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.

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.

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.

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?

Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has beenexamining portfolio risk using traditional methods such as the portfolio variance and beta. He has rankedportfolios from least risky to most risky using traditional methods.Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount ofmoney clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solelyfor Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using thevariance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviationis expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (inmillions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000scenarios). The following table provides the results of the simulation:Figure 1: Monte Carlo Simulation DataThe top row (Percentile) of the table reports the percentage of simulations that had returns below thosereported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and97.5% of the simulations provided a return of 20% or less.Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfoliomanagement practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon tojustify his use of VAR methodology and explain why the estimated VAR varies depending on the method usedto calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client,the York Pension Plan.To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluatingportfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the YorkPension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Notethat the minimum acceptable return is the risk-free rate.Figure 3: Performance Ratios for the York Pension PlanUsing the historical data over the past 100 days, the 1-day, 5% VAR for the Jude Fund is closest to: