Question 1

Walter Skinner, CFA, manages a bond portfolio for Director Securities. The bond portfolio is part of a pension

plan trust set up to benefit retirees of Thomas Steel Inc. As part of the investment policy governing the plan and

the bond portfolio, no foreign securities are to be held in the portfolio at any time and no bonds with a credit

rating below investment grade are allowable for the bond portfolio. In addition, the bond portfolio must remain

unleveraged. The bond portfolio is currently valued at $800 million and has a duration of 6.50. Skinner believes

that interest rates are going to increase, so he wants to lower his portfolio's duration to 4.50. He has decided to

achieve the reduction in duration by using swap contracts. He has two possible swaps to choose from:

1. Swap A: 4-year swap with quarterly payments.

2. Swap B: 5-year swap with semiannual payments.

Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. For

analysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity.

Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing a

dual currency bond issued by an American holding company with significant operations in Japan. The bond

makes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S.

dollars five years from now. Skinner originally purchased the bond to take advantage of the strengthening

relative position of the yen. The result was an above average return for the bond portfolio for several years.

Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in the

Japanese economy to accelerate over the next few years. Knowing Skinner's situation, one of his colleagues,

Bill Michaels, suggests the following strategy:

"You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dual

currency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bond

portfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. The

swap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure of

the portfolio."

Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his expectations

for the bond portfolio. Mann has also provided some advice to Skinner in the following comment:

"1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rate

shift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the call

features of any callable bonds in your portfolio by purchasing a payer interest rate swaption."

After his lung conversation with Director Securities' senior economist, Orval Mann, Skinner has completely

changed his outlook on interest rates and has decided to extend the duration of his portfolio. The most

appropriate strategy to accomplish this objective using swaps would be to enter into a swap to pay:

Options :

A :

fixed and receive floating.

B : floating and receive fixed.

C : floating and receive floating.

Answer: B

Question 2

Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy. One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis. Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity. Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around." The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year. Of the following VAR calculation methods, the measure that would most likely suit Smitherspoon is the:

Options :

A : variance-covariance method.

B : historical simulation method.

C : Monte Carlo simulation method.

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

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?

Options :

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 presentation

requirements.

Answer: B

Question 5

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

Free CFA-Level-III Mock Exam – Practice Online Confidently

Buying Options: