26 - 1

CHAPTER 26


1(a).

50 . 1
.04
.06
.04
.07 .13
Market
1.67
.06
.10
.06
.07 .17
S
1.00
.03
.03
.03
.07 .10
S
1.30
.10
.13
.10
.07 .20
S
60 . 1
.05
.08
0.05
.07 .15
S
S
R
Q
P

1(b).

0600 .
1.00
.06
1.00
.07 .13
Market
.0909
1.10
.10
1.10
.07 .17
T
.0500
.60
.03
.60
.07 .10
T
.0867
1.50
.13
1.50
.07 .20
T
.0800
1.00
.08
1.00
.07 .15
T
S
R
Q
P

Sharpe Treynor
P 2 3
Q 4 2
R 5 5
S 1 1
Market 3 4

1(c). It is apparent Irom the rankings above that PortIolio Q was poorly diversiIied since
Treynor ranked it #2 and Sharpe ranked it #4. Otherwise, the rankings are similar.




26 - 2




CFA Examination I (1994)

2(a). The Treynor measure (T) relates the rate oI return earned above the risk-Iree rate to the
portIolio beta during the period under consideration. ThereIore, the Treynor measure
shows the risk premium (excess return) earned per unit oI systematic risk:
R
i
- R
I

T
i

.
i

where: R
i
average rate oI return Ior portIolio i during the speciIied period
R
I
average rate oI return- on a risk-Iree investment during the speciIied period
.
i
beta oI portIolio i during the speciIied period.


Treynor Measure PerIormance Relative to the Market (S&P 500)

10 - 6
T 6.7 :950714720/
0.60



Market (S&P 500)

12 - 6
T
M
6.0
1.00


The Treynor measure examines portIolio perIormance in relation to the security market
line (SML). Because the portIolio would plot above the SML, it outperIormed the S&P
500 Index. Because T was greater than T
M
, 6.7 percent versus 6.0 percent, respectively,
the portIolio clearly outperIormed the market index.

The Sharpe measure (S) relates the rate oI return earned above the risk Iree rate to the
total risk oI a portIolio by including the standard deviation oI returns. ThereIore, the
Sharpe measure indicates the risk premium (excess return) per unit oI total risk:
R
i
- R
I

S
9
i

where: R
i
average rate oI return Ior portIolio i during the speciIied period
R
I
average rate oI return on a risk-Iree investment during the speciIied period
9
i
standard deviation oI the rate oI return Ior portIolio i during the speciIied
period.

Sharpe Measure PerIormance Relative to the Market (S&P 500)

26 - 3


10 - 6
S 0.222 &3/0750714720/
18

Market (S&P 500)

12 - 6
S
M
0.462
13

The Sharpe measure uses total risk to compare portIolios with the capital market line
(CML). The portIolio would plot below the CML, indicating that it underperIormed the
market. Because S was less than S
M
, 0.222 versus 0.462, respectively, the portIolio
underperIormed the market.

2(b). For perIectly diversiIied portIolios (that is, those without any unsystematic or speciIic
risk), the Treynor and Sharpe measures would give consistent results relative to the
market index because the total variance oI the portIolio would be the same as its
systematic variance (beta). A poorly diversiIied portIolio could show better perIormance
relative to the market iI the Treynor measure is used but lower perIormance relative to
the market iI the Sharpe measure is used. Any diIIerence between the two measures
relative to the markets would come directly Irom a diIIerence in diversiIication.

3(a). PortIolio MNO enjoyed the highest degree oI diversiIication since it had the highest R
2

(94.8). R
2
is also a measure oI diversiIication.


3(b).
Fund Treynor Sharpe 1ensen
ABC 0.975(4) 0.857(4) 0.192(4)
DEF 0.715(5) 0.619(5) -0.053(5)
GHI 1.574(1) 1.179(1) 0.463(1)
JKL 1.262(2) 0.915(3) 0.355(2)
MNO 1.134(3) 1.000(2) 0.296(3)
3(c).
Fund t(alpha)
ABC 1.7455(3)
DEF -0.2789(5)
GHI 2.4368(1)
JKL 1.6136(4)
MNO 2.1143(2)

Only GHI and MNO have signiIicantly positive alphas at a 95 level oI conIidence.




26 - 4





4(a). (InIormation ratio) IR
j
-
j
/9
u
where 9
u

standard

error oI the regression

IR
A
.058/.533 0.1088
IR
B
.115/5.884 0.0195
IR
C
.250/2.165 0.1155
4(b). Annualized IR (T)
1/2
(IR)
Annualized IR
A
(52)
1/2
(0.1088) 0.7846
Annualized IR
B
(26)
1/2
(0.0195) 0.0994
Annualized IR
C
(12)
1/2
(0.1155) 0.4001
4(c). The higher the ratio, the better.



5(a).
R

.10
SML

.05

Beta
Market
5(b). Overall PerIormance R
a
- RFR .15 - .05 .10

5(c). Selectivity R
a
- R
x
(.
a
) .15 - .11 .04

5(d). Risk |R
x
(.
a
) - RFR| .11 - .05 .06
where R
x
(.
a
) .05 1.2 (.10 - .05) .11

5(a). Overall perIormance (Fund 1) 26.40 - 6.20 20.20
Overall perIormance (Fund 2) 13.22 - 6.20 7.02

5(b). E(R
i
) 6.20 .(15.71 6.20)
6.20 . (9.51)
Total return (Fund 1) 6.20 (1.351)(9.51) 6.20 12.85 19.05
where 12.85 is the required return Ior risk
Total return (Fund 2) 6.20 (0.905)(9.51) 6.20 8.61 14.81
where 8.61 is the required return Ior risk
26 - 5


5(c)(i). Selectivity
1
20.2 - 12.85 7.35
Selectivity
2
7.02 - 8.61 -1.59

5(c)(ii).Ratio oI total risk
1
9
1/
9
m
20.67/13.25 1.56
Ratio oI total risk
2
9
2/
9
m
14.20/13.25 1.07

R
1
6.20 1.56 (9.51) 6.20 14.8356 21.04
R
2
6.20 1.07 (9.51) 6.20 10.1757 16.38

DiversiIication
1
21.04 19.05 1.99
DiversiIication
2
16.38 14.81 1.57

5(c)(iii). Net Selectivity Selectivity DiversiIication
Net Selectivity
1
7.35 - 1.99 5.36
Net Selectivity
2
-1.59 - 1.57 -3.16

5(d). Even accounting Ior the added cost oI incomplete diversiIication, Fund 1`s perIormance
was above the market line (best perIormance), while Fund 2 Iall below the line.

CFA Examination III (1995)

6(a). The Iollowing brieIly describes one strength and one weakness oI each manager.

1. Manager A

Strength. Although Manager A`s one-year total return was slightly below the EAFE
Index return (-6.0 percent versus -5.0 percent, respectively), this manager apparently has
some country/security return expertise. This large local market return advantage oI 2.0
percent exceeds the 0.2 percent return Ior the EAFE Index.

Weakness. Manager A has an obvious weakness in the currency management area. This
manager experienced a marked currency return shortIall compared with the EAFE Index
oI 8.0 percent versus -5.2 percent, respectively.

2. Manager B

Strength. Manager B`s total return slightly exceeded that oI the index, with a marked
positive increment apparent in the currency return. Manager B had a -l.0 percent currency
return versus a -5.2 percent currency return on the EAFE index. Based on this outcome,
Manager B`s strength appears to be some expertise in the currency selection area.

Weakness. Manager B had a marked shortIall in local market return. Manager B`s
country/security return was -l.0 percent versus 0.2 percent on the EAFE Index. ThereIore,
Manager B appears to be weak in security/market selection ability.
26 - 6


6(b). The Iollowing strategies would enable the Fund to take advantage oI the strengths oI the
two managers and simultaneously minimize their weaknesses.

1. Recommendation: One strategy would be to direct Manager A to make no currency
bets relative to the EAFE Index and to direct Manager B to make only currency
decisions, and no active country or security selection bets.


2. Recommendation: Another strategy would be to combine the portIolios oI Manager
A and Manager B. with Manager A making country exposure and security selection
decisions and Manager B managing the currency exposures created by Manager A`s
decisions (providing a 'currency overlay).

.

7(a)(i). .6(-5) .3(-3.5) .1(0.3) -4.02

7(a)(ii). .5(-4) .2(-2.5) .3(0.3) -2.41

7(a)(iii). .3(-5) .4(-3.5) .3(0.3) -2.81

Manager A outperIormed the benchmark Iund by 161 basis points while Manager B beat
the benchmark Iund by 121 basis points.

7(b)(i). |.5(-4 5) .2(-2.5 3.5) .3(.3 -.3)| 0.70

7(b)(ii). |(.3 - .6) (-5 4.02) (.4 - .3) (-3.5 4.02) (.3 -.1)(.3 4.02)| 1.21

Manager A added value through her selection skills (70 oI 161 basis points) and her
allocation skills (71 oI 161 basis points). Manager B added value totally through his
allocation skills (121 oI 121 basis points).