Free CFA Institute CFA-Level-III Exam Questions

William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and positions in physicalcommodities. He is reviewing his operations and strategies to increase the return of the fund. Bliss has justhired Joseph Kanter, CFA, to help him manage the fund because he realizes that he needs to increase histrading activity in futures and to engage in futures strategies other than fully hedged, passively managedpositions. Bliss also hired Kanter because of Kantcr's experience with swaps, which Bliss hopes to add to hischoice of investment tools.Bliss explains to Kanter that his clients pay 2% on assets under management and a 20% incentive fee. Theincentive fee is based on profits after having subtracted the risk-free rate, which is the fund's basic hurdle rate,and there is a high water mark provision. Bliss is hoping that Kanter can help his business because his firm didnot earn an incentive fee this past year. This was the case despite the fact that, after two years of losses, thevalue of the fund increased 14% during the previous year. That increase occurred without any new capitalcontributed from clients. Bliss is optimistic about the near future because the term structure of futures prices isparticularly favorable for earning higher returns from long futures positions.Kanter says he has seen research that indicates inflation may increase in the next few years. He states thisshould increase the opportunity to earn a higher return in commodities and suggests taking a large, marginedposition in a broad commodity index. This would offer an enhanced return that would attract investors holdingonly stocks and bonds. Bliss mentions that not all commodity prices are positively correlated with inflation so itmay be better to choose particular types of commodities in which to invest. Furthermore, Bliss adds thatcommodities traditionally have not outperformed stocks and bonds either on a risk-adjusted or absolute basis.Kanter says he will research companies who do business in commodities, because buying the stock of thosecompanies to gain commodity exposure is an efficient and effective method for gaining indirect exposure tocommodities.Bliss agrees that his fund should increase its exposure to commodities and wants Kanter's help in using swapsto gain such exposure. Bliss asks Kanter to enter into a swap with a relatively short horizon to demonstrate howa commodity swap works. Bliss notes that the futures prices of oil for six months, one year, eighteen months,and two years are $55, S54, $52, and $5 1 per barrel, respectively, and the risk-free rate is less than 2%.Bliss asks how a seasonal component could be added to such a swap. Specifically, he asks if either thenotional principal or the swap price can be higher during the reset closest to the winter season and lower for thereset period closest to the summer season. This would allow the swap to more effectively hedge a commoditylike oil, which would have a higher demand in the winter than the summer. Kanter says that a swap can onlyhave seasonal swap prices, and the notional principal must stay constanl. Thus, the solution in such a casewould be to enter into two swaps, one that has an annual reset in the winter and one that has an annual reset inthe summer.Given the information, the most likely reason that Bliss's firm did not earn an incentive fee in the past year wasbecause:

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from aprestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-westernuniversity in the United States. Northern provides investment advice for pension funds, foundations,endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.They are currently scrutinizing the performance of several portfolio managers who work for the ThompsonUniversity endowment.Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer andSeagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states thatthe advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that themoney-weighted return is, however, a better measure of the manager's performance.Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for themost recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) forThompson is the 4.5% spending rate on the endowment, which the endowment has determined using ageometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI WorldIndex was used as the market index. The World index had a return of 9% in dollar terms with a standarddeviation of 23% and a beta of 1.0.The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performanceof managers. The alternatives discussed that day are manager universes, broad market indices, style indices,factor models, and custom benchmarks. Mercer states that manager universes have the advantage of beingmeasurable but they are subject to survivor bias. Seagram states that manager universes possess only onequality of a valid benchmark.Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes inexploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engagein providing foreign currency hedges to small firms in emerging markets when deemed profitable. This mostcommonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a largeposition in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firmin Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into acurrency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.Regarding their statements about manager universes, determine whether Mercer and Seagram are correct orincorrect.

Walter Skinner, CFA, manages a bond portfolio for Director Securities. The bond portfolio is part of a pensionplan trust set up to benefit retirees of Thomas Steel Inc. As part of the investment policy governing the plan andthe bond portfolio, no foreign securities are to be held in the portfolio at any time and no bonds with a creditrating below investment grade are allowable for the bond portfolio. In addition, the bond portfolio must remainunleveraged. The bond portfolio is currently valued at $800 million and has a duration of 6.50. Skinner believesthat interest rates are going to increase, so he wants to lower his portfolio's duration to 4.50. He has decided toachieve the reduction in duration by using swap contracts. He has two possible swaps to choose from:1. Swap A: 4-year swap with quarterly payments.2. Swap B: 5-year swap with semiannual payments.Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. Foranalysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity.Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing adual currency bond issued by an American holding company with significant operations in Japan. The bondmakes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S.dollars five years from now. Skinner originally purchased the bond to take advantage of the strengtheningrelative position of the yen. The result was an above average return for the bond portfolio for several years.Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in theJapanese economy to accelerate over the next few years. Knowing Skinner's situation, one of his colleagues,Bill Michaels, suggests the following strategy:"You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dualcurrency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bondportfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. Theswap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure ofthe portfolio."Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his expectationsfor the bond portfolio. Mann has also provided some advice to Skinner in the following comment:"1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rateshift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the callfeatures of any callable bonds in your portfolio by purchasing a payer interest rate swaption."After his lung conversation with Director Securities' senior economist, Orval Mann, Skinner has completelychanged his outlook on interest rates and has decided to extend the duration of his portfolio. The mostappropriate strategy to accomplish this objective using swaps would be to enter into a swap to pay:

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Nghedges many of the risks associated with Smiler's financial transactions, which include those of a financialsubsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managingSrniler's considerable investment portfolio.Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. Thereceivable is €10 million to be received in 90 days. Srniler's bank provides the following information:Smiler borrows short-term funds to meet expenses on a temporary basis and typically makes semiannualinterest payments based on 180-day LIBOR plus a spread of 150 bp. Smiler will need to borrow S25 million in90 days to invest in new equipment. To hedge the interest rate risk on the loan, Ng is considering the purchaseof a call option on 180-day LIBOR with a term to expiration of 90 days, an exercise rate of 4.8%, and a premiumof 0.000943443 of the loan amount. Current 90-day LIBOR is 4.8%.Smiler also has a diversified portfolio of large cap stocks with a current value of $52,750,000, and Ng wants tolower the beta of the portfolio from its current level of 1.25 to 0.9 using S&P 500 futures which have a multiplierof 250. The S&P 500 is currently 1,050, and the futures contract exhibits a beta of 0.98 to the underlying.Because Ng intends to replace the short-term LIBOR-based loan with long-term financing, he wants to hedgethe risk of a 50 bp change in the market rate of the 20-year bond Smiler will issue in 270 days. The currentspread to Treasuries for Smiler's corporate debt is 2.4%. He will use a 270-day, 20-year Treasury bond futurescontract ($100,000 face value) currently priced at 108.5 for the hedge. The CTD bond for the contract has aconversion factor of 1.259 and a dollar duration of $6,932.53. The corporate bond, if issued today, would havean effective duration of 9.94 and has an expected effective duration at issuance of 9.90 based on a constantspread assumption. A regression of the YTM of 20-year corporate bonds with a rating the same as Smiler's onthe YTM of the CTD bond yields a beta of 1.05.If Ng purchases the interest rate call, and 180-day LIBOR at option expiration is 5.73%, the annualized effectiverate for the 180-day loan is closest to:

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: