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:

John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management. In one of his client portfolios, Rawlins currently holds the following positions:The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he hasregressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient forthis regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedgingcalculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futurescontracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond managementby moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in hisportfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-holdstrategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervaluedbond issues. Although Tejada has recently graduated from a prestigious university with a master's degree infinance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approachneeds further evaluation over a period of both falling and rising interest rates, as well as in different creditenvironments.Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, aU.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by BergamoMetals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. Theholding period for either bond is three months.The characteristics of the bonds are as follows:3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejadawill hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacombond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro isat a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because thenet return advantage for the Dynacom bond is 0.5% over the next three months.Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has ayield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heardrumors that the chief executive and the chairman of the board at Dynacom are both being investigated by theU.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to theexercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident couldbe damaging to Dynacom's bond price.Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes thatnews of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states thathe would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bondstays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative ofTejada's efforts, the analysis relies on an approximation.Suppose that the original dollar duration for a 100 basis point change in interest rates was $4,901,106 and thatthe bond prices remain constant during the year. Based upon the durations one year from today, and assuminga proportionate investment in each of the three bonds, the amount of cash that will need to be invested torestore the average dollar duration to the original level is closest to:

John Green, CFA, is a sell-side technology analyst at Federal Securities, a large global investment banking andadvisory firm. In many of his recent conversations with executives at the firms he researches, Green has hearddisturbing news. Most of these firms are lowering sales estimates for the coming year. However, the stockprices have been stable despite management's widely disseminated sales warnings. Green is preparing hisquarterly industry analysis and decides to seek further input. He calls Alan Volk, CFA, a close friend who runsthe Initial Public Offering section of the investment banking department of Federal Securities.Volk tells Green he has seen no slowing of demand for technology IPOs. "We've got three new issues due outnext week, and two of them are well oversubscribed." Green knows that Volk's department handled over 200IPOs last year, so he is confident that Volk's opinion is reliable. Green prepares his industry report, which isfavorable. Among other conclusions, the report states that "the future is still bright, based on the fact that 67%of technology IPOs are oversubscribed." Privately, Green recommends to Federal portfolio managers that theybegin selling all existing technology issues, which have "stagnated," and buy the IPOs in their place.After carefully evaluating Federal's largest institutional client's portfolio, Green contacts the client andrecommends selling all of his existing technology stocks and buying two of the upcoming IPOs, similar to therecommendation given to Federal's portfolio managers. Green's research has allowed him to conclude that onlythese two IPOs would be appropriate for this particular client's portfolio. Investing in these IPOs and selling thecurrent technology holdings would, according to Green, "double the returns that your portfolio experienced lastyear."Federal Securities has recently hired Dirks Bentley, a CFA candidate who has passed Level 2 and is currentlypreparing to take the Level 3 CFA® exam, to reorganize Federal's compliance department. Bentley tells Greenthat he may be subject to CFA Institute sanctions due to inappropriate contact between analysts andinvestment bankers within Federal Securities. Bentley has recommended that Green implement a firewall torectify the situation and has outlined the key characteristics for such a system. Bentley's suggestions are asfollows:1. Any communication between the departments of Federal Securities must be channeled through thecompliance department for review and eventual delivery. The firm must create and maintain watch, restricted,and rumor lists to be used in the review of employee trading.2. All beneficial ownership, whether direct or indirect, of recommended securities must be disclosed in writing.3. The firm must increase the level of review or restriction of proprietary trading activities during periods inwhich the firm has knowledge of information that is both material and nonpublic.Bentley has identified two of Green's analysts, neither of whom have non-compete contracts, who are preparingto leave Federal Securities and go into competition. The first employee, James Ybarra, CFA, has agreed totake a position with one of Federal's direct competitors. Ybarra has contacted existing Federal clients using aclient list he created with public records. None of the contacted clients have agreed to move their accounts asYbarra has requested. The second employee, Martha Cliff, CFA, has registered the name Cliff InvestmentConsulting (CIC), which she plans to use for her independent consulting business. For the new businessventure, Cliff has developed and professionally printed marketing literature that compares the new firm'sservices to that of Federal Securities and highlights the significant cost savings that will be realized by switchingto CIC. After she leaves Federal, Cliff plans to target many of the same prospects that Federal Securities istargeting, using an address list she purchased from a third-party vendor. Bentley decides to call a meeting withGreen to discuss his findings.After discussing the departing analysts. Green asks Bentley how to best handle the disclosure of the followingitems: (1) although not currently a board member. Green has served in the past on the board of directors of acompany he researches and expects that he will do so again in the near future; and (2) Green recently inheritedput options on a company for which he has an outstanding buy recommendation. Bentley is contemplating hisresponse to Green.According to Standard 11(A) Material Nonpublic Information, when Green contacted Volk, he:

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.

Garrison Investments is a money management firm focusing on endowment management for small collegesand universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocationsto high quality long-term foreign government bonds. Garrison's largest account, Point University, has a marketvalue of $800 million and an asset allocation as detailed in Figure 1.Figure 1: Point University Asset Allocation*Bond coupon payments are all semiannual. Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value. Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move. Managers at Garrison have put together the following proposal for the reallocation: To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2. Figure 2: Mid-cap index and European Index Futures DataThree months after proposing the international diversification plan, Garrison was able to persuade PointUniversity to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japaneseelectronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of itsproduction in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigateexchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HIhas one remaining purchase of Australian gold that will occur in nine months. The company has hedged thepurchase with a long 12-month futures contract on the Australian dollar (AUD).Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about theimpact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decidedto use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the localcurrency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of changes in theUSD/Yen spot rate is 0.92.Which of the following best describes the minimum variance hedge ratio for Garrison's currency futures hedgeon the Haikuza investment?