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The afternoon session of the 2019 Level III Chartered Financial Analyst Mock ®
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions Topic Minutes
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2 2019 Level III Mock Exam PM
C is correct. Zefferman states that the firm is responsible for putting clients’ interests
above the firm’s when appropriate. The General Principles of Conduct embedded in the
six components of the Asset Manager Code state that managers have the responsibility
of acting for the benefit of clients. The code does not stipulate that this responsibility is
applicable only when appropriate.
A is incorrect because the principles reflected in the statement are correct.
B is incorrect because the principles reflected in the statement are correct.
C European
3 Which of Mehta’s client service policies is consistent with the Asset Manager
Code of Professional Conduct?
A Types of disclosures
B Communication timing
C Marketing material reviews
C is correct. Section D, Risk Management, Compliance, and Support, of the Asset Manager
Code states that portfolio information provided to clients should be reviewed by an
independent third party. The compliance department would be considered an inde-
pendent third party because compliance is not involved with compiling or presenting
the information to clients. According to Section F, Disclosures, disclosures should be
truthful, accurate, complete, and understandable. It is unlikely that clients would easily
understand complicated calculations. Section F, Disclosures, also calls for communications
with clients to be on an ongoing and timely basis. Communication with clients only when
they ask for it would not be consistent with the Asset Manager Code. It is recommended
that communication be at least on a quarterly basis.
A is incorrect because according to Section F, Disclosures, disclosures should be
truthful, accurate, complete, and understandable. It is unlikely that clients would easily
understand complicated calculations.
B is incorrect because Section F, Disclosures, calls for communications with clients to be
on an ongoing and timely basis. Annual communication would not be considered timely.
A is correct. Section B(6)(b), Investment Process and Actions, requires clients to be treated
equitably, not equally. Clients have different investment objectives and risk tolerances,
so treating clients equally would be inconsistent with the Asset Manager Code.
B is incorrect because the policy is consistent with the Asset Manager Code.
C is incorrect because the policy is consistent with the Asset Manager Code.
A is correct. Section E, Performance and Valuation, of the Asset Manager Code calls for
the use of fair market values sourced by third parties when available, and when such
third-party prices are not available, the code calls for the use of “good faith” methods
to determine fair value. Athena’s policy appears consistent with this requirement. In
terms of client reporting, monthly valuation reports would be consistent with the call
for timely reporting.
B is incorrect because Gilchrist’s valuation methodology using fair value and third-
party valuers is consistent with the Asset Manager Code.
C is incorrect because Gilchrist’s monthly valuation reports to clients would be con-
sidered consistent with the Asset Manager Code.
B is incorrect because Wilson’s recommendation for disclosing the firm’s risk manage-
ment process goes beyond the Code recommendations to disclose the risk management
process to just clients, not to regulators. Wilson recommends they disclose to both.
C is incorrect because Wilson’s recommendation regarding the business continuity
plan did not include the recommended action of having a plan to contact and commu-
nicate with clients during a period of extended disruption.
During the meeting, fellow adviser Liam Roche makes the following observation
based on the information in Exhibit 1: “Mr. Donnelly should respond favorably to
education focused on how the investment program affects financial security, retire-
ment planning, and future generations. However, Ms. Connor and Mr. O'Driscoll will
respond better to education on portfolio metrics, such as the Sharpe Ratio.”
2019 Level III Mock Exam PM 7
7 Benefits of the recent changes to Emerald’s client assessment process least likely
include:
A improving Emerald’s client retention metrics.
B reducing portfolio risk.
C closer adherence to client expectations.
B is correct. Incorporating behavioral finance does not have a direct impact on portfolio
risk. In some cases, this approach will help encourage a reduction in portfolio risk, but
it may also help other clients to take on more risk as appropriate. Investing as the client
expects and improvements to client retention metrics are both benefits of incorporating
behavioral finance.
A is incorrect. Improving the advisory practice is a likely benefit of incorporating
behavioral finance.
8 2019 Level III Mock Exam PM
8 Roche’s observation regarding client education is least likely accurate for which
client?
A Kyra Conner
B Alan O’Driscoll
C Michael Donnelly
A is correct. Both Conner and Donnelly are exhibiting emotional biases. When advising
emotionally biased investors, advisers should focus on explaining how the investment
program being created affects such issues as financial security, retirement, or future
generations rather than focusing on quantitative details. The recommendation for Conner
would be more suited for a cognitively biased investor. O’Driscoll is a cognitively biased
investor (friendly follower). As such, focusing on such metrics as the Sharpe Ratio would
be appropriate for this client.
B is incorrect. O’Driscoll is a cognitive investor, so focusing on metrics such as the
Sharpe ratio would be appropriate for this client.
C is incorrect. Donnelly is an emotional investor, and this approach is appropriate.
C is correct. Donnelly is entrepreneurial and created his own wealth. He lacks spending
controls, does not believe in the benefits of portfolio diversification, has a high risk
tolerance, and prefers high-risk investments recommended by friends. These are all
attributes of an active accumulator.
A is incorrect. Independent individualists have a medium to high risk tolerance
whereas Donnelly has a very high risk tolerance. While some of the traits are similar,
active accumulator more closely describes this client.
B is incorrect. Friendly followers have a low to medium risk tolerance whereas Donnelly
has a very high risk tolerance
A gambler’s fallacy.
B self-attribution bias.
C illusion of control bias.
C is correct. The illusion of control bias can be encouraged by complex models. The
illusion of control can lead to analysts being overly confident when forecasting complex
patterns, such as future interest rate movements.
B is incorrect. With self-attribution bias, analysts take personal credit for successes
and attribute failures to external factors outside of their control. There is no evidence
that Kelly is suffering from this bias.
A is incorrect. The gambler’s fallacy is a misunderstanding of probabilities in which
analysts wrongly project reversal to a long-term mean. This bias is caused by a faulty
understanding of random events and expecting patterns to repeat. While Kelly is
expecting rates to increase to historical averages, she is basing this on output from the
macro-model.
11 Which of the following biases least likely provides behavioral support for the
factor being added to the stock selection model?
A Framing
B Hindsight
C Availability
A is correct. Framing bias is a type of cognitive error in which a person answers a question
differently based on the way in which it is asked. This behavior is unlikely to explain the
persistence of momentum. Regret is a type of hindsight bias that can result in investors
purchasing securities after a significant run-up in price because of a fear of not partici-
pating. This bias could explain momentum. With availability bias, also referred to as the
recency effect, the tendency to recall recent events more vividly can result in investors
extrapolating recent price gains into the future. This bias could also explain momentum.
B is incorrect. Regret is a type of hindsight bias that can result in investors purchasing
securities after a significant run-up in price due to fear of not participating. This could
explain momentum.
C is incorrect. With availability bias, also referred to as the recency effect, the tendency
to recall recent events more vividly can result in investors extrapolating recent price
gains into the future. This could explain momentum.
■■ Kasey was named the beneficiary of Bryn’s taxable account and two tax advan-
taged retirement accounts.
■■ Weshvia, Izlandia and Landlochen all use the euro, and none of the three tax
regimes impose any tax consequences on spousal transfers either before or after
death.
As they begin their meeting, Kasey first asks Buylak if any of the provisions of the
life insurance policy or dispositions of the investment properties might be challenged
in the probate process.
Kasey mentions to Buylak that she is aware that a large part of her wealth now
depends on the investment property in Landlochen and asks Buylak what cash flow
would be available to her annually after taxes from its lease income and what after-
tax cash proceeds might she obtain if the property was sold when the current lease
expires. Buylak had been prepared for these questions and her responses were based
on the following:
■■ The investment real estate property in Landlochen had a cost basis of
€2,900,000, a present market value of €3,000,000, and it produces income of
€450,000 (pre-tax) annually through a lease agreement that expires in five years.
By this time, the property will have been owned for seven years.
■■ After reviewing several reports analyzing Landlochen real estate values, Buylak
estimates that the property could be sold at the termination of the lease for 30%
above its present market value.
■■ The tax structure in Landlochen differs from Kasey’s home country Weshvia as
shown in Exhibit 1. Fortunately, there is a provision for some relief from double
taxation. Weshvia allows use of the deduction method with regard to income
taxes and the credit method toward capital gains.
Based on her calculations for the cash flows from the Landlochen investment
property, Buylak recommends that the three inherited investment accounts be held
for the next 12 years with all earnings and gains reinvested. In anticipation of another
after-tax cash flow question, she estimates the accrual equivalent after-tax rate of
return on the portfolio of combined accounts over the next 12-year period using the
information in Exhibit 2.
12 2019 Level III Mock Exam PM
Exhibit 2
A. Kasey McLoughlin’s Inherited Investment Portfolio
Taxable Tax Deferred Tax Exempt
Bryn’s father died about a year after Bryn, creating additional life insurance pro-
ceeds paid to Paolo’s trust from the second policy. In considering how investments
in the trust portfolio should be changed, Buylak first reviews the trust’s Investment
Policy Statement (IPS) and notes the following objectives and constraints:
■■ an expected 3.5% real, after-tax return
■■ a worst-case portfolio decline should not exceed 9% in nominal returns in any
year. Downside risk is to be measured as two standard deviations below the
expected return
■■ at least 10% of the portfolio is to be dedicated to cash and cash equivalents
which should be sufficient to meet liquidity needs.
Buylak develops the three proposed portfolios presented in Exhibit 3 which she
believes are in keeping with the trust’s IPS.
13 If Paolo had predeceased Bryn, the life insurance proceeds would most likely
have been paid to:
A Bryn.
B Kasey.
C the University of Izlandia.
2019 Level III Mock Exam PM 13
C is correct. The trust was irrevocable so neither Bryn (while alive) nor his wife would
have a claim on any of its assets including the life insurance policy or its proceeds. Had
Paolo predeceased Bryn, the proceeds of the life insurance policy would have been paid
to the remainderman on Bryn’s death, i.e., to the University of Izlandia.
A and B are incorrect. The trust was irrevocable so neither Bryn (while alive) nor his
wife had a claim on its assets including the life insurance property.
14 Buylak’s best response to which of the items might be challenged in the probate
process is the:
A Izlandia distribution center.
B proceeds of the life insurance.
C Landlochen distribution center.
A is correct. Probate is the legal process to confirm the validity of the will so that exec-
utors, heirs, and other interested parties can rely on its authenticity. Only the Izlandia
distribution center changes ownership through a provision of the will. Joint ownership
with right of survivorship automatically transfers to the surviving joint owner (Kasey).
Death benefit proceeds under a life insurance contract pass directly to policy beneficiaries
outside the probate process.
B is incorrect. Probate only deals with property that remains in the estate: Death
benefit proceeds under a life insurance contract pass directly to policy beneficiaries
outside the probate process.
C is incorrect. Probate only deals with property that remains in the estate: Joint own-
ership with right of survivorship includes a provision to transfer the deceased share [of
the Landlochen distribution center] to the surviving joint owner (Kasey).
15 Using Exhibit 1, the annual amount of after-tax cash flow that Kasey will earn
on the Landlochen property lease is closest to:
A €175,875.
B €219,375.
C €292,500.
B is correct. In each year, the tax rate under the deduction method will be:
TResidence + T Source(1 – TResidence)
which here is (0.25) + 0.35(1 – 0.25) = 0.5125
14 2019 Level III Mock Exam PM
This is the combined tax rate net of tax relief via the deduction method.
Kasey’s after-tax annual cash flow is €450,000 × (1 – 0.5125) = €219,375.
A is incorrect. The mistake is in including the annual wealth tax in annual cash flow; it is
not payable until the end of the five-year period: 219,375 – (0.015 × 2,900,000) = 175,875
C is incorrect. The mistake is applying the credit method, which uses the higher tax
rate alone: 450,000 × (1 – 0.35) = 292,500
B is correct. After applying 30% appreciation, the 1.5% per year wealth tax, and the
two capital gains taxes (local source Landlochen and residential Weshvia while applying
the credit method), the net proceeds are €3,345,500 calculated as follows:
The two-step calculation of capital gains tax under the credit method is equivalent to:
TCredit Method = Max(T Source, TResidence) = Max(20%, 25%) = 25%,
Giving a capital gains tax of (3,900,000 – 2,900,000) – 0.25 = €250,000
C is incorrect. It calculates the capital gain on the difference between current market
value (3,000,000) instead of the original cost (2.9 million) and the 3,900,000
A is incorrect. It omits the gains tax credit from the residence country. Applies the
full 0.25 capital gains rate from Weshvia thereby skipping the credit for Landlochen
gains taxes.
17 Using Exhibit 2, the accrual equivalent after tax annual return that Buylak cal-
culates for Kasey’s investment portfolio is closest to:
A 7.35%.
B 7.45%.
C 7.58%.
Taxable 1,200,000
Returns taxed annually 0.12 BV[1 + 0.12(1 – 0.28)]12 3,243,832
at 28%
Tax Deferred 700,000 0.075 BV(1 + 0.075)12 × (1 –
Net of 40% Distribution 0.40)
Tax 1,000,347
= 1,667,245 × (1 – 0.40)
Tax Exempt 180,000 0.11 BV(1+0.11)12 629,721
Combined Ending Value 4,873,900
Combined Beginning Value 2,080,000
Accrual Equivalent After-Tax Annual Return = (4,873,900/2,080,000)1/12 – 1 = 0.0735 = 7.35%
16 2019 Level III Mock Exam PM
B is incorrect. It takes a weighted average of the after-tax return rates where the
weights come from the values in each account type. This method is an invalid short-cut.
{(1,200/2,080) × [12 × (1 – 0.28)]} + [(700/2,080) × 7.50 × (1 – 0.40)] +
[(180/2,080) × 11.0]= 7.45
C is incorrect. It omits the annual taxation of income in the taxable account.
Taxable 1,200,000
Returns taxed annually 0.12 BV(1 + 0.12)12 × (1 – 0.28) 3,366,123
at 28% (tax arises only at end)
Tax Deferred 700,000 0.075 BV(1 + 0.075)12 × (1 – 0.40)
Net of 40% Distribution = 1,667,245 × (1 – 0.40) 1,000,347
Tax
Tax Exempt 180,000 0.11 BV(1 + 0.11)12 629,721
Combined Ending Value 4,996,192
Combined Beginning Value 2,080,000
Accrual Equivalent Annual Return = (4,996,192/2,080,000)1/12 – 1= 0.0758 = 7.58%
18 Of the portfolios presented in Exhibit 3, the choice that is most consistent with
the trust’s IPS is:
A portfolio X.
B portfolio Y.
C portfolio Z.
A is correct. All portfolios meet the real after-tax return requirement and liquidity con-
straints but only portfolio X meets the worse-case return constraint, as shown in the
table below which adds the Sharpe ratio and worst-case return data to the information
in Exhibit 3. Both portfolio X and Z have the same expected real after-tax total returns
and portfolio Z has the highest Sharpe ratio but Z does not meet the worse-case return
constraint. Portfolio Y has the highest real after-tax return but the lowest Sharpe ratio
and does not meet the worse-case return constraint.
(Continued)
Worst-case return = Downside risk = Expected nominal total return – 2 standard deviations.
For example, for portfolio X: 10.6 – (2 × 9.67) = –8.74.
All portfolios meet the IPSs liquidity constraint.
B is incorrect. Portfolio Y has the highest nominal and real after-tax returns, but has
both a lower Sharpe ratio and does not meet the worst-case return constraint.
C is incorrect. Portfolio X and Z have the same real after-tax returns and the same
Sharpe ratio, but portfolio Z violates the worst-case return constraint making X the best
choice.
Intercept 0.082
%ΔK 0.725
%ΔL 0.382
Given that the region tends to suffer frequent periods of currency instability and
that most of the firms are state controlled, Ronan discusses with her co-workers
Curtis Chadwick and Earl Johns the relative merits of using the H-model and another
suggested model, the Gordon model. They make the following comments:
Chadwick: A Gordon growth model analysis would produce a nominal rate, which
would be more stable than a real rate.
Johns: The currency instability should not affect the results from using either
the H-model or the Gordon growth model.
Ronan: I am still concerned about the state-controlled firms having an incen-
tive to overstate productivity, which could affect both models.
Chadwick then shares with his co-workers an analysis he is performing on the equity
market for a more developed country, Brungaria. Ronan suggests using the Fed model
to determine whether Brungaria’s equity market is correctly valued. Chadwick consid-
ers the Fed model after collecting the economic and market data shown in Exhibit 3.
Chadwick is concerned that Brungaria might not be developed enough for the
Fed model to apply, so he uses a market-level version of an “equity q” to evaluate the
Brungarian equity market. He calculates the equity q to be 0.775 using asset book val-
ues and current market data. He then discusses his calculation with Ronan and Johns:
Ronan: The equity q tends to react quickly to changes in the market and can
be very volatile.
Johns: Chadwick’s calculation may be overstated because the replacement
costs for the assets may be higher than their book values.
Chadwick: Although the measure may be overstated, the equity q is lower than
1.0 in either case, implying that the market is overvalued.
A intercept and coefficients for %ΔK and %ΔL sum to greater than one.
B coefficients for %ΔK and %ΔL sum to greater than one.
C intercept is less than one.
B is correct. For the constant returns to scale assumption to be valid, the coefficients
for %ΔK and %ΔL must sum to one. That is, a given percentage increase in capital stock
and labor input must result in an equal percentage increase in output. Because the
coefficients for %ΔK and %ΔL sum to greater than one, the constant returns to scale
assumption is violated.
The Cobb–Douglas function can be expressed as follows:
∆Y ∆A ∆K ∆L
≈ +α + (1 − α)
Y A K L
where Y is GDP, A is total factor productivity (TFP), K is capital, and L is labor.
Consequently, regressing the percentage change in GDP (%ΔGDP = ΔY/Y) against the
percentage changes in capital stock (%ΔK = ΔK/K) and labor (%ΔL = ΔL/L) means TFP is
the intercept for the regression, β1 = α, and β2 = (1 – α):
%ΔGDP = intercept + β1 × %ΔK + β2 × %ΔL
A is incorrect. The sum of the intercept and the coefficients for %ΔK and %ΔL can sum
to more than one and be consistent with the assumption of constant returns to scale as
long as the coefficients for %ΔK and %ΔL sum to one.
C is incorrect. The intercept being less than one does not violate the constant returns
to scale assumption.
20 Based on Ronan’s assumptions about the growth in capital stock and labor input
as well as the regression output in Exhibit 1, which Cobb–Douglas production
function input most likely has the greatest effect on %ΔGDP?
A Total factor productivity
B Labor
C Capital stock
A is correct. Based on the regression in Exhibit 1 and the assumed percentage changes
in capital stock (4%) and labor (10%) inputs, the Cobb–Douglas production results in an
expected growth in GDP of 14.9% as follows:
21 Compared with Ronan’s H-model estimation of the EQXX index, using her
assumptions and the data in Exhibit 2, the current index level is most likely:
A too high.
B appropriate.
C too low.
A is correct. The estimated value of the index based on the H-model is 749.92 (see the
following calculation), which is less than the current index level of 765.88. This disparity
implies that the current index level is too high.
D0 N
V0 = (1 + g L ) + (g S − g L )
r − gL 2
40.32 30
= (1 + 0.0395) + (0.072 − 0.0395)
0.1216 − 0.0395 2
= 749.92
where
C is incorrect. It uses gS in the denominator of the first term instead of gL. This will
produce an index level above the current index level, which incorrectly implies that the
current index level is too low.
40.32 30
(1 + 0.0395) + (0.072 − 0.0395) = 1, 241.30
0.1216 − 0.072 2
22 In their discussion of the relative merits of the H-model and Gordon model,
who provides the most accurate comment?
A Ronan
B Johns
C Chadwick
23 Based on the Fed model and data in Exhibit 3, Brungaria’s equity market is most
likely:
A fairly valued.
B overvalued.
C undervalued.
C is correct. The Fed model hypothesizes that, in equilibrium, the yield on long-term
treasury securities should equal the forward earnings yield. In this case, the Fed model
considers the equity market to be undervalued because the forward earnings yield
(5.25%) exceeds the long-term government treasury yield (4.67%).
A is incorrect. It uses short-term plus inflation, equaling forward earnings yield, so
based on the Fed model, the Brungaria equity market is fairly valued.
B is incorrect. It uses the justified forward earnings yield instead of forward earnings
yield, so based on the Fed model, the Brungaria equity market is under-valued.
24 Who made the most accurate statement concerning the equity q for Brungaria’s
equity market?
A Johns
B Chadwick
C Ronan
A is correct. Johns’ statement is the most accurate. Given his assertion that the replace-
ment value of assets may be higher than their book values, the equity q calculated by
Chadwick may be overestimated because he used the book value of assets instead of
the replacement value of assets in the calculation’s denominator.
B is incorrect. Chadwick is incorrect. An equity q below one indicates that the market
is under-valued.
C is incorrect. Ronan is incorrect. The equity q can persist at high and low levels for
extended periods of time.
■■ The anticipated positions would not have any associated income or liquidity
requirements.
■■ The cost of any hedging strategies used should be minimized and not materially
affect the otherwise unhedged asset return.
In regard to the anticipated currency movements related to the Spanish packaging
company investment, Fournier told Testa that HNW was forecasting that the euro
was likely to appreciate against the US dollar in the next six months.
Testa agreed with HNW’s assessment of the future course of the USD/EUR
exchange rate. His conclusion was derived from assessing various analysts’ reports
and was centered on the following three reasons:
1 real interest rates were higher in euro-based countries,
2 the potential default of several euro-based countries from their excessive debt
loads would lead to strong support measures from the IMF and the European
Central Bank, and
3 the US balance of trade deficit with euro-based countries had continued to
decline in the past several years and was expected to continue to decline.
The Spanish investment involved Testa acquiring 200,000 shares of a packaging
company at EUR90 per share. He decided to fully hedge the position with a six-
month USD/EUR forward contract. Details of the euro hedge at initiation and three
months later are provided in Exhibit 1. Three months after the purchase, the shares
had increased to EUR100 each, but Testa, believing that a still higher price was likely,
maintained the position. He also indicated that he did not anticipate having to roll the
hedge forward at its maturity. Both he and Fournier believed that further appreciation
of the euro was quite likely, and the increase in the notional size of the position was
hedged using currency options. They based their choices on the information provided
in Exhibit 2.
■■ NDFs have greater credit risk associated with them than outright forward con-
tracts because the central banks in most developing countries are not as strong
as they are in developed countries, and
■■ the pricing of NDFs may differ from what is expected on the basis of arbitrage
conditions.
In 2015, Testa informed Fournier that he had taken large positions in both a New
Zealand firm and an Australian packaging firm. The positions were roughly equal in
size in terms of the US dollar. Fournier informed Testa that the correlation between
USD/AUD and USD/NZD was approximately 0.85. Given the size of the positions,
Testa indicated that he wished to minimize any foreign exchange exposure.
25 In terms of the objectives and constraints that were incorporated into Testa’s
IPS, the one that best explains the initial euro exposure of the Spanish invest-
ment in 2009 is the one related to his:
A risk aversion.
B return objective.
C liquidity constraint.
B is correct. The main goal of Testa’s investment program is the realization of returns
based on his perceived superior ability to discover merger and acquisition targets. The
position was fully hedged even though both he and his adviser believed that the euro
was likely to appreciate over the investment horizon; there was no attempt to exploit
that belief either with futures or options (although the use of options was restricted to
strong market views at the time of rebalancing of an already winning position).
A is incorrect. Testa is not overly risk averse; his main focus is on the return generated
from his investment process.
C is incorrect. Testa’s investment program did not impose any liquidity or income
needs on the position.
26 Which of Testa’s reasons for the future course of the USD/EUR exchange rate in
2009 is most consistent with HNW’s assessment?
A Reason 1
B Reason 2
C Reason 3
A is correct. HNW’s assessment was that the euro was likely to appreciate against the US
dollar within the next six months. Reason 1, higher real rates in euro-based countries,
is consistent with an appreciation of the euro. Higher euro rates will attract “foreign”
investors and drive up demand for the euro as they acquire those investments.
B is incorrect. Reason 2, the potential default of several euro-based countries from
their excessive debt loads, would result in a lower foreign risk premium (i.e., the US dollar
would be less risky) and should lead to a depreciation of the euro.
2019 Level III Mock Exam PM 25
C is incorrect. Reason 3, a decline in the US trade deficit (i.e., net exports), means that
for the United States, imports decreased relative to exports, resulting in lower demand
for the euro, and it should weaken relative to the US dollar.
27 Using Exhibit 1, if the Spanish shares had been sold after three months, the
cash outflow (in US dollars) required to close out the forward contract would
have been closest to:
A 489,182.
B 489,850.
C 491,400.
B is correct. The initial foreign asset position was EUR18 million: 200,000 shares × EUR90/
share. The six-month forward contract would have been sold using the bid of the base
currency (euro) at an all-in forward rate of 1.3935 – 19/10,000 = 1.3916 USD/EUR.
If the position had been closed in three months, a three-month forward contract
would have to be purchased at the offer of the base currency at an all-in forward rate of
1.4210 – 21/10,000 = 1.4189 USD/EUR.
The cash outflow at settlement would have been EUR18 million × (1.4189 – 1.3916)
USD/EUR = USD491,400. This amount needs to be discounted by three months at the
US dollar Libor rate: 491,400/(1 + 0.01266 × 90/360) = USD489,850.
A is incorrect. The euro Libor rate is used to discount the settlement cash flow: 491,400/
(1 + 0.01814 × 90/360) = USD489,182.
C is incorrect. It uses the settlement cash flow, ignoring any discounting: USD491,400.
28 If the 2009 forward hedge had been rolled forward at its maturity, using
Exhibit 1, the roll yield would most likely have been:
A negative, but the currency change made it less negative.
B positive, but the currency change reduced some of this effect.
C negative, and the currency change made it even more negative.
C is correct. In implementing the hedge, euros (the base currency) must be sold against
the US dollar. The base currency is selling at a discount and thus would “roll up the
curve” as the contract approaches maturity. Settlement of the forward contract would
entail buying euros at a higher price—that is, selling low and buying high—resulting in
a negative roll yield. Since the euro has appreciated by the time the hedge needs to be
extended, this tends to further increase the cost of euros to settle the original contract
and makes the roll yield even more negative—that is, sell low, buy even higher.
26 2019 Level III Mock Exam PM
B is correct. Fournier’s statement regarding credit risk is incorrect. The credit risk does
not relate to the central bank of the developing country but, rather, the counterparty
risk faced in the contract. The credit risk underlying an NDF is lower than an outright
forward contract since the notional size of the contract is not exchanged at settlement,
but only the non-controlled currency amount by which the notional size of the controlled
currency has changed over the life of the contract—that is, the change in the controlled
currency times the notional size converted to the non-controlled currency at the spot
rate on the settlement date.
A is incorrect. Fournier’s statement regarding pricing of NDFs is correct. When capital
controls exist, the free cross-border flow of capital that ensures the arbitrage condition
underlying covered interest rate parity does not function consistently, and so the pricing
of NDFs may differ from what is expected under arbitrage conditions.
C is incorrect. Fournier’s statement regarding settlement of NDFs is correct. Non-
deliverable forwards exist in situations involving capital controls on one of the currencies.
The controlled currency cannot be physically settled (i.e., not delivered or received), but
instead it is cash settled in the non-controlled currency.
30 The most appropriate hedging strategy for the 2015 positions, in keeping with
Testa’s wishes, is based on a:
A direct hedge on each currency separately.
B cross-hedge of the two currencies in the portfolio.
C minimum-variance hedge of the two currencies in the portfolio.
A is correct. A direct hedge on each currency is the most appropriate strategy for the
long positions in the Australian and New Zealand dollar. The high correlation between
the currencies does not help here because the investor will be using forward contracts
to sell both of these currencies. The high correlation between the currencies could have
been exploited with a cross-hedge or a minimum-variance hedge if one of the foreign
assets was held long and the other short.
B is incorrect. The high correlation between the currencies could have been exploited
with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held
long and the other short.
2019 Level III Mock Exam PM 27
C is incorrect. The high correlation between the currencies could have been exploited
with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held
long and the other short. Although a minimum hedge portfolio can be constructed
without simultaneous long and short positions, the greatest risk reduction (which Testa
desires) would arise if that were to occur.
McDown expresses concern about the timing of the credit cycle as it relates to
constructing a corporate bond portfolio for CCHC. Larent explains that she uses a
bottom-up approach to determine which corporate bonds offer the best relative value
should the credit cycle deteriorate. Larent then provides the data in Exhibit 2 for three
corporate bonds in which the holding period is assumed to be one year.
28 2019 Level III Mock Exam PM
Larent explains that another approach to portfolio construction is top down. She
says, “I believe that global economic conditions are going to improve. Credit portfolios
that are overweight lower-quality bonds in industry sectors that are highly correlated
with the economic cycle, such as industrial metals, will likely outperform a global
benchmark. We can use effective duration to assess the impact of a likely steepening
in the yield curve. Within credit rating categories, we can underweight longer-maturity
bonds given my expectation that the relatively wide spread curve will flatten.”
Ronane asks Larent to discuss the factors that CCHC should consider before
investing in the bonds of international companies. Larent replies that the international
bond universe consists of companies that are located in both developed markets and
emerging markets. In term of factors to consider, Larent states that a company’s credit
ratings are independent from the sovereign rating of its domicile and that bankruptcy
laws apply equally to all investors of any particular company’s bond issuances. Larent
adds that being able to accurately predict credit cycles is important because of regional
differences across the global credit universe.
McDown asks whether structured financial instruments should be considered
for CCHC’s portfolio. Larent replies yes and states, “The credit cycle is expected to
improve. For purposes of diversification, both collateralized debt obligations (CDOs)
and their underlying corporate bonds should be included in the portfolio. AA rated
CDOs currently offer significant relative value for long-term investors as the yield
spread reflects a BB default rate expectation for the underlying collateral. Moreover,
the value of the senior tranches should increase by more than the value of the mez-
zanine tranches since default correlations are expected to increase.”
31 With respect to investment-grade bonds, Larent is most likely correct with
respect to which risk consideration?
A Credit risk
B Spread risk
C Interest rate risk
B is correct. Bond B is most likely callable because of the difference between its option-
adjusted spread (OAS) and its Z-spread. The Z-spread is the yield spread that must be
added to each point of the implied spot yield curve in order for the present value of the
bond’s cash flows to equal its market price. The OAS considers the value of optionality
in a bond’s cash flows. The theoretical value of a callable bond is less than that for an
otherwise equivalent non-callable bond because of the value of the call option (the
issuer’s right to retire the bond prior to maturity) being sold by the investor. The OAS
is the constant spread that when added to all the one-period forward rates makes the
arbitrage-free value of the bond equal to its market price.
A is incorrect because Bond A is likely a non-callable bond because its Z-spread and
OAS are equal.
C is incorrect because Bond C is likely a non-callable bond because its Z-spread and
OAS are equal.
33 The bond in Exhibit 2 with the best relative value is most likely:
A Bond D.
B Bond E.
C Bond F.
A is correct. Bond D has the best relative value; its expected excess return (EXR) has
the smallest loss given the expectation that credit spreads are going to widen by 25
bps (the change in the Z-spread). The expected excess return calculation is as follows:
EXR = (s × t) – (∆s × SD) – (t – p – L)
where
s = Z-spread
t = Holding period
SD = Spread duration
p = Probability of default
L = Loss severity
Calculations are as follows:
30 2019 Level III Mock Exam PM
C is correct. Larent’s comment about credit portfolios that are overweight lower-quality
bonds likely outperforming a global benchmark whenever global economic conditions
improve is correct.
A is incorrect. Effective duration is used to measure the impact of a parallel change
in the yield curve, not a steepening in the yield curve.
B is incorrect. With respect to the spread curve, overweighting shorter-maturity
bonds and underweighting longer-maturity bonds is not optimal whenever there is an
expectation that a relatively wide spread curve will flatten. When a wide spread curve
flattens, the yields of longer-maturity bonds decline by a magnitude that is greater
than the magnitude of changes (up or down) in the yields of shorter-maturity bonds.
Accordingly, the optimal portfolio construction strategy is to be underweight shorter-
maturity bonds and overweight longer-maturity bonds.
C is correct. Determining the timing and location of credit cycle weakening is an import-
ant top-down relative value consideration for global credit portfolio managers. Regional
differences exist in credit cycles, credit quality, sector composition, and market factors.
2019 Level III Mock Exam PM 31
A is incorrect. The ratings of emerging market debt issuers are typically concentrated
in the low-investment-grade/high-non-investment-grade range, which reflect the sover-
eign ratings of the countries in which they are domiciled. Rating agencies typically apply
a “sovereign ceiling” to corporate debt issuers, implying that any debt issuer is normally
rated no higher than the sovereign rating of its domicile.
B is incorrect. Global differences in regulations and laws, such as bankruptcy laws,
are a source of risk for investors in international bonds. Non-domestic investors of a
particular company’s bond issuances face contractual rights that are less certain than
those for domestic investors in the event of debt restructurings.
A is correct. Laurent’s statement about relative value is correct. CDOs are securities whose
underlying cash flows are the interest and principal of the underlying debt instruments
that are pledged as collateral. Whenever the value of a CDO is different from the value
of its underlying collateral (in this example, the CDO value is lower as implied by the BB
rating of its underlying debt instruments), an arbitrage opportunity exists. In this example,
the trade opportunity is to (1) short (alternatively, purchase credit default swaps on) the
underlying bonds and (2) purchase the undervalued CDO.
B is incorrect because the collateral for a CDO consists of its underlying corporate
bonds. Accordingly, there is no diversification benefit.
C is incorrect because the mezzanine tranche of a CDO increases by more than the
senior tranche whenever correlations increase.
Strategy 1: “Riding the yield curve enables me to benefit from coupon income as
well as capital gains over a particular horizon. This strategy pays off in an
upward-sloping, static yield curve scenario. As time passes, bonds in the
portfolio will roll down and can be sold at a lower yield than when they
were purchased.
Strategy 2: If we expect the yield curve to be static, we take advantage of a carry
trade. For instance, we may borrow in yen and invest in US Treasuries,
since rates in Japan are lower than in the United States. We can profit
from the interest rate differential, higher bond prices, and a favorable
exchange rate.
Strategy 3: Bullet and barbell strategies are effective in positioning portfolios to
benefit from shifts in the yield curve, regardless of whether the change is
a parallel change, a flattening, or a steepening. For example, let’s assume
that there are two potential positions we can take. The first is to own an
intermediate-term bond, whereas the second is to own a very short-
maturity bond and a very long-maturity bond. If the curve steepens, the
barbell position will outperform the bullet position.”
Kalani asks Akamu how important convexity is in a total return context. Akamu
replies, “A strategy I use frequently to generate excess total returns is to alter con-
vexity in the portfolios. The positions I take typically involve the use of options and
are dependent on my view of interest rate volatility. If I expect future volatility to be
lower than the current volatility in options, then I will either sell a call on the bonds
I own or sell a put on bonds I would like to own. I can also sell convexity by buying
mortgage-backed securities (MBSs).”
Akamu has a view that the yield curve will flatten over the next month and wants
to implement a butterfly trade to establish a position that will benefit if his view
materializes. Kalani prepares the list of securities in Exhibit 1 she believes could be
used to implement his trade.
Akamu then tells Kalani that there is a group of portfolios managed against the
same benchmark but with varying partial durations. He asks her to stress test the
portfolios against various changes to the slope of the yield curve. Kalani uses the
data in Exhibit 2 for her analysis and chooses one curve scenario to demonstrate her
results to Akamu.
2019 Level III Mock Exam PM 33
Akamu then asks Kalani to evaluate the expected return of a German bund yield
curve trade over a one-year horizon. The bond has a 2.50% coupon and a EUR100
par issue, matures in two years, and has a current market price of EUR100.25. In one
year, Akamu expects to sell the bond for EUR101.40 and convert the proceeds to US
dollars at a foreign exchange loss of 0.25%.
37 Akamu is least likely correct with regard to which yield curve strategy?
A Strategy 1
B Strategy 2
C Strategy 3
C is correct. Akamu’s comment in Strategy 3 is incorrect. If the curve steepens, the bar-
bell position will underperform the bullet position, given the position of bonds along
the curve. In a steepening, the short- and intermediate-term bonds will maintain/gain
value from flat/lower rates while long-maturity bonds will lose value from rising rates.
Strategies 1 and 2 are described accurately.
A and B are incorrect because Strategy 1 and Strategy 2 are correct.
38 Is Akamu most likely correct with regard to how he alters convexity in his
portfolios?
A Yes.
B No, he is incorrect regarding buying MBSs.
C No, he is incorrect regarding selling options.
A is correct. Akamu can sell convexity by selling a call on the bonds he owns or selling a
put on bonds he would like to own. The option premium received would augment the
yield of the portfolio. The selling lowers convexity in the portfolio, which is acceptable
if he expects future volatility to be lower than that reflected in current option prices.
Buying MBSs also provides an option-writing opportunity, in this case selling a prepay-
ment option to homeowners.
B is incorrect because buying MBSs is a way to sell convexity.
C is incorrect because selling options is a way to sell convexity.
C is correct. Akamu has a view that the yield curve will flatten, so an overweight to the
long end would benefit the most. He wants to establish a butterfly trade to protect the
portfolio from parallel shifts. The butterfly trade consists of a long (short) barbell and a
short (long) bullet. In this case, the best trade is a long barbell and a short bullet. Akamu
uses the US Treasury two-year futures contract for the front end of the barbell and a long-
duration receive-fixed swap to complete the barbell. He would short the intermediate
pay-fixed swap in an equal money duration amount to offset the long position.
A is incorrect because this is the reverse of the correct trade. This is short a barbell
and long a bullet.
B is incorrect because a receiver swaption is a long intermediate position, rather than
short. Security A should be long, and E is a bearish not bullish position in the long end.
40 Given the yield curve shift and other data in Exhibit 2, which portfolio would
most likely outperform the benchmark?
A Portfolio A
B Portfolio B
C Portfolio C
2019 Level III Mock Exam PM 35
A is correct. All three portfolios have the same total duration but varying partial
durations. The PVBP overweights/underweights would determine how each performs
relative to the benchmark. Portfolio A is overweight the 10 partial PVBP and, given that
this is where yields are expected to fall, would benefit relative to the benchmark. It is
also underweight short and long maturities where rates are expected to rise. Portfolio
B is a barbell and would fare the worst versus the benchmark. Portfolio C is positioned
for a flattening of the yield curve particularly in the long end, where most of the rise is
expected. The change in portfolio value is calculated as follows:
Predicted change = Portfolio par amount × Partial PVBP × (–Curve shift)
Actual changes are provided below to more precisely illustrate actual changes.
10 20
Total 1 year 3 year 5 year year year 30 year
41 What mix of bonds from Exhibit 3 would Akamu most likely swap into to profit
from his view? He would buy:
A 39% of 2 year and 61% of 30 year.
B 66% of 2 year and 34% of 30 year.
C 50% of 2 year and 50% of 30 year.
A is correct. Given that Akamu is uncertain regarding the direction of interest rates—that
is, they could rise or fall—the best strategy is to increase the portfolio’s convexity while
maintaining the same duration to meet client guidelines. The proportion of bonds to
sell and buy is given by:
C is incorrect because it equal weights the securities, falling short of the duration
target as well as the convexity offered by the combination in A.
42 The expected return for the horizon on the German bund trade Akamu asks
Kalani to evaluate is closest to:
A 1.99%.
B 3.39%.
C 3.64%.
B is correct. The horizon return is equal to the yield income plus the roll-down return,
which when combined equals the rolling yield, plus the FX return. In this case,
Coupon Sell price − Market price
+ ± FX gain/loss
Market price Market price
analysis in a manner in which the originally reported data exist as a lagged factor until
the revised data become available. This approach differentiates XTZZ from funds that
use only the “clean” data, which ignore the initially reported data values.
Next, Leeter describes the investment approach of the Kopernicus Fund. Kopernicus
makes extensive use of market data to support its primary focus—pairs trading
between industry peers. Statistical techniques identify two securities that have been
highly correlated with each other in the past. If the price relationship between a pair
diverges, Kopernicus expects mean reversion over a few days or weeks and places
long–short positions accordingly to take advantage of the divergence.
Leeter then uses a firm-generated brochure (Exhibit 1) to inform Clickman about
some other potential funds that may interest him.
Altitude Funds Uses the 12-month forward price-to-earnings ratio (P/E) over
the forecasted earnings per share (EPS) to select stocks.
Pioneer Funds Compares a company P/E with an industry average P/E in
order to invest in firms that are under-priced.
Regulas Funds Invests in a combination of global equity securities from 5–10
different countries. Portfolio weights are adjusted to take
advantage of companies that appear to have the best near-
term growth prospects.
Leeter states that although Altitude Funds and Pioneer Funds both use P/Es in
their strategies, both funds incorporate a growth strategy.
Clickman asks Leeter how Regulas Funds determines its equity selections. Leeter
says that Regulas uses monthly data from non-traditional, but measurable, sources
to determine the influence of customer and government attitudes toward a firm and
its products. Leeter also notes that Regulas compares its performance relative to an
equity benchmark customized to its strategy and that the factors tend to be more
volatile than traditional market factors. He also states that the fund does tend to suffer
in performance when exchange rates are volatile.
Clickman then asks Leeter how he should determine the style of the funds he
is considering. Leeter responds, “The best way to determine the style of the funds
is to perform a returns-based analysis by regressing the past returns on the funds
against the past returns on a number of style indexes to determine which styles are
most prevalent within each fund. Unfortunately, this method tends to not be as easy
to perform as holdings-based analysis. However, returns-based analysis allows for a
deeper level of analysis relative to holdings-based analysis.”
43 Which of Leeter’s statements concerning the quantitative approach to active
management is most accurate?
A Statement 1
B Statement 2
C Statement 3
38 2019 Level III Mock Exam PM
A is correct. XTZZ’s approach prevents the use of “revised” government data that are not
known when the data are initially reported. By not incorporating revised government
data until they are actually revealed, XTZZ reduces look-ahead bias.
B is incorrect. Survivorship bias occurs when analysis on past data ignores firms that
have ceased to exist at some point during the analysis period.
C is incorrect. Model overfitting occurs when the model fits the past data by finding
a pre-conceived relationship (i.e., making the model specifications biased toward the
pre-conceived relationship) or when the model is biased toward patterns that are specific
only to the past data.
45 Which risk management method is the Kopernicus Fund most likely to use to
offset the primary risk of its strategy?
A Proper identification of the pairs
B Frequent use of stop-loss order rules
C Extensive analysis of the limit order book
B is correct. The biggest risk in pairs trading is that the observed price divergence is not
temporary and could be due to structural reasons. Frequent use of stop-loss rules, which
are set to exit trades when a loss limit is reached, addresses this risk.
A is incorrect. Although proper identification of the pairs to be used is critical to the
success of this statistical arbitrage strategy, the selection process alone does nothing to
address the risk that changes in fundamentals between the companies in the pair may
occur, thereby extending (or eliminating) price convergence.
2019 Level III Mock Exam PM 39
C is incorrect. Using the limit order book to identify pairs pricing anomalies implies a
very short time frame—as brief as a few milliseconds—and focuses on high-frequency
trading. Kopernicus lets trades play out for days or weeks; therefore, using the limit
order book will not help it.
46 Using Exhibit 1, Leeter’s statement about Altitude Funds and Pioneer Funds is
most likely:
A correct.
B incorrect in regard to Altitude Funds.
C incorrect in regard to Pioneer Funds.
C is correct. The statement is incorrect in regard to Pioneer Funds but is correct in regard
to Altitude Funds. Pioneer Funds uses a relative value strategy (i.e., seeks under-priced
securities relative to an industry value benchmark) that has no aspects of a growth strat-
egy. Altitude Funds uses a hybrid of value strategies (use of P/E) and growth strategies
(use of forward EPS) known as GARP (growth at a reasonable price).
A is incorrect. The statement is incorrect in regard to Pioneer Funds but is correct
in regard to Altitude Funds. Pioneer Funds uses a relative value strategy (i.e., seeks
under-priced securities relative to an industry value benchmark) that has no aspects of
a growth strategy.
B is incorrect. The statement is incorrect in regard to Pioneer Funds but is correct in
regard to Altitude Funds. Altitude Funds uses a hybrid of value strategies (use of P/E) and
growth strategies (use of forward EPS) known as GARP (growth at a reasonable price).
47 Using Exhibit 1 and the equity selection process of Regulas Funds, the strategy
will most likely benefit from:
A a portfolio overlay.
B a new benchmark.
C using annual rebalancing.
A is correct. Regulas Funds will benefit from a portfolio overlay of derivative securities
to eliminate exchange rate risk.
B is incorrect. Regulas uses a custom benchmark that is already appropriate for its
strategy.
C is incorrect. Annual rebalancing is too infrequent given the volatile nature of the
factors used by Regulas.
In order to implement the new investments in private equity and hedge funds,
Bohmer has hired Andre Gorges, an independent consultant with expertise in these
areas. During their first meeting, Gorges explains to Bohmer, “Although different terms
may be used, private equity funds and hedge funds have similar fee structures. You
will be charged a fixed management fee, likely 1%–2%, and fund managers will receive
an incentive fee that is typically 10%–20% of any positive returns earned by the fund;
2019 Level III Mock Exam PM 41
however, the incentive fee may be based only on returns in excess of a minimum or
hurdle rate of return. Hedge funds often include a clawback provision that requires
managers to return incentive fees if the fund loses value in future years.”
Bohmer tells Gorges she is curious about the differences between venture and buy-
out funds. Gorges replies, “Buyout funds invest in established companies that produce
and sell goods and services in established markets, whereas venture funds invest in
new companies that produce more innovative products in less developed markets.
This means p ortfolio companies in buyout f unds are able to produce p ositive c ash
flow sooner than those in venture funds, which is a benefit. However, buyout funds
can add to their risk profile through their use of leverage, whereas venture funds do
not use leverage. Because the companies they invest in are younger and have simpler
business structures, it is easier for venture funds to value their portfolio companies
than it is for buyout funds.”
The discussion moves from private equity to hedge funds and managed futures.
Bohmer asks Gorges to compare managed futures programs and hedge funds. Gorges
replies, “There are many similarities, and managed futures are sometimes classified as
a type of hedge fund. Like hedge funds, managed futures are absolute return strategies
designed to produce positive returns regardless of market conditions. However, unlike
hedge funds, managed futures are available to investors only as separately managed
accounts, whereas hedge funds are generally structured as limited partnerships.”
Bohmer tells Gorges she is not sure how to go about selecting specific hedge funds
in which to invest. Gorges mentions that, despite the fees, it might be useful for
Kootenay to invest in a fund of funds because of the benefits they provide to investors
as compared to investing in individual hedge funds.
Bohmer tells Gorges, “In my review of hedge fund performance measurement
for the last two decades, I’ve read of results that seem almost too good to be true.
However, I know from that review that there are a number of potential problems with
the ways in which that performance has been measured. There are three issues that
concern me about hedge fund index performance:
Issue 1: Fund returns are often subject to stale price bias.
Issue 2: Historical fund ‘performance’ is presented by applying the fund’s strat-
egy during a period of time prior to when actual investments were made
by the fund manager.
Issue 3: Indexes include only those funds that survived long enough to meet the
requirements for inclusion in the index, rather than all funds available to
investors during the time period examined.”
49 Which of the three goals is the new allocation to private equity most likely able
to meet?
A Goal 1
B Goal 2
C Goal 3
A is correct. Private equity funds, both venture and buyout, require long-term invest-
ments and do not provide returns of capital or earnings to investors for many years,
so adding private equity does not provide increased current income from interest and
dividends relative to debt and equity index funds. Further, the returns to private equity
have relatively high correlations with publicly traded equity; therefore, diversification
benefits for a portfolio with a high allocation to equity are likely to be modest. Private
42 2019 Level III Mock Exam PM
equity is best able to improve portfolio returns, as a reward for taking on illiquidity and
higher risk relative to seasoned public equity or fixed income and for making a longer-
term commitment of capital.
B is incorrect because private equity has moderately high correlations with publicly
traded equity, especially publicly traded micro-cap shares, so the diversification benefits
for a portfolio with a high equity allocation are likely to be modest.
C is incorrect because private equity makes long investments in equity securities, and
the Kootenay portfolio already has a substantial exposure to long equity.
C is correct. It is true that managed futures programs, like most hedge funds, are designed
to produce positive returns regardless of market conditions (e.g., absolute return strate-
gies); however, it is incorrect that managed futures programs are available to investors
only as separately managed accounts, because limited partnerships are available as
private commodity pools run by commodity pool operators (CPOs).
A is incorrect because Gorges is incorrect in his assertion that managed futures are
available only through separately managed accounts.
B is incorrect because Gorges is correct that managed futures are designed as abso-
lute return strategies.
C is incorrect because the fund of funds’ access to desirable closed hedge funds would
be valuable to the Kootenay portfolio.
54 Of the problems with hedge fund indexes Bohmer describes, she is least likely
correct regarding:
A Issue 1.
B Issue 2.
C Issue 3.
A is correct. Although private equity valuations often rely on appraisals rather than
market prices, most hedge fund strategies involve traded securities for which market
prices are available. Although prices can be somewhat stale in some markets, this is no
more true for hedge funds than for other assets. There is little evidence of stale price
bias in hedge fund index returns.
B is incorrect because backfill bias—that is, applying returns that “would have been
earned” by following a strategy before it was followed—is a substantial concern for
hedge fund indexes. The bias occurs because only strategies that would have worked
historically are adopted.
C is incorrect because survivorship bias—including the returns of only those funds
that survived long enough to meet requirements for inclusion—shifts returns upward
by not including the returns of funds that failed quickly.
Exhibit 1 (Continued)
Composite
Gross Benchmark Internal Assets
Return Return Dispersion Number of ($ Firm Assets
Year (%) (%) (%) Portfolios millions) ($ millions)
2010 11 10 5.2 45 225 300
2011 20 20 4.7 50 250 350
WCM has prepared this report in compliance with the Global Investment Performance Standards
(GIPS). The US Large-Cap Equity Composite has been independently verified by a qualified third
party to be GIPS compliant. The verification report was issued only for the composite and not for
WCM. It states that during 2009, 2010, and 2011, WCM complied with all composite construction
requirements for the composite and that WCM policies are designed to calculate and present per-
formance in compliance with GIPS standards.
Notes:
1 The firm is defined as an independent investment manager that invests exclusively
in US large-cap, US mid-cap, and US small-cap equity securities for US resi-
dent clients. WCM’s policy for valuing portfolios and calculating performance is
available upon request. WCM’s calculation methodology is to use time-weighted
rates of return. Subperiod rates of return are geometrically linked. Cash equivalent
instruments are included in rate-of-return calculations. Returns are calculated
quarterly or when large external cash flows (as defined by WCM) take place.
2 The US Large-Cap Equity Composite includes all actual fee-paying portfolios. Each
portfolio contains positions in large-cap stocks, which are selected by WCM after
an extensive independent analysis. Non-discretionary portfolios are not included
in any composite. WCM does not include in any composite its large-cap model
portfolio, which is used during the investment selection process.
3 The composite benchmark is the S&P 500 Index, which represents the size-
weighted returns of the 500 largest (as measured by market capitalization) US-
based publicly traded companies.
4 Gross-of-fees returns are presented before investment management fees but after
trading expenses, which include custodial fees. All clients pay an investment
management flat fee of 75 basis points on the month-end account value plus a
10-basis-point performance fee whenever the composite return exceeds the bench-
mark return by 100 basis points.
5 Internal dispersion is the equal-weighted standard deviation of the annual gross
returns of the five portfolios included in WCM’s US Large-Cap Equity Composite.
McGourn asks Walter why he uses standard deviation as the measure of inter-
nal dispersion and whether there are better dispersion measures. Walter responds,
“Standard deviation has the advantage of comparability across investment firms.
Other measures, such as the high/low range and the interquartile range, are skewed
by outliers.”
Finally, McGourn asks Walter about WCM’s investment valuation policies. Walter
states that WCM uses a valuation hierarchy based on items 1 through 4 as follows:
46 2019 Level III Mock Exam PM
A is correct. For GIPS compliance, a single verification report must be issued with respect
to the whole firm. Verification cannot be carried out only on a composite and, accord-
ingly, does not provide assurance about the investment performance of any specific
composite. The Standards stress that firms must not state or imply that a particular
composite has been “verified.”
B is incorrect.
C is incorrect. The minimum initial period for which verification can be performed is
one year, or from the firm’s inception date through the period-end if that timeframe is
less than one year. The standards recommend (but do not require) that verification cover
all periods for which the firm claims compliance.
A is correct. WCM’s return calculation is not GIPS compliant. GIPS standards require that
returns be calculated on a monthly basis for periods beginning on or after 1 January 2001.
B is incorrect. WCM’s calculation of returns when a large external cash flow takes
place is GIPS compliant.
C is incorrect. WCM is GIPS compliant. GIPS require geometrically linking of subperiod
returns which is done.
57 Is WCM most likely compliant with GIPS standards required for composite
construction as disclosed in Note 2?
A Yes.
B No, because of how the large-cap model portfolio is treated.
C No, because of how non-discretionary portfolios are treated.
A is correct. The composite consists of all actual fee-paying portfolios that are managed
on a discretionary basis. It is therefore in compliance with GIPS standards.
B is incorrect because WCM does comply with GIPS standards with respect to non-
discretionary portfolios since their performance results are not included in any composite.
C is incorrect because WCM does comply with GIPS standards with respect to its
utilization of the model portfolio since its performance results are not included in any
composite.
58 With respect to gross-of-fees returns, Note 4 is least likely compliant with GIPS
required standards in its treatment of:
A month-end account value.
B trading expenses.
C performance fees.
B is correct. Walter is correct about the high–low range, which is skewed by outliers. He
is also correct that the standard deviation allows for comparability across investment
firms. He is incorrect, however, about the interquartile range. Because this measure
includes only the middle 50% of portfolio returns, thus excluding extreme observations,
it is not affected by outliers.
48 2019 Level III Mock Exam PM
A is incorrect.
C is incorrect.