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

Question 1

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."

Regarding Price's statements on the two methods for managing multiple liabilities, determine whether his

descriptions of cash flow matching and horizon matching are correct.

A : Only his statement about cash flow matching is correct.

B : Only his statement about horizon matching is correct.

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

Answer: B

Question 2

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 3

Gabrielle Reneau, CFA, and Jack Belanger specialize in options strategies at the brokerage firm of Damon and

Damon. They employ fairly sophisticated strategies to construct positions with limited risk, to profit from future

volatility estimates, and to exploit arbitrage opportunities. Damon and Damon also provide advice to outside

portfolio managers on the appropriate use of options strategies. Damon and Damon prefer to use, and

recommend, 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 underlying

stock 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 Belanger

contact the chief economists at Damon and Damon, Mark Blair and Fran Robinson. Blair recently joined Damon

and Damon after a successful stint at a London investment bank. Robinson has been with Damon and Damon

for the past ten years and has a considerable record of success in forecasting macroeconomic activity. In his

forecasts for the U.S. economy over the next year, Blair is quite bullish, for both the U.S. economy and the S&P

500 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 use

of 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 the

same maturity, one with a low exercise price, and the other with a high exercise price. The beginning stock

price is usually below the two option strike prices. She states that the benefit of this strategy is that the

maximum 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 a

continued holding pattern of low growth, with a similar projection for the stock market as a whole. He states that

Damon and Damon may want to pursue an options strategy where a put and call of the same maturity and

same exercise price are purchased. He asserts that such a strategy would have losses limited to the total cost

of 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. The

firm has both puts and calls sold on the Chicago Board Options Exchange. Their options have good liquidity for

the near money puts and calls and for those puts and calls with maturities less than four months. Reneau

believes that Brendan Industries will benefit from the economic expansion forecasted by Mark Blair, the Damon

and Damon economist. She decides that the best option strategy to exploit these expectations is for her to

pursue 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 stock

price 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 Industries1

volatility by using an options strategy where a put and call of the same maturity and same exercise price are

utilized. He advocates using the least expensive strategy possible.

During their discussions, Reneau cites a counter example to Brendan Industries from last year. She recalls that

Nano Networks, a technology firm, had a stock price that stayed fairly stable despite expectations to the

contrary. In this case, she utilized an options strategy where three different calls were used. Profits were earned

on the strategy because Nano Networks' stock price stayed fairly stable. Even if the stock price had become

volatile, losses would have been limited.

Later that week, Reneau and Belanger discuss various credit option strategies during a lunch time presentation

to Damon and Damon client portfolio managers. During their discussion, Reneau describes a credit option

strategy that pays the holder a fixed sum, which is agreed upon when the option is written, and occurs in the

event that an issue or issuer goes into default. Reneau declares that this strategy can take the form of either

puts or calls. Belanger states that this strategy is known as either a credit spread call option strategy or a credit

spread put option strategy.

Reneau and Belanger continue by discussing the benefits of using credit options. Reneau mentions that credit

options written on an underlying asset will protect against declines in asset valuation. Belanger says that credit

spread 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 45

call on Brendan Industries trading at $1.00, calculate the maximum gain and maximum loss on this position.

Max gain Max loss

A : $2.50 -$2.50

B : $5.00 -$5.00

C : $3.00 -$2.00

Answer: A

Question 4

Robert Keith, CFA, has begun a new job at CMT Investments as Head of Compliance. Keith has just completed a review of all of CMT's operations, and has interviewed all the firm's portfolio managers. Many are CFA charterholders, but some are not. Keith intends to use the CFA Institute Code and Standards, as well as the Asset Manager Code of Professional Conduct, as ethical guidelines for CMT to follow. In the course of Keith's review of the firm's overall practices, he has noted a few situations which potentially need to be addressed. Situation 1: CMT Investments' policy regarding acceptance of gifts and entertainment is not entirely clear. There is general confusion within the firm regarding what is and is not acceptable practice regarding gifts, entertainment and additional compensation. Situation 2: Keith sees inconsistency regarding fee disclosures to clients. In some cases, information related to fees paid to investment managers for investment services provided are properly disclosed. However, a few of the periodic costs, which will affect investment return, are not disclosed to the clients. Most managers are providing clients with investment returns net of fees, but a few are just providing the gross returns. One of the managers stated "providing gross returns is acceptable, as long as I show the fees such that the client can make their own simple calculation of the returns net of fees." Situation 3: Keith has noticed a few gaps in CMT's procedure regarding use of soft dollars. There have been cases where "directed brokerage" has resulted in less than prompt execution of trades. He also found a few cases where a manager paid a higher commission than normal, in order to obtain goods or services. Keith is considering adding two statements to CMT's policy and procedures manual specifically addressing the primary issues he noted. Statement 1: "Commissions paid, and any corresponding benefits received, are the property of the client. The benefit(s) must directly benefit the client. If a manager's client directs the manager to purchase goods or services that do not provide research services that benefit the client, this violates the duty of loyalty to the client.” Statement 2: "In cases of "directed brokerage," if there is concern that the client is not receiving the best execution, it is acceptable to utilize a less than ideal broker, but it must be disclosed to the client that they may not be obtaining the best execution." Situation 4: Keith is still evaluating his data, but it appears that there may be situations where proxies were not voted. After completing his analysis of proxy voting procedures at CMT, Keith wants to insert the proper language into the procedures manual to address proxy voting. Situation 5: Keith is putting into place a "disaster recovery- plan," in order to ensure business continuity in the event of a localized disaster, and also to protect against any type of disruption in the financial markets. This plan includes the following provisions: • Procedures for communicating with clients, especially in the event of extended disruption of services provided. • Alternate arrangement for monitoring and analyzing investments in the event that primary systems become unavailable. • Plans for internal communication and coverage of crucial business functions in the event of disruption at the primary place of business, or a communications breakdown. Keith is considering adding the following provisions to the disaster recovery plan in order to properly comply with the CFA Institute Asset Manager Code of Professional Conduct: Provision 1: "A provision needs to be added incorporating off-site backup for all pertinent account information." Provision 2: "A provision mandating testing of the plan on a company-wide basis, at periodical intervals, should be added." Situation 6: Keith is spending an incredible amount of time on detailed procedures and company policies that are in compliance with the CFA Institute Code and Standards, and also in compliance with the CFA Institute Asset Manager Code of Professional Conduct. As part of this process, he has had several meetings with CMT senior management, and is second-guessing the process. One of the senior managers is indicating that it might be a

better idea to just formally adopt both the Code and Standards and the Asset Manager Code of Conduct, which would make a detailed policy and procedure manual redundant. Keith wants to assure CMT's compliance with the requirements of the CFA Institute Code and Standards of Professional Conduct. Which of the following statements most accurately describes CMT's responsibilities in order to assure compliance?

A : CMT must adopt the Asset Manager Code of Conduct, as required by the CFA Institute Code and Standards. The policy manual is acceptable, but not necessary.

B : Although adoption of the CFA Institute Asset Manager Code of Conduct is not a requirement, the Standards of Practice encourage firms to adopt this Code. CMT must adopt supplemental policies and procedures as part of a policy manual in order to properly implement the CFA Institute guidelines

C : The Standards of Practice do not require CMT to adopt the Asset Manager Code of Conduct, nor is there a requirement to publish a detailed procedural manual. Disclosure of policies is required, and any changes or updates to policies must be immediately disseminated.

Answer: B

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 Practice CFA Institute CFA-Level-III Exam Questions 2025