CFA Level III 1999 Exam Answers PDF

Level III: Question 1
Topic: Individual Investor Policy Statements

Minutes: 24
Reading References:
1. “Individual Investors,” Ch. 3, Ronald W. Kaiser, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham
and Lamont, 1990)
2. Cases in Portfolio Management, John W. Peavy III and Katrina F. Sherrerd, (AIMR, 1990)
3. Questions 1 and 2, including Guideline Answers, 1995 Level III Examination (AIMR)
Purpose:
To test the candidate’s ability to develop a long-term investment policy statement for a family with
changing resources and return needs over time. Specific tax and unique circumstances are included
for consideration.
LOS: The candidate should be able to

“Individual Investors” (Session 13)
• analyze the objectives and constraints of a particular individual investor and use the investor’s
psychological characteristics, position in the life-cycle, long-term goals and particular
constraints (such as liquidity, taxes, gifts and estate planning) to formulate appropriate
investment policies for the investor;
• create a set of portfolio policies that is based on a multi-asset, total return approach to individual
investing.
Cases in Portfolio Management (Session 22)
• create a formal investment policy statement for an investor.
1995 CFA Level III Examination (Session 22)
• prepare an investment policy statement that clearly states the investment objectives and
constraints of a client;
• justify all recommendations and statements included in the investment policy statement.
Guideline Answer:
The objectives and constraints portion of the Muellers’ investment policy statement should include
the following objectives and constraints:
Objectives:
i. Return Objective. The Muellers’ return objective should be a total return approach that is a
combination of capital appreciation and capital preservation. After retirement, they will need
approximately $75,000 (adjusted for inflation) annually to maintain their current standard of
living. Given their limited needs and asset base, preserving their financial position on an
inflation-adjusted basis may be a sufficient objective. However, their long life expectancy and
undetermined retirement needs lead to the likely need for some growth of assets over time, at
least to counter any effects of inflation.
1999 Level III Guideline Answers

Morning Section – Page 1
Although the Muellers wish to exclude the future trust distribution from their current planning,
that distribution will substantially increase their capital base and dramatically alter the return
objective of their future investment policy statement, primarily by reducing their needed return
level.
ii. Risk Tolerance. The Muellers are in the middle stage of their investor life cycle. Their
relationship of income to expenses, total financial resources, and long time horizon give them
the ability to assume at least an average, if not an above average, level of risk in their
investments. However, their stated preference of “minimal volatility” investments apparently
indicates a below average willingness to assume risk. The large realized losses incurred in
previous investments may be a contributing factor to their desire for safety. Also, their need for
continuing cash outflow to meet their daughter’s college expenses may temporarily and slightly
reduce their ability to take risk.
Two other issues affect the Muellers’ ability to take risk. First, the holding of Andrea’s company
stock represents a large percentage of the Muellers’ total investable assets and thus is an
important risk factor for their portfolio. Reducing the size of this holding or otherwise reducing
the risk associated with a single large holding should be a priority for the Muellers. Second, the
future trust distribution will substantially increase their capital base and therefore increase their
ability to assume risk. However, the larger capital base would reduce their need for higher
returns, and the corresponding higher risk levels.
Constraints:
iii. Time Horizon. Overall, the Mueller’s ages and long life expectancies indicate a long time
horizon. However, they face a multi-stage time horizon because of their changing cash flow and
resource circumstances. Their time horizon can be viewed as three distinct stages: the next five
years (some assets, negative cash flow because of their daughter’s college expenses), the
following five years (some assets, positive cash flow), and beyond ten years (increased assets
from a sizable trust distribution, decreased income because they plan to retire).
iv. Liquidity. The Muellers need both immediate liquidity and ongoing funds over the next five
years. They need to have $50,000 available now for the contribution to the college’s endowment
fund. Alternatively, they may be able to contribute $50,000 of Andrea’s low cost basis stock to
meet the endowment obligation. In addition, they expect the regular annual college expenses to
exceed their normal annual savings (combined incomes minus usual living expenses) by
approximately $15,000 for each of the next five years. This relatively low cash flow
requirement of 2.7 percent ($15,000/$550,000 asset base after $50,000 contribution) can be
substantially met through income generation from their portfolio, further reducing the need for
sizable cash reserves. Once their daughter has completed college, their liquidity needs should be
minimal until retirement because their income more than adequately covers their living
expenses.
v. Taxes. The Muellers are subject to a 30 percent marginal tax rate for ordinary income and a 20
percent rate for realized capital gains. The difference in the rates makes investment returns in
the form of capital gains preferable to equivalent amounts of taxable dividends and interest.

While taxes on capital gains would normally be a concern to investors with low cost basis stock,
this is not a major concern for the Muellers because they have a tax loss carry forward of
$100,000. The Muellers can offset up to $100,000 in realized gains with the available tax loss
carry forward without experiencing any cash outflow or any reduction in asset base.
vi. Unique Circumstances. The large holding of the low-basis stock in Andrea’s company, a
“technology firm with a highly uncertain future,” is a key factor to be included in the evaluation
of the risk level of the Mueller’s portfolio and the future management of their assets. In
particular, the family should systematically reduce the size of the investment in this single stock.
Because of the existence of the tax loss carry forward, the stock position can be reduced by at
least 50 percent (perhaps more depending on the exact cost basis of the stock) without reducing
the asset base to pay a tax obligation.
In addition, the trust distribution in 10 years presents special circumstances for the Muellers,
although they prefer to ignore these future assets in their current planning. The trust will provide
significant assets to help meet their long term return needs and objectives. Any long-term
investment policy for the family must consider this circumstance and any recommended
investment strategy will need to be adjusted before the distribution takes place.

Topic: Investment Policy Statements
Minutes: 6
Reading references:
1. “Developing an Investment Policy Statement,” including Appendix, Ch. 5, The Management
of Investment Decisions, Donald B. Trone, William R. Allbright and Phillip R. Taylor
(Irwin, 1996)
Purpose:
To test the candidate’s knowledge of why investment policy statements are important in achieving
long term financial objectives and encouraging a healthy client/manager relationship.
LOS: The candidate should be able to:

“Developing an Investment Policy Statement” (Session 12)
• explain why creating an investment policy statement is good discipline, virtually indispensable,
and also sometimes legally required.
• discuss the overall portfolio management process leading to the asset allocation decision,
including the stage devoted to investor information requirements (i.e., objectives and
constraints) and the stage devoted to analyzing capital market expectations.
Guideline Answer:
A potential benefit of using a written investment policy statement that contradicts each of the
comments is:
• A policy statement identifies the pertinent investment objectives and constraints. Clearly
identified objectives and constraints help an investor, and investment manager, to focus on
appropriate investment strategies among the universe of possible strategies. The result should be
an optimal balance between return seeking and risk taking and an increased probability of
success in achieving investment goals.
• An investment policy statement provides a long-term plan for an investor and a basis for making
disciplined investment decisions over time. The absence of a policy statement reduces decision
making to an individual event basis and often leads to chasing short-term opportunities that may
not contribute to, or may even take away from, reaching long-term goals. The presence of a
policy encourages all parties to maintain their focus on the long-term nature of the investment
process, especially during turbulent times.
• A written policy statement can provide continuity from current manager(s) to future ones. In the
Mueller’s case, this could contribute to meeting long-term goals if they decide in the future to
hire an investment manager or if the control of their assets passes to their daughter or others
acting on their behalf. A well thought out policy will evolve over time but likely will not be
subject to a complete overhaul because of a change in managers. Similarly, a policy statement
can enhance communication between an investment manager and client by clarifying issues of
importance and concerns to either party. Improved communication, in turn, increases the
likelihood that the investment manager will faithfully implement the agreed-upon plan.

Topic: Asset Allocation
Minutes: 12
Reading References:
1. “Asset Allocation,” Ch. 7, William F. Sharpe, Managing Investment Portfolios: A Dynamic
Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham &
Lamont, 1990), pp. 7-1 through 7-27.
3. Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR)
4. Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR)
Purpose:
To test the candidate’s knowledge of asset allocation issues by using a common example of
investors, who have built up a collection of assets over time, seeking advice from a portfolio
manager on the strengths and weaknesses of their portfolio asset allocation.

“Asset Allocation” (Session 12)
• formulate major steps in the asset allocation process.
• recommend and justify a general asset allocation that would be appropriate for an investor.
• recommend an asset allocation and justify the recommendation;
• justify the use of specific asset classes and relate the asset allocation to the investment policy
statement.
• recommend and justify an asset allocation and clearly state any assumptions, especially the risk
tolerance of the client, that contributed to the recommendation.
Guideline Answer:
The Muellers’ portfolio can be evaluated in terms of the following criteria:
i. Preference for “Minimal Volatility.” The volatility of the Muellers’ portfolio is likely to be
much greater than minimal. The asset allocation of 95 percent stocks and 5 percent bonds
indicates that substantial fluctuations in asset value will likely occur over time. The asset
allocation’s volatility is exacerbated by the fact that the beta coefficient of 90 percent of the
portfolio (i.e., the four growth stock allocations) is substantially greater than 1.0. Thus the
allocation to stocks should be reduced, as should the proportion of growth stocks or higher beta
issues. Furthermore, the 5 percent allocation to bonds is in a long-term zero coupon bond fund
that will be highly volatile in response to long-term interest rate changes; this bond allocaton
should be exchanged for one with lower volatility (perhaps shorter maturity, higher grade
issues).

ii. Equity Diversification. The most obvious equity diversification issue is the concentration of 35
percent of the portfolio in the high beta small cap stock of Andrea’s company, a company with a
highly uncertain future. A substantial portion of the stock can and should be sold, which can be
done free or largely free of tax liability because of the available tax loss carry forward. Another
issue is the 90 percent concentration in high beta growth stocks, which contradicts the Muellers’
preference for minimal volatility investments. The same is true of the portfolio’s 45 percent
allocation to higher volatility small cap stocks. Finally, the entire portfolio is concentrated in the
domestic market. Diversification away from Andrea’s company’s stock, into more value stocks,
into more larger cap stocks, and into at least some international stocks is warranted.
iii. Asset Allocation (including cash flow needs). The portfolio has a large equity weighting that
appears to be much too aggressive given the Muellers’ financial situation and objectives. Their
below average risk tolerance and limited growth objectives indicate that a more conservative,
balanced allocation is more appropriate. The Muellers are not invested in any asset class other
than stocks and the small bond fund holding. A reduction in equity investments, especially
growth and small cap equities, and an increase in debt investments is warranted to produce more
consistent and desired results over a complete market cycle.
In addition, the Muellers have no cash reserve or holdings of short-term high grade debt assets.
In the very near future, the Muellers will need $50,000 (up front payment) and at least part of
$40,000 (first year’s tuition and living expenses) for their daughter’s college education, as well
as some reserve against normal expenses. In addition, they expect to have negative cash flow
each year their daughter is in college, which should lead them to increase their cash reserves.
The current portfolio is likely to produce a low level of income because of the large weighting
in growth stocks and because the only bond holding is a long-term zero coupon fund. Also, the
marketability of Andrea’s company stock is unknown and could present a liquidity problem if it
needs to be sold quickly. After their immediate cash needs are met, the Muellers will need a
modest, ongoing allocation to cash equivalents.

Topic: Tax/Mutual Fund Issues
Minutes: 16
Reading References:
1. “Mutual Fund Misclassification: Evidence Based on Style Analysis,” Dan DiBartolomeo
and Erik Witkowski, Financial Analysts Journal (AIMR, September/October 1997)
2. “Tax Considerations in Investing,” Ch. 8, Robert H. Jeffrey, The Portable MBA in
Investment, Peter L. Bernstein, ed. (John Wiley & Sons, 1995)
Purpose:
To test the candidate’s understanding of how tax and mutual fund considerations affect investment
returns and investment strategies.

“Mutual Fund Misclassification: Evidence Based on Style Analysis” (Session 11)
• discuss why a mutual fund could be misclassified in regard to its investment guidelines.
“Tax Considerations in Investing” (Session 13)
• explain the importance of taxation on investment policy and discuss taxes as an investment
expense;
• differentiate capital gains and dividends and compare the taxation of each;
• analyze the impact of turnover on the portfolio when taxes are considered and calculate the
effect of turnover at a given tax rate;
• analyze the profile of an individual investor, discuss the impact of spending requirements on
overall investment performance, discuss the probability of realizing capital gains taxes, and
discuss the benefits of deferring capital gains taxes;
• discuss the advantages and disadvantages of realizing losses.
Guideline Answer:
A. Compared to the Superior Growth and Income Fund, the Exceptional Growth and Income Fund
is more consistent with the Muellers’ goal with regard to both the return volatility and the
expected one-year after-tax return.
i. Return Volatility. The Exceptional Fund has had a substantially lower beta than the Superior
Fund. Based on the betas, Exceptional has been slightly less volatile than the overall market
while Superior has been considerably more volatile than average. Exceptional has also
exhibited more consistent performance in the past, producing a lower return in up markets
and a higher return in down markets.
ii. Expected One-Year After-Tax Return (assuming all turnover resulted in gains). The
Exceptional Fund’s expected one-year after-tax return is 9.73 percent and the Superior
Fund’s comparable return is 9.50 percent. Each fund’s gross (pre-tax) total return is
composed of the fund’s capital appreciation and dividend yield. The gross appreciation rate
is the expected realized capital gains (estimated by the fund’s turnover rate) taxed at the
client’s capital gains tax rate (20% in the case of the Muellers). The gross dividend return is

reduced by the client’s applicable ordinary income tax rate (30% for the Muellers). The
expected after-tax return can be estimated by:
= taxed capital gain + taxed dividend yield + non-taxed capital gain

OR
= [(total return – yield) × (turnover rate) × (1 – capital gains tax rate)]
+ [yield × (1 – income tax rate)] + [(total return – yield) × (1 – turnover rate)]
OR
= (total return – yield) × (1 – turnover rate × capital gains tax rate)
+ [yield × (1 – income tax rate)]
= total return – (yield × ordinary tax rate) – [(total return – yield) × turnover × capital
gains tax rate]
The Exceptional Fund’s expected after-tax return is:
= [(0.105 – 0.02) × (1 – 0.10 × 0.20)] + [0.02 × (1 – 0.30)]

= [0.085 × (1 – 0.02)] + [0.02 × 0.70]
= [0.085 × 0.98] + 0.014
= 0.0833 + 0.014
= 0.0973, or 9.73%
The Superior Fund’s expected after-tax return is:
= [(0.11 – 0.01) × (1 – 0.60 × 0.20)] + [0.01 × (1 – 0.30)]

= [0.10 × (1 – 0.12)] + [0.01 × 0.70]
= [0.10 × 0.88] + 0.007
= 0.088 + 0.007
= 0.095, or 9.50%
B. Realized losses can add value to a portfolio. Realized losses can be used as a direct offset to
capital gains already realized or to those to be realized in the future. In effect, realized losses can
be exchanged for monies that would otherwise be paid to the taxing authority, creating
additional “cash in the bank”. The greatest tax benefit and addition to portfolio value is likely to
occur if losses are realized whenever they are available rather than waiting until the end of a tax
year to sell any losers. Obviously, realizing losses can add to the value of a portfolio only as
long as the tax benefit is greater than the trading costs that are incurred. Otherwise, realizing tax
losses does have a negative effect on portfolio value.

Topic: Investment Policy Statement
Minutes: 12
Reading References:
1. “Asset Allocation,” Ch. 7, pp. 7-1 through 7-27, William F. Sharpe, Managing Investment
Portfolios: A Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds.
(Warren, Gorham & Lamont, 1990)
3. Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR)
Purpose:
To test the candidate’s ability to select appropriate asset allocation strategies for various clients’
objectives and constraints.

• formulate major steps in the asset allocation process.
• recommend an asset allocation and justify the recommendation;
• justify the use of specific asset classes and relate the asset allocation to the investment policy
statement.
• recommend and justify an asset allocation and clearly state any assumptions, especially
regarding the risk tolerance of the client, that contributed to the recommendation.
Guideline Answer:
A. Personal Portfolio
Portfolio A is the most appropriate portfolio for the Muellers. Because their pension income will
not cover their annual expenditures, the shortfall will not likely be met by the return on their
investments so the 10 percent cash reserve is appropriate. As the portfolio depletes over time, it
may be prudent to allocate more than 10 percent to cash equivalents. The income deficit will be
met each year via a combination of investment return and principal invasion.
Now that their daughter is financially independent, the Mueller’s sole objective for their
personal portfolio is to provide for their living expenses. Their willingness and need to take on
risk is fairly low. Clearly, there is no need to expose the Muellers to the possibility of a large
loss. Also, their time horizon has been shortened considerably because of their health situation.
Therefore, a 70 percent allocation to intermediate term high grade fixed income securities is
warranted.

The income deficit will rise each year as the Muellers’ expenses rise with inflation but their
pension income need remains constant. The conservative 20 percent allocation to equities
should provide diversification benefits and some protection against unanticipated inflation over
the expected maximum 10-year time horizon.
Portfolio B, the second best portfolio, has no cash reserves so the Mueller’s liquidity needs
would not be met. Also, although it has a higher expected return, Portfolio B’s asset allocation
results in a somewhat higher standard deviation of returns than Portfolio A.
Portfolios C and D offer higher expected returns but at markedly higher levels of risk and with
relatively lower levels of current income. The Mueller’s large income requirements and low risk
tolerance preclude the use of Portfolios C and D.
B. Trust Distribution Portfolio
Portfolio B is the most appropriate portfolio for the trust assets. Portfolio B’s expected return of
5.8 percent exceeds the required return of 5.4 percent, and the required return would actually
decline if the surviving spouse lives longer than five years. The time horizon for the portfolio is
relatively short, ranging from a minimum of five years to a maximum of 10 years. The
Mueller’s sole objective for these funds is to provide adequate funds for the building addition.
Growth requirements for the portfolio are modest and the Mueller’s willingness to take on risk
is low. The portfolio would be unlikely to achieve its objective if large, even short term, losses
were absorbed during the minimum five year time horizon. Except for taxes, no principal or
income disbursements are expected for at least five years; therefore, only a minimal or even
zero cash reserve is required. Accordingly, an allocation of 40 percent to equities to provide
some growth and 60 percent to intermediate fixed income to provide stability and capital
preservation is appropriate.
There is no second best portfolio. Portfolio A’s cash level is higher than necessary and the
portfolio’s expected return is insufficient to achieve the $2,600,000 value within the minimum
5-year time horizon. Portfolio C has an expected return sufficient to achieve the $2,600,000
value in five years but it has a higher cash level than is necessary and, more importantly, it has a
standard deviation of returns that is too high given the low risk tolerance of the trust portfolio.
Portfolio D has a high enough return and the appropriate cash level but a clearly excessive risk
(standard deviation) level. Portfolios C and D share the flaw of having excessive equity
allocations that fail to recognize the relatively short time horizon and that generate risk levels
that are much higher than necessary or warranted.

Topic: Derivatives
Minutes: 33
Reading Reference:
1. “Using Interest Rate Futures in Portfolio Management,” Concepts and Applications (Board
of Trade of the City of Chicago, 1988)
2. “Interest Rate Futures: Refinements,” Futures, Options and Swaps, 2nd edition, Ch. 6,
Robert W. Kolb (Blackwell 1997)
Purpose
To test the candidate’s ability to apply an understanding of interest rate futures to the adjustment of
fixed income portfolio duration; evaluate the use of futures to accomplish duration adjustment; and
demonstrate an understanding that this use of futures has not addressed immunization risk.

“Using Interest Rate Futures in Portfolio Management” (Session 17)
• create, design, and evaluate a duration-increasing or -decreasing strategy using bond futures;
• appraise the advantages and disadvantages of using financial futures for asset allocation.
“Interest Rate Futures: Refinements” (Session 17)
• compare and contrast the various hedging strategies or models that can be used when hedging
with T-bond futures, including computations involved in the various methodologies;
• compare and contrast a cross-hedge and a perfect hedge, including computing the number of
futures contracts and providing an ex post evaluation indicating the distinctions between the two
strategies.
Guideline Answer
A. Futures are an efficient, low-cost tool that can be used to alter the risk and return characteristics
of an entire portfolio with less disruption than using conventional methods. There may also be
both institutional constraints and unfavorable tax consequences that prevent a portfolio manager
such as Klein from liquidating the entire portfolio. Because Treasury bonds and Treasury bond
futures have a very high correlation, the futures approach allows one to effectively create a
temporary fully liquidated position without disturbing the portfolio. Futures can be sold against
the portfolio to replicate the price response of the portfolio with the desired duration. In
addition, there are cost advantages of using futures contracts including lower execution costs
(bid-ask spread), speed and ease of executions (time required), and the higher
marketability/liquidity of futures contracts. The bond sale strategy may well be disadvantageous
on all counts. Shortening the duration by liquidating the bond portfolio would be more costly,
time consuming, and disruptive to the portfolio, with possible adverse tax implications as well.
In Klein’s case, there may be more bonds to sell than futures contracts, because many bonds in
the portfolio could be in denominations as low as $1,000. Also, the bond sales would invoke
liquidity problems not encountered by the bond and futures strategy.
B. The value of the futures contract is 94-05 (i.e., 94 5/32 % of $100,000), which translates into
0.9415625 × $100,000 = $94,156.25.

Using the information given, there are at least two ways, modified duration (MD) or basis point
value (BPV), to calculate the number of contracts.
Using modified duration,
Target Change in Value using MD

= Change in Value using MD hedge + Change in Value using MD portfolio
= (MD hedge × change in yield × Value hedge) +
(MD portfolio × change in yield × Value portfolio)
= (MD per futures × change in yield × N × contract value) +
(MD portfolio × change in yield × Value portfolio)
where N = the number of futures contracts.
Because the target MD is zero, then:

N = – (MD portfolio × Value portfolio) / (MD per futures × contract value)
= – (10 × $100,000,000) / (8 × $94,156.25)
= – 1328 (exact answer –1327.58) or short 1328 contracts.
Using basis point value,
BPV target = BPV portfolio – BPV hedge

BPV target = BPV portfolio – (N × BPV per futures)
and N = (BPV target – BPV portfolio) / BPV per futures
Because the target BPV is zero, then:

N = ($0 – $100,000) / $75.32
= –1328 (exact answer –1327.67) or short 1328 contracts.
Klein is selling the contracts as indicated by the negative value of contracts. The difference in
the two exact answers is due to rounding the BPV number to the nearest cent.
C. Because the newly modified portfolio has approximately a zero modified duration and basis
point value, the value of this portfolio would remain relatively constant for small parallel
changes in rates. With an interest rate increase, the bond portfolio’s immediate market value
would decline, but the positive cash flow from the Treasury bond futures contracts would offset
this loss. As shown in part B, either modified duration or basis point value can be used to
compute the change in value.

Change in Value using MD = MD × change in yield × value, or
Change in Value using BPV = BPV × BP change
i. The $100,000 BPV for the portfolio means that the portfolio value will decrease (increase)
by $100,000 for each basis point increase (decrease). A 10 basis point increase in interest
rates would mean a $1,000,000 decline (or loss) in the market value of the original portfolio.
Change in Value = MD × change in yield × value

= 10 × .001 × $100,000,000
= $1,000,000
OR
Change in Value = BPV × BP change

= 10 × $100,000
= $1,000,000
ii. A $75.32 BPV for the futures contract represents a $75.32 change in value per basis point
per contract. When rates increase by 1 basis point, each futures contract will decrease by
$75.32. However, because Klein is short contracts, she will receive a cash flow of $75.32
from each short contract for each 1 basis point increase.
Using MD, the total cash inflow from the futures position is:
$94156 × 8 × .0001 × 1328 = $1,000,316.
Using BPV, the total cash inflow from the futures position is:
10 × $75.32 × 1328 = $1,000,249.
Differences from exactly $1,000,000 are due to rounding the number of contracts.
iii. The change in value of the hedged portfolio is the sum of the change in value of the original
portfolio and the cash flow from the hedge (futures) position or,
Newly-hedged portfolio change = –$1,000,000 + 1,000,316 ≈ $0 (using MD).
= –$1,000,000 + 1,000,249 ≈ $0 (using BPV).

D. Klein’s hedging strategy might not fully protect the portfolio against interest rate risk for several
reasons. First, immunization risk would remain even after execution of the strategy, because of
the possibility of non-parallel shifts in the yield curve. If the yield curve shifts in a non-parallel
fashion, the modified portfolio is not immunized against interest rate risk because the original
bond portfolio and T-Bond futures exist at different points on the yield curve and hence face
different interest rate changes. If the curve became steeper, for example, then the market value
loss on the original bond portfolio would be accompanied by a less-than-compensating market
value gain on the futures position. Second, the volatility of the yield between the T-bond futures
and the government bond portfolio may not be one-to-one. Hence a yield beta adjustment may
be needed. Third, basis risk also exists between T-bond futures and spot T-bonds, so that there
would still be risk even if the government portfolio held only T-bonds. Fourth, this may still be
a cross-hedge, because the government bonds in the portfolio may not be the same as the
cheapest-to-deliver bond. Fifth, the duration will change as time passes, so risk will arise unless
continual rebalancing takes place. Sixth, because fractional futures contacts cannot be sold, the
duration may not be able to be set exactly to zero.
E. The correct strategy would be to short (write or sell) call options and go long (buy) put options.
The short call position would create a negative cash flow if rates were to decline but the long
put position would create a positive cash flow if rates were to increase. This fully hedges the
portfolio. The call and put options should have the same exercise price and expiration date and
the appropriate notional amounts. The following diagram illustrates this strategy:
Question 6 - Short Call/Long Put at Expiration
Long Put
Short Call
Payoff
Long Put
Long Put+Short Call=Short

Short Call Futures
Combined
Position of Long Put and Short Call
Underlying Value

Topic: Derivatives
Minutes: 18
Reading Reference:
“Interest Rate Futures: Refinements,” Ch. 6, Futures, Options and Swaps, 2nd edition, Robert W.
Kolb (Blackwell 1997)
Purpose:
To test the candidate’s ability to apply an understanding of interest rate futures to the creation of
fixed rate loans from floating rate loans.

“Interest Rate Futures: Refinements” (Session 17)
• create a synthetic floating-rate (fixed-rate) loan from a fixed-rate (floating-rate) loan, including
computing the number of Eurodollar futures required;
• compare and contrast “strip” and “stack” hedges, including computing the number of futures
contracts required.
Guideline Answer
A. The basis point value (BPV) of a Eurodollar futures contract can be found by substituting the
contract specifications into the following money market relationship:
BPV FUT = Change in Value = (face value) × (days to maturity / 360) × (change in yield)
= ($1 million) × (90 / 360) × (.0001)
= $25
The number of contracts, N, can be found by:
N = (BPV spot) / (BPV futures)

= ($2,500) / ($25)
= 100
OR
N = (value of spot position) / (face value of each futures contract)

= ($100 million) / ($1 million)
= 100
OR

N = (value of spot position) / (value of futures position)
= ($100,000,000) / ($981,750)
where value of futures position = $1,000,000 × [1 – (0.073 / 4)]
≈ 102 contracts
Therefore on September 20, Johnson would sell 100 (or 102) December Eurodollar futures
contracts at the 7.3 percent yield. The implied LIBOR rate in December is 7.3 percent as
indicated by the December Eurofutures discount yield of 7.3 percent. Thus a borrowing rate of
9.3 percent (7.3 percent + 200 basis points) can be locked in if the hedge is correctly
implemented.
A rise in the rate to 7.8 percent represents a 50 basis point (bp) increase over the implied LIBOR
rate. For a 50 basis point increase in LIBOR, the cash flow on the short futures position is:
= ($25 per basis point per contract) × 50 bp × 100 contracts

= $125,000.
However, the cash flow on the floating rate liability is:
= –0.098 × ($100,000,000 / 4)
= –$2,450,000.
Combining the cash flow from the hedge with the cash flow from the loan results in a net
outflow of $2,325,000, which translates into an annual rate of 9.3 percent:
= ($2,325,000 × 4) / $100,000,000 = 0.093
This is precisely the implied borrowing rate that Johnson locked in on September 20. Regardless
of the LIBOR rate on December 20, the net cash outflow will be $2,325,000, which translates
into an annualized rate of 9.3 percent. Consequently, the floating rate liability has been
converted to a fixed rate liability in the sense that the interest rate uncertainty associated with
the March 20 payment (using the December 20 contract) has been removed as of September 20.
B. In a strip hedge, Johnson would sell 100 December futures (for the March payment), 100 March
futures (for the June payment), and 100 June futures (for the September payment). The objective
is to hedge each interest rate payment separately using the appropriate number of contracts. The
problem is the same as in Part A except here three cash flows are subject to rising rates and a
strip of futures is used to hedge this interest rate risk. This problem is simplified somewhat
because the cash flow mismatch between the futures and the loan payment is ignored.
Therefore, in order to hedge each cash flow, Johnson simply sells 100 contracts for each
payment. The strip hedge transforms the floating rate loan into a strip of fixed rate payments. As
was done in Part A, the fixed rates are found by adding 200 basis points to the implied forward
LIBOR rate indicated by the discount yield of the three different Eurodollar futures contracts.
The fixed payments will be equal when the LIBOR term structure is flat for the first year.

Topic: Economic Inputs and Portfolio Management
Minutes: 12
Reading References:
“Is Purchasing Power Parity a Useful Guide to the Dollar?” Craig S. Hakkio, Economic Review
(Federal Reserve Bank of Kansas City, Third Quarter 1992)
Purpose:
To test the candidate’s ability to compare and contrast absolute PPP and relative PPP and evaluate
the extent to which PPP is useful in forecasting exchange rate movements.

“Is Purchasing Power Parity a Useful Guide to the Dollar?” (Session 6)
• contrast the performance of relative purchasing power parity (PPP) as a guide in forecasting
short-term movements and as a guide in forecasting long-term movements in foreign exchange
rates;
• appraise the usefulness of PPP in forming expectations about future movements in exchange
rates and in making judgments about managing portfolio exposure to currency risks.
Guideline Answer
A. Purchasing power parity (PPP) is a measure of a currency’s equilibrium value (the exchange
rate to which the currency moves over time). In PPP equilibrium, any asset or service purchased
with a certain amount of currency in one country will cost the same in any other country, after
conversion into the base currency. PPP is grounded in the law of one price, which states that, in
the absence of transport costs and trade impediments, identical goods should cost the same
across all countries and currencies.
Absolute PPP states that exchange rates depend on differences in absolute price levels in
different countries. Under absolute PPP, exchange rates move to equalize the prices of identical
market baskets in different countries. That is, the exchange rate between two currencies will
tend to rise or fall toward the ratio of the two countries’ overall price levels.
Relative PPP states that exchange rates depend on differences in inflation rates in different
countries. Under relative PPP, exchange rates move to offset inflation differentials in different
countries. That is, the exchange rate between two currencies will tend to rise or fall at a rate
equal to the difference between the two countries’ inflation rates.
Because relative PPP extends directly from absolute PPP, relative PPP holds if absolute PPP
holds. But relative PPP may hold even if absolute PPP does not. Although the exchange rate is
not likely to strictly equal the ratio of foreign and domestic price levels, as absolute PPP
requires, the exchange rate may be proportional to the ratio. If the proportion is fixed, a less
restrictive condition than precise equality, relative PPP holds. Thus, relative PPP is more likely
to hold than absolute PPP.

Both absolute and relative PPP are subject to criticism. Absolute PPP is criticized because the
law of one price does not always hold and because price levels in different countries are
calculated using different price indexes. Relative PPP is criticized because different theories of
exchange rate determination can generate non-PPP equilibrium rates and because price levels
adjust at different speeds than exchange rates.
B. For several reasons, PPP has limited usefulness in predicting short-term foreign exchange rate
movements. First, because exchange rates change rapidly while price levels adjust more slowly,
deviations from PPP are likely to disappear only over longer periods of time as prices adjust.
Second, evidence suggests that:
• market exchange rates and PPP rates do not tend to move together from month to month;
• the time required for exchange rates to equal their PPP rates ranges from several months to
several years;
• trade and capital flows create long-run pressures toward PPP, but observed exchange rates
often show large and prolonged deviations from PPP levels;
• only when deviations from PPP are unusually large is it likely that exchange rates will move
toward their PPP rates in the short run;
• major political and economic events can dominate short-run exchange rate movements;
• explicit government intervention can cause exchange rates to deviate from PPP levels.

Topic: Global Markets/Instruments and Analysis of Alternative Investments
Minutes: 18
Reading References:
1. Emerging Stock Markets: Risk, Return, and Performance, Christopher B. Barry, John W.
Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997)
2. “Does Venture Make Sense for the Institutional Investor? Part I,” David F. Swensen,
Investing in Venture Capital (ICFA, 1989)
Purpose:
To test the candidate’s ability to compare the strengths and weaknesses of two different but related
asset sub-classes.

Emerging Stock Markets (Session 7)
• discuss the potential benefits from investing in emerging markets;
• summarize the problems or constraints facing the emerging market investor;
• comment on the historical performance of emerging equity markets;
• discuss the risks involved in investing in emerging markets;
• discuss performance comparisons between indexes of investable securities and indexes of all
securities in emerging markets.
“Does Venture Make Sense for the Institutional Investor? Part I” (Session 11)
• describe the distinguishing characteristics of the private equity asset class;
• determine how the inclusion of private equity might enhance the opportunity set of a multi-asset
portfolio, leading to a more efficient portfolio.
Guideline Answer
A. The potential benefits resulting from overweighting in both emerging market equities and
venture capital include the following:
• Higher Expected Returns. Over certain past time periods, both of these asset classes
experienced favorable returns relative to other asset classes. It is entirely possible that
expected returns for both will be higher than those for other asset classes.
• Low Correlation with Other Asset Classes. Likewise, over certain past periods, both of these
asset classes’ returns had low correlations with other asset classes, resulting in reduced
portfolio risk. Similar low correlations and risk-reduction effects may be forecast for the
future.
• Increased Portfolio Efficiency. If both of these asset classes have higher expected returns
and/or lower expected correlations relative to other asset classes, their inclusion in portfolios
may shift those portfolios to a higher efficient frontier.

B. The potential problems resulting from overweighting in both emerging market equities and
venture capital include the following:
• Illiquidity. Both of these asset classes may have less liquidity than other asset classes. That
is, it may not be possible to sell either at fair value in a short period of time.
• Long Time Horizon Requirement. Both of these asset classes may require investors to adopt
a long time horizon, primarily because of the high volatility each of these asset classes
exhibits.
• High Transaction Costs. Both asset classes are likely to have high transaction costs, in the
form of timing, market impact, opportunity costs, and large bid-ask spreads.
• High Information Costs. Both asset classes are likely to have high information costs,
especially relative to U.S. equities and bonds that feature easy and cheap access to massive
quantities of data.
• Low Expected Returns. Forecast returns for both asset classes may, in fact, be lower than
those for other asset classes, regardless of past return experience.
• High Future Return Volatility. Both asset classes may have high return volatility that is not
offset by prospective low correlation effects, with the net result that portfolio risk may
actually increase as a result of including these asset classes in portfolios.
• Higher Future Correlations, Especially in Down Markets. Even though return correlations
of both asset classes with other asset classes have been low in the past, they may be forecast
to be higher in the future, especially in down markets. The result will be a much lower risk
reduction benefit to the portfolio.

Topic: Ethical and Professional Standards
Minutes: 6
Reading References:
1. Standards of Practice Handbook, 7th Edition (AIMR, 1996), pp. 53-59.
2. “Avoiding Legal Problems in the Decade of Retribution,” Karl A. Groskaufmanis,
Corporate Financial Decision Making and Equity Analysis (AIMR, 1995)
3. “Managing Ethics from the Top Down,” Saul W. Gellerman, Sloan Management Review
(Sloan Management Review Association, Winter 1989)
4. “Compliance Guidelines: Introduction,” Michael S. Caccese, Good Ethics; The Essential
Element of a Firm’s Success (AIMR 1994)
Purpose:
To test the candidate’s understanding of the methods used to create and maintain an ethical
environment in an investment firm.

“Avoiding Legal Problems in the Decade of Retribution” (Session 3)
• discuss specific steps to create and apply an effective compliance policy in anticipation of
potential scrutiny.
“Managing Ethics from the Top Down” (Session 3)
• discuss issues related to management’s responsibility for creating and sustaining an ethical
environment and minimizing conditions that foster unethical acts (such as unusually large
rewards or severe punishments);
• explain how management can take explicit steps to ensure that employees do not risk
commission of an unethical act.
“Compliance Guidelines: Introduction” (Session 4)
• explain the steps to be taken in designing an effective compliance program for investment
organizations.
Guideline Answer:
Any of the following additional specific actions would contribute to implementation of an effective
compliance policy:
• minimize exposure to conditions/conflicts that induce misconduct;
• provide incentives (rewards) for good behavior;
• clearly delineate sanctions for misconduct;
• designate a compliance officer;
• provide ethics training;
• establish disclosure mechanisms (e.g., “whistle blowing”);
• review employee conduct;
• resolve compliance concerns promptly;
• keep codes of ethics and compliance programs current to reflect changes in the firm and the
industry.

Topic: Ethical and Professional Standards
Minutes: 14
Reading References:
1. Standards of Practice Handbook, 7th Edition (AIMR, 1996), pp. 83-93.
2. Establishing a Proxy Voting Policy for Professional Investors, (AIMR, 1992)
3. “Tore & Associates,” Douglas R. Hughes, Standards of Practice Casebook (AIMR, 1996)
Purpose:
To test the candidate’s understanding of the firm’s responsibility under AIMR Standards for proxy
voting.

“Establishing a Proxy Voting Policy for Professional Investors” (Session 3)
• construct a written policy on proxy voting.
“Tore & Associates” (Session 4)
• demonstrate the appropriate responsive actions and show adequate compliance procedures for
each of the violations of the Code and Standards.
Guideline Answer
A. Because FIA has discretionary authority to manage fund assets, its approach can be critiqued on
the following grounds:
• FIA has a fiduciary duty to vote all proxies associated with the assets; the firm cannot refuse
to exercise its fiduciary duty because it is too expensive or too time consuming.
• FIA should have a firm-wide policy on proxy voting so that decisions are not left up to
individual managers.
• FIA’s policy must require portfolio managers to vote proxies in a way that will maximize
the economic value of plan holdings.
B. To ensure adherence to an adequate proxy voting policy, FIA should adopt the following
specific procedures:
• designate a policy-making body or individual to implement a proxy policy;
• provide a review mechanism that will monitor the proxy voting process on a regular basis;
• identify, when appropriate, preferences of clients regarding proxy voting issues;
• consider applying internal financial ratios or other criteria (for evaluating corporate
performance) to proxy decisions;
• develop adequate record-keeping procedures;
• educate and train staff regarding proxy voting policies;
• adequately disclose proxy voting procedures to clients.

Topic: Institutional Portfolio Management
Minutes: 18
Reading References:
1. “Determination of Portfolio Policies: Institutional Investors,” Ch. 4, Keith P.
Ambachtsheer, John L. Maginn, and Jay Vawter, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham
& Lamont, 1990)
Purpose:
To test the candidate’s ability to develop objectives and constraints for a defined benefit pension
fund and a college endowment fund.

“Determination of Portfolio Policies: Institutional Investors” (Session 14)
• indicate the investment objectives, constraints, and policies of leading institutional investors;
• distinguish between defined-benefit and defined-contribution pension plans in terms of
characteristics, needs, and concerns;
• identify the return objectives and risk tolerances of endowment funds, including considerations
of spending rates and inflation rates.
• contrast the investment objectives and constraints of investors in several different economic
circumstances.
• critique an existing investment policy statement and its associated asset allocation.
Guideline Answer:
A. Investment policy objectives for the Lindsay pension plan in the three areas are:
i. Return Objective
The return objective for this mature U.S. corporate pension plan is the sum of the plan’s
required real rate of return (5.5 percent) and the expected rate of inflation (2 percent) for a
total of 7.5 percent. An alternate approach would be to multiply, rather than add, the two
rates, which produces a return objective equal to 7.6 percent, as follows:
[(1 + .055) × (1 + .02)] – 1 = 0.076
ii. Risk Tolerance

The level of risk tolerance for the pension plan is quite low, well below average. The plan is
quite mature, as indicated by the high percentage (60 percent) of employees already retired
and receiving pension payments and by the relatively advanced average age of active
employees (45 years). In addition, the plan is currently fully funded.

Afternoon Section – Page 1
iii. Time Horizon
The time horizon for the pension plan is substantially shorter than average. The horizon is
relatively short because payments must be made now (and into the future) to the 60 percent
of employees already retired and must be made in the near future to many of the active
employees because their average age is 45 years. This combination of circumstances
markedly reduces the time horizon as compared with most corporate pension plans and
reinforces the minimum risk, limited return objectives of the plan.
B. The nature of the three investment policy elements, and the impact of the change in spending
policy on each, is:
i. Return Objective
The return objective for the Mountaintop Fund will change to the sum of the new spending
policy (6 percent, up from 4 percent) and the annual college tuition inflation rate (3 percent)
for a total of 9 percent (up from 7 percent).
ii. Risk Tolerance

The level of risk tolerance for the Mountaintop Fund is high. A spending rate of 6 percent
and a tuition inflation rate of 3 percent is fairly common among U.S. university endowment
funds and a high level of risk tolerance is commonly assumed for such funds. The increased
spending rate, which raised the total return to 9 percent, would require the fund to increase
its risk tolerance. In addition, the new exposure to currency risk may alter the risk profile of
the fund.
iii. Time Horizon

The fund’s time horizon is very long term; there is no change in the fund’s time horizon as a
result of the change in the spending rate.

Topic: Institutional Portfolio Management: Asset Allocation
Minutes: 30
Reading References:
1. “Asset Allocation,” Ch. 7, pp. 7-1 through 7-27, William F. Sharpe, Managing Investment
Portfolios: A Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds.
(Warren, Gorham & Lamont, 1990)
3. Question 13, including Guideline Answer, 1996 CFA Level III Examination
Purpose:
To test the candidate’s ability to critique and existing institutional asset allocation and create and
justify a revised allocation.

• explain how an asset allocation process can reconcile investment opportunities with investor
preferences and support the explanation.
• discuss the overall portfolio management process leading to the asset allocation decision,
including the stage devoted to investor information requirements (i.e., objectives and
constraints) and the stage devoted to analyzing capital market expectations;
• recommend and justify a general asset allocation that would be appropriate for each investor.
• critique an existing investment policy statement and its associated asset allocation;
Guideline Answer:
A. Template for Question 13A
Assessment of Allocation for Mountaintop College Endowment Fund
Asset Class and
Circle Change (Lower/Same/Higher) and Justify your response.
Current Allocation
STATE YOUR ASSUMPTIONS CLEARLY.
Same
Cash There is a small ongoing need for liquidity (only for operating expenses).
2% Using a total return approach, spending requirements can be met by income
and capital gain flows.

Lower
U.S. Bonds Assuming that about 30 percent of the portfolio in total should be allocated
30% to medium- to long-term investment grade bonds, the allocation to domestic-
only bonds should be less than 30 percent. This is based on both domestic
bonds’ expected US$ return and standard deviation tradeoff relative to
international bonds and the endowment’s need to conduct substantial current
and future operations in currencies other than US$. Portfolio risk reduction
can be achieved by shifting to international bonds, if their returns are
relatively uncorrelated with domestic returns.
Higher
International Bonds A substantially higher allocation should be made to international bonds, both
0% because of their more favorable expected US$ return and standard deviation
tradeoff relative to domestic bonds and because of the endowment’s need to
conduct substantial current and future operations in currencies other than
US$. International bonds may also provide portfolio risk reduction if their
returns are relatively uncorrelated with domestic returns.
Lower
U.S Equities Assuming that about 65% of the portfolio in total should be allocated to
60% equities, a lower allocation to U.S. equities may be appropriate. This is based
on U.S. equities’ expected US$ return (lower), standard deviation (lower)
and lack of non-U.S. diversification as compared to international equities
(such as EAFE equities).
Higher
EAFE Equities A higher allocation should be made to EAFE equities, because of their more
8% favorable expected US$ return and less than perfect positive correlation with
U.S. equity returns. But the higher allocation should be moderated by the
higher expected standard deviation of EAFE equity returns. So a modestly
higher allocation to EAFE equities is warranted.

B. Template for Question 13B
Assessment of Allocation for Lindsay Corporation Pension Plan
Asset Class and Circle Change (Lower/Same/Higher) and Justify your response.
Current Allocation
STATE YOUR ASSUMPTIONS CLEARLY.
Higher
Cash A higher allocation to cash will be required to meet substantial and
2% increasing cash outflow needs that result from the large number of retired
lives pension recipients and substantial number of new retirees over the next
several years.
Higher
U.S. Bonds Given the need for substantial, steady, and growing cash outflow, a sizable,
30% stable source of cash generation is needed.
Same
International Bonds Unless large risk reduction benefits are assumed for international bonds, the
0% pension plan has little need to take the potential additional risks involved,
even in view of the additional expected return.
Lower
U.S. Equities Because of the cash flow needs and preservation of capital needs of the
60% pension fund and its fully funded status, a lower allocation to equities is
warranted. If part of this lower allocation is reallocated to EAFE equities, the
allocation to U.S. equities would be even less.
Same
EAFE Equities Potential diversification benefits resulting from an assumption regarding
8% relatively low correlations with U.S equities may warrant an overall portfolio
allocation of 8 percent. But if equities are de-emphasized relative to bonds
and cash, as recommended, the justifiable portfolio allocation to EAFE
equities would remain unchanged.

Topic: Portfolio Management: Execution and Monitoring
Minutes: 6
Reading References:
1. “Defining and Measuring Trading Costs,” Wayne Wagner, Execution Techniques, True
Trading Costs, and the Microstructure of Markets (AIMR, 1993)
Purpose:
To test the candidate’s knowledge of the nature, size, and time frame of the various costs implicit in
the execution of security trades.

“Defining and Measuring Trading Costs” (Session 16)
• illustrate how hidden transaction costs, such as market impact, timing, and opportunity costs,
affect investment management results.
Guideline Answer:
Measurement of each of the three costs implicit in the execution of trades is as follows:
i. Market impact cost is measured by the change in a stock’s price between the time an order is
presented to the (sell-side) broker and actual execution of the trade. It is sometimes described as
the “cost of buying liquidity.” The time required to complete the trade associated with this cost
is relatively short – intraday or one day – regardless of any interim movement in the stock’s
price.
ii. Timing cost is measured as the change in a stock’s price while part or all of the order is being
held on the buy-side trading desk. It is sometimes described as the “cost of seeking liquidity.”
The time required to complete the trade associated with this cost is somewhat longer than that
for market impact – interday or up to several days.
iii. Opportunity cost is measured as the change in a stock’s price from the time the order was
presented to the buy-side trader to the price at a point in the future that would have resulted in a
profit had the order been executed. It is sometimes described as “liquidity failure,” because it is
the absence of liquidity that resulted in the order not being executed at all. Because the trade
never takes place, the time required to complete the trade associated with this cost is undefined.
The opportunity cost can also be measured from the time the order was placed until it is
cancelled.

Topic: Portfolio Management: Risk Measurement and Management
Minutes: 24
Reading References:
1. “Value At Risk—New Approaches to Risk Management,” Katerina Simons, New England
Economic Review (Federal Reserve Bank of Boston, September/October 1996)
2. “Value at Risk for the Asset Manager,” Mary Ellen Stocks and Christopher Ito, The Journal
of Performance Measurement (The Spaulding Group, Summer 1997)
3. “Global Risk Management: Are We Missing the Point?” Richard Bookstaber, The Journal of
Portfolio Management (Institutional Investor, Spring 1997)
Purpose:
To test the candidate’s ability to define the three primary methods for calculating VAR and assess
the strengths and weaknesses of each method.

“Value At Risk—New Approaches to Risk Management” (Session 18)
• define VAR;
• compare parametric, historical, and simulation approaches to VAR measurement;
• support and criticize VAR as a risk-measurement tool.
“Value at Risk for the Asset Manager” (Session 18)
• explain the calculation of VAR using the three primary methods;
• describe the strengths and weaknesses of each of the three methods;
• explain the practical applications of VAR for portfolio management.
“Global Risk Management: Are We Missing the Point?” (Session 18)
• comment on the implication of fat tails for risk managers;
• explain how nonlinearity can hide potential risk.
Guideline Answer:
A. Three methods of calculating value at risk (VAR), and their associated strengths and
weaknesses, are:
i. Variance/Covariance Method
Method: The Variance/Covariance Method, which is based on Modern Portfolio Theory and
assumes a normal distribution of returns, involves mapping security positions to a simple set
of instruments or exposures, each of which is affected by only one risk factor. Risk factors
are influences such as interest rates or exchange rates that drive the valuation of securities.
After mapping all positions to risk factors, the expected standard deviation of the portfolio is
calculated based on the historical variance/covariance relationships and weighting of the risk
factors. By utilizing the resulting distribution, the appropriate confidence interval, and the
total value of the portfolio, the portfolio’s VAR can be calculated.

Strengths: Based on the Modern Portfolio Theory, the calculation is relatively easy to
perform and the market data necessary to compute VAR are readily available to the
investment manager. This method does not require powerful computer systems to perform
the calculations, separate valuation models to price the assets or liabilities in the portfolio, or
the actual historical returns of portfolios. Only the values for correlation and volatility are
required.
Weaknesses: Volatilities and correlations are not necessarily stable over time, and the
Variance/Covariance method may assume that such is the case. To the extent that volatilities
and correlations break down (e.g., are not viable in times of market dislocation), the VAR
calculated using the Variance/Covariance approach may not produce accurate forecasts. The
Variance/Covariance VAR calculation may also become cumbersome as the number of risk
factors increases, which may increase the need for computational power in order to run the
calculation. Also, non-normal distributions and lack of serial independence need to be
accounted for using advanced statistical techniques. This method requires the mapping of
the portfolio to risk factors, which subjects the analysis to mismatching and therefore may
produce inaccurate risk characteristics. While non-linear risk can be approximated using the
option delta and gamma, portfolios best suited to this methodology have no optionality.
Finally, the results may not be comparable with other managers or portfolios, because the
assumptions or risk factors utilized may be different.
ii. Historical Simulation Method I
Method: The Historical Simulation Method uses historical market data to calculate the
market value of a portfolio for each day over a specified period of time (e.g., the last 100
trading days). The empirical distribution or ranking of market values resulting from the
portfolio’s calculated marked-to-market values is constructed. The VAR for a specified
confidence level (e.g., 95%) is then determined based upon this distribution.
Strengths: The Historical Simulation Method is easy to understand. It makes no assumptions

about whether returns are normally distributed or whether volatilities and correlations are
stable and does not require statistical estimates of standard deviations, variance/covariances,
and mean return.
Weaknesses: The use of a specified period of trading days of market data may not be
representative of future market movements. The VAR may be over or underestimated
depending upon market history. The investment manager may not be able to value all of the
positions in the portfolio or have access to reliable market data for the calculations. If an
institution has a large or complicated portfolio, it may be impossible or impractical to
maintain historical data on all of the instruments involved. Moreover, historical data do not
exist for many instruments, particularly those that are customized. This method requires the
use of valuation models, which may or may not be complex depending upon the nature of
positions. The method is inflexible, in that it does not allow the analyst to try different
values for volatilities and correlations to test the sensitivity of VAR to these assumptions. In
addition, the VAR is based upon the portfolio’s previous, rather than current, asset mix and
thus may not be representative of the future nor comparable to other managers or portfolios.

ii. Historical Simulation Method II
Method: The Historical Simulation Method entails “simulating” past portfolio returns by
using the returns of factors that influence the value of portfolio instruments. For example,
for a domestic bond, the primary risk factor is the level of domestic interest rates. Risk
factors are modeled based on the current portfolio composition to create simulated portfolio
returns. Then, an empirical frequency distribution is constructed by ranking the simulated
portfolio returns into percentiles; the VAR is determined at the chosen confidence level
given the portfolio’s current value.
Strengths: The Historical Simulation Method makes no explicit assumptions about the shape
of the distributions (e.g., whether or not returns are normally distributed) or whether
volatilities or correlations are stable. This method does not require separate valuation models
to price the assets or liabilities of the portfolio. Market data necessary to compute Historical
Simulation Method VAR should be readily available to the investment manager.
Weaknesses: The Historical Simulation Method is inflexible, in that it does not allow the
analyst to try different values for volatilities and correlations to test the sensitivity of VAR
to these assumptions. It requires the mapping of the portfolio to risk factors, which subjects
the analysis to mismatching and therefore may result in inaccurate risk characteristics. The
process may become cumbersome as the number of risk factors grows. The use of a
specified period of trading days of risk factor data may not be representative of future
market movements. VAR may be over or underestimated depending upon market history. In
addition, managers or portfolios often are not comparable, because the assumptions or risk
factors utilized may be different.
iii. Monte Carlo Simulation Method
Method: The Monte Carlo Simulation Method involves identifying a number of risk factors
that affect the portfolio and constructing a distribution for each risk factor. Using the
distributions, the method generates a large number of possible market scenarios (e.g.,
10,000) that are consistent with expected volatilities and correlations. While each scenario is
different, the total simulations will aggregate to the overall statistical parameters chosen at
the outset. The portfolio positions are revalued under each scenario resulting in distributions
of market value changes. VAR is derived from the distribution produced by the Monte Carlo
simulation analysis and the portfolio value.
Strengths: The Monte Carlo approach makes no set assumptions about linearity, normality,
or position relationships. It is a powerful approach, in that it is not constrained by
assumptions about asset returns and generates many more scenarios than the Historical
Simulation method.
Weaknesses: The Monte Carlo approach requires considerable computer power. The greater
the number of risk characteristics in the portfolio, the greater the number of scenarios
required. It requires sophisticated mathematical modeling and its results are only as good as
the underlying assumptions. In addition, managers or portfolios often are not comparable,
because the assumptions or risk factors utilized may be different.

B. The two consultants may obtain dramatically different VAR results for several reasons; the
consultants may have:
• used different past time periods over which the simulations were run.
• used different models, including different assumptions about pricing, distributions, and risk
factors in the simulations.
• used different distributions to drive the simulation process. Normal distributions, lognormal
distributions, t-distributions, or actual historical distributions could be used to produce the
simulations, each resulting in different VARs.
• used different statistical parameters to drive the simulation process. Different empirical
inputs—means, variances, and correlations—can have dramatic consequences, including
markedly different VARs, for the simulation results.
• used different “risk factors” to model the portfolio. For example, if one consultant used the
10-year U.S. government bond yield to model interest rate risk while the other consultant
used the 30-year U.S. government bond yield, their computed VARs could be very different.

Topic: Global Fixed Income
Minutes: 12
Readings:
“International Bond Portfolio Management,” Ch. 26, Christopher B. Steward and J. Hank Lynch,
Managing Fixed Income Portfolios, Frank J. Fabozzi, ed. (Frank J. Fabozzi Associates, 1997)
Purpose:
To test the candidate’s understanding of the effect of the currency hedging policy on the risk and
return objectives of an international bond portfolio.

“International Bond Portfolio Management” (Session 10)
• discriminate between a domestic bond portfolio manager’s challenges and an international bond
portfolio manager’s challenges by citing specific common responsibilities and responsibilities
that differ.
• discuss the fundamental steps in the investment process—setting objectives, establishing
investment guidelines, developing portfolio strategy, constructing the portfolio, monitoring risk,
and evaluating performance—as they apply to domestic and international bonds.
Guideline Answer
A. A fully-hedged international bond portfolio strategy offers better risk reduction for domestic
investors because of the lower standard deviation of returns in home currency terms. That is, it
offers greater assurance of achieving an accurately estimated return in domestic currency terms.
However, a fully-hedged portfolio forfeits the potential performance enhancement from
successful active currency management. Depending on the nature of inter-bond correlations,
even a partially-hedged strategy offers the potential for some return enhancement while
preserving some diversification benefits.
B. Jacob’s decision to fully hedge his portfolio contradicts the fund’s objectives. The fund has
aggressive return objectives and high tolerance for risk. Eliminating the ability to add value
through active currency management is counter to the return objective, and pursuing a strategy
that attempts to eliminate currency risk entirely is counter to the risk tolerance objective.

Topic: Global Fixed Income
Minutes: 14
Readings:
“International Bond Portfolio Management,” Ch. 26, Christopher B. Steward and J. Hank Lynch,
Managing Fixed Income Portfolios, Frank J. Fabozzi, ed. (Frank J. Fabozzi Associates, 1997)
Purpose:
To test the candidate’s understanding of the limitations of duration as a portfolio measure of interest
rate sensitivity and the potential sources of excess return in international bond portfolio
management.

“International Bond Portfolio Management” (Session 10)
• discriminate between a domestic bond portfolio manager’s challenges and an international bond
portfolio manager’s challenges by citing specific common responsibilities and responsibilities
that differ;
• discuss the fundamental steps in the investment process—setting objectives, establishing
investment guidelines, developing portfolio strategy, constructing the portfolio, monitoring risk,
and evaluating performance—as they apply to domestic and international bonds;
• compare and contrast five broad strategies: currency selection, bond selection, duration
management, sector/credit/security selection, and outside-benchmark investing.
Guideline Answer
A. The consultant is incorrect in suggesting that the weighted-average portfolio duration
calculation is the same for both global and domestic bond portfolios. The portfolio duration
measure for international bond portfolios is far more limiting than for domestic portfolios. A
domestic portfolio’s duration can equal the weighted sum of its individual securities’ durations
when all the yields and corresponding term structures are the same. An international portfolio’s
total duration, however, will rarely be equal to a simple sum of the duration-weighted
components, because interest rate movements in different countries are not perfectly correlated.
Also, the differing volatility of interest rates across markets means that the contribution to
duration from a given market is not entirely comparable to that of another market. Finally, the
yield curve structures and yields on the constituent bonds are also different across markets.
B. Additional sources of excess return in global bond management are:

• Bond Market Selection/Country Selection. By correctly over or underweighting the best and
worst performing countries/markets, the added return can be large and is arguably the largest
source of potential excess return.
• Sector/Issue Selection. Investing in corporate and other non-government issues can add
incremental value. However, these bonds are not as widely available in many markets as in
the U.S. and other developed markets.

Topic: Portfolio Management - Derivatives (Study Session 17)
Minutes: 22
Readings:
1. “Stock Index Futures: Refinements,” Ch. 8, Futures, Options & Swaps, 2nd edition, Robert
W. Kolb, (Blackwell, 1997)
2. “Minimizing Cash Drag with S&P 500 Index Tools,” Joanne M. Hill and Rebecca Cheong,
Equity Derivatives Research (Goldman, Sachs, June 11, 1996, revised)
Purpose:
To test the candidate’s knowledge of futures and alternative instruments by altering a portfolio’s
expected return.

“Stock Index Futures: Refinements” (Session 17)
• compute the correct number of index futures contracts required to partially or completely hedge
an equity portfolio;
• construct a strategy to decrease/increase the beta of a portfolio, including calculating the number
of futures contracts;
• create a synthetic T-bill or synthetic equity position using the appropriate futures contracts.
“Minimizing Cash Drag with S&P 500 Index Tools” (Session 17)
• compare and contrast the two primary tools used in cash management of equity index portfolios;
• design and evaluate a cash management strategy using futures;
• calculate and appraise returns from a cash management strategy using index futures or S&P 500
Depository Receipts (SPDRs) with returns from leaving a portion of the portfolio in cash;
• compare and contrast the cost of excess cash versus an appropriate cash management strategy
using futures or SPDRs;
• illustrate similar cash management strategies using alternative index instruments.
Guideline Answer
A. The number of futures contracts required is:
N = (value of the portfolio/value of the index futures) × beta of the portfolio

= [$15,000,000 / (1,000 × 250)] × 0.88
= [$15,000,000 / 250,000] × 0.88
= 60 × 0.88
= 52.8 contracts
Selling (going short) 52 or 53 contracts will hedge $15,000,000 of equity exposure.

B. Alternative methods that replicate the futures strategy in Part A include:
1. Shorting SPDRs. SPDRs would be more expensive than futures to trade in terms of liquidity
and transaction costs. Tracking error, in theory, would be higher for futures than for SPDRs,
because S&P 500 futures can close under and over fair value. SPDRs do not incur the cost
of rolling over, which a position in futures would incur if held longer than one expiration
date.
2. Creating a synthetic short futures position using a combination of calls and puts. Either
options on the underlying index or options on the future could be used. Selling an index call
option and purchasing an index put option with the same contract specifications would
create a synthetic short futures position. This strategy would likely be more costly than
futures because two transactions are required. Longer-term options tend to be less liquid
than futures and SPDRs. Unlike futures, the option combination can be traded either as a
spread or separately. If the call and put are traded separately, bid/ask spreads and market
impact may increase the cost of the strategy. Options on some index futures are American
style, which may result in the call option being exercised at an inopportune time.
3. Creating a fixed equity swap in which Andrew pays the appreciation and dividends on the
portfolio and receives a fixed rate. The price of this transaction is negotiated between the
two parties, but in general, the swap would be more costly than the futures hedge. Also,
equity swaps are not liquid and may prove difficult to reverse once entered. Unlike futures,
which are standardized contracts with no customization possible, this alternative has the
advantage of customization; negotiable terms include length of contract, margin
requirements, cost of closing position early, and timing of payments.
4. Shorting a forward contract on the S&P 500 index. The price of this transaction is
negotiated between the two parties. Forwards are not liquid, may prove difficult to reverse
once entered, and may involve counterparty risk. Unlike futures, which are standardized
contracts with no customization possible, this alternative has the advantage of
customization; negotiable terms include length of contract, margin requirements, cost of
closing the position early, and timing of payments.
C. i. Because Andrew anticipates an imminent rebound in stock prices, he will want to equitize
his cash position as quickly as possible. Even after transaction costs, the advantages of using
SPDRs or futures (synthetic indexes) far outweigh the cost of holding cash in a rising
market. When a portfolio manager desires to be fully invested, excess cash should be
invested temporarily in an appropriate synthetic equity position until the portfolio manager
can perform stock selection. This strategy will also minimize tracking error.
If a portfolio manager cannot use futures, the manager should use SPDRs to equitize the
cash position. Even with the SPDRs’ management fees and transaction costs, Andrew’s
expected return would be higher by equitizing than leaving the $5 million in cash.

ii. The cost of holding the excess cash in U.S. Treasury bills is:
Cost = cash weight × (S&P 500 return – cash return)

= 0.05 × (12% – 6%)
= 0.30%
iii. The return enhancement of using a futures-based cash management strategy is:
Return enhancement = cash weight × (synthetic index return − cash return)

= 0.05 × (11.8% – 6%)
= 0.29%

Topic: Performance Measurement and Attribution
Minutes: 14
Reading References:
1. “Benchmark Portfolios and the Manager/Plan Sponsor Relationship,” Jeffrey Bailey,
Thomas Richards, and David Tierney, Current Topics in Investment Management, Frank
Fabozzi and T. Dessa Fabozzi, eds. (Harper Collins, 1990)
2. “Are Manager Universes Acceptable Performance Benchmarks?” Jeffery V. Bailey, The
Journal of Portfolio Management (Institutional Investor, Spring 1992)
3. “Evaluating Portfolio Performance,” Ch 14, pp. 14-23 through 14-47, Peter Dietz and
Jeannette Kirschman, Managing Investment Portfolios: A Dynamic Process, 2nd edition,
John Maginn and Donald Tuttle, eds. (Warren, Gorham & Lamont, 1990)
Purpose:
To test the candidate’s ability to evaluate investment performance relative to an appropriate
benchmark.

“Benchmark Portfolios and the Manager/Plan Sponsor Relationship” (Session 21)
• identify the characteristics of an effective benchmark portfolio and provide a critique of the
practice of using the performance of the median manager, rather than a benchmark portfolio, in
performance evaluation.
“Are Manager Universes Acceptable Performance Benchmarks?” (Session 21)
• evaluate the validity and appropriateness of using benchmarks as a standard for evaluating
manager or plan sponsor performance;
• explain the conceptual basis for valid benchmarks;
• explain how survivor bias significantly affects performance measurement results when median
manager returns rather than benchmark returns are used as the comparison standard.
Guideline Answer
A. Generally, the correct benchmark portfolio is one that both the investment manager and the
client agree fairly represents the manager’s investment process. To be valid and effective in
measuring a manager’s performance, a benchmark should be:
1. Unambiguous. The names and weights of securities comprising the benchmark can be
clearly delineated.
2. Investable. Investors can actually invest in the benchmark; that is, the option is available to
forego active management and simply hold the benchmark.
3. Measurable. The benchmark’s own return can be readily calculated on a reasonably frequent
basis.
4. Appropriate. The benchmark is consistent with the manager’s investment style or biases.
5. Reflective of current investment opinions. The investment manager has current investment
knowledge (be it positive, negative or neutral) of the securities that make up the benchmark.

6. Specified in advance. The benchmark is constructed prior to the start of an evaluation
period.
The “median manager” approach is not a reasonable benchmark for measuring Sloan & Co.’s
performance, because of the following weaknesses.
1. The median manager is ambiguous, in that the composition of the median manager’s
portfolio is unavailable for inspection, either before or after the evaluation period.
2. The median manager is not investable, in that neither Sloan & Co. nor any other portfolio
manager has the option of investing in the median manager’s portfolio. In the relative
performance measurement industry, the median fund portfolio changes from quarter to
quarter.
3. The performance of the median manager is measurable, but only by the data provider.
4. The median manager is not appropriate for the measurement of Sloan’s performance; there
is a high probability that the median manager’s investment style differs markedly from that
of Sloan.
5. The median manager will likely not be reflective of current investment opinions held by
Sloan & Co. The median fund portfolio will include many securities for which Sloan & Co.
has not formed a current investment opinion.
6. The median manager is not specified in advance, because compilers of manager peer groups
can identify the median fund only ex post. Before an evaluation period, there is no
knowledge of the future median fund. Due to the nature of producing the statistics associated
with the median fund, the composition of the median fund will change from one
measurement period to the next.
B. The S&P 500 Index is based on only 500 relatively large firms from various industries, most of
which are listed on the New York Stock Exchange (NYSE). Together, these 500 firms comprise
approximately 80 percent of the total value of the stocks listed on the NYSE.
Although the S&P 500 Index is generally regarded as an acceptable comparative index for
institutional portfolios, a number of technical problems reduce its usefulness as a universal
benchmark. Among these problems are:
• a large capitalization bias;
• double counting that results from (corporate) cross ownership of equities in the index;
• failure to cover 100 percent of the value of all traded U.S. securities, because it includes
only common stocks, most of which are listed on the NYSE, and excludes many AMEX
stocks and many over-the-counter (OTC) stocks.
• inclusion of some international (non-US based) companies.
Because Sloan & Co. is the only U.S. equity manager hired by ECB Inc. and operates under the
broad mandate of investing in any U.S. equity securities, an index representing a broad universe
of U.S. equities would be the appropriate benchmark for comparative purposes. To properly
reflect that broad investment mandate, ECB Inc. should work with Sloan to segment the
portfolio so that Sloan’s assets may be more appropriately measured against indices such as the
NASDAQ, AMEX, Russell 2000, and potentially other indices. A custom benchmark that
includes all U.S. equities (e.g., a benchmark that consists of a weighted sum of existing indices)
would be far more appropriate than either a median manager or a single index approach.

Topic: Real Estate
Minutes: 6
Readings:
1. “Real Estate Investment Performance and Portfolio Considerations,” Ch. 21, Real Estate
Finance and Investments, 10th edition, William B. Brueggerman and Jeffrey D. Fisher, eds.
(Irwin, 1997)
2. “Public and Private Real Estate: Performance Implications for Asset Allocation,” Ch. 15,
Real Estate Investment Trusts, David Geltner and Joe V. Rodriguez (McGraw Hill, 1998)
Purpose:
To test the candidate’s ability to evaluate the addition of real estate to an investment portfolio in the
context of modern portfolio theory.

“Real Estate Investment Performance and Portfolio Considerations” (Session 11)
• evaluate the shortcomings of the various means of measuring real estate returns.
“Public and Private Real Estate: Performance Implications for Asset Allocation” (Session 11)
• criticize the way data are analyzed in property markets;
• evaluate the usefulness of the main real estate indexes;
• compare the risk–return profile of real estate to that of the other investment categories;
• prepare a summary of the problems in using real estate in the context of modern portfolio theory
(MPT);
• support a rationale in the MPT framework for including real estate in a portfolio.
Guideline Answer
Because of the thin trading prevalent in property markets, return data for private real estate have
been based on appraised values. Appraisal-based valuations are inevitably subject to lagging and
smoothing across time. In addition, data on real estate transactions are incomplete. Many costs are
not included (e.g. transaction costs, management fees) and leverage is not considered. These and
other data problems cause returns from real estate, as measured by mean-variance models, to appear
to be higher, with less volatility and lower correlation with other asset classes, than is actually the
case.
In addition, the private real estate market is not informationally efficient, which means that short-
term return statistics should not be used for long-term modern portfolio theory (MPT) analysis. To
properly conduct portfolio analysis for medium- to long-term horizon investors, MPT analysis must
be applied using long-term return statistics. Unfortunately, these data do not exist in sufficient
quantity or quality for direct real estate investments. Consequently, MPT analysis using short-term
return statistics biases the role of private real estate for a long-horizon investor and should not be
used for long term investment decisions.
In view of the above weaknesses associated with real estate return and risk data, the 40 percent
allocation to direct real estate investments suggested by the consultant is too high.

Topic: Ethics
Minutes: 16
Readings:
1. Standards of Practice Handbook, 7th Edition (AIMR, 1996)
2. “The Consultant,” Jules A. Huot, Standards of Practice Casebook (AIMR, 1996).
Purpose:
To test the candidate’s understanding of the AIMR Standards of Professional Conduct related to
suitability of investments, misrepresentation, fiduciary duty, and conflicts of interest.

Standards of Practice Handbook (Session 2)
• appraise behavior that could lead to potential or actual violations of the Code and Standards.
Standards of Practice Casebook (Session 4)
• differentiate between ethical behavior that complies with the Code and Standards and conduct
that violates the Code and Standards.
Guideline Answer:
A. Template for Question 21A
U.S. Treasury Bill Investment
Suitability:
By investing 55 percent of the Fund’s assets in U.S. Treasury bills, Jennings is buying an
inappropriate and unsuitable investment for her clients (the Fund’s shareholders), despite the
positive outlook for these securities. The Fund’s investment strategy, as described in the prospectus,
is aggressive growth, to be achieved by remaining fully invested in small and micro cap stocks.
Investors in the Fund seek an aggressive, high growth investment. Thus Jennings’ conservative
investment in Treasury bills is clearly inconsistent with the Fund’s strategy and clients’ objectives.
Misrepresentation:
Jennings misrepresented the services that she was providing to her clients (the Fund’s shareholders)
when she stated in the prospectus that the Fund was an aggressive growth investment vehicle.
Specifically, her action of investing a majority of the Fund’s assets in U.S. Treasury bills suggests
that she misrepresented the Fund’s objective.
Client Interests/ Personal Interests:
Based on the facts presented, buying Treasury bills for the Fund does not benefit Jennings’ personal
interests in any way and would not skew her independence and objectivity with respect to client
interests. Thus no conflict exists between client interests and Jennings’ personal interests.

Disclosure of Conflicts:
Jennings’ purchase of Treasury bills for the Fund does not result in a conflict of interest. Therefore,
no disclosure is required to either her employer or her clients (the Fund’s shareholders).
B. Template for Question 21B

Biocure Investment
Suitability:
The Fund’s prospectus states that the Fund is seeking to achieve a high level of asset growth by
investing in small and micro cap stocks. Based on the facts presented, Biocure’s stock meets these
criteria and is a suitable investment. The stock appears to be an appropriate investment based on the
Biocure long-term earnings projections prepared by the research department of Jennings’ firm.
Misrepresentation:
The prospectus states that the Fund would invest in small and micro cap stocks. Because Biocure is
such a stock, Jennings did not make any misrepresentation about Biocure stock or her purchase of
the stock.
Client Interests/ Personal Interests:
Jennings’ purchase of Biocure stock for the Fund gives rise to the appearance that she placed her
own interests before her clients. That is, Jennings’ ownership of Biocure stock could affect her
judgment and place her personal interest in conflict with clients’ interests. Because of the recent
decline in Biocure’s stock price, Jennings’ large stock purchase on behalf of the Fund could be
interpreted as an attempt to boost the value of her personal holding of Biocure stock.
Disclosure of Conflicts:
Jennings’ purchase of Biocure stock for the Fund represents a potential conflict of interest because
she personally owns $100,000 of this stock. Therefore, Jennings must disclose her interest in the
Biocure stock to both her employer and her clients (the Fund’s shareholders).

Topic: PPS/Portfolio Management
Minutes: 18
Readings:
1. Performance Presentation Standards, 1st edition, including appendixes (AIMR, 1993) and
Description of Change included in the CFA Level III Candidate Readings or AIMR
Performance Presentation Standards Handbook, 2nd edition, including appendixes (AIMR,
1997)
2. “AIMR’s Performance Presentation Standards,” Jonathan J. Stokes, Journal of Performance
Measurement (The Spaulding Group, Winter 1997/98)
Purpose:
To test the candidate’s understanding of the requirements of the AIMR Performance Presentation
Standards.

AIMR Performance Presentation Standards Handbook (Session 20)
• determine the role of the AIMR-Performance Presentation Standards (AIMR-PPSTM) in
ensuring ethical presentations of investment returns;
• evaluate a sample performance presentation to determine whether the presentation complies
with the AIMR-PPS standards.
“AIMR’s Performance Presentation Standards” (Session 20)
• explain the AIMR-PPS standards regarding composite creation, calculation of returns,
presentation of results, and disclosures.
Guideline Answer
Template for Question 22
Application of the AIMR-PPS Standards
i. Use of Martin’s investment record at her former firm:
The AIMR-PPS standards state that the performance results of a past firm or affiliation cannot be
used to represent the historical record of a new firm entity. This requirement is especially true for
HM because the prior performance record cannot be solely attributed to the manager or managers
who are attempting to claim the record as their own. That is, Martin was only a member of the
stock selection committee of her previous firm and was not solely responsible for the
performance results. By using Martin’s investment record at her former firm, HM has failed to
comply with AIMR-PPS standards.

ii. Use of the equity segments of the HM’s balanced accounts:
The AIMR-PPS standards permit HM, when presenting performance return, to split its
balanced accounts into separate portfolios based on asset class. However, the AIMR-PPS
standards also require that cash be allocated to the segment returns of a multiple-asset
portfolio when segment returns are being presented either alone or as part of a single-asset
composite as evidence of the firm’s ability to manage the segment by itself. By not including
cash with its equity segments, HM may be distorting the performance of those segments and
has failed to comply with AIMR-PPS standards.
iii. Use of HM’s balanced accounts currently under management:

The AIMR-PPS standards require that composites must exclude terminated portfolios after the
last full performance measurement period the portfolios were under management, but
composites must continue to include terminated portfolios for all periods prior to termination.
For HM, information is not explicitly provided on whether the firm has had any terminated
portfolios. If HM had terminated portfolios, these portfolios must be included in an
appropriate composite through the last full period they were under firm management.
Otherwise, by including only the performance history of all its balanced accounts currently
under management, HM’s balanced return would not be in compliance because the return
would show survivor-only performance results and be skewed by “survivorship bias.” By
using only the balanced accounts currently under management, HM may have failed to
comply with AIMR-PPS standards.
iv. Use of model performance:

According to the AIMR-PPS standards, composites must include only assets under
management and may not link simulated and model portfolios with actual performance. HM
may present model results to a potential client as supplementary information, but the model
results must be clearly identified as such and must not be linked to actual results.
v. Use of three selected HM fixed income accounts:

The AIMR-PPS standards require that firms present the performance history of portfolio
composites and that they include all discretionary, fee-paying accounts in composites of like
style and strategy. This prevents firms such as HM from choosing their best performing
portfolios as “representative accounts” without showing the firm’s overall performance. HM’s
current practice may distort fixed income returns. By using only the performance history for
three selected accounts to represent fixed income returns, HM has failed to comply with
AIMR-PPS standards.

vi. Providing annual numbers from 1996 to the present:
The AIMR-PPS standards require firms to show annual returns for 10 years or since inception
of the firm if inception is less than 10 years. This standard prevents managers from presenting
only the selected times when the firm has excellent returns. HM must present annual returns
for all years from 1994 to present. By presenting annual numbers only from 1996 to the
present, HM has failed to comply with AIMR-PPS standards.


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Level III: Question 1

Topic: Individual Investor Policy Statements

LOS: The candidate should be able to

1999 Level III Guideline Answers

1999 Level III Guideline Answers

1999 Level III Guideline Answers

LOS: The candidate should be able to:

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

= taxed capital gain + taxed dividend yield + non-taxed capital gain

The Exceptional Fund’s expected after-tax return is:

= [(0.105 – 0.02) × (1 – 0.10 × 0.20)] + [0.02 × (1 – 0.30)]

The Superior Fund’s expected after-tax return is:

= [(0.11 – 0.01) × (1 – 0.60 × 0.20)] + [0.01 × (1 – 0.30)]

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

B. Trust Distribution Portfolio

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

Using modified duration,

Target Change in Value using MD

Because the target MD is zero, then:

Using basis point value,

BPV target = BPV portfolio – BPV hedge

Because the target BPV is zero, then:

1999 Level III Guideline Answers

Change in Value using BPV = BPV × BP change

Change in Value = MD × change in yield × value

Change in Value = BPV × BP change

$94156 × 8 × .0001 × 1328 = $1,000,316.

10 × $75.32 × 1328 = $1,000,249.

1999 Level III Guideline Answers

Question 6 - Short Call/Long Put at Expiration

Long Put+Short Call=Short

1999 Level III Guideline Answers

LOS: The candidate should be able to

The number of contracts, N, can be found by:

N = (BPV spot) / (BPV futures)

N = (value of spot position) / (face value of each futures contract)

1999 Level III Guideline Answers

= ($25 per basis point per contract) × 50 bp × 100 contracts

= ($2,325,000 × 4) / $100,000,000 = 0.093

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

LOS: The candidate should be able to

1999 Level III Guideline Answers

LOS: The candidate should be able to

[(1 + .055) × (1 + .02)] – 1 = 0.076

ii. Risk Tolerance

1999 Level III Guideline Answers