Reading 8 (IPS) - End of Chapter Question #2

CFA Level III Portfolio Management
#1

First of all, I just want to say that I been following the forum for quite a few years, but I never actually registered. Thanks to you guys for all your posts and encouragement as I feel like I’m not doing this battle by myself.

I’m a second time LIII taker. I got low scores across the entire morning session last year. Needless to say, I’m working on getting more practice in with the written section and especially want to make sure I can fully answer the IPS related questions.

With that said, I’m posting as I have a question about an EOC question that I can’t figure out. I tried searching the forum, but I couldn’t find any posts that fully answer my specific question. In the question, we are told that Christa has living expenses of 132,500 a year, but the expenses can be reduced to 100,000 if she combines her apartment and studio. Christa has 50,000 coming from art sales, so the remainder would need to come from investment returns. The asset base is 1,120,000.

The question asks to calculate the return requirement and evaluate if the portfolio can satisfy that requirement if inflation averages 3% and she reduces her living expenses to 100,000. To get the initial required rate of return, the curriculum divides the 82,500 expenses by the 1,120,000 asset base to get 7.4%. The curriculum then calculates the required real rate of return of the combined studio and apartment expenses amount (50,000) by the asset base to get a 4.5% real rate of return. The solution states that the 7.4% return calculated earlier was nominal, so it subtracts the amount by 3% to get a real rate of return of 4.4%. Because the real rate of return from the portfolio (4.4%) doesn’t exceed the 4.5% required return, the curriculum states that the portfolio isn’t expected to meet the return requirement. Here’s my questions:

  1. Why is the initial calculation of 82,500/1,120,000 assumed to be nominal? I thought the calculation would provide the real rate of return. Is the curriculum trying to assert that inflation was unexpected and reduced the return?

  2. If the inflation was taken from the first calculation, why isn’t the 50,000/1,120,00 calculation reduced by inflation as well?

Thank you for help in advance.

#2

82500 are LIVING expenses (and by their nature they include the inflation component)… nominal includes the inflation component. so using 82500 makes it a nominal return requirement.

#3

CP - Thanks for your response. I do see the 82,500 listed as a living expense. However, the 50,000 is also derived from a living expense according to the text. Why isn’t the 50,000 viewed as nominal as well?

Thank you again.

#4

50000 = 132500 - 32500 (reduction induced by problem) - 50000 (artsales)

I guess when you take away some money (or are able to reduce it so arbitrarily) you are taking off inflation piece there.