Free CFA Institute CFA-Level-III Exam Questions

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:

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 ForwardRegarding their statements concerning current and future credit risk, determine whether Cramer and McNallyare correct or incorrect.

Jacques Lepage, CFA, is a portfolio manager for MontBlanc Securities and holds 4 million shares of AirCon inclient portfolios. Lepage issues periodic research reports on AirCon to both discretionary and nondiscretionaryaccounts. In his October investment report, Lepage stated, "In my opinion, AirCon is entering a phase, whichcould put it 'in play' as a takeover target. Nonetheless, this possibility appears to be fully reflected in the marketvalue of the stock."One month has passed since Lepage's October report and AirCon has just announced the firm's executivecompensation packages, which include stock options (50% of which expire in one year), personal use ofcorporate aircraft (which can be used in conjunction with paid vacation days), and a modest base salary thatconstitutes a small proportion of the overall package. While he has not asked, he believes that the directors of MontBlanc will find the compensation excessive and sells the entire position immediately after the news. Unbeknownst to Lepage, three days earlier an announcement was made via Reuters and other financial news services that AirCon had produced record results that were far beyond expectations. Moreover, the firm has established a dominant position in a promising new market that is expected to generate above-average firm growth for the next five years. A few weeks after selling the AirCon holdings, Lepage bought 2.5 million shares of Spectra Vision over a period of four days. The typical trading volume of this security is about 1.3 million shares per day, and his purchases drove the price up 9% over the 4-day period. These trades were designated as appropriate for 13 accounts of differing sizes, including performance-based accounts, charitable trusts, and private accounts. The shares were allocated to the accounts on a pro rata basis at the end of each day at the average price for the day. One of the investment criteria used in evaluating equity holdings is the corporate governance structure of the issuing company. Because Lepage has dealt with this topic extensively, he has been asked to present a talk of corporate governance issues to the firm's portfolio managers and analysts at the next monthly meeting. At the meeting, Lepage makes the following comments: "When evaluating the corporate governance policies of a company, you should begin by assessing the responsibilities of the company's board of directors. In general, the board should have the responsibility to set long-term objectives that are consistent with shareholders' interests. In addition, the board must be responsible for hiring the CEO and setting his or her compensation package such that the CEO's interests are aligned with those of the shareholders. In that way the board can spend its time on matters other than monitoring the CEO. A firm with good corporate governance policies should also have an audit committee made up of independent board members that are experienced in auditing and related legal matters. The audit committee should have full access to the firm's financial statements and the ability to question auditors hired by the committee." According to the CFA Institute Code and Standards, Lepage's ignorance of AirCon's press release to Reuters three days before he sold shares of the company:

Robert Keith, CFA, has begun a new job at CMT Investments as Head of Compliance. Keith has just completed a review of all of CMT's operations, and has interviewed all the firm's portfolio managers. Many are CFA charterholders, but some are not. Keith intends to use the CFA Institute Code and Standards, as well as the Asset Manager Code of Professional Conduct, as ethical guidelines for CMT to follow. In the course of Keith's review of the firm's overall practices, he has noted a few situations which potentially need to be addressed. Situation 1: CMT Investments' policy regarding acceptance of gifts and entertainment is not entirely clear. There is general confusion within the firm regarding what is and is not acceptable practice regarding gifts, entertainment and additional compensation. Situation 2: Keith sees inconsistency regarding fee disclosures to clients. In some cases, information related to fees paid to investment managers for investment services provided are properly disclosed. However, a few of the periodic costs, which will affect investment return, are not disclosed to the clients. Most managers are providing clients with investment returns net of fees, but a few are just providing the gross returns. One of the managers stated "providing gross returns is acceptable, as long as I show the fees such that the client can make their own simple calculation of the returns net of fees." Situation 3: Keith has noticed a few gaps in CMT's procedure regarding use of soft dollars. There have been cases where "directed brokerage" has resulted in less than prompt execution of trades. He also found a few cases where a manager paid a higher commission than normal, in order to obtain goods or services. Keith is considering adding two statements to CMT's policy and procedures manual specifically addressing the primary issues he noted. Statement 1: "Commissions paid, and any corresponding benefits received, are the property of the client. The benefit(s) must directly benefit the client. If a manager's client directs the manager to purchase goods or services that do not provide research services that benefit the client, this violates the duty of loyalty to the client.” Statement 2: "In cases of "directed brokerage," if there is concern that the client is not receiving the best execution, it is acceptable to utilize a less than ideal broker, but it must be disclosed to the client that they may not be obtaining the best execution." Situation 4: Keith is still evaluating his data, but it appears that there may be situations where proxies were not voted. After completing his analysis of proxy voting procedures at CMT, Keith wants to insert the proper language into the procedures manual to address proxy voting. Situation 5: Keith is putting into place a "disaster recovery- plan," in order to ensure business continuity in the event of a localized disaster, and also to protect against any type of disruption in the financial markets. This plan includes the following provisions: • Procedures for communicating with clients, especially in the event of extended disruption of services provided. • Alternate arrangement for monitoring and analyzing investments in the event that primary systems become unavailable. • Plans for internal communication and coverage of crucial business functions in the event of disruption at the primary place of business, or a communications breakdown. Keith is considering adding the following provisions to the disaster recovery plan in order to properly comply with the CFA Institute Asset Manager Code of Professional Conduct: Provision 1: "A provision needs to be added incorporating off-site backup for all pertinent account information." Provision 2: "A provision mandating testing of the plan on a company-wide basis, at periodical intervals, should be added." Situation 6: Keith is spending an incredible amount of time on detailed procedures and company policies that are in compliance with the CFA Institute Code and Standards, and also in compliance with the CFA Institute Asset Manager Code of Professional Conduct. As part of this process, he has had several meetings with CMT senior management, and is second-guessing the process. One of the senior managers is indicating that it might be abetter idea to just formally adopt both the Code and Standards and the Asset Manager Code of Conduct, which would make a detailed policy and procedure manual redundant. Keith wants to assure CMT's compliance with the requirements of the CFA Institute Code and Standards of Professional Conduct. Which of the following statements most accurately describes CMT's responsibilities in order to assure compliance?

Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investmentanalysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout theworld. The firm specializes in the valuation of international bonds, with consideration of currency risk. IAtypically uses forward contracts to hedge currency risk.Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm,Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency(NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higginssuggests that they consider forward contracts with the same maturity as the investment holding period, which isestimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona(Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via aone-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if theNorwegian NKr and euro are positively correlated, then a forward contract should be entered into where euroswill be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates andspot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.Return on Bergen Petroleum bond in Norwegian NKr 7.00%Risk-free rate in Norway 4.80%Expected change in the NKr relative to the U.S. dollar -0.40%Risk-free rate in United States 2.50%Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, wherehigher forward rates imply that a country's spot rate will increase in the future."• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-yearU.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forwardpremium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen.Invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."The following day, Higgins and Tyler discuss various emerging market bond strategies and make the followingstatements.• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagionand the competitive devaluations that often accompany crises in emerging markets. When one countrydevalues their currency, others often quickly follow and as a result the countries default on their external debt,which is usually denominated in a hard currency."• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging marketbond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emergingcountry bonds outside of this region."Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds:a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by theHorgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued by a firm based inSwitzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss therelative attractiveness of each bond and, using a total return approach, which bond should be invested in,assuming a 1-year time horizon.Which of the following statements provides the best description of the advantage of using breakeven spread analysis? Breakeven spread analysis: