2O1OLevel 3 Sample Exam Version 1

Vision 2020CaseScenario
Msion 2020 Capital Partners (V2020) has operated for the past ten years originating and brokering corporate finance deals through private placements in Emerging and Frontier Markets. However, due to the global financial crisis, investmentbanking deals have diminished and have been volatile and risky; i.e., recent analysis shows that for every deal signed on, only one out often deals actually closed such that investment banks received fees. Consequently,V2020 struggles, along with its competitors, to generate enough fees to sustain its business. During a strategic planning sessionto addressthe issue of financial sustainability, the Y2020 Board of Directors, made up of the industry's top financial experts, determined they needed to create a new, consistent revenue stream to cover all of their fixed costs. The Board assessedthe company's strengths and weaknessesand identified opportunitieswhereby they could draw on their strengthsto create the required income stream.One suchopportunily identified was the developmentof an Emerging and Frontier Market BalancedFund (the Fund). The Board has had several enquiries from clients asking for such a product. The Boaid felt this was an ideal businessline to meet client demand, create monthly assetmanagementfees, as well as act as a buyer of last resortfor any of their clients'private placementdeals. Recognizing that none of the Board members or senior managers are experiencedin asset management,the Directorshire a specialist(the Consultant)to help the company set up policies and procedures the new Fund. for The Directors also stipulatethat all the recommendations from the Consultantshould ensurecompliancewith the CFA Asset Manager Code of ProfessionalConduct. Severalof the Trusteesact as trusteesfor small conservative pensions funds and so, basedon this experience, they feel thesefunds are their main targetmarket. LaurenAkinyi, CFA, an independent consultantwho works with various clients in the asset management industry is hired by the Y2020 Board to undertakea study on the creation and implementationof the Fund. She makesthe following recommendations a report to the Board concerningcompliancewith the Asset ManagerCode: in

Recommendation V2020 should follow the following principlesof conduct:(1) act at all times in a l: professional (2) manner; act for the mutualbenefitof its clientsand the firm; (3) act with independence and objectivity.
Recommendation To take advantageof their vast experiencein the finance industry,the Board of Dilectors 2: should take an active daily role in managing the Fund's assets.Board members must disclose any conflicts of interest arising from their businessassociationsoutside of Y2020. In addition, the Board must designatean : ; existing employeeas a ComplianceOfficer. Recommendation3: To avoid any conflicts between the investment banking and the nerv fund management wholly owned subsidiaryshould be createdto undertakethe fund management businesses, separate a business.

Recommendation To ensure 4: timely and efficienttrades, in one stockbroker eachcounby of investnentshould be appointedas the sole broker for the Fund. The Board should also consider buying an equrly stake in eachof the appointed brokersaswell, to increase sources ofrevenue. After completingits first year of operations, Fund receivesa letter from the Financial Services the Regulatory Body.The notificationimposes fineson the FundManagement poor disclosures their clientsand mandates for to tle replacementof the Senior Fund Manager as a condition for the renewal of their assetmanagementlicense. The Board of Directorschallenges ruling, statingthe Fund madethe necessary disblosures. wanting the full Not to incur expensivelegal fees or waste precioustime, however, the Board, without admitting or denying faul! settlesout of count. Subsequently, Senior Fund Manager leaves the employment of the Fund on his own the accordafter receiving a multimillion-dollar bonus.After the replacement the SeniorFund Manager,the license of is renewed for a further year. The Financial ServicesRegulatory Body, however, notifies the Fund that any furttrerrelatedviolationswill resultin the revocation V2020'slicense. of

2 Question WouldAkinyi's first recommendation mostlikzly resultin the Fund complying with the principlesof the Asset Manager Code? Select exactly 1 answer(s) from the following: A. No. B. Yes,because principlesarecorrectlygiven. the C. Yes,because Fund is run in a professional the manner.

3 Question Which of Akinyi's policies in Recommendation would not comply with the Asset ManagerCode if 2 implemented? Select exactly I answer(s) from the following: A. The Directorsand SeniorManagers taking an activedaily role. B. Designating existing an employee actasa Compliance to Officer. C. Disclosing conflicts interest any of arising from theirbusiness associations of outside Y2020

4 Question Which of the following would be mostefective to preventany violation of the AssetManagerCodeas reflected in Akinyi's third Recommendation? exactlyI answer(s) Select from the following: A. TheFundretains minorityshareholding theInvestment a in Bankingarm. B. The Fund doesnot buy any investments from the Investment Banking arm. C. Disclose relationship the between Investment the Bankingarmaind Fund. the

5 Question If Recommendationwereto be implemented, 4 which aspect the AssetManager of Codewould zosl likely be violated? Select exactlyI answer(s) from thefollowing: A. Fairdealing. B. Bestexecution. C. Priorityof transactions.

Given the Fund's one-yearhistory, which of the following will rt least likely discloseto its clients so as to be in compliance with theAssetManagerCode? from the following: Selectexactly 1 answer(s) A. The lossof their employee. from the FinancialServices Body. B. Communication Regulatory to C. The largepayment the SeniorManager.

Brian O'Reilly CaseScenario

Retirement System, O'Reilly is Brian O'Reilly is a capitalmarketsconsultant the Tennessee Teachers' for for with the System's boardto present capitalmarketexpectations the next year.Board memberKay his meeting biasesexist in historicaldata, O'Reilly Durdenasks O'Reilly aboutthe possibilitythat data measurement responds: "Some benchmarkindexessuffer from survivorshipbias. This occurs when a data seriesreflects only those period. The returnsof failed or mergedcompanies that have survivedto the end measurement companies are droppedfrom the data series,resulting in an upward bias to reportedreturns.This may result in an overly with respect future index returns.Another bias resultsfrom the useof appraisal to datain optimisticexpectation the absence markettransaction of data.Appraisalvaluestend to be lessvolatile than marketdetermined values for identical assets. The result is that calculatedcorrelationswith other assets tend to be biasedupward in absolute valuecompared the truecorrelations, the true variance the asset biased to of is downward." and Boardmember Arnold Brown asksO'Reilly aboutthe use of high-frequency(daily) in developing data capital market expectations. O'Reilly answers: "Sometimes is necessary usedaily datato obtaina dataseries the desired to it of length. High-frequency are data to moresensitive asynchronism across variables asa result, tendto produce higher correlation estimates." and,
Board member Harold Melson noted that he recently read an article on psychological traps related to making accurate and unbiased forecasts.He asks O'Reilly to inform the board about the anchoring trap and the confirming evidencetrap. O'Reilly offers the following explanation: "The anchoring trap is the tendency for forecaststo be overly influenced by the memory of catastrophicor dramaticpast eventsthat are anchoredin a person'smemory. The confirming evidencetrap is the bias that leads individuals to give greater weight to information that supports a preferred viewpoint than to evidence that contradictsit." The board asks O'Reilly about using a multifactor model to estimate assetreturns and covariancesamong asset returns.O'Reilly presented the factor covariancematrix for global equity and global bonds, shown in Exhibit I and market factor sensitivitiesand residualrisk, shown in Exhibit 2.

Exhibit I Factor CovarianceMatrix Global Equity Global Eouity Global Bonds o.0225 0,0022 GIoba ds Bo o,0022 0.0025

Global Equity arket1 Market2 Market3 1.20 0.90 0

GbaI Bonds o 0 0 o5 9 12.0o/o 7.0% 1.8o/o

Finally,the board asksaboutforecasting expected returnsfor major marketsgiven that price eamingsratios are not constantover time and that many companies repurchasing are sharesinsteadof increasing cash dividends. O'Reilly respondsthat the Grinold-Kronermodel accountsfor those factors and then makes the following forecasts the European for equitymarket: . Dividend yieldwill be 1.95%o. ' Shares outstanding decline1.00%. will ' Long-terminflation ratewill be l.75Yoper year. . An expansion for PIE multiplesof 0.15Yo yeaf. rate per . Long-termcorporate real earnings growth at3.5o/o year. per

'

7 Question s u Wr $ A. co : : c JlT t k

ect. ed retums. in uas results in a downward bias to repo Iect,because survivorsh ew ect,because survivorshV uas results in an overly pessimist ofexpeGted returns h

Question8 Re 1th respect to hk explanaton ofappraisal bias,0 ly r`` is om following e ; select exactly1answer(s) A correct. ue ofthe assetis uased upward. h ect,beCause the varian e F ect,because calCuhtedelon w oer asse nd to be uased downward in absolute value. : c.in

9 Question to O'Reilly mostlikely is: to With respect his answer Brown'squestion, from the following: Select exactly I answer(s) A. correct. to data high-frequency arelesssensitive asynchronism. B. incorrect, because estimates. lowercorrelation high-frequency tendto produce data because C. incorrect,

10 Question of trap mostlikely correct? Is O'Reilly's explanation the anchoring from the following: exactly I answer(s) Select A. Yes. weight to the first trap is the tendencyfor the mind to give a disproportionate the B. No, because anchoring information receives a topic. it on extreme. so trap is the tendency temperforecasts that they do not appear to the C. No, because anchoring

Question11 Given the data in Exhibits1and2,d1e co ariance between Market1and M ket2is closest to select exactly1answerls)from tlle followhg A. 0.0017 B. 0 0225 C. 0.0243

Alan SevernCaseScenario
Alan Severn,a portfolio managerat Morgan Capital, a British institutional assetmanager,is meeting the investment for committee CotswoldIndustries' pension plan. Cotswold,basedin the United Kingdom and a client of Morgan,has traditionallybeenconservative, the pensionplan's portfolio is currently investedin and U.K. stocks bonds and only.Cotswold would like to evaluate additionof a diversified U.K. stockindexto the the portfolio. existing In orderto helpthe investment committee with their evaluation, Morganhasprovidedthe datain Exhibit 1.

Exhibit1 Returns, Standard Deviations, Correlation and s Expected ReturnCurrentPortfolio( S.) Standard Deviation Retums of Current Portfolio( S) Expected Return U.S.Index($) of
Standard Deviation of Retums of U.S. Index ($)

11.5o/o 13.5o/o 14.5%

16.0o/o

Correlation U.S.IndexReturns f, ) andCunentPortfolioReturns & ) of ( (

ExpectedPercentage Changein ExchangeRate ( Si$) StandardDeviation of ExchangeRate Change( 9/$) Correlationof U.S.Index Returns($) and Percentage ExchangeRate Change(f,,/$)

0.65 6.7%

8.s%
0.45

Severn states:"In general,changingthe assetallocationto include developed and emerging market international securitiesto the current portfolio will result in a new, efficient frontier of portfolio where eachnew porlfolio will offer higher levels of return but at higher levels of risk, provided the international securities have low correlationswith the current portfolio." JamesBruch, a committeemember,responds:"I think that we should not expandour investments international to markets." He elaborates with the followins statements: Statement1: "Currenciescan fluctuatewildly and investing in U.S. stocks exposesus to currency risk that could negatively intpactreturns;for this reason'weshould not invest in overseasmarkets." Statement2: "Because most U.K. companieshave an international presence,we should focus on diversifliing acrossdifferent industriesin the U.K. and not worry about diversi$,'ingglobally acrossdifferent countries." 3: Statement "Emerging marketsare volatile and exposeus to political risks. They are prone to suffering frequent financial crises,and offer no risk diversificationbenefitsdurine these times becausecorrelationswith developed marketssuch as the U.K. increase." to Severnresponds Bruch:

"Curency risk should not prevent us from investing globally. Currencyrisk can be eliminated by hedging with currenoyforwards or by diversifying acrossmultiple currencies.Furthermore,the correlationsbetween equity andcurrencymarketsareso low that overallcurency risk is minimal." "It is true that emergingmarketsare subjectto periodiccrises,but most of the time the crisis doesnot spread beyondthe local region and developedmarketsremain low. Emergingmarketsare more likely to eqioy superior economicgrowth and over the yearshave becomemore integrated with developed economies. This increased integration with developed markets will resultin attractive equitymarketreturns."

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