2018 Level III Mock Exam 2 Questions

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The Morning Session of the AdaptPrep Level III CFA® Mock Examination has 10
questions. For grading purposes, the maximum point value for each question is equal to
the number of minutes allocated to that question.
Question Topic Minutes
1 Portfolio Management – Individual 23

2 Portfolio Management – Individual 15
3 Portfolio Management – Economics 13
4 Portfolio Management – Fixed Income 20
5 Portfolio Management – Asset Allocation 22
6 Portfolio Management – Institutional 17
7 Portfolio Management – Institutional 15
8 Portfolio Management – Equity 20
9 Portfolio Management – Trading, Monitoring, and Rebalancing 18
10 Portfolio Management – Individual/Behavioral 17
Total: 180
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QUESTION 1 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 23 MINUTES.
Phoebe Muller is a client advisor at a major wealth management firm. She is meeting with new
clients, John and Lisa Moore, in order to understand their investment objectives and prepare an
investment policy statement (IPS).
The Moores, both 50 years old, have been married for 28 years and live in a country that uses the
U.S. dollar (USD) as its currency and taxes all employment income at a flat rate of 20%. John
works as a consulting engineer on a yearly contract basis, and plans to retire at age 65. Lisa
previously worked as a business systems analyst, but has chosen to work as a full-time volunteer
with a local children’s hospital. Neither John nor Lisa have participated in a defined benefit
pension plan during their careers. The couple have a 24-year-old son, Daniel, who has recently
graduated from medical school and started working as an emergency room physician.
This past year, John’s gross income was USD 165,000 and he expects this to increase by 5% in
nominal terms for the coming year. Because John’s income is determined on a project-by-project
basis, the Moores have been disciplined savers throughout their marriage. Every month,
regardless of John’s income, the Moores contribute USD 2,000 of after-tax income to their
retirement portfolio, which is held is a tax-exempt account. The value of this account had risen to
USD 700,000 before last week, when the Moores transferred USD 200,000 into an irrevocable
trust, of which their son Daniel is the sole beneficiary. The couple plans to continue saving the
amount on a monthly basis until John’s planned retirement, at which point they intend to
purchase USD 2,000,000 of fixed and variable rate life annuities to fund their living expenses on
an ongoing basis.
The Moores will not transfer any additional wealth as gifts during their lifetimes or as part of an
estate after the surviving spouse’s death. The couple have repaid the mortgage on their home,
currently valued at USD 680,000, where they intend to live for the remainder of their lives.
Muller expects a long-term annual inflation rate of 2.0%.
In order to better understand her clients and manage their expectations, Muller classifies them
into one of the four following personality types based on her observations:
• Cautious
• Individualist
• Methodical
• Spontaneous
During his meeting with the Moores, Muller has observed that John researches potential
investments by analyzing data from a variety of sources, including several databases to which he
subscribes, and makes dispassionate, evidence-based decisions. At John’s insistence, the
Moore’s have always regularly rebalanced their portfolio in order to maintain an asset allocation
of 40% equities and 60% fixed-income securities. Additionally, John states that he is
uncomfortable holding an equity portfolio with an overall beta above 0.8.

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A. Determine each of the following for the Moores in the coming year. Show your
calculations.
i. Living expenses
ii. Liquidity requirement from their retirement portfolio
(5 minutes – Answer Question 1-A on page 4)
B. Calculate the annualized required return that would enable the Moores to meet their
objectives upon retirement. Show your calculations.
Note: Assume that all cash flows occur at the end of each period.
(5 minutes – Answer Question 1-B on page 5)
C. Identify two factors that increase and one factor that decreases the Moore’s ability to take
investment risk.
(6 minutes – Answer Question 1-C on page 6)
D. Determine the personality type (Cautious, Individualist, Methodical, Spontaneous) into

which Muller would most likely classify John Moore. Justify your response with one
reason.
(3 minutes – Answer Question 1-D on page 7)
10 years have passed, and the Moore’s portfolio, now worth USD 1,350,000 has grown at
approximately the rate required to meet their target future value of USD 2,000,000 to be used to
purchase annuities in five years. Unfortunately, Lisa has been diagnosed with a long-term critical
illness that has forced her to stop working, even in a volunteer capacity. Although, John is
confident that they will be able to cover Lisa’s medical expenses without making any early
withdrawal from their retirement savings, he has recently stopped making new contributions and
does not anticipate being able to resume making contributions during the five years remaining
until he retires. Because he chooses to spend more time with his ailing wife, John limits the
number of projects that he works on and does not have the ability to increase his income above
its current level. The Moores will not consider moving from their long-time home.
E. Identify two options available to the Moores that will allow John to retire in five years,
given their current and expected circumstances.
Note: No calculations are required.
(4 minutes – Answer Question 1-E on page 8)

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Answer Question 1-A on This Page

1-A. Determine each of the following for the Moores in the coming year. Show your calculations.
i. Living expenses
ii. Liquidity requirement from their retirement portfolio

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Answer Question 1-B on This Page

1-B. Calculate the annualized required return that would enable the Moores to meet their objectives upon
retirement. Show your calculations.
Note: Assume that all cash flows occur at the end of each period.

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Answer Question 1-C on This Page

1-C. Identify two factors that increase and one factor that decreases the Moore’s ability to take investment risk.

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Answer Question 1-D on This Page

Determine the personality type
(Cautious, Individualist,
Methodical, Spontaneous) into
Justify your response with one reason.
which Muller would most likely
classify John Moore.
(circle one)
Cautious
Individualist
Methodical
Spontaneous

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Answer Question 1-E on This Page

1-E. Identify two options available to the Moores that will allow John to retire in five years, given their current
and expected circumstances.

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QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 15 MINUTES.
Aaron Johnson advises high net worth, European-based clients on tax-efficient investment
strategies. Johnson is preparing for a series of year-end client meetings.
Johnson’s first meeting is with long-time clients Jim and Marianne Schmidt, both 56, who began
the year with a retirement portfolio valued at EUR 14,350,000. The funds, which are held in a
fully taxable account, grew at a pre-tax rate of 9.60% over the course of the year. These returns
included EUR 452,100 of dividend income, 525,000 of interest income, and EUR 284,200 of
realized capital gains. The Schmidts live in a country that uses a flat and heavy tax regime under
which interest income is taxed at a favorable rate of 20%, while dividend income and realized
capital gains are taxed at the ordinary income rate of 30%.
A. Calculate the percentage return on the Schmidts’ investment portfolio for the year on an
after-tax basis. Show your calculations.
Johnson’s second meeting is with Daphne LaFrenz, 48, whose retirement savings consist of
bonds currently valued at EUR 5,640,000 that she holds in a taxable account and EUR 7,130,000
of equities that she holds in a tax-exempt account. Given LaFrenz’s country’s tax treatment of
various sources of income, Johnson is confident that this is the most tax-efficient asset allocation.
All sources of income derived from assets held in the taxable account will be taxed at 35%.
B. Determine LaFrenz’s after-tax asset allocation. Show your calculations.
C. Identify a source of income that is most likely taxed at a lower rate than others by the
taxation authority in LaFrenz’s country. Justify your response with one reason.
Johnson’s third and final meeting is with Jakob Tand, who lives in a country that does not tax
income or capital gains derived from financial assets valued at more than EUR 3,250,000, but
instead applies an annual wealth tax of 1.5% on their full value. Tand recently purchased a
financial asset worth EUR 3,575,000 and he expects its value to appreciate at an annual rate of
7% over his anticipated holding period of 12 years.
D. Determine the proportion of Tand’s gains that is expected to be consumed by taxes over
his holding period. Show your calculations.

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2-A. Calculate the percentage return on the Schmidts’ investment portfolio for the year on an after-tax basis.
Show your calculations.

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2-B. Determine LaFrenz’s after-tax asset allocation. Show your calculations.

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2-C. Identify a source of income that is most likely taxed at a lower rate than others by the taxation authority in
LaFrenz’s country. Justify your response with one reason.

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2-D. Determine the proportion of Tand’s gains that is expected to be consumed by taxes over his holding period.

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QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 13 MINUTES.
Ewan McKenzie is a UK-based investment advisor who works with institutional clients.
McKenzie’s newest client, the Cumbria Foundation, has recently changed its investment policy
statement (IPS) to remove a constraint prohibiting investment in emerging market equities.
Cumbria Foundation CIO Fiona Sturridge has asked McKenzie to prepare a report
recommending possible emerging market asset classes. McKenzie gathers information on the
equity asset class in two emerging markets – Rumländ and Bosphor, shown in Exhibit 1.
Exhibit 1
Capital Market Expectations
Standard Degree of
Correlation Illiquidity
Asset class Deviation Integration
with GIM Premium
(annualized) with GIM
Rumländian equities 21.3% 0.62 70% 1.2%
Borsphorian equities 23.1% 0.68 65% 1.7%
Global Investable Market (GIM) 16.0%
Additional Information
Risk-free rate 3.1%
Illiquidity premium - Rumländian equities 1.2%
Illiquidity premium - Borsphorian equities 1.7%
Expected return on GIM 7.9%
A. Calculate the expected return for the Bosphorian equities asset class, using the Singer-
Terhaar method. Show your calculations.
In addition to the information presented in Exhibit 1, McKenzie’s report contains the following
analysis:
“The Rumländian government has adopted a policy of reducing the budget deficit as a
percentage of GDP. Simultaneously, the country’s central bank, which follows the Taylor rule,
has lowered its policy rate below the natural rate. These decisions have been made despite
widespread agreement among analysts that inflation will continue to remain at the central bank’s
target rate.”
B. Determine whether the Rumländian economy is expected to grow faster or slower than
its long-term trend rate. Justify your response with one reason.

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C. Describe the most likely shape of the Rumländian yield curve. Justify your response with
two reasons.

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3-A. Calculate the expected return for the Bosphorian equities asset class, using the Singer-Terhaar method.

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3-B. Determine whether the Rumländian economy is expected to grow faster or slower than its long-term trend
rate. Justify your response with one reason.

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3-C. Describe the most likely shape of the Rumländian yield curve. Justify your response with two reasons.

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QUESTION 4 HAS TWO PARTS (A, B) FOR A TOTAL OF 20 MINUTES.
Richard Cho is a fixed-income portfolio manager at Seoul-based Supyeongseon Investments

(SI). Grace Lee, one of Cho’s clients, holds a fixed-income portfolio that contains three bonds,
each with a par value of KRW 100 million. Lee’s investment policy statement (IPS) requires
that, at the end of each year, the money duration of her fixed-income portfolio be adjusted back
to its level at the beginning of that year. The relevant information for Lee’s portfolio is shown in
Exhibit 1.
Exhibit 1
Portfolio Characteristics (Prices in KRW per 100 of par value)
Beginning of Year End of Year
Modified Modified
Price Price
Duration Duration
Bond A 102.34 6.19 103.35 5.59
Bond B 99.56 3.51 98.66 2.70
Bond C 101.28 4.24 100.70 3.50
Rather than trading bonds, Cho decides to reestablish the money duration of Lee’s portfolio
using futures contracts. Information on the appropriate futures contract and the cheapest-to-
deliver (CTD) bond is provided in Exhibit 2.
Exhibit 2
Futures Contract Data
Futures contract face value KRW 100,000
Price of CTD bond KWR 96,875
Modified duration of CTD bond 5.05
CTD bond conversion factor 0.9123
A. Calculate each of the following for Lee’s fixed-income portfolio:
i. the basis point value at the end of the year.

ii. the basis point value at the beginning of the year.
iii. the number of futures contracts that Cho must buy at the end of the year to
reestablish the money duration from the beginning of the year.
Cho also manages assets for the Simon Kim, who has pledged to make a series of donations to
help renovate a library at his alma mater. The first of four annual payments, to be made in one
year, will be for KRW 50 million. In each of the subsequent three years, Kim will make
payments of KRW 35 million, KRW 64 million, and KRW 81 million, respectively.

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In order to ensure that he has the funds required to make his promised payments, Kim asks Cho
to execute a cash flow matching strategy using the default-free, annual coupon government
bonds detailed in Exhibit 3.
Exhibit 3
Selected Bond Data
Time to expiry 1 year 2 years 3 years 4 years
Coupon rate 1.90% 2.30% 3.50% 3.90%
B. Determine the face value of bonds for each maturity that Fine must buy to successfully
implement the cash flow matching strategy desired by Kim.
Note: Assume that the minimum denomination for all bond issues is KRW 10,000.

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4-A. Calculate each of the following for Lee’s fixed-income portfolio. Show your calculations.
i. the basis point value at the end of the year.
ii. the basis point value at the beginning of the year.
iii. the number of futures contracts that Cho must buy at the end of the year to reestablish the money
duration from the beginning of the year.

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4-B. Determine the face value of bonds for each maturity that Fine must buy to successfully implement the cash
flow matching strategy desired by Kim.
Note: Assume that the minimum denomination for all bond issues is KRW 10,000.

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Megan Bettinger works as a financial planner for Rocky Mountain Investing (RMI), a large
investment advisory firm catering to individual investors. After working with clients to develop
an investment policy statement (IPS), Bettinger recommends a strategic asset allocation that is
consistent with each client’s unique investment objectives and constraints.
Bettinger is preparing to meet for a second time with Henry Lockhart, 45, an engineer with
Dycon Manufacturing (DM). Lockhart recently moved his investments to RMI after becoming
dissatisfied with his previous advisor, who repeatedly recommended that he reduce his exposure
to his employer’s stock. Lockhart refused to consider any such change. Bettinger has created a
summary of her new client’s financial assets, which he has allocated to his tax deferred account
(TDA) and his taxable account.
Exhibit 1
Lockhart’s Assets by Class and Account (USD)
Tax Deferred Taxable
Asset Class
Account Account
Equity – DM stock 0 300,000
Equity – Other 75,000 0
Fixed Income 150,000 140,000
All interest income, dividends and realized capital gains from assets held in the taxable account
are subject to a 40% tax rate. Trading within the TDA does not trigger a taxable event, but the
same 40% tax rate is applied to all funds withdrawn from this account. Lockhart has no intention
of drawing upon the funds in his TDA prior to his planned retirement in twenty years and will
continue to make the maximum allowable annual contribution until that time.
During his initial meeting with Bettinger, Lockhart explained that he continues to hold several
stocks in his TDA that are trading below their purchase price and that he will not consider selling
them until they rise above this threshold. Bettinger noted that, although selling these stocks from
within the TDA would not afford the opportunity for tax loss harvesting, Lockhart should
consider replacing them with other stocks that offer superior expected returns on a risk-adjusted
basis. At that time, Bettinger and Lockhart agreed that, given his tax constraints, his ideal asset
allocation is 60% /40% fixed income with allowable ranges of +/-6% and +/-4%, respectively.
A. Identify how Lockhart has exhibited each of the following behavioral biases:
i. Loss aversion.
ii. Illusion of control.
B. Discuss how the optimal rebalancing ranges for asset classes in Lockhart’s portfolio
would be different in the absence of any taxes. Justify your response with one reason.

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Based on his responses to the questionnaire that she administered in the initial meeting, Bettinger
has assigned Lockhart a risk aversion score of 5 on a scale where 1 represents the highest level of
risk tolerance and 8 represents the highest level of risk aversion. Although the risk-free rate is
stable at 3.0%, Lockhart has said that he is unwilling to accept a return of less than 4.5%.
Bettinger believes that she may be able to convince Lockhart to sell at least some of his DM
stock and invest the proceeds in a diversified portfolio of international equities if she can frame
her argument in a way that emphasizes the benefits of the assets that he would be acquiring.
Lockhart’s previous advisor had focused exclusively on the risks associated with continuing to
hold this position. At their second meeting, Bettinger presents three global equity portfolios for
Lockhart to consider. The portfolios were created using the traditional mean-variance
optimization approach. It is assumed that the returns for these portfolios are normally distributed.
Exhibit 2
Portfolio Risk-Return Profiles
Expected Standard
Portfolio
Return Deviation
A 8.5% 15.1%
B 8.8% 15.8%
C 9.2% 17.0%
C. Determine the portfolio that Lockhart should select based only on expected utility.
Justify your response.
D. Determine the portfolio that Lockhart should select based only on the safety-first ratio.
Justify your response.
Two years later, Bettinger has persuaded Lockhart to reduce his position in DM stock and direct
the proceeds into a more diversified equity portfolio. She prepares an updated summary of her
client’s financial assets, shown below.
Exhibit 3
Lockhart’s Updated Assets by Class and Account (USD)
Tax Deferred Taxable
Asset Class
Account Account
Equity – DM stock 0 200,000
Equity – Other 95,000 115,000
Fixed Income 155,000 145,000
Bettinger meets with Lockhart to discuss a holistic approach to asset allocation that considers
both financial assets and liabilities as well as extended portfolio assets and liabilities. In addition
to his stock and bond holdings, Lockhart includes his primary residence – valued at USD

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600,000 net of a USD 200,000 mortgage – among his economic assets. Bettinger estimates
Lockhart’s human capital to be USD 925,000.
After applying an appropriate discount rate, Bettinger determines that the present values of
Lockhart’s expected future spending and contributions to his son’s post-secondary education are
USD 1,250,000 and USD 225,000, respectively.
E. Determine Lockhart’s pre-tax economic net worth.
(6 minutes – Answer Question 5-E on page 30)

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5-A. Explain how Lockhart has exhibited each of the following behavioral biases.
i. Loss aversion.
ii. Illusion of control.

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5-B. Determine the share of Lockhart’s current after-tax financial asset allocation represented by equities.

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5-C. Determine the portfolio that Lockhart should select based only on expected utility. Justify your response.

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5-D. Determine the portfolio that Lockhart should select based only on the safety-first criterion. Justify your
response.

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5-E. Determine Lockhart’s pre-tax economic net worth.

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Partko Autotek (Partko) is an automotive parts manufacturer based in Germany. Over the
company’s nearly six-decade history, revenues and operating profits have closely tracked the
trends for the overall German economy. As part of their compensation package, Partko
employees are enrolled in a company-sponsored defined-benefit pension plan (the Plan), which
remains open to new entrants and provides post-retirement benefits based on a participant’s final
salary. All benefits promised to participants will be fixed nominal payments that are not indexed
for inflation.
The Plan is administered by a board of trustees, who recently engaged the services of Jorg
Strauss, an investment consultant with significant experience working with institutional
investors. Specifically, trustees asked Strauss to provide an assessment of the Plan’s financial
health relative to the defined-benefit pension schemes sponsored by Partko’s competitors in the
automotive parts industry. Strauss prepares the summary shown in Exhibit 1.
Exhibit 1
Selected Data Comparing the Plan to Industry Average
Automotive parts
Plan
industry average
Funded status 100% 93%
Average age of participants 53 48
Sponsor’s debt-to-assets ratio 0.65 0.58
Ratio of active lives to inactive lives 0.75 0.86
Sponsor’s operating margin (most recent year) 3.47% 5.25%
Correlation of asset returns with sponsor’s operating
0.62 0.71
profits (over the past 20 quarters)
Further research reveals that Plan participants have the option of receiving as much as 40% of
the present value of their accumulated benefits upon retirement. Very few firms in the
automotive parts industry offer such a provision to their employees. Because the Plan is fully-
funded, its trustees have chosen to adopt a liability-relative approach to asset management. The
Plan’s investment policy statement (IPS) includes a constraint against using derivatives of any
kind.
A. Identify two factors related to the characteristics of Partko’s workforce that indicate that
the Plan has a below-average ability to take risk relative to its peers. Justify each
response with one reason.
B. Identify one factor indicating that the Plan’s ability to take risk is above-average relative
to its peers. Justify your response with one reason.

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Based on his analysis of the Plan’s assets and liabilities, as well as Partko’s financial status and
competitive environment, Strauss recommends that the company terminate the Plan and transfer
all current participants into a cash balance plan. In a memo supporting his recommendation,
Strauss notes that cash balance plans are considered to be hybrids – sharing characteristics of
both defined-benefit plans and defined-contribution plans.
C. Identify one characteristic that cash balance plans share with defined-benefit plans and
one characteristic that cash balance plans share with defined-contribution plans.
D. Discuss one criticism of cash balance plans that is relevant to the Plan’s existing
participants. Identify one measure that Partko could enact to mitigate its exposure to this
potential criticism.

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Identify two factors related to the
characteristics of Partko’s workforce that
indicate the Plan’s ability to take risk is Justify each response with one reason
below the automotive parts industry
average.
1.
2.

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6-B. Identify one factor indicating that the Plan’s ability to take risk is above-average relative to its peers.
Justify your response with one reason.

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6-C. Identify one characteristic that cash balance plans share with defined-benefit plans and one characteristic
that cash balance plans share with defined-contribution plans.

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6-D. Discuss one criticism of cash balance plans that is relevant to the Plan’s existing participants. Identify one
measure that Partko could enact to mitigate its exposure to this potential criticism.

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Kagami Construction (KC) designs and builds multi-storey commercial towers in Japan, where
the company is headquartered, as well as in other Asian countries. Since its inception twenty
years ago, the company-sponsored Shiseki Foundation (the Foundation) has provided grants to
preserve and restore sites of historical significance in the countries where KC operates.
The Foundation is overseen by a board of trustees that is vested with the authority to make
investment decisions subject to mandates provided by its sponsoring company, whose CEO
appoints the Foundation’s trustees. Junichiro Kagami, KC’s founder and then-CEO, originally
established the Foundation with an initial endowment of 4 million shares of KC’s common stock,
which was worth JPY 1 billion at the time. The Foundation has never been subject to a “spend
down” mandate and has no plans to deviate from its policy of making annual distributions of
5.2% of the value of its assets at the end of the previous year, which is the minimum spending
rate required to maintain tax-exempt status.
Since taking over from her father as KC’s CEO five years ago, Yuki Kagami, has continued to
mandate that Foundation maintain its holding of the original allocation of 4 million shares.
Annual cash contributions of from its company sponsor over the past two decades have allowed
the Foundation to pursue an investment strategy that has reduced the proportion of the value of
its assets represented by KC shares. A summary of the current value of the Foundation’s assets
for the year that has just ended is shown in Exhibit 1.
Exhibit 1
Current Portfolio (amounts in millions of JPY)
Asset Class Market value
KC common stock 4,017
Domestic equities (not including KC) 1,158
Domestic bonds 2,099
International equities 542
International bonds 664
Real estate and other 1,084
Total 9,564
Trustees will meet next week to approve the Foundation’s budget and operating plan for the
coming year. Overhead costs are expected to an important topic of discussion at this meeting. As
the Foundation’s assets and grants have grown in value, so have its operating costs – the
management expense rate is currently 0.45%, up from 0.40% five years ago. KC’s contribution,
JPY 145 million last year, increases annually at the Foundation’s real spending rate. The annual
rate of inflation is expected be 2.1% over the next several years.

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A. Discuss how being mandated to maintain its holding of KC shares is a disadvantage for
the Foundation. Identify one action that trustees could take to mitigate the effects of this
mandate while still complying with it.
B. Determine the Foundation’s nominal required return for the coming year. Show your
calculations.
C. Formulate the Foundation’s time horizon. Justify your response with one reason.
D. Determine the Foundation’s liquidity requirement for the coming year. Show your
calculations.

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7-A. Discuss how being mandated to maintain its holding of KC shares is a disadvantage for the Foundation.
Identify one action that trustees could take to mitigate the effects of this mandate while still complying with
it.

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7-B. Determine the Foundation’s nominal required return for the coming year. Show your calculations.

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7-C. Formulate the Foundation’s time horizon. Justify your response with one reason.

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7-D. Determine the Foundation’s liquidity requirement for the coming year. Show your calculations.

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Gaston Coupet advises French institutional investors on asset allocation and manager selection
decisions. Coupet has been asked to recommend an equity portfolio strategy for Assurance Métro
(AM), a Paris-based life insurer, by AM’s CIO Claudette St-Hubert. AM has allocated EUR 700
million to domestic equities and St-Hubert has identified the CAC 40, France’s main equity
market index, as the benchmark by which the portfolio’s overall performance will be measured.
However, St-Hubert has also indicated a willingness to accept some tracking risk to seek excess
risk-adjusted returns.
In a meeting with St-Hubert, Coupet recommends that AM’s domestic equity portfolio be
allocated among three managers. A summary of Coupet’s presentation is shown in Exhibit 1.
Exhibit 1
Recommended Allocation for AM’s Domestic Equity Portfolio
Manager A Manager B Manager C
Assets under management 200 100 400
Number of stocks 20 20 40
Dividend yield 1.1% 5.6% 3.3%
P/E ratio 7.1 3.2 5.0
P/B ratio 4.1 1.8 3.0
Earnings per share (EPS) growth 3.5% 0.2% 2.1%
Expected alpha 2.2% 1.7% 0.0%
Expected tracking risk 5.2% 4.4% 0.0%
Style fit 85% 82% 100%
Notes:
• Assets Under Management (AUM) are stated in EUR million
• EPS growth is a five-year forecast stated in annualized terms
• Style fit is calculated using the last 60 monthly returns compared to the CAC 40
• All sources of active returns are assumed to be uncorrelated with each other
St-Hubert is impressed with the thoroughness of Coupet’s presentation and authorizes EUR 700
million to be allocated to the three managers in accordance with Coupet’s recommendation.
A. Identify Manager C’s investment approach. Justify your response with one reason using
returns-based analysis.
B. Discuss why the CAC 40 index is an inappropriate benchmark for Manager B.

Recommend a more appropriate type of benchmark.

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C. Identify one risk associated with each of the following active equity investing styles:
i. growth.
ii. market-oriented.
iii. value.
(6 minutes – Answer 8-C on page 47)
D. Calculate the portfolio’s active return and portfolio tracking risk. Show your
calculations.
(4 minutes – Answer 8-D on page 48)
It is now one year later and Coupet is concerned about the results of a holdings-based analysis,
which indicate that Manager A has deviated from his stated style. Coupet arranges a meeting
with St-Hubert so that they can discuss the topic of style drift.
E. Discuss two potential disadvantages for investors when a manager deviates from his or
her stated style.
(4 minutes – Answer 8-E on page 49)

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8-A. Identify Manager C’s investment approach. Justify your response with one reason using returns-based
analysis.

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8-B. Discuss why the CAC 40 index is an inappropriate benchmark for Manager B. Recommend a more
appropriate type of benchmark.

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8-C. Identify one risk associated with each of the following active equity investing styles:
i. growth.
ii. market-oriented.
iii. value.

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8-D. Calculate the portfolio’s active return and portfolio tracking risk. Show your calculations.

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8-E. Discuss two potential disadvantages for investors when a manager deviates from his or her stated style.

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QUESTION 9 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES
Julius Valke, a 42-year-old software engineer based in Bern, Switzerland, has recently decided to
become more diligent in his efforts to plan for retirement. While he has managed to accumulate
financial assets worth CHF 400,000, Valke has never had a written investment policy statement
(IPS) and does not believe that his asset allocation is optimal. After interviewing several
potential investment advisors, Valke has decided to work with Ramona Schiff.
Exhibit 1
Schiff’s Capital Market Expectorations
Correlation Average
Expected Standard
Asset Class with rest of transaction
return deviation
portfolio cost (bps)
Domestic equities 8.4% 18.9% 0.82 45
Non-domestic equities 9.6% 23.6% 0.64 62
Domestic bonds 4.9% 12.4% 0.79 71
Non-domestic bonds 5.4% 14.5% 0.71 75
Real estate/Other 10.2% 24.5% 0.75 81
Note: The correlations with other portfolio assets have forecasted based on simulations of the
performance of a portfolio with the target weights shown in Exhibit 2.
They arrange an initial meeting for 1 April, at which Schiff conducts a detailed interview to
become familiar with Valke’s background and expectations for his retirement years. Based on
her notes from this meeting, Schiff writes a formal IPS to document Valke’s investment
objectives and constraints. Additionally, Schiff recommends the strategic asset allocation (SAA)
and corridor widths shown in Exhibit 2.
Exhibit 2
Schiff’s Recommended SAA and Corridor Widths for Valke
Asset Class Target Weight Corridor Width
Domestic equities 30% +/ - 3.6%
Non-domestic equities 30% +/ - 3.0%
Domestic bonds 20% +/ - 2.0%
Non-domestic bonds 10% +/ - 1.5%
Real estate/Other 10% +/ - 1.8%
Valke agrees to have Schiff implement this recommendation. The IPS that Schiff wrote stipulates
that the portfolio asset classes in Valke’s portfolio must be rebalanced back to their target weight
every six months if one or more has breached the outer bound of its corridor.
A. Determine two factors that support Schiff’s recommendation of a wider corridor width
for domestic equities relative to non-domestic equities.

Level III Page 51
Six months later, 1 October, Valke and Schiff meet for a second time. At this meeting, they
discuss how to rebalance the asset classes in Valke’s portfolio, which has appreciated in value to
CHF 412,800. There have been three important developments since their initial meeting.
• Development 1: Switzerland’s central bank increased its benchmark overnight lending rate.
• Development 2: The value of Valke’s domestic bond holdings is now worth CHF 73,650.
• Development 3: Valke unexpectedly inherited CHF 800,000 in cash from his uncle.
While the SNB’s decision was consistent with the central bank’s long-standing policy of
targeting a 2.0% inflation rate, it was largely unexpected and significantly affected bond prices.
B. Determine the development that would most likely cause Schiff to recommend a change
in Valke’s SAA. Explain, for each development not chosen, why it would not justify a
change to the SAA.
Valke wants to invest the CHF 800,000 that he has inherited from his uncle and directs Schiff to
purchase the shares of three Swiss firms that he has been following. The orders are summarized
in Exhibit 3.
Exhibit 3
Valke’s Trade Orders
Average
Order size
Stock Order daily volume
(shares)
(shares)
ABC Buy 5,000 15,000
KLM Buy 10,000 700,000
XYZ Buy 18,000 400,000
Valke notes that has reason to believe that the price of KLM shares will appreciate significantly
before the end of the day. By contrast, he has no urgency to purchase ABC and XYZ shares and
is comfortable to wait for his orders to be filled a price that he considers reasonable.
C. Recommend the most appropriate trade execution tactic – crossing network,

implementation shortfall, or volume-weighted average price (VWAP) – for each of the
following orders:
i. Buy ABC shares

ii. Buy KLM shares
Justify your response with one characteristic of the proposed trade.
Note: The same characteristic cannot be used for both responses.

Level III Page 52
On 1 October, shares of XYZ close at CHF 5.63 and Valke places a buy order for 18,000 XYZ
shares with that price as a limit. On 2 October, Schiff partially fills the order by purchasing 3,200
XYZ shares at CHF 5.61 before the price rises to CHF 5.65 at the end of the trading day. On
October 3, Schiff purchases an additional 4,000 shares of XYZ at CHF 5.62, but Valke cancels
his order after observing that day’s closing price of CHF 5.68.
D. Calculate the component of the implementation shortfall (in basis points) that is
attributable to unrealized profit/loss for Valke’s order to purchase shares of KLM. Show
your calculations.

Level III Page 53

9-A. Determine two factors that support Schiff’s recommendation of a wider corridor width for domestic
equities relative to non-domestic equities.

Level III Page 54

Determine the development that would
most likely cause Schiff to recommend a Explain, for each development not chosen, why it would not justify a
change in Valke’s SAA. change to the SAA.
(circle one)
Development 1
Development 2
Development 3

Level III Page 55

Note: The same characteristic cannot be used for both responses.
Recommend the most appropriate trade
execution tactic – crossing network,
Justify your response with one characteristic
implementation shortfall, or volume-
Order of the proposed trade.
weighted average price (VWAP) – for
each of the following orders:
(circle one)
i. Buy ABC shares
crossing network
implementation shortfall
volume-weighted average price

(VWAP)
ii. Buy KLM shares
crossing network
implementation shortfall
volume-weighted average price

(VWAP)

Level III Page 56

9-D. Calculate the component of the implementation shortfall (in basis points) that is attributable to unrealized
profit/loss for Valke’s order to purchase shares of KLM. Show your calculations.

Level III Page 57
QUESTION 10 HAS TWO PARTS (A, B) FOR A TOTAL OF 17 MINUTES.
Kimberly Schnetzer is an investment advisor with Fain Investments (FI), a mid-sized investment
management firm based in Golden, Colorado. When meeting with new clients for the first time,
Schnetzer begins by having a conversation about the client’s personal circumstances and career
record and then administers a questionnaire designed to reveal the client’s characteristics and
tendencies. Schnetzer then uses the information gathered in this initial meeting to develop an
investment policy statement (IPS), as well as to classify each client into one of the following
behavioral investor types:
• Active Accumulator
• Friendly Follower
• Independent Individualist
• Passive Preserver
Schnetzer is reviewing the notes that she took in two recent initial meetings with new clients,
David Sherman and Allison Warner.
Sherman, 58, is the owner and CEO of Sunny Farms, a health food company, and has overseen
its growth during the twenty years since he founded it. Sunny Farms’ products are now carried
by several national US retailers and will soon be carried by two large retailers in Canada.
Sherman describes his management style as “hands-on” and he is similarly uncomfortable
delegating responsibility for decisions about his personal investment portfolio. 60 percent of
Sherman’s portfolio (excluding his ownership of Sunny Farms) is allocated to the stocks of US
retailers and he expressed his intention to purchase stocks of the two Canadian retailers that will
be selling his company’s products. When presented with a series of reports authored by respected
analysts predicting that a weakening Canadian dollar relative to the US dollar would negatively
impact sales of US products in Canada, Sherman responded, “Whenever a US retailer has agreed
to sell our products, I have bought their stock and never been disappointed with the returns. I
expect this pattern to continue.”
Warner, 32, is a Human Resources manager with an electric utility. She recently inherited USD
3.1 million worth of shares in Rivaldi Corp. from the estate of her grandfather, who was an
executive at Rivaldi for twenty-five years and made regular purchases of the company’shares
during his career and after his retirement. Warner claims that she cannot remember the last time
she rebalanced her portfolio or even checked its performance. Although all taxes attributable to
the appreciation in the value of these shares over the decades since her grandfather purchased
them have been paid by his estate and the cost basis of the shares has been stepped up for tax
purposes to the price at the time they were transferred, Warner is unwilling to diversify her
portfolio. While she acknowledges that, if she had inherited a cash payment of the same value,
she would not use it to purchase such a large number of Rivaldi shares, Warner justifies her
decision to on the grounds that doing so would offend certain members of her family, adding
“Besides, I can sell these shares when I retire and use the proceeds to buy something special, like
a ski chalet in Vail.”

Level III Page 58
A. Identify two behavioral biases exhibited by:
i. Sherman
ii. Warner
Justify each identified bias with one example from the information provided.
12 minutes (Answer 10-A on page 59)
B. Determine the behavioral investment type (Active Accumulator, Friendly Follower,

Independent Individualist, Passive Preserver) into which Schnetzer would most likely
classify Sherman. Justify your response with one reason related to his behavioral biases
and one reason related to his investment approach.
5 minutes (Answer 10-B on page 60)

Level III Page 59

i. Identify two behavioral
biases exhibited by Sherman.
1.
2.
ii. Identify two behavioral

biases exhibited by Warner.
1.
2.

Level III Page 60

Determine the behavioral investment
type (Active Accumulator, Friendly
Follower, Independent Individualist, Justify your response with one reason related to his behavioral biases
Passive Preserver) into which Schnetzer and one reason related to his investment approach.
would most likely classify Sherman.
(circle one)
1.
Active Accumulator
Friendly Follower
2.
Independent Individualist
Passive Preserver

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Level III Page 1

Question Topic Minutes

1 Portfolio Management – Individual 23

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QUESTION 1 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 23 MINUTES.

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(5 minutes – Answer Question 1-A on page 4)

(5 minutes – Answer Question 1-B on page 5)

(6 minutes – Answer Question 1-C on page 6)

D. Determine the personality type (Cautious, Individualist, Methodical, Spontaneous) into

(3 minutes – Answer Question 1-D on page 7)

Note: No calculations are required.

(4 minutes – Answer Question 1-E on page 8)

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Answer Question 1-A on This Page

ii. Liquidity requirement from their retirement portfolio

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Answer Question 1-B on This Page

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Answer Question 1-C on This Page

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Answer Question 1-D on This Page

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Answer Question 1-E on This Page

Note: No calculations are required.

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QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 15 MINUTES.

(4 minutes – Answer Question 2-A on page 10)

B. Determine LaFrenz’s after-tax asset allocation. Show your calculations.

(3 minutes – Answer Question 2-B on page 11)

(3 minutes – Answer Question 2-C on page 12)

(5 minutes – Answer Question 2-D on page 13)

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Answer Question 2-B on This Page

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Answer Question 2-C on This Page

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Answer Question 2-D on This Page

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QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 13 MINUTES.

(5 minutes – Answer Question 3-A on page 16)

Note: No calculations are required.

(3 minutes – Answer Question 3-B on page 17)

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(5 minutes – Answer Question 3-C on page 18)

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Answer Question 3-B on This Page

Note: No calculations are required.

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Answer Question 3-C on This Page

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QUESTION 4 HAS TWO PARTS (A, B) FOR A TOTAL OF 20 MINUTES.

Richard Cho is a fixed-income portfolio manager at Seoul-based Supyeongseon Investments

A. Calculate each of the following for Lee’s fixed-income portfolio:

i. the basis point value at the end of the year.

Show your calculations.

(12 minutes – Answer Question 4-A on page 21)

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(8 minutes – Answer Question 4-B on page 22)

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