Free CFA Institute CFA-Level-III Exam Questions

Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy. One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis. Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity. Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around." The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year. Of the following VAR calculation methods, the measure that would most likely suit Smitherspoon is the:

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Nghedges many of the risks associated with Smiler's financial transactions, which include those of a financialsubsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managingSrniler's considerable investment portfolio.Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. Thereceivable is €10 million to be received in 90 days. Srniler's bank provides the following information:Smiler borrows short-term funds to meet expenses on a temporary basis and typically makes semiannualinterest payments based on 180-day LIBOR plus a spread of 150 bp. Smiler will need to borrow S25 million in90 days to invest in new equipment. To hedge the interest rate risk on the loan, Ng is considering the purchaseof a call option on 180-day LIBOR with a term to expiration of 90 days, an exercise rate of 4.8%, and a premiumof 0.000943443 of the loan amount. Current 90-day LIBOR is 4.8%.Smiler also has a diversified portfolio of large cap stocks with a current value of $52,750,000, and Ng wants tolower the beta of the portfolio from its current level of 1.25 to 0.9 using S&P 500 futures which have a multiplierof 250. The S&P 500 is currently 1,050, and the futures contract exhibits a beta of 0.98 to the underlying.Because Ng intends to replace the short-term LIBOR-based loan with long-term financing, he wants to hedgethe risk of a 50 bp change in the market rate of the 20-year bond Smiler will issue in 270 days. The currentspread to Treasuries for Smiler's corporate debt is 2.4%. He will use a 270-day, 20-year Treasury bond futurescontract ($100,000 face value) currently priced at 108.5 for the hedge. The CTD bond for the contract has aconversion factor of 1.259 and a dollar duration of $6,932.53. The corporate bond, if issued today, would havean effective duration of 9.94 and has an expected effective duration at issuance of 9.90 based on a constantspread assumption. A regression of the YTM of 20-year corporate bonds with a rating the same as Smiler's onthe YTM of the CTD bond yields a beta of 1.05.If Ng purchases the interest rate call, and 180-day LIBOR at option expiration is 5.73%, the annualized effectiverate for the 180-day loan is closest to:

Eugene Price, CFA, a portfolio manager for the American Universal Fund (AUF), has been directed to pursue acontingent immunization strategy for a portfolio with a current market value of $100 million. AUF's trustees arenot willing to accept a rate of return less than 6% over the next five years. The trustees have also stated thatthey believe an immunization rate of 8% is attainable in today's market. Price has decided to implement thisstrategy by initially purchasing $100 million in 10-year bonds with an annual coupon rate of 8.0%, paidsemiannually.Price forecasts that the prevailing immunization rate and market rate for the bonds will both rise from 8% to 9%in one year.While Price is conducting his immunization strategy he is approached by April Banks, a newly hired junioranalyst at AUF. Banks is wondering what steps need to be taken to immunize a portfolio with multiple liabilities.Price states that the concept of single liability immunization can fortunately be extended to address the issue ofimmunizing a portfolio with multiple liabilities. He further states that there are two methods for managingmultiple liabilities. The first method is cash flow matching which involves finding a bond with a maturity dateequal to the liability payment date, buying enough in par value of that bond so that the principal and final couponfully fund the last liability, and continuing this process until all liabilities are matched. The second method ishorizon matching which ensures that the assets and liabilities have the same present values and durations.Price warns Banks about the dangers of immunization risk. He states that it is impossible to have a portfoliowith zero immunization risk, because reinvestment risk will always be present. Price tells Banks, "Be cognizantof the dispersion of cash flows when conducting an immunization strategy. When there is a high dispersion ofcash flows about the horizon date, immunization risk is high. It is better to have cash flows concentrated aroundthe investment horizon, since immunization risk is reduced."Assuming an immediate (today) increase in the immunized rate to 11%, the portfolio required return that wouldmost likely make Price turn to an immunization strategy is closest to:

Geneva Management (GenM) selects long-only and long-short portfolio managers to develop asset allocationrecommendations for their institutional clients.GenM Advisor Marcus Reinhart recently examined the holdings of one of GenM's long-only portfolios activelymanaged by Jamison Kiley. Reinhart compiled the holdings for two consecutive non-overlapping five yearperiods. The Morningstar Style Boxes for the two periods for Kiley's portfolio are provided in Exhibits 1 and 2.Exhibit 1: Morningstar Style Box: Long-Only Manager for Five-Year Period 1Exhibit 2: Morningstar Style Box: Long-Only Manager for Five-Year Period 2Reinhart contends that the holdings-based analysis might be flawed because Kiley's portfolio holdings areknown only at the end of each quarter. Portfolio holdings at the end of the reporting period might misrepresentthe portfolio's average composition. To compliment his holdings-based analysis, Reinhart also conducts areturns-based style analysis on Kiley's portfolio. Reinhart selects four benchmarks:1. SCV: a small-cap value index.2. SCG: a small-cap growth index.3. LCV: a large-cap value index.4. LCG: a large-cap growth index.Using the benchmarks, Reinhart obtains the following regression results:Period 1: Rp = 0.02 + H0.01(SCV) + 0.02(SCG) + 0.36(LCV) + 0.61(LCG)Period 2: Rp = 0.02 + 0.01(SCV) + 0.02(SCG) + 0.60(LCV) + 0.38(LCG)Kiley's long-only portfolio is benchmarked against the S&P 500 Index. The Index's current sector allocations areshown in Exhibit 3.Exhibit 3: S&P 500 Index Sector AllocationsGenM strives to select managers whose correlation between forecast alphas and realized alphas has beenfairly high, and to allocate funds across managers in order to achieve alpha and beta separation. GenM givesReinhart a mandate to pursue a core-satellite strategy with a small number of satellites each focusing on arelatively few number of securities.In response to the core-satellite mandate, Reinhart explains that a Completeness Fund approach offers twoadvantages:Advantage 1: The Completeness Fund approach is designed to capture the stock selecting ability of the activemanager, while matching the overall portfolio's risk to its benchmark.Advantage 2: The Completeness Fund approach allows the Fund to fully capture the value added from activemanagers by eliminating misfit risk.Which one of the following statements about Kiley's long-only portfolio is most correct1? Kiley's portfolio:

Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. Thefunds are managed individually, but Pace has an investment committee that oversees all of the funds. Thiscommittee is responsible for evaluating the performance of the funds relative to appropriate benchmarks andrelative to the stated investment objectives of each individual fund. During a recent investment committeemeeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of theportfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee wasto review the performance of the manager responsible for each fund and dismiss those managers whoseperformance had lagged substantially behind the appropriate benchmark.The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with acapitalization between S40 billion and $80 billion. A review of the operations of the fund found the following:• The turnover of the fund was almost double that of other similar style mutual funds.• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existingholding.• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutualfunds.• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years offinancial information on that company, plus independent research reports from at least three different analysts.• The portfolio manager refuses to increase her technology sector weighting because of past losses the fundincurred in the sector.• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. Sheexpects oil prices to fall back to the $40 to S50 per barrel range.A committee member made the following two comments:Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfoliolacks recognizable companies. I believe that good companies make good investments."Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. Sheseems to sell stocks that appreciate, but hold stocks that have declined in value."The supervisor of the Mid-Cap Mutual Fund portfolio manager made the following statements:Statement 1: "The portfolio manager of the Mid-Cap Mutual Fund has engaged in quarter-end window dressingto make her portfolio look better to investors. The portfolio manager's action is a behavioral trait known as overreaction."Statement 2: "Each time the portfolio manager of the Mid-Cap Mutual fund trades a stock, she executes thetrade by buying or selling one-third of the position at a time, with the trades spread over three months. Theportfolio manager's action is a behavioral trait known as anchoring."Indicate whether Statement 1 and Statement 2 made by the supervisor are correct.