2007 CFAI Question 2B

The question is

Swann recognizes that the concentration in the small-capitalization Pitt Manufacturing stock is

too high. The Ingrams have given Swann three specific instructions related to their holding of Pitt stock: • Defer the realization of capital gains and the associated capital gains taxes. • Significantly reduce the downside risk associated with their holding of Pitt stock, but preserve some upside potential. • Do not use leverage in the portfolio. Swann notes that Pitt stock, exchange funds, and put and call options on Pitt stock all have liquid markets. Swann reviews the following four strategies for achieving the goals of the Ingrams: • Outright sale • Equity collar • Exchange fund • Completion portfolio I chose equity collar, which is correct but the second part of the question asks of the stratagies not chosen give one reason why its not appropriate. For exchange funds they stated this in the answer “This strategy would eliminate any significant upside price potential associated with the position in Pitt.” I said it does not provide downside protection which is one of their requirements, do exchange funds protect it from downside risk? I didnt think so because the stock can still fall and reduce the value of the exchange fund.

Well it protects you from idosynratic risk of an individual stock. It significantly protects them from the Pitt, since it might just be a small part of the Exchange Fund. Even if Pitt drops to 0, as long as the rest of the portfolio performs the risk in PItt decrease in prices does not have a large effect on the investor.

Exchange fund will reduce the downside risk since the holding is diluted, so it will protect somewhat from losses. If Pitt falls, the fund will fall less than the straight holding