Question 1

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety

of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management

techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,

its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the

creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other

institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).

Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit

risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,

which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable

difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the

Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in

default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims

before it could settle the agreement with Johnson Associates.

McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states

that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the

possibility of default on current obligations, while future credit risk relates to potential default on future

obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value

of current obligations and the present value of future obligations. Cramer adds that combining current and

potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a

reliable predictor of a borrower's potential credit risk.

As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with

forward agreements. Cramer states that long forward contracts gain in value when the market price of the

underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk

and forward contracts in the handbook. She offers the following:

A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.

The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds

were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He

writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral

from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a

discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives

represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in

their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the

holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap

dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash

flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like

protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus

3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond

issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is

considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the

economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond

and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The

characteristics of the forward contract are shown below.

Information on the Credit Spread Forward

Determine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.

Options :

A :

The contract has current credit risk only.

B : The contract has potential credit risk only

C : The contract has neither potential credit risk nor current credit risk.

Answer: B

Question 2

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

Question 3

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:

Options :

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 4

Security analysts Andrew Tian, CFA, and Cameron Wong, CFA, are attending an investment symposium at the

Singapore Investment Analyst Society. The focus of the symposium is capital market expectations and relative

asset valuations across markets. Many highly-respected practitioners and academics from across the AsiaPacific region are on hand to make presentations and participate in panel discussions.

The first presenter, Lillian So, President of the Society, speaks on market expectations and tools for estimating

intrinsic valuations. She notes that analysts attempting to gauge expectations are often subject to various

pitfalls that subjectively skew their estimates. She also points out that there are potential problems relating to a

choice of models, not all of which describe risk the same way. She then provides the following data to illustrate

how analysts might go about estimating expectations and intrinsic values.

The next speaker, Clive Smyth, is a member of the exchange rate committee at the Bank of New Zealand. His

presentation concerns the links between spot currency rates and forecasted exchange rates. He states that

foreign exchange rates are linked by several forces including purchasing power parity (PPP) and interest rate

parity (IRP). He tells his audience that the relationship between exchange rates and PPP is strongest in the

short run, while the relationship between exchange rates and IRP is strongest in the long run. Smyth goes on to

say that when a country's economy becomes more integrated with the larger world economy, this can have a

profound impact on the cost of capital and asset valuations in that country.

The final speaker in the session directed his discussion toward emerging market investments. This discussion,

by Hector Ruiz, head of emerging market investment for the Chilean Investment Board, was primarily

concerned with how emerging market risk differs from that in developed markets and how to evaluate the

potential of emerging market investments. He noted that sometimes an economic crisis in one country can

spread to other countries in the area, and that asset returns often exhibit a greater degree of non-normality than

in developed markets.

Ruiz concluded his presentation with the data in the tables below to illustrate factors that should be considered

during the decision-making process for portfolio managers who are evaluating investments in emerging

markets.

Determine which of the following characteristics of emerging market debt investing presents the global fixed

income portfolio manager with the best potential to generate enhanced returns.

Options :

A :

Increasing quality of emerging market sovereign debt coupled with the ability of emerging market

governments to access global capital.

B :

The Emerging Markets Bond Index Pius (EMBI+) index is dominated by Latin American debt securities.

C : Emerging market debt can be highly volatile with negatively skewed returns distributions.

Answer: B

Question 5

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

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