Question 1

Joan Weaver, CFA and Kim McNally, CFA are analysts for Cardinal Fixed Income Management. Cardinal

provides investment advisory services to pension funds, endowments, and other institutions in the U.S. and

Canada. Cardinal recommends positions in investment-grade corporate and government bonds.

Cardinal has largely advocated the use of passive approaches to bond investments, where the predominant

holding consists of an indexed or enhanced indexed bond portfolio. They are exploring, however, the possibility

of using a greater degree of active management to increase excess returns. The analysts have made the

following statements.

• Weaver: "An advantage of both enhanced indexing by matching primary risk factors and enhanced indexing

by minor risk factor mismatching is that there is the potential for excess returns, but the duration of the portfolio

is matched with that of the index, thereby limiting the portion of tracking error resulting from interest rate risk."

• McNally: "The use of active management by larger risk factor mismatches typically involves large duration

mismatches from the index, in an effort to capitalize on interest rate forecasts."

As part of their increased emphasis on active bond management, Cardinal has retained the services of an

economic consultant to provide expectations input on factors such as interest rate levels, interest rate volatility,

and credit spreads. During his presentation, the economist states that he believes long-term interest rates

should fall over the next year, but that short-term rates should gradually increase. Weaver and McNally are

currently advising an institutional client that wishes to maintain the duration of its bond portfolio at 6.7. In light of

the economic forecast, they are considering three portfolios that combine the following three bonds in varying

amounts.

Weaver and McNally next examine an investment in a semiannual coupon bond newly issued by the Manix

Corporation, a firm with a credit rating of AA by Moody's. The specifics of the bond purchase are provided

below given Weaver's projections. It is Cardinal's policy that bonds be evaluated for purchase on a total return

basis.

One of Cardinal's clients, the Johnson Investment Fund (JIF), has instructed Weaver and McNally to

recommend the appropriate debt investment for $125,000,000 in funds. JIF is willing to invest an additional

15% of the portfolio using leverage. JIF requires that the portfolio duration not exceed 5.5. Weaver

recommends that JIF invest in bonds with a duration of 5.2. The maximum allowable leverage will be used and

the borrowed funds will have a duration of 0.8. JIF is considering investing in bonds with options and has asked

McNally to provide insight into these investments. McNally makes the following comments:

"Due to the increasing sophistication of bond issuers, the amount of bonds with put options is increasing, and

these bonds sell at a discount relative to comparable bullets. Putables are quite attractive when interest rates

rise, but, we should be careful if with them, because valuation models often fail to account for the credit risk of

the issuer."

Another client, Blair Portfolio Managers, has asked Cardinal to provide advice on duration management. One

year ago, their portfolio had a market value of $3,010,444 and a dollar duration of $108,000; current figures are

provided below:

The expected bond equivalent yield for the Manix Bond, using total return analysis, is closest to:

Options :

A : 5.92%.

B : 11.86%.

C : 12.12%.

Answer: B

Question 2

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

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:

Options :

A : 11.0%.

B : 11.7%.

C : 12.5%.

Answer: B

Question 4

Joan Nicholson, CFA, and Kim Fluellen, CFA, sit on the risk management committee for Thomasville Asset

Management. Although Thomasville manages the majority of its investable assets, it also utilizes outside firms

for special situations such as market neutral and convertible arbitrage strategies. Thomasville has hired a

hedge fund, Boston Advisors, for both of these strategies. The managers for the Boston Advisors funds are

Frank Amato, CFA, and Joseph Garvin, CFA. Amato uses a market neutral strategy and has generated a return

of S20 million this year on the $100 million Thomasville has invested with him. Garvin uses a convertible

arbitrage strategy and has lost $15 million this year on the $200 million Thomasville has invested with him, with

most of the loss coming in the last quarter of the year. Thomasville pays each outside manager an incentive fee

of 20% on profits. During the risk management committee meeting Nicholson evaluates the characteristics of

the arrangement with Boston Advisors. Nicholson states that the asymmetric nature of Thomasville's contract

with Boston Advisors creates adverse consequences for Thomasville's net profits and that the compensation

contract resembles a put option owned by Boston Advisors.

Upon request, Fluellen provides a risk assessment for the firm's large cap growth portfolio using a monthly

dollar VAR. To do so, Fluellen obtains the following statistics from the fund manager. The value of the fund is

$80 million and has an annual expected return of 14.4%. The annual standard deviation of returns is 21.50%.

Assuming a standard normal distribution, 5% of the potential portfolio values are 1.65 standard deviations

below the expected return.

Thomasville periodically engages in options trading for hedging purposes or when they believe that options are

mispriced. One of their positions is a long position in a call option for Moffett Corporation. The option is a

European option with a 3-month maturity. The underlying stock price is $27 and the strike price of the option is

$25. The option sells for S2.86. Thomasville has also sold a put on the stock of the McNeill Corporation. The

option is an American option with a 2-month maturity. The underlying stock price is $52 and the strike price of

the option is $55. The option sells for $3.82. Fluellen assesses the credit risk of these options to Thomasville

and states that the current credit risk of the Moffett option is $2.86 and the current credit risk of the McNeill

option is $3.82.

Thomasville also uses options quite heavily in their Special Strategies Portfolio. This portfolio seeks to exploit

mispriced assets using the leverage provided by options contracts. Although this fund has achieved some

spectacular returns, it has also produced some rather large losses on days of high market volatility. Nicholson

has calculated a 5% VAR for the fund at $13.9 million. In most years, the fund has produced losses exceeding

$13.9 million in 13 of the 250 trading days in a year, on average. Nicholson is concerned about the accuracy of

the estimated VAR because when the losses exceed $13.9 million, they are typically much greater than $13.9

million.

In addition to using options, Thomasville also uses swap contracts for hedging interest rate risk and currency

exposures. Fluellen has been assigned the task of evaluating the credit risk of these contracts. The

characteristics of the swap contracts Thomasville uses are shown in Figure 1.

Fluellen later is asked to describe credit risk in general to the risk management committee. She states that

cross-default provisions generally protect a creditor because they prevent a debtor from declaring immediate

default on the obligation owed to the creditor when the debtor defaults on other obligations. Fluellen also states

that credit risk and credit VAR can be quickly calculated because bond rating firms provide extensive data on

the defaults for investment grade and junk grade corporate debt at reasonable prices.

Which of the following best describes the accuracy of the VAR measure calculated for the Special Strategies

Portfolio?

Options :

A : It is accurate but should be supplemented with scenario analysis.

B : It is accurate and provides a complete measure of the fund-s risk.

C : It is inaccurate and should be supplemented with comprehensive stress testing.

Answer: C

Question 5

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

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