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Portfolio Management ...

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CFA® Level III

FOR AIMR USE ONLY

Examination Book

1999 Morning Section Candidate Number:

_____ _____ _____ _____ _____ _____

© 1999 Association for Investment Management and Research All rights reserved This book is the property of: Association for Investment Management and Research Post Office Box 3668 Charlottesville VA 22903-0668 (804) 980-3668

The following list contains the command words used on the Morning Section of the 1999 Level III Examination. Candidates may want to refer to this list as they formulate their answers. calculate:

To ascertain or determine by mathematical processes.

compare:

To examine the character or qualities of for the purpose of discovering, primarily, resemblances.

construct:

To create by organizing ideas or concepts logically and coherently.

critique:

To offer a critical review or commentary; to criticize.

describe:

To transmit a mental image, an impression, or an understanding of the nature and characteristics of.

determine:

To come to a decision as the result of investigation or reasoning; to settle or decide by choice among alternatives or possibilities.

discuss:

To discourse about through reasoning or argument; to present in detail.

evaluate:

To determine or fix the value of; to determine the significance or worth of, usually by careful appraisal and study.

formulate:

To put into a systematized statement or expression; to prepare according to a formula.

identify:

To establish the identity of; to show or prove the sameness of.

justify:

To prove or show to be valid, sound, or conforming to fact or reason; to furnish grounds or evidence for.

list:

To enumerate.

select:

To choose from a number or group—usually, by fitness, excellence, or other distinguishing feature.

show:

To set forth in a statement, account, or description; to make evident or clear.

state:

To express in words.

The Morning Section of the 1999 CFA Level III Examination has 11 questions. For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question. Question 1 2 3 4 5 6 7 8 9 10 11

Topic Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Economics Global Markets and Instruments Ethics Ethics Total

Minutes 24 6 12 16 24 33 15 12 18 6 14 180

Questions 1 through 5 relate to Peter and Andrea Mueller, individual investors. A total of 82 minutes is allocated to these questions. Use the first few minutes to review the Introduction below. Candidates should answer these questions in the order presented. INTRODUCTION Peter and Andrea Mueller, U.S. residents, are reviewing their financial plan. The Muellers, both age 53, have one daughter, age 18. With their combined after-tax salaries totaling $100,000 a year, they are able to meet their living expenses and save $25,000 after taxes annually. They expect little change in either their incomes or expenses on an inflation-adjusted basis other than the addition of their daughter’s college expenses. Their only long-term financial goal is to provide for themselves and for their daughter’s education. The Muellers both wish to retire in ten years. Their daughter, a talented musician, is now entering an exclusive five-year college program. This program requires a $50,000 contribution, payable now, to the college’s endowment fund. Thereafter, her tuition and living expenses, to be paid entirely by the Muellers, are estimated at $40,000 annually. The Mueller’s personal investments total $600,000, and they plan to continue to manage the portfolio themselves. They prefer “conservative growth investments with minimal volatility.” One-third of their portfolio is in the stock of Andrea’s employer, a publicly traded technology firm with a highly uncertain future. The shares have a very low-cost basis for tax purposes. The Muellers, currently taxed at 30 percent on income and 20 percent on net realized capital gains, have accumulated losses from past unsuccessful investments that can be used to fully offset $100,000 of future realized gains. In ten years, Peter will receive a distribution from a family trust. His portion is now $1.2 million and is expected to grow prior to the distribution. Peter receives no income from the trust and has no influence over, or responsibility for, its management. The Muellers know that these funds will change their financial situation materially but have excluded the trust from their financial planning. QUESTION 1 HAS ONE PART FOR A TOTAL OF 24 MINUTES. 1.

Construct the objectives and constraints portion of an investment policy statement for the Muellers, addressing each of the following: i. ii. iii. iv. v. vi.

Return objective. Risk tolerance. Time horizon. Liquidity. Taxes. Unique circumstances. (24 minutes)

QUESTION 2 HAS ONE PART FOR A TOTAL OF 6 MINUTES. 2.

As part of their financial planning, the Muellers have been seeking advice from friends and relatives. This advice includes the following comments: “An investment policy statement won’t help you make any money.” “The key to successful investing is simply to select investments that earn an annual return higher than the stock market’s return.” “All hired investment managers will routinely change everything you have been

Discuss a potential benefit of using a written investment policy statement that contradicts each of the above comments. (Note: Three different benefits are required.) (6 minutes)

QUESTION 3 HAS ONE PART FOR A TOTAL OF 12 MINUTES. Candidates should use information from the Introduction on page 4 and Exhibit 3-1 below to answer Question 3. The Muellers built up their $600,000 investment portfolio over many years through regular purchases of mutual funds holding only U.S. securities. Each purchase was based on personal research but without consideration of their other holdings. They would now like advice on their total portfolio. Exhibit 3-1 Mueller Investment Portfolio

Andrea’s company stock Blue Chip Growth Fund Super Beta Fund Conservative Fund Index Fund No-Dividend Fund Long-Term Zero-Coupon Fund

3.

Type Stock Stock Stock Stock Stock Stock Bond

Market Sector Small-cap growth Large-cap growth Small-cap growth Large-cap value Large-cap index Large-cap growth Government

Beta 1.40 1.20 1.60 1.05 1.00 1.25 —

Evaluate the Mueller’s portfolio in terms of the following criteria: i. ii. iii.

Preference for “minimal volatility.” Equity diversification. Asset allocation (including cash flow needs). (12 minutes)

Percent of Total 35 20 10 2 3 25 5

QUESTION 4 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES. 4.

The Muellers are reviewing growth and income mutual funds in order to choose one for a new investment. Their goal is to select a fund that will minimize volatility while maximizing after-tax returns. They have narrowed the choice to the two funds in Exhibit 4-1. Assume the Muellers are subject to a 30 percent tax rate on all income except net realized capital gains, which are taxed at 20 percent. The Muellers no longer have any tax losses available to offset realized capital gains. Exhibit 4-1 Potential New Investments for the Muellers Superior Growth Exceptional Growth and Income Fund and Income Fund 10-Year Historical Averages Total return 12.0% 9.0% Return in up markets 23.0% 14.0% Return in down markets –10.0% –1.0% Beta 1.25 0.98 Forecasted Data Expected dividend yield 1.0% 2.0% Expected annual total return 11.0% 10.5% Expected annual turnover 60.0% 10.0%

A.

Select and justify which of the above funds is more consistent with the Mueller’s goal by addressing both of the following criteria: i. ii.

Return volatility. (No calculations required.) Expected one-year after-tax return. (Assume all turnover resulted in gains, and show calculations.) (12 minutes)

B.

Discuss whether realizing losses can add value to a portfolio. (4 minutes)

QUESTION 5 HAS TWO PARTS FOR A TOTAL OF 24 MINUTES. Ten years have passed. The Muellers, now both age 63, will retire this year. The distribution from Peter’s family trust will occur now. The Mueller’s current circumstances are summarized in Exhibit 5-1 below.

Exhibit 5-1 The Mueller’s Revised Circumstances Personal Circumstances and Assets Trust Distribution Assets Pension income will total $100,000 a year The trust distribution totals $2,000,000 and will not increase with inflation. and occurs now. No tax liability is created by the distribution. Annual expenses will total $180,000 initially and will increase with inflation. The Muellers will maintain separate accounts for their personal assets and the Inflation is expected to be 2 percent a year. trust distribution. Their personal investments now total They do not plan to withdraw income or $1,000,000 (excluding trust distribution). principal. The Muellers will rely on this $1,000,000 Tax liabilities produced by these assets portfolio to support their lifestyle and do will be paid from this portfolio. not wish to reduce their level of spending. They plan to donate these assets to an arts The Muellers have health problems and society when the surviving spouse dies. neither is expected to live more than ten They have made a minimum pledge of years. All health care expenses will be $2,600,000 towards construction of a new covered by insurance. building. The Muellers’ daughter is now financially The Muellers assume that at least one of independent, and their sole investment them will live at least five years and that objective is to meet their spending needs. neither will live more than ten years. The Muellers are not concerned with An after-tax annual return of 5.4 percent growing or maintaining principal. The is required over five years to meet the income deficit may be met with both minimum pledge. investment income and by invading principal. The Muellers are concerned only that a minimum gift of $2,600,000 is available.

5.

A.

Select and justify with three reasons the most appropriate of the four portfolios from Exhibit 5-2 as an asset allocation strategy for the Muellers’ $1,000,000 personal assets. (12 minutes)

B.

Select and justify with three reasons the most appropriate of the four portfolios from Exhibit 5-2 as an asset allocation strategy for the Muellers’ $2,000,000 trust distribution assets. (12 minutes)

Exhibit 5-2 Alternative Portfolios for the Muellers (in percent) Portfolios A B C Asset Allocation Domestic large-cap stocks Domestic small-cap stocks Foreign stocks Intermediate-term fixed income Cash equivalents Total Expected annual return (nominal after-tax returns) Annual standard deviation

14 3 3 70 10 100

4.2 6.0

30 5 5 60 0 100

5.8 8.0

40 10 10 30 10 100

7.5 13.0

D 30 25 25 20 0 100

8.5 18.0

QUESTION 6 HAS FIVE PARTS FOR A TOTAL OF 33 MINUTES. 6.

June Klein, CFA, manages a $100 million (market value) U.S. government bond portfolio for an institution. She anticipates a small, parallel shift in the yield curve and wants to fully hedge the portfolio against any such change. Exhibit 6-1 Portfolio and Treasury Bond Futures Contract Characteristics Conversion Factor Portfolio Value/ Modified Basis Point for Cheapest to Futures Contract Duration Value Deliver Bond Price

Security

Portfolio U.S. Treasury bond futures contract

10 years

$100,000

Not applicable

$100,000,000

8 years

$75.32

1

94-05

A. Discuss two reasons for using futures rather than selling bonds to hedge a bond portfolio. No calculations required. (6 minutes) B. Formulate Klein’s hedging strategy using the futures contracts in Exhibit 6-1 only. Calculate the number of futures contracts to implement the strategy. Show all calculations. (6 minutes) C. Determine how each of the following would change in value if interest rates increase by 10 basis points as anticipated. Show all calculations. i. ii. iii.

The original portfolio. The Treasury bond futures position. The newly hedged portfolio. (9 minutes)

D. State three reasons why Klein’s hedging strategy might not fully protect the portfolio against interest rate risk. (6 minutes) E. Describe a zero-duration hedging strategy using only the government bond portfolio and options on U.S. Treasury bond futures contracts. No calculations required. (6 minutes)

QUESTION 7 HAS TWO PARTS FOR A TOTAL OF 15 MINUTES.

7.

George Johnson is considering a possible six-month $100 million LIBOR-based, floating-rate bank loan to fund a project at terms shown in Exhibit 7-1. Johnson fears a possible rise in the LIBOR rate by December and wants to use the December Eurodollar futures contract to hedge this risk. The contract expires December 20, 1999, has a US$ 1 million contract size, and a discount yield of 7.3 percent. Johnson will ignore the cash flow implications of marking to market, initial margin requirements, and any timing mismatch between exchange-traded futures contract cash flows and the interest payments due in March.

Exhibit 7-1 Loan Terms September 20, 1999 Borrow $100 million at September 20 LIBOR + 200 basis points (bps) September 20 LIBOR = 7%

A.

December 20, 1999 Pay interest for first three months Roll loan over at December 20 LIBOR + 200 bps

Loan initiated

First loan payment (9%) and futures contract expires

9/20/99

12/20/99

March 20, 2000 Pay back principal plus interest

Second payment and principal

3/20/00

Formulate Johnson’s September 20 floating-to-fixed-rate strategy using the Eurodollar futures contracts discussed in the text above. Show that this strategy would result in a fixed-rate loan, assuming an increase in the LIBOR rate to 7.8 percent by December 20 which remains at 7.8 percent through March 20. Show all calculations. (9 minutes)

Johnson is considering a 12-month loan as an alternative. This approach will result in two additional uncertain cash flows, as follows. Loan initiated

9/20/99 B.

First payment (9%)

Second payment

Third payment

12/20/99

3/20/00

6/20/00

Fourth payment and principal

9/20/00

Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan (specify number of contracts). No calculations needed. (6 minutes)

QUESTION 8 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.

8.

A.

Compare absolute purchasing power parity (PPP) and relative PPP. (6 minutes)

B.

Evaluate the usefulness of relative PPP in predicting short-term foreign exchange rate movements. Justify by citing two reasons. (6 minutes)

QUESTION 9 HAS TWO PARTS FOR A TOTAL OF 18 MINUTES. After reviewing historical quantitative data with respect to investing in emerging markets and venture capital, a consultant has recommended a substantial overweighting in both emerging market equities and venture capital. 9.

A.

Discuss two potential benefits resulting from overweighting that are common to both asset classes. (6 minutes)

B.

Discuss four potential problems resulting from overweighting that are common to both asset classes. (12 minutes)

QUESTION 10 HAS ONE PART FOR A TOTAL OF 6 MINUTES. 10.

Anthony Dexter is President and CEO of Welsh Investment Managers. Dexter is very interested in promoting ethical conduct among his company’s employees and begins by adopting a code of ethics. List six additional specific actions that Dexter’s firm can take to implement an effective compliance policy. (6 minutes)

QUESTION 11 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES. 11.

FIA Advisors (FIA) is a medium-sized investment advisory firm that employs 15 portfolio managers. FIA has full discretionary authority in managing the pension plan assets for all of its clients. As a general policy, FIA gives each of its portfolio managers full discretion to make the proxy voting decisions for their own clients. However, tracking and voting routine proxies is discouraged as an inefficient use of firm resources. Faced with controversial proxy votes regarding takeover defenses, compensation plans, capital structure, or social responsibility, FIA management encourages managers to either vote with management or sell the stock. A.

Critique two aspects of FIA’s approach to proxy voting in the context of the AIMR Standard on Fiduciary Duty. (Do not reference ERISA.) (6 minutes)

B.

Identify four specific procedures that FIA should adopt to help ensure implementation of an adequate proxy voting policy. (8 minutes)

CFA Level III Examination 1999 Morning Section

Important Instructions to Candidates 1. Write your candidate number in the space provided on the cover of this booklet. 2. You must return this test booklet to the proctor before you leave the exam room. If you remove any exam materials from this room, your exam will not be graded. All test booklets containing your written answers become the property of AIMR. They will not be returned to you in either original or copied form. If you remove this test booklet from the exam room, you may be subject to dismissal from the CFA Program. 3. You must write all answers in the test booklet in the appropriately numbered section. Label each subpart of your answer (for example, A, B, C, and/or i, ii, iii, etc.). Only answers written on the correct pages in the test booklet will be graded. Write legibly, preferably in blue or black ink. Do not write in the margins marked for “grader use only.” 4. If you run out of room on the designated answer pages, you must check the box at the bottom of the last page of your answer and continue your answer on the unnumbered extra pages found in the back of the test booklet. Label extra pages with the appropriate question number. 5. Attempt to answer all questions. You may receive partial credit for correct work even though you do not provide a complete response. Remember, however, that inconsistent or illogical answers will not receive full credit. 6. Write only the required number of responses. Providing more than the required number of responses to a question will not earn extra points. Extra responses will be ignored. 7. Show all your calculations on the correct answer pages even if the question doesn’t specifically instruct you to do so. You will be able to check your work this way. Also, if your answer is wrong, the grader can give partial credit where warranted if you show your calculations. If the question specifically says “Show your work,” you must present your calculations and, for full credit, they must be correct. 8. No assistance in answering questions may be given to or received from others during this exam. 9. You may not use any reference materials during this exam. You must leave all reference materials in the designated area prior to the start of the exam. 10. You may use your own silent, hand-held, battery-operated, nonalphabetic keyboard calculator, but you must clear the programmable memory prior to the start of the exam.

Do Not Open This Book Until Instructed to Do So by the Proctor. Do Not Remove Thi...