Free CFA Institute CFA-Level-III Exam Questions

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:

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 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: 

Sue Gano and Tony Cismesia are performance analysts for the Barth Group. Barth provides consulting andcompliance verification for investment firms wishing to adhere to the Global Investment Performance Standards(GIPS ®). The firm also provides global performance evaluation and attribution services for portfolio managers.Barth recommends the use of GIPS to its clients due to its prominence as the standard for investmentperformance presentation.One of the Barth Group's clients, Nigel Investment Advisors, has a composite that specializes in exploiting theresults of academic research. This Contrarian composite goes long "loser" stocks and short "winner" stocks.The "loser' stocks are those that have experienced severe price declines over the past three years, while the"winner" stocks are those that have had a tremendous surge in price over the past three years. The Contrariancomposite has a mixed record of success and is rather small. It contains only four portfolios. Gano andCismesia debate the requirements for the Contrarian composite under the Global Investment PerformanceStandards.The Global Equity Growth composite of Nigel Investment Advisors invests in growth stocks internationally, andis tilted when appropriate to small cap stocks. One of Nigel's clients in the Global Equity Growth composite isCypress University. The university has recently decided that it would like to implement ethical investing criteriain its endowment holdings. Specifically, Cypress does not want to hold the stocks from any countries that aredeemed as human rights violators. Cypress has notified Nigel of the change, but Nigel does not hold any stocksin these countries. Gano is concerned that this restriction may limit investment manager freedom going forward.Gano and Cismesia are discussing the valuation and return calculation principles for both portfolios andcomposites, which they believe have changed over time. In order to standardize the manner in whichinvestment firms calculate and present performance to clients, Gano states that GIPS require the following:Statement 1: The valuation of portfolios must be based on market values and not book values or cost. Portfoliovaluations must be quarterly for all periods prior to January 1, 2001. Monthly portfolio valuations and returns arerequired for periods between January 1, 2001 and January 1, 2010.Statement 2: Composites are groups of portfolios that represent a specific investment strategy or objective. Adefinition of them must be made available upon request. Because composites are based on portfolio valuation,the monthly requirement for return calculation also applies to composites for periods between January 1, 2001and January 1, 2010.The manager of the Global Equity Growth composite has a benchmark that is fully hedged against currencyrisk. Because the manager is confident in his forecasting of currency values, the manager does not hedge tothe extent that the benchmark does. In addition to the Global Equity Growth composite, Nigel InvestmentAdvisors has a second investment manager that specializes in global equity. The funds under her managementconstitute the Emerging Markets Equity composite. The benchmark for the Emerging Markets Equity compositeis not hedged against currency risk. The manager of the Emerging Markets Equity composite does not hedgedue to the difficulty in finding currency hedges for thinly traded emerging market currencies. The managerfocuses on security selection in these markets and does not try to time the country markets differently from thebenchmark.The manager of the Emerging Markets Equity composite would like to add frontier markets such as Bulgaria,Kenya, Oman, and Vietnam to their composite, with a 20% weight- The manager is attracted to frontier marketsbecause, compared to emerging markets, frontier markets have much higher expected returns and lowercorrelations. Frontier markets, however, also have lower liquidity and higher risk. As a result, the managerproposes that the benchmark be changed from one reflecting only emerging markets to one that reflects bothemerging and frontier markets. The date of the change and the reason for the change will be provided in thefootnotes to the performance presentation. The manager reasons that by doing so, the potential investor canaccurately assess the relative performance of the composite over time.Cismesia would like to explore the performance of the Emerging Markets Equity composite over the past twoyears. To do so, he determines the excess return each period and then compounds the excess return over thetwo years to arrive at a total two-year excess return. For the attribution analysis, he calculates the securityselection effect, the market allocation effect, and the currency allocation effect each year. He then adds all theyearly security selection effects together to arrive at the total security selection effect. He repeats this processfor the market allocation effect and the currency allocation effect.What are the GIPS requirements for the Contrarian composite of Nigel Investment Advisors?

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a varietyof institutions on the management of credit risk. Some of DSI's clients are very familiar with risk managementtechniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in thecreation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and otherinstitutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of creditrisk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerabledifficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with theGrich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared indefault of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claimsbefore it could settle the agreement with Johnson Associates.McNally mentions that Cramer should include a statement about the time dimension of credit risk. She statesthat the two primary time dimensions of credit risk are current and future. Current credit risk relates to thepossibility of default on current obligations, while future credit risk relates to potential default on futureobligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face valueof current obligations and the present value of future obligations. Cramer adds that combining current andpotential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually areliable predictor of a borrower's potential credit risk.As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated withforward agreements. Cramer states that long forward contracts gain in value when the market price of theunderlying increases above the contract price. McNally encourages Cramer to include an example of credit riskand forward contracts in the handbook. She offers the following:A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no fundswere exchanged upfront.Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. Hewrites that firms can make use of netting arrangements, create a special purpose vehicle, require collateralfrom counterparties, and require a mark-to-market provision. McNally adds that Cramer should include adiscussion of some newer forms of credit protection in his handbook. McNally thinks credit derivativesrepresent an opportunity for DSL She believes that one type of credit derivative that should figure prominently intheir handbook is total return swaps. She asserts that to purchase protection through a total return swap, theholder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swapdealer) in exchange for a single, fixed payment representing the discounted present value of expected cashflows from the asset.A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would likeprotection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus3%. Weaver Trading prefers a cash settlement.Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bondissued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client isconsidering hedging the bond using a credit spread forward, because he is concerned that a downturn in theeconomy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bondand the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. Thecharacteristics of the forward contract are shown below.Information on the Credit Spread ForwardDetermine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.