Level III of CFA Program Mock Exam 1 – Questions (AM)

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Level III of CFA Program
Mock Exam 1
June 2020
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 Level III of CFA Program Mock Exam 1 – Questions (AM)

FinQuiz.com – 1st Mock Exam 2020 (AM Session)

The morning session of the 2020 Level III Examination has 8 questions. For grading
purposes, the maximum point value for each question is equal to the number of minutes
allocated to that question.

Questions Topic Minutes

1 Portfolio Management – Individual Investor 32
2 Portfolio Management – Institutional Investors 36
3 Portfolio Management – Economics 18
4 Portfolio Management – Economics 20
5 Portfolio Management – Asset Allocation 27
6 Portfolio Management – Fixed-Income Investments 24
7 Portfolio Management – Alternative Investments 14
8 Portfolio Management – Equity Investments 9

Total: 180

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 32 MINUTES.

Simon Becker is 45 years old stockbroker at P.S. Salow, a well-respected firm with a
long history. Simon is sitting down with J.D. Smithson, the advisor that manages his
retirement portfolio, to plan his retirement and other needs.

Simon has done well and would like to retire in ten years. He is married and his two twin
boys will soon be moving out and attending college at the same time he is starting
retirement. While he does not plan on paying their entire tuition, he would like to give
them a one-time gift of $25,000 each when they move out.

Simon and his wife, who works as a medical examiner, would like to retire and buy a
vacation home in Miami, which will cost about $200,000. They currently rent a home and
have no significant debts or mortgages.

The Beckers currently have an investment portfolio of $1,250,000 in a money market

account. They would like to buy an annuity for $2,000,000 when they retire that will
cover their annual expenses. While the Beckers have worked hard to fund their portfolio
to this point, they do not want to contribute any more for their remaining years to
retirement. While he is familiar with the concept of risk and return, Mr. Becker has seen
many of his coworkers lose their entire life savings to speculative investments. He feels
that he and his wife have worked hard to save up and are pretty well set for their
retirement.

A. Formulate each of the following constraints for Beckers investment policy statement
(IPS):

i. Liquidity
ii. Time horizon
iii. Unique concerns

(6 minutes)

B. Identify Beckers’ planned and unplanned goals.

(6 minutes)

After carefully preparing the Beckers’ investment policy statement (IPS), Smithson
focused his attention towards portfolio construction and monitoring process to build an
appropriate investment plan and strategy. Smithson planned to apply a goal-based
investing approach to put a greater focus on the goals that Beckers’ family want to
achieve.

C. Describe briefly goals-based investing (GBI) approach. Determine the main focus of
the wealth manager when applying goals-based investing. State one advantage and
one disadvantage of goals-based investing approach.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 1-C in the template provided at the end of the Question 1.

(8 minutes)

Five years have passed and the Beckers have recently inherited a substantial amount of
money from a relative. In addition, the Beckers have reassessed their plans in retirement
and would like to live a more lavish lifestyle which will require more expenses. To
accomplish this, Mr. Becker has decided to put part of their money to private equity and
hedge funds.

D. Identify two factors that change Mr. Becker’s capacity or perception to take risk, and
state whether the factor increases or decreases the overall risk tolerance.

Answer Question 1-D in the Template provided at the end of Question 1.

(12 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 1 on This Page

Template for Question 1-C

Goals-based Investing

Describe briefly

Main focus of
the wealth
manager

Advantage

Disadvantage

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 1 on This Page

Template for Question 1-D

Identify three Choose (encircle) Choose (encircle)

factors that whether the affect whether the affect
change is with respect to is an increase or Justify your response
Beckers’ risk capacity or decrease in his
tolerance. perception to overall risk
tolerate risk tolerance

Capacity Increase
1
Perception Decrease

Capacity Increase
2
Perception Decrease

3 Capacity Increase

Perception Decrease

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 34 MINUTES.

Iowa State University is a public, tax-exempt institution that receives a portion of its
funding needs from an endowment. Each year, the endowment pays out 3.5% of last
year’s market value to fund the current year’s spending needs. The market value of the
endowment last year was $250 million dollars, which means that this year’s funding will
be approximately 15% of the university’s total needs. The university would like to
maintain this level of support into the future. As a publicly funded institution the
investment committee is wary of certain investments that contradict with the university’s
policy of a moral and healthy lifestyle.

The last five years history for the endowment and spending is shown below. (all dollar
amounts are in thousands USD)

Market
Year Ending 3.5% Spending for
Value in
December Next Year
(‘000)
2014 $200,000 $7,000
2015 $275,000 $9,625
2016 $325,000 $11,375
2017 $215,000 $7,525
2018 $250,000 $8,750

The markets have been especially volatile over the last few years and the university
investment committee is worried that they may not be able to meet spending needs in the
future. Several of the past years have seen dramatic swings in the total assets of the fund
and large drawdowns after yearly spending needs. The committee has decided to switch
to market value rule based on 3.5% of the last five years moving average of assets.

Fund’s current investment portfolio holds 50% equity, 40% alternative investments and
10% fixed income. Fund’s investment approach involves significant active management
and rely on externally managed asset.

A. State the primary objective of Iowa State University (ISU) endowment. Name three
stakeholders of ISU.

(6 minutes)

B. Calculate the endowment’s spending needs for 2019 based on market value
spending rule by applying five year moving average. Show your calculations.

(3 minutes)

C. Select whether the change in spending rule increases or decreases the endowment’s
risk tolerance. Support your answer with one reason.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 2-C in the Template provided at the end of Question-2.

(3 minutes)

D. Identify the investment approach currently being used by the investment committee
of the ISU endowment. Justify your response. State one advantage and one
disadvantage of the selected investment approach.

Answer Question 2-D in the template provided at the end of the Question 2.

(8 minutes)

E. Formulate each of the following constraints for the ISU endowment’s investment
policy statement (IPS):

i. Unique circumstances
ii. time horizon
iii. liquidity

(6 minutes)

The Save-a-Live Foundation is a nonprofit organization focused on providing support for

the homeless in and around Minneapolis, Minnesota. The foundation has a very large
investment portfolio left to it by a wealthy benefactor and receives much of its annual
spending needs through donations. The foundation is tax-exempt as long as it meets
minimum requirements for payment of proceeds set by the IRS.

F. Identify the type of Save-a-Live foundation.

(2 minutes)

G. Choose whether the risk tolerance component of the IPS is higher, lower, or no
different for the Save a Life foundation relative to the ISU endowment. Discuss two
reasons that support your answer.

Answer Question 2-G in the Template provided at the end of Question-2.

(6 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 2 on This Page

Template for Question 2-C

Select whether the change in

spending rule increases or Support with One reason
decreases risk tolerance

Increase

Decrease

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 2 on This Page

Template for Question 2-D

(Circle one) Justify your response

Identify the
investment approach Norway Model
currently being used
by the investment
committee of ISU Endowment Model
endowment

Canadian Model

Liability-driven
investing (LDI)
Model

State one Advantage

State one
Disadvantage

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 2 on This Page

Template for Question 2-G
Choose whether the risk tolerance
component of the IPS is higher, lower,
Discuss two reasons that support your
or no different for the Save a Life
answer.
foundation relative to the ISU
endowment.

Higher

Lower

No Different

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES.

Joseph, Robert and Jason are all economic research analysts for the state’s workforce
development agency. Each is an expert in a different approach to forecast economic
growth.

Joseph follows the release of economic data closely and favors using indicators to
forecast growth. Robert uses checklists he has devised over the years and is confident
they are the most accurate method. Jason is a recent statistics graduate and is more
comfortable using econometric modeling.

The three argue for hours but cannot agree on the relative advantages and limitations of
each approach.

A. For each of the approaches to economic forecasting, describe one advantage and
one disadvantage.

Answer Question 3-A in the Template provided at the end of Question 3.

(12 minutes)

The three analysts decide to leave the debate aside for now and move on to talk about
stocks and the business cycle. They are all familiar with the price-earnings multiple and
discuss how it reacts to the business cycle and inflation. Robert makes the following
assertions,

“The price-earnings ratio tends to be low and falling during the early stages of a
recovery.”

“Inflation has no effect on price-earnings ratios.”

B. Determine whether each of the statements is accurate. Support each response with
one reason.

Answer Question 3-B in the Template provided at the end of Question 3.

(6 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 3 on This Page

Template for Question 3-A
Forecasting
Describe one advantage and one limitation.
Approach

Advantage
Econometric
Modeling
Limitation

Advantage
Economic Indicators
Limitation

Advantage
Checklist
Limitation

Template for Question 3-B

Determine
whether each of
Support each response with one reason
the statements is
accurate
“The price-
earnings ratio Accurate
tends to be low
and falling during
the early stages of Inaccurate
a recovery.”
Accurate
“Inflation has no
effect on price-
earnings ratios.” Inaccurate

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

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

Paul Shannon works at Emerging Investment LLC and has been asked to write a report
on Emerging markets.

A. List five economic risks of emerging market countries that make them potentially
unable to pay debt on time.

(5 minutes)

Shannon is observing a country named Bellvale for part of his emerging market portfolio.
Bellvale is a small but growing country. Shannon is determining the soundness of
Bellvale based on the key macroeconomic elements.

Bellvale’s bond market is offering significantly higher yields adjusted for inflation
compared to developed countries’ bond markets. Shannon believes that the debt premium
of Bellvale will reduce overtime as the country is becoming structurally stronger.
Historically, Bellvale’s bond and stock markets have long been considered as high-risk
investments. This probably stem from the perception that the Bellvale is politically
instable and central bank frequently shifts policies.

Bellvale’s annual growth rate is 5.5%. For the last eight years, the country’s annual
growth rate is ranged between 5.4% to 6.6%. Country’s fiscal deficit to GDP ratio is
consistently greater than 5%. Bellvale’s new government has been indifferent towards the
capital market that needs support. Bellvale’s debt-to-GDP ratio is 35% and foreign
reserves to short-term debt ratio is 210%.

B. Describe factors that support Shannon’s decision to invest in Bellvale? Describe the
risks Shannon might be overlooking?

Answer Question 4-B in the template provided at the end of Question 4.

(15 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 4 on This Page

Templates for Question 4-B

Factors that Justify your response

support Shannon’s
decision to invest
in Bellvale.
1

Risks Shannon Justify your response

might be
overlooking.
1

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 5 HAS THREEPARTS (A, B, C) FOR A TOTAL OF 27 MINUTES.

John Galt Investments has been experiencing some peculiarly volatile results across its
portfolios over the last year and its manager, Jim Blake, is anxious to find out why. Mr.
Blake speaks to each of his five portfolio managers and finds out that each manager was
using a different approach to asset allocation. To further complicate matters, while the
managers could describe their approach, they did not know what the approach was
formally called.

Below is the transcript from each manager’s description of their approach:

Mr. Brown: I have developed my approach through years of work as a manager. I

generally use a rule-based system that is widely used among professionals.

Ms. Emmet: I have no particular view on expected class returns and my clients have an
average risk tolerance. My main goal is to design a well-diversified
portfolio.

Mrs. Jenkins: After having tried other approaches, I found one that is not as sensitive to
changes in input estimation. By drawing on historical averages of the
inputs, I can design a portfolio around a more stable efficient frontier.

Mr. Crowley: My portfolio is designed for institutional investors like banks and
insurance companies. These institutions are considered quasi-trust
fiduciaries and are required to meet their financial obligations.

Ms. Jones: I have created a computer program that models possible capital market
assumptions and applies thousands of possible combinations over the
investing horizon. I then select the most appropriate allocation for the best
long-term results.

A. Given the statements by each manager, decide the most likely asset allocation
approach and describe one advantage of the approach. Possible allocation choices
are: Resampled Mean-Variance Optimization, Black-Litterman, Monte Carlo
Simulation, Asset-Liability Management, and Experienced-Based

Answer Question 5-A in the Template provided at the end of Question 5.

(15 minutes)

Mr. Blake is now looking over the portfolio of Shawn Bryan, a private wealth client who
just inherited $1,740,000 from the sale of his father’s business in the United States. Bryan
plans to invest approximately $75,000 of this amount in a friend’s start-up firm in about
six months’ time. When talking to Blake about his goals, Bryan states that he would not
only like to invest in his friend’s firm without eroding the initial capital, but would also
like to earn a return that would at least cover inflation in the long-term.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

In setting Bryan’s risk objective, Blake includes a risk tolerance of 4 for him. Based on
his IPS, Blake suggests three difference strategic asset allocations as given in Exhibit 1.

Exhibit 1: Strategic Asset Allocations for Blake’s Portfolio

Investor’s Forecasts
Asset Allocation Expected Return Standard deviation of Return
A 13.50% 22.00%
B 8.50% 16.00%
C 5.80% 11.00%

B. Recommend the most appropriate strategic asset allocation for Bryan based only
on his risk-adjusted expected returns. Show your calculations.

(6 minutes)

C. Justify a strategic asset allocation given Bryan’s threshold return and assuming a
normal return distribution. Show your calculations.

(6 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 5 on This Page

Template for Question 5-A
Given the statements by
each manager, decide
Manager Describe one advantage of the approach.
the most likely asset
allocation.

Mr. Brown

Ms. Emmet

Mrs. Jenkins

Mr. Crowley

Ms. Jones

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 6 HAS TWO PARTS (A & B) FOR A TOTAL OF 24 MARKS

Samantha Freeman is a specialized asset manager hired by The Iceberg Media House
(TIMH) to manage their defined benefit pension plan. The present value of the plan’s
pension liabilities equals $289 million using a discount rate of 6% and a wage growth
rate of 5.5%. The plan is currently slightly overfunded, with an asset portfolio having a
market value of $299 million respectively. Freeman has estimated the effective durations
of the pension obligations and the asset portfolio to equal 7.8 and 9.5 respectively.

Freeman’s department has cited concerns over a predicted overheated economy, with
rising inflation and increasing interest rates. Such a scenario could lead to a lower value
of the pension assets, especially if the stock market is also expected to reverse after
reaching its peak. Freeman favors a suggestion given to her by her financial team that
involves bridging the duration gap between the pension plan’s liabilities and assets to
minimize losses. However, she does advise them not to sell or buy securities directly in
the open market, as large transactions could significantly alter market prices and incur
considerable tangible transaction costs.

Freeman assigns Charlie Robins, an immunization expert and market analyst, to identify
and negotiate interest rate derivatives with a financial firm for the sole purpose of
adjusting the duration gap of the pension plan. Robins negotiates the following contracts:

i. A 10-year futures contract with a BPV of $66.245 (per $100,000 in par value) and
a conversion factor of 0.9203.
ii. A 20-year fixed-for-floating swap contract with a fixed rate of 5.00% and the 3-
month Libor as the floating rate. Its net effective duration to the fixed-rate
receiver is 19.00.
iii. An option to enter the 20-year swap contract at a strike rate of 6.3%. The
swaption premium equals 50bps per unit of the notional principal of the swap.
iv. A swaption collar that involves the above option and another that has the same
premium. The new option has a strike rate of 3.00%. The idea is to construct a
zero cost strategy so that there is no upfront premium to be paid.

Robins determines that a hedging ratio of 75% would be most appropriate for the plan
considering the size of the plan, the plan’s stakeholders, and the expected accuracy of the
interest rate predictions. The first task that Robins assigns his team is to determine the
positions that the plan would have to take under each contract based on the market values
of the obligations and assets.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

A. Construct a derivative overlay strategy using each of the interest rate derivatives put
forth by Charlie Robins.

(16 minutes)

B. Describe one challenge for each of the derivative strategies determined above.

(8 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 7 HAS THREE PARTS (A, B, and C) FOR A TOTAL OF 14

MINUTES

Abram Gael is a hedge fund manager at GI Equity Hedge Fund based in Brasília, the
capital of Brazil. He is well-known for his dedicated short biased strategies and has
currently R$150 million assets under management. Gael’s assistant has consolidated
information regarding the two potential investment candidates. The information is as
follows:

Exhibit 1:
Particulars of Potential Investment Candidates
Industry
Characteristics Stock A Stock B
Average
P/E 30 27 10
P/B 7 9 5.5
Long Term Growth 8% 3% 7%
Liquidity High High -
Borrowing cost 15% 8% -

A. Determine which stock is most likely appropriate to be added to Gael’s short

biased portfolio. Justify your response with two reasons.

Answer Question 7-A in the template provided at the end of Question 7.

(5 minutes)

Brazil’s economy was in recession from the past decade; thus, short biased strategy had
been the preferred one by all equity hedge fund managers. The country is now out of
recession and among the growing economies of the world. Gael desires to change his
equity investment strategy, keeping in view the shifting market conditions. The market
imposes no restriction on the use of leverage and Gael is indifferent for the exposure to
market beta. He is evaluating the equity market trend to determine whether he should
move to Long/Short Equity strategy or Equity Market Neutral strategy. The projected
growth rate of the equity market is highest in the history of Brazil’s economy. Equity is
more likely to outperform other alternative investments with a low degree of co-
integration among stocks. Interest rates are expected to decline further.

B. Determine the most appropriate strategy for GI Equity Hedge Fund under shifting
economic conditions. Justify your response.

Answer Question 7-B in the template provided at the end of Question 7.

(5 minutes)

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

C. State and Discuss the risks associated with dedicated short biased strategy under
changing market conditions.

(4 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 7 on This Page

Template for Question 7-A

Stock (Circle Justify your response

the correct
answer)

Template for Question 7-B

Strategy (Circle the Justify your response

correct answer)

Long/Short (L/S)
Equity Strategy

Equity Market
Neutral (EMN)
Strategy

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

QUESTION 8 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 9 MINUTES.

Thomas McGrath is 46 years old and lives in Germany. McGrath started a clothing line
for women around ten years ago. The business achieved high success and the demand for
his clothing increased manifold over the years. McGrath has managed to recently launch
his personal designer wear by the name of ‘Exquisite Fashion’ that covers designs for
both men and women. McGrath owns several boutiques in the country and has a total net
worth of around €50 million.

McGrath now wishes to invest €5 million in the stock market, and for this, has hired
Melissa Wells, the chief portfolio manager at Allen Investment Advisors. During an
introductory meeting, Wells convinces McGrath that an active management approach is
suitable based on his above-average ability to tolerate risk. McGrath instructed Wells to
invest in domestic equities only., McGrath has asked his financial adviser Denial Ross to
evaluate Wells past performance. Ross gathered the following information.

Exhibit 1
Wells Portfolio Analysis (1)
Portfolio Market Benchmark
Number of stocks 35 1000
P/E ratio 22 15
P/B ratio 2.9 2.0
Dividend yield 1.5% 2.3%
Weighted average market cap €16 billion €22 billion
Expected EPS growth rate 17% 12%

Exhibit 2
Wells Portfolio Analysis (2)
Sector Portfolio Market Benchmark
Consumer discretionary 10% 18%
Energy 15% 13%
Finance 13% 25%
Health care 22% 12%
Information Technology 25% 17%
Industrials 5% 7%
Telecommunications 10% 8%

A. Determine the investment style followed by Wells in the management of her

portfolio. Justify your response with four reasons.

Answer Question 8-A in the template provided at the end of Question 8.

(7 minutes)

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

B. Determine the major risk factor faced by investors following the investment style
identified in part (i).

(2 minutes)

Any marks made on this page will not be graded.

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 Level III of CFA Program Mock Exam 1 – Questions (AM)

Answer Question 8 on This Page

Template for Question 8-A

Determine the
investment style
followed by Wells in
Justify your response with four reasons.
the management of
her portfolio.

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