100% Free CFA Institute CFA-Level-III Practice Test Questions

Question 1

Joan Weaver, CFA and Kim McNally, CFA are analysts for Cardinal Fixed Income Management. Cardinal

provides investment advisory services to pension funds, endowments, and other institutions in the U.S. and

Canada. Cardinal recommends positions in investment-grade corporate and government bonds.

Cardinal has largely advocated the use of passive approaches to bond investments, where the predominant

holding consists of an indexed or enhanced indexed bond portfolio. They are exploring, however, the possibility

of using a greater degree of active management to increase excess returns. The analysts have made the

following statements.

• Weaver: "An advantage of both enhanced indexing by matching primary risk factors and enhanced indexing

by minor risk factor mismatching is that there is the potential for excess returns, but the duration of the portfolio

is 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 duration

mismatches 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 an

economic 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 rates

should fall over the next year, but that short-term rates should gradually increase. Weaver and McNally are

currently advising an institutional client that wishes to maintain the duration of its bond portfolio at 6.7. In light of

the economic forecast, they are considering three portfolios that combine the following three bonds in varying

amounts.

Weaver and McNally next examine an investment in a semiannual coupon bond newly issued by the Manix

Corporation, a firm with a credit rating of AA by Moody's. The specifics of the bond purchase are provided

below given Weaver's projections. It is Cardinal's policy that bonds be evaluated for purchase on a total return

basis.

One of Cardinal's clients, the Johnson Investment Fund (JIF), has instructed Weaver and McNally to

recommend the appropriate debt investment for $125,000,000 in funds. JIF is willing to invest an additional

15% of the portfolio using leverage. JIF requires that the portfolio duration not exceed 5.5. Weaver

recommends that JIF invest in bonds with a duration of 5.2. The maximum allowable leverage will be used and

the borrowed funds will have a duration of 0.8. JIF is considering investing in bonds with options and has asked

McNally 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, and

these bonds sell at a discount relative to comparable bullets. Putables are quite attractive when interest rates

rise, but, we should be careful if with them, because valuation models often fail to account for the credit risk of

the issuer."

Another client, Blair Portfolio Managers, has asked Cardinal to provide advice on duration management. One

year ago, their portfolio had a market value of $3,010,444 and a dollar duration of $108,000; current figures are

provided below:

The expected bond equivalent yield for the Manix Bond, using total return analysis, is closest to:

A : 5.92%.

B : 11.86%.

C : 12.12%.

Answer: B

Question 2

Eugene Price, CFA, a portfolio manager for the American Universal Fund (AUF), has been directed to pursue a

contingent immunization strategy for a portfolio with a current market value of $100 million. AUF's trustees are

not willing to accept a rate of return less than 6% over the next five years. The trustees have also stated that

they believe an immunization rate of 8% is attainable in today's market. Price has decided to implement this

strategy by initially purchasing $100 million in 10-year bonds with an annual coupon rate of 8.0%, paid

semiannually.

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 junior

analyst 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 of

immunizing a portfolio with multiple liabilities. He further states that there are two methods for managing

multiple liabilities. The first method is cash flow matching which involves finding a bond with a maturity date

equal to the liability payment date, buying enough in par value of that bond so that the principal and final coupon

fully fund the last liability, and continuing this process until all liabilities are matched. The second method is

horizon 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 portfolio

with zero immunization risk, because reinvestment risk will always be present. Price tells Banks, "Be cognizant

of the dispersion of cash flows when conducting an immunization strategy. When there is a high dispersion of

cash flows about the horizon date, immunization risk is high. It is better to have cash flows concentrated around

the investment horizon, since immunization risk is reduced."

Assuming an immediate (today) increase in the immunized rate to 11%, the portfolio required return that would

most likely make Price turn to an immunization strategy is closest to:

A : 11.0%.

B : 11.7%.

C : 12.5%.

Answer: B

Question 3

Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy. One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis. Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity. Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around." The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year. Of the following VAR calculation methods, the measure that would most likely suit Smitherspoon is the:

A : variance-covariance method.

B : historical simulation method.

C : Monte Carlo simulation method.

Answer: A

Question 4

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?

A : King may not accept the directorship since it creates a conflict of interest

B : King may accept the directorship as long as it is disclosed to clients and prospects

C : King may accept the directorship as long as it is disclosed to his employer, clients, and prospects

Answer: C

Question 5

Sue Gano and Tony Cismesia are performance analysts for the Barth Group. Barth provides consulting and

compliance 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 investment

performance presentation.

One of the Barth Group's clients, Nigel Investment Advisors, has a composite that specializes in exploiting the

results 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 Contrarian

composite has a mixed record of success and is rather small. It contains only four portfolios. Gano and

Cismesia debate the requirements for the Contrarian composite under the Global Investment Performance

Standards.

The Global Equity Growth composite of Nigel Investment Advisors invests in growth stocks internationally, and

is tilted when appropriate to small cap stocks. One of Nigel's clients in the Global Equity Growth composite is

Cypress University. The university has recently decided that it would like to implement ethical investing criteria

in its endowment holdings. Specifically, Cypress does not want to hold the stocks from any countries that are

deemed as human rights violators. Cypress has notified Nigel of the change, but Nigel does not hold any stocks

in 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 and

composites, which they believe have changed over time. In order to standardize the manner in which

investment 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. Portfolio

valuations must be quarterly for all periods prior to January 1, 2001. Monthly portfolio valuations and returns are

required 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. A

definition 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, 2001

and January 1, 2010.

The manager of the Global Equity Growth composite has a benchmark that is fully hedged against currency

risk. Because the manager is confident in his forecasting of currency values, the manager does not hedge to

the extent that the benchmark does. In addition to the Global Equity Growth composite, Nigel Investment

Advisors has a second investment manager that specializes in global equity. The funds under her management

constitute the Emerging Markets Equity composite. The benchmark for the Emerging Markets Equity composite

is not hedged against currency risk. The manager of the Emerging Markets Equity composite does not hedge

due to the difficulty in finding currency hedges for thinly traded emerging market currencies. The manager

focuses on security selection in these markets and does not try to time the country markets differently from the

benchmark.

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 markets

because, compared to emerging markets, frontier markets have much higher expected returns and lower

correlations. Frontier markets, however, also have lower liquidity and higher risk. As a result, the manager

proposes that the benchmark be changed from one reflecting only emerging markets to one that reflects both

emerging and frontier markets. The date of the change and the reason for the change will be provided in the

footnotes to the performance presentation. The manager reasons that by doing so, the potential investor can

accurately 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 two

years. To do so, he determines the excess return each period and then compounds the excess return over the

two years to arrive at a total two-year excess return. For the attribution analysis, he calculates the security

selection effect, the market allocation effect, and the currency allocation effect each year. He then adds all the

yearly security selection effects together to arrive at the total security selection effect. He repeats this process

for the market allocation effect and the currency allocation effect.

What are the GIPS requirements for the Contrarian composite of Nigel Investment Advisors?

A : The composite can be formed and the composite must report all performance statistics.

B : The composite can be formed, however the number of portfolios and dispersion does not have to be reported.

C : The composite cannot be formed because it has less than six portfolios in it, so there are no presentationrequirements.

Answer: B

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