100% Free CFA Institute CFA-Level-III Practice Test Questions

Question 1

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?

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

Question 2

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:

A : fixed and receive floating.

B : floating and receive fixed.

C : floating and receive floating.

Answer: B

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.

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

Andre Hickock, CFA, is a newly hired fixed income portfolio manager for Deadwood Investments, LLC. Hickock

is reviewing the portfolios of several pension clients that have been assigned to him to manage. The first

portfolio, Montana Hardware, Inc., has the characteristics shown in Figure 1.

Hickock is attempting to assess the risk of the Montana Hardware portfolio. The benchmark bond index that

Deadwood uses for pension accounts similar to Montana Hardware has an effective duration of 5.25. His

supervisor, Carla Mity, has discussed bond risk measurement with Hickock. Mity is most familiar with equity risk

measures, and is not convinced of the validity of duration as a portfolio risk measure. Mity told Hickock, "I have

always believed that standard deviation is the best measure of bond portfolio risk. You want to know the

volatility, and standard deviation is the most direct measure of volatility."

Hickock is also reviewing the bond portfolio of Buffalo Sports, Inc., which is comprised of the following assets

shown in Figure 2.

The trustees of the Buffalo Sports pension plan have requested that Deadwood explore alternatives to reduce

the risk of the MBS sector of their bond portfolio. Hickock responded to their request as follows:

"I believe that the current option-adjusted spread (OAS) on the MBS sector is quite high. In order to reduce your

risk, I would suggest that we hedge the interest rate risk using a combination of 2-year and 10-year Treasury

security futures. I would further suggest that we do not take any steps to hedge spread risk at this time."

In assessing the risk of a portfolio containing both bullet maturity corporate bonds and MBS, Hickock should

always consider that:

A : the duration of MBS securities will increase as the level of interest rates declines.

B : MBS values will benefit from higher convexity as interest rates decline.

C : MBS values will be more sensitive to changes in the shape of the yield curve than bullet maturity corporatebonds.

Answer: C

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.

A : Only Mercer is correct.

B : Only Seagram is correct.

C : Both are correct.

Answer: C

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