Free CFA Institute CFA-Level-III Exam Questions

Rowan Brothers is a full service investment firm offering portfolio management and investment banking services. For the last ten years, Aaron King, CFA, has managed individual client portfolios for Rowan Brothers, most of which are trust accounts over which King has full discretion. One of King's clients, Shelby Pavlica, is a widow in her late 50s whose husband died and left assets of over $7 million in a trust, for which she is the only beneficiary. Pavlica's three children are appalled at their mother's spending habits and have called a meeting with King to discuss their concerns. They inform King that their mother is living too lavishly to leave much for them or Pavlica's grandchildren upon her death. King acknowledges their concerns and informs them that, on top of her ever-increasing spending, Pavlica has recently been diagnosed with a chronic illness. Since the diagnosis could indicate a considerable increase in medical spending, he will need to increase the risk of the portfolio to generate sufficient return to cover the medical bills and spending and still maintain the principal. King restructures the portfolio accordingly and then meets with Pavlica a week later to discuss how he has altered the investment strategy, which was previously revised only three months earlier in their annual meeting. During the meeting with Pavlica, Kang explains his reasoning tor altering the portfolio allocation but does not mention the meeting with Pavlica's children. Pavlica agrees that it is probably the wisest decision and accepts the new portfolio allocation adding that she will need to tell her children about her illness, so they will understand why her medical spending requirements will increase in the near future. She admits to King that her children have been concerned about her spending. King assures her that the new investments will definitely allow her to maintain her lifestyle and meet her higher medical spending needs. One of the investments selected by King is a small allocation in a private placement offered to him by a brokerage firm that often makes trades for King's portfolios. The private placement is an equity investment in ShaleCo, a small oil exploration company. In order to make the investment, King sold shares of a publicly traded biotech firm, VNC Technologies. King also held shares of VNC, a fact that he has always disclosed to clients before purchasing VNC for their accounts. An hour before submitting the sell order for the VNC shares in Pavlica's trust account. King placed an order to sell a portion of his position in VNC stock. By the time Pavlica's order was sent to the trading floor, the price of VNC had risen, allowing Pavlica to sell her shares at a better price than received by King. Although King elected not to take any shares in the private placement, he purchased positions for several of his clients, for whom the investment was deemed appropriate in terms of the clients* objectives and constraints as well as the existing composition of the portfolios. In response to the investment support, ShaleCo appointed King to their board of directors. Seeing an opportunity to advance his career while also protecting the value of his clients' investments in the company, King gladly accepted the offer. King decided that since serving on the board of ShaleCo is in his clients' best interest, it is not necessary to disclose the directorship to his clients or his employer. For his portfolio management services, King charges a fixed percentage fee based on the value of assets under management. All fees charged and other terms of service are disclosed to clients as well as prospects. In the past month, however. Rowan Brothers has instituted an incentive program for its portfolio managers. Under the program, the firm will award an all-expense-paid vacation to the Cayman islands for any portfolio manager who generates two consecutive quarterly returns for his clients in excess of 10%. King updates his marketing literature to ensure that his prospective clients are fully aware of his compensation arrangements, but he does not contact current clients to make them aware of the newly created performance incentive. According to the CFA Institute Standards of Professional Conduct, which of the following statements is correct concerning King's directorship with ShaleCo?

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: 

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:

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?

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: