L3 mock sample exam CFA level III guideline answers 2000

LEVEL III, QUESTION 13
Topic:
Minutes:

Portfolio Management
20

Reading References:
1.
“Individual Investors,” Ch. 3, Ronald W. Kaiser, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren,
Gorham & Lamont, 1990)
2.
Cases in Portfolio Management, John W. Peavy III and Katrina F. Sherrerd (AIMR,
1990)
A. “Introduction”
B. “The Allen Family (A)”: Case p. 15, Guideline Answers p. 58
C. “The Allen Family (B)”: Case p. 18, Guideline Answers p. 62
3.
Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination
(AIMR)
4.
Question 1, including Guideline Answer, 1997 CFA Level III Examination (AIMR)
5.
Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR)
Purpose:
To test the candidate’s ability to evaluate an investment policy statement for an individual with
changing resources and return needs over time and to address specific liquidity and income needs
and unique circumstances.
LOS: The candidate should be able to
“Individual Investors” (Session 8)

• analyze the objectives and constraints of an individual investor and use this information to
formulate an appropriate investment policy by taking into consideration the investor’s
psychological characteristics, positions in the life cycle, long-term goals, liquidity
constraints, taxes, gifts, and estate planning.
“Cases in Portfolio Management” (Session 8)
• apply the readings in this Study Session to create an investment policy statement for an
individual investor.
“Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8)
• prepare an investment policy statement that clearly states the investment objectives and
constraints for an individual investor;
• justify all recommendations and statements included in an investment policy statement;
• criticize an investment policy statement and identify key investment constraints and
objectives not included in the statement.
“Question 1, including Guideline Answer, 1997 CFA Level III Examination” (Session 8)
• analyze the objectives and constraints of an individual investor and formulate an appropriate
set of investment policies, taking into consideration the investor’s psychological
characteristics, position in the life cycle, and long term goals;
• criticize an investment policy and determine the appropriateness of the policy given the
client’s goals and constraints.
“Question 1, including Guideline Answer, 1997 CFA Level III Examination” (Session 8)
• prepare and justify a well-organized investment policy statement;
2000 Level III Guideline Answers
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•

criticize an investment policy statement and judge whether the policy statement will meet the
stated goal of the client.

Guideline Answer:
A. i.

The return ob
•
•
•
•

•

Although Wheeler accurately indicates Taylor’s personal income requirement, she
does not recognize the need to support Renee.
Wheeler does not indicate the need to protect Taylor’s purchasing power by
increasing income by at least the rate of inflation over time.
Wheeler does not indicate the impact of income taxes on the return requirement.
Wheeler calculates required return based on assets of $900,000, appropriately
excluding Taylor’s imminent $300,000 liquidity need (house purchase) from
investable funds. However, Taylor may invest $100,000 in his son’s business. If he
does, Taylor insists this asset be excluded from his plan. In that eventuality, Taylor’s
asset base for purposes of Wheeler’s analysis would be $800,000.
Assuming a $900,000 capital base, Wheeler’s total return estimate of 2.7 percent is
lower than the actual required after-tax real return of 5.3 percent ($48,000 /
$900,000).

ii. The risk tolerance section of the IPS is inappropriate.
• Wheeler fails to consider Taylor’s willingness to assume risk as exemplified by his
aversion to loss, his consistent preference for conservative investments, his adverse
experience with creditors, and his desire not to work again.
• Wheeler fails to consider Taylor’s ability to assume risk, which is based on Taylor’s

recent life changes, the size of his capital base, high personal expenses versus income,
and expenses related to his mother’s care.
• Wheeler’s policy statement implies that Taylor has a greater willingness and ability to
accept volatility (higher risk tolerance) than is actually the case. Based on Taylor’s
need for an after-tax return of 5.3 percent, a balanced approach with both a fixed
income and growth component is more appropriate than an aggressive growth
strategy.
B. i.

The time hor
•
•
•
•

Wheeler accurately addresses the long-term time horizon based only on Taylor’s age
and life expectancy.
Wheeler fails to consider that Taylor’s investment time horizon is multi-staged.
Stage one represents the life expectancy of Renee, during which time Taylor will
supplement her income.
Stage two begins at Renee’s death, concluding Taylor’s need to supplement her
income, and ends with Taylor’s death.

ii. The liquidity section of the IPS is appropriate because Wheeler fully discloses all
potential liquidity needs.

2000 Level III Guideline Answers
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LEVEL III, QUESTION 14
Topic:
Minutes:

Portfolio Management
12

Reading References:
1.
“Individual Investors,” Ch. 3, Ronald W. Kaiser, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren,
Gorham & Lamont, 1990)
2.
Question 1 and 2, including Guideline Answers, 1995 CFA Level III Examination
(AIMR)
3.
Question 1, including Guideline Answers, 1996 CFA Level III Examination (AIMR)
Purpose:
To test the candidate’s ability to select a low risk allocation given higher return alternatives and
justify the appropriateness of that selection.
LOS: The candidate should be able to
“Individual Investors” (Session 8)
• create an asset allocation policy for an individual investor that is based on a multi-asset, total
return approach.
“Question 1 and 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8)
• recommend and justify an asset allocation.
“Question 1, including Guideline Answers, 1996 CFA Level III Examination” (Session 8)
• recommend and justify an asset allocation and clearly state any assumptions made that
contributed to the recommendation, especially the risk tolerance of the client.

Guideline Answer:
Allocation B is most appropriate for Taylor. Taylor’s nominal annual return requirement is 6.3%
based upon his cash flow (income) needs ($50,400 annually) to be generated from a current asset
base of $800,000. After adjusting for expected annual inflation of 1%, the real return
requirement becomes 7.3%. That is, to have $808,000 ($800,000 × 1.01), the portfolio must
generate $58,400 ($50,400 + $8,000) in the first year, and $58,400 / $800,000 = 7.3%.
Allocation B meets Taylor’s minimum return requirement. Of the possible allocations that
provide the required minimum real return, Allocation B also has the lowest standard deviation of
returns (i.e. least volatility risk), and by far the best Sharpe ratio. In addition, Allocation B
offers a balance of high current income and stability with moderate growth prospects.
Allocation A has the lowest standard deviation and best Sharpe ratio, but does not meet the
minimum return requirement, when inflation is included in that requirement. Allocation A also
has very low growth prospects.
Allocation C meets the minimum return requirement and has moderate growth prospects but has
a higher risk level (standard deviation) and a lower Sharpe ratio, and less potential for stability
than Allocation B.
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Allocation D also meets the minimum return requirement and has high growth prospects but has
the highest standard deviation and lowest Sharpe ratio of the allocations that provide the required
minimum real return.
Thus, of the three allocations meeting the minimum return requirement, Allocation B presents
the lowest level of risk as indicated by its lower expected standard deviation. Given Taylor’s
stated desire to assume “no more risk than absolutely necessary” to achieve his return goals,
Allocation B is the appropriate selection.

2000 Level III Guideline Answers
Morning Section – Page 4

LEVEL III, QUESTION 15
Topic:
Minutes:

Portfolio Management
12

Reading References:
Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L. Maginn and Donald
L. Tuttle, eds. (Warren, Gorham & Lamont, 1990)
A.
“Individual Investors,” Ch. 3, Ronald W. Kaiser
B.
“Monitoring and Rebalancing the Portfolio,” Ch. 13, pp. 13-4 through 13-8, Robert D.
Arnott and Robert M. Lovell Jr.
Purpose:
To test the candidate’s ability to assess how changing client circumstances and preferences affect
ongoing investment policies.
LOS: The candidate should be able to
“Individual Investors” (Session 8)
• analyze the objectives and constraints of an individual investor and use this information to
formulate an appropriate investment policy by taking into consideration the investor’s
psychological characteristics, positions in the life cycle, long-term goals, liquidity
constraints, taxes, gifts, and estate planning.
“Monitoring and Rebalancing the Portfolio” (Session 10)
• determine whether changed asset risk and return conditions require a portfolio to be
rebalanced;
• appraise the need to rebalance under altered client circumstances, including changes in

wealth, time horizon, liquidity requirements, tax treatment, and regulatory environment.

Guideline Answer:
The monitoring and rebalancing actions of a portfolio manager in the portfolio management
process can be brought into play by circumstances such as changed investor goals, resources or
constraints, changed capital market expectations, or the inclusion of new asset classes. Wheeler
has reason to believe Taylor’s new circumstances will affect the following four components of
his investment policy statement.
i. Return Requirement. Taylor’s asset base is now three times its original level, while his cash
flow needs have dropped substantially. His annual return requirement has therefore dropped
considerably; for example, if his cash flow needs have declined by 50% and his asset base
has tripled, then his minimum nominal return requirement has fallen to one-sixth of its
previous level, and his real return requirement has also decreased commensurately.
ii. Risk Tolerance. Taylor’s willingness to assume risk has apparently risen substantially, given
his new feelings of financial security. His plan to reorient his investments to provide for
future charitable goals may further indicate his willingness to assume additional risk in his
portfolio.

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Taylor’s ability to assume risk, which was already average to above average, has likely risen
materially as well, because his asset base has grown and his cash flow needs have decreased.
The increases in both his willingness and ability to assume risk point to a resulting
substantial increase in his overall risk tolerance.
iii. Time Horizon. Taylor is now five years older and his time horizon is shorter, though still
long term. Moreover, his time horizon previously was composed of two stages: his mother’s
lifetime, when his expenses and cash flow needs were higher, followed upon her death by his
remaining lifetime. Now, the appropriate horizon is one stage (his lifetime) with lower cash

flow needs.
iv. Liquidity Needs. Taylor’s ongoing liquidity needs are largely unchanged and remain
relatively low, with the exception of his possible cash charitable contribution. The size
($100,000) of this potential gift and its near term horizon is material enough to create the
need for a somewhat larger than usual cash reserve.

2000 Level III Guideline Answers
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LEVEL III, QUESTION 16
Topic:
Minutes:

Portfolio Management
12

Reading References:
1.
“The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium
Phenomenon for Investment Decision Making (AIMR, 1990)
2.
“Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing
Worldwide VI (AIMR, 1996)
3.
“Behavioral Finance versus Standard Finance,” Meir Statman, Behavioral Finance and
Decision Theory in Investment Management (AIMR, 1995)
Purpose:
To test the candidate’s ability to identify and discuss major tenets of behavioral finance in the
context of observed irrational investor behavior.

LOS: The candidate should be able to
“The Psychology of Risk” (Session 10)
• contrast the assumptions of rational investment decision-making with observed investor
behaviors, including loss aversion, reference dependence, asset segregation, mental
accounting, and biased expectations.
“Behavioral Risk: Anecdotes and Disturbing Evidence” (Session 10)
• discuss potential systematic overconfidence in analysts’ forecasts and the associated
implications, particularly for asset allocation and portfolio construction;
• appraise how prospect theory can be used to explain how investors treat losses differently
than gains.
“Behavioral Finance versus Standard Finance” (Session 10)
• contrast the standard view of human investor behavior with a behavioral finance framework;
• describe how the components of prospect theory, cognitive errors, self control, and regret
explain phenomena such as investor preference for cash dividends, preference for the stocks
of good companies, and the disposition to sell winners too early and to hold losers too long;
• show how the proliferation of new financial products, particularly derivatives, can be
explained in terms of behavioral finance;
• appraise how models of investor behavior complicate the development of rational investment
policy statements and determination of asset allocations.

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Guideline Answer:
i. Mental accounting is best illustrated by Statement #3.
Sampson’s requirement that his income needs be met via interest income and stock dividends
is an example of mental accounting. Mental accounting holds that investors segregate funds
into mental accounts (e.g., dividends and capital gains), maintain a set of separate mental
accounts, and do not combine outcomes; a loss in one account is treated separately from a

loss in another account. Mental accounting leads to an investor preference for dividends over
capital gains and to an inability or failure to consider total return.
ii. Overconfidence (illusion of control) is best illustrated by Statement #6.
Sampson’s desire to select investments that are inconsistent with his overall strategy
indicates overconfidence. Overconfident individuals often exhibit risk-seeking behavior.
People are also more confident in the validity of their conclusions than is justified by their
success rate. Causes of overconfidence include the illusion of control, self-enhancement
tendencies, insensitivity to predictive accuracy, and misconceptions of chance processes.
iii. Reference dependence is best illustrated by Statement #5.
Sampson’s desire to retain poor performing investments and to take quick profits on
successful investments suggests reference dependence. Reference dependence holds that
investment decisions are critically dependent on the decision-maker’s reference point; in this
case the reference point is the original purchase price. Alternatives are evaluated not in terms
of final outcomes but rather in terms of gains and losses relative to this reference point.
Thus, preferences are susceptible to manipulation simply by changing the reference point.

2000 Level III Guideline Answers
Morning Section – Page 8


LEVEL III, QUESTION 17
Topic:
Minutes:

Portfolio Management
22

Reading References:
1.
“Alternative Measures of Risk,” Roger G. Clarke, Investment Management, Peter L.

Bernstein and Aswath Damodaran, eds. (Wiley, 1998)
2.
“Global Risk Management: Are We Missing the Point?” Richard Bookstaber, The
Journal of Portfolio Management (Institutional Investor, Spring 1997)
3.
“Indexing,” Ch. 18, Bond Markets, Analysis and Strategies, 3rd edition, Frank J. Fabozzi
(Prentice Hall, 1996)
Purpose:
To test the candidate’s understanding of the different aspects of risk measurement and risk
management in a complex portfolio management environment.
LOS: The candidate should be able to
“Alternative Measures of Risk” (Session 12)
• evaluate circumstances in which variance or standard deviation may fail to capture some
dimensions of risk;
• contrast tracking error, beta, and standard deviation as measures of risk;
• appraise and evaluate the probability of shortfall and expected shortfall as risk measures.
“Global Risk Management: Are We Missing the Point?” (Session12)
• evaluate the implications of fat tails for risk managers;
• contrast variance and correlation measures of financial markets during financial crisis with
those during normal market environments.
“Indexing” (Session 6)
• appraise tracking error, implementation problems, and enhanced indexing in the context of
formulating indexing strategies.

Guideline Answer:
A. i. The population variance of a probability distribution is calculated by squaring the
deviation of each occurrence from the mean and multiplying each squared value by its
associated probability. The sum of these values is equal to the variance of the
distribution, and the square root of the variance is referred to as the standard deviation.
The sample variance is calculated as the sum of squared deviations from the mean

divided by the number of observations minus one.
ii. Tracking error relative to a benchmark can be viewed as a modification of variance or
standard deviation. In that context, tracking error can be defined as the standard deviation
of the difference in returns between the investment and a specified benchmark or target
position; in formula terms, tracking error is the standard deviation of:
∆R = R – B

2000 Level III Guideline Answers
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where ∆R = all differential returns, R = all investment returns,
B = the benchmark return
Alternatively, tracking error for a managed portfolio can be calculated simply as the
difference between the performance of that portfolio and the performance of a benchmark
index.
iii. Probability of shortfall is the chance that the return from an investment may fall below
some benchmark or reference return; in formula terms, probability of shortfall is:
Probability (R < B)
where R = investment return, B = benchmark or reference return
The benchmark or reference may be set at zero or any other minimum acceptable return.
Shortfall probability is most easily shown as a probability distribution. If the benchmark
return represents a risky asset or index return, the probability distribution represents the
distribution of tracking error relative to the index rather than the distribution of total or
absolute return.
iv. Expected shortfall is the difference between an investment’s actual return and the
benchmark return over the range of returns where a shortfall occurs; in formula terms,
expected shortfall is:
E (R – B)
where R = investment return over the range of returns where a shortfall occurs,

B = benchmark return
Put another way, expected shortfall is the sum of all below-benchmark returns times the
probabilities of those returns. Expected shortfall thus incorporates not only the
probability of shortfall, but also the magnitude of the potential shortfall if it does occur.
Expected shortfall represents the magnitude of the shortfall times the probability of the
shortfall occurring. Because this measure is influenced by the entire downside portion of
the probability distribution, it is a more complete measure of downside risk than the
probability of shortfall alone.
B. i. The variance (or standard deviation) of security returns has three unique weaknesses as a
risk measure:
•

Deviations above and below the mean return are given weights equal to their
respective probability of occurring. Yet, given the same probability of occurrence,
most investors are more displeased with (averse to) negative deviations than they are
pleased with positive deviations of the same magnitude. In other words, if two
investments have the same absolute deviations about the mean (same standard
deviation), but one has more negative returns, investors often view the distribution
with the lower mean as more risky. Standard deviation as a measure of risk tends to
2000 Level III Guideline Answers
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be more meaningful and useful when the probability distribution of returns is
symmetric. If one distribution is skewed to one side or the other, while another
distribution is symmetric around the mean, both might have the same standard
deviation but be perceived as having quite different risk. Investors tend to prefer
more likely but smaller losses versus less likely but larger losses. Asymmetric shapes
of probability distributions distort the conclusions that come from using variance as
the only measure of risk.

•

The Taylor series expansion (the mathematical model used to understand expected
utility) is only approximately true in the neighborhood of the expansion point (the
mean return) and not in the neighborhood where investors’ questions about risk
usually lie. Investors are often concerned about downside returns in a region where
the Taylor series expansion is known to be less accurate.

•

The use of variance as the only measure of risk assumes the distribution of returns is
normal. In that case, the Taylor series estimation of expected utility shows that the
expected utility is dependent on only the mean and variance terms and not on higher
order terms such as skewness and kurtosis. When returns are not normally distributed,
the higher order terms are nonzero and overlooking this fact can distort the
assessment of risk.

ii. Although probability of shortfall gives the probability that an undesirable event might
occur, it gives no hint as to how severe that undesirable event might be if it occurs. For
example, a 10% chance of losing 20% and a 10% chance of losing 100% would be
ranked equally by this risk measurement tool, even though most investors would clearly
be more averse to the latter than to the former.
iii. Expected shortfall fails to differentiate between a large probability of a small shortfall
and a small probability of a large shortfall, treating both cases identically. This is a
problem to the extent that investors view the consequences of large losses per unit
differently from small losses. For example, a 10% chance of losing 50% and a 50%
chance of losing 10% would be ranked equally by this risk measurement tool.

2000 Level III Guideline Answers
Morning Section – Page 11

C.
Premise

Financial market
returns are normally
distributed.

Financial market
correlations are
essentially stable.

Critique of Premise

Unique Implication of Premise

Returns are not always normally
distributed, i.e., returns at times
are asymmetric (because of the use
of options or non-linear trading
strategies, for example, or simply
because of the inherent
characteristics of the asset itself).
Empirical evidence seems to show
that large moves have a much
higher probability of occurring
than would be suggested by a
normal distribution. This is what
is meant by the statement “markets

have fat tails.” In other words,
there are events that occur
infrequently (outliers, in a normal
distribution), but that have a
dramatic effect on risk exposure.

Overlooking the fact that return
profiles are often asymmetric can
significantly distort the assessment of
risk. Particularly in cases where
variance is used as the primary
measure of risk, the asymmetric shape
of the probability distribution can lead
to seriously misleading conclusions.
Tobler's analysis does not take “fat
tails” into account, and therefore is
vulnerable to materially
underestimating major risks.

Though studies do report a
reasonably strong continuity in the
long-term relationships among
certain equity markets, the same
studies show that correlations are
subject to change. Over the shortterm, moreover, correlations have
been subject to significant
increases, particularly in times of
crisis. It is during such times that
increases in correlation are not
desired by the portfolio manager,

because the benefits of
diversification in terms of
spreading risk are weakened by
increasing correlations.

The expected return of a portfolio is a
weighted average of the individual
expected returns. The variance of the
portfolio as a whole, however,
contains a cross-product term that can
either increase or decrease the
portfolio variance depending on how
the securities move relative to each
other (i.e. their correlation). Changes
in the correlation between the equities
composing a portfolio can
dramatically and unexpectedly
change the overall variance of the
portfolio. Correlations are especially
unpredictable during major market
moves, i.e., during times when overall
volatility is markedly higher.
Unstable correlations have major
implications for the assessment of
risk, which Tobler ignores at his peril.

2000 Level III Guideline Answers
Morning Section – Page 12

LEVEL III, QUESTION 18
Topic:
Minutes:

Portfolio Management
16

Reading References:
1.
“Option Payoffs and Option Strategies,” Ch. 11, pp. 373–383, Futures,Options & Swaps,
2nd edition, Robert W. Kolb (Blackwell, 1997)
2.
“Using Interest Rate Futures in Portfolio Management,” Concepts and Applications
(Board of Trade of the City of Chicago, 1988)
Purpose:
To test the candidate’s understanding of how, when, and why to use financial futures to adjust
asset allocations.
LOS: The candidate should be able to
“Option Payoffs and Option Strategies” (Session 13)
• compare and contrast a hedging strategy that uses put options with a strategy that uses index
futures.
“Using Interest Rate Futures in Portfolio Management” (Session 13)
• evaluate the advantages and disadvantages of using financial futures for asset allocation
purposes;
• construct, formulate, and evaluate an asset allocation strategy using stock index futures and
bond futures.

Guideline Answer:
A. Delsing should sell stock index futures contracts and buy bond futures contracts. This
strategy is justified because buying the bond futures and selling the stock index futures

provides the same exposure as buying the bonds and selling the stocks. This strategy assumes
high correlations between the movements of the bond futures and bond portfolio as well as
the stock index futures and the stock portfolio.
B. The correct number of contracts in each case is:
i. 5 × $200,000,000 × 0.0001 = $100,000, and $100,000 / 97.85 = 1022 contracts
ii. $200,000,000 / ($1,378 × 250) = 581 contracts
C. i. The advantages of using financial futures for asset allocation are:
• execution speed in terms of lower transaction time
• execution efficiency in terms of lower market impact and brokerage fees
• less disruption of external manager’s performance
• less reallocation of funds among managers
• no direct cost to establishing the hedge
• high liquidity of index futures.
2000 Level III Guideline Answers
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The disadvantage of using financial futures for asset allocation is:
• exposure of portfolio to basis risk or tracking error.
ii. The advantages of using index put options for asset allocation are:
• less disruption of external manager’s performance
• less reallocation of funds among managers.
The disadvantages of using index put options for asset allocation are:
• the cost of the index put options, which must be borne regardless of the subsequent
stock index movement, i.e., significant up-front cost/cash needed to satisfy premium
• need for frequent rebalancing as delta changes with price of underlying asset
• basis risk or tracking error.
D. The stock return is: $28 / $1,378 = 2% (or 2.03%)
The bond return is: –Dmod × (basis point change / 100) = –5 × (10 / 100) = –0.5%
where: Dmod = modified duration

i. For a 50/50 allocation, the capital gain return is:
(0.5 × 2%) + (0.5 × –0.5%) = 0.75% (or 0.765%)
ii. For a 75/25 allocation, the capital gain return is:
(0.75 × 2%) + (0.25 × –0.5%) = 1.375% (or 1.3975%)

2000 Level III Guideline Answers
Morning Section – Page 14


LEVEL III, QUESTION 19
Topic:
Minutes:

Economics
20

Reading References:
1.
“The Nature of Effective Forecasts,” David B. Bostian, Jr., Improving the Investment
Decision Process—Better Use of Economic Inputs in Securities Analysis and Portfolio
Management (AIMR, 1992)
2.
“Using Economic Models,” Avery B. Shenfeld, Economic Analysis for Investment
Professionals (AIMR, 1997)
Purpose:
To test the candidate’s understanding of alternate approaches to economic forecasting and the
pitfalls involved in using economic models to predict future events.
LOS: The candidate should be able to
“The Nature of Effective Forecasts” (Session 4)
• criticize, compare, and evaluate alternative economic forecasting methods;

• evaluate the pitfalls in economic forecasting.
“Using Economic Models” (Session 4)
• compare and contrast different approaches to economic forecasting.

Guideline Answer:
A. i. The two approaches are similar with respect to role of historical data. Both forecasting
approaches use historical data to establish statistical relationships used in the different
models and by different analysts. Both assume to some degree that the past can be used to
predict the future, or at least that the past provides norms against which the present and
future can be assessed.
ii. The two approaches are different with respect to the number of analysts reflected in the
forecast. In general, there are typically many more analysts included in the consensus
approach than in an econometric approach, which can be and often is the product of only
one analyst or a small group of researchers.
iii. The two approaches are similar with respect to nature of assumptions about future
economic relationships. Both methodologies may use the same assumptions for future
economic relationships, and in both cases the underlying assumptions may be as difficult
to formulate and justify as the relationships being specified.
B. i. Consensus approaches are more likely to be distorted by group think; in fact, consensus
forecasting may tend to reinforce group think. Group think deals with the human
tendency to want to feel comfortable. People tend to gravitate towards a consensus view;
because it is a view shared by many, it represents a “safe,” comfortable, and generally
low-exposure/low-risk position.

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ii. Consensus approaches are more likely to be distorted by the inability to test sensitivity.
Analysts are unable to manipulate the consensus data provided to them. It is typical to

receive the consensus forecast for upcoming economic releases and not have the ability to
perform any form of sensitivity analysis on that consensus; in other words, it is often
difficult to answer the question “What may be wrong with this view?” with respect to a
consensus view.
iii. Econometric approaches are more likely to be distorted by simultaneity. Simultaneity
arises when the analyst is trying to measure the influence of one variable on another
when that second variable also influences the first one. Consensus approaches may
embed distortions created by simultaneous relationships, but simultaneity is more likely
to impart direct and systematic distortions to econometric approaches. Given that
econometric models are complex mathematical structures, the interaction of variables is a
concern when using that model and those variables to posit a statistical relationship.
iv. Econometric approaches are more likely to be distorted by data mining, which is testing
multiple models with the same data until the desired result is obtained. Almost by
definition, econometric approaches that are based on many complex mathematical
relationships are subject to questionable manipulation by eager analysts. Econometric
models are always subject to the risk of questionable results that arise from the process of
trying to isolate one variable or relationship from among many.
C. i. Econometric approaches, because they are much more intricate in nature, can pick
turning points in the economy or data series missed by consensus approaches. An
econometric model can create a picture of the economy, which in turn influences other
equations that give predictions of such variables as interest rates or GDP. It also provides
the forecaster with an opportunity to consider the exercise from a number of different
frames of reference. Consensus forecasts will pick turning points only if enough
participants in the consensus do so.
ii. Consensus approaches are easy to construct, typically representing a simple polling of
analysts. Numerous surveys of economists’ opinions and forecasts are available in
business publications and from commercial services. Econometric models are complex to
design, often difficult to implement, and expensive to maintain.
iii. Econometric approaches can incorporate as many market influences as the forecaster
believes may be important. Such models can be designed to try to capture the

complexities of the economy in general and specific economic sectors and can be
modified readily to accommodate changing conditions. Because consensus forecasts are
adopted as a finished product, the end user typically has no way of determining how
many or few market influences are reflected in the forecasts.

2000 Level III Guideline Answers
Morning Section – Page 16


LEVEL III, QUESTION 20
Topic:
Minutes:

Asset Valuation
16

Reading References:
“Real Estate Investment Performance and Portfolio Considerations,” Ch. 21, pp. 682–687 and
699–705, Real Estate Finance and Investments, 10th edition, William B. Brueggeman and
Jeffrey D. Fisher (Irwin, 1997)
Purpose:
To test the candidate’s understanding of the differences in the calculation of real estate
performance indexes.
LOS: The candidate should be able to
“Real Estate Investment Performance and Portfolio Considerations” (Session 7)
• compare and contrast types of real estate return indexes;
• appraise the shortcomings of the real estate indexes.

Guideline Answer:
Characteristic

NAREIT Index

NCREIF Index

i. Source of underlying asset
valuation

Security prices, as represented
by REIT shares traded on an
exchange*

Appraisal estimates, that may
include a smoothing bias*

ii. Leverage (gearing) of
underlying assets

Leveraged

Generally not leveraged

iii. Index returns calculated
before or after deduction of
investment advisory fees

Index returns calculated after
deduction of fees

Index returns calculated

before deduction of fees

iv. Correlation with broad
equity market (e.g., S&P 500
Index)

Positive and relatively high
(e.g., empirical studies have
presented correlation value
exceeding +0.60)

Relatively low to negative
(e.g., empirical studies have
presented negative correlation
value near zero)

*Analysts have at least two sources for real estate return information. The first is security prices
(exchange-traded) as represented by real estate investment trust (REIT) shares. The second is
estimates of value on individual properties owned by pension fund sponsors. The primary
difference between these data is that the first is based on trading of real estate-backed securities
and the second is based on appraisal estimates of individual properties.

2000 Level III Guideline Answers
Morning Section – Page 17


LEVEL III, QUESTION 21
Topic:
Minutes:

Asset Valuation
14

Reading References:
Bond Markets, Analysis and Strategies, 3rd edition, Frank J. Fabozzi (Prentice Hall, 1996)
A.
“Active Bond Portfolio Management Strategies,” Ch. 17
B.
“Liability Funding Strategies,” Ch. 19
Purpose:
To test the candidate’s understanding of the effect of changing yield curves on the performance
of similar duration bond portfolios and of the effect on an institution’s balance sheet from a
mismatch in asset liability duration.
LOS: The candidate should be able to
“Active Bond Portfolio Management Strategies” (Session 6)
• prepare a bullet-and-barbell analysis to specify appropriate strategies for various changes in
the shape of the yield curve;
• compare a barbell strategy to a bullet strategy under various types of yield curve (term
structure) shifts;
• recommend and justify the appropriate active bond portfolio strategy under different
expected yield curve scenarios, various interest rate expectations, changing yield spreads,
different OAS strategies, and different security selection criteria.
“Liability Funding Strategies” (Session 6)
• discriminate between economic and accounting surplus.

Guideline Answer:
A. i. A parallel shift in the yield curve refers to a shift in interest rates in which the basis point
change in yield is the same for all maturities. Portfolio A is structured as a bullet
portfolio with the entire portfolio in an intermediate-term security. For a parallel yield
curve shift involving a relatively small number of basis points, the bullet structure of

Portfolio A will outperform the barbell structure of Portfolio B, because the value of the
single intermediate-term security Portfolio A, which has shorter duration, will decrease
less than will the value of the short- and long-term security Portfolio B.
ii. A twist in the yield curve refers to a nonparallel shift in interest rates in which the basis
point change in yield is not the same for all maturities. In this case, the twist describes a
flattening yield curve because the yield spread between long- and short-term rates has
decreased. Portfolio B is structured as a barbell portfolio with half the portfolio in a
short-term security and half in a long-term security. When the yield curve twists, the
twist will affect Portfolio B favorably, with the price increase of the long-maturity bond
outweighing the price decrease of the short-maturity bond. Thus the barbell structure of
Portfolio B will outperform the bullet structure of Portfolio A when the yield curve
twists.

2000 Level III Guideline Answers
Morning Section – Page 18


B. The surplus, or difference between the market value of HEY’s assets and the market value (or
present value) of HEY’s liabilities, is $20 million. The duration of the assets and liabilities
determines how their values respond to changes in interest rates. The net effect on the
balance sheet depends on the relative interest rate sensitivity of the assets compared to that of
the liabilities. Because HEY’s liabilities now have a duration of 6.0 and HEY’s investment
portfolios now have a duration of 7.2, HEY has an asset/liability mismatch and interest rate
movements will affect the balance sheet.
If interest rates decline by 100 basis points, the higher duration of the investment portfolios
suggests that they will increase in value more than the liabilities will increase in value.
Assuming that the two portfolios together have a total market value of $200 million, HEY’s
surplus will increase by $3,600,000, to $23,600,000.
The calculations are as follows:
7.2% × $200,000,000 = $14,400,000 growth in assets

6.0% × $180,000,000 = $10,800,000 growth in liabilities
$ 3,600,000 increase in surplus
Market value of assets =
$200,000,000 + $14,400,000 = $214,400,000
Market value of liabilities = $180,000,000 + $10,800,000 = $190,800,000
Surplus
$ 23,600,000
Assuming that the two portfolios together have a total market value of $400 million, the
surplus calculations are as follows:
7.2% × $400,000,000 = $28,800,000 growth in assets
6.0% × $180,000,000 = $10,800,000 growth in liabilities
$18,000,000 increase in surplus
Market value of assets =
$400,000,000 + $28,800,000 = $428,800,000
Market value of liabilities = $180,000,000 + $10,800,000 = $190,800,000
Surplus
$238,000,000

2000 Level III Guideline Answers
Morning Section – Page 19


LEVEL III, QUESTION 22
Topic:
Minutes:

Portfolio Management / Asset Valuation
28

Reading References:

1.
“Determination of Portfolio Policies: Institutional Investors,” Ch. 4, Keith P.
Ambachtsheer, John L. Maginn, and Jay Vawter, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren,
Gorham & Lamont, 1990)
2.
“Pension Investing and Corporate Risk Management,” Robert A. Haugen, Managing
Institutional Assets, Frank J. Fabozzi, ed. (Harper Collins, 1990)
3.
“Twenty Years of International Equity Investing,” Richard O. Michaud, Gary L.
Bergstrom, Ronald D. Frashure, and Brian K. Wolahan, The Journal of Portfolio
Management (Institutional Investor, Fall 1996)
Purpose:
To test the candidate’s understanding of defined benefit pension plans and implications of
investment policies.
LOS: The candidate should be able to
“Determination of Portfolio Policies: Institutional Investors” (Session 9)
• appraise and contrast the factors that affect the investment policies of pension funds,
endowment funds, insurance companies, and commercial banks.
“Pension Investing and Corporate Risk Management” (Session 9)
• appraise the investment policy implications, especially for risk management, of the
relationship between the financial condition of a corporate pension fund and the corporation
itself;
• evaluate the effect a corporate pension fund investment policy may have on plan surplus, the
corporation’s valuation, and its constituents.
“Twenty Years of International Equity Investing” (Session 5)
• discuss the issues facing international equity investors;
• discuss patterns of global equity returns and global market correlations across different
market environments.

Guideline Answer:
A. i. Concentrating the pension assets in such a fashion subjects plan beneficiaries to an
extraordinarily high level of risk because of the high correlation between the market
values of the portfolio and LSC.
ii. By concentrating the pension assets heavily in technology and Internet companies,
Donovan has increased the risk profile of the company. LightSpeed now has the prospect
of possibly having to provide additional funding to the pension plan at a time when the
company’s own cash flow and/or earnings position may be weakened. A more prudent
approach would be to invest in assets with market values that are expected to be less
highly correlated with the company’s market value, so in the event additional funding for
2000 Level III Guideline Answers
Afternoon Section – Page 1


the pension plan becomes necessary it will be less likely to occur when the company is in
a weakened financial position.
B. i. The IPS drafted by Jeffries and the Investment Committee correctly identifies that the
return requirement should be total return, with a need for inflation protection, that is
sufficient to fund the plan’s long-term obligations.
ii. The IPS fails to address the pension plan’s risk tolerance—one of the two main objectives
of a complete investment policy statement—and fails to highlight the potential risk to the
beneficiaries and the company should the current high-risk strategy not achieve its return
goal.
iii. The IPS correctly addresses the time horizon constraint by stating that the assets are longterm in nature, both because of the young work force and the normal long-term nature of
pension investing.
iv. The IPS fails to address the liquidity constraint; although liquidity is a minimal concern
in this case, the IPS should so state.
C. Portfolio C is the only appropriate choice.
Diversification of Assets: Portfolio C is well diversified across all asset classes. Portfolio C
has minimal IPO/Tech exposure and only 34 percent of the portfolio exposed to riskier asset

classes in total (IPO/Tech, small capitalization growth, and venture capital). Portfolio C has
the largest exposure (35%) to large capitalization stocks, and provides reasonable levels of
international and corporate bond exposure. Portfolio A has relatively large cash reserves, no
international exposure, and 56 percent of the portfolio allocated to the riskier asset classes
(concentrated IPO/Tech, small capitalization, and venture capital assets). Such assets are
likely to be relatively highly correlated to each other, to share high risk/high volatility
characteristics, and therefore to not provide as diversified a portfolio as Portfolio C or as may
appear at first glance. Although Portfolio B has similar international exposure to C, it has 55
percent of the portfolio allocated to riskier asset classes (IPO/Tech, small capitalization
growth and venture capital). The Current Portfolio has a 50 percent concentration in the
IPO/Tech Fund asset class alone and an 85 percent concentration in the riskier asset
classes(IPO/Tech, small capitalization growth, and venture capital assets) in total, which
makes it inferior to Portfolio C on a diversification basis.
Correlation with Plan Sponsor’s Business: Portfolio C has the lowest exposure to the
IPO/Tech assets, which may be highly correlated with the plan sponsor’s underlying
business, thereby exposing both the company and the plan beneficiaries to excessive risk in
the event of a sharp downturn in the company’s business.
Risk/Return Tradeoff: Portfolio C has a Sharpe ratio that is lower than, but in line with, those
of Portfolios A and B, but is better diversified across asset classes and substantially less
volatile. The Current Portfolio has the worst Sharpe Ratio among the portfolios. Although
Portfolio C has the lowest expected return, it also has the lowest risk as measured by standard
deviation. Return per unit of risk is highest for Portfolio C. The coefficient of variation
(standard deviation divided by expected rate of return) is also best (lowest) for Portfolio C.
2000 Level III Guideline Answers
Afternoon Section – Page 2


Minimal Cash: Portfolio C has minimal reserves, which is appropriate; because of the plan’s
long time horizon, liquidity is not needed. Portfolio B has excessive cash reserves for a portfolio
that has no liquidity needs.

2000 Level III Guideline Answers
Afternoon Section – Page 3


LEVEL III, QUESTION 23
Topic:
Minutes:

Portfolio Management / Asset Valuation
21

Reading References:
1.
“Determination of Portfolio Policies: Institutional Investors,” Ch. 4, Keith P.
Ambachtsheer, John L. Maginn, and Jay Vawter, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren,
Gorham & Lamont, 1990)
2.
Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR)
3.
Emerging Stock Markets: Risk, Return, and Performance, Christopher B. Barry, John W.
Peavy III, Mauricio Rodriguez (Research Foundation of the ICFA, 1997)
A.
“Introduction”
B.
“Historical Performance of Emerging Equity Markets”
C.
“Portfolio Construction Using Emerging Markets”
Purpose:

To test the candidate’s understanding of the differences among institutional investors relative to
appropriate investment policies and asset allocations.
LOS: The candidate should be able to
“Determination of Portfolio Policies: Institutional Investors” (Session 9)
• appraise and contrast the factors that affect the investment policies of pension funds,
endowment funds, insurance companies, and commercial banks;
• discriminate between the return objectives, risk tolerances, constraints, regulatory
environment, and unique circumstances of endowment funds, pension funds, insurance
companies, and commercial banks.
“Question 13, including Guideline Answer” (Session 9)
• formulate the overall portfolio management process leading to an investment policy
statement and an asset allocation decision for an institutional investor, including developing
objectives and constraints and analyzing capital market expectations.
“Introduction” (Session 5)
• discuss the potential benefits from investing in emerging markets;
• summarize the problems and constraints facing the emerging market investor.
“Historical Performance of Emerging Equity Markets” (Session 5)
• discuss the risks involved in investing in emerging markets.
“Portfolio Construction Using Emerging Markets” (Session 5)
• appraise the impact of adding emerging market stocks on portfolio risk for a global equity
investor.

2000 Level III Guideline Answers
Afternoon Section – Page 4


Guideline Answer:
A.
Statement
1. Both endowments and

life insurance companies
have aggressive return
requirements.

Correct or Incorrect
(Circle One)
Incorrect

If Incorrect, Justify With One Reason
The return requirements of life insurance
companies are first and foremost liability
driven, matching assets with fixed
obligations, and are only secondarily
shaped by capital market considerations.
Life insurance companies’ return
requirements also include as an objective
the earning of a competitive return on the
assets that fund surplus.
The return requirements of endowments,
while subject to a range of risk tolerances,
are driven by the spending rate of the
endowment, the need to preserve
purchasing power, and the need to provide
a growing financial contribution to the
endowed organization.

2. Endowments are less
willing to assume risk
than life insurance
companies because of

donor concerns about
volatility and loss of
principal.

Incorrect

Insurance companies tend to have a lower
tolerance for risk than endowments. The
confidence in the ability of an insurance
company to pay its benefits (obligations) as
they come due is a crucial element in the
financial viability of the industry. Thus,
insurance companies are sensitive to the
risk of any significant chance of principal
loss or any significant interruption of
investment income.
Endowments, by contrast, tend to have a
higher tolerance for risk. Their longer-term
time horizons and predictable cash flows,
relative to their spending rate requirements,
enable them to pursue more aggressive
strategies.

2000 Level III Guideline Answers
Afternoon Section – Page 5


3. Endowments are less
able to assume risk than
life insurance companies

because of expectations
that endowments should
provide stable funding for
charitable operations.

Incorrect

Life insurance companies must match
assets and liabilities in a more clear and
quantifiable way than perhaps any other
institution. Given the interest-sensitive
nature of most modern life insurance
products, interest rate risk is the most
pervasive of the risks being managed by
life insurance companies. Financial theory
points out that interest rate risk is also
difficult to anticipate and largely
nondiversifiable. Regulatory requirements
may limit the asset classes available to a
life insurance company, further
constraining its ability to take risk.
In contrast, the main risk facing an
endowment is loss of purchasing power
over time. Therefore, endowments should
be able to accept higher volatility than life
insurance companies in the short term to
maximize long-term total returns.

4. Endowments have
lower liquidity

requirements than life
insurance companies
because endowment
spending needs are met
through a combination of
current income and
capital appreciation.

5. Both endowments and
life insurance companies
are subject to stringent
legal and regulatory
oversight.

Correct

Life insurance companies face the need for
liquidity as a key investment constraint,
because life insurance products are
basically promises to pay depending on
certain expected or unexpected events.
Endowments typically have low liquidity
needs, except to fund periodic distributions
and to cover emergency needs.
Distributions are usually foreseeable and
can usually be met from a combination of
investment income and the sale of readily
marketable securities.

Incorrect

Life insurance companies are subject to
relatively rigorous legal/regulatory
oversight with respect to their portfolio
composition and investment strategies.
In contrast, endowments are relatively
unburdened with legal/regulatory
restraints, at least at the federal level,
although some states do have specific rules
and regulations regarding management of
endowment assets.

2000 Level III Guideline Answers
Afternoon Section – Page 6