Free CFA Institute CFA-Level-III Exam Questions

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%, paidsemiannuallyPrice 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."Regarding Price's statements on the two methods for managing multiple liabilities, determine whether hisdescriptions of cash flow matching and horizon matching are correct.

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:

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.

Gabrielle Reneau, CFA, and Jack Belanger specialize in options strategies at the brokerage firm of Damon andDamon. They employ fairly sophisticated strategies to construct positions with limited risk, to profit from futurevolatility estimates, and to exploit arbitrage opportunities. Damon and Damon also provide advice to outsideportfolio managers on the appropriate use of options strategies. Damon and Damon prefer to use, andrecommend, options written on widely traded indices such as the S&P 500 due to their higher liquidity.However, they also use options written on individual stocks when the investor has a position in the underlyingstock or when mispricing and/or trading depth exists.In order to trade in the one-year maturity puts and calls for the S&P 500 stock index, Reneau and Belangercontact the chief economists at Damon and Damon, Mark Blair and Fran Robinson. Blair recently joined Damonand Damon after a successful stint at a London investment bank. Robinson has been with Damon and Damonfor the past ten years and has a considerable record of success in forecasting macroeconomic activity. In hisforecasts for the U.S. economy over the next year, Blair is quite bullish, for both the U.S. economy and the S&P500 stock index. Blair believes that the U.S. economy will grow at 2% more than expected over the next year.He also states that labor productivity will be higher than expected, given increased productivity through the useof technological advances. He expects that these technological advances will result in higher earnings for U.S.firms over the next year and over the long run.Reneau believes that the best S&P 500 option strategy to exploit Blair's forecast involves two options of thesame maturity, one with a low exercise price, and the other with a high exercise price. The beginning stockprice is usually below the two option strike prices. She states that the benefit of this strategy is that themaximum loss is limited to the difference between the two option prices.Belanger is unsure that Blair's forecast is correct. He states that his own reading of the economy is for acontinued holding pattern of low growth, with a similar projection for the stock market as a whole. He states thatDamon and Damon may want to pursue an options strategy where a put and call of the same maturity andsame exercise price are purchased. He asserts that such a strategy would have losses limited to the total costof the two options.Reneau and Belanger are also currently examining various positions in the options of Brendan Industries.Brendan Industries is a large-cap manufacturing firm with headquarters in the midwestern United States. Thefirm has both puts and calls sold on the Chicago Board Options Exchange. Their options have good liquidity forthe near money puts and calls and for those puts and calls with maturities less than four months. Reneaubelieves that Brendan Industries will benefit from the economic expansion forecasted by Mark Blair, the Damonand Damon economist. She decides that the best option strategy to exploit these expectations is for her topursue the same strategy she has delineated for the market as a whole.Shares of Brendan Industries are currently trading at $38. The following are the prices for their exchangetraded options.As a mature firm in a mature industry, Brendan Industries stock has historically had low volatility. However,Belanger's analysis indicates that with a lawsuit pending against Brendan Industries, the volatility of the stockprice over the next 60 days is greater by several orders of magnitude than the implied volatility of the options.He believes that Damon and Damon should attempt to exploit this projected increase in Brendan Industries1volatility by using an options strategy where a put and call of the same maturity and same exercise price areutilized. He advocates using the least expensive strategy possible.During their discussions, Reneau cites a counter example to Brendan Industries from last year. She recalls thatNano Networks, a technology firm, had a stock price that stayed fairly stable despite expectations to thecontrary. In this case, she utilized an options strategy where three different calls were used. Profits were earnedon the strategy because Nano Networks' stock price stayed fairly stable. Even if the stock price had becomevolatile, losses would have been limited.Later that week, Reneau and Belanger discuss various credit option strategies during a lunch time presentationto Damon and Damon client portfolio managers. During their discussion, Reneau describes a credit optionstrategy that pays the holder a fixed sum, which is agreed upon when the option is written, and occurs in theevent that an issue or issuer goes into default. Reneau declares that this strategy can take the form of eitherputs or calls. Belanger states that this strategy is known as either a credit spread call option strategy or a creditspread put option strategy.Reneau and Belanger continue by discussing the benefits of using credit options. Reneau mentions that creditoptions written on an underlying asset will protect against declines in asset valuation. Belanger says that creditspread options protect against adverse movements of the credit spread over a referenced benchmark.Assume Reneau applies the options strategy used earlier for Nano Networks. Assuming there is a 3-month 45call on Brendan Industries trading at $1.00, calculate the maximum gain and maximum loss on this position.Max gain Max loss

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: