Free CFA Institute CFA-Level-III Exam Questions

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm thathandles investments for small businesses in Northern Germany. For the most part, Wulf has been handlinglocally concentrated investments in European securities. Due to a lack of expertise in currency management heworks closely with James Bauer, a foreign exchange expert who manages international exposure in some ofUpsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of clientinvestment policy statements.To achieve global diversification, Wulf's portfolio invests in securities from developed nations including theUnited States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become ahuge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while theJapanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discusshedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with theexpectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit thisposition 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contractguarantees that the portfolio will not take any unjustified risk in the volatile dollar.Wulf recently started investing in securities from Japan. He has been particularly interested in the growth oftechnology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technologyenterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of theinvestment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen,Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedgingthis position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. Hementions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futuressince put options are only exercised if the local currency depreciates.The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of£5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected toincrease to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expectedexchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, tohedge only the principal of this investment.Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of alsohedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against apossible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested inexecuting index hedging strategies that are perfectly correlated with foreign investments. Bauer, however,cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.Regarding the Japanese investment in the technology company, determine the appropriate transaction in putoptions to adjust the current delta hedge, given that the delta changes to -0.92. Assume that each yen putallows the right to self ¥1,000,000.

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:

Joan Nicholson, CFA, and Kim Fluellen, CFA, sit on the risk management committee for Thomasville AssetManagement. Although Thomasville manages the majority of its investable assets, it also utilizes outside firmsfor special situations such as market neutral and convertible arbitrage strategies. Thomasville has hired ahedge fund, Boston Advisors, for both of these strategies. The managers for the Boston Advisors funds areFrank Amato, CFA, and Joseph Garvin, CFA. Amato uses a market neutral strategy and has generated a returnof S20 million this year on the $100 million Thomasville has invested with him. Garvin uses a convertiblearbitrage strategy and has lost $15 million this year on the $200 million Thomasville has invested with him, withmost of the loss coming in the last quarter of the year. Thomasville pays each outside manager an incentive feeof 20% on profits. During the risk management committee meeting Nicholson evaluates the characteristics ofthe arrangement with Boston Advisors. Nicholson states that the asymmetric nature of Thomasville's contractwith Boston Advisors creates adverse consequences for Thomasville's net profits and that the compensationcontract resembles a put option owned by Boston Advisors.Upon request, Fluellen provides a risk assessment for the firm's large cap growth portfolio using a monthlydollar VAR. To do so, Fluellen obtains the following statistics from the fund manager. The value of the fund is$80 million and has an annual expected return of 14.4%. The annual standard deviation of returns is 21.50%.Assuming a standard normal distribution, 5% of the potential portfolio values are 1.65 standard deviationsbelow the expected return.Thomasville periodically engages in options trading for hedging purposes or when they believe that options aremispriced. One of their positions is a long position in a call option for Moffett Corporation. The option is aEuropean option with a 3-month maturity. The underlying stock price is $27 and the strike price of the option is$25. The option sells for S2.86. Thomasville has also sold a put on the stock of the McNeill Corporation. Theoption is an American option with a 2-month maturity. The underlying stock price is $52 and the strike price ofthe option is $55. The option sells for $3.82. Fluellen assesses the credit risk of these options to Thomasvilleand states that the current credit risk of the Moffett option is $2.86 and the current credit risk of the McNeilloption is $3.82.Thomasville also uses options quite heavily in their Special Strategies Portfolio. This portfolio seeks to exploitmispriced assets using the leverage provided by options contracts. Although this fund has achieved somespectacular returns, it has also produced some rather large losses on days of high market volatility. Nicholsonhas calculated a 5% VAR for the fund at $13.9 million. In most years, the fund has produced losses exceeding$13.9 million in 13 of the 250 trading days in a year, on average. Nicholson is concerned about the accuracy ofthe estimated VAR because when the losses exceed $13.9 million, they are typically much greater than $13.9million.In addition to using options, Thomasville also uses swap contracts for hedging interest rate risk and currencyexposures. Fluellen has been assigned the task of evaluating the credit risk of these contracts. Thecharacteristics of the swap contracts Thomasville uses are shown in Figure 1.Fluellen later is asked to describe credit risk in general to the risk management committee. She states thatcross-default provisions generally protect a creditor because they prevent a debtor from declaring immediatedefault on the obligation owed to the creditor when the debtor defaults on other obligations. Fluellen also statesthat credit risk and credit VAR can be quickly calculated because bond rating firms provide extensive data onthe defaults for investment grade and junk grade corporate debt at reasonable prices.Which of the following best describes the accuracy of the VAR measure calculated for the Special StrategiesPortfolio?

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."

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: