weaverbirdllm/famma · Datasets at Hugging Face

200

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nan

Which of Adams's and Boshe's comments about counterparty risk is most accurate? The comment made by

[ "A. Adams about the short sale against the box.", "B. Boshe about her proposed strategies.", "C. Adams about the total return equity swap." ]

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A

Answer = A . Adams's statement about the short sale against the box is correct because it creates a riskless position. Although the forward conversion with options avoids counterparty risk, the equity forward sale and the total return equity swap use a derivatives dealer and thus include counterparty risk.

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nan

Using the information in Exhibit 1 and Adams's real estate proposals, which offer will provide the largest immediate addition of funds to Richards's stock and bond portfolios

[ "A. Offer 1", "B. Offer 2", "C. Offer 3" ]

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A

Answer = A . Immediate cash inflows available would include proceeds and the possible first rental payment in Offer 2; all cash flows are net of taxes. <ans_image_1>

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nan

Which of Boshe's MTL strategies least likely describes a staged exit strategy? MTL Strategy

[ "A. 1", "B. 3", "C. 2" ]

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C

Answer = C. MTL Strategy 2 is not a staged exit strategy because it does not provide for two specific liquidity events: cash up front and a sale or monetization of the remainder of Richards’s ownership in the future. Strategies 1 and 3 are staged exit strategies that provide for two liquidity events.

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portfolio management

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The Arbuckel family office was formed 10 years ago following the family’s sale of its minority ownership interest in a National Football League (NFL) franchise. The family office was created to formally manage the family’s investment affairs. The family’s investment portfolio has traditionally consisted of money market funds, corporate bonds, publicly traded US large-cap stocks, and equity small-cap mutual funds. Glen Arbuckel, the patriarch of the family, and his daughter, Jenna Arbuckel-Davis, co-manage the family office. They are considering adding alternative investments to the portfolio. They have hired Bill Clarke of Snyder Capital Management to provide independent investment counseling. Clarke states that alternative investments typically include real estate, private equity, commodities, hedge funds, managed futures, and distressed securities. Arbuckel’s intention is to select private equity as the family’s first alternative investment because he believes that private equity is similar in nature to the ownership structure of NFL teams. Clarke also states that alternative investments create some issues for private wealth investors that are distinct from those created by traditional investments. For example, consideration of decision risk will help the investor maintain his intended time horizon throughout the life of the alternative investment. Tax issues are not necessarily more complex because current income and capital appreciation are the primary sources of return for both alternative and traditional investments. Clarke notes that determining the suitability of an alternative investment is equally complex for both private wealth investors and institutional investors. Arbuckle-Davis mentions an interest in venture capital and asks Clarke to discuss the venture capital timeline. Clarke illustrates the stage characteristics of a company as it evolves from a formative-stage company to an expansion-stage company. Arbuckel-Davis studies the various stage characteristics and decides that the best opportunities are investments that support the initial expansion of a company already producing and selling a product. To invest in private equity, Clarke states that direct investment in an acquired company typically includes the purchase of common equity and convertible preferred stock. Other sources of capital for an acquired company include bank debt and senior notes. In terms of payment priority, in the event of an acquired company’s liquidation, bank debt and senior notes are normally senior to both convertible preferred stock and common equity, and convertible preferred stock is senior to common equity. When an acquired company is sold at a favorable price, bank debt, senior notes, and convertible preferred stock receive only promised payments whereas common equity earns very large returns. Arbuckel suggests to his daughter that a private equity fund of funds may be more suitable than direct investment. He explains that the family would benefit from the ability of the fund manager to select worthy investments and maintain active involvement in those investments. Clarke notes that the compensation of a fund manager typically consists of a flat management fee plus an incentive fee arrangement. He states that the incentive fee arrangement normally includes a profit-sharing component for the general partner, a hurdle rate for the limited partner, and a return of fees by the general partner to the limited partner based on the performance of the fund over the investment timeline . Clark illustrates by providing three examples of an incentive fee arrangement, as shown in Exhibit 1. <image_1> Clarke cautions that the strategy for a private equity investment should be formulated before any investment decision is made. The questions to consider with respect to the family’s investment policy statement include: Question 1: How will the choice of the exit strategy affect the return objective? Question 2: How will the limited secondary market affect the liquidity constraint? Question 3: How will the capital call commitment period affect the time horizon constraint?

Which benchmark bias least likely exists for the alternative investment Arbuckel has selected

[ "A. Survivorship bias", "B. Infrequent market transactions", "C. Vintage year effect" ]

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A

Answer = A . Survivorship bias is an interpretation issue commonly associated with Managed Futures and Hedge Funds, not private equity.

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nan

Clarke's comments regarding alternative investment issues faced by private wealth investors are most likely correct with respect to:

[ "A. decision risk", "B. tax issues", "C. suitability" ]

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A

Answer = A. Decision risk is the risk that the investor will wish to change strategies at the point of maximum loss. It is important that advisors to private wealth clients be aware of not only the long term horizon but also intermediate points within the longer term time horizon.

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multiple-choice

alternative investments

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nan

In considering the venture capital timeline, the most suitable financing stage for the Arbuckel family is most likely:

[ "A. the first stage", "B. the second stage", "C. the third stage." ]

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B

Answer = B. Venture Capital that supports the initial expansion of a company already producing and selling a product is considered Second-Stage financing.

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alternative investments

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nan

Are Clarke's statements about direct investment in an acquired company most likely correct

[ "A. Yes.", "B. No, because of payments in the event of liquidation.", "C. No, because of payments in the event of a sale at a favorable price." ]

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C

Answer = C. In the event of a sale at a favorable price, convertible preferred stock typically converts to common equity and is therefore equal in value.

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multiple-choice

alternative investments

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nan

Among the incentive fee arrangements, which example is most favorable for Arbuckel

[ "A. Example C", "B. Example B", "C. Example A" ]

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C

Answer = C. Example A is superior, as the (1) 8% preferred return and (2) clawback provision, in combination, make it superior to both Example B and Example C. Carried interest is the share of profits that a fund manager (general partner) earns following the investor's (limited partner's) preferred return (hurdle rate). The clawback provision represents a portion of the fund manager's profits which is paid back to the investor if performance of the fund was such that he has not received back his capital contribution and earned his contractual share of profits. All else equal, the fund investor benefits from a lower carried interest, a higher preferred return and having the benefit of a clawback provision & escrow

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alternative investments

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nan

In formulating a private equity investment strategy, which of the questions raised by Clarke is least likely important?

[ "A. Question 3", "B. Question 1", "C. Question 2" ]

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B

Answer = B . In realizing a return, there are a number of exit strategies including an IPO, the sale of the company to another company (including another private equity firm) or a merger with another company The exit strategy will be chosen to maximize the return at the time of exit.

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Gregory Dodson, is an investment consultant who advises individual and institutional clients on their equity portfolios. During a typical work week, he is called upon to evaluate a variety of situations and provide expert advice. This week, he is meeting with three clients. Dodson's first client meeting is with the Magnolia Foundation, a small not-for-profit organization. Magnolia currently uses three long-only portfolio managers for its equity investments. Details of those investments, including expected performance relative to Magnolia's equity benchmark, the S&P 500 Index, are shown in Exhibit 1. <image_1> Magnolia's goal for its total equity investment is expected alpha greater than 0.40% and expected tracking error less than 1.00%. Dodson's second client meeting is with Sarah Tan, a wealthy individual who is actively involved in managing her investments. Tan wants to add a $100 million allocation to US midcap stocks, represented by the US S&P 400 Midcap Index, to her long-term asset allocation. No investment has been made to meet this new allocation. Tan has not found any manager capable of generating positive alpha in US midcap stocks. She has, however, identified a long-only portfolio manager of Canadian equities whom she believes will produce positive alpha. This manager uses the S&P/TSX (Toronto Stock Exchange) Index as a benchmark. Tan wants to create a portable alpha strategy that will earn the alpha of the Canadian equity portfolio and meet the new benchmark allocation to US midcap stocks. She asks Dodson for advice to establish this strategy. Tan provides some information about the security selection methods used by the Canadian equity portfolio manager. The Canadian manager uses a proprietary discounted cash flow model to analyze all stocks in the S&P/TSX Index and purchases those with market prices that are the most below the intrinsic value estimated by his model, regardless of their price-to-earnings ratios (P/Es). Dodson's third client meeting is with the chief investment officer (CIO) of Susquehanna Industries' pension fund. The fund needs to establish a $50 million portfolio that replicates the Russell 2000 Index, an index of small-cap US equities. The CIO's goal is to minimize trading costs. He asks Dodson to suggest an investment approach that will meet this goal. The CIO also outlines his portfolio managers' sell discipline with respect to the pension fund's actively managed value and growth equity portfolios. Currently, the managers monitor the P/E of each stock held. A value stock is sold when its P/E rises to its 10-year historical average. A growth stock is sold when its P/E falls to its 10-year historical average.

The Magnolia Foundation's approach to portfolio construction is best described as:

[ "A. using a completeness fund.", "B. a portable alpha strategy.", "C. a core–satellite structure." ]

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C

Answer = C. A large portion of the portfolio is invested with a manager that is expected to match the portfolio's benchmark (zero alpha, zero tracking error), forming the core of the portfolio.

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multiple-choice

equity

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nan

Do the Magnolia Foundation's current equity investments most likely meet its total equity investment return and risk goals?

[ "A. Yes", "B. No, the expected alpha is too low", "C. No, the expected tracking error is too high" ]

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A

Answer = A. <ans_image_1> which is less than 1.00%.

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multiple-choice

equity

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nan

Which of the following combinations of futures positions would most likely be included in Dodson's advice to Tan regarding her intended portable alpha strategy

[ "A. Short position in S&P/TSX futures and long position in S&P 400 futures", "B. Long position in S&P/TSX futures and short position in S&P 400 futures", "C. Long position in S&P/TSX futures and long position in S&P 400 futures" ]

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A

Answer = A. The portfolio needs to shed exposure to the return of the S&P/TSX and gain exposure to the return of the S&P 400.

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multiple-choice

equity

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nan

The style of the Canadian equities portfolio manager is most likely

[ "A. growth.", "B. market oriented.", "C. value." ]

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B

Answer = B. The portfolio manager is willing to buy both value and growth stocks (regardless of P/E). He focuses solely on whether the stock is trading below its intrinsic value. This approach is also known as a blend or core style with reference to equity investing, which is an intermediate grouping for investment disciplines that cannot be clearly categorized as value or growth.

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equity

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nan

Given the manager's goal, what approach should Dodson most likely recommend for the $50 million portfolio of the Susquehanna Industries' pension fund?

[ "A. Full replication", "B. Optimization", "C. Stratified sampling" ]

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C

Answer = C. The portfolio contains small-cap stocks, which indicates an approach other than full replication, and the desire to minimize transaction costs indicates stratified sampling rather than optimization.

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equity

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Alpha Consultants is working with the German-based Berg Pension Fund to select a fixed-income firm to manage a €100 million global bond portfolio. Delta Managers is the third and final presenter to Berg's investment committee. After going through its investment philosophy and process, Delta addresses several questions. Alpha expresses concern about the use of leverage in the portfolio. Delta indicates that by using 100% leverage, it can generate incremental returns. Delta provides the committee with the portfolio's characteristics in Exhibit 1. <image_1> Berg's committee is concerned that the portfolio's duration is inappropriate given the committee's view that rates might rise. They ask how Delta can use the futures market to manage the portfolio's interest rate risk. The committee states that it would like a target duration of 4. Delta then makes the following statement to the committee: International interest rates are not perfectly correlated. In fact, because this is a global bond portfolio, 60% of the portfolio is from German issuers and has average duration of 7 and the remainder is from UK issuers with average duration of 4.5, both before any hedging activities to meet the committee's duration target. Historically, the country beta of the United Kingdom (i.e., for German rates relative to UK rates) is estimated to be 0.55. <image_2> Berg's committee then asks Delta to make a recommendation about whether the portfolio should be hedged back to the euro, its domestic currency. Delta responds that short interest rates are currently 2.50% in the United Kingdom and 3.25% in Germany and that Delta's currency strategists forecast that the euro will depreciate by 0.35%. Berg's committee then asks whether a global portfolio would benefit from the inclusion of emerging market debt. Delta responds that returns can be attractive in emerging markets during certain periods but that the following risks of this asset class must be understood: Risk 1: Returns are frequently characterized by substantial positive skewness. Risk 2: If a default of sovereign debt occurs, recovery against sovereign states can be difficult. Risk 3: The frequency of default and ratings transition is significantly higher than it is in developed market corporate bonds with similar ratings. At the conclusion of the presentation, Alpha and Berg's committee convene to discuss which of the three managers that presented should be selected for the €100 million mandate. Alpha advises Berg that the following considerations are important when evaluating fixed-income portfolio managers: Criterion 1: Style analysis will enable us to understand the active risks the manager has taken relative to the benchmark and which biases have consistently added to performance. Criterion 2: Decomposing the portfolio's historical returns will show whether the manager's skills will allow the manager to consistently outperform over time. Criterion 3: We could select two of the three managers that presented if our analysis shows that the correlation between their alphas is low.

Based on Exhibit 1, the duration of the equity in the leveraged portfolio is closest to:

[ "A. 5.00", "B. 11.00", "C. 5.50" ]

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B

Answer = B. Delta plans to leverage the €100 million portfolio by 100% by borrowing an additional €100 million. <ans_image_1>

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multiple-choice

fixed income

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nan

Based on Exhibits 1 and 2, and assuming no leverage is used, the number of futures contracts Delta needs to sell to achieve the Berg committee's target duration is closest to

[ "A. 682", "B. 784", "C. 902" ]

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C

Answer = C . To hedge against rising rates, Delta needs to reduce duration by selling the following number of bond futures contracts: <ans_image_1>

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fixed income

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nan

Based on Delta's statement, the contribution to the portfolio's overall duration from UK bonds is closest to:

[ "A. 0.99.", "B. 1.54.", "C. 1.49." ]

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A

Answer = A . The duration of the UK bonds is 4.5, and the country beta is estimated to be 0.55 relative to Germany. Thus, the duration contribution to a German domestic portfolio is 4.50 × 0.55 = 2.475. Because a portfolio's duration is a weighted average of the duration of the bonds in the portfolio, the contribution to the portfolio's duration is equal to the adjusted UK bond duration of 2.475 multiplied by its weight in the portfolio: 2.475 × 0.40 = 0.99.

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fixed income

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nan

Based on Delta's expectations regarding currencies, and assuming that interest rate parity holds, should Delta most likely recommend using forward contracts to hedge the portfolio's British pound exposure?

[ "A. No, because the euro is expected to depreciate by more than 0.35%", "B. Yes", "C. No, because the euro is expected to appreciate by more than 0.35%" ]

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B

Answer = B. Using interest rate parity, the euro is expected to depreciate by 3.25% – 2.50% = 0.75%. Delta's strategists believe that the euro will depreciate by only 0.35%. Based on expected returns alone, Delta should hedge the currency risk using a forward contract and lock in a 0.75% gain in British pounds.

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fixed income

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Delta is least likely correct with respect to which risk of investing in emerging market debt?

[ "A. Risk 1", "B. Risk 2", "C. Risk 3" ]

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A

Answer = A. The statement about Risk 1 is incorrect; emerging market debt returns are characterized by significant negative skewness.

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multiple-choice

fixed income

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Karin Larsson is a new employee in the risk management group at Baltic Investment Management, Inc. She is replacing Sten Reinfeldt, who has agreed to help her transition into her new role. Reinfeldt explains that risk governance refers to the process of setting risk management policies and standards for an organization, thus enabling firms to establish appropriate ranges for exposures and to emphasize individual risk factors within a centralized type of enterprise risk management. Baltic manages proprietary investment strategies, which creates risk exposures for the firm. Reinfeldt explains that these risks are both financial and nonfinancial in nature and proceeds to list several specific sources of risk: Risk 1: Model risk Risk 2: Liquidity risk Risk 3: Settlement risk Baltic uses value at risk (VaR) as a probability-based measure of loss potential for its fixed-income strategies. Reinfeldt states that the VaR for the fixed-income strategy is SEK10 million during any five-day period with a probability of 5%. Larsson asks Reinfeldt to estimate the fixed-income strategy's VaR at given levels of probability for specified periods. Baltic manages an equity strategy in addition to the fixed-income strategy. The trading desks for each strategy are granted risk budgets that consider the allocation of both capital and daily VaR. The correlation between the equity desk and the fixed-income desk is low. Exhibit 1 provides risk-budgeting data for both desks. <image_1> Reinfeldt comments that the risk management group has adopted stress testing to complement VaR analysis given some of its limitations. He lists several of limitations of VaR for Larsson: Limitation 1: VaR inaccurately measures risk exposure because it overestimates the magnitude and frequency of the worst returns. Limitation 2: VaR incompletely measures risk exposure because it does not incorporate positive results into its risk profile. Limitation 3: VaR incorrectly measures risk exposure because there are limited calculation methods and they often yield similar outcomes. Larsson is concerned about credit exposure within the fixed-income strategy and asks Reinfeldt how Baltic manages this risk. Reinfeldt responds, "We manage credit risk in a number of ways. First, we use credit derivatives in order to transfer credit risk. Second, we mark to market our credit derivatives in order to post collateral whenever a credit derivative's value is positive to Baltic and negative to the swap counterparty."

Given Reinfeldt's estimate of VaR for the fixed-income strategy, which of the following statements is most likely accurate? During a five-day period, there is a:

[ "A. 5% probability the portfolio will lose at least SEK10 million.", "B. 95% probability the portfolio will lose at least SEK10 million.", "C. 5% probability the portfolio will lose no more than SEK10 million." ]

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A

Answer = A . VaR is a minimum. That is, there is a 5% chance that the portfolio will lose SEK10 million or more.

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portfolio management

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nan

With regard to the fixed income and equity trading desks, based on Exhibit 1, which of the following statements is most likely accurate?

[ "A. The trading desks have the same risk budget.", "B. The combined daily VaR of the trading desks is less than SEK20 million.", "C. The fixed-income desk generates better returns on its allocated capital given its VaR." ]

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B

Answer = B . The trading desks engage in activities that are weakly correlated; therefore, a diversification benefit occurs. Thus it would be reasonable to expect that the combined VaR of the two desks will be less than the sum of the VaRs of the individual desks (SEK20 million).

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nan

Which of the limitations of VaR analysis given by Reinfeldt is most likely correct?

[ "A. Limitation 1", "B. Limitation 3", "C. Limitation 2" ]

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C

Answer = C . VaR fails to incorporate positive results into its risk profile and, therefore, may provide an incomplete picture of overall exposures

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Is Reinfeldt's statement regarding credit derivatives most likely correct?

[ "A. No, he is incorrect about transferring credit risk", "B. No, he is incorrect about marking to market", "C. Yes" ]

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B

Answer = B. Whenever the mark-to-market value is positive to Baltic, the credit derivative counterparty, not Baltic, will post collateral. Baltic will post collateral only if the mark-to-market value is negative to Baltic/positive to the swap counterparty.

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Mary Bing is a senior portfolio manager at NMS Advisors (NMSA), an investment and wealth management firm with offices in Boston and Chicago. NMSA provides investment advisory and asset allocation services to private and institutional clients. Bing is an expert in the use of derivatives to manage portfolios. She is assisted by two analysts, Rakesh Sharma and Hernando Torres. Bing is performing a review of client portfolios. She has collected the stock and bond index futures information that is presented in Exhibit 1. Futures prices are shown after accounting for the multiplier. Bing also notes that risk-free bonds with one year to maturity yield 1.5%. <image_1> Bing manages a portfolio invested in US small-cap stocks for the Wellington Academy Endowment. The portfolio has a current market value of $321 million. Bing and her team believe that small-cap stocks will perform well over the next three months. After consulting with the endowment's trustees, Bing decides to raise the portfolio's beta from 0.8 to 1.2 for the next three months. She has also been informed that the endowment has received a $15 million cash donation that is to be invested in small caps. Bing and her team decide to use futures to equitize the new cash inflow for a period of three months. Another one of Bing's clients is KP McLane Incorporated (KPM Inc.), a US-based manufacturer of men's apparel. The current market value of KPM Inc.'s pension portfolio is $950 million, with a 65% allocation to US midcap stocks and a 35% allocation to US bonds. The stock allocation has a beta of 1.45, and the bond allocation has a modified duration of 5.3. Bing's research indicates that midcap stocks are likely to underperform in the near term. Accordingly, she decides to reduce the allocation to midcap stocks to 60% and increase the bond allocation to 40%. KPM Inc. exports a significant portion of its products to eurozone countries. KPM Inc. expects the dollar to rise against the euro and is concerned that this change could lead to a decline in sales in the eurozone. KPM Inc. asks Bing for advice on how to manage this risk exposure. Bing asks Sharma, "We adjusted the asset allocation of the KPM Inc. pension fund using futures. Could we have used swaps to carry out the change?" Sharma responds, "Yes, we could have used a combination of a fixed-income swap on the Barclays US Aggregate Bond Index and an equity swap on the S&P 400 MidCap Index, where the notional value is $47.5 million." TCMS, a medical college, is also a client of NMSA. TCMS currently has a two-year loan outstanding with a 5.5% fixed annual interest rate. Bing expects a decline in interest rates and advises TCMS to enter into a two-year interest rate swap in which TCMS would pay Libor + 0.5% and receive a 5.5% fixed rate. From TCMS's perspective, the duration of a two-year fixed rate loan is –1.5 years and the duration of a floating rate loan is –0.125. Bing asks Torres, "Can you comment on the overall impact of the interest rate swap on TCMS?" Torres responds, "The net effect of entering the swap is to reduce the interest rate sensitivity of the overall loan plus swap position relative to the loan by itself. If the swap is added, however, it will be harder for TCMS to predict cash flows, and from this perspective, the swap does not serve as a good hedge."

To adjust the beta of the $321 million Wellington Academy Endowment portfolio, the number of small-cap futures contracts Bing would need to buy is closest to:

[ "A. 1,402", "B. 467", "C. 54" ]

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B

Answer = B. <ans_image_1>

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For Bing to equitize the $15 million cash inflow received by the Wellington Academy Endowment, the number of small-cap futures purchased and the amount invested in risk-free bonds, respectively, are closest to:

[ "A. 67 S&P Small Cap 600 Futures and $14,905,516 Risk-Free Bonds", "B. 55 S&P Small Cap 600 Futures and $15,000,000 Risk-Free Bonds", "C. 83 S&P Small Cap 600 Futures and $14,944,271 Risk-Free Bonds" ]

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A

Answer = A . To create a synthetic equity position (equitize cash) using the $15 million cash inflow, Bing should purchase futures and invest in risk-free bonds. The number of contracts is: <ans_image_2>

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derivatives

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To carry out the proposed adjustment to the KPM Inc. pension portfolio, the number of S&P 400 MidCap futures Bing would need to sell and the number of Barclays US Aggregate Bond Index futures she would need to buy, respectively, are closest to:

[ "A. 76 S&P 400 MidCap Futures and 265 Barclays US Bond Futures", "B. 99 S&P 400 MidCap Futures and 287 Barclays US Bond Futures", "C. 128 S&P 400 MidCap Futures and 312 Barclays US Bond Futures" ]

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C

Answer = C .

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The type of exchange rate risk that KPM Inc. faces is best described as

[ "A. translation exposure.", "B. transaction exposure.", "C. economic exposure" ]

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C

Answer = C . The type of exchange rate risk that causes overseas sales of a US manufacturer to decline in the face of a stronger US dollar is economic exposure. In contrast, transaction exposure arises when overseas sales denominated in a foreign currency must be converted to the domestic currency. In the face of a rising dollar, eurozone sales will convert to a lower amount in dollars relative to the amount repatriated if the dollar declines versus the euro. Translation exposure is not relevant here because KPM Inc. does not have overseas subsidiaries. Translation exposure arises when the financial statements of an overseas subsidiary must be converted to the domestic currency.

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derivatives

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nan

Is Torres’ response to Bing most likely correct?

[ "A. No, he is incorrect about hedging ability of the swap.", "B. Yes.", "C. No, he is incorrect about the sensitivity of the overall position." ]

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B

Answer = B . Torres is correct on both accounts. The duration of the original loan is –1.5. The fixed leg of the interest rate swap has a duration of 1.5, and the duration of the variable leg of the swap is –0.125. Thus, the duration of the overall position is –0.125. The overall sensitivity is reduced. The firm will find it harder to predict cash flows, however, because the net exposure is to the variable Libor rate. Therefore, Torres is correct that the swap serves as a poor hedge from the perspective of predicting cash flows.

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The pair of swaps Sharma should most likely describe are:

[ "A. Equity Swap: Pay Libor, Receive return on equity index, Fixed Income Swap: Pay Libor, Receive return on bond index", "B. Equity Swap: Pay return on equity index, Receive Libor, Fixed Income Swap: Pay Libor, Receive return on bond index", "C. Equity Swap: Pay Libor, Receive return on equity index, Fixed Income Swap: Pay return on bond index, Receive Libor" ]

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B

Answer = B . The correct combination of swaps is: Equity swap: Pay return on $47.5 million on the S&P 400 MidCap Index and receive LIBOR on $47.5 million Interest rate swap: Pay LIBOR on $47.5 million and receive return on $47.5 million on the Barclays US Aggregate Bond Index.

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Katherine Ng, a Global Investment Performance Standards (GIPS) specialist, has been hired as a consultant to assist Rune Managers in becoming a GIPS-compliant firm. Rune is a global asset manager with several divisions around the world that invest in both stock and bond strategies. James Arnott, a performance specialist at Rune, is responsible for the project. In their first meeting, Ng and Arnott discuss the GIPS standards and the steps Rune will need to take to become compliant. Ng recommends starting with the definition of the firm. She tells Arnott that how the firm is defined will affect the compliance process and that the standards recommend the firm be defined as broadly as possible. Arnott replies that Rune management has been discussing the firm definition, and they want the definition to include all Rune divisions except the European division, Rune Europe. Rune Europe has its own strategies and management team that are distinct from the rest of Rune. Ng replies that the Rune Europe division should be included in the definition of the firm because the division markets itself as part of Rune Managers. Ng then asks about Rune's policies for the inclusion of portfolios in composites. Arnott responds that Rune has the following policies for all composites: Policy 1: All new accounts funded with cash or securities on or before the 10th day of the month are added to the composite at the beginning of the following month. Those funded after the 10th day of the month are added at the beginning of the 2nd month after funding, or at the beginning of the calendar month after the proceeds are substantially invested in the appropriate strategy. Policy 2: All portfolios are deemed "non-discretionary" on the date the notice of termination of the management relationship is received and removed from the composite at the end of the month of notification. The discussion then moves on to a new composite that Rune is constructing. Arnott tells Ng that the marketing department has decided to target domestic Swiss investors and would like to carve out the Swiss portion of international and global accounts for the period of 1 January 2006 through 1 January 2011 and allocate cash to each carved-out segment to create a Swiss franc (CHF) composite. Ng responds that this new composite will comply with the standards, but Rune must disclose the percentage of composite assets that are carve-outs for each annual period end, as well as the policy used to allocate cash to the carved-out segments. Arnott interjects that the marketing department is looking forward to claiming GIPs compliance in advertisements. He is meeting with the marketing department and asks Ng what they need to be aware of regarding the Standards in advertising. Ng responds that there are several requirements in the GIPS Advertising Guidelines; specifically, the following must be disclosed in the advertisements: the firm description, composite and benchmark descriptions, and the number of accounts in the composite. Arnott and Ng then move on to discuss one of Rune's GIPS-compliant performance presentations, provided in Exhibit 1. <image_1> Rune Managers claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Rune Managers has not been independently verified. Notes: 1. Rune Managers is an investment manager registered with the US SEC. Rune Managers has divisions in Europe, Asia, and the United States that invest in various equity and bond strategies. 2. The Rune Mid-Capitalization Equity Composite includes all institutional portfolios that invest in mid-capitalization US equities, with the goal of providing long-term capital growth and steady income from dividends by investing in low price-to-earnings, undervalued securities. 3. A complete list and description of Rune Managers' composites, as well as policies for valuing portfolios and preparing compliant presentations, are available upon request. 4. The composite was created on 30 November 2005. 5. Leverage, derivatives, and short positions are not used by this strategy. 6. Performance is expressed in US dollars. The returns include the reinvestment of all income. Gross-of-fees returns are presented before management and custodial fees but after all trading expenses. Net-of-fees returns are calculated by deducting the actual fees of the accounts from the gross composite return. 7. The management fee schedule is as follows: 0.80% on the first $10 million, 0.55% on the next $40 million, 0.40% on assets greater than $50 million. 8. This presentation is not required to conform to any laws or regulations that conflict with the GIPS standards. 9. Internal dispersion is calculated using the asset-weighted standard deviation of annual gross returns of those portfolios that were included in the composite for the entire year. 10. The three-year annualized standard deviation measures the variability of the composite and the benchmark returns during the preceding 36-month period. The standard deviation is not presented for 2006 through 2010 because monthly composite and benchmark returns were not available, and it is not required for periods prior to 2011.

In their discussion of the Rune Europe division, which of the following is most likely correct

[ "A. Ng's analysis, because of how the division markets itself", "B. Arnott's analysis, because of how the division is managed", "C. Arnott's analysis, because of how the strategies are run" ]

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A

Answer = A. Ng is correct. Because Rune Europe is using the Rune Managers name and marketing materials, the division is not being held out to clients or potential clients as a distinct business entity and so it should be included in the definition of the firm.

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Which policy on the inclusion of portfolios in composites is most likely compliant with the GIPS standards?

[ "A. Policy 1 and Policy 2", "B. Policy 1", "C. Policy 2" ]

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B

Answer = B. The policy on account inclusion is compliant with the standards.

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Regarding the disclosures contained in the notes to Exhibit 1, the notes most likely required are:

[ "A. 1, 5 and 6.", "B. 6, 7 and 9.", "C. 2, 7 and 8." ]

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B

Answer = B. The currency used to express performance, whether any fees other than trading expenses are deducted from gross-of-fees returns, whether any fees other than trading expenses and management fees are deducted from net-of-fees returns, the fee schedule, and a measure of internal dispersion are all required disclosures for compliance with the GIPS standards.

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Regarding Exhibit 1, which item is least likely an error in the presentation

[ "A. Note 3", "B. Composite percentage of firm assets", "C. Three-year standard deviation" ]

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B

Answer = B. The annualized three-year ex post standard deviation of monthly returns must be presented for both the composite and the benchmark for each annual period after 1 January 2011. Firms are required to disclose that policies for valuing portfolios, calculating returns, and preparing compliant presentations are available upon request.

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Alexandra Sorenson has been made an investment strategist at Culpepper Investment Management (Culpepper) after working as a senior investment analyst the past several years. Sorenson has covered US equities throughout her career and has only limited knowledge of international capital markets. She is reviewing the economic and capital markets forecast report recently prepared by Culpepper’s economist as she evaluates the holdings in the firm’s investment portfolio. Exhibit 1 compares growth projections based on the economist’s outlook for the United States and EuroCountryX. <image_1> Sorenson discusses the valuation of the EuroCountryX Stock Index with Stefan Dreschler, a fellow investment strategist. The Index comprises mature, large-cap common equities. Sorenson plans to use the Cobb–Douglas model, assuming constant returns to scale, to estimate the country’s GDP growth. Given the mature nature of the economy and the market index, growth in both inflation-adjusted earnings and dividends is expected to equal real GDP growth. The current year annual dividend of the EuroCountryX Stock Index is €133. Sorenson assumes that a 6.0% discount rate is appropriate for the foreseeable future and calculates the fair value of the Index at 31 December. Sorenson comments to Dreschler: “I see that at the end of December this year, the index was trading nearly 20% above its level a year ago. What do you think may have caused the price gain?” The two continue discussing what changes Sorenson might face in her new position. She asks Dreschler: “What challenges do we face when using discounted dividend models and macroeconomic forecasts to estimate the intrinsic value of an equity market in a developing country?” Dreschler responds by making several points: · Discount rates are relatively easy to estimate, whereas growth rates are difficult to estimate. · Corporate profit trends should be relatively consistent with the overall growth of the country’s GDP. · Gathering accurate and consistent economic data could be a challenge. As an investment analyst, Sorenson is experienced with bottom-up analysis but realizes that top-down analysis will now be important. She asks Dreschler what they should consider when comparing the two approaches. Dreschler makes the following points: · Top-down analysis can be slower than bottom-up analysis in detecting cyclical turns. · Top-down estimates coming out of a recession may be less optimistic than bottom-up estimates. · We should expect to get the same results regardless of which method we use. Sorenson is interested in learning how earnings-based and asset-based relative value models can be used to better manage the firm’s investment portfolio. She first asks Dreschler to compare the Yardeni and Fed models. Dreschler responds by making these points: · The Yardeni model assumes that the required rate of return on equity equals the T-bond yield. · Although the Yardeni model captures a greater portion of the risk premium than the Fed model, it still does not accurately measure equity risk. · Both the Yardeni model and the Fed model are consistent in the way they measure the earnings growth rate. Sorenson decides to calculate Tobin’s q and determine the relative value of the market assuming an equilibrium level of approximately 1.0. Exhibit 2 provides partial information about the US economy that will be useful in her analysis. <image_2>

Using the data in Exhibits 1 and Sorenson's assumption about the appropriate discount rate, the fair value of the EuroCountryX Stock Index using the Gordon growth model is closest to:

[ "A. €3,677.", "B. €4,415.", "C. €3,595." ]

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A

Answer = A. The first step is to calculate the growth in gross domestic product, GDP, using the Cobb-Douglas model <ans_image_1>

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Dreschler's most appropriate response to Sorenson's question about the change in value of the EuroCountryX Index is that there was a decrease in the

[ "A. long-term, real dividend growth rate.", "B. discount rate over the period.", "C. dividends paid." ]

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B

Answer = B. The most likely cause of the price gain was a decrease in the discount rate over the period. Given the mature nature of the economy and companies in the Index, it is unlikely that the estimate of long-term real dividend growth or dividend payouts changed much, if at all.

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Which of Dreschler's responses to Sorenson's question about the challenges to equity market valuation is most accurate? His response concerning:

[ "A. the gathering of economic data.", "B. discount rates and growth rates.", "C. corporate profit and GDP growth." ]

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A

Answer = A. In a developing country, there may be severe problems with the accuracy of data inputs. It is difficult to obtain macroeconomic data in developed countries with long-established methods and facilities. The problems of obtaining accurate and historically consistent data are multiplied in developing markets.

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Which of Dreschler's points comparing top-down analysis and bottom-up analysis is the most accurate? His point regarding:

[ "A. estimates coming out of a recession.", "B. consistency of the results.", "C. detecting cyclical turns." ]

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C

Answer = C. Most top-down models are of the econometric type and rely on historical relationships to be the basis for assumptions about the future. Thus, they can be slow in detecting cyclical turns.

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Based on the data in Exhibit 2 and the calculation of Tobin's q, the market is best described as:

[ "A. undervalued.", "B. fairly valued.", "C. overvalued." ]

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A

Answer = A. Tobin's q is calculated as follows: (Liabilities at market value + Equities at market value) ÷ Assets at replacement cost(14,954 + 9,046) ÷ 26,000 = 0.92 With a Tobin's q less than 1.0, the market would be considered undervalued.

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The human resources department of The Tredway Medical Group hired Joe Boylan, a private wealth consultant, to provide a series of presentations to its employees covering the fundamentals of financial planning. Boylan’s current presentation deals with two aspects of personal risk management related to age: premature death and outliving one’s resources. He begins his presentation by stating that people often harbor misleading views about life insurance. As an example, he provides them with the following three comments which he claims to have heard many times in the past: Comment 1 Since everyone is going to die, everyone needs life insurance. Comment 2 Life insurance is an efficient method of risk reduction. Comment 3 Premiums on a newly issued life insurance policy are higher when interest rates are lower. Boylan states that when considering life insurance needs and investment strategies, it is important to understand the notion of human capital. He provides the following four examples of individuals connected to the health care industry in Exhibit 1 and asks the audience which of them has the highest human capital risk. <image_1> <image_2> Boylan provides selected information from standard mortality tables along with some market data and characteristics of Marie’s medical specialty in Exhibit 2. In addition, he also includes several assumptions which he uses to determine Marie’s total assets under a holistic balance sheet. <image_3> One of the attendees at the presentation told Boylan that she had accessed several life insurance carrier websites but found that it was very hard to compare the costs of their whole life policy offerings, as the companies often used different assumptions AMabout the amount of the death benefit, premiums, cash value growth rates and divi-dend reinvestment rates. Using the information in Exhibit 3 for a hypothetical whole life policy, Boylan illustrates a convenient method for comparing the cost of different policies when these variables change. <image_4> Boylan turns his attention to investments. He tells his audience that if the twins, Janice and Jason, wish to invest optimally, they should consider the nature of their human capital when making asset allocation decisions. He asks how this would affect their relative allocation to high grade government bonds. Boylan tells the audience that life annuities are a convenient investment to deal with longevity risk. He again uses the twins, Jason and Janice, as an example, in discussing some of the characteristics of these annuities. Assuming that they were both to invest the same amount into this product, he makes the following statements: Statement 1 If both of them were to purchase the annuity immediately, they would both receive the same annual income yield. Statement 2 If Jason were to purchase the annuity in 10 years rather than immediately, his annual income yield would be higher at that time than now. Statement 3 If Janice were to add a 10-year period certain option to her annuity, her income yield would be reduced when compared to not having the option, but it would be reduced by greater amounts the longer she waits to purchase the annuity.

Which of Boylan’s initial comments about life insurance is most accurate?

[ "A. Comment 2", "B. Comment 1", "C. Comment 3" ]

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C

C is correct: Comment 3 is correct. The most relevant considerations in pricing life insurance are mortality expectations, the discount rate and loading. The discount rate represents an assumption about the insurer’s return on its investment portfolio and it is used to discount future expected outflows, i.e., death benefits: as the discount rate decreases, the present value of those expected future cash flows increase making insurance costlier, i.e., higher premiums.

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From Exhibit 1, the individual who has the greatest amount of human capital at risk is

[ "A. Marie.", "B. Henry.", "C. Jason." ]

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B

B is correct: Human capital is the net present value of the individual’s future expected labor income weighted by the probability of surviving to each future age. According to the financial publication, Henry is in the highest paying medical profession, and being the youngest has the longest expected stream of future income. Therefore, he is most likely to have the highest human capital available, and the most to lose if the stream is not realized.

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Using Exhibits 1 and 2, Marie’s total assets under a holistic balance sheet are closest to

[ "A. $6,558,000", "B. $6,563,000", "C. $4,808,000" ]

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A

A is correct. In addition to the assets determined under a traditional balance sheet provided in Exhibit 1, a holistic (economic) balance sheet includes the present value of human capital and the value of any pensions. <ans_image_1> <ans_image_2>

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Using the information in Exhibit 3, the surrender cost index per $-thousand per year for the hypothetical whole life policy is closest to:

[ "A. $3.05", "B. $2.69", "C. $6.49" ]

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A

A is correct. <ans_image_3>

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The most appropriate response to Boylan’s question about the twins’ relative allocation to high grade bonds is that, when compared to Jason, the proportion in Janice’s investment portfolio should be:

[ "A. the same.", "B. lower.", "C. higher." ]

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C

C is correct: Janice is a stock broker specializing in medical technology and her human capital is therefore highly correlated with stock market returns. She should balance this risk by having greater exposure to financial assets that are less risky, i.e., high grade government bonds. Jason’s human capital is less correlated to stock market returns; in addition, his future pension income arising from a defined benefit plan is quite stable. His optimal portfolio should have a greater allocation to the stock market than Janice.

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Goldsboro Partners, an investment management firm, intends to offer more products invested in equities traded on the Singapore Exchange (SGX). Goldsboro is developing the Goldsboro Singapore Index (GSI), a proprietary index of Singapore equities composed of five stocks traded on the SGX with the largest market capitalization. Goldsboro must decide how to structure the GSI. Information about the prices and market caps of these firms is presented in Exhibit 1. <image_1> Goldsboro has four large institutional clients that indicated they might invest a total of $240 million in a fund indexed to the GSI. These clients are very cost sensitive. Goldsboro already offers two mutual funds that consist of stocks that are part of the Straits Times Index (STI), a value-weighted index of the 30 largest firms traded on the SGX. Exhibit 2 provides information about these two funds (GB1 and GB2), the STI, and all stocks traded on the SGX. <image_2> Goldsboro also offers three independently managed funds, GB-STI-1, GB-STI-2, and GB-STI-3. The three funds are benchmarked against the STI. In 2009, Jason Briggs, a client whose Singapore benchmark is the MSCI Singapore Free Index, pursued a core–satellite approach by investing in these three funds, and he earned a return of 12.4%. Information about these three funds, their returns, and Briggs’s investments is presented in Exhibit 3. <image_3> In 2009, the return on the MSCI Singapore Free Index was 11.7%, and the return on the STI was 12.0%.

Based on Exhibit 1, for the year 2009, assuming no stock splits or stock dividends for the stock components and no rebalancing, which of these index structures would have most likely resulted in the largest return for the GSI?

[ "A. A value-weighted index", "B. An equal-weighted index", "C. A price-weighted index" ]

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A

Answer = A . This weighting methodology produced the largest return of 13.5% for the GSI. The return on a value-weighted index is the percentage change in the total market capitalization of the firms in the index

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Goldsboro's best choice for the GSI portfolio structure is:

[ "A. an exchange-traded fund.", "B. a mutual fund.", "C. a pooled account." ]

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C

Answer = C. The clients are identified as being cost sensitive and, of the three choices offered, pooled accounts generally have the lowest fees.

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According to the information provided in Exhibit 2, Fund GB1 is best characterized as having which equity style?

[ "A. Market oriented", "B. Growth", "C. Value" ]

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A

Answer = A. A market-oriented equity style is one that is neither value nor growth. Fund GB1 has characteristics that are almost identical to the broader STI. Although two (dividend yield and P/E) of the four reported characteristics lean slightly toward a growth style, the other two (P/B and projected EPS growth) lean slightly toward a value style.

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Goldsboro's Fund GB2 would appeal to an investor who is most closely focused on

[ "A. earnings momentum.", "B. price relative to intrinsic value.", "C. relative strength." ]

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B

Answer = B. Fund GB2 follows a value style (higher dividend yield, lower P/E, P/B, and earnings growth). Value investors are focused on price relative to intrinsic value.

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The characterization of Briggs's investment as following a core–satellite approach is most likely

[ "A. correct.", "B. incorrect, because the funds invested in are benchmarked against the wrong index.", "C. incorrect, because too little of the portfolio was passively invested." ]

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A

Answer = A. Fund GB-STI-3 has an expected alpha and expected tracking error of 0% and can thus be characterized as an index fund. Twenty percent of the investment was placed in this fund, creating a core, with the remainder invested in non-index funds, creating a satellite. A small core allocation might be indicative of a high risk tolerance.

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During 2009, the "misfit" active return earned by Briggs's investments was closest to:

[ "A. 0.4%.", "B. 0.7%.", "C. 0.3%." ]

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C

Answer = C. A "misfit" active return is equal to the return of the manager's normal benchmark minus the return of the investor's benchmark: 0.3% = 12% – 11.7%, where 12% is the return on the STI fund and 11.7% is the return on the MSCI Singapore Free Index.

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Karina Mamani is a senior partner at Trujillo Partners, an investment advisory firm headquartered in Lima, Peru. Mamani specializes in domestic (Peruvian) markets. Peru's currency is the nuevo sol (PEN). Its major stock exchange is the Bolsa de Valores de Lima (BVL), and the primary index for that market is the Indice General Bolsa de Valores (IGBVL). One of Mamani's clients, Angel Huanca, anticipates receipt of PEN10,000,000 from debt investments that are maturing in two months. He will invest these proceeds in an IGBVL index fund. Huanca expects the Peruvian stock market to increase dramatically in the next two months and does not want to miss out on the expected gain. He asks Mamani to recommend a way to obtain exposure to the IGBVL immediately. Mamani recommends a long futures position using a two-month futures contract on the IGBVL that is priced at PEN21,800 and has a contract size of PEN10 times the price. The index has a beta of 0.98, and the futures contract has a beta of 1.05. Huanca owns a company that produces auto parts, primarily for export to the United States. He tells Mamani he is worried the nuevo sol will strengthen relative to the US dollar and other currencies, making it more difficult for him to compete with firms in the United States and elsewhere. He asks Mamani to help him devise long-term strategies to deal with this risk. Huanca recently received 3.2 million common stock shares of Urubamba Copper, Ltd. in partial payment for a mining equipment company he sold to Urubamba. The terms of the sale require him to hold this stock for at least 18 months before selling it. Although Huanca believes Urubamba is a well-run company, its share price is closely tied to commodity prices, which he believes might decline. He tells Mamani, "I know I can use options on Urubamba to manage the risk of my concentrated stock position. Either a covered call strategy or a protective put strategy will reduce the volatility of my position and establish a minimum value for it, but the covered call strategy will also enhance my return if Urubamba's price remains stable, and the protective put strategy will not." Another of Mamani's clients, Arequipa Industries (AI), is about to borrow PEN120 million for two years at a floating rate of 180-day Libor (currently 3.25%) plus a fixed spread of 90 basis points with semiannual resets, interest payments based on actual days/360, and repayment of principal at maturity. AI's management is worried that Libor might rise during the term of the loan and asks Mamani to recommend strategies to reduce this risk. Mamani suggests a zero-cost collar on 180-day Libor with a cap of 4.70% and a floor of 2.25%, payment dates matching the loan payments (on 30 June and 31 December, with the first payment on 31 December), and interest based on actual days/360. She develops various examples of the collar's impact, including one using the interest rate scenario in Exhibit 1. <image_1> Mamani informs AI's management that, as an alternative, it could enter into an interest rate swap to effectively convert its floating-rate loan to a fixed-rate loan. Mamani states, "You would take a position in a two-year swap with semiannual payments and a notional principal equal to your loan balance. You would pay a fixed rate equal to current two-year Libor and receive 180-day Libor." Mamani adds, "Entering into the swap would reduce your firm's market value risk and cash flow risk."

The number of IGBVL futures contracts needed to establish the position recommended by Mamani for Huanca is closest to:

[ "A. 46", "B. 43", "C. 49" ]

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B

Answer = B. <image_2>

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The type of exchange rate risk Huanca is concerned about is most likely:

[ "A. economic exposure.", "B. translation exposure.", "C. transaction exposure." ]

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A

Answer = A. Economic exposure is the type of exchange rate risk that refers to changes in exchange rates that make a business less price competitive in other countries.

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Huanca's comment about using options to manage the risk of his Urubamba common stock position is least likely correct regarding:

[ "A. establishing a minimum value.", "B. reduction of volatility.", "C. return enhancements." ]

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A

Answer = A. Although a protective put establishes a minimum value for the position when the price of the underlying stock declines, a covered call does not. Therefore, Huanca's statement is incorrect.

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Using the Libor scenario shown in Exhibit 1 and under the assumption that the zero-cost collar is put in place, the effective interest due on AI's loan for the semiannual period ended on 31 December 2013 is closest to:

[ "A. PEN1,911,000", "B. PEN1,365,000", "C. PEN2,062,667" ]

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A

Answer = A. <image_2>

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Mamani's description of the interest rate swap to be used to convert AI's floating-rate loan to a fixed-rate loan is least likely correct regarding the:

[ "A. notional principal amount.", "B. fixed interest rate to be paid.", "C. floating interest rate to be received." ]

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B

Answer = B. The fixed interest rate on the swap would not equal the Libor rate for the maturity of the swap but rather the rate that would make the present value of the fixed and floating payments equal.

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Is Mamani's explanation of the impact of the interest rate swap on AI's risk most likely correct?

[ "A. No, it is incorrect regarding cash flow risk.", "B. Yes.", "C. No, it is incorrect regarding market value risk." ]

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C

Answer = C. Although converting the loan from a floating rate to a fixed rate using the swap reduces AI's cash flow risk (because the firm's loan payments become known), it increases the firm's market value risk because the value of the firm will be negatively affected if market interest rates decrease.

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The Kohler Family Foundation, an entity not subject to taxes, partially supports the financing of annual operating expenses for Kohler College . In addition to these annual costs, the Foundation has just committed itself to partially fund five different campus building renovation projects over the next 15 years, including student housing renovations in three dormitories and the expansion of classroom wings in two academic buildings. Because of these new financial commitments, the Foundation’s investment committee, chaired by Frederick Schumacher, has decided to engage ECU Investment Management for advice on changing the Foundation’s portfolio asset allocation. Thomas Roth, a senior investment consultant at ECU, conducts an introductory meeting with Schumacher to examine the Foundation’s asset allocation. Schumacher explains to Roth: “Our investment committee has discussed the necessity for changes to our approach to strategic asset allocation. We believe that these three standards should drive the Foundation’s strategic asset allocation and we want your opinion of them: Standard 1: Our allocation should include long-term exposures to the systematic risks of the various asset classes. Standard 2: Asset class weights should satisfy our investment objectives and constraints. Standard 3: Perceived disequilibriums in markets in a given period should affect our asset weightings in the subsequent period.” Roth states: “Your future building renovation projects indicate that an asset/liability management (ALM) approach to the Foundation’s strategic asset allocation would be appropriate . ALM seeks to adopt the optimal asset allocation in relationship to funding financial obligations.” Schumacher replies: “That seems to be an intelligent suggestion. I imagine the following three outcomes would result from adopting that approach: Outcome 1: We would have a higher allocation to fixed income. Outcome 2: The global market equilibrium portfolio would be our default asset allocation to which we would make adjustments to meet our future liabilities. Outcome 3: Portfolio risk control related to our future spending needs would likely not be very precise.” Roth inquires: “Can you explain how the Foundation has approached asset allocation in the past ? I would also like to understand your asset class specification methods.” Schumacher explains: “Historically, our portfolio has comprised a diversified collection of domestic large-cap equities. We now believe we should diversify into additional asset classes, such as domestic mid-cap and small-cap equities. I have listed the asset classes we are considering in Exhibit 1 for your review.” <image_1> Schumacher observes: “Asset classes 4, 5, and 6 all have low correlations with equities . For diversification purposes, does it really make a difference which one we add?” Roth comments: “We believe the addition of asset classes to your existing equity portfolio should be done with the goal of achieving a mean–variance improvement when including the new asset class. The Foundation should invest a major portion of the portfolio internationally, diversified across asset classes. As an example, our ECU Global Tactical Allocation Fund invests in non–US dollar (USD) equities, fixed income, and real estate, as well as in real return assets, such as commodities. The primary inputs to our tactical asset allocation decisions are a long-term outlook for the next three to five years and a six-month short-term forecast for each asset class. The weighted foreign currency exposure of our equities and fixed income mirrors the US Dollar Index, and we value our real estate and real return assets in USD. Exhibit 2 shows our fund’s strategic asset allocation weightings plus investment return and currency forecasts.” <image_2> Note: Short-term US Dollar Index forecast versus weighted currencies in portfolio: +3%. Schumacher says: “I have the following three concerns with respect to investing internationally: Concern 1: In times of market stress, diversification benefits can be drastically reduced. Concern 2: Capital in some countries does not flow freely across borders, which can result in increased market segmentation. Concern 3: Traditional mean–variance analysis may not apply.” Roth replies: “Your concerns pertain to conditional correlation, market integration, and the efficient frontier; however, they are not all necessarily disadvantages.”

Which of the Kohler Foundation investment committee's three standards is least consistent with strategic asset allocation?

[ "A. Standard 3", "B. Standard 2", "C. Standard 1" ]

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A

Answer = A. Standard 3 is not consistent with strategic asset allocation; it is tactical asset allocation that is based on short-term expectations and perceived short-term disequilibriums in markets. Strategic asset allocation sets an investor’s desired long-term exposures to systematic risk. Investment objectives and constraints are inputs in determining strategic asset allocation.

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Which of Schumacher's three outcomes is most likely consistent with the ALM approach?

[ "A. Outcome 1", "B. Outcome 3", "C. Outcome 2" ]

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A

Answer = A. Outcome 1 is consistent with the ALM approach. The ALM approach to strategic asset allocation, which involves explicitly modeling liabilities and adopting the optimal asset allocation in relation to funding liabilities, characteristically results in a higher allocation to fixed-income instruments than an asset-only (AO) approach. Compared with AO, an ALM approach affords much more precision in controlling risk related to the funding of liabilities. The global market equilibrium portfolio is the default strategic asset allocation for the Black–Litterman AO approach.

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When evaluating the asset classes in Exhibit 1, Roth would most likely criticize the specification of which of the following asset classes?

[ "A. Mid cap equities", "B. Taxable municipal bonds", "C. All Commodities Index" ]

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A

Answer = A. Roth would most likely criticize the specification of mid-cap equities because they are not mutually exclusive with respect to domestic large-cap and small-cap equities. Asset class specification should support the purposes of strategic asset allocation. Domestic large-, mid-, and small-cap equities are assets within the asset class of domestic equities and have little diversification benefit between them, with the correlation between their returns being very high.

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Based on the information contained in Exhibit 1 and mean-variance analysis, Roth is least likely to improve the Foundation’s portfolio by the inclusion of:

[ "A. taxable municipal bonds.", "B. the Agricultural Commodities Index.", "C. the All Commodities Index" ]

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A

Answer = A . Roth would obtain the smallest mean–variance improvement by including taxable municipal bonds. For an investor to gain by adding a new asset class, that asset class’s Sharpe ratio must exceed the product of the existing portfolio’s Sharpe ratios and the correlation of the asset class’s return with the current portfolio’s return. All three asset classes have similar low correlations with large-cap equities; however, with a negative Sharpe ratio, municipal bonds could never produce a greater product than the product of the other two positive inputs and the existing portfolio’s Sharpe ratio.

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Based on the return and currency forecasts in Exhibit 2, ECU's tactical asset allocation shifts would most likely increase weightings in:

[ "A. real estate and real return assets and decrease equities and fixed income.", "B. fixed income and real return assets and decrease equities and real estate.", "C. equities and real return assets and decrease fixed income." ]

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A

Answer = A. Tactical asset allocation involves making short-term adjustments to asset class weights based on short-term predictions of relative performance among asset classes. Equities are forecast to perform 3% above their long-term outlook in the next six months; however, the weighted currencies are forecast to drop 3% (a gain of 3% in USD). Fixed income is forecast to return 3% less than the long-term outlook and is also forecast to be exposed to a 3% currency loss (a gain of 3% in USD). Real estate and real return assets are both forecast to perform above their long-term expected returns and are not exposed to a weakening in the currencies.

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Schumacher's concern about international investments that Roth might find advantageous most likely pertains to:

[ "A. conditional correlation.", "B. the efficient frontier.", "C. market integration." ]

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C

Answer = C. The lack of market integration (or the absence of free cross-border capital flows) can be an advantage if it increases market segmentation and helps prevent correlations with other markets from rising. Increased integration of markets can decrease diversification benefits, whereas returns in segmented markets will be influenced mostly by a specific country’s own macroeconomy and will be less subject to changes in correlations when volatility increases. Global correlations tend to increase in times of increased volatility and even appear to be conditional on global volatility. The efficient frontier and traditional mean–variance analysis using unconditional correlations would not apply because correlations remain low when returns are high but become high when returns are negative.

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Asis Subramanium was recently hired by the pension fund Nash, Barwich, and Stuart (NBS) as a Portfolio Performance Evaluation Specialist. NBS does not have a formal performance evaluation policy and Dev Radia, Director of Portfolio Management, asks Subramanium to develop such a policy for the firm. Collecting research related to performance evaluation, Subramanium tells Radia that a performance evaluation policy should address the following three major issues: 1. Performance measurement defined as the calculation of the rates of return based on investment-related changes in an account’s value over specified time periods; 2. Performance attribution which investigates the sources of the account’s performance relative to a manager’s past performance and the importance of those sources; and 3. Performance appraisal which attempts to answer the question whether the account’s performance is due to luck or skill. The two start their discussion of other issues relating to performance evaluation by comparing time-weighted return (TWR) to money-weighted return (MWR). Subramanium provides an example of the two methods using the recent month’s history of the West Riverdale Defined Benefit Plan. As indicated in Exhibit 1, the start of month value of the plan was $20,000,000. The portfolio is revalued whenever a cash flow arises and all daily cash flows occur at the end of the stated day, e.g., on the eight day into the month the account received a contribution of $200,000 and had an end of the day value of $21,200,000. At the end of the month (day 30), the terminal value of the account was $20,255,000. <image_1> Radia picks up the discussion at this point, saying, “Having calculated TWR and/or MWR, one needs a benchmark against which the account return can be compared. Many issues arise in this choice of a benchmark.” Radia points out three: 1. Consultants and fund sponsors frequently use the median manager or fund from a broad universe of managers or funds as a performance evaluation benchmark. This approach is flawed, as it fails the test of being measurable. 2. A drawback of a style index is that the definition of investment style implied in the benchmark may be inconsistent with the investment process of the manager. 3. The absolute return objective is generally the preferred approach. The two move on to consider performance evaluation of hedge funds and agree that hedge fund performance can be especially difficult to evaluate. They provide three reasons why this is so: 1. If the hedge fund consists of a long-short portfolio which nets to an initial market value of zero, the rate of return on the portfolio would be undefined, approaching either positive infinity or negative infinity due to this division by zero problem. 2. Even when the hedge fund’s assets do not net to zero, the vagueness of defining “hedge funds” makes it difficult to assign specific benchmarks. 3. The option-like features of many hedge funds make the use of the Sharpe ratio a preferred approach to performance measurement. The two agree that investment skill requires a manager to outperform an appropriate benchmark, on average over time, and on a risk-adjusted basis. Commonly used measures that adjust for risk are the Treynor measure, the Sharpe ratio, and M2. To demonstrate the differences between these three measures, Subramanium collects the data given in Exhibit 2 along with his partially completed calculations on three accounts. <image_2> Finally, Radia asks Subramanium if there are any issues to be considered regarding manager continuation policy. Subramanium answers that there are two types of mistakes you can make: · one mistake is to fire (or not hire) a manager with positive value-added management; · a second mistake is to keep (or hire) managers that provide zero value-added.

In describing the three major issues relating to a performance evaluation policy, Subramanium is least accurate with respect to performance:

[ "A. management.", "B. attribution.", "C. appraisal." ]

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B

Answer = B. Subramanium is least accurate with respect to performance attribution. Performance attribution investigates the sources of the account's performance relative to a specific investment benchmark, not a manager's past performance.

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Based on the data given in Exhibit 1, the time-weighted return (TWR) is closest to:

[ "A. 0.63%.", "B. 0.67%.", "C. 1.27%." ]

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B

Answer = B . The time-weighted return is calculated for each subperiod using the formula <ans_image_1>

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Which of Radia's points regarding the choice of a benchmark is the most accurate? His point regarding the:

[ "A. median manager or fund.", "B. absolute return objective.", "C. style index." ]

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C

Answer = C. The ability of style indexes to pass tests of benchmark validity can be problematic as the definition of investment style implied in the benchmark may be ambiguous or inconsistent with the investment process of the manager being evaluated.

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Which of Subramanium's and Radia's reasons as to why hedge funds are difficult to evaluate is the least accurate? The statement regarding:

[ "A. undefined rate of return.", "B. vagueness of definition.", "C. option-like features." ]

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C

Answer = C. The reason related to the option-like features is the least accurate. The denominator of the Sharpe ratio is the standard deviation of returns. However, the option-like features of many hedge funds make the use of standard deviation as a measure of risk questionable.

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Using the data in Exhibit 2, the account which has produced the highest return per unit of systematic risk is:

[ "A. Lee Co.", "B. G. Ltd.", "C. W-Life." ]

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C

Answer = C. The highest return per unit of systematic risk is measured by the Treynor measure. Of the given assets, the W-Life account has the highest Treynor measure. <ans_image_2>

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Subramanium's answers to Radia's question regarding manager continuation policy best describes a Type I error for:

[ "A. both statements.", "B. the second statement and a Type II error for the first statement.", "C. the first statement and a Type II error for the second statement." ]

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B

Answer = B. The null hypothesis is that the manager has no skill while the alternative is that the manager is skillful. The first statement describes a Type II error (not rejecting the null when it is incorrect) and the second statement describes a Type I error (rejecting the null when it is correct).

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Amy Allison is a fund manager at Downing Securities. The third quarter ends today, and she is preparing for her quarterly review with her five largest U.S.-based clients. To complete her analysis, she has obtained the market data in Exhibit 1. <image_1> Allison’s assistant has prepared the following summaries of each client’s current situation, including any recent inquiries or requests from the client. · Client A has a $20 million technology equity portfolio. At the beginning of the previous quarter, Allison forecasted a weak equity market and recommended adjusting the risk of the portfolio by reducing the portfolio’s beta from 1.20 to 1.05. To reduce the beta, Allison sold NASDAQ 100 futures contracts at $124,450 on 25 December. During the quarter, the market decreased by 3.5%, the value of the equity portfolio decreased by 5.1%, and the NASDAQ futures contract price fell from $124,450 to $119,347. Client A has questioned the effectiveness of the futures transaction used to adjust the portfolio beta. · Client B’s portfolio holds $40 million of U.S. large-cap value stocks with a portfolio beta of 1.06. This client wants to shift $22 million from value to growth stocks with a target beta of 1.21. Allison will implement this shift using S&P/Barra Growth and S&P/Barra Value futures contracts. · Client C anticipates receiving $75 million in December. This client is optimistic about the near-term performance of the equity and debt markets and does not want to wait until the money is received to invest it. The client wants Allison to establish a position that allocates 60% of the money to a well-diversified equity portfolio with a target beta of 1.00 and 40% of the money to a long-term debt portfolio with a target modified duration of 5.75. Allison plans to use the December U.S. Treasury-bond futures to establish the debt position. · Client D’s $100 million portfolio contains $60 million in U.S. large-cap stocks, $20 million in U.S. Treasury bills, and $20 million in U.S. Treasury bonds. The client wants to create a synthetic cash position because he believes that in three months, the level of the S&P 500 Index will be 925.00, and Treasury bond yields will have declined. · Client E’s $60 million portfolio contains $40 million in large-cap growth stocks and $20 million in U.S. Treasury bonds. The beta of the stock portfolio is 1.25 and the duration of the bond portfolio is 5.0. The client believes that macro economic conditions over the next three months are such that the level of the S&P/Barra Growth Index will be 400.00 and the price of the U.S. Treasury bond futures contract will be $110,400. · Client F has $10 million in cash and is optimistic about the near-term performance of U.S. large-cap stocks and U.S. Treasury bonds. The client anticipates positive performance for approximately three months. Client F asks Allison to implement a strategy that will create profit from this view if it proves to be correct.

With respect to Client A, Allison's most appropriate conclusion is the futures transaction used to adjust the beta of the portfolio was:

[ "A. ineffective because the effective beta on the portfolio was 1.27.", "B. effective.", "C. ineffective because the effective beta on the portfolio was 1.64." ]

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A

Answer = A . The effective beta is the (hedged) return on the portfolio divided by the return on the market. The return on the market is –3.5%. The return on the portfolio is –5.1% plus the return on the futures position. The return on the (short) futures position relative to the unhedged portfolio is –25 × (119,347 – 124,450)/20,000,000 = +0.0064. Effective beta = (–0.051 + 0.0064)/–0.035 = 1.27.

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When implementing the shift from value to growth stocks for Client B, the number of S&P/Barra Value future contracts Allison shorts will be closest to:

[ "A. 182.", "B. 177.", "C. 187." ]

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C

Answer = C. To convert $22 million of the value-stock portfolio to cash (beta = 0) will require <image_2>

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The number of December U.S. Treasury-bond futures contracts Allison will buy for Client C is closest to:

[ "A. 335.", "B. 235.", "C. 229." ]

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B

Answer = B. The number of bond futures contracts required is: <image_2>

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With respect to Client D's market view, Allison will most likely

[ "A. buy S&P 500 Index Futures and buy U.S. Treasury bond futures", "B. sell S&P 500 Index Futures", "C. sell U.S. Treasury bond futures" ]

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B

Answer = B . Selling the S&P 500 Index futures will be a profitable trade should the index decline to 925, and it effectively converts a long stock position into cash.

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For Client E to shift, for three months, the portfolio allocation to 50% large cap growth stocks and 50% U.S. Treasury, and presuming no other changes in the characteristics of the portfolio, Allison will most likely:

[ "A. sell 92 stock index contracts and buy 136 Treasury future bond contracts.", "B. sell 370 stock index contracts and buy 68 Treasury future bond contracts.", "C. sell 92 stock index contracts and buy 68 Treasury future bond contracts." ]

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C

Answer = C. Shifting the asset allocation from 66.66% stock/33.33% bonds to 50% stock/50% bonds requires that Allison sell stock index futures and buy bond index futures for a notional amount of $10,000,000. <image_2>

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To implement Client F's request, Allison's most appropriate course of action is to:

[ "A. sell U.S. Treasury bond futures contracts and buy S&P 500 Index futures contracts.", "B. buy U.S. Treasury bond futures contracts and buy S&P 500 Index futures contracts.", "C. buy stocks in the S&P 500 Index and sell U.S. Treasury bond futures contracts." ]

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B

Answer = B. Buying U.S. Treasury bond futures and S&P 500 Index futures creates synthetic bond position and synthetic stock index fund positions, respectively. Client F is long $10 million in cash, which can be used to fund the purchases.

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Pascal Montero is the director of the treasury department of the Viewmont Corporation, which is based in Chicago, Illinois. Viewmont manufactures steel and aluminum food cans in plants located in the United States and Brazil. Generally, raw materials are sourced from suppliers located in the country where the plant is located. But when shortages occur at a particular location, Viewmont imports raw materials. Montero’s duties include procuring financing and managing interest rate and currency risk for Viewmont. Montero is meeting with two of his senior analysts, Maissa Bazlamit and Jacky Kemigisa, to plan the company’s hedging and financing activities. Bazlamit informs Montero that because of domestic shortages, Viewmont will need to import aluminum from Brazil for its U.S. plant. Payment for the aluminum will be in Brazilian reals (BRL) and is due on delivery three months from now. Bazlamit states, “To manage our translation exposure from unfavorable exchange rate movements, we should enter into a long forward contract on Brazilian reals.” Kemigisa has determined that in 60 days, Viewmont will also need to raise USD50,000,000 for domestic operations. To protect against a rise in interest rates over this period, Kemigisa is evaluating the purchase of a USD50,000,000 interest rate call option. Interest and principal on the loan is due upon its maturity. Details of the loan and the interest rate call are provided in Exhibit 1. <image_1> Bazlamit suggests using an interest rate swap instead of interest rate call options. She states, “By entering into an interest rate swap in which we receive a floating rate in return for paying a fixed rate of interest, we can hedge against rising interest rates and thus stabilize Viewmont’s cash outflows. The swap will also reduce the sensitivity of Viewmont’s overall position to changes in interest rates.” Montero responds, “I think a better alternative to the interest rate swap you suggest is an interest rate swaption. For example, we could purchase a payer swaption with an exercise rate of 3% that allows us to receive a rate of LIBOR. If fixed rates rise above 3% in 60 days, then excluding the effect of the swaption premium, our net interest payment will be equal to 3%.” Viewmont is planning an expansion of its manufacturing capacity in Brazil. At the current exchange rate, BRL1.72/USD1, the expansion will cost BRL86,000,000, or USD50,000,000. Montero and his team discuss alternative ways to raise the capital required so that Viewmont can achieve the lowest borrowing cost and hedge against exchange rate risk. Bazlamit suggests Viewmont can achieve the lowest borrowing cost and avoid currency risk by borrowing directly in Brazilian reals. Kemigisa disagrees and suggests that Viewmont, being based in the United States, receives the best terms by borrowing domestically and then converting the proceeds to Brazilian reals at current exchange rates. Montero states, “Viewmont will enjoy the lowest borrowing cost by borrowing in U.S. dollars and then engaging in a currency swap to obtain Brazilian reals.” Earnings from the Brazilian operation are repatriated to the United States each quarter. Montero and his team estimate that over the next year, quarterly cash flows from the Brazilian unit will be BRL5,000,000. Montero asks his team to evaluate the use of a currency swap to manage the currency risk of the earnings repatriation. The swap will involve fixed interest for fixed payments and the annual fixed interest rate for payments in Brazilian reals is 5% and 3% for U.S. dollars.

Is Bazlamit's statement on the type of currency risk faced by Viewmont Corporation and the proposed hedge most likely correct?

[ "A. No, she is incorrect with regard to the type of forward contract.", "B. No, she is incorrect about the type of currency risk.", "C. Yes" ]

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B

Answer = B. Since the fear is that the U.S. dollar will weaken against the Brazilian real, the appropriate hedge is to enter into a long forward contract to lock in the purchase price of the real. She is correct in this regard. But Bazlamit is incorrect about the type of currency risk. The currency risk faced here is best described as transaction exposure, not translation exposure.

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If the 180-day LIBOR rate in 60 days is 2.25%, based on information in Exhibit 1, the effective annual interest rate on Viewmont's USD50,000,000 loan is closest to:

[ "A. 3%", "B. 2%", "C. 1%" ]

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B

Answer = B. Future value of call premium in 60 days = 150,000 [1+(0.015 + 0.005)(60/360)] = USD150,500 Effective loan proceeds = 50,000,000 – 150,500 = USD49,849,500 Loan interest = 50,000,000 [(0.0225 + 0.005)(180/360)] = USD687,500 Call payoff = 50,000[Max(0, 0.0225 – 0.01)(180/360)] = USD312,500 Effective interest = 687,500 – 312,500 = USD375,000 Effective annualized loan rate = [(50,000,000 + 375,000)/49,849,500]^(365/180) – 1 = 0.0215, or 2%

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With regard to the use of an interest rate swap, is Bazlamit correct with regard to the type of interest rate swap and the effect on interest sensitivity of the overall position

[ "A. Type of interest rate swap: YES and Interest Rate Sensitivity: YES", "B. Type of interest rate swap: NO and Interest Rate Sensitivity: NO", "C. Type of interest rate swap:YES and Interest Rate Sensitivity: NO" ]

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C

Answer = C. Bazlamit is correct with regard to the type of interest rate swap but incorrect with regard to the impact of the swap on the interest rate sensitivity of the overall position. Because Viewmont Corporation has a variable rate loan, entering into an interest rate swap to pay a fixed receive a variable interest rate would stabilize cash outflows and thus hedge the firm's interest rate risk. But, the swap converts the variable rate loan to a fixed rate loan. Because the duration of the fixed-rate loan will exceed the duration of the variable rate loan, the interest rate sensitivity of the overall position increases.

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With respect to the swaption, is Montero most likely correct?

[ "A. No, he is incorrect about the net interest rate paid.", "B. No, he is incorrect about the type of swaption.", "C. Yes." ]

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A

Answer = A. He is correct about the purchase of the payer swaption. But the net interest payment is likely to be in excess of 3.5%. If the fixed rate in 60 days is above 3%, the swaption will be exercised, thus locking in 3%. But the loan has a rate of LIBOR + 0.50%, and the floating receipt on the swap is LIBOR. So the net effect is that the interest payment will likely be in excess of 3.5%.

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By engaging in a currency swap, Viewmont can ensure that quarterly earnings repatriated from Brazil are closest to:

[ "A. USD2,906,976.", "B. USD4,844,961.", "C. USD1,744,186." ]

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C

Answer = C. Implied notional BRL principal = BRL5,000,000/(0.05/4) = BRL400,000,000 Equivalent notional USD principal = BRL400,000,000/1.72 = USD232,558,139.53 Implied USD interest payment = USD232,558,139.53 x (0.03/4) = USD1,744,186.05

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Virginia Norfolk, is head of the client strategy committee at Chesapeake Partners, LLC, an investment consulting firm. Chesapeake advises a diverse client base on a variety of investment matters including asset allocation and manager selection. Each month the committee meets to discuss client inquiries and assignments the consultants are working on. Norfolk convenes the committee to discuss pressing issues for several clients. Norfolk asks William Burg, a field consultant, to present on a new client, a small college that Chesapeake advises with regard to the pension fund and the endowment. Burg needs to recommend to the client an appropriate benchmark for each fund. Burg tells the committee, "I recommend that the pension fund benchmark be changed from the pension's liabilities as the benchmark to a bond market index. The pension is closed to new participants and thus the amount and timing of future cash flows are known. The endowment is invested across many asset classes and generate an adequate return to meet its obligations, which consists of a 5% annual contribution to the college's operating fund. The endowment's benchmark for fixed-income managers should continue to be a bond market index, such as Barclays Aggregate Bond Index." Alex Manassas, a committee member asks Burg, "What factors do you consider in selecting a benchmark bond index?" Burg responds, "I look at three key factors when selecting a benchmark. Market value risk should be similar for the portfolio and the benchmark. The longer the duration, the greater the total return potential because rates are low now and the yield curve is so steep. Income risk is important for comparable assured income streams, which can be more stable and dependable in a portfolio with long maturities. The average credit risk in the benchmark should be measured against the investor's overall portfolio and satisfy credit quality constraints in the policy statement." Boris Markov is the firm's actuary and expert on asset liability management. His client is a life insurance company that sells guaranteed investment contracts (GICs). The company hired Chesapeake because it has not met the target yield of 4% on the GICs it sold. Markov proposes a new approach to satisfy the obligation: "First, the new single-period immunization strategy should require as a minimum condition that the duration of the bond portfolio equal the investment horizon. In addition, if the bond portfolio has a yield to maturity equal to the target yield and a maturity equal to the investment horizon, then the target value will be achieved". Markov then discusses another client that will require a rebalancing of its portfolio after a shift in interest rates over the last year to maintain the initial dollar duration. He uses the data in the table below to explain to the committee his rebalancing methodology. <image_1> Juan Ramirez, Chesapeake's chief investment officer, brings forward to the committee two investment issues that he would like to discuss. Ramirez tells the committee, "Some of our client's portfolios are for the purpose of funding liabilities, and I am concerned that these liabilities will not be met, given certain risks. In particular, I have noticed that client portfolios have a substantial position in mortgaged-backed securities. We should reallocate these securities to invest in corporate bonds so the portfolio's convexity matches that of the liabilities." Ramirez then presents the committee with the second investment issue. He is focused on a presentation that Alpha Managers, an investment firm that hopes to make it onto Chesapeake's "buy list," made recently. He tells the committee, "I am perplexed by the bottom-up capability that Alpha claims to have in adding value to portfolios. They claim to have a bias to yield maximization across securities without regard to rating differentials."

Burg's statement regarding the factors he uses in selecting a benchmark bond index is most likely:

[ "A. incorrect regarding credit risk and incorrect regarding market risk.", "B. correct regarding market risk and incorrect regarding income risk.", "C. incorrect regarding market risk and correct regarding income risk." ]

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C

Answer = C. Burg is incorrect regarding market risk. Although market risk should be comparable for the portfolio and benchmark index, given a normal upward-sloping yield curve, a bond portfolio's yield to maturity increases as the maturity of the portfolio increases. Because a long duration portfolio is more sensitive to changes in interest rates, a long portfolio will likely fall more in price than a short one. Burg's statement on credit risk is correct.

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Is Markov correct regarding the necessary conditions to immunize the GIC portfolio for his client?

[ "A. No, he is incorrect regarding duration", "B. Yes", "C. No, he is incorrect regarding the bond portfolio characteristics" ]

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C

Answer = C. To immunize a portfolio's target value or target yield against a change in the market yield, a manager must invest in a bond or a bond portfolio whose (1) duration is equal to the investment horizon and (2) initial present value of all cash flows equals the present value of the future liability. Thus, investing in a bond portfolio with a yield to maturity equal to the target yield and a maturity equal to the investment horizon does not assure that the target value will be achieved because of reinvestment risk.

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Using dollar duration and the data in Exhibit 1, how much cash does Markov's client need to rebalance the portfolio, assuming new investments are in equal proportions of one-third of each bond?

[ "A. $7,993,335.", "B. $28,618,000.", "C. $8,098,245" ]

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A

Answer = A. First calculate the dollar duration initially and after the shift in interest rates, as shown in the table below:<ans_image_1>. Then calculate a rebalancing ratio: $1,349,500/$1,063,365 = 1.269. Rebalancing requires each position to be increased by 26.9%. The cash required for the rebalancing is calculated as: Cash required = 0.269 × (9,975,000 + 9,500,000 + 10,240,000) = $7,993,335.

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The risk that Ramirez notes is prevalent in client portfolios is most likely:

[ "A. interest rate risk.", "B. cap risk.", "C. contingent claim risk." ]

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C

Answer = C. When such assets as mortgage-backed securities have a contingent claim provision, explicit or implicit, there is an associated risk. As rates fall, the security might have coupons halted and principal repaid. This results in reinvestment risk and also limits any potential upside as would be seen with a noncallable security. Mortgaged-backed securities exhibit negative convexity. But corporate bonds, if noncallable, are positively convex.

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Bobby Sarkar is a senior consultant with Experian Financial Consultants (EFC), an investment advisory firm based in Cambridge, Massachusetts. EFC provides a range of consulting services including advice on investment strategy and selection of money managers. Currently, Sarkar is working with three clients: (1) Hayes University Endowment, (2) Bayside Foundation, and (3) Daniels Corporation Pension Plan. Hayes University Endowment The Hayes University Endowment is willing to accept a certain degree of tracking risk, provided that it is compensated with incremental returns. In particular, Hayes wants to implement an investment approach that maximizes the information ratio. Sarkar indicates that there are two alternate methods to implement the investment approach favored by Hayes: Method 1 Under this method, cash in the portfolio is equitized by using a long futures position. The cash is invested in short- to medium-term fixed-income securities. Method 2 The manager will only invest in stocks expected to outperform the index. If the manager has no opinion on a stock, or if the stock is expected to underperform, the stock will not be included in the investment portfolio. Bayside Foundation The investment policy committee for Bayside Foundation follows a fairly conservative investment strategy and pays particular attention to the minimization of tracking error. Bayside seeks to achieve two specific objectives. Objective 1 Invest a portion of the portfolio in an index with a large-cap bias. In addition to minimizing tracking error, Bayside would also like to ensure that the index strategy involves minimal rebalancing costs. Objective 2 Allocate another portion of the portfolio so it earns alpha associated with small-cap stocks but without the associated small-cap market beta exposure. Daniels Corporation Pension Plan Daniels Corporation pension trustees want to allocate a portion of the equity pension portfolio to an active money manager with a value investment style. Sarkar has collected information on three active portfolio managers and will recommend one of them to Daniels. Selected information for the three managers is presented in Exhibit 1. <image_1>

The type of index that would most likely help Bayside Foundation achieve Objective 1 is a(n):

[ "A. value-weighted index.", "B. price-weighted index.", "C. equal-weighted index." ]

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A

Answer = A. A value-weighted index is biased toward large, mature companies and minimizes tracking error. Furthermore, the index is self-rebalancing because the weights automatically adjust as stock prices change, thus rebalancing costs are minimal.

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The most appropriate approach for Bayside to achieve Objective 2 is to invest in small-cap stocks using a:

[ "A. long-only strategy.", "B. market-neutral long–short strategy.", "C. short extension strategy." ]

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B

Answer = B. A market-neutral long–short strategy implemented by using small-cap stocks will help Bayside earn alpha associated with small-cap stocks but without beta exposure to the small-cap sector. The overall market beta of the market-neutral long–short strategy is zero.

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Based on the information presented in Exhibit 1, Sarkar should recommend to the Daniels Corporation Pension Fund that the most appropriate manager to meet its investment objective is:

[ "A. Manager B", "B. Manager A", "C. Manager C" ]

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B

Answer = B. Manager A has a low P/E, high dividend yield, and a style fit of 87%, which suggests that he is following an active value strategy.

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Based on Exhibit 1, which of the following sub-styles is most consistent with Manager C’s investment style?

[ "A. Low P/E", "B. High yield", "C. Earnings momentum" ]

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C

Answer = C. Manager C follows a growth investment style. Earnings momentum is a growth investment sub-style.

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Jennifer Simko’s fixed-income portfolio has underperformed its benchmark, the Barclays Capital Aggregate Bond Index. Simko asks her investment adviser, Mike Spong, to recommend a new fixed-income manager. Spong selects three fixed-income portfolio managers for Simko to consider: - Mondavi Investment Partners - Smithers Associates - Vertex Group Selected characteristics for each manager’s portfolio are provided in Exhibit 1. <image_1> Note that in Exhibit 1, the portfolio duration for the benchmark, Mondavi Investment Partners, and Smithers Associates portfolios is 4.7. Portfolio duration for Vertex Group is 4.3. Spong makes the following statements to Simko regarding Exhibit 1: 1. Mondavi follows a full-replication approach in which portfolio performance will match the fixed-income benchmark’s performance. Mondavi’s portfolio sector weights, duration, convexity, and term structure match those of the benchmark. Smithers’s portfolio characteristics do not match the benchmark’s because Smithers has minor risk factor mismatches with the benchmark. 2. Vertex’s strategy is to construct a portfolio that has significant mismatches with the benchmark with respect to duration, key rate duration, and sector allocations. Vertex also relies on proprietary interest rate forecast models to generate superior portfolio returns. Vertex’s objectives are to ensure that tracking risk is minimized and portfolio return exceeds benchmark return. 3. Vertex evaluates potential trades using total return analysis. Total return analysis assesses the expected effect of a trade on total portfolio return based on an interest rate forecast. For example, Vertex recently evaluated the expected total return for a single bond, with a beginning price of $103, a 5% semiannual coupon, an expected price at the end of one year of $102.5, and an annual reinvestment rate of 2%. 4. Vertex also positions the portfolio to reflect the firm’s opinions on the direction of interest rates and credit spreads. Over the next six months, Vertex is forecasting · low and stable implied interest rate volatility, · spreads to narrow across all spread sectors by 25 bps, and · a positively sloped yield curve with short rates rising 50 bps and long rates rising by about 75 bps.

Based on Exhibit 1 and Statement 1, Smithers's investment strategy is best described as:

[ "A. active management.", "B. enhanced indexing.", "C. pure bond indexing." ]

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B

Answer = B. In Exhibit 1, the contributions to spread duration for the credit sector (1.6) and for the mortgage sector (1.6) are slightly higher than the corresponding contributions to spread duration in the benchmark—that is, there are minor risk factor mismatches. But note, however that the portfolio duration of the benchmark and the Smithers portfolio is 4.7. Thus, the strategy followed by Smithers is best described as an enhanced indexed strategy with minor risk factor mismatches. Also, in Statement 1, Spong states "Smithers has minor risk factor mismatches with the benchmark."

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Based on Exhibit 1and Statement 1, one disadvantage of the investment strategy followed by Mondavi is that the portfolio will most likely:

[ "A. have higher advisery and non-advisory fees.", "B. be expensive to construct.", "C. result in a poorly diversified portfolio." ]

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B

Answer = B. Statement 1 indicates that Mondavi follows a full-replication approach that is pure bond indexing. In this approach, many issues in the bond index may be illiquid and infrequently traded. This factor makes full replication of an index not only difficult but also expensive to implement.

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In Statement 2, are Vertex's objectives with regard to tracking risk and portfolio return consistent with its strategy

[ "A. No, the objective regarding portfolio return is inconsistent with its strategy.", "B. No, the objective regarding tracking risk is inconsistent with its strategy.", "C. Yes." ]

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Answer = B. The objective regarding tracking risk is inconsistent with their strategy. In Statement 2, Spong states that Vertex's strategy is to construct a portfolio with significant risk factor mismatches with the benchmark and that it relies on proprietary interest rate forecast models to generate returns. Exhibit 1 indicates that for Vertex the contributions to spread duration are significantly different from the benchmark in the credit and CMBS sectors. Note also that portfolio duration is different from the benchmark duration. All this suggests that Vertex is an active manager. As an active manager, Vertex would be willing to accept a large tracking error with the objective of generating portfolio returns that exceed the benchmark.

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For the example given in Spong's Statement 3, the one-year expected total return is closest to:

[ "A. 4.35%.", "B. 4.50%.", "C. 4.84%." ]

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A

Answer = A. The first step is to calculate the total coupon payments plus reinvestment income. Two coupon payments are received, one of which is reinvested at one-half the annual reinvestment rate, so: Income flow = $2.50 + ($2.50 × 1.01) = $5.025. The second step is to determine the horizon price that is given in Statement 3: $102.50 The third step is to add the income flow and horizon price together to equal horizon future dollars: $5.025 + $102.5 = $107.525 The fourth step is to calculate the semiannual total return by dividing the total future dollars by the beginning price: ($107.525/$103)0.5 – 1.0 = 0.02173, or 2.173% The final step is to double the semiannual total return to get the total return: 2.173% × 2 = 4.3459%.

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Given Vertex's interest rate volatility and yield curve forecasts in Statement 4, compared with bullet structures, callable structures and putable structures, respectively, will most likely

[ "A. Callable Structures: Underperform and Putable Structure: Outperform", "B. Callable Structures: Outperform and Putable Structures: Outperform", "C. Callable Structures: Outperform and Putable Structure: Underperform" ]

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B

Answer = B . Spong's fourth statement indicates that Vertex expects a 25 bp rise in short-term rates and a 75 bp increase in long-term rates—that is, the yield curve is expected to steepen. In this environment callables and putables will outperform bullet structures. As rates rise, given low implied interest rate volatility, the probability of a call diminishes as does the value of the call option. Consequently, callables will outperform bullets. As rates rise the put option becomes more valuable, furthermore the put allows the investor to put the option back at par, thus avoiding losses. For these reasons, the value of the putable structure can be expected to increase. In contrast, the bullet structure will decline in value. Thus, putables also outperform bullets.

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Given Vertex's forecasts in Statement 4, the most appropriate strategy for Vertex is to:

[ "A. shorten duration in the credit sector and lengthen duration in the Treasury sector.", "B. lengthen duration in the credit sector and shorten duration in the Treasury sector.", "C. lengthen duration in all spread sectors and the Treasury sector." ]

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Answer = B . As spreads tighten the credit sector will benefit from increased exposure to longer duration issues. Because the yield curve is expected to steepen, it would be appropriate for Vertex to shorten duration in Treasuries because rising yields will cause security prices to fall. Ideally, the net effect should be to reduce duration below the benchmark.

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The United States–based CME Foundation serves a wide variety of human interest causes in rural areas of the country. The fund’s investment policy statement sets forth allocation ranges for major asset classes, including U.S. large, mid-, and small-cap stocks, international equities, and domestic and international bonds. When revising its outlook for the capital markets, CME typically applies data from GloboStats Research on the global investable market (GIM) and major asset classes to produce long-term estimates for risk premiums, expected return, and risk measurements. Although they have worked with GloboStats for many years, CME is evaluating the services of RiteVal, a competing research firm, via a trial offer. Unlike the equilibrium modeling approach applied to GloboStats’s data, RiteVal prefers to use a multifactor modeling approach. Both research firms also provide short- and long-term economic analysis. CME has asked Pauline Cortez, chief investment officer, to analyze the benefit of adding U.S. real estate equities as a permanent asset class. To determine the appropriate risk premium and expected return for this new asset class, Cortez needs to determine the appropriate risk factor to apply to the international capital asset pricing model (ICAPM). Selected data from GloboStats is shown in Exhibit 1. <image_1> Cortez’s colleague Jason Grey notes that U.S. real estate is a partially segmented market. For this reason, Grey recommends using the Singer–Terhaar approach to the ICAPM and assumes a correlation of 0.39 between U.S. real estate and the GIM. Cortez reviews RiteVal data (Exhibit 2) and preferred two-factor model with global equity and global bonds as the two common drivers of return for all other asset classes. <image_2> Grey makes the following observations about the two different approaches the research firms use to create their respective covariance matrices: • GloboStats uses a historical sample to estimate covariances, whereas • RiteVal uses a target covariance matrix by relating asset class returns to a particular set of return drivers. Grey recommends choosing the GloboStats approach. Cortez states: I disagree. We will use the results of both firms by calculating a weighted average for each covariance estimate. Grey finds that RiteVal’s economic commentary reveals a non-consensus view on inflation. Specifically, they believe that a near-term period of deflation will surprise many investors but that the current central bank policy will eventually result in a return to an equilibrium expected level of inflation. Grey states: If RiteVal is correct, in the near-term our income producing assets, such as Treasury bonds and real estate, should do well because of the unexpected improvement in purchasing power. When inflation returns to the expected level, our equities are likely to perform well. Cortez points out that RiteVal uses an econometrics approach to economic analysis, whereas GloboStats prefers a leading indicator–based approach. Cortez and Grey discuss these approaches at length. Cortez comments: The big disadvantage to the leading indicator approach is that it has not historically worked because relationships between inputs are not static. One major advantage to the econometric approach is quantitative estimates of the effects on the economy of changes in exogenous variables.”

Using the data provided in Exhibit 1 and assuming perfect markets, the calculated beta for U.S. real estate is closest to:

[ "A. 1.08.", "B. 0.38.", "C. 0.58" ]

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C

Answer = C. <ans_image_1>

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Using the data provided in Exhibit 1 and Grey's recommended approach and assumed correlation, the expected return for U.S. real estate is closest to:

[ "A. 6.3%.", "B. 6.9%.", "C. 4.3%." ]

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A

Answer = A . Grey recommends the Singer–Terhaar approach and a correlation of 0.39 between real estate and the market. Use these steps to solve for the expected return: <ans_image_2>

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Using the multifactor model preferred by RiteVal and Exhibit 2, the standard deviation of U.S. real estate is closest to:

[ "A. 24.5%.", "B. 21.0%.", "C. 23.1%." ]

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C

Answer = C. <ans_image_3>

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Grey’s statement regarding the impact of RiteVal’s inflation scenario is most likely:

[ "A. incorrect because of his comment about real estate.", "B. incorrect because of his comment about equities.", "C. correct." ]

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A

Answer = A. In deflation, real estate experiences downward pricing pressure (negative) and bonds benefit from improving purchasing power (positive). Therefore, Grey’s comment about real estate is incorrect. In equilibrium, inflation at or below expectations is a positive for equities. The comment about equities is correct.

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Cortez’s comment with regard to the two different approaches to economic analysis is most likely:

[ "A. incorrect because of the statement regarding leading indicators.", "B. correct.", "C. incorrect because of the statement regarding econometrics." ]

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B

Answer = B . Cortez’s statement is entirely correct. A disadvantage of the leading indicators–based approach is that historically, it has not consistently worked because relationships between inputs are not static. An advantage to the econometric approach is that it provides quantitative estimates of the effects on the economy of changes in exogenous variables.

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Arcadia, LLP, is one of several independently operated investment management subsidiaries of Swiss Corp, a global bank. Arcadia is headquartered in Philadelphia, Pennsylvania, and specializes in the management of equity, fixed income and real estate portfolios. Arcadia’s CEO recently hired Joan Westley as chief compliance officer to achieve compliance with the Global Investment Performance Standards (GIPS). Arcadia just opened a division in Phoenix, Arizona, incorporated as Arcadia West, LLP, to accommodate one of its portfolio managers and his staff who manage a hedge fund. The staff in Phoenix works exclusively on the hedge fund’s strategy, using an investment process distinct from the one used in the Philadelphia office. Westley makes the following statement at a meeting with the CEO: “I am establishing and implementing policies and procedures to ensure Arcadia is in compliance with the GIPS standards. Although the hedge fund won’t be in compliance, it won’t affect our ability to be compliant firm-wide, because it is in an autonomous unit. We will be the first Swiss Corp subsidiary to be compliant. Keep in mind that even after implementation, we will not be able to claim compliance until our performance measurement policies, processes, and procedures are verified by an independent firm.” Westley begins her review of Arcadia’s current policies. She first reviews three policies regarding input data: Policy 1: The accounting systems record the cost and book values of all assets. Portfolio valuations are based on market values, provided by a third-party pricing service. Policy 2: Transactions are reflected in the portfolio when the exchange of cash, securities, and paperwork involved in a transaction is completed. Policy 3: Accrual accounting is used for fixed-income securities and all other assets that accrue interest income; dividend-paying equities accrue dividends on the ex-dividend date. Next, Westley reviews Arcadia’s policies for return calculation methodologies: Policy 4: Arcadia uses the Modified Dietz method to compute portfolio time-weighted rates of return on a monthly basis. Returns for longer measurement periods are computed by geometrically linking the monthly returns. Policy 5: Arcadia revalues portfolios when capital equal to 10% or more of current market value is contributed or withdrawn. Returns are calculated after the deduction of trading expenses. Policy 6: Cash and cash equivalents are excluded in total return calculations. Custody fees are not considered direct transaction costs. Westley also looks at the investment policy statements (IPS) for the three sample portfolios that are included in Arcadia’s large-capitalization equity composite: Portfolio A: A portfolio managed for a local church in which all fees are waived. The IPS prohibits holdings of companies involved in firearms, alcohol, or tobacco. These securities represent 5% of the benchmark, but the portfolio manager believes he can still implement his strategy with these restrictions. Portfolio B: The equity carve-out portfolio of a balanced account. The client provides Arcadia discretion in the tactical asset allocation decision. Asset allocation among subportfolios is performed quarterly and each subportfolio holds tactical or frictional cash. Portfolio C: A large-cap equity mutual fund managed for a corporate retirement plan. Employees can make contributions and withdrawals daily. The client requires the portfolio manager to maintain at least 15% of assets in cash balances to meet potential withdrawals. Finally, Westley examines a recent presentation to a prospective client regarding Arcadia’s small-cap composite. Details of this presentation are presented in Exhibit 1 and its notes. <image_1> Notes: 1. Arcadia is an investment firm affiliated with a major global bank and founded in April 2001. The firm manages portfolios in various equity, fixed-income, and real estate strategies. 2. Arcadia has a number of affiliates owned by the parent company; a schedule is provided separately. 3. The composite has an inception date of 31 December 2007. A complete list and description of firm composites is available on request. 4. The composite includes all fee-paying, discretionary, nontaxable portfolios that follow a small-cap strategy. The composite does not include any non-fee-paying portfolios. 5. 1Q13 data are not annualized. 6. Valuations are computed and performance reported in U.S. dollars. 7. Internal dispersion is calculated by using the equal-weighted standard deviation of all portfolios that are included in the composite for the entire year. 8. Gross-of-fees performance returns are presented before management and custodial fees but after all trading expenses. The management fee schedule is as follows: 1.00% on first US$25 million; 0.60% thereafter. Net-of-fees performance returns are calculated by deducting the management fee of 0.25% from the quarterly gross composite return.

In her statement to the CEO, Westley is least likely correct with respect to:

[ "A. verification.", "B. exclusion of the Phoenix division.", "C. the status of Swiss Corp's other subsidiaries." ]

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A

Answer = A. Although the GIPS standards recommend that firms undertake verification, it is not required to claim compliance. The Phoenix office holds itself separate geographically, as well as with respect to personnel and its investment process. Philadelphia will be able to be GIPS compliant even if its Phoenix office is not. Finally, because Arcadia markets itself as separate and distinct from the other affiliates, it can claim compliance even if the others units are not compliant.

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Which policy regarding input data is least likely compliant with the GIPS standards

[ "A. Policy 2", "B. Policy 3", "C. Policy 1" ]

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A

Answer = A . The GIPS standards require all transactions to be recognized on the trade date and not the settlement date. Trade date is when the transaction takes place, whereas settlement date is when the exchange of cash, securities, and paperwork involved in a transaction is completed.

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Inclusion of which portfolio reviewed by Westley in the large-capitalization equity composite would least likely be compliant with the GIPS standard?

[ "A. Portfolio A", "B. Portfolio B", "C. Portfolio C" ]

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C

Answer = C. Portfolio C is required to hold cash at 15%, which is too much for the portfolio manager to execute his strategy effectively. The unanticipated nature of the contributions and withdrawals that can occur daily makes it difficult to invest the funds in equities. This large cash balance implies the portfolio is nondiscretionary.

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