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CFA Level III FOR AIMR USE ONLY

Essay Examination Book

2000 Afternoon Section


Candidate Number:
FOR AIMR USE ONLY

_____ _____ _____ _____ _____ _____

THIS BOOK IS THE PROPERTY OF:

Association for
Investment Management
and Research
Post Office Box 3668
Charlottesville VA 22903-0668
USA
Tel: 804-951-5499

2000 Association for Investment Management and Research. All rights reserved.
The following list contains the command words used on the Afternoon Section of the 2000
Level III examination. Candidates may want to refer to this list as they formulate their answers.

calculate To ascertain or determine by mathematical processes.

cite To quote by way of evidence, authority, or proof.

construct To create by organizing ideas or concepts logically and coherently.

critique To offer a critical review or commentary; to criticize.

describe To transmit a mental image, an impression, or an understanding of the


nature and characteristics of.
determine To come to a decision as the result of investigation or reasoning; to settle
or decide by choice among alternatives or possibilities.
diagram To represent by or put into the form of a diagram.

discuss To discourse about through reasoning or argument; to present in detail.

evaluate To determine or fix the value of; to determine the significance or worth of,
usually by careful appraisal and study.
explain To give the meaning or significance of; to provide an understanding of; to
give the reason for or cause of.
give To yield or furnish as a product, consequence, or effect; to offer for the
consideration, acceptance or use of another.
identify To establish the identity of; to show or prove the sameness of.

indicate To point out or point to with more or less exactness; to show or make
known with a fair degree of certainty.
justify To prove or show to be valid, sound, or conforming to fact or reason; to
furnish grounds or evidence for.
select To choose from a number or groupusually, by fitness, excellence, or
other distinguishing feature.
state To express in words.
The Afternoon Section of the 2000 CFA Level III Examination has 11 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


22 Portfolio Management / Asset Valuation 28
23 Portfolio Management / Asset Valuation 21
24 Portfolio Management 22
25 Portfolio Management 12
26 Portfolio Management 6
27 Portfolio Management 12
28 Portfolio Management 18
29 Portfolio Management 12
30 Portfolio Management 15
31 Asset Valuation 12
32 Asset Valuation 22

Total: 180
QUESTION 22 HAS THREE PARTS FOR A TOTAL OF 28 MINUTES

Hugh Donovan is chief financial officer of LightSpeed Connections (LSC), a rapidly growing U.S. technology
company. The company provides a traditional defined benefit pension plan. Because of LSCs young
workforce, Donovan believes the pension plan has no liquidity needs and can therefore invest aggressively to
maximize pension assets. He also believes that Treasury bills and bonds, yielding 5.4 percent and 6.1 percent
respectively, have no place in a portfolio with such a long time horizon. Therefore, his strategy is to invest the
portfolio as follows:

50 percent in a concentrated pool (15 to 20 stocks) of initial public offerings (IPOs) in technology and
internet companies, managed internally by Donovan
25 percent in a small-capitalization growth fund
10 percent in a venture capital fund
10 percent in an S&P 500 index fund
5 percent in an international equity fund

Donovan has produced excellent returns utilizing this strategy for the past two years.

A. Evaluate Donovans investment strategy with respect to its effect on each of the following:

i. LSCs pension plan beneficiaries


ii. Managing pension assets in relation to LSCs corporate strength

(8 minutes)

Eileen Jeffries, LSCs president, notes the strong returns of the plan but believes LSC needs a formal
investment policy statement (IPS). Working with the Investment Committee, Jeffries writes the following IPS:

The LSC Pension Plans return objective should focus on real total returns that will fund its long-term
obligations on an inflation-adjusted basis. The time to maturity of the corporate workforce is a key
element for any defined pension plan; given our young workforce, LSCs Plan has a long investment
horizon and more time available for wealth compounding to occur. Therefore the Plan can pursue an
aggressive investment course and focus on the higher return potential of capital growth. Under present
U.S. tax laws, pension plan portfolio income and capital gains are not taxed. The portfolio should focus
primarily on investments in businesses directly related to our main business to leverage our knowledge
base.
B. Evaluate LSCs investment policy statement in the context of each of the following:

i. Return requirement
ii. Risk tolerance
iii. Time horizon
iv. Liquidity

(8 minutes)

Exhibit 22-1 contains three alternative asset allocations that Jeffries is considering in addition to the allocation
for the current portfolio.

Exhibit 22-1
Alternative Asset Allocations and Current Portfolio
Current
Portfolio A Portfolio B Portfolio C
Portfolio
S&P 500 Index 25% 16% 35% 10%
IPO/Tech Portfolio 20 40 10 50
Small Cap Growth Fund 26 10 19 25
International Equity Fund 0 16 15 5
Venture Capital Fund 10 5 5 10
Money Market Fund 7 7 2 0
Corporate Bond Fund 12 6 14 0
Total 100% 100% 100% 100%

Expected Return 16.6% 22.1% 13.3% 26.2%


Standard Deviation 26.7% 38.4% 19.8% 55.2%

C. Select and justify the portfolio that is most appropriate for LSCs pension plan.

(12 minutes)
QUESTION 23 HAS TWO PARTS FOR A TOTAL OF 21 MINUTES

Susan Leighton, treasurer for Donner Life Insurance, a U.S. based company, has just joined the board of a
charitable organization that has a large endowment portfolio. She is researching how the investment policy for
an endowment is different from that of life insurance companies.

She has reached the following conclusions:

1. Both endowments and life insurance companies have aggressive return requirements.
2. Endowments are less willing to assume risk than life insurance companies because of donor concerns about
volatility and loss of principal.
3. Endowments are less able to assume risk than life insurance companies because of expectations that
endowments should provide stable funding for charitable operations.
4. Endowments have lower liquidity requirements than life insurance companies because endowment spending
needs are met through a combination of current income and capital appreciation.
5. Both endowments and life insurance companies are subject to stringent legal and regulatory oversight.

A. Indicate whether each of Leightons statements is correct or incorrect. If incorrect, justify your
response by citing one reason.

Answer Question 23-A in the Template provided on pages 13 and 14.

(15 minutes)

Both the life insurance and endowment portfolios are currently invested exclusively in domestic securities. In
order to increase returns, Leighton plans to invest 5 percent of the assets of each portfolio in emerging market
equities.

B. Critique Leightons plan with respect to its appropriateness for the:

i. life insurance portfolio.


ii. endowment portfolio.

(6 minutes)
Template for Question 23-A
Correct or
Statement Incorrect If Incorrect, Justify With One Reason
(Circle One)

1. Both endowments and


life insurance companies Correct
have aggressive return
requirements. Incorrect

2. Endowments are less


willing to assume risk than Correct
life insurance companies
because of donor concerns Incorrect
about volatility and loss of
principal.

3. Endowments are less


able to assume risk than Correct
life insurance companies
because of expectations Incorrect
that endowments should
provide stable funding for
charitable operations.

(Template continued on next page)


Template for Question 23-A, Continued
Correct or
Statement Incorrect If Incorrect, Justify With One Reason
(Circle One)

4. Endowments have lower


liquidity requirements than Correct
life insurance companies
because endowment Incorrect
spending needs are met
through a combination of
current income and capital
appreciation.

5. Both endowments and


life insurance companies Correct
are subject to stringent
legal and regulatory Incorrect
oversight.
QUESTION 24 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES

Fran Arseneault manages investment assets and liabilities for Allied Corporation. Allieds portfolio currently
has the following characteristics:

$300 million of the assets must be invested short term. These assets currently earn a six-month LIBOR rate
of five percent.
$300 million in debt is outstanding; $100 million is seven-year term fixed at a 6.5 percent rate and $200
million is short term at the six-month LIBOR rate.

A. Describe Arseneaults asset/liability exposure to declining interest rates.

(6 minutes)

Allied has been unable to issue additional variable rate debt at reasonable fees. Hogan Stanfield Investment
Bank stands ready to swap intermediate term 6.5 percent fixed and six-month LIBOR.

B. Diagram an appropriate interest rate swap, using the boxes provided in the template on page 21. Label
all boxes. Draw and label arrows to specify the rates, the payer and receiver for all fixed and floating
rates, and the notional amount(s) involved. Your diagram must identify the fixed-rate bonds and
variable-rate assets.

Answer Question 24-B on the Template provided on page 21.

(12 minutes)

After the swap is executed, LIBOR immediately decreases substantially and remains at the lower level until the
swap contract expires.

C. Determine the effect of the LIBOR decline on Allieds asset and liability positions. Explain why this
effect occurs.

(4 minutes)
Template for Question 24-B
QUESTION 25 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES

A stock currently sells for $77.50. Call options on the stock have an exercise price of $75 and sell for $7.75, and
put options have an exercise price of $75 and sell for $4. These options will expire in three months. The three-
month U.S. Treasury bill annualized yield is 5 percent. There are no transaction costs and no restrictions against
using the proceeds from the short sale of any security.

A. A synthetic Treasury bill can be constructed by investing in a combination of the securities identified
above.

i. Identify the three transactions needed to construct a synthetic Treasury bill.


ii. Calculate the synthetic Treasury bills annualized yield.

(4 minutes)

B. An arbitrage strategy can be constructed with 75 actual and 100 synthetic Treasury bills, producing a
face amount of $750,000.

i. State the arbitrage strategy.


ii. Calculate the immediate incoming net cash flow.

(4 minutes)

C. Determine the net cash flow of the arbitrage strategy at the six-month expiration date if the stock price
at expiration is $80. (Ignore any cash flows stemming from the original arbitrage profit.)

(4 minutes)
QUESTION 26 HAS ONE PART FOR A TOTAL OF 6 MINUTES

Duffy Chow, a principal at Portable Alpha Consulting, has a client who wishes to capture excess equity returns
from small capitalization U.S. stocks while simultaneously establishing exposure to the large capitalization U.S.
equity market. Chow has determined that the Russell 2000 Index and the S&P 500 Index are the appropriate
small capitalization and large capitalization benchmarks, respectively. Chow proposes the following two
strategies:

Strategy One:

Hire an equity manager who has consistently outperformed the Russell 2000 Index.
Buy the same dollar amount of Russell 2000 futures exposure.
Sell short the same dollar amount of S&P 500 futures exposure.

Strategy Two:

Hire a market neutral (i.e., long/short) small capitalization manager.


Buy the same dollar amount of S&P 500 futures exposure.

Indicate whether or not each strategy should achieve the clients objectives, and justify your response.

Answer Question 26 in the Template on page 31.

(6 minutes)
Template for Question 26
Should Achieve
Strategy Clients Objectives Justification
(Circle One)

One Yes

No

Two Yes

No
QUESTION 27 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES

Dinah Kees, the chief financial officer of Murphy Corporation, is reviewing a performance measurement report
for Murphys defined benefit pension plan. She notes that Arctic Asset Management (Arctic), a large
capitalization U.S. equity value manager, has significantly underperformed the S&P 500 for the year to date and
past one- and three-year periods.

Exhibit 27-1 identifies factors that are included in the performance measurement report.

Exhibit 27-1
Performance Measurement Factors
Arctics portfolio return P
S&P 500 index return M
Salomon World ex-U.S. index return E
Russell 1000 Value index return B
Russell 2000 Growth index return X
Risk-free rate of return R

A. Construct a formula, using factors from Exhibit 27-1, that measures the contribution of style to Arctics
relative performance.

(3 minutes)

B. Construct a formula, using factors from Exhibit 27-1, that measures the contribution of stock selection
to Arctics relative performance.

(3 minutes)

C. Discuss one advantage and one limitation of using return-based style analysis to identify unintended
style bets in portfolio construction.

(6 minutes)
QUESTION 28 HAS ONE PART FOR A TOTAL OF 18 MINUTES

The following sequence of events describes a stock trade of TRP, Incorporated:

10:00 a.m. A portfolio manager gives the following order to a trader: SELL 50,000 shares TRP (market
price $43.00).
10:30 a.m. The trade desk places the order with a broker (market price $41.00).
10:31 a.m. The broker executes the sale of 50,000 TRP shares at $40.25; commission is $0.05 per share.
Three days later The market price of TRP closes at $38.00.

Answer Question 28 by completing the blank boxes in the Template on page 41.

(18 minutes)
Template for Question 28
(Provide answers only in the blank boxes.)
Identify the Describe the Explain how the trading costs are Calculate the
trading cost. trading costs. measured. trading costs
(per share).

Explicit fee charged Provided for listed trades $0.05


Commission by a broker for
services

Cost of immediate
Price Impact execution

Timing

Cost of failing to Three-day return for unexecuted shares


find liquidity (cancelled trades)

Total Cost Sum of the costs


of Trade
QUESTION 29 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES

Trustees of the Pallor Corp. pension plan ask consultant Donald Millip to comment on the validity and
appropriateness of using the performance of a median manager as a benchmark.

Millip states the following:

Median manager benchmarks are statistically unbiased measures of performance over long periods of time.
Median manager benchmarks are unambiguous and are therefore easily replicated by managers wishing to
adopt a passive/indexed approach.
Median manager benchmarks are not appropriate in all circumstances because the median manager universe
encompasses many investment styles.

A. Indicate whether each of Millips statements is correct or incorrect. If incorrect, justify your answer by
referring to one characteristic of a valid benchmark.

Answer Question 29-A in the Template provided on page 45.

(6 minutes)

A trustee asks Millip to comment on the advantages and disadvantages of Value at Risk (VAR) as a risk
management methodology.

Millip states the following:

VAR provides managers with information on the risk characteristics of the total portfolio because VAR can
measure risk on a comparable basis across asset classes.
VAR analyses are typically quite accurate because the model inputs are easy to determine.
VAR results are not dependent on past market conditions being representative of the future.

B. Indicate whether each of Millips statements is correct or incorrect. If incorrect, justify your conclusion
by citing one reason.

Answer Question 29-B in the Template provided on page 47.

(6 minutes)
Template for Question 29-A
Statement: Correct or
Median manager Incorrect If Incorrect, Justify with One Characteristic of
benchmarks are (Circle One) Valid Benchmark

statistically unbiased
measures of
performance over long Correct
periods of time.

Incorrect

unambiguous and
are therefore easily
replicated by managers Correct
wishing to adopt a
passive/indexed
approach.
Incorrect

not appropriate in all


circumstances because
the median manager Correct
universe encompasses
many investment styles.

Incorrect
Template for Question 29-B
Correct or
Statement Incorrect If Incorrect, Justify with One Reason
(Circle One)

VAR provides
managers with
information on the Correct
risk characteristics
of the total
portfolio because
VAR can measure Incorrect
risk on a
comparable basis
across asset
classes.

VAR analyses are


typically quite
accurate because Correct
the model inputs
are easy to
determine.
Incorrect

VAR results are


not dependent on
past market Correct
conditions being
representative of
the future.
Incorrect
QUESTION 30 HAS ONE PART FOR A TOTAL OF 15 MINUTES

Dayne Investment Managers, in existence since 1988, has created the performance presentation shown in
Exhibit 30-1. Dayne believes that this presentation complies with the Global Investment Performance Standards
(GIPS).

Exhibit 30-1
Dayne Investment Managers, LLP
Equity Composite
January 1, 1995, through December 31, 1999

Total Number of Composite Total Assets at Percentage Total Firm


Year Return Portfolios Dispersion End of Period of Firm Assets
(percent) (percent) Assets

1995 11.0 20 1.5 123 45 273

1996 8.3 24 3.0 187 46 407

1997 5.4 33 4.4 222 56 396

1998 13.1 51 1.2 289 64 452

1999 15.6 65 2.9 355 62 572


Dayne has calculated the returns in this presentation in accordance with the Global Investment
Performance Standards (GIPS).

Cite five reasons why the presentation is not in compliance with GIPS. Your answer should only be based on
any errors or omissions in the presentation itself.

(15 minutes)
QUESTION 31 HAS ONE PART FOR A TOTAL OF 12 MINUTES

Benjamin Sparks is a consultant to Regal, Incorporated, a large U.S. corporation. Regals chief financial officer
is considering adding bonds from other countries to Regals fixed income portfolio. In a presentation to the
CFO, Sparks makes the following statements:

1. Forward currency exchange rates are poor predictors of future spot exchange rates.
2. The presence of a significant non-government bond market in developed countries provides
opportunities to enhance returns through sector selection.
3. Investing in bond markets in countries outside the target international index can enhance returns, but
also dramatically increases the risk in the portfolio.
4. Duration management is equally challenging for U.S. bond portfolios and for portfolios containing
bonds from several developed markets.

Indicate whether each statement is correct or incorrect. If incorrect, justify your conclusion by citing one
reason.

Answer Question 31 in the Template provided on page 57.

(12 minutes)
Template for Question 31
Correct or
Statement Incorrect If Incorrect, Justify With One Reason
(Circle One)

1. Forward currency
exchange rates are poor Correct
predictors of future spot
exchange rates.

Incorrect

2. The presence of a
significant non-government Correct
bond market in developed
countries provides
opportunities to enhance
returns through sector Incorrect
selection.

3. Investing in bond
markets in countries Correct
outside the target
international index can
enhance returns, but also
dramatically increases the Incorrect
risk in the portfolio.

4. Duration management is
equally challenging for Correct
U.S. bond portfolios and
for portfolios containing
bonds from several
developed markets. Incorrect
QUESTION 32 HAS FOUR PARTS FOR A TOTAL OF 22 MINUTES

Carol Harrod is the investment officer for a $100 million U.S. pension fund. The fixed income portion of the
portfolio is actively managed, and a substantial portion of the funds large capitalization U.S. equity portfolio is
indexed and managed by Webb Street Advisors.

Harrod has been impressed with the investment results of Webb Streets equity index strategy and is
considering asking Webb Street to index a portion of the actively managed fixed income portfolio.

A. Describe two advantages and two disadvantages of bond indexing relative to active bond management.

(8 minutes)

Webb Street manages indexed bond portfolios that are constructed using two different methods. Webb Street
has stated that the source of tracking error is different for each method.

B. Discuss how an indexed portfolio is constructed under each of the following methods:

i. Stratified sampling
ii. Optimization

(4 minutes)

C. Describe the main source of tracking error for each of the following methods:

i. Stratified sampling
ii. Optimization

(4 minutes)

Harrod believes that an indexed bond portfolio should have less tracking error than an indexed equity portfolio.

D. Indicate whether Harrods belief is correct or incorrect. Give two reasons to support your position.

(6 minutes)
CFA Level III Examination
2000 Afternoon Section

IMPORTANT INSTRUCTIONS TO CANDIDATES


1. Write your candidate number in the spaces provided at the top left corner of the front cover of this exam
book.

2. Write your answers in blue or black ink on the correct answer pages in the exam book.

3. Label each part of your answer (A, B, C, or i, ii, iii, etc.).

4. Only answers written on the correct answer pages will be graded. You may make marks and notes on the
question pages, but these marks will not be graded.

5. If you use all of the designated answer pages, check the box at the bottom of the last page of your answer
and continue your answer on the unnumbered extra pages at the back of the exam book. Label extra pages
with the correct question number.

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