CFA LV 3 2019 Mock Exam - Morning Session With Solutions

2019 Level III Mock Exam AM
The morning session of the 2019 Level III Chartered Financial Analyst Mock ®
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions Topic Minutes
1–6 Ethical and Professional Standards 18

7–12 Private Wealth 18
13–18 Economics 18
19–24 Asset Allocation 18
25–30 Fixed Income 18
31–36 Fixed Income 18
37–42 Equity 18
43–48 Equity 18
49–54 Derivatives 18
55–60 Performance Evaluation 18
Total: 180
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© 2018 CFA Institute. All rights reserved.
2 2019 Level III Mock Exam AM
2019 LEVEL III MOCK EXAM AM
Foster Asset Management Case Scenario

Jerome Foster, CFA, is the CEO of Foster Asset Management and the chair of the firm’s
Investment Committee. Twenty years ago, he started the firm with 2 employees, and
it has grown to 25 employees, of whom 5 are investment managers. Foster’s clients
range from individuals with very conservative risk profiles allowing only money market
instruments to large institutional investors with higher risk tolerance profiles. Foster
is looking to further expand his business through acquisitions of privately owned asset
management companies. He informs Mercy Ogalo, CFA, the head of compliance and
risk, of his plans to be out of the office for extended periods of time while conducting
initial interviews and due diligence visits.
In a surprising turn of events, Constantile Life, a publicly listed insurance firm that
wishes to enter the asset management industry, approaches Foster. It is interested in
buying Foster Asset Management to complement its product line and to significantly
increase its profitability. Constantile presents an extensive list of documents the firm
wants to examine as part of its due diligence process. Foster updates Ogalo about the
potential buyer and asks her to help gather the due diligence documents, including
the contact information of all the current board members and other shareholders, as
well as copies of all the firm’s policies and procedures. Ogalo mentions to Foster that
she has yet to complete her statutory annual review of the policies and procedures.
Ogalo walks into Foster’s office to update him on the gathering of due diligence
documents requested by Constantile and finds Foster on the phone. He motions for
her to take a seat and hands her a note indicating he is talking with the potential buyer.
She overhears Foster tell the buyer, “We haven’t lost a client in over five years. We’ve
been able to outperform the market on a consistent basis, so our clients love us!” Ogalo
knows the comment about the firm outperforming the market is likely to be true, but
the firm lost two clients just in the last month owing to increasing management fees.
As a condition of purchasing his firm, Constantile requires Foster to remain the
CEO for three years. After the three years, he would be eligible for a significant retire-
ment package if he met certain key performance indicators, including above-average
investment performance. They agreed the performance measurement would be based
on the recommended procedures for compliance with Standard III(D): Performance
Presentation—specifically,
Procedure 1 The firm will create and track weighted composites of similar
portfolios based on their risk profiles.
Procedure 2 When performance includes simulated results due to the intro-
duction of new products, it will be clearly stated in the perfor-
mance presentation.
Procedure 3 Terminated accounts will be removed from the performance
history after 10 years.
In the first Foster Asset Management board meeting after the sale, Calvin Lim,
CFA, the firm’s chief investment officer (CIO), stated, “My investment team recently
added real estate investment trust (REITs) to our model portfolio to see what the
impact would be on investment returns for our clients if we added them to their port-
folios. But this asset class has a much higher risk profile than our normal allowable
assets.” Foster added, “After we analyzed the impact of adding this new asset class to
our model portfolio, we made the decision to add the real estate exposure to all of
our client accounts. We found it is having a positive impact on portfolio returns and
still complies with the firm’s performance measurement policy.”
2019 Level III Mock Exam AM 3
After her annual review of the firm’s policies and procedures, Ogalo decided to make
some changes to strengthen monitoring procedures for the supervisors. Subsequently,
Ogalo presented the proposed changes to the board for approval. She mentioned that
the suggested changes specifically enhance the requirements for the firm’s supervisors.
The c hanges a re a s r ecommended b y t he C FA I nstitute S tandards o f P rofessional
Conduct. If approved by the board, supervisors would be required to implement the
following policy changes once they detect a violation of the firm’s policies:
Policy 1 Give the employee a warning to cease the activity.
Policy 2 Place limits on the employee’s activities.
Policy 3 Report the misconduct up the chain of command.
1 When learning of Foster’s plans to be out of the office, what CFA Institute
Standard of Professional Conduct should Ogalo be least concerned about Foster
violating?
A Disclosure of Conflicts
B Preservation of Confidentiality
C Diligence and Reasonable Basis
B is correct because there was no indication at the time Ogalo learned about Foster’s plan
to acquire additional companies to expand the business that he would potentially share
any confidential client information causing him to violate Standard III(E): Preservation of
Confidentiality. Because Foster is the buying entity, it is unlikely he would share client
information with the target companies.
A is incorrect. Ogalo should be concerned about Foster violating Standard VI(A):
Disclosure of Conflicts, which requires members and candidates to make full and fair
disclosure of all matters that could reasonably be expected to interfere with respective
duties to their clients. As chair of the Investment Committee, Foster has a duty to the
firm’s clients and is responsible for ensuring the clients’ interests are first and foremost.
Because Foster expects to be out of the office for extended periods of time looking for
potential acquisitions, he could potentially be putting his interests ahead of his clients,
whose demands are increasing. To avoid violating the Standards of Professional Conduct,
Foster needs to appoint a new Investment Committee chair who is capable of protecting
the interests of the clients.
C is incorrect. Because Foster is chair of the investment committee, Ogalo should be
concerned about his ability to appropriately oversee the firm’s investment responsibil-
ities as required by Standard V(A): Diligence and Reasonable Basis given his extended
time out of the office.
Guidance for Standards I–VII

LOS a
Standard VI(A): Disclosure of Conflicts
2 Given Constantile’s due diligence requests, what should Ogalo’s priority be to

most likely avoid violating any CFA Institute Standards of Professional Conduct?
A Update all of the firm’s policies and procedures.
B Get permission from the board and shareholders.
C Add the potential buyer to the firm’s restricted list.
C is correct. To avoid violating any Standards of Professional Conduct, Ogalo’s priority

should most likely be adding the potential buyer to the firm’s restricted list. Standard II(A):
Material Nonpublic Information requires members and candidates who are in possession
of material nonpublic information that could affect the value of an investment not to act
on this information or cause others to act on the information. Because Ogalo knows the
potential buyer is a publicly listed company and the purchase of Foster Asset Management
would likely be considered material, she needs to ensure that no one in the firm acts
on the information that the publicly listed company is interested in acquiring the asset
management firm. She can do this by putting the potential buyer on the firm’s restricted
list to ensure no one trades in the public shares. Protecting the integrity of the capital
markets is of higher importance than protecting the confidentiality of the board and the
shareholders and updating the firm’s policies and procedures as legally required. Both
of these things can be done, after the restricted list has been updated.
A is incorrect because although updating the firm’s policies and procedures after a
review is legally required, there is no indication of any urgency; no deadline was stated.
Ensuring the restricted list is updated immediately helps protect the integrity of the
capital markets. Therefore, she can update the policies and procedures after she has
added the potential buyer to the firm’s restricted list.
B is incorrect because although Ogalo should protect confidential information of the
board members and the shareholders, she should protect the integrity of the capital
markets first by adding the potential buyer to the firm’s restricted list. If she sought per-
mission from the board and shareholders to give their confidential information to the
potential buyer before adding the potential buyer to the restricted list, a conflict could
arise if the firm were to trade in shares of the insurance company.

LOS a
Standard II(A): Material Nonpublic Information
3 After overhearing Foster’s phone conversation, what should Ogalo most likely
do regarding Foster’s potential violation of any CFA Institute Standards of
Professional Conduct?
A Find out the context in which Foster responded, “No clients had been lost.”
B Anonymously report Foster to the CFA Institute Professional Conduct staff.
C Independently confirm that the firm has consistently outperformed the
market.
A is correct. Ogalo should most likely determine the context in which Foster made his
comment. She may initially believe Foster violated Standard I(D): Misconduct by mis-
stating that the firm had not lost any clients in five years, when she knows for a fact the
firm had lost clients. However, as the firm’s compliance officer and a CFA charterholder,
she has a responsibility—according to Standard IV(C): Responsibilities of Supervisors—to
discover the context in which Foster made the statement. He may have been answering
any one of a variety of questions, such as a question related to having lost any clients
as a result of poor investment performance. If that is how the question was framed to
Foster, his answer would not have violated Standard I(D): Misconduct.
B is incorrect because Ogalo should first try to find out more about why Foster made
the statement to determine the likelihood a violation has occurred. If she reports Foster to
CFA Institute without finding out more information, Foster’s reputation could be harmed.
C is incorrect because Ogalo does not need to independently confirm the firm’s per-
formance. As the firm’s compliance officer, she would likely have been monitoring the
performance measurement procedures and the performance figures all along.

LOS a
Standard I(D): Misconduct and Standard IV(C): Responsibilities of Supervisors
4 Which of the performance reporting procedures agreed upon by Foster and

Constantile least likely satisfies the recommended procedures to comply with
Standard III(D): Performance Presentation?
A Procedure 1
B Procedure 2
C Procedure 3
C is correct. Procedure 3—“Terminated accounts will be removed from the performance

history after 10 years”—least likely satisfies the recommended procedures to comply with
Standard III(D): Performance Presentation. Recommended procedures for complying with
this standard state that terminated accounts always remain as part of the performance
history, with a clear indication of when the accounts were terminated. There is no set
timeframe to remove the data.
A is incorrect because it is a recommendation that performance of weighted compos-
ites of similar portfolios be presented rather than using a single representative account.
The fact it was agreed that similarities be defined by the risk profile of the client would
likely be appropriate.
B is incorrect because it is a recommendation when performance includes simulated
results, in this case because of the introduction of new products, that this fact should
be clearly disclosed in the performance presentation.

LOS b
Standard III(D): Performance Presentation
5 During Lim’s presentation to the board of directors, who mostly likely violated
Standard III: Duties to Clients?
A Lim
B Foster
C Lim and Foster
C is correct. Both Lim, as CIO, and Foster, as the chair of the Investment Committee, most
likely violated Standard III(C): Suitability. After realigning the model portfolio, they added
REITs, a much riskier new asset class, to client portfolios. There is no indication they
obtained client approval prior to adding the new riskier asset class to the clients’ port-
folios or that the new asset class was even allowable according to the clients’ investment
policy statements (some clients were invested only in money market instruments), nor
did they confirm the suitability of a higher-risk asset class for all clients given that some of
the clients had conservative risk profiles. Members and candidates have a responsibility
to manage assets according to a predetermined specific mandate, including risk and

liquidity constraints. Any change in the investment philosophy would require clients’
permission prior to implementation.
A and B are incorrect because both Lim and Foster most likely violated Standard III(C):
Suitability—not just Lim or just Foster.

LOS a
Standard III(C) Suitability
6 Which of Ogalo’s proposed policy changes would most likely prevent supervi-
sors from being in violation of Standard IV(C): Responsibilities of Supervisors?
A Policy 1
B Policy 2
C Policy 3
B is correct. Standard IV(C): Responsibilities of Supervisors requires members and candi-

dates to make reasonable efforts to ensure that anyone subject to their supervision or
authority complies with applicable laws, rules, regulations, and the Code and Standards.
Pending the outcome of an investigation after a violation has been detected, a supervisor
should take steps to ensure that the violation will not be repeated, such as placing limits
on the employee’s activities or increasing the monitoring of the employee’s activities.
A is incorrect. Standard IV(C): Responsibilities of Supervisors requires members and
candidates to make reasonable efforts to ensure that anyone subject to their supervision
or authority complies with applicable laws, rules, regulations, and the Code and Standards.
Relying on an employee’s statements about the extent of the violation or assurance that
the wrongdoing will not reoccur is not enough to ensure an effective monitoring system
is in place as required by the Standard.
C is incorrect. Standard IV(C): Responsibilities of Supervisors requires members and
candidates to make reasonable efforts to ensure that anyone subject to their supervision
or authority complies with applicable laws, rules, regulations, and the Code and Standards.
Reporting the violation up the chain of command is not enough to ensure an effective
monitoring system is in place as required by the Standard.

LOS b
Standard IV(C): Responsibilities of Supervisors
Edvard Richards Case Scenario

Edvard Richards is president and sole owner of More Than Lumber Corporation
(MTL), a privately held building materials company. Founded by the Richards family,
the company has been run by Edvard Richards for more than 40 years. Richards also
owns investment real estate in the form of a warehouse unrelated to MTL, as well as
70,000 common shares of publicly traded Cintas (CTAS) that he inherited. He wants
these two items to be considered concentrated positions.
Now 68, Richards is seeking advice on how to transition to retirement. He pro-
vides information about his holdings, shown in Exhibit 1, to two competing financial
advisers, Todd Adams and Linda Boshe.
Exhibit 1 Richards’ Values

Estimated Value Cost Basis
Asset ($ thousands) ($ thousands)
Primary residence (no mortgage) 2,000 2,000

MTL Corp 11,000 2,000
Common stock (70,000 shares CTAS) 4,000 1,000
Warehouse 3,000 4,300
Municipal bond portfolio 3,000 3,150
Global all-cap equity fund 3,400 1,650
Cash equivalents 300 300
Tax Rates
Capital gains tax rate = 20%

Income tax rate = 40%
Richards asks each adviser to apply a goal-based planning framework he has read
about that uses three risk buckets: personal, market, and aspirational. As a first step,
he estimates his own after-tax primary capital assuming that all assets are sold today
and converted into cash. He asks the two advisers to assess his after-tax primary
capital under the same assumptions (all three estimates are provided in Exhibit 2).
Exhibit 2 Estimates of After-Tax Primary Capital ($

thousands)
Richards 11,780
Adams 8,380
Boshe 11,640
Richards wants to monetize and eliminate the concentration risk of his CTAS hold-
ing without paying taxes on capital gains and then invest the proceeds in a balanced
portfolio. He notes the following comments in his discussions with the two advisers:
Richards: “My broker says he can arrange a cashless collar against CTAS or a
short sale against the box. I understand that both methods will avoid
incurring an immediate capital gain and both will expose me to the
same level of market risk. I can borrow against the position in both
cases and offset the cost of borrowing with the CTAS dividends.”
Adams: “We could help you complete a short against the box transaction. This
strategy will provide a high loan-to-value (LTV) ratio and avoid coun-
terparty risk. A total return equity swap has these same advantages.
You can thus realize the economic gain on CTAS while deferring capital
gains taxes.”
Boshe: “We suggest either a forward conversion with options or an equity
forward sale. Either will achieve high LTV ratio monetization without
incurring immediate capital gains taxes, and both methods avoid coun-
terparty risk.”
Adams has strong connections to the real estate market and informs Richards that
the market value estimate of $3 million for the warehouse is much too low. He advises
Richards to consider reducing his real estate risk directly by using the immediate cash
inflows net of tax liabilities and costs to increase his stock and bond portfolios. Adams
is confident he can arrange any of the following real estate offers:
1 Sell the warehouse for $4.8 million to an outside investor.
2 Enter into a recourse mortgage loan, with the warehouse valued at $5.8 million
by the lender and an LTV ratio of 80%.
3 Enter into a sale-and-leaseback, with the warehouse valued at $4.9 million and
the first year’s rental payment of $150,000 payable at the start of the lease.
Boshe has strong connections to the investment banking community. Richards has
authorized her to ascertain the level of interest for the sale of MTL. Boshe is confident
she can arrange any of the following strategies:
MTL A private equity firm can arrange to leverage MTL, paying Richards 40%
Strategy 1: of his estimated value of MTL (as shown in Exhibit 1) in cash up front
and rolling the remaining 60% of the value into new shares that pay no
dividends. Richards will stay on as president for five years, during which
time he will help transition leadership to a new team. After five years,
he will sell or monetize the remaining ownership.
MTL A small but rapidly growing publicly traded building materials com-
Strategy 2: pany is willing to acquire 100% ownership and pay Richards $7 million
in cash up front and employee stock options that he can exercise after
two years and that expire in five years. The public company is too small
to support publicly traded stock options. Should the public company’s
stock rise, Richards can exercise his employee stock options, which will
be taxed as ordinary income. To protect the value of his appreciated
stock while participating in further upside potential, he can purchase
long-term protective put options on an industry exchange-traded fund
(ETF) that closely tracks the building materials industry. If the public
company’s stock subsequently drops along with the industry, he can sell
the puts.
MTL Create an employee stock ownership plan (ESOP) that would borrow
Strategy 3: sufficient funds to purchase 40% of Richards’s ownership. Richards
would maintain upside potential in his retained shares, which could be
sold at some point in the future.
7 Using the planning framework that Richards suggests, which person’s estimate
of the after-tax primary capital is most accurate?
A Boshe
B Richards
C Adams
C is correct. Primary capital is the sum of assets that fall into the personal and market
risk buckets. It includes the residence, municipal bond portfolio, global equity fund,
and cash equivalents. It excludes the values of MTL and the concentrated positions in
CTAS public stock and the warehouse (investment real estate)—those are considered
aspirational.
Gain= Tax = Gain Net Value

Value Cost Value – Cost × 0.20 after Tax
Asset ($000s) ($000s) ($000s) ($000s) ($000s)
Residence 2,000 2,000 0 0 2,000

Muni Bonds 3,000 3,150 (150) –30 3,030
Global 3,400 1,650 1750 350 3,050
Equities
Cash 300 300 0 0 300
Equivalents
Total Net Value = 8,380
Adams has the correct value.

B is incorrect. Richards’ error was to include the net value of the CTAS, which is aspi-
rational: 8,380 + 4,000 – [(4,000 – 1,000) × 0.20] = 11,780.
A is incorrect. Boshe’s error was to include the net value of the investment real estate
(aspirational): 8,380 + 3,000 + tax loss of (cost of 4,300 – 3,000) × 0.20 = 8,380 + 3,000 +
260 = 11,640.
Concentrated Single-Asset Positions

LOS f
Section 3
8 Richards’ understanding about monetizing CTAS is most accurate with respect

to:
A using the CTAS dividends to offset borrowing costs.
B avoiding immediate capital gains under both strategies.
C the risk exposure of both strategies.
B is correct. Richards’ understanding about avoiding immediate capital gains is correct.

The short sale against the box approach defers capital gains. No sale of stock occurs
in establishing the collar. The short against the box strategy is riskless, but the collar
does carry risk within the range between the exercise prices of the put and the call. The
dividends will continue to be paid to Richards only in the collar. The dividends will pass
through to the lender of the shares that were borrowed in the short against the box
strategy and thus not available to Richards.
A is incorrect. The dividends will pass through to the lender of the shares that were
borrowed in the short against the box strategy and are therefore not available to Richards.
C is incorrect. The short against the box strategy is riskless, but a collar does carry
market risk within a range of the stock’s trading price.

LOS d, h
Section 4.3
9 Which of Adams’ and Boshe’s comments about counterparty risk is most accu-
rate? The comment made by:
A Boshe about her proposed strategies.
B Adams about the total return equity swap.
C Adams about the short sale against the box.
C is correct. Adams’ statement about the short sale against the box is correct because it
creates a riskless position. Although the forward conversion with options avoids coun-
terparty risk, the equity forward sale and the total return equity swap use a derivatives
dealer and thus include counterparty risk.
A is incorrect. Although the forward conversion with options avoids counterparty risk,
the equity forward sale uses a derivatives dealer and therefore includes counterparty risk.
B is incorrect. The total return equity swap uses a derivatives dealer and therefore
includes counterparty risk.

LOS d, h
Section 4.2, 4.3
10 Using the information in Exhibit 1 and Adams’ real estate proposals, which
offer will provide the largest immediate addition of funds to Richards’ stock and
bond portfolios?
A Offer 3
B Offer 1
C Offer 2
B is correct. Immediate cash inflows available would include proceeds and the pos-
sible first rental payment in Offer 2; all cash flows are net of taxes. As shown in the table
below, Offer 1, selling the warehouse outright, produces the highest immediate cash
flow net of taxes:
Income Tax
Deduction
Taxes Paid Loan on Rent Net to Reinvest
Offer Gains Taxes Proceeds Initial Lease Income Tax Offer less all
Offer Amount Cost = 20% LTV = 80% Payment rate = 40% taxes
1 4,800,000 4,300,000 (100,000) 4,700,000

2 5,800,000 4,300,000 0 as no sale 4,640,000 4,640,000
occurs
3 4,900,000 4,300,000 (120,000) (150,000) 60,000 4,690,000
A is incorrect. It assumes that rental payment is income received (not paid) in Offer 3.
C is incorrect. It assumes that Offer 2 involves a sale.

LOS k, l
Section 6
11 Which of Boshe’s MTL strategies least likely describes a staged exit strategy?
A MTL Strategy 3
B MTL Strategy 1
C MTL Strategy 2
C is correct. MTL Strategy 2 is not a staged exit strategy because it does not provide for
two specific liquidity events: cash up front and a sale or monetization of the remainder
of Richards’ ownership in the future. Strategies 1 and 3 are staged exit strategies that
provide for two liquidity events.
A is incorrect. Strategy 3 is a staged exit strategy. It provides for two specific liquidity
events: cash up front and a sale or monetization of the remainder of his ownership in
the future.
B is incorrect. Strategy 1 is a staged exit strategy. It provides for two specific liquidity
events: cash up front and a sale or monetization of the remainder of his ownership in
the future.

LOS j
Section 4.3
12 Which of the following statements about Boshe’s proposed exit strategies from
MTL is most accurate?
A MTL Strategy 2 exhibits cross hedging.
B MTL Strategy 2 provides for the possibility of yield enhancement.
C MTL Strategy 3 exhibits a mismatch in character.
A is correct. Evidence of both cross-hedging and a mismatch in character is present in

MTL Strategy 2. Buying put options on the ETF is a cross-hedge against the industry risk
faced by the public company. The scenario outlines an exercise of employee stock options,
which will be taxed as ordinary income, and an eventual profit from a put option, which
will be taxed as a capital gain. This difference in tax type is a mismatch in character.
B is incorrect. Yield enhancement involves covered call writing, which is not evident.
C is incorrect. The mismatch in character is evident in Strategy 2 but not Strategy 3.

LOS h, i
Section 4
Ptolemy Foundation Case Scenario

The Ptolemy Foundation was established to provide financial assistance for education
in the field of astronomy. Tom Fiske, the foundation’s chief investment officer, and his
staff of three analysts use a top-down process that begins with an economic forecast,
assignment of asset class weights, and selection of appropriate index funds. The team
meets once a week to discuss a variety of topics ranging from economic modeling,
economic outlook, portfolio performance, and investment opportunities, including
those in emerging markets.
At the start of the meeting, Fiske asks the analysts, Len Tuoc, Kim Spenser, and
Pier Poulsen, to describe and justify their different approaches to economic forecast-
ing. They reply as follows.
Tuoc: I prefer econometric modeling. Robust models built with detailed

regression analysis can help predict recessions well because the estab-
lished relationships among the variables seldom change.
Spenser: I like the economic indicators approach. For example, the composite of
leading economic indicators is based on an analysis of its forecasting
usefulness in past cycles. They are intuitive, simple to construct, require
only a limited number of variables, and third-party versions are also
available.
Poulsen: The checklist approach is my choice. This straightforward approach
considers the widest range of data. Using a simple statistical method,
such as time-series analysis, an analyst can quickly assess which mea-
sures are extreme. This approach relies less on subjectivity and is less
time-consuming.
The team then discusses what the long-term growth path for US GDP should be
in the aftermath of exogenous shocks because of the financial crisis that began in
2008. They examine several reports from outside sources and develop a forecast for
aggregate trend growth using the simple labor-based approach and appropriate data
chosen from the items in Exhibit 1.
Exhibit 1 10-Year Forecast of US Macroeconomic Data

Growth in real consumer spending 3.1%
Growth in potential labor force 1.9%
Growth in labor force participation –0.3%
Growth in labor productivity 1.4%
Yield on 10-year Treasury bonds 2.7%
Growth in total factor productivity 0.5%
Change in trade deficit –0.5%
Upon a review of the portfolio and his discussion with the investment team, Fiske
determines a need to increase US large-cap equities. He prefers to forecast the average
annual return for US large-cap equities over the next 10 years using the Grinold–Kroner
model and the data in Exhibit 2.
Exhibit 2 Current and Expected Market Statistics, US

Large-Cap Equities
Expected dividend yield 2.1%
Expected repurchase yield 1.0%
Expected real earnings growth 2.6%
Expected inflation rate 2.3%
Current P/E 15.6
Expected P/E 10 years hence 15.0
The analysts think that adding to US Treasuries would fit portfolio objectives, but
they are concerned that the US Federal Reserve Board is likely to raise the fed funds
rate soon. They assemble the data in Exhibit 3 in order to use the Taylor rule (giving
equal weights to inflation and output gaps) to help predict the Fed’s next move with
respect to interest rates.
Exhibit 3 Current Data and Forecasts from the Fed

Statistic Status Value (%)
Fed funds rate Current 3

Neutral 2.5
GDP growth rate Trend 4.5
Forecast 3
Inflation Target 2.5
Forecast 3.2
To assess the attractiveness of emerging market equities, Fiske suggests that they
use the data in Exhibit 4 and determine the expected return of small-cap emerging
market equities using the Singer–Terhaar approach.
Exhibit 4 Data for Analyzing Emerging Markets

Degree of
Standard Correlation Integration
Asset Class Deviation with GIM with GIM
Emerging small-cap equity 23% 0.85 65%

Global investable market (GIM) 7.00%
Additional information
Risk-free rate: 2.5%

Illiquidity premium: 60 bps
Sharpe ratio for GIM and emerging small-cap equity: 0.31
Finally, after examining data pertaining to the European equity markets, the
investment team believes that there are attractive investment opportunities in selected
countries. Specifically, they compare the recent economic data with long-term average
trends in three different countries, shown in Exhibit 5.
Exhibit 5 Relationship of Current Economic Data to Historical Trends: Selected European Countries
Ireland Spain Hungary
Production Above trend, declining Well above trend Below trend, rising
Inflation Above trend, declining Average, rising Below trend, stable
Capacity utilization Above trend Average, rising Below trend
(continued)
Exhibit 5 (Continued)
Ireland Spain Hungary

Confidence Average, declining Well above trend Below trend, rising
Fiscal/monetary policies Cautionary Restrictive Stimulatory
13 Regarding the approaches to economic forecasting, the statement by which

analyst is most accurate?
A Poulsen
B Tuoc
C Spenser
C is correct. Spenser’s statement is most accurate. In the economic indicators approach,

for example, the composite of leading economic indicators is based on an analysis of its
forecasting usefulness in past cycles. The indicators are intuitive, simple to construct,
require only a limited number of variables, and third-party versions are also available.
A is incorrect. Contrary to Poulson’s statement, the checklist approach is highly sub-
jective and time-consuming.
B is incorrect. Contrary to Tuoc’s statement, the relationships between variables
are likely to change. In practice, model-based forecasts rarely forecast recessions well,
although they have a better record of anticipating upturns.
Capital Market Expectations

LOS n
Section 4.5.4
14 Using the data in Exhibit 1 and the labor-based method chosen by the team, the
most likely estimate for the 10-year annual GDP growth is:
A 3.0%.
B 3.5%.
C 3.6%.
A is correct. The simplest way to analyze an economy’s aggregate trend growth is to

split it into
■ growth from changes in employment (growth from labor inputs), and
■ growth from changes in labor productivity.
For longer-term analysis, growth from changes in employment is broken down further
into growth in the size of the potential labor force and growth in the actual labor force
participation rate.
Growth from Changes in Percent
Employment Growth in potential labor force +1.9

Growth in labor force −0.3
participation
+ Labor productivity Growth in labor productivity +1.4
= Estimate of GDP growth rate 3.0
B is incorrect. It incorrectly added total factor productivity, but this is a sub-component

of total labor productivity: 1.9 + (–0.3) + 1.4 + 0.5 = 3.5.
C is incorrect. It incorrectly uses consumer growth average of 3.1% plus benefit of
0.5% reduction in the trade deficit = 3.6%. Or, alternatively, simply ignoring the (–) for
the labor force participation will also result in: 1.9 + 0.3 + 1.4 = 3.6%.

LOS j
Section 4.2.2
15 Using the data in Exhibit 2 and Fiske’s preferred approach, the estimated
expected annual return for US large-cap equities over the next 10 years is clos-
est to:
A 7.9%.
B 7.6%.
C 7.4%.
B is correct. The Grinold–Kroner model formula is

E(R) = D/P ‒ ∆S + i + g + ∆PE
First, compute the compound annual growth rate of the P/E: (15.0/15.6)1/10 – 1 = ‒0.4%.
Next, compute, as a percentage, the expected return per the Grinold–Kroner model
formula:
E(R) = 2.1 ‒ (‒1.0) + 2.3 + 2.6 – 0.4 = 7.6
where
E(R) = expected rate of return on equity

D/P = expected dividend yield
∆S = expected percent change in number of shares outstanding
i = the expected inflation rate
g = the expected real total earnings growth rate (not identical to EPS
growth rate in general, with changes in shares outstanding)
∆PE = per period percent change in the P/E multiple
A is incorrect. It ignores compounding of change in P/E over ten years and just uses
the percent change in P/E, which is −0.6/15 = −0.04.
E(R) = 2.1 – (–1.0) + 2.3 + 2.6 – 0.04 = 7.9
C is incorrect. It uses a simple difference in the P/E of 15.6 – 15 = 0.6.

E(R) = 2.1 – (–1.0) + 2.3 + 2.6 – 0.6 = 7.4

LOS c
Section 3.1.2.1
16 Using the data in Exhibit 3 and the investment team’s approach to predict the
Fed’s next move, the new fed funds rate will most likely be:
A 2.9%.
B 2.6%.
C 2.1%.
C is correct. The Taylor rule is
Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)] + [0.5 × (Iforecast

– Itarget)]
= 2.5 + [0.5 × (3.0 – 4.5)] + [0.5 × (3.2 – 2.5)]
= 2.5 – 0.75 + 0.35
= 2.10%
A is incorrect. It incorrectly reversed the terms within the parentheses:
2.5 + [0.5 × (4.5 – 3.0)] + [0.5 × (2.5 – 3.2)] = 2.5 + 0.75 – 0.35 = 2.9
B is incorrect. It incorrectly uses the current rate of 3.0 for the first term instead of
the neutral rate of 2.5%.

LOS h
Section 4.1.5.3
17 Using the data in Exhibit 4 and Fiske’s suggested approach, the forecast of the
expected return for small-cap emerging market equities is closest to:
A 8.9%.
B 9.9%.
C 9.5%.
C is correct. The Singer and Terhaar approach for determining the expected return on
an asset class involves determining the risk premium arising from systematic risk as a
weighted average of the risk premiums arising from a fully integrated market and fully
segmented market, where the weights for the fully integrated market is the degree of
integration of the markets.
■■ The risk premium for the fully integrated market is given by:
RPi = σiρi,M(RPM/σM) where (RPM/σM) is the Sharpe ratio for the

world market portfolio
■■ The risk premium for the fully segmented market is given by: RPi = σi(RPM/σM)
■■ In addition, if there are market imperfections such as illiquidity premiums, they
must be added in
■■ Finally, the expected return on the asset class is determined by adding these risk
premiums to the risk-free rate, in the classical CAPM fashion.
Step 1: Systematic risk premium in fully integrated market
Risk Premium: RPi = σiρi,M(RPM/σM)

= [23% × 0.85 × 0.31]
= 6.06%
Step 2: Systematic risk premium in fully segmented market
Risk Premium: RPi = σi(RPM/σM)

= [23% × 0.31]
= 7.13%
Step 3: Weight systematic risk premiums by degree of integration:
0.65 × 6.06 + 0.35 × 7.13 = 6.43%
Step 4: Add the illiquidity premium
6.43% + 0.60% = 7.03%
Step 5: Add the risk-free rate:
2.5% + 7.03% = 9.53%
A is incorrect. It omits the liquidity premium.

= [23% × 0.85 × 0.31]
= 6.06%

= [23% × 0.31]
= 7.13%
Step 3: Weight systematic risk premiums by degree of integration:
0.65 × 6.06 + 0.35 × 7.13 = 6.43%
Step 4: Error: Omit the illiquidity premium
6.43%
2.5% + 6.43% = 8.93%
B is incorrect. It incorrectly reverses weights: apply 0.65 weighting to 7.73% and 0.35
weighting to 6.06.

= [23% × 0.85 × 0.31]
= 6.06%

= [23% × 0.31]
= 7.13%
Step 3: Error: reverse weights of systematic risk premiums by degree of integration:
0.35 × 6.06 + 0.65 × 7.13 = 6.76%
Step 4: Add the illiquidity premium
6.76% + 0.60% = 7.36%
2.5% + 7.36% = 9.86%

LOS c
Section 3.1.4
18 Among the three countries examined by the investment team, which is in the
most attractive phase of the business cycle for equity returns?
A Hungary
B Ireland
C Spain
A is correct. The most favorable phases when considering equity returns are initial
recovery and early upswing; the late upswing, slowdown, and recession phases carry
the greater risk for equities.
Hungary has the combination of factors consistent with the initial recovery/early
upswing phases of the business cycle—increasing production, low inflation, improving
confidence, stimulatory fiscal/monetary policies, and abundant capacity. These indicators
point to strongly rising stock prices and therefore most attractive for equity returns.
C is incorrect as discussed above. Spain appears to be in late upswing with high
production, exuberant confidence and rising inflation, and restrictive fiscal/monetary
policies. Stocks would be topping out and often volatile.
B is incorrect as discussed above. Ireland is likely at risk of entering a recession with
production, utilization and inflation each above long-term averages while confidence
is weakening. Fiscal/monetary policies are on a cautionary note. Stocks would be in
bottoming/starting to rise stage.

LOS f, g
Sections 4.1.2, 4.6.2, 4.6.6
Remington Wealth Partners Case Scenario

Preston Remington is the managing partner of Remington Wealth Partners. The firm
manages high-net-worth private client investment portfolios using various asset allo-
cation strategies. Analyst Hannah Montgomery assists Remington.
Remington and Montgomery’s first meeting of the day is with a new client, Spencer
Shipman, who recently won $900,000 in the lottery. Shipman wants to fund a comfort-
able retirement. Earning a return on his investment portfolio that outpaces inflation
over the long term is critical to him. He plans to withdraw $54,000 from the lottery
winnings investment portfolio in one year to help fund the purchase of a vacation
home and states that it is important that he be able to withdraw the $54,000 without
reducing the initial $900,000 principal. Montgomery suggests they use a risk-adjusted
expected return approach in selecting one of the portfolios provided in Exhibit 1.
Exhibit 1 Investment Portfolio One-Year Projections

Return Standard Deviation
Portfolio 1 10.50% 20.0%

Portfolio 2 9.00 13.0
Portfolio 3 7.75 10.0
All data are tax adjusted.
Remington and Montgomery discuss the importance of strategic asset allocation

with Shipman. Remington states that the firm’s practice is to establish targeted asset
allocations and a corridor around the target. Movements of the asset allocations
outside the corridor trigger a rebalancing of the portfolio. Remington explains that
for a given asset class, the higher the transaction costs and the higher the correlation
with the rest of the portfolio, the wider the rebalancing corridor. Montgomery adds
that the higher the volatility of the rest of the portfolio, excluding the asset class being
considered, the wider the corridor.
Remington and Montgomery next meet with client Katherine Winfield. The firm
had established Winfield’s current asset allocation on the basis of reverse optimiza-
tion using the investable global market portfolio weights with further adjustments to
reflect Winfield’s views on expected returns.
Remington and Montgomery discuss with Winfield some alternative asset allocation
models that she may wish to consider, including resampled mean–variance optimization
(resampling). Remington explains that resampling combines mean–variance optimiza-
tion (MVO) with Monte Carlo simulation, leading to more diversified asset allocations.
Montgomery comments that resampling, like other asset allocation models, is subject
to criticisms, including that risker asset allocations tend to be under-diversified and
the asset allocations inherit the estimation errors in the original inputs.
Montgomery inquires whether asset allocation models based on heuristics or
other techniques might be of interest to Winfield and makes the following comments:
1 The 60/40 stock/bond heuristic optimizes the growth benefits of equity and the
risk reduction benefits of bonds.
2 The Norway model is a variation of the endowment model that actively invests
in publicly traded securities while giving consideration to environmental, social,
and governance issues.
3 The 1/N heuristic allocates assets equally across asset classes with regular rebal-
ancing without regard to return, volatility, or correlation.
Finally, Remington and Montgomery discuss Isabelle Sebastian. During a recent
conversation, Sebastian, a long-term client with a $2,900,000 investment portfolio,
reminded Remington that she will soon turn age 65 and wants to update her invest-
ment goals as follows:
Goal 1: Over the next 20 years, she needs to maintain her living expenditures,
which are currently $120,000 per year (90% probability of success).
Inflation is expected to average 2.5% annually over the time horizon, and
withdrawals take place at the beginning of the year, starting immediately.
Goal 2: In 10 years, she wants to donate $1,500,000 in nominal terms to a chari-
table foundation (85% probability of success).
Exhibit 2 provides the details of the two sub-portfolios, including Sebastian’s allo-
cation to the sub-portfolios and the probabilities that they will exceed the expected
minimum return.
Exhibit 2 Investment Sub-Portfolios & Minimum Expected Return for

Success Rate
Sub-Portfolio BY CZ
Expected return (%) 5.70 7.10

Expected volatility (%) 5.10 7.40
Current portfolio allocations (%) 40 60
Probability (%) Minimum Expected Return (%)
Time horizon: 10 years

99 2.90 2.50
90 3.40 2.80
85 3.60 3.00
Time horizon: 20 years
95 5.10 5.40
90 5.20 5.70
85 5.60 5.90
Assume 0% correlation between the time horizon portfolios.
19 Which of the portfolios provided in Exhibit 1 has the highest probability of

enabling Shipman to meet his goal for the vacation home?
A Portfolio 1
B Portfolio 2
C Portfolio 3
B is correct. Portfolio 2 has the highest probability of enabling Shipman to meet his goal
for the vacation home. All three of the portfolios’ expected returns over the next year
exceed the 6.0% (see calculations below) required return threshold to avoid reducing
the portfolio. However, on a risk-adjusted basis, Portfolio 2 (probability ratio of 0.231)
has a higher probability of meeting and surpassing the threshold than either Portfolio
1 (probability ratio of 0.175) or Portfolio 3 (probability ratio of 0.225).
Step 1: Calculate the required return threshold: 54,000 ÷ 900,000 = 0.06 = 6.0%.
Step 2: To decide which allocation is best for Shipman, calculate the probability ratio:
[E(RP) – RL] ÷ σP, where
RP = The return for the portfolio

RL = The required return threshold
σP = The standard deviation of the portfolio
Portfolio 1: (10.50% – 6.0%) ÷ 20.0% = 4.50% ÷ 20.0% = 0.225.
Portfolio 2: (9.00% – 6.0%) ÷ 13.0% = 3.00% ÷ 13.0% = 0.231. (Highest)
Portfolio 3: (7.75% – 6.0%) ÷ 10.0% = 1.75% ÷ 10.0% = 0.175.
A is incorrect. Portfolio 1 was chosen because it has the highest projected return.
C is incorrect. Portfolio 3 was chosen because it has the lowest projected standard
deviation.
Principles of Asset Allocation

LOS b
Section 2.1
20 When discussing asset allocation corridors with Shipman, which of Remington’s

and Montgomery’s statements is the least accurate? The one regarding:
A volatility.
B correlation.
C transaction costs.
A is correct. The statement regarding volatility is the least accurate. The higher the vol-
atility of the rest of the portfolio, excluding the asset class being considered, the more
likely a large divergence from the strategic asset allocation becomes, which should point
to a narrower optimal corridor, all else being equal.
B is incorrect. The higher the correlation of an asset class with the rest of the portfolio,
the wider the optimal corridor. When asset classes move in sync, further divergence from
target weights is less likely.
C is incorrect. The higher the transaction costs, the wider the optimal corridor. High
transaction costs set a high hurdle for rebalancing benefits to overcome.

LOS o
Section 6
Monitoring and Rebalancing
LOS d
Section 3.2.2
21 The model on which Winfield’s current asset allocation is based is best charac-
terized as:
A mean–variance optimization.
B Black–Litterman.
C reverse optimization.
B is correct. Winfield’s current asset allocation is most likely based on the Black–Litterman
model. Black–Litterman starts with the excess returns produced from reverse optimi-
zation, which commonly uses the observed market-capitalization value of the assets or
asset classes of the global opportunity set. It then alters the reverse-optimized expected
returns that reflect an investor’s own distinctive views yet still behaves well in an optimizer.
A is incorrect. Asset allocations using mean–variance optimization tend to be con-
centrated in a subset of the available asset classes. Winfield’s portfolio will be allocated
to all or most of the asset classes through the reverse-optimization process followed by
adjustments reflecting the investor’s views.
C is incorrect. Reverse optimization takes as its inputs a set of asset allocation weights
that are assumed to be optimal and, with covariances and the risk aversion coefficient,
solves for expected returns. The starting weights are commonly the observed market-
capitalization value of the assets or asset classes of the global opportunity set. The asset
allocation using reverse optimization would not take into account the investor’s own views.

LOS i
Sections 2.4.1, 2.4.2
22 In Remington and Montgomery’s discussion with Winfield on resampling,

Montgomery’s comment is most likely:
A correct.
B incorrect regarding estimation errors.
C incorrect regarding diversification of asset allocations.
C is correct. Montgomery’s comment about the criticisms of resampling is incorrect

regarding diversification of asset allocations. Risker asset allocations are over-diversified,
not under-diversified. The comment is correct with regard to estimation errors because
the asset allocations do inherit the estimation errors in the original inputs.
A and B are incorrect. Risker asset allocations are over-diversified, not under-diversified.
However, the asset allocations do inherit the estimation errors in the original inputs.

LOS g, a
Section 2.4.4
23 In describing heuristics and other modeling techniques, Montgomery is most

accurate with respect to:
A Comment 1.
B Comment 2.
C Comment 3.
C is incorrect. The 1/N rule asset allocation heuristic involves equally weighting allocations
to assets; 1/N of wealth is allocated to each of N assets available for investment at each
rebalancing date. All assets are treated as indistinguishable in terms of mean returns,
volatility, and correlations.
A is incorrect. It is not an optimization model. The 60/40 stock/bond heuristic allocates

60% of assets to equities, supplying a long-term growth foundation, and 40% to fixed
income, supplying risk reduction benefits.
B is incorrect. The Norway model passively invests in publicly traded securities subject
to environmental, social, and governance concerns. In comparison, the endowment model
asset allocation emphasizes active management of large allocations to non-traditional
investments, seeking to earn illiquidity premiums.

LOS n
Section 5
24 Using Exhibit 2, which of the sub-portfolio allocations is most likely to meet

both of Sebastian’s goals?
A The current sub-portfolio allocation
B A 43% allocation to sub-portfolio BY and a 57% allocation to sub-portfolio
CZ
C A 37% allocation to sub-portfolio BY and a 63% allocation to sub-portfolio
CZ
C is correct. Sebastian needs to adjust the sub-portfolio allocation to achieve her

goals. By adjusting the allocations to 37% × $2,900,000 = $1,073,000 in BY and 63% ×
$2,900,000 = $1,827,000 in CZ, she will be able to achieve both of her goals based on
the confidence intervals.
Goal 1: Sebastian needs to maintain her current living expenditure of $120,000 per
year over 20 years with a 90% probability of success. Inflation is expected to average
2.5% annually over the time horizon.
Sub-portfolio CZ should be selected because it has a higher expected return (5.70%)
at the 90% probability for the 20-year horizon. Although sub-portfolio CZ has an
expected annual return of 7.10%, based on the 90% probability of success requirement,
the discount factor is 5.70%.
Goal 1: k = 5.70%; g = 2.50%.
Determine the inflation-adjusted annual cash flow generated by sub-portfolio CZ:
$1,827, 000 × (0.057 − 0.025)
= $120, 432.04 > $120, 000
 1 + 0.025 20 
1 −    (1.057)
 1 + 0.057  
Goal 2: Sebastian wants to contribute $1,500,000 to a charitable foundation in 10
years with an 85% probability of success.
Sub-portfolio BY should be selected because it has a higher expected return (3.60%) at
the 85% probability for the 10-year horizon. Although sub-portfolio BY has an expected
annual return of 5.70%, based on the 85% probability of success requirement, the dis-
count factor is 3.60%.
Goal 2: k = 3.60%.
Determine the amount needed today in sub-portfolio BY:
$1,500, 000
= $1, 053,158.42 < $1, 073, 000
(1 + 0.036)10
A is incorrect: 40% × $2,900,000 = $1,160,000 in BY, and 60% × $2,900,000 = $1,740,000

in CZ.
Goal 1: k= 5.70%; g = 2.50%.
$1, 740, 000 × (0.057 − 0.025)
= $114, 697.18 < $120, 000
 1 + 0.025 20 
1 −    (1.057)
 1 + 0.057  
Goal 2: k = 3.60%.
$1,500, 000
= $1, 053,158.42 < $1160
, , 000
(1 + 0.036)10
Goal 1 is not realized because the inflation-adjusted annual payment is below $120,000.
Goal 2 is realized.
B is incorrect: 43% × $2,900,000 = $1,247,000 in BY, and 57% × $2,900,000 = $1,653,000
in CZ.
Goal 1: k = 5.70%; g = 2.50%.
$1, 653, 000 × (0.057 − 0.025)
= $108,962.32 < $120, 000
 1 + 0.025 20 
1 −    (1.057)
 1 + 0.057  
Goal 2: k = 3.60%.
$1,500, 000
= $1, 053,158.42 < $1, 247, 000
(1 + 0.036)10
Goal 1 is not realized because the inflation-adjusted annual payment is below $120,000.
Goal 2 is realized.

LOS m
Sections 4.2, 4.3
Betty Derran Case Scenario

Betty Derran has a $30.0 million investment portfolio that is invested entirely in
growth-oriented equity securities. Prior to the recent and unexpected death of Derran’s
husband, the portfolio’s investment policy prioritized long-term wealth generation.
Derran’s financial adviser is Tim Edge, of HSCC Advisers, a fee-only financial
advisory firm.
Because of the death of her husband, Derran has asked Edge to contemplate a
revision to the investment policy. Going forward, Derran would like for the invest-
ment portfolio returns to fund her modest living expenses and her donations to the
endowment of Placid Lake University (PLU), her alma mater.
Bryan Shield, CFA, of BND Asset Management, manages Derran’s investment
portfolio. Derran and Edge are meeting with Shield to discuss the contemplated
revisions to the investment policy. Derran informs Edge and Shield of her intention
to donate $1.5 million in each of the next 10 years to the PLU endowment. Further,
she states that upon her death, the remaining balance of her estate is to be donated
to the PLU endowment.
Shield considers Derran’s financial situation and her stated objectives. He suggests
repositioning the portfolio by selling equities and purchasing bonds such that the
aggregate effect on the portfolio will be to produce regular cash flows, reduce volatility,
and create a direct link between the amount of the reallocated principal and an index
of consumer prices. To accommodate the addition of bonds, Shield recommends an
investment approach that combines immunization with duration matching in order
to reduce the risk associated with changes in market interest rates.
Edge acknowledges the benefits o f a dding b onds to the p ortfolio b ut expresses
concern about the liquidity of bonds relative to publicly traded stocks. Shield responds
by advising that liquidity varies across various subsectors of the bond market and that
the portfolio be structured such that it benefits from illiquid sectors.
Edge is mindful that the aggregate nominal amount of the $1.5 annual giving pro-
gram equals one half of the current $30.0 million portfolio value. Given a life expec-
tancy of an additional 20 years for Derran, Edge asks Shield about the yield income
of the fixed income portfolio. Shield replies by stating that fixed income investment
strategies should be evaluated in terms of expected return, of which yield income
is one component. Shield illustrates by providing the characteristics of a corporate
bond, shown in Exhibit 1.
Exhibit 1 Corporate Bond Characteristics

Par amount $100
Coupon amount (annual frequency) $4.25
Current bond price $97.0000
Expected bond price at investment horizon (assum- $97.2425
ing an unchanged yield curve)
Convexity 0.25
Duration 4.00
Expected yield and yield spread change 0.15%
Shield states that his return expectation for a portfolio of corporate bonds is
3%–6% per annum over a 10-year period. Edge questions whether that level of return
is sufficient for Derran and offers the following suggestions with respect to increasing
portfolio returns.
Suggestion 1 Overweight the portfolio with bonds of highly leveraged com-
panies because their yields generally exceed those of companies
that have lower debt levels.
Suggestion 2 Consider using inverse floaters and fixed-rate receiver swaps
in order to position the portfolio to benefit from any decline in
interest rates over the 10-year market cycle.
Suggestion 3 Enter into repurchase agreements and securities lending transac-
tions with counterparties that are conservatively leveraged.
Derran thanks Shield and Edge for their counsel. She decides that she would like to
alter the portfolio by reducing the allocation to equity securities and adding exposure
to both inflation-protected notes and corporate bonds. Because she will be paying
capital gains taxes on the sale of the equity securities, she wishes to minimize future
investment-related taxes. Derran makes the following comment: “My priority is for
the annual donation to the PLU endowment to be funded from interest income and
maturing bonds. At times, we may need to swap similar bonds for tax management pur-
poses. Unless you are offsetting gains with losses, you should realize short-term gains
while deferring short-term losses because I consider myself to be a patient investor.”
25 In repositioning the portfolio, Shield should most likely add:
A inflation-linked bonds.
B fixed-coupon bonds.
C floating-coupon bonds.
A is correct. Adding inflation-linked bonds to the portfolio incorporates each of the ele-
ments of producing regular cash flows, reducing volatility, and maintaining a direct link
to an index of consumer prices. Inflation-linked bonds provide investors with valuable
inflation-hedging benefits by paying a return that is directly linked to an index of con-
sumer prices and adjusting the principal for inflation. There are several different structures
for inflation-linked bonds, such as zero-coupon bonds with the inflation adjustment
made to the principal payment and capital-indexed bonds, where a fixed coupon rate
is applied to a principal amount that is adjusted for inflation throughout the bond’s life.
B is incorrect. Fixed-coupon bonds do not provide inflation protection for a bond’s
coupon payments or principal.
C is incorrect. Floating-coupon bonds provide inflation protection for a bond’s coupon
but not for its principal.
Introduction to Fixed-Income Portfolio Management

LOS a
Section 2
26 The investment approach Shield recommends is best described as:

A absolute return.
B horizon matching.
C enhanced indexing.
B is correct. Horizon matching is a hybrid approach to liability-based mandates that

combines cash flow matching and duration matching. Cash flow matching intends to
match a short- to medium-term liability stream (charity donations for the first five years)
to a stream of bond portfolio cash inflows. Duration matching further considers that the
bond portfolio’s reinvestment risk and market price risk offset each other as it relates to
the charity donations during Years 6 through 10.
A is incorrect. Absolute return (and relative return) is an established objective within
a total return mandate. A total return mandate makes no attempt to match investment
returns with future liabilities.
C is incorrect. Enhanced indexing is an approach to a total return mandate.

LOS b
Section 3
27 In comparing bonds with publicly traded stocks, Shield should most likely sug-
gest buying and holding:
A longer-maturity, smaller-issue, BBB rated corporate bonds.

B recently issued sovereign government bonds.
C shorter-maturity, larger-issue, AA rated corporate bonds.
A is correct. The liquidity premium represents the incremental yield that investors require
to buy and hold illiquid bonds. Among bond market subsectors, recently issued sovereign
bonds are more liquid than higher-rated corporate bonds. Higher-rated corporate bonds
are more liquid than lower-rated corporate bonds. Across all credit spectrums, bonds
of nearer-term maturity are more liquid than bonds of longer maturity. For corporate
bonds, larger issues are more liquid than smaller issues.
B is incorrect. The liquidity premium relates to buying and holding illiquid bonds.
Active trading is inconsistent with buy and hold. Sovereign government bonds are
generally more liquid than either AA or BBB rated corporate bonds.
C is incorrect. Nearer-to-maturity, larger-issue, higher-rated corporate bonds are
more liquid than longer-term, smaller-issue, lower-rated corporate bonds and thus have
a smaller liquidity premium.

LOS c
Section 4
28 Based on Exhibit 1, the expected return over a one-year horizon for the corpo-
rate bond is closest to:
A 3.90%.
B 4.63%.
C 4.03%.
C is correct. The expected return of the corporate bond is 4.03%, calculated as follows.
4.38% yield Coupon 4.25

income: =
Current bond price 97.00
+ 0.25% roll-down Bond price (end of period) − Bond price (beginning of period) $97.2425 − $97.00
yield: = = 0..25%
Bond price (beginning of period) $97.00
– 0.60% change in –(Duration × ΔYield) + [0.5 × Convexity × (ΔYield2) = (–4.0 × 0.0015) + [0.5 × 0.25 ×
yield and spread: (0.00152) = –0.60%
= 4.03%
A is incorrect because 3.90% incorrectly substitutes the coupon (4.25%) for the income
yield (4.38%) in the calculation of expected return.
B is incorrect because 4.63% represents the rolling yield, which is equal to the income
yield (4.38%) plus the roll-down return (0.25%).

LOS d
Section 5
29 Which one of Edge’s suggestions least likely uses portfolio leverage to increase
returns?
A Suggestion 3
B Suggestion 2
C Suggestion 1
C is correct. Adding bonds of highly leveraged companies does not involve the use of
leverage. The following methods of leverage may be used to increase portfolio returns
relative to an unleveraged portfolio: (1) futures contracts, (2) swap agreements, (3)
structured financial instruments, (4) repurchase agreements, and (5) securities lending.
Each of these methods adds leverage to an unleveraged portfolio, including, as in this
example, an unleveraged portfolio of bonds from highly leveraged companies.
A is incorrect. Suggestion 3 does entail adding methods of leverage. Repurchase
agreements and securities lending transactions are leveraged methods to increase
portfolio returns relative to an unleveraged portfolio.
B is incorrect. Suggestion 2 does entail adding methods of leverage. A fixed-rate
receive swap and an inverse floater are leveraged methods to increase portfolio returns
relative to an unleveraged portfolio.

LOS e
Section 6
30 Is Derran’s comment most likely correct as it relates to tax loss harvesting?

A No. She is incorrect about short-term gains and short-term losses.
B Yes
C No. She is incorrect about offsetting gains with losses.
A is correct. Derran’s comment about realizing short-term gains while deferring short-term
losses is not correct in the context of tax loss harvesting. Tax loss harvesting involves the
timing of investment sales and thus the realization of gains and losses. Controlling the
timing of realizing gains and losses can be valuable for a taxable investor because it may
be optimal to delay realizing gains and related tax payments and to realize losses as soon
as possible. Among the important considerations of tax loss harvesting is a comparison
of short-term and long-term capital gains rates.
B is incorrect. Derran’s comment is not correct.
C is incorrect. Derran’s comment about offsetting gains with losses is correct in the
context of tax loss harvesting.

LOS f
Section 7
Pavonia Case Scenario

Pavonia LDI Consultants offers asset management and advisory services to small firms
with defined benefit plans and to individuals planning for retirement.
At the beginning of 2019, Whitney Adams, senior adviser, meets with her new
client, Donald Berendsen, in order to review the fixed-income portion of his retire-
ment portfolio. Berendsen, who plans to retire in four years, intends to use this part
of the portfolio to supplement income he will be receiving from Social Security, a US
government retirement income program.
Berendsen explains to Adams, “I plan to continue saving for retirement, regularly
adding funds to the portfolio until I retire, and I would like a low-risk solution to
provide additional retirement income.”
Adams replies to Berendsen, “We focus on the ability of the portfolio to meet future
cash flow needs and seek to immunize the liabilities as an objective in the management
of the portfolio. If the fixed-income portfolio achieves an average annual investment
return of at least 4% for the next four years, the proceeds of its liquidation will be
enough to purchase an annuity sufficient to provide the funds needed to supplement
your Social Security benefits. Until then, we will observe the following principles for
managing the portfolio:
Principle I. Our investment strategy is structured to address a Type I liability.
Principle II. The strategy should begin by analyzing the size and timing of
liabilities.
Principle III. The solution will require an asset-driven liability framework as
opposed to a liability-driven investing one.
I have summarized your fixed-income portfolio consisting of three government

bonds in Exhibit 1. The yield curve has steepened since the bonds were purchased,
which can be seen by comparing their respective yield to maturities (YTMs) of the
purchase price yield to today’s yield.”
Exhibit 1 Berendsen Fixed-Income Portfolio Characteristics

Bond A Bond B Bond C
Coupon rate 0.50% 9.00% 4.45%

Maturity date 15-Feb-2021 15-Aug-2023 15-Feb-2027
YTM at time of purchase 2.95% 4.72% 4.97%
YTM at current price 1.85% 4.70% 5.07%
Market value USD732,412 USD930,720 USD986,100
Allocation 28% 35% 37%
Macaulay duration 1.49 3.48 6.43
Note 1: Interest earned on cash: 1.00%

Note 2: Portfolio cash flow yield: 4.15%
Adams states, “Generally when we evaluate similar situations, we will use a passive,
as opposed to an active, management strategy for the fixed-income portfolio, which
means the risk of measurement error will be greater than asset liquidity risk.”
Later, Adams and junior portfolio manager Frank Neeson review the fixed-income
portfolios of two new defined benefit plan clients, Lawson Doors & Cabinets, Inc.,
and Wharton Farms. Lawson’s plan has 30 participants, who are mostly experienced
craftsmen and machinists, whereas Wharton has over 100 participants in its plan. The
average participant age is 15 years younger for the Wharton plan compared with the
Lawson plan. In both plans, participants receive a monthly benefit upon retirement
based on average final pay and have no option for a lump sum distribution. The two
plans’ portfolio characteristics are shown in Exhibit 2.
Exhibit 2 Selected Plan Portfolio Statistics

Lawson Wharton
Market value of assets USD15,498,000 USD8,351,000

Duration of assets 7.79 7.82
Duration of liabilities 7.78 10.01
Semiannual portfolio dispersion 46.07 147.22
Accumulated benefit obligation USD14,389,000 USD7,470,000
Portfolio cash flow yield 4.47% 4.51%
Adams states to Neeson, “For the Lawson and Wharton plans, we can consider
one of three alternative strategies to manage the multiple liabilities associated with
these plans. Whenever a plan’s surplus is less than 5%, we favor passive management
strategies. We could also use a derivatives strategy, and I prefer derivatives strategies
that protect the portfolio against an increase in interest rates but will not produce
large losses if rates decrease.”
Neeson comments, “The durations for almost half of the bonds in the Wharton
portfolio are clustered around 4 years, and the durations of the remainder around
12 years, while the durations of the Lawson portfolio bonds are clustered between
6 years and 8 years. In general, a laddered bond portfolio approach would improve
liquidity management for both, although the Lawson portfolio would experience an
increase in cash flow reinvestment risk and the Wharton portfolio would experience
a decrease in convexity.”
31 Which of Adams’s three principles is least likely relevant for managing
Berendsen’s fixed-income portfolio?
A Principle I
B Principle II
C Principle III
C is correct. Managing the portfolio to Berendsen’s retirement needs is an example of

a liability-driven investment, not an asset-driven liability. The aim of a liability-driven
investment is to manage the assets to meet the liabilities. The liabilities are given and
not driven by the assets.
A is incorrect because this is an example of a Type 1 liability. The price of the annuity
and the timing of its purchase are both known.
B is incorrect because analyzing the size and timing of the liabilities is relevant to
managing Berendsen’s portfolio.
Liability-Driven and Index-Based Strategies

LOS a
Section 2
32 According to the information in Exhibit 1 and assuming Berendsen retires in

four years, the fixed-income portfolio most likely:
A should have a shorter duration.
B needs a higher cash flow yield.
C has currently achieved zero replication.
C is correct. The portfolio’s Macaulay duration of approximately 4.0 matches the time
horizon of the liability and can be calculated as follows:
[(Portfolio weightBond 1 × DurationBond 1) + (Portfolio weightBond 2 ×
DurationBond 2) + (Portfolio weightBond 3 × DurationBond 3)] ÷ 3 = 3.99.
When compared with the single liability due in four years, the portfolio has the same
return and duration characteristics of a single zero-coupon bond maturing in four years.
The interest rate risk has been immunized, which is known as zero replication.
A is incorrect because the portfolio’s current duration matches the duration of the
liability, or retirement date.
B is incorrect because the cash flow yield matches the required investment return.
Although not equivalent to investment return, it is likely the portfolio’s return will meet
the required rate of return.

LOS b
Section 3
33 Is Adams most likely correct in her assessment of measurement error?

A Yes
B No, because passive management would preclude measurement error
C No, because asset liquidity risk is greater than the risk of measurement error
A is correct. Measurement error for Asset BPV can arise even in the classic passive
immunization strategy for Type I cash flows, which have set amounts and dates. Asset
liquidity can become a risk factor in strategies that add active investing to otherwise
passive fixed-income portfolios and would not be applicable here.

LOS e
Section 6
34 Which of the following three strategies is least likely appropriate for the plans
in Exhibit 2?
A Duration matching
B Cash flow matching
C Contingent immunization
B is correct. Cash flow matching is least appropriate for both plans. In both the Lawson
and Wharton plans, participants are entitled to receive a monthly benefit. Cash flow
matching entails building a dedicated portfolio of zero-coupon or fixed-income bonds
to ensure there are sufficient cash inflows to pay the scheduled cash outflows. However,
such a strategy is impractical and can lead to large cash flow holdings between payment
dates, resulting in reinvestment risk and forgone returns on cash holdings.
C is incorrect. Contingent immunization is an appropriate strategy for both plans.

Contingent immunization allows for active bond portfolio management until a minimum
threshold in the surplus is reached. The threshold of 5% (of assets greater than liabilities)
is exceeded in both plans; the Lawson portfolio has a surplus of 7.7%, and the Wharton
portfolio has a surplus of 11.8%.
A is incorrect. Duration management is also appropriate for both the Lawson and
Wharton plans. In this case, however, because they enjoy a surplus of assets to liabilities,
the contingent immunization strategy is most appropriate. Since the plans are in the
process of being advised by Pavonia, Wharton would likely be advised to eliminate the
duration gap in similar form to Lawson.

LOS c
Section 4.1
35 Which of the following strategies most likely meets Adams’ preferences?

A Buy a payer swaption.
B Write a receiver swaption.
C Enter into a pay fixed swap.
A is correct. Adams would most likely buy a payer swaption. Although all three choices
would hedge against rising interest rates, the potential losses on a payer swaption if
rates fell would be limited to the option premium and would not be potentially large
with uncertain timing.
B is incorrect because the potential loss on writing a receiver swaption if rates fell
would be contingent on the interest rate and would be uncertain until termination of
the contract.
C is incorrect because the amount of the potential loss if interest rates fell is contin-
gent on the interest rate and would be uncertain until termination of the contract with
a pay fixed swap.

LOS d
Section 5
36 Is Neeson most likely correct in his assessment of the effects of a laddered bond
portfolio approach on the Wharton and Lawson portfolios?
A Yes
B No, because the Lawson portfolio is a bullet portfolio where the duration of
its assets are matched to the duration of its liabilities
C No, because the duration of the Wharton liabilities is greater than that of
the Lawson liabilities owing to the younger age of its participants
A is correct. A laddered portfolio has lower convexity and dispersion than a barbell
portfolio but more than a bullet portfolio, given comparable duration and cash flow
yields. Lower convexity and dispersion are desirable aspects in liquidity management.
In a laddered portfolio, there is always a bond close to redemption enhancing liquidity.
As bonds mature, the final coupon and principal are available for distribution or can be
reinvested in a long-term bond at the back of the ladder. The Wharton portfolio is more
of a barbell, has higher convexity than the Lawson portfolio, and would see a larger
reduction in cash flow reinvestment risk with the reduction of convexity.
Neither duration nor the projected life of the plan reveal the convexity or dispersion
characteristics of the portfolio.

LOS l
Section 10
Lisette Langham Case Scenario

Lisette Langham is an independent consultant specializing in analysis of active equity
portfolio management, and in her work she often uses such accepted concepts as
alternative beta, Active Share, and active risk. A client, Bob Shaw, asks her to help
evaluate various funds he owns that are managed by the Master Fund Company (MFC).
Langham describes how she uses rewarded factor analysis, regardless of whether a
manager uses factor exposure explicitly. She shows Shaw her analysis of the MFC
Value Fund compared with its benchmark (Exhibit 1).
Exhibit 1 Rewarded Factor Results

Russell
Factor Sources of 1000 Value MFC Value
Performance over 15 years Market (Benchmark) Fund
Market 0.71% 0.59% 0.50%

Size 0.0% –0.04% 0.02%
Value 0.0% 0.08% 0.11%
Momentum 0.0% 0.08% 0.05%
Alpha (non-factor related) 0.0% –0.05% –0.05%
Total monthly performance 0.71% 0.66% 0.63%
On viewing Exhibit 1, Shaw makes the following comments about the MFC Value
Fund:
■■ The small-cap tilt helped.
■■ Value funds were out of favor, as shown by the Value factor results.
■■ Of course, the MFC Value Fund must have a lower alpha because its perfor-
mance was 0.03 percentage point worse than its benchmark.
Shaw has particular interest in MFC’s popular Soar Fund (Soar), which relies on
returns from factor exposures. The description of the fund states that it emphasizes
security-specific factors, maintains low security concentration to keep idiosyncratic
risk down, and embraces quality and value styles. Soar occasionally considers the
economic and geopolitical environment, especially during unusual economic condi-
tions. Langham tells Shaw how she classifies Soar’s portfolio construction approach.
Noting that MFC has two managers who use the same index as their benchmark,
Shaw observes that Fund A and Fund B have similar Active Share and a similar number
of positions, but Fund A’s realized active risk of 7% is almost three times greater than
that of Fund B. Shaw makes the following comments:
■■ I think Fund B makes a lot of sector bets.
■■ Fund A likely has higher fees than Fund B

■■ Fund A should have a greater dispersion of returns about the benchmark.
Shaw next asks Langham to show how risk targets and constraints might differ
between fund managers depending on their respective skills. Langham has Shaw
consider three fund managers, each of whom use the MSCI World Index benchmark.
For each fund, risk targets have been assigned that allow the portfolio managers some
flexibility to exercise their perceived skillsets. Skills include stock picking, factor
exposure, and sector rotation. Based on only the data shown in Exhibit 2, Langham
identifies the skill applied by each manager.
Exhibit 2 Risk Targets and Constraints

Manager constraints Fund X Fund Y Fund Z
Target active risk 8% 7% 4%

Max. sector deviations 1% 15% 10%
Max. risk contribution, single security 4% 2% 1%
Another of Langham’s clients, Marianne Quint, sits on the investment committee

of the Amity Island Endowment. The $2 billion equity portion of the Amity fund is
invested using a global equity index approach. Quint has been charged with identifying
an active equity fund to replace 20% of the indexed portfolio. Three candidate funds
with similar performance histories, benchmarks, and fees have been identified. Based
on the characteristics shown in Exhibit 3, Quint asks Langham to recommend the
fund that has demonstrated the best risk-efficient delivery of results.
Exhibit 3 Characteristics of Candidates for Amity Equity Portfolio

Fund Name Blue Ash March
Sharpe ratio 1.11 0.90 0.92

Annualized active risk 5.5% 6.0% 3.2%
Active Share 0.41 0.48 0.75
Number of securities 340 290 140
Annualized portfolio volatility 11.5% 14.7% 14.9%
Covariance with Amity Fund Low High Low
Langham also identifies the fund that could minimize the active risk of the total
$2 billion Amity equity portfolio after replacement is complete.
37 Which of Shaw’s comments about the MFC Value Fund in Exhibit 1 is most
accurate? The comment concerning:
A alpha.
B small-cap tilt.
C value being out of favor.
B is correct. Shaw’s comment about a small-cap tilt is correct. Additional exposure to

smaller firms resulted in a positive performance of 0.02% for the Size factor.
A is incorrect. Alpha is defined here to include performance unexplained by the factors
and matches that of the benchmark.
C is incorrect. Although the value style does appear to be out of favor as shown by
the lower return than that of the market (0.66% versus 0.71%), the Value factor has a
positive contribution to the return (0.08%).
Active Equity Portfolio Construction

LOS a
Section 2
38 From the description of the Soar Fund, the most appropriate classification of its
portfolio construction process is:
A top-down systematic.
B bottom-up systematic.
C bottom-up discretionary.
B is correct. The Soar Fund has characteristics most consistent with those of a bottom-up
systematic manager. Emphasizing security-specific factors is a bottom-up method.
Targeting low idiosyncratic risk along with low concentrations indicates a systematic
approach, not a discretionary approach. Although the Soar Fund does sometimes consider
macro data and events, this is not its primary top-down driver of portfolio construction.
A is incorrect. Although Soar does sometimes consider macro data and events, this
is not its primary top-down driver of portfolio construction.
C is incorrect. Targeting low idiosyncratic risk along with low concentrations indicates
a systematic approach, not a discretionary approach.

LOS b
Section 3
39 In regard to Shaw’s comments about Fund A and Fund B, the one that is most
accurate concerns:
A Fund A’s fees.
B Fund A’s dispersion.
C Fund B’s sector bets.
B is correct. Shaw’s comment about Fund A’s dispersion is correct. With a higher active
risk (tracking error), Fund A has a greater likelihood of having results dispersed more
broadly (both positive and negative) around benchmark results than Fund B has. Investors
are more likely to be willing to pay higher fees for higher Active Share as an indicator of
greater active management, but Active Share is identical for Fund A and Fund B. Sector
bets are likely to affect active risk; therefore, Fund A is more likely to be using sector
bets, not Fund B.
A is incorrect. Investors are more likely to be willing to pay higher fees for higher
Active Share as an indicator of greater active management, but Active Share is identical
for Fund A and Fund B.
C is incorrect. Sector bets are likely to affect active risk; therefore, it is Fund A that is
more likely to be using sector bets, not Fund B.

LOS c
Section 3.1.4
40 Among the funds shown in Exhibit 2, which one is most likely managed using a
diversified multi-factor investor approach?
A Fund X
B Fund Y
C Fund Z
C is correct. The risk targets for Fund Z are most likely those of a manager using a diversified
multi-factor approach. Low single-security risk of 1% and modest overall portfolio risk of
4%, combined with flexibility on sector risk, demonstrate a highly diversified portfolio
that primarily emphasizes factor exposures. Fund X has risk targets consistent with an
emphasis on stock picking—namely, high active risk, high exposure to risk from a single
security, and low sector deviations. Fund Y has risk targets consistent with an emphasis
on sector rotation—namely, high active risk and a high tolerance for sector deviations.
A is incorrect. Fund X has risk targets consistent with an emphasis on stock pick-
ing—namely, high active risk, high exposure to risk from a single security, and low
sector deviations.
B is incorrect. Fund Y has risk targets consistent with an emphasis on sector rotation—
namely, high active risk and a high tolerance for sector deviations.

LOS c, b
Section 3.1.4
41 The fund in Exhibit 3 that is most consistent with Quint’s requirements is:
A Ash.
B Blue.
C March.
C is correct. The March Fund is the fund that is most consistent with Quint’s requirements
for the best risk-efficient delivery of results. It delivers the lowest active risk (3.2%) using
far fewer securities (140), indicating an efficient approach. The higher Active Share (0.75)
for the similar level of fees also supports this decision.
A is incorrect. Ash has the highest active risk, which indicates active return contri-
butions of a greater dispersion than the benchmark and the competing funds. More
securities and lower Active Share are not supportive of this fund choice.
B is incorrect. Blue has the highest number of securities and a relatively low Active
Share. Although the overall portfolio volatility is the lowest of the three (producing a
higher Sharpe ratio), the more relevant risk is that attributable to active management.
Greater active risk despite more securities is not the most efficient method.

LOS g
Section 7
42 From Exhibit 3, the replacement candidate fund that, if included, will most
likely minimize the active risk of the final Amity equity fund is:
A Ash.
B Blue.
C March.
A is correct. Active risk is a measure of the volatility of portfolio returns relative to the
volatility of benchmark returns. The Ash fund will most likely minimize the active risk
when combined in the final Amity equity portfolio because of its high covariance with
the present fund. The low-covariance funds may reduce overall portfolio volatility but
not active risk.
B is incorrect. The low covariance with the Amity portfolio will lower the overall
volatility of the fund but not the active risk, because active risk measures the volatility
of portfolio returns relative to that of the benchmark: This will be achieved through the
substitution of a high-covariance fund.
C is incorrect. The low covariance with the Amity portfolio will lower the overall
volatility of the fund but not the active risk, because active risk measures the volatility
of portfolio returns relative to that of the benchmark: This will be achieved through the
substitution of a high covariance fund.

LOS d
Section 4.1.2
Sapphire Bay Foundation Case Scenario

Edward Cullen advises the board of directors of the Sapphire Bay Foundation (Sapphire)
regarding all aspects of the investment portfolio of Sapphire’s endowment fund.
Traditionally, Cullen drove the selection of active investment managers for the various
asset classes. Despite historically ranking well among peers, several of the managers
have performed below the level of their respective benchmarks in the past few years.
Cullen’s colleague Paige Stapleton recommends that some passive management should
be introduced into Sapphire’s investment mix using pooled investments. They agree
to introduce the idea to Sapphire’s board at its next meeting.
At the next board meeting, Cullen begins by introducing passive investing to
Sapphire’s board. He states that open-end mutual funds and exchange-traded funds
(ETFs) are appropriate approaches. Both alternatives are readily available, offer a broad
spectrum of investment choices, and are easy to buy and sell. He makes the following
comments comparing the two alternatives.
1 Both mutual funds and ETFs can be purchased on margin.
2 Investors can take short positions in ETFs but not in mutual funds.
3 Both mutual funds and ETFs have the same degree of liquidity.
Stapleton then begins a description of factor-based strategies. These include com-
mon equity factors, such as value, size, and quality, and they can be used either in
place of or to complement market-cap-weighted indexing. She points out that relative
to market-cap weighting, factor-based strategies tend to diversify risk exposures; are
transparent in terms of factor selection, weighting, and rebalancing; but can be copied
by other investors, which can reduce the advantages of a strategy.
Cullen provides Sapphire’s board with an example comparing the performance of
the River Valley Fund, a factor-based fund, with its benchmark portfolio (Exhibit 1).
The fund uses benchmark segments of four mutually exclusive sub-categories. Cullen
calculates the percentage of River Valley’s excess return that resulted from active
factor-weighting decisions.
Exhibit 1 Attribution Data for River Valley Fund and Benchmark

River Valley Fund Benchmark Portfolio
% # of %
Factor Weight Return Stocks Weight Return # of Stocks
Growth 0.22 7.9 23 0.25 7.9 23

Value 0.19 5.2 27 0.19 5.2 27
Quality 0.29 6.7 20 0.26 6.7 20
Momentum 0.30 3.9 24 0.30 4.5 30
Total 1.00 5.84 94 1.00 6.06 100
For the large-cap US equity portion of Sapphire’s investment portfolio, Cullen

believes that there are some existing passive indexed-based funds that track the S&P
500 Index that the foundation should consider. Cullen presents Exhibit 2 to Sapphire’s
board.
Exhibit 2 S&P 500 Index Funds

Manager A Manager B Manager C
Benchmark S&P 500 S&P 500 S&P 500

Number of holdings: fund/ 498/500 504/500 475/500
index
Dividends reinvested Next day Same day Next day
Management fee (in basis 12 15 10
points)
Rebalance Quarterly Quarterly Quarterly
Reconstitution Quarterly Quarterly Semi-Annually
For the international portion of the investment portfolio, Stapleton suggests that
Sapphire invest in an MSCI EAFE index portfolio specifically tailored for the founda-
tion rather than investing in an existing index fund. Anne Rowland, Sapphire’s board
chair, asks her how this could be accomplished, given that the initial allocation is only
$15 million. Stapleton suggests that Sapphire hire a manager to purchase a portfolio

of securities that are a mutually exclusive yet comprehensive subgroup of the index
designed to track the index return and risk characteristics.
43 In comparing mutual funds and ETFs, Cullen is most accurate in:
A Comment 1.
B Comment 2.
C Comment 3.
B is correct. Only ETF investors can take short positions.

A is incorrect. Only ETF investors can purchase shares on margin.
C is incorrect. Mutual funds and ETFs do not have the same degree of liquidity.
Although ETFs allow for inter-day trading they could experience periods of market illi-
quidity. Mutual fund units are redeemed directly from the mutual fund.
Passive Equity Investing

LOS c
Section 3.1
44 When comparing factor-based strategies relative to the market-cap weighting of

an index, Stapleton’s comments are most likely:
A incorrect regarding transparency.
B correct.
C incorrect regarding risk exposure.
C is correct. Stapleton’s comment is incorrect regarding risk exposure. Relative to broad-

market-cap-weighting, passive factor-based strategies tend to concentrate risk exposures,
leaving investors exposed during periods when a chosen risk factor is out of favor.
A is incorrect. Stapleton’s comment is correct regarding transparency. Passive factor-
based strategies tend to be transparent in terms of factor selection, weighting, and
rebalancing. The strategies can be easily replicated by other investors which can produce
overcrowding and reduce the realized advantages of a strategy.
B is incorrect. Stapleton’s comment is correct regarding transparency but incorrect
regarding risk exposure. Passive factor-based strategies tend to be transparent in terms
of factor selection, weighting, and rebalancing. The strategies can be easily replicated
by other investors which can produce overcrowding and reduce the realized advantages
of a strategy. Relative to broad-market-cap-weighting, passive factor-based strategies
tend to concentrate risk exposures, leaving investors exposed during periods when a
chosen risk factor is out of favor.

LOS b
Section 2.4
45 In Exhibit 1, the percentage of the excess return of the River Valley Fund arising
from active factor weighting is closest to:
A 18.18%.
B –0.04%.
C –0.22%.
A is correct. The percentage of excess return arising from active factor weighting is
18.18%. In comparing the weights between the fund and the benchmark, the factors with
different weights are Growth and Quality. The total contribution to the return caused
by active factor weighting is
(Underweighting of the Growth factor + Overweighting of the Quality fac-
tor) Total effect
= (–0.24% + 0.20%) ÷ –0.22% = –0.04% ÷ –0.22% = 18.18%.
The fund’s holding of Momentum securities was less than the benchmark’s (24 versus
30), and thus, the fund incurred active security selection risk. But it did not incur active
factor risk, since the factor weight is the same as that of the benchmark.
River Valley Attribution

Fund Benchmark Return Contribution Analysis Difference Due to:
Benchmark Total Effect
Weight Return Weight Return River Valley (C) × (D) = (E) – (F) = Factor Security
Factor (A) (B) (C) (D) (A) × (B) = (E) (F) (G) Weight Selection
Growth 0.22 7.9% 0.25 7.9% 1.74% 1.98% –0.24% –0.24%

Value 0.19 5.2% 0.19 5.2% 0.99% 0.99% 0.00%
Quality 0.29 6.7% 0.26 6.7% 1.94% 1.74% 0.20% 0.20%
Momentum 0.30 3.9% 0.30 4.5% 1.17% 1.35% –0.18% –0.18%
Total 1.00 1.00 5.84% 6.06% –0.22% –0.04% –0.18%
B is incorrect. The candidate did not divide the sum of the difference due to factor
weights (–0.04%) by the total effect (–0.22%).
C is incorrect. This is the value of the total effect (–0.22%).

LOS f
Section 6.1
46 Based on Exhibit 2, the portfolio manager most likely to have the largest track-
ing error is:
A Manager A.
B Manager C.
C Manager B.
B is correct. Tracking error indicates how closely the portfolio behaves like its benchmark
and measures a manager’s ability to replicate the benchmark return. Manager C is most
likely to have the largest tracking error for three reasons:
■ The portfolio contains a smaller number of the index holdings than the other two
portfolios, resulting in a lower level of replication.
■ Dividends are reinvested the day following receipt rather than the same day,
which would cause cash drag relative to Manager B.
■ The portfolio is reconstituted less frequently than the other two portfolios.
Although Manager C has a slightly lower management fee, which would result in a
lower tracking error, the benefit is unlikely to offset the combined higher tracking error
related to the other portfolio characteristics.
A and C are incorrect.

LOS e
Section 5.2
47 As an indexing technique, the number of holdings in Manager B’s index most

likely illustrates:
A reconstituting.
B packeting.
C buffering.
C is correct. Buffering involves establishing ranges around breakpoints that define whether
a stock belongs in one index or another. Some index providers have adopted policies
intended to limit stock migration problems and keep trading costs low for investors
who replicate indexes. Size rankings may change daily with market price movements,
so buffering makes index transitions a more gradual and orderly process. As long as
stocks remain within the buffer zone, they stay in the current index, and as a result, the
holdings of the fund may exceed the holdings of the index.
A is incorrect. Reconstitution involves deleting names that are no longer in the index
and adding names that have been approved as new index members.
B is incorrect. Packeting involves splitting stock positions into multiple parts. For exam-
ple, if a mid-cap stock’s capitalization increases and breaches the breakpoint between
the mid-cap and large-cap indexes, a portion of the total holding is transferred to the
large-cap index but the rest stays in the mid-cap index. On the next reconstitution date
if the stock value remains large cap and all other qualifications are met, the remainder
of the shares are moved out of the mid-cap index into the large-cap index.

LOS a
Section 2.1
48 The portfolio method suggested by Stapleton to replicate the MSCI EAFE Index
is best described as:
A optimization.
B stratified sampling.
C a blended approach.
B is correct. The portfolio method that Stapleton is describing is stratified sampling. In

equity indexing, stratified sampling methods are most frequently used when the portfolio
manager wants to track indexes that have a large number of constituents or when dealing
with a relatively low level of assets under management. In stratified sampling, the portfolio
manager holds a limited sample of the index constituents arranged in distinct strata or
subgroupings. Arranged correctly, the various strata will be mutually exclusive and also
exhaustive and should closely match the characteristics and performance of the index.
A is incorrect. Optimization typically involves maximizing a desirable characteristic or

minimizing an undesirable characteristic, subject to one or more constraints.
C is incorrect. An indexed portfolio can be managed using a blended approach con-
sisting of full replication for more liquid issues and stratified sampling or optimization
for less liquid issues.

Sections 4.2–4.4
LOS d
Kamiko Watanabe Case Scenario

Kamiko Watanabe, CFA, is a portfolio adviser at Wakasa Bay Securities. She special-
izes in the use of derivatives to alter and manage the exposures of Japanese equity
and fixed-income portfolios. She has meetings today with two clients, Isao Sato and
Reiko Kondo.
Sato is the manager of the Tsushima Manufacturing pension fund, which has a
target asset allocation of 60% equity and 40% bonds. The fund has separate equity
and fixed-income portfolios, whose characteristics are provided in Exhibits 1 and 2.
Sato expects equity values to increase in the coming two years and, in order to avoid
substantial transaction costs now and in two years, would like to use derivatives to
temporarily rebalance the portfolio. He wants to maintain the current beta of the
equity portfolio and the current duration of the bond portfolio.
Exhibit 1 Tsushima Pension Fund Equity Portfolio

Characteristics
Current market value ¥27.5 billion
Benchmark Nikkei 225 Index
Current beta 1.15
Exhibit 2 Tsushima Pension Fund Bond Portfolio

Characteristics
Current market ¥27.5 billion
value
Benchmark Nikko Bond Performance Index composite
Current duration 4.75
In order to rebalance the pension fund to its target allocations to equity and bonds,
Watanabe recommends using Nikkei 225 Index futures contracts, which have a beta of
1.05 and a current contract price of ¥1,525,000, and Nikko Bond Performance Index
futures, which have a duration of 6.90 and a current contract price of ¥4,830,000. She
assumes the cash position has a duration of 0.25.
Sato wants to know if other derivatives could be used to rebalance the portfolio.
In response, Watanabe describes the characteristics of a pair of swaps that, together,
would accomplish the same rebalancing as the proposed futures contracts strategy.
Kondo manages a fixed-income portfolio for the Akito Trust. The portfolio’s market
value is ¥640 million, and its duration is 6.40. Kondo believes interest rates will rise
and asks Watanabe to explain how to use a swap to decrease the portfolio’s duration
to 3.50. Watanabe proposes a strategy that uses a pay-fixed position in a three- year
interest rate swap with semi-annual payments. Kondo decides he wants to use a four-
year swap to manage the portfolio’s duration. After some calculations, Watanabe tells
him a pay-fixed position in a four- year interest rate swap with a duration of –2.875
would require a notional principal of ¥683 million (rounded to the nearest million
yen) to achieve his goals.
Kondo asks Watanabe whether it would be possible to cancel the swap prior to
its maturity. Watanabe responds with three statements:
Statement 1 If you purchase a swaption from the same counterparty as the
original swap, it is common to require the payments of the two
swaps be netted or cash settled if the swaption is exercised.
Statement 2 You could purchase a payer swaption with the same terms as the
original swap. This approach would protect you from falling fixed
swap rates but at the cost of the premium you would pay to the
swaption counterparty.
Statement 3 During the life of the swap, you could enter into a new pay-
floating swap with the same terms as the original swap, except
it would have a maturity equal to the remaining maturity of the
original swap. However, the fixed rate you receive might be lower
than the fixed rate you are paying on the original swap.
49 The number of Nikko Bond Performance Index futures Sato must sell to rebal-
ance the Tsushima pension fund to its target allocation is closest to:
A 743.
B 149.
C 1,594.
A is correct. The total value of the portfolio is ¥55.0 billion, and the 40% target allocation
to bonds would be ¥22.0 billion, but the current allocation is ¥27.5, or ¥5.5 billion more. In
order to correct this discrepancy, the equivalent of ¥5.5 billion in bonds with a duration of
4.75 must be sold using bond futures and then converted to equity exposure with a 1.15
beta using stock futures. The number of bond futures contracts to be sold (shorted) is
(MDURT − MDUR B ) B
Nbf = ×
MDUR f fB
where MDURT is the target modified duration (0.25 for cash), MDURB is the current bond
portfolio duration (4.75), MDURf is the modified duration of the futures contract (6.90), B
is the value of the bonds being converted to cash (¥5.5 billion), and fB is the price of one
bond futures contract (¥4,830,000). Therefore, the number of contacts is;
(0.25 − 4.75) 5,500, 000, 000
Nbf = × = −742.64
6.90 4,830, 000
or sell 743 bond contacts.
B is incorrect because it is calculated using the beta of equity portfolio rather than
the duration of the bond portfolio or
(0.25 − 1.15) 5,500, 000, 000
Nbf = × = −148.53
6.90 4,830, 000
C is incorrect because it is calculated reversing the modified durations of the current
portfolio and the futures or
(0.25 − 6.90) 5,500, 000, 000
Nbf = × = −1,594.20
4.75 4,830, 000
Risk Management Applications of Forward and Futures Strategies

LOS d
Section 4.1
50 The number of Nikkei 225 Index futures Sato must buy to rebalance the
Tsushima pension fund to its target allocation is closest to:
A 3,950.
B 3,293.
C 4,148.
A is correct. The total value of the portfolio is ¥55.0 billion, and the 60% target allo-
cation to equity would be ¥33.0 billion. The current allocation is ¥27.5 or ¥5.5 billion
less. In order to correct this discrepancy, the equivalent of ¥5.5 billion in bonds with a
duration of 4.75 must be sold using bond futures (converted to synthetic cash) and then
converted to equity exposure with a 1.15 beta using stock futures. The number of equity
futures contracts to be bought is;
(βT − βS ) S
N sf = ×
βf fS
where βT is the target beta (1.15), βS is the beta of the synthetic cash position (0), βf is
the beta of the futures contract (1.05), S is the value of the stock being created from the
synthetic cash position (¥5.5 billion), and fS is the price of one equity futures contract
(¥1,525,000). Therefore, the number of contracts is
(1.15 − 0.00) 5,500, 000, 000
N sf = × = −3,950.04
1.05 1,525, 000
B is incorrect.
C is incorrect.
Risk Management Applications of Forward and Futures Strategies

LOS d
Section 4.1
51 Which of these is most likely to be a characteristic of one of the two swaps

Watanabe describes to Sato?
A Receive return on Nikko Bond Performance Index
B Receive Libor
C Pay return on Nikkei 225 Index
B is correct. One of the swaps would be pay Nikko Bond Performance Index return and
receive Libor.
C is incorrect because one of the swaps would be pay Libor and receive, not pay,
Nikkei 225 index return.
A is incorrect because one of the swaps would be receive Libor and pay, not receive,
return on Nikko Bond Performance Index.
Risk Management Applications of Swap Strategies

LOS g
Section 4.3
52 The duration of the swap in Watanabe’s first proposal to Kondo is closest to:
A –2.00.
B –1.75.
C –2.75.
A is correct. A pay-fixed (receive-floating) position in an interest rate swap is similar to

issuing a fixed-rate bond and buying a floating-rate bond with the proceeds. The dura-
tion of the fixed-rate bond is approximately 75% of the maturity, and the swap is short
this duration. The duration of the floating-rate bond is approximately half its repricing
frequency, and the swap is long this duration. Therefore, the duration of the three-year
swap with semi-annual payments is (0.5 × 0.5) – (0.75 × 3) = –2.00.
B is incorrect because it is calculated using the repricing frequency of the floating-rate
bond rather than half of its repricing frequency.
C is incorrect because it is calculated using the maturity of the fixed-rate bond rather
than 75% of its maturity.

LOS b
Section 2.1
53 Is the notional principal of the swap Watanabe recommends to Kondo most

likely correct?
A No, it is too high.
B No, it is too low.
C Yes.
A is correct. The notional principal needed is;
 MDUR T − MDUR B 
NP = B ×  
 MDUR S 
where B is the value of the fixed-income portfolio, and MDUR is the duration of T =
target, B = current portfolio, and S = swap. Therefore, the correct notional principal is
 3.50 − 6.40 
NP = 640 ×   = 645.57
 −2.875 
or ¥646 million rounded to the nearest million yen. Watanabe recommends a notional

principal of ¥683, which is too high.
B is incorrect because the recommended notional principal is too high.
C is incorrect because the recommended notional principal is too high.

LOS d
Section 2.2
54 Which of Watanbe’s three statements to Kondo is least likely correct?

A Statement 1
B Statement 3
C Statement 2
C is correct. The original swap is pay-fixed, implying that the offsetting swap would be
pay-floating. A receiver swaption provides its owner with the right to enter a pay-floating
(receive-fixed) in a swap at the exercise fixed rate, whereas a payer swaption provides
the right to enter the swap in a pay-fixed position.
A is incorrect because a swap position can be cancelled by entering into an offsetting
swap, but the fixed rate of the offsetting swap may be higher or lower than the fixed
rate of the original swap.
B is incorrect because it is common to require netting or cash settlement on exercise
when a swaption is purchased from the counterparty of an existing swap.

LOS h
Section 5
Claire Andrews Case Scenario

Downing Funds (DF) provides investment opportunities for clients by creating funds
that invest in a mix of other existing funds. Claire Andrews evaluates the managers
of funds in which DF currently invests and the managers of funds that may create
future investment opportunities for DF.
Currently, Andrews is considering the performance of the BITR3 fund with some
limited information, shown in Exhibit 1.
Exhibit 1 One Month of Fund Performance for BITR3 Fund

(in € millions)
Fund Contribution/ Fund Value with
Day Value (Withdrawal) Contributions
0 9.5 0 9.5
10 9.8 –2.5 7.3
25 8 1.5 9.5
30 9.6 0 9.6
Rates of Return
Exhibit 1 (Continued)
Fund Contribution/ Fund Value with

Day Value (Withdrawal) Contributions
Time-weighted (TWR): 14.24%
Money-weighted (MWR): 13.57%
Andrews also receives incomplete attribution information for another fund, EATR7,
shown in Exhibit 2. Similar to the BITR3 fund, the EATR7 fund may have some future
investment potential. She requests that her analyst, Ted Kukar, complete the analysis.
Exhibit 2 EATR7 Fund Attribution Information (in $ millions)

Incremental
Return Incremental Value
Investment Alterative Fund Value Contribution Contribution
Beginning value 104.56

Net contributions 105.77 0.00% 1.21
Risk-free asset 107.72 1.95
Asset category 115.7 7.98
Benchmarks 116.23 0.53
Investment managers 118.55 2.32
Allocation effects 120.33 1.78
Total fund 120.33 15.77
Kukar tells Andrews that he has heard that the EATR7 fund generates a portion
of its return from investing in smaller companies within its sector that are about to
be acquired.
Kukar states that he cannot confirm whether the fund is following this “small
company” strategy based on the existing data. He further states that with aggregate
industry sector data supplied by the EATR7 fund, he could determine whether this
strategy is being used.
After receiving the assignment and discussing it with Andrews, Kukar discusses
some benchmarking issues with a fellow analyst, Rob Kinney. Kukar states: “I want
to calculate a return based on a given manager’s style of investing. I intend to find an
appropriate benchmark portfolio that is not a market index and subtract the bench-
mark portfolio return from the manager’s portfolio return.”
Kinney replies: “I believe your calculation will capture the manager’s active return
and not a style return.”
Kinney continues: “To capture the style return, you will need to subtract a market
index return instead of a benchmark portfolio return from the manager’s portfolio
return.”
Andrews assigns Kinney to perform a micro attribution analysis for a current fund
manager within the DF family of funds. This manager invests in four specific sectors
of the US economy and holds some cash, as shown in Exhibit 3.
Exhibit 3 Micro Attribution Data for DF Fund Manager

Benchmark Benchmark
Portfolio Portfolio Portfolio Portfolio Return
Sector: Weight (%) Weight (%) Return (%) (%)
1 20 30 –0.4 –0.7
2 40 30 3.8 4.2
3 10 20 2.4 2.6
4 25 20 5.4 2.92
Cash: 5 0 0.09 0
Note: DF fund manager has trading costs of 27 basis points.
Before Andrews leaves, Kukar states that he has calculated the Sharpe ratios for
a fund and a benchmark that is based on the market portfolio when the risk-free rate
is zero, as indicated in Exhibit 4.
Exhibit 4 Sharpe Ratios for a Fund and Its Benchmark

Fund Benchmark
Sharpe Ratio 0.35 0.4

Expected Return 7.20% 6.80%
Risk-free rate: 0%; Benchmark is based on the market portfolio
Kukar tells Kinney and Andrews that the information ratio should simply be the
difference between the two Sharpe ratios.
■■ Kinney disagrees but says that at least M2 for the fund could be calculated by
multiplying the Sharpe ratios.
■■ Andrews disagrees with both analysts and states that M2 for the fund can be
calculated as the product of the fund’s Sharpe ratio and the expected return of
the benchmark, divided by the benchmark’s Sharpe ratio.
55 The primary reason for the TWR differing from the MWR for the BITR3 fund
is most likely:
A a contribution prior to the fund value rising.
B withdrawals being larger in magnitude than contributions.
C a withdrawal prior to the fund value rising.
C is correct. The TWR is greater than the MWR because there is a large withdrawal of
€2.5 million prior to significant fund growth of 9.6% (i.e., [8.0/7.3] – 1 = 9.6%). In this case,
the €1.5 million contribution prior to modest growth is inconsequential and, in isolation,
would actually move the MWR to be greater than the TWR.
Fund
Fund Contribution/ Value with Subperiod Return for
Day Value (Withdrawal) Contributions TWR calculation:
0 9.5 0 9.5
10 9.8 –2.5 7.3 3.2% = (9.8/9.5) – 1
25 8 1.5 9.5 9.6% = (8.0/7.3) – 1
30 9.6 0 9.6 1.1% = (9.6/9.5) – 1
Evaluating Portfolio Performance

LOS c
Section 4.5
56 The incremental return contribution of the total fund for the EATR7 fund is
closest to:
A 13.9%.
B 14.9%.
C 15.1%.
A is correct. The incremental return contribution of the total fund is the total fund
incremental value contribution ($120.33 – $104.56 = $15.77 million) minus the net con-
tributions ($1.21 million) divided by the beginning value of the fund ($104.46 million).
(120.33 – 104.56 – 1.21)/104.56 = 14.56/104.56 = 0.1393 = 13.9%
B is incorrect. The net contributions of 1.21 are included in the initial fund value only:
15.77/(104.56 + 1.21) = 0.1491 = 14.91%.
C is incorrect. The net contributions of 1.21 are not in the calculation: 15.77/104.56 =
0.1508 = 15.08%.

LOS k, l
Section 6.4
57 When Kukar discusses the data in Exhibit 2 with Andrews, his statement with
regard to analyzing the “small company” strategy is most likely:
A incorrect in regard to the additional data requirements.
B correct in regard to the existing data and the additional data requirements.
C incorrect in regard to the existing data.
A is correct. The existing data is macro attribution data and cannot be used to analyze
a “small company” strategy. Industry sector micro attribution data are necessary, but at
the individual firm level and not at the aggregate level. Otherwise, there is no means to
determine whether the investment is in a small or large firm (i.e., based on the “funda-
mental factor” of firm size).
B is incorrect. Kukar’s additional data requirements will not allow him to analyze
small companies.
C is incorrect. Kukar is correct in regard to the existing data.

LOS k, l, m
Sections 6.4 and 6.7
58 In the conversation between Kukar and Kinney about benchmarking, which

statement is most accurate?
A Kukar’s statement about the style of investing
B Kinney’s statement about active return
C Kinney’s statement about the style of investing
B is correct. Kinney’s statement concerning the active return is correct because the
active return is assessed by subtracting the benchmark return from the manager’s
portfolio return.
The portfolio return can be defined as P = M + S + A,
where
M = Return on market index

S = Return from manager’s investment style (B – M)
B = Return on selected benchmark
A = Return from manager’s active decisions
P = P ≥ P = B + (P – B) ≥ P = B + A (where A = Active return)
Doing what Kukar suggests and what Kinney states will be the active return: P – B = A.

LOS e
Section 5.1
59 The total value-added return by the DF fund manager is closest to:

A 0.9%.
B 2.8%.
C 0.6%.
C is correct. The total value-added return is the weighted average of the manager’s port-
folio return minus the weighted average of the benchmark return minus the trading costs.
Weighted average of manager’s portfolio return: (20% × –0.40%) + (40% × 3.80%) +
(10% × 2.40%) + (25% × 5.40%) + (5% × 0.09%) = 3.03%.
Weighted average of benchmark portfolio return: (30% × –0.70%) + (30% × 4.20%) +
(20% × 2.60%) + (20% × 2.92%) = 2.15%.
Total value added return, r v = 3.03% – 2.15% – 0.27% = 0.61%.
A is incorrect. The trading costs are not included in the calculation: 3.03% – 2.15%
= 0.88%.
B is incorrect. The benchmark return is not included in the calculation: 3.03% – 0.27%
= 2.76%.

LOS k, l
Section 6.6
60 When discussing the Sharpe ratios in Exhibit 4, the person who makes the most
accurate assessment regarding the information ratio or the M2 measure is:
A Kinney.
B Kukar.
C Andrews.
C is correct. Assuming the risk-free rate is zero:
Sharpe ratio = Expected return (R) /Standard deviation of return σ


()
M
M2 = Sharpe ratio × Standard deviation of the market portfolio return σ ( )
Information ratio = (RA − RB ) σ  A − B , where A indicates a fund and B indicates a
benchmark. The “A – B” subscript indicates the difference between the return on A and
 A − B does not equal σ
the return on B. To be perfectly clear, σ  A less σ
 B.
Following Andrews’ solution and using the notation above demonstrates that the
M2 measure is produced:
RA
× RB B
A
σ RA σ R
= × RB ×  B = M2
= A ×σ
RB 
σA R B

σA
B
σ
To find the information ratio while knowing the Sharpe ratios, one would still need
the individual standard deviations and the covariance between the fund and the bench-
mark to find the standard deviation of the difference in the returns,
i.e.,  2A + σ
σ  2B − 2 × Cov ( A, B) .
A is incorrect. Multiplying the Sharpe ratios will not produce the M2 measure.
B is incorrect. The information ratio cannot be produced from this information.

LOS k, l
Section 7.1

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2019 Level III Mock Exam AM

1–6 Ethical and Professional Standards 18

2019 LEVEL III MOCK EXAM AM

Foster Asset Management Case Scenario

Guidance for Standards I–VII

2 Given Constantile’s due diligence requests, what should Ogalo’s priority be to

C is correct. To avoid violating any Standards of Professional Conduct, Ogalo’s priority

Guidance for Standards I–VII

Guidance for Standards I–VII

4 Which of the performance reporting procedures agreed upon by Foster and

C is correct. Procedure 3—“Terminated accounts will be removed from the performance

Guidance for Standards I–VII

to manage assets according to a predetermined specific mandate, including risk and

Guidance for Standards I–VII

B is correct. Standard IV(C): Responsibilities of Supervisors requires members and candi-

Guidance for Standards I–VII

Edvard Richards Case Scenario

Exhibit 1 Richards’ Values

Primary residence (no mortgage) 2,000 2,000

Capital gains tax rate = 20%

Exhibit 2 Estimates of After-­Tax Primary Capital ($

Gain= Tax = Gain Net Value

Residence 2,000 2,000 0 0 2,000

Adams has the correct value.

Concentrated Single-­Asset Positions

8 Richards’ understanding about monetizing CTAS is most accurate with respect

B is correct. Richards’ understanding about avoiding immediate capital gains is correct.

Concentrated Single-­Asset Positions

Concentrated Single-­Asset Positions

1 4,800,000 4,300,000 (100,000) 4,700,000

Concentrated Single-­Asset Positions

Concentrated Single-­Asset Positions

A is correct. Evidence of both cross-­hedging and a mismatch in character is present in

Concentrated Single-­Asset Positions

Ptolemy Foundation Case Scenario

Tuoc: I prefer econometric modeling. Robust models built with detailed

Exhibit 1 10-­Year Forecast of US Macroeconomic Data

Exhibit 2 Current and Expected Market Statistics, US

Exhibit 3 Current Data and Forecasts from the Fed

Fed funds rate Current 3

Exhibit 4 Data for Analyzing Emerging Markets

Emerging small-­cap equity 23% 0.85 65%

Risk-­free rate: 2.5%

Ireland Spain Hungary

13 Regarding the approaches to economic forecasting, the statement by which

C is correct. Spenser’s statement is most accurate. In the economic indicators approach,

Capital Market Expectations

A is correct. The simplest way to analyze an economy’s aggregate trend growth is to

Growth from Changes in Percent

Employment Growth in potential labor force +1.9

B is incorrect. It incorrectly added total factor productivity, but this is a sub-­component

Capital Market Expectations

B is correct. The Grinold–Kroner model formula is

E(R) = expected rate of return on equity

C is incorrect. It uses a simple difference in the P/E of 15.6 – 15 = 0.6.

Capital Market Expectations

C is correct. The Taylor rule is

Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)] + [0.5 × (Iforecast

Capital Market Expectations

RPi = σiρi,M(RPM/σM) where (RPM/σM) is the Sharpe ratio for the

Risk Premium: RPi = σiρi,M(RPM/σM)

Risk Premium: RPi = σi(RPM/σM)

Risk Premium: RPi = σiρi,M(RPM/σM)

Risk Premium: RPi = σi(RPM/σM)

Exhibit 1 Richards’ Values

Exhibit 2 Estimates of After-Tax Primary Capital ($

Concentrated Single-Asset Positions

Concentrated Single-Asset Positions

Concentrated Single-Asset Positions

Concentrated Single-Asset Positions

Concentrated Single-Asset Positions

A is correct. Evidence of both cross-hedging and a mismatch in character is present in

Concentrated Single-Asset Positions

Exhibit 1 10-Year Forecast of US Macroeconomic Data

Exhibit 2 Current and Expected Market Statistics, US

Exhibit 3 Current Data and Forecasts from the Fed

Exhibit 4 Data for Analyzing Emerging Markets

Emerging small-cap equity 23% 0.85 65%

Risk-free rate: 2.5%

B is incorrect. It incorrectly added total factor productivity, but this is a sub-component

Exhibit 1 Investment Portfolio One-Year Projections

Exhibit 2 Investment Sub-Portfolios & Minimum Expected Return for

24 Using Exhibit 2, which of the sub-portfolio allocations is most likely to meet

C is correct. Sebastian needs to adjust the sub-portfolio allocation to achieve her

Exhibit 1 Corporate Bond Characteristics

Introduction to Fixed-Income Portfolio Management

B is correct. Horizon matching is a hybrid approach to liability-based mandates that

Introduction to Fixed-Income Portfolio Management

A longer-maturity, smaller-issue, BBB rated corporate bonds.

Introduction to Fixed-Income Portfolio Management

Introduction to Fixed-Income Portfolio Management

Introduction to Fixed-Income Portfolio Management

Introduction to Fixed-Income Portfolio Management

I have summarized your fixed-income portfolio consisting of three government

Exhibit 1 Berendsen Fixed-Income Portfolio Characteristics

Exhibit 2 Selected Plan Portfolio Statistics

Liability-Driven and Index-Based Strategies

Liability-Driven and Index-Based Strategies

Liability-Driven and Index-Based Strategies

Liability-Driven and Index-Based Strategies

Liability-Driven and Index-Based Strategies

Liability-Driven and Index-Based Strategies

Exhibit 1 Rewarded Factor Results

Exhibit 2 Risk Targets and Constraints

Exhibit 3 Characteristics of Candidates for Amity Equity Portfolio