Free CFA Institute CFA-Level-III Exam Questions

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:

Joan Weaver, CFA and Kim McNally, CFA are analysts for Cardinal Fixed Income Management. Cardinalprovides investment advisory services to pension funds, endowments, and other institutions in the U.S. andCanada. Cardinal recommends positions in investment-grade corporate and government bonds.Cardinal has largely advocated the use of passive approaches to bond investments, where the predominantholding consists of an indexed or enhanced indexed bond portfolio. They are exploring, however, the possibilityof using a greater degree of active management to increase excess returns. The analysts have made thefollowing statements.• Weaver: "An advantage of both enhanced indexing by matching primary risk factors and enhanced indexingby minor risk factor mismatching is that there is the potential for excess returns, but the duration of the portfoliois matched with that of the index, thereby limiting the portion of tracking error resulting from interest rate risk."• McNally: "The use of active management by larger risk factor mismatches typically involves large durationmismatches from the index, in an effort to capitalize on interest rate forecasts."As part of their increased emphasis on active bond management, Cardinal has retained the services of aneconomic consultant to provide expectations input on factors such as interest rate levels, interest rate volatility,and credit spreads. During his presentation, the economist states that he believes long-term interest ratesshould fall over the next year, but that short-term rates should gradually increase. Weaver and McNally arecurrently advising an institutional client that wishes to maintain the duration of its bond portfolio at 6.7. In light ofthe economic forecast, they are considering three portfolios that combine the following three bonds in varyingamounts.Weaver and McNally next examine an investment in a semiannual coupon bond newly issued by the ManixCorporation, a firm with a credit rating of AA by Moody's. The specifics of the bond purchase are providedbelow given Weaver's projections. It is Cardinal's policy that bonds be evaluated for purchase on a total returnbasis.One of Cardinal's clients, the Johnson Investment Fund (JIF), has instructed Weaver and McNally torecommend the appropriate debt investment for $125,000,000 in funds. JIF is willing to invest an additional15% of the portfolio using leverage. JIF requires that the portfolio duration not exceed 5.5. Weaverrecommends that JIF invest in bonds with a duration of 5.2. The maximum allowable leverage will be used andthe borrowed funds will have a duration of 0.8. JIF is considering investing in bonds with options and has askedMcNally to provide insight into these investments. McNally makes the following comments:"Due to the increasing sophistication of bond issuers, the amount of bonds with put options is increasing, andthese bonds sell at a discount relative to comparable bullets. Putables are quite attractive when interest ratesrise, but, we should be careful if with them, because valuation models often fail to account for the credit risk ofthe issuer."Another client, Blair Portfolio Managers, has asked Cardinal to provide advice on duration management. Oneyear ago, their portfolio had a market value of $3,010,444 and a dollar duration of $108,000; current figures areprovided below:The expected bond equivalent yield for the Manix Bond, using total return analysis, is closest to:

John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management. In one of his client portfolios, Rawlins currently holds the following positions:The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he hasregressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient forthis regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedgingcalculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futurescontracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond managementby moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in hisportfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-holdstrategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervaluedbond issues. Although Tejada has recently graduated from a prestigious university with a master's degree infinance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approachneeds further evaluation over a period of both falling and rising interest rates, as well as in different creditenvironments.Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, aU.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by BergamoMetals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. Theholding period for either bond is three months.The characteristics of the bonds are as follows:3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejadawill hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacombond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro isat a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because thenet return advantage for the Dynacom bond is 0.5% over the next three months.Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has ayield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heardrumors that the chief executive and the chairman of the board at Dynacom are both being investigated by theU.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to theexercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident couldbe damaging to Dynacom's bond price.Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes thatnews of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states thathe would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bondstays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative ofTejada's efforts, the analysis relies on an approximation.Suppose that the original dollar duration for a 100 basis point change in interest rates was $4,901,106 and thatthe bond prices remain constant during the year. Based upon the durations one year from today, and assuminga proportionate investment in each of the three bonds, the amount of cash that will need to be invested torestore the average dollar duration to the original level 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.

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from aprestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-westernuniversity in the United States. Northern provides investment advice for pension funds, foundations,endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.They are currently scrutinizing the performance of several portfolio managers who work for the ThompsonUniversity endowment.Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer andSeagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states thatthe advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that themoney-weighted return is, however, a better measure of the manager's performance.Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for themost recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) forThompson is the 4.5% spending rate on the endowment, which the endowment has determined using ageometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI WorldIndex was used as the market index. The World index had a return of 9% in dollar terms with a standarddeviation of 23% and a beta of 1.0.The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performanceof managers. The alternatives discussed that day are manager universes, broad market indices, style indices,factor models, and custom benchmarks. Mercer states that manager universes have the advantage of beingmeasurable but they are subject to survivor bias. Seagram states that manager universes possess only onequality of a valid benchmark.Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes inexploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engagein providing foreign currency hedges to small firms in emerging markets when deemed profitable. This mostcommonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a largeposition in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firmin Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into acurrency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.Regarding their statements about manager universes, determine whether Mercer and Seagram are correct orincorrect.