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

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:

Options :

A : 11.0%.

B : 11.7%.

C : 12.5%.

Answer: B

Question 3

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 4

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

Options :

A : $2.50 -$2.50

B : $5.00 -$5.00

C : $3.00 -$2.00

Answer: A

Question 5

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?

Options :

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

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