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CFA Institute CFA-Level-III Exam Questions
Provided By: CFA Institute
Exam: CFA Level III Chartered Financial Analyst
Certification: CFA Level III

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Question 1
- John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management. In one of his client portfolios, Rawlins currently holds the following positions:
  
  The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.
  In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he has
  regressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient for
  this regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedging
  calculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futures
  contracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).
  In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond management
  by moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in his
  portfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-hold
  strategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervalued
  bond issues. Although Tejada has recently graduated from a prestigious university with a master's degree in
  finance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approach
  needs further evaluation over a period of both falling and rising interest rates, as well as in different credit
  environments.
  Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, a
  U.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by Bergamo
  Metals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. The
  holding period for either bond is three months.
  The characteristics of the bonds are as follows:
  
  3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejada
  will hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.
  Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacom
  bond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro is
  at a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because the
  net return advantage for the Dynacom bond is 0.5% over the next three months.
  Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has a
  yield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heard
  rumors that the chief executive and the chairman of the board at Dynacom are both being investigated by the
  U.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to the
  exercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident could
  be damaging to Dynacom's bond price.
  Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes that
  news of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states that
  he would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bond
  stays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative of
  Tejada's efforts, the analysis relies on an approximation.
  Suppose that the original dollar duration for a 100 basis point change in interest rates was $4,901,106 and that
  the bond prices remain constant during the year. Based upon the durations one year from today, and assuming
  a proportionate investment in each of the three bonds, the amount of cash that will need to be invested to
  restore the average dollar duration to the original level is closest to:
  
  A : $5,885,167.
  
  B : $10,888,662.
  
  C : $12,793,588.
  
  D :
  
  Answer: C
Question 2
- William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and positions in physical
  commodities. He is reviewing his operations and strategies to increase the return of the fund. Bliss has just
  hired Joseph Kanter, CFA, to help him manage the fund because he realizes that he needs to increase his
  trading activity in futures and to engage in futures strategies other than fully hedged, passively managed
  positions. Bliss also hired Kanter because of Kantcr's experience with swaps, which Bliss hopes to add to his
  choice of investment tools.
  Bliss explains to Kanter that his clients pay 2% on assets under management and a 20% incentive fee. The
  incentive fee is based on profits after having subtracted the risk-free rate, which is the fund's basic hurdle rate,
  and there is a high water mark provision. Bliss is hoping that Kanter can help his business because his firm did
  not earn an incentive fee this past year. This was the case despite the fact that, after two years of losses, the
  value of the fund increased 14% during the previous year. That increase occurred without any new capital
  contributed from clients. Bliss is optimistic about the near future because the term structure of futures prices is
  particularly favorable for earning higher returns from long futures positions.
  Kanter says he has seen research that indicates inflation may increase in the next few years. He states this
  should increase the opportunity to earn a higher return in commodities and suggests taking a large, margined
  position in a broad commodity index. This would offer an enhanced return that would attract investors holding
  only stocks and bonds. Bliss mentions that not all commodity prices are positively correlated with inflation so it
  may be better to choose particular types of commodities in which to invest. Furthermore, Bliss adds that
  commodities traditionally have not outperformed stocks and bonds either on a risk-adjusted or absolute basis.
  Kanter says he will research companies who do business in commodities, because buying the stock of those
  companies to gain commodity exposure is an efficient and effective method for gaining indirect exposure to
  commodities.
  Bliss agrees that his fund should increase its exposure to commodities and wants Kanter's help in using swaps
  to gain such exposure. Bliss asks Kanter to enter into a swap with a relatively short horizon to demonstrate how
  a commodity swap works. Bliss notes that the futures prices of oil for six months, one year, eighteen months,
  and two years are $55, S54, $52, and $5 1 per barrel, respectively, and the risk-free rate is less than 2%.
  Bliss asks how a seasonal component could be added to such a swap. Specifically, he asks if either the
  notional principal or the swap price can be higher during the reset closest to the winter season and lower for the
  reset period closest to the summer season. This would allow the swap to more effectively hedge a commodity
  like oil, which would have a higher demand in the winter than the summer. Kanter says that a swap can only
  have seasonal swap prices, and the notional principal must stay constanl. Thus, the solution in such a case
  would be to enter into two swaps, one that has an annual reset in the winter and one that has an annual reset in
  the summer.
  Given the information, the most likely reason that Bliss's firm did not earn an incentive fee in the past year was
  because:
  
  A : the normal return was subtracted.
  
  B : the 2% asset-under-management fee is greater than the risk-free rate.
  
  C : of a high water mark provision, which states the value of the fund must exceed its previous high point before managers are paid an incentive fee.
  
  Answer: C
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."
  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:
  
  A : 11.0%.
  
  B : 11.7%.
  
  C : 12.5%.
  
  Answer: B
Question 4
- Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Many
  of MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all credit
  qualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worth
  inc., Enertech Company, and SBK Company.
  Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of its
  fixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued two
  years ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to decline
  by as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. The
  company has decided to enter into a 2-year interest rate swap with semiannual payments, a swap rate of 5.8%,
  and a floating rate based on 6-month EURIBOR. The duration of the fixed side of the swap is 1.2. Analysts at
  MIA have made the following comments regarding Worth's swap plan:
  • "The duration of the swap from the perspective of Worth is 0.95."
  • "By entering into the swap, the duration of Worth's long-term liabilities will become smaller, causing the value
  of the firm's equity to become more sensitive to changes in interest rates."
  Enertech Company is a U.S.-based provider of electricity and natural gas. The company uses a large proportion
  of floating rate notes to finance its operations. The current interest rate on Enertech's floating rate notes, based
  on 6-month LIBOR plus 150bp, is 5.5%. To hedge its interest rate risk, Enertech has decided to enter into a
  long interest rate collar. The cap and the floor of the collar have maturities of two years, with settlement dates
  (in arrears) every six months. The strike rate for the cap is 5.5% and for the floor is 4.5%, based on 6-month
  LIBOR, which is forecast to be 5.2%, 6.1%, 4.1%, and 3.8%, in 6,12, 18, and 24 months, respectively. Each
  settlement period consists of 180 days. Analysts at MIA are interested in assessing the attributes of the collar.
  SBK Company builds oil tankers and other large ships in Norway. The firm has several long-term bond issues
  outstanding with fixed interest rates ranging from 5.0% to 7.5% and maturities ranging from 5 to 12 years.
  Several years ago, SBK took the pay floating side of a semi-annual settlement swap with a rate of 6.0%, a
  floating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6
  months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given its
  interest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, an
  underlying swap rate of 6.0%, and a floating rate based on LIBOR.
  MIA is considering investing in the debt of Rio Corp, a Brazilian energy company. The investment would be in
  Rio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest rate
  decline in Brazil over the short term.
  Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effects
  of the swap on the company's balance sheet are correct or incorrect.
  
  A :
  Only the comment regarding the swap duration is correct.
  
  B :
  Only the comment regarding the swap balance sheet effects is correct.
  
  C : Both comments are correct.
  
  Answer: C
Question 5
- Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixedincome firm based in the United States. AA employs numerous quantitative models to invest in both domestic
  and international securities.
  During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a
  $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is
  paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change
  scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.
  Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned,
  however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy. In
  response, Castillo explains the factors that affect the repo rate and makes the following statements:
  1. "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral,
  and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers
  using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is
  usually quite low. "
  2. "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the
  collateral is limited, the repo rate will be higher."
  Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on
  bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under
  discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the
  $200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The
  expected return on the portfolio is 8% and the cost of borrowed funds is 3%.
  The next day, the chief investment officer for the Washington Investment Fund expresses her concern about
  the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios. In
  response, Diaz distinguishes between the standard deviation and downside risk measures, making the
  following statements:
  1. ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it
  considers all returns over the entire distribution, variance and the resulting standard deviation are artificially
  inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios,
  managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns
  below a given return, such as the mean or a hurdle rate."
  2. "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected
  return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss
  if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall
  risk is a more appropriate measure, because it provides the probability of not meeting a target return."
  AA has a corporate client, Shaifer Materials with a €20,000,000 bond outstanding that pays an annual fixed
  coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within
  the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a
  lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has
  found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt
  would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond
  at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a
  payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.
  Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year. The terms of
  each instrument are provided below:
  Payer swaption fixed rate7.90%
  Receiver swaption fixed rate7.60%
  Current Euribor7.20%
  Projected Euribor in one year5.90%
  Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in
  their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.
  Regarding their statements concerning the synthetic refinancing of the Shaifer Materials fixed rate euro debt,
  are the comments correct?
  
  A : Only Castillo is correct.
  
  B : Only Diaz is correct.
  
  C :
  Both Castillo and Diaz are incorrect.
  
  Answer: A

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