Free CFA Institute CFA-Level-III Exam Questions

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:

Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. Thefunds are managed individually, but Pace has an investment committee that oversees all of the funds. Thiscommittee is responsible for evaluating the performance of the funds relative to appropriate benchmarks andrelative to the stated investment objectives of each individual fund. During a recent investment committeemeeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of theportfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee wasto review the performance of the manager responsible for each fund and dismiss those managers whoseperformance had lagged substantially behind the appropriate benchmark.The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with acapitalization between S40 billion and $80 billion. A review of the operations of the fund found the following:• The turnover of the fund was almost double that of other similar style mutual funds.• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existingholding.• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutualfunds.• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years offinancial information on that company, plus independent research reports from at least three different analysts.• The portfolio manager refuses to increase her technology sector weighting because of past losses the fundincurred in the sector.• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. Sheexpects oil prices to fall back to the $40 to S50 per barrel range.A committee member made the following two comments:Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfoliolacks recognizable companies. I believe that good companies make good investments."Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. Sheseems to sell stocks that appreciate, but hold stocks that have declined in value."The supervisor of the Mid-Cap Mutual Fund portfolio manager made the following statements:Statement 1: "The portfolio manager of the Mid-Cap Mutual Fund has engaged in quarter-end window dressingto make her portfolio look better to investors. The portfolio manager's action is a behavioral trait known as overreaction."Statement 2: "Each time the portfolio manager of the Mid-Cap Mutual fund trades a stock, she executes thetrade by buying or selling one-third of the position at a time, with the trades spread over three months. Theportfolio manager's action is a behavioral trait known as anchoring."Indicate whether Statement 1 and Statement 2 made by the supervisor are correct.

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."

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:

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