CFA Society Boston Level III

2023 Practice Exam A

Session 1

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© 2023 CFA Society Boston

 Level III 2023 Practice Exam
2 ⅕ Hours (132 Minutes)

Session 1 of the 2023 Practice Exam has 11 question sets. The format consists of
either a free form constructed response question set (essay), or a question set
consisting of a vignette or a short case followed by four multiple choice questions based
on the vignette. Each question set is allocated 12 minutes for a total of 132 minutes.

Question Set Topic Minutes

1 Portfolio Management – Asset Allocation 12
2 Equity Investments 12
3 Derivatives 12
4 Fixed Income 12
5 Fixed Income 12
6 Fixed Income 12
7 Derivatives 12
8 Portfolio Management – Asset Allocation 12
9 Economics 12
10 Portfolio Management – Behavioral Finance 12
11 Fixed Income 12

Total 132

© 2023 CFA Society Boston 2

QUESTION SET 1
TOPIC: PORTFOLIO MANAGEMENT – ASSET ALLOCATION
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Julie Brown, a research analyst at an investment management firm, has developed and
validated a questionnaire for determining a client’s preference and capacity for taking
risk. The end product of the questionnaire is the investor’s risk aversion coefficient or
lambda (λ). Brown administers the questionnaire to a new client, Robert Simon, and
finds that Simon, with a lambda value of 4, is moderately risk averse. Taking into
account Simon’s level of risk aversion, Exhibit 1 presents three strategic asset allocation
choices developed by Brown.

Exhibit 1
Strategic Asset Allocation A B C
Expected return 9.25% 7.25% 6.85%
Standard deviation of return 13% 10% 5%

Brown takes a second approach to determining Simon’s strategic asset allocation that
distinguishes a nominal risk-free asset and minimizes volatility subject to satisfying his
expected return objective. Simon’s primary goal is to maintain his portfolio’s purchasing
power, after a 2% annual distribution of assets. The management fee charged to Simon
is 30 bps of the portfolio value. Economists at Brown’s firm expect the annual rate of
inflation to be 4.5%. As of the date of the optimization, the risk-free rate is determined to
be 2.2%. Exhibit 2 presents the corner portfolios that partially define the risky-asset
efficient frontier.

Exhibit 2
Portfolio 1 2 3
Expected nominal return 9.45% 8.88% 7.24%
Standard deviation 20.65% 18.10% 13.95%
Sharpe ratio 0.351 0.369 0.361

Concerned with the accuracy of her analysis, Brown decides to examine the marginal
contribution to total risk (MCTR) of each asset class in Portfolio 2. Brown forms a
version of the global market portfolio using approximate global market-capitalization
weights for the six asset classes in the opportunity set. She then calculates the beta of
each asset class relative to this version of the global market portfolio. Exhibit 3 lists
these beta values along with the weights of the asset classes in Portfolio 2.

Exhibit 3
Asset Class Weight Beta
Domestic equity 30.4% 1.09
International equity 24.4% 1.05
Domestic fixed income 20.0% 0.98
International fixed income 15.0% 0.39
Real assets 10.0% 1.60
Cash 0.2% 0.00
Total 100.0% –

© 2023 CFA Society Boston 3

As part of new client orientation, Brown reviews the firm’s percent-range portfolio
rebalancing policies. Factors that are taken into consideration when setting the optimal
corridor width for each asset class include transaction costs, correlation, and volatility.

For each asset class Brown considers the balance of the portfolio to be a single
hypothetical asset and computes the asset class’s correlation with it, which is the asset
class’s correlation factor. The volatility factor of each asset class is the volatility of the
balance of the portfolio, excluding the asset class itself. Exhibit 4 lists these factors and
the firm’s recommended corridor widths for the asset classes Simon is likely to consider
for investment. Brown assumes that Simon’s risk tolerance is constant across all asset
classes.

Exhibit 4
Volatility
Factor Correlation
with Factor with
Corridor Rest of Rest of
Asset Class Width Cost Portfolio Portfolio
Domestic equity ± 5% 10 bps 14% 0.52
International equity ± 8% 12 bps 16% 0.45
Domestic fixed income ± 4% 6 bps 22% 0.35
International fixed income ± 6% 8 bps 20% 0.28
Real assets ± 10% 25 bps 15% 0.19

1. Which strategic asset allocation in Exhibit 1 would provide the highest certainty-
equivalent return for Simon?

A. Allocation A
B. Allocation B
C. Allocation C

2. Given Simon’s return objective, what is the most appropriate strategic asset
allocation between a portfolio and the risk-free asset?

A. 64.5% Portfolio 1 / 35.5% risk-free asset

B. 70.5% Portfolio 2 / 29.5% risk-free asset
C. 93.5% Portfolio 3 / 6.5% risk-free asset

3. Which asset class in Portfolio 2 has the highest marginal contribution to total
risk?

A. Real assets
B. Domestic equity
C. Domestic fixed income

© 2023 CFA Society Boston 4

4. The narrower rebalancing corridor for domestic equity relative to international
equity for Simon’s portfolio is most likely the result of the difference in:

A. volatility.
B. correlation.
C. transaction costs.

© 2023 CFA Society Boston 5

QUESTION SET 2
TOPIC: EQUITY INVESTMENTS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Emily Reed is the founder and CIO of Two Bridges Capital (TBC), a New York-based
investment manager with $2 billion in assets under management (AUM). TBC manages
US equity portfolios for institutional clients by applying an actively managed quantitative
strategy developed by Reed five years ago. The strategy, branded Accelerated Equity
(AE), produced strong results for the first two years before underperforming for the last
three. Eager to improve results, Reed meets with her mentor, Danielle Schiller, for
advice.

Reed begins by expressing her eagerness to find new ways for AE to generate
additional income and reduce costs. She explains that the strategy generates a regular
stream of dividends by virtue of its broad diversification but that this is the only source of
income for AE. Reed is reluctant to reduce management or performance fees and would
prefer to explore other ways of improving after-fee returns. She also states that TBC’s
clients are all non-taxable entities. Schiller suggests several changes Reed can make to
both generate additional income and reduce costs without changing management or
performance fees.

After noting Schiller’s suggestions, Reed turns the discussion to her investment
process, which posits that overweighting an unconventional factor related to consumer
spending results in excess returns versus the US equity market. After developing her
thesis, Reed acquired ten years of historical unstructured data through a third party
provider, processed it for consistency, and back-tested and evaluated the AE strategy.
Schiller responds by asking Reed if she considered any pitfalls associated with
quantitative strategies while evaluating the back-tested results.

Reed asks Schiller to provide some feedback on AE’s approach to portfolio

construction. Reed has gathered current portfolio data on AE and on a strategy
managed by TBC’s closest competitor, Cortland Capital (CC). These data are
summarized in Exhibit 1. Reed is eager to understand why AE’s relative performance
has been so disappointing the last three years and is hopeful that a comparative
analysis will reveal some useful insights. She notes that the benchmark, the Russell
1000® Index, a US large cap index, has delivered trailing 3-year annualized
performance of 10.0%. Schiller reviews the data and makes a few observations.

Exhibit 1
AE CC Factor Return
3-year performance (annualized) 7.5% 12.0% –
Active share 0.92 0.71 –
Active risk 15.1% 7.2% –
Number of positions 42 124 –
Beta to:
Market 0.96 0.97 7.8%
Size 0.20 0.20 9.2%
Value 0.10 0.05 3.2%
Momentum –0.20 0.30 8.1%
R 2 0.72 0.98 –
© 2023 CFA Society Boston 6
Before concluding their discussion, Reed mentions to Schiller that as AE’s AUM have
grown over the last five years, she has increased the percentage weighting of small-cap
companies. Currently, the average small-cap company in her pipeline has a market
capitalization of $1 billion and 2% of its capitalization trades each day. Reed has a rule
that limits an individual position size to 2% of AE’s AUM and another rule that limits
AE’s daily trading activity to 5% of a company’s daily volume. Schiller is surprised to
learn that Reed has been purchasing small-cap names and wonders what else may
have changed about the AE product over the last five years. She asks Reed if she can
provide some additional historical data. The data are provided in Exhibit 2.

Exhibit 2
First 2 Last 3
Years Years
Performance – AE (annualized) 12.5% 7.5%
Performance – Russell 1000® (annualized) 8.4% 10.0%
Average AUM ($ millions) 235 1,770
Average number of positions 18 40
Portfolio turnover (average) 40% 20%
Beta to:
Market 0.84 0.96
Size 0.05 0.20
Value 0.20 0.10
Quality 0.30 0.00
Momentum 0.00 –0.20

A. Describe one suggestion Schiller can make to increase income and one
suggestion she can make to reduce costs without changing management and
performance fees.

B. Describe two pitfalls associated with quantitative strategies that Reed should
have considered while evaluating the back-tested results of AE.

C. Discuss one way in which differences in portfolio construction reflect differences

in the investment strategies of AE and CC.

D. Calculate the number of days it would take Reed to purchase the maximum
allowable position in the average small-cap company in her pipeline.

© 2023 CFA Society Boston 7

E. Discuss one way in which AE’s growth in AUM over the last five years has
most likely impacted Reed’s portfolio construction decisions.

© 2023 CFA Society Boston 8

QUESTION SET 3
TOPIC: DERIVATIVES
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Alpha Gamma Advisors (AGA) is a Florida-based investment firm that provides multiple
investment and hedging services to its clients. Ying Yue is a portfolio manager and Pete
David is a senior derivatives analyst at AGA. Yue manages client portfolios and David
oversees hedging portfolio risk using exchange-traded derivative instruments. Yue is
meeting with David to review client portfolios and to discuss hedging strategies.

Russ Condon is a client portfolio manager at Lonestar Investments, a small institutional

money manager. Three months ago, Condon purchased 500,000 shares of Telestar
Motor Corporation (TMC) at a price of $750 per share. TMC is actively looking for
potential targets within the auto manufacturing sector to gain synergies from supply
chain management. TMC is in advanced stages of negotiation to acquire Torque Inc., a
lithium-ion battery manufacturing firm. Due to the recent acquisition news, TMC’s share
price fell more than 5% and is currently trading at $710.50 per share.

Condon meets with Yue and David to review his position in TMC stock and seek
suitable strategies based on his immediate outlook and portfolio requirements. Condon
explains that he is confident about the long-term performance of TMC stock and does
not want to sell his position. Condon also mentions that he must generate immediate
cash flow of $1 million to pay for client redemptions and wants to gain downside
protection from any negative earnings surprises. Condon asks Yue and David to
develop option strategies that would meet at least one of these two objectives. David
gathers TMC option prices and Greeks as shown in Exhibit 1. Each option contract
covers 100 shares.

Exhibit 1
Call Call Call Exercise Put Put
Vega Delta Premium Price Premium Put Vega
Delta
0.161 0.895 32.15 680 1.21 –0.213 0.161
0.197 0.763 23.04 690 2.83 –0.347 0.197
0.215 0.652 15.54 700 5.27 –0.422 0.215
0.321 0.507 9.71 710 9.23 –0.515 0.321
0.226 0.383 5.46 720 15.66 –0.613 0.226
0.191 0.273 3.41 730 22.81 –0.746 0.191
0.176 0.214 2.12 740 31.31 –0.892 0.176

After reviewing the data, David recommends that Condon use one of the following
strategies.

Strategy 1: To generate temporary cash flow, implement a covered call strategy by

selling call options with a strike price of $730.

Strategy 2: To protect downside risk, implement a collar by buying $700 puts

and selling $720 calls.

© 2023 CFA Society Boston 9

Strategy 3: To generate temporary cash flow, implement a bull spread by selling $740
puts and buying $710 puts.

TMC’s stock price increases to $790 at the option expiration date.

1. The number of covered call contracts required to generate a $1 million cash flow
in Strategy 1 is closest to:

A. 1,833.
B. 2,433.
C. 2,933.

2. The combined delta of Strategy 2 and Condon’s TMC stock position is closest to:

A. 0.039.
B. 0.195.
C. 1.039.

3. The minimum percentage change in TMC’s stock price required for Strategy 3 to
break even is closest to:

A. 1.04%.
B. 3.67%.
C. 4.41%.

4. Which of David’s recommended strategies results in the largest profit at

expiration?

A. Strategy 1
B. Strategy 2
C. Strategy 3

© 2023 CFA Society Boston 10

QUESTION SET 4
TOPIC: FIXED INCOME
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Mark Thorn is a senior investment officer at a large global asset manager, Zero Capital
(ZC). ZC manages fixed income investments for institutional clients. Thorn is preparing
for his quarterly meeting with one of his biggest clients, Alpha Corporation (AC).

In preparation for the meeting, Thorn meets with his team to discuss potential fixed
income investment strategies. Alex Book, a junior fixed income portfolio manager,
updates Thorn on the spread analysis he has used to identify potential trades. Book
makes the following statements.

Statement 1: An increase in interest rate volatility will cause nominal spreads on

callable corporate bonds to widen.

Statement 2: Using putable bonds will allow us to obtain full protection from any large
deterioration in an issuer’s credit.

Statement 3: Buying MBS will add convexity to the portfolio, which will result in a
greater benefit from a large change in interest rates.

The conversation next turns to the state of the economy. Another member of Thorn’s
team, David Yung, concludes that the economy will weaken, causing the yield curve to
experience a downward parallel shift. Yung proposes two trades.

Trade 1: Sell a 5-year A-rated callable corporate bond

Buy a 5-year A-rated non-callable bond of the same issuer

Trade 2: Sell a 10-year fixed-rate corporate bond

Buy a 10-year floating-rate bond of the same issuer

A. Determine whether each of Book’s three statements is most likely correct.

Justify each response.

B. Determine, given Yung’s conclusions, whether each of his proposed trades

would most likely be profitable. Justify each response.

© 2023 CFA Society Boston 11

QUESTION SET 5
TOPIC: FIXED INCOME
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Kevin Black is a junior analyst at Capital Advisors Ltd. (CAL), a UK-based investment
firm specializing in fixed income securities. Black was tasked with evaluating a US fixed
income fund that CAL is planning to offer to its UK clients. Selected financial data for the
fund are presented in Exhibit 1. All expected values are for a one-year investment time
horizon. Black assumes that there is no reinvestment income.

Exhibit 1
Notional principal $120 million
Average annual coupon (per 100 par) $5.50
Current average bond price $94.28
Expected average bond price in 1 year
(assuming an unchanged yield curve) $95.14
Average bond modified duration 6.12
Average bond convexity 12.30
Average bond ratings BBB+/Baa1
Expected spread change +0.28%
Expected credit losses –0.05%
Expected USD gain vs. GBP +0.14%

Black meets with his supervisor, John Clooney, to present the findings of his work.
Black makes the following statements.

Statement 1: High-yield bonds are generally more liquid than investment-grade bonds
because they are equity-like.

Statement 2: The total outstanding dollar amount of US investment-grade bonds is

larger than that of US high-yield bonds.

Clooney makes a few observations about credit markets in emerging markets.

Statement 3: Emerging markets debt indexes are dominated by issuers concentrated in

the commodities and banking sectors.

Statement 4: Governments own significant stakes in many emerging markets bond

issuers. Hence, it is imperative to also monitor the legal risk associated
with these bonds.

1. The rolling yield of the fund over a one-year investment horizon is closest to:

A. 5.50%.
B. 6.41%.
C. 6.74%.

© 2023 CFA Society Boston 12

2. Based only on the expected spread change, the expected change in the average
bond price over a one-year investment horizon is closest to:

A. –1.71%.
B. 0.00%.
C. 1.72%.

3. Which of Black’s statements about the characteristics of the investment-grade

and high-yield bond markets is(are) most likely correct?

A. Statement 1 only
B. Statement 2 only
C. Both Statements 1 and 2

4. Which of Clooney’s statements about emerging markets debt is(are) most likely
correct?

A. Statement 3 only
B. Statement 4 only
C. Both Statements 3 and 4

© 2023 CFA Society Boston 13

QUESTION SET 6
TOPIC: FIXED INCOME
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Kevin Baker is a fixed income portfolio manager at White Capital Inc. (WC). WC is a
US-based investment firm specializing in fixed income and alternative investments and
manages accounts for many institutional clients.

Baker meets with a client, Thomas Zerke, who wants to immunize a single 8-year
liability of $65,000,000. The present value of the liability is $55,450,550.

Baker explains to Zerke that immunization is a process of structuring and managing a

fixed income bond portfolio to minimize the variance in the realized rate of return over a
known time horizon. This variance arises from the volatility of future interest rates.
Baker adds that there are several available methods for immunizing a liability, including
cash flow matching, duration matching, and contingent immunization.

To immunize Zerke’s liability, Baker considers three possible portfolios which consist of
non-callable investment-grade coupon-paying bonds. Baker presents the details of the
portfolios in Exhibit 1 to Zerke.

Exhibit 1
Portfolio A Portfolio B Portfolio C
Market value $55,600,000 $55,300,000 $55,500,000
Cash flow yield 4.12% 4.13% 4.11%
Macaulay duration 7.98 8.01 7.50
Convexity 43.00 38.00 49.00
Average maturity 9.50 years 9.75 years 9.05 years
Average ratings A–/Baa1 BBB+/Baa1 A–/Aa3

One year later, the liability has a present value of $56,200,350 and a modified duration
of 6.54. The immunization portfolio has a market value of $57,350,400 and a modified
duration of 6.85. Baker closes the duration gap with a derivative overlay strategy using
US Treasury note futures. Based on the cheapest-to-deliver (CTD) bond, Baker
determines that the BPV (basis point value) for one futures contract is $68.49.

A. Describe the cash flow matching and the duration matching immunization
methods.

B. Determine which portfolio in Exhibit 1 would best immunize Zerke’s liability.

Justify your response.

© 2023 CFA Society Boston 14

C. Determine whether Baker should take a long or short position in the futures
contracts to close the duration gap. Calculate the number of futures contracts
required to close the duration gap.

© 2023 CFA Society Boston 15

QUESTION SET 7
TOPIC: DERIVATIVES
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Patricia Cunningham is a risk analyst at Hillside Analytics, which specializes in portfolio

management and hedging services for institutional and retail clients. Cunningham uses
advanced risk management strategies to achieve specific investment objectives and to
mitigate downside risk exposures.

Lynn Braceras, age 55, is an operations manager at Seaport Inc. (SEA), an

international logistics firm. Braceras has a portfolio valued at $5 million, which is
allocated 60% to equities and 40% to bonds. Within the equity portion of her portfolio,
Braceras has allocated $2 million to the stock of her employer, SEA.

Cunningham advises Braceras to reduce the concentrated exposure to SEA. Braceras

is confident about her employer’s long-term performance and expects a significant
increase in the stock price. Braceras does not want to sell her employer’s stock but
requests a recommendation to protect the position from any short-term downside risk.
SEA is currently trading at $110.50. Cunningham gathers the option pricing information
in Exhibit 1. Each option contract covers 100 shares.

Exhibit 1
Call Premium Strike Price Put Premium
$21.30 $90 $0.84
$10.80 $100 $1.40
$3.08 $110 $5.05
$0.93 $120 $12.65
$0.31 $130 $22.35

Cunningham makes the following statements:

Statement 1: Across the option series, a delta hedge of at-the-money options would be
the most difficult to maintain because it has the highest gamma.

Statement 2: In a bearish market, implied volatility of out-of-the-money puts increases

compared to that of out-of-the-money calls, resulting in a volatility skew.

Another Hillside client, Mark Frazier, manages a small endowment portfolio valued at
$450 million with a beta of 1.08. Frazier has invested 40% of the portfolio in QQQ, a
technology sector ETF which has a beta of 1.45. With the recent downturn in technology
stocks, Frazier wants to reduce his exposure to QQQ and to reduce the beta of this
portion of the portfolio to 1.08, but he is also concerned about tax consequences. He
asks Cunningham to recommend a suitable strategy to temporarily eliminate the
endowment’s exposure to QQQ without having to sell any of the position. Cunningham
presents selected information for S&P 500® futures contracts and QQQ futures
contracts in Exhibit 2. She recommends selling QQQ futures contracts and buying S&P
500® futures contracts such that the beta of this portion of the portfolio is reduced to
1.08.

© 2023 CFA Society Boston 16

 Exhibit 2
S&P 500® Futures QQQ Futures
Futures price 3,975 305
Multiplier $250 $1,000
Futures beta 0.90 1.16
Maturity 6 months 6 months

A. Formulate a strategy that would limit the downside exposure of SEA. Calculate
the cost of the strategy.

B. Determine whether each of Cunningham’s statements is most likely correct.

Justify each response.

C. Calculate the number of QQQ futures contracts and the number of S&P 500®
futures contracts required to eliminate the QQQ exposure and to reduce the beta
of the current QQQ exposure to 1.08.

© 2023 CFA Society Boston 17

QUESTION SET 8
TOPIC: PORTFOLIO MANAGEMENT – ASSET ALLOCATION
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

The Endowment Fund (TEF) of a domestic research university is currently undergoing

its triennial governance audit and review of operations. The research, selection, and
evaluation of investment managers are the responsibilities of the investment committee.
Individual asset selection is delegated by the committee to outside managers and
reviewed by internal staff. Performance evaluation and reporting are conducted by the
internal staff, with input from consultants and custodians.

TEF’s mission is threefold: (1) support scholarships, (2) support capital improvements,
and (3) fund a portion of the university’s operating budget. In addition to considering
expected return in relation to volatility, the investment committee wants to include the
following factors in its strategic asset allocation review:

• The domestic equity market represents only 7% of global equity market

capitalization.
• The university attracts a global student body, and enrollment levels tend to track
the performance of developed market economies.
• The university plans to significantly increase its spending on capital
improvements over the next several years.
• Since contributions typically come from external donors, TEF has little control
over the timing and amounts of contributions to the fund.

TEF’s current investment objective is to generate a real rate of return in excess of that
required to fund ongoing distributions in accordance with TEF’s mission, with a
maximum acceptable volatility of 16% per year, and to maximize the Sharpe ratio of
TEF’s total financial assets . TEF is intent on selecting portfolios that make efficient use
of asset risk. TEF employs a mean–variance optimization approach that considers only
the expected returns, risks, and correlations of the asset classes in the opportunity set.

The current financial assets of TEF consist of $45 million in domestic large and mid-cap
equities and $35 million in domestic nominal fixed income. The present value of
expected future contributions to TEF is estimated to be $230 million. The financial
liabilities of TEF consist of mortgage debt currently valued at $19 million. The present
value of expected future support is estimated to be $171 million. TEF invests through
external managers.

As part of the review of operations, a consultant examines the asset class correlations
of TEF’s current equity investments, finding that none of the classes’ pairwise
correlations exceed 0.95.

The consultant considers domestic small-cap equities a separate asset class that would
not raise any new regulatory restrictions. The consultant recommends that TEF
consider adding this asset class to its existing domestic equity allocation.

© 2023 CFA Society Boston 18

A range of potential strategic asset allocation choices for consideration by the
investment committee are developed by the internal staff through optimization exercises
and are presented in Exhibit 1.

Exhibit 1
Description Mix A Mix B Mix C
Domestic equity 50% 20% 45%
Global equity, ex-domestic – 30% 10%
Fixed income, nominal 30% 15% 10%
Fixed income, inflation-linked – 15% 10%
Private/direct real estate 20% 10% 25%
Hedge funds – 10% –
Expected return 7.46% 7.41% 7.84%
Standard deviation 14.11% 13.87% 15.83%
Sharpe ratio 0.369 0.371 0.353

1. Which of the following rights and responsibilities within TEF’s investment

program is most likely inconsistent with effective investment governance?

A. Portfolio construction
B. Performance evaluation
C. Investment manager selection

2. TEF’s broad approach to asset allocation can best be described as:

A. asset-only.
B. goals-based.
C. liability-relative.

3. Adding domestic small-cap equities to TEF’s portfolio will most likely result in:

A. overlapping asset classes.

B. duplicating risk exposures already present.
C. diminished opportunities for applying active strategies.

4. Which strategic asset allocation in Exhibit 1 best meets TEF’s investment

objective and addresses the factors noted by the investment committee?

A. Mix A
B. Mix B
C. Mix C

© 2023 CFA Society Boston 19

QUESTION SET 9
TOPIC: ECONOMICS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Anne Klein and Josh Tao are research analysts at Prudent Capital, an investment
advisory firm in the US. Klein and Tao are responsible for creating and updating the
firm’s capital market expectations. Klein focuses on equities and low-credit-quality fixed
income, utilizing only data from liquid public markets. Tao focuses on high-credit-quality
fixed income and real assets.

Klein and Tao work together to analyze the global macroeconomic environment and the
expected trend rate of economic growth. Their analysis incorporates a blend of the most
commonly used approaches: checklists, econometric models, and leading indicators. In
a recent investment committee meeting, Klein and Tao discussed the strengths and
weaknesses of each approach. During the meeting, the following statements were
made.

Statement 1: One approach to economic modeling is to use the checklist approach. It is

quite simple, as well as flexible, since one can include a wide array of
economic data. However, it is time consuming due to the need to
continually monitor the data already being used, as well as to consider
other data that could be included. Also, it is inherently subjective as it
relies on the analyst’s opinion of what economic data should be included.

Statement 2: Another approach is to use statistics to model relationships among types

of economic data. By understanding the past relationship between
consumer spending, housing income, and interest rates, an analyst can
forecast future economic growth rates based on their belief of where
certain economic variables will be in the coming years. These models are
robust and tend to forecast turning points in an economy well.

Statement 3: An approach that is commonly used and easy to understand is looking at

leading economic indicators. These can be individual economic data
items, such as the unemployment rate, or a combination of items to create
a composite index. While this approach is helpful, the data used are
subject to frequent revisions, which impact the reliability of interpreting the
data in real time.

Klein and Tao are assessing the impact that each phase of the business cycle has on
their short- and long-term capital market expectations. Within the US, they have
observed low unemployment, strong profits, rising wages and inflation, and capacity
pressures. The central bank has communicated its intent to raise rates for the
foreseeable future.

Based on this assessment of the US business cycle, Klein and Tao make the following
statements.

Statement 4: Equity and low-credit-quality fixed income will deliver higher returns
over the next three years than our long-term forecasted returns.

© 2023 CFA Society Boston 20

Statement 5: The US has transitioned beyond initial recovery and is firmly in the early
expansion phase.

Statement 6: We are considering a recommendation to increase the allocation to real

assets over the short term, as we expect inflation to be higher than the
consensus expectation and overall economic growth to be durable but
weakening.

For the US, Klein and Tao estimate the neutral real policy rate to be 2.5%, the target
inflation rate to be 2.0%, and trend real growth to be 3.0%. Their forecasts are 3.5% for
inflation and 5.0% for real growth. The US central bank is expected to target a nominal
policy rate of 5.25%.

1. Which data measurement error or bias most likely impacts the asset classes
covered by Tao more than those covered by Klein?

A. Survivorship bias
B. Transcription errors
C. Appraisal (smoothed) data

2. Which statement made during the investment committee meeting is least likely to
be correct?

A. Statement 1
B. Statement 2
C. Statement 3

3. Given Klein’s and Tao’s assessment of the US business cycle, which of the
following statements is most likely correct?

A. Statement 4
B. Statement 5
C. Statement 6

4. Based on the Taylor rule, if the central bank targets a 5.25% nominal policy rate,
what is the mostly likely near-term outcome for the US economy?

A. Lower inflation and higher real growth

B. Stable inflation and stable real growth
C. Higher inflation and lower real growth

© 2023 CFA Society Boston 21

QUESTION SET 10
TOPIC: PORTFOLIO MANAGEMENT – BEHAVIORAL FINANCE
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Herman Clark advises small and medium-sized companies on retirement savings plan
offerings for employees. These companies typically have less than 1,000 participants in
their retirement savings plans. Clark has been working with Castle Computer
Corporation (CCC) to improve the defined contribution (DC) plan participant experience
and results. CCC sponsors the DC retirement savings plan, but each participant has
their own account and makes their own investment decisions for that account.

Within CCC’s plan, participants can make trades without transaction costs and do not
incur taxes. Clark recommends that the company expand the number of fund offerings
in the plan and provide information to help employees make investment decisions. As
part of the education process Clark suggests that, in addition to annual returns, CCC
provide plan participants with long-term compound annual return data for the funds.

Clark notes that many participants have larger-than-expected allocations to company

stock. He suggests to the company that this may be inappropriate given the risk
tolerance of some of the participants. CCC’s stock has outperformed the broad market
over the most recent five and ten year periods.

Additionally, Clark makes the following observations about participants’ behavior:

Observation 1: New plan participants tend to allocate evenly across all mutual
funds in the plan.

Observation 2: Plan participants have little to no exposure to foreign stocks.

Observation 3: Many participants have not reallocated their portfolios since they
joined the plan.

A. Identify which of the following behavioral characteristics may be mitigated by

providing long-term compound return data as suggested by Clark.

(Adjustment bias, Framing bias, Illusion of control, Myopic loss aversion, Status
quo bias)

Explain the impact this characteristic may have on portfolio risk.

B. Discuss two reasons why some participants’ allocations to company stock may
be higher than expected.

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C. Select, for each of the following observations, the behavioral bias that is most
likely exhibited by the plan participants.

i. Observation 1
ii. Observation 2
iii. Observation 3

(1/n diversification, Adjustment bias, Endowment bias, Framing bias, Illusion of

control, Sample-size neglect, Status quo bias, Self-control bias)

Explain the potential impact of each bias on portfolio construction, risk, or return.

© 2023 CFA Society Boston 23

QUESTION SET 11
TOPIC: FIXED INCOME
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Andy Smith is a fixed income portfolio manager at Ivory Capital (IC), a US-based
investment firm specializing in fixed income and alternative investments for individual
and institutional clients.

Smith meets with Thomas Kane, a potential client who is interested in adding fixed
income investments to his personal portfolio. Kane has limited experience with fixed
income securities and has recently read a financial paper describing bonds as safe
investments that pay regular cash flows.

Smith makes the following statements about the roles of fixed income securities in a
portfolio.

Statement 1: Fixed income securities typically produce regular cash flows.

Statement 2: Fixed income securities are an excellent hedge for inflation.

Smith then proceeds to discuss the use of leverage in fixed income portfolios. He states
that there are a number of instruments that allow investors to take leveraged positions
and thus amplify gains, such as futures contracts, interest rate swaps, and repo
transactions.

Smith makes the following statements related to these instruments.

Statement 3: Futures contracts exhibit significant leverage because they provide

exposure to a large quantity of the underlying asset without having to
transact in the asset.

Statement 4: Entering a pay-fixed, receive-floating swap increases exposure to fixed-

coupon bonds and increases the portfolio’s duration.

Kane inquires about fixed income active management, specifically with regard to credit
strategies. Smith explains credit strategies in detail and then proceeds to show
numerical examples for the two bonds shown in Exhibit 1.

Exhibit 1
Rating Credit Spread Effective Spread Duration
A– 2.75% 5.5
BBB+ 3.25% 4.7

In the first example, Smith presents a scenario for the bond rated A– in which credit
spreads narrow by 10 bps over a three-month horizon. In the second example, Smith
presents a scenario for the bond rated BBB+ that involves an instantaneous 20 bps
decline in yields. The BBB+ rated bond has a loss given default of 20% and an
annualized probability of default of 1%.

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1. Which of Smith’s statements about the roles of fixed income securities in a
portfolio is(are) correct?

A. Statement 1 only
B. Statement 2 only
C. Both Statements 1 and 2

2. Which of Smith’s statements about the use leverage in fixed income portfolios
is(are) correct?

A. Statement 3 only
B. Statement 4 only
C. Both Statements 3 and 4

3. Ignoring spread duration changes and assuming no default losses, the excess
return of the A– rated bond in Smith’s first example is closest to:

A. 0.1375%.
B. 0.6875%.
C. 1.2375%.

4. Ignoring spread duration changes, the expected excess return of the BBB+ rated
bond in Smith’s second example is closest to:

A. –1.14%.
B. 0.74%.
C. 0.94%.

END OF SESSION 1

© 2023 CFA Society Boston 25