I’ve been going through the previous years’ exams and I’ve got a couple of questions about the guideline answers on the 2010 AM exam.
Q1 A(i) asks what are the liquidity constraints in Elisa Lima’s IPS.
I wrote my answer based on the framework @sophie had suggested in her comments on tackling IPS problems — Immediate (current one offs), Ongoing (living/medical expenses), Other (e.g. house in future, expected receipt of large cash flow). I mentioned her immediate need in the next year to fund her children’s education (USD 50,000) and since Lima expects to receive USD 1,000,000 when she retires, and expects to pay USD 3,000,000 to buy an annuity upon retirement, I mentioned those as part of the ‘Other’ liquidity needs.
But the guideline answer just says, “Lima will fund education expenses for her children in one year at a cost of USD 50,000. Lima has no other liquidity needs.”
What are your thoughts on that – is it still okay to mention the long-term liquidity need in the future?
Q1 E: This question is about the amount of bonds to buy and sell in order to achieve the most tax-efficient allocation. I did not understand the guideline answer for this at all — is there a worked example or EOC problem I can refer to in order to understand?
Q8 A: This question is about rebalancing schedules. There are two methods —- calendar and percentage-of-portfolio (with tolerance band +/- 10%).
The guideline answer says,” Although the 28% weighting in international equities is within the tolerance band under the percentage of portfolio rebalancing approach, the 45% weighting in UK fixed income is outside the tolerance band. Thus, all asset classes would be rebalanced to target weights.”
But the thing is that the UK fixed income target weighting is 40%, so if it was 45% as of 31st March, it would be well within the 10% corridor, wouldn’t it?
Or do they mean to say that 45-40 = 5 which makes it greater than 10% of the target allocation 40% and that’s why we have to rebalance?
@vincentt , I am also planning to do around 6-7, but want to do more of individal portfolio management if there is time. I am failing pretty bad in calculating return requirements. missing few terms like pretax, after tax , to calculate for how many years, whether expenses are last year or current year. every time :(. Terminilogy very confusing.
From the papers done so far, I realized that most of the percentage of mistakes are the ones I already know. Because of hurry missed few keywords. Need to be more careful on that
@MockTurtle I’ve only looked at Q1 A(i):
From what I understand under the liquidity section we usually list out immediate or on-going liquidity needs, as for something far in the future it should be within the return objective, just like “i would like to leave £1m for each of my kids and £1m to charity x after my death”.
@RaviVooda The IPS isn’t too bad I think as the format is pretty much fixed and even if you didn’t get the answer correctly you still get points for working out the answers (assuming you did write out the steps). However, what I’m worried about are some very vague questions or some that has got nothing to guide you.
E.g. there’s one question in schweser’s mock that asked to list out all 7 due diligence criteria.
Hope the actual exam doesn’t question candidates like this.
QUESTION 1 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 35 MINUTES.
Elisa Lima is a 34-year-old widow residing in a country that uses U.S. dollars (USD) as its currency. She has two children: age 10 and age 6. Lima works as the director of marketing at Relex Corporation. Exhibit 1 presents details of the financial environment in Lima’s home country.
Selected Data from Lima’s Home Country
￼• Flat income tax rate of 25%.
• Wages, realized capital gains, and interest are taxed as income.
• Dividends are not taxed.
• Realized losses may be offset against income and may be
carried forward to offset income in future years.
• Government provides at no direct cost to citizens.
Tax-deferred accounts (TDAs)
• Contributions are pretax and annual maximum is USD 40,000.
• Income and gains grow tax-deferred and portfolio reallocations
are not subject to tax.
• Income taxes are paid on full amount of withdrawals.
• No penalties on withdrawals for housing or education.
Lima’s current pretax annual compensation is USD 140,000 and her current annual living expenses are USD 96,000. Her future salary increases are expected to match any increases in living expenses on a pretax basis. Lima is in good health, owns her home, and has no debt.
Lima is a disciplined investor, but a recent equity market decline caused her great anxiety. She is worried about her ability to fund her children’s education and her retirement. Lima meets with her financial advisor, Mark DuBord, to review her financial plan.
DuBord notes the following factors:
• Lima invests USD 12,000 (pretax) in a TDA at the end of every year and intends to continue doing so until she retires. The current value of the TDA is
• Lima makes annual contributions to charity of USD 6,000. These contributions are included in her annual living expenses.
• She will prepay her children’s future education costs at the end of this year.
• Lima participates in Relex’s executive retirement program. At the mandatory
retirement age of 60, she will receive a pretax payment of USD 1,000,000.
DuBord determines that the prepaid education costs for both children will require a total of USD 50,000, including all taxes. He recommends that Lima purchase a life annuity to fund her retirement. DuBord calculates she will need USD 3,000,000 (pretax) to purchase the annuity at age 60. Lima agrees with DuBord’s recommendation.
A. Formulate each of the following constraints of Lima’s investment policy statement
ii. time horizon
One year later, after prepaying her children’s education costs and after making her annual TDA contribution, Lima has USD 225,000 invested in her TDA. Lima’s other financial information remains the same.
B. i. State the return objective portion of Lima’s IPS.
ii. Calculate Lima’s required average annual pretax nominal rate of return until her
retirement in 25 years. Show your calculations.
DuBord also advises Abella Rual, Lima’s sister, a 37-year-old single woman with no children. Rual works as a bankruptcy lawyer and is president of her own firm. Rual’s annual income is USD 450,000 and her annual living expenses are USD 180,000. She is in good health, owns her home, and has no debt.
Rual’s investment portfolio is currently valued at USD 1,500,000. Rual is confident that long- term equity market returns will more than offset losses in market downturns. She continues to invest regularly. Rual plans to retire at age 52, sell her business, and donate the proceeds to charity. Her investment portfolio will fund her retirement expenses.
C. i. Identify two factors that increase Lima’s ability to take risk. ii. Identify two factors that increase Rual’s ability to take risk.
D. Determine whether Lima or Rual has a greater willingness to take risk. Justify your
response with one reason.
During a recent review with Rual, DuBord notes that tax law changes, effective next year, will lower the tax on capital gains to 15% but eliminate the ability to offset income with realized losses. To minimize Rual’s tax liability, DuBord is considering the optimal location (tax- deferred or taxable) for her assets prior to the tax law changes. DuBord and Rual agree to maintain Rual’s current asset allocation. Rual’s investment portfolio and asset location are shown in Exhibit 2.
Rual’s Investment Portfolio
DuBord recommends the transactions necessary to achieve the most tax efficient asset allocation of bonds and equities in each account.
Current Value (USD)
Current Value (USD)
Cost Basis (USD)
Determine the “sell” amount of bonds and the “sell” amount of equities to achieve the most tax-efficient allocation in each account (tax-deferred and taxable).
ii. Determine the “buy” amount of bonds and the “buy” amount of equities to achieve the most tax-efficient allocation in each account (tax-deferred and taxable).
iii. Justify, with two reasons, why this is the most tax-efficient allocation.
Note: Assume no transaction costs or liquidity needs.
ANSWER QUESTION 1-E IN THE TEMPLATE PROVIDED ON PAGE 9.
QUESTION 8 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 17 MINUTES.
Rav Malik, an investment advisor, meets with a new client in the U.K., Ian Brown, to discuss his investment portfolio. Brown has managed his own assets in the past and rebalances his portfolio to target weights at the beginning of each month.
Malik suggests that Brown consider percentage-of-portfolio rebalancing with daily monitoring and rebalancing to target weights. He offers to demonstrate how the two approaches would differ after rebalancing on 1 April, given the allocations shown in Exhibit 1, with tolerance bands or corridor widths set at ± 10% of the target allocation.
Exhibit 1 Brown Asset Allocation
Strategic Asset Allocation: Target Weights
Closing 31 March Allocation
Large-cap U.K. equity
U.K. fixed income
A. Determine whether Brown’s calendar rebalancing method would result in a higher, lower, or the same weighting in international equity holdings on 1 April, as compared to Malik’s percentage-of-portfolio rebalancing method. Explain your response.
@MockTurtle I have written this paper today. My view on your doubts.
1. For Liquidity, if it is very far like retirement not needed to mention. However we should mention Current liquidity targets, education, Ongoing expenses (The answer in the paper does not mention this (96000 after taxes). But I believe this can be included. I also got wrong in this answer 🙂
2. 10% corridor is of the actual target. So if target is 40, and it reached 45. it has reached because it is more than 10% -> 40*0.1 , So it has to be rebalanced. I also got wrong in this answer 🙂
Hey @MockTurtle would you share the whole vignette of the question with the community? So some oldies (like me) who doesn’t have access to the paper like me could have a look as well? May interest the other Level 3 gang as well @vincentt , @Marc, @Alta12 , @RaviVooda @Betankrich @MM12 @AjFinance
@RaviVooda so far I’ve not find much issues with individual IPS in general, though there are some minor ones like not including all the unique constraints (not too sure if marks will be reduced as it did not mention how many to list) or over complicate calculation (e.g. PV the future college fees of the 3 kids, all are attending college at different age and college fees are affected by inflation… lol).
Still have not come across that many behavioral finance questions (only just completed 1 schweser mock), but I know it can be very vague (e.g. could be status quo or regret aversion, as both seem to illustrate the fact that they are afraid to make changes?).
Maybe how we feel might change after doing a few more mocks.
I’m also afraid of the questions that requires you to ‘memorise’ in the constructed response section and list out x number steps or strategies. I don’t see why concepts would be tested in that way. Thoughts?
For IPS, the simple thing I planned is.
1. Write cash flows
2. Write investable assets
3. Bring both of them to same phase (after or pre tax or inflation adjusted bases)
4. calculate no of years properly. if they say next year, remember to use inflation adjusted data
5. Calculate return. if nominal (and already not included in question), add inflation
6. If before tax( and not included in question data already), calculate.
mistakes made me come up with a format 😀
@vincentt I am sure exam will not test that way. Schweser’s target is to make candidates ready for exam by testing all concepts in its little area of 6 exams.
In some places, while defining reasons for constraints, If we just write a one or two liners will that be sufficient. The guideline answers show more than that. I am sure if we write that much we will not complete all questions. (atleast for me 🙁 )
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