5) setting up the after-tax real calculation, 6) 4.28%, 7) including inflation, and 8) dividing by 1 -
marginal tax rate.
Retirement starts in one year and all the figures given are in one year except the 263,000;
remember to increase it for inflation.
An effective annual tax rate considers the effects of deferring some taxes and is the pertinent
annual tax rate to apply.
You may notice we did not display an in/outflow analysis in this solution. We actually did one,
but there was no reason to show it. Go check the case facts and determine the salary inflow
versus living expense and mortgage outflow. You should not need a calculator.
Exam answers for individuals have been accepted using either addition or geometric
compounding, only show one method. Addition is preferred for individuals.
(Study Session 4, LOS 8.f, h, i)
B. Discuss two factors that decrease and one factor that increases the Martins' risk tolerance.
Grading Guide
Answer for Question 2-B
Factors that decrease the Martins' risk tolerance:
Retired with no additional income from working to replace any investment shortfalls.
Small pension relative to living expenses and must depend primarily on their investment
portfolio.
Large amount of living expenses relative to investable assets making them less able to
tolerate volatility and negative short-term returns.
They want their portfolio invested conservatively-an indication of low willingness to bear risk.
Inherited wealth (passive source of wealth), may indicate a reduced willingness to take risk.
Factors that increase risk tolerance:
They plan to leave their estate to charity; if this is a lower priority goal, they could spend the
principal on living expenses if needed.
They consider their investment base to be large, which increases willingness to bear risk.
They have a long time horizon, which gives the portfolio time to recover from market losses.
Candidate discussion: Only discuss the requested two items that decrease and one that
increases risk tolerance. 2 points each for two factors that decrease risk tolerance, and 2 points
for one factor that increases risk tolerance.
C. Formulate each of the following constraints for the Martins' investment policy statement
(IPS):
i. Liquidity.
ii. Time horizon.
Answer for Question 2-C
i. Liquidity needs:
o AUD 3,860,000 total debt repayments in one year comprised of the mortgage and other debts.
o AUD 219,890 ongoing living expenses. o Expect an AUD 9 million after-tax inheritance in one year. ii. Time horizon is long-term (they are age 50):
o One year until retirement. o Retired when both spouses are alive. o After one spouse dies and expenses drop 25%. Candidate discussion:
Listing the debt payoff items is essential for full credit. Listing the inheritance is recommended.
Past exam answers are inconsistent in discussing a need for ongoing distributions under liquidity. It needs to be discussed and analyzed under return, and to be safe you can list it
under liquidity as well.
It is not necessary to call the next year a stage as the portfolio investment does not start until retirement in one year, two stages and only listing the second two is also full credit.
The discussion of pre- and post-death of one spouse is unusual. This case provided specific information, so ignoring the information will reduce the score.
(Study Session 4, LOS 8.f, h, i)
QUESTION 3 HAS SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 21 MINUTES
The Martins have approached Steve Perry, a charterholder, for asset allocation advice. The
Martins have read about the benefits of diversification and how it will allow them to take less risk
but earn a higher return. They bring in articles on three investments that they have seen regularly
discussed in the press and want to know if they will help the portfolio return. The portfolio is
currently invested in domestic (Australian) stocks and bonds. Perry agrees to look into it and get
back to them.
As a first step, Perry compiles the following historical data:
Sharpe
Standard
Deviation E(R) Correlation to
Existing Portfolio
Ratio
Current Portfolio 7.8% 6.5% 1.0
Additions:
International Equity 12.5% 8.7% 0.4 0.50
Real Estate 6.4% 7.1% 0.1 0.72
Managed Futures 13.9% 9.2% -0.2 0.48
Risk-free rate 2.5%
Using the data in the table, Perry decides to examine how return to risk would be affected if he
adds one of the new asset classes. He will liquidate existing assets so the characteristics
(expected return, standard deviation, and correlations) for that portion of the existing portfolio are
unaffected.
...
A. Compute the Sharpe ratio if the Martins reallocate their existing portfolio. The reallocated
portfolio would be 90% of the existing portfolio assets and 10% international equity. Show your
calculations.
Answer for Question 3-A
E(R) = 0.10(8.7) + 0.90(6.5) = 6.72%
σ
2 = (0.10
2 × 12.5
2) + (0.90
2 × 7.8
2) + (2 × 0.10 × 0.90 × 12.5 × 7.8 × 0.4) = 1.5625 + 49.2804 +
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