Free CFA Institute CFA-Level-III Exam Questions

Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has beenexamining portfolio risk using traditional methods such as the portfolio variance and beta. He has rankedportfolios from least risky to most risky using traditional methods.Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount ofmoney clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solelyfor Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using thevariance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviationis expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (inmillions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000scenarios). The following table provides the results of the simulation:Figure 1: Monte Carlo Simulation DataThe top row (Percentile) of the table reports the percentage of simulations that had returns below thosereported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and97.5% of the simulations provided a return of 20% or less.Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfoliomanagement practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon tojustify his use of VAR methodology and explain why the estimated VAR varies depending on the method usedto calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client,the York Pension Plan.To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluatingportfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the YorkPension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Notethat the minimum acceptable return is the risk-free rate.Figure 3: Performance Ratios for the York Pension PlanUsing the historical data over the past 100 days, the 1-day, 5% VAR for the Jude Fund 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:

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."

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that inthe bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize trackingerror.One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectusreveals the following fund objectives and strategies:“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asianregion (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investmentsin both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that areexpected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added byfinding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency onthe part of issuer."Although Northern Capital does examine the availability of excess returns in foreign markets by investingoutside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the optionadjusted spread and the swap spread and makes the following statements:Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjustedspread is increasingly valuable for analyzing the attractiveness of bond investments.Statement 2: The advantage of the swap spread framework is that investors can compare the relativeattractiveness of fixed-rate and floating-rate bond markets.Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidityfrom the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts thatinterest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of businessinvestment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low inorder to stimulate the economy. Although she sees the level of yields declining, she believes that the spread onrisky securities will increase due to the decline in business prospects. She therefore has reallocated her bondportfolio away from high-yield bonds and towards investment grade bonds.Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated QuincyCorporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhancedhis annual income, which he considers quite favorable given the declining yields in the market.Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, sheexpects that the yields on mortgages will decline. As a result, she has reallocated the portion of NorthernCapital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in pricemore than the higher coupon mortgages. She identifies this trade as a structure trade.Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:Which of the following best describes the relative value analysis used in the Northern Capita! Emerging marketbond fund? It is a:

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: