Free CFA Institute CFA-Level-III Exam Questions

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:

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%, paidsemiannuallyPrice 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."Regarding Price's statements on the two methods for managing multiple liabilities, determine whether hisdescriptions of cash flow matching and horizon matching are correct.

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:

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:

Jerry Edwards is an analyst with DeLeon Analytics. He is currently advising the CFO of Anderson Corp., amultinational manufacturing corporation based in Newark, New Jersey, USA. Jackie Palmer is Edwards'sassistant. Palmer is well versed in risk management, having worked at a large multinational bank for the lastten years prior to coming to Anderson.Anderson has received a $2 million note with a duration of 4.0 from Weaver Tools for a shipment delivered lastweek. Weaver markets tools and machinery from manufacturers of Anderson's size. Edwards states that inorder to effectively hedge the price risk of this instrument, Anderson should sell a series of interest rate calls.Palmer states that an alternative hedge for the note would be to enter an interest rate swap as the fixed-ratepayer.As well as selling products from a Swiss plant in Europe, Anderson sells products in Switzerland itself. As aresult, Anderson has quarterly cash flows of 12,000,000 Swiss franc (CHF). In order to convert these cashflows into dollars, Edwards suggests that Anderson enter into a currency swap without an exchange of notionalprincipal. Palmer contacts a currency swap dealer with whom they have dealt in the past and finds the followingexchange rate and annual swap interest rates:Exchange Rate (CHF per dollar) 1.24Swap interest rate in U.S. dollars 2.80%Swap interest rate in Swiss franc 6.60%Discussing foreign exchange rate risk in general, Edwards states that it is transaction exposure that is mostoften hedged, because the amount to be hedged is contractual and certain. Economic exposure, he states, isless certain and thus harder to hedge.To finance their U.S. operations, Anderson issued a S10 million fixed-rate bond in the United States five yearsago. The bond had an original maturity often years and now has a modified duration of 4.0. Edwards states thatAnderson should enter a 5-year semiannual pay floating swap with a notional principal of about $11.4 million totake advantage of falling interest rates. The duration of the fixed-rate side of the swap is equal to 75% of itsmaturity or 3.75 (= 0.75 x 5). The duration of the floating side of the swap is 0.25. Palmer states that Anderson'sposition in the swap will have a negative duration.For another client of DeLeon, Edwards has assigned Palmer the task of estimating the interest rate sensitivityof the client's portfolios. The client's portfolio consists of positions in both U.S. and British bonds. The relevantinformation for estimating (he duration contribution of the British bond and the portfolio's total duration isprovided below.U.S. dollar bond $275,000British bond $155,000British yield beta 1.40Duration of U.S. bond 4.0Duration of British bond 8.5When discussing portfolio management with clients, Edwards recommends the use of emerging market bondsto add value to a core-plus strategy. He explains the characteristics of emerging market debt to Palmer bystating:1. "The performance of emerging market debt has been quite resilient over time. After crises in the debtmarkets, emerging market bonds quickly recover after a crisis, so long-term returns can be poor."2. "Emerging market debt is quite volatile due in part to the nature of political risk in these markets. It istherefore important that the analyst monitor the risk of these markets. I prefer to measure the risk of emergingmarket bonds with the standard deviation because it provides the best representation of risk in these markets."Regarding his two statements about the characteristics of emerging market debt, is Edwards correct?