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.

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.

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 ForwardDetermine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.

Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping.Matrix sponsors a traditional defined benefit pension plan. Plan assets are valued at $5.5 billion, while recentdeclines in interest rates have caused plan liabilities to balloon to $8.3 billion. Average employee age at Matrixis 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1.1. JoeElliot, Matrix's CFO, has made the following statement about the current state of the pension plan."Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in ourlong history, but I am sure these low rates are temporary. I have looked at the charts and estimated theprobability of higher interest rates at more than 90%. Given the expected improvement in interest rate levels,plan liabilities will again come back into line with our historical position. Our investment policy will therefore beto invest plan assets in aggressive equity securities. This investment exposure will bring our plan to an overfunded status, which will allow us to use pension income to bolster our profitability."

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?