Free CFA Institute CFA-Level-III Exam Questions

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.

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:

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:

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%, paidsemiannually.Price 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."Assuming an immediate (today) increase in the immunized rate to 11%, the portfolio required return that wouldmost likely make Price turn to an immunization strategy is closest to:

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: