Free CFA Institute CFA-Level-III Exam Questions

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?

Rowan Brothers is a full service investment firm offering portfolio management and investment banking services. For the last ten years, Aaron King, CFA, has managed individual client portfolios for Rowan Brothers, most of which are trust accounts over which King has full discretion. One of King's clients, Shelby Pavlica, is a widow in her late 50s whose husband died and left assets of over $7 million in a trust, for which she is the only beneficiary. Pavlica's three children are appalled at their mother's spending habits and have called a meeting with King to discuss their concerns. They inform King that their mother is living too lavishly to leave much for them or Pavlica's grandchildren upon her death. King acknowledges their concerns and informs them that, on top of her ever-increasing spending, Pavlica has recently been diagnosed with a chronic illness. Since the diagnosis could indicate a considerable increase in medical spending, he will need to increase the risk of the portfolio to generate sufficient return to cover the medical bills and spending and still maintain the principal. King restructures the portfolio accordingly and then meets with Pavlica a week later to discuss how he has altered the investment strategy, which was previously revised only three months earlier in their annual meeting. During the meeting with Pavlica, Kang explains his reasoning tor altering the portfolio allocation but does not mention the meeting with Pavlica's children. Pavlica agrees that it is probably the wisest decision and accepts the new portfolio allocation adding that she will need to tell her children about her illness, so they will understand why her medical spending requirements will increase in the near future. She admits to King that her children have been concerned about her spending. King assures her that the new investments will definitely allow her to maintain her lifestyle and meet her higher medical spending needs. One of the investments selected by King is a small allocation in a private placement offered to him by a brokerage firm that often makes trades for King's portfolios. The private placement is an equity investment in ShaleCo, a small oil exploration company. In order to make the investment, King sold shares of a publicly traded biotech firm, VNC Technologies. King also held shares of VNC, a fact that he has always disclosed to clients before purchasing VNC for their accounts. An hour before submitting the sell order for the VNC shares in Pavlica's trust account. King placed an order to sell a portion of his position in VNC stock. By the time Pavlica's order was sent to the trading floor, the price of VNC had risen, allowing Pavlica to sell her shares at a better price than received by King. Although King elected not to take any shares in the private placement, he purchased positions for several of his clients, for whom the investment was deemed appropriate in terms of the clients* objectives and constraints as well as the existing composition of the portfolios. In response to the investment support, ShaleCo appointed King to their board of directors. Seeing an opportunity to advance his career while also protecting the value of his clients' investments in the company, King gladly accepted the offer. King decided that since serving on the board of ShaleCo is in his clients' best interest, it is not necessary to disclose the directorship to his clients or his employer. For his portfolio management services, King charges a fixed percentage fee based on the value of assets under management. All fees charged and other terms of service are disclosed to clients as well as prospects. In the past month, however. Rowan Brothers has instituted an incentive program for its portfolio managers. Under the program, the firm will award an all-expense-paid vacation to the Cayman islands for any portfolio manager who generates two consecutive quarterly returns for his clients in excess of 10%. King updates his marketing literature to ensure that his prospective clients are fully aware of his compensation arrangements, but he does not contact current clients to make them aware of the newly created performance incentive. According to the CFA Institute Standards of Professional Conduct, which of the following statements is correct concerning King's directorship with ShaleCo?

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?

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.

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that inthe bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize trackingerror.One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectusreveals the following fund objectives and strategies:“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asianregion (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investmentsin both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that areexpected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added byfinding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency onthe part of issuer."Although Northern Capital does examine the availability of excess returns in foreign markets by investingoutside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the optionadjusted spread and the swap spread and makes the following statements:Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjustedspread is increasingly valuable for analyzing the attractiveness of bond investments.Statement 2: The advantage of the swap spread framework is that investors can compare the relativeattractiveness of fixed-rate and floating-rate bond markets.Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidityfrom the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts thatinterest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of businessinvestment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low inorder to stimulate the economy. Although she sees the level of yields declining, she believes that the spread onrisky securities will increase due to the decline in business prospects. She therefore has reallocated her bondportfolio away from high-yield bonds and towards investment grade bonds.Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated QuincyCorporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhancedhis annual income, which he considers quite favorable given the declining yields in the market.Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, sheexpects that the yields on mortgages will decline. As a result, she has reallocated the portion of NorthernCapital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in pricemore than the higher coupon mortgages. She identifies this trade as a structure trade.Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:Which of the following best describes the relative value analysis used in the Northern Capita! Emerging marketbond fund? It is a: