QUESTION: 121 Exam Topic: Portfolio Management and Wealth Planning

Maurice Taylor, CFA, FRM, is responsible for managing risk in his firm's commodity portfolios. Taylor has extensive experience in the risk management field and as a result has been appointed the task of mentoring entry-level employees. Steven Jacobs is a newly hired Financial Analyst who has been assigned to research the company's risk management process. To verify the accuracy of his findings he consults Taylor. Taylor agrees to thoroughly review Jacobs* findings and volunteers to contribute his knowledge to enhance any part of the report that mentions Taylor's department.

A week later Jacobs, submits his report to his supervisor without reading Taylor's suggestions. Some excerpts from the report are as follows;
• "Many portfolio managers use a ratio that compares the average alpha to the standard deviation of alpha to measure risk-adjusted performance. This ratio can be used to rank their ability to generate excess returns on a consistent basis."
"The main difference between risk governance and risk budgeting is that risk governance is concerned with policies and standards, whereas risk budgeting is concerned with allocating risk."
• "In an ERM system individual portfolio managers are charged with measuring, managing, and monitoring their portfolio risk as well as determining their optimal amount of capital at risk. With this information upper management gains a better overall picture of the firm's risk."
• "The two general categories of risk are financial and non-financial risks. Financial risks include market risk and credit risk. Non-financial risks include settlement risk, regulatory risk, model risk, liquidity risk, operations risk, and political risk."

Jacobs' supervisor thanks him for the report and assigns him the next task of researching the firm's VAR calculation methodologies. His supervisor is wondering if the firm should switch to the Monte Carlo Method from the Historical Method. Jacobs again decides to consult Taylor for his expertise. Taylor agrees that using the Monte Carlo Method would be useful since it incorporates returns distributions rather than single point estimates of risk and return- This may be appropriate for Taylor's portfolios since commodity returns can exhibit skewed distributions. Taylor, however, informs Jacobs that there are also advantages to using historical VAR including that it is based on modern portfolio theory (MPT).
Jacobs uses the firm's small cap value portfolio to illustrate the calculation of VAR. The value of the portfolio is $140 million and it has an annual expected return of 12.10%. The annual standard deviation of returns is 18.20%. Assuming a standard normal distribution, 5% of the potential portfolio values are more than 1.65 standard deviations below the expected return.
Jacobs completes his research report on VAR by adding an appendix section on extensions of VAR. He states that one extension that can be particularly valuable in risk management measures the impact of a single asset on the portfolio VAR. This measure captures the effects of the correlations of the individual assets on the overall portfolio VAR.

In the Appendix to his research report, the extension to VAR that Jacobs describes is most likely:

portfolio VAR.
incremental VAR.
correlation VAR.

Answer(s): B

Explanation:

Incremental VAR (IVAR) is used to measure the impact of a single asset on the portfolio VAR. By measuring the VAR of the portfolio with and without the asset, IVAR captures the effects of the correlations of the individual assets on the overall portfolio VAR. (Study Session 14, LOS 40.g)
Sample Scoring Key: 3 points for each correct response.

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QUESTION: 122 Exam Topic: Portfolio Management and Wealth Planning

SIMULATION
The local bank trust department also custodies the Finnegans' taxable $1.5 million inheritance account, but for this account Sara Finnegan directs all the trades. Ms. Finnegan expresses her social priorities through her financial investments. She deliberately excludes tobacco, defense, oil and gas, and chemical companies from her universe of potential investments and she is obsessed with tax minimization. The Finnegans do not want to pay the government one dollar more than is required. Ms. Finnegan's portfolio allocation is shown in Exhibit 2.

Exhibit 2: Finnegan's Portfolio

Ms. Finnegan is passionate about animals. Her activism has led the Finnegans to become involved with the Spay Neuter Action Project (SNAP). The Finnegans are providing a charitable donation to SNAP. It is their intention to bequest the stock of Conglomerate Inc. to the organization. They also hope to use the growth in the portfolio's assets to make additional contributions of similar size as often as possible.
From the information provided, indicate one item that would affect Sara's ability to tolerate risk and one item that would affect her willingness to tolerate risk and explain each with one reason.
Template for Question

See explanation below.

Answer(s): A

Explanation:

6 points: 1 point for each reason and 2 points for each discussion.(Study Session A, LOS 14.j.I)

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QUESTION: 123 Exam Topic: Portfolio Management and Wealth Planning

SIMULATION
The local bank trust department also custodies the Finnegans' taxable $1.5 million inheritance account, but for this account Sara Finnegan directs all the trades. Ms. Finnegan expresses her social priorities through her financial investments. She deliberately excludes tobacco, defense, oil and gas, and chemical companies from her universe of potential investments and she is obsessed with tax minimization. The Finnegans do not want to pay the government one dollar more than is required. Ms. Finnegan's portfolio allocation is shown in Exhibit 2.

Exhibit 2: Finnegan's Portfolio

Ms. Finnegan is passionate about animals. Her activism has led the Finnegans to become involved with the Spay Neuter Action Project (SNAP). The Finnegans are providing a charitable donation to SNAP. It is their intention to bequest the stock of Conglomerate Inc. to the organization. They also hope to use the growth in the portfolio's assets to make additional contributions of similar size as often as possible.

In the template provided, formulate the constraints portion of an investment policy statement for Ms. Finnegan, addressing each of the following.

Template for Question

See explanation below.

Answer(s): A

Explanation:

12 points: 3 points each (Study Session 4, LOS l4.k,l)

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QUESTION: 124 Exam Topic: Portfolio Management and Wealth Planning

Travis Smith, CFA, is chief economic strategist and market analyst for Nashville Capital Management. He is developing a forecast of the S&P 500 stock market index utilizing different approaches.
Using microeconomic analysis, Smith wants to value the S&P using a dividend discount model (DDM) valuation approach. The trailing recent 52-week dividend for the S&P 500 equaled $60. Used as a proxy for the nominal risk-free rate, Treasury rates are as follows:
• 3-month T-bill rate: 3.5%
• 30-year T-bond rate: 5.0%
Smith uses an equity market premium equal to 6%. His estimate for the long-term outlook for ROE is 11%, and the long-run earnings retention rate is estimated at 40%.
Smith also is forecasting the market trends using varied macroeconomic techniques. He believes that security prices reflect expectations about the general economy. During his monitoring and forecasting of the overall economy, Smith is evaluating cyclical indicators and the business cycle. Smith has focused his analysis on three indicators:
1. Index of industrial production.
2. Interest rate spread between 10-year T-bonds and the fed funds rate.
3. Stock prices.
Smith is particularly interested in using stock market trends to predict economic turning points.
In conducting his research, Smith has found that the business cycle appears to be in the slowdown phase. In his capital markets forecasting activities, Smith looks at government policy, and attempts to predict business and consumer activity, along with foreign trade. Smith has determined that government policy has a significant influence on the business cycle, and he is trying to predict changes in government policy. Smith predicts that the government fiscal policy will loosen and that the Federal Reserve monetary policy will tighten. Smith estimates the following variables:
• Short-term neutral interest rate: 3.5%
• Nominal GDP long-term growth rate trend: 4.25%
• Federal Reserve inflation target: 2.25%
Smith forecasts that inflation will increase to 3.0%, and nominal GDP will grow at a 1.5% rate.
Smith's supervisor, Rasheed Gupta, requests a valuation of the S&P500 using a free cash flow to equity (FCFE) model. Gupta makes the following statement:
"A valuation model that replaces dividends with free cash flow to equity is a good alternative to the DDM If 1 remember correctly, free cash flow to equity equals net income plus depreciation."
Using the dividend discount model. Smith's estimate of the current S&P 500 valuation should be closest to:

545.
950.
3915

Answer(s): B

Explanation:

The reduced form DDM refers to the constant growth model:
V0=D1= / (k-g)
The growth rate in dividends is estimated as the product of the return on equity (ROE) and the earnings retention rare:
g - 0.40 x 0.11 -= 0.044 - 4.4% (retention rate x ROE)
The required return is estimate-d as the sum of the risk-free rare plus marker equity risk premium: k = 0.05 + 0.06 = 0.11 (long-term RFR + risk premium)
D1= = $60 (1 + g) = 560 (1.044) = $62.64
V0= = D1 = / (k - g) = $62.64 I (0.11 - 0.044) = 949.09
(Study Session 7, LOS 24.c)

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QUESTION: 121 Exam Topic: Portfolio Management and Wealth Planning

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QUESTION: 122 Exam Topic: Portfolio Management and Wealth Planning

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QUESTION: 123 Exam Topic: Portfolio Management and Wealth Planning

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QUESTION: 124 Exam Topic: Portfolio Management and Wealth Planning

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