CFA Level III FOR AIMR USE ONLY

Essay Examination Book

2000 Morning Section

Candidate Number:
FOR AIMR USE ONLY

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Investment Management
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2000 Association for Investment Management and Research. All rights reserved.
The following list contains the command words used on the Morning Section of
the 2000 Level III examination. Candidates may want to refer to this list as they
formulate their answers.

calculate To ascertain or determine by mathematical processes.

compute To determine, especially by mathematical means.

contrast To compare in respect to differences.

critique To offer a critical review or commentary; to criticize.

describe To transmit a mental image, an impression, or an understanding of the

nature and characteristics of.
discuss To discourse about through reasoning or argument; to present in detail.

evaluate To determine or fix the value of; to determine the significance or worth of,
usually by careful appraisal and study.
explain To give the meaning or significance of; to provide an understanding of; to
give the reason for or cause of.
justify To prove or show to be valid, sound, or conforming to fact or reason; to
furnish grounds or evidence for.
select To choose from a number or groupusually, by fitness, excellence, or
other distinguishing feature.
state To express in words.
The Morning Section of the 2000 CFA Level III Examination has 21 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.

Question Topic Minutes

Item Set Book
112 Ethical & Professional Standards 36
Essay Book
13 Portfolio Management 20
14 Portfolio Management 12
15 Portfolio Management 12
16 Portfolio Management 12
17 Portfolio Management 22
18 Portfolio Management 16
19 Economics 20
20 Asset Valuation 16
21 Asset Valuation 14

Total: 180
Questions 13 through 15 relate to Robert Taylor. A total of 44 minutes is allocated to these
questions. First review the Introduction below and Exhibit 13-1 on page 3. Candidates
should answer these questions in the order presented.

Introduction

Robert Taylor, aged 50 and a U.S. resident, recently retired and received a $500,000 cash
payment. He also obtained $700,000 through the exercise of stock options. Both figures are net
of tax. Taylor is not entitled to a pension; however, his medical expenses are covered by
insurance paid for by his former employer. Taylor is in excellent health and has a normal life
expectancy.

Taylors wife died last year after a long illness, which resulted in devastating medical expenses.
All their investments, including a home, were liquidated to fully satisfy these medical expenses.

Taylor has no assets other than the $1,200,000 cash referenced above, and has no debts. He plans
to acquire a $300,000 home in three months and insists on paying cash given his recent adverse
experience with creditors. When presented with investment options, Taylor consistently selects
the most conservative alternative.

After settling into his new home, Taylors living expenses will be $2,000 per month and will rise
with inflation. He does not plan to work again.

Taylors father and his wifes parents died years ago. His mother, Renee, is 72 years old and in
excellent physical health. Her mental health, however, is deteriorating and she has relocated to a
long-term care facility. Renees expenses total $3,500 per month. Her monthly income is $1,500
from pensions. Her income and expenses will rise with inflation. She has no investments or
assets of value. Taylor, who has no siblings, must cover Renees income shortfall.

Taylor has one child, Troy. Troy and a friend need funds immediately for a start up business.
First year costs are estimated at $200,000. The partners have no assets and have been unable to
obtain outside financing. The friends family has offered to invest $100,000 in the business in
exchange for a minority equity stake if Taylor agrees to invest the same amount.

Taylor would like to assist Troy; however, he is concerned about the partners ability to succeed,
the potential loss of his funds, and whether his assets are sufficient to support his needs and to
support Renee. He plans to make a decision on this investment very soon. If he invests $100,000
in Troys business, he insists that this investment be excluded from any investment strategy
developed for his remaining funds.

With the above information, portfolio manager Sarah Wheeler prepared the investment policy
statement for Taylor shown in Exhibit 13-1.
 Exhibit 13-1
Robert Taylor Investment Policy Statement
Return Objective: Income requirement is $2,000 monthly.
Total return requirement is 2.7% annually ($24,000 / $900,000).
Risk Tolerance: Substantial asset base and low return requirement provide ample
resources to support an aggressive, growth-oriented portfolio.
Time Horizon: Client is 50 years old, recently retired, and in excellent health.
Time horizon exceeds 20 years.
Liquidity Needs: $300,000 is needed in three months for purchase of home.
Modest additional cash is needed for normal relocation costs.
$100,000 may be needed for possible investment in sons business.
A normal, ongoing cash reserve level should be established.
Tax: There is little need to defer income.
Mothers expenses may have an effect.
Legal and No special considerations exist.
Regulatory:
Unusual Client desires to support mother.
Circumstances: Client insists that any investment in sons business be excluded from
long term planning.
Client has strong aversion to debt.
QUESTION 13 HAS TWO PARTS FOR A TOTAL OF 20 MINUTES

A. Evaluate the appropriateness of Taylors investment policy statement in Exhibit 13-1

with regard to the following objectives:

i. Return Requirement
ii. Risk Tolerance

(12 minutes)

B. Evaluate the appropriateness of Taylors investment policy statement in Exhibit 13-1

with regard to the following constraints:

i. Time Horizon
ii. Liquidity Needs

(8 minutes)
QUESTION 14 HAS ONE PART FOR A TOTAL OF 12 MINUTES

After revising the investment policy statement and confirming it with Taylor, Wheeler is now
developing a long-term asset allocation strategy for him. Wheeler will use the following revised
information to recommend one of the allocations in Exhibit 14-1:

Taylor has decided to invest $100,000 in his sons business but still insists that this
investment be disregarded in making his allocation decision.
Taylors total cash flow needs have changed to $4,200 a month.
The available asset base is $800,000.
Wheeler estimates that the inflation rate will be 1 percent next year.
Taylor is determined to maintain the real value of his assets because he plans to set up
a charitable foundation in the future.
Taylor insists on taking no more risk than absolutely necessary to achieve his return
goals.

Exhibit 14-1
Potential Long Term Asset Allocation Strategies
Allocation Allocation Allocation Allocation
A B C D
Asset Class Weighting
Stocks 20% 40% 60% 80%
Bonds 75% 55% 35% 15%
Cash 5% 5% 5% 5%
Expected Annual
Return 6.7% 7.5% 8.2% 9.1%
Standard Deviation 9.0% 11.5% 15.3% 19.0%
Potential for
Asset Growth Very Low Low Moderate High
Income Growth Very Low Low Moderate High
Current Income High High Low Very Low
Stability Very High High Moderate Low

Select the allocation strategy from Exhibit 14-1 that is most appropriate for Taylor, and justify
your selection with two supporting reasons related to the revised information shown above.

(12 minutes)
QUESTION 15 HAS ONE PART FOR A TOTAL OF 12 MINUTES

After five years, Wheeler is reviewing whether Taylors investment policy statement is still
appropriate for his situation. She discovers that:

Taylors expenses have decreased significantly because of the death of his mother.
His net worth has tripled, largely because of profits realized from the sale of his investment
in his sons business.
Taylor now feels financially secure and plans to invest primarily to provide for future
charitable goals.
Taylor believes the only significant change to his cash flow needs during the next few
months will be a $100,000 gift to a charity.

Wheeler concludes that a revised investment policy statement is needed.

Discuss the effect of Taylors new circumstances on the following four components of his
investment policy statement. Your discussion should focus on the direction and magnitude of
change in each factor rather than on a specific numerical change.

i. Return Requirement
ii. Risk Tolerance
iii. Time Horizon
iv. Liquidity Needs

(12 minutes)
QUESTION 16 HAS ONE PART FOR A TOTAL OF 12 MINUTES

Wheeler has concluded her work with Taylor and is meeting with Don Sampson, a potential new
client. Sampson begins the meeting by outlining his investment philosophy as shown in Exhibit
16-1.

Exhibit 16-1
Don Sampsons Investment Philosophy
Statement
Number Statement
1 Investments should offer strong return potential but with very limited risk. I prefer to
be conservative and to minimize losses, even if I miss out on substantial growth
opportunities.
2 All non-governmental investments should be in industry-leading and financially
strong companies.
3 Income needs should be met entirely through interest income and cash dividends.
All equity securities held should pay cash dividends.
4 Investment decisions should be based primarily on consensus forecasts of general
economic conditions and company-specific growth.
5 If an investment falls below the purchase price, that security should be retained until
it returns to its original cost. Conversely, I prefer to take quick profits on successful
investments.
6 I will direct the purchase of investments, including derivative securities,
periodically. These aggressive investments result from personal research and may
not prove consistent with my investment policy. I have not kept records on the
performance of similar past investments, but I have had some big winners.

Select the statement from Exhibit 16-1 that best illustrates each of the following behavioral
finance concepts. Justify your selection.

i. Mental Accounting
ii. Overconfidence (illusion of control)
iii. Reference Dependence

Note: Candidates should not select any statement more than once.

(12 minutes)
QUESTION 17 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES

Walter Tobler is considering a substantial change in investment strategy for the portfolio he
manages. His supervisor has raised concerns about the measurement and management of the
increased risks to the portfolio that might result from such a change in strategy. In response to
those concerns, Tobler states:

Our approach to risk will not change. As we have done in the past, we will monitor both
variance of security returns and tracking error relative to our benchmark. I have looked at
additional risk measurement tools, in particular probability of shortfall and expected
shortfall, but I believe that these measures do not add value to our process.

A. Describe the calculation of each of the following four measures of risk:

i. Variance of security returns

ii. Tracking error relative to a benchmark
iii. Probability of shortfall
iv. Expected shortfall

(8 minutes)

B. Discuss one unique weakness for each of the following measures:

i. Variance of security returns

ii. Probability of shortfall
iii. Expected shortfall.

(6 minutes)

In response to further questions about whether his risk management system really captures the
riskiness inherent in financial markets, Tobler replies:

Fortunately, our entire approach to risk management is based on two well-supported

premises: Financial market returns are normally distributed, and financial market
correlations are essentially stable. These two basic conditions will serve to limit our risk
as we move to invest in new markets.

C. Critique each of Toblers two premises, using the template on page 37. State, for each
premise, one unique implication for Toblers approach to risk management.

Answer Question 17-C in the Template provided on page 37.

(8 minutes)
Template for Question 17-C
Premise Critique of Premise Unique Implication of Premise

Financial market
returns are normally
distributed.

Financial market
correlations are
essentially stable.
QUESTION 18 HAS FOUR PARTS FOR A TOTAL OF 16 MINUTES

Janice Delsing, a U.S.-based portfolio manager, manages an $800 million portfolio ($600 million
in stocks and $200 million in bonds). In reaction to anticipated short-term market events, Delsing
wishes to adjust the allocation to 50 percent stock and 50 percent bonds through the use of
futures. Her position will be held only until the time is right to restore the original asset
allocation. Delsing determines a financial futures-based asset allocation strategy is appropriate.
The stock futures index multiplier is 250 and the denomination of the bond futures contract is
$100,000. Other information relevant to a futures-based strategy is given in Exhibit 18-1.

Exhibit 18-1
Information for Futures-Based Strategy
Bond portfolio modified duration 5 years
Bond portfolio yield to maturity 7%
Basis Point Value (BPV) of bond futures $97.85
Stock Index Futures Price $1378
Stock Portfolio Beta 1.0

A. Describe the financial futures-based strategy needed and explain how the strategy allows
Delsing to implement her allocation adjustment. No calculations are necessary.

(4 minutes)

B. Compute the number of each of the following needed to implement Delsings asset
allocation strategy:

i. Bond futures contracts

ii. Stock index futures contracts

(4 minutes)

C. Discuss one advantage and one disadvantage of using each of the following for asset
allocation:

i. Financial futures
ii. Index put options

(4 minutes)
One month later, the yield to maturity on comparable bond portfolios has increased by 10 basis
points and the stock index has risen by $28.

D. Calculate the percentage return (from price changes only) for the past month, assuming:

i. Delsing executed the 50/50 asset allocation strategy using futures.

ii. Delsing did not execute the strategy but instead preserved her original long-term
asset allocation.

(4 minutes)
QUESTION 19 HAS THREE PARTS FOR A TOTAL OF 20 MINUTES

The Board of Directors of Evergreen Pension Fund asked consultant Whitney Hannah to review
two approaches to forecasting economic trends: econometric and consensus.

A. Discuss whether econometric approaches and consensus approaches to forecasting

economic trends are different or similar with respect to:

i. Role of historical data

ii. Number of analysts reflected in the forecast
iii. Nature of assumptions about future economic relationships

(6 minutes)

B. State and discuss whether econometric approaches or consensus approaches to

forecasting economic trends are more likely to be distorted by:

i. Group think
ii. Inability to test sensitivity
iii. Simultaneity
iv. Data mining

(8 minutes)

C. State and discuss whether econometric approaches or consensus approaches to

forecasting economic trends are more likely to reflect the following strengths:

i. Ability to identify turning points in trends

ii. Ease of construction
iii. Ability to capture multiple market influences

(6 minutes)
QUESTION 20 HAS ONE PART FOR A TOTAL OF 16 MINUTES

Kirby Anderson is reviewing the nature of the data used in constructing two U.S. real estate
indexes. One index, published by the National Association of Real Estate Investment Trusts
(NAREIT), measures the performance of equity real estate investment trusts. The other index,
published by the National Council of Real Estate Investment Fiduciaries (NCREIF), measures
the performance of commingled investment funds.

Anderson is convinced that the two indexes are comparable in terms of the types of real estate
properties, geographic distribution, and market capitalization.

Contrast the NAREIT and NCREIF indexes with respect to:

i. Source of underlying asset valuation
ii. Leverage (gearing) of underlying assets
iii. Index returns calculated before or after deduction of investment advisory fees
iv. Correlation with broad equity market (e.g., S&P 500 Index)

Answer Question 20 in the Template provided on page 55.

(16 minutes)
Template for Question 20
Characteristic NAREIT Index NCREIF Index

i. Source of
underlying asset
valuation

ii. Leverage
(gearing) of
underlying assets

iii. Index returns

calculated before
or after
deduction of
investment
advisory fees

iv. Correlation with

broad equity
market (e.g.,
S&P 500 Index)
QUESTION 21 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES

James Norwood, a fixed income portfolio manager, was recently hired to manage two U.S.
Treasury portfolios for HEY Corporation. These portfolios, shown in Exhibit 21-1, comprise
HEYs total investments. Norwood noticed that although the yields to maturity and modified
durations of the two portfolios were similar, the portfolios were structured differently.

Exhibit 21-1
Portfolio Characteristics
Characteristics Portfolio A Portfolio B

2-year maturity 0% 50%

10-year maturity 100% 0%
30-year maturity 0% 50%

Modified Duration 7.2 7.7

Yield to maturity 5.9% 5.8%

A. Select and justify the portfolio in Exhibit 21-1 that will provide the higher return in each
of the following scenarios (assume an initial yield curve that is upward sloping). No
calculations are necessary.

i. An upward parallel shift of 50 basis points in the yield curve.

ii. A twist in the slope of the yield curve. Two-year interest rates rise by 10 basis
points, while 30-year interest rates decline by 10 basis points.

(8 minutes)

One year has passed. Each investment portfolio now has a total market value of $200 million and
a modified duration of 7.2. HEYs liabilities now total $180 million and have a modified
duration of 6.

B. Calculate the effect on HEYs assets and liabilities if interest rates decline by 100 basis
points (ignore convexity). Show your calculations.

(6 minutes)
CFA Level III Examination
2000 Morning Section

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1. Write your candidate number in the spaces provided at the top left corner of the front cover
of this Essay Exam book and of the Item Set Exam book.

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