Free CFA Institute CFA-Level-III Exam Questions

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 ForwardDetermine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.

Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios whichhave just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints,as welt as an initial strategic asset allocation. However, Draper has found that all of the portfolios haveexperienced changes in asset values. As a result, the current allocations have drifted away from the initialallocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with theirproposed asset allocation targets.Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing. During their conversation,Sterling made the following comments:Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatilityof the asset classes in the portfolio.Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to morefrequent rebalancing.Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing,but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As anexample, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.Draper has been reviewing Madison files on four high net worth individuals, each of whom has a $1 millionportfolio. He hopes to gain insight as to appropriate rebalancing strategies for these clients. His research so farshows:Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerancedrops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook,which is for a long-term bull market with few reversals.Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees withthe Madison stock market outlook.Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio.She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked bynumerous reversals, over the coming months.In selecting a rebalancing strategy for his clients, Draper would most likely select a constant mix strategy for:

Garrison Investments is a money management firm focusing on endowment management for small collegesand universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocationsto high quality long-term foreign government bonds. Garrison's largest account, Point University, has a marketvalue of $800 million and an asset allocation as detailed in Figure 1.Figure 1: Point University Asset Allocation*Bond coupon payments are all semiannual. Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value. Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move. Managers at Garrison have put together the following proposal for the reallocation: To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2. Figure 2: Mid-cap index and European Index Futures DataThree months after proposing the international diversification plan, Garrison was able to persuade PointUniversity to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japaneseelectronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of itsproduction in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigateexchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HIhas one remaining purchase of Australian gold that will occur in nine months. The company has hedged thepurchase with a long 12-month futures contract on the Australian dollar (AUD).Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about theimpact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decidedto use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the localcurrency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of changes in theUSD/Yen spot rate is 0.92.Which of the following best describes the minimum variance hedge ratio for Garrison's currency futures hedgeon the Haikuza investment?

Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Quaker Fund. BIC is an asset management firm headquartered in Holland with regional offices in several other European countries. After accepting the position, Bair received a letter from the three principals of BIC. The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations. Among other things, the letter stated the following: "Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund. It is your responsibility to obtain this knowledge and comply with appropriate regulations. This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully. You will likely need to arrange for our sister companies to quietly buy and sell Quaker Fund shares over the first month of operations. This will provide sufficient price support to allow the fund to trade closer to its net asset value than other small-cap closed-end funds. Because these funds generally trade at a discount to net asset value, if our fund trades close to its net asset value, the market may perceive it as more desirable than similar funds managed by our competitors." Bair heeded the advice from her firm's principals and collected information on the laws and regulations of three countries: Norway, Sweden, and Denmark. So far, all of the investors expressing interest in the Quaker Fund are from these areas. Based on her research, Bair decides the following policies are appropriate for the fund: Note: Laws mentioned below are assumed for illustrative purposes. • For clients located in Norway the fund will institute transaction crossing, since, unlike in Holland, the practice is not prohibited by securities laws or regulations. The process will involve internally matching buy and sell orders from Norwegian clients whenever possible. This will reduce brokerage fees and improve the fund's overall performance. • For clients located in Denmark, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by Denmark's securities regulators, even though the laws in Holland only require such reports to be generated on a quarterly basis. • For clients located in Sweden, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment. This policy is consistent with the laws and regulations in Holland. Sweden's securities regulations do not cover this type of situation.Three months after the inception of the fund, its market value has grown from $200 million to $300 million and Bair's performance has earned her a quarter-end bonus. Since it is now the end of the quarter, Bair is participating in conference calls with companies in her fund. Bair calls into the conference number for Swift Petroleum. The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Swift discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter. The restatement will not be announced until the year's end, six months from now. Bair does not remind the officers that she can hear their conversation. Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call. Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call. The investment bankers then proceed to sell their personal holdings of Swift Petroleum stock. After her meeting, Bair sells the Quaker Fund's holdings of Swift Petroleum stock. By selling the Quaker Fund's shares of Swift Petroleum, did Bair violate any CFA Institute Standards of Professional Conduct?

John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management. In one of his client portfolios, Rawlins currently holds the following positions:The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he hasregressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient forthis regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedgingcalculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futurescontracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond managementby moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in hisportfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-holdstrategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervaluedbond issues. Although Tejada has recently graduated from a prestigious university with a master's degree infinance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approachneeds further evaluation over a period of both falling and rising interest rates, as well as in different creditenvironments.Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, aU.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by BergamoMetals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. Theholding period for either bond is three months.The characteristics of the bonds are as follows:3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejadawill hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacombond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro isat a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because thenet return advantage for the Dynacom bond is 0.5% over the next three months.Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has ayield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heardrumors that the chief executive and the chairman of the board at Dynacom are both being investigated by theU.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to theexercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident couldbe damaging to Dynacom's bond price.Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes thatnews of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states thathe would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bondstays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative ofTejada's efforts, the analysis relies on an approximation.Suppose that the original dollar duration for a 100 basis point change in interest rates was $4,901,106 and thatthe bond prices remain constant during the year. Based upon the durations one year from today, and assuminga proportionate investment in each of the three bonds, the amount of cash that will need to be invested torestore the average dollar duration to the original level is closest to: