L3 mock sample exam CFA level III essay questions 2004

2004 CFA® Level III Examination

FOR AIMR USE ONLY

Morning Session – Essay
Candidate Number:
FOR AIMR USE ONLY

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The following list contains the command words used on the Morning Session of
the 2004 CFA Level III examination. Candidates may want to refer to this list as
they formulate their answers.
Calculate:

To ascertain or determine by mathematical processes.

Describe:

To transmit a mental image, an impression, or an understanding of the nature
and characteristics of.

Determine:

To come to a decision as the result of investigation or reasoning; to settle or
decide by choice among alternatives or possibilities.

Discuss:

To discourse about through reasoning or argument; to present in detail.

Explain:

To give the meaning or significance of; to provide an understanding of; to give
the reason for or cause of.

Formulate:

To put in a systematized statement or expression; to prepare according to a
formula.

Give:

To yield or furnish as a product, consequence, or effect; to offer for the
consideration, acceptance, or use of another.

Identify:

To establish the identity of; to show or prove the sameness of.

Indicate:

To point out or point to with more or less exactness; to show or make known
with a fair degree of certainty.

Judge:

To form an opinion about through careful weighing of evidence and testing of
premises.

Justify:

To prove or show to be valid, sound, or conforming to fact or reason; to
furnish grounds or evidence for.

Recommend:

To bring forward as being fit or worthy; to indicate as being one’s choice for
something or as otherwise having one’s approval or support.

Show:

To set forth in a statement, account, or description; to make evident or clear.

Support:

To provide with verification, corroboration, or substantiation.

The Morning Session of the 2004 CFA Level III Examination has 13 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.

Question
1
2
3
4
5
6
7
8
9
10
11
12
13

Topic
Portfolio Management
Portfolio Management
Portfolio Management
Portfolio Management
Portfolio Management
Portfolio Management
Portfolio Management
Portfolio Management
Asset Valuation
Asset Valuation

Asset Valuation
Portfolio Management
Portfolio Management
Total:

Minutes
9
20
18
7
18
22
7
6
18
16
18
10
11
180


Questions 1 through 5 relate to Louise and Christopher Maclin. A total of 72 minutes is
allocated to these questions. Candidates should answer these questions in the order
presented.
QUESTION 1 HAS ONE PART FOR A TOTAL OF 9 MINUTES.
Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment
in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher
Maclin makes the following statements to the Maclins’ financial advisor, Grant Webb:
•

“I have used the Internet extensively to research the outlook for the housing
market over the next five years, and I believe now is the best time to buy a house.”

•

“I do not want to sell any bond in my portfolio for a lower price than I paid for the
bond.”

•

“I will not sell any of my company stock because I know my company and I
believe it has excellent prospects for the future.”

Identify the behavioral finance concept most directly exhibited in each of Maclin’s three
statements. Explain how each behavioral finance concept is affecting Maclin’s investment
decision-making.
Answer Question 1 in the Template provided on page 3.
(9 minutes)


Answer Question 1 on This Page
Template for Question 1
Maclin’s three
statements

“I have used the Internet
extensively to research the
outlook for the housing
market over the next five

years, and I believe now is
the best time to buy a
house.”

“I do not want to sell any
bond in my portfolio for a
lower price than I paid for
the bond.”

“I will not sell any of my
company stock because I
know my company and I
believe it has excellent
prospects for the future.”

Identify the behavioral
finance concept most
directly exhibited in
each of Maclin’s three
statements

Explain how each behavioral finance
concept is affecting Maclin’s investment
decision-making


QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 20 MINUTES.
Christopher Maclin, aged 40, is a supervisor at Barnett Co. and earns an annual salary of £80,000
before taxes. Louise Maclin, aged 38, stays home to care for their newborn twins. She recently
inherited £900,000 (after wealth-transfer taxes) in cash from her father’s estate. In addition, the

Maclins have accumulated the following assets (current market value):
•

£5,000 in cash

•

£160,000 in stocks and bonds

•

£220,000 in Barnett common stock

The value of their holdings in Barnett stock has appreciated substantially as a result of the
company’s growth in sales and profits during the past ten years. Christopher Maclin is confident
that the company and its stock will continue to perform well.
The Maclins need £30,000 for a down payment on the purchase of a house and plan to make a
£20,000 non-tax deductible donation to a local charity in memory of Louise Maclin’s father.
The Maclins’ annual living expenses are £74,000. After-tax salary increases will offset any
future increases in their living expenses.
During their discussions with Grant Webb, the Maclins express concern about achieving their
educational goals for their children and their own retirement goals. The Maclins tell Webb:
•

They want to have sufficient funds to retire in 18 years when their children begin
their four years of university education.

•

They have been unhappy with the portfolio volatility they have experienced in

recent years and they do not want to experience a loss greater than 12 percent in
any one year.

•

They do not want to invest in alcohol and tobacco stocks.

•

They will not have any additional children.

After their discussions, Webb calculates that in 18 years the Maclins will need £2 million to meet
their educational and retirement goals. Webb suggests that their portfolio be structured to limit
shortfall risk (defined as expected total return minus two standard deviations) to no lower than a
negative 12 percent return in any one year. Maclin’s salary and all capital gains and investment
income are taxed at 40 percent and no tax-sheltering strategies are available. Webb’s next step is
to formulate an investment policy statement for the Maclins.


A.

i.

Formulate the risk objective of an investment policy statement for the Maclins.

ii.

Formulate the return objective of an investment policy statement for the Maclins.
Calculate the pre-tax rate of return that is required to achieve this objective.
Show your calculations.

(12 minutes)

B.

Formulate the constraints portion of an investment policy statement for the Maclins,
addressing each of the following:
i.
ii.
iii.
iv.

Time horizon
Liquidity requirements
Tax concerns
Unique circumstances

Note: Your response should not address legal and regulatory factors.
(8 minutes)


QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES.
Louise and Christopher Maclin have purchased their house and made the donation to the local
charity. Now that an investment policy statement has been prepared for the Maclins, Grant
Webb recommends that they consider the strategic asset allocation described in Exhibit 3-1.
Exhibit 3-1
Louise and Christopher Maclin
Recommended Strategic Asset Allocation

Asset Class

Recommended
Allocation

Cash
15.0%
U.K. Corporate Bonds
55.0
U.K. Small-capitalization Equities
0.0
U.K. Large-capitalization Equities
10.0
U.S. Equities*
5.0
Barnett Co. Common Stock
15.0
Total Portfolio
100.0
*U.S. equity data are in British pound terms.
A.

Current
Yield
1.0%
4.0
0.0
2.0
1.5
1.0
---

Projected
Annualized
Pre-tax
Total
Return
1.0%
5.0
11.0
9.0
10.0
16.0
6.7

Expected
Standard
Deviation
2.5%
11.0
25.0
21.0
20.0
48.0
12.4

Identify two aspects of the recommended asset allocation in Exhibit 3-1 that are
inconsistent with the Maclins’ investment objectives and constraints. Support each of
your responses with one reason.
Answer Question 3-A in the Template provided on page 15.
(6 minutes)

After further discussion, Webb and the Maclins agree that any suitable strategic asset allocation
will include:
•

5 to 10 percent in U.K. small-capitalization equities

•

10 to 15 percent in U.K. large-capitalization equities

For the remainder of the portfolio, Webb is considering the asset class ranges described in
Exhibit 3-2.


Asset Class

Exhibit 3-2
Louise and Christopher Maclin
Asset Class Ranges
Allocation Ranges

Cash

0% to 3%

5% to 10%

15% to 20%

10% to 20%

30% to 40%

50% to 60%

U.S. Equities

0% to 5%

10% to 15%

20% to 25%

Barnett Co. Common Stock

0% to 5%

10% to 15%

20% to 25%

U.K. Corporate Bonds

B.

Recommend the most appropriate allocation range for each of the asset classes in Exhibit
3-2. Justify each appropriate allocation range with one reason based on the Maclins’
investment objectives and constraints.
Note: No calculations are required.
Answer Question 3-B in the Template provided on page 16.

(12 minutes)


Answer Question 3 on This Page
Template for Question 3-A
Identify two aspects of the
recommended asset allocation in
Exhibit 3-1 that are inconsistent with
the Maclins’ investment objectives
and constraints
1.

2.

Support each of your responses with one reason


Answer Question 3 on This Page
Template for Question 3-B
Note: No calculations are required.
Recommend the most
appropriate
allocation range for
Asset Class
each of the asset
classes in Exhibit 3-2
(circle one for each
asset class)
0% to 3%
Cash

5% to 10%
15% to 20%

10% to 20%
U.K.
Corporate
Bonds

30% to 40%
50% to 60%

0% to 5%
U.S. Equities

10% to 15%
20% to 25%

0% to 5%
Barnett Co.
Common
Stock

10% to 15%
20% to 25%

Justify each appropriate allocation range with one
reason based on the Maclins’ investment objectives
and constraints

QUESTION 4 HAS TWO PARTS (A, B) FOR A TOTAL OF 7 MINUTES.
Louise and Christopher Maclin are considering the rebalancing implications of two possible
strategic asset allocation scenarios. Grant Webb outlines a rebalancing methodology that sets
upper and lower limits for the weights of each asset class based on the same fixed percentage
bands for each asset class. The portfolio will be rebalanced to the target allocations whenever
the weight of an asset class violates the fixed percentage limits. Webb also describes an alternate
rebalancing methodology, based on standard deviation, in which each asset class is rebalanced
when the weight for the asset class exceeds the number of standard deviations set for all asset
classes.
A.

Discuss why a rebalancing methodology based on fixed percentage bands may result in
excessive transaction costs in each of the following strategic asset allocation scenarios:
i.
ii.

The Maclins hold a small allocation (less than 5 percent) to an emerging market
equities fund
The Maclins hold a sizable allocation to a hedge fund that has experienced a
persistently very low correlation with the other assets in the portfolio
(4 minutes)

Webb is concerned about the negative effect of realized capital gains on the Maclins’ portfolio.
B.

Determine, given Webb’s concern about realized capital gains, whether a rebalancing
methodology based on standard deviation is likely to be more or less appropriate than a
rebalancing methodology based on fixed percentage bands. Justify your response with
one reason.

(3 minutes)


QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 18 MINUTES.
Christopher Maclin, after reading an article in a business publication, expresses concern to Grant
Webb that the U.S. equity market is overvalued, especially when measured on a market value to
book value basis. Maclin is particularly concerned about the U.S. technology and service
sectors. Webb states that Tobin’s Q theory adjusts for possible distortions in market value to
book value relationships; he also indicates, however, that the theory may not be appropriate for
valuing technology and service sectors.
A.

i.

Describe one adjustment that Tobin’s Q theory makes to address distortions in
market value to book value relationships.

ii.

Describe one weakness of applying Tobin’s Q theory to technology and service
sectors.
(6 minutes)

Webb explains to Maclin that equity market values can be compared to Gross Domestic Product
(GDP) to determine whether a market is overvalued. Webb states that while the ratio of market
value of equity to GDP is currently high, he is not sure about the usefulness of the ratio given
deleveraging activity in the U.S. market and the fact that an increasing number of U.S. firms are
becoming public companies.
B.

Explain how the usefulness of the ratio of market value of equity to GDP is likely to be
affected by:
i.
ii.

Deleveraging activity in a market
An increasing number of firms in a market becoming public companies
(6 minutes)

Webb indicates to Maclin that the Fed model can be used to forecast equity returns. He tells
Maclin, however, that he expects continued low interest rates and very low inflation in the U.S.
economy, and that such an economic scenario may have implications for the effectiveness of the
Fed model.
C.

i.

Explain how the Fed model identifies an overvalued equity market.

ii.

Determine, in the economic scenario that Webb expects, whether the Fed model
is likely to be effective in identifying whether the equity market is overvalued or
undervalued. Justify your response with one reason.
(6 minutes)


Questions 6 through 11 relate to the Hale Health Foundation and the Glover Scholastic Aid
Foundation. A total of 87 minutes is allocated to these questions. Candidates should answer
these questions in the order presented.

QUESTION 6 HAS TWO PARTS (A, B) FOR A TOTAL OF 22 MINUTES.
The Hale Health Foundation is a company-sponsored U.S. foundation with the sole mission of
supporting the Graceville Clinic. Over the past five years, Hale has contributed 75-80 percent of
the Clinic’s operating budget. Health care costs have grown at 1 percent above the annual rate of
inflation, and this trend is expected to continue.
This year, Hale estimates that its spending budget for the Clinic will be $11 million. Hale’s
management expenses average 0.40 percent of assets. In addition to the ongoing spending
budget, Hale is funding a new facility for the Clinic, which will require a final outlay of
$4 million within six months.
Hale was founded five years ago by Nord Pharmaceuticals with a gift consisting of Nord
company stock and a 100 percent ownership interest in a privately-held computer consulting
business. Nord has contributed $2 million annually to Hale since the initial gift. However, Nord
has faced increasing capital expenditures and recently announced that it will be unable to make
additional contributions to Hale. The computer consulting business is expected to generate $1.25
million of pre-tax income this year; pre-tax income will grow with little volatility at the annual
inflation rate, which is expected to be 1.5 percent for the foreseeable future. The corporate tax
rate is 20 percent.
The following information relates to Hale’s Board of Trustees:
•

The Board has diversified the portfolio over time so that Nord common equity
now comprises a small proportion of the overall portfolio. The Board has
expressed a desire to sell the computer consulting business because it requires an
excessive amount of oversight by Hale’s Board and management. Excluding the
computer consulting business, Hale’s portfolio has a market value of $200
million.

•

The Board is concerned about the uncertainty of the exact dollar amount of

required spending during the year. Historically, the Board has designated a
portion of the portfolio to serve as a reserve of approximately 15 percent of its
spending budget for the Clinic to ensure that Hale’s annual spending goals will be
met.

•

The Board is aware of the market risk/return tradeoff and is willing to accept the
risk necessary to support Hale’s long-term growth orientation. With respect to
return on investable assets, the Trustees have agreed that a shortfall risk limit
(defined as expected total return minus two standard deviations) of –14 percent in
any one year is acceptable.


Sarah Cole, an executive of Nord, has recently been appointed Trustee of Hale, with
responsibility for formulating a new investment policy statement to guide Hale’s investing
activities.

A.

i.

Formulate the risk objective of an investment policy statement for Hale.

ii.

Formulate the return objective of an investment policy statement for Hale.
Calculate the rate of return that is required to achieve this objective. Show your
calculations.
(12 minutes)

B.

Formulate the constraints portion of an investment policy statement for Hale, addressing
each of the following:
i.
ii.
iii.
iv.
v.

Time horizon
Liquidity requirements
Tax concerns
Legal and regulatory factors
Unique circumstances
(10 minutes)


QUESTION 7 HAS ONE PART FOR A TOTAL OF 7 MINUTES.
The Hale Health Foundation has made the $4 million facility payment. Sarah Cole is
considering the most appropriate strategic asset allocation for the Hale portfolio, given Hale’s
investment objectives and constraints.
A consultant has developed five alternative portfolios for Cole to consider, as shown in Exhibit
7-1.
Exhibit 7-1
Hale Health Foundation
Strategic Asset Allocation
Five Alternative Portfolios
Alternative Portfolios

Asset Allocation Percentages
Asset Class
(%)
A
B
C
D
E
Cash Equivalents
1
2
4
3
6
U.S. Intermediate-term Bonds
20
23
10
15
15
U.S. High-yield Corporate Bonds
16
25
20
25
25
U.S. Equities
35
35
20

30
24
Non-U.S. Equities
13
5
25
15
15
Real Estate Investment Trusts
15
10
21
12
15
Total
100
100
100
100
100
Alternative Portfolios
Portfolio Measures
A
B
C
D
E
Expected Annual Total Return (%)
8.42
7.59

8.77
8.13
7.90
Expected Standard Deviation (%)
11.18 10.31 11.54
10.85 10.28
Recommend the one alternative portfolio in Exhibit 7-1 that is the most appropriate strategic
asset allocation for the Hale portfolio. Justify your response with three reasons. Show your
calculations.
(7 minutes)


QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 6 MINUTES.
Sarah Cole, in addition to serving as Trustee for the Hale Health Foundation, is a board member
of the Glover Scholastic Aid Foundation. Glover, a community foundation with $40 million in
assets, was established to provide financial assistance to students attending a regional school for
the learning disabled. Glover’s investment policy statement, written eight years ago, is as
follows:
“The purpose of the Glover Scholastic Aid Foundation is to provide ongoing assistance to
students of the school. Investments should focus on maximizing income while avoiding
any losses. The Board of Directors has a duty to preserve Glover’s assets and tax-exempt
position while maximizing its ability to support the school.”
Glover has a current spending rate equal to 80 percent of interest and dividend income.
Presently, the Glover portfolio’s asset allocation is 85 percent to U.S. government bonds, 10
percent to U.S. equities, and 5 percent to a U.S. money market fund. The long-term expected
total annual return of the portfolio is 4.0 percent, which includes a 3.5 percent income
contribution. Education costs are expected to increase by 2.0 percent annually over the long
term, and the school is committed to maintaining its current size.
Since joining Glover’s board, Cole has been evaluating Glover’s current risk tolerance, spending
policy, and asset allocation, given its mandate, current funding, and long-term goals.

A.

Judge whether Glover or Hale has the greater ability to take risk. Justify your response
with one reference each to:
i.
ii.

Glover’s ability to take risk
Hale’s ability to take risk
(3 minutes)

B.

Judge whether Glover is likely to achieve intergenerational neutrality with respect to
current students and future students of the regional school. Justify your response with
one reference each to:
i.
ii.

Glover’s spending policy
The Glover portfolio’s asset allocation
(3 minutes)


QUESTION 9 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES.
The Glover Scholastic Aid Foundation has received a €20 million global government bond
portfolio from a Greek donor. This bond portfolio will be held in euros and managed separately
from Glover’s existing U.S. dollar-denominated assets. Although the bond portfolio is currently
unhedged, the portfolio manager, Raine Sofia, is investigating various alternatives to hedge the
currency risk of the portfolio.

The bond portfolio’s current allocation and the relevant country performance data are given in
Exhibits 9-1 and 9-2. Historical correlations for the currencies being considered by Sofia are
given in Exhibit 9-3. Sofia expects that future returns and correlations will be approximately
equal to those given in Exhibits 9-2 and 9-3.
Exhibit 9-1
Glover Scholastic Aid Foundation
Current Allocation
Global Government Bond Portfolio
Allocation
Maturity
Country
(%)
(years)
Greece
25
5
A
40
5
B
10
10
C
10
5
D
15
10

Country

Greece
A
B
C
D

Exhibit 9-2
Country Performance Data
(in local currency)
5-year
10-year
Unhedged
Cash
Excess
Excess
Currency
Return
Bond
Bond
Return
(%)
Return
Return
(%)
(%)
(%)
2.0
1.5
2.0

--1.0
2.0
3.0
–4.0
4.0
0.5
1.0
2.0
3.0
1.0
2.0
–2.0
2.6
1.4
2.4
–3.0

Liquidity
of 90-day
Currency
Forward
Contracts
Good
Good
Fair
Fair
Good


Exhibit 9-3

Historical Currency Correlation Table
(1998-2003, weekly observations)
€
Currency
A
B
C
D
(Greece)
€ (Greece)
1.00
–0.77
0.45 –0.57
0.77
A
--1.00 –0.61
0.56 –0.70
B
----1.00 –0.79
0.88
C
------1.00 –0.59
D
--------1.00
A.

Calculate the expected total annual return (euro-based) of the current bond portfolio if
Sofia decides to leave the currency risk unhedged. Show your calculations.
(4 minutes)

B.

Explain, with respect to currency exposure and forward rates, the circumstance in which
Sofia should use a currency forward contract to hedge the current bond portfolio’s
exposure to a given currency.
(3 minutes)

C.

Determine which one of the currencies being considered by Sofia would be the best
proxy hedge for Country B bonds. Justify your response with two reasons.
(5 minutes)

Sofia has been disappointed with the low returns on the current bond portfolio relative to the
benchmark—a diversified global bond index—and is exploring general strategies to generate
excess returns on the portfolio. She has already researched two such strategies: duration
management and investing in markets outside the benchmark index.
D.

Identify three general strategies (other than duration management and investing in
markets outside the benchmark index) that Sofia could use to generate excess returns on
the current bond portfolio. Give, for each of the three strategies, a potential benefit
specific to the current bond portfolio.
Answer Question 9-D in the Template provided on page 52.
(6 minutes)


Answer Question 9 on This Page
Template for Question 9-D
Identify three general strategies

(other than duration
management and investing in
markets outside the benchmark
index) that Sofia could use to
generate excess returns on the
current bond portfolio
1.

2.

3.

Give, for each of the three strategies, a potential benefit
specific to the current bond portfolio


QUESTION 10 HAS TWO PARTS (A, B) FOR A TOTAL OF 16 MINUTES.
After several years, the Board of Trustees of the Glover Scholastic Aid Foundation has decided
to allocate 12 percent of Glover’s total portfolio to international equities.
The Board is considering three alternative international equity managers: Highlands
Investments, Coastal Asset Management, and Valley Advisors. Portfolio statistics for Glover’s
current total portfolio and each of the three alternative equity managers are given in Exhibit 10-1.
Exhibit 10-2 gives portfolio statistics for Glover’s current total portfolio combined with Coastal
and Valley, respectively. The appropriate risk-free rate of return is 3.82 percent. All returns are
U.S.-dollar based.
Exhibit 10-1
Glover Scholastic Aid Foundation
Portfolio Statistics
Glover’s
Coastal

Current
Highlands
Asset
Total
Investments Management
Portfolio
Return Prior 5 Years

2.10%

–2.60%

–3.50%

–0.50%

---

0.83

0.80

0.87

Expected Return

8.50%

8.50%

9.75%

10.50%

Expected Standard Deviation

13.50%

27.00%

18.50%

32.00%

---

309.80

162.34

367.20

---

0.85

0.65

0.85

Correlation Prior 5 Years with
Current Glover Portfolio

Expected Covariance with
Current Glover Portfolio
Expected Correlation with
Current Glover Portfolio

Exhibit 10-2
Glover Scholastic Aid Foundation
Combined Portfolio Statistics
Highlands and
Coastal and
Glover Portfolio Glover Portfolio
Combined
Combined
Return Prior 5 Years
1.43%
Expected Return
8.65%
Expected Standard Deviation
13.43%
A.

Valley
Advisors

Valley and
Glover Portfolio
Combined

1.79%
8.74%
15.28%

Recommend one of the three alternative international equity managers being considered
by Glover’s Board of Trustees. Justify your response with reference to the portfolio
statistics for all three managers.
(7 minutes)


The Board has asked a consultant about possible determinants of the long-term performance of
Glover’s international equity investments. The consultant makes the following statements:

B.

•

“Because Glover’s portfolio has a long-term time horizon, currency risk makes a
much larger contribution to total risk than would be the case for an investor with a
short-term time horizon.”

•

“So-called ‘correlation breakdowns’ present Glover with an opportunity to
enhance portfolio diversification.”

•

“Glover can expect to realize superior long-term returns by identifying and
investing in international economies that have consistently offered superior

performance over time.”

Indicate whether each of the consultant’s three statements is correct or incorrect. If
incorrect, give one reason why the statement is incorrect.
Answer Question 10-B in the Template provided on page 59.
(9 minutes)


Answer Question 10 on This Page
Template for Question 10-B

Consultant’s three
statements

“Because Glover’s portfolio
has a long-term time horizon,
currency risk makes a much
larger contribution to total
risk than would be the case
for an investor with a shortterm time horizon.”

“So-called ‘correlation
breakdowns’ present Glover
with an opportunity to
enhance portfolio
diversification.”

“Glover can expect to realize
superior long-term returns by
identifying and investing in

international economies that
have consistently offered
superior performance over
time.”

Indicate whether each of
the consultant’s three
statements is correct or
incorrect
(circle one for each
statement)

Correct

Incorrect

Correct

Incorrect

Correct

Incorrect

If incorrect, give one reason why the
statement is incorrect


QUESTION 11 HAS ONE PART FOR A TOTAL OF 18 MINUTES.
Several more years have passed, and the Board of Trustees of the Glover Scholastic Aid

Foundation has invested in developed international equity markets with reasonable success.
Recently, the Board discussed adding emerging market equities to the portfolio. During the
discussion, Board members Mark McDuff and Freda Dorton made statements, shown in Exhibit
11-1, about three aspects—currency risk, segmentation and integration, and volatile markets—of
investing in emerging markets.

McDuff
Dorton

McDuff
Dorton

McDuff
Dorton

Exhibit 11-1
Mark McDuff and Freda Dorton
Statements about Three Aspects of Investing in Emerging Markets
I. Currency Risk
For emerging markets, we should expect the local currency movement to be in
the opposite direction of the local stock market movement.
Because of the nature of the correlation of market returns and currencies, we
could suffer more in a down market by investing in emerging markets than if
we had invested in a developed market.
II. Segmentation and Integration
Because of economic linkages, the expected returns of the individual countries
should be a function of those countries’ commonly shared risks.
Market efficiency transcends borders because of the global nature of world
economies. Local market prices will reflect these efficiencies.
III. Volatile Markets

When looking at investing in volatile emerging markets, we will find that
standard deviation is a sufficient measure of risk.
Because emerging markets are often highly volatile, we need to be aware of the
possibility of large shocks to returns. The distribution of those returns tends to
be non-normal.

Indicate, for each of the three aspects of investing in emerging markets, whether each of the
statements made by McDuff and Dorton is correct or incorrect. If incorrect, give one reason
why the statement is incorrect.
Answer Question 11 in the Template provided on pages 63, 64, and 65.
(18 minutes)


Answer Question 11 on This Page
Template for Question 11
Indicate, for each of the
three aspects of investing
in emerging markets,
whether each of the
statements made by
Three aspects
McDuff and Dorton is
correct or incorrect
(circle correct or
incorrect for each
statement)

If incorrect, give one reason why the statement
is incorrect

Correct
McDuff’s
statement
Incorrect

I. Currency Risk

Correct
Dorton’s
statement
Incorrect

Template for Question 11 continued on pages 64 and 65