STRATHMORE INSTITUTE OF MATHEMATICAL SCIENCES

BACHELOR OF BUSINESS SCIENCE IN FINANCIAL ENGINEERING, FINANCIAL

ECONOMICS AND ACTUARIAL SCIENCE
END OF SEMESTER EXAMINATION
BSF 4234 ADVANCED PORTFOLIO MANAGEMENT

DATE: 14th DECEMBER 2022 Time: 2 Hours

QUESTION 1 (30 MARKS)

1. Louise and Christopher Maclin live in Nairobi, and currently rent an apartment in the
metropolitan area. Christopher Maclin, aged 40, is a supervisor at Barnett Co. and earns
an annual salary of Ksh. 8,000,000 before taxes. Louise, aged 38, stays home to care for
their newborn twins. She recently inherited Ksh. 90,000,000 (after wealth-transfer taxes)
in cash from her father’s estate. In addition, the Maclins have accumulated the following
assets (current market value):
• Ksh. 500,000 in cash
• Ksh. 16,000,000 in stocks and bonds
• Ksh. 22, 000,000 in Barnett common stock
The value of their holdings in Barnett stock has appreciated substantially as a result of the
company’s growth in sales and profits during the past 10 years. Christopher Maclin is
confident that the company and its stock will continue to perform well.
The Maclins need Ksh. 3,000,000 for a down payment on the purchase of a house and
plan to make a Ksh. 2,000,000 non-tax-deductible donation to a local charity in memory
of Louise Maclin’s father. The Maclins’ annual living expenses are Ksh. 7,400,000.
After-tax salary increases will offset any future increases in their living expenses.
During discussions with their financial adviser, Grant Webb, the Maclins express concern
 about achieving their educational goals for their children and their own retirement goals.
The Maclins tell Webb:
• They want to have sufficient funds to retire in 18 years when their children begin their
four years of university education.
• They have been unhappy with the portfolio volatility they have experienced in recent
years. They state that they do not want to experience a loss in portfolio value greater than
12 percent in any one year. They do not want to invest in alcohol and tobacco stocks.
• They will not have any more children.
After their discussions, Webb calculates that in 18 years the Maclins will need Ksh. 200
million to meet their educational and retirement goals. Webb suggests that their portfolio
be structured to limit shortfall risk (defined as expected total return minus two standard
deviations) to no lower than a negative 12 percent return in any one year. Maclin’s salary
and all capital gains and investment income are taxed at 40 percent and no tax-sheltering
strategies are available. Webb’s next step is to formulate an investment policy statement
for the Maclins.

Required:
i. Formulate the risk objective of an investment policy statement for the Maclins.
(2 Marks)
ii. Formulate the return objective of an investment policy statement for the Maclins.
(2 Marks)
iii. Formulate the constraints portion of an investment policy statement for the Maclins,
addressing each of the following (8 Marks)
a. Time horizon
b. Liquidity requirements
c. Tax concerns
d. Unique circumstances

2. Explain the following challenges in formation of micro and macro expectations process
(6 Marks)
a) Anchoring Trap
b) Recallability Trap
c) Model and Input uncertainty
d) Survivorship Bias
e) Data Mining Bias
f) Confirming Evidence Bias
 3. For the purposes of asset allocation, it is necessary to define asset classes. With this
information, investors and managers can better distinguish among asset classes when
developing an investment strategy. Explain 2 criteria that can be used to specify asset
classes (4 Marks)
4. Clients’ needs and circumstances change, and portfolio managers must respond to these
changes to ensure that the portfolio reflects those changes. Discuss 2 other benefits that
are realized by portfolio rebalancing. (4 Marks)
5. Differentiate between the following styles of investment
a. Social Responsible investing
b. Contrarian Investing. (4 marks)

QUESTION 2 (20 MARKS)

1. The portfolio management process is an integrated set of steps undertaken in a consistent
manner to create and maintain an appropriate portfolio (combination of assets) to meet
clients’ stated goals. Evaluate the portfolio management process (10 Marks)

2. An analyst estimates that the expected return on the stock in the following table is 11
percent. Using a two-factor model, calculate the stock’s return if the company-specific
surprise for the year is 3 percent. (5 marks)

Variable Expected Value Actual Value Sensitivity

Interest rates 0.0% 2.0% -1.5
GDP 1.0% 4.0% 2.0

3. An analyst considers three widely diversified portfolios shown in the following table
below:

Expected Return 1st Factor Sensitivity 2nd Factor Sensitivity

Portfolio A 17% 1.3 0.8
Portfolio B 15% 0.8 1.4
Portfolio C 10% 0.3 0.3

Suppose that another portfolio, portfolio D, is well diversified with a betas of 0.7 and 1.1
and expected return of 13%. Would an arbitrage opportunity exist? If so, what would be
the arbitrage strategy? Verify that the portfolio is priced correctly. (5 marks)
QUESTION 3 (20 MARKS)
1. Active managers attempt to “beat the market” by forming portfolios capable of producing
actual returns that exceed risk-adjusted expected returns. The difference between the
actual and expected return is often called the portfolio’s alpha, and it represents the
amount of value that the active manager has added. Examine 2 major reasons why a fund
sponsor would prefer an active management approach over a passive one. (4 marks)
2. An investment firm holds KSh. 10,000,000 investment in an S&P 500 index fund. They
then replace 10 percent of their investment in the index fund with an investment in a
stock having a beta of 2 with respect to the index. Show mathematically, that is it
impossible for the new portfolio, consisting of the index fund and the stock, to have a
lower standard deviation of return than the original portfolio? (6 marks)
3. Macro performance attribution is done at the fund sponsor level and begins with the
funds beginning market value and ends with its ending market value. Under each decision
making variable, the question under consideration is: How much did each of the decision
making levels contribute, in either a return or a value metric, to the Fund’s change in
value over an evaluation period. Explain the following levels of analysis for macro
attribution (6 Marks)

a) Asset Categories (Pure Indexing)

b) Benchmarks
c) Asset Allocation

4. The common types of benchmarks in common use are: absolute return, manager
universes, broad market indexes, style indexes, factor-model-based, returns-based, and
custom security-based. A custom security-based benchmark should meet all fundamental
and quality-based benchmark criteria. Explain 2 characteristics of a good benchmark.
(4 Marks)

QUESTION 4 (20 MARKS)

1. Discuss any 3 factors that each influence international market integration and market
segmentation (6 Marks)
2. In the formations of capital markets expectations, a multifactor model can be used. A
multifactor model is a model that explains the returns to an asset in terms of the values of
 a set of return drivers or risk factors. Given the returns of two well-diversified portfolios,
portfolio L and Portfolio K in two markets L and market K is:
𝑅 𝛼 𝑏 𝐹 𝑏 𝐹 𝜀
𝑅 𝛼 𝑏 𝐹 𝑏 𝐹 𝜀
a) Determine the expression for Covariance and the value of Covariance between the two
portfolios (6 marks)
b) Given that portfolio K is a new portfolio that contains an additional asset class.
Determine whether the incorporation of this new asset class into portfolio K is an optimal
choice over holding portfolio L under Safety First Criterion and Utility Framework given
the benchmark return of 3% and tolerance of 0.01. (8 Marks)
Assuming that the two factors, GDP and INT have a covariance matrix of the form below.
GDP Factor INT Factor
GDP Factor 0.0196 0.0017
INT Factor 0.0017 0.0016

And that the factor loading for the portfolios and the expected returns are obtained as:
GDP INT Residual Risk E(R) Risk free
Portfolio K 1.10 0.6 10.0% 13% 5%
Portfolio L 1.05 0.8 8.0% 9% 5%

QUESTION 5 (20 MARKS)

1. An institution holds Portfolio K. The institution wants to use Portfolio L and Portfolio J to
hedge its exposure to inflation. Specifically, it wants to combine K, L and J to reduce its
inflation exposure to 0. Portfolios K, L and J are well diversified, so the manager can ignore
the risk of individual assets and assume that the only source of uncertainty in the portfolio is
the surprises in the two factors. The returns to the three portfolios are

𝑅 0.12 0.5 𝐹 1.0 𝐹

𝑅 0.11 1.5 𝐹 2.5 𝐹
 𝑅 0.19 0.3 𝐹 1.5 𝐹
Calculate the weights and consequent strategy that a manager should have on K and L to achieve
this goal given the analyst would like to hold 0.3 of portfolio J. What is the novel return equation
given this adopted strategy. (6 marks)
2. You are an African Markets Equity Analyst and have been asked to prepare a fundamental
analysis of one of the companies you will cover. Explain any 3 of the quantitative factors that
you would investigate. (6 marks)
3. Explain the main behaviour bias being exhibited in each of the following scenarios (8 marks)
(a) A pension scheme has been advised by the same investment consultancy over a five-year
period. The trustees are now carrying out a review to decide whether they would like to
continue working with this investment consultancy or appoint a new investment consultancy.
During the selection process the trustees decide to re-appoint the current consultancy, even
though other firms had clearly given better presentations.
(b) A group of pension scheme trustees has seen high returns in their equity portfolio over the
last five years and views among market commentators suggest this performance will
continue. The trustees decide to increase their allocation to equities in order to generate
further returns for the scheme.
(c) Market commentators have been suggesting for several months that equity valuations are
not justified and they expect a market correction. However, an equity trader who is investing
their own portfolio has allocated a large proportion to equities.
(d) An investment consultant comments on the poor performance of a hedge fund’s strategy.
The consultant believes that the hedge fund should have been able to foresee market events
based on historic market data, although the consultant did not provide any views on hedge
funds prior to this.

---------------------------------------------All the Best ----------------------------------------------------