CFA Level III Mock Exam 4 June, 2018 Revision 1

FinQuiz.
com
CFA Level III Mock Exam 4
June, 2018
Revision 1
Copyright © 2010-2018. FinQuiz.com. All rights reserved. Copying, reproduction

or redistribution of this material is strictly prohibited. info@finquiz.com.
CFA Level III Mock Exam 4 – Solutions (AM)
FinQuiz.com – 4th Mock Exam 2018 (AM Session)
The morning session of the 2017 Level III CFA Examination has 8 questions. For
grading purposes, the maximum point value for each question is equal to the number of
minutes allocated to that question.
Questions Topic Minutes

1 Portfolio Management – Behavioral Finance 20
2 Portfolio Management – Institutional Investors 20
3 Portfolio Management – Fixed Income Investments 19
4 Portfolio Management – Individual-Asset Allocation 39
5 Portfolio Management – Asset Allocation 22
6 Portfolio Management – GIPS 20
7 Portfolio Management – Trading and Rebalancing 20
Portfolio Management – Risk Management & Performance
8 20
Evaluation
Total: 180
FinQuiz.com © 2018 - All rights reserved. 2

QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MINUTES
Dano Parker works as a portfolio manager at Picasso Investments (PICIN), a large and
reputable financial advisory firm offering a range of capital management services and
investment products to individual and institutional investors. Parker has been with the
firm for over five years now, and has managed more than fifteen client portfolios. As
such, PICIN has appointed Parker to appraise the performance of private wealth
portfolios at regular intervals. During his appraisals, and also as part of experience,
Parker notices that, in many instances, the assumptions of traditional finance with respect
to the behaviors of individuals do not hold true. Parker was not sure what effects this
might have on optimal portfolio construction by financial market participants. To discuss
this further, Parker invited David Hulsey, a behavioral financial analyst, to talk about
investor behavior in detail. During their conversation, Hulsey made the following
comment:
“I believe that investors behave rationally when making investment decisions and try to
maximize the expected utility, given their budget constraint. When faced with new
information, market participants revise expectations consistent with Bayes’ formula.
Also, investors are risk-averse, demanding more return for each unit of risk.”
Parker disagreed with Hulsey on the basis of the ‘Prospect Theory’, but was not sure how
this theory provided an alternative explanation to investor behavior. He was, however,
convinced that the theory explained apparent deviations in decision making from those
explained under the utility theory.
A. Justify how the prospect theory supports Parker’s notion of an apparent departure
of investor behavior from the behavior of the rational economic man. Give three
ways the prospect theory differs from the utility theory.
(6 minutes)

After his meeting with Hulsey, Parker proceeded with developing an earnings forecast for
Sparkle Fixtures Incorporated (SFI), a US firm famous for its lighting fixtures and
decorative lamps. The lighting industry has seen tremendous growth over the past decade
due to a rising trend of professional interior designing of homes and offices. Historical
data of the past 15 years shows earnings growth for SFI at 1.0-1.5% above the GDP
growth rate. Just recently, however, the firm reported a drop of 5.0% in earnings growth
due to a number concerns regarding the supply of raw materials. In addition, a few other
firms also reported losses for the recent quarter. In developing his forecasts, Parker
decided to revise his earnings estimate downward for the stock in order to avoid any
losses and keep his estimate conservative.
B. Determine the bias that Parker is most likely subject to while developing an
earnings estimate for SFI. Give one example where such a bias may result in
excessive trading by financial market participants.
(4 minutes)
While reviewing the asset allocation decisions of his clients, and their stated preferences
during regular meetings for updating their IPSs, Parker noticed that many portfolios
lacked the appropriate amount of diversification, as would be present if investors behaved
rationally and took a holistic view of their portfolios. Parker was assured that this was
due to the presence of behavioral biases.
C. Give three behavioral explanations for inadequately diversified portfolios. State

the bias inherent in each explanation.
(6 marks)
Before ending his day, Parker shortlisted five potential stock investments for his portfolio
that met his risk and return constraints and had approximately similar risk-return profiles.
Given his budget constraint, Parker decided to invest in two of the most well-known and
established firms amongst those he had shortlisted.
D. Determine, using behavioral finance, the behavior that guided Parker to select
stocks for his portfolio. State the bias leading to such a behavior. Justify your
response.
(4 marks)

Solution for Question 1.
A Solution:
Unlike the utility theory, the prospect theory considers how prospects are perceived based
on their ‘framing’, how ‘gains’ and ‘losses’ are evaluated, and how uncertain outcomes
are weighted.
The three ways in which the prospect theory differs from the utility theory are:
1. The probability-weighting function expresses the fact that people tend to

overreact to small probability events but underreact to mid-sized and large
probabilities.
2. The value function is asymmetric, implying that there is a bigger impact of losses
than of gains. People are not risk-averse but rather are loss-averse.
3. The value function is reference dependent. Same situations may evoke different
preferences merely due to the framing effect.
Reference:
CFA Level III, Volume 2, Study Session 3, Reading 5, LOS-b.
B Solution:
Parker is most likely subject to the representative bias. He is ignoring the base rate
information of an above average earnings growth rate for SFI for so many years and is
assuming that the small sample of firms that reported losses is representative of all firms
in the industry. Hence, he is guilty of both base-rate neglect and sample-size neglect.
Example:
Investors tend to buy a fund immediately following rapid price appreciation.
Representativeness causes them to categorize the funds as good investments based on this
recent information. Similarly, when prices fall, they sell their holdings. Moving in and
out of investments based on categorizations like these is likely to result in excessive
trading.
Reference:
CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-c.

C Solution:
The three behavioral explanations are as follows:
1. Illusion of Control bias: Investors tend to hold positions in companies they feel
they have some control over, leading them to hold concentrated positions.
2. Confirmation bias: FMPs may become convinced of the value of a single stock
and tend to ignore negative news about that stock. This can lead them to build a
large position in the stock and hold poorly diversified portfolios.
3. Availability bias: Since this bias leads FMPs to base investment choices on
information that can be easily recalled, their choices would reflect a narrow range
of experience. This can lead to overweighing securities and a lack of
diversification.
Reference:
CFA Level III, Volume 2, Study Session 3, Reading 6, LOS-d.
D Solution:
Parker is most likely engaging in herding behavior by investing in the most popular
investments. The regret-aversion bias leads to such a behavior. People prefer the stocks
of well-known companies even in the face of equal risk and return characteristics because
choosing less familiar stocks is perceived riskier and involves greater personal
responsibility and greater potential for regret.
Reference:

QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS
Renee Russo works as a portfolio manager at Panther Investment Management Firm

(PIMF), a financial advisory firm offering portfolio management services to institutional
investors, including pension plans, endowments and foundations. Pension funds make up
the largest portfolio of PIMF’s client base. Russo has recently been appointed as the
Chief Portfolio Manager (CPM) for the pension fund of Revolutionary Technologies
Limited (RTEL), a large, US based firm operating in the electronics and technology
industry. The firm has been quite profitable over the past five years, as has been the
general industry trend. Working in association with Dennie Thorpe, the Chief Financial
Officer (CFO) of RTEL, Russo compiles the data provided in Exhibit 1.
Exhibit 1:
Financial Information of RTEL (Average of the past five years)
RTEL Industry Average
Debt/Total Assets 35% 55%
Net Income/Sales 22% 19%

Expected Gross Profit
45% 47%
Margin
Russo’s team at PIMF presents her with the data in Exhibit 2.
Exhibit 2:
Economic Data
Duration Interest Rate
25 year, US Treasury bonds 16 years 7.5%
35 year, US Treasury bonds 22 years 8.5%
Inflation rate:
5.0%

Utilizing the opportunity to work with the CFO of the firm, Russo also accumulates the
following facts:
• The projected benefit obligation (PBO) as reported on the current balance sheet,
dated 31 December 2013, equals $10 billion.
• The duration of the liabilities equals 22 years.
• The total value of the firm’s pension assets as of 31 December 2013 equal $13
billion.
• The ratio of the retired lives to active lives for the firm equals 0.33.
• The correlation between pension plan assets and plan liabilities is close to 0.33,
with pension assets invested mostly in growth oriented investments.
While talking to Russo about the pension plan’s objectives, Thorpe also states the
following:
“RTEL primary focus is to maintain the funded status of the plan at a level of at least
100% with respect to the PBO. The board has decided that a probability of 10% of falling
short of meeting this objective is reasonable. In addition, the plan’s objectives need to be
set so as to minimize the probability of making future contributions to the plan. Also,
since proficient human resource is a key element of success in this industry, to retain our
employees, we keep modifying our plan provisions according to changes in the industry.
This helps ensure retention of the best possible human resource in the face of
competition.”
Thorpe continues with the following comment:
“To meet our long-term objectives of minimizing contributions, the board has estimated
that a return of 2.5% over and above the minimum required return would be appropriate
for the fund.”
A. Formulate an appropriate risk objective for Revolutionary Technologies

Limited’s (RTEL) pension fund. Determine whether RTEL’s ability to take risk
is above-average, average, or below average. Give three reasons why the ability
may be high, and three reasons why it might be low. Use the template on the
following page to answer the question.
(8 marks)

B. Determine the minimum return requirement for RTEL’s pension fund.

Formulate an appropriate return objective for the RTEL pension fund.
(4 marks)
Ten years have passed, and Russo is still the manager of the RTEL pension fund. The
following changes have occurred during this time period:
• The ratio of the retired lives to average lives is 0.66.

• The industry has seen a large number of new entrants, which has squeezed profit
margins for existing firms. The overall growth rate of the industry is now
approximately in line with the rate of growth of the general economy.
• The firm introduced a provision for early retirement two years ago. 10% of
employees have opted for this option.
• The asset base is now $9 billion with plan liabilities unchanged.
For the current month, RTEL made a contribution to the pension plan of $10 million.
Given the number of retired employees, Russo estimates a cash disbursement of $60
million per month to satisfy obligations.
C. Determine the current liquidity requirement of the RTEL pension fund. Explain
whether the liquidity constraint for the fund has improved, remained stable, or
deteriorated. Justify your response with three reasons.
(5 marks)
D. Formulate the time horizon portion of the IPS of the RTEL pension fund as of
today and ten years ago.
(3 marks)

Solution for Question 2:
A Solution:
Reasons (High) Reasons (Low)
Ability 1. RTEL’s debt/total assets ratio is less 1. A significant amount of pension

to than the industry average. Its profit assets invested in growth
take margins (gross profit margin and net oriented investments increases
risk income margin) are higher than the the volatility of the portfolio and
industry average. Hence, RTEL has decreases the risk tolerance.
a greater tolerance for risk.
2. The ratio of retired lives to active 2. A pension plan that keeps

lives is 0.33 implying that active modifying its provisions is likely
lives are much greater than retired to introduce competitive plan
lives. This implies a longer time features like early retirement or
horizon and greater risk tolerance. lump-sum distributions. This
decreases the ability to take risk.
3. RTEL has a pension surplus of $3 3. A low correlation between
billion ($13-$10=$3 billion) pension assets and pension
implying greater risk tolerance. liabilities implies a greater
mismatch between them, and a
lower ability to take risk.
Overall: Ability to take risk is above-average because of:
• High surplus.
• Higher financial profitability than the industry average.
• No current plan features that would require early disbursements.
• Greater number of active lives relative to retired lives.
• Long time horizon.
Risk objective:
“The probability that the funded status falls below 100% should be equal to 10% or less.
In addition, the portfolio should minimize the probability of making future
contributions.”

Reference:
B Solution:
Return requirement:
The discount rate applicable to RTEL’s pension liabilities will be the rate on U.S.
government bonds with the same duration as that of the liabilities (it will include
inflation). This rate equals 8.5% (rate on government bonds with a duration of 22). This
is the minimum return requirement. In addition, the board wants an additional 2.5% to
minimize the probability of making future contributions.
Total return objective: 8.5%+2.5% = 11.0%
Return objective:
• The overall return objective is to achieve a return sufficient to maintain a specific

level of funded status on an inflation-adjusted basis.
• To earn a total return of 11.0%, that includes a minimum return requirement of
8.5% (including inflation) and a 2.5% additional return to minimize the
probability of making future contributions to the plan.
Reference:
CFA Level III, Volume 2, Study Session 6, Reading 13, LOS-b,d.
C Solution:
Liquidity requirement:
Cash payments: $60 million
Cash contribution: $10 million
Current liquidity requirement: 60-10 = $50 million
Ignoring contributions to the plan, cash disbursements of $60 million/month on an asset

base of $9 billion translates to an annual liquidity requirement of 8.0%.

The liquidity constraint has deteriorated because:
• The ratio of retired lives to active lives has increased.

• The funded status of the plan has deteriorated; the surplus is -1.0 million now.
• The fund has introduced a provision of early retirement increasing the liquidity
needs.
Reference:
D Solution:
Time horizon (ten years ago):
RTEL’s pension fund has a long, multistage time horizon. The average duration of the
liabilities is 22 years:
• For the active lives the time horizon is the average time to the normal retirement
age.
• For the retired lives, the time horizon is a function of the average life expectancy
of retired plan beneficiaries.
Time horizon (as of now):
RTEL’s pension fund has a long, multistage time horizon. However, due to an increase in
the number of retired lives, the duration of the plan has shortened. It is still, however,
long-term:
• For the active lives the time horizon is the average time to the normal retirement
age.
• For the retired lives, the time horizon is a function of the average life expectancy
of retired plan beneficiaries.
Reference:

QUESTION 3 HAS THREE PARTS (A, B AND C) FOR A TOTAL OF 19 MARKS

David Channing is a 45-year-old computer engineer who owns an established small
software house in the United States. Channing has saved $2 million from his business and
has invested part of it in an investment portfolio managed by Shawn Murphy of Murphy
Financial Associates (MFA). Exhibit 1 displays the composition of his current portfolio.
Exhibit 1: Current Asset Allocation

Asset Category Percentage Allocation
International Equities 15%
Domestic Equities 55%
Corporate bonds 20%
Real estate 10%
Channing is responsible for the medical expenses of his parents that amount to
approximately $40,000 per year. His business profits sufficiently cover his living
expenses, and also allow for a contribution to his savings. Channing now plans to invest
some of these savings in a fixed-income security that would complement his existing
portfolio. He wishes to cash out of the investment in a year, at which time he hopes to
earn a reasonable return from his outlay. For this purpose, Channing meets with Murphy
to discuss available options for investment. Murphy presents him with data on four
bonds. Exhibit 2 displays this data.
Exhibit 2: Bond Investments

Spread
Bond Yield Z-spread Credit Rating
Duration
A 2.75% 1.50% 3 A2
B 4.00% 3.50% 4 Ba1

C 5.75% 2.00% 6 Baa3
D 8.00% 2.75% 5 B3
To comprehensively present the risk inherent in each option, Murphy provides Channing
with estimated annual default rates and recovery rates data for each bond. Exhibit 3
provides this information based on empirical analysis. Murphy also states that he expects
spreads to narrow by almost 75bps over the holding period since he believes the economy
to pick up in the short-term.

Exhibit 3: Default and Recovery Data

Average Annual Default
Credit Rating Recovery Rate
Rate
A2 0.33% 70%
Baa3 1.00% 60%
Ba1 1.90% 55%
B3 4.98% 40%
About 75% of Channing’s current fixed-income allocation is in investment grade

corporate bonds with a minimum rating of A3, some of which are floating-rate bonds.
The remaining is invested in high-yield corporates with almost the same seniority ranking
in their respective issuers’ capital structures. Channing’s current IPS gives him a risk
aversion score of 4 with no other special concerns.
1. State the bond that Channing should purchase based on a relative value analysis
considering only the data given about the four bonds in isolation. Show your
calculations.
(9 minutes)
2. Recommend a bond that is most suitable for Channing. Justify your response
with three reasons.
(5 marks)
3. State which risk is most inherent in Channing’s current fixed-income allocation

consisting of floating-rate bonds and high-yield bonds. Justify an appropriate
measure of risk for each category.
(5 marks)


A. The information in the vignette can be summarized as follows:
Bond Expected Expected loss Expected Z- spread in Spread

probability of severity (1- spread change % Duration
default recovery rate) (in bps)
A 0.33% 30% -75 1.50% 3

B 1.90% 45% -75 3.50% 4
C 1.00% 40% -75 2.00% 6
D 4.98% 60% -75 2.75% 5
Expected excess returns given the information:
Bond A: (1.50 × 1) – (-0.75% × 3) – (1 ×0.33% ×30%) = 3.749%

Bond B: (3.50 × 1) – (-0.75% × 4) – (1 ×1.90% ×45%) =5.645%
Bond C: (2.00 × 1) – (-0.75% × 6) – (1 ×1.00% ×40%) =6.1%
Bond D: (2.75 × 1) – (-0.75% × 5) – (1 ×4.98% ×60%) =3.512%
Based on expected excess returns, Bond C offers the highest returns and so Channing
should invest in it.
Reference:
CFA Level III, Volume 4, Study Session 11, Reading 24
B.
The most appropriate bond for Channing is Bond C because:
1. It offers the highest expected excess returns given the annual expected probability
of default, spread, spread duration and expected loss severity.
2. Most of Channing’s current fixed income portfolio is invested in investment grade
bonds of rating A3 or more. A rating of Baa3 would offer some diversification to
this portfolio without adding much risk (while adding additional yield).
3. Channing’s risk tolerance permits him to invest in bonds that are relatively risky.
Since most of his current portfolio is invested in high risk equities and alternative
investments, he should not take on too much risk. But his minimum liquidity
needs and long-time horizon are suggestive of his ability to take on considerable
risk. A rating of Baa3 seems most appropriate for Channing, since it falls in the
moderate risk range.
Reference:

C.
Investment grade floating-rate bonds:
In investment grade bonds, there is more exposure to spread risk, credit migration risk
and interest rate risk. For spread risk inherent in investment grade floating-rate bonds, the
best measure is spread duration, not modified duration. This is because their modified
duration is usually very short.
High-yield bonds:
High yield bonds have a much greater exposure to credit risk and credit loss risk. Credit
spreads are a useful measure of risk for high yield bonds.
Reference:

QUESTION 4 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 39 MARKS
John Devlin is a portfolio manager at All-Mark Associates (AMA), a financial advisory

firm that manages portfolios for high net worth individual clients. AMA has gained
significant acclaim in the financial community, and the core reason for its success is its
strategy of appointing a dedicated portfolio manager for each of its clients. As such,
Devlin has been assigned the task of managing the portfolio of Sean Hart, a private
wealth investor that just joined AMA as a client.
Hart is a renowned physician and works at a state-owned hospital in Massachusetts,

USA. His superior technical expertise, professionalism and interpersonal skills, have
contributed to his success in the medical community. Consequently, after ten years of
working as a physician, Hart was offered a distinguished administrative position in his
hospital around five years ago. Hart is 45 years old and has decided to stay single. He is,
however, very close to his mother, who lives alone and left her job ten years ago. Hart
pays her $50,000/year to support her living expenses; he would continue to do so for the
coming fifteen years, after which, his mother’s pension disbursements will support her.
Hart goes to the gym regularly, and has managed to keep himself physically fit and
healthy.
During the course of several meetings with Hart, Devlin accumulated the following facts:
• Hart earns a salary of $200,000/year as a physician, and an additional $50,000 for

the administrative duties.
• Hart is planning to renovate his home and needs $40,000 in the coming three
months for this purpose.
• Hart wishes to donate $20,000 next month to a charity that funds the education
expenses of orphans.
• Hart’s living expenses average $300,000/ year.
• Before he passed away, Hart’s father put some money in a trust fund that pays
Hart $15,000/year.
• The income tax applicable to Hart equals 25% and the gift fund is subject to a
15% tax rate.
• Hart’s expenses and salary are expected to increase with inflation.
• The risk-free rate is 5% and the inflation rate is 3.0%.

With his hard work at the hospital, Hart has managed to accumulate a significant amount
of assets. Exhibit 1 displays details about them.
Exhibit 1:
Investable Assets
Investable Assets Amount
Stock holdings $50,000
Bond holdings $2,000,000
Co. Stock $500,000
**Cash $40,000
Home $1,200,000
Gold $200,000
*Stock holdings represent investments in stable, value stocks
**Investible assets have been adjusted for current year’s living expenses
Hart wants at least $3,000,000 in investable assets in 15 years. Even though his
employer’s stock forms a considerable portion of his investable assets, Hart wants Devlin
to carefully analyze the profitability and appropriateness of the investment. He is
prepared to liquidate the holding if circumstances suggested.
A. Formulate the return objective portion of Hart’s IPS. Show your calculations.
(10 marks)
B. Determine whether Hart’s ability and willingness to take risk are above-average,
average, or below-average. Justify your response with three reasons each. Use the
template on the following page to answer this question.
(8 marks)
C. Formulate the liquidity constraint portion of Hart’s IPS.
(5 marks)
D. Determine the personality type that Hart would fall into. Justify your response
with three reasons.
(5 marks)

After his analysis, Devlin considers the asset allocations given in Exhibit 2 for Hart.
Exhibit 2:
Proposed Asset Allocation Alternatives
Asset Class Allocation A Allocation B Allocation C Allocation D
Cash 10% 5% 0% 5%
Corporate bonds 0% 20% 10% 15%
Government bonds 40% 15% 5% 10%
Large-cap US
20% 20% 25% 20%
stocks
Small-cap US
20% 20% 20% 30%
stocks
International
- 10% 20% 10%
stocks
Real estate 10% 10% 15% 5%
Venture Capital - 0% 5% 0%
He also gathered the information given in Exhibit 3.
Exhibit 3:
Data on the Asset Allocations
After-tax, Nominal
Allocation Standard Deviation
Expected Return
A 16.66% 22.0%
B 12.99% 14.50%
C 21.00% 29.90%
D 12.50% 18.40%
The risk-free rate is 3.0%.
E. Determine the asset allocation that is most appropriate for Hart. Justify your
response with four reasons. For each of the allocations not selected, give one
reason each why they were not appropriate. Use the template on page – to answer
the question
(11 marks)

A Solution:
Return Calculations:
Cash Inflows: Cash Outflows:
Salary: 200,000+50,000 = Living expenses: $300,000(1.03) = $309,000

$250,000(1.03) = $257,500
Gift fund: $15,000 Mother’s living expenses: $50,000(1.03) = $51,500
Total: $272,500 Income tax: 257,500(0.25) = $64,375
Gift tax: 15,000(0.15) = $2,250
Total: $427,125
Net cash outflow: 272,500-427,125 = $(154,625)
Investable asset base:

Stocks: $50,000
Bonds: $2,000,000
Co. Stock: $500,000
Cash: $40,000
Total: $2,590,000
Less: $20,000 (for charitable donation)
Less: $40,000 (for renovation)
Total: $2,530,000
The required return to accumulate $3 million in 15 years with an investable asset base of
$2,530,000 and with annual outflows of $154,625 is 6.86% on a real after tax basis. The
nominal return after-tax return will equal (.0686)(1.03)-1 = 10.06%
Return objective:
To earn an after-tax, nominal return of 10.06% that would cover annual cash outflows of
$154,625 and would be sufficient to accumulate $3,000,000 in 15 years.

Reference:
CFA Level III, Volume 2, Study Session 4, Reading 8, LOS-g,i.
B Solution:
Above-
average,
Risk
average or Reasons
tolerance
below-
average
1.Long time horizon with good physical health.
Ability to Above- 2.Average return requirement relative to asset base.
take risk average
3.Minimum dependents, and a stable income flow for
the foreseeable future (stable job).
1.A higher percentage of fixed-income in its investable
asset base implies a risk-averse behavior.
2. Assets have been accumulated over several years with

Willingness Below the help of hard work and effort. This implies a lower
to take risk average willingness of taking risk.
3.The ability to detach himself from the investment in
his company’s stock and to judge its appropriateness
implies a methodical method of investing and a risk-
averse behavior.
Reference:
CFA Level III, Volume 2, Study Session 4, Reading 8, LOS-g.
C Solution
Liquidity constraint:
Hart has the following liquidity needs:
• An ongoing need of $154,625 each year to meet expenses.

• A one-time need of $40,000 in three months for the renovation of his home.
• A one-time need of $20,000 in one month to make a charitable donation.
Hart owns a house worth $1.2 million that represents a significant illiquid holding.

Given Hart’s circumstances, an emergency reserve equal to three months of his expenses
would be sufficient.
D Solution
Hart is a methodical investor as is evident from the following facts:
1. The equity portion of his portfolio is mostly invested in value stocks of stable
companies.
2. He refrains from developing emotional attachments to investment positions. Hart
instructed Devlin to research the appropriateness of the investment in his
company’s stock and retain the position only if it is supported by proper analysis
and research.
3. He holds a more risk-averse portfolio which is a trait of methodical investors.
Reference:
CFA Level III, Volume 2, Study Session 4, Reading 8, LOS-h.

E Solution:
For each of the allocations

Recommended not selected, give one reason
Four Reasons to support decision
asset allocation each why they were not
appropriate.
Meets the return requirement of an A: Has too much allocation to

after-tax, nominal return of 10.06%. cash.
C: Has too much allocated to

Is properly diversified with
real estate, with 85% of the
appropriate amounts invested in
portfolio invested in risky
stocks and bonds.
assets.
Allocation B Has a suitable allocation to cash
(5%) ensuring enough cash for D: Has a lower Sharpe ratio
emergencies and not too much as to than allocation B.
increase the cash drag.
Has the highest Sharpe ratio:
A: 16.66-5/22 = 0.53
B:12.99-5/14.50 = 0.55
C:21-5/29.90 =0.535
D:12.50-5/18.50 = 0.405
Reference:
CFA Level III, Volume 2, Study Session 4, Reading 8, LOS-j.

QUESTION 5 HAS THREE PARTS (A, B, AND C) PARTS FOR A TOTAL OF 22

MARKS
James Preston, 48, is a renowned professor of English literature, philosophy and

sociology at a State university in Massachusetts, USA. Preston is a single parent to two
children; Alyssa and Justin. Alyssa is 19 years old who has just graduated from college
and is planning to join a four-year bachelors program in anthropology. Justin, who is 28
years old, has completed his education and works for Clark & Peers Software
Developers, a well-established software house in the US. Alyssa’s academic program is
estimated to cost her $450,000 in total and Preston has agreed to contribute 75% of this
amount as assistance, with the rest being taken as a student loan by her. Although Justin
is financially independent, he has requested Preston to help him make a down payment of
$40,000 of a town home he plans to buy in two years that is very close to his workplace.
Preston feels a strong need to support his children in whatever way he can.
Preston has written a book on philosophy that is used as a textbook for first year college
students. With the help of his published book and some additional savings, Preston has
managed to accumulate a portfolio worth $15 million. The present value of his earnings
as a professor is estimated to total $12 million. Preston’s current residence is worth
$800,000 with around $2 million in mortgage loans. Other than the mortgage, Preston has
no other debt or liabilities. As a tribute to his late wife, Miranda Preston, James wishes to
make a contribution, worth $3 million, in ten years to a school for underprivileged
children. In addition, he wishes to leave $15 million as a bequest to his children at the
time of his death. Preston’s living expenses average $80,000 per year that he needs to
meet for his estimated life expectancy of 25 years.
Preston has hired Robert Stanton, a portfolio manager and research analyst, to manage his
financial assets and liabilities. While setting Preston’s investment policy statement,
Stanton determined the following probabilities of success for Preston’s stated goals:
§ Extremely high need corresponds to a 95% probability of success.

§ A want corresponds to an 85% probability of success.
§ A wish corresponds to moderate required probability of achieving and a 75%
chance.
A(i). State and describe four goals for Preston’s IPS.
(4 minutes)
A(ii). Present Preston’s economic balance sheet, detailing the components of his assets
and liabilities, and his total net worth.
(6 minutes)
To determine the appropriate asset allocation for Preston, Stanton requests the investment
department of his firm to provide him with a set of pre-optimized, sub-portfolio modules.
The department provides Stanton with details presented in Exhibit 1. In addition, Stanton

also requests data on expected returns of each module for a given time-frame and
probability of success.
Exhibit 1: Pre-optimized Portfolios

A B C D E
Expected
5.0% 5.5% 6.7% 7.8% 8.6%
Return
Expected
2.4% 4.9% 6.2% 8.0% 11.5%
volatility
Exhibit 2: Annualized Minimum Expected Returns

Time 5 years
Horizon
95% 1.7% 1.0% 0.8% 0.2% -2.1%
85% 2.2% 3.1% 3.3% 2.9% 1.0%
75% 3.3% 3.5% 4.3% 4.5% 4.2%
Time 10 years
Horizon
95% 2.0% 2.3% 2.2% 1.8% -0.9%
85% 3.3% 3.6% 4.0% 3.9% 3.8%
75% 3.5% 4.5% 5.5% 6.0% 6.2%
Time 20 years
Horizon
95% 3.5%% 3.6% 4.2% 4.7% 4.4%
85% 3.8% 4.1% 5.0% 5.5% 5.7%
75% 4.0% 4.7% 5.8% 6.1% 6.9%
Time 25 years
Horizon
95% 3.2% 3.5% 4.5% 4.9% 5.1%
85% 3.6% 4.2% 4.7% 5.5% 5.9%
75% 3.9% 4.7% 5.9% 6.6% 7.1%

B. Considering that only Preston’s financial assets are investable, determine the amount
of money that needs to be allocated to each goal in absolute terms as well as relative to
the total assets. State if any further goals can be met with the portfolio.
(6 minutes)
Once Stanton selected the optimal sub-portfolios for Preston, he worked towards deriving
an overall asset allocation. The detailed compositions of the sub-portfolios with respect to
five major areas of investment are given below:
Exhibit 3: Sub-Portfolio Composition

A B C D E
Cash 65% 15% 5% 3.2% 2.6%
Investment grade
30% 40% 20% 5% 0
bonds
High-yield bonds 5% 30% 25% 30% 10%
Developed equities 15% 20% 33.8% 50%
Emerging market
30% 28% 37.4%
equities
At a final meeting with Preston, Stanton stated that even though goals were properly
articulated, and money was allocated to each goal, there is a high chance that the
portfolio would fall short of meeting the goals. Hence, a surplus fund is always necessary
to act as a buffer in case things do no turn out as anticipated.
C.(i). Derive the overall goal-based asset allocation for Preston. Justify your response.
C(ii). State whether Stanton’s comment about a surplus is accurate using empirical
evidence.
(6 minutes)

SOLUTION:
A. Part (i).
Four important goals for Preston are as follows:
1. He needs a 95% chance of being able to support Alyssa’s education and pay
$337,500 right now, and to make a down payment of $40,000 to support Justin.
2. He needs a 95% chance of being able to meet his living expenses over the coming
25 years which is an estimation of his life expectancy.
3. He wishes to have a 75% chance of being able to make a contribution of $3
million to a school, ten years from now.
4. He wishes have a 75% chance of being able to bequest $15 million to his children
at the time of his death, which is expected to be after 25 years (his estimated life
expectancy).
Reference:
A Part (ii).
Financial Assets:
Investment Portfolio: $15 million
Real estate: $0.8 million
Extended Assets:
Human Capital: $12 million
Financial Liabilities:
Mortgage loan: $2 million
Extended liabilities:
Alyssa’s academic program cost: $0.3375 million
Justin’s down payments: $0.04 million
Contribution to school: $1.644 million

[ $3 million in ten years discounted at 6.2% (from the exhibits; corresponding to 75%
probability and 10 year investment horizon)]
Bequest: $2.6999 million

[$15 million in twenty five years at 7.1% (from the exhibits; corresponding to 75%
PV of future living expenses: $1.116301 million

[$80,000 for 25 years at 5.1% (from the exhibits; corresponding to 95% probability and a
25 year investment horizon)]
Economic net worth:

Economic assets-economic liabilities = $21.9623 million

Reference:
Solution B.
Total financial assets are $15 million
Goal Academic Down Contribution Bequest PV of
program cost Payment to school living
(Module E) expenses
Required 450,000×75% $0.04 $1.644 $2.6999 $1.116301
capital = $0.3375 million million million million
million
As a % of 2.25% 0.26667% 10.96% 17.999% 7.442%
total
Alyssa’s academic program cost: $0.3375 million
Justin’s down payments: $0.04 million
Contribution to school: $1.644 million

[ $3 million in ten years discounted at 6.2% (from the exhibits; corresponding to 75%
Bequest: $2.6999 million

[$15 million in twenty five years at 7.1% (from the exhibits; corresponding to 75%
PV of future living expenses: $1.116301 million

[$80,000 for 25 years at 5.1% (from the exhibits; corresponding to 95% probability and a
25 year investment horizon)]
A surplus of $9.1623 million remains, less $2 million of mortgage loan: $7.1623 which is
47.75% financial assets. Hence, further goals can be met, for example:
§ Capital preservation.
§ Return enhancement.
§ Any additional extended objectives.
Reference:
Solution C.
Part (i).
For each goal, Module E is the most appropriate given their time horizons and
probabilities:
Goal 1: In present value terms, 2.6% in cash covers Alyssa’s academic cost and Justin’s
down payment.

Goal 2: Living expenses (95% chance and 25 years’ time horizon) is best covered by
Module E.
Goal 3: Contribution of $3 million ten years from now (75% probability) is also best
covered using Module E.
Goal 4: A bequest of $10 million after 25 years (75% probability) is best covered using
Module E.
Hence, Module E would be the goal-based asset allocation for Preston [no calculations
necessary].
Reference:
Part (ii).
The statement is inaccurate. Portfolios generally outperform the discount rate used to
compute the initial capital, leading to a surplus. This is because of:
§ Preference for upward rather than downward volatility.

§ Goals having higher required probability of success than is truly the case.
Reference:

QUESTION 6 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 2O MINUTES
Capital Enhancement Investment Group (CEIG) is a capital management firm in the US

that holds a prestigious position amongst similar firms in its industry. CEIG has
introduced a number of revolutionary products in the financial industry that combine
traditional assets with simultaneous derivative positions to cash on profitable
opportunities. To remain competitive in this growing industry, CEIG appointed James
Hull, a compliance officer, to implement the Global Investment Performance Standards
(GIPS) within the firm. Hull has worked with CEIG for over three years now and deems
himself fruitful in the proper implementation of the Standards. CEIG considers itself
amongst the list of GIPS complaint firms, and, in doing so, believes it has gained the trust
of many prospective clients. Just recently, the CEO of CEIG hired Darin Hollings, a
performance evaluation and presentation expert, to review the firm’s procedures for GIPS
compliance. During his review, as of January 2011, Hollings noted the following:
• CEIG used trade date accounting to report transactions. Assets and liabilities were
recognized within a week of entering into a transaction.
• When reporting fixed-income securities, interest income earned but not yet
received was also included in their total value. For dividend paying equities,
dividends not yet paid were not accrued due to their uncertainty.
• CEIG has a fiscal year that corresponds to the calendar year. Consequently, every
portfolio within its composites was valued at the last business day of each year.
• When reviewing the frequency of portfolio valuations, Hollings discovered that
CEIG valued all portfolios at least monthly.
• When presenting net-of-fees returns, CEIG did not accrue investment
management fees, especially performance-based fees.
After the review, Hollings met with the CEO and posed the following question:
“In reporting portfolio values, which definition of value do you use?”
The CEO responded with the following comment:
“Last year, we measured and reported all portfolio values at market value. However,
recently, we have started to use the ‘fair value’ of portfolios for reporting purposes. If fair
values are not easily obtainable, a best estimate of market value is used.”

A. List three ways in which CEIG’s procedures violate the GIPS requirements with
regards to input data. Support your answer with proper justifications for each
reason.
(6 marks)
After his review, Hollings proceeded with evaluating the performance of the portfolios
managed by CEIG’s portfolio managers. While doing so, Hollings met with Ricardo
Nadu, a portfolio manager who managed a few of the firm’s private wealth accounts.
Nadu told Hollings that all portfolio managers were required to measure the time-
weighted rates of return that adjusted for external cash flows. In addition, returns for
longer measurement periods were computed by geometrically linking the monthly
returns. Upon further questioning by Hollings, Nadu stated the following:
• Cash and cash equivalents were included in the total return calculations.
However, if the cash was not actually invested by the same group of portfolio
managers that managed the portfolio, it was excluded from the return calculations.
• In addition, returns were always calculated after the deduction of trading
expenses. To be conservative and ensure compliance with GIPS, if actual values
for such expenses were unavailable, estimated values were used based on
historical averages.
• Custody fees were not considered direct trading expenses. However, if they were
charged on a per-transaction basis, they were included in trading expenses.
• When trading expenses could not be broken out of bundled fees, gross-of-fee
returns were reduced by the entire amount of the bundled fee to estimate returns
gross of investment management fees.
• Withholding taxes were not considered when estimating net of fee returns.
• CEIG’s definition of what constituted ‘a large cash flow’ varied with each
composite depending on the nature of the investment strategy.
B. For each of the facts stated by Nadu, state whether they are in compliance with
the GIPS. For each of the procedures not in compliance, determine the changes
necessary to make them GIPS compliant. Use the template on the following page
to answer the question.
Answer Question 6-B in the Template provided on page 20.
(6 marks)

Hollings knew that his analysis of CEIG would not be complete without assessing the
appropriateness of the construction of composites within CEIG. Specifically, Hollings
analyzed the following actual, fee-paying client portfolios:
Portfolio A The client specifically instructed not to invest more than 10% of the portfolio
value or 115% of the benchmark weight, whichever is greater, in any given
economic sector.
Portfolio B The client is the CEO of his firm and has holdings in his company’s stock.
He has instructed his portfolio manager not to sell any part of this holding,
even if capital market conditions stated otherwise.”
Portfolio C More than 60% of the client’s portfolio constitutes holdings in his
grandfather’s firm that has been managed by family over the course of many
years. Since the holding has a very low cost basis, the client has directed his
portfolio manager that it should not be sold.”
C. Select the portfolio that is likely to be not included in a composite under the
Global Investment Performance Standards. For the portfolio selected, list three
ways in which it can be handled with regards to GIPS compliant composite
construction.
(4 marks)
Hollings was particularly interested in the firm’s traditional asset class composites,
mainly:
1. Balanced Fund Composite (50% equities, 50% fixed income).

2. Growth Fund Composite (70% equities, 30% fixed income).
3. Income Fund Composite (30% fixed income, 70% equities).
The equity portions of the three funds were managed by a group of equity managers at
CEIG, whereas the fixed-income portions, along with cash and cash equivalents, were
managed by the fixed-income managers. Just recently, CEIG created a new composite by
the name of “Standard Equity Account Composite” that included only the equity
segments of the above-mentioned composites. This was created to ensure proper
performance evaluation of the equity managers of CEIG.
D. Determine whether the construction of the new composite is in compliance with

the GIPS. Support your answer with two reasons.
(4 marks)

Template for Question 6-B
Procedures Compliance Changes (if necessary)

with GIPS to be in compliance
Cash and cash equivalents were included
in the total return calculations. However,
if the cash was not actually invested by
the same group of portfolio managers
that managed the portfolio, it was
excluded from the return calculations.
Custody fees were not considered direct

trading expenses. However, if they were
charged on a per-transaction basis, they
were included in trading expenses.
When trading expenses could not be

broken out of bundled fees, gross-of-fee
returns were reduced by the entire
amount of the bundled fee to estimate
returns gross of investment management
fees.
In addition, returns were always

calculated after the deduction of trading
expenses. To be conservative and ensure
compliance with GIPS, if actual values
for such expenses were unavailable,
estimated values were used based on
historical averages.
Withholding taxes were not considered
when estimating net of fee returns.
CEIG’s definition of what constituted ‘a

large cash flow’ varied with each
composite depending on the nature of
the investment strategy.

A Solution:
Three ways in which CEIG’s procedures violate the GIPS requirements with regards to
input data are:
1. Although CEIG used trade date accounting, assets and liabilities are to be
recognized within three days of entering into a transaction (not a week)
2. CEIG did not accrue dividends not yet paid. GIPS standards recommend that
dividends be accrued as of the ex-dividend date.
3. CEIG valued all portfolios at least monthly. However, for periods beginning on or
after 1 January 2010, portfolios must be valued:
a. On the date of all large cash flows as defined by the firm for each
composite; and
b. As of each calendar month-end or the last business day of each month.
Reference:
B Solution:
Procedures Compliance Changes (if necessary) to be

with GIPS in compliance
Cash and cash equivalents were Not in Cash and cash equivalents
included in the total return compliance need to be included in the
calculations. However, if the cash total return calculation even
was not actually invested by the if the cash is not actually
same group of portfolio managers invested by the same person
that managed the portfolio, it was or group.
excluded from the return
calculations.
Custody fees were not considered Not in Custody fees are not to be
direct trading expenses. However, compliance considered direct trading
if they were charged on a per- expenses, even when they
transaction basis, they were are charged on a per-
included in trading expenses. transaction basis.

When trading expenses could not In

be broken out of bundled fees, compliance
gross-of-fee returns were reduced
by the entire amount of the
bundled fee to estimate returns
gross of investment management
fees.
In addition, returns were always Not in The GIPS standards require

calculated after the deduction of compliance that returns be calculated
trading expenses. To be after the deduction of
conservative and ensure actual, not estimated,
compliance with GIPS, if actual trading expenses. So actual
values for such expenses were values should be used.
unavailable, estimated values were
used based on historical averages.
Withholding taxes were not Not in Withholding taxes that
considered when estimating net of compliance cannot be recovered should
fee returns. be deducted when
calculating returns.
CEIG’s definition of what In
constituted ‘a large cash flow’ compliance
varied with each composite
depending on the nature of the
investment strategy.
Reference:

C Solution:
Since all portfolios are actual, fee-paying, the portfolio that is non-discretionary should
not be included in any composite. Portfolio C is likely to be considered non-
discretionary. This is because 60% of the portfolio’s value is not to be sold or managed
according to the portfolio manager’s intended strategy. 60% is considered a significant
amount.
The portfolio can be handled in the following three ways to be GIPS compliant:
1. The entire portfolio should be considered non-discretionary and removed from the
firm’s composites.
2. The individual assets over which the manager has no discretion should be
removed and the remaining assets could be added to a composite.
3. A materiality threshold could be stated in the policy, enabling the manager to
consider a portfolio discretionary if the non-discretionary assets consist of less
than a certain percentage of portfolio assets.
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS-f.
D Solution:
The GIPS Standards state, that for periods beginning on or after January 1 2010, a carve-
out must not be included in a composite unless it is managed separately with its own cash
balance. The construction of the new composite is not in compliance with GIPS because:
• In this case, it seems that the cash is pooled and is invested for the balanced funds
as a whole. The equity segments are not managed with their own cash balances.
• The equity segments do not seem to be managed separately from their fixed-
income counterparts (i.e. without keeping them in consideration).
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS-i.

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 20 MARKS
Jocelyn Mathews works as a portfolio manager at Victor Investment and Capital

Management (VICM). Mathews manages a number of VICM’s private wealth accounts
invested in asset classes ranging from equities and fixed-income to alternative
investments. Mathews believes strongly in not only the value of research and analysis in
proper security selection, but also in the significance of trading and implementation in
managing costs. Accordingly, he is analyzing the trading costs of his most recent
purchase: 1,000 shares of the stock of Stripes Incorporated. He accumulates the following
facts for his evaluation:
• The benchmark price was $60.00/share.

• The order was placed on last Tuesday, when the shares of Stripes closed at
$59.90/share. 500 shares were purchased at a price of $61.05 per share.
Commissions and fees were $50.
• On Wednesday, 200 more shares were purchased at $62.05 per share.
Commissions and fees were $20. Shares of Stripes closed at $61.03 during the
same day.
• On Thursday, no more shares were purchased and the order was canceled. The
market closed at $62.00 per share.
Mathews meant to use this data to calculate the implementation shortfall of his trade.
A. Calculate the total implementation shortfall for the trade in the stock of Stripes
Incorporated. Determine the contribution of the various cost components to the
total implementation shortfall. Show your calculations.
(6 marks)
Upon completion of his analysis, Mathews met with is fellow colleagues to share his
conclusion. They were all intrigued with the impact that trading costs could have on
investment results. As their discussion continued, each manager presented ways in which
they attempted to minimize trading expenses. They made the following comments:
Manager A: “I always use extensive competitor and industry data while screening
securities. A comprehensive fundamental analysis is a trialed and tested
method for selecting superior investments. While placing an order, I wait till
the price reaches the level I deem fit. “

Manager B: “I believe that markets are efficient, and costs to actively managed funds
overweight the benefits of doing so. Most of my investments are in indexed
funds. To minimize the costs of trading, I only trade at regular intervals for
rebalancing purposes.”
Manager C: “Just recently, I traded in the stock of Star Industries that I believed was
significantly overvalued. They had met fierce opposition from their largest
suppliers, which led to the cancellation of a supply contract just a few days
ago. My trading costs were quite low.”
B. Determine which category of traders types would each of the above managers fall
into. State the order type that they are most likely to use along with one limitation
for each order type.
(6 marks)
After their discussion, Jim McGraw (Manager B) stayed back to talk a little more about
rebalancing needs and methodologies. When Mathews inquired about the frequency of
his rebalancing trades, McGraw stated that he rebalanced his portfolio to target weights
on a semiannual basis; a choice linked to the schedule of his portfolio’s reviews. For
investment advice from Mathews, McGraw presented him with the following details of
his portfolio:
Exhibit 1:
Asset Class Weights (Strategic Asset Allocation)
Asset Class Weights
Domestic bonds 25%
International bonds 15%
Domestic Equities 40%
International Equities 20%

In addition, McGraw also mentioned that over the course of the previous year, some
economic, personal, and financial changes occurred, affecting each of these asset classes.
Specifically, he pointed out the following:
• Direct transaction costs of trading in domestic bonds increased considerably over

the year.
• Due to a large down payment to be made for the purchase of a new home, the
portfolio experienced a significant cash outflow. As such, minimizing tracking
risk relative to the benchmark became a prime objective.
• The volatility of international bonds increased, maybe due to differing economic
changes worldwide. Its correlation with domestic equities increased, reflecting
less of a diversification benefit.
• The correlation of international equities with domestic equities decreased
however, adding to the diversification benefits.
• The volatility of international equities increased too, over the same time period.
C. (i) State the rebalancing method used by McGraw. List two ways in which
percentage-of-portfolio rebalancing can mitigate the drawbacks of the rebalancing
method used by McGraw.
(3 marks)
C. (ii) Evaluate the implications of each of the above mentioned changes on the
tolerance bands of the asset classes assuming percentage-of-portfolio rebalancing
was used. Use the template on the following page to answer the question.
(5 marks)

A Solution:
Cost of paper portfolio: 1,000(60) = $60,000
Value on Thursday close: 1,000(62) = $62,000
Net value: 2,000
Real portfolio value on Thursday close: 700(62) = $43,400
Cost of real portfolio:
500(61.05) = 30,525+50 = $30,575
200(62.05) = 12,410+20 =$12,430
Total: $43,005
Net value: 43,400-43,005 = $395
Implementation shortfall: 2,000-395=$1,605
Cost components:
• Delay: Tuesday: 500/1000 [60-60/60] = 0%

Wednesday: 200/1000[59.90-60/60] = -0.0333%
• Realized profit and loss: Tuesday: 500/1000 [ 61.05-60/60] =0.875%
Wednesday: 200/1000 [62.05-59.90/60]=0.716667%
• Missed trade opportunity cost: 300/1000 [62.00-60/60] =1.00%
• Commissions: $50 + $20 = $70
• In percentage Commission = 70/60,000 = 0.1167%
Reference:
CFA Level III, Volume 6, Study Session 16, Reading 31, LOS-g.

B Solution:
Manager A is a value-oriented trader since he/she only trades when the price moves into
his/her value range. Value-oriented traders use limit orders. One
disadvantage of the limit order is that it may fail to execute.
Manager B is a passive trader since he seeks liquidity in his rebalancing transactions and
is concerned with minimizing costs. They are likely to use portfolio trades or
limit orders. One disadvantage of such trades is the uncertainty of completion
within a given time frame.
Manager C is an information-motivated trader since he is used a significant piece of

information to trade urgently. Such traders are likely to trade with dealers or
market orders. Limitations include high potential for market impact and
information leakage.
Reference:
CFA Level III, Volume 6, Study Session 16, Reading 31, LOS-j.
C (i) & (ii) Solution:
C (i) McGraw uses the calendar rebalancing method since he balances his portfolio on a
periodic basis (semiannually). The percentage of portfolio rebalancing mitigates the
following drawbacks of calendar rebalancing:
1. Percentage of portfolio rebalancing can exercise tighter control on divergences

from target proportions since it sets upper and lower limits for an asset class
weightage (corridor).
2. Percentage of portfolio rebalancing is directly related to market performance (the

trigger depends on asset class market values).
C (ii)
Changes Tolerance Implications

Band for:
Direct transaction costs of Domestic Higher transaction costs, wider
trading in domestic bonds bonds tolerance band
increased considerably over
the year.

Due to a large down payment International Lower risk tolerance, narrower

to be made for the purchase bonds tolerance band
of a new home, the portfolio
experienced a significant
cash outflow. As such,
minimizing tracking risk
relative to the benchmark
became a prime objective.
The volatility of international Domestic Increased volatility, narrower

bonds increased, maybe due equities tolerance band.
to differing economic Increased correlation with
changes worldwide. Its international bonds, wider
correlation with domestic tolerance band.
equities increased, reflecting Effect: Inconclusive
less of a diversification
benefit.
The correlation of Domestic No effect on the tolerance band

international equities with bonds of domestic bonds
domestic equities decreased
however, adding to the
diversification benefits.
The volatility of domestic International Higher volatility, narrower the

equities increased too, over equities tolerance band.
the same time period.
*Consider each in isolation
Reference:
CFA Level III, Volume 6, Study Session 16, Reading 32, LOS-f.

QUESTION 8 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS
Susanne Karen is an architect who works for a prominent multinational firm in the
industry. Karen has managed to accumulate a portfolio worth $10 million with her annual
savings. The portfolio is invested to track a balanced fund with 50% invested in stocks
and 50% in bonds. To suitably manage her portfolio, Karen hired Robin Clark, a portfolio
manager and investment management expert. For estimating the expected performance of
Karen’s portfolio, Clark accumulated the information given in Exhibit 1.
Exhibit 1:
Annual Expected Return and Risk
Asset Class Standard Deviation Return
Stocks 22% 15%
Bonds 9% 6%
The correlation between stocks and bonds is 0.65. During a meeting with Karen, Clark
extracted all pertinent information about her financial situation and personal preferences.
This was then used to construct an appropriate IPS. Keeping the objectives, as stipulated
by the IPS, in mind, Clark suggested investing a small portion of her portfolio in
derivatives. Specifically, he proposed the following option:
‘A forward contract on the stock of Titan Enterprises with a maturity of 18 months. The
stock is currently worth $120/share. The risk-free rate is 5.5%.”
Clark is convinced that the stock price would rise in the coming year or so, due to a
change in the firm’s product strategy. He constructed a position for Karen which would
take advantage of this expectation.
A. Determine the 1 percent VAR of Karen’s portfolio before the addition of the
forward contract. Express it in the most conservative way.
(4 marks)
Nine months have passed since Clark has been managing Karen’s portfolio. Titan
Enterprises’ stock is now worth $135/share. The stock paid no dividends during this
period and is not expected to do so for the coming five years.

B. Evaluate the credit risk position of Karen in the forward contract. Determine the
new price of the forward contract if it were to be marked to market.
(4 marks)
After two years, Karen requested Clark to present her with a comprehensive analysis of
her portfolios performance. Displeased with the results, Karen instructed Clark to look
for other investment opportunities. Clark stated, that over a year ago, his investment
management firm introduced a new fund managed by a team of reputable portfolio
managers and invested in a number of financial sectors. The fund managers used their
skills and expertise to earn above-average returns for the fund. Upon further request,
Clark presented Karen with the information given in Exhibit 2.
Exhibit 2:
GHE Investment Fund Annual Performance Attribution
Beginning Value $150,000,000
Net Contributions $850,000

(Risk-free asset) Incremental
$675,000
Value Contribution
Fund value (asset category) $165,500,000
Fund Value (benchmarks) $165,900,000

Incremental return contribution
0%
for allocation effects
Total fund return 11.05%
C. (i) Determine how much of the total return was attributed to style bias. Show
your calculations.
(4 marks)
C. (ii) Determine how much value active stock selection added to the fund.
(2 marks)
Karen was greatly impressed with the fund’s performance. Convinced with the superior
stock picking ability of managers at the firm, she decided to give Clark more discretion in
making investment decisions for her portfolio. After six months, Karen’s portfolio earned
an unexpectedly higher return than its benchmark. To confirm the results, Karen
requested the details given in Exhibit 3.

Exhibit 3:
Portfolio Performance Results (Extract)
Sector Sector
Portfolio Weight Portfolio Return
Economic Sector Benchmark Benchmark
(%) (%)
weight (%) Return
Capital Goods 8.9 8.0 -0.55 -0.67
Consumer
7.5 8.5 0.30 -0.40
durables
Technology 12.0 10.5 3.95 2.90
The total portfolio earned a return of 2.12% whereas the total benchmark return was
0.70%.
D. Determine the within sector selection return and the pure sector allocation return
for each of the above mentioned economic sectors. Show your calculations. Use
the template on page number—to answer the question
(6 marks)

A Solution:
Portfolio’s expected return: 0.50(0.15)+0.50(0.06) = 10.50%
Portfolio’s standard deviation: (0.5)2 (0.22)2 +(0.5)2(0.09)2 +

2(0.65)(0.5)(0.5)(0.22)(0.09) = 0.020560
P = √0.0205650 = 0.143388
VAR = 0.1050-2.33(0.143388) = -0.2291
$10,000,000(0.2291) = $2.291 million
“The VAR for the portfolio is $2.291 million for one year with a probability of 0.01. This
means there is a 1% chance that the portfolio will lose at least $2.291 million in a year.”
Reference:
CFA Level III, Volume 1, Study Session 14, Reading 27, LOS-e.
B Solution:
Forward price was: 120(1.055)1.5 = $130.03490
Current value of contract: 135-130.03490/(1.055)9/12 = $10.0833
Since Karen must have taken the long position to benefit from a rise in price, the contract
is positive to Karen and she faces a credit risk of $10.0833.
New forward price: 135 (1.055)9/12 = $140.53
Reference:
CFA Level III, Volume 1, Study Session 14, Reading 27, LOS-i.
C Solution:
(i) Total fund value at net contribution level: $150,850,000

Total return at asset category level: [165,500,000/150,850,000]-1= 9.71%
Total return at benchmark level: [165,900,000/150,850,000]-1 = 9.9768%
Style bias: 9.9768%-9.71% = 0.267%

(ii) Since allocation effects are 0%, the total return less the return at the benchmark level
will give us the return to active managers (the incremental return at the investment
manager level). This is 11.05%-9.9768 = 1.0732%
Reference:
CFA Level III, Volume 6, Study Session 17, Reading 33, LOS-l.
D Solution:
Pure Sector Within Sector
Allocation Selection
Capital Goods (8.9-8.0)(-0.67-0.70) 8.0[(-0.55-(-
= -1.23% 0.67)]=0.96%
Consumer (7.5-8.5)(-0.40- 8.5((0.30-(-
durables 0.70)=1.1% 0.40))=5.95%
Technology (12.0-10.5)(2.90- 10.5(3.95-2.90) =
0.70)=3.3% 11.025%
Reference:
CFA Level III, Volume 6, Study Session 17, Reading 33, LOS-l, m.

CFA Level III Mock Exam 4 June, 2018 Revision 1

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA Level III Mock Exam 4 June, 2018 Revision 1

Uploaded by

Copyright:

Available Formats

FinQuiz.

Copyright © 2010-2018. FinQuiz.com. All rights reserved. Copying, reproduction

FinQuiz.com – 4th Mock Exam 2018 (AM Session)

Questions Topic Minutes

FinQuiz.com © 2018 - All rights reserved. 2

QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MINUTES

FinQuiz.com © 2018 - All rights reserved. 3

C. Give three behavioral explanations for inadequately diversified portfolios. State

FinQuiz.com © 2018 - All rights reserved. 4

Solution for Question 1.

1. The probability-weighting function expresses the fact that people tend to

FinQuiz.com © 2018 - All rights reserved. 5

The three behavioral explanations are as follows:

FinQuiz.com © 2018 - All rights reserved. 6

QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MARKS

Renee Russo works as a portfolio manager at Panther Investment Management Firm

Debt/Total Assets 35% 55%

Net Income/Sales 22% 19%

Russo’s team at PIMF presents her with the data in Exhibit 2.

FinQuiz.com © 2018 - All rights reserved. 7

Thorpe continues with the following comment:

A. Formulate an appropriate risk objective for Revolutionary Technologies

FinQuiz.com © 2018 - All rights reserved. 8

B. Determine the minimum return requirement for RTEL’s pension fund.

• The ratio of the retired lives to average lives is 0.66.

FinQuiz.com © 2018 - All rights reserved. 9

Solution for Question 2:

Reasons (High) Reasons (Low)

Ability 1. RTEL’s debt/total assets ratio is less 1. A significant amount of pension

2. The ratio of retired lives to active 2. A pension plan that keeps

Overall: Ability to take risk is above-average because of:

FinQuiz.com © 2018 - All rights reserved. 10

Total return objective: 8.5%+2.5% = 11.0%

• The overall return objective is to achieve a return sufficient to maintain a specific

Ignoring contributions to the plan, cash disbursements of $60 million/month on an asset

FinQuiz.com © 2018 - All rights reserved. 11

The liquidity constraint has deteriorated because:

• The ratio of retired lives to active lives has increased.

Time horizon (ten years ago):

Time horizon (as of now):

FinQuiz.com © 2018 - All rights reserved. 12

QUESTION 3 HAS THREE PARTS (A, B AND C) FOR A TOTAL OF 19 MARKS

Exhibit 1: Current Asset Allocation

International Equities 15%

Domestic Equities 55%

Corporate bonds 20%

Real estate 10%

Exhibit 2: Bond Investments

B 4.00% 3.50% 4 Ba1

FinQuiz.com © 2018 - All rights reserved. 13

Exhibit 3: Default and Recovery Data

Baa3 1.00% 60%

Ba1 1.90% 55%

About 75% of Channing’s current fixed-income allocation is in investment grade

3. State which risk is most inherent in Channing’s current fixed-income allocation

FinQuiz.com © 2018 - All rights reserved. 14

Solution for Question 3:

Bond Expected Expected loss Expected Z- spread in Spread

A 0.33% 30% -75 1.50% 3

Expected excess returns given the information:

Bond A: (1.50 × 1) – (-0.75% × 3) – (1 ×0.33% ×30%) = 3.749%

FinQuiz.com © 2018 - All rights reserved. 15

FinQuiz.com © 2018 - All rights reserved. 16