a long position in the EUR is reduced by: in SchweserNotes - Book A) forward euro exchange rates are below the spot exchange rates B) lower relative interest rates in the euro zone bo ok c C) negative roll yield Explanation m A long position in the euro is hedged by selling the euro forward Positive roll yield is a reduction in hedging cost Positive roll yield for the seller of the euro occurs if the forward exchange rate for the euro is above the spot exchange rate This will occur if euro zone interest rates are relatively low w w Related Material o (Study Session 10, Module 21.4, LOS 21.f) w SchweserNotes - Book Question #12 of 24 Goals based investing is most directly useful to counter: A) loss aversion B) illusion of control C) representativeness Explanation The answer is loss aversion based speci cally on what the reading says You have taken at least CFA exams and know such picky questions are unusual Exhibit good judgement, give your best guess, and move on (Study Session 10, Module 20.3, LOS 20.e) Related Material SchweserNotes - Book Question #13 of 24 in Which of the following statements regarding hedging of emerging market currencies is least en tre accurate? A) Hedging costs for managers who buy emerging market currencies are increased by the relatively high interest rates in emerging markets B) Hedging cost varies with normally large bid/asked spreads followed by infrequent bo ok c periods of even higher spreads C) Tail risk and contagion both refer to relatively infrequent events that increase the di culty of hedging emerging market currencies Explanation w w w o m The relatively high interest rates of emerging market economies leads to an inverted pricing curve with forward prices of the emerging market currencies below their spot prices This raises hedging cost for sellers of the currency, not buyers; sellers receive negative roll yield while buyers receive positive roll yield EM currencies have relatively high bid/asked spreads which increase in periods of crisis Contagion and tail risk refer to infrequent events Contagion refers to all EM currencies tending to decline together in periods of crisis, and tail risk to the downside in those periods of crisis being large in relation to typical upside movement in the currencies (Study Session 10, Module 21.6, LOS 21.i) Related Material SchweserNotes - Book Question #14 of 24 A European investor holds a diversi ed portfolio From the euro perspective the portfolio is weighted 60% and 40% in U.S and U.K investments Additional information: Returns measured from investor's perspective: U.S 5% 6% 4.5% U.K 7% 8% 3.5% 3.7% 4.7% en tre Assets: Stand deviation of the foreign currency's returns: in Returns measured in foreign currency: Standard deviation of asset's returns measured in foreign currency: The correlation between the foreign-currency asset's returns and returns on the foreign currency are 0.81 and 0.67 respectively for the U.S and U.K assets Compute the standard bo ok c deviation of returns for the investor in the U.K assets A) 7.8% B) 60.9% C) 7.5% m Explanation w w o It depends on the standard deviation of the asset returns measured in the foreign currency, the standard deviation of the currency's returns, and the correlation between these two sources of returns Variance = (1.02)(3.52) + (1.02)(4.72) + 2(1.0)(1.0)(0.67)(3.5)(4.7) = 56.38 w Standard deviation = 7.5% (Study Session 10, Module 21.1, LOS 21.a) Related Material SchweserNotes - Book Question #15 of 24 A Djiboutian (DJF) investor holds an international portfolio with beginning investments of USD 1,253,000 and EUR 2,347,800 Measured in the foreign currencies these investments appreciate 5% and depreciate 7% respectively Additional information: Beginning Forward Exchange Rate Ending Spot Exchange Rate DJF/USD 179.54 DJF/USD 185.67 DJF/USD 192.85 EUR/DJF 0.00416 EUR/DJF 0.00413 EUR/DJF 0.00421 The ending value of the EUR investment is closest to: en tre A) EUR 2,200,000 .in Beginning Spot Exchange Rate B) EUR 2,500,000 C) DJF 575,000 bo ok c Explanation The ending value in EUR EUR 2,347,800 × 93 = EUR 2,183,454 is: EUR 2,183,454 / (EUR/DJF 0.00421) = DJF 518,635,154 m The ending value in DJF is: Related Material o (Study Session 10, Module 21.1, LOS 21.a) w w w SchweserNotes - Book Question #16 of 24 The strategic asset allocation, current allocation, and upper and lower policy limits for a retirement portfolio are shown in the table below Asset Class Fixed Income Current Weight SAA Upper Limit Lower Limit 35% 40% 45% 35% Domestic Equity 60% 50% 60% 40% Real Estate 10% 15% 5% 5% The portfolio manager takes a discretionary approach to tactical asset allocation She follows various indicators that she believes are useful in evaluating speci c asset classes Her current in observations and interpretations are: en tre Equity brokers have reported that margin borrowing levels increased dramatically over the last two months and now sit at their highest levels for 15 months, a bearish sign Real estate indexes have started to rise suggesting the market may be 'heating up', a bullish sign bo ok c Indications from the federal reserve are that interest rates will rise several times in the next 12 months, a clearly obvious sign Which of the following tactical allocation shifts is the manager most likely to make? A) Increase the weighting to real estate m B) Decrease the weighting to xed income w w Explanation o C) Increase the weighting to domestic equity w She is bullish on RE and RE is at the bottom of her range; she should increase the allocation if possible Admittedly RE is a less liquid asset She is bearish on equity and would not want to increase the weight Increasing interest rates is bearish for bonds, but she is already at the bottom of the range Avoid convoluted arguments that to change one weight she must something else as well That is not a direct answer to the question, was not asked, and we'd be guessing what that other action is She may already have some cash assets (Study Session 10, Module 20.2, LOS 20.d) Related Material SchweserNotes - Book Question #17 of 24 A pension fund is searching for an optimal portfolio by comparing the present value of contributions and contribution risk as measured by a 95% dence interval that contributions will not exceed a given threshold Which of the following portfolios would be the most e cient under these criteria? A) PV Contributions $69 million and Contribution risk $390 million B) PV Contributions $65 million and Contribution risk $392 million C) PV Contributions $60 million and Contribution risk $385 million Explanation in The best choice will: minimize contribution risk which is the chance of having to increase contributions, and also minimize the expected present value of future contributions en tre (Study Session 10, Module 20.1, LOS 20.a) Related Material Question #18 of 24 bo ok c SchweserNotes - Book Which of the following comments is most accurate? m A) A cost/bene t analysis of whether to hedge currency should include all of the o following: bid/asked transaction costs, option premiums, back o ce and w w li B) Currency volatility becomes a more signi cant issue in global portfolios over a longer time horizon as returns compound w C) Discretionary currency hedging allows wider deviations from the strategic hedging than active currency management Explanation All of the expenses listed should be included in cost/bene t analysis of when and how to hedge currency risk including items such as back o ce and other overhead expenses; ultimately these direct and indirect expenses and costs will a ect the client's net return The other two answer choices are false Active management allows the wider deviations In the long run currency has less impact on risk as currency tends to mean revert in the long run A short run perspective supports currency hedging (Study Session 10, Module 21.1, LOS 21.b) Related Material SchweserNotes - Book Jane Archer manages a Swiss (CHF) based hedge fund A portion of the fund is currently allocated 60% and 40% respectively to EUR and ASD risk-free investments, pending other investment opportunities She has collected the following information: Estimates: Euro Zone Australia 2.0% 2.5% Change in spot exchange rate versus the CHF −1.0% 3.0% Asset risk measured in foreign currency (σ) 0.0% 0.0% Currency risk (σ) 7.0% in Asset return in foreign currency en tre 9.0% Correlation of currency returns (CHF/EUR, CHF/ASD) +0.70 Question #19 of 24 bo ok c The following questions are from the portfolio perspective, measured in CHF The expected return of the risk-free portion of the portfolio is closest to: o C) 3.74 w w B) 2.82% m A) 6.56% Explanation w The expected returns measured in the investor's domestic currency (CHF) are: EUR asset: (1.02)(0.99) − = +0.98% ASD asset: (1.025)(1.03) − = +5.58% The weighted average return is: 0.6(0.98%) + 0.4(5.58%) = 2.82% (Study Session 10, Module 21.1, LOS 21.a) Related Material SchweserNotes - Book Question #20 of 24 The standard deviation of the risk-free portion of the portfolio is closest to: A) 54.13% B) 7.36% C) 7.98% Explanation The standard deviations of the risk-free assets measured in the investor's domestic currency are: in EUR asset: 7.0%(1.02) = 7.14% en tre ASD asset: 9.0%(1.025) = 9.23% The variance of returns of the risk-free portion of the portfolio is: 0.62(7.142) + 0.42(9.232) + 2(0.6)(0.4)(0.70)(7.14)(9.23) = 54.13 bo ok c The standard deviation of returns of the risk-free portion of the portfolio is: 54.13½ = 7.36% Related Material o m SchweserNotes - Book w w Question #21 of 24 What is the expected return of the risk-free portion of the portfolio if Archer takes a leveraged w position with a 150% positive weight in Australia and a 150% negative weight in the euro zone? A) 6.75% B) 6.90% C) 9.72% Explanation The expected returns measured in the investor's domestic currency (CHF) are: EUR asset: (1.02)(0.99) − = +0.98% ASD asset: (1.025)(1.03) − = +5.58% The weighted average return is: −1.5(0.98%) + 1.5(5.58%) = 6.90% (Study Session 10, Module 21.1, LOS 21.a) Related Material in SchweserNotes - Book en tre Question #22 of 24 What is the expected standard deviation of returns of the risk-free portion of the portfolio if Archer takes a leveraged position with a 150% positive weight in Australia and a 150% negative weight in the euro zone bo ok c A) 98.80% B) 3.00% C) 9.94% m Explanation o The standard deviations of the risk-free assets measured in the investor's domestic currency are: w w EUR asset: 7.0%(1.02) = 7.14% ASD asset: 9.0%(1.025) = 9.23% w The variance of returns of the risk-free portion of the portfolio is: (-1.5)2(7.142) + (1.5)2(9.232) + 2(-1.5)(1.5)(0.70)(7.14)(9.23) = 98.796 The standard deviation of returns of the risk-free portion of the portfolio is: 98.796½ = 9.94% (Study Session 10, Module 21.1, LOS 21.a) Related Material SchweserNotes - Book Question #23 of 24 If Archer takes a short position in a forward contract in the euro and assuming the forward exchange rate for the euro vs the CHF is downward sloping which of the follow is most accurate? A) She will earn a negative return by shorting the currency B) She will earn a negative roll return increasing hedging costs C) Her position will result in a loss if the euro depreciates more than predicted by interest rate parity .in Explanation bo ok c en tre Since forward curve is downward sloping for the euro exchange rate vs the CHF by taking a short position in the forward contract she will earn a negative roll return A positive roll return is earned by taking a long position in a currency with a downward sloping forward exchange rate and Archer is taking the opposite position Conversely with an upward sloping forward exchange rate curve a long position in the forward contract would result in a negative roll return and a short position would result in a positive roll return By entering into the forward contract Archer locks in the forward discount of the euro predicted by interest rate parity If the euro depreciates more than predicted by interest rate parity she would lose less by locking in a smaller depreciation of the euro using the forward contract than if she did not hedge with the forward contract Archer is shorting the forward contract not the currency itself If she had shorted the euro currency and it depreciates as expected then she would earn a pro t on the decrease in value of the short position m (Study Session 10, Module 21.1, LOS 21.a) o Related Material w w w SchweserNotes - Book Question #24 of 24 Assuming the correlation between the ASD currency and underlying asset is highly positive which hedge ratio is most appropriate for hedging the ASD? A) A hedge ratio 1 C) Cannot be determined with the information given Explanation Since the ASD currency and underlying Australian asset are highly positively correlated a hedging ratio of >1, shorting more than 100% of Australian investment, would result in reduced volatility when measuring the ASD investment in the domestic CHF currency (Study Session 10, Module 21.1, LOS 21.a) Related Material w w w o m bo ok c en tre in SchweserNotes - Book ... foreign currency: Standard deviation of asset' s returns measured in foreign currency: The correlation between the foreign -currency asset' s returns and returns on the foreign currency are 0.81... in foreign currency (σ) 0.0% 0.0% Currency risk (σ) 7.0% in Asset return in foreign currency en tre 9.0% Correlation of currency returns (CHF/EUR, CHF/ASD) +0.70 Question #19 of 24 bo ok c The... active manager should take a neutral exposure to the currency Being underweighted in the assets would produce an underweighting in the currency which is corrected by buying the currency forward