Free CFA Institute CFA-Level-III Exam Questions

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.

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:

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm thathandles investments for small businesses in Northern Germany. For the most part, Wulf has been handlinglocally concentrated investments in European securities. Due to a lack of expertise in currency management heworks closely with James Bauer, a foreign exchange expert who manages international exposure in some ofUpsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of clientinvestment policy statements.To achieve global diversification, Wulf's portfolio invests in securities from developed nations including theUnited States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become ahuge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while theJapanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discusshedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with theexpectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit thisposition 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contractguarantees that the portfolio will not take any unjustified risk in the volatile dollar.Wulf recently started investing in securities from Japan. He has been particularly interested in the growth oftechnology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technologyenterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of theinvestment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen,Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedgingthis position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. Hementions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futuressince put options are only exercised if the local currency depreciates.The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of£5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected toincrease to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expectedexchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, tohedge only the principal of this investment.Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of alsohedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against apossible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested inexecuting index hedging strategies that are perfectly correlated with foreign investments. Bauer, however,cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.Regarding the Japanese investment in the technology company, determine the appropriate transaction in putoptions to adjust the current delta hedge, given that the delta changes to -0.92. Assume that each yen putallows the right to self ¥1,000,000.

Andre Hickock, CFA, is a newly hired fixed income portfolio manager for Deadwood Investments, LLC. Hickockis reviewing the portfolios of several pension clients that have been assigned to him to manage. The firstportfolio, Montana Hardware, Inc., has the characteristics shown in Figure 1.Hickock is attempting to assess the risk of the Montana Hardware portfolio. The benchmark bond index thatDeadwood uses for pension accounts similar to Montana Hardware has an effective duration of 5.25. Hissupervisor, Carla Mity, has discussed bond risk measurement with Hickock. Mity is most familiar with equity riskmeasures, and is not convinced of the validity of duration as a portfolio risk measure. Mity told Hickock, "I havealways believed that standard deviation is the best measure of bond portfolio risk. You want to know thevolatility, and standard deviation is the most direct measure of volatility."Hickock is also reviewing the bond portfolio of Buffalo Sports, Inc., which is comprised of the following assetsshown in Figure 2.The trustees of the Buffalo Sports pension plan have requested that Deadwood explore alternatives to reducethe risk of the MBS sector of their bond portfolio. Hickock responded to their request as follows:"I believe that the current option-adjusted spread (OAS) on the MBS sector is quite high. In order to reduce yourrisk, I would suggest that we hedge the interest rate risk using a combination of 2-year and 10-year Treasurysecurity futures. I would further suggest that we do not take any steps to hedge spread risk at this time."In assessing the risk of a portfolio containing both bullet maturity corporate bonds and MBS, Hickock shouldalways consider that:

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."