Free CFA Institute CFA-Level-III Exam Questions

William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and positions in physicalcommodities. He is reviewing his operations and strategies to increase the return of the fund. Bliss has justhired Joseph Kanter, CFA, to help him manage the fund because he realizes that he needs to increase histrading activity in futures and to engage in futures strategies other than fully hedged, passively managedpositions. Bliss also hired Kanter because of Kantcr's experience with swaps, which Bliss hopes to add to hischoice of investment tools.Bliss explains to Kanter that his clients pay 2% on assets under management and a 20% incentive fee. Theincentive fee is based on profits after having subtracted the risk-free rate, which is the fund's basic hurdle rate,and there is a high water mark provision. Bliss is hoping that Kanter can help his business because his firm didnot earn an incentive fee this past year. This was the case despite the fact that, after two years of losses, thevalue of the fund increased 14% during the previous year. That increase occurred without any new capitalcontributed from clients. Bliss is optimistic about the near future because the term structure of futures prices isparticularly favorable for earning higher returns from long futures positions.Kanter says he has seen research that indicates inflation may increase in the next few years. He states thisshould increase the opportunity to earn a higher return in commodities and suggests taking a large, marginedposition in a broad commodity index. This would offer an enhanced return that would attract investors holdingonly stocks and bonds. Bliss mentions that not all commodity prices are positively correlated with inflation so itmay be better to choose particular types of commodities in which to invest. Furthermore, Bliss adds thatcommodities traditionally have not outperformed stocks and bonds either on a risk-adjusted or absolute basis.Kanter says he will research companies who do business in commodities, because buying the stock of thosecompanies to gain commodity exposure is an efficient and effective method for gaining indirect exposure tocommodities.Bliss agrees that his fund should increase its exposure to commodities and wants Kanter's help in using swapsto gain such exposure. Bliss asks Kanter to enter into a swap with a relatively short horizon to demonstrate howa commodity swap works. Bliss notes that the futures prices of oil for six months, one year, eighteen months,and two years are $55, S54, $52, and $5 1 per barrel, respectively, and the risk-free rate is less than 2%.Bliss asks how a seasonal component could be added to such a swap. Specifically, he asks if either thenotional principal or the swap price can be higher during the reset closest to the winter season and lower for thereset period closest to the summer season. This would allow the swap to more effectively hedge a commoditylike oil, which would have a higher demand in the winter than the summer. Kanter says that a swap can onlyhave seasonal swap prices, and the notional principal must stay constanl. Thus, the solution in such a casewould be to enter into two swaps, one that has an annual reset in the winter and one that has an annual reset inthe summer.Given the information, the most likely reason that Bliss's firm did not earn an incentive fee in the past year wasbecause:

John Green, CFA, is a sell-side technology analyst at Federal Securities, a large global investment banking andadvisory firm. In many of his recent conversations with executives at the firms he researches, Green has hearddisturbing news. Most of these firms are lowering sales estimates for the coming year. However, the stockprices have been stable despite management's widely disseminated sales warnings. Green is preparing hisquarterly industry analysis and decides to seek further input. He calls Alan Volk, CFA, a close friend who runsthe Initial Public Offering section of the investment banking department of Federal Securities.Volk tells Green he has seen no slowing of demand for technology IPOs. "We've got three new issues due outnext week, and two of them are well oversubscribed." Green knows that Volk's department handled over 200IPOs last year, so he is confident that Volk's opinion is reliable. Green prepares his industry report, which isfavorable. Among other conclusions, the report states that "the future is still bright, based on the fact that 67%of technology IPOs are oversubscribed." Privately, Green recommends to Federal portfolio managers that theybegin selling all existing technology issues, which have "stagnated," and buy the IPOs in their place.After carefully evaluating Federal's largest institutional client's portfolio, Green contacts the client andrecommends selling all of his existing technology stocks and buying two of the upcoming IPOs, similar to therecommendation given to Federal's portfolio managers. Green's research has allowed him to conclude that onlythese two IPOs would be appropriate for this particular client's portfolio. Investing in these IPOs and selling thecurrent technology holdings would, according to Green, "double the returns that your portfolio experienced lastyear."Federal Securities has recently hired Dirks Bentley, a CFA candidate who has passed Level 2 and is currentlypreparing to take the Level 3 CFA® exam, to reorganize Federal's compliance department. Bentley tells Greenthat he may be subject to CFA Institute sanctions due to inappropriate contact between analysts andinvestment bankers within Federal Securities. Bentley has recommended that Green implement a firewall torectify the situation and has outlined the key characteristics for such a system. Bentley's suggestions are asfollows:1. Any communication between the departments of Federal Securities must be channeled through thecompliance department for review and eventual delivery. The firm must create and maintain watch, restricted,and rumor lists to be used in the review of employee trading.2. All beneficial ownership, whether direct or indirect, of recommended securities must be disclosed in writing.3. The firm must increase the level of review or restriction of proprietary trading activities during periods inwhich the firm has knowledge of information that is both material and nonpublic.Bentley has identified two of Green's analysts, neither of whom have non-compete contracts, who are preparingto leave Federal Securities and go into competition. The first employee, James Ybarra, CFA, has agreed totake a position with one of Federal's direct competitors. Ybarra has contacted existing Federal clients using aclient list he created with public records. None of the contacted clients have agreed to move their accounts asYbarra has requested. The second employee, Martha Cliff, CFA, has registered the name Cliff InvestmentConsulting (CIC), which she plans to use for her independent consulting business. For the new businessventure, Cliff has developed and professionally printed marketing literature that compares the new firm'sservices to that of Federal Securities and highlights the significant cost savings that will be realized by switchingto CIC. After she leaves Federal, Cliff plans to target many of the same prospects that Federal Securities istargeting, using an address list she purchased from a third-party vendor. Bentley decides to call a meeting withGreen to discuss his findings.After discussing the departing analysts. Green asks Bentley how to best handle the disclosure of the followingitems: (1) although not currently a board member. Green has served in the past on the board of directors of acompany he researches and expects that he will do so again in the near future; and (2) Green recently inheritedput options on a company for which he has an outstanding buy recommendation. Bentley is contemplating hisresponse to Green.According to Standard 11(A) Material Nonpublic Information, when Green contacted Volk, he:

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a varietyof institutions on the management of credit risk. Some of DSI's clients are very familiar with risk managementtechniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in thecreation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and otherinstitutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of creditrisk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerabledifficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with theGrich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared indefault of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claimsbefore it could settle the agreement with Johnson Associates.McNally mentions that Cramer should include a statement about the time dimension of credit risk. She statesthat the two primary time dimensions of credit risk are current and future. Current credit risk relates to thepossibility of default on current obligations, while future credit risk relates to potential default on futureobligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face valueof current obligations and the present value of future obligations. Cramer adds that combining current andpotential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually areliable predictor of a borrower's potential credit risk.As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated withforward agreements. Cramer states that long forward contracts gain in value when the market price of theunderlying increases above the contract price. McNally encourages Cramer to include an example of credit riskand forward contracts in the handbook. She offers the following:A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no fundswere exchanged upfront.Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. Hewrites that firms can make use of netting arrangements, create a special purpose vehicle, require collateralfrom counterparties, and require a mark-to-market provision. McNally adds that Cramer should include adiscussion of some newer forms of credit protection in his handbook. McNally thinks credit derivativesrepresent an opportunity for DSL She believes that one type of credit derivative that should figure prominently intheir handbook is total return swaps. She asserts that to purchase protection through a total return swap, theholder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swapdealer) in exchange for a single, fixed payment representing the discounted present value of expected cashflows from the asset.A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would likeprotection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus3%. Weaver Trading prefers a cash settlement.Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bondissued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client isconsidering hedging the bond using a credit spread forward, because he is concerned that a downturn in theeconomy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bondand the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. Thecharacteristics of the forward contract are shown below.Information on the Credit Spread ForwardRegarding their statements concerning current and future credit risk, determine whether Cramer and McNallyare correct or incorrect.

Sue Gano and Tony Cismesia are performance analysts for the Barth Group. Barth provides consulting andcompliance verification for investment firms wishing to adhere to the Global Investment Performance Standards(GIPS ®). The firm also provides global performance evaluation and attribution services for portfolio managers.Barth recommends the use of GIPS to its clients due to its prominence as the standard for investmentperformance presentation.One of the Barth Group's clients, Nigel Investment Advisors, has a composite that specializes in exploiting theresults of academic research. This Contrarian composite goes long "loser" stocks and short "winner" stocks.The "loser' stocks are those that have experienced severe price declines over the past three years, while the"winner" stocks are those that have had a tremendous surge in price over the past three years. The Contrariancomposite has a mixed record of success and is rather small. It contains only four portfolios. Gano andCismesia debate the requirements for the Contrarian composite under the Global Investment PerformanceStandards.The Global Equity Growth composite of Nigel Investment Advisors invests in growth stocks internationally, andis tilted when appropriate to small cap stocks. One of Nigel's clients in the Global Equity Growth composite isCypress University. The university has recently decided that it would like to implement ethical investing criteriain its endowment holdings. Specifically, Cypress does not want to hold the stocks from any countries that aredeemed as human rights violators. Cypress has notified Nigel of the change, but Nigel does not hold any stocksin these countries. Gano is concerned that this restriction may limit investment manager freedom going forward.Gano and Cismesia are discussing the valuation and return calculation principles for both portfolios andcomposites, which they believe have changed over time. In order to standardize the manner in whichinvestment firms calculate and present performance to clients, Gano states that GIPS require the following:Statement 1: The valuation of portfolios must be based on market values and not book values or cost. Portfoliovaluations must be quarterly for all periods prior to January 1, 2001. Monthly portfolio valuations and returns arerequired for periods between January 1, 2001 and January 1, 2010.Statement 2: Composites are groups of portfolios that represent a specific investment strategy or objective. Adefinition of them must be made available upon request. Because composites are based on portfolio valuation,the monthly requirement for return calculation also applies to composites for periods between January 1, 2001and January 1, 2010.The manager of the Global Equity Growth composite has a benchmark that is fully hedged against currencyrisk. Because the manager is confident in his forecasting of currency values, the manager does not hedge tothe extent that the benchmark does. In addition to the Global Equity Growth composite, Nigel InvestmentAdvisors has a second investment manager that specializes in global equity. The funds under her managementconstitute the Emerging Markets Equity composite. The benchmark for the Emerging Markets Equity compositeis not hedged against currency risk. The manager of the Emerging Markets Equity composite does not hedgedue to the difficulty in finding currency hedges for thinly traded emerging market currencies. The managerfocuses on security selection in these markets and does not try to time the country markets differently from thebenchmark.The manager of the Emerging Markets Equity composite would like to add frontier markets such as Bulgaria,Kenya, Oman, and Vietnam to their composite, with a 20% weight- The manager is attracted to frontier marketsbecause, compared to emerging markets, frontier markets have much higher expected returns and lowercorrelations. Frontier markets, however, also have lower liquidity and higher risk. As a result, the managerproposes that the benchmark be changed from one reflecting only emerging markets to one that reflects bothemerging and frontier markets. The date of the change and the reason for the change will be provided in thefootnotes to the performance presentation. The manager reasons that by doing so, the potential investor canaccurately assess the relative performance of the composite over time.Cismesia would like to explore the performance of the Emerging Markets Equity composite over the past twoyears. To do so, he determines the excess return each period and then compounds the excess return over thetwo years to arrive at a total two-year excess return. For the attribution analysis, he calculates the securityselection effect, the market allocation effect, and the currency allocation effect each year. He then adds all theyearly security selection effects together to arrive at the total security selection effect. He repeats this processfor the market allocation effect and the currency allocation effect.What are the GIPS requirements for the Contrarian composite of Nigel Investment Advisors?

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from aprestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-westernuniversity in the United States. Northern provides investment advice for pension funds, foundations,endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.They are currently scrutinizing the performance of several portfolio managers who work for the ThompsonUniversity endowment.Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer andSeagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states thatthe advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that themoney-weighted return is, however, a better measure of the manager's performance.Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for themost recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) forThompson is the 4.5% spending rate on the endowment, which the endowment has determined using ageometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI WorldIndex was used as the market index. The World index had a return of 9% in dollar terms with a standarddeviation of 23% and a beta of 1.0.The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performanceof managers. The alternatives discussed that day are manager universes, broad market indices, style indices,factor models, and custom benchmarks. Mercer states that manager universes have the advantage of beingmeasurable but they are subject to survivor bias. Seagram states that manager universes possess only onequality of a valid benchmark.Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes inexploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engagein providing foreign currency hedges to small firms in emerging markets when deemed profitable. This mostcommonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a largeposition in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firmin Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into acurrency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.Regarding their statements about manager universes, determine whether Mercer and Seagram are correct orincorrect.