2013 Level 3 Essay Question #1 Review

Passing the Level III CFA exam is all about the essay questions. You know what to expect on the afternoon vignette section and the curriculum is more or less consistently difficult in both the morning and afternoon sessions. The only unknown variable is three hours of application and writing.
Do not underestimate the physical challenge of the morning essays. Who really writes things out by pencil or pen anymore? You need to condition the muscles in your hand to be able to write non-stop.
Fortunately, the CFA Institute is uncharacteristically generous to level III candidates and supplies copies of the actual essay questions and the guideline answers for the last three years’ exams. The single best advice I can offer to level III candidates is download and practice those exams. Work through each exam at least twice.
We’ve covered a general review of the Private Wealth Management topic area last year and not much has changed in the curriculum. Click here for a review of the topic and how to approach it. You absolutely must know how to work through the two types of return questions and apply the constraints of the IPS. Remember TUTLL!

2013 Level III Exam, Question #1 Individual Wealth Management

Between the first two questions last year, the individual wealth management topic accounted for nearly 10% of your entire exam score (35 points of 360). Besides the technical importance, starting off the day by doing well on the first couple of questions will give you a huge confidence boost and sets you up for success.
Hit this section hard and master it!
Last year’s first question covers the Voorts and their needs in retirement. Some candidates like to read the questions first then the vignette. I always liked reading through the vignette first and underlining important information. Try it both ways in practice to see which you prefer for the exam.
A)    This is a single-period return calculation (as opposed to the other type of question you might see, a multi-period return calculation. Be ready for both). Notice almost every questions says, “Show your calculations.” You can get partial credit if you show your calculations even if your final answer is wrong. Don’t forget!
The guideline answer is a pretty standard format. List out the living expenses with an inflation adjustment and reduce it by any guaranteed income like pension payments. Taxes and inflation are two of the biggest hurdles in these. Make sure you note where you need to incorporate taxes and inflation into the given data.
After you know how much is needed from portfolio assets, you need to list out all investable assets to find the portfolio size. After that it is a fairly easy calculation of cash needs divided by the portfolio value. Note, this will give you a real return requirement (without inflation) so you need to adjust upwards.
B)   Part B is fairly easy. Understand which factors go into ability and which factors affect willingness to assume risk. Remembering this, you can quickly scan the vignette for specific details when you see either word. Notice the guideline answers lists five possible answers but the question ask for only two. Do not waste your time listing every possible answer! The grader will only check the first two.
Typically portfolio size to needed cash is a strong factor in ability. Even if higher risk led to a decrease in portfolio value, they could still probably meet their needs. Age is also a common topic with younger people having the ability to return to work.
C)   The liquidity requirement is basically done in the return calculation above but I guarantee a lot of candidates forgot to include the cash reserve. Liquidity is not necessarily only the money you plan to spend but what you need set aside.
D)   This ‘choose the most appropriate portfolio’ is fairly common and easy points. A few pieces of information are key: goal return, preference for risk and the risk-adjusted return.
Given the goal return of 3.5% means a return of 8.57% on a nominal pre-tax basis ((3.5% +2.5%/(1- 0.7)). Only portfolios X and Z meet this preference.
The Voorts do not want the portfolio to decline by 10%. Only Portfolio Y and Z meet this requirement.
Only portfolio Z meets both reasons.
With a little preparation, that is 20 easy points, nearly 6% of the entire exam in the bag. Be ready for these essay questions and they will be no problem.
We reviewed multiple essay questions from previous years on the blog last year. Click here for the review of Question #1 in the 2011 exam and scroll through for other essay questions.
‘til next time, happy studyin’
Joseph Hogue, CFA

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