FACULTY OF COMMERCE

DEPARTMENT OF FINANCE
BACHELOR OF COMMERCE HONOURS DEGREE IN FINANCE
PART IV 2011/12
INSTITUTIONAL INVESTMENT MANAGEMENT [CFI 4203] MOCK EXAMINATION
TIME ALLOWED: 2 HOURS

ATTEMPT ALL QUESTIONS

QUESTION ONE [25 marks] - allocate 10 minutes

Write the letter that corresponds to the correct letter.

1 Portfolio management is:

a. an ad hoc procedure.
b. an inflexible system.
c. a process.
d. a set of rules. [1]
Ans. c.

2 The first step of portfolio management is :

a. to assess market conditions.
b. to determine objectives, constraints and preferences.
c. to develop strategies and implement them.
d. to adjust the portfolio as necessary. [1]
Ans. b.

3 Which of the following statements regarding individual and institutional investors is true?
a. Taxes are generally more important to institutional investors than to individual investors.
b. Institutional investors tend to be less precise about their assets and liabilities than individual
investors.
c. Individuals generally have greater freedom in their investment decisions than do institutional
investors.
d. Institutional investors are more defined by their personalities than are individual investors.
[1]
Ans. c.

4. Which of the following is NOT one of the phases of the life-cycle theory of asset allocation?
a. Accumulation phase
b. Consolidation phase
c. Taxation phase
d. Gifting phase [1]
Ans. c

5. Investors can normally afford to assume larger risks in the ____ phase of the life-cycle.
a. accumulation
b. consolidation
c. spending

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 d. gifting [1]
Ans. a.

6. Which of the following statements regarding inflation and investing are true?
a. Futures are the best hedge against inflation.
b. Inflation is not a problem if you follow a buy and hold strategy.
c. Common stock is not always an inflationary hedge.
d. All of the above statements are true. [1]
Ans. c.

7. __________ is the most important investment decision because it determines the risk-return
characteristics of the portfolio.
a. Hedging
b. Market timing
c. Performance measurement
d. Asset allocation [1]
Ans. d.

8. The life-cycle theory of asset allocation proposes that as investors progress through life, their
a. asset allocation should change to meet changing needs.
b. earnings increase in their 20s, reach a peak at about age 45, then decline.
c. assets must grow geometrically in order to achieve reasonable goals.
d. asset allocation should remain fixed in order to avoid short-sighted adjustments. [1]
Ans. a.

9. An aggressive asset allocation would contain larger proportions of __________ than a conservative
allocation.
a. cash and bonds
b. bonds and large-cap stocks
c. small-cap and international stocks
d. bonds [1]
Ans. c.

10. A model for optimizing the selection of securities is the ______ model.
a. Miller-Orr
b. Black-Scholes
c. Markowitz
d. Gordon [1]
Ans. c.

11. The Markowitz model identifies the efficient set of portfolios, which offers the
a. highest return for any given level of risk or the lowest risk for any given level of return.
b. least-risk portfolio for a conservative, middle-aged investor.
c. long-run approach to wealth accumulation for a young investor.
d. risk-free alternative for risk-averse investors. [1]
Ans. a.

12. Which type of portfolio allocation is usually done once every few years?
a. integrated asset allocation
b. strategic asset allocation
c. tactical asset allocation

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 d. command asset allocation [1]
Ans. b.

13. Which of the following is not normally one of the reasons for a change in an investor's circumstances?
a. change in market conditions
b. change in legal considerations
c. change in time horizon
d. change in tax circumstances [1]
Ans. b.

14. Monitoring and rebalancing a portfolio over time involves all of the following costs EXCEPT
a. commissions.
b. possible impact on market price.
c. holding a portfolio that is no longer adequately diversified.
d. time involved in decision making. [1]
Ans. c.

15. A market timing approach that increases the proportion of funds in stocks when the stock market is
expected to be rising, and increases cash when the stock market is expected to be falling is a:
a. strategic asset allocation.
b. tactical asset allocation.
c. portfolio optimization.
d. liquidity expectation timing. [1]
Ans. b.

16. When interest rates decline, the duration of a 30-year bond selling at a premium:
a. Increases.
b. Decreases.
c. Remains the same.
d. Increases at first, then declines. [1]
Ans. a.

17. If a bond manager swaps a bond for one that is identical in terms of coupon rate, maturity, and credit
quality but offers a higher yield to maturity, the swap is:
a. A substitution swap.
b. An interest rate anticipation swap.
c. A tax swap.
d. An intermarket spread swap. [1]
Ans. a.

18. Which bond has the longest duration?

a. 8-year maturity, 6% coupon.
b. 8-year maturity, 11% coupon.
c. 15-year maturity, 6% coupon.
d. 15-year maturity, 11% coupon. [1]
Ans. c.

19. The figure below is a typical illustration of which timing strategy for bond investments?

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 a. Bullet strategy
b. Ladder strategy
c. Barbell strategy
d. Dedicated strategy . [1]
Ans. a.

20. The difference between an arithmetic average and a geometric average of returns
a. Increases as the variability of the returns increases.
b. Increases as the variability of the returns decreases.
c. Is always negative.
d. Depends on the specific returns being averaged, but is not necessarily sensitive to their variability.
[1]
Ans. a.

21. In measuring the performance of a portfolio, the time-weighted rate of return is superior to the dollar-
weighted rate of return because:
a. When the rate of return varies, the time-weighted return is higher.
b. The dollar-weighted return assumes all portfolio deposits are made on day 1.
c. The dollar-weighted return can only be estimated.
d. The time-weighted return is unaffected by the timing of portfolio contributions and withdrawals.
[1]
Ans. d.

22. Pure market timers attempt to maintain a _____________portfolio beta and a __________portfolio
alpha.
a. Constant; shifting
b. Shifting; zero
c. Shifting; shifting
d. Zero; zero [2]
Ans. b.

23. An investor in the common stock of companies in a foreign country may wish to hedge against the
______________ of the investor’s home currency and can do so by __________ the foreign currency in
the forward market.
a. depreciation; selling
b. appreciation; purchasing
c. appreciation; selling
d. depreciation; purchasing. [2]
Ans. c.

QUESTION TWO [25 marks] – allocate 25 minutes

You have been named as investment advisers to a foundation established by Dr. Peter Maphosa with an
original contribution consisting entirely of the common stock of Medico. Inc. Founded by Dr Maphosa,
Medico manufactures and markets medical devices invented by the doctor and collects royalties on other

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patented innovations.

All of the shares which made up the initial contribution to the foundation were sold at a public offering of
Medico common stock and the $5 billion proceeds will be delivered to the foundation within the next week. At
the same time, Mrs Maphosa will receive $5 billion in proceeds from the sale of her stock in Medico.

Dr Maphosas’ purpose in establishing the Maphosa Foundation was to “offset the effect of inflation on medical
school tuition for the maximum number of worthy students.”

You are preparing for a meeting with the foundation trustees to discuss investment policy and asset allocation.

a) Suggest an appropriate investment policy statement for the Maphosa Foundation to be recommended for
adoption by the trustees. [15]

b) Using the data in exhibit A and your own assumptions for the other critical variables, state the optimal
asset allocation that you would recommend for the Maphosa Foundation for the coming annual holding
period and explain how you determined that asset mix. [10]

Exhibit A - Expected Returns for Major Asset Categories over the Next 12 Months

Asset Category Expected Return

Treasury Bills (90 days) 11%
Long Treasury Bonds 14%
Common Stock 15%

a) Candidates are expected to come up with own creative answers, where possible, stating own
assumptions, based on the following sub-headings:

 Investment Portfolio Objectives

 Investment Constraints [Relevant constraints to be discussed]
- Allowable securities
- Diversification
- Liquidity needs
- Tax concerns
- Time horizon
- Legal and regulatory factors
- Social investing
- Unique needs and preferences
 Strategy

b) Candidates are given the opportunity to come up with asset allocation proportions of their own given the
objectives, constraints and strategy recommended in (a) above, as long as
(i) assumptions are clearly spelt out, e.g. assumptions about the effective tax rates, liquidity
requirements, time horizons, etc
(ii) the method used to determine the allocation is clearly spelt out and justified
(iii) the asset mix itself is convincingly justified
(iv) in addition to the asset mix (in decimal or percentage format) and the forecasted/expected
returns, the weighted portfolio return should be shown, preferable in tabular format , e.g. as
follows:

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 Asset Category Weight (%) Return (%) Weighted Return or
Contribution (%)
Treasury Bills (90 days)
Long Treasury Bonds
Common Stock
Portfolio Expected Return

QUESTION THREE [25 marks] – allocate 25 minutes

3.1 In relation to equity portfolio management, identify and explain one (1) of the generic themes that could
be used by active managers to time the market and add value to their portfolios in comparison to the
benchmark. Further, discuss any one (1) strategy that is used to implement the generic themes.
[6]
3.2 Top-down adherents would argue that the biggest differences in portfolio performance come
from differences in asset allocation than in individual stock selection. Why is this likely to be
the case? [5]

3.3 Delta Securities uses the cellular method to construct indexed bond portfolios. Suggest and describe the
main source of tracking error for this approach. [3]

3.4 The yield curve on Government Treasury obligations is shown below:

Maturity YTM Maturity YTM

1 year 10% 5 year 11%
2 year 10 6 year 10
3 year 11 7 year 10
4 year 12 8 year 10

(a) You are the financial executive for a casualty insurance firm and have estimated that the firm will
have to pay $7 million in damage claims in exactly one year and $10 million in exactly two years.
How could you immunize these liabilities today? [6]

3.5 Identify and briefly explain or demonstrate any one active bond management strategy that is available to
an investment manager. [5]

Ans.
3.1 Select one theme from any of the following:
1. They can try to time the equity market by shifting funds into and out of stock, bonds, and T-bills
depending on broad market forecasts and estimated risk premiums.
2. They can shift funds among different equity sectors and industries (financial stocks, consumer
cyclicals, durable goods, and so on) or among investment styles (large capitalization, small
capitalization, value, growth, and so on) to catch the next “hot” concept before the rest of the
market does.
3. They can do stock-picking, looking at individual issues in an attempt to find undervalued stocks
– i.e., buy low and sell high.

Select any one of the following strategies that can be used to implement these investment themes:

a) Global portfolios can apply economic analysis to identify different countries whose equity
markets are potentially undervalued or overvalued. The countries can then be overweight or

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 underweight relative to a global benchmark portfolio. Some global portfolio managers analyze
economic trends, industry competitive forces, and company strength and strategies with a global
perspective. The analyses of financial statements, industries and companies are applied in a
global rather than a national setting in order to identify undervalued industrial sectors and firms.

b) A sector rotation strategy involves positioning the portfolio to take advantage of the market’s
next move. Often this means emphasizing or overweighting (relative to the benchmark
portfolio) certain economic sectors or industries in response to the next expected phase of the
business cycle. This is illustrated below.

Consumer
Durables excel
Economic cycle Peak

Trough Basic
Industries
excel
Financial Capital Consumer
Stocks excel goods excel Staples excel

“Sector” can also include different stock attributes. Because the market seems to favour some
attributes more than others over time, sector rotation may involve overweighting stocks with
certain characteristics, such as small or large capitalization stock, high or low P/E stocks, or
stocks classified as “value” or “growth” stocks.

c) Earnings momentum and price momentum strategies are used because the market at times
seems to reward the stocks of companies whose earnings have steady, above-average growth, or
whose prices are rising because of market optimism.

d) The existence of computer databases has encouraged the use of computer screening and other
quantitatively based methods of evaluating stocks. These screening methods search for
portfolios of stocks with certain characteristics rather than examining individual stocks to
determine whether they are underpriced. E.g. it is possible to generate a list of “value” stocks
with at least a 20% return on equity, stable or growing dividends over he past 10 years, and
below-market P/E ratios.

e) Factor models, similar to those used in the APT, can identify stocks whose earnings or prices
are sensitive to economic variables, such as exchange rates, inflation,, interest rates, or consumer
sentiment. With this information, portfolios can be “tilted” by trading those stocks most
sensitive to the analyst’s economic forecast. The manager can try to improve the portfolio’s
relative performance in a recession by purchasing stocks that are least sensitive to the analyst’s
pessimistic forecast.

f) Some quantitatively oriented portfolio managers use what is called a long-short approach to
investing in the approach, stocks are passed through a number of screens and assigned a rank.
Stocks at the top of the ranking are purchased, stocks at the bottom are sold short.

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 g) Some managers let the computers do all the work. Neural networks are computer programs that
attempt to imitate the thinking patterns of the human brain. They use vast databases and
artificial intelligence capabilities to find cause-and-effect patterns in stock returns. The
computer attempts to discover undervalued securities by identifying abnormal risk-adjusted
return patterns and “learning” what stock attributes drive the market.

h) Active managers also use quadratic programming to solve the efficient frontier optimization
problem of Markowitz. The manager’s expectations about returns, risk, and correlations are
used by the optimizer to select portfolios that offer the optimal risk-return trade-off.

i) Linear programming techniques can be used to construct portfolios that maximize an objective
(such as expected return) while satisfying linear constraints dealing with such items as the
portfolio’s beta, dividend yield, and diversification.

3.2 Expand on the following -

This is likely to be the case because the returns provided by the individual securities within any
particular asset class will generally be a lot more closely (positively) correlated (as they are affected by
similar factors) than will the returns provided by individual securities in different asset classes.

3.3 The stratified sampling, or cellular, method divides the index into cells, with each cell representing a
different characteristic of the index. Common cells used in the cellular method combine (but are not
limited to) duration, coupon, maturity, market sectors, credit rating, and call and sinking fund features.
The index manager then selects one or more bond issues to represent the entire cell. The total market
weight issues held for each cell is based on the target index’s composition of that characteristic.

3.4 End of Present Value Percent of Weighted

Year Liability at 10% Total Duration
1 $7.00 million $6.363636 43.50% 0.4350
2 10.00 million $8.264463 56.50% 1.1300
$14.628099 100.00% 1.5560

An investment of $14.63 million will have to be made in a bond portfolio having a duration of 1.565
years. This could be a single bond, multiple bonds, or even a perfect cash-matched dedicated portfolio.

3.5 Select one active bond management strategy from the following [Refer to notes on bond portfolio
management strategies]

Interest Rate Anticipation.

This is perhaps the riskiest active management strategy because it involves relying on uncertain forecasts
of future interest rates. The idea is to preserve capital when an increase in interest rates is anticipated
and achieve attractive capital gains when interest rates are expected to decline. Such objectives usually
are attained by altering the maturity (duration) structure of the portfolio (i.e., reducing portfolio duration
when interest rates are expected to increase and increasing the portfolio duration when a decline in yields
are anticipated.

Once future interest rates have been determined, the procedure relies largely on technical matters. The
portfolio manager who anticipates higher interest rates has two strategies available:
 Shorten the duration of the portfolio in order to preserve capital at the same time maintain
liquidity by buying high-yielding, short-term obligations, such as Treasury Bills.

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  Look for an attractive cushion bond – a high-yielding, long-term obligation that carries a
coupon substantially above the current market rate and that, due to its current call feature and
call price, has a market price lower than what it should be given current market yield. As a
result, its yield is higher than normal.

When you anticipate a decline in interest rates, you should increase the duration of the portfolio because
the longer the duration, the greater, the price volatility. Also, liquidity is important because you want to
be able to close out the position quickly when the drop in rates has been completed.

Valuation Analysis
The portfolio manager attempts to select bonds based on their intrinsic value. In turn, the bond’s value is
determined based on its characteristics and the average value of these characteristics in the marketplace.
As an example, a bond’s rating will dictate a certain spread relative to comparable Treasury Bonds: long
maturity might be worth an added 60 basis points relative to short maturity (i.e., the maturity spread); a
given deferred call feature might require a higher or lower yield; a specified sinking fund would likewise
mean higher or lower required yields. Given all the characteristics of the bond and the normal cost of
the characteristics in terms of yield, you would determine the required yield and, therefore, the bond’s
implied intrinsic value. Then you would compare these derived bond values to the prevailing market
prices to determine which bonds are undervalued or overvalued. Based on your confidence in the
characteristic costs, you would buy the undervalued issues and ignore or sell the overvalued issues.

Credit Analysis
The strategy involves detailed analysis of the bond issuer to determine expected changes in its default
risk. This involves attempting to project changes in the quality ratings assigned to bonds by the rating
agencies. These rating changes are affected by internal changes in the entity (e.g., changes in important
financial ratios) and by changes in the external environment (e.g., changes in the firm’s industry and the
economy). During periods of strong economic expansion, even financially weak firms may survive and
prosper. In contrast, during severe economic contractions, normally strong firms may find it very
difficult to meet financial obligations. Therefore, historically there has been a strong cyclical pattern to
rating changes: typically, downgradings increase during economic contractions and decline during
economic expansions.

To use credit analysis as a portfolio management strategy, it is necessary to project rating changes prior
to the announcement by the rating agencies. The market adjusts rather quickly to bond rating changes –
especially downgradings. Therefore, you want to acquire bond issues expected to experience upgradings
and sell or avoid those expected to be downgraded.

Yield Spread Analysis

Spread analysis assumes normal relationships exist between the yields for bonds in alternative sectors
(e.g. the spread between high-grade versus low-grade industrial or between industrial versus utility
bonds). Therefore, a bond portfolio manager would monitor these relationships, and, when an abnormal
relationship occurs, execute various sector swaps. The crucial factor is developing the background to
know the normal yield relationship and to evaluate the liquidity necessary to buy or sell the required
issues quickly enough to take advantage of the temporary abnormality.

Bond Swaps
Bond swaps involve liquidating a current position and simultaneously buying a different issue in its
place with similar attributes but having a chance for improved return. Swaps can be executed to increase
current yield, to increase yield to maturity, to take advantage of shifts in interest rates or the realignment
of yield spreads, to improve the quality of a portfolio, or for tax purpose.

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 Types of swaps include:
 Pure yield pickup swap
 Substitution swap
 Tax swap.

QUESTION FOUR [25 marks] – allocate 25 minutes

4.1 Consider the two (excess return) index-model regression results for stocks A and B. The risk-free
rate over the period was 6%, and the market’s average return was 14%. Performance is measured using
an index model regression on excess returns.
Stock A Stock B
Index model regression estimates 1 % + 1.2 (rM – rF) 2% + 0.8(rM – rF)
R-square .576 .436
Residual standard deviation, σ(e) 10.3% 19.1%
Standard deviation of excess returns 21.6% 24.9%

(a) Which stock is the best choice under the following circumstances?
(i) This is the only risky asset to be held by the investor. [4]
(ii) This stock will be mixed with the rest of the investor’s portfolio, currently composed solely of
holdings in the market index fund. [4]
(iii) This is one of many stocks that the investor is analyzing to form an actively managed stock
portfolio. [4]

(b) Explain why the Sharpe ratio versus the Treynor measure often produces conflicting results in measuring
performance. [4]

4.2 Consider the following information regarding the performance of a money manager in a recent month.

Actual Actual Benchmark Index

Return Weight Weight Return
Equity 2% .70 .60 2.5%
Bonds 1% .20 .30 1.2%
Cash 0.5% .10 .10 0.5

(a) What was the manager’s return in the month? What was her overperformance or underperformance?
[5]
(b) What was the contribution of security selection to relative performance? [2]
(c) What was the contribution of asset allocation to relative performance? [2]

Ans.
4.1

(a) (i) If this is the only risky asset held by the investor, then Sharpe’s measure is the appropriate
measure.
Stock A Stock B
*Sharpe measure = (rP – rf)/ σP 0.4907 0.3373

Since the Sharpe measure is higher for Stock A, then A is the best choice.

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 (ii) If the stock is mixed with the market index fund, then the contribution to the overall Sharpe
measure is determined by the appraisal ratio:

Stock A Stock B
Information ratio = αP /σ(eP) 0.0971 0.1047

Therefore, Stock B is preferred.

(iii) If the stock is one of many stocks, then Treynor’s measure is the appropriate measure.
Stock A Stock B
(iv) **Treynor measure = (rP – rf )/β P 8.833 10.500

Stock B is preferred.

4.2
(a) Bogey: (0.60 x 2.5%) + (0.30 x 1.2%) + (0.10 x 0.5%) = 1.91%
Actual: (0.70 x 2.0%) + (0.20 x 1.0%) + (0.10 x 0.5%) = 1.65%
Underperformance: 0.26%
(b) Security Selection:
(1) (2) (3) = (1) x (2)
Differential return
Manager's Contribution to
Market within market
portfolio weight performance
(Manager – index)
Equity –0.5% 0.70 −0.35%
Bonds –0.2% 0.20 –0.04%
Cash 0.0% 0.10 0.00%
Contribution of security selection: −0.39%
(c) Asset Allocation:
(1) (2) (3) = (1) x (2)
Excess weight Index Contribution to
Market
(Manager – benchmark) Return performance
Equity 0.10% 2.5% 0.25%
Bonds –0.10% 1.2% –0.12%
Cash 0.00% 0.5% 0.00%
Contribution of asset allocation: 0.13%
Summary:
Security selection –0.39%
Asset allocation 0.13%
Excess performance–0.26%

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