**THURSDAY: 7 December 2023. Morning Paper. Time Allowed: 3 hours.**

**Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings. Do NOT write anything on this paper.**

**QUESTION ONE**

1. Summarise FOUR benefits that could accrue to investors who includes pooled investment products in their portfolio. (4 marks)

2. With respect to program trading in portfolio management:

Explain the concept of program trading. (2 marks)

Highlight FOUR characteristics of program trading. (4 marks)

3. The following annual returns are available for a portfolio with an active strategy and the corresponding benchmark of the same investment style:

**Required:**

Calculate the average annual information ratio from the year 2018 to year 2022 assuming sample of return data. (4 marks)

2. The risk free rate is 8.25%.

**Required:**

Calculate the required return of Omega Ltd. using the Arbitrage Pricing Theory (APT) model. (3 marks)

Outline THREE merits of the Arbitrage Pricing Theory (APT). (3 marks)

**(Total: 20 marks)**

**QUESTION TWO**

1. Summarise SIX objectives of documentation within the investments industry. (6 marks)

2. Gabriel Otiti is a portfolio manager with Penda investment firm. He is interested in using Value at Risk (VaR) model to monitor the risk exposure of Penda’s government bond portfolio.

He gathers the following information:

**Required:**

Determine the monthly expected return. (1 mark)

Compute the monthly standard deviation. (1 mark)

Determine the expected loss at % monthly VaR. (2 marks)

Determine the 1% monthly (VaR) in shillings for the government bond portfolio. (2 marks)

3. Eldah Kendi obtains the following information from her portfolio of two stocks trading in the securities exchange:

**Additional information:**

1. The risk free rate is 7%.

2. The market is expected to make a return of 6% and 20% and each of those occurrences have an equal

chance.

**Required:**

Compute the following for Eldah Kendi’s equally weighted portfolio:

Beta for each company shares. (2 marks)

Expected weighted average return for each company shares. (2 marks)

Estimate the security market line (SML). (2 marks)

Alpha for each company’s share. (2 marks)

**(Total: 20 marks)**

**QUESTION THREE**

1. Examine THREE benefits of a well written investment policy statement (IPS). (6 marks)

2. Tamu Capital has to engage an investment manager whose details are as follows:

Manager M: Follows 500 share index with annual forecasts and with an information coefficient (IC) for each forecast is 0.03.

Manager N: Follows 100 share index with annual forecasts and the information coefficient (IC) is 0.06 for each forecast.

**Required:**

Explain the term “fundamental law of active management”. (2 marks)

Determine the Information Ratio (IR) for manager N and manager M. (3 marks)

Advise Tamu Capital on which manager to select using the fundamental law of active management. (1 mark)

3. Eva Njuki is carrying out a portfolio performance review of their main investment, Fedha Fund for the month of October 2023 and she obtains the following data:

**Required:**

Evaluate the performance of Fedha Fund and the market using:

Treynor’s ratio. (2 marks)

Sharpe’s measure. (2 marks)

Jensen’s (Alpha) measure. (2 marks)

Explain whether Fedha Fund outperformed the market using the results above. (2 marks)

**(Total: 20 marks)**

**QUESTION FOUR**

1. In relation to behavioural finance, explain the following emotional biases that could affect the financial decisions:

Loss aversion bias. (2 marks)

Over confidence bias. (2 marks)

Self control bias. (2 marks)

2. The tangent portfolio of risky assets, which lies on the most efficient capital allocation line, has an expected return of 12% and a standard deviation of returns of 30%. The yield on non-interest treasury bills is 2%. The investor has a risk aversion coefficient of 4.

**Required**:

Determine the weights of the tangent portfolio and the risk free rates in the client’s optimal portfolio that lies on the most efficient capital allocation line. (2 marks)

Calculate the expected return and standard deviation of returns of the optimal portfolio. (2 marks)

Calculate the Sharpe ratio of the optimal portfolio. (2 marks)

3. Smith Wanjala, a wealthy individual, is planning his estate. His total assets are valued at Sh.10 million. He wishes to understand the potential impact of estate taxes and the distribution of his wealth, taking into account the various elements of estate planning including basic concepts of domestic estate planning and non-tax issues like the legal system, a family’s core capital and excess capital.

**Additional information:**

1. Estate tax rate is at 40%.

2. Smith Wanjala decides to use the annual exclusion gifts to reduce his taxable estate with annual exclusion gift limit of Sh.15,000 per recipient.

3. Smith Wanjala resides in a jurisdiction where a 5% legal fees of the total estate for probate and legal

processes are applicable.

4. Smith Wanjala requires 20% of his assets as core capital.

**Required:**

Calculate the legal fees applicable to Smith Wanjala’s estate. (1 mark)

Estimate Smith Wanjala’s estate tax liability. (2 marks)

If Smith Wanjala decides to use his annual exclusion gifts to reduce his taxable estate, calculate the

maximum amount he can gift each of his two children without incurring gift taxes. (2 marks)

Calculate the shilling value of his estate designated as core capital and excess capital. (3 marks)

**(Total: 20 marks)**

**QUESTION FIVE**

1. Distinguish between “Strategic Asset Allocation (SAA)” and “Tactical Asset Allocation (TAA)”. (4 marks)

2. An investment advisor gathers the following data for a new client:

1. Age: 40

2. Family: Married but divorce proceedings are pending; three children aged 14 years, 16 years and 18 years.

3. Hobbies: Scuba diving

4. Profession: Derivatives trader at an investment bank

5. Net worth: Sh.10 million in a non-diversified portfolio and a house worth Sh.4 million

6. Planned retirement: At the age of 65 years

7. Current income: Cost of living slightly exceeds current income

8. Future expected expenses: Education cost of Sh.200,000 per year per child; the capital settlement expected from the divorce for the wife amounts to half of the net worth.

**Required:**

Discuss the following as they relate to the long-term investment policy statement (IPS) for the client:

Risk objectives. (3 marks)

Liquidity. (3 marks)

Investment horizon. (3 marks)

3. An investor is considering four individual securities whose active returns are uncorrelated with each other and forecasts are independent from year to year. The relevant data for the four securities is provided below:

The benchmark portfolio for these four securities is equally weighted and the forecasted return on the benchmark portfolio is 12%.

**Required:**

Calculate the following for the managed portfolio:

The forecasted total return. (3 marks)

The active return. (1 mark)

The active risk. (3 marks)

**(Total: 20 marks)**