2009 CFAI paid sample exam Q13 leverage effect

[annexguy]

Q: ave. portfolio expected asset return 7.4%, average portfolio leverage is 40%. pay 4.25% in the repo market for borrowing.
the expected return of average portfolio is
a. 8.66% b.10.55% c.11.81%
Answer A
7.4+40/100*(7.4-4.25)=8.66
Based on the fomula in notes and CFAI text, should be 7.4+40/60*(7.4-4.25)=9.5
it is not one of choice.
anything missed?

 

[mxz583]

I like thinking of it this way:
With 40% levereged, 140% of Equity is earning 7.4%, so 7.4%*1.4=10.36%. We then subtract out the payment for the leverage which is 4.25%*0.4=1.7%, so 10.36%-1.7%=8.66%. This seems to be a nice intuitive way to figure it out with out memorizing formulas.
Your calculation above coming to 9.5% is taking a leverage percent of 40/60, or 66.67% rather than 40%. The calculation in the answer is correct, as it uses the 40% leverage ratio.

 

[annexguy]

mxz583 Wrote:
tks a lot!