This income is taxed at a flat rate of 20%, so the amount of net income available to the Moores
on an after-tax basis is:
The Moore’s will continue to save USD 2,000 of after-tax income per month, which reduces the
amount of after-tax income available to cover living expenses as follows:
Note that, because the Moores are net savers, living expenses are equal to the amount of after-tax
income that is not allocated to savings.
ii.
The Moores have no liquidity requirement for the coming year. The USD 200,000 transfer to an
irrevocable trust for the benefit of their son has already been executed. Moores are net savers,
which means that they will not need to draw upon funds from their retirement account over the
next twelve months. Note that the Moores’ living expenses and their contributions to their
retirement account are not included in the calculation of their liquidity requirement.
.
Allocation:
✓ 1 point for correctly calculating gross income for the coming year
✓ 1 point for correctly calculating net after-tax income for the coming year
✓ 1 point for correctly calculating living expenses for the coming year
✓ 2 points for providing the correct liquidity requirement for the coming year
Allocation:
✓ 1 point for calculating the number of years until retirement
✓ 1 point for calculating the investable asset base
✓ 1 point for calculating the number of years until retirement
✓ 2 points for calculating the required rate of return
Commentary on Question:
The rate of return required to achieve the target portfolio value is calculated based on the
current portfolio value and the monthly saving of USD 2,000. The current value of the portfolio
is equal to the current amount invested minus the amount transferred to the irrevocable trust.
Note that the value of their home is not included in the investable asset base because they intend
to live in it for the remainder of their lives.
The following factors decrease the Moores’ ability to take investment risk:
• John’s income is uncertain
• Neither has accumulated pension benefits
Allocation:
✓ 2 points for correctly identifying a factor that increases ability to take investment risk
(maximum of 4)
✓ 2 points for correctly identifying a factor that decreases ability to take investment risk
Methodical
Spontaneous
Allocation:
✓ 1 point for correctly identifying the personality type
✓ 2 points for providing a correct justification
Commentary on Question:
Cautious investors generally do not take risks, which may be a result of their financial position
or various life experiences.
Methodical investors base their decisions on the “hard facts” and do analysis of the facts. They
do not involve emotion while making investment decisions. They are more risk averse.
Spontaneous investors constantly readjust their portfolio, allocations and holdings. They are
more risk averse and fear negative results with every new development in the marketplace.
Individualist investors have a self-assured approach to investing. They gain information from a
variety of sources and are not averse to putting in efforts needed to reconcile conflicting data
from their trusted sources. They place great importance on hard work and insight. Because they
are confident in their ability to meet their financial objectives over the long-term, they are
willing to take more investment risk.
Allocation:
✓ 2 points for correctly identifying each option (maximum 4)
Commentary on Question:
The Moores are subject to several constraints. Neither has the ability and/or willingness to
increase their current income and it is not possible to reduce their expected living expenses
during retirement. With no new contributions from work income and no change in the expected
cost of the annuities that they intend to purchase in order to cover their future living expenses,
the most obvious option that will allow John to retire as planned in five years is to increase the
expected return on their portfolio assets. This will require a greater allocation to higher-risk,
higher-expected-return asset classes. Additionally, while the Moores are unwilling to sell their
home, they could borrow against its value and invest the proceeds.
Allocation:
✓ 1 point for calculating the total pre-tax gain
✓ 1 point for calculating total taxes paid
✓ 1 point for calculating the after-tax return in currency terms
✓ 1 point for calculating the percentage return on an after-tax basis
Allocation:
✓ 1 point for correctly calculating the after-tax value of bonds in tax-deferred account
✓ 1 point for correctly calculating the after-tax value of equities in tax-exempt account
✓ 1 point for correctly calculating the after-tax asset allocations
Allocation:
✓ 2 points each for identifying interest income as being taxed at a lower rate than dividend
income and realized capital gains
✓ 1 point for noting Johnson’s opinion on the tax efficiency of this allocation as a justification
Commentary on Question:
When allocating assets among taxable and tax-exempt accounts, it is most efficient to hold assets
that provide tax-advantaged sources of income in taxable accounts.
With a 1.5% wealth tax applied annually, the after-tax future value of Tand’s asset is:
3,575,000 [(1.07)(1 – 1.5%)]12 = 6,716,084
The amount of the gain consumed by the wealth tax is calculated as:
4,476,585 – 3,141,084 = 1,335,501
The proportion of the gain consumed by the wealth tax is calculated as:
1,335,501 / 4,476,585 = 29.8%
Allocation:
✓ 2 points for correctly calculating the gain in the absence of taxes
✓ 2 points for correctly calculating the gain after the wealth tax is applied
✓ 1 point for correctly calculating the proportion of the gain consumed by the wealth tax
𝐸(𝑅𝑀 ) − 𝑅𝐹
𝑆𝑅𝐺𝐼𝑀 =
𝜎𝑀
where
𝑆𝑅𝐺𝐼𝑀 = GIM Sharpe ratio
𝐸(𝑅𝑀 ) = expected return on GIM
𝑅𝐹 = risk-free rate
𝜎𝑀 = standard deviation of GIM returns
In this example,
𝐸(𝑅𝑀 ) − 𝑅𝐹 7.9% − 3.1%
𝑆𝑅𝐺𝐼𝑀 = = = 0.30
𝜎𝑀 16.0%
Step 2) Calculate the Bosphorian equity risk premium under the assumption of perfect
integration with GIM.
where
RP𝑖 = risk premium for asset class i
𝜎𝑖 = standard deviation of returns on asset class i
𝜌𝑖,𝑀 = correlation
𝑆𝑅𝐺𝐼𝑀 = GIM Sharpe ratio
In this example,
𝑅𝑃𝑖 = [(23.1%)(0.68)(0.30)] + 1.7% = 6.41%
Step 3) Calculate the Bosphorian equity risk premium under the assumption of perfect
segregation from GIM.
In this example,
𝑅𝑃𝑖 = [(23.1%)(0.30)] + 1.7% = 8.63%
Step 4) Calculate the weighted-average Bosphorian equity risk premium based on degree of
integration with GIM.
Step 5) Add the risk-free rate to arrive at the expected return on Bosphorian equities.
Allocation:
✓ 1 point for calculating the GIM Sharpe ratio
✓ 1 point for calculating the risk premium of markets assuming full integration
✓ 1 point for calculating the risk premium of markets assuming full segmentation
✓ 1 point for calculating the weighted-average equity risk premium
✓ 1 point for calculating the portfolio return
where,
𝑅𝑜𝑝𝑡𝑖𝑚𝑎𝑙 = target short-term interest rate (policy rate)
𝑅𝑛𝑒𝑢𝑡𝑎𝑙 = policy rate if GDP growth was on trend and inflation was forecasted to be on target
𝐺𝐷𝑃𝑔𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = expected GDP growth rate
𝐺𝐷𝑃𝑔𝑡𝑟𝑒𝑛𝑑 = long-term trend GDP growth rate
𝐼𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 = expected inflation rate
𝐼𝑡𝑎𝑟𝑔𝑒𝑡 = target inflation rate
In this example, inflation is at the target rate and is expected to remain at this level. For the
Rumländian central bank to set its policy rate below the natural rate, it must be that GDP growth
is forecast to be below its long-term trend rate.
Allocation:
✓ 1 point for noting that the GDP growth rate is expected to be below its long-term trend
✓ 2 points for correctly explaining the parameters of the Taylor rule that support this
conclusion
Allocation:
✓ 1 point for correctly identifying the most likely shape of the yield curve
✓ 2 points for correctly describing the country’s fiscal policy
✓ 2 points for correctly describing the country’s monetary policy
Commentary on Question:
The following table gives the policy mix and the shape of yield curve.
If the fiscal and monetary policies are both tight, then the situation is unambiguous and the
economy is certain to slow. This leads to an inverted yield curve. On the other hand, if the fiscal
and monetary policies are both expansionary, then the economy can be expected to grow. This
leads to a steep yield curve.
In this example, the portfolio’s BPV at the end of the period is calculated as follows:
End of Year
Modified Market Value Basis Point Value
Security Price
Duration (KWR) (KWR)
Bond A 103.40 5.59 103,400,000 57,801
Bond B 98.66 2.70 98,660,000 26,638
Bond C 100.70 3.50 100,700,000 35,245
Total 119,684
ii.
In this example, the portfolio’s BPV at the beginning of the period is calculated as follows:
Beginning of Year
Modified Market Value Basis Point Value
Security Price
Duration (KWR) (KWR)
Bond A 102.34 6.19 102,340,000 63,348
Bond B 99.56 3.51 99,560,000 34,946
Bond C 101.28 4.24 101,280,000 42,943
Total 141,237
iii.
In accordance with Lee’s IPS, the money duration of her portfolio must be reset to its level from
the beginning of the year. To accomplish this using futures contracts, it is first necessary to
calculate the basis point value for the cheapest-to-deliver bond (BPVCTD):
The basis point value of the futures contract (BPVf) can then be calculated as follows:
𝐵𝑃𝑉𝐶𝑇𝐷 48.92
𝐵𝑃𝑉𝑓 ≈ ≈ ≈ 53.62
𝐶𝐹𝐶𝑇𝐷 0.9123
Note that CFCTD is the conversion factor for the CTD bond.
The number of futures contracts (Nf) required to reestablish a target money duration is calculated
as follows:
Note that BPVT is the target basis point value and BPVP is the portfolio’s current basis point
value.
Because partial contracts cannot be used, Cho will need to purchase 402 futures contracts.
Allocation:
✓ 1 point for correctly stating the formula for basis point value
✓ 3 points for correctly calculating the portfolio’s basis point value a year ago
✓ 3 points for correctly calculating the portfolio’s basis point value today
✓ 2 points for correctly calculating the basis point value of the CTD bond
✓ 2 points for correctly calculating the number of futures contracts required
✓ 1 point for correctly providing the rounded number of futures contracts required
To make a payment of KRW 81 million in four years, Kim will need to hold 4-year, 3.90%
coupon bonds with a face value of:
81,000,000
= 77,959,577
1.039
Given the KRW 10,000 minimum size constraint, the face value of 4-year bonds required is
KRW 77,960,000. Note that the coupon payment and repayment of principal at the end of Year 4
will be 77,960,000 x 1.039 = 81,000,440.
Purchasing 4-year bonds with a face value of 77,960,000 will provide the following annual
coupon payments: 77,960,000 x 0.039 = 3,040,440.
At the end of Year 3, Kim must pay KRW 64 million. However, this amount will be partially
offset by the KRW 3,040,440 coupon payment from the 4-year bond. The face value of 3-year
bonds required is:
64,000,000 − 3,040,440
= 58,898,126
1.035
Again, due to the minimum size constraint, this rounds to KRW 58,900,000 for the face value of
3-year bonds required. The annual coupon payments from these bonds total KRW 2,061,500.
This rounds to a face value of KRW 29,230,000, which provide annual coupon payments of
KRW 672,290.
This rounds to a face value of KRW 43,400,000, which provide a single coupon payment of
KRW 824,600.
Allocation:
✓ 2 points for correctly calculating the face value of 4-year bonds required
✓ 2 points for correctly calculating the face value of 3-year bonds required
✓ 2 points for correctly calculating the face value of 2-year bonds required
✓ 2 points for correctly calculating the face value of 1-year bonds required
ii.
Lockhart exhibits illusion of control bias by refusing to reduce his exposure to the large,
concentrated position in his employer’s stock.
Allocation:
✓ 2 points for correctly explaining how Lockhart has exhibited each bias (maximum 4)
Allocation:
✓ 2 points for correctly noting that the optimal corridor widths would be narrower
✓ 2 points for citing higher volatility of returns as the justification
Um = E(Rm) – 0.005RAσ2m
where
Um = expected utility of asset mix m
E(Rm) = expected return of asset mix m
RA = investor’s risk aversion
σ2m = variance of return of asset mix m
Note that E(Rm) and σ2m are expressed as percentages rather than as decimals in the calculation.
Portfolio A is chosen because it offers the highest expected utility given the investor’s level of
risk aversion.
Allocation:
✓ 1 point each for each correct calculation of utility-adjusted expected returns (maximum 3)
✓ 1 point for providing a justification of Portfolio A as the best allocation based on this metric
𝐸(𝑅𝑝 ) − 𝑀𝐴𝑅
𝑆𝐹𝑅𝑎𝑡𝑖𝑜 =
𝜎𝑝
where
SFRatio = safety-first ratio
E(Rp) = expected return of the portfolio
MAR = minimum acceptable return
σp = standard deviation of portfolio returns
Portfolio C is chosen because it offers the highest safety-first ratio given Lockhart’s minimum
acceptable return.
Allocation:
✓ 1 point each for each correct calculation of Roy’s safety-first ratio (maximum 3)
✓ 1 point for providing a justification of Portfolio C as the best allocation based on this metric
Extended portfolio
Extended portfolio assets
liabilities
Equity – DM stock 200,000 Mortgage 200,000
Equity – Other 210,000 PV of future spending 1,250,000
Fixed Income 300,000 PV of son’s education 225,000
Human capital 925,000
Home (gross) 800,000
Total 2,435,000 1,675,000
Allocation:
✓ 2 points for correctly calculating Lockhart’s total economic assets
✓ 2 points for correctly calculating Lockhart’s total economic liabilities
✓ 2 points for correctly calculating Lockhart’s economic net worth
2. Average age of participants The ability of a defined-benefit pension plan to take risk
decreases as the average age of its participants increases
because the duration of liabilities decreases and must be
offset by holding shorter duration assets. The Plan’s average
age (53) is higher than the industry average (48)
Allocation:
✓ 1 point for correctly identifying a factor relating to Partko’s workforce characteristics
(maximum 2)
✓ 2 points for providing an accurate justification for this factor indicating an ability to take risk
that is below the industry average (maximum 4)
Commentary on Question:
The Plan’s below-average ability to take risk is also indicated by other factors, such as:
• the provision for a partial lump-sum payment, which is not common in the industry
• the sponsor’s below-average operating margin and above-average debt-to-assets ratio
However, these factors are not related to workforce characteristics. Other factors (higher funded
status and lower correlation between asset returns and sponsor’s operating profits) indicate an
above-average ability to take risk if considered in isolation.
It has a higher funded status than its peers. Compared to plans in a deficit position relative to the
present value of their liabilities (the average status of plans in this industry), Partko’s fully-
funded plan is better positioned to absorb the greater potential losses associated with risker
investments.
The correlation between the Plan’s returns and its sponsor’s profitability is lower than the
industry average. This increases ability to take risk because it is more likely that the sponsor will
have the funds required to make additional contributions in the event that the Plan experiences
poor returns and its funded status falls into a deficit position.
Allocation:
✓ 1 point for correctly identifying a factor indicating above-average risk tolerance
✓ 2 points for providing an accurate justification for this factor indicating an ability to take risk
that is below the industry average
Cash balance plans are like defined-contribution plans in that participants receive individual
account statements with information on accumulated value, contributions, and earnings credits.
Cash balance plans may also be like defined-contribution plans to the extent that employees bear
any investment risk, however, the sponsor retains most (if not all) of this risk.
Allocation:
✓ 2 points for identifying a characteristic shared with defined-benefit plans
✓ 2 points for identifying a characteristic shared with defined-contribution plans
Allocation:
✓ 2 points for identifying a criticism of cash balance plans
✓ 2 points for identifying a measure to mitigate Partko’s exposure to this potential criticism
Allocation:
✓ 2 points for discussing limited ability to diversify as a disadvantage
✓ 2 points for identifying a swap agreement (or similar derivative contract as a possible action
to mitigate the effects of this mandate
Nominal required return can be calculated using one of the following methods:
Allocation:
✓ 2 points for correctly identifying the components of nominal required return
✓ 1 point for correctly calculating nominal required return using one of two acceptable methods
Commentary on Question:
The additive method of calculating required return produces an approximate estimate, but does
not account for the effect of compounding over multiple periods. The multiplicative method is
more precise because it does account for this effect. Either method appears to be acceptable for
exam purposes.
Allocation:
✓ 1 point for correctly identifying the time horizon as single-stage
✓ 1 point for correctly identifying the time horizon as long-term
✓ 2 points for providing an appropriate justification
Allocation:
✓ 1 point for correctly identifying the components of the Foundation’s liquidity requirement
✓ 2 points for calculating the correct values of these components
✓ 1 point for correctly calculating the Foundation’s liquidity requirement
Commentary on Question:
Note that the sponsor contribution was JPY 145 million last year and grew by the real spending
rate of 5.2%.
Allocation:
✓ 1 point for correctly identifying the investment approach as passive
✓ 2 points for using a returns-based approach as justification (citing style fit)
Commentary on Question:
In a passive investment approach, the investor does not try to adjust his expectations by making
changes in the securities holdings. The investor tries to mimic any index to get the same returns
as that of the index.
Returns-based analysis is conducted using historical return data. The portion of a manager’s
returns attributable to active selections is calculated as (1 – style fit score).
Allocation:
✓ 1 point for noting that the CAC 40 is a broad market index
✓ 1 point for noting that Manager B is pursuing a value investing style
✓ 1 point for recommending a value style index as a more appropriate benchmark
iii.
The risks associated with a value investing style are:
- There may be valid reasons for a stock to be trading at an apparently attractive price
multiple
- Even if stocks are mispriced, it is not possible to know when their prices will adjust to be
reflective of intrinsic value
Allocation:
✓ 2 points for correctly identifying one risk associated with each investment style (no more
than one risk per style, maximum 6 points total)
Allocation:
✓ 2 points for correctly calculating active return
✓ 2 points for correctly calculating tracking risk
Commentary on Question:
Active return is the return of a portfolio above the benchmark returns. Active returns for a
portfolio are calculated as the weighted average of the managers’ active returns for all the
managers weighted by the assets under management.
Active risk is the standard deviation of the difference in the portfolio and benchmark returns
over time. When all its sources of active return are assumed to be uncorrelated, a portfolio’s
active risk is calculated as the square root of the weighted average of the squared managers’
active risk for all the managers, weighted by the squared assets under management.
Allocation:
✓ 2 points for correctly identifying each potential disadvantage (maximum 4)
Allocation:
✓ 2 points for each correct reason cited as justification (maximum 4)
Commentary on Question:
Transaction costs are lower for domestic equities compared to non-domestic equities, which
would support a relatively narrower corridor width.
Development 3
Allocation:
✓ 1 point for selecting the correct development
✓ 2 points for each correct explanation for why a development that wasn’t chosen would justify
a change to SAA (maximum 4 points)
Allocation:
✓ 1 point for recommending the correct trade execution tactic (maximum 2)
✓ 2 points for providing an appropriate justification (maximum 4)
𝑃𝑐 − 𝑃𝑏
% 𝑜𝑓 𝑜𝑟𝑑𝑒𝑟 𝑢𝑛𝑓𝑖𝑙𝑙𝑒𝑑 × ( )
𝑃𝑏
where
𝑃𝑐 = cancellation price
𝑃𝑏 = original benchmark price
In this example,
Allocation:
✓ 1 point for recognizing that unrealized profit/loss is missed opportunity trading cost (MOTC)
✓ 1 point for correctly identifying the formula for calculating MOTC
✓ 1 point for correctly calculating MOTC in bps
Commentary on Question:
Implementation shortfall is the difference between the money return on the “paper” portfolio in
which positions are established at the price when the trade decision is made (the decision price),
and the portfolio’s actual return.
2. Availability bias Sherman’s narrow range of experience has limited his investment opportunity
set and resulted in an insufficiently diversified portfolio in which retailers are
significantly overweighted.
3. Representativeness bias Sherman is confident that his investments in the shares of Canadian retailers
will be successful because he has “never been disappointed” with similar
investments in the shares of US retailers that carry Sunny Farms’ products and
he expects this trend to continue.
2. Status quo bias Warner claims that she cannot remember the last time she rebalanced or even
checked the value of her portfolio.
3. Mental accounting bias Warner has mentally allocated the shares that she has inherited from her
grandfather to fund the purchase of “something special” when she retires.
Allocation:
✓ 1 point for correctly identifying a behavioral bias (maximum 2 per client)
✓ 2 points for providing a correct justification from the information provided (maximum 4
points per client)
Friendly Follower
2. Sherman has risked his own capital to create wealth and prefers to be in
control of both his business and his investments. Additionally, equities
Independent Individualist represent a significant proportion of his wealth. All of this indicates that
Sherman is an active investor with an above-average level of risk tolerance,
which is consistent with the profile of an Independent Individualist.
Passive Preserver
Allocation:
✓ 1 point for correctly identifying Sherman’s behavioral investor type
✓ 2 points for providing a correct justification (maximum 4)