Professional Documents
Culture Documents
The Morning Session of the Level III CFA® Examination has 10 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.
Total: 180
Page 2 Level III
Mika Välimaa is an equity portfolio manager with two new clients: The Pinheiro University
Endowment Fund and the Missipina Foundation.
The Pinheiro University Endowment Fund (the Fund) is overseen by an investment committee.
Välimaa is tasked with developing a strategy for the equity portion of the Fund’s portfolio. In her
initial meeting with the Fund’s investment committee, Välimaa compiles the following notes:
• The Fund pays taxes on interest, dividends, and realized capital gains.
• The committee expects an increase in interest rates.
• The committee believes that equity markets are highly efficient.
• The committee mandates that the portfolio shall have minimal tracking risk.
At the end of the initial meeting, Välimaa recommends that the Fund’s portfolio be managed
using a passive investment approach.
A. Justify, with three reasons based only on Välimaa’s notes, why the use of the passive
investment approach is appropriate for the Fund’s portfolio.
Välimaa next considers the transition of the Fund’s portfolio holdings, which have a total market
value of EUR 150 million. She is constructing the portfolio using individual equities and
considers the following methods: full replication, stratified sampling, and optimization. The
benchmark for the portfolio is the FTSE Eurotop 100 Index, which is based on market
capitalization and consists of 100 of the largest publicly traded European companies. The
investment committee prefers not to use sophisticated algorithms that are difficult to understand.
B. Determine, from the three methods that Välimaa is considering, the most appropriate
method for constructing the equity portfolio. Justify your response.
Before hiring Välimaa, the Missipina Foundation’s portfolio had been managed internally.
Välimaa reviews a memo from Missipina’s investment committee that summarizes the previous
internal manager’s approach to portfolio construction:
C. Determine, based solely on the memo’s content, the previous manager’s two approaches
to portfolio construction (bottom-up or top-down / systematic or discretionary). Justify
each response.
D. Determine, based solely on the memo’s content, whether the former manager’s portfolio
would most likely be characterized as having high or low:
i. Active risk
ii. Active Share
Top-down
Bottom-up
Systematic
Discretionary
Page 8 Level III
Low
Active risk
High
Low
Active Share
High
Level III Page 9
Exhibit 1
Edonia Capital Market Expectations
Standard deviation of returns 30%
Correlation with global investable market (GIM) portfolio 0.50
Sharpe ratio of GIM portfolio 0.28
Degree of integration with GIM portfolio 0.55
10-year government bond yield 6.50%
A. Calculate the risk premium for Edonia equities using the Singer-Terhaar approach.
Show your calculations.
Lyon previously estimated the risk premium for Edonia equities using the Grinold-Kroner
model. She updates her estimates for two factors for Edonia equities in Exhibit 2.
Exhibit 2
Factor Estimates for Edonia Equities
Previous Updated
Factor
Estimate Estimate
Percent change in P/E ratio +2.0% +1.0%
Percent change in shares outstanding +0.5% +1.5%
B. Determine the most likely combined effect (decrease, no change, increase) of Lyon’s
updated estimates on the risk premium for Edonia equities using the Grinold-Kroner
model. Justify your response with two reasons.
Lyon then reviews selected macroeconomic research summarized in Exhibit 3. She forecasts that
inflation in Edonia will increase over the next six months.
Exhibit 3
Edonia Macroeconomic Data
December June
December
2017 2018
Macroeconomic Indicator 2018
(Past (Current
(Forecast)
value) value)
Consumer confidence index 92 99 107
Ratio of government spending to tax receipts 1.54 1.55 1.43
Global crude oil production (million barrels per day) 76 79 81
Inventory/sales ratio 1.35 1.30 1.25
Output gap [(actual GDP – potential GDP)/potential GDP] –2.1% –1.2% 1.7%
2.
Page 14 Level III
2.
Level III Page 15
The Musadi Foundation (the Foundation) is based in the country of Denom, where the DNM is
the currency and the tax rate is 25%. In Denom, foundations are tax-exempt if they meet a
5% annual minimum spending requirement, which includes operating costs but excludes
management fees. Preserving the Foundation’s tax-exempt status and maintaining the real value
of its portfolio after spending are priorities for the Foundation’s board.
The Foundation’s portfolio is currently DNM 30 million and the Foundation is not expected to
receive new donations. The Foundation is the sole source of funding for local youth centers and
is intended to operate long into the future. The Foundation has operating costs of 20 bps per year
and investment management fees of 33 bps per year.
Over the past two years, the portfolio’s average annual nominal return was 7.9%, while inflation
averaged 1.5% per year. Inflation is forecast to remain at the same annual rate, but the portfolio’s
nominal return is forecast to decline to 7.0% per year.
A. Determine, based on the forecasts, the maximum spending rate that will allow the
Foundation to maintain the real value of the current portfolio. Show your calculations.
B. Discuss, for each of the following, two factors for the Foundation that contribute to a:
Note: Restating case facts without additional support will not receive credit.
Denom’s regulatory agency decides to change the policy for determining the annual minimum
spending requirement for foundations to retain their tax-exempt status. The requirement will
change from 5% of the beginning-of-the-year asset value to 5% of the average monthly asset
value in that same year. The Foundation minimizes cash holdings to improve expected
performance.
C. Determine, as a result of the new spending requirement policy, the most likely change
(lower, no change, higher) in the Foundation’s cash reserve. Justify your response.
i. low ability
to take risk. 2.
1.
Richard Seal manages his own investment portfolio and meets with Michelle Beech, an
investment advisor. Richard tells Beech that his equity portfolio has outperformed and he is
certain it would continue to outperform under his management. However, demands on his time
have increased and he now needs some assistance.
Beech calculates the performance of Richard’s self-managed equity portfolio and compares the
results with the median active equity mutual fund and a passive equity index fund in Exhibit 1.
Beech concludes that Richard has overconfidence bias.
Exhibit 1
Selected Portfolio Characteristics
Richard’s Median Active Passive
Self-managed Equity Mutual Equity Index
Equity Portfolio Fund Fund
3-year annualized net return 9.1% 9.7% 9.1%
Top 5 holdings (as % of portfolio) 50% 16% 8%
3-year cumulative turnover 45% 65% 18%
Beech meets with Richard’s three adult children, John, Sara and Patrick, who also manage their
own portfolios. Beech reviews the net worth and spending of each of them. She determines that
John and Patrick have a low standard of living risk, while Sara has a high standard of living risk.
Beech asks each of them to complete a questionnaire to indicate if any of them have potential
behavioral biases. Results are shown in Exhibit 2.
Exhibit 2
Adult Children Potential Biases
John Self-control
Sara Representativeness
Patrick Conservatism
Level III Page 21
Sara and Patrick own shares in Alphadog Corp. The company’s profitability has been higher than
the industry average over the past few years. However, in the most recent quarter, Alphadog’s
earnings were below the consensus estimate. In addition, the company reduced earnings
guidance for the coming year.
B. Determine, based on their potential bias, whether each of the following will most likely
hold or sell their shares of Alphadog.
i. Sara
ii. Patrick
Beech provides John with a mean-variance optimized portfolio. Based on John’s standard of
living risk and his potential behavioral bias, Beech also produces a behaviorally modified
portfolio. The asset class weights of the modified portfolio differ from those of the optimized
portfolio by +/− 10%. Beech then repeats the process for Sara, preparing both a mean-variance
optimized portfolio and a behaviorally modified portfolio.
C. Determine the most likely amount (less than +/− 10%, equal to +/− 10%, greater
than +/− 10%) by which the asset class weights of Sara’s two portfolios will differ.
Justify your response.
2.
Level III Page 23
hold
i. Sara
sell
hold
ii. Patrick
sell
Page 24 Level III
less than +/− 10% equal to +/− 10% greater than +/− 10%
Bert and Emma Gondo, ages 75 and 65 respectively, live with their three children in a European
country that is a community property regime. This regime entitles a surviving spouse to receive
one-half of the community property after their spouse’s death. The forced heirship rules entitle
the surviving spouse to one-third of the total estate, and the children are entitled to split one-third
of the total estate. The Gondos’ total estate has grown from EUR 6 million to EUR 16 million
during their marriage. The country in which Bert and Emma reside imposes an estate tax of 40%
on estate values above a statutory allowance of EUR 500,000.
A. Determine the minimum amount (in EUR) that Bert should be entitled to before estate
taxes, if Emma were to die today. Show your calculations.
B. Determine the minimum amount (in EUR) that each child should receive if Emma were
to die today. Show your calculations.
The Gondos meet with their investment advisor to determine the optimal way to accomplish
some specific bequests. The Gondos seek to transfer a sum of EUR 150,000 to Emma’s cousin
Erica, for the benefit of Erica’s son. Erica and her son live in the same country as the Gondos,
and Erica is subject to a lower income tax rate than the Gondos. The investment advisor assumes
that Erica’s pre-tax investment returns on any gifted assets would be equal to the Gondos, and
that Erica’s estate will not be subject to estate tax. The country’s annual gift exclusion allowance
is EUR 30,000, with no lifetime limit. Any gifts over the exclusion allowance are taxed to the
donor at a flat rate of 40%. The advisor recommends the Gondos make an annual gift of EUR
30,000 to Erica over the next five years, rather than transferring wealth to her upon Emma’s
death.
C. Justify, with two reasons, why tax considerations favor the Gondos making annual gifts
to Erica.
4 minutes (Answer 5-C on page 30)
The majority of the Gondos’ wealth is in the form of illiquid shares of a family-owned business.
Bert is concerned about a lack of liquidity to pay estate taxes upon his death. He does not want
the family to be forced to sell shares to pay the taxes and he wants to minimize estate taxes. Bert
consults with the investment advisor, who recommends that Bert consider purchasing a life
insurance policy on himself. The investment advisor notes that death benefit proceeds paid to life
insurance beneficiaries are tax exempt.
D. Discuss two benefits, specific to the Gondos’ circumstances, of Bert purchasing the life
insurance policy.
Bert, who prefers to keep family financial affairs private, wants to provide a secure financial
future for Emma, their three children, and potential future grandchildren. He worries about
disputes among his wife and children and potential legal claims from outside the family. Bert
consults with the investment advisor, who recommends that Bert establish an irrevocable trust.
Juan and Mariana Hidalgo, both age 55, meet with their advisor to discuss their IPS. The
Hidalgos are residents in the country of Oroplata, where the currency is the ORP and annual
inflation is expected to be 3%. Juan recently sold a software company he founded in exchange
for equity shares in a publicly listed company. He also recently became disabled and can no
longer work. Mariana plans to retire in 10 years. During their meeting, the advisor notes the
following.
Income
Mariana earned a pre-tax annual salary of ORP 250,000 last year. Her salary will increase each
year at the expected inflation rate of 3% and is taxed at 25%. Mariana has a defined-benefit
pension plan, and she is fully vested.
Expenses
Last year, the Hidalgos’ living expenses were ORP 280,000. These expenses will increase each
year at the expected inflation rate of 3%. The Hidalgos will reevaluate their spending upon
Mariana’s retirement.
Assets
The Hidalgos’ taxable investment portfolio is valued at ORP 4,000,000. The portfolio includes
ORP 1,000,000 in the equity shares that Juan received from the sale of his company. In the rest
of the portfolio, the Hidalgos prefer short-term fixed income and cash investments rather than
equities. They own a home with no mortgage, valued at ORP 1,250,000, which is excluded from
the investment portfolio. Investment returns are taxed at 25%.
Funding Goal
The Hidalgos’ funding goal is to maintain the after-tax real value of their portfolio after making a
donation to support a research organization. The donation is not deductible for tax purposes.
They want to determine the maximum amount they can donate immediately that will allow the
remaining portfolio to continue to fund their net cash need next year. Their advisor expects the
portfolio to have a real after-tax return of 2.75% per year.
A. Determine, given the Hidalgos’ funding goal for the next year, the maximum amount
(in ORP) that can be donated immediately. Show your calculations.
Note: Assume that annual income and expenses are end-of-year cash flows.
B. Identify, for each of the following, two factors for the Hidalgos that contribute to a:
Ten years later, Mariana is retired. The Hidalgos’ taxable investment portfolio is now valued at
ORP 4,200,000. The expected annual inflation rate is now 4%, and investment returns are still
taxed at 25%. The Hidalgos and their advisor review the asset allocation for their portfolio to
determine if it meets the following retirement goals:
Return Objective: Earn a minimum real after-tax return of 4.5% per year.
Risk objective: Have a small probability of declining more than 14% (in nominal
pre-tax terms) in any one year. A two-standard-deviation approach
is used to monitor shortfall risk of the portfolio.
Liquidity constraint: Have a cash reserve between ORP 250,000 and ORP 300,000.
Exhibit 1
Hidalgos’ Portfolio
Asset Class and Allocation
Investment-grade bonds 31%
Equities 61%
Cash equivalents 8%
Total 100%
Expected Return and Risk (annual)
Pre-tax nominal rate of return 12.8%
Standard deviation of return 13.2%
Real risk-free rate 0.5%
i. return objective.
ii. risk objective.
iii. liquidity constraint.
i. low ability
to take risk. 2.
1.
Poquessing Zerbe is a fixed-income portfolio manager. One of her institutional clients, Mahanoy
Oswayo, needs to immunize a single 10-year liability of USD 120,000,000. Zerbe calculates the
present value of this future liability to be USD 92,221,521.
Zerbe decides not to use zero-coupon bonds to immunize the liability and considers three
possible immunization portfolios using non-callable, fixed-rate US Treasury bonds. Zerbe
prepares a comparative analysis of the three portfolios in Exhibit 1. Zerbe explains to Oswayo
that, once chosen, the immunization portfolio will need to be rebalanced over time.
Exhibit 1
Comparative Analysis of Immunization Portfolios
Portfolio A B C
Market value (in USD) 92,339,315 92,101,324 92,298,633
Cash flow yield 2.679% 2.681% 2.677%
Macaulay duration 9.998 10.002 9.537
Convexity 119.079 121.344 108.969
A. Determine which portfolio in Exhibit 1 would best immunize the future liability. Justify
your response.
One year later, a duration gap exists between the liability and the immunization portfolio. The
future liability now has a present value of USD 91,732,436 and a modified duration of 8.867.
The immunization portfolio has a market value of USD 92,749,570 and a modified duration of
9.107.
Zerbe closes this duration gap using a US Treasury note futures contract in a derivatives overlay
strategy. Based on the cheapest-to-deliver bond she determines the basis point value (BPV) for
one futures contract is USD 71.32.
B. Determine whether Zerbe should take a long or short position in the futures contracts.
Calculate the number of futures contracts required to close the duration gap. Show your
calculations.
Oswayo also asks Zerbe for advice on how to position the domestic fixed-income portion of
Oswayo’s investment portfolio. Zerbe expects the US Treasury yield curve to immediately
flatten and presents her forecast in Exhibit 2.
Level III Page 41
Exhibit 2
Zerbe’s Forecasted Changes in Yields
Maturity (years) 2 5 10 30
Forecasted change in yield 0.35% 0.20% 0.00% –0.35%
Oswayo wants to position the domestic portion of the portfolio to benefit from Zerbe’s yield
curve forecast. Zerbe and Oswayo consider three portfolios of non-callable, fixed-rate US
Treasury bonds with 2, 5, 10, and 30-year maturities. Selected data for the portfolios are
presented in Exhibit 3.
Exhibit 3
Selected Data for Portfolios 1, 2, 3
Maturity Portfolio Allocations Portfolio
Modified
2y 5y 10y 30y Duration
Portfolio 1 0.00% 0.00% 100.00% 0.00% 8.5442
Portfolio 2 62.45% 0.00% 0.00% 37.55% 8.5463
Portfolio 3 26.00% 26.10% 23.90% 24.00% 8.5455
C. Determine the portfolio in Exhibit 3 that is most appropriate for Oswayo, given Zerbe’s
yield curve forecast. Justify your response.
Zerbe also examines the fixed-income portion of Oswayo’s investment portfolio invested in
Country X. Zerbe expects the yield curve and yield spreads in Country X to be unchanged for the
next year. For this portion of the portfolio, Oswayo holds only a mix of investment-grade,
corporate bonds issued in Country X and denominated in Country X currency. Zerbe fully
hedges the currency risk for this portion of the portfolio.
Selected characteristics and expectations for the fixed-income portion of the portfolio invested in
Country X are presented in Exhibit 4. Oswayo asks Zerbe to estimate the annual return for this
portion of the portfolio.
Page 42 Level III
Exhibit 4
Selected Characteristics and Expectations
for the Fixed-Income Portion of the Portfolio invested in Country X
Current average bond coupon rate 4.15%
Coupon frequency Annual
Investment horizon 1 year
Current average bond price (% of par) 95.55
Expected average bond price in one year (% of par) 96.12
Average bond convexity 47
Average bond modified duration 4.50
Expected credit losses for the next year 0.12%
D. Calculate the expected return for the next year on the fixed-income portion of Oswayo’s
portfolio invested in Country X. Show your calculations.
Long Short
Calculate the number of futures contracts required to close the duration gap.
Level III Page 45
Claudia Yang is a portfolio manager for Ubiquity Advisors, a firm based in the country of
Covina, where the currency is the CVA. Yang is reallocating CVA 10,000,000 of a portfolio’s
financial sector exposure to the energy sector using futures contracts on financial sector and
energy sector indexes. She gathers portfolio and futures information in Exhibit 1.
Exhibit 1
Portfolio and Futures Information
Equity Portfolio
Beta of financial sector 1.04
Target beta of energy sector 1.21
Financial Sector Index Futures
Price (in CVA) 78,500
Beta 0.92
Energy Sector Index Futures
Price (in CVA) 62,500
Beta 1.10
Yang has a client in Covina with a portfolio of US equities valued at USD 50,000,000. Yang’s
objective is to completely hedge the value (in CVA) of the client’s portfolio over the next
12 months. Yang considers the following strategies to achieve this objective:
Strategy 1: Use equity index futures to hedge exposure to US equity market returns
and currency forwards to hedge the initial exposure to exchange rate risk.
Strategy 2: Use currency forwards to hedge the expected value (in CVA) of the
portfolio over the next 12 months.
Level III Page 49
Yang determines that the one-year forward rates are consistent with prevailing risk-free rates and
uses the data in Exhibit 2.
Exhibit 2
Spot, Forward, and Risk-free Rates
Current CVA/USD spot rate 12.00
One-year CVA/USD forward rate 12.18
One-year US risk-free rate 2.00%
One-year Covina risk-free rate 3.53%
Note: CVA/USD is the number of CVA per USD.
B. Calculate the value (in CVA) of the portfolio in 12 months if Yang uses Strategy 1 to
completely hedge the client’s portfolio over the next 12 months. Show your calculations.
C. Explain why it is not possible to completely hedge the value (in CVA) of the portfolio
over the next 12 months using Strategy 2.
Yang is also the portfolio manager for TerraNumeric Properties. On 15 December 2016,
TerraNumeric took out a CVA 120,000,000, 18-month floating rate loan. Interest was paid on
15 June 2017, 15 December 2017, and 15 June 2018. Loan principal was repaid on 15 June 2018.
The interest rate was equal to 180-day Libor plus 180 bps.
At the time the loan was initiated, Yang purchased an interest rate cap with an exercise rate of
2.25%, a notional value of CVA 120,000,000, and two reset dates, 15 June 2017 and
15 December 2017.
For the loan and the cap, there were 183 days in the settlement period for 15 December 2017 and
interest was calculated on an actual days/360-day basis. Libor rates are provided in Exhibit 3.
Exhibit 3
Libor at Reset Dates
Date Libor
15 June 2017 2.45%
15 December 2017 2.15%
D. Calculate the effective interest paid (in CVA) on 15 December 2017. Show your
calculations.
Sandeep Sarzi is an investment advisor who has institutional and high net worth clients. Sarzi
meets with a potential new client, Jerry Robson, to assess his capacity for risk. Sarzi estimates
the risk aversion coefficient for Robson to be 5 on a scale of 1 to 10, where 10 represents the
highest risk aversion. Sarzi provides expected returns and standard deviations of returns for two
possible portfolios for Robson in Exhibit 1.
Exhibit 1
Portfolio Expected Returns and Standard Deviations
Expected Expected Standard Deviation
Portfolio Return of Return
A 8% 14%
B 6% 10%
A. Determine which portfolio Sarzi should recommend to Robson based solely on expected
utility. Justify your response.
Sarzi was recently hired as the investment advisor for the ZTA Corporation pension fund. The
current market value of the pension fund’s assets is USD 10 billion, and the present value of the
fund’s liabilities is USD 8 billion. The fund has been managed using an asset-only approach, but
Sarzi recommends that the risk-averse ZTA board of directors consider adopting a liability-
relative method, specifically the hedging/return-seeking portfolio approach.
Sarzi assumes that the returns of the fund’s liabilities are driven by changes in the returns of
index-linked government bonds. Exhibit 2 presents three potential asset allocation choices for the
pension fund.
Exhibit 2
Potential Asset Allocation Choices for ZTA Corporation’s Pension Fund
Asset Class Allocation 1 Allocation 2 Allocation 3
Cash 30% 0% 5%
Index-linked government bonds 50% 80% 10%
Corporate bonds 10% 5% 25%
Equities 10% 15% 60%
Portfolio Statistics
Expected return 3.5% 3.9% 6.4%
Expected standard deviation 6.8% 7.9% 12.1%
B. Determine which asset allocation would be most appropriate for the pension fund given
Sarzi’s recommendation. Justify your response.
Sarzi also advises James and Karen Rozeer, a married couple who recently retired with total
assets of USD 10 million. The Rozeers have two goals they wish to achieve during their
retirement:
Goal 1: The Rozeers wish to have an 85% chance of transferring USD 7.5 million to their
children in 10 years.
Goal 2: The Rozeers wish to have a 75% chance of being able to donate USD 15 million to a
charitable organization in 25 years.
Exhibit 3
“Highest Probability-and Horizon-Adjusted Return” Sub-Portfolio Modules
Under Different Horizon and Probability Scenarios
Module A Module B Module C
Portfolio Characteristics
Expected return 6.1% 7.5% 8.3%
Expected volatility 5.9% 7.9% 10.1%
C. Construct the overall goals-based asset allocation for the Rozeers given their two goals
and Sarzi’s suggestion for investing any excess capital. Show your calculations.
Note: The answer should be the percentage of total assets to be invested in each module.
Portfolio A Portfolio B
Robert Kinloch meets with one of his private wealth clients, Patricia Marquez, who resides in the
UK. Marquez’s portfolio is currently rebalanced using the percentage-of-portfolio method.
Target asset allocation and corridor widths are shown in Exhibit 1.
Exhibit 1
Target Asset Allocation and Corridor Widths
Asset Class Target Allocation Corridor Width
Equities 60% ±5%
Commodities 15% ±3%
Fixed income 25% ±4%
Kinloch and Marquez discuss a recent analyst report that forecasts the following changes in
market conditions.
Kinloch concludes an appropriate change to the corridor width for equities cannot be determined
but concludes the corridor width for commodities should narrow.
i. equities.
ii. commodities.
Kinloch enters a good-till-cancelled order to buy 30,000 shares of an equity, ticker SJTL, to the
trading desk with a limit of GBP 11.20 and a benchmark price of GBP 11.10. Transaction costs
are GBP 0.02 per share and the trade is executed in the following manner:
• 4 June: 15,000 shares are bought at GBP 11.12; SJTL closes at GBP 11.15.
• 5 June: 10,000 shares are bought at GBP 11.14; SJTL closes at GBP 11.25 and
the remainder of the order is cancelled.
Kinloch compares the returns of the paper portfolio with the actual portfolio that resulted from
these trades.
B. Calculate the implementation shortfall (in bps) of the SJTL order at the close of trading
on 5 June. Show your calculations.
Kinloch enters orders to sell two equities, HRET and WPGS. HRET released its financial results
yesterday morning and they were in line with consensus expectations. WPGS releases its
financial results tomorrow and Kinloch wants to complete the WPGS trade ahead of the release.
Kinloch considers the following algorithmic trading strategies: volume-weighted average price
(VWAP), implementation shortfall algorithm (IS), and opportunistic. The order size for each
trade and related market data are shown in Exhibit 2.
Exhibit 2
Order Size and Related Market Data
Average Last Trade
Order Size
Equity Daily Price
(shares)
Volume (in GBP)
HRET 14,000 20,000 8.50
WPGS 200,000 2,000,000 16.00
C. Determine which trading strategy (VWAP, IS, opportunistic) is most appropriate for:
i. HRET.
ii. WPGS.
ii. commodities.
Level III Page 63
VWAP
i. HRET. IS
opportunistic
VWAP
ii. WPGS. IS
opportunistic
Level III Page 65