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

Question 1

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:

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 2

Rowan Brothers is a full service investment firm offering portfolio management and investment banking services. For the last ten years, Aaron King, CFA, has managed individual client portfolios for Rowan Brothers, most of which are trust accounts over which King has full discretion. One of King's clients, Shelby Pavlica, is a widow in her late 50s whose husband died and left assets of over $7 million in a trust, for which she is the only beneficiary. Pavlica's three children are appalled at their mother's spending habits and have called a meeting with King to discuss their concerns. They inform King that their mother is living too lavishly to leave much for them or Pavlica's grandchildren upon her death. King acknowledges their concerns and informs them that, on top of her ever-increasing spending, Pavlica has recently been diagnosed with a chronic illness. Since the diagnosis could indicate a considerable increase in medical spending, he will need to increase the risk of the portfolio to generate sufficient return to cover the medical bills and spending and still maintain the principal. King restructures the portfolio accordingly and then meets with Pavlica a week later to discuss how he has altered the investment strategy, which was previously revised only three months earlier in their annual meeting. During the meeting with Pavlica, Kang explains his reasoning tor altering the portfolio allocation but does not mention the meeting with Pavlica's children. Pavlica agrees that it is probably the wisest decision and accepts the new portfolio allocation adding that she will need to tell her children about her illness, so they will understand why her medical spending requirements will increase in the near future. She admits to King that her children have been concerned about her spending. King assures her that the new investments will definitely allow her to maintain her lifestyle and meet her higher medical spending needs. One of the investments selected by King is a small allocation in a private placement offered to him by a brokerage firm that often makes trades for King's portfolios. The private placement is an equity investment in ShaleCo, a small oil exploration company. In order to make the investment, King sold shares of a publicly traded biotech firm, VNC Technologies. King also held shares of VNC, a fact that he has always disclosed to clients before purchasing VNC for their accounts. An hour before submitting the sell order for the VNC shares in Pavlica's trust account. King placed an order to sell a portion of his position in VNC stock. By the time Pavlica's order was sent to the trading floor, the price of VNC had risen, allowing Pavlica to sell her shares at a better price than received by King. Although King elected not to take any shares in the private placement, he purchased positions for several of his clients, for whom the investment was deemed appropriate in terms of the clients* objectives and constraints as well as the existing composition of the portfolios. In response to the investment support, ShaleCo appointed King to their board of directors. Seeing an opportunity to advance his career while also protecting the value of his clients' investments in the company, King gladly accepted the offer. King decided that since serving on the board of ShaleCo is in his clients' best interest, it is not necessary to disclose the directorship to his clients or his employer. For his portfolio management services, King charges a fixed percentage fee based on the value of assets under management. All fees charged and other terms of service are disclosed to clients as well as prospects. In the past month, however. Rowan Brothers has instituted an incentive program for its portfolio managers. Under the program, the firm will award an all-expense-paid vacation to the Cayman islands for any portfolio manager who generates two consecutive quarterly returns for his clients in excess of 10%. King updates his marketing literature to ensure that his prospective clients are fully aware of his compensation arrangements, but he does not contact current clients to make them aware of the newly created performance incentive. According to the CFA Institute Standards of Professional Conduct, which of the following statements is correct concerning King's directorship with ShaleCo?

A : King may not accept the directorship since it creates a conflict of interest

B : King may accept the directorship as long as it is disclosed to clients and prospects

C : King may accept the directorship as long as it is disclosed to his employer, clients, and prospects

Answer: C

Question 3

Albert Wulf, CFA, is a portfolio manager with Upsala Asset Management, a regional financial services firm that

handles investments for small businesses in Northern Germany. For the most part, Wulf has been handling

locally concentrated investments in European securities. Due to a lack of expertise in currency management he

works closely with James Bauer, a foreign exchange expert who manages international exposure in some of

Upsala's portfolios. Both individuals are committed to managing portfolio assets within the guidelines of client

investment policy statements.

To achieve global diversification, Wulf's portfolio invests in securities from developed nations including the

United States, Japan, and Great Britain. Due to recent currency market turmoil, translation risk has become a

huge concern for Upsala's managers. The U.S. dollar has recently plummeted relative to the euro, while the

Japanese yen and British pound have appreciated slightly relative to the euro. Wulf and Bauer meet to discuss

hedging strategies that will hopefully mitigate some of the concerns regarding future currency fluctuations.

Wulf currently has a $1,000,000 investment in a U.S. oil and gas corporation. This position was taken with the

expectation that demand for oil in the U.S. would increase sharply over the short-run. Wulf plans to exit this

position 125 days from today. In order to hedge the currency exposure to the U.S. dollar, Bauer enters into a

90-day U.S. dollar futures contract, expiring in September. Bauer comments to Wulf that this futures contract

guarantees that the portfolio will not take any unjustified risk in the volatile dollar.

Wulf recently started investing in securities from Japan. He has been particularly interested in the growth of

technology firms in that country. Wulf decides to make an investment of ¥25,000,000 in a small technology

enterprise that is in need of start-up capital. The spot exchange rate for the Japanese yen at the time of the

investment is ¥135/€. The expected spot rate in 90 days is ¥132/€. Given the expected appreciation of the yen,

Bauer purchases put options that provide insurance against any deprecation of the euro. While delta-hedging

this position, Bauer discovers that current at-the-money yen put options sell for €1 with a delta of -0.85. He

mentions to Wulf that, in general, put options will provide a cheaper alternative to hedging than with futures

since put options are only exercised if the local currency depreciates.

The exposure of Wulf’s portfolio to the British pound results from a 180-day pound-denominated investment of

£5,000,000. The spot exchange rate for the British pound is £0.78/€. The value of the investment is expected to

increase to £5,100,000 at the end of the 180 day period. Bauer informs Wulf that due to the minimal expected

exchange rate movement, it would be in the best interest of their clients, from a cost-benefit standpoint, to

hedge only the principal of this investment.

Before entering into currency futures and options contracts, Wulf and Bauer discuss the possibility of also

hedging market risk due to changes in the value of the assets. Bauer suggests that in order to hedge against a

possible loss in the value of an asset Wulf should short a given foreign market index. Wulf is interested in

executing index hedging strategies that are perfectly correlated with foreign investments. Bauer, however,

cautions Wulf regarding the increase in trading costs that would result from these additional hedging activities.

Regarding the Japanese investment in the technology company, determine the appropriate transaction in put

options to adjust the current delta hedge, given that the delta changes to -0.92. Assume that each yen put

allows the right to self ¥1,000,000.

A : Sell 2 yen put options.

B : Sell 27 euro put options.

C : Buy 29 yen put options.

Answer: A

Question 4

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?

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 5

Geneva Management (GenM) selects long-only and long-short portfolio managers to develop asset allocation

recommendations for their institutional clients.

GenM Advisor Marcus Reinhart recently examined the holdings of one of GenM's long-only portfolios actively

managed by Jamison Kiley. Reinhart compiled the holdings for two consecutive non-overlapping five year

periods. The Morningstar Style Boxes for the two periods for Kiley's portfolio are provided in Exhibits 1 and 2.

Exhibit 1: Morningstar Style Box: Long-Only Manager for Five-Year Period 1

Exhibit 2: Morningstar Style Box: Long-Only Manager for Five-Year Period 2

Reinhart contends that the holdings-based analysis might be flawed because Kiley's portfolio holdings are

known only at the end of each quarter. Portfolio holdings at the end of the reporting period might misrepresent

the portfolio's average composition. To compliment his holdings-based analysis, Reinhart also conducts a

returns-based style analysis on Kiley's portfolio. Reinhart selects four benchmarks:

1. SCV: a small-cap value index.

2. SCG: a small-cap growth index.

3. LCV: a large-cap value index.

4. LCG: a large-cap growth index.

Using the benchmarks, Reinhart obtains the following regression results:

Period 1: Rp = 0.02 + H0.01(SCV) + 0.02(SCG) + 0.36(LCV) + 0.61(LCG)

Period 2: Rp = 0.02 + 0.01(SCV) + 0.02(SCG) + 0.60(LCV) + 0.38(LCG)

Kiley's long-only portfolio is benchmarked against the S&P 500 Index. The Index's current sector allocations are

shown in Exhibit 3.

Exhibit 3: S&P 500 Index Sector Allocations

GenM strives to select managers whose correlation between forecast alphas and realized alphas has been

fairly high, and to allocate funds across managers in order to achieve alpha and beta separation. GenM gives

Reinhart a mandate to pursue a core-satellite strategy with a small number of satellites each focusing on a

relatively few number of securities.

In response to the core-satellite mandate, Reinhart explains that a Completeness Fund approach offers two

advantages:

Advantage 1: The Completeness Fund approach is designed to capture the stock selecting ability of the active

manager, while matching the overall portfolio's risk to its benchmark.

Advantage 2: The Completeness Fund approach allows the Fund to fully capture the value added from active

managers by eliminating misfit risk.

Which one of the following statements about Kiley's long-only portfolio is most correct1? Kiley's portfolio:

A : is only exposed to systematic risk.

B : is only exposed to unsystematic risk.

C : attempts to earn a positive alpha through security selection.

Answer: C

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