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2021 CFA LIII mock exam answer solutions
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CFA Society Boston Level III
2021 Practice Exam
Answer Key
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LEVEL III MORNING SESSION—GUIDELINE ANSWERS
QUESTION 1
Topic:
Minutes:
Derivatives and Currency Management
12
LOS:
Study Session 6-17-a, b, c, d, g
Reference: Reading 17, Currency Management: An Introduction, Sections 2.4, 4.3, 5.3, 6.2,
6.3, 6.4, & 7.1.
Guideline Answer:
Part A
The carry trade is a trading strategy of borrowing in low-yield currencies and investing in highyield currencies.
Borrow in USD at 2.211%
Invest in China at 5.667%
Profit = 5.667% – 2.211% = 3.456%
Risks involved in carry trade (include at least two):
1. High-yielding currencies are typically from high-risk countries.
2. In times of global financial crisis, there is a rapid movement from high-risk currencies to
low-risk currencies, resulting in unwinding of carry trades.
3. Large-scale losses can be incurred quickly due to the large amount of leverage involved
with a carry trade.
Part B
A bull call spread is buying an ITM call and writing a deeper OTM call to gain income from
premium. Both options will have the same maturity.
Premium paid to buy BRL/USD ITM call at Strike $5.00 = –$1.95
Premium received to write BRL/USD ITM call at Strike $6.00 = $1.50
Total premium paid per bull call spread contract = $1.95 – $1.50 = $0.45
Maximum gain = Difference b/w call strike prices – Total premium paid
= ($6.00 – $5.00) – $0.45 = $0.55
Breakeven price = $5.00 + $0.45 = $5.45
Part C
Statement 3 is correct.
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A protective put strategy involves buying a put to protect against the downside of the long
position. The base currency is USD and the protection against the base currency is to purchase a
put option on the CNY/USD exchange rate.
Statement 1 is incorrect.
Technical analysis is not driven by underlying economic factors, but instead takes historical price
data into consideration to project future exchange rate movements.
Statement 2 is incorrect.
Expansionary monetary policy in India should contribute to lower real interest rates, leading the
INR to depreciate.
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QUESTION 2
Topic:
Minutes:
Equity Portfolio Management
28
LOS:
10-24-d, i; 10-25-d, f
Reference:
Reading 24, Active Equity Investing: Strategies, Sections 3.3, 6.1 & 6.2; Reading
25, Active Equity Investing: Portfolio Construction, Sections 4.1 & 6.2.
Guideline Answer:
Part A
There are four ways in which the Spencer Fund’s investment style has evolved between 2010
and 2020 based on Fitz’s returns-based analysis (any three answers provided below are suitable):
• Size: The fund has increased its exposure to smaller capitalization equities. This is
evidenced by the fact that exposure coefficients for both Russell 1000 indices
declined between 2010 and 2020 (from 0.73 to 0.51 for the Russell 1000 Growth and
from 0.17 to 0.07 for the Russell 1000 Value) while exposure coefficients for both
Russell 2000 indices increased during the same period (from 0.52 to 0.87 for the
Russell 2000 Growth and from 0.08 to 0.14 for the Russell 2000 Value).
• Income: The fund has decreased its exposure to high-dividend–paying equities. This
is evidenced by the exposure coefficient for the Dow Jones Select Dividend Index
declining from 0.38 to 0.12 between 2010 and 2020.
• Quality: The fund has decreased its exposure to high-quality equities. This is
evidenced by the exposure coefficient for the MSCI USA Quality Index declining
from 0.69 to 0.49 between 2010 and 2020.
• Momentum: The fund has increased its exposure to high momentum equities. This is
evidenced by the exposure coefficient for the MSCI USA Momentum Index
increasing from 0.51 to 0.80 between 2010 and 2020.
Note that the exposure coefficients provided for the growth and value indices suggest that there
was no change in style between 2010 and 2020. The fund remained growth oriented.
Drawbacks or limitations associated with the use of a returns-based style analysis relative to a
holdings-based analysis include (either would be acceptable):
• Returns-based analyses are generally less accurate than holdings-based analyses
because they do not utilize actual portfolio holdings.
• Most returns-based models impose unnecessary constraints that make it difficult to
detect more aggressive positions such as deep value or micro-cap.
Part B
Fitz’s concerns about implicit costs suggest that the Artie Fund has suffered from higher
effective trading costs (i.e., slippage) as assets have grown. This issue is highly relevant to smallcap managers, particularly those that manage concentrated portfolios, such as the Artie Fund.
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There are at least four options available to the managers of the Artie Fund to mitigate the impact
of these implicit costs (any two are acceptable):
• The fund could limit its AUM by not accepting any new funds. This could include
returning some capital to existing investors.
• The fund could increase the number of portfolio holdings from the current 40, thus
limiting the market impact of trading by reducing the number of days it takes to build
a full position.
• The fund could reduce turnover from the current 70%, which will result in a decrease
in trading volume and the associated related implicit costs.
• The manager could devise a trading strategy to mitigate market impact costs.
Part C
The contribution of an asset to total portfolio variance is calculated as: 𝐶𝐶𝐶𝐶𝑖𝑖 n = ∑𝑛𝑛𝑗𝑗=1 𝑥𝑥𝑖𝑖 𝑥𝑥𝑗𝑗 𝐶𝐶𝑖𝑖𝑗𝑗
where xj = the asset’s weight in the portfolio, and Cij = the covariance of returns between asset i
and asset j. (Note: This is Equation 8b in Reading 25.)
The contribution to total portfolio variance for each fund is calculated as follows:
• Spencer Fund: (0.35*0.35*0.032) + (0.35*0.25*0.004) + (0.35*0.40*0.003) =
0.00469
• Artie Fund: (0.25*0.25*0.048) + (0.25*0.35*0.004) + (0.25*0.40*0.004) = 0.00375
• S&P 500 Index Fund: (0.40*0.40*0.040) + (0.40*0.35*0.003) + (0.40*0.25*0.004) =
0.00722
Total portfolio variance is equal to the sum of these three values, or 0.01566. (A good check we
can do is take the square root of this value to obtain and confirm the portfolio standard deviation
of 12.51%, which is provided in Exhibit 2.) The percentage contributions are calculated as:
• Spencer Fund: 0.00469 ÷ 0.01566 = 30%
• Artie Fund: 0.00375 ÷ 0.01566 = 24%
• S&P 500 Index Fund: 0.00722 ÷ 0.01566 = 46%
The S&P 500 Index Fund is the largest contributor to total portfolio variance despite having a
lower standard deviation than either the Spencer Fund or Artie Fund.
There are two potential changes that can be made to reduce the total portfolio variance (either
would be acceptable):
• Kibble could add a new fund to the US equity portfolio that has a lower covariance
with the portfolio than the existing funds in the portfolio.
• Kibble could replace one of the existing funds in the US equity portfolio with another
fund that has a lower covariance with the portfolio than the fund being replaced.
Part D
There are several potential drawbacks to the “hedged portfolio” approach (any two would be
acceptable):
• The hedged portfolio is not a “pure” factor portfolio because it has significant
exposures to other risk factors (e.g., Size, Value, Momentum, Growth, etc.).
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•
•
•
•
The information contained in the middle deciles of the ranked universe (i.e., the
Russell 1000) are not utilized, only the information contained in the top and bottom
deciles.
This hedged-portfolio approach assumes the relationship between future stock returns
and the factor (i.e., Quality) are linear, which may not be the case.
Portfolios using this approach tend to be concentrated. If many managers adopt a
similar strategy, the resulting portfolios will be highly concentrated in specific stocks,
increasing overall risk to the strategy.
Shorting might be prohibitively expensive for certain stocks, or not possible
altogether in certain markets (although this is less of an issue for a universe as deep
and liquid as the Russell 1000 Index).
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QUESTION 3
Topic:
Minutes:
Fixed Income Portfolio Management
34
LOS:
8-20-c, d, e, h, i; 8-21-d, f
Reference:
Reading 20, Yield Curve Strategies, Sections 4, 6 & 7; Reading 21, Fixed-Income
Active Management: Credit Strategies, Sections 4.1, 4.2, 4.3, 5.2 & 6.2.
Guideline Answer:
Part A
By using macro factors such as economic growth, default rates and industry trends, Harwich is
using a top-down approach.
Advantage: The main advantage of a top-down approach is that a sizable portion of credit returns
can be attributed to macro factors.
Limitation: A top-down approach may be difficult to implement since the expectations for
interest rates, economic cycles and other macro influences are closely examined by market
participants and, in many cases, reasonably reflected in current credit market prices. As a result,
it can be difficult for an investor to gain an informational advantage in a top-down approach.
Part B
Excess return ≈ (s × t) – (Δs × SD) – (t × p × L)
Spread duration ≈ DTS / OAS
Aa: (0.008 × 1) – [(0.007 – 0.008) × (720 / 80)] – (1 × 0.00) = 1.70%
A: (0.0105 × 1) – [(0.009 – 0.0105) × (840 / 105)] – (1 × 0.0005) = 2.20%
Baa: (0.0195 × 1) – [(0.0165 – 0.0195) × (1560 / 195)] – (1 × 0.0008) = 4.27%
Ba: (0.0295 × 1) – [(0.0265 – 0.0295) × (1180 / 295)] – (1 × 0.0020) = 3.95%
From the above calculations, Baa outperformed the other sectors as the Baa sector’s higher
spread duration resulted in superior gains with spreads tightening 30 bps for both the Baa and Ba
sectors.
However, if spreads remain constant over the next year, the benefit of higher spread carry
(adjusted for credit losses) provides for higher expected returns for the Ba sector.
Aa: (0.008 × 1) – (1 × 0.00) = 0.80%
A: (0.0105 × 1) – (1 × 0.0005) = 1.00%
Baa: (0.0195 × 1) – (1 × 0.0008) = 1.87%
Ba: (0.0295 × 1) – (1 × 0.0020) = 2.75%
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Part C
Option 1:
Harwich can use portfolio diversification and add exposure to automotive companies.
Automotive companies are large consumers of metals and would benefit from falling metal
prices.
Drawback: An investor may find it difficult to identify attractively valued investment
opportunities that can protect against every tail risk that the investor foresees. Also, the use of
portfolio diversification as tail risk protection may not fully achieve an investor’s objectives.
Option 2:
Harwich can use derivatives either by buying put options on metal prices or by buying CDS or
credit spread options on the bonds of miners whom he finds least attractively valued.
Drawback: The primary drawback of tail risk hedging is that, like insurance, it typically has a
cost and, therefore, lowers portfolio returns if the tail risk event does not occur. Not surprisingly,
tail risk hedges tend to be most expensive when the tail risk event seems most likely to occur.
Investors must carefully consider the costs.
Part D
In the event of an instantaneous 50 bps parallel shift higher in rates, Portfolio A will most likely
underperform the index. Portfolio A has a lower overall convexity than that of the index (the
market value loss would be more than that of the index). Portfolio A’s overall duration is neutral
to the index and should not be a factor.
Portfolio B will most likely outperform the index. Portfolio B has a higher overall convexity than
that of the index (the market value loss should be lower than that of the index). Portfolio B’s
overall duration is neutral to the index and should not be a factor.
For both portfolios, curve positioning is not a factor for parallel shifts.
Index
Portfolio A
Portfolio B
Effective Duration
7.14
7.15
7.15
Effective Convexity
1.10
0.63
1.64
Part E
The investment committee is forecasting for a steepening yield curve. Portfolio A can be
classified as a bullet portfolio with no exposure to long end rates. Therefore, Portfolio A will
outperform the index in the event that long end rates rise, given the index has 12% exposure in
30-year bonds.
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Portfolio B can be classified as a barbell portfolio with significantly higher exposure in the 30year bonds relative to the index. Therefore, Portfolio B will underperform the index in the event
of long end rates moving higher.
Part F
Rolling yield = Yield income + Rolldown return
Yield income = Annual coupon / Current bond price
Rolldown return = Bond price (eh) – Bond price (bh) / Bond price (bh)
where (eh) is end of horizon and (bh) is beginning of horizon
Portfolio X = [1.80% / 95.60] + [(97.00 – 95.60) / 95.60] = 3.35%
Portfolio Y = [1.65% / 99.00] + [(100.50 – 99.00) / 99.00] = 3.18%
Total expected return = Rolling yield + E (change in price based on yield view)
E = [–MD × ΔYield] + [0.5 × Convexity × (ΔYield)2]
Portfolio X = [–4.12 × –0.95%] + [0.5 × 14.68 × (–0.95%)2] = 3.98%
Portfolio Y = [–4.35 × –0.95%] + [0.5 × 24.98 × (–0.95%)2] = 4.25%
Total Return:
Portfolio X = 3.35% + 3.98% = 7.33%
Portfolio Y = 3.18% + 4.25% = 7.43%
Based on the total expected return, Portfolio Y should be recommended. The higher duration
and convexity of this portfolio relative to Portfolio X results in a larger positive change in price,
which results in the greater total expected return.
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QUESTION 4
Topic:
Minutes:
Behavioral Finance
16
LOS:
3-8-b, c, d; 3-9-a, b, c, d
Reference:
Reading 8, The Behavioral Biases of Individuals, Section 3.1, 3.2, 4.1 & 4.2;
Reading 9, Behavioral Finance and Investment, Section 2.1, 4.1, 4.2, 4.4 & 4.5.
Guideline Answer:
Part A
“1/n” naïve diversification strategy is dividing contributions equally among available funds
irrespective of the underlying composition of the funds. This appears to have been Cheng’s prior
approach to portfolio construction.
Possible consequences of this strategy would be any two of the following:
• Maintaining an under-diversified portfolio with assets having high correlations with each
other.
• Missing long-term objectives—not achieving the required returns or capital accumulation
necessary to meet long-term expenses or goals, and potentially outliving the assets.
• Selecting suboptimal investments that may result in incurring higher risk and lower
returns.
Part B
Cheng appears to exhibit framing bias. This is an information-processing bias, in which a person
answers questions or makes decisions differently based on the way in which the question is
asked or the decision is framed. In this case, Cheng changes his portfolio allocation based on the
information provided by Winters.
Part C
Independent Individualist. Russo exhibits the characteristics of an Independent Individualist by
being an active investor with medium to high risk tolerance. He is a strong-willed independent
thinker. Russo depends on his own research but is willing to listen to sound advice when
presented in a way that respects his intelligence.
Any three of these biases would receive credit:
• Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own
intuitive reasoning, judgement and cognitive abilities. Russo wants to maintain control over
his portfolio.
• Self-attribution bias is a bias in which people take credit for successes and assign
responsibility to external factors for failures. Russo claims his industry knowledge is the
reason for his success.
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•
•
•
•
Conservatism is a belief perseverance bias in which people maintain their prior views or
forecasts by inadequately incorporating new information. Russo wishes to continue to focus
on the software sector.
Availability bias is an information-processing bias in which people take a heuristic approach
to estimating the probability of an outcome based on how easily the outcome comes to mind.
Russo works in the software sector and has greater accessibility to software-related start-ups.
Confirmation bias is a belief perseverance bias in which people tend to look for and notice
what confirms their beliefs, and to ignore or undervalue what contradicts their beliefs.
Russo’s past success confirms his continued strategy in the software sector.
Representativeness bias is a belief perseverance bias in which people tend to classify new
information based on past experiences and classifications. Russo wishes to focus on the
software sector.
Part D
Any two of the following would be acceptable:
• Mental Accounting Bias: Mental accounting bias is an information-processing bias in
which people treat one sum of money differently from another equal-sized sum based on
which mental account the money is assigned to.
Overcome this bias by showing the correlations and risks between investments within the
portfolio, instead of segregating individual investments within the portfolio.
•
Loss-Aversion Bias: Loss-aversion bias is a bias in which people tend to strongly prefer
avoiding losses as opposed to achieving gains.
Overcome this bias by adopting a disciplined approach, using fundamental analysis, to
understand the benefits of diversification and tax-loss harvesting.
•
Status Quo Bias: Status quo bias is an emotional bias in which people do nothing
instead of making a change that is beneficial.
Overcome this bias by educating Moylan about the return-enhancing and risk-reducing
benefits of a portfolio approach.
•
Endowment Bias: Endowment bias is an emotional bias in which people value an asset
more when they hold rights to it than when they do not.
Overcome this bias by explaining to Moylan that her parents left her the portfolio’s
overall capital and the benefits from which may be derived, and not the specific
investments. Start by making small changes over time to redeploy existing portfolio
assets into investments possessing greater diversification benefits and growth to offset
inflation effects.
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QUESTION 5
Topic:
Minutes:
Private Wealth Management
30
LOS:
12-28-g, h, i, j; 12-29-d, e; 12-30-g; 13-31-a; 13-32-a, e, f, j; 16-38-c, d
Reference:
Reading 28, Overview of Private Wealth Management, Sections 2, 3, 4.2, 5 & 6;
Reading 29, Taxes and Private Wealth Management in a Global Context, Sections
3–6; Reading 30, Estate Planning in a Global Context, Section 5.1; Reading 31,
Concentrated Single-Asset Positions, Section 2; Reading 32, Risk Management
for Individuals, Sections 2–5; Reading 38, Case Study in Risk Management:
Private Wealth, Sections 2, 3 & 4.3.
Guideline Answer:
Part A
Any three of the additional insurance coverage products that Serensen should consider include:
•
•
•
•
More life insurance—€50 thousand (or 1 × his salary) is insufficient to address his
mortality risk, given the ages of the three children. He should obtain additional coverage
through his employer, or, preferably, obtain it privately, if he can afford it. Individually
obtained life insurance will be underwritten based on his own health (excellent) and will
be portable should he leave his current employer.
Disability insurance—will mitigate the earnings risk due to a reduction or elimination of
Serensen’s human capital because of injury or illness. The time horizon of the risk to his
human capital is presently 23 years.
Property insurance—Serensen may suffer significant theft or casualty loss on his assets,
particularly his residence.
Liability insurance—will mitigate, or cover completely, any loss Serensen might suffer
as a result of an adverse court judgment.
Part B
Reasons in support of using an irrevocable trust as the beneficiary of Serensen’s employerprovided life insurance include any two of the following:
•
•
•
•
•
•
•
The children are minors and cannot receive the life insurance proceeds directly at this
time.
A trust permits Serensen to nominate a trustee of his choosing, rather than one appointed by a
government authority, to manage the insurance benefit while the children are underage.
Serensen can designate the age(s) and circumstance(s) under which each child will
receive trust distributions.
The trustee may be given discretionary powers to alter the timing and/or amount of
payments as well as the ability to treat the beneficiaries unequally if the children’s needs
are unequal or change over time.
There is the possibility of professional investment management of the proceeds.
The trust may add a degree of privacy for the receipt and distribution of the insurance
payouts to the children.
There may be asset protection features that place the insurance proceeds beyond the reach
of Serensen’s creditors or the creditors of his estate.
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Part C
Additional recommendations would include any two of the following:
•
•
•
•
•
•
•
•
•
Increase cash holdings as an emergency fund. This is particularly important when raising
young children.
Sell the company stock to increase liquidity, or to redeploy capital on a tax-efficient
basis. The losses realized from the sale can shelter other income from taxation.
Sell the company stock to reduce the dual risk to which Serensen is exposed. His
employer currently factors into his human and financial capital. By selling the stock, he
will remove the financial capital risk, but retain the human capital (earnings) risk.
Increase life insurance coverage (if not identified previously in Part A).
Obtain disability insurance (if not identified previously in Part A).
Obtain property insurance (if not identified previously in Part A).
Obtain liability insurance (if not identified previously in Part A).
Refinance the mortgage on the residence, if the savings justify the refinancing costs.
Downsize to a smaller residence with a smaller mortgage to reduce his overhead expense
and financing costs.
Part D
Serensen’s ability to bear risk appears below average due to his small asset base and the fact
that little of his salary remains for savings/investment after household expenses are met, his
salary is not expected to grow in real terms, and he is the sole provider for three young children.
Serensen’s willingness to bear risk also appears to be below average because of his unfamiliarity
and discomfort with financial matters, his avowed intent to be cautious, and his willingness to
seek advice from experienced professionals.
Because both his ability and his willingness to bear risk are in agreement, neither one will take
precedence over the other. His overall risk tolerance is below average.
Part E
i. Liquidity
Serensen has an immediate liquidity requirement of €215,000 for debt reduction and education
funding. Thereafter, his salary (indexed) will track his current expenses but will not grow in real
terms. As long as his spending remains at current levels (on an inflation-adjusted basis) and no
extraordinary expenses occur, Serensen has no other identifiable liquidity constraints until he
retires.
At retirement, he will need to purchase an annuity that will provide him with an inflationadjusted, after-tax cash flow that will bridge the gap between his pension and his retirement
spending needs.
ii. Time Horizon
Serensen’s time horizon is long-term and multi-stage:
•
•
23 years until he retires
30 years in retirement
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Part F
Education Account
The Domestic Corporate Bonds should be placed in the tax-exempt education account because
they exhibit a higher expected return (3% vs. 2%) with the same amount of risk as the Domestic
Tax-Exempt Bonds.
Retirement Account
The Domestic Corporate Bonds should also be placed in the taxable retirement account because
they will exhibit a higher after-tax expected return (3% × 0.7 = 2.1% vs. 2%) and a lower aftertax risk (6% × 0.7 = 4.2% vs. 6%) than the Domestic Tax-Exempt Bonds.
Part G
The Global Small-Cap Equity in the taxable account will have a lower effective risk (16% × 0.7
= 11.2%) due to the risk-sharing of the tax rate than the Global Large-Cap Equity in the taxexempt account, where the account holder is fully exposed to the investment’s risk (12%).
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QUESTION 6
Topic:
Minutes:
Institutional Investors
30
LOS:
14-33-a, b, c, d, e, f, g, h, i
Reference:
Reading 33, Portfolio Management for Institutional Investors, Sections 2.3, 3, &
4.
Guideline Answer:
Part A
The risk tolerance of the existing plan is above average.
Justification (any two reasons are acceptable):
• Younger overall workforce with a large portion having little service time
• Perpetual time horizon
• Low current payouts to retired workers
• Balance sheet has low debt-to-equity ratio
Part B
Whatsit uses the Norway model.
Justification:
• Client utilizes low-cost passive investments.
• A 60/40 asset allocation
Advantages (any one of these is acceptable):
• Easy to understand
• Low costs
• Transparent investments
• Low risk of poor manager selection
Disadvantage:
• Inability to capture returns over markets, that is, limited value-added potential
Part C
Whatsit should use the endowment model.
Justification (either two of these is acceptable):
• Long time horizon
• High risk tolerance
• Relatively small liquidity needs
• Stuart’s experience with external managers to help with investment
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Advantage:
• Ability to capture alpha and outperform the market over a long time horizon, that is,
high value-added potential
Disadvantages (either one of these is acceptable):
• The endowment model is costly because of high alternative exposure, active
management and outsourcing compared to a passive approach.
• Difficult to implement if fund has large asset size
Part D
For a defined contribution plan, Whatsit is responsible to ensure (any two of the following are
acceptable):
• Appropriate investment of plan assets
• Suitable investment options
• Selecting administrative providers
Part E
The objective of the Commonwealth’s pension reserve fund is to earn sufficient returns to
maximize the likelihood of being able to meet future unfunded pension, social security and/or
health care liabilities of plan participants as they arise.
Part F
Portfolio D has the best-suited asset allocation.
Justification:
The Commonwealth’s pension reserve fund is currently in the accumulation phase. During this
phase, the pension reserve funds are not taking withdrawals and will generally invest in a
diversified portfolio with the majority in equities and alternative investments. Given the
allocation choices provided, Portfolio D has the greatest weighting in equities and alternative
investments.
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QUESTION 7
Topic:
Minutes:
Trade Strategy and Execution
12
LOS:
Study Session 15-34-a, d, e, g
Reference:
Reading 34, Trade Strategy and Execution, Sections 2, 3.1, 3.2, 4.2 & 5.1.
Guideline Answer:
Part A
Implementation shortfall (IS) = Execution cost + Opportunity cost + Fees
1. Execution cost = Σs j p j − Σs j pd
= [(15,000 * $60.30) + (25,000 * $60.50) + (30,000 * $60.40)] – (70,000 * $60.00)
= $4,229,000 – $4,200,000 = $29,000
2. Opportunity cost = (S − Σs j )(pn − pd )
= (100,000 – 70,000) * ($61.35 – $60.00)
= $40,500
3. Fees = 70,000 * $0.04 = $2,800
IS = $29,000 + $40,500 + $2,800 = $72,300
The implementation shortfall is expressed in basis points as follows:
Implementation shortfall (bps) = [Implementation shortfall ($) / Total shares (Pd)] * 10,000 bps
= [$72,300 / (100,000 * $60.00)] * 10,000 bps
= 120.5 bps
Part B
The time-weighted average price (TWAP) trading strategy is best suited in this case. The
strategy can be used to avoid volume uncertainties and outliers and should achieve a fair and
reasonable price for liquidating shares over the two-day period of time without market impact.
TWAP will slice the order into smaller amounts to send to the market following an equalweighted time schedule. TWAP will send the same number of shares and the same percentage of
the order to be traded in each time period.
The advantages of using TWAP trading strategy are (either one is acceptable):
• TWAP excludes potential trade price outliers.
• TWAP should achieve fair and reasonable prices over the trading period.
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Part C
Statement 3 is correct. Short-term profit-seeking trades typically involve higher levels of trade
urgency as portfolio managers attempt to realize short-term alpha before it dissipates (decays).
These managers seek to transact before the rest of the market recognizes the mispricing and as a
result are less price sensitive and more aggressive (seek to transact at accelerated rates) in their
trading.
Statement 1 is incorrect. Trading a large order creates greater market impact than trading a
smaller order, all else being equal. Smaller orders have less market impact and can be traded
more quickly over a short time horizon. However, trading smaller pieces over time may increase
the market risk, which could result in an even higher trading cost. This is called trader’s
dilemma.
Statement 2 is incorrect. A trader with a high level of risk aversion is likely to be more
concerned about market risk and will trade with immediate trade urgency to avoid the greater
market exposure associated with trading.
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LEVEL III AFTERNOON SESSION—GUIDELINE ANSWERS
ITEM SET 1: Ethics—Questions 1 through 4
1.
B
LOS: Study Session 1-2-a
Reporting the violation to governmental or regulatory organizations is not mandatory
under the Code. It may, however, be required under applicable regulations.
Reference:
2.
Reading 2, Guidance for Standards I–VII, Standard I(A)–Knowledge of
the Law.
A
LOS: Study Session 1-1-a
Shultz’s matter will be handled by the Disciplinary Review Committee (DRC), a
volunteer committee.
Reference:
3.
Reading 1, Code of Ethics and Standards of Professional Conduct.
B
LOS: Study Sessions 1-2-a; 2-4-b
There is no violation for a conflict of interest if it has been fully and fairly disclosed in
advance, using effective and relevant communication.
Soft dollars are permissible if they are used to benefit clients. Whistleblowing for
personal gain is not allowed.
Reference:
4.
Reading 2, Guidance for Standards I–VII, Standards IV(A)–Market
Manipulation & VI(A)–Disclosure of Conflicts; Reading 5, Asset
Manager Code of Professional Conduct, Section C.
B
LOS: Study Session 2-4-a
Partial compliance with the Code is prohibited.
Reference:
Reading 5, Asset Manager Code of Professional Conduct, Introduction.
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ITEM SET 2: Ethics—Questions 5 through 8
5.
B
LOS: Study Sessions 1-2-a; 2-4-c
Bray is incorrect regarding her comment that the CFA Institute conferred compliance
status upon S&B. The CFA Institute does not confer AMC compliance nor does it
enforce nor exercise quality control over a firm’s compliance claim.
Bray does not need to verify the government data and may reasonably assume that they
are sound, using them in good faith as input to her report.
Reference:
6.
Reading 2, Guidance for Standards, Standard V(A)–Diligence and
Reasonable Basis; Reading 4, Asset Manager Code of Professional
Conduct, Introduction.
B
LOS: Study Session 1-2-a, b
Having all employees sign an anti-disclosure and confidentiality agreement may help
contain information. However, this process still relies upon the behavior, discretion and
ethical standards of many individuals. Limiting the number of personnel in possession of
new impactful information and shortening the time between decision-making and
announcement are more within Donovan’s control and do not rely upon the subsequent
joint performance of others.
Reference:
7.
Reading 2, Guidance for Standards, Standard III(B)–Fair Dealing.
C
LOS: Study Sessions 1-1-a, b; 1-2-a; 2-4-a
Bray is incorrect in that candidates in the CFA program are already required to follow
and comply with the Code and Standards. She is also incorrect in that the AMC applies to
firms, and not to individuals.
Reference:
8.
Reading 1, Code of Ethics and Standards of Professional Conduct,
Preface; Reading 4, Asset Manager Code of Professional Conduct,
Introduction.
A
LOS: Study Session 1-2-a
Past CFA charterholders may identify themselves as such. An inactive candidate is not
subject to the Code. A charterholder may say that each level exam was passed on the first
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try as long as it is factually correct and the charterholder makes no claim to, nor implies,
superior ability because of this fact.
Reference:
Reading 2, Guidance for Standards, Standard VII(B)–Reference to CFA
Institute, the CFA Designation, and the CFA Program.
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ITEM SET 3: Capital Market Expectations—Questions 9 through 14
9.
A
LOS: Study Session 4-11-h
Possible questions suggested for the analyst in the reading explicitly include a reference
as to whether current account balances are trending and sustainable. However, it makes
no mention of capital account balances as in choice A.
Choices B and C are explicitly referenced in the reading and are referred to in the table.
Reference:
10.
Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class
Returns, Section 8.1.
C
LOS: Study Session 4-11-c
E(Re) = D/P + (%ΔE - %ΔS) + %ΔP/E
The expected rate of return would be 2.75% + [5.5% – (–1.5%)] + 0.35% = 10.1%.
Reference:
11.
Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class
Returns, Section 4.2.
B
LOS: Study Session 4-11-c
The segmented market risk premium for the 2020 estimated data is 17.0% × 0.25 =
4.25%. The segmented market risk premium for the 2021 projected data is 21% × 0.25 =
5.25%.
The fully integrated risk premium for the 2020 estimated data is 0.60 × 17.0% × 0.25 =
2.55%. The fully integrated risk premium for the 2021 projected data is 0.50 × 21.0% ×
0.25 = 2.63%.
The weighted average premium for the 2020 estimated data is [(0.65 × 2.55%) + (0.35 ×
4.25%)] = 3.15%. The weighted average premium for the 2021 projected data is [(0.55 ×
2.63%) + (0.45 × 5.25%)] = 3.81%. Therefore, the net effect is (3.81% – 3.15%) = + 66
bps.
Reference:
12.
Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class
Returns, Section 4.3.
B
LOS: Study Session 4-10-h
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The formula for the Taylor rule requires the real policy rate that would be targeted if
growth is expected to be at trend and inflation on target, the expected and target inflation
rates, and the expected and trend real GDP growth rates. The expected and trend
nominal GDP growth rates (choice B) are not explicitly part of the formula for the
Taylor rule.
Reference:
13.
Reading 10, Capital Market Expectations, Part 1: Framework & Macro
Considerations, Section 3.5.
B
LOS: Study Session 4-10-i
When bond yields and the yield curve are in a state where:
“Yields rising. Possibly stable at longest maturities. Front section of yield curve steepening, back
half likely flattening.”
and monetary policy and automatic stabilizers are:
“Withdrawing stimulus”
then money market rates are “Moving up. Pace may be expected to accelerate.”
Choice A could be expected during a contraction phase, while choice C could be
expected in a late expansion phase.
Reference:
14.
Reading 10, Capital Market Expectations, Part 1: Framework & Macro
Considerations, Section 3.5.
C
LOS: Study Session 4-11-f
A rising current account deficit will tend to put upward pressure on real required returns
so as to encourage a higher saving rate in the deficit country and to attract the increased
flow of capital from outside the country needed to fund the deficit.
For choice A, a secularly rising current account surplus generally puts upward (not
downward) pressure on asset prices in order to induce a lower saving rate in the surplus
country to lessen the narrowing surplus. For choice B, a secularly rising current account
deficit generally puts downward pressure on asset prices in order to induce a higher (not
lower) saving rate in the deficit country.
Reference:
Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class
Returns, Section 6.1.
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ITEM SET 4: Asset Allocation—Questions 15 through 18
15.
B
LOS: Study Session 5-12-e
The fixed income option meets all three criteria Kumar mentioned.
Equity does not meet the last criterion, as public and private equity are not homogenous.
Similarly, alternatives do not meet the last criterion, as direct real estate investments and
Bitcoin are not homogenous.
Reference:
16.
Reading 12, Overview of Asset Allocation, Section 5.3.
B
LOS: Study Session 5-12-b
An economic balance sheet includes conventional (financial) assets and liabilities as well
as additional (extended) assets and liabilities that can be relevant in making asset
allocation decisions for an investor’s financial portfolio.
Garcias’ Economic Balance Sheet (in $)
Assets
Liabilities and Economic Net Worth
Financial Assets
Investment portfolio
Real estate
2,500,000
1,000,000
Financial Liabilities
Mortgage debt
Extended Assets
Human capital
PV of expected inheritance
1,500,000
1,000,000
Extended Liabilities
Special needs trust
PV of future consumption
2,000,000
2,000,000
Total Economic Assets
6,000,000
Total Economic Liabilities
4,500,000
Economic Net Worth
1,500,000
Reference:
17.
500,000
Reading 12, Overview of Asset Allocation, Section 4.
C
LOS: Study Sessions 5-12-g; 5-13-m
Relative to Portfolios A and B, Portfolio C stresses liquidity and stability. The trust is to
be funded in five years, and the Garcias’ have a strong desire to attain this goal.
Therefore, Portfolio C is the most appropriate to meet their short-term funding goal.
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Reference:
18.
Reading 12, Overview of Asset Allocation, Section 6.3; Reading 13,
Principles of Asset Allocation, Section 4.
B
LOS: Study Session 5-12-a, i
Risk budgeting is not a relevant factor for Kumar to select investment vehicles (passive
vs. active management).
Tax status is more likely, not less, to influence Kumar’s selections. Taxable investors
tend to have higher hurdles to profitable active management than tax-exempt investors,
with other variables constant. For taxable investors, such as the Garcias, active
investments are held, in general, in tax-advantaged accounts, and passive investments are
held in taxable accounts.
Beliefs concerning market informational efficiency are more likely, not less, to influence
Kumar’s choices. If Kumar has a strong belief in market efficiency for the asset class(es)
under consideration, he will orient the Garcias away from active management.
Reference:
Reading 12, Overview of Asset Allocation, Sections 3 & 7.2.
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ITEM SET 5: Derivatives and Currency Management—Questions 19 through 22
19.
C
LOS: Study Session 6-15-e, f
Jacobs holds the BKLN shares. A covered call involves selling out-of-the-money (OTM)
calls to receive a premium against the existing BKLN shares.
From Exhibit 1, Jacobs will sell the calls with an exercise price of $540, generating a
premium of $251 per contract.
To generate $100,000 cash flow by selling $540 calls, the number of contracts to sell
= $100,000 / $251 = 398.40 = 399 contracts
Reference:
20.
Reading 15, Options Strategies, Section 7.1.
B
LOS: Study Session 6-15-a, c, e, f
A straddle strategy is implemented by buying ATM calls and ATM puts.
Cost of ATM call option (i.e., $510 strike) is $9.70
Cost of ATM put option (i.e., $510 strike) is $9.22
Overall cost of the straddle = $9.70 + $9.22 = $18.92
Percentage change = $18.92 / $510 = 3.71%
Reference:
21.
Reading 15, Options Strategies, Section 4.2.
A
LOS: Study Session 6-15-a, f
A bullish seagull strategy involves a bull call spread (debit call spread) and the sale of
an OTM put.
The three positions involve:
Buying an in-the-money (ITM) call at strike $490 by paying a premium $23.05
Selling an OTM call at strike $530 by receiving a premium $3.40
Selling an OTM put at strike $490 by receiving a premium $2.82
Cost of bullish seagull strategy is $23.05 – $3.40 – $2.82 = $16.83
Reference:
Reading 15, Options Strategies, Section 6.3.
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22.
A
LOS: Study Session 6-15-a, e, f
Statement 1 is incorrect.
Vega of ATM options with a strike price of $510 is 0.320
Vega of straddle = 0.320 + 0.320 = 0.640
For a 1% move in the options volatility, the value of ATM straddle would change by
$0.640.
Statement 2 is correct.
ATM straddle = Call delta + Put delta = 0.506 + (– 0.514) = –0.008
Negative delta results in a short volatility position.
Statement 3 is correct.
Collar = Protective put + Short call (OTM)
Collar = Covered call + Long put (OTM)
Covered call = Long stock + Short OTM call
Protective put = Long stock + Long put
Reference:
Reading 15, Options Strategies, Section 7.3.
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ITEM SET 6: Derivatives and Currency Management—Questions 23 through 26
23.
A
LOS: Study Session 6-16-f
Recommendation 1 is correct.
If the base currency, USD, is appreciated against GBP, then the Concord Associates’
holdings of GBP 400 million will buy fewer USD in the future when the acquisition is
completed.
The hedge is implemented in protecting against an appreciation of the base currency of
the P/B quote, the USD. The hedge is established with an ATM call option (a long
position in the USD).
P/B refers to the price of one unit of the base currency, “B,” expressed in terms of the
price currency, “P.”
Recommendation 2 is incorrect.
Risk reversal, also referred to as a collar strategy, is created by buying stock and by
simultaneously buying puts to protect the position against downside risk and selling calls
to offset the cost.
Recommendation 3 is incorrect.
All-or-none asymmetric payoff is characteristic of a binary option and not a knockin/knock-out option.
Reference:
24.
Reading 16, Swaps, Forwards and Future Strategies, Section 6.3.
C
LOS: Study Session 6-17-a, b, c
h = ρGBP/USD * { σ(RDC) / σ(RFC) }
= 0.25 * (4.6% / 2.5%) = 0.46
Hedge position = 0.46 * GBP 400 million = GBP 184 million
Bluerock Holdings will have a holding of GBP 400 million after the acquisition.
Bluerock Holdings should short the GBP in a forward contract to hedge the risk of
exchange rate fluctuations.
Hence, Bluerock Holdings should be long GBP/USD.
Reference:
Reading 17, Currency Management—An Introduction, Section 6.5.
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25.
A
LOS: Study Session 6-16-a, e
The notional principal of the interest rate swap Rocky LLC should use to reduce the
modified duration from 6.5 to 5.6 is:
CAD 200,000,000(6.50) + (IRS notional principal) (–1.5) = CAD 200,000,000(5.6)
IRS notional principal = [(5.6 – 6.5) / (–1.5)] * CAD 200,000,000
= CAD 120,000,000
Reference:
26.
Reading 16, Swaps, Forwards and Future Strategies, Sections 2.1 & 2.3.
B
LOS: Study Sessions 6-15-a, c; 6-16-a; 6-17-a
To mitigate euro appreciation, Nate Alternatives should buy EUR and sell USD.
Strategy 2 is correct.
USD/EUR call option is implemented to buy EUR and sell USD, which is in accordance
with the risk mitigation required by Nate Alternatives.
Strategy 1 is incorrect.
USD/EUR put option is implemented to sell EUR and buy USD.
Strategy 3 is incorrect.
EUR/USD call option is implemented to sell EUR and buy USD.
Reference:
Reading 15, Options Strategies, Section 3.5; Reading 16, Swaps, Forwards
and Future Strategies, Section 2.2; Reading 17, Currency Management–
An Introduction, Section 2.
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ITEM SET 7: Fixed-Income Portfolio Management—Questions 27 through 30
27.
B
LOS: Study Session 8-19-c
Futures BPV ≈ BPVCTD / CFCTD
Nf = [Liability portfolio BPV – Asset portfolio BPV] / Futures BPV
Liability portfolio BPV = 750,000,000 × 6.25 = 468,750
Asset portfolio BPV = 775,000,000 × 6.50 = 503,750
Futures BPV ≈ 50.28 / 0.77 = 65.3
Nf = (468,750 – 503,750) / 65.3 = –536
Reference:
28.
Reading 19, Liability-Driven and Index-Based Strategies, Section 4.3.
B
LOS: Study Session 8-19-h
Strategy 2 is least likely to be suitable given the significantly higher duration relative to
either Strategy 1 or Strategy 3. Changes in interest rates will result in larger price
fluctuations for which Dudley has indicated an aversion.
Reference:
29.
Reading 19, Liability-Driven and Index-Based Strategies, Section 9.
B
LOS: Study Session 8-19-f
Statement 2 is incorrect. Stevens is not accounting for idiosyncratic risk related to issuer
exposure. Concentration of issuers within a portfolio exposes the asset manager to issuerspecific event risk. The manager should, therefore, seek to match the portfolio duration
effect from holdings in each issuer.
Reference:
30.
Reading 19, Liability-Driven and Index-Based Strategies, Section 7.
C
LOS: Study Session 8-20-c, e
Given Cole’s view that yields will not move in the short term, the best strategy is most
likely to sell put options. The option premium received would increase the yield of the
portfolio and result in higher returns. The portfolio convexity would be lower, but that is
an acceptable condition based on Cole’s view of stable interest rates.
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The best strategy is unlikely to be the purchase of call or put options if Cole does not
believe that rates will move in the short term. Buying either puts or calls would result in
lower yields due to the cost of the option premium. While increasing the portfolio’s
convexity, the anticipated move in rates must occur within a short window of time for the
portfolio to benefit from higher convexity.
Reference:
Reading 20, Yield Curve Strategies, Section 3.
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ITEM SET 8: Fixed-Income Portfolio Management—Questions 31 through 34
31.
B
LOS: Study Session 8-21-a
Due to the addition of Caa-rated bonds, which are not in the index, Newman’s portfolio is
most likely to have the largest empirical duration gap compared to the benchmark.
Typically, bonds with lower ratings have lower empirical durations, and Caa bonds
actually have negative empirical durations. By contrast, Jones holds only investmentgrade bonds and should more closely mirror the empirical duration of the investmentgrade index, all else being equal.
Reference:
32.
Reading 21, Fixed Income Active Management: Credit Strategies, Section
2.3.
C
LOS: Study Session 8-21-g
Statement 3 is not correct: Many emerging markets bond issuers are government owned
or have a controlling or partial stake owned by the local government. However, a primary
disadvantage for credit investors is uncertainty in the contractual rights and interests of
non-domestic bondholders as part of a debt restructuring. Historically, recovery rates for
emerging markets bonds in default, on average, are lower than in developed markets.
Statement 1 is correct: If Newman believes commodity prices will rise, that should
support emerging markets’ corporate credit profiles. Commodity producers represent a
higher proportion of emerging market indices as compared to US indices.
Statement 2 is correct: Credit portfolio managers need to recognize global illiquidity
issues when seeking to expand their portfolios to global credit markets, including the
effects on valuation. If Newman believes that liquidity is improving and his portfolio is
being compensated for the risk, it is supportive of his argument to invest in emerging
markets.
Reference:
33.
Reading 21, Fixed Income Active Management: Credit Strategies,
Sections 6.2 & 6.3.
C
LOS: Study Session 8-20-g
Pay 2-year USD/receive 5-year BRL = 5.11% – 0.22% = 4.89%
Pay 10-year USD/receive 10-year COP= 5.57% – 1.08% = 4.49%
Pay 2-year USD/receive 10-year COP = 5.57% – 0.22% = 5.35%
Reference:
Reading 20, Yield Curve Strategies, Section 3.1.
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34.
A
LOS: Study Session 8-20-g
Statement 4 is correct.
It is the lack of credibly fixed exchange rates that allows default-free yield curves, and
hence bond returns, to be less than perfectly correlated across markets. Investors must
believe there is no risk that the currencies will exchange at a different rate in the future or
yield differentials will emerge giving rise to differential risk and return expectations in
the two markets, thus allowing each market to trade on its own fundamentals.
Statement 5 is incorrect because over most investment horizons any significant spread
change will dominate the carry component of the relative return for an inter-market trade.
Statement 6 is incorrect because rolling the hedge will generate a profit/loss if the spread
between the three-month base currency rate and the three-month foreign currency rate
increases/decreases over time. Thus, the currency hedge introduces a bet on the spread at
the short end of the yield curves.
Reference:
Reading 20, Yield Curve Strategies, Section 5.
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ITEM SET 9: Alternative Investments for Portfolio Management—Questions 35 through
40
35.
C
LOS: Study Session 11-26-b, e, f
An increased accommodative policy by the central bank will likely mean that equity and
fixed income markets will move higher. This will negatively impact short-biased
strategies immediately.
Benign market conditions may have longer-term impacts on the effectiveness of global
macro strategies, as accommodative policy may prevent certain global macro trends from
fully materializing. However, global macro managers tend to be anticipatory in setting
their strategies, so an expected move by the central bank may have only a limited
immediate effect.
Life settlements strategies would be relatively unaffected by changes in central bank
policy.
Reference:
36.
Reading 26, Hedge Fund Strategies, Sections 3.2, 6.1 & 7.2.
B
LOS: Study Session 11-26-c, d, e
The uncorrelated nature of managed futures with stocks and bonds generally makes them
a potentially attractive addition to traditional portfolios. The value added from managed
futures has typically been demonstrated during periods of market stress as they tend to
exhibit natural positive skewness, which is useful in balancing negatively skewed
strategies.
Both merger arbitrage and convertible arbitrage tend to be more correlated to broader
equity market movements and may not offer protection against tail risk events.
Reference:
37.
Reading 26, Hedge Fund Strategies, Sections 4.1, 5.2 & 6.2.
A
LOS: Study Session 11-26-b, e, f
Dedicated short sellers and short-biased strategies tend to focus on single equity stock
selection, as opposed to index shorting.
The other two statements are correct.
Reference:
38.
Reading 26, Hedge Fund Strategies, Sections 3.2, 6.1 & 7.2.
A
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LOS: Study Session 11-26-h
While certain hedge fund strategies may exhibit serial correlation, that is not a reason to
use a conditional risk factor model. Hedge funds are likely to experience
multicollinearity, which factor models can attempt to address. Hedge funds’ dynamic
trading strategies and unexpected exposures to risk factors are also reasons to use a
conditional risk factor model.
Reference:
39.
Reading 26, Hedge Fund Strategies, Section 9.1.
A
LOS: Study Session 11-26-h
During crisis periods, VIX exposure falls from 0.123 to –0.111 (0.123 – 0.234 = –0.111).
This negative exposure indicates that there is overall short volatility during times of
crisis.
Reference:
40.
Reading 26, Hedge Fund Strategies, Section 9.2.
A
LOS: Study Session 11-26-h
The negative VIX loading implies that the fund is short volatility. Selling puts is short
volatility. The other two options are long volatility or neutral volatility.
Reference:
Reading 26, Hedge Fund Strategies, Section 9.2.
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ITEM SET 10: Trading, Performance Evaluation, and Manager Selection—Questions 41
through 44
41.
B
LOS: Study Session 15-35-d
Statement 2 is correct. Holdings-based attribution is not appropriate because it references
the beginning-of-period holdings and does not capture the impact of transactions over the
measurement period. Holdings-based attribution can be inaccurate for portfolios with
high turnover.
Statement 1 is incorrect. Returns-based attribution is the least accurate of the three
attribution approaches. This technique does not use underlying holdings and is most
vulnerable to data manipulation.
Reference:
42.
Reading 35, Portfolio Performance Attribution, Section 3, p.177.
A
LOS: Study Session 15-35-f
Treetop overweighted low-credit quality bonds (35% vs. 30%) and underweighted highquality bonds (35% vs. 40%) relative to the benchmark. So, Treetop’s portfolio will
outperform his benchmark when low-credit quality bonds overperform and when highquality bonds underperform. A credit portfolio that holds more low-quality bonds than a
credit benchmark will usually outperform the benchmark when credit spreads narrow.
Also, a higher-quality credit portfolio usually underperforms a credit benchmark when
credit spreads narrow. As Treetop overweighted low-quality bonds and underweighted
high-quality bonds as compared to the benchmark, his portfolio would most likely
outperform his benchmark when credit spreads narrow.
Reference:
43.
Reading 35, Portfolio Performance Attribution, Section 3.1; Reading 21,
Fixed Income Active Management: Credit Strategies, Section 4.2.
B
LOS: Study Session 15-35-g
Treetop is a bottom-up manager as his process starts with individual bonds. Treetop also
has a relative return target, so marginal contribution to tracking risk is most important.
Choices A and C refer to total risk and thus are best suited to portfolios with absolute
return targets.
Reference:
44.
Reading 35, Portfolio Performance Attribution, Section 3.2.
B
LOS: Study Session 15-35-f
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To calculate the portfolio’s total return relative to the benchmark, one needs to sum the
contributions to return from all groups and effects. Since the contribution to return for
each of the three bond credit rating groups is provided in the rightmost column of Exhibit
2, we need only to sum those totals:
0.22% + –0.25% + 0.17% = 0.14%
Choices A and C reflect positive and negative sums of the bond selection column totals.
Reference:
Reading 35, Portfolio Performance Attribution, Section 3.1.
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