Financial Exam Help 123
2023 Level III Mock Exam
Morning Session Sample Exam
Full Guideline Answers
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 1
Question 1 relates to Derivative Securities
AJBWU Case Scenario
1.1 To achieve Degenek’s target asset allocation and target betas, determine the action (buy
or sell) and the number of small-cap equity futures contracts required.
Degenek wants to reallocate 30% of AUD 200,000,000 – AUD 60,000,000 – from large-cap
equity to small-cap equity. To do this, he will, in essence, convert AUD 60,000,000 from
large-cap equity to cash (with a beta of zero), then convert AUD 60,000,000 of cash to small-
cap equity. He also wants to increase the beta on the small-cap equity allocation from 0.90 to
1.25.
To accomplish this, there are broadly three approaches Degenek can follow:
1. First reallocate the portfolio, then increase the beta of the resulting small-cap equity
portfolio.
2. First increase the beta of the existing small-cap equity portfolio, then reallocate the
portfolio.
3. Increase the beta of the existing small-cap equity portfolio and reallocate the portfolio
simultaneously.
I’ll cover all three approaches.
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Page 2 2023 Morning Mock Exam #1 Full Guideline Answers Level III
Reallocation, then Beta
Graphically. changing the allocation, then changing the beta, looks like this:
Step 1: To change the allocation from AUD 60,000,000 (= AUD 200,000,000 × 30%) to
AUD 120,000,000 (= AUD 200,000,000 × 60%), the number of small-cap equity index futures
contracts that Degenek needs to execute is:
ST – SP β P
N sf
= ×
fs βf
where:
Nsf = number of small-cap equity index (stock) futures contracts
ST = target portfolio size (AUD 120,000,000)
SP = existing portfolio size (AUD 60,000,000)
fs = small-cap equity index (stock) futures price (AUD 104,000)
βP = beta of the existing small-cap portfolio (0.90)
βs = beta of the small-cap equity index futures contract (1.30)
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 3
ST – SP β P
N sf
= ×
fs βf
AUD 120, 000, 000 − AUD 60, 000, 000 0.90
= = × 399.41
AUD 104, 000 1.30
Step 2: To increase the beta from 0.90 to 1.25 (on the new small-cap equity allocation of
AUD 120,000,000), the number of small-cap equity futures contracts that Degenek needs to
execute is:
β T – β P SP
N sf
= ×
βf fs
1.25 – 0.90 AUD 120,000,000
= × 310.65
=
1.30 AUD 104,000
The total number of small-cap equity index futures contracts that Degenek needs to execute is:
399.41 + 310.65 =
710.06
Therefore, Degenek should buy (i.e., take the long position in) 710 small-cap equity index
futures contracts.
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Page 4 2023 Morning Mock Exam #1 Full Guideline Answers Level III
Beta, then Reallocation
Graphically. changing the beta, then changing the allocation, looks like this:
Step 1: To increase the beta from 0.90 to 1.25 (on the existing small-cap allocation of
AUD 60,000,000 (= 30% × AUD 200,000,000)), the number of small-cap equity futures
contracts that Degenek needs to execute is:
β T – β P SP
N sf
= ×
βf fs
1.25 − 0.90 AUD 60,000,000
= × 155.33
=
1.30 AUD 104,000
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 5
Step 2: To change the allocation from AUD 60,000,000 (= AUD 200,000,000 × 30%) to
AUD 120,000,000 (= AUD 200,000,000 × 60%) on a portfolio that now has a beta of 1.25, the
number of small-cap equity index futures contracts that Degenek needs to execute is:
ST – SP β P
N sf
= ×
fs βf
AUD 120, 000, 000 − AUD 60, 000, 000 1.25
= = × 554.73
AUD 104, 000 1.30
The total number of small-cap equity index futures contracts that Degenek needs to execute is:
155.33 + 554.73 =
710.06
Therefore, Degenek should buy (i.e., take the long position in) 710 small-cap equity index
futures contracts.
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Page 6 2023 Morning Mock Exam #1 Full Guideline Answers Level III
Reallocation and Beta Simultaneously
Graphically. changing the allocation and beta simultaneously looks like this:
Step 1: The existing AUD-beta (money beta) of the small-cap portfolio is:
AUD 60, 000, 000 × 0.90 =
AUD 54, 000, 000
The target AUD-beta of the portfolio is:
AUD 120, 000, 000 ×1.25 =
AUD 150, 000, 000
The AUD-beta of a small-cap equity index futures contract is:
AUD 104, 000 ×1.30 =
AUD 135, 200
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 7
The number of small-cap equity index futures contracts to execute to change the small-cap
equity portfolio’s value and beta is:
money-β T – money-β P
N sf =
money-β f
AUD 150, 000, 000 − AUD 54, 000, 000
= = 710.06
AUD 135, 200
Therefore, Degenek should buy (i.e., take the long position in) 710 small-cap equity index
futures contracts.
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Page 8 2023 Morning Mock Exam #1 Full Guideline Answers Level III
Allocation of marks:
6 marks for the correct answer (710 contracts, buy or long position)
If the answer is incorrect:
1 mark for the correct formula for increasing the allocation to small-cap equity
1 mark for the correct calculation of the number of contracts to increase the
allocation to small-cap equity
1 mark for the correct formula for changing the beta of the resulting small-cap
equity allocation
1 mark for the correct calculation of the number of contracts to change the beta
of the resulting small-cap equity allocation
1 mark for correctly adding the numbers of contracts
1 mark for correctly interpreting the positive sign as buying / taking the long
position
Reading:
Swaps, Forwards, and Futures Strategies
LOS a: Demonstrate how interest rate swaps, forwards, and futures can be used to modify
a portfolio’s risk and return.
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 9
1.2 Identify one alternative derivative strategy that Degenek could use to achieve his goals
instead of his proposed futures strategy.
Synthetic futures using options
– or –
Total return equity swap
Identify the derivative security(ies) that Degenek would use, and describe his position
(e.g., long, short, buy, sell, etc.) in each derivative security.
The short position in large-cap equity index futures can be created synthetically with a
combination of a short position in large-cap equity index call options and a long position in
large-cap equity index put options. To duplicate the futures position exactly, the strike price
on the options would have to equal the large-cap equity index futures price.
The long position in small-cap equity index futures can be created synthetically with a
combination of a long position in small-cap equity index call options and a short position in
small-cap equity index put options. To duplicate the futures position exactly, the strike price
on the options would have to equal the small-cap equity index futures price.
– or (respectively) –
The short position in large-cap equity index futures and the long position in small-cap equity
index futures can be approximated with a total return equity swap. In this case, Degenek
would enter into the swap to pay the large-cap equity return and receive the small-cap equity
return on a notional value equal to the value that Degenek wants to reallocate from large-cap
to small-cap.
A wrinkle in using the swap is that the notional value typically does not change over time,
even though the values of the underlying equity portfolios will change over time. However, as
swaps are custom derivatives, the details are open to negotiation; Degenek could negotiate to
have the returns calculated on notional values that change over time.
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Page 10 2023 Morning Mock Exam #1 Full Guideline Answers Level III
Allocation of marks:
2 marks for identifying the strategy of creating a synthetic futures position using options
1 mark for identifying the short position in large-cap equity call options
1 mark for identifying the long position in large-cap equity put options
1 mark for identifying the long position in small-cap equity call options
1 mark for identifying the short position in small-cap equity put options
– or –
2 marks for identifying the strategy of using an equity swap
2 marks for specifying paying the large-cap equity total return
(Less: 1 mark for not specifying total return)
2 marks for specifying receiving the small-cap equity total return
(Less: 1 mark for not specifying total return)
Reading:
Swaps, Forwards, and Futures Strategies
LOS c: Demonstrate how equity swaps, forwards, and futures can be used to modify a
portfolio’s risk and return.
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 11
Question 2 relates to Equity Investments
SGIA Case Scenario
2.1 Each of the correlations that Garcia asks Chirwa to calculate is most accurately described
as a:
a. Transfer coefficient (TC)
b. Pearson information coefficient (IC)
c. Spearman information coefficient (IC)
The correlation between factor exposures and stock returns is known as the information
coefficient (IC). When a correlation is calculated on calculated values of the exposures and the
calculated values of the returns (rather than ranking the calculated exposures, ranking the
calculated returns, and computing the correlation of the rankings), it is known as a Pearson
correlation. Thus, Chirwa’s calculation is a Pearson IC.
Answer a. is incorrect: the transfer coefficient measures the manager’s ability to translate his or
her insight into investment decisions; here, it would be the correlation between the factor
exposures and the corresponding active weights the manager would implement for those
exposures.
Answer c. is incorrect: the Spearman IC is the correlation between the ranks of the exposures and
the ranks of the return values, rather than between their respective calculated values.
Reading:
Active Equity Investing: Strategies
LOS h: Describe how quantitative active investment strategies are created.
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Page 12 2023 Morning Mock Exam #1 Full Guideline Answers Level III
2.2 The futures position undertaken be Edathodika is best described as a:
a. Currency overlay
b. Completion overlay
c. Rebalancing overlay
A completion overlay is used when an index portfolio has drifted from its proper (or mandated)
exposures. A common example is a portfolio that has a large cash balance (e.g., from a large
cash contribution, or from accumulated dividends that have not been reinvested), causing the
portfolio’s beta to be significantly lower than desired. This is exactly the situation that
Edathodika is addressing with the futures position.
Answer a. is incorrect: a currency overlay transforms the return in one currency into a return in a
different currency (e.g., by using currency forwards, currency futures, or currency swaps). A
common use of a currency overlay is to hedge the returns on holdings denominated in foreign
currencies back to the home currency of the investor.
Answer c. is incorrect: although a rebalancing overlay is also used when a portfolio’s exposures
have drifted from their desired levels, it is used specifically in situations where some securities
would need to be sold and others purchased, which is not the case here (no securities need to be
sold). A common use for a rebalancing overlay is in a mixed equity/fixed income portfolio to
return the equity percentage and the fixed income percentage to their desired levels, which would
normally involve selling stocks and buying bonds or vice versa.
Reading:
Passive Equity Investing
LOS c: Compare different approaches to passive equity investing.
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 13
2.3 The most appropriate management styles for Benjamin to employ for the Kendall and
Geneva portfolios, respectively, are:
Kendall Geneva
a. Active Passive
b. Active Active/Passive Mix
c. Active/Passive Mix Passive
Kendall’s board do not believe that markets are efficient, so they believe that there are
opportunities for active management. Their restriction against certain types of investments
(military, alcohol, tobacco, gaming) also suggests an active approach. Furthermore, their
benchmark is a broad market index of actively traded stocks, so an active strategy can take
advantage of market liquidity. Finally, as they are likely to be exempt from taxes (most
foundations are), an active strategy is not constrained by concerns about taxable gains. All these
characteristics point to an active strategy.
Geneva’s management prefer sector-specific portfolios with sector-specific benchmarks, for
which a passive strategy is likely more appropriate (as these benchmarks may not be broad
enough to allow scope for additional alpha). As they have no specific ESG goals, it’s likely that
they will not object to any specific investments contained in any of these benchmarks. Finally,
life insurance companies are taxable, so an active strategy runs the risk of generating taxable
gains, whereas a passive strategy is less likely to do so. All of these characteristics point to a
passive strategy.
Reading:
Overview of Equity Portfolio Management
LOS e: Describe rationales for equity investment across the passive-active spectrum.
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Page 14 2023 Morning Mock Exam #1 Full Guideline Answers Level III
2.4 The statements made by Álvarez and Mandouki are, respectively, most likely:
Álvarez Mandouki
a. Correct Incorrect
b. Correct Correct
c. Incorrect Incorrect
Álvarez’ statement is correct:
• Suppose that you have a benchmark with 500 stocks, and a portfolio with 100 stocks.
The Active Share is 80% (quite high), but if the portfolio is optimized to minimize
tracking error (another name for active risk), then the active risk can be quite low,
perhaps less than 2% annualized.
• Suppose that you have a benchmark with 500 stocks and that your portfolio holds 400 of
those at the benchmark weights (totaling 80% of the portfolio weight). The Active Share
is 20% (quite low). However, if the remaining 20% of the portfolio is invested in a stock
whose returns are wildly different from those of the benchmark, it’s possible that the
tracking error (active risk) could be 10% or more annualized, which is rather high.
Mandouki’s statement is incorrect. Active Share is controllable by the manager: the manager
decides whether to overweight or underweight each security in the benchmark, and by how
much. He is correct about active risk: the manager cannot control the returns on the securities
held, which means that the manager cannot control active risk (except within extremely broad
ranges).
Reading:
Active Equity Investing: Portfolio Construction
LOS c: Distinguish between Active Share and active risk and discuss how each measure
relates to a manager’s investment strategy.
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 15
Question 3 relates to Alternative Investments
Lake Volta Capital Case Scenario
3.1 Determine whether each manager (Mumin, Samir, Franque, Bekele) is appropriate for
the Plan. For each manager who is appropriate, identify the most accurate classification
for that manager’s strategy according to LVC’s list. For each manager who is
inappropriate, justify your conclusion with one reason.
Mumin
Mumin is inappropriate for the Plan.
In Statement 2, the Plan’s investment committee says that it will accept risks that are the main
focus of a strategy, but that it wants other risks removed or eliminated: hedged. Mumin’s
strategy is exposed to credit risk, interest rate risk, and equity market volatility risk, which
Mumin prefers not to hedge; thus, his approach does not comply with Statement 2, so Mumin
is inappropriate for the Plan.
Samir
Samir is appropriate for the Plan.
Samir’s quantitative market-neutral strategy is classified as an equity-related strategy, which is
not restricted by the Plan’s statements.
Franque
Franque is appropriate for the Plan.
Franque’s relative value volatility arbitrage strategy is classified as a specialist strategy, which
is not restricted by the Plan’s statements.
Bekele
Bekele is appropriate for the Plan.
Bekele’s fixed income arbitrage strategy is classified as a relative value strategy, which is not
restricted by the Plan’s statements.
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Page 16 2023 Morning Mock Exam #1 Full Guideline Answers Level III
Allocation of marks:
For each manager:
1 mark for writing the correct conclusion: whether the manager is appropriate for
the Plan or not
For each appropriate manager:
1 mark for one the correct categorization
For each inappropriate manager:
2 marks for one correct justification
(Note: no marks are earned for justifying an incorrect conclusion.)
Reading:
Hedge Fund Strategies
LOS a: Discuss how hedge fund strategies may be classified.
LOS b: Discuss investment characteristics, strategy implementation, and role in a
portfolio of equity-related hedge fund strategies.
LOS c: Discuss investment characteristics, strategy implementation, and role in a
portfolio of event-driven hedge fund strategies.
LOS d: Discuss investment characteristics, strategy implementation, and role in a
portfolio of relative value hedge fund strategies.
LOS f: Discuss investment characteristics, strategy implementation, and role in a
portfolio of specialist hedge fund strategies.
Reading:
Portfolio Management for Institutional Investors
LOS g: Evaluate the investment policy statement of an institutional investor.
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Level III 2023 Morning Mock Exam #1 Full Guideline Answers Page 17
3.2 Identify the most appropriate proxy for the Endowment’s private real assets investment
(public REITs, high-yield bonds, commodity futures). Justify your identification.
The most appropriate proxy for an investment in private real assets is an investment in
commodity futures.
Private real assets comprises timber, commodities, farmland, energy, and infrastructure assets.
Therefore, a proxy for real assets should have the characteristics of an investment in timber,
commodities, farmland, energy, or infrastructure.
Public REITs are real estate investments, and so would be a proxy for private real estate
investments, but not real assets. High-yield bonds would be a proxy for private credit
investments, but not real assets. Only commodity futures would be a proxy for private real
asset investments.
Allocation of marks:
1 mark for writing “Commodity futures”
2 marks for an appropriate justification
(Note: no marks are earned for justifying an incorrect selection.)
Readings:
Asset Allocation to Alternative Investments
LOS d: Discuss investment considerations that are important in allocating to different
types of alternative investments.
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