2004 CFA® Level III Examination FOR AIMR USE ONLY

Morning Session – Essay

Candidate Number:
FOR AIMR USE ONLY

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The following list contains the command words used on the Morning Session of
the 2004 CFA Level III examination. Candidates may want to refer to this list as
they formulate their answers.

Calculate: To ascertain or determine by mathematical processes.

Describe: To transmit a mental image, an impression, or an understanding of the nature

and characteristics of.

Determine: To come to a decision as the result of investigation or reasoning; to settle or

decide by choice among alternatives or possibilities.

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

Explain: To give the meaning or significance of; to provide an understanding of; to give
the reason for or cause of.

Formulate: To put in a systematized statement or expression; to prepare according to a

formula.

Give: To yield or furnish as a product, consequence, or effect; to offer for the

consideration, acceptance, or use of another.

Identify: To establish the identity of; to show or prove the sameness of.

Indicate: To point out or point to with more or less exactness; to show or make known
with a fair degree of certainty.

Judge: To form an opinion about through careful weighing of evidence and testing of
premises.

Justify: To prove or show to be valid, sound, or conforming to fact or reason; to

furnish grounds or evidence for.

Recommend: To bring forward as being fit or worthy; to indicate as being one’s choice for
something or as otherwise having one’s approval or support.

Show: To set forth in a statement, account, or description; to make evident or clear.

Support: To provide with verification, corroboration, or substantiation.

The Morning Session of the 2004 CFA Level III Examination has 13 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.

Question Topic Minutes

1 Portfolio Management 9
2 Portfolio Management 20
3 Portfolio Management 18
4 Portfolio Management 7
5 Portfolio Management 18
6 Portfolio Management 22
7 Portfolio Management 7
8 Portfolio Management 6
9 Asset Valuation 18
10 Asset Valuation 16
11 Asset Valuation 18
12 Portfolio Management 10
13 Portfolio Management 11

Total: 180
Questions 1 through 5 relate to Louise and Christopher Maclin. A total of 72 minutes is
allocated to these questions. Candidates should answer these questions in the order
presented.

QUESTION 1 HAS ONE PART FOR A TOTAL OF 9 MINUTES.

Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment
in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher
Maclin makes the following statements to the Maclins’ financial advisor, Grant Webb:

• “I have used the Internet extensively to research the outlook for the housing
market over the next five years, and I believe now is the best time to buy a house.”

• “I do not want to sell any bond in my portfolio for a lower price than I paid for the
bond.”

• “I will not sell any of my company stock because I know my company and I
believe it has excellent prospects for the future.”

Identify the behavioral finance concept most directly exhibited in each of Maclin’s three
statements. Explain how each behavioral finance concept is affecting Maclin’s investment
decision-making.

Answer Question 1 in the Template provided on page 3.

(9 minutes)
 Answer Question 1 on This Page
Template for Question 1
Identify the behavioral
finance concept most Explain how each behavioral finance
Maclin’s three
directly exhibited in concept is affecting Maclin’s investment
statements
each of Maclin’s three decision-making
statements

“I have used the Internet

extensively to research the
outlook for the housing
market over the next five
years, and I believe now is
the best time to buy a
house.”

“I do not want to sell any

bond in my portfolio for a
lower price than I paid for
the bond.”

“I will not sell any of my

company stock because I
know my company and I
believe it has excellent
prospects for the future.”
QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 20 MINUTES.

Christopher Maclin, aged 40, is a supervisor at Barnett Co. and earns an annual salary of £80,000
before taxes. Louise Maclin, aged 38, stays home to care for their newborn twins. She recently
inherited £900,000 (after wealth-transfer taxes) in cash from her father’s estate. In addition, the
Maclins have accumulated the following assets (current market value):

• £5,000 in cash

• £160,000 in stocks and bonds

• £220,000 in Barnett common stock

The value of their holdings in Barnett stock has appreciated substantially as a result of the
company’s growth in sales and profits during the past ten years. Christopher Maclin is confident
that the company and its stock will continue to perform well.

The Maclins need £30,000 for a down payment on the purchase of a house and plan to make a
£20,000 non-tax deductible donation to a local charity in memory of Louise Maclin’s father.
The Maclins’ annual living expenses are £74,000. After-tax salary increases will offset any
future increases in their living expenses.

During their discussions with Grant Webb, the Maclins express concern about achieving their
educational goals for their children and their own retirement goals. The Maclins tell Webb:

• They want to have sufficient funds to retire in 18 years when their children begin
their four years of university education.

• They have been unhappy with the portfolio volatility they have experienced in
recent years and they do not want to experience a loss greater than 12 percent in
any one year.

• They do not want to invest in alcohol and tobacco stocks.

• They will not have any additional children.

After their discussions, Webb calculates that in 18 years the Maclins will need £2 million to meet
their educational and retirement goals. Webb suggests that their portfolio be structured to limit
shortfall risk (defined as expected total return minus two standard deviations) to no lower than a
negative 12 percent return in any one year. Maclin’s salary and all capital gains and investment
income are taxed at 40 percent and no tax-sheltering strategies are available. Webb’s next step is
to formulate an investment policy statement for the Maclins.
A. i. Formulate the risk objective of an investment policy statement for the Maclins.

ii. Formulate the return objective of an investment policy statement for the Maclins.
Calculate the pre-tax rate of return that is required to achieve this objective.
Show your calculations.

(12 minutes)

B. Formulate the constraints portion of an investment policy statement for the Maclins,
addressing each of the following:

i. Time horizon
ii. Liquidity requirements
iii. Tax concerns
iv. Unique circumstances

Note: Your response should not address legal and regulatory factors.

(8 minutes)
QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES.

Louise and Christopher Maclin have purchased their house and made the donation to the local
charity. Now that an investment policy statement has been prepared for the Maclins, Grant
Webb recommends that they consider the strategic asset allocation described in Exhibit 3-1.

Exhibit 3-1
Louise and Christopher Maclin
Recommended Strategic Asset Allocation
Projected
Annualized Expected
Recommended Current
Asset Class Pre-tax Standard
Allocation Yield
Total Deviation
Return
Cash 15.0% 1.0% 1.0% 2.5%
U.K. Corporate Bonds 55.0 4.0 5.0 11.0
U.K. Small-capitalization Equities 0.0 0.0 11.0 25.0
U.K. Large-capitalization Equities 10.0 2.0 9.0 21.0
U.S. Equities* 5.0 1.5 10.0 20.0
Barnett Co. Common Stock 15.0 1.0 16.0 48.0
Total Portfolio 100.0 --- 6.7 12.4
*U.S. equity data are in British pound terms.

A. Identify two aspects of the recommended asset allocation in Exhibit 3-1 that are
inconsistent with the Maclins’ investment objectives and constraints. Support each of
your responses with one reason.

Answer Question 3-A in the Template provided on page 15.

(6 minutes)

After further discussion, Webb and the Maclins agree that any suitable strategic asset allocation
will include:

• 5 to 10 percent in U.K. small-capitalization equities

• 10 to 15 percent in U.K. large-capitalization equities

For the remainder of the portfolio, Webb is considering the asset class ranges described in
Exhibit 3-2.
 Exhibit 3-2
Louise and Christopher Maclin
Asset Class Ranges
Asset Class Allocation Ranges

Cash 0% to 3% 5% to 10% 15% to 20%

U.K. Corporate Bonds 10% to 20% 30% to 40% 50% to 60%

U.S. Equities 0% to 5% 10% to 15% 20% to 25%

Barnett Co. Common Stock 0% to 5% 10% to 15% 20% to 25%

B. Recommend the most appropriate allocation range for each of the asset classes in Exhibit
3-2. Justify each appropriate allocation range with one reason based on the Maclins’
investment objectives and constraints.

Note: No calculations are required.

Answer Question 3-B in the Template provided on page 16.

(12 minutes)
 Answer Question 3 on This Page
Template for Question 3-A
Identify two aspects of the
recommended asset allocation in
Exhibit 3-1 that are inconsistent with Support each of your responses with one reason
the Maclins’ investment objectives
and constraints
1.

2.
 Answer Question 3 on This Page
Template for Question 3-B
Note: No calculations are required.
Recommend the most
appropriate
allocation range for Justify each appropriate allocation range with one
Asset Class each of the asset reason based on the Maclins’ investment objectives
classes in Exhibit 3-2 and constraints
(circle one for each
asset class)

0% to 3%

Cash 5% to 10%

15% to 20%

10% to 20%
U.K.
Corporate 30% to 40%
Bonds
50% to 60%

0% to 5%

U.S. Equities 10% to 15%

20% to 25%

0% to 5%
Barnett Co.
Common 10% to 15%
Stock
20% to 25%
QUESTION 4 HAS TWO PARTS (A, B) FOR A TOTAL OF 7 MINUTES.

Louise and Christopher Maclin are considering the rebalancing implications of two possible
strategic asset allocation scenarios. Grant Webb outlines a rebalancing methodology that sets
upper and lower limits for the weights of each asset class based on the same fixed percentage
bands for each asset class. The portfolio will be rebalanced to the target allocations whenever
the weight of an asset class violates the fixed percentage limits. Webb also describes an alternate
rebalancing methodology, based on standard deviation, in which each asset class is rebalanced
when the weight for the asset class exceeds the number of standard deviations set for all asset
classes.

A. Discuss why a rebalancing methodology based on fixed percentage bands may result in
excessive transaction costs in each of the following strategic asset allocation scenarios:

i. The Maclins hold a small allocation (less than 5 percent) to an emerging market
equities fund
ii. The Maclins hold a sizable allocation to a hedge fund that has experienced a
persistently very low correlation with the other assets in the portfolio

(4 minutes)

Webb is concerned about the negative effect of realized capital gains on the Maclins’ portfolio.

B. Determine, given Webb’s concern about realized capital gains, whether a rebalancing
methodology based on standard deviation is likely to be more or less appropriate than a
rebalancing methodology based on fixed percentage bands. Justify your response with
one reason.

(3 minutes)
QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES.

Christopher Maclin, after reading an article in a business publication, expresses concern to Grant
Webb that the U.S. equity market is overvalued, especially when measured on a market value to
book value basis. Maclin is particularly concerned about the U.S. technology and service
sectors. Webb states that Tobin’s Q theory adjusts for possible distortions in market value to
book value relationships; he also indicates, however, that the theory may not be appropriate for
valuing technology and service sectors.

A. i. Describe one adjustment that Tobin’s Q theory makes to address distortions in

market value to book value relationships.

ii. Describe one weakness of applying Tobin’s Q theory to technology and service
sectors.

(6 minutes)

Webb explains to Maclin that equity market values can be compared to Gross Domestic Product
(GDP) to determine whether a market is overvalued. Webb states that while the ratio of market
value of equity to GDP is currently high, he is not sure about the usefulness of the ratio given
deleveraging activity in the U.S. market and the fact that an increasing number of U.S. firms are
becoming public companies.

B. Explain how the usefulness of the ratio of market value of equity to GDP is likely to be
affected by:

i. Deleveraging activity in a market

ii. An increasing number of firms in a market becoming public companies

(6 minutes)

Webb indicates to Maclin that the Fed model can be used to forecast equity returns. He tells
Maclin, however, that he expects continued low interest rates and very low inflation in the U.S.
economy, and that such an economic scenario may have implications for the effectiveness of the
Fed model.

C. i. Explain how the Fed model identifies an overvalued equity market.

ii. Determine, in the economic scenario that Webb expects, whether the Fed model
is likely to be effective in identifying whether the equity market is overvalued or
undervalued. Justify your response with one reason.

(6 minutes)
Questions 6 through 11 relate to the Hale Health Foundation and the Glover Scholastic Aid
Foundation. A total of 87 minutes is allocated to these questions. Candidates should answer
these questions in the order presented.

QUESTION 6 HAS TWO PARTS (A, B) FOR A TOTAL OF 22 MINUTES.

The Hale Health Foundation is a company-sponsored U.S. foundation with the sole mission of
supporting the Graceville Clinic. Over the past five years, Hale has contributed 75-80 percent of
the Clinic’s operating budget. Health care costs have grown at 1 percent above the annual rate of
inflation, and this trend is expected to continue.

This year, Hale estimates that its spending budget for the Clinic will be $11 million. Hale’s
management expenses average 0.40 percent of assets. In addition to the ongoing spending
budget, Hale is funding a new facility for the Clinic, which will require a final outlay of
$4 million within six months.

Hale was founded five years ago by Nord Pharmaceuticals with a gift consisting of Nord
company stock and a 100 percent ownership interest in a privately-held computer consulting
business. Nord has contributed $2 million annually to Hale since the initial gift. However, Nord
has faced increasing capital expenditures and recently announced that it will be unable to make
additional contributions to Hale. The computer consulting business is expected to generate $1.25
million of pre-tax income this year; pre-tax income will grow with little volatility at the annual
inflation rate, which is expected to be 1.5 percent for the foreseeable future. The corporate tax
rate is 20 percent.

The following information relates to Hale’s Board of Trustees:

• The Board has diversified the portfolio over time so that Nord common equity
now comprises a small proportion of the overall portfolio. The Board has
expressed a desire to sell the computer consulting business because it requires an
excessive amount of oversight by Hale’s Board and management. Excluding the
computer consulting business, Hale’s portfolio has a market value of $200
million.

• The Board is concerned about the uncertainty of the exact dollar amount of
required spending during the year. Historically, the Board has designated a
portion of the portfolio to serve as a reserve of approximately 15 percent of its
spending budget for the Clinic to ensure that Hale’s annual spending goals will be
met.

• The Board is aware of the market risk/return tradeoff and is willing to accept the
risk necessary to support Hale’s long-term growth orientation. With respect to
return on investable assets, the Trustees have agreed that a shortfall risk limit
(defined as expected total return minus two standard deviations) of –14 percent in
any one year is acceptable.
Sarah Cole, an executive of Nord, has recently been appointed Trustee of Hale, with
responsibility for formulating a new investment policy statement to guide Hale’s investing
activities.

A. i. Formulate the risk objective of an investment policy statement for Hale.

ii. Formulate the return objective of an investment policy statement for Hale.
Calculate the rate of return that is required to achieve this objective. Show your
calculations.

(12 minutes)

B. Formulate the constraints portion of an investment policy statement for Hale, addressing
each of the following:

i. Time horizon
ii. Liquidity requirements
iii. Tax concerns
iv. Legal and regulatory factors
v. Unique circumstances

(10 minutes)
QUESTION 7 HAS ONE PART FOR A TOTAL OF 7 MINUTES.

The Hale Health Foundation has made the $4 million facility payment. Sarah Cole is
considering the most appropriate strategic asset allocation for the Hale portfolio, given Hale’s
investment objectives and constraints.

A consultant has developed five alternative portfolios for Cole to consider, as shown in Exhibit
7-1.

Exhibit 7-1
Hale Health Foundation
Strategic Asset Allocation
Five Alternative Portfolios
Alternative Portfolios
Asset Allocation Percentages
Asset Class
(%)
A B C D E
Cash Equivalents 1 2 4 3 6
U.S. Intermediate-term Bonds 20 23 10 15 15
U.S. High-yield Corporate Bonds 16 25 20 25 25
U.S. Equities 35 35 20 30 24
Non-U.S. Equities 13 5 25 15 15
Real Estate Investment Trusts 15 10 21 12 15
Total 100 100 100 100 100
Alternative Portfolios
Portfolio Measures
A B C D E
Expected Annual Total Return (%) 8.42 7.59 8.77 8.13 7.90
Expected Standard Deviation (%) 11.18 10.31 11.54 10.85 10.28

Recommend the one alternative portfolio in Exhibit 7-1 that is the most appropriate strategic
asset allocation for the Hale portfolio. Justify your response with three reasons. Show your
calculations.

(7 minutes)
QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 6 MINUTES.

Sarah Cole, in addition to serving as Trustee for the Hale Health Foundation, is a board member
of the Glover Scholastic Aid Foundation. Glover, a community foundation with $40 million in
assets, was established to provide financial assistance to students attending a regional school for
the learning disabled. Glover’s investment policy statement, written eight years ago, is as
follows:

“The purpose of the Glover Scholastic Aid Foundation is to provide ongoing assistance to
students of the school. Investments should focus on maximizing income while avoiding
any losses. The Board of Directors has a duty to preserve Glover’s assets and tax-exempt
position while maximizing its ability to support the school.”

Glover has a current spending rate equal to 80 percent of interest and dividend income.
Presently, the Glover portfolio’s asset allocation is 85 percent to U.S. government bonds, 10
percent to U.S. equities, and 5 percent to a U.S. money market fund. The long-term expected
total annual return of the portfolio is 4.0 percent, which includes a 3.5 percent income
contribution. Education costs are expected to increase by 2.0 percent annually over the long
term, and the school is committed to maintaining its current size.

Since joining Glover’s board, Cole has been evaluating Glover’s current risk tolerance, spending
policy, and asset allocation, given its mandate, current funding, and long-term goals.

A. Judge whether Glover or Hale has the greater ability to take risk. Justify your response
with one reference each to:

i. Glover’s ability to take risk

ii. Hale’s ability to take risk

(3 minutes)

B. Judge whether Glover is likely to achieve intergenerational neutrality with respect to

current students and future students of the regional school. Justify your response with
one reference each to:

i. Glover’s spending policy

ii. The Glover portfolio’s asset allocation

(3 minutes)
QUESTION 9 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES.

The Glover Scholastic Aid Foundation has received a €20 million global government bond
portfolio from a Greek donor. This bond portfolio will be held in euros and managed separately
from Glover’s existing U.S. dollar-denominated assets. Although the bond portfolio is currently
unhedged, the portfolio manager, Raine Sofia, is investigating various alternatives to hedge the
currency risk of the portfolio.

The bond portfolio’s current allocation and the relevant country performance data are given in
Exhibits 9-1 and 9-2. Historical correlations for the currencies being considered by Sofia are
given in Exhibit 9-3. Sofia expects that future returns and correlations will be approximately
equal to those given in Exhibits 9-2 and 9-3.

Exhibit 9-1
Glover Scholastic Aid Foundation
Current Allocation
Global Government Bond Portfolio
Allocation Maturity
Country
(%) (years)
Greece 25 5
A 40 5
B 10 10
C 10 5
D 15 10

Exhibit 9-2
Country Performance Data
(in local currency)
5-year 10-year Liquidity
Unhedged
Cash Excess Excess of 90-day
Currency
Country Return Bond Bond Currency
Return
(%) Return Return Forward
(%)
(%) (%) Contracts
Greece 2.0 1.5 2.0 --- Good
A 1.0 2.0 3.0 –4.0 Good
B 4.0 0.5 1.0 2.0 Fair
C 3.0 1.0 2.0 –2.0 Fair
D 2.6 1.4 2.4 –3.0 Good
 Exhibit 9-3
Historical Currency Correlation Table
(1998-2003, weekly observations)
€
Currency A B C D
(Greece)
€ (Greece) 1.00 –0.77 0.45 –0.57 0.77
A --- 1.00 –0.61 0.56 –0.70
B --- --- 1.00 –0.79 0.88
C --- --- --- 1.00 –0.59
D --- --- --- --- 1.00

A. Calculate the expected total annual return (euro-based) of the current bond portfolio if
Sofia decides to leave the currency risk unhedged. Show your calculations.

(4 minutes)

B. Explain, with respect to currency exposure and forward rates, the circumstance in which
Sofia should use a currency forward contract to hedge the current bond portfolio’s
exposure to a given currency.

(3 minutes)

C. Determine which one of the currencies being considered by Sofia would be the best
proxy hedge for Country B bonds. Justify your response with two reasons.

(5 minutes)

Sofia has been disappointed with the low returns on the current bond portfolio relative to the
benchmark—a diversified global bond index—and is exploring general strategies to generate
excess returns on the portfolio. She has already researched two such strategies: duration
management and investing in markets outside the benchmark index.

D. Identify three general strategies (other than duration management and investing in
markets outside the benchmark index) that Sofia could use to generate excess returns on
the current bond portfolio. Give, for each of the three strategies, a potential benefit
specific to the current bond portfolio.

Answer Question 9-D in the Template provided on page 52.

(6 minutes)
 Answer Question 9 on This Page
Template for Question 9-D
Identify three general strategies
(other than duration
management and investing in
Give, for each of the three strategies, a potential benefit
markets outside the benchmark
specific to the current bond portfolio
index) that Sofia could use to
generate excess returns on the
current bond portfolio
1.

2.

3.
QUESTION 10 HAS TWO PARTS (A, B) FOR A TOTAL OF 16 MINUTES.

After several years, the Board of Trustees of the Glover Scholastic Aid Foundation has decided
to allocate 12 percent of Glover’s total portfolio to international equities.

The Board is considering three alternative international equity managers: Highlands

Investments, Coastal Asset Management, and Valley Advisors. Portfolio statistics for Glover’s
current total portfolio and each of the three alternative equity managers are given in Exhibit 10-1.
Exhibit 10-2 gives portfolio statistics for Glover’s current total portfolio combined with Coastal
and Valley, respectively. The appropriate risk-free rate of return is 3.82 percent. All returns are
U.S.-dollar based.

Exhibit 10-1
Glover Scholastic Aid Foundation
Portfolio Statistics
Glover’s Coastal
Current Highlands Asset Valley
Total Investments Management Advisors
Portfolio
Return Prior 5 Years 2.10% –2.60% –3.50% –0.50%
Correlation Prior 5 Years with
--- 0.83 0.80 0.87
Current Glover Portfolio
Expected Return 8.50% 8.50% 9.75% 10.50%

Expected Standard Deviation 13.50% 27.00% 18.50% 32.00%

Expected Covariance with
--- 309.80 162.34 367.20
Current Glover Portfolio
Expected Correlation with
--- 0.85 0.65 0.85
Current Glover Portfolio

Exhibit 10-2
Glover Scholastic Aid Foundation
Combined Portfolio Statistics
Highlands and Coastal and Valley and
Glover Portfolio Glover Portfolio Glover Portfolio
Combined Combined Combined
Return Prior 5 Years 1.43% 1.79%
Expected Return 8.65% 8.74%
Expected Standard Deviation 13.43% 15.28%

A. Recommend one of the three alternative international equity managers being considered
by Glover’s Board of Trustees. Justify your response with reference to the portfolio
statistics for all three managers.

(7 minutes)
The Board has asked a consultant about possible determinants of the long-term performance of
Glover’s international equity investments. The consultant makes the following statements:

• “Because Glover’s portfolio has a long-term time horizon, currency risk makes a
much larger contribution to total risk than would be the case for an investor with a
short-term time horizon.”

• “So-called ‘correlation breakdowns’ present Glover with an opportunity to

enhance portfolio diversification.”

• “Glover can expect to realize superior long-term returns by identifying and

investing in international economies that have consistently offered superior
performance over time.”

B. Indicate whether each of the consultant’s three statements is correct or incorrect. If

incorrect, give one reason why the statement is incorrect.

Answer Question 10-B in the Template provided on page 59.

(9 minutes)
 Answer Question 10 on This Page
Template for Question 10-B
Indicate whether each of
the consultant’s three
Consultant’s three statements is correct or If incorrect, give one reason why the
statements incorrect statement is incorrect
(circle one for each
statement)

“Because Glover’s portfolio

has a long-term time horizon, Correct
currency risk makes a much
larger contribution to total
risk than would be the case
for an investor with a short- Incorrect
term time horizon.”

“So-called ‘correlation Correct

breakdowns’ present Glover
with an opportunity to
enhance portfolio
diversification.” Incorrect

“Glover can expect to realize

superior long-term returns by Correct
identifying and investing in
international economies that
have consistently offered
superior performance over Incorrect
time.”
QUESTION 11 HAS ONE PART FOR A TOTAL OF 18 MINUTES.

Several more years have passed, and the Board of Trustees of the Glover Scholastic Aid
Foundation has invested in developed international equity markets with reasonable success.
Recently, the Board discussed adding emerging market equities to the portfolio. During the
discussion, Board members Mark McDuff and Freda Dorton made statements, shown in Exhibit
11-1, about three aspects—currency risk, segmentation and integration, and volatile markets—of
investing in emerging markets.

Exhibit 11-1
Mark McDuff and Freda Dorton
Statements about Three Aspects of Investing in Emerging Markets
I. Currency Risk
For emerging markets, we should expect the local currency movement to be in
McDuff
the opposite direction of the local stock market movement.
Because of the nature of the correlation of market returns and currencies, we
Dorton could suffer more in a down market by investing in emerging markets than if
we had invested in a developed market.
II. Segmentation and Integration
Because of economic linkages, the expected returns of the individual countries
McDuff
should be a function of those countries’ commonly shared risks.
Market efficiency transcends borders because of the global nature of world
Dorton
economies. Local market prices will reflect these efficiencies.
III. Volatile Markets
When looking at investing in volatile emerging markets, we will find that
McDuff
standard deviation is a sufficient measure of risk.
Because emerging markets are often highly volatile, we need to be aware of the
Dorton possibility of large shocks to returns. The distribution of those returns tends to
be non-normal.

Indicate, for each of the three aspects of investing in emerging markets, whether each of the
statements made by McDuff and Dorton is correct or incorrect. If incorrect, give one reason
why the statement is incorrect.

Answer Question 11 in the Template provided on pages 63, 64, and 65.

(18 minutes)
 Answer Question 11 on This Page
Template for Question 11
Indicate, for each of the
three aspects of investing
in emerging markets,
whether each of the
statements made by If incorrect, give one reason why the statement
Three aspects
McDuff and Dorton is is incorrect
correct or incorrect
(circle correct or
incorrect for each
statement)

Correct

McDuff’s
statement

Incorrect

I. Currency Risk

Correct

Dorton’s
statement

Incorrect

Template for Question 11 continued on pages 64 and 65

 Answer Question 11 on This Page
Template for Question 11 (continued)
Indicate, for each of the
three aspects of investing
in emerging markets,
whether each of the
statements made by If incorrect, give one reason why the statement
Three aspects
McDuff and Dorton is is incorrect
correct or incorrect
(circle correct or
incorrect for each
statement)

Correct

McDuff’s
statement

Incorrect

II. Segmentation
and Integration

Correct

Dorton’s
statement

Incorrect

Template for Question 11 continued on page 65

 Answer Question 11 on This Page
Template for Question 11 (continued)
Indicate, for each of the
three aspects of investing
in emerging markets,
whether each of the
statements made by If incorrect, give one reason why the statement
Three aspects
McDuff and Dorton is is incorrect
correct or incorrect
(circle correct or
incorrect for each
statement)

Correct

McDuff’s
statement

Incorrect

III. Volatile
Markets

Correct

Dorton’s
statement

Incorrect
QUESTION 12 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 10 MINUTES.

Kenneth Lee, CFA, is evaluating the performance of several asset management firms. Dragon
International Advisors Ltd. (DIAL), a well-known Singapore-based firm, states that its objective
is to be a regional specialist in security selection and market allocation. DIAL indicates that it
seeks to outperform the MSCI Far East Index (MSCI-FEI) by: (1) identifying substantial
investment opportunities in undervalued and under-researched securities within the index’s
country components, and (2) overweighting/underweighting country components versus the
MSCI-FEI. DIAL further states that it does not practice active currency management as part of
its investment strategy.

The recent performance of DIAL’s growth equity composite is summarized in Exhibit 12-1. The
country components of the composite have average risk relative to their respective country
indexes. Relevant information for the MSCI-FEI is summarized in Exhibit 12-2.

Exhibit 12-1
Dragon International Advisors Ltd.
Growth Equity Composite
Rate of Rate of
MSCI-FEI Rate
Country Country Return in Return in Currency
of Return in
Component Weights Base Local Contribution
Local Currency
Currency Currency
Hong Kong 30% –4.70% –8.70% 4.00% –8.00%
Japan 45% 10.40% 2.40% 8.00% 4.00%
Singapore 25% 15.60% 15.60% 0.00% 7.50%
Composite 100% 7.17% 2.37% 4.80% 1.28%

Exhibit 12-2
MSCI Far East Index (MSCI-FEI)
Rate of Return Rate of Return
Country Country Currency
in Base in Local
Component Weights Contribution
Currency Currency
Hong Kong 30% –4.00% –8.00% 4.00%
Japan 55% 12.00% 4.00% 8.00%
Singapore 15% 7.50% 7.50% 0.00%
Index 100% 6.53% 0.93% 5.60%

Lee has evaluated the contribution of market allocation to the total return of DIAL’s growth
equity composite. He wants to further evaluate the performance of the composite, especially
with respect to DIAL’s statements about security selection and active currency management.
A. Determine the performance of DIAL’s growth equity composite relative to the MSCI-
FEI in terms of:

i. Base currency
ii. Local currency

Show your calculations.

(4 minutes)

B. Judge whether the contribution of security selection to the total return of DIAL’s
growth equity composite is consistent with DIAL’s stated objective regarding security
selection. Justify your response with one reason.

(3 minutes)

C. Judge whether the contribution of currency movements to the total return of DIAL’s
growth equity composite is consistent with DIAL’s statement about active currency
management. Justify your response with one reason.

(3 minutes)
QUESTION 13 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 11 MINUTES.

Julia Lueck, principal of Dragon International Advisors Ltd. (DIAL), has decided that DIAL will
comply with the Global Investment Performance Standards (GIPS®). She begins by reviewing
all monthly composite calculations to ensure that DIAL has complied with all of the GIPS
composite calculation requirements. DIAL currently presents its investment performance using a
composite, calculated on a monthly basis, for each investment objective. DIAL’s growth equity
composite consists of four client portfolios that are fully invested in large-capitalization growth
equities, as shown in Exhibit 13-1.

Exhibit 13-1
Dragon International Advisors Ltd.
Growth Equity Composite
Performance Period: December 2003
Beginning Market Ending Market
Monthly
Client Value Value
Return
Portfolio (Millions of (Millions of
(%)
Singapore Dollars) Singapore Dollars)
A 125.0 126.5 1.20
B 220.0 218.0 0.91
C 68.0 69.8 1.65
D 92.0 93.9 1.10
Total 505.0 508.2

A. Calculate the GIPS-compliant composite-level return for DIAL’s growth equity

composite for December 2003. Show your calculations.

(3 minutes)

Lueck determines that the monthly returns are gross of both management fees and transaction
costs.

B. Discuss whether DIAL can present each of the following in compliance with the account-
level calculation requirements of GIPS:

i. Returns that are gross of management fees

ii. Returns that are gross of transaction costs

(4 minutes)

Lueck has decided that DIAL will obtain an independent third-party verification prior to
claiming compliance with GIPS, and has contracted with a local firm to perform a verification of
only the growth equity composite.
C. Discuss whether:

i. DIAL may claim compliance with GIPS without independent third-party

verification
ii. Lueck’s plan to obtain independent verification of only the growth equity
composite would comply with GIPS

(4 minutes)
2004 CFA® Level III Examination
Morning Session – Essay

IMPORTANT INSTRUCTIONS TO CANDIDATES

1. Write your candidate number in the spaces provided on the front cover of this
examination book.

2. Complete and sign the pledge attached to the front cover of this examination book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.

3. Write your answers in blue or black ink on the designated answer pages in the
examination book.

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

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

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

7. Use only the Texas Instruments BAII Plus, Hewlett Packard 12C or 12C Platinum
calculator. Use of any other calculator will result in the submission of a Violation
Report to AIMR.

8. You must stop writing immediately when instructed to do so at the conclusion of

the examination.

9. Violation of any of AIMR’s examination rules will result in AIMR voiding your
examination results and may lead to a suspension or termination of your candidacy
in the CFA Program.

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