Mock exam a afternoon session

2018 Level III Mock Exam PM
The afternoon session of the 2018 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

Private Wealth

18

13–18

Private Wealth

18

19–24

Economics

18

25–30

Asset Allocation

18

31–36

Fixed Income

18

37–42

Equity

18

43–48

Alternative Investments

18

49–54

Derivatives

18

55–60

Global Investment Performance Standards
Total:

18
180

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© 2017 CFA Institute. All rights reserved.


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2018 Level III Mock Exam PM

2018 LEVEL III MOCK EXAM PM
CleanTech Research Fund Case Scenario
Kim Tang, CFA, is a consultant reviewing a hedge fund, CleanTech Research Fund.
CleanTech invests in high-­risk and volatile “clean technology” companies. CleanTech
has adopted the CFA Institute Code of Ethics and Standards of Professional Conduct.

Tang examines the various forms of advertising used by CleanTech to attract
new clients. In one of its advertising messages, CleanTech states, “We have a very
experienced research team and are proud they are all CFA’s. Several of our managers
serve as volunteers for CFA Institute. CFA Institute recognizes their expertise, and
as a result, you can rely on our team for superior performance results.”
In reviewing CleanTech’s marketing brochure, Tang reads the following statements:
Statement 1 The share prices of companies in the clean technology sector
have increased recently because of the growing awareness of climate change issues and the rising cost of energy. There are many
risks in this sector, some of which include new technology that is
unproven. Also, the addition or removal of government incentives can make markets dysfunctional. Nevertheless, it is our
opinion that returns in this area will continue to be above average
for several years. In fact, our proprietary investment analytics
software has determined that investments in green transportation
companies are likely to double in value in the next six months
based on a multiple factor regression analysis. Key risks associated with analytics software include the fact that they rely on historical data and that a set of unknown factors could interfere with
the anticipated results. We will earn a 200% return over the next
year on one of our solar power company investments based on
sales projections we prepared, assuming that last year’s generous
tax incentives stay in place.
Statement 2 The CleanTech fund invests in publicly traded and highly liquid companies and is recommended only for investors who are
able to assume a high level of risk. Last month, we invested in
EnergyAlgae, a “green energy” company that partnered with
a global energy firm early last year to create oil from algae.
EnergyAlgae’s market capitalization quadrupled shortly after
the partnership was formed. Recently, EnergyAlgae also patented a waste plastic-­to-­oil process that produces oil at less than
$30 a barrel. One of the founders of CleanTech is on the board
of EnergyAlgae, and information he gave us on the company’s
patent process led us to purchase additional stock in EnergyAlgae
before the patent became widely publicized with the release of
the company’s semiannual financial report.* (*Information supporting the statements made in this communication is available

upon request.)
When Tang asks CleanTech’s founders for supporting documents related to their
investment in EnergyAlgae, she is told that this information is based on third-­party
research from Slar Brokerage (Slar), who maintains all necessary records. Tang
completes a due diligence exercise on this research and learns that Slar has used
sound assumptions and rigor in its analysis of EnergyAlgae. In particular, Tang
learned that Slar used, at a minimum, the following attributes to form the basis of


2018 Level III Mock Exam PM

the recommendation: the company’s past three years of operational history, current
stage of the industry’s business cycle, an annual research update, a historical financial
analysis, and a one-year earnings forecast.
Tang also learns that the founders of CleanTech are majority shareholders of
Slar, which underwrote the public offering of EnergyAlgae. Additionally, CleanTech’s
analysts inform Tang that they did not need to look at the quality of Slar’s research
because one of their former colleagues recently left CleanTech and established the
research department at the brokerage firm.
In researching EnergyAlgae, Tang finds that potential customers and suppliers of
EnergyAlgae are highly skeptical of the claims made regarding the company’s respective
products. She also contacts several energy companies and is unable to locate anyone
who has even heard of EnergyAlgae. When Tang reviews CleanTech’s trading activity
in EnergyAlgae shares, she finds that CleanTech liquidated its position in EnergyAlgae
soon after CleanTech’s portfolio managers presented positive views on EnergyAlgae
in a number of media interviews. In addition, many of CleanTech’s employees also
sold their shares in EnergyAlgae immediately after CleanTech sold its shares of the
company. The share price of EnergyAlgae dropped dramatically after the stock sales
made by CleanTech and its employees.
1

CleanTech’s advertising is least likely in violation of the CFA Institute Standards
of Professional Conduct with respect to:
A expected performance results.
B managers’ volunteer activities.
C use of the CFA designation.

2 In Statement 1, CleanTech management most likely violated the CFA Institute
Standards of Professional Conduct with regard to their comments on:
A investment analytics software.
B clean technology sector returns.
C solar power company investment.
3 In Statement 2, CleanTech most likely violated which of the following Standards
of Professional Conduct?
A Material Nonpublic Information
BSuitability
CMisrepresentation
4 To be in compliance with the CFA Institute Standards of Professional Conduct,
CleanTech should most likely question the validity of Slar’s research on
EnergyAlgae for deficiencies in which of the following areas?
A Operational analysis
B Earnings projections
C Annual research update
5Tang’s most appropriate course of action concerning the relationship between
CleanTech and Slar is to recommend that CleanTech:
A communicate relevant information to all clients.
B explain the ownership structure to all clients.
C sever the relationship immediately.
6 The EnergyAlgae trades are least likely to have violated the CFA Institute
Standards of Professional Conduct with regard to:

A the adverse and skeptical opinions of EnergyAlgae products.

3


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2018 Level III Mock Exam PM

B the order in which the shares were traded.
C share price distortion because of positive media presentations.

Connor McClelland Case Scenario
Conner McClelland is a private client financial consultant with US-­based Edmonstone
Wealth Management LLC. McClelland has been engaged by Bradley and Reagan
Graham to develop a personal wealth management plan. Prior to meeting with
McClelland, the Grahams filled out a personal profile questionnaire that will be used
in developing their wealth management plan. Using information from the questionnaire, McClelland prepares Exhibit 1.
Exhibit 1  Graham Family: Personal and Financial Information
Occupations and Family Structure
■

Bradley is a 50-­year-­old electrical engineer at a major utility company. His annual income of $175,000 is projected to
increase 3% per year. He has a defined-­contribution pension plan and expects to retire at age 65.

■

Reagan is a 48-­year-­old pharmacist with a pharmaceutical company. Her annual income of $132,000 is projected to
increase 3% per year. She has a defined-­contribution pension plan and expects to retire at age 65. Prior to joining the
pharmaceutical company, Reagan had a 20-­year career in the US Navy, retiring at the rank of commander.

■

The family has two children, ages 10 and 8.

Financial Information
Checking account

$27,000

Taxable investment account

625,000

Residence

525,000

Residential mortgage

285,000

Outstanding balance on a $100,000 home equity line of credit

38,000

Bradley’s defined-­contribution plan (vested; normal retirement age for the plan is 65)

796,000

Cash value of Bradley’s life insurance ($250,000 death benefit)

67,000

Estimated present value of Bradley’s future earnings

2,150,000

Reagan’s defined-­contribution plan (vested; normal retirement age for the plan is 65)

160,000

Present value of Reagan’s military pension (vested; inflation indexed; survivor benefit)

1,320,000

Cash value of Reagan’s life insurance ($250,000 death benefit)

52,000

Estimated present value of Reagan’s future earnings

1,790,000

Estimated present value of the Grahams’ future consumption

3,700,000

Aspirational and Other Goals
■

Cost of four years of university for the two children, with an estimated present value of $350,000

■

Purchase of a vacation home in the next five years, with an estimated present value of $325,000

■

Donations to charitable organizations during the next 15 years, with an estimated present value of $400,000

At their initial meeting, Bradley tells McClelland that he recently attended a
financial planning seminar conducted by his employer’s human resources department.
One of the presenters discussed the importance of preparing and understanding the


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2018 Level III Mock Exam PM

components of an economic balance sheet compared with a traditional balance sheet.
Bradley was confused by a few of the presenter’s comments and asks McClelland for
further clarification. The presenter’s comments were as follows:
■■

Real estate can be described as a personal asset, an investment asset, and a
mixed asset.

■■

Financial capital consists of tangible and intangible assets, including both the
vested and unvested portions of an employer pension plan.

■■

The value of human capital relative to overall economic wealth is typically
higher for an individual in mid-­career with an established earnings record than
for an individual in the early stages of his career.

As McClelland reviews insurance coverage with the Grahams, he explains that
there are various ways to manage risk. “It depends on the frequency of a risk occurring
and the severity of the potential loss. For example, consider the following two risks:
■■

An earthquake: This risk seldom occurs but would result in a large financial
loss;

■■

Dental cavities: This risk arises frequently, resulting in small financial losses.”

McClelland determines that both Bradley’s and Reagan’s life insurance coverage is
inadequate. Bradley is particularly concerned about the inadequacy of his life insurance
and asks McClelland to calculate how much additional insurance he should purchase
to cover him until he retires in exactly 15 years and begins to receive his employer
pension. McClelland prefers to use the human life value method to determine the
appropriate level of life insurance coverage. Exhibit  2 contains additional personal
and financial information about Bradley.
Exhibit 2  Bradley Graham: Additional Personal and Financial Information
Current annual income; salary and expenses expected to increase 3% per

year

$175,000

Income and payroll taxes (percentage of annual income)

30%

Employer contribution to defined-­contribution plan (percentage of
annual income)

5%

Annual family expenses attributable to Bradley

20,000

Estimated tax rate on income earned on insurance proceeds

20%

Applicable discount rate

4%

The Grahams mention that a primary concern is the ability to manage the risks to
both their financial and human capital so that they can achieve their financial goals of
maintaining a comfortable lifestyle while having sufficient assets to purchase a vacation
home, pay for their children’s university education, and fund charitable donations.
Bradley mentions that he and Reagan have some concern about possibly outliving

their assets and that he understands annuities can help protect against this risk. He is
interested in an annuity that will provide income for as long as one of them is alive.
The Grahams have average risk tolerance and expect they will be able to adjust their
spending in retirement if necessary.
7 Using the data in Exhibit 1, the Grahams’ net wealth (in thousands) is closest to:
A$2,174.
B$2,414.
C$2,795.


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2018 Level III Mock Exam PM

8 Which of the presenter’s comments regarding economic and traditional balance
sheets is most accurate?
A The comment about human capital
B The comment about financial capital
C The comment about real estate
9 Which of the following risk management techniques is most appropriate for the
second risk exposure example provided by McClelland?
A Risk retention
B Risk reduction
C Risk transfer
10 Based on the data in Exhibits 1 and 2 and using the human life value method
for determining life insurance needs, the additional amount of life insurance
that Bradley should purchase is closest to:
A$1,701,345.
B$1,547,862.
C$1,951,345.

11 Risk to which of the following is least likely to compromise the Grahams’ ability
to achieve their financial and aspirational goals?
AHealth
BEarnings
CProperty
12 The type of life annuity that is most consistent with the Grahams’ risk tolerance
and retirement spending plans is a:
A variable joint life annuity.
B fixed joint life annuity.
C variable life annuity with period certain.

Rhys Jacobs Case Scenario
Rhys Jacobs is a 70-­year-­old resident of Sahjong, a small island country off the coast
of Australia that caters to high-­net-­worth individuals because of its low tax rates
and status as a sought-­after free trade zone. Jacobs grew up in Sahjong and is a well-­
respected entrepreneur.
Jacobs has long put it off but believes that now is the time to finally receive some
much-­needed assistance in tax-­efficient wealth accumulation, retirement and estate
planning, and other financial matters, so he recently hired Jassica Simson as his tax
and financial adviser.
In preparing for their introductory meeting, Jacobs performs initial research on
various tax-­planning strategies available in Sahjong, where the capital gains tax rate
is much lower than the income tax rate. He finds several strategies that might be
appropriate for his investment portfolio and summarizes them as follows:
1 A strategy based on low portfolio turnover whereby assets are held for extended
periods
2 A strategy that concentrates on tax-­exempt securities
3 A strategy to restructure his portfolio to focus on annual capital gains versus
income generation

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2018 Level III Mock Exam PM

Jacobs provides materials to Simson, including the following notes he took from
a recent financial blog discussing the various tools currently being used in retirement
planning:
1 Long-­term market return and historical inflation averages are simple but effective strategies for accurately extrapolating how much wealth will be accumulated after a period of time if one could earn, say, 10% a year.
2 The Monte Carlo approach helps an investor get to a straightforward “yes/no”
determination on whether a particular retirement income goal can be achieved.
3 Given a particular investment strategy, the likelihood of achieving a certain
percentage return throughout retirement can be answered with a Monte Carlo
simulation.
4 Sustainable spending rates in retirement can be approximated without the need
for a Monte Carlo simulation by using the notion of ruin probabilities.
Jacobs asks Simson to evaluate these notes.
Simson states that she is very much in favor of a long-­term buy-­and-­hold strategy
focused on capital appreciation. She states that investors often do not realize just how
much of their investment returns are consumed by taxes, and she provides Jacobs with
the data in Exhibit 1 to illustrate the point.
Exhibit 1  Data Illustrating the Effect of Taxes on Wealth
Accumulation
Initial investment

$250,000

Holding period

25 years

Expected annual gain

8%

Tax rate on investment returns

10%

Turning to retirement planning, Simson confirms that sustainable spending rates
in retirement can be approximated without the need for a Monte Carlo simulation
by using the notion of ruin probabilities (as developed by Milevsky and Robinson).
The analysis incorporates lifespan uncertainty as well as financial market risk. After
they discuss the method, Jacobs asks her to determine how much he could withdraw
annually from a balanced portfolio if he wants to be at least 94% certain that the
portfolio will last for the remainder of his life. He states that the current value of his
(balanced) portfolio is $2 million, made up of 50% income-­producing equities and 50%
bonds. Simson uses the ruin probabilities in Exhibit 2 as the basis for her calculation
of Jacobs’ lifetime sustainable annual withdrawal.
Exhibit 2

 Ruin Probabilities for a Balanced Portfolio: 50% Equity and 50% Bonds
Real Annual Spending per $100 of Initial Nest Egg

Current
Age
70

Hazard Rate,
λ (%)

$2 (%)

$3 (%)

$4 (%)

$5 (%)

$6 (%)

$7 (%)

$8 (%)

$9 (%)

$10 (%)

4.75

0.8

2.8

6.3

11.4

17.6

24.7

32.2

39.8

47.2

Assumptions: Portfolio return: arithmetic: 5%; geometric: 4.28%; standard deviation: 12%


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2018 Level III Mock Exam PM

Jacobs owns a controlling interest in a rapidly growing private firm that explores
for and produces oil. The firm generates steady cash flow but is considered illiquid.
Simson explains that Jacobs’ death could create significant inheritance taxes. She
suggests an insurance policy to help fund any future inheritance taxes and help offset
the risk of a tax liability combined with an illiquid asset. Jacobs is confused about the
use of life insurance and asks Simson to verify the following statements:
■■

The combination of a life insurance policy and a trust is likely to be redundant
and unnecessary.

■■

Death benefits from a life insurance policy are usually taxable at favorable rates.

■■

Premiums paid by the policyholder are typically neither part of the policyholder’s taxable estate at the time of his or her death nor are subject to a gratuitous
transfer tax.

The oil firm that Jacobs controls is headquartered in the island country of Mahjong,
located near Sahjong. Because of the foreign location of the oil firm, Simson believes
there might be opportunities to reduce taxes.
Simson knows that Sahjong uses the exemption method, whereby it does not
impose taxes on income that stems from a foreign country. However, Sahjong will soon
hold parliamentary elections, and the opposition party is said to favor the deduction
method. Simson plans to investigate how this possible change might affect Jacobs’ tax
liability. She compares the tax rates in the two countries in Exhibit 3.
Exhibit 3  Comparative Income Tax Rates
Country
Income tax rate

Sahjong

Mahjong

10.00%

15.50%

13 Which of the tax-­planning strategies summarized by Jacobs is best described as
tax deferral?
A Strategy 1
B Strategy 2

C Strategy 3
14 Which of Jacobs’ notes on retirement planning from the financial blog is most
accurate?
A Note 3
B Note 2
C Note 1
15 Based on the data in Exhibit 1 and assuming that all returns are taxed annually,
the proportion of the investment’s return that is consumed by taxes is closest to:
A19.9%.
B17.0%.
C10.0%.
16 Based on Exhibit 2 and Jacobs’ stated level of concern for the probability of
retirement ruin, the lifetime sustainable annual withdrawal is closest to:
A$80,000.
B$120,000.
C$95,000.


2018 Level III Mock Exam PM

17 Which of the statements about life insurance is most appropriate?
A The statement about tax treatment of death benefits.
B The statement about combination of life insurance and trusts.
C The statement about premiums paid by policyholders.
18 If the opposition party wins the election in Sahjong and its tax proposals are
passed into law, the tax rate that Jacobs will face on income stemming from
Mahjong will be closest to:
A0.0%.
B15.5%.
C24.0%.

Brian O’Reilly Case Scenario
Brian O’Reilly is a capital markets consultant for the Tennessee Teachers’ Retirement
System (TTRS). O’Reilly is meeting with the TTRS board to present his capital market
expectations for the next year. Board member Kay Durden asks O’Reilly about the
possibility that data measurement biases exist in historical data. O’Reilly responds:
“Some benchmark indexes suffer from survivorship bias. For example, the
returns of failed or merged companies are dropped from the data series,
resulting in an upward bias to reported returns. This bias may result in an
overly optimistic expectation with respect to future index returns. Another
bias results from the use of appraisal data in the absence of market transaction data. Appraisal values tend to be less volatile than market determined
values for identical assets. The result is that calculated correlations with
other assets tend to be biased upward in absolute value compared with the
true correlations, and the true variance of the asset is biased downward.”
Board member Arnold Brown asks O’Reilly about the use of high-­frequency
(daily) data in developing capital market expectations. O’Reilly answers, “Sometimes
it is necessary to use daily data to obtain a data series of the desired length. High-­
frequency data are more sensitive to asynchronism across variables and, as a result,
tend to produce higher correlation estimates.”
Board member Harold Melson notes he recently read an article on psychological
traps related to making accurate and unbiased forecasts. He asks O’Reilly to inform
the board about the anchoring trap and the confirming evidence trap. O’Reilly offers
the following explanation:
“The anchoring trap is the tendency for forecasts to be overly influenced
by the memory of catastrophic or dramatic past events that are anchored
in a person’s memory. The confirming evidence trap is the bias that leads
individuals to give greater weight to information that supports a preferred
viewpoint than to evidence that contradicts it.”
The board asks O’Reilly about using a multifactor model to estimate asset returns
and covariances among asset returns. O’Reilly presents the factor covariance matrix

for global equity and global bonds shown in Exhibit 1 and market factor sensitivities
and residual risk shown in Exhibit 2.

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2018 Level III Mock Exam PM

Exhibit 1  Factor Covariance Matrix

Exhibit 2

Global Equity

Global Bonds

Global equity

0.0225

0.0022

Global bonds

0.0022

0.0025

 Market Factor Sensitivities and Residual Risk
Sensitivities
Global Equity

Global Bonds

Residual Risk

Market 1

1.2

0

12.00%

Market 2

0.9

0

7.00%

Market 3

0

0.95

1.80%

Finally, the board asks about forecasting expected returns for major markets,
given that price earnings ratios are not constant over time and that many companies
are repurchasing shares instead of increasing cash dividends. O’Reilly responds that
the Grinold–Kroner model accounts for those factors and then makes the following
forecasts for the European equity market:
■■

The dividend yield will be 1.95%.

■■

Shares outstanding will decline 1.00%.

■■

The long-­term inflation rate will be 1.75% per year.

■■

An expansion rate for P/E multiples will be 0.15% per year.

■■

The long-­term corporate earnings growth premium will be 1% above GDP
growth.

■■

GDP growth will be 2.5% per year.

■■

The risk-­free rate will be 2.5%.

19 With respect to his explanation of survivorship bias, O’Reilly most likely is:
Acorrect.
B incorrect, because survivorship bias results in a downward bias to reported
returns.
C incorrect, because survivorship bias results in an overly pessimistic view of
expected returns.
20 With respect to his explanation of appraisal data bias, O’Reilly most likely is:
Acorrect.
B incorrect, because the true variance of the asset is biased upward.
C incorrect, because calculated correlations with other assets tend to be
biased downward in absolute value.
21 With respect to his answer to Brown’s question, O’Reilly most likely is:
A incorrect, because high-­frequency data tend to produce lower correlation
estimates.
Bcorrect.
C incorrect, because high-­frequency data are less sensitive to asynchronism.


2018 Level III Mock Exam PM

11

22 Is O’Reilly’s explanation of the anchoring trap most likely correct?
A No, because the anchoring trap is the tendency for the mind to give a disproportionate weight to the first information it receives on a topic.

BYes.
C No, because the anchoring trap is the tendency to temper forecasts so that
they do not appear extreme.
23 Given the data in Exhibits 1 and 2, the covariance between Market 1 and
Market 2 is closest to:
A0.0225.
B0.0243.
C0.0027.
24 Given O’Reilly’s forecasts for the European market, the expected long-­term
equity return using the Grinold–Kroner model is closest to:
A7.35%.
B6.35%.
C8.35%.

Sabanai Investimentos Case Scenario
Marina Campos is a senior portfolio manager for Sabanai Investimentos in Sao Paulo,
Brazil. Sabanai provides investment management and advisory services for high-­
net-­worth and institutional clients. She is assisted by two portfolio analysts, Fabiana
Traldi and Pedro Peixaria. Campos is meeting with Traldi and Peixaria to discuss the
portfolios of three clients.
The first client is Gilvan Araujo Dias, a high-­net-­worth client who has given
Sabanai responsibility for managing his foreign investments, which consist of equity
investments in the United Kingdom and Germany. His other assets consist of equity
and corporate bond investments in Brazil. Exhibit 1 summarizes information on Dias’s
foreign portfolio holdings and exchange rates.
Exhibit 1

 Gilvan Araujo Dias, Information on Foreign Asset Holdings and
Exchange Rates
UK Assets

German Assets

Value in GBP

Value in EUR

BRL/GBP

BRL/EUR

1/1/2013

83,400,000

55,000,000

3.8729

3.0359

1/1/2014

86,000,000

51,000,000

4.1025

3.5142

Date

Spot Exchange Rates

Dias has asked whether it would be appropriate for him to hedge his foreign currency exposure. Campos raises the issue with Traldi and Peixaria. Traldi responds, “In
the short run, if the correlation between foreign asset returns and foreign currency
returns is negative, then there may be a need to hedge all foreign currency exposure.
Alternatively, one could implement a currency overlay program in which the currency
exposure is fully hedged and currency alpha is generated separately. This currency
overlay strategy will only be successful in adding value to the portfolio if the currency
alpha has a high correlation with Brazilian equities and corporate bonds.”
The second client, BC Fundos de Pensao (BC), manages pension funds for numerous
local companies and has currency exposure to the USD, the EUR, and the GBP. BC
wants Sabanai to provide guidance on using active currency management strategies


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2018 Level III Mock Exam PM

for the portfolios they manage. Peixaria has been assigned this task and has collected
information on one-­year yield levels in the United States, United Kingdom, and
Eurozone, as well as one-­year implied volatility for various currency pairs extracted
from option pricing models. This information is provided in Exhibit 2.
Exhibit 2  One-­Year Yield Levels and Implied Volatilities
Panel A
One-­Year Yield

Country

United States

0.05%

United Kingdom

0.40%

Eurozone

0.11%

Panel B
One-­Year Implied Volatility

Currency Pair
USD/GBP

5.50%

GBP/EUR

7.50%

USD/EUR

9.50%

Peixaria indicates that his research suggests that the USD/EUR currency pair will
become more volatile over the near term. He recommends that BC implement an

options-­based strategy using USD/EUR options to profit from the expected increase
in volatility.
The third client is Fundo do Brasil (FB), a Brazilian sovereign wealth fund. FB
has long equity positions in Australian and Swiss equities. Spot and forward market
currency information for AUD and CHF is provided in Exhibit 3. FB managers have
asked Campos for advice on whether it would be appropriate to hedge the currency
exposure with forward contracts in AUD and CHF. Campos indicates that she will
examine the use of forward contracts to hedge currency exposure.
Exhibit 3  Spot and Forward Rates for AUD and CHF
Current Spot Rate

Six-­Month
Forward Rate

Six-­Month Forecast
Spot Rate

BRL/AUD

2.1046

2.1523

2.0355

BRL/CHF

2.5309

2.4641

2.5642

Currency Pair


2018 Level III Mock Exam PM

Traldi suggests that the use of put options might be a better way to hedge currency
exposure. Campos responds that there are better options-based strategies that can
exploit market views and reduce hedging costs. She suggests the following strategies:
■■

■■

Strategy 1: For AUD exposure, the appropriate strategy is to be long put
options at a strike price of 2.1046, short put options with a strike price 2.1006,
and short call options with a strike price of 2.1456.
Strategy 2: For CHF exposure, the appropriate strategy is to be long put
options at a strike price of 2.5309, short put options with a strike price 2.5049,
and short call options with a strike price of 2.5669.

25 Based on the information provided in Exhibit 1, the domestic currency value of
Dias’s foreign investments most likely:
A decreased because of changes in the domestic currency value of foreign
asset holdings.
B increased because of changes in the domestic currency value of UK assets
but decreased because of changes in the domestic currency value of German
assets.
C increased because of changes in the domestic currency value of foreign asset

holdings.
26 In her response regarding hedging foreign currency exposure in Dias’s portfolio,
Traldi is most likely:
A incorrect about the correlations, but correct about the currency overlay
program.
B incorrect about the correlations and the currency overlay program.
C correct about the correlations and the currency overlay program.
27 Based on the information in Exhibit 2, it would be best for Sabanai to implement a carry trade for BC by borrowing in:
A USD and investing in GBP.
B GBP and investing in USD.
C EUR and investing in GBP.
28 In regard to using USD/EUR options, Peixaria is least likely to recommend a
strategy to go:
A long an equal number of 25-­delta puts and calls.
B long an equal number of 50-­delta puts and calls.
C short an equal number of 15-­delta puts and calls.
29 Based on the information provided in Exhibit 3, the most appropriate risk neutral strategy is for FB to:
A over-­hedge AUD and not hedge CHF.
B under-­hedge AUD and over-­hedge CHF.
C under-­hedge CHF and not hedge AUD.
30 Is Campos most likely correct that Strategy 1 and Strategy 2 will accomplish the
goals of exploiting market views and reducing hedging costs?
A No, she is incorrect about reducing hedging costs.
B No, she is incorrect about exploiting market views.
CYes.

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2018 Level III Mock Exam PM

Beatriz Maestre Case Scenario
Beatriz Maestre is a fixed-­income consultant who has been retained by Filipe Ruelas,
the CFO of Cávado Produtos Agricolas, SA (Cávado). Cávado is a manufacturer of
prepared foods headquartered in Braga, Portugal. Ruelas has a number of concerns
regarding the firm’s exposure to interest rate movements, particularly with respect
to its defined-­benefit pension plan and an outstanding debt it would like to retire.
In their first face-­to-­face meeting, Ruelas gathers a group of his employees and
asks Maestre to explain the methods Cávado uses to manage interest rate risk. Maestre
starts by discussing the nature of pension fund management. She tells the group, “With
a defined-­benefit pension fund, the assets are structured to match the expected cash
outflows required to meet the liabilities, making it a form of liability-­driven investing
(LDI). Pension funds can be difficult to manage, because neither the timing nor the
amount of the liabilities is known in advance with certainty. With LDI, interest rate
risk management efforts focus on changes in the values of the assets because the
liabilities, while uncertain, aren’t affected by changes in interest rates.”
During the meeting, Maestre presents some information about Cávado’s pension
fund, which is primarily invested in corporate bonds with a mixture of investment-­
grade and speculative-­grade issues. This information is presented in Exhibit 1.
Exhibit 1  Cávado Pension Fund Liabilities and Assets

Value

Liabilities

Assets

EUR47.3 million

EUR49.8 million

Modified Duration

12.6 years

18.4 years

Basis Point Value (BPV)

EUR59,598

EUR91,632

Ruelas explains that he uses futures contracts on euro-­denominated German government bonds to reduce the duration gap between assets and liabilities. However,
because the pension fund has only a small surplus and he would like to increase this
surplus through active management of the portfolio, he employs a contingent immunization strategy. The fund is currently short 254 contracts based on a 10-­year bond with
a par value of EUR100,000 and a basis point value (BPV) of EUR97.40 per contract.
Ruelas tells Maestre he is concerned about the many risks Cávado faces both in
managing the pension fund and in managing the derivatives overlay. He asks if any
risks can be avoided. Maestre names a risk that is not faced in managing the portfolio
and would be virtually eliminated through careful selection of the type of derivatives
used in the overlay.
Ruelas also tells Maestre that he has considered moving to a passively managed
bond portfolio. He is not convinced it is worth his or his staff ’s time and effort to try
to beat the broad market bond index. He is concerned, however, that it may be no
less expensive either in time or transaction costs to replicate an index than to actively
manage a portfolio. Maestre recommends a bond-­indexing strategy.
As Maestre continues, she discusses an example of a single liability owed by

Cávado, a EUR2.3 million balloon payment due to the former CEO of the company
in approximately six and a half years as a part of her deferred compensation package.
Maestre tells the group, “Suppose you wanted to immunize this liability. One way to
do so would be to purchase zero-­coupon bonds with essentially zero credit risk that
mature in six-­and-­a-half years and have a face value of EUR2.3 million. Unfortunately,
no zero-­coupon bonds are available with this maturity. Therefore, a portfolio of high-­
quality government bonds with a duration of approximately six-­and-­a-half years could


15

2018 Level III Mock Exam PM

be used, although this portfolio might have to be adjusted over time to maintain a
matched duration with the liability.” She proposes to select one of the three portfolios
shown in Exhibit 2.
Exhibit 2  German Euro-­Denominated Government Bond Portfolios

Cash Flow Yield
Macaulay Duration
Convexity

Portfolio A

Portfolio B

Portfolio C

2.18%

2.14%

2.16%

6.50

6.52

6.47

102.64

86.16

129.43

At a second meeting, Ruelas tells Maestre about a EUR22  million bond issue
Cávado would like to retire. The issue is currently rated A–, and credit spreads for
that rating are relatively high. Ruelas expects spreads to narrow in the future as the
economy improves and as Cávado’s performance for the coming year is factored into
markets. The bond is closely held by two investment funds, and Ruelas feels they
would be willing to sell their bond exposure at a small premium over the market price.
Ruelas also feels Cávado’s auditors would permit accounting defeasement if Cávado
purchased a portfolio of high-­quality government bonds whose cash flow characteristics closely matched the Cávado bonds or if it purchased a portfolio of corporate
bonds with similar duration and convexity characteristics and higher yields. Maestre
recommends a strategy for retiring the bond.
31 Is Maestre’s description of pension fund management as a form of LDI most
likely correct?
AYes.
B No, she is incorrect regarding the focus of interest rate risk management.

C No, she is incorrect regarding the difficulty of managing pension funds.
32 Given the futures position entered into by the pension fund, Ruelas most likely
believes interest rates will:
Afall.
Brise.
C remain the same.
33 In her response to Ruelas regarding risks, Maestre is most likely referring to:
A spread risk.
B model risk.
C counterparty credit risk.
34 What bond indexing strategy would Maestre least likely recommend?
A A stratified sampling approach
B An index mutual fund
C A synthetic strategy using a total return swap
35 Which of the portfolios described in Exhibit 2 would most likely be recommended by Maestre?
A Portfolio A
B Portfolio B
C Portfolio C


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2018 Level III Mock Exam PM

36 Which of the following strategies would Maestre most likely recommend for
retiring the Cávado bond?
A Bond tender offer
B Cash flow matching with government bonds
C Duration matching with corporate bonds

McMorris Asset Management Case Scenario
McMorris Asset Management (MCAM) is an investment adviser based in Atlanta,
Georgia. Tom Morris manages the active equity portfolios. Dan McKeen manages
the semi-­active equity portfolios and the semi-­active derivatives portfolios. They
are preparing to meet with Maggie Smith, the chief investment officer of Philaburgh
Capital, who is considering hiring MCAM to replace one of its current managers.
At the meeting, Morris and McKeen discuss MCAM’s investment approaches with
Smith and present her with the risk and return characteristics detailed in Exhibit 1.
Exhibit 1  Summary Information for MCAM’s Investment Strategies
Approaches
Active Equity

Semi-­active
Equity

Semi-­active
Derivatives

Tracking risk

4.90%

3.70%

3.30%

Information ratio

0.50%

0.60%

0.70%

Expected alpha

2.40%

2.20%

2.30%

Smith asks if MCAM’s active equity strategy is long only. McKeen responds that
MCAM uses market-­neutral long–short strategies for several reasons. He indicates
that long–short strategies:
Reason 1 enhance portfolio performance by increasing the beta.
Reason 2 generate alpha by identifying undervalued or overvalued securities.
Reason 3 benefit from events that give rise to price changes, which are more
prevalent on the short side than on the long side.
Smith considers each approach listed in Exhibit  1 but is uncertain about what
would be an optimal investment strategy. She makes the following comments about
market efficiency:
Comment 1 A firm’s stock price does not reflect all publicly available company
information, and good research can uncover sound investment
opportunities.
Comment 2 Philaburgh’s mandate is for managers to limit volatility around
the benchmark return while providing incremental returns that
exceed management costs.
Smith states, “In order to ensure investment discipline, Philaburgh uses two
methods to evaluate an investment manager’s style.” She then reviews the current

characteristics of MCAM’s active equity approach using the first method, as presented
in Exhibit 2.


2018 Level III Mock Exam PM

17

Exhibit 2  Method 1—Portfolio Characteristics for MCAM Active Equity
Strategy Based on Current-­Period Data
Active Equity
Number of stocks

Benchmark

50

1,000

Market value

$180 billion

$4,400 billion

Weighted average market capitalization

$4.0 billion

$4.1 billion

Dividend yield

3.00%

2.00%

Price/Earnings

8×

12×

Smith then selects three benchmarks—value, blend, and growth—in addition to
the normal benchmark to assess the manager’s style using the second method, as
presented in Exhibit 3.
Exhibit 3  Method 2—Return Correlations between
MCAM’s Active Equity Approach and
Benchmarks Based on 36 Months of Historical
Data

Coefficient of determination

Value

Blend

Growth

0.39

0.45

0.65

Smith indicates that Philaburgh’s performance measurement is compliant with the
Global Investment Performance Standards. In considering investment performance,
Morris identifies three risks that may prevent MCAM’s active equity approach from
generating incremental returns:
Risk 1: Overestimating a stock’s earnings per share growth.
Risk 2: Deciding incorrectly that a stock’s earnings multiple would not contract.
Risk 3: Misjudging whether a stock’s undervaluation will correct within the
investor’s investment horizon.
Smith concludes by telling Morris that she is impressed by MCAM’s track record
in adding alpha in the US stock market. However, she believes that the European
equity markets are likely to outperform the US equity markets over the next five years.
She asks whether MCAM can structure a portfolio to capture both opportunities.
Morris offers to combine his long–short active equity strategy with a EURO STOXX
50 Index strategy.
37 Based on Exhibit 1, the approach that is least likely efficient with respect to
delivering active returns for a given level of tracking risk is:
A

semi-­active derivatives.

B

semi-­active equity.

C active equity.

38 McKeen’s response to Smith’s question about MCAM’s active equity style is
least likely correct with respect to:
A Reason 3.
B Reason 2.
C Reason 1.


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2018 Level III Mock Exam PM

39 Smith’s Comment 1 and Comment 2, respectively, are most likely consistent
with an investment style that is:
A active; active
B

semi-­active; active

C

active; semi-­active

40 Based on Exhibits 2 and 3, what can Smith most likely determine about
MCAM’s investment style over time? MCAM's style has:
A drifted from growth to value.
B drifted from value to growth.
C not drifted.
41 Which of the risks Morris identifies with respect to MCAM’s active equity
strategy is least likely applicable to a growth-­oriented investor?
A Risk 3

B Risk 1
C Risk 2
42 The type of portfolio that Morris recommends to Smith to take advantage of
both US and European equity market opportunities is most likely a(n):
A completeness fund.
Bcore–satellite.
C alpha and beta separation.

Faith Wanja Case Scenario
Faith Wanja is an asset consultant to many large Kenyan pension funds. In response
to numerous client inquiries about alternative investment products now being offered
in the market to pension funds, she decides to hold a seminar for her clients. She
believes it is important for her clients to understand the pros and cons of adding
alternate investments to their existing portfolios, which are made up of public equity,
fixed-­income securities, and direct real estate investments.
To start off the seminar, Wanja discusses the general characteristics of real estate
investment trusts (REITs), private equity, and hedge funds. She makes the following
statements:
Statement 1 Hedge funds have tended to be more heavily regulated than
other pooled investments because of their perceived higher risk
profiles.
Statement 2 Successful private equity investments, unlike public equity investments, rely heavily on a portfolio manager’s business skills rather
than his or her portfolio management skills.
Statement 3 REITs act as cash flow conduits for underlying real estate assets.
Wanja discusses the possible benefits of adding REIT investments to her clients’
portfolios that currently only hold equities and fixed-­income securities. She indicates
to the seminar participants that two existing private property investment companies
(Batian and Lenana) are converting to a REIT structure and will soon be listed on
the local securities exchange. In Exhibit 1, Wanja shows the audience the projected
impact on her clients’ portfolios, as reflected in a client composite, by adding one of

the two REITs to a portfolio that had a 50/50 allocation to equities and fixed income.


2018 Level III Mock Exam PM

19

Exhibit 1  Forecast Data for Portfolio Returns
Client
Composite with
Traditional
50/50 Equity/
Bond
(%)

Client Composite
with Batian REIT
45/45/10 Equity/
Bond/REIT
(%)

Client Composite
with Lenana REIT
45/45/10 Equity/
Bond/REIT
(%)

Expected return

15.5

18.3

20.6

Standard deviation
of returns

9.8

12.5

18.4

Measure

The next topic Wanja discusses is private equity investments. She lists the attributes of private equity and the possible benefits of adding private equity to a pension
fund as follows:
1 Private equity has low correlations with public equity, so it can greatly contribute to a portfolio’s ability to diversify risks.
2 The asset class’s low liquidity generally implies a smaller allocation.
3 Small pension funds should invest in a fund-­of-­funds structure to help increase
diversification without increasing expenses.
She tells the audience that private equity management fees are often based on a
percentage of the value of the limited partners’ committed funds and tend to stay the
same throughout the life of the investment. In addition, managers typically receive
carried interest of about 20%, which is paid before any limited partner distribution of
profits. But limited partners sometimes require a clawback provision that mandates
if they do not achieve the preferred return over the full life of the investment, the
manager is required to forfeit carried interest previously earned.
After Wanja finishes her presentation, she opens the floor to questions. An audience member tells Wanja she recently met an investment adviser for high-­net-­worth

individuals who stated that she has a tougher job advising high-­net-­worth clients than
someone managing funds for institutional investors. She asks, “Is this true? I would
have thought the level of responsibility would be very similar for both types of clients.”
Wanja responds, “Investment advisers have a fiduciary duty to both individual
clients and institutional clients, so it is vital to discuss the issue of suitability with
both types of client. But advisers working with high-­net-­worth clients must recognize
that they are more prone to panicking and changing strategies when there are large
losses than institutional investors.”
Wanja ends the seminar by stating that pension fund managers should consider
investing in distressed securities if approved by the pension regulator. She states,
“Because government security yields remain low, pension funds will need to chase
yield, and distressed securities can add value to a portfolio because Sharpe ratios of
distressed securities tend to be understated.” She further explains her recommendation
by saying, “Credit risk assessments are also often similar across distressed companies
because they have similar cash flow problems, so due diligence costs are not very
high. I should also point out that market risk is not as important as liquidity risk for
distressed securities.”
43 Which of Wanja’s statements regarding the new asset classes available in the
Kenyan market is least likely correct?
A Statement 2
B Statement 3


20

2018 Level III Mock Exam PM

C Statement 1
44 Based only on the information in Exhibit 1 and a risk-­free rate of 8%, should
Wanja most likely recommend a 10% REIT exposure to her clients’ existing

portfolios?
A Yes, the Batian REIT.
BNo.
C Yes, the Lenana REIT.
45 When discussing the possible benefits of adding private equity to a pension
fund, Wanja is most likely correct regarding the:
A relationship between liquidity and size of the exposure.
B ability to diversify portfolio risks.
C use of a fund-­of-­funds structure.
46 Wanja’s explanation of a private equity fund manager’s fees is least likely correct
with regards to:
A management fees.
B clawback provisions.
C carried interest.
47 Is Wanja most likely correct when she explains the differences between managing high-­net-­worth client funds and institutional funds?
A No, in regard to decision risk.
BYes.
C No, in regard to communication with clients.
48 Which of the distressed security characteristics described by Wanja is most
likely correct?
A Sharpe ratio
B Due diligence costs
C Market risk

Omega Analytics Case Scenario
Omega Analytics provides risk management consulting services for institutional and
individual clients. Rachel Osborne, CFA, is an investment adviser for Omega who
works with the firm’s larger accounts. She is considering derivative strategies for four
separate clients: HMM Foundation, Bob Valentine, Bedford Trust, and Kung Chen.
HMM Foundation owns 30,000 shares of NASDAQ 100 Index Tracking Stock

(QQQQ), which has a current price of $30 per share. Osborne believes there is substantial risk of downside price movement in the index over the next six months. She
recommends HMM use a six-­month collar for the entire position of 30,000 shares
as protection against the QQQQ price falling below $27. HMM would maintain the
collar strategy until expiration of the put and call options. Exhibit 1 provides data on
current QQQQ puts and calls expiring in six months.
Exhibit 1  QQQQ Puts and Calls Expiring in Six Months
Option Type

Exercise Price ($)

Option Premium ($)

Call

35

0.80

Put

27

0.95


21

2018 Level III Mock Exam PM

Another client, Bob Valentine, believes the prices of large-capitalization stocks will

rise slightly, and he wants to profit from this movement using a bull spread strategy.
Osborne recommends that Valentine use 1/100 Dow Jones Industrial Average (DJX)
options expiring in two months. The current price of DJX is $91. Exhibit 2 provides
current option information for two DJX call options expiring in two months.
Exhibit 2  DJX Call Options Expiring in Two Months
Option Premium
($)

Delta

88

4.40

0.75

94

1.00

0.30

Exercise Price ($)

Valentine decides to use 100 contracts per position. Each contract is equal to 100
shares.
The Bedford Trust is focused on long-­term growth and invests only in equities. The
trust has an equity portfolio with a market value of $60 million, of which $20 million
is allocated to WTO stock. Its trustees are considering a temporary decrease in the
allocation to WTO stock in order to diversify into small-­capitalization US stocks.

Osborne recommends the Russell 2000 Index as an appropriate small-­capitalization
index and recommends that Bedford Trust enter into an equity swap on $20 million
of WTO stock with the Russell 2000.
Kung Chen expects the tracking stock on the SPDR Dow Jones Industrial Average
ETF (DIA) to trade within a narrow range around its current price over the near term.
On the basis of this expectation, he believes a profitable trading opportunity is to
initiate a butterfly spread strategy using call options on DIA. Osborne suggests using
three one-­month call options on the DJIA. Chen initiates a butterfly spread using a
total of 200 long contracts and 200 short contracts. Exhibit 3 illustrates current DJIA
call options expiring in one month.
Exhibit 3  DJIA Call Options Expiring in One Month
Exercise Price ($)

Option Premium ($)

88

4.20

92

2.00

96

0.50

49 If HMM enters into the collar recommended by Osborne, and the market value
of QQQQ is $33 when the options expire, the change in the profit of the collar
would be closest to:

A$94,500.
B$85,500.
C$90,000.
50 If HMM enters into the collar recommended by Osborne, the maximum profit
of the collar at option expiration would be closest to:
A$154,500.
B$150,000.


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2018 Level III Mock Exam PM

C$145,500.
51 At expiration of the DJX call options, the maximum potential profit from the
bull spread strategy recommended for Valentine is closest to:
A$60,000.
B$6,000.
C$26,000.
52 If the price of DJX is $91, the delta of Valentine’s bull spread just before contract expiration, will most likely be in the range of:
A 0.00 to 0.20.
B 0.40 to 0.60.
C 0.80 to 1.00.
53 If Bedford Trust implements Osborne’s recommendation regarding WTO, it
will least likely experience a cash outflow if the returns on WTO stock and the
Russell 2000 Index are:
A WTO Return: Positive and Russell 2000 Return: Negative
B WTO Return: Negative and Russell 2000 Return: Positive
C WTO Return: Zero and Russell 2000 Return: Negative
54 If Chen creates a butterfly spread using the three one-­month call options suggested by Osborne, the maximum potential loss at expiration is closest to:

A$7,000.
B$3,000.
C$27,000.

Katherine Ng Case Scenario
Katherine Ng, a Global Investment Performance Standards (GIPS) specialist, has been
hired as a consultant to assist Rune Managers in becoming a GIPS-­compliant firm.
Rune is a global asset manager with several divisions around the world that invest
in both stock and bond strategies. James Arnott, a performance specialist at Rune,
is responsible for the project. In their first meeting, Ng and Arnott discuss the GIPS
standards and the steps Rune will need to take to become compliant.
Ng recommends starting with the definition of the firm. She tells Arnott that how
the firm is defined will affect the compliance process and that the standards recommend the firm be defined as broadly as possible. Arnott replies that Rune management
has been discussing the firm definition, and they want the definition to include all
Rune divisions except the European division, Rune Europe. Rune Europe has its own
strategies and management team that are distinct from the rest of Rune. Ng replies
that the Rune Europe division should be included in the definition of the firm because
the division markets itself as part of Rune Managers.
Ng then asks about Rune’s policies for the inclusion of portfolios in composites.
Arnott responds that Rune has the following policies for all composites:
Policy 1 All new accounts funded with cash or securities on or before the
10th day of the month are added to the composite at the beginning of
the following month. Those funded after the 10th day of the month
are added at the beginning of the 2nd month after funding, or at the
beginning of the calendar month after the proceeds are substantially
invested in the appropriate strategy.


2018 Level III Mock Exam PM

23

Policy 2 All portfolios are deemed “non-­discretionary” on the date the notice
of termination of the management relationship is received and
removed from the composite at the end of the month of notification.
The discussion then moves on to a new composite that Rune is constructing.
Arnott tells Ng that the marketing department has decided to target domestic Swiss
investors and would like to carve out the Swiss portion of international and global
accounts for the period of 1 January 2006 through 1 January 2011 and allocate cash
to each carved-­out segment to create a Swiss franc (CHF) composite. Ng responds
that this new composite will comply with the standards, but Rune must disclose the
percentage of composite assets that are carve-­outs for each annual period end, as well
as the policy used to allocate cash to the carved-­out segments.
Arnott interjects that the marketing department is looking forward to claiming
GIPs compliance in advertisements. He is meeting with the marketing department
and asks Ng what they need to be aware of regarding the Standards in advertising.
Ng responds that there are several requirements in the GIPS Advertising Guidelines;
specifically, the following must be disclosed in the advertisements: the firm description,
composite and benchmark descriptions, and the number of accounts in the composite.
Arnott and Ng then move on to discuss one of Rune's GIPS-­compliant performance
presentations, provided in Exhibit 1.
Exhibit 1

 Rune Mid-­Capitalization Value Equity Composite (Benchmark: Russell Midcap Value Index)

Year

Composite
Gross Return
(%)

Composite
Net Return
(%)

Benchmark
Return
(%)

2006

11.2

10.69

2007

18.92

18.68

Composite
3-­Year Std.
Dev.
(%)

Number of
Portfolios

Internal

Dispersion
(%)

Composite % of
Firm Assets

12.65

15

0.09

7.1

20.22

19

0.06

7.2

2008

0.07

–0.17

–1.42

22

0.46

6.8

2009

–33.75

–33.95

–38.44

23

0.25

5.5

2010

31.44

31

34.21

26

0.95

5.9

2011

22.09

21.73

24.75

25

0.21

6.9

22.83

Rune Managers claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report
in compliance with the GIPS standards. Rune Managers has not been independently verified.
Notes:

1 Rune Managers is an investment manager registered with the US SEC. Rune Managers has divisions in Europe, Asia,
and the United States that invest in various equity and bond strategies.

2 The Rune Mid-­Capitalization Equity Composite includes all institutional portfolios that invest in mid-­capitalization

US equities, with the goal of providing long-­term capital growth and steady income from dividends by investing in low

price-­to-­earnings, undervalued securities.

3 A complete list and description of Rune Managers’ composites, as well as policies for valuing portfolios and preparing
compliant presentations, are available upon request.

4 The composite was created on 30 November 2005.
5 Leverage, derivatives, and short positions are not used by this strategy.
6 Performance is expressed in US dollars. The returns include the reinvestment of all income. Gross-­of-­fees returns are
presented before management and custodial fees but after all trading expenses. Net-­of-­fees returns are calculated by
deducting the actual fees of the accounts from the gross composite return.

7 The management fee schedule is as follows: 0.80% on the first $10 million, 0.55% on the next $40 million, 0.40% on
assets greater than $50 million.

8 This presentation is not required to conform to any laws or regulations that conflict with the GIPS standards.
(continued)


24

2018 Level III Mock Exam PM

Exhibit 1  (Continued)
9 Internal dispersion is calculated using the asset-­weighted standard deviation of annual gross returns of those portfolios
that were included in the composite for the entire year.

10 The three-­year annualized standard deviation measures the variability of the composite and the benchmark returns
during the preceding 36-­month period. The standard deviation is not presented for 2006 through 2010 because
monthly composite and benchmark returns were not available, and it is not required for periods prior to 2011.

55 In their discussion of the Rune Europe division, which of the following is most
likely correct?
A Ng’s analysis, because of how the division markets itself
B Arnott’s analysis, because of how the strategies are run
C Arnott’s analysis, because of how the division is managed
56 Which policy on the inclusion of portfolios in composites is most likely compliant with the GIPS standards?
A Policy 1
B Policy 2
C Policy 1 and Policy 2
57 In the discussion of carve-­outs, Ng is least likely correct in her statement
regarding the:
A disclosure of the cash allocation policy.
B compliance of the composite.
C disclosure of the percentage of composite assets.
58 In the discussion of the GIPS Advertising Guidelines, Ng is most likely correct
in her statement regarding the disclosure of:
A composite description.
B number of accounts in the composite.
C firm description.
59 Regarding the disclosures contained in the notes to Exhibit 1, the notes most
likely required are:
A 1, 5 and 6.
B 2, 7 and 8.
C 6, 7 and 9.
60 Regarding Exhibit 1, which item is least likely an error in the presentation?
A Composite percentage of firm assets
B Note 3
C Three-­year standard deviation