Free CFA Level III Portfolio Management Practice: 2027 Cases

This free selection contains 11 original cases and 44 questions for the 2027 CFA Level III common core and Portfolio Management pathway. Each case has four independently answerable questions with three alternatives and one best answer.

These are independent Finance Prep exercises, not official CFA Institute questions or copied exam content. Finance Prep is not affiliated with or endorsed by CFA Institute.

Use this as item-set practice

Allow about 132 minutes for a pacing exercise, or work through one case at a time. This timing is editorial: the official Level III sessions each mix multiple-choice and constructed-response sets. This page is not a complete mixed-format mock, a writing assessment or a prediction of passing.

Read the case exhibits, dates and assumptions before each question. Answers and explanations appear below the questions; cover them while attempting the set. Review the reasons for rejected choices, including answers you guessed correctly.

The fixed selection covers all six practice areas. The app has 277 cases and 1,108 questions for further topic and mixed-case work. Reopening this page keeps the same public questions and displayed answers.

Case 1

Topic: Asset Allocation

Moreno Family Goal Funding

On 1 January 2027, Asha Mehta, CFA, is allocating the Moreno family’s $4.80 million of investable wealth. All amounts are in January 2027 purchasing-power US dollars. No additional contributions or borrowing are available. A separate emergency reserve is excluded from both investable wealth and goal funding.

Goals and decision rules

The family ranks its goals in the following order:

• Essential: Provide $2.40 million for residential care on 1 January 2031, with a maximum shortfall probability of 1%.
• Lifestyle: Provide $1.40 million for a second home on 1 January 2035, with a maximum shortfall probability of 10%.
• Aspirational: Make a $2.50 million charitable gift on 1 January 2042, with a maximum shortfall probability of 25%.

A higher-priority goal must be fully funded at its required success standard before a lower-priority goal receives capital. Subject to that ordering, the family wants to fund as many goals as possible and then minimize committed capital. Unassigned wealth remains in daily-liquid Treasury bills. Goal amounts and dates are fixed unless an explicit change is permitted.

Approved funding configurations

The family permits only the discrete, whole-goal configurations below. Configurations cannot be blended, rescaled or partially funded. Each row specifies its complete initial commitment and modeled success probability.

All results come from one joint scenario model incorporating shared market shocks, goal dates, fees and assumed taxes. Success means having the full required capital available on the goal date.

For a paired-goal diagnostic, the model evaluates essential defensive and aspirational diversified at their listed commitments. The probability that both goals experience a shortfall is 0.8%.

Household liquidity screen

Goal accounts are reporting designations, not legally segregated pools. The family permits transfers among them.

Mehta also evaluates a proposed locked investment that permits neither redemptions nor distributions before 1 January 2033. The family imposes a separate liquidity test: under a specified 2031 stress, daily-liquid assets have a terminal real value, including reinvested income, equal to 90% of their initial allocation. The household must still have enough liquid assets to make the entire essential payment on 1 January 2031.

This liquidity screen applies to the original $4.80 million, including unassigned wealth. No borrowing, early sale of the locked investment or external cash inflows are available.

Question 1

Under the original goal dates and success requirements, how much initial wealth remains unassigned after applying the family’s allocation rules?

• A. $0
• B. $750,000
• C. $950,000

Best answer: B

Goals-based allocation assigns capital according to goal priority and acceptable shortfall risk, rather than simply selecting the cheapest configurations. The essential goal requires at least 99% success, so its qualifying configuration costs $2.50 million. The lifestyle goal requires at least 90% success, making its qualifying commitment $1.55 million. The aspirational goal’s qualifying commitment is $1.35 million.

Funding all three would require $5.40 million, exceeding available wealth. Funding the essential and lifestyle goals requires $4.05 million and respects the stated priority order. The remaining $750,000 cannot fund the indivisible aspirational configuration, so it stays unassigned in Treasury bills. Using cheaper configurations to fund additional goals would improperly substitute greater shortfall risk for the family’s explicit requirements.

Answer choices explained:

A — Incorrect: All three goals fit exactly only by using essential balanced and lifestyle growth alongside aspirational diversified; the first two configurations violate their required success standards.

B — Correct: Essential defensive and lifestyle balanced require $4.05 million, leaving $750,000, which is insufficient for the aspirational goal’s qualifying $1.35 million commitment.

C — Incorrect: Funding essential defensive and aspirational diversified would leave $950,000, but this combination skips a feasible lifestyle goal that has higher priority.

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Question 2

For the model’s paired-goal diagnostic, the probability that at least one of the essential and aspirational goals experiences a shortfall is closest to:

• A. 25.75%
• B. 26.00%
• C. 25.20%

Best answer: C

Separate goal labels do not make investment outcomes independent. Let \(E\) denote an essential-goal shortfall and \(A\) an aspirational-goal shortfall. Their marginal probabilities follow from the configurations’ success rates, while the joint model supplies the overlap.

\[ P(E\cup A)=P(E)+P(A)-P(E\cap A)=0.01+0.25-0.008=0.252. \]

Thus, at least one goal fails in 25.20% of scenarios. Under independence, simultaneous failure would occur with probability \(0.01\times0.25=0.0025\), or 0.25%, rather than 0.8%. The modeled shortfall events are therefore positively associated. This dependence concentrates failures into common scenarios; it does not necessarily increase the probability of at least one failure. Household risk assessment should consider both individual goal probabilities and the clustering of shortfalls.

Answer choices explained:

A — Incorrect: This independence estimate, \(1-0.99\times0.75=25.75\%\), ignores the model’s reported 0.8% simultaneous-shortfall probability.

B — Incorrect: Adding the 1% and 25% shortfall probabilities without subtracting their 0.8% overlap counts simultaneous failures twice.

C — Correct: The shortfall probabilities are 1% and 25%; adding them and subtracting the 0.8% simultaneous-shortfall probability gives 25.20%.

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Question 3

Based solely on the household’s 2031 stress-liquidity requirement, the maximum percentage of original investable wealth that could be allocated to the locked investment is closest to:

• A. 50.0%
• B. 55.6%
• C. 44.4%

Best answer: C

Liquidity must be assessed across the household using assets that can actually supply cash when the essential payment is due. The locked investment contributes no cash before 2033, regardless of its reported value or goal designation.

Let \(w\) be the fraction of original wealth invested in the locked investment. With amounts measured in millions, the 2031 constraint is:

\[ 0.90(1-w)\times4.80\ge2.40. \]

Initially liquid assets must therefore equal at least $2.40 million divided by 0.90, or approximately $2.667 million. This leaves approximately $2.133 million eligible for locking, equivalent to 44.4% of initial wealth. Transfers among reporting accounts are permitted, so liquid resources can be pooled. This result is a liquidity ceiling, not confirmation that the allocation also satisfies every goal-success requirement.

Answer choices explained:

A — Incorrect: Locking 50.0% leaves $2.40 million initially liquid, but the stress reduces its terminal value to $2.16 million, below the essential payment.

B — Incorrect: Approximately 55.6% is the required daily-liquid share, not the permitted locked share; locking that proportion leaves only about $1.92 million liquid under stress.

C — Correct: Approximately $2.667 million must initially remain liquid, leaving $2.133 million, or 44.4% of original wealth, available for the locked investment.

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Question 4

For this question only, investable wealth falls to $3.95 million immediately before allocation. Original-date funding requirements and model results remain unchanged. The family permits the lifestyle payment to be deferred to 1 January 2039; an approved deferred configuration requires $1.40 million initially and has a 90% success probability. Priorities and shortfall limits remain unchanged, and any balance stays unassigned. Which revised allocation best follows the family’s instructions?

• A. Allocate $2.50 million to essential defensive and $1.15 million to original-date lifestyle growth.
• B. Allocate $2.50 million to essential defensive and $1.35 million to aspirational diversified.
• C. Allocate $2.50 million to essential defensive and $1.40 million to deferred lifestyle.

Best answer: C

A decline in wealth requires reassessing feasibility without automatically relaxing the family’s risk limits. Essential defensive still requires $2.50 million, leaving $1.45 million. That balance cannot fund the original lifestyle balanced configuration, which requires $1.55 million.

The permitted date change makes the deferred lifestyle configuration feasible at $1.40 million while retaining its required 90% success probability. Together, essential defensive and deferred lifestyle require $3.90 million, leaving $50,000 unassigned. The aspirational goal remains unfunded because it follows lifestyle in priority and requires substantially more capital than the remaining balance. The appropriate adjustment uses an explicitly flexible goal dimension, its date, rather than increasing shortfall risk or bypassing a feasible higher-priority goal.

Answer choices explained:

A — Incorrect: The $3.65 million commitment is affordable, but lifestyle growth succeeds only 82% of the time, below the required 90%.

B — Incorrect: The $3.85 million commitment is affordable, but it bypasses the lifestyle goal even though that higher-priority goal is feasible after the permitted deferral.

C — Correct: The $3.90 million commitment preserves the essential 99% and lifestyle 90% success standards using the permitted deferral, leaving $50,000 unassigned.

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Case 2

Topic: Asset Allocation

Alderbridge Pension Trust Allocation Review

Maya Chen advises the trustees of Alderbridge’s closed defined benefit pension plan. The trustees are reviewing the allocation because the sponsor’s cyclical business limits its ability to support the plan during equity-market declines. All monetary amounts below are in USD millions.

Benefit obligations and valuation

The actuary uses the following four-date approximation of all remaining benefit payments. Amounts are rounded and already incorporate expected inflation.

At every payment date, 60% of the projected payment is fixed in nominal terms and 40% is fully CPI-linked until payment. There are no indexation caps or floors.

For the trustees’ funding measure, projected payments are discounted using a flat nominal AA corporate zero curve of 5.0%, comprising a 3.5% Treasury yield plus a 150 bp AA spread. Expected inflation is 2.0%. Yield curves and expected inflation are expressed as annual continuously compounded rates.

The liability present value is $200.0 million, with nominal yield duration of 12.0 years. The fixed and CPI-linked components have the same payment-date distribution and duration. Use first-order yield sensitivities and ignore convexity.

Assets and available portfolios

Current assets total $210.0 million: $126.0 million in nominal Treasuries and $84.0 million in a diversified growth portfolio. The reported funded ratio is 105%, and dollar surplus, defined as assets minus liabilities, is $10.0 million.

Duration refers to nominal yields for nominal Treasuries and real yields for CPI-linked Treasuries. For this analysis, nominal Treasury yields equal real Treasury yields plus expected inflation, with inflation risk premia held constant. Thus, at unchanged expected inflation, both bond portfolios have the same sensitivity to a parallel nominal Treasury yield shift. Neither has direct AA spread exposure.

The growth portfolio has zero direct yield or inflation sensitivity in this first-order model; it is held to earn long-horizon risk premiums. All portfolios are liquid, and taxes and transaction costs are ignored.

Surplus risk and sponsor support

The risk team supplies the following baseline assumptions for one-year arithmetic returns on current assets and on liability present value, before contributions. No benefit payments occur during that year.

The sponsor can contribute at most $4.0 million during the next year. The trustees intend to retain a growth sleeve but prioritize controlling underfunding risk rather than minimizing stand-alone asset volatility. Each question’s stress is assessed independently from the baseline.

Question 5

In an immediate stress, the AA spread widens by 50 bp while Treasury yields, expected inflation, and asset market values remain unchanged. Using the first-order duration approximation, the reported funded ratio is closest to:

• A. 105.0%.
• B. 111.7%.
• C. 99.1%.

Best answer: B

The funding measure discounts liabilities using AA corporate yields, so a wider AA spread reduces reported liability value even without a Treasury yield change. Let \(L_1\) denote stressed liability value in USD millions. The first-order estimate is:

\[ L_1 \approx 200[1-12(0.005)]=188. \]

With asset value unchanged, the funded ratio becomes:

\[ \frac{210}{188}=111.7\%. \]

This improvement is valuation-driven: the plan has received no additional assets, and its promised benefit payments have not declined. It therefore should not be interpreted as an equivalent improvement in the economic resources available to pay benefits. The result also illustrates the credit-basis exposure created when government bonds support liabilities valued using corporate discount rates.

Answer choices explained:

A — Incorrect: An unchanged funded ratio ignores the AA spread’s role in the liability discount rate, even though Treasury yields and asset prices remain unchanged.

B — Correct: The discount yield rises by 0.005, reducing liability value by 6% to $188 million; unchanged assets of $210 million produce a 111.7% funded ratio.

C — Incorrect: This estimate reverses the effect of the spread widening, increasing liability value to $212 million rather than reducing it.

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Question 6

For this question only, the growth portfolio immediately loses 25% of its value, while nominal Treasury holdings and liability value remain unchanged. No contribution is made. What target percentage of post-shock assets should be invested in nominal Treasuries, with the remainder in growth, to eliminate first-order dollar-surplus sensitivity to a parallel Treasury yield shift? Hold expected inflation and the AA spread constant.

• A. 79.4%.
• B. 75.0%.
• C. 71.4%.

Best answer: A

Surplus immunization requires matching asset and liability dollar sensitivities, not simply their percentage durations. After the growth loss, asset value is:

\[ A=126+84(1-0.25)=189. \]

Let \(B\) be the nominal Treasury holding in USD millions. Because growth has zero modeled yield duration and the AA spread is unchanged, matching dollar duration requires:

\[ 16B=200(12),\qquad B=150. \]

The required bond weight is therefore:

\[ w_B=\frac{150}{189}=79.4\%. \]

The underfunded position requires an asset duration greater than liability duration to produce the same dollar sensitivity. This hedge addresses only parallel nominal rate changes under the stated assumptions. It does not match individual benefit payments or remove inflation and credit-basis exposures.

Answer choices explained:

A — Correct: Post-shock assets equal $189 million. Matching liability dollar duration requires $150 million in bonds, giving a target weight of approximately 79.4%.

B — Incorrect: Dividing liability duration by bond duration matches percentage durations but ignores that post-shock assets are smaller than liabilities.

C — Incorrect: This percentage divides the required $150 million bond holding by the pre-shock asset value of $210 million, rather than the remaining $189 million.

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Question 7

Using the baseline asset values and risk assumptions, the one-year standard deviation of the change in dollar surplus is closest to:

• A. $26.4 million.
• B. $21.0 million.
• C. $16.1 million.

Best answer: C

Dollar-surplus risk depends on both sides of the balance sheet and their covariance. Let \(A\) and \(L\) denote starting asset and liability values, \(\sigma_A\) and \(\sigma_L\) their return volatilities, and \(\rho\) their return correlation. Then:

\[ \sigma_{\Delta S}=\sqrt{(A\sigma_A)^2+(L\sigma_L)^2-2AL\sigma_A\sigma_L\rho}. \]

Asset dollar volatility is $21 million and liability dollar volatility is $16 million. Therefore:

\[ \sigma_{\Delta S}=\sqrt{21^2+16^2-2(0.65)(21)(16)}=\sqrt{260.2}\approx16.1. \]

Positive covariance reduces surplus volatility because asset and liability changes partially offset. Nevertheless, this volatility is substantial relative to the $10 million initial surplus and $4 million maximum contribution. The sponsor’s limited support reinforces the importance of liability-relative risk rather than asset volatility alone.

Answer choices explained:

A — Incorrect: This estimate combines asset and liability variances but assumes zero correlation, omitting the risk reduction from their positive covariance.

B — Incorrect: This is asset dollar volatility alone, calculated as 10% of $210 million; it omits liability volatility and asset–liability covariance.

C — Correct: Combining asset and liability dollar volatilities with their 0.65 correlation gives surplus variance of 260.2 million-squared and standard deviation of approximately $16.1 million.

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Question 8

For the baseline strategic policy, the trustees will scale the bond sleeve to match liability nominal dollar duration and retain the remaining assets in growth. Which bond-sleeve composition best neutralizes first-order dollar-surplus exposure to a change in expected inflation, with nominal Treasury yields and the AA spread unchanged?

• A. 0% nominal Treasuries and 100% CPI-linked Treasuries.
• B. 100% nominal Treasuries and 0% CPI-linked Treasuries.
• C. 60% nominal Treasuries and 40% CPI-linked Treasuries.

Best answer: C

The indexed component accounts for 40% of liability value and, because both liability components share the same duration, 40% of liability dollar duration. At unchanged nominal yields, higher expected inflation lowers real yields. CPI-linked Treasury values rise, offsetting the higher projected indexed benefits.

Once the overall bond sleeve matches nominal dollar duration, its inflation-sensitive share should match the liability’s inflation-sensitive share. Both bond portfolios have duration of 16 years, so allocating 40% of the sleeve to CPI-linked Treasuries and 60% to nominal Treasuries achieves this first-order balance.

This design addresses the mixed nominal and indexed obligations without eliminating growth assets. It is not cash-flow matching or complete immunization: nonparallel curve changes, AA spread movements, growth shocks, and changes in benefit experience remain sources of surplus risk.

Answer choices explained:

A — Incorrect: An entirely indexed bond sleeve overhedges inflation exposure because only 40% of liabilities are indexed; the remaining obligations are fixed nominal payments.

B — Incorrect: Nominal Treasuries can match parallel nominal rate exposure but do not offset the increase in CPI-linked benefit values when expected inflation rises.

C — Correct: The indexed liabilities represent 40% of liability dollar duration. With equal bond durations, a 40% indexed sleeve allocation matches that inflation-sensitive exposure.

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Case 3

Topic: Portfolio Construction

Reviewing a Common Institutional Portfolio

Mira Chen advises six institutional clients. Her firm’s investment committee proposes a common strategic allocation, arguing that institutional scale, professional governance and continuing operations support a shared investment approach. Chen must assess whether the proposal reflects each client’s stakeholders and obligations.

Proposed allocation

The proposal emphasizes long-term total return and measures risk using asset-return volatility. All amounts and stated obligations below are in US dollars.

Client mandates

Defined benefit pension: A closed corporate plan has $4.50 billion of assets and pension liabilities with a present value of $5.00 billion. Its nominal benefit payments extend over several decades, but net benefit outflows are already substantial. The financially constrained sponsor cannot materially increase contributions during the next three years. In an instantaneous interest-rate stress test, before any cash flows, asset values increase by 4% and the present value of liabilities increases by 10%.

Sovereign fund: A $10.00 billion fiscal stabilization fund serves taxpayers by financing government spending when resource revenues decline. Its charter has no termination date. Government revenues tend to decline during global equity downturns. Under the specified 12-month stress scenario, the fund must transfer $3.50 billion to the treasury. It cannot borrow or receive additional government contributions during that scenario.

University endowment: A $2.00 billion endowment supports scholarships for current and future students in perpetuity. Next year’s spending is 5% of the preceding three-year average market value, which is $2.40 billion. An additional $160 million of private-market capital calls must be funded during the next 12 months. The university cannot replace these distributions from its operating budget.

Foundation: A $600 million foundation supports community health programs. Its charter requires it to distribute all remaining assets by the end of year six. Legally committed grants of $120 million are payable during the next 12 months, with additional grants scheduled thereafter. It has no private-market capital calls. Assume both the foundation and endowment are exempt from tax on investment income.

Bank: An $8.00 billion treasury portfolio forms part of a deposit-taking bank’s balance sheet. Deposits are payable on demand, and concentrated corporate depositors can generate substantial withdrawals within days. The bank has no dependable minimum deposit balance for investment planning. Shareholders seek profitability, while depositors and supervisors require liquidity and solvency.

Insurer: A $6.00 billion portfolio supports a closed book of non-surrenderable nominal annuities. Benefit payments are predictable and extend over 20 years; liability duration is approximately 11 years. Policyholders depend on payment of contractual benefits, while shareholders bear residual investment and solvency risk. Both the bank and insurer must comply with their applicable regulatory capital requirements.

Review assumptions

For the sovereign fund, endowment and foundation, the committee requires eligible liquid assets to cover the stated next-12-month outflows without selling equities or private assets. Only the short-term government-bond allocation qualifies. Value it at its current market value, assume no haircut, and exclude borrowing, new gifts, investment distributions and other inflows.

For the bank-insurer duration comparison, consider nominal government bonds in the liability currency, without derivatives. Both short- and long-duration alternatives satisfy the applicable investment eligibility requirements; the comparison concerns alignment with the stated liabilities.

Question 9

In the instantaneous stress test, the change in the DB pension’s funded ratio is closest to:

• A. An increase of 3.6 percentage points.
• B. A decrease of 4.9 percentage points.
• C. A decrease of 5.5 percentage points.

Best answer: B

A pension’s funded ratio compares assets with the present value of promised benefits. A positive asset return need not improve its ability to meet those benefits. Let \(F\) denote the funded ratio.

\[ F_0=\frac{4.50}{5.00}=90.00\%, \qquad F_1=\frac{4.50(1.04)}{5.00(1.10)}=85.09\%. \]

The change is approximately negative 4.91 percentage points. The proportional decline is a different measure, approximately 5.45%. This deterioration matters particularly because the plan is closed, already making substantial net benefit payments, and cannot readily obtain additional sponsor contributions. Asset-return volatility alone therefore does not capture the risk most relevant to participants and the sponsor; liability-relative funding outcomes are essential.

Answer choices explained:

A — Incorrect: A 3.6-percentage-point increase results from recognizing the asset gain while incorrectly holding liabilities constant at $5.00 billion.

B — Correct: The funded ratio falls from 90.00% to approximately 85.09% because liabilities increase faster than assets, producing a 4.91-percentage-point decline.

C — Incorrect: Approximately 5.5% is the proportional decline in the funded ratio, not its percentage-point change: \(1.04/1.10-1=-5.45\%\).

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Question 10

Among the sovereign fund, endowment and foundation, which client fails the committee’s 12-month liquidity test under the proposed allocation?

• A. The sovereign fund.
• B. The foundation.
• C. The university endowment.

Best answer: A

Liquidity adequacy depends on the amount and timing of obligations, not simply the institution’s stated life. Under the proposed allocation, eligible liquid assets equal 20% of each portfolio.

The sovereign fund has $2.00 billion available against a $3.50 billion stressed withdrawal. The endowment has $400 million available against spending of $120 million and capital calls of $160 million, totaling $280 million. The foundation has $120 million available against $120 million of grants.

Only the sovereign fund fails. Its indefinite charter does not eliminate near-term fiscal demands. Moreover, withdrawals arise when resource revenues and equity markets weaken together, making reliance on equity sales particularly problematic. The shared allocation overlooks this connection between funding demands and market conditions.

Answer choices explained:

A — Correct: Its $2.00 billion government-bond allocation falls $1.50 billion short of the required $3.50 billion treasury transfer.

B — Incorrect: Its $120 million government-bond allocation exactly covers the $120 million of grants due during the test period.

C — Incorrect: Eligible bonds total $400 million, exceeding $120 million of spending plus $160 million of capital calls.

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Question 11

Which paired return-objective recommendation is most consistent with the endowment’s and foundation’s mandates?

• A. Endowment: preserve real capital after spending. Foundation: fund scheduled grants and planned exhaustion of assets.
• B. Endowment: preserve real capital after spending. Foundation: preserve real capital after grants.
• C. Endowment: fund current spending through planned principal depletion. Foundation: fund scheduled grants and planned exhaustion of assets.

Best answer: A

An endowment’s perpetual purpose creates an intergenerational objective: support current beneficiaries while maintaining the purchasing power available to future beneficiaries. Its return objective should therefore account for spending and inflation, rather than treating distributions as permission for planned depletion. Spending smoothing changes annual cash requirements but does not remove this long-term objective.

The foundation has a different purpose and horizon. Its grant commitments and mandatory termination require an investment policy designed around scheduled payments and eventual asset exhaustion. Consuming principal is part of fulfilling that mandate, not necessarily an investment failure. Their common tax exemption and charitable purposes do not justify identical return objectives or asset allocations. The identity of beneficiaries, timing of distributions and governing charter remain decisive.

Answer choices explained:

A — Correct: The endowment serves successive generations indefinitely, whereas the foundation’s finite charter requires grant funding and eventual distribution of its remaining principal.

B — Incorrect: Real-capital preservation fits the endowment, but imposing it on the foundation conflicts with the foundation’s mandated spend-down.

C — Incorrect: Planned principal depletion fits the foundation’s finite mandate, but it undermines the endowment’s obligation to support future as well as current students.

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Question 12

Which government-bond duration positioning best aligns the bank’s and insurer’s assets with their stated liabilities?

• A. Bank: favor short duration. Insurer: favor long duration.
• B. Bank: favor long duration. Insurer: favor long duration.
• C. Bank: favor short duration. Insurer: favor short duration.

Best answer: A

A continuing institution does not necessarily have long-duration funding. The bank’s deposits are payable on demand, and no dependable deposit floor supports treating them as stable long-term financing. Short-duration government bonds reduce exposure to adverse price changes when securities must be sold to meet withdrawals.

The insurer’s non-surrenderable annuities create a different liability profile. Predictable nominal payments and an approximately 11-year liability duration support longer-duration nominal bonds and cash flows aligned with benefit payments. Although these bonds can have greater standalone price volatility, they can reduce liability-relative interest-rate risk. Both institutions must also respect regulatory capital requirements. Their scale, professional management and continuing operations do not justify ignoring their different funding structures or adopting a common asset-risk budget.

Answer choices explained:

A — Correct: The bank needs assets suited to short-notice withdrawals, while longer-duration nominal bonds better align with the insurer’s predictable, long-dated annuity obligations.

B — Incorrect: Long duration fits the insurer’s obligations, but exposes the bank to greater price sensitivity when concentrated depositors may require immediate cash.

C — Incorrect: Short duration addresses the bank’s withdrawal exposure, but leaves the insurer’s long-duration nominal annuities exposed to substantial asset-liability interest-rate mismatch.

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Case 4

Topic: Portfolio Construction

Bellweather Endowment’s Downside-Risk Review

Mara Chen, CFA, manages Bellweather Endowment’s $200 million portfolio. The investment committee wants to reduce losses associated with its long-equity allocation while preserving resources for annual spending.

Portfolio and Spending

The current portfolio holds 70% in global equities, 20% in high-quality nominal government bonds, and 10% in cash. The government bonds have approximately eight years of modified duration and negligible credit risk. All exposures are measured in US dollars, with foreign-currency exposure hedged.

Annual spending is $10 million, payable at year-end. Existing cash reserves cover this payment. The committee evaluates investment losses before spending and permits reallocations from equities while leaving existing government bonds and cash unchanged.

Conditional Return Evidence

The investment team develops the following one-year stress assumptions. Returns include income and are net of investment costs. Each alternative’s return is measured on a fully funded allocation. Cash earns zero.

The inflation scenario involves sustained price pressures and rising nominal yields. The recession scenario involves weakening demand, falling inflation, and declining government-bond yields. Trend-following returns assume that signals adjust as persistent market trends develop; they do not represent protection from the first day of a shock.

The risk model estimates the equity–government bond correlation at -0.10 over the full sample, +0.60 in the inflation regime, and -0.50 in the recession regime. In the inflation regime, annualized equity volatility is 25% and government-bond volatility is 12%. Cash has zero volatility.

Alternative Investment Characteristics

• Trend-following: Uses liquid equity-index and government-bond futures, among other markets. Positions can be long or short and change at scheduled signal updates. Daily redemption is available.
• Defensive hedge fund: Maintains low net equity exposure and purchases listed equity put options. It does not finance returns by selling volatility or taking leveraged credit exposure. Daily redemption is available.
• Private property: Owns debt-financed commercial buildings with rents generally fixed for several years. Tenant income is economically sensitive, and some borrowing must be refinanced within two years.
• Private credit: Holds floating-rate senior secured loans to leveraged, cyclical businesses. Rising reference rates increase contractual coupons but also borrowers’ debt-service burdens.

Property and private credit have five-year lockups and quarterly manager-valued NAVs. Their reported equity betas, estimated against contemporaneous quarterly equity returns, are 0.18 and 0.09, respectively. The committee’s preliminary risk assessment uses these reported betas without an adjustment for valuation smoothing.

Question 13

Under the persistent-inflation stress assumptions, what minimum percentage of total fund assets must Chen transfer from equities to trend-following to limit the portfolio’s investment loss to 14%?

• A. 12.0%
• B. 30.0%
• C. 7.0%

Best answer: A

A funded reallocation changes both sides of the portfolio: it adds the mitigator’s return and removes the return of the asset sold. The original portfolio’s inflation-stress return is:

\[ R_0=0.70(-0.24)+0.20(-0.10)+0.10(0)=-0.188. \]

Let \(x\) denote the fraction of total fund assets transferred from equities to trend-following. The return improvement per unit transferred is \(0.16-(-0.24)=0.40\). Therefore:

\[ -0.188+0.40x\ge-0.14 \quad\Rightarrow\quad x\ge0.12. \]

The required transfer is 12% of total assets, or $24 million. Existing bonds and cash remain unchanged, so the spending reserve is preserved. This result applies to the specified persistent-inflation scenario, not to every possible equity drawdown.

Answer choices explained:

A — Correct: The original loss is 18.8%. Each percentage point transferred improves the stress return by 0.40 percentage points, requiring a 12.0% allocation.

B — Incorrect: Dividing the required 4.8-percentage-point improvement by the trend strategy’s 16% return ignores the avoided loss on the equities being sold.

C — Incorrect: This allocation results from omitting the existing government-bond loss: \((16.8\%-14.0\%)/40.0\%=7.0\%\). The bond allocation contributes an additional 2.0 percentage points of loss.

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Question 14

Using the inflation-regime risk estimates, the annualized volatility of the original, unreallocated portfolio is closest to:

• A. 16.2%
• B. 19.0%
• C. 17.4%

Best answer: B

Diversification depends on covariance in the relevant regime, not merely on a full-sample correlation. With zero cash volatility, portfolio variance depends only on equities and government bonds. Using weights \(w_E=0.70\) and \(w_B=0.20\), volatilities \(\sigma_E=0.25\) and \(\sigma_B=0.12\), and correlation \(\rho_{EB}=0.60\):

\[ \sigma_P=\sqrt{(0.70\times0.25)^2+(0.20\times0.12)^2+2(0.70)(0.20)(0.25)(0.12)(0.60)}\approx19.0\%. \]

The positive covariance increases portfolio risk relative to an estimate based on the negative full-sample correlation. Inflation shocks can depress both equity valuations and nominal-bond prices. Government bonds can nevertheless provide valuable protection in a disinflationary recession, when falling yields support bond prices while equity cash-flow expectations deteriorate.

Answer choices explained:

A — Incorrect: This estimate reverses the conditional correlation’s sign to -0.60, incorrectly treating government bonds as a strong diversifier in the inflation regime.

B — Correct: Using the +0.60 conditional correlation gives variance of 0.036241 and annualized volatility of approximately 19.0%.

C — Incorrect: This estimate uses the full-sample correlation of -0.10 rather than the inflation-regime correlation, understating risk when stocks and bonds become positively correlated.

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Question 15

For a severe growth-and-liquidity shock, which revision to the committee’s assessment of property and private credit is most justified?

• A. Treat them as more equity-sensitive than reported betas suggest because stale NAVs can conceal common growth and funding exposures.
• B. Reduce their assumed equity sensitivity because contractual income and lockups protect their underlying economic values.
• C. Retain their reported equity sensitivities because infrequent pricing affects measured volatility rather than measured covariance.

Best answer: A

Low reported beta is not sufficient evidence of crisis protection when returns are based on infrequent, smoothed valuations. Economic losses may occur alongside equity losses but enter private-asset NAVs gradually, reducing measured contemporaneous co-movement.

Bellweather’s property holdings depend on tenant cash flows and access to refinancing. Its private loans depend on leveraged borrowers’ ability to service debt. Both therefore retain growth, credit, and funding exposures that can worsen during an equity drawdown. Floating-rate coupons reduce private credit’s direct interest-rate duration, but higher debt-service burdens can increase default risk. Senior security affects potential recovery rather than eliminating losses.

The committee should assess economic exposures and stressed realizable values, rather than treating the reported betas or investment lockups as evidence of downside protection.

Answer choices explained:

A — Correct: Quarterly valuations can delay loss recognition, while leveraged borrowers, cyclical tenants, and refinancing needs create economic exposures shared with equities.

B — Incorrect: Lockups restrict investor exits rather than protecting asset values, while tenant distress and borrower defaults can undermine contractual cash flows.

C — Incorrect: Infrequent valuations can distort both volatility and contemporaneous covariance, weakening the reported betas as measures of economic downside exposure.

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Question 16

For this question only, an unexpected five-day inflation-and-liquidity shock causes equities to fall 10% and government bonds to fall 5%. Before its next signal update, trend-following holds long equity futures equal to 40% of NAV and short government-bond futures equal to 60% of NAV; all other exposures have zero return. Assume linear futures profit and loss, zero collateral return, and no trading costs. Full revaluation estimates the defensive hedge fund’s return at +2%.

For an equal-sized allocation, which daily-liquid candidate provides the greatest immediate offset to the endowment’s equity loss?

• A. Defensive hedge fund
• B. Nominal government bonds
• C. Trend-following

Best answer: A

Trend-following is path-dependent: its immediate shock response depends on positions established before the shock, not solely on its ability to adapt to a persistent trend. Here, its return is:

\[ R_T=0.40(-0.10)+(-0.60)(-0.05)=-0.01=-1\%. \]

The short government-bond position helps, but does not fully offset losses on the existing long equity position. Government bonds themselves lose 5%. The defensive hedge fund’s independently estimated +2% return therefore provides the greatest immediate offset among the three candidates.

The one-year trend-following gain in the shared inflation scenario assumes subsequent signal adjustments. It should not be interpreted as immediate crisis insurance. The hedge fund’s put exposure offers a different payoff mechanism, although its effectiveness still depends on the actual positions and shock.

Answer choices explained:

A — Correct: Its estimated +2% return exceeds the government bonds’ -5% return and the trend strategy’s -1% return during the immediate shock.

B — Incorrect: Government bonds lose 5% in this local shock, adding to rather than offsetting the endowment’s equity loss.

C — Incorrect: The short bond position earns 3% of NAV, but the long equity position loses 4%, leaving a net 1% loss before rebalancing.

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Case 5

Topic: Performance Measurement

Alden Asset Management’s Equity Presentation

Maya Ellis, CFA, investment director of Wescott Endowment, is evaluating Alden Asset Management for a US equity mandate. She receives a draft 2025 GIPS Composite Report for Alden’s US Core Equity Composite.

Alden has claimed firm-wide GIPS compliance continuously since January 2014. The composite began on 1 January 2014 and has appeared in Alden’s annual reports since inception. Monthly composite and benchmark returns are available for its entire history.

The excerpts below contain all annual performance and asset rows in the draft; earlier years do not appear elsewhere. Narrative disclosures outside these excerpts have been confirmed complete.

Annual Performance and Assets

Returns are calendar-year total returns in US dollars. Composite returns are gross of investment management fees but after all trading expenses. The benchmark is the Broad US Equity Total Return Index, which includes reinvested dividends and has no investment management fees.

All assets below are year-end amounts in USD millions.

Year-end portfolio counts for 2021–2025 are 4, 5, 6, 8, and 9, respectively. Full-year portfolio counts are four in 2021–2022, five in 2023–2024, and seven in 2025.

Portfolio Dispersion

The report identifies its internal-dispersion measure as the equal-weighted population standard deviation of annual gross returns for portfolios included in the composite throughout the calendar year. However, dispersion is shown as unavailable for every year, with this footnote:

Dispersion is omitted when fewer than ten portfolios were included for the full year.

The seven full-year portfolios’ 2025 gross returns are 7.0%, 8.0%, 9.0%, 10.0%, 11.0%, 12.0%, and 13.0%.

Fees and Risk Figures

The disclosed investment management fee applicable to Wescott is 0.75% annually. For a client-specific illustration, Ellis assumes a hypothetical account earns the composite’s 2025 gross return, has no external cash flows, and pays its management fee once on 31 December, based on year-end assets immediately before that fee. No additional charges apply beyond trading expenses already reflected in the gross return.

The draft correctly presents the required three-year annualized ex post standard deviations for both the composite and benchmark for 2021–2024. For 2025, it reports 3.00% for the composite and 2.50% for the benchmark under the same annualized-risk label. The calculation file identifies these two figures as unannualized standard deviations of the 36 monthly returns from January 2023 through December 2025.

Question 17

What is the minimum annual reporting history Alden must present in its 2025 GIPS Composite Report?

• A. 2014–2025
• B. 2016–2025
• C. 2021–2025

Best answer: B

GIPS reporting initially requires at least five years of compliant performance, or performance since inception when the history is shorter. A firm must then add another year annually until it presents at least ten years. Alden has claimed compliance and reported this composite continuously since 2014, so the initial five-year minimum no longer determines its required presentation length. For the report ending in 2025, the minimum history is 2016–2025. Reporting 2014–2015 as additional history would be permissible and potentially helpful, but those years are not necessary to meet the minimum. The accompanying required annual information must also cover the required reporting history.

Answer choices explained:

A — Incorrect: Presenting all twelve years since inception is permitted, but the minimum required history does not continue expanding beyond ten years.

B — Correct: Alden has progressed beyond the initial five-year presentation requirement and must present at least the most recent ten annual periods.

C — Incorrect: Five years is the initial minimum, not a continuing option for a composite included in compliant reports since 2014.

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Question 18

Which 2025 internal-dispersion presentation is consistent with both GIPS requirements and Alden’s stated calculation method?

• A. Omit dispersion because only seven portfolios were included for the full year.
• B. Report dispersion of 6.0% using the seven full-year portfolios.
• C. Report dispersion of 2.0% using the seven full-year portfolios.

Best answer: C

Internal dispersion describes differences among the annual returns of portfolios within a composite. A measure is required when more than five portfolios were included for the full year. Alden therefore must report dispersion for 2025, using the seven full-year portfolios rather than the nine portfolios present at year-end.

For Alden’s chosen population-standard-deviation method, the mean return is 10.0%. Expressed in percentage points, the deviations are -3, -2, -1, 0, 1, 2, and 3. Their squared values sum to 28, so the population standard deviation is \(\sqrt{28/7}=2.0\) percentage points, reported as 2.0%. This cross-portfolio measure is distinct from the variability of the composite’s monthly returns over time.

Answer choices explained:

A — Incorrect: Dispersion may be omitted when five or fewer portfolios were included for the full year; seven full-year portfolios exceed that threshold.

B — Incorrect: Six percentage points is the highest return minus the lowest return, not the population standard deviation specified in Alden’s methodology.

C — Correct: The seven returns average 10.0%; their squared deviations sum to 28 in percentage-point units, producing a population standard deviation of 2.0%.

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Question 19

Using arithmetic return differences, the hypothetical account’s 2025 net-of-management-fee return relative to the benchmark is closest to:

• A. 50.0 basis points above the benchmark.
• B. 32.5 basis points below the benchmark.
• C. 25.0 basis points below the benchmark.

Best answer: B

A gross-of-fees composite return is not the prospective client’s after-management-fee return. Gross-only reporting can be permissible with the required disclosures, but the client-specific comparison must reflect the applicable fee and its stated assessment base.

For each $100 initially invested, the hypothetical account grows to $110 before the management fee. The fee is 0.75% of $110, or $0.825, leaving $109.175. Equivalently:

\[ R_{\mathrm{net}}=(1+0.10)(1-0.0075)-1=9.175\%. \]

Compared with the benchmark’s 9.50%, the account underperforms by 0.325 percentage points, or 32.5 basis points. Trading expenses must not be deducted again because they are already reflected in the reported gross return. This illustration estimates the prospective account’s return; it is not an actual historical net composite return.

Answer choices explained:

A — Incorrect: This compares the 10.00% gross return with the 9.50% benchmark return without deducting the prospective client’s management fee.

B — Correct: The account earns \((1.10)(1-0.0075)-1=9.175\%\), which is 0.325 percentage points below the benchmark’s 9.50% return.

C — Incorrect: Subtracting 0.75 percentage points directly from the gross return ignores that the fee is charged on the larger year-end pre-fee asset value.

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Question 20

Which correction is required for the draft’s 2025 three-year risk disclosure?

• A. Report annualized standard deviations of 36.00% for the composite and 30.00% for the benchmark.
• B. Retain 3.00% and 2.50%, but relabel them as monthly standard deviations.
• C. Report annualized standard deviations of 10.39% for the composite and 8.66% for the benchmark.

Best answer: C

When the necessary monthly return history exists, the GIPS risk disclosure requires three-year annualized ex post standard deviations for both the composite and its benchmark. The three-year designation identifies the 36-month measurement window; it does not mean that the monthly standard deviation is already annualized.

For monthly observations, annualized standard deviation is calculated as:

\[ \sigma_{\mathrm{annual}}=\sigma_{\mathrm{monthly}}\sqrt{12}. \]

Thus, the composite figure becomes 10.39% and the benchmark figure becomes 8.66%. Multiplication by twelve confuses the scaling of standard deviation with that of variance. The unannualized figures could be shown as supplementary information if clearly labeled, but they cannot replace the required annualized statistics. These time-series risk measures also do not replace internal dispersion across portfolios.

Answer choices explained:

A — Incorrect: Multiplying monthly standard deviations by twelve scales volatility incorrectly; the conventional annualization factor for monthly standard deviation is the square root of twelve.

B — Incorrect: Relabeling would accurately describe the figures, but monthly statistics alone would not satisfy the required three-year annualized ex post risk disclosure.

C — Correct: Annualizing the monthly figures gives \(3.00\%\sqrt{12}=10.39\%\) and \(2.50\%\sqrt{12}=8.66\%\), using the required 36-month observation period.

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Case 6

Topic: Derivatives and Risk Management

Caldera Endowment’s 90-Day Overlay

Leena Rao manages derivatives overlays for the USD-reporting Caldera Endowment. The investment committee wants to reduce selected risks for 90 days while keeping its underlying equity and bond holdings unchanged. All overlays are initiated today and closed or settled on day 90.

Holdings and targets

The US equity beta is measured against the index underlying the available futures contract. The committee targets a beta of 0.85 for this sleeve, including its overlay. It targets a modified duration of 4.5 for the bond sleeve, including its overlay. Both targets use the sleeves’ current market values as their denominators.

For initial sizing, assume stable betas, negligible convexity, and unchanged market values. Ignore taxes and transaction costs.

Available derivative contracts

• Interest rate swap: A ten-year USD swap initiated at par. Each leg’s initial present value equals its notional. The fixed-rate leg has modified duration of 7.5; assume the floating-rate leg has zero duration. A pay-fixed swap pays fixed and receives floating; a receive-fixed swap does the reverse. The swap will be terminated at market value on day 90.
• Equity futures: The index futures price is 6,000, with a multiplier of $50 per index point and a beta of 1.00. A long position gains when the futures price rises; a short position gains when it falls. The contract expires on day 90.
• Currency forward: Spot is $1.1000 per euro, and the day-90 forward rate is $1.1050 per euro. A long euro forward buys euros and sells dollars at maturity; a short euro forward does the reverse.

All contracts have zero initial market value before margin requirements.

Euro exposure

The endowment must pay a €8 million grant on day 90. Its policy is to hedge 75% of the net euro asset exposure after deducting this liability. For currency attribution, value the grant at face value and ignore discounting and investment income.

Liquidity stress

A separate stress forecast for the overlays identifies the following USD cash flows:

Posted margin remains unavailable through day 1. No other cash inflows are available before day 90, and cross-counterparty netting is prohibited. Rao may arrange unsecured cash financing but may not sell or pledge the retained securities or derivative receivables. The endowment may finish day 1 with zero unencumbered cash.

Question 21

Which interest rate swap position should Rao initiate to achieve the bond sleeve’s duration target?

• A. Pay fixed on $72 million notional.
• B. Pay fixed on $32 million notional.
• C. Receive fixed on $32 million notional.

Best answer: B

A pay-fixed, receive-floating swap contributes negative interest rate duration because the fixed-payment obligation has greater rate sensitivity than the floating receipts. The bond sleeve requires a duration reduction of 2.0, measured against its unchanged $120 million value. With equal initial leg values and zero floating-leg duration, the required notional is:

\[ N = \frac{120(6.5-4.5)}{7.5-0} = 32\text{ million dollars}. \]

Equivalently, the overlay must remove $24,000 of DV01. Each $1 million of pay-fixed swap notional removes $750 of DV01. The swap changes rate exposure without requiring a sale of the underlying bonds.

Answer choices explained:

A — Incorrect: This notional offsets the target sensitivity rather than the required change, reducing the sleeve’s effective modified duration to 2.0.

B — Correct: Paying fixed reduces duration. A $32 million notional removes sensitivity equivalent to 2.0 years of duration on the $120 million bond sleeve.

C — Incorrect: Receiving fixed adds interest rate sensitivity, increasing the sleeve’s effective modified duration from 6.5 to 8.5 rather than reducing it.

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Question 22

Which equity futures position should Rao initiate to achieve the US equity sleeve’s beta target?

• A. Sell 175 contracts.
• B. Sell 510 contracts.
• C. Sell 210 contracts.

Best answer: C

An equity futures overlay adjusts the sleeve’s beta exposure while leaving its securities and market-value denominator unchanged. Each contract represents $300,000 of index exposure. The position must offset the difference between current and target beta-adjusted exposures, not the target exposure itself.

\[ n = \frac{(0.85-1.20)\times180{,}000{,}000}{1.00\times6{,}000\times50} = -210. \]

The negative sign indicates a short position. Selling 210 contracts offsets $63 million of index exposure, reducing beta-adjusted exposure from $216 million to $153 million. Dividing the remaining exposure by the $180 million sleeve value gives the target beta of 0.85. Actual hedge effectiveness remains dependent on the assumed stability of beta.

Answer choices explained:

A — Incorrect: This applies the proportional beta reduction directly to portfolio value, understating the required reduction in exposure to the beta-one futures index.

B — Incorrect: This divides the target beta-adjusted exposure of $153 million by contract value, rather than sizing the change from current exposure.

C — Correct: The required reduction in beta-adjusted exposure is $63 million, and each futures contract represents $300,000 of beta-one index exposure.

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Question 23

Assume the euro equities remain worth €80 million and spot falls to $1.0200 per euro on day 90. Relative to today’s net euro position valued at spot, the total USD value change, including the prescribed forward hedge and grant liability, is closest to:

• A. A loss of $1.81 million.
• B. A loss of $1.44 million.
• C. A loss of $1.17 million.

Best answer: C

The euro liability provides a natural hedge, so the initial net currency exposure is €72 million. The policy therefore requires selling €54 million forward, equal to 75% of that exposure. Euro depreciation reduces the USD value of the net assets, but the short euro forward gains because euros can be sold above the terminal spot rate.

\[ \Delta V = 72(1.0200-1.1000)+54(1.1050-1.0200)=-1.17\text{ million dollars}. \]

The initial net USD value is $79.20 million, compared with $78.03 million at maturity after including forward settlement. The result reflects both the remaining 25% unhedged exposure and the difference between the initial spot and contracted forward rates.

Answer choices explained:

A — Incorrect: This applies depreciation to the gross €80 million assets, ignoring the $640,000 reduction in the USD value of the grant liability.

B — Incorrect: This uses today’s spot rate instead of the contracted forward rate, omitting the $270,000 benefit from positive forward points.

C — Correct: The net euro position loses $5.76 million from depreciation, while selling €54 million forward generates a $4.59 million gain.

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Question 24

Under the liquidity stress forecast, what minimum additional USD cash financing must Rao secure to meet all obligations through day 1?

• A. $1 million.
• B. $3 million.
• C. $0 million.

Best answer: B

Derivative overlays modify economic exposure without releasing the cash that a sale of securities would generate. Initial margin also encumbers cash, while adverse futures movements create additional cash demands through variation margin. Funding must therefore be assessed using payment dates rather than eventual net derivative gains.

\[ \text{Additional financing}=2+5+4-8=3\text{ million dollars}. \]

After posting initial margin, only $6 million remains available against $9 million of day-1 obligations. The projected day-90 receipts cannot meet those earlier payments and cannot be pledged. A $3 million financing commitment is sufficient because the endowment is permitted to finish day 1 with no unencumbered cash.

Answer choices explained:

A — Incorrect: This covers variation margin and the USD grant after using current cash, but ignores the $2 million already committed as initial margin.

B — Correct: Cash requirements through day 1 total $11 million, exceeding the $8 million available cash by $3 million.

C — Incorrect: This offsets early cash requirements with $3 million of day-90 receipts, which are unavailable when margin and the grant must be paid.

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Case 7

Topic: Ethical and Professional Standards

Cedar Vale’s Quarter-End Review

Nadia Ross, CFA, leads Cedar Vale Asset Management’s active equity team for Oakmere Endowment. As the next quarter-end rebalance approaches, Cedar Vale reviews the team’s investment research, brokerage arrangements and recent trading. Eli Venn, CFA, is the team’s trader.

Portfolio and research

Oakmere’s investment policy includes the following provisions:

Six months earlier, Ross purchased Lydon Components at 1.5% of total endowment assets. The purchase complied with the investment policy and the portfolio’s risk budget.

Ross used forecasts from an independent research provider. Before using its forecasting system, she completed relevant training, tested sensitivity to key assumptions, and reviewed the provider’s methodology, data quality, timeliness and controls against issuer influence. She corroborated important operating assumptions using company filings but did not independently reproduce every forecast. Her investment memorandum documented the valuation, downside scenarios and portfolio implications.

Lydon subsequently lost a major customer unexpectedly, and its shares declined 25%. The team is now reducing the holding following a documented reassessment.

Broker allocation

Cedar Vale owns Cedar Vale Securities, an approved broker. Oakmere previously received clear written disclosure of this ownership relationship.

Under a newly announced, employer-approved compensation plan, Ross can earn a $30,000 annual award if at least 60% of commissions from her accounts are routed to Cedar Vale Securities. Oakmere has not been told about this personal award. Ross proposes routing most of the upcoming rebalance through the affiliate.

Independent transaction-cost analysis supports equivalent expected execution quality and commissions at Cedar Vale Securities and an approved unaffiliated broker.

Employment transition

Ross has given six weeks’ resignation notice and will remain employed during the upcoming rebalance. She intends to establish an investment firm after leaving. No post-employment noncompete applies, and Cedar Vale has approved no special departure arrangements.

Ross remembers Oakmere’s contact information. She also wants to retain valuation workbooks that she authored during paid working hours using Cedar Vale’s systems. No agreement transfers ownership of those workbooks to her.

Earlier closing-auction trades

The review also examines Venn’s trading at the previous quarter-end. After completing the approved rebalance, Venn made additional purchases in a thinly traded portfolio holding. His internal message stated:

Investment targets are already met. These extra purchases are solely to improve the closing mark shown in Oakmere’s quarterly report. Reverse the extra position tomorrow.

The purchases remained within portfolio limits and raised the closing price. All trades settled normally, and no client loss has been established. Under the case’s hypothetical local law, these genuine purchases are lawful.

Question 25

Which assessment of Ross’s original Lydon purchase decision is most consistent with the Code and Standards?

• A. Her documented review supports reasonable reliance on the external forecasts despite the subsequent investment loss.
• B. A reasonable basis was absent because she did not independently reproduce every forecast supplied by the provider.
• C. The subsequent investment loss establishes insufficient professional competence despite her preparatory training and research review.

Best answer: A

Standard V(A), Diligence and Reasonable Basis, requires an adequately supported investment process, not a guarantee of favorable results. Reliance on external research can be appropriate when the investment professional evaluates its soundness and reliability. Ross reviewed the provider’s methods, inputs, timeliness and independence, tested assumptions, and documented her analysis. Complete duplication of the provider’s work was not required.

Standard I(E), Competence, separately requires knowledge and skills appropriate to professional responsibilities. Her preparation and applied analysis support compliance on the stated facts. The investment also fit Oakmere’s policy and portfolio risk budget. The unexpected customer loss warrants reassessment, which the team performed, but the resulting share-price decline does not itself establish misconduct.

Answer choices explained:

A — Correct: Ross evaluated the provider, tested important assumptions and documented portfolio implications; an unexpected adverse outcome does not invalidate that reasonable process.

B — Incorrect: Standard V(A) permits reliance on third-party research after appropriate evaluation; it does not require independent reproduction of every forecast.

C — Incorrect: Competence is assessed through the knowledge and skills applied to professional responsibilities, not inferred solely from an individual investment’s negative return.

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Question 26

Before routing Oakmere’s rebalance orders, which action is required to address Ross’s conflict of interest?

• A. Disclose the personal award’s amount and routing condition to Oakmere before routing its rebalance orders.
• B. Reconfirm that the affiliate’s expected execution quality and commissions match those of the unaffiliated broker.
• C. Obtain written confirmation from Cedar Vale that the personal award is part of her approved compensation.

Best answer: A

Standard VI(A), Avoid or Disclose Conflicts, requires avoidance or full and fair disclosure of matters reasonably expected to impair independence and objectivity or interfere with duties to clients. Oakmere’s existing disclosure identifies Cedar Vale’s ownership interest, but not Ross’s separate financial incentive to direct commissions to the affiliate.

Before proceeding, Ross must clearly disclose the award’s amount and routing condition so Oakmere can understand the actual conflict. Employer authorization does not substitute for client disclosure. Nor does equivalent expected execution remove the incentive: the conflict exists even without demonstrated client harm. Disclosure addresses the conflict obligation but does not replace Ross’s continuing responsibility to seek best execution and act in Oakmere’s interests.

Answer choices explained:

A — Correct: The award creates a personal incentive beyond affiliate ownership; Oakmere needs timely, full and fair disclosure of its amount and condition.

B — Incorrect: Equivalent expected execution addresses an important client duty but does not eliminate or disclose Ross’s personal financial incentive.

C — Incorrect: The employer already approved the award. Its approval does not inform Oakmere about the personal incentive affecting Ross’s brokerage decisions.

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Question 27

During Ross’s notice period, which proposed action is most consistent with her duty to Cedar Vale?

• A. Copy the valuation workbooks she authored, deleting all client identifiers before her notice period ends.
• B. Register her new firm’s business name using personal funds outside Cedar Vale’s working hours.
• C. Invite Oakmere, using remembered contact information, to transfer its account after her notice period ends.

Best answer: B

Standard IV(A), Loyalty, distinguishes permissible preparation to leave an employer from competing against that employer while still employed. Registering a future firm’s business name using personal time and funds is administrative preparation, not the provision of competing investment services.

Ross remains an employee throughout her notice period. Inviting Oakmere to transfer would therefore be predeparture solicitation, even if she remembers the contact information and proposes a later transfer date. The absence of a post-employment noncompete does not authorize solicitation during employment. Similarly, authorship does not confer ownership of workbooks created for Cedar Vale using its time and systems. Removing client information may address a confidentiality concern, but it does not resolve the separate employer-property obligation.

Answer choices explained:

A — Incorrect: Workbooks produced during her employment are Cedar Vale’s work product; removing client identifiers does not give Ross permission to take copies.

B — Correct: Administrative preparation for future competition is generally permissible when it does not involve competing services, client solicitation or misuse of employer resources.

C — Incorrect: Soliciting Oakmere while still employed competes with Cedar Vale; using memory and scheduling the transfer after departure do not change the solicitation’s timing.

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Question 28

Which assessment of Venn’s additional closing-auction purchases is most accurate?

• A. The trades implicate only the Code’s broad market-integrity principles because genuine purchases are lawful in the jurisdiction.
• B. The trades comply with the Code and Standards because genuine purchases within portfolio limits cannot constitute market manipulation.
• C. The trades violate a specific Standard because their purpose is to mislead through the reported closing price.

Best answer: C

The Code expresses broad commitments to integrity and the integrity of capital markets. Standard II(B), Market Manipulation, supplies a specific prohibition against practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

Venn’s message establishes that the additional purchases had no investment or rebalancing purpose: they were intended to raise the closing mark and improve Oakmere’s reported results. The purchases actually raised the closing price. Normal settlement, compliance with portfolio limits and the absence of established client loss do not make the conduct acceptable. When applicable law is less restrictive than the Code and Standards, members and candidates must follow the stricter requirement.

Answer choices explained:

A — Incorrect: Standard II(B) specifically addresses manipulative trading, and compliance with a less restrictive local law does not excuse violating that Standard.

B — Incorrect: Genuine purchases can manipulate prices when undertaken to mislead; portfolio limits do not authorize deliberately distorting a reporting-date price.

C — Correct: Venn deliberately raised the closing mark to improve reported results, constituting transaction-based market manipulation despite lawful settlement and no established client loss.

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Case 8

Topic: Portfolio Management Pathway

Riverton Manufacturing Pension Review

Maya Chen advises Riverton Manufacturing’s closed defined-benefit pension plan. The trustees’ primary objective is to limit variability in the dollar contribution needed to eliminate any funding shortfall, rather than maximize asset returns in isolation. No new benefits accrue.

All monetary amounts are in USD millions. The trustees measure economic funded status using a default-free nominal spot curve, currently flat at 4.00% with annual compounding. This is an economic valuation convention, not a statutory funding rule.

Projected benefit payments

For hedge analysis, the actuary represents remaining benefits as two payments. The year-5 payment is fixed. The year-15 payment is linked to cumulative CPI; its projection assumes annual inflation of 2.00%.

Actual CPI determines the indexed payment. Unless a question states otherwise, rate scenarios hold projected inflation and nominal benefit amounts unchanged. No benefits are paid before year 5.

Current portfolio measures

Current assets consist of nominal zero-coupon government securities maturing in years 4, 10, and 20.

Duration and conventional price convexity measure sensitivity to parallel changes in annually compounded nominal spot rates. Use these aggregate measures for rate-shock estimates; displayed cash flows are rounded. All rate shocks occur immediately, before any cash flows.

Proposed interest-rate overlay

Chen proposes an overlay whose design requires total asset dollar duration to equal total liability dollar duration while leaving current asset market value unchanged. Interest-rate swaps with zero initial market value are permitted. Ignore transaction costs, counterparty risk, and collateral effects.

The risk team supplies the following distribution of dollar duration after the proposed overlay. The percentages are shares of each side’s aggregate dollar duration in a two-node key-rate model.

Question 29

For this question only, over the next year assets earn a total return of 4.00%, while the present value of liabilities increases by 6.00%. There are no external cash flows. Which change best describes performance relative to the trustees’ primary objective?

• A. A $36.0 million deterioration in dollar surplus.
• B. A $14.4 million deterioration in dollar surplus.
• C. A $21.6 million improvement in dollar surplus.

Best answer: B

Liability-driven performance must reflect changes in obligations as well as asset returns. The trustees are concerned with the dollar funding shortfall, so positive asset performance alone does not establish success.

Initially, assets of $540 million support liabilities of $600 million, producing a $60 million deficit and a 90.00% funded ratio. After the stated changes:

\[ A_1=540(1.04)=561.6,\qquad L_1=600(1.06)=636.0. \]

The ending deficit is $74.4 million, a deterioration of $14.4 million. The funded ratio also declines, to approximately 88.30%. With no external cash flows, the entire deterioration results from liabilities increasing more than assets. Asset-return reporting therefore needs to be supplemented by liability-relative measures.

Answer choices explained:

A — Incorrect: The $36.0 million liability increase ignores the offsetting $21.6 million asset gain, overstating the deterioration in the plan’s funding position.

B — Correct: Assets increase by $21.6 million and liabilities by $36.0 million, so the dollar funding shortfall increases by $14.4 million.

C — Incorrect: The $21.6 million asset gain measures standalone asset performance; liabilities increase by a larger amount, causing the dollar funding shortfall to worsen.

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Question 30

To satisfy the proposed overlay’s aggregate interest-rate condition, the total asset portfolio’s modified duration must be closest to:

• A. 11.75 years.
• B. 10.58 years.
• C. 9.52 years.

Best answer: A

A first-order hedge of dollar surplus against a parallel rate shift requires equal asset and liability dollar durations, not equal modified durations. Let \(A\) and \(L\) denote current asset and liability values, and let \(D_A\) and \(D_L\) denote their modified durations. The required condition is \(AD_A=LD_L\).

\[ D_A^*=\frac{L}{A}D_L=\frac{600}{540}(10.5769)=11.7521\text{ years}. \]

Because the plan is underfunded, each dollar of assets must carry more rate sensitivity than each dollar of liabilities. Equal modified durations would approximately stabilize the funded ratio under a small parallel shift, but would not stabilize dollar surplus: identical percentage changes apply to different starting values. The calculated target addresses first-order parallel sensitivity only. It does not establish cash-flow matching or hedge changes in the inflation-linked benefit amount.

Answer choices explained:

A — Correct: Matching dollar durations requires asset duration of \((600/540)\times10.5769=11.7521\) years because asset value is below liability present value.

B — Incorrect: Equal modified durations create equal percentage sensitivities, but liabilities have a larger present value and therefore greater dollar sensitivity than current assets.

C — Incorrect: This reverses the funding adjustment by multiplying liability duration by assets divided by liabilities, further reducing the underfunded asset portfolio’s dollar duration.

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Question 31

For the current asset portfolio, before the proposed overlay, the nominal spot curve shifts down by 100 bp in parallel. Using the second-order duration-convexity approximation, the estimated post-shock funding position is closest to:

• A. A deficit of $60.28 million.
• B. A deficit of $66.62 million.
• C. A deficit of $66.35 million.

Best answer: B

For a value \(V\), modified duration \(D\), convexity \(C\), and decimal yield change \(\Delta y\), the second-order approximation is:

\[ \Delta V\approx V\left[-D\Delta y+\frac{1}{2}C(\Delta y)^2\right]. \]

Here, \(\Delta y=-0.01\). Applying the approximation separately gives:

\[ \begin{aligned}\Delta A&\approx540[10.5769(0.01)+0.5(150)(0.01)^2]=61.165,\\\Delta L&\approx600[10.5769(0.01)+0.5(144.2308)(0.01)^2]=67.788.\end{aligned} \]

The initial surplus is negative $60 million. After the shock, estimated surplus is \(-60+61.165-67.788=-66.623\) million. Despite equal modified durations, liabilities have greater dollar duration because their present value is larger. Liabilities also have greater dollar convexity, despite their lower convexity per dollar. Both effects worsen dollar surplus when rates decline. The calculation holds the projected CPI-linked payment unchanged.

Answer choices explained:

A — Incorrect: This retains only the convexity mismatch, incorrectly canceling duration effects even though asset and liability values differ by $60 million.

B — Correct: Assets gain approximately $61.165 million while liabilities increase by $67.788 million, expanding the initial $60 million deficit to approximately $66.62 million.

C — Incorrect: This is the first-order estimate, which omits the additional $0.277 million surplus loss attributable to the dollar-convexity mismatch.

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Question 32

Assume the proposed overlay is implemented. In the two-node model, the 5-year spot rate rises by 50 bp and the 15-year spot rate falls by 50 bp. Holding projected CPI unchanged and ignoring convexity, what most likely happens to the plan’s dollar surplus?

• A. Dollar surplus decreases.
• B. Dollar surplus increases.
• C. Dollar surplus remains unchanged.

Best answer: A

Matching aggregate dollar duration does not match sensitivity to changes in yield-curve shape. The proposed assets place 75% of their dollar duration at the 5-year node, compared with only 18.18% for liabilities. At the 15-year node, liabilities have the larger exposure.

With equal aggregate dollar durations and equal but opposite rate changes, the assets experience a net loss: most asset sensitivity is exposed to the rising 5-year rate. Liabilities experience a net gain because most liability sensitivity is exposed to the falling 15-year rate. Lower assets and higher liabilities both reduce dollar surplus.

The overlay therefore leaves material nonparallel rate risk. Matching key-rate dollar durations would address this first-order curve-shape mismatch. Separately, the CPI-linked benefit remains exposed to changes in projected inflation; the stated nominal-rate hedge assumes that projected payment is unchanged.

Answer choices explained:

A — Correct: Assets concentrate sensitivity at the rising 5-year rate, while liabilities concentrate sensitivity at the falling 15-year rate, reducing asset value and increasing liability value.

B — Incorrect: The larger liability exposure to falling 15-year rates increases liability value, while assets lose value overall; both effects reduce rather than increase surplus.

C — Incorrect: Aggregate dollar-duration matching offsets a parallel shift, but the unequal distribution across the two key-rate nodes leaves exposure to this curve twist.

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Case 9

Topic: Portfolio Management Pathway

Riverton Government-Bond Mandate

Mara Ivers manages a $200 million US Treasury sleeve for Riverton Asset Management. The mandate permits active yield-curve positions but requires aggregate effective duration to match the benchmark. Treasury futures may be used to adjust exposures.

Current Rate Exposures

The benchmark reference portfolio is scaled to the same initial market value as the sleeve. Key-rate durations are normalized by each portfolio’s current market value. The risk model uses annual-effective spot yields, with three key-rate nodes spanning all modeled interest-rate exposure.

The reported convexities measure sensitivity to parallel shifts. Node-specific and cross-node convexities are not available.

Strategist’s Forecast

The strategist forecasts the following instantaneous changes:

All analysis excludes coupon accrual, carry, rolldown, fees, and transaction costs. Other valuation inputs remain unchanged. Active price return is defined as the sleeve’s percentage price change minus the benchmark’s percentage price change, each measured against its initial market value. Use first-order approximations unless a question explicitly requests convexity.

Any proposed futures overlay has zero initial market value, leaves the benchmark unchanged, and has key-rate-duration changes normalized by the sleeve’s unchanged initial $200 million market value.

Question 33

Under the strategist’s forecast, the first-order change in the sleeve’s value minus the first-order change in the benchmark’s value is closest to:

• A. -$700,000
• B. $0
• C. +$700,000

Best answer: C

Key-rate durations measure first-order price sensitivity at individual curve nodes. Let \(D_{P,i}\) and \(D_{B,i}\) denote sleeve and benchmark key-rate durations, and let \(\Delta y_i\) denote yield changes in decimal form. With equal initial market values \(V_0\), the value difference is:

\[ \Delta V_P-\Delta V_B \approx -V_0\sum_i(D_{P,i}-D_{B,i})\Delta y_i. \]

The active key-rate durations are -0.50, +1.00, and -0.50 years. Therefore:

\[ r_P-r_B\approx-[(-0.50)(0.0020)+(1.00)(-0.0010)+(-0.50)(0.0030)]=0.0035. \]

The 0.35% active price return represents $700,000 on $200 million. Both portfolios decline: the sleeve returns approximately -0.81%, versus -1.16% for the benchmark. Aggregate duration neutrality does not eliminate the effect of differently distributed exposures.

Answer choices explained:

A — Incorrect: Reversing the active-duration signs produces -$700,000. The sleeve’s forecast loss is actually $700,000 smaller than the benchmark’s loss.

B — Incorrect: Equal aggregate durations neutralize first-order relative sensitivity to parallel shifts, not to the strategist’s nonparallel yield changes.

C — Correct: The sleeve loses approximately $1.62 million, while the benchmark loses $2.32 million, producing a positive $700,000 difference.

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Question 34

For this question only, replace the strategist’s forecast with one of the following stress vectors. Which vector produces the greatest first-order benchmark-relative loss? Vectors list yield changes at the two-, five-, and ten-year nodes, respectively.

• A. \((+40,\ +40,\ +40)\) bps
• B. \((-40,\ 0,\ +40)\) bps
• C. \((-20,\ +40,\ -20)\) bps

Best answer: C

Duration matching addresses parallel yield-level risk but can leave substantial curvature risk. Riverton has positive active duration at five years and negative active duration at both endpoints. It therefore underperforms when the belly yield rises while endpoint yields fall.

For the adverse curvature stress:

\[ r_P-r_B\approx-[(-0.50)(-0.0020)+(1.00)(0.0040)+(-0.50)(-0.0020)]=-0.0060. \]

This is a 0.60% relative loss, equivalent to $1.2 million. The parallel stress has zero first-order active effect because active durations sum to zero. The specified endpoint steepening also has zero active effect because equal endpoint exposures face equal-and-opposite yield changes. That cancellation does not imply neutrality to every possible steepening; unequal endpoint changes or movements at five years could produce a different result.

Answer choices explained:

A — Incorrect: The parallel rise produces no first-order active return because the sleeve and benchmark have identical total effective durations.

B — Incorrect: The equal negative active durations at the two endpoints offset under these equal-and-opposite shocks; the resulting first-order active return is zero.

C — Correct: Rising five-year yields hurt the active duration overweight, while falling endpoint yields hurt the active underweights, generating a 0.60% relative loss.

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Question 35

Starting from the current positions, Ivers wants to eliminate active two-year exposure, retain the existing active five-year exposure, and remain duration-matched. Which feasible futures-overlay change vector achieves these objectives? Vectors list changes in sleeve key-rate durations at two, five, and ten years, respectively.

• A. \((+0.50,\ 0.00,\ -0.50)\) years
• B. \((-0.50,\ 0.00,\ +0.50)\) years
• C. \((+0.50,\ -0.50,\ 0.00)\) years

Best answer: A

The overlay must be designed against active exposures, rather than absolute sleeve durations. Current two-year active duration is \(0.30-0.80=-0.50\) year, so eliminating that exposure requires adding 0.50 year. Retaining five-year active exposure requires no change at that node. Maintaining total duration then requires removing 0.50 year at ten years.

The resulting sleeve key-rate durations are 0.80, 2.40, and 2.80 years, which still sum to 6.00 years. Relative to the unchanged benchmark, active durations become 0.00, +1.00, and -1.00 years. The trade reallocates the curve position toward five-year versus ten-year exposure; it does not eliminate all active interest-rate risk. Zero initial market value does not mean a futures overlay has zero rate sensitivity.

Answer choices explained:

A — Correct: Adding 0.50 year at two years eliminates the active underweight; removing the same amount at ten years preserves total duration and five-year exposure.

B — Incorrect: This deepens the two-year active underweight from -0.50 to -1.00 year rather than eliminating it, although aggregate duration remains matched.

C — Incorrect: Two-year active exposure becomes zero, but five-year active duration falls from +1.00 to +0.50 year, contrary to Ivers’s objective.

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Question 36

For this question only, assume an instantaneous parallel increase of 100 bps from the current yield curve, with no overlay executed. Using duration and the supplied convexities, the sleeve’s approximate active price return is closest to:

• A. -0.16%
• B. 0.00%
• C. -0.08%

Best answer: C

For a parallel shift, the second-order price-return approximation is:

\[ r\approx-D\Delta y+\tfrac{1}{2}C(\Delta y)^2, \]

where \(D\) is effective duration, \(C\) is parallel-shift convexity, and \(\Delta y\) is the decimal yield change. Both portfolios have duration of 6.00 years, so their first-order effects cancel in active return. Active convexity is \(54-70=-16\) years squared:

\[ r_P-r_B\approx\tfrac{1}{2}(-16)(0.01)^2=-0.0008=-0.08\%. \]

The sleeve’s approximate return is -5.73%, compared with -5.65% for the benchmark. Its lower convexity provides less positive second-order price support. The supplied parallel convexities support this calculation, but not a complete second-order analysis of a nonparallel shock. The total-duration effect must not be added again to the equivalent summed key-rate-duration effect.

Answer choices explained:

A — Incorrect: This result omits the one-half coefficient in the convexity adjustment, doubling the magnitude of the second-order relative loss.

B — Incorrect: Matching durations cancels the first-order active effect, but it does not cancel the second-order effect of the different convexities.

C — Correct: The active convexity contribution is \(\tfrac{1}{2}(54-70)(0.01)^2=-0.0008\), equivalent to an active return of -0.08%.

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Case 10

Topic: Portfolio Management Pathway

Calder Research Foundation: Investment Committee Review

Calder Research Foundation supports scientific research through a perpetual endowment. Its investment committee is reviewing the coming fiscal year’s spending, strategic allocation, and liquidity under a market stress scenario.

Spending and operating dependence

For fiscal 2028, running from 1 July 2027 through 30 June 2028, the endowment distribution equals 4.5% of the arithmetic average of the three preceding 30 June fair values. Those values are:

The downside case changes only the latest valuation. All policy distributions are eligible to support the foundation’s research operating budget.

The approved fiscal 2028 operating budget is $75 million, including anticipated inflation. Revenue other than endowment distributions and gifts is $45 million in both cases. Unrestricted operating gifts are expected to be $7.5 million in the base case but only $2.5 million in the downside case. Downside gifts arrive in the final month of fiscal 2028. No automatic supplemental endowment appropriation covers an operating shortfall.

Portfolio and near-term commitments

The committee’s portfolio exhibit shows values immediately before fiscal 2028:

During the first 90 days of fiscal 2028, binding private-investment capital calls total $38 million, and previously authorized operating transfers total $9 million. Private assets cannot be monetized during this window.

For the downside liquidity test:

• Cash and bonds are unencumbered and eligible to fund these obligations.
• Selling the entire bond position produces cash equal to 95% of its downside fair value, net of execution costs. Proceeds are available before scheduled payments.
• Public equities can be sold to generate additional net cash proceeds.
• No other endowment cash inflows or outflows occur during the window, and no operating-account support is available.
• Unrestricted cash must be at least $5 million at the end of the window.

Separately, the foundation holds an $8 million building reserve outside the endowment. Its donor agreement restricts its use exclusively to construction expenditures.

Strategic planning assumptions

For strategic allocation comparisons only, the committee uses a normalized, deterministic planning year. Spending equals 4.5% of opening capital rather than the trailing-average amount. Investment fees equal 0.5% of opening capital, and both spending and fees are paid at year-end. Inflation is 2.5%. There are no gifts, taxes, or other flows in this model.

The objective is to preserve opening capital’s purchasing power after spending and fees. Revised strategic allocations must also hold at least 20% in cash and high-quality bonds. Each proposal’s remaining assets are diversified among the growth asset classes in the exhibit; all other allocation requirements are satisfied.

Decision rights and a proposed distribution

The full board approves annual endowment appropriations and any spending exceptions. The investment committee selects managers and trades investments within approved allocation ranges. The CFO administers payments within approved appropriations.

The chair proposes an additional $3 million operating distribution, beyond the formula appropriation, financed by selling public equities held in a board-designated, donor-unrestricted portion of the endowment. The operating budget has been approved, but the full board has not approved this additional distribution.

Question 37

Under the downside case, the projected fiscal 2028 operating funding shortfall after the policy distribution and expected gifts is closest to:

• A. $5.0 million
• B. $6.5 million
• C. $9.5 million

Best answer: B

A trailing-average spending rule cushions the immediate effect of a market decline but does not eliminate operating vulnerability. Using amounts in millions of dollars, the downside distribution is:

\[ \text{Distribution} = 0.045 \times \frac{480 + 520 + 400}{3} = 21.0 \]

The operating funding gap is therefore:

\[ \text{Funding gap} = 75 - 45 - 2.5 - 21 = 6.5 \]

The base-case formula would have distributed $22.5 million. Smoothing limits the immediate distribution reduction to $1.5 million, while gifts decline by another $5 million. The institution’s perpetual horizon does not resolve this near-term operating gap; spending resilience depends on both the distribution rule and other funding sources.

Answer choices explained:

A — Incorrect: This amount reflects only the $5 million decline in gifts and incorrectly leaves the endowment distribution unchanged at its base-case amount.

B — Correct: The trailing-average policy produces a $21 million distribution. Total operating funding is $68.5 million, leaving $6.5 million against the $75 million budget.

C — Incorrect: This amount applies 4.5% only to the latest $400 million valuation, producing an $18 million distribution instead of using the required three-year average.

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Question 38

Which proposed strategic allocation satisfies both the defensive-liquidity minimum and the real-capital-preservation objective in the normalized planning year?

• A. 35% in cash and high-quality bonds; 7.0% assumed annual gross return.
• B. 20% in cash and high-quality bonds; 7.7% assumed annual gross return.
• C. 15% in cash and high-quality bonds; 8.2% assumed annual gross return.

Best answer: B

Strategic allocation must satisfy both capital-preservation and liquidity requirements. Because spending and fees are specified as percentages of opening capital and paid at year-end, the required gross nominal return is:

\[ r_{\mathrm{required}} = 4.5\% + 0.5\% + 2.5\% = 7.5\% \]

The proposal with a 20% defensive allocation and a 7.7% assumed gross return meets both requirements. The comparison uses the normalized planning assumptions, not the actual trailing-average distribution. A perpetual horizon supports long-term growth investing, but dependence on distributions and binding capital calls still requires defensive liquidity. Passing this deterministic screen establishes consistency with the stated assumptions; it does not guarantee preservation of purchasing power under uncertain returns.

Answer choices explained:

A — Incorrect: The allocation meets the defensive minimum, but capital grows only 2.0% after spending and fees, below the assumed 2.5% inflation rate.

B — Correct: The allocation meets the 20% defensive minimum and leaves 2.7% capital growth after spending and fees, exceeding 2.5% inflation in the planning model.

C — Incorrect: The assumed return exceeds the capital-preservation requirement, but the 15% defensive allocation falls below the required 20% minimum.

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Question 39

Under the downside case, what minimum net cash proceeds must be raised from public-equity sales during the first 90 days to meet scheduled obligations and the ending cash requirement?

• A. $1.5 million
• B. $0.0 million
• C. $4.0 million

Best answer: C

Liquidity analysis matches eligible, realizable resources to dated obligations. All amounts below are in millions of dollars. Cash and net bond-sale proceeds provide:

\[ \text{Available cash} = 10 + 0.95 \times 40 = 48 \]

Capital calls, operating transfers, and the required ending cash balance together require:

\[ \text{Required cash} = 38 + 9 + 5 = 52 \]

Public-equity sales must therefore generate $4 million of additional net proceeds. The private holdings cannot be monetized within the window, gifts arrive too late, and the building reserve is legally unavailable. This is a need to raise cash from another eligible portfolio source, not evidence that the endowment lacks sufficient total assets.

Answer choices explained:

A — Incorrect: This amount incorrectly counts the $2.5 million of downside gifts as available during the first 90 days, although they arrive in the final month.

B — Incorrect: The separate $8 million building reserve cannot close the cash gap because its donor restriction prohibits funding capital calls, operating transfers, or general reserves.

C — Correct: Cash and stressed bond proceeds provide $48 million, while calls, operating transfers, and required ending cash total $52 million.

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Question 40

The proposed additional $3 million operating distribution is subject to which approval?

• A. Full-board approval under its reserved authority over endowment appropriations.
• B. Investment-committee approval under delegated authority to trade unrestricted endowment assets.
• C. CFO approval under delegated authority to administer the approved operating budget.

Best answer: A

Governance separates authority over investments from authority over spending. Selling public equities changes the portfolio’s composition; transferring the proceeds to operations removes capital from the endowment. The committee’s trading authority does not extend to approving that additional appropriation. Similarly, approval of the operating budget establishes permitted expenditures, not permission to increase endowment funding. The proposed assets are donor-unrestricted, so donor restrictions are not the governing obstacle. The binding requirement is the full board’s reserved authority over spending exceptions. Even an economically reasonable distribution from readily saleable assets must follow the institution’s allocation of decision rights.

Answer choices explained:

A — Correct: The additional operating payment exceeds the formula appropriation, making it a spending exception reserved to the full board regardless of its funding source.

B — Incorrect: Authority to sell unrestricted investments governs portfolio implementation, not authority to transfer additional endowment capital to operations beyond the approved appropriation.

C — Incorrect: Approval of operating expenditures does not authorize an additional endowment appropriation; the CFO administers payments only within already approved appropriations.

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Case 11

Topic: Portfolio Management Pathway

Briar Endowment’s Index-Manager Review

Leena Rao, CFA, reviews Briar Endowment’s incumbent equity index manager, Cedar Index Management, and a prospective replacement, Rowan Asset Management. Cedar uses full replication; Rowan uses optimized sampling. Both reported portfolios track the same unhedged USD gross-dividend total-return index.

Historical performance

The following six consecutive quarters precede a separate Cedar implementation pilot. Treat the displayed returns as exact. Portfolio returns include management fees, unrecoverable withholding taxes, trading costs, cash effects and securities-lending revenue.

Active return is portfolio return minus benchmark return. Tracking difference is the arithmetic average active return; tracking error is its sample standard deviation. Annualize quarterly tracking difference arithmetically and quarterly tracking error using square-root-of-time scaling, assuming no serial correlation.

Cedar’s management fee is 4 bp per quarter; Rowan’s is 2 bp per quarter. Fees are assessed on beginning-of-quarter NAV and paid at quarter-end, making their effects exact deductions from quarterly simple returns.

Cedar’s return reconciliation

Cedar’s performance desk publishes an annualized subtotal of -3 bp, labelled “implementation tracking difference.” Rao receives the exhaustive attribution ledger below for the same six-quarter period. All entries are additive annualized arithmetic contributions to active return; there is no unexplained residual. Lending revenue is net of lending-agent charges.

Cedar’s implementation pilot

Cedar subsequently completes a separately funded pilot using optimized sampling and expanded securities lending against cash collateral. Collateral is reinvested in approved instruments. The pilot lowers trading costs and increases expected lending revenue, while introducing additional sampling and collateral-reinvestment exposures.

For the upcoming allocation decision, the risk team supplies these assumptions:

• The pilot’s expected annualized net active return is 12 bp higher than the existing Cedar implementation’s.
• The pilot’s annualized tracking error is 36 bp, including sampling and collateral-reinvestment variability.
• Existing Cedar risk is estimated from the six reported quarters. Its active returns are assumed uncorrelated with the pilot’s active returns.
• Both implementations retain Cedar’s current management fee. Expected return effects scale linearly with allocation weights, with no incremental transition or rebalancing costs.

The committee will allocate only 0%, 50% or 100% of Cedar’s mandate to the pilot, leaving the balance in the existing implementation. It seeks the highest expected net return subject to an annualized tracking-error limit of 20 bp. Every permitted allocation meets separate liquidity and securities-lending limits.

Question 41

Using the six reported quarters, Rowan’s annualized tracking error is closest to:

• A. 0.46%
• B. 0.50%
• C. 1.01%

Best answer: B

Tracking error measures dispersion around average active return, not the average shortfall itself. Rowan’s quarterly active returns are -24, +18, -12, +30, -30 and +18 bp. Their mean is zero, and their squared deviations sum to 3,168 bp squared. Let \(s_a\) denote quarterly sample tracking error.

\[ s_a=\sqrt{\frac{3{,}168}{6-1}}=25.17\text{ bp},\qquad \mathrm{TE}_{\mathrm{ann}}=\sqrt{4}\,s_a=50.34\text{ bp}=0.5034\%. \]

Rowan therefore has zero average tracking difference over the sample but substantial tracking error. Positive and negative deviations offset in the mean, not in the variance. A manager with a persistent relative-return shortfall can consequently have lower tracking error than a manager whose average active return is zero.

Answer choices explained:

A — Incorrect: Using the population divisor of six produces approximately 0.46%; the review requires the sample divisor of five.

B — Correct: Rowan’s quarterly sample standard deviation is 25.17 bp; multiplying by the square root of four gives 50.34 bp, approximately 0.50%.

C — Incorrect: Multiplying the quarterly sample standard deviation by four produces approximately 1.01%; tracking error requires square-root-of-time annualization.

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Question 42

Which reconciliation of Cedar’s published -3 bp subtotal is most accurate?

• A. The subtotal excludes management fees and withholding taxes; all-in tracking difference is -24 bp.
• B. The subtotal excludes management fees only; all-in tracking difference is -19 bp.
• C. The subtotal includes every listed item; all-in tracking difference is -3 bp.

Best answer: A

A performance label does not establish which costs a reported figure includes. Cedar’s published subtotal can be reconstructed from lending revenue, cash drag and trading costs alone:

\[ 8-3-8=-3\text{ bp}. \]

It is therefore net of those implementation effects but gross of management fees and unrecoverable withholding taxes. The investor-level tracking difference is:

\[ -3-16-5=-24\text{ bp annually}. \]

This reconciles with the reported return series, whose average quarterly active return is -6 bp. The gross-dividend benchmark does not bear Cedar’s withholding-tax expense. Lending revenue offsets part of the implementation burden, but it should neither be omitted nor counted twice when reconciling the investor’s net outcome.

Answer choices explained:

A — Correct: Lending revenue less cash drag and trading costs equals -3 bp; deducting 16 bp of fees and 5 bp of taxes gives -24 bp.

B — Incorrect: Subtracting the 16 bp management fee gives -19 bp, but the subtotal also excludes the 5 bp withholding-tax effect.

C — Incorrect: The exhaustive ledger totals -24 bp, so the published -3 bp subtotal cannot already include every listed revenue and cost effect.

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Question 43

For a fee-only counterfactual, Cedar reduces its fee to 2 bp for each of the six reported quarters. Pre-fee returns and every other cost effect remain unchanged. Relative to the reported series, how do Cedar’s annualized tracking difference and tracking error change?

• A. Tracking difference increases by 8 bp; tracking error is unchanged.
• B. Tracking difference increases by 8 bp; tracking error decreases by 50%.
• C. Tracking difference increases by 2 bp; tracking error is unchanged.

Best answer: A

Under the stated opening-NAV fee convention, reducing Cedar’s quarterly fee from 4 bp to 2 bp adds exactly 2 bp to every quarterly active return. Arithmetic annualization therefore improves tracking difference by 8 bp.

A constant shift changes the mean but not deviations from that mean. If \(a_t\) is an original quarterly active return and \(a'_t\) is its revised value, then \(a'_t=a_t+2\text{ bp}\), while \(a'_t-\bar a'=a_t-\bar a\). Both quarterly and annualized tracking error remain unchanged. Fee effects that vary across periods can alter tracking error, depending on their relationship with pre-fee active returns; a constant proportional deduction does not.

Answer choices explained:

A — Correct: The fee reduction adds 2 bp to every quarterly active return, improving annualized tracking difference by 8 bp without changing dispersion.

B — Incorrect: Halving the constant fee halves its mean-return deduction, not active-return dispersion; every observation receives the same 2 bp upward shift.

C — Incorrect: The 2 bp improvement applies each quarter; arithmetic annualization makes the annualized tracking-difference improvement 8 bp.

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Question 44

Which permitted allocation to Cedar’s pilot maximizes expected net return while satisfying the committee’s tracking-error limit?

• A. 100% to the pilot
• B. 50% to the pilot
• C. 0% to the pilot

Best answer: B

Combined tracking error depends on active-return variances and covariance, not a simple weighted average of individual tracking errors. Cedar’s historical quarterly active returns have sample variance of 2 bp squared, giving annualized variance of 8 bp squared and tracking error of approximately 2.83 bp.

Let \(w\) be the pilot weight. With zero active-return correlation and tracking error expressed in basis points:

\[ \mathrm{TE}(w)=\sqrt{(1-w)^2(8)+w^2(36^2)}. \]

At a 50% pilot weight, tracking error is \(\sqrt{326}=18.06\) bp, below the 20 bp limit. Expected annualized net active return improves by 6 bp. Full adoption breaches the limit, while retaining only the existing implementation offers less expected return. Thus, 50% is optimal among the permitted allocations. Increased lending revenue is an expected contribution, not a guaranteed cost reimbursement; its associated exposures remain relevant, and tracking error does not capture every lending tail risk.

Answer choices explained:

A — Incorrect: An all-pilot allocation has annualized tracking error of 36 bp, exceeding the 20 bp limit despite offering the largest expected return improvement.

B — Correct: The uncorrelated 50/50 mix has annualized tracking error of approximately 18.06 bp and improves expected annualized net active return by 6 bp.

C — Incorrect: The existing implementation satisfies the limit but forgoes the feasible 6 bp expected annualized return improvement available from a 50% pilot allocation.

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Continue with a fresh case

Use explanations to identify the missed condition, then attempt another case in Finance Prep. Combine item-set work with separate written-response practice from your authorized candidate materials.