Reading 12 Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & FinQuiz.

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Simulations

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CFA Level II Item-set Solution
Study Session 3
June 2017

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Reading 12 Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & FinQuiz.com
Simulations

FinQuiz Level II 2017 Item-sets Solution

Reading 12: Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Tree & Simulation

1. Question ID: 48612

Correct Answer: B

B is correct. Because of the shifts in the market, Campbell has judged historical data to be unreliable.
Instead, he has decided to employ cross-sectional data. One of the potential issues which may be
encountered is that the real estate funds offered in the market may not be comparable to the three
shortlisted funds.

A is incorrect. An issue which is encountered when using historical data is that market shifts may
render the data unreliable. Campbell is not employing historical data.

C is incorrect. An issue with using statistical distributions is that the data may not precisely fit the
stringent requirements of a statistical distribution. Therefore, the distribution selected may only
approximate and not be close enough to the real distribution.

2. Question ID: 48613

Correct Answer: C

C is correct. The first stage of the simulation process involves determining probabilistic variables.
Although there is no limit on how the variables can be allowed to vary in a simulation, analysts
should focus their attention on a few variables that have a significant impact on value.

A is incorrect. While it is true that specifying probability distributions represents the most difficult
and crucial stage, this is the second stage of the simulation process.

B is incorrect. Checking for correlation across variables is done right after specifying probability
distributions (Step 2) and before the actual simulation is run (Step 3).

3. Question ID: 48614

Correct Answer: B

B is correct. Campbell will need to run the greatest number of simulations for the Alpha Fund as it
has the second highest number of probabilistic inputs and, in addition, has diversity in its
distributions. The required number of simulations will be lower where all the inputs have normal
distribution (Zone) than one is which some are based on statistical and some on normal, for example
(Vector and Alpha).

A is incorrect. Although the distributions for Vectors input variables are diverse, Campbell has
specified the lowest number of probabilistic inputs for this fund.

C is incorrect. Although Zone has the highest number of probabilistic inputs, the distributions of its
input variables are not as diversified as that of Alphas.

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Reading 12 Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & FinQuiz.com
Simulations

4. Question ID: 48615

Correct Answer: A

A is correct. Simulation is least appropriate for Vector. Simulations are better suited for continuous
risks. On the other hand, decision trees and scenario analysis are better suited for discrete outcomes.

B is incorrect. Simulation is appropriate for Alpha as the approach is better suited for continuous risks
and allows for the explicit modeling of correlations.

C is incorrect. Simulation is appropriate for Zone as the approach is better suited for continuous risks
and can be used when the correlations across variables (risks) are independent.

5. Question ID: 48616

Correct Answer: B

B is correct. Since Campbell is basing his decision on the variability in simulated values, he will be
assuming that all of the risks built into simulations are solely relevant for the investment decision. In
effect, he will be ignoring the line between the risks which could have been diversified away
(nonsystematic risk) and asset-specific risk. In other words, he may be rejecting a fund which has a
high standard deviation in simulated values, even though much of the risk can be diversified when
the fund holdings are allocated to client portfolios.

A is incorrect. The values derived from simulation represent expected cash flows and are not risk-
adjusted.

C is incorrect. Since Campbell is making his selection of the real estate fund solely based on
standard deviation in simulated values, he is not penalizing the unsuitable funds for risk on two
counts. Had Campbell rejected Alpha and Zone based on their risk-adjusted discount rates in
addition to volatility in simulated values, he would have been penalizing the funds twice for their
risk.

6. Question ID: 48617

Correct Answer: C

The factor outlined by Campbell in his research report represents an earnings and cash flow
constraint. The constraint is internally imposed and managers will want to avoid the possibility of
failing to meet performance expectations and missing out on being awarded an incentives
compensation.

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