Question 1

Harold Chang, CFA, has been the lead portfolio manager for the Woodlock Management Group (WMG) for the last five years. WMG runs several equity and fixed income portfolios, all of which are authorized to use derivatives as long as such positions are consistent with the portfolio's strategy. The WMG Equity Opportunities Fund takes advantage of long and short profit opportunities in equity securities. The fund's positions are often a relatively large percentage of the issuer's outstanding shares and fund trades frequently move securities prices. Chang runs the Equity Opportunities Fund and is concerned that his performance for the last three quarters has put his position as lead manager in jeopardy. Over the last three quarters, Chang has been underperforming his benchmark by an increasing margin and is determined to reduce the degree of underperformance before the end of the next quarter. Accordingly, Chang makes the following transactions for the fund: Transaction 1: Chang discovers that the implied volatility of call options on GreenCo is too high. As a result, Chang shorts a large position in the stock options while simultaneously taking a long position in GreenCo stock, using the funds from the short position to partially pay for the long stock. The GreenCo purchase caused the share price to move up slightly. After several months, the GreenCo stock position has accumulated a large unrealized gain. Chang sells a portion of the GreenCo position to rebalance the portfolio. Richard Stirr, CFA, who is also a portfolio manager for WMG, runs the firm's Fixed Income Fund. Stirr is known for his ability to generate excess returns above his benchmark, even in declining markets. Stirr is convinced that even though he has only been with WMG for two and a half years, he will be named lead portfolio manager if he can keep his performance figures strong through the next quarter. To achieve this positive performance, Stirr enters into the following transactions for the fund: Transaction 2: Stirr decides to take a short forward position on the senior bonds of ONB Corporation, which Stirr currently owns in his Fixed Income Fund. Stirr made his decision after overhearing two of his firm's investment bankers discussing an unannounced bond offering for ONB that will subordinate all of its outstanding debt. As expected, the price of the ONB bonds falls when the upcoming offering is announced. Stirr delivers the bonds to settle the forward contract, preventing large losses for his investors. Transaction 3: Sitrr has noticed that in a foreign bond market, participants are slow to react to new information relevant to the value of their country's sovereign debt securities. Stirr, along with other investors, knows that an announcement from his firm regarding the sovereign bonds will be made the following day. Stirr doesn't know for sure, but expects the news to be positive, and prepares to enter a purchase order. When the positive news is released, Stirr is the first to act, making a large purchase before other investors and selling the position after other market participants react and move the sovereign bond price higher. Because of their experience with derivatives instruments, Chang and Stirr are asked to provide investment advice for Cherry Creek, LLC, a commodities trading advisor. Cherry Creek uses managed futures strategies that incorporate long and short positions in commodity futures to generate returns uncorrelated with securities markets. The firm has asked Chang and Stirr to help extend their reach to include equity and fixed income derivatives strategies. Chang has been investing with Cherry Creek since its inception and has accepted increased shares in his Cherry Creek account as compensation for his advice. Chang has not disclosed his arrangement with Cherry Creek since he meets with the firm only during his personal time. Stirr declines any formal compensation but instead requests that Cherry Creek refer their clients requesting traditional investment services to WMG. Cherry Creek agrees to the arrangement. Three months have passed since the transactions made by Chang and Stirr occurred. Both managers met their performance goals and are preparing to present their results to clients via an electronic newsletter published every quarter. The managers want to ensure their newsletters are in compliance with CFA Institute Standards of Professional Conduct. Chang states, "in order to comply with the Standards, we are required to disclose the process used to analyze and select portfolio holdings, the method used to construct our portfolios, and any changes that have been made to the overall investment process. In addition, we must include in the newsletter all factors used to make each portfolio decision over the last quarter and an assessment of the portfolio's risks." Stirr responds by claiming, "we must also clearly indicate that projections included in our report are not factual evidence but rather conjecture based on our own statistical analysis. However, I believe we can reduce the amount of information included in the report from what you have suggested and instead issue more of a summary report as long as we maintain a full report in our internal records." Determine whether Chang's comments regarding the disclosure of investment processes used to manage WMG's portfolios and the disclosure of factors used to make portfolio decisions over the last quarter are correct.

Options :

A : Both of Chang-s comments are correct.

B : Neither of Chang-s comments is correct.

C : Only Chang-s comments regarding disclosure of investment processes are correct.

Answer: C

Question 2

Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investment

analysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout the

world. The firm specializes in the valuation of international bonds, with consideration of currency risk. IA

typically uses forward contracts to hedge currency risk.

Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm,

Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency

(NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higgins

suggests that they consider forward contracts with the same maturity as the investment holding period, which is

estimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona

(Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via a

one-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.

Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if the

Norwegian NKr and euro are positively correlated, then a forward contract should be entered into where euros

will be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates and

spot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.

Return on Bergen Petroleum bond in Norwegian NKr 7.00%

Risk-free rate in Norway 4.80%

Expected change in the NKr relative to the U.S. dollar -0.40%

Risk-free rate in United States 2.50%

Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.

• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, where

higher forward rates imply that a country's spot rate will increase in the future."

• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-year

U.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forward

premium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen.

Invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."

The following day, Higgins and Tyler discuss various emerging market bond strategies and make the following

statements.

• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagion

and the competitive devaluations that often accompany crises in emerging markets. When one country

devalues their currency, others often quickly follow and as a result the countries default on their external debt,

which is usually denominated in a hard currency."

• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging market

bond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emerging

country bonds outside of this region."

Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds:

a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by the

Horgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued by a firm based in

Switzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss the

relative attractiveness of each bond and, using a total return approach, which bond should be invested in,

assuming a 1-year time horizon.

Which of the following statements provides the best description of the advantage of using breakeven spread analysis? Breakeven spread analysis:

Options :

A : provides an estimate of exchange rate risk.

B : quantifies the change in spread needed to offset a foreign yield advantage.

C : assesses the risk of a foreign bond investment independent of the bond-s duration.

Answer: B

Question 3

Jerry Edwards is an analyst with DeLeon Analytics. He is currently advising the CFO of Anderson Corp., a

multinational manufacturing corporation based in Newark, New Jersey, USA. Jackie Palmer is Edwards's

assistant. Palmer is well versed in risk management, having worked at a large multinational bank for the last

ten years prior to coming to Anderson.

Anderson has received a $2 million note with a duration of 4.0 from Weaver Tools for a shipment delivered last

week. Weaver markets tools and machinery from manufacturers of Anderson's size. Edwards states that in

order to effectively hedge the price risk of this instrument, Anderson should sell a series of interest rate calls.

Palmer states that an alternative hedge for the note would be to enter an interest rate swap as the fixed-rate

payer.

As well as selling products from a Swiss plant in Europe, Anderson sells products in Switzerland itself. As a

result, Anderson has quarterly cash flows of 12,000,000 Swiss franc (CHF). In order to convert these cash

flows into dollars, Edwards suggests that Anderson enter into a currency swap without an exchange of notional

principal. Palmer contacts a currency swap dealer with whom they have dealt in the past and finds the following

exchange rate and annual swap interest rates:

Exchange Rate (CHF per dollar) 1.24

Swap interest rate in U.S. dollars 2.80%

Swap interest rate in Swiss franc 6.60%

Discussing foreign exchange rate risk in general, Edwards states that it is transaction exposure that is most

often hedged, because the amount to be hedged is contractual and certain. Economic exposure, he states, is

less certain and thus harder to hedge.

To finance their U.S. operations, Anderson issued a S10 million fixed-rate bond in the United States five years

ago. The bond had an original maturity often years and now has a modified duration of 4.0. Edwards states that

Anderson should enter a 5-year semiannual pay floating swap with a notional principal of about $11.4 million to

take advantage of falling interest rates. The duration of the fixed-rate side of the swap is equal to 75% of its

maturity or 3.75 (= 0.75 x 5). The duration of the floating side of the swap is 0.25. Palmer states that Anderson's

position in the swap will have a negative duration.

For another client of DeLeon, Edwards has assigned Palmer the task of estimating the interest rate sensitivity

of the client's portfolios. The client's portfolio consists of positions in both U.S. and British bonds. The relevant

information for estimating (he duration contribution of the British bond and the portfolio's total duration is

provided below.

U.S. dollar bond $275,000

British bond $155,000

British yield beta 1.40

Duration of U.S. bond 4.0

Duration of British bond 8.5

When discussing portfolio management with clients, Edwards recommends the use of emerging market bonds

to add value to a core-plus strategy. He explains the characteristics of emerging market debt to Palmer by

stating:

1. "The performance of emerging market debt has been quite resilient over time. After crises in the debt

markets, emerging market bonds quickly recover after a crisis, so long-term returns can be poor."

2. "Emerging market debt is quite volatile due in part to the nature of political risk in these markets. It is

therefore important that the analyst monitor the risk of these markets. I prefer to measure the risk of emerging

market bonds with the standard deviation because it provides the best representation of risk in these markets."

Regarding his two statements about the characteristics of emerging market debt, is Edwards correct?

Options :

A :

Only statement 1 is correct.

B :

Only statement 2 is correct.

C :

Both statements are incorrect.

Answer: A

Question 4

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 5

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from a

prestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-western

university in the United States. Northern provides investment advice for pension funds, foundations,

endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.

They are currently scrutinizing the performance of several portfolio managers who work for the Thompson

University endowment.

Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,

the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000

that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $

17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer and

Seagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states that

the advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that the

money-weighted return is, however, a better measure of the manager's performance.

Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for the

most recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) for

Thompson is the 4.5% spending rate on the endowment, which the endowment has determined using a

geometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI World

Index was used as the market index. The World index had a return of 9% in dollar terms with a standard

deviation of 23% and a beta of 1.0.

The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performance

of managers. The alternatives discussed that day are manager universes, broad market indices, style indices,

factor models, and custom benchmarks. Mercer states that manager universes have the advantage of being

measurable but they are subject to survivor bias. Seagram states that manager universes possess only one

quality of a valid benchmark.

Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes in

exploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engage

in providing foreign currency hedges to small firms in emerging markets when deemed profitable. This most

commonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a large

position in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firm

in Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into a

currency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.

Regarding their statements about manager universes, determine whether Mercer and Seagram are correct or

incorrect.

Options :

A :

Only Mercer is correct.

B :

Only Seagram is correct.

C : Both are correct.

Answer: C

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