Free Online CFA-Level-III Practice Test

Question 1

William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and positions in physical

commodities. He is reviewing his operations and strategies to increase the return of the fund. Bliss has just

hired Joseph Kanter, CFA, to help him manage the fund because he realizes that he needs to increase his

trading activity in futures and to engage in futures strategies other than fully hedged, passively managed

positions. Bliss also hired Kanter because of Kantcr's experience with swaps, which Bliss hopes to add to his

choice of investment tools.

Bliss explains to Kanter that his clients pay 2% on assets under management and a 20% incentive fee. The

incentive 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 did

not earn an incentive fee this past year. This was the case despite the fact that, after two years of losses, the

value of the fund increased 14% during the previous year. That increase occurred without any new capital

contributed from clients. Bliss is optimistic about the near future because the term structure of futures prices is

particularly 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 this

should increase the opportunity to earn a higher return in commodities and suggests taking a large, margined

position in a broad commodity index. This would offer an enhanced return that would attract investors holding

only stocks and bonds. Bliss mentions that not all commodity prices are positively correlated with inflation so it

may be better to choose particular types of commodities in which to invest. Furthermore, Bliss adds that

commodities 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 those

companies to gain commodity exposure is an efficient and effective method for gaining indirect exposure to

commodities.

Bliss agrees that his fund should increase its exposure to commodities and wants Kanter's help in using swaps

to gain such exposure. Bliss asks Kanter to enter into a swap with a relatively short horizon to demonstrate how

a 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 the

notional principal or the swap price can be higher during the reset closest to the winter season and lower for the

reset period closest to the summer season. This would allow the swap to more effectively hedge a commodity

like oil, which would have a higher demand in the winter than the summer. Kanter says that a swap can only

have seasonal swap prices, and the notional principal must stay constanl. Thus, the solution in such a case

would be to enter into two swaps, one that has an annual reset in the winter and one that has an annual reset in

the summer.

Given the information, the most likely reason that Bliss's firm did not earn an incentive fee in the past year was

because:

A : the normal return was subtracted.

B : the 2% asset-under-management fee is greater than the risk-free rate.

C : of a high water mark provision, which states the value of the fund must exceed its previous high point before managers are paid an incentive fee.

Answer: C

Question 2

Security analysts Andrew Tian, CFA, and Cameron Wong, CFA, are attending an investment symposium at the

Singapore Investment Analyst Society. The focus of the symposium is capital market expectations and relative

asset 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 estimating

intrinsic valuations. She notes that analysts attempting to gauge expectations are often subject to various

pitfalls that subjectively skew their estimates. She also points out that there are potential problems relating to a

choice of models, not all of which describe risk the same way. She then provides the following data to illustrate

how 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. His

presentation concerns the links between spot currency rates and forecasted exchange rates. He states that

foreign exchange rates are linked by several forces including purchasing power parity (PPP) and interest rate

parity (IRP). He tells his audience that the relationship between exchange rates and PPP is strongest in the

short run, while the relationship between exchange rates and IRP is strongest in the long run. Smyth goes on to

say that when a country's economy becomes more integrated with the larger world economy, this can have a

profound 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 primarily

concerned with how emerging market risk differs from that in developed markets and how to evaluate the

potential of emerging market investments. He noted that sometimes an economic crisis in one country can

spread to other countries in the area, and that asset returns often exhibit a greater degree of non-normality than

in developed markets.

Ruiz concluded his presentation with the data in the tables below to illustrate factors that should be considered

during the decision-making process for portfolio managers who are evaluating investments in emerging

markets.

Determine which of the following characteristics of emerging market debt investing presents the global fixed

income portfolio manager with the best potential to generate enhanced returns.

A : Increasing quality of emerging market sovereign debt coupled with the ability of emerging marketgovernments to access global capital.

B : The Emerging Markets Bond Index Pius (EMBI+) index is dominated by Latin American debt securities.

C : Emerging market debt can be highly volatile with negatively skewed returns distributions.

Answer: B

Question 3

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 domestic

and 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% is

paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change

scenarios, 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. In

response, 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 dealers

using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is

usually quite low. "

2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the

collateral is limited, the repo rate will be higher."

Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on

bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under

discussion 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. The

expected 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 about

the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. In

response, Diaz distinguishes between the standard deviation and downside risk measures, making the

following statements:

1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it

considers all returns over the entire distribution, variance and the resulting standard deviation are artificially

inflated, 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 returns

below 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 expected

return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss

if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall

risk 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 fixed

coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within

the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a

lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has

found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt

would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond

at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a

payer 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 of

each 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 in

their 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?

A : Only Castillo is correct.

B : Only Diaz is correct.

C : Both Castillo and Diaz are incorrect.

Answer: A

Question 4

Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Many

of MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all credit

qualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worth

inc., Enertech Company, and SBK Company.

Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of its

fixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued two

years ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to decline

by as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. The

company 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 at

MIA 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 value

of 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 proportion

of floating rate notes to finance its operations. The current interest rate on Enertech's floating rate notes, based

on 6-month LIBOR plus 150bp, is 5.5%. To hedge its interest rate risk, Enertech has decided to enter into a

long 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-month

LIBOR, which is forecast to be 5.2%, 6.1%, 4.1%, and 3.8%, in 6,12, 18, and 24 months, respectively. Each

settlement 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 issues

outstanding 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%, a

floating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6

months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given its

interest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, an

underlying 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 in

Rio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest rate

decline in Brazil over the short term.

Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effects

of the swap on the company's balance sheet are correct or incorrect.

A : Only the comment regarding the swap duration is correct.

B : Only the comment regarding the swap balance sheet effects is correct.

C : Both comments are correct.

Answer: C

Question 5

Andre Hickock, CFA, is a newly hired fixed income portfolio manager for Deadwood Investments, LLC. Hickock

is reviewing the portfolios of several pension clients that have been assigned to him to manage. The first

portfolio, Montana Hardware, Inc., has the characteristics shown in Figure 1.

Hickock is attempting to assess the risk of the Montana Hardware portfolio. The benchmark bond index that

Deadwood uses for pension accounts similar to Montana Hardware has an effective duration of 5.25. His

supervisor, Carla Mity, has discussed bond risk measurement with Hickock. Mity is most familiar with equity risk

measures, and is not convinced of the validity of duration as a portfolio risk measure. Mity told Hickock, "I have

always believed that standard deviation is the best measure of bond portfolio risk. You want to know the

volatility, and standard deviation is the most direct measure of volatility."

Hickock is also reviewing the bond portfolio of Buffalo Sports, Inc., which is comprised of the following assets

shown in Figure 2.

The trustees of the Buffalo Sports pension plan have requested that Deadwood explore alternatives to reduce

the risk of the MBS sector of their bond portfolio. Hickock responded to their request as follows:

"I believe that the current option-adjusted spread (OAS) on the MBS sector is quite high. In order to reduce your

risk, I would suggest that we hedge the interest rate risk using a combination of 2-year and 10-year Treasury

security futures. I would further suggest that we do not take any steps to hedge spread risk at this time."

In assessing the risk of a portfolio containing both bullet maturity corporate bonds and MBS, Hickock should

always consider that:

A : the duration of MBS securities will increase as the level of interest rates declines.

B : MBS values will benefit from higher convexity as interest rates decline.

C : MBS values will be more sensitive to changes in the shape of the yield curve than bullet maturity corporatebonds.

Answer: C

Free Online CFA Institute CFA-Level-III Practice Test