2019 CFA level 3 qbank r 20 21 asset allocation with real world c currency management answers

Question #1 of 24
A U.S.-based investor has purchased a 15,000,000 peso o ce building in Mexico. He has
hedged his investment by selling forward futures at $0.1098/peso. Two months later, the
futures exchange rate has fallen to $0.0921/peso. The investor's net change in the futures
position is:

A) $265,500.00
B) ($265,500.00)

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C) $1,647,000.00

The realized gain on the futures position is:

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Explanation

V0(-Ft + F0) = 15,000,000 pesos × (-$0.0921/peso + $0.1098/peso) = $265,500.

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(Study Session 10, Module 21.4, LOS 21.f)
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Question #2 of 24

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Currency trading based on economic fundamentals would be most likely to sell a currency
forward if the country issuing the currency is experiencing:

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A) declining levels of relative risk in the economy.
B) rising relative in ation.
C) increasing real rates of return.
Explanation
Higher relative in ation is associated with declining value of the currency and would tend to
encourage sale of the currency by the manager. The other two factors are associated with
currency appreciation.
(Study Session 10, Module 21.3, LOS 21.d)
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SchweserNotes - Book 3


Question #3 of 24
Jane Simms manages a German portfolio denominated in the EUR and decides to use an option
collar to reduce her downside risk exposure to the Mexican peso (MXP) while retaining some
potential upside. Which of the following strategies will accomplish her objective?

A) Buy an OTM call on the EUR and sell an OTM put on the EUR.
B) Buy an OTM put on the MXP and sell an in-the-money call on the MXP.
C) Buy an OTM put on the MXP and sell an OTM put on the MXP with a lower strike

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price.

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Explanation

The collar Simms describes requires buying OTM puts and selling OTM calls on the MXP.
However, this is directly equivalent to buying OTM calls on the EUR and selling OTM puts on
the EUR. Note that selling an in-the-money call on the MXP removes all portfolio upside and
will not meet her objectives.

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(Study Session 10, Module 21.5, LOS 21.g)
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Question #4 of 24

The Howarth School Foundation (HSF) has historically provided 30% of the annual operating
costs of running the Howarth Law school. Recent changes in government funding mean that

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previously fully funded scholarships will now only be 40% funded and that HSF must provide
more support to the school. Based on this information, HSF will most likely:

A) Increase the allocation to zero-coupon bonds to increase duration.
B) Increase the allocation to riskier timber and farmland to generate higher expected
return and cover the required out ows.
C) Decrease the allocation to private equity in order in increase the liquidity of the
portfolio.
Explanation


The school is becoming more dependent on the foundation, decreasing the ability to take risk
and increasing liquidity demands for payouts to the school. Shifting to more liquid
investments makes sense. Higher duration is not relevant and is probably riskier plus zerocoupons provide no regular cash ow. Higher return may seem logical but taking more risk to
get it is not appropriate when ability to take risk has declined. Plus land is an illiquid asset.
(Study Session 10, Module 20.2, LOS 20.c)
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SchweserNotes - Book 3

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Question #5 of 24

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Which scenario would most likely lead a portfolio manager to buy a foreign currency in the
forward market?

A) A portfolio that is overweighted in assets denominated in that currency.

the higher relative yield.

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B) An active manager implementing a carry trade when the currency being bought as

C) An active currency manager who is underweighted in assets denominated in that
currency.

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Explanation

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No manager views were indicated in the question; lacking views, an active manager should
take a neutral exposure to the currency. Being underweighted in the assets would produce
an underweighting in the currency which is corrected by buying the currency forward. The
other two answers are incorrect. Being overweighted would lead to selling the currency
forward. A carry trade would buy the higher yield currency in the spot, not forward, market.

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(Study Session 10, Module 21.4, LOS 21.e)
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Question #6 of 24


Dan Vustings, 51, is a senior account executive at an advertising agency in San Francisco. He
currently has su cient capital in his two investment portfolios to retire in 14 years. His capital
is evenly split between a taxable portfolio which he uses to fund current consumption goals
and a tax-deferred retirement account. Vustings received advice from an investment manager
last year who suggested the following asset allocation:
High-yield bonds 15%
High dividend yield equities 50%
High growth equities 35%
Vustings has the same allocation in both the taxable and the retirement account. Which of the

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following allocations would be most likely to improve the e ciency of the portfolios, ignoring
rebalancing or withdrawal penalties?

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A) Increase the allocation to high-yield bonds in the retirement account, and increase
the allocation to high growth equity investments in the taxable account.
B) Increase the allocation to high-dividend yield equities in the taxable account, and

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increase the allocation to high growth equities in the retirement account.
C) Increase the allocation to high-yield bonds in the taxable account, and increase the
allocation to high growth equities in the retirement account.
Explanation

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Assets subject to the highest rates of tax should be rst allocated to tax advantaged
accounts. Interest on high yield bonds is typically taxed at a higher rate than dividend income
which in turn is taxed at a higher rate than capital gains. Vustings should therefore allocate
high-yield bonds rst to the retirement account, and leave the high growth equity in the

taxable account.
(Study Session 10, Module 20.1, LOS 20.b)

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Question #7 of 24
Which of the following portfolios would most likely follow a passive currency hedging strategy?

A) One with a shorter time horizon and higher liquidity needs.
B) One very concerned with minimizing regret and higher allocation to equity
investments.


C) One with more con dence in the portfolio manager and high income needs.
Explanation
The following will shift the portfolio towards more passive currency management:
A short time horizon for portfolio objectives
High risk aversion
Lack of concern with regret at missing opportunities to add value through discretionary
currency management
High short-term income and liquidity needs
Signi cant foreign currency bond exposure
Low hedging costs
Clients who doubt the bene ts of discretionary management

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(Study Session 10, Module 21.1, LOS 21.c)
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Question #8 of 24

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SchweserNotes - Book 3

A U.S. investor who holds a £2,000,000 investment wishes to hedge the portfolio against
currency risk. The investor should:

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A) buy £2,000,000 worth of futures for U.S. dollars.

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B) sell $2,000,000 worth of futures for British pounds.

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C) sell £2,000,000 worth of futures for U.S. dollars.

Explanation

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The investor should sell £2,000,000 worth of futures contracts for U.S. dollars. This will o set
the existing long position in pound-denominated assets. In so doing, the investor has
e ectively xed the exchange rate for pounds into dollars for the duration of the futures
contract.
(Study Session 10, Module 21.1, LOS 21.b)
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Question #9 of 24


The basis risk in a currency hedge is most likely highest in a:

A) cross hedge.
B) minimum-variance hedge ratio.
C) direct hedge.
Explanation

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Question #10 of 24

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SchweserNotes - Book 3

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(Study Session 10, Module 21.6, LOS 21.h)

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A Basis risk exists when movement in the hedge currency is not matched by movement in the
hedging vehicle. A direct hedge will short forwards on the currency to be hedged and basis
risk will therefore be low. A cross hedge can range from lower to higher basis risk depending
on what is used as the hedging vehicle. The MVHR depends on regressing past asset returns
and currency movement to calculate a hedge ratio that would had minimized past volatility of
returns to the domestic investor in a foreign asset. It is exposed to changing correlation and
likely to have the highest basis risk.

Kevin Collison has several di erent places where he has assets in which he manages as

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separate accounts such as his checking account which he uses for short term cash and

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emergency needs, his 401(k) account for retirement, and his children's college fund. In his

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401(k) he owns a small cap stock in a company which makes catheters to be used in
experimental cancer treatment in which the catheter is used to deliver cancer killing drugs to
hard to reach tumors in the body. The stock has recently taken a downturn in price due to the

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FDA not approving their most recent catheter. As a result of the downturn in price, Collison
purchases more of the stock in hopes of recouping his losses at some future time. Collison's
management of his portfolio is indicative of:

A) money illusion and fear of regret.
B) mental accounting and loss aversion.
C) asset allocation and pyramiding.
Explanation


Collison is exhibiting mental accounting by having separate accounts for his assets which he
manages each account separately for a speci c purpose and does not manage his assets as a
complete portfolio for asset allocation purposes. He is also exhibiting loss aversion by not
accepting the loss on the stock which is also leading to risk seeking behavior by buying more
of the losing stock.
(Study Session 10, Module 20.3, LOS 20.e)
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Question #11 of 24

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The cost to hedge a long position in the EUR is reduced by:

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A) forward euro exchange rates are below the spot exchange rates.
B) lower relative interest rates in the euro zone.

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C) negative roll yield.
Explanation

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A long position in the euro is hedged by selling the euro forward. Positive roll yield is a
reduction in hedging cost. Positive roll yield for the seller of the euro occurs if the forward
exchange rate for the euro is above the spot exchange rate. This will occur if euro zone
interest rates are relatively low.

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(Study Session 10, Module 21.4, LOS 21.f)

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Question #12 of 24
Goals based investing is most directly useful to counter:

A) loss aversion.
B) illusion of control.
C) representativeness.
Explanation


The answer is loss aversion based speci cally on what the reading says. You have taken at
least 2 CFA exams and know such picky questions are unusual. Exhibit good judgement, give
your best guess, and move on.
(Study Session 10, Module 20.3, LOS 20.e)
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SchweserNotes - Book 3

Question #13 of 24

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Which of the following statements regarding hedging of emerging market currencies is least

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accurate?

A) Hedging costs for managers who buy emerging market currencies are increased by
the relatively high interest rates in emerging markets.

B) Hedging cost varies with normally large bid/asked spreads followed by infrequent

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periods of even higher spreads.

C) Tail risk and contagion both refer to relatively infrequent events that increase the
di culty of hedging emerging market currencies
Explanation

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The relatively high interest rates of emerging market economies leads to an inverted pricing
curve with forward prices of the emerging market currencies below their spot prices. This
raises hedging cost for sellers of the currency, not buyers; sellers receive negative roll yield
while buyers receive positive roll yield. EM currencies do have relatively high bid/asked

spreads which increase in periods of crisis. Contagion and tail risk refer to infrequent events.
Contagion refers to all EM currencies tending to decline together in periods of crisis, and tail
risk to the downside in those periods of crisis being large in relation to typical upside
movement in the currencies.
(Study Session 10, Module 21.6, LOS 21.i)
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Question #14 of 24


A European investor holds a diversi ed portfolio. From the euro perspective the portfolio is
weighted 60% and 40% in U.S. and U.K. investments.
Additional information:

Returns
measured
from investor's
perspective:

U.S.

5%

6%

4.5%

U.K.

7%

8%

3.5%

3.7%
4.7%

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Assets:

Stand
deviation of
the foreign
currency's
returns:

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Returns
measured in
foreign
currency:

Standard
deviation of
asset's

returns
measured in
foreign
currency:

The correlation between the foreign-currency asset's returns and returns on the foreign
currency are 0.81 and 0.67 respectively for the U.S. and U.K. assets. Compute the standard

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deviation of returns for the investor in the U.K. assets.

A) 7.8%.
B) 60.9%.
C) 7.5%.

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Explanation

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It depends on the standard deviation of the asset returns measured in the foreign currency,
the standard deviation of the currency's returns, and the correlation between these two
sources of returns.

Variance = (1.02)(3.52) + (1.02)(4.72) + 2(1.0)(1.0)(0.67)(3.5)(4.7) = 56.38

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Standard deviation = 7.5%

(Study Session 10, Module 21.1, LOS 21.a)
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SchweserNotes - Book 3

Question #15 of 24


A Djiboutian (DJF) investor holds an international portfolio with beginning investments of USD
1,253,000 and EUR 2,347,800. Measured in the foreign currencies these investments appreciate
5% and depreciate 7% respectively.
Additional information:

Beginning Forward
Exchange Rate

Ending Spot
Exchange Rate

DJF/USD 179.54

DJF/USD 185.67

DJF/USD 192.85

EUR/DJF 0.00416

EUR/DJF 0.00413

EUR/DJF 0.00421

The ending value of the EUR investment is closest to:

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A) EUR 2,200,000.

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Beginning Spot
Exchange Rate

B) EUR 2,500,000.
C) DJF 575,000.

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Explanation

The ending value in EUR
EUR 2,347,800 × .93 = EUR 2,183,454
is:

EUR 2,183,454 / (EUR/DJF 0.00421) = DJF
518,635,154

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The ending value in DJF
is:

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(Study Session 10, Module 21.1, LOS 21.a)

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Question #16 of 24


The strategic asset allocation, current allocation, and upper and lower policy limits for a
retirement portfolio are shown in the table below.

Asset Class
Fixed Income

Current Weight SAA Upper Limit Lower Limit
35%

40% 45%

35%

Domestic Equity 60%

50% 60%

40%

Real Estate

10% 15%

5%

5%

The portfolio manager takes a discretionary approach to tactical asset allocation. She follows
various indicators that she believes are useful in evaluating speci c asset classes. Her current

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observations and interpretations are:

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Equity brokers have reported that margin borrowing levels increased dramatically over
the last two months and now sit at their highest levels for 15 months, a bearish sign.
Real estate indexes have started to rise suggesting the market may be 'heating up', a
bullish sign.

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Indications from the federal reserve are that interest rates will rise several times in the
next 12 months, a clearly obvious sign.

Which of the following tactical allocation shifts is the manager most likely to make?

A) Increase the weighting to real estate.

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B) Decrease the weighting to xed income.

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Explanation

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C) Increase the weighting to domestic equity.

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She is bullish on RE and RE is at the bottom of her range; she should increase the allocation if
possible. Admittedly RE is a less liquid asset. She is bearish on equity and would not want to
increase the weight. Increasing interest rates is bearish for bonds, but she is already at the
bottom of the range. Avoid convoluted arguments that to change one weight she must do
something else as well. That is not a direct answer to the question, was not asked, and we'd
be guessing what that other action is. She may already have some cash assets.
(Study Session 10, Module 20.2, LOS 20.d)
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Question #17 of 24


A pension fund is searching for an optimal portfolio by comparing the present value of
contributions and contribution risk as measured by a 95% con dence interval that
contributions will not exceed a given threshold. Which of the following portfolios would be the
most e cient under these criteria?

A) PV Contributions $69 million and Contribution risk $390 million.
B) PV Contributions $65 million and Contribution risk $392 million.
C) PV Contributions $60 million and Contribution risk $385 million.
Explanation

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The best choice will: minimize contribution risk which is the chance of having to increase
contributions, and also minimize the expected present value of future contributions.

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(Study Session 10, Module 20.1, LOS 20.a)
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Question #18 of 24

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Which of the following comments is most accurate?

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A) A cost/bene t analysis of whether to hedge currency should include all of the

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following: bid/asked transaction costs, option premiums, back o ce and

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B) Currency volatility becomes a more signi cant issue in global portfolios over a
longer time horizon as returns compound.

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C) Discretionary currency hedging allows wider deviations from the strategic hedging
than active currency management.
Explanation
All of the expenses listed should be included in cost/bene t analysis of when and how to
hedge currency risk including items such as back o ce and other overhead expenses;
ultimately these direct and indirect expenses and costs will a ect the client's net return.
The other two answer choices are false. Active management allows the wider deviations. In
the long run currency has less impact on risk as currency tends to mean revert in the long
run. A short run perspective supports currency hedging.
(Study Session 10, Module 21.1, LOS 21.b)
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SchweserNotes - Book 3

Jane Archer manages a Swiss (CHF) based hedge fund. A portion of the fund is currently
allocated 60% and 40% respectively to EUR and ASD risk-free investments, pending other
investment opportunities. She has collected the following information:

Estimates:

Euro Zone

Australia

2.0%

2.5%

Change in spot exchange rate versus the CHF

−1.0%

3.0%

Asset risk measured in foreign currency (σ)

0.0%

0.0%

Currency risk (σ)

7.0%

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Asset return in foreign currency

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9.0%

Correlation of currency returns (CHF/EUR,
CHF/ASD)

+0.70

Question #19 of 24

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The following questions are from the portfolio perspective, measured in CHF.

The expected return of the risk-free portion of the portfolio is closest to:

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C) 3.74.

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B) 2.82%.

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A) 6.56%

Explanation

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The expected returns measured in the investor's domestic currency (CHF) are:

EUR asset: (1.02)(0.99) − 1 = +0.98%
ASD asset: (1.025)(1.03) − 1 = +5.58%
The weighted average return is: 0.6(0.98%) + 0.4(5.58%) = 2.82%
(Study Session 10, Module 21.1, LOS 21.a)
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Question #20 of 24
The standard deviation of the risk-free portion of the portfolio is closest to:

A) 54.13%.
B) 7.36%.
C) 7.98%.
Explanation
The standard deviations of the risk-free assets measured in the investor's domestic currency
are:

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EUR asset: 7.0%(1.02) = 7.14%

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ASD asset: 9.0%(1.025) = 9.23%

The variance of returns of the risk-free portion of the portfolio is:
0.62(7.142) + 0.42(9.232) + 2(0.6)(0.4)(0.70)(7.14)(9.23) = 54.13

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The standard deviation of returns of the risk-free portion of the portfolio is:
54.13½ = 7.36%
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Question #21 of 24

What is the expected return of the risk-free portion of the portfolio if Archer takes a leveraged

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position with a 150% positive weight in Australia and a 150% negative weight in the euro zone?

A) 6.75%.
B) 6.90%.
C) 9.72%.

Explanation

The expected returns measured in the investor's domestic currency (CHF) are:
EUR asset: (1.02)(0.99) − 1 = +0.98%
ASD asset: (1.025)(1.03) − 1 = +5.58%
The weighted average return is: −1.5(0.98%) + 1.5(5.58%) = 6.90%
(Study Session 10, Module 21.1, LOS 21.a)
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SchweserNotes - Book 3

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Question #22 of 24

What is the expected standard deviation of returns of the risk-free portion of the portfolio if
Archer takes a leveraged position with a 150% positive weight in Australia and a 150% negative
weight in the euro zone.

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A) 98.80%.
B) 3.00%.
C) 9.94%.

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Explanation

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The standard deviations of the risk-free assets measured in the investor's domestic currency
are:

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EUR asset: 7.0%(1.02) = 7.14%
ASD asset: 9.0%(1.025) = 9.23%

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The variance of returns of the risk-free portion of the portfolio is:
(-1.5)2(7.142) + (1.5)2(9.232) + 2(-1.5)(1.5)(0.70)(7.14)(9.23) = 98.796
The standard deviation of returns of the risk-free portion of the portfolio is:
98.796½ = 9.94%

(Study Session 10, Module 21.1, LOS 21.a)
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Question #23 of 24
If Archer takes a short position in a forward contract in the euro and assuming the forward
exchange rate for the euro vs. the CHF is downward sloping which of the follow is most

accurate?

A) She will earn a negative return by shorting the currency.
B) She will earn a negative roll return increasing hedging costs.
C) Her position will result in a loss if the euro depreciates more than predicted by
interest rate parity.

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Explanation

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Since forward curve is downward sloping for the euro exchange rate vs. the CHF by taking a
short position in the forward contract she will earn a negative roll return. A positive roll
return is earned by taking a long position in a currency with a downward sloping forward
exchange rate and Archer is taking the opposite position. Conversely with an upward sloping
forward exchange rate curve a long position in the forward contract would result in a
negative roll return and a short position would result in a positive roll return. By entering into
the forward contract Archer locks in the forward discount of the euro predicted by interest
rate parity. If the euro depreciates more than predicted by interest rate parity she would lose
less by locking in a smaller depreciation of the euro using the forward contract than if she did
not hedge with the forward contract. Archer is shorting the forward contract not the currency
itself. If she had shorted the euro currency and it depreciates as expected then she would

earn a pro t on the decrease in value of the short position.

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(Study Session 10, Module 21.1, LOS 21.a)

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Question #24 of 24
Assuming the correlation between the ASD currency and underlying asset is highly positive
which hedge ratio is most appropriate for hedging the ASD?

A) A hedge ratio <1.
B) A hedge ratio >1.
C) Cannot be determined with the information given.
Explanation


Since the ASD currency and underlying Australian asset are highly positively correlated a
hedging ratio of >1, shorting more than 100% of Australian investment, would result in
reduced volatility when measuring the ASD investment in the domestic CHF currency.

(Study Session 10, Module 21.1, LOS 21.a)
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