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:

Options :

A : 5.92%.

B : 11.86%.

C : 12.12%.

Answer: B

Question 2

Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Quaker Fund. BIC is an asset management firm headquartered in Holland with regional offices in several other European countries. After accepting the position, Bair received a letter from the three principals of BIC. The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations. Among other things, the letter stated the following: "Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund. It is your responsibility to obtain this knowledge and comply with appropriate regulations. This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully. You will likely need to arrange for our sister companies to quietly buy and sell Quaker Fund shares over the first month of operations. This will provide sufficient price support to allow the fund to trade closer to its net asset value than other small-cap closed-end funds. Because these funds generally trade at a discount to net asset value, if our fund trades close to its net asset value, the market may perceive it as more desirable than similar funds managed by our competitors." Bair heeded the advice from her firm's principals and collected information on the laws and regulations of three countries: Norway, Sweden, and Denmark. So far, all of the investors expressing interest in the Quaker Fund are from these areas. Based on her research, Bair decides the following policies are appropriate for the fund: Note: Laws mentioned below are assumed for illustrative purposes. • For clients located in Norway the fund will institute transaction crossing, since, unlike in Holland, the practice is not prohibited by securities laws or regulations. The process will involve internally matching buy and sell orders from Norwegian clients whenever possible. This will reduce brokerage fees and improve the fund's overall performance. • For clients located in Denmark, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by Denmark's securities regulators, even though the laws in Holland only require such reports to be generated on a quarterly basis. • For clients located in Sweden, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment. This policy is consistent with the laws and regulations in Holland. Sweden's securities regulations do not cover this type of situation.

Three months after the inception of the fund, its market value has grown from $200 million to $300 million and Bair's performance has earned her a quarter-end bonus. Since it is now the end of the quarter, Bair is participating in conference calls with companies in her fund. Bair calls into the conference number for Swift Petroleum. The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Swift discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter. The restatement will not be announced until the year's end, six months from now. Bair does not remind the officers that she can hear their conversation. Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call. Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call. The investment bankers then proceed to sell their personal holdings of Swift Petroleum stock. After her meeting, Bair sells the Quaker Fund's holdings of Swift Petroleum stock. By selling the Quaker Fund's shares of Swift Petroleum, did Bair violate any CFA Institute Standards of Professional Conduct?

Options :

A : Yes, Bair violated Standard II Integrity of Capital Markets

B : No, because she ensured public dissemination of the earnings restatement information before she traded the shares

C : Yes, because waiting to trade the stock would severely disadvantage investors in her fund and would have violated her duty of loyalty to her clients.

Answer: A

Question 3

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

Question 4

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.

Options :

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 5

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,

which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in

the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,

foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,

Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking

error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus

reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian

region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments

in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are

expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by

finding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on

the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing

outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option

adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted

spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative

attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity

from the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts that

interest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of business

investment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low in

order to stimulate the economy. Although she sees the level of yields declining, she believes that the spread on

risky securities will increase due to the decline in business prospects. She therefore has reallocated her bond

portfolio away from high-yield bonds and towards investment grade bonds.

Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.

As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a

7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated Quincy

Corporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhanced

his annual income, which he considers quite favorable given the declining yields in the market.

Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, she

expects that the yields on mortgages will decline. As a result, she has reallocated the portion of Northern

Capital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to

7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in price

more than the higher coupon mortgages. She identifies this trade as a structure trade.

Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:

Which of the following best describes the relative value analysis used in the Northern Capita! Emerging market

bond fund? It is a:

Options :

A : top-down approach.

B : bottom-up approach.

C : combination of a top-down approach and a bottom-up approach.

Answer: B

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