CFA Society Boston Level III 2021 Practice Exam Morning Session

CFA Society Boston Level III
2021 Practice Exam
Morning Session
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© 2021 CFA Society Boston

The morning session of the CFA Society Boston Level III 2021 Practice Exam has 7 questions.
For grading purposes, the maximum point value for each question is equal to the number of
minutes allocated to that question.
Question Topic Minutes

1 Portfolio Management – Derivatives and Currency Management 9
2 Portfolio Management – Equity 20
3 Portfolio Management – Fixed Income 29
4 Portfolio Management – Behavioral 14
5 Portfolio Management – Individual 27
6 Portfolio Management – Institutional 24
7 Portfolio Management – Trading, Portfolio Performance,
and Trading 9
Total 132
79/134=59%
Derivs: 44%
EQ 10%
FI 93%
BF: 64%
PWM: 51%
II:75%
Trading 44%
© 2021 CFA Society Boston 2

QUESTION 1 HAS A TOTAL OF THREE PARTS (A, B, C) FOR A TOTAL OF 9
MINUTES.
Viaan Nadela, CFA, is a foreign exchange analyst at a US-based hedge fund that invests in
emerging market currencies. Nadela has been asked to formulate a forward-looking, sustainable
investment strategy. Exhibit 1 provides the details of the hedge fund’s exposure to emerging
market currencies.
Exhibit 1
Hedge Fund’s Exposure to Emerging Market Currencies
Percentage
of Overall Six-Month Annual
Country Portfolio Spot Rate Forward Rate Yield
Brazil 20% BRL/USD = 5.41 BRL/USD = 5.71 1.562%
Russia 25% RUB/USD = 74.15 RUB/USD = 74.85 3.255%
India 25% INR/USD = 74.50 INR/USD = 73.26 2.356%
China 30% CNY/USD = 6.46 CNY/USD = 6.37 5.667%
Annual yield for US is 2.211%
The COVID-19 pandemic led many investors to flee from emerging market currencies due to
concerns of exchange rate volatility. The flight to safety created several short positions in
BRL/USD, leading to the depreciation of the Brazilian real. Zhang Lei, the hedge fund’s CEO,
predicts that the Brazilian real will appreciate soon and requests that Nadela create a bull spread
using options.
Exhibit 2
Option Prices for BRL/USD
BRL/USD Strike Call Option Price
$5.00 $1.95
$5.50 $1.70
$6.00 $1.50
$6.50 $1.10
$7.00 $0.75
Nadela interviews a potential new hire, Camila Beth, an external currency overlay manager, to
take directional views on the future currency movements of India and China. The newly elected
government in India is promoting business growth through expansionary monetary policy. China
continues to face pressure from developed countries over trade. However, China’s GDP is
projected to grow at over 5%. Beth makes the following statements during her interview:
Statement 1: Use technical analysis to examine interest rates, inflation rates and risk premium
differentials to project future exchange rate movements. Nope! TA uses historical prices!
not econ factors!
Statement 2: Implementation of expansionary monetary policy in India contributed to the
appreciation of the Indian rupee.
expansionary monetary->should depreciate rupee

Statement 3: Hedge the currency exposure to China by using the CNY/USD protective put
exchange rate option strategy to protect against USD depreciation.
Yes China Y is rising USD is falling get a put for your USD
A. Construct the CNY/USD carry trade, using the information in Exhibit 1. Explain two
risks involved in this carry trade.
4 minutes (Answer 1-A on page 5)
B. Calculate the maximum gain and breakeven price per option contract with a $5.00/$6.00
bull spread, using data in Exhibit 2.
3 minutes (Answer 1-B on page 6)
C. Identify which of Beth’s statements is most likely correct. Justify your response with one
reason.
2 minutes (Answer 1-C on page 7)

Answer Question 1A on this page
Construct the CNY/USD carry trade, using the information in Exhibit 1. Explain two risks
involved in this carry trade.
Carry trade
borrow US$ at 2.211% borrow low
exchange for CNY at 6.46 invest high
invest CNY at 5.667%
exchange for USD /6.37 Profit of a carry trade=
and pay back the 2.211% Rhigh-Rlow
you return 6.46% 5.667%-2.211%=3.456%
Risk 1
Exchange rate risk if the exchange rate changes such that CNY deflates more than
the rate of its interest advantage
Carry trade danger!
High-yield currency
b/c high-risk!
Risk 2
interest rate risk, if CNY does not return as much as expected
Carry trade danger!

During financial crisis,
rapid moves to low-risk currencies -> unwind
carry trades
Carry Trade Danger!

Losses incurred quickly because LARGE
LEVERAGE->LARGE LOSS!

Answer Question 1B on this page
Calculate the maximum gain and breakeven price per option contract with a $5.00/$6.00 bull
spread, using data in Exhibit 2.
max gain: profit=(St-Xlow)-(St-Xhigh)-call low+call high

profit = 1-1.95+1.5=.55
0.55
breakeven price:
St=X+1.95-1.5=5+1.95-1.5=5.45

Answer Question 1C on this page
Identify which of Beth’s statements is most likely correct. (circle your answer)
Statement 1
Statement 2
Statement 3
Justify your response with one reason.

Technical analysis, looking at the short term movements in rates
inflation and RP’s to predict the movement is legit way to predict
FX movements
TA is wrong, looks at historical not econ factors
Expansionary monetary policy should deflate not inflate the currency!
3 is correct, think that CNY is increasing a lot so protect your US$ with
a CNY/USD put

QUESTION 2 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20
MINUTES.
Ella Fitz is a managing partner at Staysail Associates, an investment consulting firm based in
New York City. Fitz plans to meet with Olive Duggan, the chief investment officer of The
Kibble Foundation, a charitable organization focused on caring for stray cats and dogs. Duggan
retained Fitz’s firm to obtain independent, objective advice on how the foundation can improve
its US equity portfolio returns. Fitz leads Staysail’s US equity practice and is excited to share her
strategic recommendations with Duggan.
Fitz begins the discussion by reviewing the Spencer Fund, one of the foundation’s two actively
managed US equity fund holdings. Duggan asked Fitz to examine the Spencer Fund and share
some thoughts on its role in Kibble’s overall US equity portfolio. Fitz shares the results of a
returns-based style analysis she performed by regressing the Spencer Fund’s daily returns on
several US equity style indices over the trailing ten-year period ending December 31, 2020.
Eager to understand how the fund’s investment style may have evolved over the last decade, Fitz
repeated this process for the ten-year period ending December 31, 2010. Results are presented in
Exhibit 1. Duggan is appreciative of Fitz’s work but wishes she had produced a holdings-based
style analysis as well.
Exhibit 1
Exposure Coefficients December 31, 2010 December 31, 2020
Russell 1000 Growth Index 0.73 0.51
Russell 1000 Value Index 0.17 0.07
Russell 2000 Growth Index 0.52 0.87
Russell 2000 Value Index 0.08 0.14
Dow Jones Select Dividend Index 0.38 0.12
MSCI USA Quality Index 0.69 0.49
MSCI USA Momentum Index 0.51 0.80
CBOE Volatility Index 0.84 0.84
After reviewing the Spencer Fund, Fitz shifts the discussion to the Artie Fund, the foundation’s
other actively managed US equity fund holding, the Artie Fund. Fitz points out that the Artie
Fund’s assets have experienced tremendous growth over the last decade, climbing from $280
million to $1.285 billion. However, the fund has struggled to outperform its benchmark during
this period, averaging zero alpha on a gross-of-fee basis. This is well below the 3% annual
outperformance averaged by the Artie Fund in the prior decade, when the fund was much
smaller. The Artie Fund holds just 40 stocks and exhibits annual turnover of 70%. Fitz expresses
her concern to Duggan that the Artie Fund’s strong growth in assets has caused the implicit costs
associated with the fund’s strategy to weigh on performance.
Fitz transitions the discussion to the topic of risk budgeting. Before their meeting, Duggan
expressed concern to Fitz about the high level of absolute risk, as measured by portfolio variance
experienced by Kibble’s US equity portfolio over the last several years. Duggan asked Fitz to

discuss the key drivers of absolute risk in the US equity portfolio and to make suggestions on
how Kibble could reduce it. Fitz presents Duggan with Exhibit 2, a risk analysis she performed
on Kibble’s US equity portfolio, which displays fund-level data. Although she is surprised by
Fitz’s findings, Duggan now feels she has a better grasp of the key sources of volatility for the
US equity portfolio.
Exhibit 2
Correlation
Portfolio Standard Spencer Artie S&P 500
Weight Deviation Fund Fund Index Fund
Spencer Fund 35% 17.0% 1.00 0.30 0.65
Artie Fund 25% 24.0% 0.30 1.00 0.20
S&P 500 Index Fund 40% 12.0% 0.65 0.20 1.00
Total Portfolio 100% 12.51%
Covariance
Spencer Artie S&P 500 Index
Fund Fund Fund
Spencer Fund 0.032 0.004 0.003
Artie Fund 0.004 0.048 0.004
S&P 500 Index Fund 0.003 0.004 0.040
Total Portfolio 0.025 0.030 0.036
Fitz concludes the discussion by recommending that Duggan consider investing in a new factor-
based strategy managed by Leash Capital. The strategy creates a hedged long/short portfolio
focused on the Quality factor. It ranks Russell 1000 constituents from best to worst, based on this
factor, and divides them into decile portfolios. The top decile portfolio is then purchased, while
the bottom decile portfolio is shorted.
A. Describe three ways in which the Spencer Fund’s investment style evolved between
2010 and 2020 based on the data provided in Exhibit 1 and identify one limitation of
using a returns-based style analysis relative to a holdings-based analysis.
B. Identify two changes that could be applied to the Artie Fund that would mitigate the
impact of implicit costs on performance.

C. Calculate the percentage contribution to total portfolio risk for each of the three funds
held in Kibble’s US equity portfolio and identify one change that could be made to the
portfolio’s holdings to reduce its absolute risk.
D. Identify two potential drawbacks to the hedged portfolio approach utilized by Leash
Capital.
3 minutes (Answer 2-D on page 14)

Describe three ways in which the Spencer Fund’s investment style evolved between 2010 and
2020 based on the data provided in Exhibit 1
1.
Moved away from income investing, as dividend stocks exposure
decreased
2.
growth stock allocation increased and diversified as indicated by
the growth 2000 index factor increase and increase relative to 1000
factor Size: increase exposure to smaller cap equities as exposure to
growth and value 2000 index grew versus the 1000 indexes
3.
value stock allocation increased and diversified as indicated by the
value 2000 index factor increase and increase relative to 1000 factor
Quality exposure decreased
and identify one limitation of using a returns-based style analysis relative to a holdings-based
analysis.
Limitation
when stocks composition frequently changes returns based style is

not as sufficient
Returns-based is NOT as ACCURATE as holdings based, doesn’t use

ACTUAL PF holdings
Returns based UNNECESSARY CONSTRAINTS difficult to detect DEEP

VALUE or MICRO-CAP

Identify two changes that could be applied to the Artie Fund that would mitigate the impact of
implicit costs on performance.
Change 1
Use derivitaives or overlays such as total return swaps instead of

the actual securities which have high implicit costs as sizes of
trades are too large limit AUM, no new funds
reduce turnover of 70%

Change 2
increase the number of stocks more than just 40 to decrease the
market impact of trades
large concentrated trades, have larger market impact and
therefore higher implicit costs
increase stock number

Calculate the percentage contribution to total portfolio risk for each of the three funds held in
Kibble’s US equity portfolio
wi*wi*covii+wi*wj*covij+wi*wk*covik for each fund

add each for total pf
each fund/total pf risk
and identify one change that could be made to the portfolio’s holdings to reduce its absolute
risk.
Change
decrease weight of S&P500 allocation
add new fund to US eqity portfolio that has

lower covariance with other funds
replace funds in US equity portfolio that has

lower covariance with the portfolio

Answer Question 2D on this page
Identify two potential drawbacks to the hedged portfolio approach utilized by Leash Capital.
Drawback 1
Using the factor based approach is subject to bias
Not a pure factor pf b/c significant exposures to other

facors
Drawback 2
Lack of consistency
info in the middle deciles are not utilized, only top and bottom
assumes linear relationship, may not be
tend to be concentrated with this approach
shorting may be expensive or not possible

QUESTION 3 HAS A TOTAL OF SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 29
MINUTES.
Bailey Harwich, CFA, is a fixed income portfolio manager at Woodland Asset Management.
Woodland specializes in managing global bond portfolios for large institutional and private
wealth management clients. Harwich bases investment decisions on his view of economic
growth, default rates and industry trends.
Harwich manages the global corporate bond portfolio of Fenway Inc., a client of Woodland.
Harwich has been asked by Fenway to forecast expected excess returns and quality sectors that
will perform best over the coming year. Harwich compiles the following data in Exhibit 1, which
contains credit spread forecasts from his strategy team. Harwich also wants to consider a
scenario in which spreads remain constant over the next twelve months.
Exhibit 1
Current Current Duration One-Year OAS Expected Credit
Rating Sector OAS (bps) Times Spread (DTS) Forecast (bps) Loss (p × L)
Aa 80 720 70 0.00%
A 105 840 90 0.05%
Baa 195 1560 165 0.08%
Ba 295 1180 265 0.20%
During a quarterly investment review, Fenway’s treasurer asks Harwich about the portfolio’s
large overweight in metals companies. Harwich states that, given the increased demand from
automotive companies, he expects metals prices to remain high. Harwich also notes that
automotive company spreads are moderately attractive and profits for the sector will be steady
regardless of overall economic growth. Given a known large supply of metals coming to the
market, Fenway’s treasurer is still concerned about the concentration risk in the portfolio and
asks Harwich to explore ways to mitigate the tail risk of falling metal prices.
Fenway’s pension manager also chooses Woodland to actively manage a US Treasury portfolio
against the Bloomberg Barclays US Treasury index. Sandra George is a US interest rate portfolio
manager at Woodland. George has been asked to recommend a portfolio based on the outlook for
an instantaneous 50 bps parallel shift higher across the US Treasury yield curve. George builds
two model portfolios and constructs the summary information presented in Exhibit 2.
Exhibit 2
Market Value
US Treasury Yield to Effective Effective Portfolio Portfolio
Notes and Bonds Maturity Duration Convexity Index A B
2-Year 0.50% 1.9 0.05 30% 75%
5-Year 0.85% 4.8 0.28 23% 30%
7-Year 1.20% 6.6 0.49 18% 25%
10-Year 1.35% 9.1 0.95 17% 45%
30-Year 2.50% 22.9 6.40 12% 25%

Woodland’s investment committee met earlier in the month to formulate an annual outlook for
US Treasury interest rates. The committee believes that the Federal Reserve will remain
accommodative and front-end rates will be maintained at current levels. They also noted that
improving economic growth expectations will cause longer end rates to rise modestly and
interest rate volatility will decrease over the coming year.
A prospective client asks George to evaluate the expected return for two government bond
portfolios, both with a time horizon of one year. George has been asked to use an expected yield
change of –0.95% in any appropriate calculation. The client provides George with the data
summarized in Exhibit 3, which contains prospective statistics for the two portfolios.
Exhibit 3
Portfolio X Portfolio Y
Expected modified duration (at horizon) 4.12 4.35
Average coupon rate 1.80% 1.65%
Current average bond price 95.60 99.00
Average ending bond price for portfolio (assuming stable yield curve) 97.00 100.50
Expected convexity for portfolio (at horizon) 14.68 24.98
A. Identify Harwich’s credit strategy approach. Identify one advantage and one limitation of using
this approach.
B. Calculate the expected excess return for each rating sector over the one-year time horizon
(assume that spread duration remains constant). Determine which quality sector will most likely
have the highest expected excess return if current OAS levels do not change over the next year
for each of the ratings sectors.
C. Recommend one approach Harwich can use to manage the tail risk of falling metal prices in his
portfolio. Explain one potential drawback or limitation of the approach.
D. Determine whether Portfolio A and B in Exhibit 2 are most likely to outperform or underperform
the index in the event of an instantaneous 50 bps parallel shift higher in rates. Justify your
response for each using one key characteristic of the portfolio compared to the index (overall
duration, convexity, curve positioning).

E. Determine which portfolio in Exhibit 2 is most likely to outperform relative to the index. Justify
your response with one reason.
3 minutes (Answer 3-E on page 22)
F. Calculate the rolling yield for each portfolio in Exhibit 3. Determine which portfolio to
recommend to the client using the statistics contained in Exhibit 3 and based on the expected
total return for one year.
5 minutes (Answer 3-F on page 23)

Identify Harwich’s credit strategy approach. Identify one advantage and one limitation of
using this approach.
Approach
Top-down approach
fundamental
Advantage
Systematic and consistent

a lot of credit returns can be attributed to macro factors
Limitation
It ignores idiosyncratic risk from individual securities that may

difficult to implement
most tp down info is observable and reflected,
hard to have info advantage and alpha for top-down

Calculate the expected excess return for each rating sector over the one-year time horizon
(assume that spread duration remains constant).
Aa
E(XR)= s*T-change in spd*d-tpl
80-(-10)*9=170bps
A
105-(-15)*8-5=220bps
Baa
195-(-3o)*8-8=427bps
Ba
295-(-30)*4-20=395bps
Determine which quality sector will most likely have the highest expected excess return if
current OAS levels do not change over the next year for each of the ratings sectors.
Sector
Ba

Recommend one approach Harwich can use to manage the tail risk of falling metal prices in
his portfolio. Explain one potential drawback or limitation of the approach.
Approach
Hedge away tail risk using a put option
Potential drawback or limitation
drawback is cost of option, which will reduce your returns

Determine whether Portfolio A and B in Exhibit 2 are most likely to outperform or
underperform the index in the event of an instantaneous 50 bps parallel shift higher in rates.
(circle your answer)
Outperform
Portfolio A
Underperform
Outperform
Portfolio B
Underperform
Justify your response for each using one key characteristic of the portfolio compared to the
index (overall duration, convexity, curve positioning).
Portfolio A
less convexity in Pf a versus benchmark, which leads to less returns
therefore underperform
Portfolio B
greater convexity in Pf a versus benchmark, which leads to higher

returns therefore outperform

Answer Question 3E on this page
Determine which portfolio in Exhibit 2 is most likely to outperform relative to the index.
(circle your answer)
Portfolio A
Portfolio B
Justify your response with one reason.

Reason
the curve is steepening because Long term increase short term stable
therefore bullet portfolio will benefit,
less volatility therefore less convexity needed

Answer Question 3F on this page
Calculate the rolling yield for each portfolio in Exhibit 3.
Portfolio X
1.8/95.6 + 97/95.6-1 = 3.347%
Portfolio Y
1.65/99+100.5/99-1= 3.182%
Determine which portfolio to recommend to the client using the statistics contained in Exhibit
3 and based on the expected total return for one year.
Pf Y has higher expected total return of

7.43%
(versus 7.33% pf X)

QUESTION 4 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 14
MINUTES.
Enda Winters, CFA, has recently joined a 401(k) management company as a senior financial
advisor. Winters is meeting with three clients to present their yearly portfolio performance, and
to update investment policy statements regarding any potential changes in return objectives and
risk preferences. Winters also wants to examine the characteristics of the clients and determine if
any of those characteristics may be driven by behavioral biases.
Tsu-Jui Cheng
Tsu-Jui Cheng, 45 years of age, is a supervisor at a manufacturing firm in New Hampshire.
Cheng has accumulated a portfolio of $1.2 million, of which $800,000 is in cash. Cheng’s salary
is the primary source of income for Cheng’s family as he reinvests all the dividend and interest
income from the portfolio. Exhibit 1 shows the allocation of Cheng’s portfolio. Winters suggests
that the portfolio should contain a greater allocation to equities. Cheng is reluctant to change the
percentage allocation of money.
Exhibit 1
Fund Percentage Money Allocated Standard Deviation
Allocated
ABC (US Equity) 8.33% $100,000 8%
XYZ (US Bond) 8.33% $100,000 2.5%
PQR (REIT’s) 8.33% $100,000 12%
IEQ (Int’l Equity) 8.33% $100,000 18%
Cash - USD 66.67% $800,000 NA
Winters presents the yearly returns of the Cheng’s funds. He explains that there is a greater
chance of achieving higher returns and capital growth by investing a large percentage of the
$800,000 cash position in the ABC Equity Fund. The most recent annual performance by asset
class and the new percentage allocations recommended by Winters are shown in Exhibit 2. After
reviewing the equity fund return statistics, Cheng agrees to a higher allocation to the ABC Fund.
Exhibit 2
New Percentage
Fund Yearly Return Allocation Standard Deviation
ABC (US Equity) 10.65% 75% 8%
XYZ (US Bond) 3.26% 10% 2.5%
PQR (REIT’s) 5.5% 10% 12%
IEQ (Int’l Equity) -4.9% 5% 18%
Michael Russo
Michael Russo is a 32 year-old database analyst working for a blue chip software firm. Russo
has accumulated a portfolio of $500,000 by investing in software start-ups and claims that his
industry knowledge is responsible for the success of his investments. During the meeting with
Winters, Russo expresses his desire to maintain control over his portfolio and to assume a higher
risk tolerance in order to capitalize on any new opportunities in the software sector. However,

Russo agrees to more closely examine the yearly performances and Sharpe Ratios of the
investments and to modify the asset allocations of his existing portfolio as suggested by Winters.
Linda Moylan
Linda Moylan is a 56 year-old divorcee and is currently unemployed. Moylan maintains a simple
lifestyle with expenses of approximately $40,000 per year. Moylan holds an inherited portfolio
with a present value of $2 million.
While reviewing Moylan’s portfolio and her expenses, Winters notices that Moylan has
structured most of her portfolio into various fixed income investments in such a way as to
receive quarterly, bi-annual and annual income streams to meet her expenses. Moylan re-
emphasizes that capital preservation is one of her important objectives. She has no appetite for
losses. During their meeting, Winters suggests to slightly alter the portfolio to reflect recent tax
changes and to achieve moderate capital growth.
Moylan decides not to make any change to her investments, as the current portfolio’s return
meets her expense expectations. She also rejects Winters’ advice to sell some of the losing
investments, instead of claiming the advantage of tax loss harvesting. Moylan also states that her
desire to keep these investments is because she inherited them from her parents.
A. Identify the behavioral bias exhibited by Cheng. Discuss two consequences of holding
the portfolio in Exhibit 1.
B. Identify and describe the behavioral bias influencing Cheng’s decision to accept
Winter’s recommendations.
C. Classify Russo’s likely Behavioral Investor Type. Determine three behavioral biases
exhibited by Russo prior to his meeting with Winters.
D. Identify two behavioral biases exhibited by Moylan. Recommend how Moylan might
overcome each of these biases.

Identify the behavioral bias exhibited by Cheng. Discuss two consequences of holding the
portfolio in Exhibit 1.
Behavioral bias
Mental Accounting
naive diversification
Consequence 1
Not optimal asset allocation and risk diversification

undiversified pf, high correlations
Consequence 2
Inappropriate return given risk capacity
missing long-term objectives, req returns/cap accumulation

Identify and describe the behavioral bias influencing Cheng’s decision to accept Winter’s
recommendations.
Framing
by framing the returns to highlight the superior returns
Cheng is convinced
he has not provided return for risk ratios like sharpe ratio which may
be better
the framing highlights the high returns and not the risk associated

Classify Russo’s likely Behavioral Investor Type. (circle your answer)
Passive Preserver
Friendly Follower
Independent Individualist
Active Accumulator
Determine three behavioral biases exhibited by Russo prior to his meeting with Winters.
Bias 1
self-attribution
Illusion of Control
conservatism
confirmation
Bias 2
representativeness
Availability
Bias 3
Overconfidence

Identify two behavioral biases exhibited by Moylan. Recommend how Moylan might
overcome each of these biases.
Bias 1 Overcome
Focus on final-long-term
Loss Aversion
wealth
adopt disciplined approach
use fundamental analysis
Bias 2 Overcome
Focus on her parents’
intention of giving her assets
Endowment to gift to her, to provide for
her, not to hold onto the asset
itself. Can best optimize their
intention by looking at a
optimal return for risk

QUESTION 5 HAS SEVEN PARTS (A, B, C, D, E, F, G) FOR A TOTAL OF 30
MINUTES.
Aksel Serensen, a 37 year-old widower, resides in a country which uses the euro as its monetary
unit. His wife, a CFA charterholder, died recently, leaving him alone to raise their three children:
an 8-year-old and 2-year-old twins. He has decided that he will not remarry and will devote
himself, as much as his work permits, to the children’s care and upbringing. Serensen has
arranged for supplemental child care through a local au pair agency.
Serensen earns €50 thousand annually. He is covered by a pension plan that uses a formula based
on years of service and final compensation to determine his monthly pension benefit. Because of
his short tenure with his employer, his present vested pension benefit is modest.
Serensen’s salary and pension benefits are indexed to inflation, but no increase in real terms is
expected for either. Inflation over the long term is expected to be 2.5% annually.
Serensen pays tax on all income at an annual 30% rate. Capital losses may be used to offset
other income of any nature. Serensen and the children are all in excellent health and have
comprehensive medical coverage through Serensen’s employer. Serensen has no insurance
coverage other than his employer-provided health and life insurance.
Without his wife’s earnings, Serensen believes that he will struggle financially to meet the
household’s current expenses, including child care, with little remaining from his salary to save
for the children’s educations and for his own retirement.
Through her employer, his wife was covered by a €400 thousand life insurance policy with
Serensen named as the beneficiary. He received the proceeds recently with no taxes due.
Because Serensen is not as familiar with finances as his wife was, he is uneasy about managing
such a large sum on his own. He has vowed to approach all financial matters cautiously and
prudently as he does not wish to put the children’s welfare at risk. As a result, he has sought the
counsel of a well-respected financial advisor.
Exhibit 1
Current Balance Sheet of Aksel Serensen
(Thousand EUR)
Assets Liabilities
Cash 2 Mortgage5 240
1
Stock 23 Short-term debt 35
2
DB pension 50
Insurance3,4 400
Residence 300
Household furnishings 25 Net Worth 525
Total Assets 800 Total Liabilities 800
Footnotes to Exhibit 1:
1
non-dividend paying employer stock held in a taxable account. There are no trading restrictions
on the stock, which presently has a FMV well below Serensen’s acquisition cost.

2
present value of vested pension benefit to start at age 60
3
proceeds of wife’s life insurance policy currently held in a non-interest bearing, insured bank
account.
4
Serensen has a €50 thousand term policy on his life, provided by his employer, with the
children named as equal beneficiaries.
5
Obtained several years prior to his wife’s passing at higher prevailing interest rates.
Serensen’s financial advisor recommends that Serensen change the beneficiary designation on
Serensen’s employer-provided life insurance from the children in equal shares to an irrevocable
trust established for the collective benefit of the children.
The financial advisor strongly recommends that Serensen:

• use the insurance proceeds to pay off the short-term debt and half of the mortgage
immediately because these debts incur relatively high interest charges,
• send the children to public schools and public university in order to reduce immediate future
education-related expenses,
• set aside €60 thousand (€20 thousand per child) in a tax-exempt education account to
meet the future miscellaneous and incidental educational expenses of the children, and
• invest the remaining insurance proceeds to meet the expected retirement spending
requirement that will likely not be met by his employer’s current pension formula.
Serensen tells his advisor that a 30-year retirement period should be the basis for planning
purposes. The advisor estimates that Serensen’s pension, including future service and salary
credits, will likely not cover his retirement spending needs and that Serensen will probably
experience a shortfall. This projected shortfall could be offset entirely, however, by purchasing
an immediate, inflation-indexed annuity at age 60 at a cost of €450 thousand (in today’s €).
Serensen’s advisor prepares return and risk data for several asset classes in preparation for
selecting investments for the children’s tax-exempt education account and Serensen’s taxable
retirement account.
Exhibit 2
Asset Class Characteristics (%)
Asset Class E(r) σ
Cash 1 0
Domestic Corporate Bonds 3 6
Domestic Tax-Exempt Bonds 2 6
Global Large-Cap Equity 5 12
Global Small-Cap Equity 6 16
Fund of Hedge Funds 15 25
Leveraged Global Real Estate 12 20
The advisor recommends that the Global Large-Cap Equity be placed in the education account
and that the Global Small-Cap Equity be placed in the retirement account.

A. Identify three additional insurance products Serensen should consider purchasing at this
time. Support each of your selections with one reason.
B. Justify the advisor’s recommendation to establish a trust as the beneficiary of Serensen’s

employer-provided life insurance with two supporting benefits.
C. Describe two additional recommendations that Serensen should consider at this time, in
addition to the advisor’s four recommendations. Justify each of your recommendations
with one reason. (Note: each recommendation cited must be different from any
selection made in Part A.)
D. Determine Serensen’s ability and willingness to bear risk. Justify each of your
answers with two reasons. Determine whether his ability or his willingness should take
precedence in determining his overall risk tolerance.
E. Formulate each of the following constraints for Serensen’s Investment Policy

Statement (IPS).
i. Liquidity
ii. Time Horizon
F. Select the one bond asset class from Exhibit 2 that is most appropriate for inclusion in the
education account and one bond asset class that is most appropriate for inclusion in the
retirement account. Support each of your choices with one reason.

G. Contrast the risk character of the two Global Equity investments presented in Exhibit 2,
if the advisor’s recommendations are implemented.
2 minutes (Answer 5-G on page 40)

Identify three additional insurance products Serensen should consider purchasing at this time.
Support each of your selections with one reason.
Insurance Product Supporting Reason
1.
In case the house is
Home insurance destroyed by fire or other
disaster, the family needs a
place to live, house is a large
portion of their assets
2.
In case he becomes injured
disability insurance
and cannot work but still
needs to provide for the kids
3.
In addition to the life
additional life insurance insurance provided, can add
suppliemental life insurance to
provide ALL the kids needs,
such as all expenses,
education, etc for future if he
dies and income stops

Why use trust?

Justify the advisor’s recommendation to establish a trust as the beneficiary of Serensen’s
employer-provided life insurance with two supporting benefits.
Benefit 1
Tax benefit, as the assets grow in the trust it will not be taxed to
Serensen’s tax rate
can APPOINT a TRUSTEE for children
add PRIVACY for receipt and distribution to kids
PROTECTION from his creditors
Benefit 2
The assets will easily pass on to the kids without the need of going
through probate.

Describe two additional recommendations that Serensen should consider at this time, in
addition to the advisor’s four recommendations. Justify each of your recommendations with
one reason. (Note: each recommendation cited must be different from any selection made in
Part A.)
Recommendation 1 Reason
Invest mom’s 400K in at least inflation is 2.5%

interest bearing account they should invest this amount
in at least inflation linked
account if not in equities, etc to
Increase cash for emergency fund esp for kids
earn higher returns
refinance mortgage
downsize house to reduce expenses
Recommendation 2 Reason
Diversify sources of risk,
employment already impacted
Sell company stock and buy by this source, invest in a
other equities different company or industry or
index

Determine Serensen’s ability and willingness to bear risk. Justify each of your answers with
two reasons.
Ability to Bear risk (circle your answer) Reason 1
Current income and assets not
sufficient for his retirement
Low spendings
Reason 2
High
Current income will see no
growth after inflation
Willingness to bear risk (circle your answer) Reason 1
Stocks fully invested in own

Low company
unfamiliar and discomfort
Reason 2
High
Willing to seek advice vow to stay cautious
Determine whether his ability or his willingness should take precedence in determining his
overall risk tolerance. (circle your answer)
Ability
Willingness
Neither takes precedence

Formulate each of the following constraints for Serensen’s Investment Policy Statement
(IPS).
i. Liquidity
ii. Time Horizon
Liquidity
Short term: daily expenses for family, childcare expenses, mortgage
payments, 35K short term debt payment
Long-term: education expenses and retirement daily expenses
mention the amounts!!: immediate need 215K for debt and education
if spending maintains current infl-adj basis, no unusual expenses, no other liquisity constraint until retirement
retirement: need annuity, inf-adj, after tax to bridge pension and retirement spending needs
Time Horizon
short-term horizon: paying down short-term debt within 1 year or so

mid/long-term time horizon: kids will go to college in 10~15 years
long-term time horizon: retirement in about 23 years
23 years to retirement
30 years in retirement

Select the one bond asset class from Exhibit 2 that is most appropriate for inclusion in the
education account and one bond asset class that is most appropriate for inclusion in the
retirement account. Support each of your choices with one reason.
For education account Reason
Higher return for risk and
education account already tax
Domestic corporate bonds
exempt
For retirement account Reason
Domestic corporate bonds

Higher return for risk even after
tax

Answer Question 5G on this page
Contrast the risk character of the two Global Equity investments presented in Exhibit 2, if the
advisor’s recommendations are implemented.
Global large cap equity has a higher risk return sharpe ratio of 0.42
where as
global small cap has a sharpe ratio of 0.37
small cap is much more risky and volatile with a higher return but
lower sharpe ratio.
effective tax
for small cap global is onnly 11.2% after the 30% tax since the
account is taxable
the global large cap in the education account is tax exempt to risk is
the full 12%
small cap global is less risky then global large cap

QUESTION 6 HAS A TOTAL OF SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 24
MINUTES.
Ralph Stuart, CFA has been hired to review the pension plan for Whatsit Widget Company
(‘Whatsit’). Stuart has significant experience with pension plans and an extensive knowledge of
external managers. Whatsit is the leading manufacturer of widgets, with the majority of sales
generated within the United States. In recent years new competitors have entered the industry
leading to declining sales, although Whatsit remains the market leader and the firm’s balance
sheet has low debt to equity ratios.
To assist in the penetration of new markets utilizing social media, Whatsit has recently hired a
large team of younger workers. Several employees have retired in recent years and are drawing
payouts from the plan, but with the addition of the new hires, the average age of the workforce
remains low. Employees currently taking distributions from the fund represent approximately 5%
of the total workforce.
Stuart begins to review the investments for the plan, and notices that the most recent returns are
lower than those realized in the previous five years. Due to the plan’s lackluster returns, it is on
the verge of becoming underfunded. The existing asset allocation of the plan is 60% domestic
equity and 40% investment-grade fixed income in mainly low-cost passive investments.
Whatsit’s board asks Stuart to look into a new investment approach that could potentially
outperform the market.
Several competitors in the industry have switched from offering a defined benefit plan to a
defined contribution plan. The board asks Stuart what responsibilities the firm would have if the
switch from a defined benefit to a defined contribution plan was implemented.
After success working with Whatsit Widgets, Stuart has been called to help with the Pension
Reserves fund of the Commonwealth of Massachusetts. Presently, the plan is overfunded. There
are no liquidity requirements at this time, and none expected for many years. Stuart considers the
four portfolios shown in Exhibit 1.
Exhibit 1
Asset Class Portfolio A Portfolio B Portfolio C Portfolio D
Cash 40% 10% 5% 2%
Fixed Income 30% 90% 45% 8%
Equity 30% - 20% 70%
Alternatives - - 30% 20%
Total 100% 100% 100% 100%
A. Determine the risk tolerance of Whatsit’s existing pension plan. Justify your response
with two reasons.

B. Identify the current investment approach (i.e., model) utilized for Whatsit’s existing
pension plan. Justify your response and identify one advantage and one disadvantage for
this approach.
C. Recommend a new investment approach based for the Whatsit’s pension plan that is
most likely to outperform the market. Justify your response and identify one advantage
and one disadvantage of this approach.
D. Identify two responsibilities Whatsit has if it transitions to a defined contribution plan

from its current defined benefit plan.
E. Define the objective of the Commonwealth’s pension reserve fund.
F. Recommend an asset allocation in Exhibit 1 for the Commonwealth’s pension reserve

fund and justify your response with two reasons.

Determine the risk tolerance of Whatsit’s existing pension plan. (circle your answer)
Low
High
Justify your response with two reasons.

Reason 1
Low average age of workforce-> longer time horizon-

>more tolerance for deviations
Reason 2
low debt to equity ratio, healthy cap structure, has
capacity to borrow more money to fund needs if
needed

Identify the current investment approach (i.e., model) utilized for Whatsit’s existing pension
plan. Justify your response and identify one advantage and one disadvantage for this
approach.
Approach
Norway model
Justify
the current portfolio is made of 60% bonds 40 % equity, it is

on the verge of underfunded so it is not appropriate, it is
simply an old heuristic allocation approach
Advantage
simple
Disadvantage
not always appropriate considering risk tolerance and return

requirements

Recommend a new investment approach based for the Whatsit’s pension plan that is most
likely to outperform the market. Justify your response and identify one advantage and one
disadvantage of this approach.
New approach
endowment model
Justify
endowment models can add some alternative investments will
increase return and improve performance over market
because they have a long investment horizon they can do this
Advantage
Higher return
Disadvantage
lower liquidity Costly
Difficult to implement

Identify two responsibilities Whatsit has if it transitions to a defined contribution plan from its
current defined benefit plan.
Responsibility 1
Provide investment portfolio options and take on fiduciary

duty
Responsibility 2
Maintain/manage or find portfolio managers to manage the

plan portfolios
Appropriate INVESTMENT of plan ASSETS
Suitable investment OPTIONS
SELECT ADMIN PROVIDERS

Define the objective of the Commonwealth’s pension reserve fund.
EARN RETURNS to
To expand the value of the fund within reasonable risk to meet
the future obligations of the pension on an inflation adjusted
basis
Earn sufficient returns to maximize likelihood of being able to meet future

unfunded pension, SS, healthcare liabilities of plan participants as they arise

Recommend an asset allocation in Exhibit 1 for the Commonwealth’s pension reserve fund
and justify your response with two reasons.
Recommendation
Portfolio D
Reason 1
No liquidity requirements for a long while; therefore allocate,
some to alternative investments, which is less liquid but
higher return
Reason 2
Overfunded and no requirement for a while so decrease the
allocation to fixed income, which is not necessary to be so
conservative, allocate more to both equities and alternative
investments which have higher returns
Mention case fact! Case D
has greatest weighting in AI
and equities so choose D

QUESTION 7 HAS A TOTAL OF THREE PARTS (A, B, C) FOR A TOTAL OF 9
MINUTES.
Thomas Oliver, CFA, is a portfolio manager at Patriot Capital, a multinational financial services
corporation based in Boston, Massachusetts. Emily Matilda, a portfolio analyst at Patriot Capital,
meets with Oliver monthly to review her portfolio. The goal for this month’s meeting is to find
rebalancing opportunities for generating enhanced returns by creating a systematic way of
buying stocks below fair value and selling at above fair value.
Matilda has been tracking MKR Corporation, a manufacturing firm whose price earnings ratio is
low compared to its peers in the industry. Matilda believes that MKR stock is undervalued at the
current price of $60.00. The recent increase in the trading volumes leads her to believe that there
is an undisclosed quantity of orders pending in the dark pool venues and that the MKR stock
price will soon increase. Oliver agrees with Matilda’s research and instructs her to buy 100,000
shares without exceeding a limit price of $61.00. Matilda releases the order for market execution
when the price of MKR stock is $60.10. The fund is charged a commission of $0.04 per share.
Order and execution details are summarized in Exhibit 1. At market close, MKR stock trades at
$61.35.
Exhibit 1
Summary of Trades Executed for MKR Stock
Trades Shares Executed Execution Price
Trade 1 15,000 $60.30
Trade 2 25,000 $60.50
Trade 3 30,000 $60.40
Oliver then turns his attention to another holding in Matilda’s portfolio, OBA Ltd. Oliver is
concerned that the deteriorating financial condition of OBA may worsen in the next few quarters.
OBA is moderately liquid and the trading volumes on the exchanges have been steadily
declining. Oliver does not expect an adverse price movement because of low volumes and
wishes to exclude potential trade price outliers. To reduce the negative effects of market impact,
Oliver requests Matilda to slowly liquidate the holdings over the next few days and reinvest the
proceeds into US Treasury bills and bonds.
Oliver is interviewing Archie Hunter, a CFA Level II candidate, for an intern position with the
trading team. Oliver explains the fund’s investment objectives, portfolio manager’s motivation to
trade, and the importance of a solid trading approach to achieve the firm’s investment objectives.
After further discussion, Hunter makes the following statements to reaffirm his understanding of
the trading strategies.
Statement 1: A trader will use a trading strategy to slice a large order into smaller pieces and
trade with low trade urgency to reduce the market impact and market risk of
entering a large order.

Statement 2: A trader with a low level of risk aversion is likely to be more concerned about
market risk and will trade with immediate trade urgency to avoid the greater
market exposure associated with trading.
Statement 3: A trader seeking short term profit will typically trade with higher levels of trade
urgency to realize short term alpha before it dissipates.
A. Calculate the implementation shortfall of MKR in basis points.
B. Recommend a suitable trading strategy to liquidate the OBA holding. Discuss one
advantage of using the recommended trading strategy.
C. Identify which of Hunter’s statements is most likely correct. Justify your response with
one reason.

Calculate the implementation shortfall of MKR in basis points.
IS=Execution Cost+Opp Cost+Fees=72.3
Execution cost= actual shares*decision price-actual shares*actual price

Opp cost=(actual shares-decision shares)*paper return
Fees
bps
72.3K
/135K*10,000=5356bps
BPS =
Implementation Shortfall
/
(Decision Cost * Decision Shares) *10,000 bps = 120.5bps

Recommend a suitable trading strategy to liquidate the OBA holding. Discuss one advantage
of using the recommended trading strategy.
Recommendation
sell different exercise price call options
TWAP
avoid volume uncertainties and outliers, fair reasonable
price over 2-days, limit market impact, slice order in
smaller amounts using equal-weight time schedule.
Advantage
earn the option premium and liquidate the holding as shares
fall past the different exercise prices
excludes potential trade price outliers

achieve fair reasonable prices over trading period

Identify which of Hunter’s statements is most likely correct. Justify your response with one
reason. (circle your answer)
Statement 1
Statement 2
Statement 3
Reason
true, short-term alpha may dissapate soon so traders will

urgently trade to capture short=term mispricing
END OF MORNING SESSION

CFA Society Boston Level III 2021 Practice Exam Morning Session

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CFA Society Boston Level III

2021 Practice Exam

CFA® is a licensed service mark owned by CFA Institute.

© 2021 CFA Society Boston

Question Topic Minutes

© 2021 CFA Society Boston 2

© 2021 CFA Society Boston 3

4 minutes (Answer 1-A on page 5)

3 minutes (Answer 1-B on page 6)

2 minutes (Answer 1-C on page 7)

© 2021 CFA Society Boston 4

interest rate risk, if CNY does not return as much as expected

Carry trade danger!

Carry Trade Danger!

© 2021 CFA Society Boston 5

max gain: profit=(St-Xlow)-(St-Xhigh)-call low+call high

© 2021 CFA Society Boston 6

Justify your response with one reason.

Expansionary monetary policy should deflate not inflate the currency!

© 2021 CFA Society Boston 7

© 2021 CFA Society Boston 8

6 minutes (Answer 2-A on page 11)

3 minutes (Answer 2-B on page 12)

© 2021 CFA Society Boston 9

8 minutes (Answer 2-C on page 13)

3 minutes (Answer 2-D on page 14)

© 2021 CFA Society Boston 10

when stocks composition frequently changes returns based style is

Returns-based is NOT as ACCURATE as holdings based, doesn’t use

Returns based UNNECESSARY CONSTRAINTS difficult to detect DEEP

© 2021 CFA Society Boston 11

Use derivitaives or overlays such as total return swaps instead of

reduce turnover of 70%

© 2021 CFA Society Boston 12

wi*wi*covii+wi*wj*covij+wi*wk*covik for each fund

each fund/total pf risk

decrease weight of S&P500 allocation

add new fund to US eqity portfolio that has

replace funds in US equity portfolio that has

© 2021 CFA Society Boston 13

Using the factor based approach is subject to bias

Not a pure factor pf b/c significant exposures to other

assumes linear relationship, may not be

tend to be concentrated with this approach

shorting may be expensive or not possible

© 2021 CFA Society Boston 14

© 2021 CFA Society Boston 15

3 minutes (Answer 3-A on page 18)

8 minutes (Answer 3-B on page 19)

6 minutes (Answer 3-C on page 20)

4 minutes (Answer 3-D on page 21)

© 2021 CFA Society Boston 16

3 minutes (Answer 3-E on page 22)

5 minutes (Answer 3-F on page 23)

© 2021 CFA Society Boston 17

Systematic and consistent

It ignores idiosyncratic risk from individual securities that may

© 2021 CFA Society Boston 18

© 2021 CFA Society Boston 19

Hedge away tail risk using a put option

Potential drawback or limitation

drawback is cost of option, which will reduce your returns

© 2021 CFA Society Boston 20

wiwicovii+wiwjcovij+wiwkcovik for each fund