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Level III essay questions 2016
International Business (Ap/Adms 3960)
York University
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CFA Institute
Chartered Financial Analyst® Examination
2016 Level III Morning Session
Essay Questions
The following is provided for informational purposes only and may not be used in any commercial manner without prior written permission from CFA Institute. © 2016 CFA Institute. All Rights Reserved.
Level III Page 1
The Morning Session of the 2016 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.
Question Topic Minutes
1 Portfolio Management – Institutional 20
2 Portfolio Management – Fixed Income 22
3 Portfolio Management – Equity 19
4 Portfolio Management – Asset Allocation 13
5 Portfolio Management – Trading, Monitoring, Rebalancing 13
6 Portfolio Management – Individual 22
7 Portfolio Management – Individual 17
8 Portfolio Management – Risk Management 20
9 Portfolio Management – Economics 18
10 Portfolio Management – Individual/Behavioral 16
Total: 180
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QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 20 MINUTES.
Sopho College is a small, private university. The university library has an endowment currently valued at USD 21,000,000. The endowment’s only purpose is to fully fund the library’s annual subscription expense for online academic journals. The journals are considered essential to keep Sopho competitive.
Sopho is changing the library’s subscription service to a new provider. The provider offers two subscription options as shown in Exhibit 1. The administration desires the highest level subscription that the endowment can fund in perpetuity. Mark Madison, a financial advisor to the endowment’s board, is analyzing the subscription options and reviewing the IPS.
Exhibit 1 Summary of Subscription Options
Option
One-time Initiation Fee (due immediately)
Annual Subscription Expense (due at year end)
Expected Increase in Annual Subscription Expense Basic USD 500,000 USD 800,000 Inflation plus 1% Premium USD 1,000,000 USD 1,000,000 Inflation plus 1%
The objective of the endowment is to fully fund the subscription costs in perpetuity and maintain the purchasing power of the investable asset base after payment of the one-time initiation fee. The endowment’s risk management practices require Madison to use Monte Carlo simulations to account for return volatility in evaluating the risk of purchasing power erosion. Given capital market expectations and the endowment’s asset allocation, the expected long-term total return of the endowment is 8% per year with an expected standard deviation of 18%. Annual management fees are 0% of the market value of the endowment’s assets.
The endowment’s board understands that the spending rate affects risk tolerance, and they are comfortable with an above-average risk exposure. The endowment reinvests any portfolio surplus. No donations are expected in the foreseeable future. Economy-wide inflation is forecast to be 2% per year.
A. Calculate the return requirement to fully fund each subscription option. Determine which subscription option is most appropriate for the endowment, given its objective and risk management practices. Justify your response.
Note: Use arithmetic returns, rather than geometric returns, for the return requirement calculations.
8 minutes (Answer 1-A on page 5)
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B. Discuss , other than the portfolio return requirement, one factor that:
i. decreases the endowment’s ability to take risk. ii. increases the endowment’s ability to take risk.
Note: Restating case facts without additional support will not receive credit.
4 minutes (Answer 1-B on page 6)
Madison also advises the board of Prairie Foundation. The foundation funds annual research grants on a discretionary basis for the development of agricultural technologies. The foundation’s return objective is to earn the highest total return consistent with its risk objective while maintaining the purchasing power of the investable asset base.
The legally required minimum spending rate for the foundation to maintain its tax-exempt status is 4%. The foundation’s spending rate is slightly above that at 4%. Annual management fees are 0% of the market value of assets and are not included in the minimum spending rate calculation for tax purposes. The current market value of the foundation’s portfolio is USD 20,000,000.
The foundation recently received a donation commitment of USD 2,000,000 for each of the next five years. Following this new development, Madison reviews the foundation’s IPS.
C. Determine whether the foundation’s ability to take risk is lower than, the same as, or higher than that of the Sopho College library endowment. Justify your response with two reasons.
5 minutes (Answer 1-C on page 7)
Three years later, the foundation’s portfolio value has decreased. At the beginning of the year, the board decides to switch from the current fixed target spending rate to a rolling three-year average spending rule, with the same spending rate of 4%.
D. Determine whether the foundation’s target spending for the coming year will be lower, the same, or higher using the new spending rule instead of the old spending rate. Justify your response.
3 minutes (Answer 1-D on page 8)
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Answer Question 1-B on This Page
1-B. Discuss , other than the portfolio return requirement, one factor that: (see i. and ii. below) Note: Restating case facts without additional support will not receive credit.
i. decreases the endowment’s ability to take risk.
ii. increases the endowment’s ability to take risk.
Level III Page 7
Answer Question 1-C on This Page
Determine whether the foundation’s ability to take risk is lower than, the same as, or higher than that of the Sopho College library endowment. (circle one)
Justify your response with two reasons.
lower than
the same as
higher than
1.
2.
Level III Page 9
THIS PAGE INTENTIONALLY LEFT BLANK
MARKS MADE ON THIS PAGE ARE
NOT GRADED
Page 10 Level III
QUESTION 2 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 22 MINUTES.
William MacDougal, a portfolio manager for Ethereal Capital, manages fixed income investments for institutional clients in the country of Scorponia. He manages a portfolio that invests in both domestic government bonds and domestic corporate bonds.
MacDougal manages the portion of the portfolio invested in government bonds to match the duration of the 10-year Scorponia government bond. He is concerned about an upward shift in interest rates and is seeking ways to increase the fund’s return. He assesses the effect of adding foreign sovereign debt from Tauravia and adjusting the current portfolio’s duration. Bond market data and MacDougal’s exchange rate forecast appear in Exhibit 1.
Exhibit 1 Bond Market Data and Exchange Rate Forecast Scorponia Tauravia Currency SCF TRF 1-year risk-free interest rate 1% 4% Yield to maturity of 10-year government bond 4% 7% Duration of 10-year government bond 7 8. Country beta 0. Current spot exchange rate 2 SCF = 1 TRF MacDougal’s forecast spot exchange rate in one year 1 SCF = 1 TRF
MacDougal determines that adding bonds from Tauravia to his existing government bond portfolio will increase the portfolio’s yield and decrease its duration. However, he is concerned about the effect of changes in exchange rates on the returns for these bonds. He assumes the forward exchange rates of both currencies reflect interest rate parity.
A. Calculate the percentage of MacDougal’s domestic government portfolio that should be allocated to 10-year Tauravia government bonds to decrease the portfolio’s duration to 6. Show your calculations.
4 minutes (Answer 2-A on page 12)
B. Calculate the minimum change (in bps) in the yield for the Tauravia bond that would eliminate its quarterly yield advantage relative to the Scorponia bond. Show your calculations.
Note: Ignore the impact of currency movements.
4 minutes (Answer 2-B on page 13)
Page 12 Level III
Answer Question 2-A on This Page
2-A. Calculate the percentage of MacDougal’s domestic government portfolio that should be allocated to 10-year Tauravia government bonds to decrease the portfolio’s duration to 6. Show your calculations.
Level III Page 13
Answer Question 2-B on This Page
2-B. Calculate the minimum change (in bps) in the yield for the Tauravia bond that would eliminate its quarterly yield advantage relative to the Scorponia bond. Show your calculations.
Note: Ignore the impact of currency movements.
Level III Page 15
Answer Question 2-D on This Page
Hedging strategy
Select , for each of the following, the most appropriate hedging strategy (buy long or sell short) that would address MacDougal’s concern using a credit spread: (circle one)
Determine whether each strategy has a negative, zero, or positive payoff to Ethereal if the credit spread is 150 bps at expiration. (circle one)
i. forward contract.
buy long
sell short
negative
zero
positive
ii. call option contract.
buy long
sell short
negative
zero
positive
Page 16 Level III
Answer Question 2-E on This Page
Determine whether MacDougal should buy or sell interest rate futures to achieve his duration objective. (circle one)
Calculate the number of contracts MacDougal should trade. Show your calculations.
buy
sell
Page 18 Level III
QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 19 MINUTES.
James Nielsen is a consultant for the Laurier pension fund. Based on performance, he proposes replacing Laurier’s US large-cap growth equity mandate with a pure indexing mandate with zero alpha and zero tracking risk. He reviews the pension fund’s current equity allocation as shown in Exhibit 1. All expected active returns are uncorrelated.
Exhibit 1 Laurier Pension Fund Equity Allocation Details
Equity Mandate Weight in Equity Allocation (%)
Expected Alpha (%)
Expected Active Risk (%) US large-cap g rowth 55 2 5. European large-cap g rowth 20 2 4. Emerging market 25 3 8.
A. Calculate the information ratio for the total equity allocation, assuming Nielsen’s proposal is adopted. Show your calculations.
5 minutes (Answer 3-A on page 20)
Nielsen notices an increase in realized tracking risk for the European large-cap g rowth mandate and is concerned that its manager may be experiencing style drift. He conducts both a returns- based and a holdings-based style analysis. The result of his returns-based analysis are shown in Exhibit 2. The regression using the four indexes produced a style fit of 96%. Nielsen also reviews the characteristics of the European large-cap growth mandate and its benchmark, shown in Exhibit 3.
Exhibit 2 Regression Results for the European Large-cap Growth Mandate Index Past Style Weights (%)
Current Style Weights (%) European large-cap growth 85 58 European large-cap value 5 5 European small-cap growth 5 32 European small-cap value 5 5
Exhibit 3 Portfolio and Benchmark Characteristic for the European Large-cap Growth Mandate Characteristic Portfolio Benchmark P/E ratio 22 20. Dividend yield 2% 2% Price-to-book ratio 2 2. Holdings in Each Quartile by Market Cap (%) Top quartile 33 45 Second quartile 34 31 Third quartile 28 22 Bottom quartile 5 2
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Based on these analyses, Nielsen believes that the European large-cap growth mandate deviates from its large-cap style but not from its growth style.
B. Support , with both a returns-based reason and a holdings-based reason for each of the following, Nielsen’s belief regarding the mandate’s:
i. large-cap style. ii. growth style.
8 minutes (Answer 3-B on page 21)
Nielsen wants to capture alpha by appointing a new small-cap manager. He will fund this new position by replacing an existing emerging market equity manager and implementing an equitization strategy based on the following guidelines:
- Maintain the beta exposure of the emerging market equity allocation
- Provide no additional beta exposure
- Prohibit borrowing of cash
- Limit derivatives to long-only futures
Nielsen considers adding one of the small-cap managers in Exhibit 4 as a component of his overall strategy. All of the managers have positive expected alpha but apply different investment styles. Futures on small-cap and emerging equity indexes exist in the marketplace.
Exhibit 4 Active Small-cap Equity Managers Manager Investment Style Benchmark Carina Long only Small-cap equity Ara Short extension Small-cap equity Octans Market neutral Risk-free rate
C. Select the manager from Exhibit 4 that is most appropriate as a component of Nielsen’s overall strategy. Explain how a strategy following Nielsen’s guidelines would:
i. maintain the beta exposure of the emerging market equity allocation. ii. provide no additional beta exposure.
6 minutes (Answer 3-C on page 22)
Level III essay questions 2016
Course: International Business (Ap/Adms 3960)
University: York University
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