Kaplan Constructed Response Writing Workshop

TOPIC: EQUITY PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 17 POINTS

Belinda Burgess is a consultant for the Enderby Endowment (Enderby). She reviews the
endowment’s current equity allocation as shown in Exhibit 1. All expected active returns are
uncorrelated.

Exhibit 1
Enderby Endowment Equity Allocation Details
Allocation (%) Expected Expected Active
Equity Mandate
Alpha (%) Risk (%)
U.K. large-cap value 60 1.8 5.2
U.S. large-cap value 25 1.6 4.2
Emerging markets 15 2.9 9.3

Based on performance, she formulates her Proposal 1:

Proposal 1: Enderby’s U.K. large-cap value equity mandate should be replaced with a pure
indexing mandate having both zero alpha and zero tracking risk.
Burgess notices an increase in realized tracking risk for the U.S. large-cap value mandate and is
concerned that its manager may be experiencing style drift. She conducts both returns-based and
holdings-based style analyses. The results of the returns-based analysis are shown in Exhibit 2.
The regression using the four indices produced a style fit of 96.2%. Burgess also reviews the
characteristics of the U.S. large-cap value mandate and the large-cap value benchmark as shown in
Exhibit 3.

Exhibit 2
Regression Results for the U.S. Large-Cap Value Mandate
Past Style Current Style
Index
Weights (%) Weights (%)
U.S. large-cap growth 4 4
U.S. large-cap value 86 62
U.S. small-cap growth 5 5
U.S. small-cap value 5 29

Exhibit 3
Portfolio and Benchmark Characteristics for the U.S. Large-Cap Value Mandate
Characteristic Portfolio Benchmark
P/E ratio 9.6 9.9
Dividend yield 4.1% 3.9%
Price-to-book ratio 1.6 1.7
Holdings in Each Quartile by Market Cap (%)
Top quartile 36 52
Second quartile 31 27
Third quartile 29 16
Bottom quartile 4 5
Kaplan Constructed Response Writing Workshop

Based on those analyses, Burgess believes that the U.S. large-cap value mandate deviates from
its large-cap style but not from its value style.

In a second proposal, Burgess plans to capture alpha by appointing a new mid-cap manager. She
will fund this new position by replacing an existing emerging market equity manager. At the same
time, she will implement an equitization strategy based on the following guidelines:

 The beta exposure of the emerging market equity allocation should be maintained.
 No additional beta exposure should be provided.
 The use of derivatives should be limited to long-only futures.

In addition to the equitization strategy, Burgess will add one of the mid-cap managers in Exhibit 4.
All of the managers have positive expected alpha but apply different investment styles. Futures
contracts on mid-cap and emerging equity indices are available.
Exhibit 4
Active Mid-Cap Equity Managers
Manager Investment Style Benchmark
Appleton Long only Small-cap equity
Bannon Market neutral Risk-free rate
Campbell Short extension Small-cap equity

6.1 Calculate the information ratio for the total equity allocation, assuming Burgess’s
Proposal 1 is adopted.
Kaplan Constructed Response Writing Workshop
6.2 Justify, with both a returns-based reason and a holdings-based reason for each of the
following, Burgess’s belief regarding the U.S. large-cap value mandate’s:
i. large-cap style.

ii. value style.

Kaplan Constructed Response Writing Workshop
6.3.i. Identify the manager from Exhibit 4 who is most appropriate as a component of
Burgess’s Proposal 2.

A. Appleton.
B. Bannon.
C. Campbell.
Explain how a strategy following Burgess’s guidelines would:
ii. maintain the beta exposure of the emerging market equity allocation.

iii. provide no additional beta exposure.

Kaplan Constructed Response Writing Workshop

TOPIC: FIXED INCOME PORTFOLIO MANAGEMENT AND DERIVATIVES

TOTAL POINT VALUE OF THIS QUESTION SET IS 16 POINTS

Antonio Vivarino is a fixed-income portfolio manager. One of his institutional clients, Peter
Schilling, needs to immunize a single eight-year liability of USD 75,000,000. Vivarino calculates
the present value of this future liability to be USD 65,820,753.

Vivarino considers three possible immunization portfolios using noncallable, fixed-rate U.S.
Treasury bonds. He prepares a comparative analysis of the three portfolios in Exhibit 1. Vivarino
explains to Schilling that, whichever portfolio is chosen, the immunization portfolio will need to
be rebalanced over time.
Exhibit 1
Comparative Analysis of Immunization Portfolios
Portfolio 1 2 3
Market value (in USD) 65,986,231 65,692,875 66,017,226
Cash flow yield 1.6521% 1.6442% 1.6487%
Macaulay duration 7.989 7.675 8.014
Convexity 97.105 87.235 91.034

One year later, a duration gap exists between the liability and the immunization portfolio. The
future liability now has a present value of USD 69,102,348 and a modified duration of 6.103. The
immunization portfolio has a market value of USD 70,569,017 and a modified duration of 5.916.

Vivarino closes this duration gap using U.S. Treasury note futures contracts in a derivatives
overlay strategy. He determines the basis point value (BPV) for one futures contract worth of the
cheapest-to-deliver bond is USD 81.20, while the conversion factor for the CTD bond is 0.9642.

Schilling also asks Vivarino for advice on how to position the domestic fixed-income portion of
Schilling’s investment portfolio. Vivarino expects the U.S. Treasury yield curve to steepen
immediately, and he presents his forecast in Exhibit 2.
Exhibit 2
Vivarino’s Forecasted Changes in Yields
Maturity (Years) 2 5 10 25
Forecasted change in yield –0.40% –0.25% 0.00% +0.50%

Schilling wants to position the domestic portion of the portfolio to benefit from Vivarino’s yield
curve forecast. They consider three portfolios of noncallable, fixed-rate U.S. Treasury bonds
with 2-, 5-, 10-, and 25-year maturities. Selected data for the portfolios are presented here in
Exhibit 3.
Exhibit 3
Selected Data for Portfolios P, Q, R
Maturity Portfolio Allocations Portfolio
Modified
2y 5y 10y 25y Duration
Portfolio P 0.0% 0.0% 100.0% 0.0% 9.1189
Portfolio Q 71.4% 0.0% 0.0% 28.6% 9.1205
Portfolio R 26.2% 24.1% 24.6% 25.1% 9.1165
Kaplan Constructed Response Writing Workshop
Vivarino also examines the fixed-income portion of Schilling’s investment portfolio invested in
Canada. Vivarino expects yield spreads in Canada to be unchanged for the next year, but
anticipates that there will be a uniform 40 bp decline in yields for all maturities. For this portion
of the portfolio, Schilling holds only a mix of investment-grade corporate bonds issued in
Canada and denominated in Canadian dollars. Vivarino fully hedges the currency risk for this
portion of the portfolio.

Exhibit 4 shows selected characteristics and expectations for the fixed-income portion of the
portfolio invested in Canada. Schilling asks Vivarino to estimate the annual return for this portion
of the portfolio.
Exhibit 4
Selected Characteristics and Expectations
for the Portion of the Fixed-Income Portfolio Invested in Canada
Current average bond coupon rate 3.47%
Coupon frequency Annual
Investment horizon 1 year
Current average bond price (% of par) 96.81
Expected average bond price in one year (% of par) 96.45
Average bond convexity 62
Average bond modified duration 5.2
Expected credit losses for the next year 0.09%

7.1 Determine which of the following portfolios would best immunize the future liability
initially, given the data in Exhibit 1.

A. Portfolio 1.
B. Portfolio 2.
C. Portfolio 3.

Justify your response with two reasons.

Kaplan Constructed Response Writing Workshop

7.2.i. State and justify whether Vivarino should take a long or short position in the
futures contracts to close the duration gap.

7.2.ii. Calculate the number of futures contracts required to close the duration gap.

7.3 Determine which of the following portfolios is most appropriate for Schilling,
given the data in Exhibits 2 and 3.

A. Portfolio P.
B. Portfolio Q.
C. Portfolio R.

Justify your response with one reason (no calculations are required).
Kaplan Constructed Response Writing Workshop
7.4 Calculate the expected return (in percentage terms) for the next year on the fixed-
income portion of Schilling’s portfolio invested in Canada, based on the data in
Exhibit 4.
Kaplan Constructed Response Writing Workshop
TOPIC: ASSET ALLOCATION AND PRIVATE WEALTH MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 14 POINTS

Alfonso Dos Passos is 37 years old and lives in the United States. He worked as an equity
analyst for 12 years but recently lost his job due to a market downturn. His earnings were
strongly positively correlated with equity market returns, and he expects that it will remain that
way for the rest of his working life. Dos Passos still manages his personal portfolio of domestic
equities and bonds, currently valued at $450,000, which he rebalances using the mean-variance
optimization (MVO) technique. The allocation is currently 60% to equities and 40% to fixed
income, including cash. In managing his portfolio, he has been concerned about the level of
transaction costs resulting from frequent rebalancing.

Dos Passos has a variable-rate mortgage on his home, and if he fails to make the mortgage
payments for four months, he risks losing his home. However, he does not want to sell assets
from his investment portfolio to pay his monthly mortgage payments; he hopes to find a new job
before his cash runs out. His effective tax rate is currently very low, but he expects it to increase
significantly once he finds a new job.

Dos Passos turns to Domenica Cruz, a portfolio manager with whom he worked in his former
job, regarding his asset allocation approach. Dos Passos tells Cruz that he had above-average
risk tolerance when he was employed but that until he finds new employment, it is likely that his
risk tolerance will be much lower. He mentions that if he starts a new job within the year, he
intends to make a deposit of $40,000 on a home in a retirement community for his parents,
which would require sales to be made from his portfolio. Dos Passos tells Cruz that he analyzed
North American tech stocks and that he still takes a positive view on many of the firms in that
sector, which he would like to incorporate into his investment strategy.

Cruz suggests to Dos Passos that based on his circumstances, the standard MVO process can be
improved upon by using the Black-Litterman approach, the resampled efficient frontier
technique, or Monte Carlo simulation.

Cruz observes that Dos Passos is currently following an asset-only (AO) approach to strategic
asset allocation. She strongly advises that he should move to an asset-liability management
(ALM) approach.

Cruz also advises Dos Passos that his human capital should be taken into account in the asset
allocation process and that in doing so, it would result in an increased allocation to fixed income.

8.1 Explain, compared to the standard MVO process and based on Dos Passos’s
circumstances:

i. one advantage of using the Black-Litterman approach.

Kaplan Constructed Response Writing Workshop

ii. one advantage of using the resampled efficient frontier technique.

iii. one advantage of using Monte Carlo simulation.

8.2 Discuss two reasons, based on Dos Passos’s circumstances, why an ALM approach
would be more appropriate than an AO approach.

8.3 Discuss two reasons, based on his human capital, why Dos Passos’s current allocation
to fixed income should be higher.
Kaplan Constructed Response Writing Workshop

TOPIC: PRIVATE WEALTH MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 16 POINTS

Gabriel and Isabelle Fauré are both 40 years old. They have been married six years and have a four-
year-old son.
Isabelle, a theatrical agent, currently earns a total of €110,000 per annum, with free private health
insurance covering her entire family provided at no cost to herself; however, currently neither she
nor her husband belong to a pension plan. Gabriel is a self-employed music copyist, and his annual
income will most likely remain in the range of €15,000 to €20,000, increasing with inflation. On a
combined basis, they are taxed at a rate of 30%.
Although the couple currently have no plans to retire before they reach age 60, they know that they
must make provisions for their retirement because the government will only provide them with a
basic level of pension income. Disability insurance is also provided by the government, paying
regular income in the event of illness or disability that is serious enough to render a person unable
to work. The government disability benefits, while salary related and tax free, are capped at €2,300
per month.
The couple’s home is a rented apartment that costs €3,000 per month. Beyond that, they spend
roughly €2,250 per month on other living expenses. They take one vacation each year, which
typically costs around €6,000. They have a joint investment portfolio that is currently valued at
€230,000. They want to make sure that adequate funds will be available when their son reaches age
18 to pay for the costs of college or vocational training.
Isabelle’s parents died in an automobile accident, but Gabriel’s parents are retired at ages 67 and
69. They are not wealthy but live on an adequate pension and are both currently in excellent health.
The Faurés worry that Gabriel’s parents may need financial support as they age (e.g., nursing home
bills) but if needed, it would be at least 15 years or more from now.
They have just appointed a financial advisor, Phillipe Buffet, who has begun preparing an
investment policy statement (IPS) for them, identifying their goals and liquidity needs. He explains
to them the difference between planned and unplanned goals and states that retirement is the classic
example of a planned goal.

Neither Gabriel nor Isabelle have any disability insurance beyond the basic government coverage.
Buffet points out that it is particularly an issue with respect of Isabelle, given that she is the family’s
main financial provider. He calculates the amount of disability insurance that should be purchased
for her, assuming a nominal discount rate of 4.1% and an annual inflation rate of 1.7% in their
income and expenses (including any government benefits). Disability insurance receipts are tax
free.
Kaplan Constructed Response Writing Workshop

9.1 Determine whether the Faurés have a relatively high or low degree of risk aversion in
relation to their retirement goal.

A. Relatively high.
B. Relatively low.

Justify your response.

9.2.i. Describe one unplanned goal of the Faurés.

9.2.ii. For the unplanned goal you described in Part i, state and justify whether the Faurés
have a relatively high or low degree of risk tolerance in relation to it.
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9.3 Determine whether the IPS that Buffet prepares should identify the Faurés as having high
or low liquidity needs in relation to their portfolio for the coming year.

A. High.
B. Low.

Justify your response.

9.4 Calculate the amount of disability insurance coverage (rounded to the nearest €1,000) that
Isabelle should purchase. Assume end-of-year cash flows.
Kaplan Constructed Response Writing Workshop

TOPIC: DERIVATIVES

TOTAL POINT VALUE OF THIS QUESTION SET IS 11 POINTS

Logan Craig, a portfolio manager for the Ocean Endowment (Ocean), manages a GBP 400 million
investment portfolio. Ocean’s investment committee has recently become nervous, anticipating a
major change in Bank of England policy. To reflect this view, Craig wishes temporarily to make the
following changes in the portfolio:

 Craig wants to decrease the portfolio’s equity allocation and decrease its equity beta.
 Craig wants to increase the portfolio’s bond allocation but decrease its modified duration.

The Ocean portfolio’s current and target characteristics are shown in Exhibit 1.

Exhibit 1
Ocean Endowment Portfolio Characteristics
Current Allocation Target Allocation
Allocation Allocation
Asset Modified Equity Asset Modified Equity
(GBP (GBP
Class Duration Beta Class Duration Beta
Millions) Millions)
Equities --- 0.97 250 Equities --- 0.92 185
Bonds 6.3 --- 150 Bonds 5.5 --- 215

To avoid high trading costs for what will be only a temporary reallocation, Craig decides to use the
following futures contracts to achieve the portfolio targets:

 Equity futures: currently priced at 6,740 (quoted in index points; the contract has a GBP 10
multiplier) with an equity beta of 0.99
 Bond futures: currently priced at GBP 99,500 per contract with a modified duration of
7.25

Craig also manages the Martin Family Foundation (Martin) portfolio, which initially consists of
GBP 72 million of equities and GBP 43 million of bonds. Due to an amendment to the foundation’s
investment policy statement (IPS), the Martin portfolio is rebalanced using the transactions shown
in Exhibit 2.

Exhibit 2
Transactions for Rebalancing the Martin Family Foundation Portfolio
Number of
Futures Price Per
Type of Futures Contracts Action
Contracts to Futures Contract
Buy/Sell
Equity futures contract Buy 34 6,535
Bond futures contract Sell 45 GBP 102,000

Two months after the transactions, the market value of the Martin portfolio’s equities has increased by
2.5%, and the market value of its bonds has increased by 1.9%. The prices of the equity and bond
futures contracts are now 6,690 and GBP 104,000, respectively.
Kaplan Constructed Response Writing Workshop

10.1.i. Calculate the number of futures contracts Craig will buy/sell to adjust the Ocean
portfolio’s equity exposure (use a plus sign for buy, minus sign for sell).

ii. Calculate the number of futures contracts Craig will buy/sell to adjust the Ocean
portfolio’s bond exposure (use a plus sign for buy, minus sign for sell).
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10.2 Calculate the return for the Martin portfolio over the past two months, inclusive of the
futures transactions (provide the return both in absolute and percentage [nonannualized]
terms, indicating whether they represent a profit or a loss).