Free CFA Institute CFA-Level-III Exam Questions

Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Manyof MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all creditqualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worthinc., Enertech Company, and SBK Company.Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of itsfixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued twoyears ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to declineby as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. Thecompany has decided to enter into a 2-year interest rate swap with semiannual payments, a swap rate of 5.8%,and a floating rate based on 6-month EURIBOR. The duration of the fixed side of the swap is 1.2. Analysts atMIA have made the following comments regarding Worth's swap plan:• "The duration of the swap from the perspective of Worth is 0.95."• "By entering into the swap, the duration of Worth's long-term liabilities will become smaller, causing the valueof the firm's equity to become more sensitive to changes in interest rates."Enertech Company is a U.S.-based provider of electricity and natural gas. The company uses a large proportionof floating rate notes to finance its operations. The current interest rate on Enertech's floating rate notes, basedon 6-month LIBOR plus 150bp, is 5.5%. To hedge its interest rate risk, Enertech has decided to enter into along interest rate collar. The cap and the floor of the collar have maturities of two years, with settlement dates(in arrears) every six months. The strike rate for the cap is 5.5% and for the floor is 4.5%, based on 6-monthLIBOR, which is forecast to be 5.2%, 6.1%, 4.1%, and 3.8%, in 6,12, 18, and 24 months, respectively. Eachsettlement period consists of 180 days. Analysts at MIA are interested in assessing the attributes of the collar.SBK Company builds oil tankers and other large ships in Norway. The firm has several long-term bond issuesoutstanding with fixed interest rates ranging from 5.0% to 7.5% and maturities ranging from 5 to 12 years.Several years ago, SBK took the pay floating side of a semi-annual settlement swap with a rate of 6.0%, afloating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given itsinterest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, anunderlying swap rate of 6.0%, and a floating rate based on LIBOR.MIA is considering investing in the debt of Rio Corp, a Brazilian energy company. The investment would be inRio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest ratedecline in Brazil over the short term.Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effectsof the swap on the company's balance sheet are correct or incorrect.

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:

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixedincome firm based in the United States. AA employs numerous quantitative models to invest in both domesticand international securities.During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a$10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% ispaid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate changescenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned,however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. Inresponse, Castillo explains the factors that affect the repo rate and makes the following statements:1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral,and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealersusing repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate isusually quite low. "2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of thecollateral is limited, the repo rate will be higher."Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage onbond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio underdiscussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the$200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. Theexpected return on the portfolio is 8% and the cost of borrowed funds is 3%.The next day, the chief investment officer for the Washington Investment Fund expresses her concern aboutthe risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. Inresponse, Diaz distinguishes between the standard deviation and downside risk measures, making thefollowing statements:1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since itconsiders all returns over the entire distribution, variance and the resulting standard deviation are artificiallyinflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios,managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returnsbelow a given return, such as the mean or a hurdle rate."2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expectedreturn distribution. Although it can assign a probability to some maximum loss, it does not predict the actual lossif the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfallrisk is a more appropriate measure, because it provides the probability of not meeting a target return."AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixedcoupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further withinthe next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at alower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and hasfound that the call premium is quite high and that the investment banking costs of issuing new floating rate debtwould be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bondat a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy apayer swaption, which would give them the option to pay a lower floating interest rate if rates drop.Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms ofeach instrument are provided below:Payer swaption fixed rate7.90%Receiver swaption fixed rate7.60%Current Euribor7.20%Projected Euribor in one year5.90%Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call intheir old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.Regarding their statements concerning the synthetic refinancing of the Shaifer Materials fixed rate euro debt,are the comments correct?

Security analysts Andrew Tian, CFA, and Cameron Wong, CFA, are attending an investment symposium at theSingapore Investment Analyst Society. The focus of the symposium is capital market expectations and relativeasset valuations across markets. Many highly-respected practitioners and academics from across the AsiaPacific region are on hand to make presentations and participate in panel discussions.The first presenter, Lillian So, President of the Society, speaks on market expectations and tools for estimatingintrinsic valuations. She notes that analysts attempting to gauge expectations are often subject to variouspitfalls that subjectively skew their estimates. She also points out that there are potential problems relating to achoice of models, not all of which describe risk the same way. She then provides the following data to illustratehow analysts might go about estimating expectations and intrinsic values.The next speaker, Clive Smyth, is a member of the exchange rate committee at the Bank of New Zealand. Hispresentation concerns the links between spot currency rates and forecasted exchange rates. He states thatforeign exchange rates are linked by several forces including purchasing power parity (PPP) and interest rateparity (IRP). He tells his audience that the relationship between exchange rates and PPP is strongest in theshort run, while the relationship between exchange rates and IRP is strongest in the long run. Smyth goes on tosay that when a country's economy becomes more integrated with the larger world economy, this can have aprofound impact on the cost of capital and asset valuations in that country.The final speaker in the session directed his discussion toward emerging market investments. This discussion,by Hector Ruiz, head of emerging market investment for the Chilean Investment Board, was primarilyconcerned with how emerging market risk differs from that in developed markets and how to evaluate thepotential of emerging market investments. He noted that sometimes an economic crisis in one country canspread to other countries in the area, and that asset returns often exhibit a greater degree of non-normality thanin developed markets.Ruiz concluded his presentation with the data in the tables below to illustrate factors that should be consideredduring the decision-making process for portfolio managers who are evaluating investments in emergingmarkets.Determine which of the following characteristics of emerging market debt investing presents the global fixedincome portfolio manager with the best potential to generate enhanced returns.

Joan Nicholson, CFA, and Kim Fluellen, CFA, sit on the risk management committee for Thomasville AssetManagement. Although Thomasville manages the majority of its investable assets, it also utilizes outside firmsfor special situations such as market neutral and convertible arbitrage strategies. Thomasville has hired ahedge fund, Boston Advisors, for both of these strategies. The managers for the Boston Advisors funds areFrank Amato, CFA, and Joseph Garvin, CFA. Amato uses a market neutral strategy and has generated a returnof S20 million this year on the $100 million Thomasville has invested with him. Garvin uses a convertiblearbitrage strategy and has lost $15 million this year on the $200 million Thomasville has invested with him, withmost of the loss coming in the last quarter of the year. Thomasville pays each outside manager an incentive feeof 20% on profits. During the risk management committee meeting Nicholson evaluates the characteristics ofthe arrangement with Boston Advisors. Nicholson states that the asymmetric nature of Thomasville's contractwith Boston Advisors creates adverse consequences for Thomasville's net profits and that the compensationcontract resembles a put option owned by Boston Advisors.Upon request, Fluellen provides a risk assessment for the firm's large cap growth portfolio using a monthlydollar VAR. To do so, Fluellen obtains the following statistics from the fund manager. The value of the fund is$80 million and has an annual expected return of 14.4%. The annual standard deviation of returns is 21.50%.Assuming a standard normal distribution, 5% of the potential portfolio values are 1.65 standard deviationsbelow the expected return.Thomasville periodically engages in options trading for hedging purposes or when they believe that options aremispriced. One of their positions is a long position in a call option for Moffett Corporation. The option is aEuropean option with a 3-month maturity. The underlying stock price is $27 and the strike price of the option is$25. The option sells for S2.86. Thomasville has also sold a put on the stock of the McNeill Corporation. Theoption is an American option with a 2-month maturity. The underlying stock price is $52 and the strike price ofthe option is $55. The option sells for $3.82. Fluellen assesses the credit risk of these options to Thomasvilleand states that the current credit risk of the Moffett option is $2.86 and the current credit risk of the McNeilloption is $3.82.Thomasville also uses options quite heavily in their Special Strategies Portfolio. This portfolio seeks to exploitmispriced assets using the leverage provided by options contracts. Although this fund has achieved somespectacular returns, it has also produced some rather large losses on days of high market volatility. Nicholsonhas calculated a 5% VAR for the fund at $13.9 million. In most years, the fund has produced losses exceeding$13.9 million in 13 of the 250 trading days in a year, on average. Nicholson is concerned about the accuracy ofthe estimated VAR because when the losses exceed $13.9 million, they are typically much greater than $13.9million.In addition to using options, Thomasville also uses swap contracts for hedging interest rate risk and currencyexposures. Fluellen has been assigned the task of evaluating the credit risk of these contracts. Thecharacteristics of the swap contracts Thomasville uses are shown in Figure 1.Fluellen later is asked to describe credit risk in general to the risk management committee. She states thatcross-default provisions generally protect a creditor because they prevent a debtor from declaring immediatedefault on the obligation owed to the creditor when the debtor defaults on other obligations. Fluellen also statesthat credit risk and credit VAR can be quickly calculated because bond rating firms provide extensive data onthe defaults for investment grade and junk grade corporate debt at reasonable prices.Which of the following best describes the accuracy of the VAR measure calculated for the Special StrategiesPortfolio?