2019 mock exam a afternoon session with solutions pdf

2019 Level III Mock Exam PM
The afternoon session of the 2019 Level III Chartered Financial Analyst Mock
®

Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions

Topic

Minutes

1–6

Ethical and Professional Standards

18

7–12

Behavioral Finance

18

13–18

Private Wealth

18

19–24

Economics

18

25–30

Asset Allocation

18

31–36

Fixed Income

18

37–42

Fixed Income

18

43–48

Equity

18

49–54

Alternative Investments

18

55–60

Global Investment Performance Standards
Total:

18
180

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© 2018 CFA Institute. All rights reserved.


2

2019 Level III Mock Exam PM

2019 LEVEL III MOCK EXAM PM
Athena Investment Services Case Scenario
Caitlyn Wilson, CFA, recently started her own asset management company, Athena
Investment Services. The board of directors of Athena adopted both the CFA Institute
Code of Ethics and Standards of Practice (Code and Standards) and the CFA Institute

Asset Manager Code of Professional Conduct (Asset Manager Code) to institutionalize ethical behavior within the firm. The board also implemented half-­yearly staff
performance reviews, including an assessment of each manager’s ability to ensure
their department’s compliance with the both the Code and Standards and the Asset
Manager Code.
Six months into the first financial year, Wilson meets with all of the managers
to assess each department’s compliance. Wilson asks the compliance officer, Mark
Zefferman, CFA, to make an opening statement to set the right tone for the meeting.
Zefferman states,
“At a minimum, we are responsible for implementing procedures addressing the general principles embedded in the six components of the Asset
Manager Code. As stated below, we must:
Statement 1
Statement 2
Statement 3

Act with skill, competence, and diligence while exhibiting independence and objectivity when giving investment advice,
Put our clients’ interests above the firm’s when appropriate and act in a professional and ethical manner at
all times, and
Communicate with our clients in a timely and non-­
misleading manner and obey all rules governing capital
markets.”

Zefferman adds,
“With regard to the last statement, please be aware that we must implement the new anti-­money-­laundering regulations introduced by our local
regulator, effective the first quarter of next year. I have analyzed the new
regulations and have found that all of the local requirements are part of
regulations recently introduced in Europe, where only a few of our clients
reside. When we start taking on new clients based in Singapore in the
second half of next year, we will also need to follow that country’s anti-­
money-­laundering regulations. The local anti-­money-­laundering legislation
appears to be embedded in the Singapore regulations as well.”

Wilson continues, “I would like each of you to explain how the implementation
of the Asset Manager Code within your department is being supervised. Let us start
with Shenal Mehta, our client service manager.”
Mehta states,
“With respect to the Asset Manager Code relating to client services, we have
ensured that we enforce the following policies: All disclosures are accurate
and complete, and our calculations are shown, no matter how complicated.
We also ensure that the client sees some sort of communication from us
when they request it and that the marketing material sent to clients is
checked by the compliance department for accuracy and completeness.”


2019 Level III Mock Exam PM

3

Anders Peterson, CFA, chief investment officer, states,
“In addition to what Mehta has said, I have the following comments:
Comment 1

Comment 2
Comment 3

On occasion, we are able to acquire securities we expect
will be particularly strong performers, such as oversubscribed initial public offerings. In order to ensure
that all clients are treated fairly, each client portfolio
is given the same number of shares.
Any communication with clients is kept confidential
and is only accessible by authorized personnel.
A gift and entertainment policy is in place to help ensure

our managers and analysts keep their independence
and objectivity.”

Richard Gilchrist, head of portfolio administration, then adds, “Our portfolio
policies call for all assets to be valued at fair market prices using third-­party pricing
services. When a security price is not available from the service, a committee whose
members have experience in valuing illiquid assets uses the hierarchy dictated by
Global Investment Performance Standards (GIPS) to determine values.”
Wilson concludes the meeting by mentioning that Athena must do even more to
ensure its clients continue to have faith in Athena’s ability to protect and grow their
assets. She recommends they disclose their risk management practices, which identify, measure, and manage the various risk aspects of the business to clients and the
regulator. She adds, “In addition, we need to create a business continuity plan covering
data backup and recovery, alternate trading systems if the primary system fails, and
methods to communicate to employees, critical vendors, and suppliers in case of an
emergency that could disrupt normal business functions.”
1 Which of Zefferman’s opening statements is inconsistent with the Asset
Manager Code of Professional Conduct?
A Statement 1
B Statement 3
C Statement 2

C is correct. Zefferman states that the firm is responsible for putting clients’ interests
above the firm’s when appropriate. The General Principles of Conduct embedded in the
six components of the Asset Manager Code state that managers have the responsibility
of acting for the benefit of clients. The code does not stipulate that this responsibility is
applicable only when appropriate.
A is incorrect because the principles reflected in the statement are correct.
B is incorrect because the principles reflected in the statement are correct.
Asset Manager Code of Professional Conduct
LOS b

General Principles of Conduct

2 Which of the following anti-­money-­laundering laws must Athena currently
comply with to be consistent with the CFA Institute Standards of Professional
Conduct?
ALocal
BSingaporean


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2019 Level III Mock Exam PM

CEuropean

C is correct. Zefferman, as a CFA charterholder, will be responsible for ensuring that
Athena complies with the stricter anti-­money-­laundering laws of Europe, where some of
its clients reside, as per Standard I(A)–Knowledge of the Law. Europe’s new laws, which
encompass and exceed the local anti-­money-­laundering regulations, are already in place;
therefore, these are the regulations that must be currently followed.
A is incorrect because Zefferman will be responsible for implementing the more strict
laws of Europe that are currently in place.
B is incorrect because Zefferman will be responsible for implementing the more strict
laws of Europe that are currently in place.
Guidance for Standards I–VII
LOS b
Standard I(A)–Knowledge of the Law

3 Which of Mehta’s client service policies is consistent with the Asset Manager
Code of Professional Conduct?

A Types of disclosures
B Communication timing
C Marketing material reviews

C is correct. Section D, Risk Management, Compliance, and Support, of the Asset Manager
Code states that portfolio information provided to clients should be reviewed by an
independent third party. The compliance department would be considered an independent third party because compliance is not involved with compiling or presenting
the information to clients. According to Section F, Disclosures, disclosures should be
truthful, accurate, complete, and understandable. It is unlikely that clients would easily
understand complicated calculations. Section F, Disclosures, also calls for communications
with clients to be on an ongoing and timely basis. Communication with clients only when
they ask for it would not be consistent with the Asset Manager Code. It is recommended
that communication be at least on a quarterly basis.
A is incorrect because according to Section F, Disclosures, disclosures should be
truthful, accurate, complete, and understandable. It is unlikely that clients would easily
understand complicated calculations.
B is incorrect because Section F, Disclosures, calls for communications with clients to be
on an ongoing and timely basis. Annual communication would not be considered timely.
Asset Manager Code of Professional Conduct
LOS c
Section A, Loyalty to Clients; Section D, Risk Management, Compliance, and Support; Section F,
Disclosures

4 Which of Peterson’s comments is inconsistent with the Asset Manager Code of
Professional Conduct?
A Comment 1
B Comment 3
C Comment 2

2019 Level III Mock Exam PM

A is correct. Section B(6)(b), Investment Process and Actions, requires clients to be treated
equitably, not equally. Clients have different investment objectives and risk tolerances,
so treating clients equally would be inconsistent with the Asset Manager Code.
B is incorrect because the policy is consistent with the Asset Manager Code.
C is incorrect because the policy is consistent with the Asset Manager Code.
Asset Manager Code of Professional Conduct
LOS c
Section A, Loyalty to Clients; Section B, Investment Process and Actions

5 Are Gilchrist’s comments regarding portfolio valuation consistent with the
Asset Manager Code of Professional Conduct?
AYes.
B No, with regard to third-­party pricing services.
C No, with regard to the process used to price illiquid securities.

A is correct. Section E, Performance and Valuation, of the Asset Manager Code calls for
the use of fair market values sourced by third parties when available, and when such
third-­party prices are not available, the code calls for the use of “good faith” methods
to determine fair value. Athena’s policy appears consistent with this requirement. In
terms of client reporting, monthly valuation reports would be consistent with the call
for timely reporting.
B is incorrect because Gilchrist’s valuation methodology using fair value and third-­
party valuers is consistent with the Asset Manager Code.
C is incorrect because Gilchrist’s monthly valuation reports to clients would be considered consistent with the Asset Manager Code.
Asset Manager Code of Professional Conduct
LOS c
Section E, Performance and Valuation; Section F, Disclosures

6 Are Wilson’s closing remarks consistent with recommended practices and
procedures designed to prevent violations of the Asset Manager Code of
Professional Conduct?
A No, with regard to the business continuity plan.
B No, with regard to disclosure of the firm’s risk management process.
CYes.

A is correct. At a minimum, Section D, Risk Management, Compliance, and Support, of
the Asset Manager Code recommends that a business continuity plan include plans for
contacting and communicating with clients during a period of extended disruption.
Wilson’s continuity plan includes no such strategy. Wilson’s recommendation for disclosing the firm’s risk management process to both clients and regulators goes beyond the
code recommendation, which is to disclose the risk management process only to clients.

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2019 Level III Mock Exam PM

B is incorrect because Wilson’s recommendation for disclosing the firm’s risk management process goes beyond the Code recommendations to disclose the risk management
process to just clients, not to regulators. Wilson recommends they disclose to both.
C is incorrect because Wilson’s recommendation regarding the business continuity
plan did not include the recommended action of having a plan to contact and communicate with clients during a period of extended disruption.
Asset Manager Code of Professional Conduct
LOS d
Section D, Risk Management, Compliance, and Support; Appendix 6, Recommendations and
Guidance

Emerald Private Bank Case Scenario

Laura Davidson is a financial advisory partner with Emerald Private Bank (Emerald).
Emerald is based in Dublin, Ireland, and manages money on behalf of high-­net-­worth
individual investors, foundations, and endowments. Davidson works in Emerald’s
private wealth group (PWG). This group is tasked with meeting clients, developing
financial plans, and implementing recommendations from Emerald’s investment
committee. The PWG meets weekly to review new client relationships and to discuss
the most appropriate approach for working with each client. Emerald believes there
are significant benefits to incorporating behavioral finance as part of their client
assessment process and has recently made changes to this effect. During preparation
for the weekly PWG meeting, Davidson reviews the financial holdings of three new
clients along with their risk assessment questionnaires. Her observations are summarized in Exhibit 1.
Exhibit 1  Client Assessment Highlights
Client

Assessment Notes

Kyra Conner

Conner is a mid-­level executive at a publicly traded technology company. Approximately 80 percent of her defined-­contribution plan is
invested in her own company’s stock. Conner focuses on short-­term
performance and is not comfortable with change. Her assessment
indicates she is not comfortable taking excessive risks.

Michael
Donnelly

Donnelly recently sold a large publishing firm that he founded 20
years ago. Although he has substantial assets, he spends at a rate
that does not appear to be sustainable. He has a very high risk
tolerance and enjoys chasing high-­risk investments recommended

by friends. He is strong willed and questions the benefits of portfolio
diversification.

Alan
O’Driscoll

O’Driscoll is a retired biotechnology executive. His investment
portfolio is comprised of a variety of mutual funds and stocks he has
acquired over the years based on recommendations from friends and
colleagues. He tends to be drawn to the latest, popular investment
themes. He is indicated as a moderate risk taker.

During the meeting, fellow adviser Liam Roche makes the following observation
based on the information in Exhibit  1: “Mr. Donnelly should respond favorably to
education focused on how the investment program affects financial security, retirement planning, and future generations. However, Ms. Connor and Mr. O'Driscoll will
respond better to education on portfolio metrics, such as the Sharpe Ratio.”


2019 Level III Mock Exam PM

Amanda Kelly is an investment strategist and a member of Emerald’s investment
committee. Kelly sits in on the PWG meeting to provide an update on the firm's
investment themes and positioning. Emerald has developed a multifactor macro
model to forecast such variables as GDP growth and interest rate movements. At the
meeting, Kelly provides detailed information about the macro model, including many
statistics on how the factors have performed using both in-sample and out-of-sample
backtesting. The model appears to have had a good track record of predicting changes
in the macro environment over time.
As part of her investment update, Kelly notes that the macro model predicts that
interest rates in Europe are going to revert to their historical averages over the next

three years and that this move will start within the next six to nine months. Davidson
asks Kelly if recent unprecedented monetary policy actions by the Bank of England
and European Central Bank have affected the reliability of the model. Kelly responds
that because the macro model incorporates more than 100 different variables, central
bank policies are accurately accounted for.
Later that day, Kelly attends Emerald’s weekly investment committee meeting.
Kelly brings up Davidson's concerns regarding how central bank activity may affect
the accuracy of their macro model. Emerald's chief investment officer (C IO), wh o
chairs the meeting, dismisses Davidson's concerns as uninformed. The r est o f t he
committee members agree. The C IO t hen s uggests u pdating t heir s tock s election
model to incorporate a price momentum factor. Kelly states that she is concerned that
momentum will not be effective across all sectors. The CIO counters that because a
number of behavioral biases support the persistence of price momentum, they would
be foolish not to incorporate this factor. After a brief discussion, the other committee
members agree with the CIO, and momentum is added to the stock selection model.
Following the meeting, Kelly is frustrated and writes an email to the CIO with
suggestions she believes will improve the dynamics of the investment committee in
the future. Her recommendations include the following:
1 Spending more time analyzing prior committee decisions
2 Structuring the committee to ensure a higher level of common skills and
experiences
3 Requesting stated opinions from members prior to any formal committee
discussion
7 Benefits of the recent changes to Emerald’s client assessment process least likely
include:
A improving Emerald’s client retention metrics.
B reducing portfolio risk.
C closer adherence to client expectations.

B is correct. Incorporating behavioral finance does not have a direct impact on portfolio

risk. In some cases, this approach will help encourage a reduction in portfolio risk, but
it may also help other clients to take on more risk as appropriate. Investing as the client
expects and improvements to client retention metrics are both benefits of incorporating
behavioral finance.
A is incorrect. Improving the advisory practice is a likely benefit of incorporating
behavioral finance.

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2019 Level III Mock Exam PM

C is incorrect. Investing as the client expects is a likely benefit of incorporating
behavioral finance.
Behavioral Finance and Investment Processes
LOS b
Section 3

8 Roche’s observation regarding client education is least likely accurate for which
client?
A Kyra Conner
B Alan O’Driscoll
C Michael Donnelly

A is correct. Both Conner and Donnelly are exhibiting emotional biases. When advising
emotionally biased investors, advisers should focus on explaining how the investment
program being created affects such issues as financial security, retirement, or future
generations rather than focusing on quantitative details. The recommendation for Conner

would be more suited for a cognitively biased investor. O’Driscoll is a cognitively biased
investor (friendly follower). As such, focusing on such metrics as the Sharpe Ratio would
be appropriate for this client.
B is incorrect. O’Driscoll is a cognitive investor, so focusing on metrics such as the
Sharpe ratio would be appropriate for this client.
C is incorrect. Donnelly is an emotional investor, and this approach is appropriate.
Behavioral Finance and Investment Processes
LOS b
Section 2

9 Which behavioral investor type most likely describes Michael Donnelly?
A Independent individualist
B Friendly follower
C Active accumulator

C is correct. Donnelly is entrepreneurial and created his own wealth. He lacks spending
controls, does not believe in the benefits of portfolio diversification, has a high risk
tolerance, and prefers high-­risk investments recommended by friends. These are all
attributes of an active accumulator.
A is incorrect. Independent individualists have a medium to high risk tolerance
whereas Donnelly has a very high risk tolerance. While some of the traits are similar,
active accumulator more closely describes this client.
B is incorrect. Friendly followers have a low to medium risk tolerance whereas Donnelly
has a very high risk tolerance
Behavioral Finance and Investment Processes
LOS a
Section 2

10 In Kelly’s response to Davidson, she is most likely exhibiting:

2019 Level III Mock Exam PM

A gambler’s fallacy.
B

self-­attribution bias.

C illusion of control bias.

C is correct. The illusion of control bias can be encouraged by complex models. The
illusion of control can lead to analysts being overly confident when forecasting complex
patterns, such as future interest rate movements.
B is incorrect. With self-­attribution bias, analysts take personal credit for successes
and attribute failures to external factors outside of their control. There is no evidence
that Kelly is suffering from this bias.
A is incorrect. The gambler’s fallacy is a misunderstanding of probabilities in which
analysts wrongly project reversal to a long-­term mean. This bias is caused by a faulty
understanding of random events and expecting patterns to repeat. While Kelly is
expecting rates to increase to historical averages, she is basing this on output from the
macro-­model.
Behavioral Finance and Investment Processes
LOS e
Section 5

11 Which of the following biases least likely provides behavioral support for the
factor being added to the stock selection model?
AFraming
BHindsight
CAvailability

A is correct. Framing bias is a type of cognitive error in which a person answers a question
differently based on the way in which it is asked. This behavior is unlikely to explain the
persistence of momentum. Regret is a type of hindsight bias that can result in investors
purchasing securities after a significant run-­up in price because of a fear of not participating. This bias could explain momentum. With availability bias, also referred to as the
recency effect, the tendency to recall recent events more vividly can result in investors
extrapolating recent price gains into the future. This bias could also explain momentum.
B is incorrect. Regret is a type of hindsight bias that can result in investors purchasing
securities after a significant run-­up in price due to fear of not participating. This could
explain momentum.
C is incorrect. With availability bias, also referred to as the recency effect, the tendency
to recall recent events more vividly can result in investors extrapolating recent price
gains into the future. This could explain momentum.
Behavioral Finance and Investment Processes
LOS g
Section 5 and 7

12 Which of Kelly’s recommendations is least likely to be effective?
A Recommendation 2
B Recommendation 3
C Recommendation 1

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2019 Level III Mock Exam PM

A is correct. It is recommended that investment committees be composed of people

with differing skills and experiences, not similar as Kelly has suggested. Decision makers
are most likely to learn to control harmful behavioral biases when they have repeated
attempts at decision making and there is good quality feedback on prior outcomes. The
investment committee chair should actively encourage alternative opinions so that all
perspectives are covered. Asking for individual views prior to discussion can help mitigate
the impact of group thinking.
B is incorrect. Individuals may moderate their own views in a committee setting to fit
with consensus. The chair should actively encourage alternate opinions so that all perspectives are covered. Asking for individual views prior to discussion can help mitigate
the impact of group thinking.
C is incorrect. It is recommended that investment committees are comprised of people
with differing skills and backgrounds, not similar as Kelly has suggested.
Behavioral Finance and Investment Processes
LOS f
Section 8.6

Geri Buylak Case Scenario
Geri Buylak, a financial advisor, is preparing for a meeting with Kasey McLoughlin,
the recent widow of,
Bryn McLoughlin, a resident of the country of Weshvia. From her files of the
McLoughlin family, Buylak notes the following which she thinks might be relevant
in the meeting:
■

Kasey was Bryn’s second wife.

■

Bryn has been the sole provider for his grandson Paulo for the past 20 years;
Paulo was orphaned at the age of three and initially lived with Bryn and his first
wife.

Mainly as a result of the stress arising from the disabilities and medical problems that Paulo developed, Bryn’s first marriage ended in divorce within one
year. Two years later, it was determined that Paulo would be better off living in
a private care facility in the sunny warm climate of Izlandia where he continues
to live today.

■

To insure that Paolo’s future needs would be met, shortly after the child was
orphaned, Bryn purchased a €3 million life insurance policy on his own life for
a one-­time premium of €500,000. At the same time, Bryn’s father bought a similar, but smaller policy on his own life. Ownership of both policies was transferred to a discretionary irrevocable trust with Paolo as the primary beneficiary
and the University of Izlandia as the remainderman.

■

Buylak was appointed as the investment advisor for the trust.

■

Bryn and Kasey were married two years after Bryn’s divorce.

Buylak had been faxed a copy of Bryn’s will and in combination with other information she had available made the following notes:
■

Two years ago, Bryn disposed of his very successful construction company and
invested the proceeds in two overseas distribution centers. The first property is
located in the country of Landlochen and at the time of his death it was jointly
owned with Kasey with the right of survivorship. For the second of these properties Bryn’s will named Paolo as the beneficiary of the property – the property
is located in Izlandia where he resides.

2019 Level III Mock Exam PM

11

■■

Kasey was named the beneficiary of Bryn’s taxable account and two tax advantaged retirement accounts.

■■

Weshvia, Izlandia and Landlochen all use the euro, and none of the three tax
regimes impose any tax consequences on spousal transfers either before or after
death.

As they begin their meeting, Kasey first asks Buylak if any of the provisions of the
life insurance policy or dispositions of the investment properties might be challenged
in the probate process.
Kasey mentions to Buylak that she is aware that a large part of her wealth now
depends on the investment property in Landlochen and asks Buylak what cash flow
would be available to her annually after taxes from its lease income and what after-­
tax cash proceeds might she obtain if the property was sold when the current lease
expires. Buylak had been prepared for these questions and her responses were based
on the following:
■■

The investment real estate property in Landlochen had a cost basis of
€2,900,000, a present market value of €3,000,000, and it produces income of
€450,000 (pre-­tax) annually through a lease agreement that expires in five years.
By this time, the property will have been owned for seven years.

■■

After reviewing several reports analyzing Landlochen real estate values, Buylak
estimates that the property could be sold at the termination of the lease for 30%
above its present market value.

■■

The tax structure in Landlochen differs from Kasey’s home country Weshvia as
shown in Exhibit 1. Fortunately, there is a provision for some relief from double
taxation. Weshvia allows use of the deduction method with regard to income
taxes and the credit method toward capital gains.

Exhibit 1  Tax Rates on Investment Property relevant to Kasey McLoughlin
Country
Type of Real Estate Property
Tax

Landlochen

Weshvia

• Wealth Tax

1.5% of cost basis, accumulated annually and
paid at the time of sale

None

• Income Tax

35% of annual income

25% of annual income

• Capital Gains
Applies to location

20% at time of sale

25% at time of sale

Locally operating within
borders

Owned by residents anywhere in the world

Based on her calculations for the cash flows from the Landlochen investment
property, Buylak recommends that the three inherited investment accounts be held
for the next 12 years with all earnings and gains reinvested. In anticipation of another
after-­tax cash flow question, she estimates the accrual equivalent after-­tax rate of
return on the portfolio of combined accounts over the next 12-­year period using the
information in Exhibit 2.


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2019 Level III Mock Exam PM

Exhibit 2 

A. Kasey McLoughlin’s Inherited Investment Portfolio

Current asset value in €

Taxable

Tax Deferred

Tax Exempt

1,200,000

700,000

180,000

12.0%

7.5%

11.0%

Expected rate of annual pre-­tax return:

B. Tax Treatment of Investment Income in Weshvia
Taxable Accounts

Total returns are taxed at 28% annually

Tax Deferred Accounts

Distributions are taxed at 40%, with deferral allowed for a
maximum of 12 years at which time a full distribution is
required

Bryn’s father died about a year after Bryn, creating additional life insurance proceeds paid to Paolo’s trust from the second policy. In considering how investments
in the trust portfolio should be changed, Buylak first reviews the trust’s Investment
Policy Statement (IPS) and notes the following objectives and constraints:
■■

an expected 3.5% real, after-­tax return

■■

a worst-­case portfolio decline should not exceed 9% in nominal returns in any
year. Downside risk is to be measured as two standard deviations below the
expected return

■■

at least 10% of the portfolio is to be dedicated to cash and cash equivalents
which should be sufficient to meet liquidity needs.

Buylak develops the three proposed portfolios presented in Exhibit 3 which she
believes are in keeping with the trust’s IPS.
Exhibit 3  Annual Portfolio Statistics from Three Potential Portfolio
Allocations
X (%)

Y (%)

Z (%)

10.6

11.5

11.0

Expected real after-­tax total return

3.9

4.2

3.9

Expected standard deviation

9.67

12.70

10.10

Nominal expected total return

All portfolios meet the IPSs liquidity constraint
Risk-­free return: 4.0%

13 If Paolo had predeceased Bryn, the life insurance proceeds would most likely
have been paid to:
ABryn.
BKasey.
C the University of Izlandia.


2019 Level III Mock Exam PM

C is correct. The trust was irrevocable so neither Bryn (while alive) nor his wife would
have a claim on any of its assets including the life insurance policy or its proceeds. Had
Paolo predeceased Bryn, the proceeds of the life insurance policy would have been paid
to the remainderman on Bryn’s death, i.e., to the University of Izlandia.
A and B are incorrect. The trust was irrevocable so neither Bryn (while alive) nor his
wife had a claim on its assets including the life insurance property.
Estate Planning in a Global Context
LOS g
Section 5.1
Managing Individual Investor Portfolio
LOS i
Section 4.2.4

14Buylak’s best response to which of the items might be challenged in the probate
process is the:
A Izlandia distribution center.
B proceeds of the life insurance.
C Landlochen distribution center.

A is correct. Probate is the legal process to confirm the validity of the will so that executors, heirs, and other interested parties can rely on its authenticity. Only the Izlandia
distribution center changes ownership through a provision of the will. Joint ownership

with right of survivorship automatically transfers to the surviving joint owner (Kasey).
Death benefit proceeds under a life insurance contract pass directly to policy beneficiaries
outside the probate process.
B is incorrect. Probate only deals with property that remains in the estate: Death
benefit proceeds under a life insurance contract pass directly to policy beneficiaries
outside the probate process.
C is incorrect. Probate only deals with property that remains in the estate: Joint ownership with right of survivorship includes a provision to transfer the deceased share [of
the Landlochen distribution center] to the surviving joint owner (Kasey).
Estate Planning in a Global Context
LOS a, h
Sections 2.1 and 5.3

15 Using Exhibit 1, the annual amount of after-­tax cash flow that Kasey will earn
on the Landlochen property lease is closest to:
A€175,875.
B€219,375.
C€292,500.

B is correct. In each year, the tax rate under the deduction method will be:

TResidence + T Source(1 – TResidence)
which here is (0.25) + 0.35(1 – 0.25) = 0.5125

13


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2019 Level III Mock Exam PM

This is the combined tax rate net of tax relief via the deduction method.
Kasey’s after-­tax annual cash flow is €450,000 × (1 – 0.5125) = €219,375.
A is incorrect. The mistake is in including the annual wealth tax in annual cash flow; it is
not payable until the end of the five-­year period: 219,375 – (0.015 × 2,900,000) = 175,875
C is incorrect. The mistake is applying the credit method, which uses the higher tax
rate alone: 450,000 × (1 – 0.35) = 292,500
Estate Planning in a Global Context
LOS i, k
Section 6.3.1

16 If Buylak’s expectations about the Landlochen investment property are realized, using Exhibit 1, the after-­tax net cash proceeds that Kasey will receive on
disposal of the property at the expiration of the lease is closest to:
A€3,145,500.
B€3,345,500.
C€3,370,500.

B is correct. After applying 30% appreciation, the 1.5% per year wealth tax, and the
two capital gains taxes (local source Landlochen and residential Weshvia while applying
the credit method), the net proceeds are €3,345,500 calculated as follows:
Sale price

€3,000,000 – 1.30

Less total taxes (calculated below)

€3,900,000
–554,500
€3,345,500

Net Proceeds

Calculation of total taxes
Wealth tax

2,900,000 × 0.015 – 7 years

Plus: Capital Gains Tax from Landlochen

(3,900,000 – 2,900,000) – 0.20

200,000

Plus: Capital Gains Tax from Weshvia of 0.25
minus 0.20 credit

(3,900,000 – 2,900,000) – 0.05

50,000

Total taxes

€304,500

€554,500
The two-­step calculation of capital gains tax under the credit method is equivalent to:

TCredit Method = Max(T Source, TResidence) = Max(20%, 25%) = 25%,
Giving a capital gains tax of (3,900,000 – 2,900,000) – 0.25 = €250,000
C is incorrect. It calculates the capital gain on the difference between current market
value (3,000,000) instead of the original cost (2.9 million) and the 3,900,000
Sale price

Less total taxes (calculated below)

€3,000,000 × 1.30

€3,900,000
–529,500

€3,370,500

Net Proceeds
Calculation of total taxes
Wealth tax
Plus: Capital Gains Tax from Landlochen
Plus: Capital Gains Tax from Weshvia of
0.25 minus 0.20 credit
Total taxes

2,900,000 × 0.015 × 7
(3,900,000 – 3,000,000) × 0.20
(3,900,000 – 3,000,000) × 0.05

€304,500
180,000
45,000
€529,500


2019 Level III Mock Exam PM

15

A is incorrect. It omits the gains tax credit from the residence country. Applies the
full 0.25 capital gains rate from Weshvia thereby skipping the credit for Landlochen
gains taxes.
Sale price

€3,000,000 × 1.30

Less total taxes (calculated below)

€3,900,000
–754,500
€3,145,500

Net Proceeds
Calculation of total taxes
Wealth tax

2,900,000 × 0.015 × 7

Plus: Capital Gains Tax from Landlochen

(3,900,000 – 2,900,000) × 0.20

200,000

Plus: Capital Gains Tax from Weshvia of 0.25
IGNORING 0.20 credit

(3,900,000 – 2,900,000) × 0.25

250,000

Total taxes

€304,500

€754,500

Estate Planning in a Global Context
LOS i, k
Sections 6.2 and 6.3
Taxes and Private Wealth Management in a Global Context
LOS b
Section 3.1

17 Using Exhibit 2, the accrual equivalent after tax annual return that Buylak calculates for Kasey’s investment portfolio is closest to:
A7.35%.
B7.45%.
C7.58%.

A is correct. Calculate ending value after taxes at the end of 12 years.

Accrual Equivalent Annual Return % = 100% × [(Ending Value/Beginning
Value)1/12 – 1]
Return

Beginning Value
or “BV”
Taxable

Ending Value
or “EV”

1,200,000

Tax Deferred

Returns taxed annually
at 28%

0.12

BV[1 + 0.12(1 – 0.28)]12

700,000

0.075

BV(1 + 0.075)12 × (1 –
0.40)

Net of 40% Distribution
Tax
Tax Exempt

Formula

180,000

= 1,667,245 × (1 – 0.40)

0.11

3,243,832

1,000,347

BV(1+0.11)12

629,721

Combined Ending Value

4,873,900

Combined Beginning Value

2,080,000

Accrual Equivalent After-­Tax Annual Return = (4,873,900/2,080,000)1/12 – 1 = 0.0735 = 7.35%


16

2019 Level III Mock Exam PM

B is incorrect. It takes a weighted average of the after-­tax return rates where the
weights come from the values in each account type. This method is an invalid short-­cut.

{(1,200/2,080) × [12 × (1 – 0.28)]} + [(700/2,080) × 7.50 × (1 – 0.40)] +
[(180/2,080) × 11.0]= 7.45
C is incorrect. It omits the annual taxation of income in the taxable account.
Beginning Value or
“BV”
Taxable

Tax Deferred

Return

1,200,000
BV(1 + 0.12)12 × (1 – 0.28)
(tax arises only at end)

3,366,123

Returns taxed annually
at 28%

0.12

700,000

0.075

BV(1 + 0.075)12 × (1 – 0.40)
= 1,667,245 × (1 – 0.40)

1,000,347

0.11

BV(1 + 0.11)12

629,721

Net of 40% Distribution
Tax
Tax Exempt

Ending Value
or “EV”

Formula

180,000
Combined Ending Value

4,996,192

Combined Beginning Value
Accrual Equivalent Annual Return =

2,080,000
(4,996,192/2,080,000)1/12

– 1= 0.0758 = 7.58%

Taxes and Private Wealth Management in a Global Context

LOS d
Sections 3.3 and 4.0

18 Of the portfolios presented in Exhibit 3, the choice that is most consistent with
the trust’s IPS is:
A portfolio X.
B portfolio Y.
C portfolio Z.

A is correct. All portfolios meet the real after-­tax return requirement and liquidity constraints but only portfolio X meets the worse-­case return constraint, as shown in the
table below which adds the Sharpe ratio and worst-­case return data to the information
in Exhibit 3. Both portfolio X and Z have the same expected real after-­tax total returns
and portfolio Z has the highest Sharpe ratio but Z does not meet the worse-­case return
constraint. Portfolio Y has the highest real after-­tax return but the lowest Sharpe ratio
and does not meet the worse-­case return constraint.

Annual Portfolio Statistics from three potential portfolio allocations
X (%)

Y (%)

Z (%)

10.6

11.5

11.0

Expected real after-­tax total return

3.9

4.2

3.9

Expected standard deviation

9.67

12.70

10.10

Nominal expected total return


2019 Level III Mock Exam PM

17

(Continued)
X (%)
Sharpe ratio
Worst-­case return

Y (%)

0.683

0.591

–8.74

–13.9

Z (%)
0.693
–9.2

Worst-­case return = Downside risk = Expected nominal total return – 2 standard deviations.
For example, for portfolio X: 10.6 – (2 × 9.67) = –8.74.
All portfolios meet the IPSs liquidity constraint.

B is incorrect. Portfolio Y has the highest nominal and real after-­tax returns, but has
both a lower Sharpe ratio and does not meet the worst-­case return constraint.
C is incorrect. Portfolio X and Z have the same real after-­tax returns and the same
Sharpe ratio, but portfolio Z violates the worst-­case return constraint making X the best
choice.
Managing Individual Investor Portfolios
LOS k
Section 5

Emily Ronan Case Scenario
Emily Ronan provides economic analysis of developing countries in her role at CZT
Partners. For the country of Antegria, she models gross domestic product (GDP) by
regressing the percentage change in GDP (%ΔGDP) against the percentage changes
in capital stock (%ΔK) and labor (%ΔL) during the previous 10 years using quarterly
data. Ronan assumes a Cobb–Douglas production function with constant returns to

scale (see Exhibit 1).
Exhibit 1  Regression for %ΔGDP
Variable

Regression Coefficient

Intercept

0.082

%ΔK

0.725

%ΔL

0.382

Based on the regression output, Ronan compares the effects of a 4% increase in
capital stock, a 10% increase in labor, and the Solow residual on GDP growth.
Ronan runs a similar regression for Bangalla, another country in the region, which
projects %ΔGDP to be 7.2% during the next 12 months. Turning to Bangalla’s equity
market, the EQXX, a composite index that represents the country’s equity market, she
projects its short-­term dividend growth rate to be the same as the expected %ΔGDP.
Ronan notes that the 7.2% expected short-­term dividend growth rate for the EQXX
substantially exceeds both its historical average dividend growth rate and its long-­
term sustainable dividend growth rate, as shown in Exhibit 2. Using her short-­term
dividend growth rate assumption, Ronan applies an H-­model (assuming a 30-­year
time horizon) to determine the appropriate intrinsic value for the EQXX.

18

2019 Level III Mock Exam PM

Exhibit 2  EQXX Equity Index Data
EQXX current index level

765.88

EQXX current dividend level

40.32

EQXX discount rate*

12.16%

30-­year future sustainable EQXX dividend growth
rate*

3.95%

Historical average dividend growth rate

6.22%

Note: All rates shown are inflation adjusted.
* This information is provided from a consensus of multiple analysts’ forecasts.

Given that the region tends to suffer frequent periods of currency instability and
that most of the firms are state controlled, Ronan discusses with her co-­workers
Curtis Chadwick and Earl Johns the relative merits of using the H-­model and another
suggested model, the Gordon model. They make the following comments:
Chadwick:

A Gordon growth model analysis would produce a nominal rate, which
would be more stable than a real rate.

Johns:

The currency instability should not affect the results from using either
the H-­model or the Gordon growth model.

Ronan:

I am still concerned about the state-­controlled firms having an incentive to overstate productivity, which could affect both models.

Chadwick then shares with his co-­workers an analysis he is performing on the equity
market for a more developed country, Brungaria. Ronan suggests using the Fed model
to determine whether Brungaria’s equity market is correctly valued. Chadwick considers the Fed model after collecting the economic and market data shown in Exhibit 3.
Exhibit 3  Brungaria Economic and Market Data
Long-­term government treasury yield

4.67%

Short-­term government treasury yield

2.93%

Forward earnings yield

5.25%

Forecasted inflation

2.32%

Justified forward earnings yield

4.35%

Chadwick is concerned that Brungaria might not be developed enough for the
Fed model to apply, so he uses a market-­level version of an “equity q” to evaluate the
Brungarian equity market. He calculates the equity q to be 0.775 using asset book values and current market data. He then discusses his calculation with Ronan and Johns:
Ronan:

The equity q tends to react quickly to changes in the market and can
be very volatile.

Johns:

Chadwick’s calculation may be overstated because the replacement
costs for the assets may be higher than their book values.

Chadwick:

Although the measure may be overstated, the equity q is lower than
1.0 in either case, implying that the market is overvalued.

19 The constant returns to scale assumption for the Cobb–Douglas production
function is most likely violated in the regression results in Exhibit 1 because
the:


2019 Level III Mock Exam PM

19

A intercept and coefficients for %ΔK and %ΔL sum to greater than one.
B coefficients for %ΔK and %ΔL sum to greater than one.
C intercept is less than one.

B is correct. For the constant returns to scale assumption to be valid, the coefficients
for %ΔK and %ΔL must sum to one. That is, a given percentage increase in capital stock
and labor input must result in an equal percentage increase in output. Because the
coefficients for %ΔK and %ΔL sum to greater than one, the constant returns to scale
assumption is violated.
The Cobb–Douglas function can be expressed as follows:

∆Y
∆A
∆K
∆L
≈
+α
+ (1 − α)
Y
A
K

L
where Y is GDP, A is total factor productivity (TFP), K is capital, and L is labor.
Consequently, regressing the percentage change in GDP (%ΔGDP = ΔY/Y) against the
percentage changes in capital stock (%ΔK = ΔK/K) and labor (%ΔL = ΔL/L) means TFP is
the intercept for the regression, β1 = α, and β2 = (1 – α):

%ΔGDP = intercept + β1 × %ΔK + β2 × %ΔL
A is incorrect. The sum of the intercept and the coefficients for %ΔK and %ΔL can sum
to more than one and be consistent with the assumption of constant returns to scale as
long as the coefficients for %ΔK and %ΔL sum to one.
C is incorrect. The intercept being less than one does not violate the constant returns
to scale assumption.
Equity Market Valuation
LOS a, b
Section 2.1

20 Based on Ronan’s assumptions about the growth in capital stock and labor input
as well as the regression output in Exhibit 1, which Cobb–Douglas production
function input most likely has the greatest effect on %ΔGDP?
A Total factor productivity
BLabor
C Capital stock

A is correct. Based on the regression in Exhibit 1 and the assumed percentage changes
in capital stock (4%) and labor (10%) inputs, the Cobb–Douglas production results in an
expected growth in GDP of 14.9% as follows:

%∆GDP

Growth in

Total Factor
Productivity

Growth in Capital
Stock × Output
Elasticity of Capital

Growth in Labor Input
× Output Elasticity of
Labor

0.082

4% × 0.725 = 0.029

10% × 0.382 = 0.0382

The greatest effect on %∆GDP arises from TFP.
The Cobb–Douglas function can be expressed as

∆Y
∆A
∆K
∆L
≈
+α
+ (1 − α)
Y
A
K

L


20

2019 Level III Mock Exam PM

where Y is GDP, A is total factor productivity (TFP), K is capital, and L is labor.
Consequently, regressing the percentage change in GDP (%ΔGDP = ΔY/Y) against the
percentage changes in capital stock (%ΔK = ΔK/K) and labor (%ΔL = ΔL/L) means TFP is
the intercept for the regression, β1 = α, and β2 = (1 – α):

%ΔGDP = intercept + β1 × %ΔK + β2 × %ΔL
C is incorrect. The %∆GDP resulting from the %∆K (capital stock) is the regression
coefficient multiplied by 4%: 0.029 = 0.725 × 0.04 and is lower than 0.08. It may be selected
because it has the highest regression coefficient.
B is incorrect. The %∆GDP resulting from the %∆L (labor) is the regression coefficient
multiplied by 10%: 0.0382 = 0.382 × 0.10 and is lower than 0.08. It may be selected because
it has the highest percentage change (10%).
Equity Market Valuation
LOS b
Section 2.1

21 Compared with Ronan’s H-­model estimation of the EQXX index, using her
assumptions and the data in Exhibit 2, the current index level is most likely:
A too high.
Bappropriate.
C too low.

A is correct. The estimated value of the index based on the H-­model is 749.92 (see the

following calculation), which is less than the current index level of 765.88. This disparity
implies that the current index level is too high.

D0 
N
(1 + g L ) + (g S − g L )

r − gL 
2

40.32
30

=
(1 + 0.0395) + (0.072 − 0.0395)
0.1216 − 0.0395 
2

= 749.92

V0 =

where

V0 = estimated value of the index
From Exhibit 2:

D0 = current dividend = 40.32
r = inflation-­adjusted discount rate = 12.16%
gL = future sustainable dividend growth rate = 3.95%

Her assumptions:

gS = initial dividend growth rate = 7.20%
N = length of time for sustainable dividend growth rate to emerge = 30
B is incorrect. It uses (1 + gS) in the bracketed term instead of (1 + gL). This will produce
an index level that is equal to the current index level, which incorrectly implies that the
current index level is appropriate.

40.32
30

(1 + 0.072) + (0.072 − 0.0395) = 765.88
0.1216 − 0.0395 
2



2019 Level III Mock Exam PM

C is incorrect. It uses gS in the denominator of the first term instead of gL. This will
produce an index level above the current index level, which incorrectly implies that the
current index level is too low.

40.32
30

(1 + 0.0395) + (0.072 − 0.0395) = 1, 241.30
0.1216 − 0.072 
2


Equity Market Valuation
LOS c
Section 2.4

22 In their discussion of the relative merits of the H-­model and Gordon model,
who provides the most accurate comment?
ARonan
BJohns
CChadwick

A is correct. Ronan’s concern about an incentive to overstate productivity at the firm
level is a legitimate problem when estimating the H-­model and the Gordon model. The
models depend on firm-­level data that is collected and aggregated to determine the
index’s sustainable growth rate.
C is incorrect. Chadwick is incorrect because real rates tend to be more stable than
nominal rates.
B is incorrect. Johns is incorrect because frequent periods of currency instability
would invalidate the data used in the models.
Equity Market Valuation
LOS d
Section 2.4

23 Based on the Fed model and data in Exhibit 3, Brungaria’s equity market is most
likely:
A fairly valued.
Bovervalued.
Cundervalued.

C is correct. The Fed model hypothesizes that, in equilibrium, the yield on long-­term
treasury securities should equal the forward earnings yield. In this case, the Fed model

considers the equity market to be undervalued because the forward earnings yield
(5.25%) exceeds the long-­term government treasury yield (4.67%).
A is incorrect. It uses short-­term plus inflation, equaling forward earnings yield, so
based on the Fed model, the Brungaria equity market is fairly valued.
B is incorrect. It uses the justified forward earnings yield instead of forward earnings
yield, so based on the Fed model, the Brungaria equity market is under-­valued.
Equity Market Valuation
LOS g
Section 4.1

21


22

2019 Level III Mock Exam PM

24 Who made the most accurate statement concerning the equity q for Brungaria’s
equity market?
AJohns
BChadwick
CRonan

A is correct. Johns’ statement is the most accurate. Given his assertion that the replacement value of assets may be higher than their book values, the equity q calculated by
Chadwick may be overestimated because he used the book value of assets instead of
the replacement value of assets in the calculation’s denominator.
B is incorrect. Chadwick is incorrect. An equity q below one indicates that the market
is under-­valued.
C is incorrect. Ronan is incorrect. The equity q can persist at high and low levels for
extended periods of time.

Equity Market Valuation
LOS f
Section 4.2

HNW Worldwide Case Scenario
HNW Worldwide Inc. (HNW) is a wealth management company located in Chicago
that specializes in very-­high- and ultra-­high-­net worth clients. Pierre Fournier, a
currency specialist at the company, is reviewing the file of a long-­time client, Alex
Testa, an American. Testa is a former engineer in the plastics industry who has been
very successful in identifying potential takeover candidates during the consolidation
of the plastics and packaging industry that has been occurring since about 2001.
As US opportunities declined in the plastics industry, Testa began to consider foreign investments. In the fall of 2008, he acquired a position in a South African plastics
processor. Although the foreign currency return on the investment was impressive,
his domestic return was substantially negative because of the foreign currency change
against the US dollar.
Testa’s association with HNW began in 2009 as he was about to undertake a
position in a Spanish packaging company. Fournier used Testa’s description of his
investment process to develop an investment policy statement (IPS) for him, which
included the following objectives and constraints:
■■

Testa fully believed in his investment process, which was to be the primary
focus in generating investment returns.

■■

Testa was not overly risk averse.

■■

Only the major currencies against the US dollar were likely to be used for the
next several years.

■■

Currency exposure would usually not extend beyond a six-­month period.

■■

Negative currency moves were to be rebalanced monthly if they exceeded 3% of
the initial exposure.

■■

Currency options could be used selectively—only if a strong market view was
held when rebalancing a hedged position that had already proved profitable.


2019 Level III Mock Exam PM

23

■■

The anticipated positions would not have any associated income or liquidity
requirements.

■■

The cost of any hedging strategies used should be minimized and not materially

affect the otherwise unhedged asset return.

In regard to the anticipated currency movements related to the Spanish packaging
company investment, Fournier told Testa that HNW was forecasting that the euro
was likely to appreciate against the US dollar in the next six months.
Testa agreed with HNW’s assessment of the future course of the USD/EUR
exchange rate. His conclusion was derived from assessing various analysts’ reports
and was centered on the following three reasons:
1 real interest rates were higher in euro-­based countries,
2 the potential default of several euro-­based countries from their excessive debt
loads would lead to strong support measures from the IMF and the European
Central Bank, and
3 the US balance of trade deficit with euro-­based countries had continued to
decline in the past several years and was expected to continue to decline.
The Spanish investment involved Testa acquiring 200,000 shares of a packaging
company at EUR90 per share. He decided to fully hedge the position with a six-­
month USD/EUR forward contract. Details of the euro hedge at initiation and three
months later are provided in Exhibit 1. Three months after the purchase, the shares
had increased to EUR100 each, but Testa, believing that a still higher price was likely,
maintained the position. He also indicated that he did not anticipate having to roll the
hedge forward at its maturity. Both he and Fournier believed that further appreciation
of the euro was quite likely, and the increase in the notional size of the position was
hedged using currency options. They based their choices on the information provided
in Exhibit 2.
Exhibit 1  2009 Spot and Forward USD/EUR Quotes (Bid-­Offer) and
Annualized Libor Rates
Maturity

At Initiation

Three Months Later

At Maturity

Spot (USD/EUR)

1.4189/1.4289

1.3935/1.3983

1.4106/1.4210

3-­month forward

–8.1/–7.6

–21.6/–21.0

6-­month forward

–19.0/–18.3

–27.0/–26.2

USD Libor

1.266%

EUR Libor

1.814%

In 2014, Testa notified Fournier that he anticipated taking a position in a plastics
producer located in India. Fournier warned him that the Indian rupee (INR) was a
restricted currency and that currency management would not be as simple as in the
other transactions handled previously. Fournier said that non-­deliverable forwards
(NDFs) on the rupee were available, as they were for the currencies of other developing
countries. When asked how non-­deliverable forwards differed from the contracts they
had used in the past, Fournier responded:
■■

NDFs are cash settled in the non-­controlled currency of the currency pair,


24

2019 Level III Mock Exam PM

■■

NDFs have greater credit risk associated with them than outright forward contracts because the central banks in most developing countries are not as strong
as they are in developed countries, and

■■

the pricing of NDFs may differ from what is expected on the basis of arbitrage
conditions.

In 2015, Testa informed Fournier that he had taken large positions in both a New
Zealand firm and an Australian packaging firm. The positions were roughly equal in

size in terms of the US dollar. Fournier informed Testa that the correlation between
USD/AUD and USD/NZD was approximately 0.85. Given the size of the positions,
Testa indicated that he wished to minimize any foreign exchange exposure.
25 In terms of the objectives and constraints that were incorporated into Testa’s
IPS, the one that best explains the initial euro exposure of the Spanish investment in 2009 is the one related to his:
A risk aversion.
B return objective.
C liquidity constraint.

B is correct. The main goal of Testa’s investment program is the realization of returns
based on his perceived superior ability to discover merger and acquisition targets. The
position was fully hedged even though both he and his adviser believed that the euro
was likely to appreciate over the investment horizon; there was no attempt to exploit
that belief either with futures or options (although the use of options was restricted to
strong market views at the time of rebalancing of an already winning position).
A is incorrect. Testa is not overly risk averse; his main focus is on the return generated
from his investment process.
C is incorrect. Testa’s investment program did not impose any liquidity or income
needs on the position.
Currency Management: An Introduction
LOS c
Section 4.5

26 Which of Testa’s reasons for the future course of the USD/EUR exchange rate in
2009 is most consistent with HNW’s assessment?
A Reason 1
B Reason 2
C Reason 3

A is correct. HNW’s assessment was that the euro was likely to appreciate against the US

dollar within the next six months. Reason 1, higher real rates in euro-­based countries,
is consistent with an appreciation of the euro. Higher euro rates will attract “foreign”
investors and drive up demand for the euro as they acquire those investments.
B is incorrect. Reason 2, the potential default of several euro-­based countries from
their excessive debt loads, would result in a lower foreign risk premium (i.e., the US dollar
would be less risky) and should lead to a depreciation of the euro.


2019 Level III Mock Exam PM

C is incorrect. Reason 3, a decline in the US trade deficit (i.e., net exports), means that
for the United States, imports decreased relative to exports, resulting in lower demand
for the euro, and it should weaken relative to the US dollar.
Currency Management: An Introduction
LOS e
Section 5.1
Capital Market Expectations
LOS l
Sections 4.6.8, 4.6.9.4

27 Using Exhibit 1, if the Spanish shares had been sold after three months, the
cash outflow (in US dollars) required to close out the forward contract would
have been closest to:
A489,182.
B489,850.
C491,400.

B is correct. The initial foreign asset position was EUR18 million: 200,000 shares × EUR90/
share. The six-­month forward contract would have been sold using the bid of the base
currency (euro) at an all-­in forward rate of 1.3935 – 19/10,000 = 1.3916 USD/EUR.

If the position had been closed in three months, a three-­month forward contract
would have to be purchased at the offer of the base currency at an all-­in forward rate of
1.4210 – 21/10,000 = 1.4189 USD/EUR.
The cash outflow at settlement would have been EUR18 million × (1.4189 – 1.3916)
USD/EUR = USD491,400. This amount needs to be discounted by three months at the
US dollar Libor rate: 491,400/(1 + 0.01266 × 90/360) = USD489,850.
A is incorrect. The euro Libor rate is used to discount the settlement cash flow: 491,400/
(1 + 0.01814 × 90/360) = USD489,182.
C is incorrect. It uses the settlement cash flow, ignoring any discounting: USD491,400.
Currency Management: An Introduction
LOS a
Section 2.2

28 If the 2009 forward hedge had been rolled forward at its maturity, using
Exhibit 1, the roll yield would most likely have been:
A negative, but the currency change made it less negative.
B positive, but the currency change reduced some of this effect.
C negative, and the currency change made it even more negative.

C is correct. In implementing the hedge, euros (the base currency) must be sold against
the US dollar. The base currency is selling at a discount and thus would “roll up the
curve” as the contract approaches maturity. Settlement of the forward contract would
entail buying euros at a higher price—that is, selling low and buying high—resulting in
a negative roll yield. Since the euro has appreciated by the time the hedge needs to be
extended, this tends to further increase the cost of euros to settle the original contract
and makes the roll yield even more negative—that is, sell low, buy even higher.

25