Subject no. 57A Diploma in Offshore Finance and Administration Portfolio Management Sample questions and answers This practice material consists of three sample Section B and three sample Section C questions, together with their suggested answers. These sample questions and answers are provided as practice material for students taking examinations on the revised DOFA syllabus and are based on the recommended ICSA Publishing text. Please note: The assessment format for the Diploma in Offshore Finance and Administration examinations is not changing and will retain the three section structure of: Section A answer all parts of Question 1. Section B answer all ten questions. Section C answer two questions only. ICSA, 2013 Page 1 of 11
Section B Sample questions 1. Outline two reasons why efforts to match asset maturities to planned investment periods can be a complex issue. 2. A three-year bond has just been issued offering an annual coupon rate of 5% on a face value of 100. Both coupon and redemption payments are index-linked to the annual rate of inflation with the index set at 100 on the issue date of the bond. Calculate the coupon and redemption payments, assuming that the index for the next three years is 104, 105.5 and 108. 3. A portfolio consisting of two assets has a correlation coefficient of 0.8. Another twoasset portfolio has a correlation coefficient of -0.8. In the absence of any other information, which portfolio should you invest in? Justify your reasoning. Section C Sample questions 4. A portfolio consists of two assets, the expected returns and standard deviations of returns of which are listed in the table below: Asset 1 Asset 2 Expected return 8% 10% Standard deviation 16% 20% Required (a) Calculate: (i) (ii) (iii) (iv) The expected return for a portfolio which is equally weighted between the two assets. The correlation coefficient for the two-asset portfolio, assuming that the covariance is 32. The variance of returns for the equally weighted portfolio, assuming a covariance of 32. The standard deviation of returns for the equally weighted portfolio. (8 marks) (continued) ICSA, 2013 Page 2 of 11
(b) (c) Calculate the simple weighted standard deviation of the portfolio and comment on the scale of risk reduction. (5 marks) In principle, the two-asset model of portfolio risk can be applied to portfolios which include far greater numbers of assets. Explain the implications of this approach for the understanding of portfolio risk and discuss the practical problems of applying the model in this fashion. (12 marks) (Total: 25 marks) 5. (a) Discuss the key characteristics of passive fund management and illustrate your points with reference to index tracking funds and exchange traded funds. (15 marks) (b) Discuss the key characteristics of active fund management, focusing in particular on how the objectives of active management differ from those of passively managed funds. (10 marks) (Total: 25 marks) 6. Discuss the benefits of using the Capital Asset Pricing Model to analyse investment portfolios compared to earlier formulations of portfolio theory such as the meanvariance and capital market line methods. (25 marks) ICSA, 2013 Page 3 of 11
The answers follow on the next page. ICSA, 2013 Page 4 of 11
s Important notice When reading these suggested answers, please note that the answers are intended as an indication of what is required rather than a definitive right answer. In many cases, there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated compared with what might be achieved in the reality of an unseen, time-constrained examination. Section B Sample questions and answers 1. Outline two reasons why efforts to match asset maturities to planned investment periods can be a complex issue. In many circumstances, it is impossible to be precise about when investors will liquidate assets. Imagine that you manage an equity fund on behalf of investors. You cannot know exactly when they will choose to cash in and, therefore, you cannot be precise about choosing assets with matching maturities. Secondary markets in which assets are traded make asset maturity, in principle, more flexible. Take the example of company shares which characteristically do not have maturity dates but exist in perpetuity. Many of these shares are publicly traded on stock exchanges, meaning that individual investors can determine the maturity at any time by the simple act of selling the asset. Maturity matching is liable to occur as some form of term averaging procedure. For instance, an investment with a five year maturity could consist of two equallyweighted components, one with a maturity of 2.5 years, the second with a maturity of 7.5 years. Situations of mismatched maturities can often be very profitable and, therefore, attractive to investors. In the years preceding the recent banking collapse, many investors were able to borrow money on a very short-term basis at exceptionally low rates. They used the funds to invest in longer-term assets offering higher yields. The trick was to repeatedly renew the short-term loans and, thereby, retain ownership of the higher yielding assets. It worked very well for a time. (Candidates may be given credit where alternative, correct and relevant answers are provided). ICSA, 2013 Page 5 of 11
2. A three-year bond has just been issued offering an annual coupon rate of 5% on a face value of 100. Both coupon and redemption payments are index-linked to the annual rate of inflation with the index set at 100 on the issue date of the bond. Calculate the coupon and redemption payments, assuming that the index for the next three years is 104, 105.5 and 108. Payments: 5 x 104 = 5.20 100 5 x 105.5 = 5.275 100 5 x 108 = 5.40 100 100 x 108 = 108 100 3. A portfolio consisting of two assets has a correlation coefficient of 0.8. Another two-asset portfolio has a correlation coefficient of -0.8. In the absence of any other information, which portfolio should you invest in? Justify your reasoning. The portfolio with a correlation coefficient of -0.8 should be preferred. The high level of negative correlation suggests that the two assets return patterns are highly independent of one another, meaning that a considerable component of the risk of each is offset by the other. By contrast, the portfolio with a correlation coefficient of 0.8 consists of two assets whose returns tend to evolve in very similar ways. This limits the scope of risk reduction. ICSA, 2013 Page 6 of 11
Section C Sample questions and answers 4. A portfolio consists of two assets, the expected returns and standard deviations of returns of which are listed in the table below: Asset 1 Asset 2 Expected return 8% 10% Standard deviation 16% 20% Required (a) Calculate: (i) (ii) (iii) (iv) The expected return for a portfolio which is equally weighted between the two assets. The correlation coefficient for the two-asset portfolio, assuming that the covariance is 32. The variance of returns for the equally weighted portfolio, assuming a covariance of 32. The standard deviation of returns for the equally weighted portfolio. (8 marks) (b) (c) Calculate the simple weighted standard deviation of the portfolio and comment on the scale of risk reduction. (5 marks) In principle, the two-asset model of portfolio risk can be applied to portfolios which include far greater numbers of assets. Explain the implications of this approach for the understanding of portfolio risk and discuss the practical problems of applying the model in this fashion. (12 marks) (Total: 25 marks) (a) (i) Expected return = 0.5(8) +0.5(10) = 9% (ii) Correlation coefficient = 32/(16 x 20) = 0.1 (iii) Variance of returns = 180 (iv) Standard deviation of returns 13.4% ICSA, 2013 Page 7 of 11
(b) Weighted standard deviation = (20 + 16)/2 = 18% The actual risk, calculated in part (a), is 13.4%. It suggests that the portfolio offers a considerable element of risk reduction. This is not surprising because the correlation coefficient of 0.1 is low. It indicates that the return patterns of the two assets are liable to exhibit a significant degree of independence from one another, which is key to the notion of asset diversification reducing risk. (c) The solution to the measurement of risk for larger portfolios is to regard them as amalgams of pairs of assets. Portfolio risk is the sum of the weighted variances of the individual assets and the weighted covariances. A critically important feature of portfolio risk emerges as we increase the number of assets in a portfolio. The significance of individual asset risks declines. Portfolio risk is increasingly dependent on the covariance of returns. Individual risk components become progressively less relevant. This is the essence of portfolio theory; diversification makes differences less important. The covariances reflect the shared risks that cannot be neutralised through asset diversification. The shared risk occurs as multiple covariance calculations. The computational task grows rapidly with the number of assets incorporated into a portfolio, e.g. 10 assets = 45 covariance calculations, 100 assets = 4950 calculations. Furthermore, it complicates the task of constructing portfolios with efficient risk return trade-off due to the growth of possible asset combinations. ICSA, 2013 Page 8 of 11
5. (a) Discuss the key characteristics of passive fund management and illustrate your points with reference to index tracking funds and exchange traded funds. (15 marks) (b) Discuss the key characteristics of active fund management, focusing in particular on how the objectives of active management differ from those of passively managed funds. (10 marks) (Total: 25 marks) (a) The key points that should be discussed are: The essence of passive fund management is to replicate the performance of a benchmark, usually an index. Common examples are well known stock indices such as SP500 and the FTSE 100. There are many other variations some indices are created specifically to operate as benchmarks for particular types of fund replication. The meaning of passive. The benchmark determines the components of the managed portfolio. There is no need to analyse individual constituents beyond the issue of monitoring relative prices/weightings and adjusting accordingly. Identify and explain types of replication: full, partial, synthetic. The most common example is index trackers: open ended mutual funds with investors exchanging units with the fund. A newer development is exchange traded funds. They are also open ended but issue publicly traded shares rather than units. Investors deal in the stock market rather than directly with funds. Tracking error and tracking difference can be used to measure the efficiency of replication. Successful replication implies negligible tracking error/difference. (b) Active fund management: The decisive characteristic of active management is, it must seek to exceed the benchmark return. Furthermore, it must aim to exceed the return on a risk adjusted basis and net of the additional expense of managing the fund. Otherwise, it is pointless for investors. It embraces a range of strategic approaches to investment management. Some funds stress a top-down approach whilst others favour a bottom-up style (the meanings should be explained). Some focus on growth stocks, others value stocks (explain). Nevertheless, the key is that investment involves some sense of discriminating among alternatives accepting some, rejecting others. ICSA, 2013 Page 9 of 11
Performance of active funds is typically assessed in terms of the alpha return, which is a measure of the return due to fund management skill. There are a range of methods for assessing whether fund managers outperform benchmarks, such as the Sharpe and Treynor ratios. 6. Discuss the benefits of using the Capital Asset Pricing Model to analyse investment portfolios compared to earlier formulations of portfolio theory such as the mean-variance and capital market line methods. (25 marks) Start by explaining the relationship between CAPM and the preceding strands of portfolio theory. Portfolio theory suggests that the broader the range of securities that an investor owns, the less important the individual security risks. Portfolio risk increasingly revolves around factors that cause individual investments to perform in similar rather than independent ways; risk factors that continue to impact irrespective of the scale of asset diversification. The Capital Market Line model portrays this as risk attached to a fully diversified investment which, by inference, is the market portfolio. The CAPM takes the reasoning a step further by assuming that investors view assets not in isolation, but purely as components of diversified portfolios. The dissipation of idiosyncratic risks is an integral aspect of the investor mindset. Investors disregard singular characteristics because they have a negligible impact on portfolio returns and are interested only in the market risk of individual securities and how it will affect portfolio risk. The portfolio is the primary object of the decision-making process. Hence asset prices are determined by market risk alone, sometimes described as systematic risk as distinct from the non-systematic (diversifiable) risk. If market risk can be measured, it offers the prospect of a system of asset evaluation that can be applied to individual securities. Practicality of CAPM is rooted in the idea that the covariance of an asset s return with the market return is all that matters. Expressing this as a ratio of the market variance produces beta. Asset betas measure the exposure of individual assets to systematic risk which, according to CAPM, is the only risk that matters. This produces a simple and usable model: ICSA, 2013 Page 10 of 11
Benefits The modification has profound implications. The CAPM can be employed to construct portfolios from individual securities. In comparison, the Capital Market Line model offers the implausible scenario of investors managing risk by varying the scale of their investments in a market portfolio. It should be clear that CAPM is far more workable. It resolves the problem of the mean-variance approach s dependence on measuring enormous numbers of covariances. All that is needed is the covariance between the asset and the market portfolio to produce beta. The beta for any size portfolio is then a simple weighted average of the relevant betas. In the case of a 100-asset portfolio, CAPM requires the calculation of 100 covariances whilst the mean-variance method requires 4950. Less directly related to portfolio theory itself, CAPM is used by companies for capital budgeting purposes. In particular, it can be used to provide estimates of required rates of return in a host of capital investment scenarios. CAPM has prompted innovations in financial behaviour and the packaging of investments. Its association of the principle of asset diversification with sound investment practice has encouraged the growth of financial practice and products that offer to minimise investors exposure to idiosyncratic risk factors. It is worth noting that there is some controversy regarding the putative benefits of such developments. (Candidates may be given credit where alternative, correct and relevant answers are provided). The scenarios included here, except where expressly identified, are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. ICSA, 2013 Page 11 of 11