Free CFA Institute CFA-Level-III Exam Questions

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:

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:

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?

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.

Garrison Investments is a money management firm focusing on endowment management for small collegesand universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocationsto high quality long-term foreign government bonds. Garrison's largest account, Point University, has a marketvalue of $800 million and an asset allocation as detailed in Figure 1.Figure 1: Point University Asset Allocation*Bond coupon payments are all semiannual. Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value. Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move. Managers at Garrison have put together the following proposal for the reallocation: To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2. Figure 2: Mid-cap index and European Index Futures DataThree months after proposing the international diversification plan, Garrison was able to persuade PointUniversity to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japaneseelectronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of itsproduction in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigateexchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HIhas one remaining purchase of Australian gold that will occur in nine months. The company has hedged thepurchase with a long 12-month futures contract on the Australian dollar (AUD).Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about theimpact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decidedto use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the localcurrency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of changes in theUSD/Yen spot rate is 0.92.Which of the following best describes the minimum variance hedge ratio for Garrison's currency futures hedgeon the Haikuza investment?