THROUGH 18 RELATE TO ALTERNATIVE INVESTMENTS CAROLINE KIN...

Questions 13 through 18 relate to Alternative Investments Caroline King Case Scenario Caroline King is the chief investment officer for the Ray Foundation (RF), a small-sized recently established foundation. RF’s portfolio is invested 60% in equity and 40% in bonds. King has selected Jeremy Brown, a consultant, for recommending the addition of alternative investments to RF’s portfolio. To hire Brown, King had conducted a lengthy search process which was based on several key criteria. According to King, “Such criteria ensure that we select the best advisor”. During his first meeting with King, Brown proposes that RF allocate its portfolio to indirect real estate, particularly REITs. He justifies his proposal with the following statement: Statement 1: “Given RF’s limited funds and small size, investing in REITs is more appropriate compared to a direct real estate investment.” King responds by stating that she has heard that the evaluation of REIT investments is complicated by the low volatility bias often associated with the NAREIT index. Brown assures King that he intends to use a benchmark corrected for this bias. After their meeting concludes, Brown decides to explore commodity investments. He is particularly interested in the diversification potential the asset class can bring to RF’s portfolio. He has read in an article that this potential arises from the low correlation between commodities and stock and bond returns. For RF’s portfolio, Brown would like to invest in commodity futures. He has chosen futures over an indirect investment in the commodity producing companies with the intention of providing maximum exposure to the underlying commodities. He collects data on three 3-month oil futures contracts with different expiration dates (Exhibit 1). Brown notices that many oil producers participating in the futures market hold real production options.

CFA Level III Mock Exam 3 – Questions (PM)

Exhibit 1 Oil Futures Contract Prices ($) Contract Futures Price as Futures Price as of Change in spot Maturity of May 2011 April 2011 price June 2011 45.10 44.71 0.80 September 2011 46.55 45.88 0.80 December 2011 46.99 46.02 0.80 Finally, King requests Brown to consider hedge funds for RF’s portfolio. King identifies three conditions which need to be satisfied before making a final selection: Condition 1: Enhance risk-adjusted portfolio returns Condition 2: Minimize the momentum effect in returns Condition 3: Sensitivity of the index to the direction of the underlying stock and bond markets should be minimal. Brown collects data on three hedge fund indices (Exhibit 2). The funds underlying each index are collectively managed using a distinct strategy. The Treasury bill rate is 4.0%. Exhibit 2 Data Concerning Three Hedge Fund Indices Correlation Annual Value/ Standard with the Equal Index Return Deviation Lehman S&P 500 (%) Weighted Gov./Corp Equity Hedge 9.5 7.8 0.65 0.10 Equal Equity market neutral 11.2 10.7 0.04 0.24 Equal Long-only 14.4 12.1 0.26 0.30 Value 13. Which of the following criteria is least important in the process used by King to evaluate advisors? A. The lenders providing financial support to the advisor. B. The advisor’s communication skills with respect to clients. C. Whether the market environment will continue to support the advisor’s investment strategy. 14. Based on Brown’s statement, his recommendation is most likely: A. justified. B. not justified; REITs are restricted to wealthy investors. C. not justified; direct real estate tends to offer higher risk-adjusted returns. 15. With respect to King’s concerns and Brown’s response concerning the NAREIT index, which individual is most likely correct? A. King B. Brown C. Neither King nor Brown. 16. Which of the following statements least likely justify the low correlation observed between commodities and stock and bonds? A. Commodity prices tend to rise during weak economies due to their inflation hedging capability. B. Commodities have a positive correlation whereas stocks and bonds have a negative correlation with inflation. C. Commodity future prices are affected by short-term expectations while equity and bonds are affected by long-term expectations. 17. Using the data in Exhibit 1, what is the roll return on the September contract and will oil producers exercise their real options? Roll return: Exercise? A. –$0.13 Yes B. –$0.13 No C. $0.80 Yes 18. Considering Conditions 2 and 3 only, which index will Brown most likely select? A. Long-only B. Equity hedge C. Equity market neutral