Saturday, April 16, 2011

CIPM Expert Level - Sample Exam Solution #7

One of the participants in last week's webinar on CIPM Q & A asked me to explain the solution to the question #7 from the sample exam questions found on the CFA Institute's CIPM Program page (). The vignette and question follow below:

Longitudinal Asset Management is a US-based portfolio manager investing in international equities. One of the firm’s portfolios is invested entirely in Canadian and United Kingdom equities. At the beginning of an evaluation period, the market values of the portfolio’s Canadian and UK segments are 5,000,000 Canadian dollars (CAD) and 3,000,000 pounds sterling (GBP), respectively. At the prevailing exchange rates, one CAD equals 0.80 US dollars (USD), and one GBP equals 2.00 USD.
Excluding dividend income, at the end of the period the Canadian equities are valued at CAD 5,300,000 and the UK equities are valued at GBP 2,880,000. The CAD now equals 0.90 USD while the GBP now equals 1.90 USD. Dividend payments of CAD 100,000 and GBP 180,000, respectively, are received at the prevailing exchange rates on the last day of the period.

7. The currency component of the Canadian equities segment return in USD is closest to
A. 9.0%
B. 12.5%%.
C. 13.5%.

The relationship that you should understand to solve this question is that currency return is not simply the exchange rate return. Rather, exchange rate return compounds the local return components (capital yield and income yield). That is,

c = s * (1 + p + y)

where c is the currency return, s is the exchange rate return, p is the price return in local currency terms (i.e., the capital return) and y is the income return.

The exchange rate return is (0.9 - 0.8) / (0.8) = .125.

The capital return is (5,300,000 - 5,000,000) / 5,000,000 = 6% = .06.

The income return is 100,000 / 5,000,000 = 2% = .02.

Thus the currency component of the Canadian equities segment return is:

.125 * (1 + .06 + .02) = 13.5%

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