Free CFA-Level-III Practice Exam Questions

Question 1

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

Question 2

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 3

Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Many

of MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all credit

qualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worth

inc., Enertech Company, and SBK Company.

Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of its

fixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued two

years ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to decline

by as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. The

company 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 at

MIA 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 value

of 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 proportion

of floating rate notes to finance its operations. The current interest rate on Enertech's floating rate notes, based

on 6-month LIBOR plus 150bp, is 5.5%. To hedge its interest rate risk, Enertech has decided to enter into a

long 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-month

LIBOR, which is forecast to be 5.2%, 6.1%, 4.1%, and 3.8%, in 6,12, 18, and 24 months, respectively. Each

settlement 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 issues

outstanding 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%, a

floating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6

months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given its

interest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, an

underlying 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 in

Rio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest rate

decline in Brazil over the short term.

Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effects

of the swap on the company's balance sheet are correct or incorrect.

A : Only the comment regarding the swap duration is correct.

B : Only the comment regarding the swap balance sheet effects is correct.

C : Both comments are correct.

Answer: C

Question 4

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is

responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a

candidate 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%. The

current 1-year forward rate is C$1.60/£.

Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is

provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond

is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United

States.

Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of

currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also

decide 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 having

difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a

forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His

reason 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 hedging

strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest

rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates

may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an

interest rate floor as a hedge.

Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is

contemplating 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:

A : proxy hedge.

B : cross hedge.

C : forward hedge.

Answer: A

Question 5

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety

of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management

techniques 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 the

creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other

institutions 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 credit

risk 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 considerable

difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the

Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in

default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims

before it could settle the agreement with Johnson Associates.

McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states

that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the

possibility of default on current obligations, while future credit risk relates to potential default on future

obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value

of current obligations and the present value of future obligations. Cramer adds that combining current and

potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a

reliable 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 with

forward agreements. Cramer states that long forward contracts gain in value when the market price of the

underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk

and 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 funds

were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He

writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral

from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a

discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives

represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in

their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the

holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap

dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash

flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like

protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus

3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond

issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is

considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the

economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond

and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The

characteristics of the forward contract are shown below.

Information on the Credit Spread Forward

Regarding their statements concerning current and future credit risk, determine whether Cramer and McNally

are correct or incorrect.

A : Only Cramer is correct.

B : Only McNally is correct.

C : Both are correct -OR- both are incorrect.

Answer: B

Free CFA-Level-III Exam Questions - Easiest Way for Success