Question 1

Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. The

funds are managed individually, but Pace has an investment committee that oversees all of the funds. This

committee is responsible for evaluating the performance of the funds relative to appropriate benchmarks and

relative to the stated investment objectives of each individual fund. During a recent investment committee

meeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of the

portfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee was

to review the performance of the manager responsible for each fund and dismiss those managers whose

performance 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 a

capitalization 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 existing

holding.

• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutual

funds.

• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years of

financial 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 fund

incurred in the sector.

• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. She

expects 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 portfolio

lacks 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. She

seems 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 dressing

to 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 the

trade by buying or selling one-third of the position at a time, with the trades spread over three months. The

portfolio manager's action is a behavioral trait known as anchoring."

Indicate whether Statement 1 and Statement 2 made by the supervisor are correct.

Options :

A : Only Statement 1 is correct.

B : Only Statement 2 is correct.

C : Neither Statement is correct.

Answer: C

Question 2

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,

feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Ng

hedges many of the risks associated with Smiler's financial transactions, which include those of a financial

subsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managing

Srniler's considerable investment portfolio.

Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. The

receivable is €10 million to be received in 90 days. Srniler's bank provides the following information:

Smiler borrows short-term funds to meet expenses on a temporary basis and typically makes semiannual

interest payments based on 180-day LIBOR plus a spread of 150 bp. Smiler will need to borrow S25 million in

90 days to invest in new equipment. To hedge the interest rate risk on the loan, Ng is considering the purchase

of a call option on 180-day LIBOR with a term to expiration of 90 days, an exercise rate of 4.8%, and a premium

of 0.000943443 of the loan amount. Current 90-day LIBOR is 4.8%.

Smiler also has a diversified portfolio of large cap stocks with a current value of $52,750,000, and Ng wants to

lower the beta of the portfolio from its current level of 1.25 to 0.9 using S&P 500 futures which have a multiplier

of 250. The S&P 500 is currently 1,050, and the futures contract exhibits a beta of 0.98 to the underlying.

Because Ng intends to replace the short-term LIBOR-based loan with long-term financing, he wants to hedge

the risk of a 50 bp change in the market rate of the 20-year bond Smiler will issue in 270 days. The current

spread to Treasuries for Smiler's corporate debt is 2.4%. He will use a 270-day, 20-year Treasury bond futures

contract ($100,000 face value) currently priced at 108.5 for the hedge. The CTD bond for the contract has a

conversion factor of 1.259 and a dollar duration of $6,932.53. The corporate bond, if issued today, would have

an effective duration of 9.94 and has an expected effective duration at issuance of 9.90 based on a constant

spread assumption. A regression of the YTM of 20-year corporate bonds with a rating the same as Smiler's on

the YTM of the CTD bond yields a beta of 1.05.

If Ng purchases the interest rate call, and 180-day LIBOR at option expiration is 5.73%, the annualized effective

rate for the 180-day loan is closest to:

Options :

A : 6.6982%.

B : 6.5346%.

C : 6.3785%

Answer: A

Question 3

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.

Options :

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 4

Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios which

have just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints,

as welt as an initial strategic asset allocation. However, Draper has found that all of the portfolios have

experienced changes in asset values. As a result, the current allocations have drifted away from the initial

allocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with their

proposed asset allocation targets.

Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing. During their conversation,

Sterling made the following comments:

Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatility

of the asset classes in the portfolio.

Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to more

frequent rebalancing.

Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing,

but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As an

example, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.

Draper has been reviewing Madison files on four high net worth individuals, each of whom has a $1 million

portfolio. He hopes to gain insight as to appropriate rebalancing strategies for these clients. His research so far

shows:

Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerance

drops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook,

which is for a long-term bull market with few reversals.

Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees with

the Madison stock market outlook.

Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio.

She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked by

numerous reversals, over the coming months.

In selecting a rebalancing strategy for his clients, Draper would most likely select a constant mix strategy for:

Options :

A : Client A.

B : Client B.

C : Client C.

Answer: C

Question 5

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:

Options :

A : proxy hedge.

B : cross hedge.

C : forward hedge.

Answer: A

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