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Level III Page 1

Question 1 (23 minutes total)


Question 1, Part A (5 minutes)
i.
The Moores rely on John’s income, which was USD 165,000 last year and is expected to
increase by 5% in nominal terms for the coming year.

165,000 x 1.05 = 173,250

This income is taxed at a flat rate of 20%, so the amount of net income available to the Moores
on an after-tax basis is:

173,250 x (1 – 20%) = 138,600

The Moore’s will continue to save USD 2,000 of after-tax income per month, which reduces the
amount of after-tax income available to cover living expenses as follows:

138,600 – (2,000 x 12) = 114,600

Note that, because the Moores are net savers, living expenses are equal to the amount of after-tax
income that is not allocated to savings.

ii.
The Moores have no liquidity requirement for the coming year. The USD 200,000 transfer to an
irrevocable trust for the benefit of their son has already been executed. Moores are net savers,
which means that they will not need to draw upon funds from their retirement account over the
next twelve months. Note that the Moores’ living expenses and their contributions to their
retirement account are not included in the calculation of their liquidity requirement.
.

Allocation:
✓ 1 point for correctly calculating gross income for the coming year
✓ 1 point for correctly calculating net after-tax income for the coming year
✓ 1 point for correctly calculating living expenses for the coming year
✓ 2 points for providing the correct liquidity requirement for the coming year

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Level III Page 2

Question 1, Part B (5 minutes)


Number of periods = 65 – 50 = 15 years x 12 months/year = 180 months
Periodic savings = USD 2,000/month
Investable asset base = (700,000 – 200,000) = USD 500,000
Target portfolio value = USD 2,000,000

Using financial calculator:


N = 180
PV = -500,000
PMT = -2,000
FV = 2,000,000
CPT I/Y

Required annualized rate of return = 0.56486% x 12 = 6.78%

Allocation:
✓ 1 point for calculating the number of years until retirement
✓ 1 point for calculating the investable asset base
✓ 1 point for calculating the number of years until retirement
✓ 2 points for calculating the required rate of return

Commentary on Question:
The rate of return required to achieve the target portfolio value is calculated based on the
current portfolio value and the monthly saving of USD 2,000. The current value of the portfolio
is equal to the current amount invested minus the amount transferred to the irrevocable trust.
Note that the value of their home is not included in the investable asset base because they intend
to live in it for the remainder of their lives.

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Level III Page 3

Question 1, Part C (6 minutes)


The following factors increase the Moores’ ability to take investment risk:
• Demonstrated ability to save for retirement despite variable income
• Long-term time horizon
• Lisa Moore can return to the paid workforce if necessary
• No plans to leave an estate or make additional lifetime gifts
• No dependents
• Ability to borrow against the value of their home

The following factors decrease the Moores’ ability to take investment risk:
• John’s income is uncertain
• Neither has accumulated pension benefits

Allocation:
✓ 2 points for correctly identifying a factor that increases ability to take investment risk
(maximum of 4)
✓ 2 points for correctly identifying a factor that decreases ability to take investment risk

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Level III Page 4

Question 1, Part D (3 minutes)


Template for Question 1-D
Determine the personality type
(Cautious, Individualist,
Methodical, Spontaneous) that
Justify your response with one reason.
Muller would most likely
classify John Moore into.
(circle one)

John Moore’s personality type is that of a “methodical


investor” because:
Cautious • he bases his decisions on the “hard facts” and does
analysis of the facts;
• he does not involve emotion while making
investment decisions; and
Individualist • he is a relatively conservative, risk-averse investor.

Methodical

Spontaneous

Allocation:
✓ 1 point for correctly identifying the personality type
✓ 2 points for providing a correct justification

Commentary on Question:
Cautious investors generally do not take risks, which may be a result of their financial position
or various life experiences.

Methodical investors base their decisions on the “hard facts” and do analysis of the facts. They
do not involve emotion while making investment decisions. They are more risk averse.

Spontaneous investors constantly readjust their portfolio, allocations and holdings. They are
more risk averse and fear negative results with every new development in the marketplace.

Individualist investors have a self-assured approach to investing. They gain information from a
variety of sources and are not averse to putting in efforts needed to reconcile conflicting data
from their trusted sources. They place great importance on hard work and insight. Because they
are confident in their ability to meet their financial objectives over the long-term, they are
willing to take more investment risk.

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Level III Page 5

Question 1, Part E (4 minutes)


Two options available to the Moores are:
• Allocate a greater share of their portfolio to asset classes with higher expected returns
• Borrow against the value of their home and invest the proceeds

Allocation:
✓ 2 points for correctly identifying each option (maximum 4)

Commentary on Question:
The Moores are subject to several constraints. Neither has the ability and/or willingness to
increase their current income and it is not possible to reduce their expected living expenses
during retirement. With no new contributions from work income and no change in the expected
cost of the annuities that they intend to purchase in order to cover their future living expenses,
the most obvious option that will allow John to retire as planned in five years is to increase the
expected return on their portfolio assets. This will require a greater allocation to higher-risk,
higher-expected-return asset classes. Additionally, while the Moores are unwilling to sell their
home, they could borrow against its value and invest the proceeds.

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Level III Page 6

Question 2 (15 minutes total)


Question 2, Part A (4 minutes)
The Schmidts’ portfolio began the year with a value of EUR 14,350,000 and appreciates in value
by 9.60% for a total pre-tax gain of:

14,350,000 x 9.60% = 1,377,600

The following taxes are paid:


Source of income Pre-tax gain (EUR) Tax rate Taxes paid (EUR)
Dividends 452,100 30% 135,600
Interest 525,000 20% 105,000
Realized capital gains 284,200 30% 85,260
Total 325,890

The after-tax return is calculated as follows:


1,377,600 – 325,890 = 1,051,710

The percentage return on an after-tax basis is calculated as follows:


1,051,710 / 14,350,000 = 7.33%

Allocation:
✓ 1 point for calculating the total pre-tax gain
✓ 1 point for calculating total taxes paid
✓ 1 point for calculating the after-tax return in currency terms
✓ 1 point for calculating the percentage return on an after-tax basis

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Level III Page 7

Question 2, Part B (3 minutes)


LaFrenz’s portfolio consists of the following:
• EUR 5,640,000 of bonds in a taxable account, which will be taxed at a rate of 35% upon
being withdrawn.
• EUR 7,130,000 of equities in a tax-exempt account that can be withdrawn without triggering
a tax liability.

The after-tax asset allocation is:


Asset After-tax value (EUR) Allocation (%)
Bonds in taxable account 5,640,000 x (1 – 35%) = 3,666,000 33.96%
Equities in tax-exempt account 7,130,000 66.04%
Total 10,796,000 100.00%

Allocation:
✓ 1 point for correctly calculating the after-tax value of bonds in tax-deferred account
✓ 1 point for correctly calculating the after-tax value of equities in tax-exempt account
✓ 1 point for correctly calculating the after-tax asset allocations

Question 2, Part C (3 minutes)


LaFrenz’s decision to allocate bonds to the taxable account and equities in the tax-exempt
account indicates that interest income is taxed at a lower rate than dividend income and realized
capital gains. This is confirmed by Johnson’s belief that this is the most tax-efficient allocation.

Allocation:
✓ 2 points each for identifying interest income as being taxed at a lower rate than dividend
income and realized capital gains
✓ 1 point for noting Johnson’s opinion on the tax efficiency of this allocation as a justification

Commentary on Question:
When allocating assets among taxable and tax-exempt accounts, it is most efficient to hold assets
that provide tax-advantaged sources of income in taxable accounts.

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Level III Page 8

Question 2, Part D (5 minutes)


In the absence of any taxes, the future value of Tand’s asset would be:
3,575,000 x (1.07)12 = 8,051,585

In this scenario, the gain on this investment would be:


8,051,585 – 3,575,000 = 4,476,585

With a 1.5% wealth tax applied annually, the after-tax future value of Tand’s asset is:
3,575,000 [(1.07)(1 – 1.5%)]12 = 6,716,084

In this scenario, the gain on this investment would be:


6,716,084 – 3,575,000 = 3,141,084

The amount of the gain consumed by the wealth tax is calculated as:
4,476,585 – 3,141,084 = 1,335,501

The proportion of the gain consumed by the wealth tax is calculated as:
1,335,501 / 4,476,585 = 29.8%

Allocation:
✓ 2 points for correctly calculating the gain in the absence of taxes
✓ 2 points for correctly calculating the gain after the wealth tax is applied
✓ 1 point for correctly calculating the proportion of the gain consumed by the wealth tax

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Level III Page 9

Question 3 (13 minutes total)


Question 3, Part A (5 minutes)
The expected return on Bosphorian equities is 10.29%. This answer can be arrived at by
following these steps:

Step 1) Calculate GIM Sharpe ratio:

𝐸(𝑅𝑀 ) − 𝑅𝐹
𝑆𝑅𝐺𝐼𝑀 =
𝜎𝑀

where
𝑆𝑅𝐺𝐼𝑀 = GIM Sharpe ratio
𝐸(𝑅𝑀 ) = expected return on GIM
𝑅𝐹 = risk-free rate
𝜎𝑀 = standard deviation of GIM returns
In this example,
𝐸(𝑅𝑀 ) − 𝑅𝐹 7.9% − 3.1%
𝑆𝑅𝐺𝐼𝑀 = = = 0.30
𝜎𝑀 16.0%

Step 2) Calculate the Bosphorian equity risk premium under the assumption of perfect
integration with GIM.

𝑅𝑃𝑖 = [(𝜎𝑖 )(𝜌𝑖,𝑀 )(𝑆𝑅𝐺𝐼𝑀 )] + 𝐼𝑙𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

where
RP𝑖 = risk premium for asset class i
𝜎𝑖 = standard deviation of returns on asset class i
𝜌𝑖,𝑀 = correlation
𝑆𝑅𝐺𝐼𝑀 = GIM Sharpe ratio
In this example,
𝑅𝑃𝑖 = [(23.1%)(0.68)(0.30)] + 1.7% = 6.41%

Step 3) Calculate the Bosphorian equity risk premium under the assumption of perfect
segregation from GIM.

𝑅𝑃𝑖 = [(𝜎𝑖 )(𝑆𝑅𝐺𝐼𝑀 )] + 𝐼𝑙𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

In this example,
𝑅𝑃𝑖 = [(23.1%)(0.30)] + 1.7% = 8.63%

Step 4) Calculate the weighted-average Bosphorian equity risk premium based on degree of
integration with GIM.

𝑅𝑃𝑖 = [(6.41%)(0.65)] + [(8.63%)(1 − 0.65)] = 7.19%

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Level III Page 10

Step 5) Add the risk-free rate to arrive at the expected return on Bosphorian equities.

𝐸(𝑅𝑖 ) = 𝑅𝑃𝑖 + 𝑅𝐹 = 7.19% + 3.1% = 10.29%

Allocation:
✓ 1 point for calculating the GIM Sharpe ratio
✓ 1 point for calculating the risk premium of markets assuming full integration
✓ 1 point for calculating the risk premium of markets assuming full segmentation
✓ 1 point for calculating the weighted-average equity risk premium
✓ 1 point for calculating the portfolio return

Question 3, Part B (3 minutes)


The Rumländian economy is expected to grow below its long-term trend rate. This can be
determined by analyzing the Taylor rule:

𝑅𝑜𝑝𝑡𝑖𝑚𝑎𝑙 = 𝑅𝑛𝑒𝑢𝑡𝑟𝑎𝑙 + [0.5 ( 𝐺𝐷𝑃𝑔𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 − 𝐺𝐷𝑃𝑔𝑡𝑟𝑒𝑛𝑑 )] + [0.5 ( 𝐼𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 − 𝐼𝑡𝑎𝑟𝑔𝑒𝑡 )]

where,
𝑅𝑜𝑝𝑡𝑖𝑚𝑎𝑙 = target short-term interest rate (policy rate)
𝑅𝑛𝑒𝑢𝑡𝑎𝑙 = policy rate if GDP growth was on trend and inflation was forecasted to be on target
𝐺𝐷𝑃𝑔𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = expected GDP growth rate
𝐺𝐷𝑃𝑔𝑡𝑟𝑒𝑛𝑑 = long-term trend GDP growth rate
𝐼𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = expected inflation rate
𝐼𝑡𝑎𝑟𝑔𝑒𝑡 = target inflation rate

In this example, inflation is at the target rate and is expected to remain at this level. For the
Rumländian central bank to set its policy rate below the natural rate, it must be that GDP growth
is forecast to be below its long-term trend rate.

Allocation:
✓ 1 point for noting that the GDP growth rate is expected to be below its long-term trend
✓ 2 points for correctly explaining the parameters of the Taylor rule that support this
conclusion

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Level III Page 11

Question 3, Part C (5 minutes)


The Rumländian yield curve is most likely moderately steep. This is the result of a combination
of tight fiscal policy and loose monetary policy. The Rumländian government has adopted a
policy of reducing the budget deficit as a percentage of GDP (tight fiscal policy) and the central
bank has set its policy rate below the natural rate (loose monetary policy). The curve is
moderately steep (as opposed to flat) because the steepening effect of monetary policy trumps
the inverting effect of tight fiscal policy.

Allocation:
✓ 1 point for correctly identifying the most likely shape of the yield curve
✓ 2 points for correctly describing the country’s fiscal policy
✓ 2 points for correctly describing the country’s monetary policy

Commentary on Question:
The following table gives the policy mix and the shape of yield curve.

Policy Mix and The Yield Curve


Fiscal Policy
Loose Tight
Loose Yield curve steep Yield curve moderately
Monetary steep
Policy Tight Yield curve flat Yield curve inverted

If the fiscal and monetary policies are both tight, then the situation is unambiguous and the
economy is certain to slow. This leads to an inverted yield curve. On the other hand, if the fiscal
and monetary policies are both expansionary, then the economy can be expected to grow. This
leads to a steep yield curve.

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Level III Page 12

Question 4 (20 minutes total)


Question 4, Part A (12 minutes)
i.
The basis point value (BPV) for a fixed-income portfolio is the sum of the basis point values of
its component bonds. BPV is calculated as follows:

BPV = (Market value of bond) x (Bond duration) x 0.0001

In this example, the portfolio’s BPV at the end of the period is calculated as follows:

End of Year
Modified Market Value Basis Point Value
Security Price
Duration (KWR) (KWR)
Bond A 103.40 5.59 103,400,000 57,801
Bond B 98.66 2.70 98,660,000 26,638
Bond C 100.70 3.50 100,700,000 35,245
Total 119,684

ii.
In this example, the portfolio’s BPV at the beginning of the period is calculated as follows:

Beginning of Year
Modified Market Value Basis Point Value
Security Price
Duration (KWR) (KWR)
Bond A 102.34 6.19 102,340,000 63,348
Bond B 99.56 3.51 99,560,000 34,946
Bond C 101.28 4.24 101,280,000 42,943
Total 141,237

iii.
In accordance with Lee’s IPS, the money duration of her portfolio must be reset to its level from
the beginning of the year. To accomplish this using futures contracts, it is first necessary to
calculate the basis point value for the cheapest-to-deliver bond (BPVCTD):

𝐵𝑃𝑉𝐶𝑇𝐷 = 96,875 × 5.05 × 0.0001 = 48.92

The basis point value of the futures contract (BPVf) can then be calculated as follows:

𝐵𝑃𝑉𝐶𝑇𝐷 48.92
𝐵𝑃𝑉𝑓 ≈ ≈ ≈ 53.62
𝐶𝐹𝐶𝑇𝐷 0.9123

Note that CFCTD is the conversion factor for the CTD bond.

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Level III Page 13

The number of futures contracts (Nf) required to reestablish a target money duration is calculated
as follows:

𝐵𝑃𝑉𝑇 − 𝐵𝑃𝑉𝑃 141,237 − 119,684


𝑁𝑓 = = = 401.96
𝐵𝑃𝑉𝑓 53.62

Note that BPVT is the target basis point value and BPVP is the portfolio’s current basis point
value.

Because partial contracts cannot be used, Cho will need to purchase 402 futures contracts.

Allocation:
✓ 1 point for correctly stating the formula for basis point value
✓ 3 points for correctly calculating the portfolio’s basis point value a year ago
✓ 3 points for correctly calculating the portfolio’s basis point value today
✓ 2 points for correctly calculating the basis point value of the CTD bond
✓ 2 points for correctly calculating the number of futures contracts required
✓ 1 point for correctly providing the rounded number of futures contracts required

Question 4, Part B (8 minutes)


To execute a cash flow matching strategy, the first step is to calculate the face value of bonds
with the longest duration required to offset the final cash flow.

To make a payment of KRW 81 million in four years, Kim will need to hold 4-year, 3.90%
coupon bonds with a face value of:

81,000,000
= 77,959,577
1.039

Given the KRW 10,000 minimum size constraint, the face value of 4-year bonds required is
KRW 77,960,000. Note that the coupon payment and repayment of principal at the end of Year 4
will be 77,960,000 x 1.039 = 81,000,440.

Purchasing 4-year bonds with a face value of 77,960,000 will provide the following annual
coupon payments: 77,960,000 x 0.039 = 3,040,440.

At the end of Year 3, Kim must pay KRW 64 million. However, this amount will be partially
offset by the KRW 3,040,440 coupon payment from the 4-year bond. The face value of 3-year
bonds required is:
64,000,000 − 3,040,440
= 58,898,126
1.035

Again, due to the minimum size constraint, this rounds to KRW 58,900,000 for the face value of
3-year bonds required. The annual coupon payments from these bonds total KRW 2,061,500.

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Level III Page 14

The face value of 2-year bonds required is:

35,000,000 − 3,040,440 − 2,061,500


= 29,225,865
1.023

This rounds to a face value of KRW 29,230,000, which provide annual coupon payments of
KRW 672,290.

Finally, the face value of 1-year bonds required is:

50,000,000 − 3,040,440 − 2,061,500 − 672,290


= 43,401,148
1.019

This rounds to a face value of KRW 43,400,000, which provide a single coupon payment of
KRW 824,600.

Allocation:
✓ 2 points for correctly calculating the face value of 4-year bonds required
✓ 2 points for correctly calculating the face value of 3-year bonds required
✓ 2 points for correctly calculating the face value of 2-year bonds required
✓ 2 points for correctly calculating the face value of 1-year bonds required

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Level III Page 15

Question 5 (22 minutes total)


Question 5, Part A (4 minutes)
i.
Lockhart has exhibited loss aversion bias by continuing to hold stocks that are trading below
their purchase prices rather than recognizing a loss despite the opportunity to replace these stocks
with ones that offer higher expected risk-adjusted returns.

ii.
Lockhart exhibits illusion of control bias by refusing to reduce his exposure to the large,
concentrated position in his employer’s stock.

Allocation:
✓ 2 points for correctly explaining how Lockhart has exhibited each bias (maximum 4)

Question 5, Part B (4 minutes)


Based on Lockhart’s current tax constraints, the optimal corridor widths are +/-6% for equities
and +/-4% for fixed income. In the absence of any tax considerations, these corridor widths
would be narrower because untaxed returns are more volatile than taxable returns on the same
assets. Because volatility is inversely related to optimal corridor width, higher volatility tax-free
returns would result in lower rebalancing ranges.

Allocation:
✓ 2 points for correctly noting that the optimal corridor widths would be narrower
✓ 2 points for citing higher volatility of returns as the justification

Question 5, Part C (4 minutes)


Based only on expected utility, Lockhart should select Portfolio A because it offers the highest
risk-adjusted expected return. Expected utility is calculated as follows:

Um = E(Rm) – 0.005RAσ2m

where
Um = expected utility of asset mix m
E(Rm) = expected return of asset mix m
RA = investor’s risk aversion
σ2m = variance of return of asset mix m

The expected utilities of the portfolios shown in Exhibit 1 are:

Portfolio A: 8.5% - (0.005)(5)(15.1%)2 = 2.80%


Portfolio B: 8.8% - (0.005)(5)(15.8%)2 = 2.56%
Portfolio C: 9.2% - (0.005)(5)(17.0%)2 = 1.98%

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Level III Page 16

Note that E(Rm) and σ2m are expressed as percentages rather than as decimals in the calculation.

Portfolio A is chosen because it offers the highest expected utility given the investor’s level of
risk aversion.

Allocation:
✓ 1 point each for each correct calculation of utility-adjusted expected returns (maximum 3)
✓ 1 point for providing a justification of Portfolio A as the best allocation based on this metric

Question 5, Part D (4 minutes)


Based only on the safety-first criterion, Lockhart should select Portfolio C because it maximizes
the safety-first ratio and has the lowest probability of falling below his stated minimum
acceptable return of 4.5%. The safety-first ratio is calculated as follows:

𝐸(𝑅𝑝 ) − 𝑀𝐴𝑅
𝑆𝐹𝑅𝑎𝑡𝑖𝑜 =
𝜎𝑝
where
SFRatio = safety-first ratio
E(Rp) = expected return of the portfolio
MAR = minimum acceptable return
σp = standard deviation of portfolio returns

The safety-first ratios of the portfolios shown in Exhibit 1 are:

Portfolio A: (8.5% - 4.5%)/15.1% = 0.265


Portfolio B: (8.8% - 4.5%)/15.8% = 0.272
Portfolio C: (9.2% - 4.5%)/17.0% = 0.276

Portfolio C is chosen because it offers the highest safety-first ratio given Lockhart’s minimum
acceptable return.

Allocation:
✓ 1 point each for each correct calculation of Roy’s safety-first ratio (maximum 3)
✓ 1 point for providing a justification of Portfolio C as the best allocation based on this metric

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Level III Page 17

Question 5, Part E (6 minutes)


Economic net worth is the value of extended portfolio assets net of his extended portfolio
liabilities. For Lockhart these inputs can be summarized on a pre-tax basis as follows:

Extended portfolio
Extended portfolio assets
liabilities
Equity – DM stock 200,000 Mortgage 200,000
Equity – Other 210,000 PV of future spending 1,250,000
Fixed Income 300,000 PV of son’s education 225,000
Human capital 925,000
Home (gross) 800,000
Total 2,435,000 1,675,000

Lockhart’s economic net worth is 2,435,000 – 1,675,000 = 760,000

Allocation:
✓ 2 points for correctly calculating Lockhart’s total economic assets
✓ 2 points for correctly calculating Lockhart’s total economic liabilities
✓ 2 points for correctly calculating Lockhart’s economic net worth

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Level III Page 18

Question 6 (17 minutes total)


Question 6, Part A (6 minutes)
Template for Question 6-A
Identify two factors related to
the characteristics of Partko’s
workforce that indicate the
Justify each response with one reason
Plan’s ability to take risk is
below the automotive parts
industry average.
1. Ratio of active to inactive A larger proportion of inactive lives reduces a defined-
participants benefit pension plan’s ability to take risk by increasing the
liquidity requirement as there are more participants collecting
benefits relative to the number of active participants who are
contributing new funds. The Plan’s ratio of active lives to
inactive lives (0.75) is below the industry average (0.86).

2. Average age of participants The ability of a defined-benefit pension plan to take risk
decreases as the average age of its participants increases
because the duration of liabilities decreases and must be
offset by holding shorter duration assets. The Plan’s average
age (53) is higher than the industry average (48)

Allocation:
✓ 1 point for correctly identifying a factor relating to Partko’s workforce characteristics
(maximum 2)
✓ 2 points for providing an accurate justification for this factor indicating an ability to take risk
that is below the industry average (maximum 4)

Commentary on Question:
The Plan’s below-average ability to take risk is also indicated by other factors, such as:
• the provision for a partial lump-sum payment, which is not common in the industry
• the sponsor’s below-average operating margin and above-average debt-to-assets ratio

However, these factors are not related to workforce characteristics. Other factors (higher funded
status and lower correlation between asset returns and sponsor’s operating profits) indicate an
above-average ability to take risk if considered in isolation.

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Level III Page 19

Question 6, Part B (3 minutes)


There are two indicators that the Plan has an above-average risk tolerance relative to its peers.

It has a higher funded status than its peers. Compared to plans in a deficit position relative to the
present value of their liabilities (the average status of plans in this industry), Partko’s fully-
funded plan is better positioned to absorb the greater potential losses associated with risker
investments.

The correlation between the Plan’s returns and its sponsor’s profitability is lower than the
industry average. This increases ability to take risk because it is more likely that the sponsor will
have the funds required to make additional contributions in the event that the Plan experiences
poor returns and its funded status falls into a deficit position.

Allocation:
✓ 1 point for correctly identifying a factor indicating above-average risk tolerance
✓ 2 points for providing an accurate justification for this factor indicating an ability to take risk
that is below the industry average

Question 6, Part C (4 minutes)


Cash balance plans are like defined-benefit plans in that the sponsor is still largely (if not
entirely) responsible for bearing investment risk.

Cash balance plans are like defined-contribution plans in that participants receive individual
account statements with information on accumulated value, contributions, and earnings credits.
Cash balance plans may also be like defined-contribution plans to the extent that employees bear
any investment risk, however, the sponsor retains most (if not all) of this risk.

Allocation:
✓ 2 points for identifying a characteristic shared with defined-benefit plans
✓ 2 points for identifying a characteristic shared with defined-contribution plans

Question 6, Part D (4 minutes)


Cash balance plans are typically provided as a result of a defined-benefit plan being terminated
and converted into a hybrid plan. Such plans have been criticized for providing existing
participants with lower benefits than they would have received if their existing defined-benefit
plan had not been converted. Partko could mitigate its exposure to this potential criticism by
“grandfathering” the Plan’s current participants – giving them the option to continue with the
existing defined-benefit plan rather than requiring them to participate in the new cash balance
plan.

Allocation:
✓ 2 points for identifying a criticism of cash balance plans
✓ 2 points for identifying a measure to mitigate Partko’s exposure to this potential criticism

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Level III Page 20

Question 7 (15 minutes total)


Question 7, Part A (4 minutes)
A mandate requiring the Foundation to maintain a concentrated position of KC common stock
(42% of total asset value) limits its ability to hold a diversified portfolio and creates significant
unsystematic risk exposure. One action that trustees could take to mitigate this disadvantage
while still complying with the mandate is to enter a derivative contract such as a swap agreement
that exchanges the returns on the concentrated position of KC shares for the returns on a
diversified portfolio.

Allocation:
✓ 2 points for discussing limited ability to diversify as a disadvantage
✓ 2 points for identifying a swap agreement (or similar derivative contract as a possible action
to mitigate the effects of this mandate

Question 7, Part B (3 minutes)


The components of the Foundation’s nominal required return are:
• 5.2% annual spending requirement
• 0.45% management expense rate
• 2.1% expected inflation

Nominal required return can be calculated using one of the following methods:

Additive method 5.2% + 0.45% + 2.1% = 7.75%


Multiplicative method (1 + 0.052) x (1 + 0.0045) x (1 + 0.021) – 1 = 7.89%

Allocation:
✓ 2 points for correctly identifying the components of nominal required return
✓ 1 point for correctly calculating nominal required return using one of two acceptable methods

Commentary on Question:
The additive method of calculating required return produces an approximate estimate, but does
not account for the effect of compounding over multiple periods. The multiplicative method is
more precise because it does account for this effect. Either method appears to be acceptable for
exam purposes.

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Level III Page 21

Question 7, Part C (4 minutes)


The Foundation has a single-stage, long-term investment time horizon. There are two appropriate
justifications:
• The Foundation does not have a spend down mandate
• Trustees plan to maintain the 5.2% spending rate

Allocation:
✓ 1 point for correctly identifying the time horizon as single-stage
✓ 1 point for correctly identifying the time horizon as long-term
✓ 2 points for providing an appropriate justification

Question 7, Part D (4 minutes)


The Foundation’s liquidity requirement for the coming year is the sum of its spending and
management expenses, which are both based on the year-end value of portfolio assets, less
sponsor contributions. Specifically:

Spending 9,564 million x 0.052 = 497,328,000


Management expenses 9,564 million x 0.0045 = 43,038,000
Sponsor contribution 145 million x (1.052) = 152,540,000

497,328,000 + 43,038,000 – 152,540,000 = JPY 387,826,000

Allocation:
✓ 1 point for correctly identifying the components of the Foundation’s liquidity requirement
✓ 2 points for calculating the correct values of these components
✓ 1 point for correctly calculating the Foundation’s liquidity requirement

Commentary on Question:
Note that the sponsor contribution was JPY 145 million last year and grew by the real spending
rate of 5.2%.

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Level III Page 22

Question 8 (20 minutes total)


Question 8, Part A (3 minutes)
Manager C is following the passive investment approach. A returns-based analysis reveals that,
with a style fit score of 100%, none of Manager C’s returns are attributable to selection – the
portion of return that is unexplained by style.

Allocation:
✓ 1 point for correctly identifying the investment approach as passive
✓ 2 points for using a returns-based approach as justification (citing style fit)

Commentary on Question:
In a passive investment approach, the investor does not try to adjust his expectations by making
changes in the securities holdings. The investor tries to mimic any index to get the same returns
as that of the index.

Returns-based analysis is conducted using historical return data. The portion of a manager’s
returns attributable to active selections is calculated as (1 – style fit score).

Question 8, Part B (3 minutes)


The CAC 40 index, which represents the performance of the broad asset class of French equities,
is an inappropriate benchmark for Manager B, who appears to be pursuing a valuing investing
style characterized by stock with low P/E and P/B ratios, high dividend yields, and low expected
EPS growth. It would be more appropriate to assess Manager B’s performance relative to a style
index composed of value stocks.

Allocation:
✓ 1 point for noting that the CAC 40 is a broad market index
✓ 1 point for noting that Manager B is pursuing a value investing style
✓ 1 point for recommending a value style index as a more appropriate benchmark

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Level III Page 23

Question 8, Part C (6 minutes)


i.
The risks associated with a growth investing style are:
- Expected earnings growth may not materialize
- A contracting P/E ratio can compound the losses associated with lower-than-expected
earnings
ii.
The main risk of a market-oriented investing style is that investors may pay higher fees for
active management, while earning returns that are not significantly higher (and possibly
lower) than the returns that could have been earned by following a passive indexing strategy.
These returns must be compared on a net-of-fees basis.

iii.
The risks associated with a value investing style are:
- There may be valid reasons for a stock to be trading at an apparently attractive price
multiple
- Even if stocks are mispriced, it is not possible to know when their prices will adjust to be
reflective of intrinsic value

Allocation:
✓ 2 points for correctly identifying one risk associated with each investment style (no more
than one risk per style, maximum 6 points total)

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Level III Page 24

Question 8, Part D (4 minutes)


The active return and tracking risk for AM’s EUR 700 million domestic equity portfolio are
calculated as follows:

Portfolio active return

200 100 400


= (700) × (2.2%) + (700) × (1.7%) + (700) × (0.0%) = 0.87%

Portfolio tracking risk


0.5
200 2 100 2 400 2
= [( ) × (5.2%)2 + ( ) × (4.4%)2 + ( ) × (0%)2 ] = 1.61%
700 700 700

Allocation:
✓ 2 points for correctly calculating active return
✓ 2 points for correctly calculating tracking risk

Commentary on Question:
Active return is the return of a portfolio above the benchmark returns. Active returns for a
portfolio are calculated as the weighted average of the managers’ active returns for all the
managers weighted by the assets under management.

Active risk is the standard deviation of the difference in the portfolio and benchmark returns
over time. When all its sources of active return are assumed to be uncorrelated, a portfolio’s
active risk is calculated as the square root of the weighted average of the squared managers’
active risk for all the managers, weighted by the squared assets under management.

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Level III Page 25

Question 8, Part E (4 minutes)


The potential disadvantages investors face when a manager drifts away from his or her stated
style are:
- Investors are no longer getting their desired level of systematic risk exposure
- Managers who drift away from their stated style may be trading securities about which
they lack sufficient expertise

Allocation:
✓ 2 points for correctly identifying each potential disadvantage (maximum 4)

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Level III Page 26

Question 9 (18 minutes total)


Question 9, Part A (4 minutes)
Schiff’s recommendation of a wider corridor for domestic equities relative to non-domestic
equities is supported by the following:
• Returns for domestic equities have a higher correlation with portfolio returns
• Returns for domestic equities are less volatile
• The volatility of other asset classes in the portfolio is slightly higher for domestic equities
because non-domestic equities are relatively more volatile

Allocation:
✓ 2 points for each correct reason cited as justification (maximum 4)

Commentary on Question:
Transaction costs are lower for domestic equities compared to non-domestic equities, which
would support a relatively narrower corridor width.

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Level III Page 27

Question 9, Part B (5 minutes)


Template for Question 9-B
Determine the development that would
most likely cause Schiff to recommend a Explain, for each development not chosen, why it
change in Valke’s SAA. would not justify a change to the SAA.
(circle one)
While an unexpected interest rate rise might justify
a change in tactical asset allocation based on
changes in short-term capital market expectations,
the Swiss central bank’s actions are consistent with
Development 1 its long-standing policy and there is no reason to
believe that long-term capital market expectations,
which determine SAA, have been altered.

Although the proportion of Valke’s portfolio


represented by domestic bonds has breached the
lower bound of that asset class’ corridor, the
appropriate response is to rebalance the portfolio
Development 2 back to target weights. This is not a reason to alter
Valke’s SAA.

Development 3

Allocation:
✓ 1 point for selecting the correct development
✓ 2 points for each correct explanation for why a development that wasn’t chosen would justify
a change to SAA (maximum 4 points)

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Level III Page 28

Question 9, Part C (6 minutes)


Template for Question 9-C
Note: The same characteristic cannot be used for both responses.
Recommend the most
appropriate trade execution
tactic – crossing network,
implementation shortfall, or Justify your response with one characteristic of the
Order
volume-weighted average price proposed trade.
(VWAP) – for each of the
following orders:
(circle one)
i. Buy ABC 1. The urgency to complete the trade is low.
shares crossing network
2. The order size represents a relatively large
proportion of average daily trading volume.
implementation shortfall

volume-weighted average price


(VWAP)

ii. Buy KLM 1. The urgency to complete the trade is high.


shares crossing network
2. The order size represents a relatively small
proportion of average daily trading volume.
implementation shortfall

volume-weighted average price


(VWAP)

Allocation:
✓ 1 point for recommending the correct trade execution tactic (maximum 2)
✓ 2 points for providing an appropriate justification (maximum 4)

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Level III Page 29

Question 9, Part D (3 minutes)


The unrealized profit/loss component of implementation shortfall, also known as missed
opportunity trading cost, is calculated as follows:

𝑃𝑐 − 𝑃𝑏
% 𝑜𝑓 𝑜𝑟𝑑𝑒𝑟 𝑢𝑛𝑓𝑖𝑙𝑙𝑒𝑑 × ( )
𝑃𝑏

where
𝑃𝑐 = cancellation price
𝑃𝑏 = original benchmark price

In this example,

18,000 − 7,200 5.68 − 5.63


( )×( ) = 0.005328, 𝑜𝑟 53 𝑏𝑎𝑠𝑖𝑠 𝑝𝑜𝑖𝑛𝑡𝑠
18,000 5.63

Allocation:
✓ 1 point for recognizing that unrealized profit/loss is missed opportunity trading cost (MOTC)
✓ 1 point for correctly identifying the formula for calculating MOTC
✓ 1 point for correctly calculating MOTC in bps

Commentary on Question:
Implementation shortfall is the difference between the money return on the “paper” portfolio in
which positions are established at the price when the trade decision is made (the decision price),
and the portfolio’s actual return.

There are four components of implementation shortfall:


1. Explicit costs, which include commissions, taxes, and fees
2. Realized profit/loss – price movement from decision price to execution price for the
portion of the trade executed on the day it is placed
3. Slippage / delay – change in price over the day an order is placed when the order is not
executed that day
4. Missed trade opportunity cost – price difference between trade cancellation price and
original benchmark price, based on amount of order not filled

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Level III Page 30

Question 10 (17 minutes total)


Question 10, Part A (12 minutes)
Template for Question 10-A
Note: Two biases are required for each client but there are three possible answers
i. Identify two behavioral biases
Justify each identified bias with one example from the information provided.
exhibited by Sherman.
1. Confirmation bias Sherman ignores evidence that contradicts his view that now is a good time to
purchase the shares of the Canadian retailers that will be selling Sunny Farms’
products.

2. Availability bias Sherman’s narrow range of experience has limited his investment opportunity
set and resulted in an insufficiently diversified portfolio in which retailers are
significantly overweighted.

3. Representativeness bias Sherman is confident that his investments in the shares of Canadian retailers
will be successful because he has “never been disappointed” with similar
investments in the shares of US retailers that carry Sunny Farms’ products and
he expects this trend to continue.

ii. Identify two behavioral


Justify each identified bias with one example from the information provided.
biases exhibited by Warner.
1. Endowment bias Warner will not sell her Rivaldi Corp. shares based on a sense of loyalty to her
family, despite acknowledging that this is not how she would allocate an
equivalent amount of cash.

2. Status quo bias Warner claims that she cannot remember the last time she rebalanced or even
checked the value of her portfolio.

3. Mental accounting bias Warner has mentally allocated the shares that she has inherited from her
grandfather to fund the purchase of “something special” when she retires.

Allocation:
✓ 1 point for correctly identifying a behavioral bias (maximum 2 per client)
✓ 2 points for providing a correct justification from the information provided (maximum 4
points per client)

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Level III Page 31

Question 10, Part B (5 minutes)


Template for Question 10-B
Note: Two justifications are required but there are three possible answers
Identify the behavioral
investment type (Active
Accumulator, Friendly Follower, Justify your response with one reason related to his behavioral biases and one
Independent Individualist, Passive reason related to his investment approach.
Preserver) that Schnetzer would
most likely classify Sherman into.
1. Sherman’s exhibits confirmation bias, availability bias, and
representativeness bias, which are all cognitive, not emotional, in nature and
typically observed in Independent Individualists.
Active Accumulator

Friendly Follower

2. Sherman has risked his own capital to create wealth and prefers to be in
control of both his business and his investments. Additionally, equities
Independent Individualist represent a significant proportion of his wealth. All of this indicates that
Sherman is an active investor with an above-average level of risk tolerance,
which is consistent with the profile of an Independent Individualist.

Passive Preserver

Allocation:
✓ 1 point for correctly identifying Sherman’s behavioral investor type
✓ 2 points for providing a correct justification (maximum 4)

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