Free CFA Institute CFA-Level-III Exam Questions

Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investmentanalysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout theworld. The firm specializes in the valuation of international bonds, with consideration of currency risk. IAtypically uses forward contracts to hedge currency risk.Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm,Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency(NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higginssuggests that they consider forward contracts with the same maturity as the investment holding period, which isestimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona(Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via aone-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if theNorwegian NKr and euro are positively correlated, then a forward contract should be entered into where euroswill be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates andspot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.Return on Bergen Petroleum bond in Norwegian NKr 7.00%Risk-free rate in Norway 4.80%Expected change in the NKr relative to the U.S. dollar -0.40%Risk-free rate in United States 2.50%Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, wherehigher forward rates imply that a country's spot rate will increase in the future."• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-yearU.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forwardpremium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen.Invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."The following day, Higgins and Tyler discuss various emerging market bond strategies and make the followingstatements.• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagionand the competitive devaluations that often accompany crises in emerging markets. When one countrydevalues their currency, others often quickly follow and as a result the countries default on their external debt,which is usually denominated in a hard currency."• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging marketbond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emergingcountry bonds outside of this region."Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds:a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by theHorgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued by a firm based inSwitzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss therelative attractiveness of each bond and, using a total return approach, which bond should be invested in,assuming a 1-year time horizon.Which of the following statements provides the best description of the advantage of using breakeven spread analysis? Breakeven spread analysis: 

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:

Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy. One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis. Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity. Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around." The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year. Of the following VAR calculation methods, the measure that would most likely suit Smitherspoon is the:

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."

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: