CFAI 2010 Mock Exam Q49

[Persistance86]

“…the expected return of Kyung’s average client portfolio is closest to:”
A) 8.66%
B) 10.55%
C) 11.81%
I am calculating 9.5% as the return.
Using 40% leverage i see it as
7.4% + (40/60)(7.4-4.25%)
Can anyone help?

 

[monger187]

the 40% is in addition to the $500M. So $500M is the Equity, $700M is the total invested. Here’s how I worked it out:
(Return of total invested - cost of borrowing)/Equity
(($700M * 0.074) - ($200M * 0.0425))/$500M = 0.0866

 

[Persistance86]

so I guess my confusion comes from the phrase “our average portfolio leverage is 40%”. You are implying that 40% is a percentage of equity, versus the entire portfolio (which would include leverage).
that correct?

 

[monger187]

Yes, due to the way it was worded, that “Our mandate allows us to borrow between 0 and 75 percent *of the equity* of the portfolio.” Also, they noted that the investor had $500M before discussing any leverage - indicates that the $500M is the equity before leverage.

 

[Persistance86]

thanks for the explanation