2008 Exam: IPS constraints

I am not sure how much credit I would get on this one. I seem to have added too much info?

2008 exam AM Q1.C

This is the guideline answer:

Constraint Prepare the following constraints of the Carvalhos’ IPS. i. Liquidity - The Carvalhos need their investment portfolio to provide BRL55,000 for next year’s mortgage payment. ii. Time horizon - The Carvalhos have a long-term multi-stage time horizon. In the short term, they must pay living expenses and provide a home for their family. They may also have to pay tuition for their children. Their second stage is retirement, thirty years from now. ------------------------- My response: 1. Liquidity - They will need BRL255,000 for the down payment on a house and will receive BRL750,000 as 50% disbursement from trust. BRL55,000 will be needed for mortgage payment. 2. Time horizon - Long time horizon, multi-stage. 1st stage is now until 10 years when 2nd trust disbursement is received, then until age 60 when they will retire. The 3rd phase is retirement, another 20-25 years.

pretty sure you don’t haveto add 255k and 750k as part of liquidity. 750k is an inflow thus does not constitute liquidity needs. 255k will be deducted as part of the investable asset base so it’s also not a liquidity need.

refer to Galli’s post #5 here


Right, but I remember reading to mention outflows AND inflows in liquidity…

if you find out where, please let me know as I’ve always thought only outflows were necessary for liquidity. Maybe for unique contraint, it can work?

My two cents:

The liquidity constraint is essentially the upcoming liquidity requirements for the investor. If they have a net cash outflow (Expenses larger than income) you should mention it and mention how much that liquidity shortfall is. But, if their income is more than their expenses, It wouldn’t hurt (in my opinion) to mention that “with income greater than expenses, no major liquidity concerns.” I always add the following line too as I have seen it added specifically for liquidity in some of the previous mocks “It would be a good idea to set aside a small amount of money as a cushion in case of emergencies”.

Now I have a question as well. I did this mock a few days ago so I do not remember specifically which question it is but it was the Carvalho case. They are 30 years old, no major liquidity needs except for a net cash out flow of 55,000 a year for the next 30 years. The question asked for risk tolerance and the answer was above-average. I have come across this in other mocks where everything else points to a high risk tolerance, (long time horizon, no major liquidity needs, etc.) but because the person’s income was not enough to cover expenses, THIS was the deciding factor and the risk tolerance was set as below-average.

How come for the Carvalho’s, their risk tolerance is above average when clearly they have a net cash shortfall of 55,000 a year for the next 30 years?

The question clearly states that their income just covers all living expenses.

The mtg payment comes from portfolio not from income.

Yes, that is exactly my point - they don’t have any income. They have 0 cashflow (salaries minus expenses is flat) and on top of that they need to pay 55,000 for a mortgage expense that is fixed for 30 years. Essentially they have a shortfall of 55k for 30 years - does this not qualify as a below-average risk tolerance (even though their time-horizon, and the 750k coming in might state otherwise) ?

If this is an above-average risk tolerance like the answer says it is then what if they had a net positive cash flow (salary > expenses), that would obviously be an above-average risk tolerance as well - how can it be above-average in both of these situations? Doesn’t make sense to me…

The only reason I could come up with was that their risk tolerance is above average due to the large sums they expect from the trust and eventual inheritance. Other than that all other factors suggested low to average risk tolerance.

I find in the older exams (which the CFAI says we shouldn’t give much weight to, just the past 3 years exams) the guidance answers make more speculative reasons such as

-they could conceiveable return to work and earn an income again

-their children could potentially get a scholarship and they won’t have to pay for tuition

-they could anticipate an inheritence whenever their favorite uncle dies and leaves them money

-they could cut back a bit on spending

I don’t see these sort of guideline answers in the more recent exams.