3. Initiate a program to protect the The implementation of an inflation index adjustment financial program would protect the plan participants, not the plan itself, from the effects of higher U.K. inflation. strength of the pension plan With an inflation index adjustment program, Acme’s from the effects costs of funding the defined benefit plan would Incorrect of U.K. actually increase (thereby weakening the plan’s financial position) as U.K. inflation increases. inflation by indexing benefits paid by the plan.
LEVEL III, QUESTION 3
Topic: Portfolio Management Minutes: 10Reading Reference: Emerging Stock Markets: Risk, Return, and Performance, Christopher B. Barry, John W. Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997) A. “Introduction” B. “Historical Performance of Emerging Equity Markets,” Ch. 1 C. “Portfolio Construction Using Emerging Markets,” Ch. 2 Purpose: To test the candidate’s understanding of the investment opportunities and risks of emerging markets and of the potential diversification benefits of investing in emerging markets. LOS: The candidate should be able to “Introduction” (Study Session 5) b) describe the characteristics of an emerging market. “Historical Performance of Emerging Equity Markets” (Study Session 5) c) discuss the risks involved in investing in emerging markets. “Portfolio Construction Using Emerging Markets” (Study Session 5) a) appraise the impact of adding emerging market equities on portfolio risk for a global equity investor; b) discuss the variations of various correlations over time between different emerging markets and between emerging and international developed markets. Guideline Answer:
A. Rose should pursue Strategy #1, the 100 percent domestic market strategy (his current portfolio). The correlation of the domestic market with both the international emerging market and the international developed market is high (0.80 and 0.84, respectively), thus limiting any diversification benefits. In addition, the domestic market has the highest expected return (22.9 percent) by a substantial margin. Also, the standard deviations of the three markets are not expected to be significantly different (17.4 percent, 17.3 percent, and
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