2009 l3 sample exam v3 qa

NEW-Level III Version 2009 Sample Exam Don Rowan Case Scenario Don Rowan, CFA, works for an investment bank that is advising a client about a potential acquisition of Martin Industries Although Rowan is not working on the Martin deal, Julia Carney, CFA, a colleague in the same department who is directly involved with the acquisition, telephones Rowan at home to ask for his advice about the acquisition Rowan’s wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, “She is a colleague in my department who is working on an important deal with Martin and was simply seeking my advice.” That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney Two weeks later, Boyle, a research assistant at an asset management firm, reads an article about Martin Industries in the financial press After further reading and investigation, Boyle, who is a CFA candidate, hypothesizes that the firm may be a prime takeover target She informs her supervisor of her hypothesis Her supervisor, a CFA charterholder and portfolio manager who emphasizes diligent research, tells Boyle to more research and then write a report Boyle collects the data needed for her report and gathers previously published research reports from reputable firms to assist in her analysis She conducts primary research and scrutinizes the reports including the assumptions, the timeliness, and the rigor of analysis During lunch, she observes that Martin’s common stock price is starting to increase She completes her report and places a call to her father, a member of CFA Institute who is an advisor at the firm where she holds her children’s education fund Boyle tells him, “I think Martin stock may be a good buy Buy 300 shares for the children’s education fund.” Her father immediately purchases the shares according to his daughter’s instructions He then places an order to purchase a block of 5,000 shares of Martin stock, which he allocates among his client and personal accounts Late the next day, Boyle gives her completed report to her supervisor She takes care to disclose in the report that “the author is a beneficial owner of Martin Industries common stock.” The report, which references previously published reports as Boyle’s main sources, recommends purchase of Martin stock for investors with above-average risk tolerance The supervisor reads the report immediately and is impressed with Boyle’s work He questions Boyle about her research, her sources, and her recommendation Satisfied with Boyle’s responses, he places an order to purchase a block of 25,000 shares to be allocated among his clients Question When disclosing the Martin Industries deal to Rowan, did Carney violate any CFA Institute Standards of Professional Conduct? A No B Yes, relating only to client confidentiality C Yes, relating to both client confidentiality and fiduciary duty to employer Correct Answer = A "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 67-71 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity According to Standard III (E), Duties to Clients: Preservation of Confidentiality, members may disclose information received from clients to fellow employees in an effort to improve client service The Standard relating to Duties to Employers does not include a fiduciary duty When disclosing Carney's involvement in the Martin Industries deal to West, did Rowan violate any CFA Institute Standards? A No B Yes, only the Standard relating to client confidentiality C Yes, the Standards relating to client confidentiality and to fiduciary duty to employer Correct Answer = B "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 67-68 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Standard III (E) Duties to Clients: Preservation of Confidentiality, requires that members preserve the confidentiality of information communicated to them by their clients The Standard relating to Duties to Employers does not include a fiduciary duty When buying Martin Industries stock for her children's education fund, did Boyle violate any CFA Institute Standards? A No B Yes, relating to priority of transactions C Yes, relating to material nonpublic information Correct Answer = B "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 94-95 Study Session 1-2-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity According to Standard VI (B), Conflicts of Interest: Priority of Transactions, members may undertake transactions in accounts for which they are a beneficial owner only after their clients and employers have had adequate opportunity to act With respect to the block trade in Martin Industries stock, did Boyle's father violate any CFA Institute Standards? A No B Yes, relating only to reasonable basis C Yes, relating to both reasonable basis and material nonpublic information Correct Answer = B "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 80-81 "Pearl Investment Management (A), (B), and (C)," Glen Holdern, Jr., CFA 2009 Modular Level III, Vol 1, p 197 Study Sessions 1-2-a, 2-5-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Evaluate professional conduct and formulate an appropriate response to actions that violate the CFA Institute Code of Ethics and Standards of Professional Conduct According to Standard V (A), Investment Analysis, Recommendations, and Action: Diligence and Reasonable Basis, members must exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions They must have a reasonable and adequate basis, supported by appropriate research and investigation for any investment action Boyle did not have a reasonable and adequate basis, supported by appropriate research and investigation for his block purchase When completing and submitting her report on Martin Industries, did Boyle violate any CFA Institute Standards? A No B Yes, because she did not disclose the amount of her beneficial ownership C Yes, because she did not attempt to disseminate the material nonpublic information Correct Answer = A "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 24-25, 38-39, 80-81, 89-91 "Pearl Investment Management (A), (B), and (C)," Glen Holdern, Jr., CFA 2009 Modular Level III, Vol 1, pp 195-198 Study Sessions 1-2-a, 2-5-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Evaluate professional conduct and formulate an appropriate response to actions that violate the CFA Institute Code of Ethics and Standards of Professional Conduct Boyle did not commit a violation By disclosing that she was beneficial owner of Martin stock, she alerted readers that her recommendation may be biased Including other people's work is not a violation if it is referenced, as it was by Boyle Boyle's report was based on the Mosaic Theory and she was free to act on the collection of material When trading in Martin Industries stock, did Boyle's supervisor violate any CFA Institute Standards? A No B Yes, because he was trading on material nonpublic information C Yes, because he purchased a single block rather than purchasing shares for individual client accounts Correct Answer = A "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 38-39, 53, 80-81 "Pearl Investment Management (A), (B), and (C)," Glen Holdern, Jr., CFA 2009 Modular Level III, Vol 1, pp 191-198 Study Sessions 1-2-a, 2-5-a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity Evaluate professional conduct and formulate an appropriate response to actions that violate the CFA Institute Code of Ethics and Standards of Professional Conduct Boyle's supervisor did not commit a violation The new research report provided a reasonable basis for his investment decision He did not possess material nonpublic information Fair dealing allows a single block purchase to be allocated among individual accounts Bobby Sarkar Case Scenario Bobby Sarkar, Chief Investment Officer for the Daniels Corporation pension plan, is meeting with the Investment Policy Committee to evaluate portfolio managers for the pension fund To help with the evaluation Sarkar has collected information on three active portfolio managers This information is presented below in Exhibit and Exhibit Exhibit Investment Manager Data December 31, 2007 Manager Manager Manager A B C 2876 3752 4619 8.7 17.5 23.1 Dividend yield 3.50% 1.70% 1.00% EPS growth (5-year projected) 6.75% 5.25% 14.50% Portfolio active return 3.50% 3.00% 4.30% Portfolio tracking risk 5.00% 1.50% 6.00% Style fit 87.00% 95.00% 85.00% Assets under management ($ millions) P/E Exhibit Returns-Based Style Analysis December 31, 2007 Style Index Weights Manager Manager Manager A B C Russell 1000 Value Index 58% 0% 4% Russell 1000 Growth Index 4% 0% 28% Russell 2000 Value Index 35% 50% 3% Russell 2000 Growth Index 3% 50% 65% 100% 100% 100% The Russell 1000 indexes consist of large capitalization stocks, while the Russell 2000 indexes consist of small capitalization stocks Reena Hashmi, one of the members of the investment policy committee, makes the following statement, "I think it would be cheaper to use a passive investment strategy instead of using active portfolio managers." Question Based on the information presented in Exhibits and 2, manager A is most likely following a: A value investment strategy B growth investment strategy C semi-active investment strategy Correct Answer = A "Equity Portfolio Management," Gary L Gastineau, Andrew R Olma, and Robert G Zielinski 2009 Modular Level III, Vol 4, pp 179-181, 206-215 Study Session 11-33-b, i Discuss the rationales for passive, active, and semi-active (enhanced index) equity investment approaches and distinguish among those approaches with respect to expected active return and tracking risk Compare and contrast techniques for identifying investment styles and characterize the style of an investor when given a description of the investor's security selection method, details on the investor's security holdings, or the results of a returns-based style analysis Manager A has a low P/E, high dividend yield and a style fit of 87%, which suggests that he is following an active value strategy Furthermore, Exhibit shows that he is following a value strategy, 58% weight on the Russell 1000 value index, and 35% weight on the Russell 2000 value index The weights on the other two growth indexes are minimal Based on the information presented in Exhibits and 2, manager B is most likely following a: A value investment strategy B growth investment strategy C semi-active investment strategy Correct Answer = C "Equity Portfolio Management," Gary L Gastineau, Andrew R Olma, and Robert G Zielinski 2009 Modular Level III, Vol 4, pp 179-181, 206-215 Study Session 11-33-b, i Discuss the rationales for passive, active, and semi-active (enhanced index) equity investment approaches and distinguish among those approaches with respect to expected active return and tracking risk Compare and contrast techniques for identifying investment styles and characterize the style of an investor when given a description of the investor's security selection method, details on the investor's security holdings, or the results of a returns-based style analysis The data in Exhibits and indicate that manager B has no clear value or growth bias However, manager B has the lowest overall tracking risk, which is a feature of semi-active managers Also note that the style fit is 95% compared to 87% for manager A and 85% for manager B, both of whom are active managers Based on the information presented in Exhibits and 2, manager C is most likely following a: A value investment strategy B growth investment strategy C semi-active investment strategy Feedback: You have answered incorrectly Correct Answer = B "Equity Portfolio Management," Gary L Gastineau, Andrew R Olma, and Robert G Zielinski 2009 Modular Level III, Vol 4, pp 179-181, 206-215 Study Session 11-33-b, i Discuss the rationales for passive, active, and semi-active (enhanced index) equity investment approaches and distinguish among those approaches with respect to expected active return and tracking risk Compare and contrast techniques for identifying investment styles and characterize the style of an investor when given a description of the investor's security selection method, details on the investor's security holdings, or the results of a returns-based style analysis Manager C has a high P/E, low dividend yield, high EPS growth and a style fit of 85%, which suggests that he is following an active growth strategy Furthermore, Exhibit shows that he is following a growth strategy, 28% weight on the Russell 1000 growth index, and 65% weight on the Russell 2000 growth index The weights on the other two growth indexes are minimal 10 A contrarian investing substyle would most likely be used by: A manager A B manager B C manager C Correct Answer = A "Equity Portfolio Management," Gary L Gastineau, Andrew R Olma, and Robert G Zielinski 2009 Modular Level III, Vol 4, pp 202-203 Study Session 11-33-h Explain the rationales and primary concerns of value investors and growth investors and discuss the key risks of each investment style Manager A is a value manager and contrarian investing is a value investing substyle Manager A has a low P/E, high dividend yield and a style fit of 87%, which suggests that he is following an active value strategy Furthermore, Exhibit shows that he is following a value strategy, 58% weight on the Russell 1000 value index, and 35% weight on the Russell 2000 value index The weights on the other two growth indexes are minimal 11 Which of the following managers most likely follows a market oriented style with a small capitalization bias? A Manager A B Manager B C Manager C Correct Answer = B "Equity Portfolio Management," Gary L Gastineau, Andrew R Olma, and Robert G Zielinski 2009 Modular Level III, Vol 4, pp 200-212 Study Session 11-33-g, h, i Explain and justify the use of equity investment style classifications and discuss the difficulties in applying style definitions consistently Explain the rationales and primary concerns of value investors and growth investors and discuss the key risks of each investment style Compare and contrast techniques for identifying investment styles and characterize the style of an investor when given a description of the investor's security selection method, details on the investor's security holdings, or the results of a returns-based style analysis Manager B follows a market oriented style with a small cap bias The data in Exhibits and indicate that manager B has no clear value or growth bias However, Exhibit shows weights of 50% each on the Russell 2000 growth and Russell 2000 value indexes Both of these indexes are small cap indexes 12 The investment strategy suggested by Hashmi can be implemented by: A equitizing a market neutral portfolio B following a long-short investment strategy C taking a long position in cash and index futures contracts Correct Answer = C "Equity Portfolio Management," Gary L Gastineau, Andrew R Olma, and Robert G Zielinski 2009 Modular Level III, Vol 4, p 192 Study Session 11-33-e Compare and contrast alternative methods for establishing passive exposure to an equity market, including indexed separate or pooled accounts, index mutual funds, exchange-traded funds, equity index futures, and equity total return swaps One way to implement a passive investment strategy is to take a long position in cash and to take a long position in index futures contracts 13 Nabil Shariff Case Scenario Nabil Shariff is the senior manager for MIR Capital's U.S.-based Global Bond Portfolio Shariff is meeting with a junior portfolio manager, Jennifer Eastwood, to discuss strategies to improve performance and manage the risk exposure of the portfolio Summary data for the portfolio is presented in Exhibit Exhibit Summary Information for MIR Capital's Global Bond Portfolio Country Country Risk-Free US$ / Currency Bond Weight Duration Beta Return Spot Forecast Yield U.S 55% 5.90 3.50% 4.47% U.K 20% 5.67 0.80 5.00% 1.84 1.80 6.00% Euro-Zone 25% 5.50 0.70 4.50% 1.20 1.19 5.50% Their discussion initially centers on the U.S component of the portfolio Commenting on the U.S interest rate outlook, Shariff states, "The consensus of economic forecasters is that the yield curve will shift up in the coming months, with the yields on longer maturities rising by more than those on shorter maturities." Eastwood responds with the following statements: Statement 1: "This will also result in a widening of credit spreads as U.S companies issue more investment grade bonds." Statement 2: "Given the yield curve outlook, callable bonds will outperform bullet maturities and bullets will outperform putable bonds." Shariff concludes the discussion on the U.S component of the global bond portfolio by asking Eastwood to report back with a recommendation for an appropriate strategy to moderate portfolio credit risk The discussion then turns to the international component of the Global Bond Portfolio Eastwood asks Shariff: "Given the data in Exhibit 1, should we hedge our currency risk in the pound or euro?" At this point Shariff must leave to attend a meeting with MIR Capital's partners, but he indicates that he will respond to Eastwood after the meeting 10 Question 13 Is Eastwood's first statement regarding credit spreads most likely correct? A Yes B No; the increased supply of investment grade bonds will cause prices to fall and spreads to narrow C No; the increased supply of investment grade bonds will cause prices to rise and spreads to narrow Correct Answer = C "Relative-Value Methodologies for Global Credit Bond Portfolio Management," Jack Malvey 2009 Modular Level III, Vol 4, p 67 Study Session 9-30-b Evaluate the portfolio implications of cyclical changes in the primary corporate bond market (such as an increase or decrease in new issue supply) and secular changes (such as a shift in dominant product structures) Contrary to the normal supply-price relation where rising supply causes prices to fall and spreads to widen, increased supply in the investment grade credit market causes spreads to narrow as new issue valuations validate and enhance secondary market valuations 14 In Statement 2, is Eastwood most likely correct with regard to the performance of callable bonds and putable bonds, respectively, compared to bullets? A Yes B No, because callable and putable bonds both outperform bullets C No, because callable bonds underperform bullets while putable bonds outperform bullets Correct Answer = B "Relative-Value Methodologies for Global Credit Bond Portfolio Management," Jack Malvey 2009 Modular Level III, Vol 4, pp 68, 71, 77-80 Study Session 9-30-d, e Discuss the primary reasons for secondary market trading, including yield/spread pickup trades, credit-upside trades, credit-defense trades, new issue swaps, sector-rotation trades, yield curve-adjustment trades, structure trades, and cash flow reinvestment Discuss and evaluate corporate bond portfolio strategies that are based on relative value, including total return analysis, primary market analysis, liquidity and trading analysis, secondary trading rationales and trading constraints, spread analysis, structure analysis, credit curve analysis, credit analysis, and asset allocation/sector 11 analysis Callable bonds will outperform bullet maturities as the probability of an early call diminishes with rising interest rates Putable bonds will outperform bullet maturities because investors can avoid losses associated with rising interest rates by putting the bond back to the company 15 When Eastwood responds to Shariff's regarding portfolio credit risk, the most appropriate recommendation is to: A reduce the duration of U.S bond portfolio B invest in shorter maturity Treasuries and longer maturity corporate bonds C invest in shorter maturity corporate bonds and longer maturity Treasuries Correct Answer = C "Relative-Value Methodologies for Global Credit Bond Portfolio Management," Jack Malvey 2009 Modular Level III, Vol 4, pp 71, 81 Study Session 9-30-d, e Discuss the primary reasons for secondary market trading, including yield/spread pickup trades, credit-upside trades, credit-defense trades, new issue swaps, sector-rotation trades, yield curve-adjustment trades, structure trades, and cash flow reinvestment Discuss and evaluate corporate bond portfolio strategies that are based on relative value, including total return analysis, primary market analysis, liquidity and trading analysis, secondary trading rationales and trading constraints, spread analysis, structure analysis, credit curve analysis, credit analysis, and asset allocation/sector analysis Shariff asked Eastwood to recommend a strategy to moderate credit risk This may be accomplished with a credit barbell strategy in which portfolio managers invest in shorter term corporate bonds and less risky Treasury securities with longer maturities 16 If bond yields in the U.S rise by 25 basis points, then the percentage decline in the value of Euro-Zone bonds is closest to: A 0.96% B 1.03% C 1.38% Correct Answer = A "Fixed-Income Portfolio Management — Part II," H Gifford Fong and Larry D Guin, CFA 2009 Modular Level III, Vol 4, pp 123-124 Study Session 10-31-h Analyze the change in value for a foreign bond when domestic interest rates change, given the bond's duration and 12 the country beta, and analyze the contribution of a foreign bond to a domestic portfolio's duration, given the duration of the foreign bond and the country beta Change in value of Euro-Zone bond = Euro-Zone Duration × Country beta × change in U.S interest rates = 5.5 × 0.7 × 0.0025 = 0.009625 = 0.96% 17 Shariff's most appropriate response to Eastwood regarding the hedging of currency risk is to: A hedge exposure to euros only B hedge exposure to pounds only C hedge exposure to pounds and euros Correct Answer = B "Fixed-Income Portfolio Management — Part II," H Gifford Fong and Larry D Guin, CFA 2009 Modular Level III, Vol 4, pp 125-129 Study Session 10-31-i Recommend and justify whether to hedge or not hedge an international bond investment The difference between short-term rates in the U.S and U.K is: ius — iuk = —1.5% According to interest rate parity, this implies that the pound will decline in value by 1.5% relative to the dollar According to MIR Capital's forecasts, the pound is expected to decline in value by —2.174% = (1.8 — 1.84) / 1.84 Therefore the exposure to pounds should be hedged The situation with the euro is the opposite and it should not be hedged 18 Over a 1-year horizon, the spread change that will eliminate the yield advantage of Euro-zone bonds over U.S bonds is closest to: A 0.17% B 0.19% C 0.36% Correct Answer = A "Fixed-Income Portfolio Management — Part II," H Gifford Fong and Larry D Guin, CFA 2009 Modular Level III, Vol 4, pp 129-130 Study Session 10-31-j Illustrate how breakeven spread analysis can be used to evaluate the risk in seeking yield advantages across international bond markets The spread change is calculated as follows: (Euro-zone bond yield — U.S bond yield) / U.S duration = (0.055 — 0.0447) / 5.9 = 0.17% 13 19 Amy Allison Case Scenario Amy Allison is a pension fund manager at Downing Securities The third quarter ends today and she is preparing for her quarterly review with her five largest U.S.-based clients To complete her analysis, she has obtained the market data in Exhibit Exhibit Level of NASDAQ 100 Index 1223.14 Level of FTSE 100 Index 4176.70 Level of S&P 500 Index 984.03 Level of S&P/Barra Growth Index 496.24 Level of S&P/Barra Value Index 484.28 Price of December FTSE 100 futures contract £41,760 Price of December S&P 500 Index futures contract $245,750 Price of December S&P/Barra Growth futures contract $117,475 Price of December S&P/Barra Value futures contract $120,875 Beta of FTSE 100 futures contract 1.03 Beta of S&P/Barra Growth futures contract 1.15 Beta of S&P/Barra Value futures contract 1.03 Price of December U.S Treasury-bond futures contract $106,906 Modified Duration of U.S Treasury-bond futures contract 6.87 Macaulay Duration of U.S Treasury-bond futures contract 7.05 Price of December £-Forward Contract ($/£) 1.595 Spot $/£ Exchange Rate 1.603 U.S Risk-free Rate (90-day)* 0.95% U.K Risk-free Rate (90-day) * 2.86% 14 Long-term U.S Treasury-bond Yield* 5.10% Market Data As of September 30 *annualized rates Allison's assistant has prepared the following summaries of each client's current situation, including any recent inquiries or requests from the clients  Client A has a $20 million technology equity portfolio At the beginning of the last quarter, Allison forecasted a weak equity market and adjusted the risk of the portfolio by lowering the portfolio's beta from 1.20 to 1.05 To lower the beta, Allison sold 25 December NASDAQ 100 futures contracts at $124,450 During the quarter, the market decreased by 3.5 percent, the value of the equity portfolio decreased by 5.1 percent, and the NASDAQ futures price fell from $124,450 to $119,347 Client A has questioned the effectiveness of the futures transaction used to adjust the portfolio beta  Client B has a $40 million value-stock portfolio with a portfolio beta of 1.06 This client wants to shift $22 million from the value-stock portfolio to a growth-stock portfolio with a target beta of 1.21 Allison will implement this shift using S&P/Barra Growth and S&P/Barra Value futures contracts  Client C anticipates receiving $75 million in December This client is optimistic about the near-term performance of the equity and debt markets and does not want to wait until the money is received to invest it The client wants Allison to establish a position that allocates 60 percent of the money to a welldiversified equity portfolio with a target beta of 1.00 and 40 percent of the money to a long-term debt portfolio with a target modified duration of 5.75 Allison plans to use the December U.S Treasury-bond futures to establish the debt position  Client D has £15 million invested in U.K equities with a portfolio beta of 0.87 and is concerned about currency and market risk over the next 90 days Allison would use the £-forward contract and the December FTSE 100 futures contract as hedging instruments to manage those risks, respectively Allison forecasts a negative return on the U.K equity market of 4.25 percent, a reduction in the spot $/£ exchange rate to 1.48, and a decline in the FTSE 100 futures contract price to £38,940 at the expiration of the December contract  Client E has $10 million in cash and is optimistic about the near-term performance of the large-cap stocks in the U.S equity market The client anticipates positive performance for approximately months, at which time inflation fears will begin to be priced into the market and the large-cap stocks will underperform cash Client E asks Allison to implement a strategy that will create profit from this view if it proves to be correct and can be exited quickly if it proves to be incorrect 15 Question 19 With respect to Client A, Allison's most appropriate conclusion is that the futures transaction used to adjust the beta of the portfolio was: A effective B ineffective, because the effective beta on the portfolio was 1.27 C ineffective, because the effective beta on the portfolio was 1.64 Correct Answer = B "Risk Management Applications of Forward and Futures Strategies," Don M Chance 2009 Modular Level III, Vol 5, pp 322-324 Study Session 15-42-a Demonstrate the use of equity futures contracts to achieve a target beta for a stock portfolio, and calculate and interpret the number of futures contracts required The effective beta is the (hedged) return on the portfolio divided by the return on the market The return on the market is —3.5% The return on the portfolio is —5.1% plus the return on the futures position The return on the (short) futures position relative to the unhedged portfolio is —25 × (119,347 — 124,450) / 20,000,000 = + 0.0064 Effective beta = (—0.051 + 0.0064) / —0.035 = 1.27 20 When implementing the shift from value to growth for Client B, the number of S&P/Barra value futures contracts that Allison should short is closest to: A 177 B 87 C 193 Correct Answer = B "Risk Management Applications of Forward and Futures Strategies," Don M Chance 2009 Modular Level III, Vol 5, pp 338-341 Study Session 15-42-e Demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class To convert $22 million of the value-stock portfolio to cash (beta = 0) will require: 16 To convert the $22 million of cash into growth-stock will require: 21 The number of December U.S Treasury-bond futures contracts Allison should buy for Client C is closest to: A 229 B 235 C 335 Correct Answer = B "Risk Management Applications of Forward and Futures Strategies," Don M Chance 2009 Modular Level III, Vol 5, pp 341-344 Study Session 15-42-e Demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class The number of bond futures required is: 22 Suppose that Client D instructs Allison to hedge 100 percent of the portfolio's U.K equity market risk, but not its currency risk The expected dollar value of the hedged portfolio according to Allison's forecasts is closest to: A $15,299,835 B $22,643,756 C $24,403,237 Correct Answer = B "Risk Management Applications of Forward and Futures Strategies," Don M Chance 2009 Modular Level III, Vol 5, pp 348-352 17 Study Session 15-42-g Explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss two feasible strategies for managing such risk According to Allison's forecasts, the portfolio's value in pounds will be: (1 + (portfolio beta × market return)) × value of portfolio = (1 + (0.87 × —0.0425)) × £15 million = £14,445,375 The futures contracts payoff at expiration will be (£38,940 — £41,760) × —303 = £854,460 The total value is £15,299,835 At the forecasted exchange rate of $1.48/£, the expected dollar value of the portfolio is £15,299,835 × $1.48/£ = $22,643,756 23 Suppose that Client D believes Allison's forecasts are accurate and that her proposed FTSE 100 futures contract position will fully hedge the portfolio's market risk If Client D wants to fully hedge currency risk with a £-forward contract, the notional principal on the contract is closest to: A £14,893,511 B £15,000,000 C £15,107,250 Correct Answer = C "Risk Management Applications of Forward and Futures Strategies," Don M Chance 2009 Modular Level III, Vol 5, pp 348-352 Study Session 15-42-g Explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss two feasible strategies for managing such risk The fully market-risk hedged stock portfolio should earn the foreign risk-free rate The forward contract should allow the client to exchange the expected value of the portfolio into dollars The appropriate notional principal on the forward contract = the beginning value × (1 + current U.K interest rate) = £15,000,000 × (1 + (0.0286 / 4) = £15,107,250 24 In order to implement the request from Client E, Allison's most appropriate course of action is to: A purchase risk-free bonds and sell S&P 500 index futures contracts B PUrchase risk-free bonds and buy S&P 500 index futures contracts C purchase the stocks in the S&P 500 index and sell S&P 500 index futures contracts Correct Answer = B "Risk Management Applications of Forward and Futures Strategies," Don M Chance 2009 Modular Level III, Vol 5, pp 328-330 Study Session 15-42-b 18 Construct a synthetic stock index fund using cash and stock index futures (equitizing cash) These steps create a synthetic stock index fund, which replicates a position in the underlying stocks This is an appropriate strategy since Client E is long $10 million in cash The synthetic stock index fund results in significant transaction cost savings and preserves the liquidity Client E requires 25 Brian O'Reilly Case Scenario Brian O'Reilly is a capital markets consultant for the Tennessee Teachers' Retirement System (TTRS) O'Reilly is meeting with the TTRS board to present his capital market expectations for the next year Board member Kay Durden asks O'Reilly about the possibility that data measurement biases exist in historical data O'Reilly responds: "Some benchmark indexes suffer from survivorship bias This occurs when a data series reflects only those companies that have survived to the end of the measurement period The returns of failed or merged companies are dropped from the data series, resulting in an upward bias to reported returns This may result in an overly optimistic expectation with respect to future index returns Another bias results from the use of appraisal data in the absence of market transaction data Appraisal values tend to be less volatile than market determined values for identical assets The result is that calculated correlations with other assets tend to be biased upward in absolute value compared to the true correlations and the true variance of the asset is biased downward." Board member Arnold Brown asks O'Reilly about the use of high-frequency (daily) data in developing capital market expectations O'Reilly answers: "Sometimes it is necessary to use daily data to obtain a data series of the desired length High-frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce higher correlation estimates." Board member Harold Melson noted he recently read an article on psychological traps related to making accurate and unbiased forecasts He asks O'Reilly to inform the board about the anchoring trap and the confirming evidence trap O'Reilly offers the following explanation: "The anchoring trap is the tendency for forecasts to be overly influenced by the memory of catastrophic or 19 dramatic past events that are anchored in a person's memory The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports a preferred viewpoint than to evidence that contradicts it." The board asks O'Reilly about using a multifactor model to estimate asset returns and covariances among asset returns O'Reilly presented the factor covariance matrix for global equity and global bonds shown in Exhibit and market factor sensitivities and residual risk shown in Exhibit Exhibit Factor Covariance Matrix Global Equity Global Bonds Global Equity 0.0225 0.0022 Global Bonds 0.0022 0.0025 Exhibit Market Factor Sensitivities and Residual Risk Sensitivities Global Equity Global Bonds Residual Risk Market 1.20 12.0% Market 0.90 7.0% Market 0.95 1.8% Finally, the board asks about forecasting expected returns for major markets given that price earnings ratios are not constant over time and that many companies are repurchasing shares instead of increasing cash dividends O'Reilly responds that the Grinold-Kroner model accounts for those factors and then makes the following forecasts for the European equity market:  Dividend yield will be 1.95 percent  Shares outstanding will decline 1.00 percent  Long-term inflation rate will be 1.75 percent per year  An expansion rate for P/E multiples of 0.15 percent per year 20 ... "Guidance" for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 80-81 "Pearl Investment Management (A), (B), and (C)," Glen Holdern, Jr., CFA 2009 Modular Level III, Vol 1, p 197 Study... Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 24-25, 38-39, 80-81, 89-91 "Pearl Investment Management (A), (B), and (C)," Glen Holdern, Jr., CFA 2009 Modular Level III, Vol 1,... for Standards I — VII, CFA Institute 2009 Modular Level III, Vol 1, pp 38-39, 53, 80-81 "Pearl Investment Management (A), (B), and (C)," Glen Holdern, Jr., CFA 2009 Modular Level III, Vol 1, pp