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MFIN5600 Practice questions

Chapter 1

1. Characterize each of the investment objectives given below as one of the following: an absolute risk objective, a relative risk objective, an absolute return objective, or a relative return objective.

a) Achieve a rate of return of 8% a year.

b) Limit the standard deviation of portfolio returns to 20% a year or less.

c) Achieve returns in the top quartile of the portfolio’s peer universe (the set of portfolios with similar investment objectives and characteristics).

d) Maintain a 10% or smaller probability that the portfolio’s return falls below the threshold level of 5% per annum over a one-year time horizon.

e) Achieve a tracking risk of no more than 4% per annum with respect to the portfolio’s benchmark.

2. Maple College Endowment fund

Case Facts

Type of investor Institutional; endowment

Purpose Provide annual scholarships currently totalling $39.5 million

Asset base $1 billion

Stated return desire 6%, calculated as spending rate of 4% plus previously expected college tuition inflation of 2%

Other return factors Revised expectation of college tuition inflation is 3%

Tax concerns Tax exempt

i. Choose the word at the right that best describes the client’s:

a) Risk Tolerance Below Average Above Average

b) Liquidity Requirement Significant Not Significant

c) Time Horizon Single Stage Multistage

d) Overall Time Horizon Short to Intermediate Term Long Term

e) Tax concerns Significant Not Significant

ii. Discuss appropriate client objectives:

a) Risk

b) Return

Chapter 3

LightSpeed Connections

Hugh Donovan is chief financial officer (CFO) of LightSpeed Connections (LSC), a rapidly growing U.S technology company with a traditional defined-benefit pension plan. Because of LSC’s young workforce, Donovan believes the pension plan has no liquidity needs and can thus invest aggressively to maximize returns. He also believes that U.S. Treasury bills and bonds, yielding 5.4% and 6.1%, respectively, have no place in a portfolio with such long time horizon. His strategy, which has produced excellent returns for the past two years, has been to invest the portfolio as follows:

• 50% in a concentrated pool (15 to 20 stocks) of initial public offerings in technology and Internet companies, managed internally by Donovan

• 25% in a small-capitalization growth fund

• 10% in a venture capital fund

• 10% in an S&P 500 index fund

• 5% in an international equity fund

Working with LSC’s Investment Committee, the firm’s president, Eileen Jeffries has produced a formal investment policy statement, which reads as follows:

“The LSC Pension Plan’s return objective should focus on real total returns that will fund its long-term obligations on an inflation-adjusted basis. The “time-to-maturity” of the corporate workforce is a key element for any defined pension plan; given our young workforce, LSC’s Plan has a long investment horizon and more time available for wealth compounding to occur. Therefore, the Plan can pursue an aggressive investment strategy and focus on the higher return potential of capital growth. Under present U.S. tax laws, pension portfolio income and capital gains are not taxed. The portfolio should focus primarily on investments in businesses directly related to our main business to leverage our knowledge base.”

A. Evaluate Donovan’s investment strategy with respect to its effect on each of the following:

i. LSC’s pension plan beneficiaries

ii. Managing pension assets in relation to LSC’s corporate strength

B. Evaluate LSC’s investment policy statement in the context of the following:

i. Return requirement

ii. Risk tolerance

iii. Time horizon

iv. Liquidity

Chapter 5

For the following types of investors, appraise the importance of using the specified asset class for strategic asset allocation.

A. Long-term bonds for a life insurer and for a young investor.

B. Common stock for a bank and for a young investor.

C. Domestic tax-exempt bonds for an endowment and for a mid-career professional.

D. Private equity for a major foundation and for a young investor.

2. The table below shows William Smith’s financial and human capital in constant dollars terms at 30, 50, and 65 years of age. Smith’s target asset allocation for total wealth (i.e., financial plus human capital) is 60/40 stocks/bonds. Assume that his human capital is approximately risk free and uncorrelated with stock returns. Determine Smith’s optimal asset allocation for stocks and bonds in his financial portfolio at the following ages:

A. 30

B. 50

C. 65

D. Discuss whether your conclusions in Parts A, B, and C are consistent with experience based approaches to asset allocation.

|Age |Financial capital |Human capital |

|30 |$ 100,000 |$ 2,100,000 |

|50 |$ 900,000 |$ 1,300,000 |

|65 |$ 2,000,000 |$ 200,000 |

Chapter 7

1. How would you characterize the following pooled fund in terms of style? Explain your answer.

| |Fund |Benchmark |

|Number of stocks |80 |600 |

|Average market capitalization |$37 billion |$40 billion |

|Dividend Yield |2.5% |2.1% |

|P/E |16 |19 |

|P/B |1.6 |1.9 |

|EPS growth (5-year projected) |11% |12% |

|Sector | | |

|Consumer discretionary |16% |10% |

|Consumer staples |9 |12 |

|Energy |9 |9 |

|Finance |15 |20 |

|Health care |9 |7 |

|Industrials |12 |9 |

|Information technology |8 |7 |

|Materials |5 |8 |

|Telecommunications |7 |10 |

|Utilities |10 |7 |

2. Jason Smith is a consultant evaluating a market neutral long-short strategy for his client. Based on the holdings data he receives from his client, Smith notices a small but persistent difference between the alphas generated on the long side and those generated from the short side. State which of the two alphas is more likely the larger one, and provide three reasons why that might be the case.

3. Mary Nettle has been asked to manage a FTSE 100 index mutual fund. Because the index's 10 largest stocks make up of more than 50 percent of its weights, Nettle is considering using optimization to build the portfolio using many fewer than 100 stocks. All 100 stocks are considered very liquid. What are the pros and cons of optimization (using fewer stocks) versus full replication (holding all the stocks in the index)?

Chapter 8

1. Jane Farkas tells Susan DiMarco that she has seen exciting data on the performance of market-neutral, convertible arbitrage, and global macro hedge funds. Farkas states: ‘‘The Sharpe ratios of all of these hedge fund strategies are much higher than for traditional equities or bonds, which means they have a great risk/return profile. We should definitely plan a major investment in hedge funds.’’ DiMarco responds: ‘‘There are several reasons that the Sharpe ratio may be misleading.’’

i. Discuss the situations that could cause an upward bias in the calculation of the Sharpe ratio.

ii. Evaluate the reasons that statistically indicate that the Sharpe ratio is not the most appropriate measure of risk for hedge funds.

2. Capital market analysts John Lake and Julie McCoy are reviewing the information in Exhibit 8-13 (in our textbook). Lake and McCoy note that the Sharpe ratio for the GSCI is significantly lower than that of the S&P 500 and the Lehman Government/Corporate Bond indices. They also note that the minimum monthly returns for the GSCI and S&P 500 are similar. Lake states to McCoy: ‘‘Based on the historical record, I don’t understand why we would invest in the GSCI when the annualized return for the GSCI is lower than that of the S&P 500 and Lehman Government/Corporate indices, the minimum monthly return is similar to that of the S&P 500, and the Sharpe ratio is significantly lower than either of the domestic equity or bond asset classes. The risk measure in the Sharpe ratio should completely capture a commodity index’s risk.’’

i. Critique Lake’s statement, focusing on the GSCI.

McCoy shows Lake in Exhibit 8-15 (in our textbook) and suggests that these more recent data, which show a significant outperformance of commodity returns versus domestic and international equities and bonds, make a much stronger case for investing in commodities. McCoy also states that the low correlations of commodities with the other asset classes indicate that inclusion of commodities will provide significant diversification benefits to the portfolio.

ii. Judge the validity of McCoy’s conclusions regarding returns and correlations of the various asset classes, again focusing on the GSCI.

3. Real estate investments

i. Summarize the major categories of direct and indirect investment in real estate.

ii. Using the data in Exhibit 8-3 in our textbook, evaluate the historical relative diversification benefits of both forms of investment when added to a 50 percent stock/50 percent bond portfolio. Use the National Council of Real Estate Investment Fiduciaries (NCREIF) Index unsmoothed to represent direct investment and the National Association of Real Estate Investment Trusts (NAREIT) Index to represent indirect investment.

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