7FNCE021W exam paper 17-18 PDF

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UNIVERSITY OF WESTMINSTER WESTMINSTER BUSINESS SCHOOL

EXAMINATION PAPER SEMESTER ONE JANUARY 2018 MODULE CODE:

7FNCE021W

MODULE TITLE:

MODERN PORTFOLIO MANAGEMENT

DATE: TIME:

This is a CLOSED book exam. You may use the following limited materials in this examination: INSTRUCTIONS TO CANDIDATES: PLEASE DO NOT WRITE IN PENCIL Answer Question 1 and Question 4 and any Two out of the rest of the questions

TIME ALLOWED:

3 HOURS

The use of calculators is permitted. The use of dictionaries is not permitted.

PLEASE DO NOT TURN OVER THIS PAGE UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR

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Answer Question 1 and Question 4 and choose additional Two Questions to answer from the remaining Questions Question 1 Lucy Michael, a 60 year old US citizen, has just retired after a 35 year career in the fashion industry. Through a modest life style, disciplined saving and the help of a financial advisor, she accumulated $2000, 000 diversified portfolio. Over the last several years, the portfolio allocation has been gradually adjusted to only domestic large cap stocks and bonds. She holds only investments she has thoroughly researched and continually looks for better, more definitive information. Lucy’s house has been paid off for several years and she does not intend to purchase another house. She has always led a modest life style and intends to continue doing so. During her retirement, she will help support her son Harry, his wife Vicky, and their two children. Harry’s and Vicky’s combined salaries barely meet their living expenses. Lucy estimates she will need $60,000 her first year of retirement, and she plans to continue supporting her son and his family by providing them with $30,000 next year. Both figures are before tax and are expected to increase each year at the general rate of inflation of 3%. She has informed Harry that at her death her portfolio will be gifted to a local charity with instructions to pay Harry and Vicky a life time $20,000 annuity. In addition to meeting spending needs, she wishes to maintain the real value of her portfolio. Lucy is in the 25% marginal tax bracket. Possible portfolio asset allocations for Lucy are shown in the table below Asset Class Cash Domestic large cap equities Domestic small cap equities Domestic government bonds Domestic corporate bonds Direct real estate Global bond fund Global equity fund Private equity fund Fund of funds hedge fund Total Expected before tax return (%) Expected standard deviation (%)

Asset Class Weights (%) A B 20 5 25 20 25 10 15 15 0 20 0 0 0 15 15 15 0 0 0 0 100 100 8.0 12.5

7.7 10.1

Required 2

C 5 15 15 15 15 20 0 0 10 5 100

D 10 10 10 10 10 10 10 10 10 10 100

8.4 10.1

8.1 12.7

1. Formulate Lucy’s return objective and calculate the required before tax return over the coming year. (7 marks)

2. Formulate Lucy’s risk objective (willingness, ability and overall)

(8 Marks)

3. Select the most appropriate asset allocation for Lucy and justify your selection. For each allocation not selected, state why it was rejected

(10 Marks)

(25 marks in total) Question 2 You are working for BMJ capital and managing the Mathews family portfolio. The Mathews would like to invest all of their wealth in the equities of two sectors: The Financial Sector (FS) and the Real Estate Sector (RE). The financial analyst of BMJ has provided you with the following macroeconomic factor model of the two sectors: RFS =0.16−1.4 F INF +0.7 FGDP + ε FS

Rℜ=0.08+2.2 F INF + 0.3 F GDP +ε ℜ Assume that the Mathews would like to invest 60% of their wealth in the financial sector. 1. Compute the Expected Return of the portfolio (7 marks) Suppose that over last year GDP grew at a rate that was 2 percentage points higher than originally expected, and inflation was 1 percentage point lower than originally expected. Over the past year, the Financial Sector experienced a 2% sector unique surprise returns that is unrelated to the factors. You forecast that these same surprises will repeat next year. 2. Based on that compute the Expected Returns of the Portfolio 3

(8 marks)

Assume your investment firm uses a single factor model to evaluate assets. Consider the following data for portfolios A, B and C Portfolio A B C

Expected Returns 10% 20% 13%

Beta 1.0 2.0 1.5

3. Calculate the arbitrage opportunity from the data above (10 marks) (25 marks in total) Question 3 Alice Sims, CFA is working for Global Capital, a big investment bank, as the manager of the small cap portfolios of individual as well as institutional clients. Alice expects that due to Brexit the economic conditions will deteriorate over the coming two year and that small cap equities will underperform the market. To protect her clients, she sells the small cap equities in the portfolio and buys large companies instead. She believes that large caps are more able to withstand the expected economic decline. Before buying she makes considerable research and she provides complete disclosure of these trades to her clients after the purchase. For the last 10 years, Alice has managed the account of Olivia Olga and during that time the relationship between Olivia and Alice has become strong. Olivia has a beach house in Barcelona which she offers to Alice and her daughter Jenny free use for three weeks as a reward for the good returns generated in her account. Alice is so busy at work and she does not tell anyone where she is vacating. Alice has no beneficial interest in any of the fee-paying accounts and she is managing the account of her daughter Jenny. When shares in initial public offerings (IPOs) become available, Alice first allocates shares to all her clients for whom the investment is appropriate. Only if shares are still available does she purchase shares to her daughter’s account, if the issue is appropriate for her. Alice gathers clients’ orders and trade blocks. When Alice allocates shares from block trades she fills the institutional account orders first and then allocates the remaining shares to the individual accounts based on portfolio size. James Brian, CFA works as an equity analyst for Global Capital. Brian writes a research report on a pharmaceutical company recommending a buy. After reviewing his report, Sally Antrobus, a pension fund manager asks James if Global Capital is currently undertaking any finance activity with the pharmaceutical company. James 4

states that Global Capital is presently not working with the company but has done so in the past. The analyst does not mention or include in his report that he is a relative to one of the majority shareholders and owns shares in the pharmaceutical company. In his presentation of the research report to the investment committee, James strongly recommends the company. Charles Thornton, the Chairman of the investment committee is sceptical on James’ research recommendations. However, James states” I’m a CFA Charter holder and I know what I’m saying and you better recommend buying the company”. 1. Indicate whether Alice has violated any of the CFA institute Standards of Professional Conduct in the following situations and justify your answer (15 marks)

2. Indicate whether James has violated any of the CFA institute Standards of Professional Conduct in the following situations and justify your answer (10 marks) (25 marks in total) Question 4 1. A UK manager would like to establish a new fund that tracks the performance of a European market index that represents both Western and Eastern Europe and that contains 1500 companies. The manager has £10 million initially to invest. Should the manager use replication, stratified sampling, or optimisation? Justify your answer (5 marks)

2. You want to use return based analysis and holding based analysis in order to evaluate a manager who claims to invest in mid-cap value stocks. a. Explain why the manager is investing in these stocks (3 marks) b. Describe the indexes that you should include in the return based analysis (3 marks) c. Describe the expected characteristics using the holding based style analysis (4 marks)

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3. Use the figures below to evaluate the manager’s performance:

Manager return Investor’s Benchmark Normal Portfolio Returns Total Active Risk Misfit Active Risk

15.0% 11.0% 8.0% 5.2% 3.8% (10 marks) (25 marks in total)

Question 5 1. You expect the stock market to be relatively volatile over the next year. You also expect that the annual holding period return will be around zero. Recommend and justify a portfolio investment strategy given your projection (7 marks) 2. Compare the relative risk tolerance of a buy and hold investor, a constant mix investor and constant proportion portfolio insurance investor (8 marks) 3. For each of the following, state whether the optimal corridor width should be wide or narrow and explain your response a. High a version to risk b. Illiquid assets c. High volatility (10 marks) (25 marks in total) Question 6 1. Suppose your account was £2,500,000 at the beginning of the month and £2,700,000 at the end. During the month, there was a cash inflow of £45,000 on day 7 and £25,000 on day 19. The values of your account are £2,555,000 and £2,575,000 on day 7 and day 19 respectively. Calculate the time weighted rate of returns (8 marks) 2. Suppose that the total monthly return of Nader’s account is 5.04%. During the same period, the portfolio benchmark returned 5.32% and the market index returned 3.92%. Calculate the amount of the portfolio return attributable to the manger’s active management and style. (5 marks)

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3. Compare time weighted rate of returns with money weighted rate of returns and discuss how both measures of performance are affected by cash contributions and withdrawals. (12 marks) (25 marks in total)

Question 7 Mohammed Ali is responsible for analysing companies in the retail industry and he is currently reviewing the status of MHS Company. MHS traditional markets are in Europe and has recently gone through major restructuring. MHS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long term growth rate of 4%. The company recently paid an annual dividend of £1. At the end of 2016, MHS announce that it would be expanding its business, use warehouse concepts to expand and open new stores around the UK. The company will also close down some of its existing stores, write down assets and carry out a major restructuring change. Upon reviewing the company’s prospects Ali issued an earnings per share forecast for 2017 of £0.9. He set a 12 month share price target of £22.50. Immediately following the expansion announcement, the share price of MHS jumped from £14 to £18. In 2016, MHS also reported an unusual expense of £189.1 million related to restructuring costs and asset write downs. The company’s earnings before tax in 2016 is £30,400,000. The number of its outstanding shares is 106,530,610. The company sales is £6,435,900,000 in 2016 Selected Industry information Estimated earnings growth rate Mean trailing price earnings ratio (P/E) Mean Price/sales ratio

0.10 22.5 0.50

In response to his manager, Ali makes the following statements regarding the merits of earnings yield compared to the P/E ratio: 

For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero



A high E/P ratio implies the security is over priced

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1. Use the H-model to value one share of MHS and indicate its appropriateness given Ali’s dividend forecast of MHS (5 marks) 2. If the cost of equity for MHS does not change, compute the present value of growth opportunities in the share price following the announcement that the company would be expanding its retail operations (5 marks) 3. Indicated whether Ali’s statements regarding the earnings yield and the E/P ratio are correct (5 marks) 4. Assuming a tax rate of 34%, compute the underlying earnings per share for MHS in 2008 (5 marks) 5. Compute price to sales ratio of MHS post the expansion announcement and indicate whether the share is under- priced, overpriced, or correctly valued (5 marks) (25 marks in total) Question 8 George Andrew is the portfolio manager of high yield corporate bond investors. His current £20 million bond position is distributed as follows Bond Emerging Markets Bonds Eastern European Markets Bonds South American Markets Bonds

Market Value Weight (%) 50 40

Effective Duration 2.00 3.00

10

4.00

1. Compute the duration of the Bond Portfolio. Compute the contribution of Eastern European Markets Bonds to the duration of the bond portfolio (5 marks) 2. Discuss the risks that George’s bond portfolio is exposed to (5 marks) 3. What conditions are required for immunizing a portfolio against a future liability (5 marks) An investor wishes to immunize a single liability payment that will occur 8 years from today using one of the following portfolios: Portfolio 1: A 16 year coupon bond with duration of 8 years

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Portfolio 2: 50% invested in 4 year zero coupon bond and 50% invested in a 12 year zero coupon bond Portfolio 3: 50% investment in a 7 year zero coupon bond and 50% investment in a 9 year zero coupon bond 4. Which of the portfolios most likely have the least immunization risks and why (10 marks) (25 marks in total)

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