CFA Level III Mock Exam 2 – Questions (AM)

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CFA Level III Mock Exam 2
June, 2018

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 CFA Level III Mock Exam 2 – Questions (AM)

FinQuiz.com – 2nd Mock Exam 2018 (AM Session)

Questions Topic Minutes

1 Portfolio Management – Individual Investors 32
2 Portfolio Management – Behavioral Finance 18
3 Portfolio Management – Institutional Investors 30
Portfolio Management – Individual Investors/Asset
4 24
Allocation
5 Portfolio Management – Equity Investments 21
6 Portfolio Management – Fixed-Income Investments 19
7 Portfolio Management – Risk Management 17
8 Portfolio Management – Monitoring and Rebalancing 13
Portfolio Management – Performance Evaluation and
9 6
Attribution

Total: 180

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 32 MINUTES.

Michael and Andy Seinfeld are married and live in Minneapolis, Minnesota. Michael, 45
years old, is a physician working in the North Memorial Hospital in Minneapolis. The
Seinfelds have two children; Ryan, a college student in the State University of New York,
and Rebecca, a marketing specialist working for a multinational firm, with headquarters
in Boston. The Seinfelds are in excellent health and have sufficient medical insurance.

Michael earns a current salary of $150,000 annually which is taxed as income at 25%.
Andy earns $75,000, and her income is taxed at a rate of 20%. Both Michael and Andy
expect their salaries to grow at the inflation rate of 3.5%. In addition, the Seinfelds are
obligated to pay Ryan’s tuition fee, which equals $50,000 per year. Ryan expects to
specialize in economic studies in a university in Boston, a year from now. The admission
fee will equal $25,000, which would be paid at the beginning of the next year, and the
annual tuition fee will equal that he pays currently—this fee will remain constant till he
graduates in about seven years’ time. Rebecca is independent and her salary sufficiently
covers her living expenses. The Seinfelds fully own and live in a well furnished home in
Minneapolis with a current price of $1,800,000.

The family also owns a small side business of home furnishing that they plan to sell by
next year. Michael has received an offer of $5,000,000 for his business, and if he decides
to sell, the entire amount will be taxed at a capital gains tax rate of 17%. Exhibit 1
displays information about the Seinfelds personal assets as of today.

Exhibit 1
Stock holdings $950,000
Fixed-Income holdings $850,000
Cash and cash Equivalents $550,000
Real Estate $1,800,000

Michael just hired Jay Peck, a financial advisor and portfolio manager, to manage their
personal portfolio. During a conversation with Michael, Peck discovered that the average
living expenses of the family equal $155,000 a year that will increase at 3.5% annually,
the U.S. inflation rate. Peck also found out that both Michael and Andy (who is currently
43 years old) want to retire in about ten years time after which they want to fulfill their
lifelong dream of travelling around the globe. They believe that by that time, Ryan would
also be independent and earning.

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 CFA Level III Mock Exam 2 – Questions (AM)

To make sure that their portfolio allows for the achievement of their goals, Michael often
reads financial journals to gain information on what trading strategies would reap the
most profit. Most of his investments were based on research of several analyst
recommendations and market information. Andy believes that investing should be done
after careful analysis to minimize the probability of the loss of principal. Her past
experience has shown her that rushing into investments can cause unexpected losses.
Peck is in the process of developing an appropriate investment policy statement for the
Seinfelds.

A. Assuming that the market value of the current portfolio remains unchanged and
Michael sells the family business, calculate the after-tax nominal rate of return
that is required by the Seinfelds for year 2. Show your calculations.

(12 minutes)

B. Prepare the following portions of Seinfelds’ Investment Policy Statement, after

the sale of the furnishing business:

i. Risk tolerance.
ii. Time horizon.

Answer Question 1-B in the template provided on page 6.

(8 minutes)

C. Characterize Michael and Andy Seinfeld as cautious, individualistic, methodical,

or spontaneous investors. Justify your selection with two reasons each.

Answer Question 1-C in the template provided on page 7.

(4 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Five years have passed and Michael and Andy Seinfeld have incomes that just cover their
current expenses. Their joint after-tax salary equals $350,000 and both their incomes and
expenses grow at the inflation rate of 5.0%. The Seinfelds current investment portfolio
includes stocks, corporate bonds and short-term instruments and has a current market
value of $3,500,000. Ryan and Rebecca are each financially independent and earn
competitive salaries in their respective fields. Both Michael and Andy plan to retire in
five years time, after which they want their portfolio to provide sufficient income to cover
their expenses. Neither of the two has participated in a pension plan. Peck has continued
to be their financial advisor and the Seinfelds have explained to him that a real after-tax
return of 4.5% would be adequate to meet their objectives, while instructing him to take
on only those risks with their portfolio that are absolutely necessary to meet their return
requirement. They also mentioned that they would like to maintain their current standard
of living during retirement and have no further goals or objectives. The Seinfelds are now
taxed at a rate of 30%. The U.S. inflation rate will continue to be 5.0% even after their
retirement.

D. i. Prepare the current return objectives portion of the Seinfeld’s IPS.

ii. Assuming the market value of the current portfolio remains unchanged,
calculate the after-tax nominal rate of return that will be required by the
portfolio during the first year of retirement. Show your calculations.

(8 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 1-B

Prepare the following portions of Seinfelds’ IPS

i. Risk
tolerance

ii. Time
horizon

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 1-C

Circle the type that Explain your choice with two

best describes them justifications each.

Cautious

Methodical
Andy Individualistic

Spontaneous

Cautious

Methodical
Michael Individualistic

Spontaneous

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 2 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES.

Secure Capital Investments (SCI) is a financial advisory firm headed by Lucy Appleby,
the firm’s chief portfolio manager and head of the advisory department. Appleby has
been introducing a number of new concepts and techniques toward an improved
management of clients’ capital. One such change has been the application of behavioral
finance in the development of clients’ investment policy statements, and in implementing
portfolio investment strategies. During a conversation with a member of the portfolio
management team, Appleby mentioned the following client behaviors reflecting
deviations from perfect rationality:

Client A: “I regularly follow the recommendations of the most successful analysts in

the field to ensure that the right decisions are made. Popular investments
are likely to return positive returns since everyone must be investing in
them for a reason.”

Client B: “These last few years, my portfolio experienced a number of ups and
downs. Most of my gains resulted from my accurate prediction for the
telecommunications sector. However, last year my portfolio’s value
dropped by 15%, primarily due to the unanticipated turn of economic
events in Canada and Europe.”

A. Identify the biases inherent in each of the above statements. Give one reason
each for their existence.

Answer Question 2-A in the template provided on page 11.

(4 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Appleby is currently managing the investment portfolio for Chris Moss, a civil engineer
working as a consultant for a number of construction companies in the U.S. He is 50
years old, is not married, and has no children. Moss earns a salary of $175,000 annually
and has living expenses well within his annual income (net of tax). However, Moss
spends a considerable amount on travelling and entertainment, and so, frequently spends
more than his net income. Due to a comprehensive retirement savings and investment
plan at his firm, Moss has managed to accumulate a portfolio worth $2,500,000, invested
mostly in international and domestic equities. Over the past few years the equity
allocation of his portfolio had an 18% annual return, primarily due to some successful
bets made by him on oil stocks. Appleby noticed that Moss’s equity allocation is
concentrated in the stocks of a few oil companies. In addition, Moss frequently traded in
and out of investments based on his predictions since he believes they have helped him
earn high returns in the past. Appleby also observed an investment in the stock of Lions
Enterprises (LEN) that had been performing poorly for the past two years. When he
recommended liquidating the investment, Moss stated that he would hold it for another
year until the stock price reaches his purchase price. When Appleby asked him about his
retirement goals, Moss mentioned that he would not like to compromise his current
spending for future consumption. He believed in ‘living in the present’.

B. i. Identify three biases that Moss is most likely subject to. Justify your response
for each bias.

(6 minutes)

ii. Determine whether to adapt to, moderate, or adapt to and moderate Moss’s
biases. Justify your response.

(4 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Roger Wong is a financial advisor at SCI. Wong has been assigned the responsibility to
work with Jasmine Arcus, a 35-year old successful entrepreneur who owns a fashion
boutique in Chicago, USA. Arcus has an investment portfolio worth $5,000,000 that is
invested 55% is stocks, and 45% in bonds. She manages to make an annual profit from
her boutique that comfortably covers her living expenses and also contributes to her
savings. Arcus is convinced about the future prospects of the U.S. automobile sector and
has invested 25% of her equity allocation in automobile stocks. When Wong suggested
diversifying part of the holding due to a deterioration of the industry’s fundamentals,
Arcus disagreed, and stated that his predictive model validated the industry’s positive
outlook. Arcus also mentioned that most of the companies within the auto industry had
high P/E multiples which confirmed that her investment in the industry is of good value.
When Wong asked her how she gathered the information about the P/E multiples, Arcus
mentioned that she read in most of the best selling financial journals about how high P/E
multiples for companies within the industry prove that their stocks have growth potential
and can yield high returns for investors.

C. Determine whether to adapt to, moderate, or adapt to and moderate Arcus’s

biases. Justify your response.

(4 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 2-A

Identify the biases inherent Give one reason each for

Client Statements
in the statements why they might exist

“I regularly follow the

recommendations of the most
successful analysts in the
field to ensure that the right
decisions are made. Popular
investments are likely to
return positive returns since
everyone must be investing in
them for a reason.”

“These last few years, my

portfolio experienced a
number of ups and downs.
Most of my gains resulted
from my accurate prediction
for the telecommunications
sector. However, last year my
portfolio’s value dropped by
15%, primarily due to the
unanticipated turn of
economic events in Canada
and Europe.”

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 3 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 30

MINUTES.

Charlotte Browning is a portfolio manager at Get Right Investments (GRI), an asset

management firm providing portfolio management services to institutional investors.
Browning has currently been assigned the task of managing the investment portfolio of an
independent foundation. The Towers Foundation (TTF) was formed by the Towers
family and is headed by Mark Towers, the sole decision maker for the institute. Mark
Towers is a large industrialist in the U.S. and has made significant donations to the
foundation for the purpose of aiding educational activities in the country. The investment
portfolio for TTF is worth $85 million and is entirely responsible to give funding for, and
make grants to, numerous independent educational programs for 3-4 years. Towers’s
objective is to preserve the purchasing power of its corpus, and to maintain a minimum
level of spending at 5.0% of the 12-month average asset value in a year, which a
requirement in order to be tax exempt. In addition, during a meeting with Browning,
Towers instructed him to maintain 15% of the annual grant-making and spending budget
in cash, as a reserve for contingencies. Browning has determined that expenses associated
with the management of the foundation’s assets will equal 1.23%, and that the U.S.
inflation rate will equal 4.5%. The U.S. Internal Revenue Service does not allow for
carry-forwards and carry-backs for foundations. TTF does not use a smoothing rule to
determine the level of spending in a given year.

During her regular lunch break at office, Browning met Denise Petcher, her colleague,
and a portfolio manager at GRI. Petcher is responsible for the management of the
investment portfolio of the Shining Star Endowment (SSE), an endowment owned and
established by a nonprofit institution, operating in the health care industry. The
endowment was established to provide budgetary support for the Medical Care Hospital
(MCH), established in Chicago, USA. The endowment is worth $45 million, composed of
$25 million of a restricted fund to support the procurement of medical equipment, and
$20 million for unrestricted use. SSE receives donations from its sponsor organization,
and its annual spending comprises of 25% of the hospital’s overall revenues. About 55%
of the endowment is invested in domestic stocks of the health care industry, and 35% is
invested in bonds. The sponsoring nonprofit institution has established the endowment to
permanently fund the Medical Care Hospital. Exhibit 1 displays some information about
SSE. MCH has recently taken a loan worth $25 million to expand its operations to other
states of the country.

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 CFA Level III Mock Exam 2 – Questions (AM)

Exhibit 1
Long-term average spending rate 4.75%
Long-term expected real return 5.85%
Expected annual inflation as determined by the CPI 4.5%
Last year’s inflation rate as determined by the CPI 2.55%
Policy spending rate 4.75%
Last year’s spending $1,675,500
Smoothing rate 0.75
Last year’s beginning market value $37.5 million
Last year’s ending market value $44.75 million

SSE uses a smoothing rule that determines the spending level in a year well before the
endowment market value at the beginning of the fiscal year becomes known. In addition,
Medical Care Hospital’s inflation rate has averaged 1.2% above the economy in general.
The investment management expenses equal 0.10%. Due to the increase in the growth of
patients under 12 years of age, SSE is expected to pay $10 million at the end of the
coming six months for the construction of a medical facility with accommodation for
more than 200 patients. Petcher determined that the endowment’s smoothed spending rate
for the past few years has been 4.0%.

A. Calculate the return objective for:

i. The Towers Foundation, and

ii. Shining Star Endowment.

Show your calculations.

(8 minutes)

B. Prepare the liquidity constraint portion of the investment policy statement of:

i. The Towers Foundation, and

ii. Shining Star Endowment.

(6 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

C. i. Identify two factors that increase the Towers Foundation’s ability to

take risk.
ii. Identify two factors that increase the Shining Star Endowment’s ability to
take risk.
iii. Identify two factors that decrease the Towers Foundation’s ability to take
risk.
iv. Identify two factors that decrease the Shining Star Endowment’s ability to
take risk.

Note: Each factor can be used only once.

Answer Question 3-C in the template provided on page 15.

(8 minutes)

D. Calculate the dollar spending amount for Shining Star Endowment for the
coming year based on the smoothing rule. Show your calculations.

(4 minutes)

After a meeting with Browning, Petcher met Simon Jones, the head of the research
department at Get Right Investments. Jones has worked with a number of institutional
clients and has played an active role in determining appropriate asset allocations for
them. During a conversation with Petcher, Jones made the following comments:

Statement 1: “Since most endowments have to meet spending needs of the beneficiary
institution, their portfolios should invest significantly in high-yielding,
high quality fixed-income securities that typically make their promised
nominal payments on time, according to a predetermined schedule.”

Statement 2: “The presence of a cash reserve in a foundation, as a percentage of its

annual grant making budget, can sometimes create a year-end rush of
grants paid by the foundation during an ‘up year’ for markets, and
overspending during a ‘down’ year.”

E. Determine whether each statement is correct or incorrect, and give one reason
each for your selection.

Answer Question 3-E in the template provided on page 16.

(4 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 3-C

Identify two factors that increase the institution’s ability to

Institution
take risk

The Towers
Foundation

Increase

The Shining Star

Endowment

Identify two factors that decrease the institution’s ability to

Institution
take risk

The Towers
Foundation

Decrease

The Shining Star

Endowment

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 3-E

Determine whether each

Give one reason each
of the statements is
for your selection
correct or incorrect

“Since most endowments have

to meet spending needs of the
beneficiary institution, their
portfolios should invest
significantly in high-yielding,
high quality fixed-income
securities that typically make
their promised nominal
payments on time according to a
predetermined schedule.”

The presence of a cash reserve in

a foundation can sometimes
create a year-end rush of grants
paid by the foundation during an
‘up year’ for markets and
overspending during a ‘down’
year.”

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 4 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 24 MINUTES.

Gwyneth Larson is a successful lawyer living in Boston, USA. Larson works as a

consultant for multinational corporations and manages to make around $200,000
annually, net of tax. Larson did not marry and lives in a home worth $1,800,000 for
which all mortgage payments have been made. After working as a lawyer for the past
twenty years, Larson, at 48 years of age, has finally decided to retire, and spend the rest
of her years visiting her family and travelling. To manage her investment portfolio,
Larson hired Adam Wood, a financial analyst and portfolio manager at a reputable
investment management firm in the U.S. When talking to Larson, Adam noted the
following information:

• Larson is in good medical condition and has medical insurance.

• Since Larson has not been working for a specific employer, she is not entitled to
receive a pension.
• After three months, Larson plans to travel to Europe and has estimated that it would
cost her $80,000.
• Larson’s investment portfolio worth $2 million is invested 60% in domestic and
international stocks, and 30% in bonds. The rest is invested in cash.
• After retiring, Larson’s living expenses will equal $95,000 a year and will rise with
inflation.
• To help support child education in the country, Larson will make a $65,000 donation,
payable now, to ‘The Light’, a public service organization engaged in promoting
education in the less developed areas of the U.S.
• In addition to the investment portfolio, Larson just received $800,000 from a family
trust. Larson has asked Adam to exclude this inflow when determining an appropriate
asset allocation and required return for her.
• Larson wants to maintain at least 5% of her investment portfolio in cash.
• Larson’s risk aversion score is 3. She has expressed that her strategic asset allocation
should minimize the probability of falling short of her required return and wants to
maximize the risk adjusted expected return from the portfolio.
• Larson wants to invest a maximum of 20% of her portfolio in emerging market
equities.
• The risk free rate is 3.5% and the inflation rate is expected to be 1.5% next year.

Adam has shortlisted the following asset allocations for Larson.

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 CFA Level III Mock Exam 2 – Questions (AM)

Exhibit 1
Proposed Strategic Asset Allocations for Gwyneth Larson

Asset Class A B C D E
Cash 7% 5% 6% 4% 5%
Treasury bills and notes 15% 15% 10% 5% 0%
Intermediate and long-term
25% 20% 15% 5% 0%
corporate bonds
International emerging
5% 15% 20% 25% 35%
market equities
U.S. equities 25% 25% 25% 30% 30%
International developed
15% 15% 20% 20% 20%
market equities
Alternative Investments 10% 5% 4% 1% 10%
Expected return 15% 12% 9% 17% 19%
Expected standard deviation 25% 17.5% 10.3% 27% 29%

A. Determine the most appropriate portfolio for Larson, assuming she retires
immediately. State, for each portfolio not selected, one reason why it is not the
most appropriate.

Answer Question 4-A in the Template provided on page 20.

(14 minutes)

Woods also manages the investment portfolio for Chris Hayes, who is 60 years old,
retired, and lives in Canada. Hayes wants to transfer his estate worth CAD2 million to his
only relative, Jeff Graham. During the process of developing an estate planning strategy
to transfer wealth to Graham, Hayes discovered that the relevant tax for bequests is 45%
in Canada. However, he determined that gifts made prior to the age of 75 are subject to
only 65% of the normal estate tax. Hayes pays a 35% tax rate on investment income and
will be responsible to pay the gift tax in case he decides to gift his estate prior to death.
Graham falls in a low income tax bracket, and hence pays a tax rate of 25% on
investment income. Woods has determined that Hayes’s assets will earn an 8.0% return
over the next 15 years.

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 CFA Level III Mock Exam 2 – Questions (AM)

B. Determine whether it is appropriate for Hayes to gift the assets or bequeath them
as part of his estate. Justify your response.

(3 minutes)

Graham knows that the appropriate asset allocation for his portfolio also depends on his
human capital. He works for the sales department at a large utility company, with his
compensation based on the amount of sales he makes to retail stores in his allotted region.
Graham has no contractual relationship with his company regarding his employment
tenure. In addition, Graham has indicated a strong desire to leave an estate to his children.

C. Determine whether Graham’s human capital and bequest desire increase or

decrease his demand for life insurance. Justify your response with one reason
each.

Answer Question 4-C in the template provided on page 21.

(7 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 4-A

Determine the most
appropriate portfolio for State, for each portfolio not selected, one reason why it
Larson. is not the most appropriate.
(circle one)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 4-C

Determine whether
Graham’s human capital Justify your response with one
and bequest desire increase reason each.
or decrease his demand for
life insurance.

Increase
Human Capital
Decrease

Increase
Bequest Desire
Decrease

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 21 MINUTES.

Thomas McGrath is 46 years old and lives in Germany. McGrath started a clothing line
for women around ten years ago. The business achieved high success and the demand for
his clothing increased manifold over the years. McGrath has managed to recently launch
his personal designer wear by the name of ‘Exquisite Fashion’ that covers designs for
both men and women. McGrath owns several boutiques in the country and has a total net
worth of around €50 million. Even though he has taken several risks to grow his business
to its current level, McGrath has always remained a conservative investor and has tried to
take minimum amounts of debt. He now wishes to invest some of his money in the stock
market, and for this, has hired Martin Allen, the chief portfolio manager at Allen
Investment Advisors. McGrath believes that active management of funds is a way too
risky strategy, and that given the costs of trading, administrative expenses and
management fees, average active investors generally underperform market indices over
time. Therefore, during an introductory meeting with Allen, McGrath instructed him to
passively manage his investment portfolio by indexing it to a comprehensive equity
benchmark index. Allen stated the following categories of indexed portfolios to choose
from:

• Euro-equity Index Mutual Fund with more than 20 shareholders.

• Questa Investor Right ETF indexed to a broad based local equity market index.
• Indexed Equity Shares managed as pooled accounts.
• Euro-equity Index Futures.

Since McGrath wants to invest indefinitely and may use his portfolio for hedging his
business risks, he wants to minimize costs as measured by the fund’s expense ratio, as
well as the costs associated with cash drag. McGrath is not sure which indexed portfolio
to invest in; the one that would be most suitable to meet his objectives.

Allen considers McGrath as having an above average ability to tolerate risk, since he has
a well-established business, has minimum liabilities and a long-term time horizon. Allen
has tried to convince him during several client meetings to take some risk with his capital
and has explained how he could generate higher returns if he relaxed his stringent rules
with regards to risk-taking. McGrath has finally agreed to manage part of his assets using
an active management approach and has hired Melissa Wells for this purpose. Wells will
manage €5 million for McGrath and is instructed to invest in domestic equities only. To
evaluate Wells past performance, Allen has gathered the following information.

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 CFA Level III Mock Exam 2 – Questions (AM)

Exhibit 1
Wells Portfolio Analysis (1)
Portfolio Market Benchmark
Number of stocks 35 1000
P/E ratio 22 15
P/B ratio 2.9 2.0
Dividend yield 1.5% 2.3%
Weighted average market cap €16 billion €22 billion
Expected EPS growth rate 17% 12%

Exhibit 2
Wells Portfolio Analysis (2)
Sector Portfolio Market Benchmark
Consumer discretionary 10% 18%
Energy 15% 13%
Finance 13% 25%
Health care 22% 12%
Information Technology 25% 17%
Industrials 5% 7%
Telecommunications 10% 8%

As part of his evaluation process, Allen met with Wells to ask her how well she
performed in the past. Wells stated that her age old belief that value stocks outperform
the market in general finally paid off last year. She made the following comment:

“Last year, not only did value stocks outperform the market as a whole, my superior stock
picking skill also added to my portfolio’s outperformance relative to the market.”

To confirm Wells’s statement, Allen requested her to provide him with some facts about
her portfolio’s performance. Allen gathered the following information:

• The Euro-zone Value Stock Index earned a return of 18% during the past year.
• The Euro-zone Market Stock Index earned a return of 15% during the past year.
• During the same period, Well’s portfolio earned a return of 21%.
• Wells active risk computed with respect to the Euro-zone Market Stock Index is 6.7%
annually.
• Wells misfit risk is 5.5% annually.

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 CFA Level III Mock Exam 2 – Questions (AM)

A. Determine which indexed portfolio would be most suitable to meet McGrath’s

objectives. Determine for each indexed portfolio not selected, one reason why it
is not appropriate.

Answer Question 5-A in the template provided on page 25.

(6 minutes)

B. i. Determine the investment style followed by Wells in the management

of her portfolio. Justify your response with four reasons.

Answer Question 5-B(i) in the template provided on page 26.

(7 minutes)

ii. Determine the major risk factor faced by investors following the
investment style identified in part (i).

(2 minutes)

C. Determine whether Wells comment about her portfolio’s performance is correct.

Justify your response.

(6 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 5-A

Circle the indexed portfolio that

Determine for each indexed portfolio not
would be most suitable to meet
selected, one reason why it is not appropriate.
McGrath’s objectives

Euro-equity Index Mutual Fund with

more than 20 shareholders.

Questa Investor Right ETF indexed

to a broad based local equity market
index.

Indexed Equity Shares managed as

pooled accounts.

Euro-equity Index Futures.

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 5-B(i)

Determine the
investment style
followed by Wells in
Justify your response with four reasons.
the management of
her portfolio.

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 6 HAS THREE PARTS (A, B AND C) FOR A TOTAL OF 19

MINUTES

Graham Kelly works for Multiple Investment Management (MIM), a capital management
firm that serves as a comprehensive financial solution provider. Kelly is in charge of
managing the MIMF Short Duration Fixed Income Fund that invests only in investment
grade fixed-income securities with effective durations of 5 or less. The fund’s mandate
gives Kelly the flexibility to alter the fund’s duration as long as it stays within ±0.50 of
the benchmark duration of 3. Exhibit 1 displays the fund’s current composition.

Exhibit 1: MIMF Short Duration Fixed Income Fund

Beginning % Total
Maturity Coupon Price Effective Market
Duration Value
1 year 1.70 100 0.976 2%

2 year 1.99 100 1.930 10%

3 year 2.45 100 2.700 20%

4 year 2.78 100 2.861 70%

Kelly strongly believes that the yield curve will experience an upward parallel shift of 50
bps within the next year. Given the confidence in his forecast, he plans to alter the fund’s
composition to reap maximum benefits from the change in yields. Consequently, Kelly
requests MIM’s research department to work with him towards estimating expected
returns for each maturity.

A. Given the forecast yields, estimate the total expected return for each maturity
given in Exhibit 1. Based on your calculations, justify an appropriate strategy to
maximize returns over the next year. Give two reasons to support your answer.

(6 minutes)

When working with the research department of MIM, Kelly met with Ian Jackson, a yield
curve specialist that has been working with the firm for over ten years. As the discussion
on the future discourse of interest rates progressed, Jackson mentioned that his
department had developed several scenarios detailing the changes in yields in the
imminent future. He presented the following views:

Scenario 1: “Short-term rates are expected to fall as monetary policy aims to help the
economy reach the target growth rate. However, long-term rates are
expected to remain stable.”

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 CFA Level III Mock Exam 2 – Questions (AM)

Scenario 2: “Even though the economy lags the long-term target, a rise in inflation will
encourage monetary policy setters to raise short-term interest rates; with the
rise being greater than the rise in long-term rates.”

Scenario 3: “Future volatility of interest rates is likely to be much less than that reflected
in current prices. Neither short-term nor long-term rates are expected to
change much owing to a stable economic environment.”

B. State a suitable strategy for each of the interest rate scenarios presented by
Jackson. Support your answer by explaining why each strategy is appropriate.
Use the template on page 28 to answer the question.

(6 minutes)

Jackson has been exploring numerous investment opportunities in international markets

and has been particularly interested in German bonds. He has constructed a portfolio that
tracks the German Government Bond Index, with a part of the portfolio being fully
invested in 15-year German bonds. The rest of the portfolio is constructed so as to match
the duration of the benchmark index. Jackson expects German interest rates to be
considerably volatile next year due to uncertainties surrounding the amount of private and
public investment in the country. He anticipates interest rates to move by at least 2% in
either direction. Exhibit 2 presents information that Jackson’s research team has
accumulated about German notes and bonds.

Exhibit 2: German Sovereign Securities

Effective Effective Coupon
Security YTM
Duration Convexity Rate

6-month bill 2.07% 0.555 0.004 5.00%

5-year note 4.10% 4.709 0.301 7.50%

15-year bond 5.49% 11.965 1.740 7.00%

30-year bond 5.73% 14.950 2.890 4.50%

C. Suggest one way Jackson could alter the part of the portfolio that is fully invested
in 15-year German bonds to take advantage of the move in interest rates.
Construct the new portfolio and show its convexity and yield. State one risk
factor of the suggested alteration.

(7 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

B.

Most Suitable Strategy Justification

Scenario 1

Scenario 2

Scenario 3

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 17 MINUTES.

Total Asset Management is an investment firm in the U.S. that invests funds for high net-
worth private wealth clients. TAM specializes in excess return and risk management
strategies involving traditional asset classes as well as alternative investments and
derivatives. Recently, the firm launched the “Global Equity Fund’, an investment vehicle
that invests in foreign markets. Marc Fishman is part of the portfolio management team
for the fund, and is responsible for managing investments made in the euro-zone. The
high growth in the region, development in the services sector, and the removal of barriers
to foreign capital inflow has caused Fishman to believe that the euro market would be an
attractive inclusion to the Global Equity Fund. Based on his research, Marc has
determined that a $39,550,000 investment in an equity portfolio of European stocks with
a beta of 1.27 would be appropriate. The fund will make this investment for a year,
starting from 31 January 2009, till 31 January 2010. TAM, however, does not yet
specialize in currency risk management. In addition, Fishman is uncertain about the
future movements in the pound-dollar exchange rate. For these reasons, Fishman wants to
fully hedge the currency risk associated with the investment and not base his hedge on
estimates or uncertain expectations. For this purpose, Marc approached a currency risk
dealer, who gave him the following quotes:

• A stock index futures contract on a euro-denominated index trades at €259,394 and

has a beta of 1.10.
• A currency forward contract based on the $/€ exchange rate has a price of $1.1742/€.

In addition, Fishman determined that the euro-zone risk free rate is 4.67% and the dollar
risk free rate is 2.95%. Both these rates are annually compounded rates. Also, the current
spot exchange rate is $1.1938.

A. Determine and explain the hedging strategy that Fishman should implement to
achieve his objective. Show your calculations.

(5 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

A year has passed, and the Global Equity Fund has performed well. TAM’s upper
management has decided to continue the fund and expand its scope to include stocks
from other regions as well. Jeff Glave, an international portfolio manager, has been
assigned the task of investing part of the fund’s assets in British stocks. Glave allocates
£2.5 million to British stocks and assigns Matha Walters, an independent currency
specialist, to devise a solution for hedging currency exposure. Walters establishes a two-
month short forward position equal to the amount of the investment. Two months later
the market value of the GBP denominated assets increases to £2.8 million and Walters
expects the GBP to depreciate. Walters informs Glave that she intends to rebalance and
rollover the forward position using a foreign currency (FX) swap.

The USD/GBP spot rate and the three-month forward points (scaled by 10,000) at the
time of the rollover is 1.6621/1.6639 and -14/-12 respectively.

B. Determine:
i. the type of FX swap used to rebalance the hedged position and
ii. whether the size of the hedged position should be increased, decreased, or
remain constant.
(2 minutes)

iii. Determine the rates at which the spot and forward legs of the FX swap are
transacted. Show your calculations.
(2 minutes)

(4 minutes)

Melissa Bretherton is part of the research management team at Total Asset Management,
and is analyzing the performance of her equity portfolio under different possible
scenarios. As part of her research, Bretherton executes the following analysis:

• Bretherton has developed a multifactor model to explain the returns on her portfolio.
The model includes factors that she believes explain the majority of returns to her
portfolio. After every six months, she determines the combined effect of the risk
factors on her portfolio assuming they move in the most unfavorable way.
• Based on her probability models and expectations, Bretherton determines the worst
possible return outcome for her portfolio, one that she expects has some probability of
occurring. She then compares this return to her threshold return requirement.
• Every year, Bretherton creates scenarios based on certain investment fears she has,
and then analyzes how her portfolio would react to such events. She knows that such
scenarios have an extremely small or maybe even a zero probability of occurring, but
she still feels it is necessary to remove any uncertainties.

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 CFA Level III Mock Exam 2 – Questions (AM)

Bretherton has worked with Fishman on several assignments, for the past many years.
Recently, Fishman took the task of managing an institutional fund worth $10 million
owned by Orange Enterprises (OE). OE has instructed Fishman to use the funds provided
to manage the risk of their foreign transactions, and the risk of their bond portfolio. Marc
has decided to use forward contracts to meet OE’s objectives related to risk management.

C. i. Identify the risk management approaches used by Bretherton in the

management of her portfolio. Justify your response for each approach.

Answer Question 7-C (i) in the template provided on page 32

Note: Consider each approach independently.

(6 minutes)

ii. Determine why Fishman might have preferred the use of forwards over
futures and options for meeting Orange Enterprises’s risk management
objectives.

Answer Question 7-C (ii) in the template provided on page 33.

(2 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 7-C(i)

Identify the risk management approaches used

by Bretherton in the management of her
portfolio. Justify your response for each
approach.

Note: Consider each approach independently.

Bretherton has developed a

multifactor model to explain the
returns on her portfolio. The model
includes factors that she believes
explain the majority of returns to
her portfolio. After every six
months, she determines the
combined effect of the risk factors
on her portfolio assuming they
move in the most unfavorable way.

Based on her probability models

and expectations, Bretherton
determines the worst possible return
outcome for her portfolio, one that
she expects has some probability of
occurring. She then compares this
return to her threshold return
requirement.

Every year, Bretherton creates

scenarios based on certain
investment fears she has, and then
analyzes how her portfolio would
react to such events. She knows that
such scenarios have an extremely
small or maybe even a zero
probability of occurring, but she
still feels it is necessary to remove
any uncertainties.

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 7-C(ii)

Determine why Fishman might have preferred the use of

forwards over futures and options for meeting Orange
Enterprises’s risk management objectives.

Futures Contracts

Option Contracts

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 13 MINUTES.

Anthony Reyna is responsible for the implementation of portfolio management decisions

made by the research and management department at his investment firm. Recently,
Reyna was instructed to buy 1,500 shares of W-Tech Corporation, a company
specializing in high-tech security equipment. In the process of selecting the best broker,
Reyna searched the market and decided to select the Chicago Brokers for the execution of
the order. Reyna ordered Chicago Brokers to buy 1,500 shares of W-Tech stock on
Monday, with a benchmark price of $56. On the same day, Chicago Brokers managed to
purchase 750 shares at a price of $56.703/share. To trade these shares, Reyna had to pay
commissions of $55. No more shares were purchased that day, and the stock closed at a
price of $55.302/share. On Tuesday, 300 more shares were purchased at $57.923/share,
and the commissions on the trade were $25. The closing price for the stock that day was
$56.201. The remaining shares could not be purchased, and Reyna cancelled the order on
Wednesday, the day when W-Tech stock closed at $57.034.

Reyna’s employer just launched an investment product that invests in emerging and
developing markets, including Brazil, Russia and India. Reyna knows that although these
markets offer attractive return and diversification opportunities, they also have inherent
risks. One of the risks is the absence of an established and well-organized market
structure, one that encourages secondary trades. To examine the quality of Brazil’s
capital market, Reyna gathered the following information.

A. The Crossover Clearing House has recently been established to serve as an

intermediary to capital market transactions. The entity is subject to financial and
ethical standards imposed by the Brazilian government.
B. The market offers attractive opportunities to investors who can identify
mispricings before others, especially in the small-cap sector. Those who act early
can earn significant gains.

Reyna is working with Sam Walter, a portfolio manager, towards setting the appropriate
corridor width for asset classes within the Brazilian market. The asset classes include
Brazilian corporate bonds, Brazilian equities, and Brazilian government bonds. Walter
has determined the following about the asset c lasses:

• The volatility of Brazilian government bonds and equities has increased over the past
few years.
• The correlation of Brazilian equities with Brazilian corporate bonds is higher than
their correlation with Brazilian government bonds.

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 CFA Level III Mock Exam 2 – Questions (AM)

A. Calculate the components of the implementation shortfall for the trade of W-Tech
Stock. Show your calculations separately for each component.

(5 minutes)

B. i. Determine whether the Brazilian market information suggests an

increase or a decrease in the quality of the Brazilian market. Identify
the market quality factor that each affect. Justify your response with
one reason each.

Note: Consider each point independently.

Answer Question 8-B (i) in the template provided on page 37.

(4 minutes)

ii. Evaluate the effect of the information Walter gathered, on the optimal
corridor width of Brazilian corporate bonds. Justify your response with
one reason each.

Note: Use an all-else equal assumption in each case.

Answer Question 8-B (ii) in the template provided on page 38.

(4 minutes)

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 8-B(i)

Determine whether the

Identify the market
Brazilian market
quality factor that each
information suggests an
affect. Justify your
increase or a decrease in
response with one
the quality of the
reason each.
Brazilian market.

The Crossover Clearing

House has recently been
established to serve as an
intermediary to capital market
transactions. The entity is
subject to financial and ethical
standards imposed by the
Brazilian government.

The market offers attractive

opportunities to investors who
can identify mispricings
before others, especially in
the small-cap sector. Those
who act early can earn
significant gains.

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 CFA Level III Mock Exam 2 – Questions (AM)

Template for Question 8-B(ii)

Evaluate the effect Justify your response
of the information with one reason each.
Walter gathered, on
the optimal corridor Note: Use an all-else
width of Brazilian equal assumption in
corporate bonds. each case.

The volatility of Brazilian

government bonds and
equities has increased over
the past few years.

The correlation of Brazilian

equities with Brazilian
corporate bonds is higher than
their correlation with
Brazilian government bonds.

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 CFA Level III Mock Exam 2 – Questions (AM)

QUESTION 9 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

Hugh Ross is a fixed income analyst at White Stripes Investment Management, a firm
that offers bond portfolio management services. Ross has managed more than twenty
portfolios over the course of his career, some for institutional investors, and others for
private wealth clients. Recently, Larry Kemp, the chief investment officer at White
Stripes, instructed Ross to analyze the performance of a bond portfolio managed by one
of his subordinates, Anne Couk. While evaluating the portfolio’s performance, Ross
calculated the impact of the following on the portfolio’s total return:

• The sector/quality effect.

• The security selection effect.
• The trading effect.

A. Determine for each of the effects mentioned how Ross might have calculated
their impact on the portfolio’s total return.

Note: No calculations are necessary.

(6 minutes)

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