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.

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.

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:

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:

Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios whichhave just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints,as welt as an initial strategic asset allocation. However, Draper has found that all of the portfolios haveexperienced changes in asset values. As a result, the current allocations have drifted away from the initialallocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with theirproposed asset allocation targets.Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing. During their conversation,Sterling made the following comments:Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatilityof the asset classes in the portfolio.Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to morefrequent rebalancing.Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing,but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As anexample, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.Draper has been reviewing Madison files on four high net worth individuals, each of whom has a $1 millionportfolio. He hopes to gain insight as to appropriate rebalancing strategies for these clients. His research so farshows:Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerancedrops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook,which is for a long-term bull market with few reversals.Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees withthe Madison stock market outlook.Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio.She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked bynumerous reversals, over the coming months.In selecting a rebalancing strategy for his clients, Draper would most likely select a constant mix strategy for: