Free CFA Institute CFA-Level-III Exam Questions

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He isresponsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, acandidate for the Level 1 CFA exam.Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain.He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£.Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. Thecurrent 1-year forward rate is C$1.60/£.Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information isprovided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bondis denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the UnitedStates.Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge ofcurrency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must alsodecide whether or not to hedge the currency exposure.Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is havingdifficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered aforward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. Hisreason for choosing the yen is that it is positively correlated with the won.One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedgingstrategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interestrate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest ratesmay increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or aninterest rate floor as a hedge.Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle iscontemplating using either a covered call or a protective put on a T-bond futures contract.The hedge that Rolle uses to hedge the currency exposure of the Korean bond is best referred to as a:

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:

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:

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixedincome firm based in the United States. AA employs numerous quantitative models to invest in both domesticand international securities.During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a$10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% ispaid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate changescenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned,however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. Inresponse, Castillo explains the factors that affect the repo rate and makes the following statements:1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral,and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealersusing repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate isusually quite low. "2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of thecollateral is limited, the repo rate will be higher."Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage onbond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio underdiscussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the$200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. Theexpected return on the portfolio is 8% and the cost of borrowed funds is 3%.The next day, the chief investment officer for the Washington Investment Fund expresses her concern aboutthe risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. Inresponse, Diaz distinguishes between the standard deviation and downside risk measures, making thefollowing statements:1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since itconsiders all returns over the entire distribution, variance and the resulting standard deviation are artificiallyinflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios,managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returnsbelow a given return, such as the mean or a hurdle rate."2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expectedreturn distribution. Although it can assign a probability to some maximum loss, it does not predict the actual lossif the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfallrisk is a more appropriate measure, because it provides the probability of not meeting a target return."AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixedcoupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further withinthe next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at alower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and hasfound that the call premium is quite high and that the investment banking costs of issuing new floating rate debtwould be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bondat a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy apayer swaption, which would give them the option to pay a lower floating interest rate if rates drop.Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms ofeach instrument are provided below:Payer swaption fixed rate7.90%Receiver swaption fixed rate7.60%Current Euribor7.20%Projected Euribor in one year5.90%Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call intheir old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.Regarding their statements concerning the synthetic refinancing of the Shaifer Materials fixed rate euro debt,are the comments correct?

John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management. In one of his client portfolios, Rawlins currently holds the following positions:The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he hasregressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient forthis regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedgingcalculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futurescontracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond managementby moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in hisportfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-holdstrategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervaluedbond issues. Although Tejada has recently graduated from a prestigious university with a master's degree infinance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approachneeds further evaluation over a period of both falling and rising interest rates, as well as in different creditenvironments.Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, aU.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by BergamoMetals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. Theholding period for either bond is three months.The characteristics of the bonds are as follows:3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejadawill hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacombond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro isat a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because thenet return advantage for the Dynacom bond is 0.5% over the next three months.Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has ayield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heardrumors that the chief executive and the chairman of the board at Dynacom are both being investigated by theU.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to theexercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident couldbe damaging to Dynacom's bond price.Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes thatnews of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states thathe would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bondstays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative ofTejada's efforts, the analysis relies on an approximation.Suppose that the original dollar duration for a 100 basis point change in interest rates was $4,901,106 and thatthe bond prices remain constant during the year. Based upon the durations one year from today, and assuminga proportionate investment in each of the three bonds, the amount of cash that will need to be invested torestore the average dollar duration to the original level is closest to: