Free CFA Institute CFA-Level-III Exam Questions

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?

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?

Gabrielle Reneau, CFA, and Jack Belanger specialize in options strategies at the brokerage firm of Damon andDamon. They employ fairly sophisticated strategies to construct positions with limited risk, to profit from futurevolatility estimates, and to exploit arbitrage opportunities. Damon and Damon also provide advice to outsideportfolio managers on the appropriate use of options strategies. Damon and Damon prefer to use, andrecommend, options written on widely traded indices such as the S&P 500 due to their higher liquidity.However, they also use options written on individual stocks when the investor has a position in the underlyingstock or when mispricing and/or trading depth exists.In order to trade in the one-year maturity puts and calls for the S&P 500 stock index, Reneau and Belangercontact the chief economists at Damon and Damon, Mark Blair and Fran Robinson. Blair recently joined Damonand Damon after a successful stint at a London investment bank. Robinson has been with Damon and Damonfor the past ten years and has a considerable record of success in forecasting macroeconomic activity. In hisforecasts for the U.S. economy over the next year, Blair is quite bullish, for both the U.S. economy and the S&P500 stock index. Blair believes that the U.S. economy will grow at 2% more than expected over the next year.He also states that labor productivity will be higher than expected, given increased productivity through the useof technological advances. He expects that these technological advances will result in higher earnings for U.S.firms over the next year and over the long run.Reneau believes that the best S&P 500 option strategy to exploit Blair's forecast involves two options of thesame maturity, one with a low exercise price, and the other with a high exercise price. The beginning stockprice is usually below the two option strike prices. She states that the benefit of this strategy is that themaximum loss is limited to the difference between the two option prices.Belanger is unsure that Blair's forecast is correct. He states that his own reading of the economy is for acontinued holding pattern of low growth, with a similar projection for the stock market as a whole. He states thatDamon and Damon may want to pursue an options strategy where a put and call of the same maturity andsame exercise price are purchased. He asserts that such a strategy would have losses limited to the total costof the two options.Reneau and Belanger are also currently examining various positions in the options of Brendan Industries.Brendan Industries is a large-cap manufacturing firm with headquarters in the midwestern United States. Thefirm has both puts and calls sold on the Chicago Board Options Exchange. Their options have good liquidity forthe near money puts and calls and for those puts and calls with maturities less than four months. Reneaubelieves that Brendan Industries will benefit from the economic expansion forecasted by Mark Blair, the Damonand Damon economist. She decides that the best option strategy to exploit these expectations is for her topursue the same strategy she has delineated for the market as a whole.Shares of Brendan Industries are currently trading at $38. The following are the prices for their exchangetraded options.As a mature firm in a mature industry, Brendan Industries stock has historically had low volatility. However,Belanger's analysis indicates that with a lawsuit pending against Brendan Industries, the volatility of the stockprice over the next 60 days is greater by several orders of magnitude than the implied volatility of the options.He believes that Damon and Damon should attempt to exploit this projected increase in Brendan Industries1volatility by using an options strategy where a put and call of the same maturity and same exercise price areutilized. He advocates using the least expensive strategy possible.During their discussions, Reneau cites a counter example to Brendan Industries from last year. She recalls thatNano Networks, a technology firm, had a stock price that stayed fairly stable despite expectations to thecontrary. In this case, she utilized an options strategy where three different calls were used. Profits were earnedon the strategy because Nano Networks' stock price stayed fairly stable. Even if the stock price had becomevolatile, losses would have been limited.Later that week, Reneau and Belanger discuss various credit option strategies during a lunch time presentationto Damon and Damon client portfolio managers. During their discussion, Reneau describes a credit optionstrategy that pays the holder a fixed sum, which is agreed upon when the option is written, and occurs in theevent that an issue or issuer goes into default. Reneau declares that this strategy can take the form of eitherputs or calls. Belanger states that this strategy is known as either a credit spread call option strategy or a creditspread put option strategy.Reneau and Belanger continue by discussing the benefits of using credit options. Reneau mentions that creditoptions written on an underlying asset will protect against declines in asset valuation. Belanger says that creditspread options protect against adverse movements of the credit spread over a referenced benchmark.Assume Reneau applies the options strategy used earlier for Nano Networks. Assuming there is a 3-month 45call on Brendan Industries trading at $1.00, calculate the maximum gain and maximum loss on this position.Max gain Max loss

John Green, CFA, is a sell-side technology analyst at Federal Securities, a large global investment banking andadvisory firm. In many of his recent conversations with executives at the firms he researches, Green has hearddisturbing news. Most of these firms are lowering sales estimates for the coming year. However, the stockprices have been stable despite management's widely disseminated sales warnings. Green is preparing hisquarterly industry analysis and decides to seek further input. He calls Alan Volk, CFA, a close friend who runsthe Initial Public Offering section of the investment banking department of Federal Securities.Volk tells Green he has seen no slowing of demand for technology IPOs. "We've got three new issues due outnext week, and two of them are well oversubscribed." Green knows that Volk's department handled over 200IPOs last year, so he is confident that Volk's opinion is reliable. Green prepares his industry report, which isfavorable. Among other conclusions, the report states that "the future is still bright, based on the fact that 67%of technology IPOs are oversubscribed." Privately, Green recommends to Federal portfolio managers that theybegin selling all existing technology issues, which have "stagnated," and buy the IPOs in their place.After carefully evaluating Federal's largest institutional client's portfolio, Green contacts the client andrecommends selling all of his existing technology stocks and buying two of the upcoming IPOs, similar to therecommendation given to Federal's portfolio managers. Green's research has allowed him to conclude that onlythese two IPOs would be appropriate for this particular client's portfolio. Investing in these IPOs and selling thecurrent technology holdings would, according to Green, "double the returns that your portfolio experienced lastyear."Federal Securities has recently hired Dirks Bentley, a CFA candidate who has passed Level 2 and is currentlypreparing to take the Level 3 CFA® exam, to reorganize Federal's compliance department. Bentley tells Greenthat he may be subject to CFA Institute sanctions due to inappropriate contact between analysts andinvestment bankers within Federal Securities. Bentley has recommended that Green implement a firewall torectify the situation and has outlined the key characteristics for such a system. Bentley's suggestions are asfollows:1. Any communication between the departments of Federal Securities must be channeled through thecompliance department for review and eventual delivery. The firm must create and maintain watch, restricted,and rumor lists to be used in the review of employee trading.2. All beneficial ownership, whether direct or indirect, of recommended securities must be disclosed in writing.3. The firm must increase the level of review or restriction of proprietary trading activities during periods inwhich the firm has knowledge of information that is both material and nonpublic.Bentley has identified two of Green's analysts, neither of whom have non-compete contracts, who are preparingto leave Federal Securities and go into competition. The first employee, James Ybarra, CFA, has agreed totake a position with one of Federal's direct competitors. Ybarra has contacted existing Federal clients using aclient list he created with public records. None of the contacted clients have agreed to move their accounts asYbarra has requested. The second employee, Martha Cliff, CFA, has registered the name Cliff InvestmentConsulting (CIC), which she plans to use for her independent consulting business. For the new businessventure, Cliff has developed and professionally printed marketing literature that compares the new firm'sservices to that of Federal Securities and highlights the significant cost savings that will be realized by switchingto CIC. After she leaves Federal, Cliff plans to target many of the same prospects that Federal Securities istargeting, using an address list she purchased from a third-party vendor. Bentley decides to call a meeting withGreen to discuss his findings.After discussing the departing analysts. Green asks Bentley how to best handle the disclosure of the followingitems: (1) although not currently a board member. Green has served in the past on the board of directors of acompany he researches and expects that he will do so again in the near future; and (2) Green recently inheritedput options on a company for which he has an outstanding buy recommendation. Bentley is contemplating hisresponse to Green.According to Standard 11(A) Material Nonpublic Information, when Green contacted Volk, he:

Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Manyof MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all creditqualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worthinc., Enertech Company, and SBK Company.Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of itsfixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued twoyears ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to declineby as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. Thecompany has decided to enter into a 2-year interest rate swap with semiannual payments, a swap rate of 5.8%,and a floating rate based on 6-month EURIBOR. The duration of the fixed side of the swap is 1.2. Analysts atMIA have made the following comments regarding Worth's swap plan:• "The duration of the swap from the perspective of Worth is 0.95."• "By entering into the swap, the duration of Worth's long-term liabilities will become smaller, causing the valueof the firm's equity to become more sensitive to changes in interest rates."Enertech Company is a U.S.-based provider of electricity and natural gas. The company uses a large proportionof floating rate notes to finance its operations. The current interest rate on Enertech's floating rate notes, basedon 6-month LIBOR plus 150bp, is 5.5%. To hedge its interest rate risk, Enertech has decided to enter into along interest rate collar. The cap and the floor of the collar have maturities of two years, with settlement dates(in arrears) every six months. The strike rate for the cap is 5.5% and for the floor is 4.5%, based on 6-monthLIBOR, which is forecast to be 5.2%, 6.1%, 4.1%, and 3.8%, in 6,12, 18, and 24 months, respectively. Eachsettlement period consists of 180 days. Analysts at MIA are interested in assessing the attributes of the collar.SBK Company builds oil tankers and other large ships in Norway. The firm has several long-term bond issuesoutstanding with fixed interest rates ranging from 5.0% to 7.5% and maturities ranging from 5 to 12 years.Several years ago, SBK took the pay floating side of a semi-annual settlement swap with a rate of 6.0%, afloating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given itsinterest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, anunderlying swap rate of 6.0%, and a floating rate based on LIBOR.MIA is considering investing in the debt of Rio Corp, a Brazilian energy company. The investment would be inRio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest ratedecline in Brazil over the short term.Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effectsof the swap on the company's balance sheet are correct or incorrect.