Level III of CFA Program Mock Exam 3 June, 2019 Revision 1

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Level III of CFA Program
Mock Exam 3
June, 2019
Revision 1
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CFA Level III Mock Exam 3 – Solutions (AM)
FinQuiz.com – 3rd Mock Exam 2019 (AM Session)
The morning session of the 2019 Level III Examination has 12 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 – Individual 26
4 Portfolio Management – Institutional 18
5 Portfolio Management – Institutional 16
6 Portfolio Management – Asset Allocation 10
8 Portfolio Management – Economics 19
9 Portfolio Management – Equity Investments 17
10 Portfolio Management – Monitoring and Rebalancing 6
11 Portfolio Management – Risk Management 15
12 Portfolio Management – Derivatives 5
Total: 180
FinQuiz.com © 2019 - All rights reserved. 2

QUESTION 1 HAS SIX PARTS (A, B, C, D and E) FOR A TOTAL OF 26

MINUTES
Kyle Lucas is the owner of a small privately traded manufacturing concern which is
currently worth $12 million and was established twenty-five years ago. Lucas is 65 years
of age and intends to sell the business two years from today.
Lucas has approached portfolio manager Gus Weaver to manage his investment portfolio
which is currently worth $8.5 million and is equally allocated to long-term corporate
bonds, domestic and international equities, and alternative asset classes. In response to a
question regarding his investment experience, Lucas states, “I have faced significant
financial crises in the past and now always look to avoid making investment choices
which hold the potential for disastrous consequences.”
Lucas earns annual business income which is fixed at a pre-tax amount of $100,000. His
living expenses are $98,000 in the current year and are expected to increase at the annual
rate of inflation of 5%. Upon retirement, he will no longer earn business income and his
annual living expenses will become constant at $150,000.
If Lucas sells his business at its expected market price, two years from today, he will be
able to purchase his dream house for $8 million and a boat currently sold at a price of
$1.0 million and will donate the remaining amount to a local charity. He has instructed
Weaver to exclude the sale of his business from the investment decision. Lucas intends to
finance his grandson’s college education as well as purchase residential property for him.
Total estimated costs will amount to $30 million and will be required fifteen years from
today.
Lucas is subject to an ordinary income and capital gains tax rate of 25% and 30%
respectively. He always maintains an emergency reserve equal to 3 years of his annual
business income in addition to his portfolio holdings.
A. Formulate each of the following constraints for Lucas’ investment policy

statement (IPS):
I. Time Horizon
II. Unique Circumstances
(4 minutes)

B. Determine whether an increase in inflation rate, reduction in the sales price of the
business, and an increase in the price of his dream house will increase, decrease or
have no impact on risk tolerance. Justify your choice with one reason.
Answer Question 1-B in the template provided at the end of Question 1.
(6 minutes)
C. State Lucas’s return objective for his IPS.
(3 minutes)
D. Calculate Lucas’ annual after-tax nominal rate of return for the IPS if his
business is sold at its current market price two years from today. Show your
calculations.
(6 minutes)
Walker strongly feels that incorporating behavioral considerations in an IPS is essential

to fulfilling the client’s long-term goals. To achieve this purpose, he holds a meeting with
Lucas to determine his behavioral investor type (BIT) and associated biases by holding a
meeting with the client.
E. Discuss two benefits of including behavioral finance into the IPS.
(4 minutes)
Lucas is an avid follower of the stock market and makes investment decisions on behalf
of friends and family members. His most recent investment decision involved a $100,000
purchase of French Inc.’s stock. The decision was influenced by recent media attention
on the corporation following a ‘brave’ policy shift towards unconventional production
processes promising shorter lead times and a greater focus on organic raw materials as
input. He further justifies his decisions by stating, “Over the course of industry history,
companies who were experimental in setting their policy have been popular amongst
investors.”

F. Identify the bias demonstrated by Lucas and justify your selection with one
reason.
(3 minutes)
Answer Question 1-F in the template provided at the end of Question 1.

Template for Question 1-B
Impact on Risk
Tolerance (Circle Justify Your Choice With
Factor the Correct One Reason
Answer)
Increase
Increase in inflation rate Decrease
No impact
Increase
Reduction in sales price of business Decrease
No impact
Increase
Increase in the price of his dream Decrease

house
No impact

Template for Question 1-F
Identify the Bias (Circle the Justify Your Choice with One
Correct Choice) Reason
Regret Aversion
Overconfidence
Availability Bias

Solutions for Question 1:
A Solution:
I. Time Horizon:
Lucas has a time horizon comprising of three stages.
Stage 1: Present to sale of business or retirement – 2 years
Stage 2: Retirement to the funding of his grandson’s college education and home
purchase – 15 years
Stage 3: Stage 2 onwards
II. Unique Circumstances:
Lucas’ ownership suggests a large concentrated position. Weaver will need to

consider diversifying the position and accordingly devise a strategy. It is
important that Weaver consider a number of factors including Lucas’ loyalty to
the position and his willingness to reduce his holding in the business prior to the
date of sale.
Reference:
CFA Level III, Volume 2, Study Session 5, Reading 10, LOS h

B Solution:
Impact on Risk
Tolerance (Circle Justify your choice with one
Factor the Correct reason
Answer)
An increase in the inflation
rate will increase the shortfall
Increase between business income and
Increase in inflation living expenses which is
rate Decrease
Decrease expected to equal $27,900
s [($100,000 × 0.75)– ($98,000
No impact × 1.05)] in the following year
and increase annually
thereafter.
Given that Lucas’ living
Increase expenses after retirement are
not dependent on the sale of
Reduction in sales Decrease the business, therefore
price of business reduction in this source of
funds will not impact his
No impact ability to tolerate risk.
Lucas has expressly stated

Increase that the sale of the business
or any purchase from that
Increase in the price Decrease amount should not be
of his dream house included in the investment
No impact
No impact process. Therefore, a change
in the price of the his dream
house should not affect his
risk tolerance.
Reference:
CFA Level III, Volume 2, Study Session 5, Reading 10, LOS g

C Solution:
Lucas needs to generate sufficient income to fund his living expenses on an inflation-
adjusted basis, provide for his retirement spending needs and grow his portfolio to
finance his grandson’s college education and the purchase of residential property.
Reference:
D Solution:
Current Year 1 Year 2

Inflows
Annual business income $100,000 $100,000 $100,000
Sale of business
[$15,000,000 × (1 – 0.3)] - - -
Outflows
Living expenses* $98,000 $102,900 $108,045
Tax on salary ($100,000
× 0.25) $25,000 $25,000 $25,000
Net inflows/(outflows) ($23,000) ($27,900) ($33,045)
* expected to increase at the annual rate of inflation of 5%
Investable Asset Base at the beginning of Year 3:
Current
Cash flow – Year 2 ($33,045)
Portfolio assets $8,500,000
Cash reserve (3 × $100,000) $300,000
Total $8,766,955
PV = - 8,766,955
N = 12 years
FV = 30,000,000
PMT = - 150,000
I/Y = 9.771%
The after-tax nominal required rate of return is 9.771%
Reference:

E Solution:
The benefits of incorporating behavioral finance in the IPS include:
• Formulating financial goals: While defining financial goals is a critical phase of

the investment process, advisers must understand the psychology and emotions
involved in the decisions underlying the goals. Behavioral finance will help
advisors determine why investors set certain goals.
• Maintaining a consistent approach: Behavioral finance helps to add

professionalism and structure to relationship between a wealth advisor and his or
her clients allowing them to deliver relevant investment advice.
• Investing as the client expects: Behavioral finance allows advisors to better

understand their clients’ expectations so that they are in a better position to satisfy
them.
• Ensuring mutual benefits: By incorporating behavioral finance into the investment

process, managers will be in a better position to satisfy clients and improve their
own practice and work life. Clients will feel that their managers better understand
them as well as their financial objectives. Therefore, a stronger bond can be
developed between the two.
Reference:
CFA Level III, Volume 2, Study Session 4, Reading 9, LOS b

F Solution:
Identify the Bias Justify Your Choice With One

(Circle the Correct Choice) Reason
Lucas is exhibiting availability
bias because he is
Regret Aversion overestimating the success
probability of the investment
decision based on information
most readily available. The
Overconfidence availability bias can be
classified as retrievability and
categorization as he focuses on
recent information (media
Availability
AvailabilityBias attention) as well as uses a
Bias narrow search set (historical
policy changes by industry
participants), respectively.
Reference:
CFA Level III, Volume 2, Study Session 4, Reading 8, LOS c

QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES
Carl Segal is an asset advisor at Vector Asset Management. Segal is working closely with
a private client, Timothy Allen; aged 45 to ascertain the behavioral investor type (BIT)
exhibited by Allen. Allen has considerable investment experience and often recommends
potential investments for further evaluation to his adviser. During a discussion between
Segal and Allen, the client shares his investment approach:
“I have devoted a significant amount of time to studying security markets and asset
classes. Based on the insight which I have gained over these years, I can comfortably
trust my instincts when making investment decisions for myself as well as acquaintances,
who have entrusted me with the management of their financial wealth. I trust nothing but
my own research and prefer not to let my judgment get influenced by the advice of those
who possess little knowledge about wealth planning.”
A. Classify Carl’s BIT, determine the risk tolerance, and identify one emotional bias
typically associated with the identified behavioral category.
(3 minutes)
Answer Question 2-A in the Template provided at the end of Question 2.
B. Carl participates in the defined contribution (DC) offered by his employer. Segal
determines that Carl is fifteen years away from retirement. Segal would like to
compare the client’s current allocation to plan assets with the average allocation
held over the past five years. Segal also determines that:
• Carl’s annual income sufficiently covers his living expenses.

• he is unmarried but finances his brother’s medical care. His brother is
mentally challenged. His salary is not sufficient to cover these expenses.
• he has inherited $1.5 million from his deceased father’s estate in the
beginning of the current year. He intends to employ these funds for
investment purposes.
• he has assigned a risk score of 3.1 to the average company stock, in
comparison with 3.6 to domestic stock funds and 4.1 to global stock funds.

Exhibit:
Carl’s Allocations to the DC Plan Assets
Average
Historical Current
Allocation Allocation
(2009-2013) (2014)
Stocks – Corporate stock 36% 34%
Stocks – Domestic Non-corporate stocks 6 7
Stocks – Global stocks 3 4
Fixed Income 45 48
Short-term income 10 9
Total 100% 100%
I. Using the data collected by Segal, explain one bias exhibited by Carl in his
portfolio selection decisions with respect to the DC plan. Support your response
with two reasons.
(4 minutes)
II. Based on Segal’s findings, he intends to employ an autopilot strategy to align

Carl’s allocations with his circumstances. Explain how such a strategy would
affect the current allocation.
(3 minutes)

Template for Question 2-A
Determine Risk Tolerance

Associated With the Identify One Emotional
Classify Carl’s BIT Behavioral Category Bias Typically Associated
(Circle the Correct Choice) (Circle the correct choice) With the Behavioral
Category
Passive Preserver (PP) Low
Active Accumulator (AA) Low to Medium
Friendly Follower (FF) Medium to High
Independent Individualist (II) High

Solution for Question 2.
A Solution.
Determine risk tolerance
associated with the Identify one emotional bias
Classify Carl’s BIT behavioral category typically associated with
(Circle the Correct Choice) (Circle the correct choice) the behavioral category
Possible answers include:

Passive Preserver (PP) Low
Overconfidence
Active Accumulator (AA) Low to Medium Self-attribution
Friendly Follower (FF) Medium to

Medium to High
High
Independent
Independent Individualist (II) High
Individualist (II)
Reference:

B – (i) Solution:
Bias 1: Carl demonstrates inertia and default by maintaining the composition of his
current allocations at the average level observed over the previous five years. A
decomposition of his holdings reveals that the allocation to:
• fixed income has only increase by 3%

• short-term income has decrease by 1%
• stocks has decreased [(34% + 7% + 4%) – (36% + 6% + 4%) =-1]
The receipt of inheritance should increase Carl’s risk tolerance which should be reflected
by an increase in the allocation to stocks as opposed to an allocation with a higher
proportion of less risky (fixed income and short-term income) securities. By keeping the
allocation constant despite the change in financial circumstances and risk tolerance, the
client demonstrates inertia.
Bias 2: Carl also demonstrates familiarity. His allocation to corporate stock outweighs
that to domestic non-corporate and global stocks (34% vs. 7% and 4%
respectively). Furthermore, his allocation to domestic stocks his higher relative to
global stocks (7% and 4% respectively) which lead to a confirmation of this bias.
Bias 3: Carl demonstrates overconfidence in their estimate of company performance. He

has assigned the lowest risk score to his employer’s stock. This enthusiasm for
own company stocks stems from overconfidence as well as familiarity bias.
Reference:
B–(ii) Solution:
Following the receipt of the inheritance, Carl’s risk tolerance will increase, and an
autopilot strategy should increase his equity allocation which is currently lower than the
allocation to the less risky fixed income and short-term income combined (45% vs. 55%
respectively).
Furthermore, his long-term horizon (fifteen years) dictates a higher allocation to risky
securities such as equities. The autopilot strategy would also diversify the equity
allocation and reduce the high concentration in own company stock.
Reference:
CFA Level III, Volume 2, Study Session 4, Reading 9

QUESTION 3 HAS ONE PART FOR A TOTAL OF 3 MINUTES
Mr. and Mrs. Fairview, aged 65 and 60 respectively, are the owners of a hotel chain
which has branches located across the US and has been in establishment for the past
thirty years. Their business is currently worth $60 million and has appreciated by 10% in
the current year leading to an increase in the wealth of its owners. The hotel chain is a
privately traded concern.
The Fairviews are seeking to transfer the business to their daughter, Samantha, but would
like to retain ownership rights. They have approached Kim Young, a tax advisor, for a
solution. Under current tax laws a donor’s annual gift exclusions are limited to $13,000
per donee. Gifts exceeding this allowance are taxed at a rate of 25%. Young discovers
that the couple has consumed this allowance and now sets out to devise a wealth transfer
strategy which will minimize transfer taxes and retain ownership rights.
After considerable evaluation, Young has identified three potential wealth transfer
strategies. She would now like to determine the most appropriate strategy.
Recommend the most suitable wealth transfer strategy. For the choices not selected
provide one reason for their unsuitability.
Answer Question 3 in the template provided at the end of Question 3.
(3 minutes)

Template for Question 3
Recommend the most Suitable Wealth Provide One Reason for Why the
Transfer Strategy Choices Not Selected are Unsuitable
Corporate Estate Tax Freeze
Family Limited Partnership
Direct Gifting to Samantha

Solution for Question 3.
Recommend the most Suitable Wealth Provide One Reason for Why the Choices
Transfer Strategy Not Selected are Unsuitable
Corporate estate tax freezes are suitable
wealth transfer strategies before the
concentrated position has appreciated
Corporate Estate Tax Freeze significantly. The position has increased by
10% in the current year and before the
Fairviews approach Young. Therefore, this
is not a suitable wealth transfer strategy.
Family Limited
Family Limited Partnership
Partnership
Reason 1: The Fairviews have already

utilized their combined gift tax allowance
of $26 million ($13 million per donee or
Direct Gifting to the Samantha donor) and so any further gifting would
trigger the 25% gift tax.
Reason 2: Direct gifting would require the

Fairviews to give up their ownership rights
which they do not want to do.
Reference:

QUESTION 4 HAS SEVEN PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES
Yellow Tires (YT) offers a defined benefit pension plan to its employees. Sean Martin is
managing YT’s investment portfolio and has collected the following details which are
relevant for the analysis:
• The plan is fully funded

• The average age of the participants is 38 years
• The active to retired participants ratio is 3:1
• The company has reported strong financial results in the current year.
• The discount rate used to determine the present value of future obligations is
8.0%.
• The duration of plan liabilities is 22 years
• The sponsor has proposed a return objective of 8.5%
• YT offers a one-for-one inflation indexation via a cost of living allowance
(COLA)
• Future benefits are twice as high relative to accrued benefits and are attributable
to future real wage growth.
• YT is considered the inclusion of an early retirement provision
A. State YT’s return objective.
(2 minutes)
B. Identify one purpose which the sponsor may have in stating a return objective of
8.5%.
(2 minutes)
C. Characterize each of the following components for YT’s IPS:
I. risk tolerance
II. liquidity
III. time horizon
(6 minutes)

D. For each of the following scenarios, determine whether risk tolerance will
increase or decrease. Explain your choice.
Answer 4-D in the Template provided at the end of Question 4.
(8 minutes)

Template for Question 4-D
Impact on
Risk
Factor Tolerance Explain Your Choice
Introduction of an early
retirement provision
Increase in discount rate
Increase in the allocation of

fund assets to YT stock
Increase in bankruptcy risk

Solutions for Question 4.
A Solution:
YT is required to achieve a minimum return equal to the discount rate used to determine
the present value of fund liabilities, 8.0%.
Reference:
B Solution:
Possible purposes behind a higher desired return (8.5%) include:
• To minimize YT’s future pension contribution and/or

• To generate pension income.
Reference:
C Solution:
I. Risk tolerance:
YT’s risk tolerance can be described as being above average due to the following
reasons:
• the plan is fully funded

• participants are relatively young
• the positive operating results generated by the sponsor
• the greater the proportion of active lives relate to retired lives
II. Liquidity:
YT’s liquidity requirements are low as evidenced by the low number of retired
lives and an absence of early retirement provisions.
III. Time horizon:

The time horizon can be characterized as long-term with multiple stages. YT’s
workforce is young with an average age of 38 years and the duration of its
liabilities is 20 years.

Reference:
D Solution:
Template for Question 4 D.
Impact on
Risk
Factor Tolerance Explain Your Choice
An early retirement provision will
Introduction of an early Decrease reduce the duration of plan liabilities,
retirement provision resulting in a lower risk tolerance.
A higher discount rate will reduce the
present value of plan liabilities and the
Increase in discount rate Increase funded status will most likely change
from fully funded to a surplus.
The sponsor stock is highly correlated
with its operating results. A lower
Decrease in the allocation of allocation will reduce the correlation
fund assets to YT stock Increase between the performance of plan assets
and that of the sponsor and increase risk
tolerance.
An increase in the degree of bankruptcy
risk may increase financial obligations
Increase in bankruptcy risk Decrease and may jeopardize YT’s going concern
status and/or weaken its financial status.
Reference:

QUESTION 5 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 16 MINUTES
First Bank is a commercial lending institution operating in the U.S. Sasha Wilson is the
bank’s senior investment officer. Wilson would like to implement more stringent risk
management measures with respect to the bank’s liabilities and has convened a meeting
to address the following objectives:
Objective 1: Address the possibility of a positive interest rate shock

Objective 2: Minimize the leveraged-adjusted duration gap
Objective 3: Maximize return-on-invested capital
Wilson is analyzing the implications of the recent unexpected rise in interest rates on the
bank’s market value of equity.
The current structure of the bank’s balance sheet is as follows:
Exhibit:
First Bank’s Balance Sheet
Market value Market value
Duration ($ millions) Duration ($ millions)
Assets Liabilities
Loans 7.4 65
Fixed 4.5 31 Time 3.0 60
assets deposits
Cash 0.0 4 Demand 3.5 40
deposits
Total 6.2* 100 3.2* 100
*Represents weighted average duration
A. Discuss one implication of a positive interest rate shock on the bank’s balance
sheet.
(2 minutes)
B. Determine what course of action should most likely be taken to achieve Objective
2.
(2 minutes)

C.. Formulate the following constraints for First Bank’s IPS:
I. time horizon
II. liquidity
III. unique circumstances
(6 minutes)
D. First Bank has implemented three policy changes with respect to its loan
portfolio. Wilson would like to determine how each policy change will impact the
objectives and constraints for the securities portfolio. The three policies are as
follows:
Policy 1: Expanding lending activities by opening branches in other cities of the

country.
Policy 2: Restricting lending to customers with a credit rating of A or higher.
Policy 3: Increase the holdings of long-term mortgage-backed securities.
Explain the impact of each policy change on the bank’s objectives and constraints. Your
response should consider each policy in isolation.
(6 minutes)
Answer Question 5-D in the template provided at the end of Question 5.

Evaluate the Impact of the Policy

Change on the Bank’s Objectives and
Policy Change Constraints. Consider each Policy in
Isolation
Expanding lending activities by opening

branches in other cities of the country
Restricting lending to customers with a

credit rating of A of higher
Increase the holdings of long-term

mortgage-backed securities

Solutions for Question 5:
A Solution.
A positive interest rate shock will reduce the market value of the company’s equity.
Although the market values of assets and liabilities will both decline in response to an
increase in interest rates, the decline in the value of assets will be greater due to a higher
weighted average duration.
Reference:
CFA Level III, Volume 2, Study Session 7, Reading 15, LOS m
B Solution.
Given that the weighted average duration of the assets exceeds that of liabilities, the most
suitable course of action would be reduce the duration of the securities portfolio by
purchasing shorter maturity securities.
Reference:
C Solution.
I. Time horizon: A bank’s liability structure tends to have a shorter overall maturity
than its loan portfolio. The time horizon of the securities portfolio is therefore of
an intermediate term.
II. Liquidity: Requirements for liquidity are determined by net outflows of deposits
as well as demand for loans.
III. Unique circumstances: There are no unique circumstances.
Reference:
CFA Level III, Volume 2, Study Session 7, Reading 15, LOS k

D Solution:
Evaluate the Impact of the Policy Change

on the Bank’s Objectives and
Policy Change Constraints. Consider each Policy in
Isolation
• Diversification of the loan pool will
reduce the risk of the loan portfolio
Expanding lending activities by opening • Risk objective of the securities portfolio
branches in other cities of the country can be increased
• Credit risk of the asset portfolio is
decreased
Restricting lending to customers with a • Risk objective of the securities portfolio
credit rating of A of higher can be increased
• Increases the need for liquidity in the
securities portfolio
• Duration of assets is increased
Increase the holdings of long-term • Securities portfolio will need to be used
mortgage-backed securities reduce overall duration.
Reference:

QUESTION 6 HAS TWO PARTS (A & B) FOR A TOTAL OF 10 MINUTES
Becky Sands established the “Sands & Steel Financial Firm (S&S)” with her classmate
and colleague, Linda Steels, around five years ago. S&S is a financial consultancy firm
that assists institutional clients in managing their investment portfolios. Often, the firm
works in coordination with an already established, internal financial team of the clients
they deal with. Over the course of its business, S&S has built a client base of more than
twenty regular and loyal institutional funds. A few days ago, the firm landed consultancy
of three additional funds totaling a net worth of approximately 300 million US dollars.
Sands appointed three of the firm’s most seasoned portfolio managers to meet with the
board of directors of each of the concerned institutions. After their initial meeting with
the clients, Sands met with the managers to inquire about strategic issues relating to the
respective investment strategies and constraints of each of the clients. The managers
presented Sands with the following key summarized information:
§ Insurance fund:
The portfolio is overfunded and offers life insurance policies to individual clients.
It incorporates a very low risk premium in the discount rate used to find the
present value of its liabilities. The discount rate is primarily determined by
regulatory authorities and then adjusted downward to reflect the conservative
nature of the fund’s policy. The board wishes to reduce the need of any additional
contribution over the next year and also, to significantly decrease the risk of not
being able to pay next year’s liabilities.
§ Pension Fund:
The present value of the pension fund’s liabilities equals $550 million whereas the
fund’s assets equal $475 million. The fund’s board of directors has instructed
S&S to maintain a surplus volatility of not more than 8% per year. The fund has
an established risk aversion score of 6.5. The focus has primarily been on the
systematic risk of the asset mix and how it relates to that of the portfolio of
liabilities. The board has directed S&S to achieve a return of 13% over the next
year, while ensuring that the risk objective is not violated.

§ A hospital endowment:
The endowment has sporadic spending needs due to an erratic influx of patients at
irregular intervals. The fund’s board of directors wants to ensure that enough
capital is available at the time liabilities are due. They want to minimize tail risk
and ensure that worst-case outcomes are properly incorporated when constructing
a strategic asset allocation. As such, their main goal is to minimize the probability
of not being able to make future contributions and to keep the 1% VAR at the
desired level.
A. For each of the above funds, determine the most appropriate way to account for
liabilities. Justify your response for each fund with three reasons each.
(6 minutes)
Sands selects the following strategic asset allocation for the insurance fund based on
mean variance optimization:
Exhibit 1: Asset Class Ranges

Asset Class Strategic Target Cost-Benefit Ranges
Corporate Bonds 65% 62%-67%

Domestic Equity 20% 17%-23%
International Equity 10% 6%-15%
International Real Estate 5% 4%-6%
The research analysts at S&S provide Sands with the following information about the
different asset classes:
§ A rising trend in US stock prices has been observed for the past three years, which
is expected to continue. Since the overall market is also expected to rise, the US
stocks will have a correlation between 0.80-0.85 with the rest of the asset classes.
§ Trading stocks in the international market is exceedingly challenging due to a lack
of a properly functional financial market in many countries. However, the
presence of derivatives on international stocks makes it easy to synthetically
create the desired positions.
§ US fixed-income has historically shown little diversion from its base values over
the past 25 years.
§ Taxes on interest income are expected to be lower than taxes on dividend income.

§ The insurance fund has a conservative approach to investing and thus wants to
keep exposure to volatile asset classes to a minimum.
§ International equity, although illiquid, offers significant diversification benefits.
B. For the cost-benefit ranges given, state the asset class for which the range is most
inconsistent. Justify your response with four reasons.
(4 minutes)

SOLUTION:
Part A.
Insurance Fund:
Most suitable approach is the ‘hedging/return seeking approach’
Reasons:
1. It has a conservative (risk-averse) policy for which hedging is appropriate.
2. It is an overfunded plan that will allow the surplus to be invested in a return-
seeking portfolio (the basic two portfolio approach can easily be used).
3. The focus is on a single period, and also on the ability to reduce the risk of not
being able to meet liabilities. Hedging the liabilities will help ensure that.
Pension Fund:
Most suitable approach is the ‘surplus optimization using MVO’.
Reasons:
1. The plan is underfunded.
2. Focus is on a single period—return should be met over the next year—and also on
surplus volatility.
3. Emphasis is on systematic risk, which is what the correlation between assets and
liabilities is based on, the main focus of MVO.
Hospital Endowment:
Most suitable approach is the ‘Integrated Asset-Liability Approach’.
Reasons:
1. The multi-period model works best in incorporating the probability of not being
able to make future contributions.
2. Since spending needs are sporadic, it is best to manage assets along with liabilities
in an integrated approach so that best compromise decisions can be made.
3. Worst-case scenarios and tail risk can best be managed using an integrated
approach. It can incorporate multiple assumptions and constraints.
Reference:

Part B.
The cost-benefit range seems most inconsistent for domestic equity.
Justification:
1. A momentum of trend in US stock prices is expected to continue. This warrants a
wider rebalancing range (the range is only slightly higher than that for fixed
income).
2. The correlation of US stocks with the rest of the portfolio is significantly high,
again meriting a wider range.
3. Even though international stocks are illiquid, the presence of derivatives can make
synthetic rebalancing possible and reduces the need to widen the range (relative to
domestic stocks). This indicates that the difference in the range of domestic and
international stocks should not be as high. International stocks also have a lower
correlation with the rest of the portfolio (offer diversification) meriting a tighter
balance than that of domestic stocks.
4. Unlike domestic stocks, US fixed-income has shown mean reversion and has
lower taxes than those on dividend income. This indicates that the rebalancing
range of fixed-income should be reasonably lower than that of domestic stocks.
Yet, the difference is only of 1%.
Reference:

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES
Jill Starc is a senior asset manager at RP Financial (RPF), a portfolio management firm.
Starc oversees the Global Equity Fund I (GEF I) which is being offered by the firm. The
fund holds global (Canadian, Mexican and British) and domestic U.S. equities. Foreign
currency exposures are currently unhedged. The exhibit below illustrates the values of the
fund assets, spot exchange rates, and correlations between movements in foreign
currency-asset returns and foreign currency returns.
Exhibit
GEF I Fund Asset Values,
Spot Rates, and Correlations
Last Year Current
(2013) Year
(2014)
CAD-denominated asset value 100 150
in CAD millions
MXN-denominated asset 80 70
value in MXN millions
GBP-denominated asset value 230 300
in GBP millions
USD-denominated asset value 500 450
in USD millions
CAD/USD spot rate 0.7900 0.8100
USD/MXN spot rate 15.2420 15.0050
GBP/USD spot rate 1.4754 1.5000
p(RCAD,RCAD/USD) + 0.7
p(RMXN,RMXN/USD) - 0.3
p(RGBP,RGBP/USD) + 0.2
Gracy Singh is one of Starc’s clients. Singh’s investment portfolio comprises solely of
the securities held in the GEF I fund. Her allocation to CAD-, MXN-, GBP- and USD-
denominated equities is 30%, 40%, 25% and 5% respectively.
A. Calculate the domestic currency return on Singh’s portfolio. Show your

calculations.
(4 minutes)

Based on a discussion with Singh, Starc determines that hedging the client’s foreign
currency risk exposures is essential. However, she is yet to establish the degree to which
currency risk exposures should be hedged.
B. Describe two potential considerations which Starc will need to account for when
determining the degree of currency risk exposures to undertake. Your answer
should focus on Singh’s current portfolio allocation and the information in the
exhibit.
(6 minutes)
To aid her currency hedging decision, Starc collects necessary details with respect to
Singh. She will examine each factor independently to determine whether a full currency
hedge will be required.
Information on Singh:
• Risk averse to portfolio losses

• Has a relatively long time-horizon
• Desire for foreign fixed-income security exposure
• Required to make a down payment for the purchase of a home in three month’s
time and pays for her son’s ongoing medical expenses.
C. For each of the four points collected, determine whether the strategic currency
position of the portfolio should be biased towards a fully hedged currency
management program. Consider each factor independently and support each
answer with one reason.
Answer Question 7-C in the template provided at the end of Question 7.
(8 minutes)

Template for Question 7-C
Strategic Currency
Position Biased
Towards a Fully
Hedged Currency Support Each Answer
Point Collected Management with One Reason
Program?
Circle the Correct
Answer.
Yes
Risk averse to portfolio
losses No
Yes
Has a relatively long time-
horizon No
Yes
Desire for foreign fixed-
income security exposure No
Required to make a down

payment for the purchase of Yes
a home in three month’s
time and pays for her son’s No
ongoing medical expenses

Solutions for Question 7
A Solution.
Domestic currency return (RDC) =
or 10.42%
Reference:
CFA Level III, Volume 4, Study Session 10, Reading 21, LOS a
B Solution.
Marks will be awarded for any two of the three points discussed.
1. Diversification Considerations:
Starc will need to consider the asset composition of the foreign-currency asset portfolio.
• Foreign currency asset returns of MXN-denominated assets have a negative

correlation with foreign currency returns; some MXN FX exposure may help
portfolio diversification and reduce domestic-currency return risk, σ(RDC).
• The other two correlations are positive and so Starc should consider a lower
degree of active currency exposure to the CAD and GBP relative to the MXN.
2. Trading Cost Considerations:
Maintaining a 100% hedge results in no currency risk exposure but is costly to maintain
especially if a large number of rebalancing trades are required increasing the frequency of
payments based on the bid-ask spread.
3. Opportunity Cost of the Hedge:
To be 100% hedged requires forgoing the possibility and favorable foreign currency rate
moves. A less than 100% hedge ratio may be desirable to minimize regret.
Reference:

C Solution.
Strategic Currency
Position Biased Towards a
Fully Hedged Currency
Management Program? Support Each Answer with One
Point Collected Circle the Correct Reason
Answer.
Risk aversion will reduce the
Yes
Yes propensity to assume active currency
Risk averse to risk exposure.
portfolio losses No
In the long-run, currencies tend to

mean revert and so currency risk is
Yes lower in the long run. Adding
Has a relatively long unhedged foreign currency returns will
time-horizon No
No not significantly affect long-run
portfolio returns.
The currency risk exposure of fixed
income securities will provide little
Desire for foreign Yes diversification benefits to the portfolio
Yes
fixed-income and so currency risk should be hedged.
security exposure No Further explanation: The correlation
between foreign currency returns and
foreign currency asset returns tends to
be greater for fixed-income portfolios
as bonds and currencies react strongly
to exchange rates. Therefore,
Required to make a Singh has significant immediate
down payment for Yes
Yes liquidity needs and so she would like
the purchase of a to reduce the risk of liquidating
home in three No foreign-currency assets as
month’s time and disadvantageous exchange rates.
pays for her son’s
ongoing medical
expenses
Reference:

QUESTION 8 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF

19 MINUTES
Simon Weaver is an economic analyst working at Time Analytics. Weaver covers

developed and emerging markets specializing in bonds and equities.
Weaver is making inflation forecasts for Lidon, a country with an emerging market. His
analysis focuses on two historical periods, 1990-1995 and 1996-2001. The first time
period was marked with above average inflation, GDP growth exceeding its target, and
an economy in danger of becoming overheated. The cause of the high inflation was a
global rise in energy prices triggering cost-push inflation in the country. Circumstances
changed in the 1996-2001 period when monetary authorities implemented restrictive
policy measures to cool down the economy.
Based on economic analysis, Weaver projects that Lidon’s economy is once again
expected to overheat due to the rapid supply of money currently being injected by
monetary authorities. To calculate the anticipated increase in inflation, Weaver uses the
average inflation prevailing over the two time periods, assigning a higher probability to
the inflation observed during 1990-1995, as input to his analytical model.
A. Discuss the bias observed demonstrated by Weaver’s analytical methods.
(2 minutes)
B.
i. Identify the psychological trap which Weaver has fallen into. Justify you choice.
Answer B-i in the template provided below.
ii. For the identified bias, discuss two possible measures which can be taken to avoid
this bias.
(5 minutes)
Template for Question 8-B (i) is provided at the end of Question 8.

C. Three months later Weaver’s inflation forecast materializes. The analyst

anticipates Lidon’s central bank will deal with this scenario by tightening the
monetary policy and increasing the short-term interest rate to 7.0% from its
current level of 6.0%.
Recommend which asset class will be a suitable investment choice given Weaver’s
expectations. For the asset classes not selected, explain why they are inappropriate.
Answer Question 8-C in the template provided at the end of Question 8.
(7 minutes)
D. The authorities in Lidon have announced their intention to peg the local currency,
LDN, to the U.S. dollar (USD). The market is weary of the strategy’s
effectiveness and expects the LDN to be devalued shortly before Lidon
implements the policy. The current interest rate differential between Lidon and
U.S. sovereign bonds is 4.5%.
i. Identify two benefits of maintaining an exchange rate peg.
(2 minutes)
ii. Determine whether the change in interest rate differential will be positive,
negative or neutral based on the information provided on the market’s
views concerning the exchange rate peg. Justify you answer.
(3 minutes)

Template for Question 8-B (i)
Identify the Psychological Trap which

Weaver has Fallen Into (Circle the For the Trap Not Selected, Provide
Correct Answer) one Reason Why it is Inappropriate.
Overconfidence
Confirming evidence
Status Quo
Select the most suitable asset class given Explain why the choices not selected
Weaver’s expectations are inappropriate
Stocks
Cash
7.5% Mortgage-backed securities

A Solution.
Weaver has introduced time period bias while developing inflation forecasts. His forecast
is heavily influenced by the inflation observed in the 1990-2005 time period. His analysis
is not appropriate given that the underlying cause of inflation is not cost push. His
forecast for inflation would have differed if he had given both time periods the same or
relatively similar emphasis.
Reference:
B-(i) Solution:
Identify the Psychological Trap which

Weaver has Fallen Into (Circle the Justify Your Selection
Correct Answer)
Overconfidence
He is assigning greater weight to the time

Confirming
Confirming evidence period when inflation was high; he
evidence emphasizes on data which supports his
point of view concerning future inflation.
Status Quo
Reference:

B-ii Solution:
Possible measures include:
• Examining all evidence with equal rigor

• Enlisting an independent individual to argue your preferred conclusion or
decision
• Being honest about your motives.
Reference:
C Solution:
Select the most suitable asset class given Explain why the choices not selected are
Weaver’s expectations inappropriate
There are signs of inflation moving out of
equilibrium as demonstrated by the
Equities expectation that the central bank will act to
slow down the economy. Equity securities
will not be an appropriate investment
choice in this scenario.
Cash
Cash
Despite the predicted increase in short-term

rates, they will continue to remain below
the 7.5% mortgage rate. Therefore,
7.5% Mortgage-backed securities borrowers will continue to exercise their
prepayment option which will result in
lower cash flows and lower reinvestment
income for security holders.
Reference:

D-(i) Solution.
Domestic businesses have some reassurance that exchange rates will not fluctuate wildly.
By pegging its exchange rate, a pegged country often hopes to control inflation.
Reference:
CFA Level III, Volume 3, Study Session 7, Reading 18, LOS l
D-(ii) Solution
The interest rate differential will widen with the LDN rate being higher relative to the US
rate as:
• investors will demand a substantial interest rate differential because they see
the peg policy as being unsustainable.
• the LDN is expected to be devalued before Lidon pegs its currency.
Reference:
CFA Level III, Volume 3, Study Session 10, Reading 21, LOS l

QUESTION 9 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF

17 MINUTES
Melissa Reed manages the equity allocation of institutional client portfolios at Wood-
Carter. The Smithson Foundation (SF) is Reed’s most recent client. During a meeting
with the foundation’s chief executive, Reed deems that the portfolio’s equity allocation
should be indexed to the Russell 3000 index.
In her conversation with the chief executive concerning the portfolio management
strategy, the latter states, “The chosen passive management strategy should minimize
portfolio rebalancing costs and be cost effective in terms of portfolio construction costs.”
A. Select which strategy is most suitable for the passive management of SF

portfolio’s equity allocation. Justify your choice. Your answer should also
explain why the strategies not selected are unsuitable.
(Note: The provided justifications for the three strategies should be distinct.)
Answer Question 9-A in the Template provided at the end of Question 9.
(7 minutes)
Reed is of the opinion that the investment universe of SF’s portfolio should be expanded
to include global equities. However, she does not wish to undertake the purchase of
individual stocks and so engages in an equity index swap whereby the SF policy portfolio
will receive the return on the MSCI global equity index in exchange for interest payments
on U.S. Treasury bonds.
B. Discuss two usual motivations for Reed’s global equity swap strategy.
(4 minutes)
Reed also manages the equity portion of Glenn Endowment’s (GE) policy portfolio. The
fund’s prospectus identifies the investment mandate as “active large-cap exposure with a
growth bias.”
Reed’s manager, Carl Edgar, evaluates his subordinate’s performance using a returns-
based style analysis and employs four benchmarks – Russell 1000 Value Index, Russell
1000 Growth Index, Russell 2000 Growth Index, and Russell 2000 Value Index. The
results of the performance evaluation are summarized below.

Exhibit:
Results of Edgar’s Returns-Based Style Analysis
Factor Weights
Russell 1000 Value 0.45
Russell 1000 Growth 0.25
Russell 2000 Value 0.20
Russell 2000 Growth 0.10
Annualized portfolio return 14.50%

Annualized tracking risk 7.85%
Error term 9.58%
C. State one advantage and one disadvantage of the performance evaluation

approach being used by Edgar.
(2 minutes)
D. State and justify whether GE’s portfolio is invested in accordance with the stated
mandate.
(4 minutes)

Template for Question 9-A
Select the most Suitable

Strategy for the Justify Your Response with One Reason.
Passive Management
of SF’s Portfolio
Full Replication
Stratified Sampling
Optimization

A Solution.
Select the most Suitable

Strategy for the Passive Justify Your Response with One Reason.
Management of SF’s
Portfolio
Possible answers:
Full Replication • The full replication approach is more suitable
when the index stocks are less than 1,000.
• Portfolio rebalancing costs reduce the return
of the portfolio relative to that of the
benchmark index.
Explanation:
Stratified Sampling
Stratified • Suitable when the benchmark comprises a
Sampling large number of stocks (> 1,000)
• Cost-effective; managers can construct
portfolio which replicates the benchmark
index exposure without having to purchase all
of the stocks in the index.
Optimization requires periodic trading to keep the
Optimization portfolio’s risk exposures in line with the benchmark
generating portfolio rebalancing costs.
Reference:
CFA Level III, Volume 4, Study Session 12, Reading 27, LOS d

B Solution.
Typical motivations for using equity index swaps are given below:
Efficient asset allocation: Equity swaps can be used to efficiently effect a change in asset
allocation. A manager can use swaps to rebalance portfolios to the strategic asset
allocation and incur rebalancing costs which are lower than having to trade the
underlying securities.
Tax savings: One prime motivation for using equity swaps is to avoid high taxes on the
full return amount from an equity investment under circumstances where tax laws are
favorable. Equity swap applications are motivated by differences in the tax treatment of
shareholders domiciled in different countries.
Other motivations may include gaining synthetic exposure to index returns, adding
leverage or hedging a portfolio etc.
Reference:
C Solution.
Possible advantages include:
• Characterizes the entire portfolio

• Facilitates comparisons of portfolios
• Aggregates the effect of the investment process
• Different models usually give broadly similar results and portfolio
characterizations
• Clear theoretical basis for portfolio categorization
• Requires minimal information
• Can be executed quickly
• Cost effective
Possible disadvantages include:
• May be ineffective in characterizing current style

• Error in specifying indices in the model may lead to inaccurate conclusions
Reference:
CFA Level III, Volume 4, Study Session 13, Reading 28, LOS i

D Solution:
The fraction of the portfolio explained by the manager’s security selection ability is
9.58% indicating that the portfolio is indeed being managed actively. A closer look at the
benchmark weights reveals that Reed has drifted from her stated investment style.
His factor weight of .70 (0.45 + 0.25) on large-cap stocks exceeds his weight of 0.30
(0.20 + 0.10) on small-cap stocks. However, his allocation to small-cap stocks is not
insignificant. In addition, his factor weight of 0.45 on large-cap value stocks exceeds his
factor weight of 0.25 on large-cap growth stocks. GE’s portfolio appears to be an actively
managed large- and small-cap market-oriented portfolio with a value bias.
Reference:

Carl Storm is an institutional portfolio manager at Theta Asset Management. Storm

works closely with Green Associates, a broker/dealer firm, to execute trades on behalf of
client accounts. Below are excerpts from her meetings with the chief executives of two of
her clients. Storm needs to determine which type of order will be submitted to Green
Associates based on the details collected.
Smithson Corp’s Defined Benefit Pension Fund:
Smithson has placed an order to purchase 100,000 shares of Reliable Corp, a software
manufacturer. The average day’s volume of the manufacturer’s stock is 400,000. The
firm’s purchase decision is based on earnings growth projections generated by the firm’s
in-house forecasting model. The chief executive has instructed to Storm, “We would not
like to reveal the full extent of our purchase order to the market.”
Thornton Endowment Fund:
The chief executive emphasizes on giving brokers free reign to make purchase decisions
for the fund’s policy portfolio whenever the market presents a favorable opportunity. All
trades must be executed within three trading days of placing the order.
Determine which order is most suitable for the two clients. Explain your choice.
Answer Question 10 in the template provided at the end of Question 10.
(6 minutes)

Template for Question 10
Determine which order is

most suitable for the two
clients
Client (Circle the Correct Answer) Explain your Choice
Reserve order
Smithson Corp’s Market-not-held order

Defined Benefit
Pension Fund
Market on open order
Participate order
Thornton Best efforts order

Endowment Fund
Market on open order

Solution for Question 10
Determine which order is

most suitable for the two
clients
Client (Circle the Correct Answer) Explain your Choice
Reserve orders are suitable
for those traders who place
an order which represents a
substantial fraction of the
average daily trading
Reserve order volume, but do not wish to
Reserve order display the full size of their
orders.
Smithson Corp’s Defined
Benefit Pension Fund Market-not-held order Smithson’s order represents
40% (100,000/400,000) of
the stock’s trading volume
Market on open order in a day which is significant
and the chief executive has
expressed his desire to
conceal a portion of the
order.
Best efforts orders are

Participate order suitable for those clients
who are willing to give their
Thornton Endowment Best efforts broker/agent full discretion
Fund order order
Best efforts to work the order only when
the broker judges the market
to be favorable. Based on
Market on open order the chief executive’s
demands, this order is most
suitable for the client.
Reference:

QUESTION 11 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 15 MINUTES
Bjore Traders is a shipping company listed on the NYSE. The company has divisions
operating in several states across the U.S. Each divisional manager is responsible for
overseeing the risk management of its exposures.
A. Identify one benefit and one drawback of BT’s risk management system
structure.
(2 minutes)
Jacqueline Andrew is the head of risk management at BT’s Idaho division. Andrew is
preparing a report on the division’s risk exposures in order to determine how to manage
them effectively. She begins her report by discussing the division’s strategy for risk
management:
Statement: “We manage risk strategically by avoiding risk taking in areas in which we do
not have expertise and hedging only tactically in areas in which we have an edge.”
B. Does Andrew’s statement reflect efficient risk management practices? Justify

your response.
(3 minutes)
Answer Question 11-B in the template provided at the end of Question 11.
The Idaho Division is BT’s only division delivering orders to customers outside the U.S.
A portion of its sales are on credit. Shipping fuel is procured by paying for 12 months’
fuel in advance using over-the-counter (OTC) prepaid commodity swaps. The firm has
hedged its foreign currency exposures using currency futures.
In the current year, the management is seeking to expand the division’s delivery
destinations and will be purchasing three freight ships from a U.S. supplier. Funds from
the purchase will come from issuing a combination of equities and corporate bonds.
C. Identify five risk exposures faced by the Idaho division. Your answer should
explain each risk exposure by identifying one source.
Answer Question 11-C in the Template provided at the end of Question 311.
(10 minutes)

Template for Question 11-B

Does Andrew’s Statement
Reflect Efficient Risk
Andrew’s Statement: Management Practices?
(Circle the Correct Option) Justify Your Response
“We manage risk
strategically by avoiding
risk taking in areas in which Yes
we do not have expertise
and hedging only tactically No
in areas in which we have
an edge.”

Identify Five Risk Exposures Faced by Explain Each Risk Exposure with
the Idaho Division One Identified Source
1.
2.
3.
4.
5.

A Solution.
BT has a decentralized risk management system as each division is responsible for

managing its own risk exposures.
Advantage: People who are most familiar with the risk will be managing exposures.
Disadvantage (Marks will be awarded for any one of the following disadvantages
identified):
• Does not permit economies of scale

• Does not allow a company to recognize the offsetting nature of distinct exposures
that an enterprise may assume in its day-to-day operations.
Reference:
B Solution:
Does Andrew’s Statement
Reflect Efficient Risk
Andrew’s Statement: Management Practices? Justify Your Answer:
(Circle the Correct Option)
Although the tactical
hedging of areas in which
the entity has comparative
“We manage risk advantage is an efficient
strategically by avoiding strategy, the division should
risk taking in areas in which Yes hedge risks in areas in
we do not have expertise which they have no
and hedging only tactically No
No expertise. Efficient risk
in areas in which we have management involves
an edge.” adjusting levels of risk to
appropriate levels and not
necessarily eliminating
risks.
Reference
CFA Level III, Volume 5, Study Session 16, Reading 31, LOS a

C Solution:
Identify Five Risk Exposures Faced by the Explain Each Risk Exposure with
Idaho Division One Identified Source
Possible sources of credit risk

include:
• Credit risk arises from
credit sales
1. Credit risk • Credit risk arises from
prepaid swaps as the dealer
may not fulfill his side of
the agreement by either
delaying or failing to
deliver the shipment of fuel
to the division.
2. Commodity risk Potential sources of commodity

risk include:
• The company has exposure
in fuel
• The company has exposure
in shipments to customers
Settlements on the swap can

3. Settlement risk expose the division to settlement
risk. The division has prepaid for
fuel which it may not receive.

4. Equity market risk The success of its expansion

operations will be affected by the
price it receives from issuing
shares.
The division is exposed to the risk

5. Liquidity risk that securities may not be bought
or sold as quickly to finance the
freights purchase.
Potential sources of interest rate

risk include:
• The division is financing
the purchase of freights by
6. Interest rate risk issuing corporate bonds.
• A portion of sales are
offered on credit terms.
Reference:

Capex Asset Management is a U.S. based portfolio management firm which has always
invested in domestic stocks on behalf of client portfolios. Victor Solanki is CAM’s senior
most portfolio manager. Solanki has allocated €100 million for investing in German
stocks with an average beta of 0.75. The spot exchange rate is $0.89. The German interest
rate is 4%.
Solanki will be hedging both German market risk as well as currency risk for a three
month period. A three-month futures contract on the German market is priced at
€200,000 and has a beta of 0.60. The three-month forward rate is $0.9560.
i. Identify the strategy Capex Asset Management will need to undertake for
hedging German local market return.
ii. Calculate the hedged portfolio return. Use a ‘n/360’ days convention and show
your calculations.
(5 minutes)

Question 12 Solution:
i. Capex Asset Management will need to sell futures contracts to hedge the German
local market return.
Explanation: Capex has a long exposure to the German equity market. A fall in
return will generate losses for its investment portfolio. Therefore, to hedge against
potential losses the company will need to sell futures contracts.
ii. The portfolio is hedged for local market risk and therefore it will grow to a value
of €101,000 = €100,000[1 + (0.04 × 90/360)]. Capex can hedge this amount using
a currency forward contract with a notional principal of €101,000.
With the portfolio hedged for currency risk, the dollars received at contract
expiration will equal to $96,556 (€101,000 × $0.9560).
Based on the original portfolio value of $89,000 (€100,000 × $0.89), the hedged
portfolio return is equal to 8.49% ($96,556/$89,000 – 1).
Reference:
CFA Level III, Volume 5, Study Session 17, Reading 32, LOS f

QUESTION 13 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 17 MINUTES.
Steven Blair, CFA, has been contracted to help Betty Davis put together an Investor
Policy Statement and a strategic allocation for her $2.5 million in assets. The funds are
currently allocated to the asset classes established by a previous advisor
Money Market Instruments 20%

U.S. Large Cap Fund 20%
U.S. Corporate Bonds 20%
U.S. Treasuries 20%
S&P500 Fund 20%
They begin to discuss the asset classes and recommendations in their first meeting.
Steven tells Betty that the previous advisor did not correctly specify the asset classes. He
also recommends treasury-inflation protected securities as a separate asset class from the
nominal bonds currently in the portfolio and provides the table below as evidence.
Historical Correlation of Returns

Asset Class TIPS Corporates Treasuries
Treasury Inflation Protected Securities 1.00
U.S. Corporate Bonds 0.85 1.00
U.S. Treasuries 0.71 0.80 1.00
A. Support Stevens recommendation to add TIPS with two reasons
(2 minutes)
B. Describe three errors that were made in the specification of asset classes
(6 minutes)
Steven has experience developing strategic asset allocations using traditional mean
variance optimization with unadjusted historical returns, variances and covariances. To
construct a strategic allocation for Betty, he is interested in using other approaches like
Black-Litterman and Monte Carlo simulation.
C. Identify one advantage and one limitation for each of the approaches listed in the
case (Mean-Variance, Black-Litterman, and Monte Carlo)
(9 minutes)

Solution for Question 4
A Solution:
TIPS are a homogenous asset class (they are correlated with themselves). They also
provide important protection against inflation, which is not provided in nominal bonds.
Reference:
CFA Level III, Volume 3, Study Session 9, Reading 19.
B Solution:
1) The asset classes listed do not make up a preponderance of global investable

wealth, no international investments are listed.
2) Asset classes should be mutually exclusive or have no overlap. The U.S. large
cap and the S&P500 fund will overlap significantly.
3) Asset classes should be diversifying for risk control. The U.S. corporate bonds
and Treasuries are highly correlated and it is assumed that the U.S. large cap
and S&P500 funds will also be highly correlated.
Reference:
C Solution:
Mean-Variance:
Advantage is that it identifies portfolios with the highest expected return at each level of
risk, though it is limited in the number and nature of estimates can overwhelm the
analyst.
Black-Litterman:
Advantage is that it provides portfolios that are well-diversified and a stable efficient
frontier, though it is limited in that it relies on historical returns and variances.
Monte Carlo:
Advantage is that it can be used to generate a distribution of probabilities, though its
limitation is the complexity of the approach.
Reference:

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Questions Topic Minutes

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QUESTION 1 HAS SIX PARTS (A, B, C, D and E) FOR A TOTAL OF 26

A. Formulate each of the following constraints for Lucas’ investment policy

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Answer Question 1-B in the template provided at the end of Question 1.

C. State Lucas’s return objective for his IPS.

Walker strongly feels that incorporating behavioral considerations in an IPS is essential

E. Discuss two benefits of including behavioral finance into the IPS.

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Answer Question 1-F in the template provided at the end of Question 1.

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Template for Question 1-B

Increase in inflation rate Decrease

Reduction in sales price of business Decrease

Increase in the price of his dream Decrease

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Template for Question 1-F

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Solutions for Question 1:

Lucas has a time horizon comprising of three stages.

Stage 1: Present to sale of business or retirement – 2 years

Stage 3: Stage 2 onwards

II. Unique Circumstances:

Lucas’ ownership suggests a large concentrated position. Weaver will need to

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Lucas has expressly stated

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Current Year 1 Year 2

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The benefits of incorporating behavioral finance in the IPS include:

• Formulating financial goals: While defining financial goals is a critical phase of

• Maintaining a consistent approach: Behavioral finance helps to add

• Investing as the client expects: Behavioral finance allows advisors to better

• Ensuring mutual benefits: By incorporating behavioral finance into the investment

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Identify the Bias Justify Your Choice With One

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QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 10 MINUTES

Answer Question 2-A in the Template provided at the end of Question 2.

• Carl’s annual income sufficiently covers his living expenses.

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II. Based on Segal’s findings, he intends to employ an autopilot strategy to align

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Template for Question 2-A

Determine Risk Tolerance

Passive Preserver (PP) Low

Active Accumulator (AA) Low to Medium

Friendly Follower (FF) Medium to High

Independent Individualist (II) High

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Solution for Question 2.

Possible answers include:

Active Accumulator (AA) Low to Medium Self-attribution

Friendly Follower (FF) Medium to

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• fixed income has only increase by 3%

Bias 3: Carl demonstrates overconfidence in their estimate of company performance. He

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QUESTION 3 HAS ONE PART FOR A TOTAL OF 3 MINUTES