Question 1

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.

Options :

A :

Sell 2 yen put options.

B :

Sell 27 euro put options.

C :

Buy 29 yen put options.

Answer: A

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:

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 3

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,

which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in

the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,

foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,

Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking

error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus

reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian

region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments

in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are

expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by

finding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on

the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing

outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option

adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted

spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative

attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity

from the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts that

interest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of business

investment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low in

order to stimulate the economy. Although she sees the level of yields declining, she believes that the spread on

risky securities will increase due to the decline in business prospects. She therefore has reallocated her bond

portfolio away from high-yield bonds and towards investment grade bonds.

Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.

As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a

7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated Quincy

Corporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhanced

his annual income, which he considers quite favorable given the declining yields in the market.

Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, she

expects that the yields on mortgages will decline. As a result, she has reallocated the portion of Northern

Capital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to

7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in price

more than the higher coupon mortgages. She identifies this trade as a structure trade.

Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:

Which of the following best describes the relative value analysis used in the Northern Capita! Emerging market

bond fund? It is a:

Options :

A : top-down approach.

B : bottom-up approach.

C : combination of a top-down approach and a bottom-up approach.

Answer: B

Question 4

Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. The

funds are managed individually, but Pace has an investment committee that oversees all of the funds. This

committee is responsible for evaluating the performance of the funds relative to appropriate benchmarks and

relative to the stated investment objectives of each individual fund. During a recent investment committee

meeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of the

portfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee was

to review the performance of the manager responsible for each fund and dismiss those managers whose

performance had lagged substantially behind the appropriate benchmark.

The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with a

capitalization between S40 billion and $80 billion. A review of the operations of the fund found the following:

• The turnover of the fund was almost double that of other similar style mutual funds.

• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existing

holding.

• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutual

funds.

• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years of

financial information on that company, plus independent research reports from at least three different analysts.

• The portfolio manager refuses to increase her technology sector weighting because of past losses the fund

incurred in the sector.

• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. She

expects oil prices to fall back to the $40 to S50 per barrel range.

A committee member made the following two comments:

Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfolio

lacks recognizable companies. I believe that good companies make good investments."

Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. She

seems to sell stocks that appreciate, but hold stocks that have declined in value."

The supervisor of the Mid-Cap Mutual Fund portfolio manager made the following statements:

Statement 1: "The portfolio manager of the Mid-Cap Mutual Fund has engaged in quarter-end window dressing

to make her portfolio look better to investors. The portfolio manager's action is a behavioral trait known as overreaction."

Statement 2: "Each time the portfolio manager of the Mid-Cap Mutual fund trades a stock, she executes the

trade by buying or selling one-third of the position at a time, with the trades spread over three months. The

portfolio manager's action is a behavioral trait known as anchoring."

Indicate whether Statement 1 and Statement 2 made by the supervisor are correct.

Options :

A : Only Statement 1 is correct.

B : Only Statement 2 is correct.

C : Neither Statement is correct.

Answer: C

Question 5

Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is

responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a

candidate for the Level 1 CFA exam.

Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain.

He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£.

Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The

current 1-year forward rate is C$1.60/£.

Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is

provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond

is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United

States.

Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of

currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also

decide whether or not to hedge the currency exposure.

Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having

difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a

forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His

reason for choosing the yen is that it is positively correlated with the won.

One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging

strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest

rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates

may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an

interest rate floor as a hedge.

Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is

contemplating using either a covered call or a protective put on a T-bond futures contract.

The hedge that Rolle uses to hedge the currency exposure of the Korean bond is best referred to as a:

Options :

A : proxy hedge.

B : cross hedge.

C : forward hedge.

Answer: A

Higher Test Marks with Free Online CFA-Level-III Exam Practice

Buying Options: