©2011 Kaplan, Inc.

CFA Level III Mock Exam 2011 Morning Session Specially designed as preparation for the Level III 2011 CFA® Exam The morning session of the Schweser 2011 Level III Mock Exam comprises 9 questions. For grading purposes, the maximum point value of each question is equal to the number of minutes allocated to that question.

Question Topic Minutes 1 Portfolio Management—Individual 35 2 Portfolio Management—Economics 22 3 Portfolio Management—Individual 21 4 Portfolio Management—Institutional 26 5 Portfolio Management—Monitoring and Rebalancing 18 6 Portfolio Management—Alternative Investments 12 7 Portfolio Management—Evaluation and Attribution 15 8 Portfolio Management—Risk Management Application of Derivatives 13 9 Portfolio Management—Individual 18 Total 180

Do not proceed until instructed to do so.

Start Time:_________

©2011 Kaplan, Inc.

SCHWESER 2011 CFA LEVEL III LIVE MOCK EXAM, MORNING SESSION

©2011 Kaplan, Inc. All rights reserved.

Published in 2011 by Kaplan, Inc.

Printed in the United States of America.

ISBN: 978-1-4277-2821-0 / 1-4277-2821-6

PPN: 3200-0263

Required CFA Institute® disclaimer: “CFA® and Chartered Financial Analyst® are trademarks owned by

CFA Institute. CFA Institute (formerly the Association for Investment Management and Research) does

not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan

Schweser.”

These materials may not be copied without written permission from the author. The unauthorized

duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.

Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: Schweser study tools should be used in conjunction with the original readings as set forth

by CFA Institute in their 2011 CFA Level III Study Guide. The information contained in Schweser

study tools covers topics contained in the readings referenced by CFA Institute and is believed to be

accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your

ultimate exam success. The authors of the referenced readings have not endorsed or sponsored Schweser

study tools.

©2011 Kaplan, Inc.

QUESTION 1 HAS SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 35 MINUTES Mark Reid, 60, plans to retire in two years, and his wife, Eunice, 55, will retire in one year. They have asked Jonathon Smith, their financial advisor, to help with their retirement planning. Mark is currently vice president of finance at Smooth-Borden Industries (SBI), and Eunice is quality manager at a local hospital. Over the coming year they expect their living expenses to total $175,000. Neither Mark nor Eunice expects to work during retirement, but they plan to travel and take care of their grandchildren as much as possible. Including these expenditures, they expect their total living expenses in the first year of Mark’s retirement to be $250,000. Mark and Eunice have two children who live on their own. Mark’s 82-year-old mother, Delores, however, is widowed and in failing health and lives with them. Mark and Eunice provide for her care in their home with the help of medical professionals who visit three to four times a week. The cost of her care for the coming year is expected to total $65,000. Given her health, she is not expected to live more than five to seven years, and Mark and Eunice feel strongly that she should remain in their home as long as possible. Mark’s salary over the past year was $550,000, and upon retirement he will receive a one-time taxable payment of $1,500,000. Eunice, who will receive a taxable bonus of $250,000 on the day she retires, will earn $90,000 this coming year. Mark and Eunice have already committed to giving $100,000 to Eunice’s favorite charity within the next three months. Their investment portfolio has a current market value of $6,000,000 and, since Mark has worked at SBI for 38 years, 20% of it is invested in the company’s stock. The Reids’ house has an estimated market value of $750,000, and Smith estimates that the after-tax return on the portfolio for the next two years will be 5%. The Reids pay an average tax rate of 30% on income and capital gains, and they have no reason to expect this rate to change within the next three years. Inflation is expected to average 3% annually for the foreseeable future. The Reids’ living expenses and the care for Mark’s mother are expected to increase at the rate of inflation. Because of Mark’s plan to retire in two years, he will only receive cost-of-living (3%) increases in salary for the next two years. When addressing acceptable investment risk, Mark states that he wants their portfolio to suffer no loss greater than 5% in any year. He also states that both he and Eunice wish to avoid high-risk investments, such as derivatives, global equities, and hedge funds. The Reids wish to leave their estate to their children, divided equally. They plan to leave their home to a local charity upon the death of the surviving spouse, estimated to be when Eunice would be 85.

©2011 Kaplan, Inc.

A. Based solely on information contained in the vignette, (i) formulate the return objective for the Reids for the first year of Mark’s retirement, and (ii) calculate the after-tax nominal rate of return required to achieve the Reids’ objectives for the first year of Mark’s retirement. Show your calculations.

(9 minutes)

Note: Assume there are no tax benefits to the Reids’ charitable gift.

©2011 Kaplan, Inc.

B. Characterize the Reids’ ability to tolerate risk, willingness to tolerate risk, and overall tolerance of risk. Support each choice with one reason:

(6 minutes)

Answer Part B in this template.

Constraint Characterize (circle one) Justification

Ability

Below-average

Average

Above-average

Willingness

Below-average

Average

Above-average

Overall

Below-average

Average

Above-average

©2011 Kaplan, Inc.

C. Determine the time horizon and liquidity constraints for Mark and Eunice, assuming Mark has just retired.

(4 minutes)

Answer Part C in this template.

Constraint Justification

Time horizon

Liquidity

©2011 Kaplan, Inc.

It is two years later, and Mark has just retired. Due to distractions at work, he has not authorized any changes in their portfolio allocation since the investment policy statement was prepared. Mark states that they are ready to do so now, however, and would like Smith’s advice on how to allocate their assets for retirement. His financial situation is unchanged from that indicated in the investment policy statement. In addition to their current allocation, Smith has constructed four alternative portfolio allocations for Mark and Eunice to consider. The five allocations are shown in Exhibit 1. Exhibit 1: Alternative Asset Allocations for Mark and Eunice Reid

Asset Class Alternative Asset Allocations (%)

Current A B C D

Cash equivalents 16 10 5 3 15

U.S. corporate bonds 16 5 20 30 25

U.S. Treasury bonds 16 8 20 15 25

U.S. small cap equities 16 30 15 22 10

U.S. large cap equities 16 20 15 25 20

Global equities 0 17 10 0 0

Robinson Industries stock 20 10 15 5 5

Expected after-tax return 7.1% 11.1% 9.2% 7.4% 5.9%

Expected standard deviation 6.5% 9.9% 6.9% 5.3% 5.1% D. From Exhibit 1, select the most appropriate allocation for the Reids’ retirement

portfolio. Justify your selection with two reasons based on the objectives, constraints, and other information for the Reids. For each of the four allocations not selected, provide one reason why it is inappropriate.

(8 minutes) Answer Part D in the template provided.

©2011 Kaplan, Inc.

Template for Part D. Selected

Allocation (circle one →) Current A B C D

1st justification for selected allocation

2nd justification for selected allocation

Rejected ↓ Allocations ↓ One justification for rejecting

1.

2.

3.

4.

©2011 Kaplan, Inc.

Throughout his discussion with the Reids, Smith has been taking notes so that he can determine their investor personality types. During their discussions, Mark and Eunice made the following statements: Mark: “During my career I saw many of my competitors fail because they undertook

too much risk. That’s the reason I always look for ways to minimize risk, in investing as well as in business. I might be slow in making investment decisions, but once I make them, I stick with them. I also use my intuition when I make decisions because it has served me well when dealing with clients and employees.”

Eunice: “I study investments before making decisions, and I subscribe to several

investment newsletters and publications. I’ve created a spreadsheet that helps me pick investments based on the firm’s PE ratio and other value indicators. I am careful with my selections and will sell stocks if the level of risk becomes inappropriate.”

E. Determine whether Mark and Eunice Reid would be classified as cautious,

methodical, or spontaneous investors. Justify each classification with one reason.

(4 minutes) Answer Part E in this template. Classification

(circle one) Justification

Mark

Cautious

Methodical

Spontaneous

Eunice

Cautious

Methodical

Spontaneous

©2011 Kaplan, Inc.

One of Mark’s concerns is that any sale of his holding in Robinson Industries stock will trigger a large tax bill. In his 38 years at Robinson, Mark bought much of the stock during periods when he correctly thought the stock was undervalued. As a result, he has a low cost basis in much of his Robinson stock. Smith discusses the Reids’ tax situation and makes the following comments to Mark:

“One option is for you to enter into a public exchange fund. You would join in a partnership with other investors who hold the same stock, and the manager hedges the shares with derivatives positions. This allows you to avoid the taxes on a sale of the Robinson stock, while at the same time limiting your downside exposure. However, you still retain upside potential in the stock to the extent that it is not fully hedged.” “Your tax planning should be based on a longer horizon than your life expectancy. One reason is that in some states, the surviving spouse is not taxed on assets received when the other spouse passes away. Taxes are deferred, which is a substantial benefit because the surviving spouse can live many more years.”

F. Determine whether each of Smith’s statements is accurate or inaccurate. If

inaccurate, support your response with one reason.

(4 minutes) Answer Part F in this template.

Smith’s Statements Accurate or inaccurate? (circle one)

Explanation

“One option is for you to enter into a public exchange fund…”

Accurate

Inaccurate

“Your tax planning should be based on a longer horizon than your life expectancy...”

Accurate

Inaccurate

©2011 Kaplan, Inc.

QUESTION 2 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 22 MINUTES. Maria Gonzales generates capital market forecasts for Southern Corp, a large investment management firm located in Mexico City, Mexico. Fernando Costa, director of research at Southern, has asked Gonzales to explain the forecasting approach that would best suit one of his clients, an equity long-short hedge fund. Costa also asks Gonzales to forecast GDP growth for a developing economy. In order to do this, Gonzales obtains predictions for changes in underlying macroeconomic factors, including those listed in Figure 1 and the economic growth data in Figure 2. Figure 1: Predicted Changes in Economic Factors

Factor Predicted Change

Overall Savings Rate Decrease

Government-mandated pollution controls Increase

Children per household Decrease

Figure 2: Historical Economic Data

Gonzales notes that the economy’s major equity market index is currently at 1200 and the last aggregate dividend was $45. She estimates the required rate of return for the market is 9.0%. Figure 3 contains valuation data related to the market index: Figure 3: Valuation Data ($Billions)

Growth in

Total Factor Productivity

Growth in Capital Stock

Growth in Labor Input

Output Elasticity of Capital (α)

2001–2010 2.75% 2.25% 0.42% 0.75

Estimated market value (replacement cost) of assets 5,000

Book value of assets 3,500

Estimated market value of liabilities 2,600

Estimated market value of equity 2,500

©2011 Kaplan, Inc.

Costa then asks Gonzales to explain the major relative valuation models and provide short descriptions of each. Gonzales explains the Fed model, the Yardeni model, and the 10-year moving average price/earnings ratio model, P/10-year MA(E). Gonzales makes the following comments:

“The Fed model compares the earnings yield for the S&P 500 index to the yield on U.S. Treasury securities. When the earnings yield for the S&P 500 is greater than the yield on Treasury securities, equities are said to be over-valued and should fall.”

“The Yardeni model is used to estimate the earnings yield for a market index and is computed as the yield on A-rated corporate bonds less the long-term growth rate forecast multiplied by a weighting factor. Although the Yardeni model incorporates a risk premium above that of Treasuries, the premium is not a true measure of equity risk.”

“The 10-year moving average price/earnings ratio model is computed as the value of the S&P 500 index divided by the average of the previous 10-years’ reported earnings. A major drawback of this model, however, is that it does not consider the effects of inflation.”

A. Of the top-down and bottom-up methods of forecasting, determine the more

appropriate for the hedge fund. Justify your response with one reason.

(3 Minutes)

Template for Part A.

Appropriate forecasting method (circle one) Justification

Top-down

Bottom up

©2011 Kaplan, Inc.

B. Using the data provided in Figure 2 and the log form of the Cobb-Douglas production function, determine the estimated percentage change in output (i.e., the real rate of economic growth) for the economy.

(4 minutes)

C. Determine, using the constant growth dividend growth model and the real rate of

growth calculated in part B, whether the market is most likely correctly valued, undervalued, or overvalued. Show your calculations.

(3 minutes)

©2011 Kaplan, Inc.

D. In the template provided, determine whether you agree or disagree with each of Gonzales’ comments. If you disagree with a comment, justify your decision with one reason.

(9 minutes)

Template for Part D.

Comment Agree or Disagree (circle one)

Justification

“The Fed model compares the earnings yield for the S&P 500 index to the yield on U.S. Treasury securities. When the earnings yield for the S&P 500 is greater than the yield on Treasury securities, equities are said to be over-valued and should fall.”

Agree

Disagree

“The Yardeni model is used to estimate the earnings yield for a market index and is computed as the yield on A-rated corporate bonds less the long-term growth rate forecast multiplied by a weighting factor. Although the Yardeni model incorporates a risk premium above that of Treasuries, the premium is not a true measure of equity risk.”

Agree

Disagree

“The 10-year moving average price/earnings ratio model is computed as the value of the S&P 500 index divided by the average of the previous 10-years’ reported earnings. One of the major drawbacks of this model is that it does not consider the effects of inflation.”

Agree

Disagree

©2011 Kaplan, Inc.

E. In the space provided below, calculate and interpret the Equity Q ratio for the equity market. Show your calculations.

(3 minutes)

©2011 Kaplan, Inc.

QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 21 MINUTES Blake McCurdy, CFA, has been asked to evaluate the portfolio of Reggie Perkins, a U.S. citizen who just turned 58 years old. Perkins is a retired inventor with a significant taxable investment portfolio as well as a tax-deferred retirement account portfolio worth $3.7 million. All contributions to the retirement account have been made on a before-tax basis, so there have been no taxes paid on any funds in the account. By law Perkins cannot, without significant penalty, withdraw the funds before he is 59½, and any withdrawals after 59½ are taxable as ordinary income. In addition to his two portfolios, Perkins receives $36,000 monthly representing royalties on several of his inventions. At his death these checks will go directly to his heirs. Perkins has three children ages 25, 27, and 31. He has told McCurdy that, although he plans to make no more deposits to his retirement account, on his 65th birthday (7 years from now) he would like to close his retirement account and give the money to his children. His goal is to pay all taxes on the withdrawal and have enough remaining for each child to receive $1,000,000. The tax code provides an annual $13,000 gift allowance; a taxpayer may give annually, tax free, up to $13,000 each to as many individuals as desired. For gifts greater than $13,000 in the same year to the same individual, the amount in excess of $13,000 is subject to a gift tax of 25%. Perkins has taken advantage of the gift allowance for many years as a means of distributing a small portion of his estate to his children each year. He takes three $13,000 annual gifts out of earnings on his taxable investment portfolio and plans to continue these annual gifts until his death. Perkins is subject to 40% taxes on ordinary income, and neither the gift tax rate nor the ordinary tax rate is expected to change in the foreseeable future. A. Formulate the return objective for Perkins’s retirement portfolio.

(3 minutes)

©2011 Kaplan, Inc.

B. Calculate the required return for Perkins’s retirement portfolio, assuming all ordinary and gift taxes will be taken out of the final balance in the retirement portfolio in seven years. Assume the annual $13,000 gift allowance continues to be met by gifts from Perkins’s taxable investment portfolio. Show your calculations.

(8 minutes)

©2011 Kaplan, Inc.

It is now seven years later. Perkins has reached his 65th birthday, closed his retirement account, and distributed just over $1,000,000 to each of his three children. Perkins wants to transfer $2,000,000 of his investment portfolio to each child, after which he will use his wealth to establish perpetual scholarships and an endowment for his alma mater. Due to significant annual investment returns, Perkins pays income taxes at 40%, while his children pay investment taxes at 30%. Gift and capital gains taxes have remained constant at 25% and 20%, respectively, and the assets are expected to earn 8.5% before-taxes annually, regardless of who holds them. C. From a relative value standpoint, determine whether it would be better for

Perkins to pay the gift taxes and give $2,000,000 in stock to each child now or leave the stock to his children as part of his estate. If he waits until his death to transfer the assets, estimated to be in 20 years, they will be subject to 50% estate taxes. Show your calculations.

(10 minutes)

©2011 Kaplan, Inc.

QUESTION 4 HAS TWO PARTS (A, B) FOR A TOTAL OF 26 MINUTES First National Bank (FNB), a regional bank with $5 billion in assets, has most of its offices in rural areas. During the most recent year, FNB earned $27 million, or $1.80 per share. The bank’s loan portfolio could be characterized as having above-average risk, with loans to many small- to medium-sized companies, a substantial portion of which are to the farming community. Richard Gray, FNB’s CFO, manages the bank’s $2 billion securities portfolio. Gray has neither the time nor the resources to effectively manage the portfolio, so he simply buys and holds securities, with an objective of earning the highest current income possible to support the bank’s operations. Exhibit 1 shows the allocation of the bank’s security portfolio. Exhibit 1: FNB Securities Portfolio Allocation

First National Bank: Security Portfolio Interest Rate Market Value($ million)

Short-term tax exempt securities 1.5% $200

Intermediate tax exempt securities 3.0% 200

Long-term tax exempt securities 4.5% 400

BBB rated 15-year corporate securities 8.0% 150

BB+ rated 20-year corporate securities 10.0% 150

BBB- rated CMO with a duration of 20 7.0% 400

20-year Treasury bonds 5.5% 500

Total $2,000 FNB uses an economic consultant to provide interest rate and GDP forecasts, upon which management bases all of their operational planning. The economist is currently projecting that interest rates will increase by 75 to 150 basis points during the next year. Though FNB is attempting to increase income from fees, the effort has had mixed results. A. Identify four objectives of the securities portfolio for a typical commercial bank.

For each objective, determine whether or not FNB’s securities portfolio is appropriately structured. If not appropriately structured, explain your decision with one reason.

(16 minutes)

Answer Part A in the template provided.

©2011 Kaplan, Inc.

Template for Part A.

Objectives of the Typical Commercial Bank’s Securities Portfolio

Structured Appropriately

for FNB? (circle one)

Justification

1.

Yes

No

2.

Yes

No

3.

Yes

No

4.

Yes

No

©2011 Kaplan, Inc.

B. In the template provided, determine the constraints portion of an Investment Policy Statement (IPS) for FNB.

(10 minutes)

Template for Part B.

Constraints For FNB

Time horizon

Liquidity

Legal / regulatory

Taxes

Unique circumstances

©2011 Kaplan, Inc.

QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES Douglas Paulson is evaluating the annual performance of two portfolio managers, Common Sense Investments (CSI) and Full House Managers (FHM). Both portfolios invest only in an S&P 500 Index fund and cash. Both managers followed their stated rebalancing strategy over the entire year, and there were no cash flows into or out of either portfolio. Tables 1 and 2 show the end-of-quarter, post-rebalancing market values for the two portfolios as well as the end-of-quarter values of the S&P 500. During the first quarter, the S&P went from 875 to 1,000, a gain of approximately 14.3%.

Table 1: CSI and S&P 500 Time

Period Portfolio Value

(End of Qtr) Stock Value After

Rebalancing S&P 500

Index Qtr 1 2,000,000 1,500,000 1000 Qtr 2 1,775,000 1,331,250 850 Qtr 3 1,908,125 1,431,094 935 Qtr 4 1,716,788 1,287,591 810

Table 2: FHM and S&P 500

Time Period

Portfolio Value (End of Qtr)

Stock Value After Rebalancing

S&P 500 Index

Qtr 1 2,000,000 1,500,000 1000 Qtr 2 1,775,000 1,230,000 850 Qtr 3 1,898,000 1,377,600 935 Qtr 4 1,713,815 1,156,578 810

Following his review of the CSI and FHM portfolios, Alex Beeman asks Paulson which rebalancing strategy would have been best over the year. Paulson states that "a buy and hold strategy (B/H) would probably have outperformed a constant proportion portfolio insurance (CPPI) strategy, but a concave strategy would have outperformed a convex strategy during the year.” Later that day Paulson tells Beeman, “Constant mix (CM) managers are contrarians because they actively bet against trending markets. In addition, following a strict CPPI strategy can be a very risky proposition in a down-trending market, as it would dictate selling equities until the portfolio reaches a zero floor value.”

©2011 Kaplan, Inc.

A. Identify the rebalancing strategy (B/H, CM, or CPPI) employed by Common Sense Investments and by Full House Managers. Provide one justification for each from the data provided in Tables 1 and 2.

(6 minutes)

B. Determine whether the rebalancing slope coefficients (m) employed by Common

Sense Investments and by Full House Managers are less than one (< 1), equal to one (= 1), or greater than one (> 1.0). Provide one justification for each from the data provided in Tables 1 and 2.

(6 minutes)

Answer Parts A and B in this template.

Fund Strategy (circle one) Justification

Slope Coeff.

(m) Justification

CSI

Buy/Hold

Constant Mix

CPPI

< 1

= 1

> 1

FHM

Buy/Hold

Constant Mix

CPPI

< 1

= 1

> 1

©2011 Kaplan, Inc.

C. Determine whether each of Paulson’s statements is correct or incorrect. If incorrect, justify with one reason.

(6 minutes)

Answer Part C in this template.

Statement Correct or incorrect

(circle one) Justification

"A buy and hold strategy (B/H) would probably have outperformed a constant proportion portfolio insurance (CPPI) strategy, but a concave strategy would have outperformed a convex strategy during the year.”

Correct

Incorrect

“Constant mix (CM) managers are contrarians because they actively bet against trending markets. In addition, following a strict CPPI strategy can be a very risky proposition in a down-trending market, as it would dictate selling equities until the portfolio reaches a zero floor value.”

Correct

Incorrect

©2011 Kaplan, Inc.

QUESTION 6 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12 MINUTES Otis Burg, CFA, is a consultant currently advising the investment committee of the Luther Manufacturing, Inc. pension plan. Burg has recommended to the committee that they consider adding an investment in real estate to their current portfolio. Currently, the Luther pension plan portfolio, with $60 million in assets, is invested 65% in stocks and 35% in fixed-income securities. Burg has presented a model to the committee comparing their current portfolio with his proposed portfolio (Exhibit 1 below). The proposed portfolio changes the asset allocation to 55% stocks, 30% bonds, and 15% real estate. The risk-free rate is 4%. Exhibit 1: Burg Model Current Portfolio Proposed Portfolio

Expected return 7.1% 8.0%

Expected standard deviation 12.1% 12.4% A. Based solely on the data in Exhibit 1, determine whether the investment

committee should accept Burg’s proposal, and justify your response with one supporting reason.

(3 minutes)

Answer Part A in this template.

Burg’s Proposal (circle one) Justification

Accept

Reject

©2011 Kaplan, Inc.

Burg suggests that the pension plan make direct investments in real estate as opposed to investing in real estate investment trusts (REITs). His preference for direct investment as opposed to REITs is based on his interpretation of the relative advantages of direct real estate investment. B. For each issue below, identify whether the issue is considered an advantage or

disadvantage of direct investment in real estate relative to investing in REITs, and justify your answer with one reason. i. Portfolio diversification. ii. Liquidity.

(6 minutes)

Answer Part B in this template.

Issue

Direct Investment vs. REITs

(circle one)

Justification

i. Portfolio diversification

Advantage

Disadvantage

ii. Liquidity Advantage

Disadvantage

©2011 Kaplan, Inc.

C. Determine whether the returns volatility indicated by the NCREIF index would be considered understated, correctly stated, or overstated relative to the true return volatility of direct real estate investment. If overstated or understated, justify your response with one reason.

(3 minutes)

Answer Part C in this template

Volatility (circle one) Justification

Understated

Correctly stated

Overstated

©2011 Kaplan, Inc.

QUESTION 7 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 15 MINUTES Martin Allan, CFO of a large retailing chain, is responsible for manager selection for the firm’s defined benefit plan. Allan is assessing the performance of an international portfolio manager. The manager in question invests in European stocks denominated in euros and in British stocks denominated in British pounds. Returns data are summarized in Table 1. Table 1: Data for the Allan Portfolio and its Benchmark Sector Weight Local Returns U.S. $ Returns

Portfolio Benchmark Portfolio Benchmark Portfolio Benchmark Euro 60% 40% 13.00% 15.00% 13.00% 15.00% U.K. 40% 60% 17.00% 14.00% 15.30% 12.60% Total 100% 100% 14.60% 14.40% 13.92% 13.56%

A. Calculate the portion of the portfolio’s total return that can be attributed to the

managers’ currency allocation decisions. Show your calculations. (3 minutes) Regarding performance attribution in general, Allan makes the following two statements: (1) “To determine the fund’s excess return over several periods, we compound the

fund’s single-period returns and compound the benchmark’s single-period returns. The difference between the two would be the total excess return attributable to active management.”

(2) “Calculating individual multi-period performance attributes, such as security

selection, are somewhat more complex because we cannot simply compound individual period figures for the attributes. Instead, there are two subtle impacts that must be considered in each period for each individual attribute. Using security selection as an example:

(i) The excess return attributable to security selection in Period One must be

compounded with the benchmark return in Period Two, and (ii) The excess return attributable to security selection in Period One must be

compounded with the portfolio value in the Period Two.”

©2011 Kaplan, Inc.

B. Determine whether each of Allan’s statements is correct or incorrect. If incorrect,

justify your decision with one reason.

(6 minutes) Answer Part B in this template.

Statement Correct or incorrect (circle one) Justification

“To determine the fund’s excess return over several periods, we compound the fund’s single-period returns and compound the benchmark’s single-period returns. The difference between the two would be the total excess return attributable to active management.”

Correct

Incorrect

(i) “The excess return attributable to security selection in Period One must be compounded with the benchmark return in Period Two, and

(ii) The excess return

attributable to security selection in Period One must be compounded with the portfolio value in the Period Two.”

Correct

Incorrect

©2011 Kaplan, Inc.

C. Allan is analyzing the performance of the Dayton Fixed Income Fund (Dayton). The data in Table 2 represent a sample of his analysis:

Table 2: Fixed Income Attribution for Dayton Dayton Benchmark Expected interest rate effect 1.24% 1.24% Unexpected interest rate effect 0.80% 0.80% Duration 0.40% 0.00% Convexity –0.13% 0.00% Yield curve shape change 0.12% 0.00% Sector/quality –0.03% 0.00% Bond selection 0.11% 0.00% Transactions costs 0.00% 0.00% Trading activity 0.26% 0.00% Total return 2.77% 2.04%

i. Determine the portion of the total return for Dayton that was beyond the control of

its portfolio managers over the period. Show your calculations.

(3 minutes)

ii. Dayton managers claim expertise in generating excess returns through duration and interest rate management. Determine whether the data in Table 2 support this claim. Support your decision with evidence from Table 2.

(3 minutes)

©2011 Kaplan, Inc.

QUESTION 8 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 13 MINUTES The Robins Portfolio Management firm invests the funds of small institutions and wealthy individuals. Two of their portfolio managers, Tori Goebel and Alex Meighan, use derivative contracts to hedge their bond and stock positions. Five-month S&P 500 futures contracts are trading at 1112.50, and the current level of the index is 1098.23. The multiplier for the contract is 250. The risk-free rate is 5.2%, and the beta of the futures contract is 1.04. A. Goebel has a portfolio of 270-day T-bills that is valued at $52.83 million.

Calculate the number of contracts that Goebel should use to create a synthetic equity position for a period of five months with risk similar to the futures index. Indicate whether Goebel should buy or sell the contracts.

(4 minutes)

©2011 Kaplan, Inc.

B. Meighan will receive $140 million in five months. He expects that the equity market will do well over the next five months and would like to take an equity position now in advance of receiving the funds. His desired equity beta is 1.20. Calculate the number of contracts he should use to accomplish this and indicate whether a long or short position is necessary.

(4 minutes)

©2011 Kaplan, Inc.

C. It is now one year later. Meighan eventually invested the $140 million in a portfolio of stocks. The portfolio has grown in value from $140 million to $150 million. Meighan would like to use a swap to hedge his equity portfolio, so he enters into a semiannual-pay, 1-year swap with a notional principal of $150,000,000. In the swap, the return on the index is exchanged for a fixed rate of 6.1% annually. The current level of the index is 1100. Describe the payment on the swap at the end of six months if the index is 1124 and indicate Meighan’s position in the swap.

(5 minutes)

©2011 Kaplan, Inc.

QUESTION 9 HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES Jackson and Jonnie Tumpter are 95 and 93 years old, respectively. They expect to spend $109,273 on living expenses in the next year, and they would like to maintain a real growth rate in annual spending of 3%. Their current portfolio contains $350,000 in bonds and cash and a $100,000 in diversified equities. The Tumpters contacted a local financial planner, Mike Pitts, CFA, to assist them in their planning, and Pitts has constructed the mortality table in Exhibit 1 below for the Tumpters. The Tumpters have agreed with Pitts that the table most likely represents their remaining time horizon. Average inflation over the 5-year period is estimated at 3% and the applicable nominal risk-free rate is 5%. Exhibit 1: Mortality Table for Jackson and Jonnie Tumpter

Yrs Jackson Jonnie Combined

Probability*

Desired Real

Spending Age Prob. Age Prob. 1 96 0.1032 94 0.1566 $109,2732 97 0.0673 95 0.1011 0.1616 $112,5513 98 0.0462 96 0.0828 0.1252 $115,9274 99 0.0280 97 0.0455 0.0722 $119,4055 100 0.0010 98 0.0100 0.0110 $122,987

* Combined probability has been deliberately left blank for year 1. Based solely on data provided: A. Calculate the core capital requirement for the Tumpters for their remaining time

horizon. Determine the maximum amount the Tumpters could gift to charity today (assume no tax effects associated with the gift to charity).

(15 minutes)

©2011 Kaplan, Inc.

B. Determine whether the Tumpters should give the maximum to charity at this

time. If you recommend against it, support your decision with one reason.

(3 minutes)