2011 l3 sample exam v1 2 qa

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Volume 1 with Answers and Explanations

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2011 CFA Level 3 Sample Exam

2011 Level 3 Sample Exam Volume 1 Questions

SS1/2: Code of Ethics and Professional Standards Q1-6: Kim Tang Case Scenario

Kim Tang, CFA, a consultant for a Sovereign Wealth Fund, is reviewing a hedge fund, Clean Tech Research Management (CRM).CRM is owned by the original three hedge funds’ founders and invests in “clean technology” companies CRM adopted the CFA Institute Code of Ethics and Professional Standards

Tang examines the various forms of advertising that CRM uses The firm is aggressively seeking new clients by using media outlets ranging from blogs and test messages to

webinars to promote its business In one of its advertising messages CRM states,” We have a very experienced research team and are proud that they all are CFAs.”

In reviewing CRM'’s marketing brochure, Tang reads the following statements:

Statement 1:

“Clean technology companies share prices have increased recently due to the growing awareness of climate change issues and the rising cost of energy It is our opinion that

returns in this area will continue to be above average for several years In fact, out

proprietary investment analysis software, which we also use to manage our portfolios, has determined that investments in green transportation companies will double in

value in the next six months, In the clean energy area we expect to earn a 200 percent

return over the next year on one of our solar power company investments based upon sales projections we prepared assuming that last year’s generous tax incentives stay in place.”*

Statement2:

“The CRM fund invests in publicly traded and highly liquid companies and is

recommended only for investors who seek returns from breakthrough technology and

are able to assume a high level of risk One of the "green energy” companies that we recently invested in ,EnergyAlgae(EA), partnered with a global energy firm last year to create oil from algae EA’s market capitalization rose to over $2 billion from $500

million immediately after this deal was announced, benefiting the fund Another

company CRM invested in, Plastic40il (P40), just patented a waste plastic-to-oil

process that produces oil at less than $30 per barrel One of the founders of CRM is on

the board of P40 and his information on the companies patent process let us purchase

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*Information supporting the statements made in this communication is available upon request

When Tang asks CRM’s founders for supporting documents related to Statement 2, she is told that this information was based upon third-party research from a brokerage firm that,

in addition to conducting the research, also maintains all necessary records, In addition,

Tang also learns that CRM is a majority shareholder of this brokerage firm, which brought both EA and P40 public Additionally, CRM’s analysts inform Tang they did not need to look at the quality of this third-party research because one of their former colleagues recently left CRM and established the research department in this brokerage firm

In researching EA and P40, Tang finds that potential customers and suppliers of both EA

and P40 are highly skeptical of the claims made regarding these companies’ respective products She also contacts several major and minor energy companies and is unable to

locate anyone who has even heard of EA When Tang reviews CRM’s trading activity in EA and P40 shares, she finds that CRM liquidated its position in EA and P40 soon after CRM's portfolio managers positively mentioned EA and P40 in a number of media interviews In addition, many of CRM’s employees also sold their shares.in EA and P40 immediately after CRM sold its shares of EA and P40 Share prices of EA and P40 both

dropped dramatically after the stock sales made by CRM and it employees Question 1

Should Tang inform CRM’s founders that they are in violation of CFA Institute Standards with respect to referencing the CFA designation in their advertising?

A No

B Yes, because the CFA designation must be used as an adjective

C Yes, because the CFA designation should be used with the CFA certification mark Question 2

In Statement 1, the founders of CRM are least likely to have violated the CFA Institute

Standards of Professional Conduct with regard to their;

A investment analysis software

B solar power company investment

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Question 4

With respect to the relationship between CRM and the brokerage fim, which of the

following should the founders of CRM not do to be in compliance with CFA Institute

Standards of Professional Conduct?

A Perform due diligence on the research firm

B Obtain the research information from an independent firm

C Maintain a record of the third-party research used in their analysis Question 5

Tang’s most appropriate course of action concerning the relationship between CRM and the brokerage firm, is to recommend that CRM;

A sever the relationship immediately

B communicate relevant information to all clients

C explain the arrangement to the Sovereign Wealth Fund Question 6

The trades cenceming EA and P40 are least likely to have victated the CFA Institute

Standards of Professional Conduct because:

A of the order of priority in which these two stocks were traded

B both CRM’s and employees’ trades distorted prices for the stocks

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SS6: Capital Market Expectation in Portfolio Management Q7-12: Rogers Case Scenario

Ted Rogers, CFA, is the director of a research team that analyzes traditional and

nontraditional sources of energy for investment purposes For traditional energy sources, a number of high-frequency historical data series are available For nontraditional energy sources, the data are generally quarterly and tend to hide a great deal of the volatility that Rogers knows to exist because appraised values are used instead of market values To supplement the quarterly data, Rogers’ team uses an index of the top thirty firms in new and experimental technologies, called the NEXT index While not all of the firms in the NEXT are energy firms, the index is available as a weekly series However, the NEXT does change its composite mix of firms frequently as firms in the index fail or are sold to larger firms that are not in the index

To determine the correlation matrix within the different energy sectors, Rogers’ team relies on a weighted average of correlations derived from multifactor models and historical correlations Although the combined experience within the team favors emphasizing the correlations derived from ihe multifactor models, historical correlations are given a greater ~ weight within the weighted average calculations to lower the future expected performance

estimates of different investment models being considered This practice of purposefully

understating the expected future performance of these investment models is viewed as a

safety measure by the team and as a way to manage client expectations

In a recent meeting, the team discussed how using the last two years of historical data for

oil-related industries generated relationships between factors that had not existed in the past One member of the team, Steve Phillops, stated;

“ The relationships reflect the fact that hurricane activity in the last two years has

impacted oil concerns worldwide There is no reason to believe that such relationships

will continue in the future.”

Most of the team agree with Philips, but conceded that a number of clients specifically

requested analysis of the previous two years of data with an expectation that new trends

were emerging within the industry The team decided to add more variables to the analysis

to show that the relationships the team believed to be significant actually outweighed the

importance of these recently found relationships After adding several additional variables,

the team found that the model did not improve in predictive ability, but the recently found

relationships were indeed no longer significant Question 7

The date available for nontraditional energy sources are best described as date with: A smocthing

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2011 CFA Level 3 Sample Exam C asurvivorship bias Question & The NEXT index date most likely reflects: A survivorship bias B transcription errors C volatility clustering Question 9

The approach taken by Rogers’ team to calculate the correlation matrix is best described as which type of estimator?

A Historical B Shrinkage

C Time-series Question 10

Which of the following psychological traps best describes Rogers’ team’s decision to

give historical correlation more weight in the correlation matrix?

A Prudence trap B Anchoring trap

C Overconfidence trap

Question 11

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2011 CFA Level 3 Sample Exam SS8: Asset Allocation

Q13-18: Jerold Munoz Case Scenario

Jerold Munoz is a wealthy U.S investor whose current portfolio consists entirely of U.S equities He has read that there are benefits and risks associated with international

diversification and is interested in learning more about these He contacts Mei-li Chen, CFA, an investment advisor who specializes in international investments for U.S.- based investor Munoz provides Chen with information about his current portfolio and asks her to

show him how an allocation of international securities could benefit his portfolio

When they meet, Chen tells Munoz;” Your current all- domestic equity portfolio has a standard deviation of 10.4 percent | have constructed a well-diversified portfolio of

international stocks and bonds with the same expected return and standard deviation as

your domestic portfolio This portfolio has a correlation of 0.5 with your current all-domestic portfolio Allocating 30 percent of your investments to this portfolio of foreign

stocks and bonds will not affect your expected return but will substantially reduce your

portfolio risk.”

Munoz says that he has read a number of things about currency risk that he isn’t sure

about, including:

Statement1: Currency risk is difficult to eliminate

Statement2: Currency risk should be netted across all portfolios Statement2: Currency risk tends to be smaller over longer horizons

He asks Chen to verify these statements He also asks Chen for an example of how currency risk and market risk interact Chen explains that, from the perspective of a U.S

investor like Munoz, the risk of a foreign stock investment depends on the market risk of international stock in local currency, the risk of the exchange rate of the stock’s currency relative to the U.S dollar, and the correlation between the two She provides an example

in which the market risk is 9 percent, the exchange rate risk is 6 percent, and the

correlation is 0.4

Munoz tells Chen that he understands that low correlations are the key to effective international diversification, but asks her whether he should hedge currency risk when he

makes investments in international stocks and bonds Chen replies that it doesn't really

matter from a portfolio risk perspective, because there is little difference between the correlations when comparing hedged and unhedged returns

After the have talked extensively, Chen recommends that Munoz change his focus from

international diversification to global investing She explains that such a change in focus will alter Munoz’s analysis, causing him to place more emphasis on some factors and less

emphasis on others

Finally, Munoz asks Chen to comment about the benefits and risks associated with

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emerging markets Chen says that expected retums and risks are generally higher in

emerging markets than in developed countries She also points out that the factors related to portfolio risk, such as the way correlations change during periods of increased volatility

and the correlation relationship between market returns and exchange rates, behave in the same qualitative ways for both types of markets

Question13

Assuming Munoz reallocates 30 percent of his current U.S equity portfolio to the

international portfolio Chen recommends, the standard deviation of the portfolio will be closest to: A 5.20% B 8.61% C 9.24% Question 14

Of the 3 statements Munoz makes about makes about currency risk, Chen shouid be

least likely to agree with:

A Statement 1 B Statement 2

C Statement 3

Question 15

From Munoz’s perspective, the contribution of currency risk to the international stock

investment in Chen's example is closest to: A 2.77% B 3.66% C 6.00% Question 16 Chen's statement regarding hedged and unhedged returns is most likely: A correct

B Incorrect with regard to bond markets

C Incorrect with regard to stock markets Question 17

If Munoz changes his focus as suggested by Chen, which factors will his analysisi most likely emphasize less?

A Country

B Industry

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2011 CFA Level 3 Sample Exam C Individual company

Question18

What part of Chen’s statement about emerging markets is least likely correct? A Correlations between market returns and exchange rates

B Changes in correlations when market returns are volatile

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SS10: Portfolio Management of Global Bonds and Fixed Income Derivatives Q19-24: Berg Case Scenario

Alpha Consultants is working with the Swedish-based Berg Pension Fund to select a

fixed-income firm to manage a €100 million global bond portfolio Delta Mangers, LLP is the third and final presenter to Berg’s investment committee After going through its investment philosophy and process, Delta addresses several questions,

Alpha expresses concern about the use of leverage in the portfolio Delta has indicated that by employing 100 percent leverage, it can generate incremental returns and Delta provides the committee with the data in Exhibit 1 Exhibit 1 Portfolio Characteristics Assets * Liabilities Portfolio (€ millions) 200 100 Duration | 6.00 1.00 Expected Return or (Cost) (%) - 5.50 4.75

Berg is concerned that the duration of the portfolio is inappropriate given its view that rates might rise and asks how Delta can use the futures market, referring to Exhibit 2, to

manage the interest rate risk of the portfolio The committee in fact states that it would like target duration of 4 l Exhibit 2

Futures Market Data

Futures Contract Price €100,000

Conversion Factor 1.15

Duration of Cheapest to Deliver Bond 5.2

Price of Cheapest to Deliver Bond €98,000

Delta responds with the following statement:

“International interest rates are not perfectly correlated In fact, since this is a global bond portfolio, 60 percent of the portfolio is from U.K issuers and has duration of 7 and the remainder is from German issuers with average duration of 4.5 years, both

before any hedging activities, to meet Berg's duration target Historically the

country beta between the U.K and Germany is 0.55.”

Berg then asks Delta to make a recommendation as to whether the portfolio should be hedged back to its domestic currency, the Swedish Kronor Delta responds that actively

managing currency risk is an expected source of incremental returns for the portfolio and has historically accounted for 25 percent of Berg's outperformance Berg refers to the data in Exhibit 3 to support its current view that currency exposure in the portfolio should be

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2011 CFA Level 3 Samp!e Exam actively managed Exhibit 3

Currency Market Data

U.K Eurozone Sweden

Risk-free rate 2.50% 2.74% 1.20

Spot rate (SEK/GBP, (SEK/EUR)) 10.86 9.72 -

Forward rate (SEK/GBP),(SEK/EUR) 10.72 9.57 -

Delta forecast spot rate in 6 months 10.80 9.61 -

Berg then asks whether a global portfolio would benefit from the inclusion of emerging

market debt Delta responds that returns can be attractive in emerging markets during

certain periods, but that risks also abound and notes the following:

Risk 1: Returns are frequently characterized by positive skewness as the potential large downside is offset by a comparable upside

Risk 2: If a default of sovereign debt occurs, recovery against sovereign states

can be very difficult

Risk 3: The frequency of default and ratings transition is significantly higher

than that of developed market corporate bonds with similar ratings

At the conclusion of the presentation Alpha and Berg convene to discuss which of the

three managers who presented should be selected for the €100 million mandate Alpha

advises Berg that the following criteria are important when evaluating fixed-income portfolio managers:

Criteria 1: Style analysis will enable us to understand the active risks relative to

the benchmark that the manager has taken, and which biases have

consistently added to performance

Criteria 2: Historical performance is a primary consideration in selecting a manager because good managers persistently outperform over time

Criteria 3: We could select two of the three managers who presented if our

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Cc 11.00

Question 20

Given Berg’s target duration and the data in Exhibits 1 and 2, the most appropriate action for Delta to take is to:

A ‘sell 682 contracts

B buy 784 contracts C sell 902 contracts Question 21

Based on Delta’s statement regarding international interest rates, the impact of a 100

basis point change in U.K interest rates on portfolio return is closest to :

A 3.30% *

B 4.11% C 5.20%

Question 22

Based on the data in Exhibit 3 the most likely action that Delta would take to actively manage the currency exposure is to hedge the:

A Euro bonds into GBP B Sterling bonds into Euro

C Portfolio to the base currency, Kronor Question 23 Dalta is least likely correct with respect to which risk regarding investing in emerging market debt? A Risk 1 B Risk 2 C Risk 3 Question24

Which of the criteria outlined by Alpha is least accurate with respect to the selection of a

fixed income manager?

A Criteria 1

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SS14: Risk Management

Q25-30: Karin Larsson Case Scenario

Karin Larsson is a new employee in the risk management group at Baltic Investment Management, Inc Her co-worker, Sten Reinfeldt, is good resource for any risk management information she may require or questions she may have

Larsson and Reinfeldt discuss the importance of risk management for increasingly _complex investment management firms and investment portfolios During this discussion,

Larsson makes the following comments about risk management

Comment: Risk governance is a business process system that puts risk

management into practice

Comment: Risk management is a process that identifies and continuously

measures exposures to risk

Comments: Enterprise risk management is based on the consideration of

each risk factor within the corporate governance structure

Baltic has a number of portfolios under management that use derivative instruments Reinfeldt tells Larsson that derivatives can expose the firm to both financial and nonfinancial risks Larsson mentions that she has a good understanding of the financial

risks associated with derivatives, but not the nonfinancial ones Reinfeldt responds by

listing several nonfinancial risks and suggests that Larsson review them carefully

One of Baltic’s portfolios, the PGP Fund, holds only derivative instruments and has a monthly value at risk (VAR) of SEK 10 million at a probability of 0.05 Larsson asks

Reinfeldt to explain the VAR of the PGP Fund to her

Baltic has a fixed-income trading desk and an equity trading desk The two trading desks

are allocated specific levels of risk and engage in activities that have low correlations with

each other Both desks are permitted a daily VAR of SEK 10 million The fixed income desk is allocated capital of SEK 100 million and makes an average monthly profit of SEK

15 million The equity desk is allocated capital of SEK 200 million and makes an average

monthly profit of SEK 25 million

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simple way to portfolio VAR

Limitation 3: VAR incorporates positive outcomes into risk profile, reducing the impact of negative outcomes

Larsson focuses on a derivative portfolio, the KP Fund, that contains a number of

over-the-counter (OTC) derivative contracts She asks Reinfeldt how Baltic manages its

counterparty credit risk Reinfeldt responds, “There are a number of ways we manage counterparty credit risk We periodically mark to market all OTC derivatives contracts In addition, we use credit default swaps to reduce credit risk.” Question 25 Of the three comments Larsson makes about risk management, the least accurate is: A Comment 1 B Comment 2 C Comment 3 Question 26 Which of the following risks is least likely to be included in the list that Reinfeldt provides to Larsson? A Liquidity B Accounting C Operational Question27

With regard to the PGP fund, what is the most accurate response that Reinfeldt can

provide Larsson? There is a 5 percent probability that in a month, the portfolio’s loss will be; A equal to SEK10,000,000 B atleast SEK 10,000,000 C no more than SEK 10,000,000 Question 28

With regard to the fixed-income and equity trading desks, which of the following

statements is most likely accurate?

A The trading desks have the same risk budgets

B The fixed-income desk generates better returns on the allocation of VAR and capital C The combined daily VAR of the trading desks is less than SEK 20 million

Question 29

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2011 CFA Level 3 Sample Exam correct? A Limitation 1 B Limitation 2 C Limitation 3 Question30 Is Reinfeldt’s response to Larsson’s question about the KP Fund most likely correct? A, Yes

B No, he is incorrect about marking to market

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2011 Level 3 Sample Exam Volume 1 Answers

1 Correct answer: B

2011 Modular Level III, Vol.1,p.145 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

The CFA designation must always be used as an adjective; e.g., the entire research team is made up of CFA charterholders

2 Correct answer: C

2011 Modular Level Ill, Vol.1, pp 115-116 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

Fact has been clearly indentified and separated from opinion

3 Correct answer: A

2011 Modular Level III, Vol.1, pp 36,47,77 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 professional integrity

Standard III(C), Duties to Clients (Suitability),does not appear to have been violated as the fund is characterized as the fund is characterized as a high-risk investment

4 Correct answer: B

2011 Modular Level Ill, Vol.1, pp 107-109,119-120 Study Session 1-2-b

Recommend practices and procedures designed to prevent violations of the Code of

Ethics and Standards of Professional Conduct

There is no requirement that the research has to be obtained from an independent

third-party research organization However, there is an obligation that third-party research

may be relied upon only when a reasonable and diligent effort has been made to

determine that the research is sound, and in this case the research does not appear to have been performed

5 Correct answer: B

2011 Modular Level Ill, Vol.1, pp 25,114-115 Study Session 1-2-b

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Recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct

Full and fair disclosure of all matters that could reasonably be expected to impair independence and objectivity must be made to all clients In this case, the controlling position in the broker, who has underwritten two stocks the hedge fund holds and whose

recommendations the fund relied upon to make these investments, must be disclosed to all clients so that they may be better able to judge motives and possible biases for themselves

6 Correct answer: B

2011 Modular Level Ill, Vol.1, pp 57, 107, 129 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

Even though the hedge fund had priority in trading these two stocks, ahead of employees, that does not aileviate the stock price manipulation that was engaged in by the fund and its employees

7 Correct answer: A

2011 Modular Level III, Vol 3, pp.15-16 Study Session 6-23-b

Discuss, in relation to capital market expectations, the limitations of economic date, data measurement errors and biases, the limitations of historical estimates, ex post risk as a biased measure of ex ante risk, biases in analysts’ methods, the failure to account for conditioning information, the misinterpretation of correlations, psychological traps, and

model uncertainty

Smoothed or appraisal data are when appraised values are used instead of market values

This tends to make correlation magnitudes smaller and underestimate volatility

8 Correct answer: A

2011 Modular Level III, Vol 3, p.15 Study Session 6-23-b

Discuss, in relation to capital market expectations, the limitations of economic data, data

measurement errors and biases, the limitations of historical estimates, ex post risk as a

biased measure of ex ante risk, biases in analysts’ methods, the failure to account for conditioning information, the misinterpretation of correlations, psychological traps, and

model uncertainty

Survivorship bias is when a data series reflects only companies that exist at a given

moment in time and not companies that may left prior to given moment in time (i.e., only

the surviving firms are in the data) The NEXT index has survivorship bias as evidenced by the frequent change in its component firms due to failure and acquisition by larger

non-index firms

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9 Correct answer: B

2011 Modular Level Ill, Vol 3, p 27 Study Session 6-23-b

measurement errors and biases, the limitations of historical estimates, ex post risk as a biased measure of ex ante risk, biases in analysts’ methods, the failure to account for

conditioning information, the misinterpretation of correlations, psychological traps, and model uncertainty

To determine the correlation matrix within the different energy sectors, Rogers’ team relies on a weighted average of correlations derived from multifactor models and historical correlations A shrinkage estimator is a weighted average of correlation (or covariance) matrices created from at least two different correlation (or covariance) matrices generated form different sources

10 Correct answer: A

2011 Modular Level Ill, Vol 3, pp 22-23 Study Session 6-23-b

Discuss, in relation to capital market expectations, the limitations of economic data, data measurement errors and biases, the limitations of historical estimates, ex post risk as a biased measure of ex ante risk, biases in analysts’ methods, the failure to account for conditioning information, the misinterpretation of correlations, psychological traps, and

model uncertainty

Rogers’ team views giving more weight to the historical correlations as a safety measure,

and as a way to manage client expectations The prudence trap is a tendency to be overly cautious in forecasts due to potentially damaging results from being incorrect

11 Correct answer: B

2011 Modular Level Ill, Vol 3, p.19 Study Session 6-23-b

Discuss, in relation to capital market expectations, the limitations of economic data, data measurement errors and biases, the limitations of historical estimates, ex post risk as a

biased measure of ex ante risk, biases in analysts’ methods, the failure to account for

conditioning information, the misinterpretation of correlations, psychological traps, and

model uncertainty

Phillips believes the impact of hurricane activity will not necessarily continue in the future

A time-period bias occurs when particular relationships or sensitivities occur only during a particular period of time

2011 Modular Level Ill, Vol 3,:p 19 Study Session 6-23-b

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conditioning information, the misinterpretation of correlations, psychological traps, and

model uncertainty

A data-mining bias occurs when variables are added to an analysis without any predictive

merit (i.e., there is no causal relationship for adding the variables) In this case, the

variables are not added to enhance prediction, but to thwart the predictive relationship between other variables

13 Correct answer: C

“The Case for International Diversification,” Bruno Solnik and Dennis McLeavey, CFA 2011 Modular Level Ill, Vol.3, pp 350-351 Study Session 8-27-a

Evaluate the implications of international diversification for domestic equity and fixed-income portfolios, based on the traditional assumptions of low correlations across international markets The standard deviation of the portfolio is: (w,, 4) + v, a) 2, Wi, OG ] 2 ay ` = J (0.7 x 10.4%)? + (0.3 x 10.4%)? + (2 x 0.5 x 0.7 0.3 x 10.4% x 10.4%)? = 9.24% 14 Correct answer: C

2011 Modular Level Ill, Vol.3, pp 336-367, Study Session 8-27-f

Explain why currency risk should not be a significant barrier to international investment

The currency risk of an investment may be hedged by shorting futures or forward

contracts, buying put currency options, or borrowing foreign currency to finance the

investment

2011 Modular Level Ill, Vol.3, pp 351-353 Study Session 8-27-c

Evaluate the contribution of currency risk to the volatility of an international security

position ©

The risk of the international investment is is ` ` where ø isthe risk of the stock in its local currency , 9 ,is the standard deviation of the exchange rate, and

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2011 Modular Level Ill, Vol.3, pp 353-358 Study Session 8-27-d

Explain and justify the impact of international diversification on the efficient frontier

There are substantial differences between the U.S./foreign bond market return

correlations for hedged and unhedged returns

2011 Modular Level Ill, Vol.3, pp 377-380 Study Session 8-27-i

Distinguish between global investing and international diversification and discuss the growing importance of global industry factors as a determinant of risk and performance Global investing focuses more on competition of firms within industries across national

boundaries, not where a firm happens to be headquartered

2011 Modular Level Ill, Vol.3, pp 380-384 Study Session 8-27-j

Summarize the basic case for investment in emerging markets, as well as the risks and

restrictions often associated with such investments

Correlations between emerging market returns and exchange rates are usually high and positive, while for developed countries they are much lower and sometimes negative

19 Correct answer: c

2011 Modular Level Ill, Vol.4, pp.107-109 Study Session 10-30-a Evaluate the effects of leverage on portfolio duration and investment returns,

Delta plans to leverage the €100 million portfolio by 100% by borrowing an additional €100 million De= DeA- Dil E De= 6.00(200) — 1.60(100) =ll 100 20 Correct answer: c

2011 Modular Level III, Vol.4, pp.114-118 Study Session 10-30-d

Demonstrate the advantages of using futures instead of cash market instruments to alter portfolio risk

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(4.00 ~ 6.00) x 200,000,000 KLIS oe x 1,15 8 ~ 902.669 ~ 400,000,000

[ 3.2 x 98,000 ] 509,600

21 Correct answer: c

2011 Modular Level Ill, Vol.4, pp.131-132 Study Session 10-30-i

Evaluate (1) the change in value for a foreign bond when domestic interest rates changes and (2) the bond’s contribution to duration in a domestic portfolio given the duration of the foreign bond and the country beta

The U.K component contributes 4.2 in duration to the portfolio (0.60x7=4.2) Therefore, a 100 basis point change would contribute +/-4.20% to the value of the portfolio The

German component has duration of 1.8 (0.4x4.5=1.8) but moves only 0.55 times the movement in U.K rates, therefore contributing +/-0.99% to portfolio return

(1.8X0.55=0.99)

2011 Modular Level Ili, Vol.4, pp.132-137 Study Session 10-39-j

Interest rate parity holds versus the GBP:

Recommend and justify whether to hedge or not hedge currency risk in an international

bond investment :

The forward rates for both Sterling and Euro fully reflect the interest rate differentials as

expected by interest rate parity As such, forwards reflect that both currencies are

expected to depreciate relative to the Kronor Delta's view, however, is that the GBP will

depreciate less than the forward implies and less than the Euro The result in actively managing the portfolio is that the Euro bonds should be hedged in GBP

Interest rate parity holds versus the GBP:

f= (10.72-10.86)/10.86=-0.01289=-1.3%

Based on expected spot rates (10.8-10.86)/10.86=-0.00552=-0.552%

Interest rate parity holds versus the Euro:

f= (9.57-9.72)/9.72=-0.0154

Based on expected spot rates, (9.61-9.72)/9.72=-0.0113=-1.13%

2011 Modular Level Ill, Vol.4, pp.139-141, 146 Study Session 10-30-I

Discuss the advantages and risks of investing in emerging market debt

Emerging market debt returns are characterized by significant negative skewness, 24 Correct answer: B

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Over tong periods of time, after factoring in fund fees and expenses, the realized alpha of fixed-income managers has averaged very close to zero and little evidence of persistence

exists

2011 Modular Level Ill, Vol.5, pp 213-217 Study Session 14-39-a

Compare and contrast the main features of the risk management process, risk

governance, risk reduction, and an enterprise risk management system

Enterprise risk management (ERM) is a type of risk governance structure that provides an

overall picture of the company’s risk position The corporate governance structure is much

broader than risk governance and encompasses the system of internal controls and

procedures used to manage individual companies : 26 Correct answer: A

2011 Modular Level Ill, Vol.5, pp 218-227 Study Session 14-39-b

Recommend and justify the risk exposures an analyst should report as part of an

enterprise risk management system

Liquidity is a financial risk Reinfeldt provides Larsson with a list of non-financial risks

2011 Modular Level III, Vol.5, pp.231-232 Study Session 14-39-e

Interpret and compute value at risk (VAR) and explain its role in measuring overall and

individual position market risk

VAR is an estimate of the loss that is expected to be exceeded for a given probability and time period For this portfolio, there is a 5 percent chance that there will be a monthly loss

of SEK 10,000,000 or more

2011 Modular Level III, Vol.5, pp.260-262 Study Session 14-39-j

Demonstrate the use of risk budgeting, position limits, and other methods for managing

market risk

The trading desks engage in activities that are weakly correlated and, therefore, a diversification benefit is experienced and it would be reasonable to expect that the combined VAR of the two desks will be less than the sum of the VARs of the individual

desks (SEK 20 million)

2011 Modular Level Ill, Vol 5, pp.245 Study Session 14-39-g

Discuss the advantages and limitations of VAR and its extensions including cash flow at

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VAR fails to incorporate positive results into its risk profile and, therefore, arguably provides an incomplete picture of overall exposures

2011 Modular Level Ill, Vol.5, pp 263-267 Study Session 14-39-k

Demonstrate the use of exposure limits, marking to market, collateral, netting arrangements, credit standards, and credit derivatives to manage credit risk

Marking to market and the use of credit default swaps reduce counterparty credit risk for Baltic

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2011 Level 3 Sample Exam Volume 2

Questions

SS9: Management of Passive and Active Fixed-Income Portfolios Q1-6: Midwest Case Scenario

Erik Smith, CFA is Director of Investments for Midwest Industries’ pension fund He is

meeting with James Brown, ASA, his actuary, and Paul Jones, CFA, an investment

consultant, to discuss changes to the fund’s management and asset allocation Brown makes the foilowing statement regarding Midwest’ pension plan;

“The actuarial analysis estimates the present value of Midwest's pension fund at $1 billion, discounting the projected benefit cash flows using a market-based discount rate of 6.2 percent The fund’s duration is 12 and the plan assets currently cover 100 percent of this liability Since the objective is primarily to meet these liabilities, and we

are using market rates as the discount rate, we should select a bond market index as the benchmark.”

Jones offers his opinion on the appropriate investment strategy for the pension fund:

“Il believe that an immunization strategy that meets multiple liabilities is the best

strategy For multiple liability immunization, the necessary and sufficient conditions are: (1) the duration of the portfolio must equal the duration of the weighted average

liabilities, and (2) the distribution of durations of individual portfolio assets must have a wider range than the distribution of the liabilities As such, this strategy will not require us to rebalance the portfolio if interest rates change or as time elapses.”

Smith expresses some concerns regarding immunization as strategy and states:

“Even if immunization minimizes risk, it assumes that the yield curve shifts in a

parallel fashion, which is not what | have observed in the market In addition, the

ability to earn some incremental return to offset additional benefit requirements is not

possible.”

Jones then comments on portfolio holdings:

“The current portfolio contains 40 percent in mortgage-backed securities that present certain risks when immunizing a portfolio These securities have a market value that is below their purchase price and | am reluctant to recommend a sale in which we have to recognize a loss.”

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The discussion progresses to implementation of an investment strategy Brown presents several alternative portfolios that may be used to implement this strategy, and states:

“Although we are currently fully funded, | am concerned that future service benefits

are not covered unless we make additional contributions We should evaluate the

alternative portfolios below to determine which one best addresses this concern while covering the liability’s market-related exposures.”

Portfolio A: The fixed-income assets will closely mimic the liabilities with regard to both expected return and variability This is a low-risk strategy to meet our objectives

Portfolio B: Hedges uncompensated liability risks, such as interest rate risk, with derivatives This frees up capital to invest in higher

returning assets like equities and bonds

Portfolio C: A traditional mix of securities with 60 percent in equities and the remainder in-medium duration bonds, but not fully hedging

interest rate risk

Smith is not completely convinced about the portfolio choices and offers the following

alternative:

“| believe cash flow matching is a superior strategy This strategy will allow funds to be available when each liability is due, and will require less cash to fund liabilities A

conservative interest rate assumption for cash must be made throughout the life of the plan.” Question 1 Based on Midwest's stated objective, has Brown recommended the most appropriate benchmark? A Yes |

B No, because the liability itself is the benchmark

C No, because the benchmark should contain a broader universe of asset classes Question 2

In Jones’ investment strategy statement, he is least likely correct with respect to: A matching durations

B the distribution of durations

C Rebalancing the portfolio under certain conditions

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Smith's concems regarding the investment strategy are best addressed by: A decreasing the dispersion of cash flows around the horizon date

matching assets to liabilities using functional duration and targeting a cushion spread C Increasing the dispersion of cash flows around the horizon date and targeting a

cushion spread

”

Question 4

The specific risk that Jones is most likely concerned about with regard to the holdings in

the current portfolio is: A cap risk

B interest rate risk

C contingent claim risk Question 5 Based on Brown’s concerns regarding future benefits, which portfolio is the most appropriate? A Portfolio A B Portfolio B C Portfolio C Question 6 Is Smith's assertion about cash flow matching most likely correct? A Yes

B No, he is incorrect regarding cash balances

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$S11: Equity Portfolio Management

Q7-12: Gregory Dodson Case Scenario

Gregory Dodson, CFA, is an investment consultant who advises individual and institutional clients on their equity portfolios During a typical workweek, he is called upon

to evaluate a variety of situations and provide expert advice This week, he is meeting with

three clients

Dodson’s first client meeting is with the Magnolia Foundation, a small not-for-profit

organization Magnolia currently uses three long-only portfolio managers for its equity

investments Details of those investments, including expected performance relative to

Magnolia’s equity benchmark, the S&P 500 stock index, are provided below Exhibit 1

Magnolia Foundation Equity Portfolio Mangers

Investment Size (in Expected Alpha Expected Tracking millions) Error Manager A US$140 0% 0% Manager B US$40 1.5% 2.5% Manager C US$20 2.0% 4.0%

The Magnolia Foundation's goal for its total equity investment is expected alpha greater than 0.40 percent and expected tracking error less than 1.00 percent

Dodson's second client meeting is with Sarah Tan, a wealthy individual who is actively

involved in managing her investments Tan wants to add a US$100 million allocation to U.S midcap stocks, represented by the U.S S&P 400 midcap index, to her long-term

asset allocation No investment has been made to meet this new allocation Tan has not

found any manager capable of generating positive alpha in U.S midcap stocks She has, however, identified a long-only portfolio manager of Canadian equities who she believes

will produce positive alpha This manager uses the S&P/TSX (Toronto Stock Exchange)

index as a benchmark Tan wants to create a portable alpha strategy that will earn the alpha of the Canadian equity portfolio and meet the new benchmark allocation to U.S

midcap stocks She asks Dodson for advice to establish this strategy Tan provides some

information about the security selection methods used by the Canadian equity portfolio

manager He uses a proprietary discounted cash flow model to analyze all stocks in the

S&P/TSX index, purchasing those with market prices most below the intrinsic value estimated by his model

Dodson’s third client meeting is with the chief investment office (CIO) of the Susquehanna

Industries’ pension fund The fund needs to establish a US$50 million portfolio that

replicates the Russell 2000, an index of small-cap U.S equities The CIO's goal is to

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respect to the pension fund’s actively managed value and growth equity portfolios Currently, the managers monitor the P/E (price-to-earnings) ratio of each stock held A

value stock is sold when its P/E ratio rises its 10-year historical average A growth stock is sold when its P/E ratio falls to its 10-year historical average Question 7 The Mangolia Foundation’s portfolio structure is best characterized as: A core-satellite B completeness fund C alpha and beta separation Question 8

Do the Magnolia Foundation’s current equity investments most likely meet its total equity investment return and risk goals? _

A Yes

B No, the expected alpha is too low

C No, the expected tracking error is too high Question 9

Which of these futures positions combinations would most likely be included in

Dodson's advice to Tan regarding her intended portable alpha strategy?

A Long position in S&P/TSX futures and long position in S&P 400 futures

B Short position in S&P/TSX futures and long position in S&P 400 futures C Short position in S&P/TSX futures and short position in S&P 400 futures Question 10 The style of the Canadian equities portfolio manager is most likely: A value B growth C market-oriented Question 11

Given the manager’s goal, what approach should Dodson most likely recommend for

the Susquehanna Industries pension fund's US$50 million portfolio? A Optimization

B Full replication

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The Susquehanna Industries’ pension fund value and growth portfolio managers follow a sell discipline that is best descrived as:

A rule-driven

B opportunity cost

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$S15: Risk Management Applications of Derivatives

Q13-18: Manuel Silva Case Scenario

Manuel Silva is a principal at Raintree Partners, a financial advisory firm and a specialist in providing advice on risk management and trading strategies using derivatives

Raintree’s clients include high net worth individuals, corporations, banks, hedge funds, and other financial market participants

One of Silva’s clients, Iria Sampras, is a sophisticated investor and is meeting with Silva to

discuss the use of options in her portfolio Silva has collected information on S&P 500

stock index options, which is shown in Exhibit 1

Exhibit 1

Options Data for S&P 500 Stock Index Options Expire in 6 Months Multiplier $100 Exercise Price Call Price Put Price 1,100 $95.85 $42.60 1,125 $80.50 $48.00 1,150 $64.70 $60.00

At the beginning of the meeting Sampras states:” My investment in Eagle Corporation stock has increased considerably in value and | would like suggestions on option strategies that | can use to protect my gains.” Silva responds:” There are two strategies

that you may wish to consider: covered calls or protective puts, Covered calls provide a way to protect your gains in Eagle Corporation stock Adding a short call to your long position in Eagle stock will provide some protection against price declines but will reduce

upside gains A protective put also provides downside protection but it retains upside potential Unlike covered calls, protective puts require an upfront premium payment.”

At the end of the meeting, Sampras asks Silva to provide a written analysis of the following option strategies:

Strategy A: A butterfly spread strategy using the options information provided in

Exhibit 1

Strategy B: A straddle strategy using options in Exhibit 1 with an exercise price

of 1125

Strategy C: A collar strategy using options information in Exhibit 1

On 16 March 2009, First Citizen Bank (FCB) approached Silva for advice on a loan

commitment At that time, FCB had committed to lend $100 million in 30 days (on 15 April 2009), with interest and principal due on 12 October 2009, or 180 days from the date of the loan The interest rate on the loan was 180-day LIBOR + 50 bps and FCB was

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purchase a $100 million interest rate put on 180-day LIBOR with an exercise rate of 5.75 percent and expiring on 15 April 2009 The put premium was $25.000 LIBOR rates on 16 March 2009 and 15 April 2009 were 6 percent and 4 percent, respectively The option was exercised on 15 April 2009 and the payoff was received on 12 October 2009 FCB has asked for a written evaluation of the success of the strategy

On 15 October 2010, another client, Short Hills Corporation (SHC) indicates that it

expects to take out a $25 million dollar loan on 15 December 2010 The loan rate is 90-day LIBOR + 100 basis points Interest and principal will be paid on 15 March 2011, 90 days after the loan is made on 15 December 2010 SHC is concerned about rising interest rates and has approached Silva for recommendations on addressing this issue On Silva's advice, SHC purchases a $25 million interest rate call on 90-day LIBOR with an exercise rate of 3.5 percent The option premium is $45,000 and it expires in 61 days, on 15

December 2010 If the option is exercised on 15 December 2010, the payoff will be received on 15 March 2011 SHC has asked Silva to provide a report on potential outcomes relative to potential interest rate scenarios

Question13

Is Silva's response to Sampras regarding reducing exposure to Eagle Corporation stock most likely correct?

A Yes

B No, he is incorrect about covered calls C No, he is incorrect about protective puts Question 14 Based on the information in Exhibit 1, the maximum profit, per contract, for Strategy A is closest to: A $2,545 B $5,855 C $9,015 Question 15

Based on the information presented in Exhibit 1, the maximum loss, per contract, for

Strategy B is closest to: A $10,350

B $12,850 C $20,900

Question 16

The expected volatility of the S&P 500 stock index, relative to market expectations, is

least likely to be a factor in the decision to implement:

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2011 CFA Level 3 Sample Exam A strategyA B strategyB C strategy C Question17 Based on Silva’s advice, the effective annual interest rate for First Citizen Bank’s loan is closest to: A 4.56% B 5.75% C 6.38% Question 18

Assuming Silva’s advice is followed and LIBOR rates are 5 percent and 6 percent on 15 October 2010, respectively, the effective annual interest rate on Short Hills Corporation's

loan is closest to: A 2.03%

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2011 CFA Level 3 Sample Exan:

$S18: Global Investment Performance Standards Q19-24: Anton Case Scenario

Beatriz Anton, CFA, is the Chief Compliance Officer at Long Pond Advisors, an asset

management firm catering to institutional, Long Pond is not currently GIPs compliant, but Anton would like to market the firm as being cempliant as soon possible To assist Anton in achieving compliance, she hires Ana Basco, CFA, from Nantucket Advisors to provide guidance on a achieving compliance

At their initial meeting to discuss a framework for the implementation of GIPs, Anton asks

Basco what she believes the fundamentals of GIPs encompass Basco responds," A good starting point is input data, because the Standards rely on the integrity of input data to accurately calculate results Portfolios must be valued in accordance with the definition of

fair value, not cost or book values; in fact, fair value supersedes market value

Transactions are reflected in the portfolio at settlement when the exchange of cash,

securities, and paperwork involved in a transaction is completed Accrual accounting is used for fixed-income securities and all other assets that accrue interest income;

dividend-paying equities accrue dividends on the ex-dividend date”

Basco then asks Anton about Long Pond's policies for return calculation methodologies Anton responds that she has recently implemented the following polices;

Policy1: Total return is calculated for portfolios using time-weighted rates of

return computed by geometrically linking the periodic returns It does not matter in the calculation whether gains and losses are actually realized

Policy2: Large-and mid-cap equity portfolios are revalued on the date when capitai

equal to 10 percent or more of current market value is contributed or withdrawn Small-cap

and fixed-income portfolios use a 5 percent threshold

Policy3: Cash and cash equivalents are excluded in total return calculations Custody fees are not considered direct transaction casts Returns are calculated after

deduction of trading expenses

Their conversation turns to the construction of composites and composite return calculations, Anton tells Basco;

“Long Pond calculates composite returns by asset-weighting the individual portfolio

returns using beginning- of-period values For periods beginning 1 January 2010, we calculate composite returns by asset weighting the individual portfolio returns quarterly All actual, fee-paying, discretionary portfolios are in at least one composite

Non-fee-paying discretionary portfolios are included in a composite and appropriate

disclosure are provided Client portfolios that restrict the purchase of certain

securities are excluded if this restriction hinders the portfolio manager's ability to

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execute on the strategy We consider a hierarchical structure of criteria for composite definition that promotes primary and secondary strategy characteristics such as asset classes, style, benchmarks and risk/return characteristics The composites are not

always defined according to each level of the hierarchy.”

Then Anton provides Basco a recent presentation to a prospective client for Long Pond’s

mid-capitalization composite Details of this presentation are found in Exhibit 1 and its Notes

Exhibit 1

Mid-Capitalization Equity Composite Benchmark:

Russell Midcap Index Column 1 2 3 4 5 6 7

Year Gross of|Net of | Benchmark | Number | Internal Total Assets

# Fees Fees Return (%) | of Dispersi

Return Return Portfoli | on (%) (%) (%) es Comp Firm osite 2005 7.6 6.6 6.6 3 4.9 75 600 2006 4.4 3.4 3.6 E 3.1 125 1000 2007 2.7 1.7 6.2 8 4.0 220 1,150 2008 -1.5 -2.5 -4.3 7 1.9 345 910 2009 8.3 7.3 11.1 11 2.6 430 1,020 1Q10 6.6 5.6 -2.9 13 4.1 600 1,100 Notes:

1 Long Pond is an independent investment firm founded in May 1998 and has a single

office in Seattle, WA The firm manages portfolios in various equity, fixed-income and

real estate strategies

2 The composite has an inception date of 12/31/1999 A complete list and description of

firm composites is available upon request

3 The composite includes all fee-paying discretionary, nontaxable portfolios that follow a mid-cap strategy The composite does not include any non-fee-paying portfolios

4 1Q10 data is not annualized

5 Valuations are computed and performance reported in US$

6 Internal dispersion is calculated using the equal weighted standard deviation of all

portfolios that were included in the composite for the entire year

7 Gross-of-fees performance returns are presented before management and custodial

fees but after all trading expenses The management fee schedule is as follows: 1.00

percent on first US$25M; 0.60 percent thereafter Net-of-fees performance returns are

calculated by deducting the management fee of 0.25 percent from the quarterly gross

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Anton then concludes by describing to Basco Long Pond's real estate valuation practices: “Long Pond uses fair value to calculate returns on real estate assets, although for periods before 1 January 2011 we use market values We value real estate holdings as of the end of each quarter and have a credentialed expert value our real estate every 12 months as required by our clients The capital return, or capital appreciation return,

is calculated by dividing the capital employed into the change in value during the

measurement period plus capital expenditures minus net sales proceeds The income

return is calculated by dividing capital employed into investment income earned during

the period minus non-recoverable expenditures, interest expense on debt, and property taxes.” Question 19 In her statement regarding input data, Basco is most likely incorrect with respect to: A fair value B accrual accounting C settlement date accounting Question 20 Which policy regarding return calculation methodology is most likely not compliant with GIPS standards? A Policy 1 B Policy 2 C Policy 3 Question 21

With regard to Long Pond’s procedures for composites, which of the following should

be modified in order to be compliant with GIPs standards? A Return calculations

B Composite definition C Composite construction

Question 22

Based on Exhibit 1 and the Notes following the table, Long Pond is most likely not in

compliance with GIPs with regard to the:

A length of performance record

B measure of internal dispersion

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Question 23

Regarding the disclosures contained in Notes to Table 1, GIPS would most likely: A require Notes 3 and 7 and recommend Note 6

B require Columns 2 and 5 and recommend Column 1 C require Columns 6 and recommend Columns 4 and 7

Question 24

In order for the real estate composite to be GIPs compliant, which of Long Pond’s practices would have to be modified?

A Real estate valuations

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2011 CFA Level 3 Sample Exain

$S13: Alternative Investments for Portfolio Management Q25-30: Victor Ruiz Case Scenario

Inez Morales and Victor Ruiz are investment managers for a university endowment fund They are currently evaluating the asset allocation of the endowment including the possibility of adding new asset classes such as alternative assets They currently invest

only in traditional asset classes such as equities and fixed income Morales and Ruiz have

different views of the impact of this potential change on the risk and return characteristics of the endowment's portfolio

Morales is against adding alternative assets to the endowment, noting the following: |

prefer to continue investing in traditional asset classes My opinion is that alternative investments have risk and return characteristics that are markedly different from those of

traditional asset classes | do not know if we currently have the required skills to analyze these investments.”

Morales continues: “| am concerned that due diligence to identify superiorly skilled or

informed managers is more challenging with alternative investments.”

Ruiz is aware of the major due diligence checkpoints for alternative investments and responds: The due diligence process follows a straightforward logic The market

opportunity that is producing active returns is identified and evaluated for sustainability The investment process is studied to evaluate that the firm is well-organized and stable

And, the structure of the investment is evaluated to confirm that it is appropriate for the

opportunity.”

Ruiz analyzes the impact that an allocation to alternative investments would have

compared to a traditional asset mix of 50 percent equity and 50 percent fixed income The

analysis is based on correlations provided in Exhibit1 below Exhibit 1

Asset Class Correlations

- Equity | Fixed Income Index Index | Correlation with Direct Real Estate 0.04 -0.20 Index Correlation with Commodity Index -0.05 0.05

Two sample portfolios are created for analysis by reducing equity and fixed-income allocations by 5 percent each and then allocating the resulting 10 percent in capital to either real estate or indirect commodity investment The ex post performance of the

various portfolios is summarized in Exhibit2

Exhibit2

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2011 CFA Level 3 Sample Exam Performance of Alternative Portfolios

50%Equity/ 40%Equity/ 40%Equity/

50%Fixed Income | 40%Fixed Income/ | 40%Fixed Income/ 10%Real Estate 10%Commodity Annualized return Annualized 9.60% 7.85% 9.33% 6.60% 9.50% 7.20% standard deviation - Sharpe Ratio 0.97 1.11 1.04

To bolster the case for adding direct real estate investments to the traditional equity/fixed income portfolio, Ruiz lists the following advantages:

Advantage: Real estate returns have lower volatility than do public equity returns Advantage2: Real estate investors can take actions to increase the market vaiue of their properties Advantage3: The cost of acquiring information about real estate is lower than for traditional investments

Ruiz then turns his attention to commodities and explains that investing in commodities

can be approached on a direct or indirect basis He states that indirect investment has

historically been the primary approach used to gain exposure to commodities and lists the common types of indirect commodity investments:

Investment1: Commodity futures

Investment2: Commodity exchange-traded funds

Investment3: Equities of commodity-linked businesses

Morales notes that the university endowment partially supports the costs of operating the university These costs are very sensitive to inflation

Question 25

Which of these alternative investment characteristics best supports Morales’ opinion of

alternative investments?

A Investment illiquidity

B Unknown diversification potential

C Need to establish a valid benchmark

Question 26

Ruzi is least likely correct with regard to which due diligence checkpoint?

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A Market opportunity B Investment process C Terms and structure

Question 27

Based on the results of Ruzi’s analysis presented in Exhibit 2, it would be reasonable to conclude that the addition of alternative investments most likely:

A enhances portfolio return

B improves the risk and return profile

C provides very little diversification benefit

Question 28

Which of the following in Ruiz’s list of advantages of direct equity investing in real estate is

least likely correct? - A Advantage 1 B Advantage 2 C Advantage 3 Question 29 Which of the commodity investments Ruiz lists is most accurately descried as an indirect investment? A Investment 1 B Investment 2 C Investment 3 Question 30

Given Morals’ comment about the costs of operating the university, the most appropriate

commodity for the fund to invest in would be: A energy

B livestock

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2011 Level 3 Sample Exam Volume 2 Answers

1 Correct answer: B

2011 Modular Level Ill, Vol.4, pp.8-10, 25-26 study session 9-28-a

Compare and contrast, with respect to investment objectives, the use of liabilities as a

benchmark with the use of a bond index as a benchmark

The investor with liabilities will measure success by whether the portfolio generates the

funds necessary to pay out the cash outflows associated with the liabilities, in this case a defined benefit pension plan Meeting the liability is the investment objective; as such it also becomes the benchmark for the portfolio

2 Correct answer: C

2011 Modular Level Ill, Vol.4, pp.26-29, 41-42 study session 9-28-f;k

Design a bond immunization strategy that will ensure funding of a predetermined liability

and evaluate the strategy under various interest rate scenarios

Compare and contrast immunization strategies for a single liability, multiple liabilities, and

general cash flows

The portfolio does need to be rebalanced As interest rates fluctuate or as time elapses,

the portfolio duration will also change, thus the portfolio must be rebalanced to adjust duration to the desired level

3 Correct answer: B

2011 Modular Level Ill, Vol.4, pp.36.38-39 study session 9-28-i

Discuss the extensions that have been made to classical immunization theory, including the introduction of contingent immunization

Applying functional duration or key rate durations allows durations along the yield curve to

match those of the liabilities A non-parallel shift in the yield curve will affect assets and

liabilities in an offsetting manner In addition, the portfolio could allow for active management to generate additional returns, for an incremental difference between the minimum acceptable return and the higher possible immunized rate, which is referred to as the cushion spread

4 Correct answer: C

2011 Modular Level Ill, Vol.4, pp.38 study session 9-28-}

Explain the risks associated with managing a portfolio against a liability structure, including interest rate risk, contingent claim risk, and cap risk

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