2013 level III sample exam version 2

2013 Level III Sample Exam Version Laredo Case Scenario Tyler Austin is a fixed-income portfolio manager at Laredo Advisors He manages a USD ($) l billion fund that opportunistically seeks the best ideas across fixed-income markets He meets daily with Odessa Houston, the fund's senior analyst, to discuss trade ideas that might be implemented that day Austin has identified six ideas that he would like Houston to evaluate in more detail for potential inclusion in the fund Austin notes that the current low level of interest rates is limiting the potential absolute return the fund generates He asks Houston to evaluate the use of leverage to enhance returns He can borrow 25% of the fund's value at an annual interest rate of 1.50% and earn a rate of return of 5% per year on the invested funds Austin tells Houston that he is concerned about the potential for rates to rise and wants to explore how the fund's duration can be changed using the futures market The fund currently has duration of 5, and he would like to eliminate all interest rate risk Houston uses the data in Exhibit for her analysis Austin is intrigued by the incremental yield he could earn by buying an Italian sovereign bond A dealer provides a quote at a spread of 350 basis points over U.S Treasuries for a 5% coupon, 10-year maturity Italian Buoni Del Tesoro Poliennali (BTP) bond with duration of 6.75 He asks Houston to assess how much this bond spread could widen over the six-month period he intends to hold the bond before the yield advantage relative to Treasuries would be eliminated Austin asks Houston whether the euro-denominated bonds they buy should be hedged back to the U.S dollar, the fund's domestic currency Houston responds that they should hedge back to the U.S dollar because short-term interest rates are 2.50% in the eurozone and 0.25% in the U.S and her forecast shows that she expects the euro to depreciate by 1.75% relative to the U.S dollar There are U.S.-denominated and euro-denominated bonds in the fund; therefore, Austin wonders whether the fund's duration is still simply an average of the durations of each bond Houston comments, "International interest rates are not perfectly correlated Currently, the fund has 80% of the portfolio in U.S issuers with average duration of 5.5 and the remainder in German issuers with average duration of 3.5 Historically, the country beta of Germany - i.e., for German rates relative to U.S rates - is estimated to be 0.62." Finally, Austin tells Houston that his models are showing mortgage securities as having the most attractive spread relative to other fixed-income sectors He believes there are certain risks associated with mortgages and would like to hedge them He asks Houston to identify the risks and possible ways to hedge them Houston replies with the following statements: Statement 1: Option-adjusted spread (OAS) is the risk premium for holding mortgage securities; therefore, you don't want to hedge this spread risk If you hedge against the spread widening, you'll also give up the benefit from the spread narrowing If you believe yield spreads are wide, try to capture the OAS over time by increasing the allocation to mortgage securities Statement 2: The durations of mortgage securities change in an undesirable way when interest rates change You can effectively manage this negative convexity by buying options or by hedging dynamically Hedging dynamically with futures requires lengthening duration after rates have declined and shortening it after rates have risen The cost associated with dynamically managing negative convexity is forgoing part of the spread over Treasuries Statement 3: You can manage volatility risk by buying options or by hedging dynamically When the volatility implied in option prices is higher than you believe future realized volatility will be, you should hedge by purchasing options When you believe future volatility will be higher than implied volatility, you should hedge dynamically 1 If Austin utilizes leverage as he proposes, the rate of return on the portfolio's equity funds will be closest to: A 4.70% B 5.88% C 6.25% Based on Exhibit 1, the number of futures contracts Austin needs to sell in order to eliminate all interest rate risk in the portfolio is closest to: A 9,038 B 10,574 C 12,372 Given Austin's time horizon, the amount by which spreads for BTPs could widen before their yield advantage relative to Treasuries would be eliminated is closest to: A 26 bps B 37 bps C 52 bps Based on Houston's forecast for the EUR relative to the USD and assuming interest rate parity holds, should Austin most likely hedge the portfolio's EUR exposure using forward contracts? A Yes B No, because the euro is expected to depreciate by less than implied by the forward contracts C No, because the euro is expected to depreciate by more than implied by the forward contracts 5 Based on Houston's comment regarding international interest rates, the contribution to the portfolio's overall duration from German bonds is closest to: A 0.43 B 0.68 C 2.17 Houston is least likely correct about hedging risks of mortgage securities in: A Statement B Statement C Statement McMorris Asset Management Case Scenario McMorris Asset Management (MCAM) is an investment adviser based in Atlanta, Georgia Tom Morris manages the active equity portfolios Dan McKeen manages the semiactive equity portfolios and the semiactive derivatives portfolios They are preparing to meet with Maggie Smith, the chief investment officer of Philaburgh Capital, who is considering hiring MCAM to replace one of its current managers At the meeting, Morris and McKeen discuss with Smith MCAM's investment approaches and present her with the risk and return characteristics detailed in Exhibit Smith asks if MCAM's active equity strategy is long only McKeen responds that MCAM uses market-neutral long-short strategies for several reasons He indicates that long-short strategies: Reason 1: Enhance portfolio performance by increasing the beta Reason 2: Generate alpha by identifying undervalued or overvalued securities Reason 3: Benefit from events that give rise to price changes, which are more prevalent on the short side than the long side Smith considers each approach listed in Exhibit but is uncertain as to an optimal investment strategy She makes the following comments about market efficiency: Comment 1: A firm's stock price does not reflect all publically available company information, and good research can uncover sound investment opportunities Comment 2: Our mandate is for managers to limit volatility around the benchmark return while providing incremental returns which exceed management costs Smith states, "In order to ensure investment discipline, Philaburgh uses two methods to evaluate an investment manager's style." She then reviews the current characteristics of MCAM's active equity approach as presented in Exhibit Smith then selects three benchmarks - value, blend, and growth - in addition to the normal benchmark to assess the manager's style, as presented in Exhibit Smith indicates that Philaburgh's performance measurement is compliant with the Global Investment Performance Standards In considering investment performance, Morris identifies three risks that may prevent MCAM's active equity approach from generating incremental returns: Risk 1: Misjudging that a stock's earnings multiple will not contract Risk 2: Incorrectly estimating a stock's earnings per share growth vs consensus expectation Risk 3: Misjudging whether a stock's undervaluation will correct within the investor's investment horizon Smith concludes, by telling Morris that she is impressed by MCAM's track record in adding alpha in the U.S stock market However, she believes that the European equity markets are likely to outperform the U.S equity markets over the next five years She asks whether MCAM can structure a portfolio to capture both opportunities Morris offers to combine his long-short active equity strategy with a Euro Stoxx 50 index strategy Based on Exhibit 1, the approach that is least likely efficient with respect to delivering active returns for a given level of tracking risk is: A active equity B semiactive equity C semiactive derivatives McKeen's response to Smith's question about MCAM's active equity style is least likely correct with respect to: A Reason B Reason C Reason Smith's Comment and Comment respectively are most likely consistent with an investment style that is: Comment Comment A active active B semiactive active C active semiactive 10 Based on Exhibits and 3, what can Smith most likely determine about MCAM's investment style over time? MCAM's style has: A not drifted B drifted from growth to value C drifted from value to growth 11 Which of the risks Morris identifies with respect to his active equity strategy is least likely applicable to a growth-oriented investor? A Risk B Risk C Risk 12 The type of portfolio that Morris recommends to Smith to take advantage of both U.S and European equity market opportunities is most likely: A core-satellite B completeness fund C alpha and beta separation Mary Bing Case Scenario Mary Bing is a senior portfolio manager at NMS Advisors (NMSA), an investment and wealth management firm with offices in Boston and Chicago NMSA provides investment advisory and asset allocation services to private and institutional clients Bing is an expert in the use of derivatives to manage portfolios Bing is assisted by two analysts, Rakesh Sharma and Hernando Torres Bing is performing a review of client portfolios She has collected the stock and bond index futures information that is presented in Exhibit Futures prices are shown after accounting for the multiplier Bing also notes that risk-free bonds with one year to maturity yield 1.5% Bing manages a portfolio invested in U.S small-cap stocks for the Wellington Academy Endowment The portfolio has a current market value of $321 million Bing and her team believe that small-cap stocks will perform well over the next three months After consulting with the trustees of the endowment, Bing decides to raise the beta of the portfolio from 0.8 to 1.2 for the next three months Bing has also been informed that the endowment has received a $15 million cash donation that is to be invested in small caps Bing and her team decide to use futures to equitize the new cash inflow for a period of three months Another one of Bing's clients is KP McLane Incorporated (KPM Inc.), a U.S.-based manufacturer of men's apparel The current market value of KPM Inc.'s pension portfolio is $950 million with a 65% allocation to U.S midcap stocks and a 35% allocation to U.S bonds The stock allocation has a beta of 1.45, and the bond allocation has a modified duration of 5.3 Bing's research indicates that midcap stocks are likely to underperform over the near term Accordingly, she decides to reduce the allocation to midcap stocks to 60% and increase the bond allocation to 40% KPM Inc exports a significant portion of its products to eurozone countries KPM Inc expects the dollar to rise against the euro and is concerned that this could lead to a decline in sales in the eurozone KPM Inc asks Bing for advice on how to manage this risk exposure TCMS is a medical college that is a client of NMSA TCMS currently has a two-year loan outstanding with a 5.5% fixed annual interest rate Bing expects a decline in interest rates and advises TCMS to enter into a two-year interest rate swap where TCMS would pay LIBOR+0.5% and receive a 5.5% fixed rate From TCMS's perspective, the duration of a two-year fixed rate loan is -1.5 years and the duration of a floating rate loan is -0.125 Bing asks Torres, "Can you comment on the overall impact of the interest rate swap on TCMS?" Torres responds, "The net effect of entering the swap is to reduce the interest rate sensitivity of the overall loan plus swap posit ion relative to the loan by itself; however, if the swap is added, it will be harder for TCMS to predict cash flows, and from this perspective, the swap does not serve as a good hedge." Bing asks Sharma, "We adjusted the asset allocation of the KPM Inc pension fund using futures Could we have used swaps to carry out the change?" Sharma responds, "Yes, we could have used a combination of a fixed-income swap on the Barclays US Aggregate Bond Index and an equity swap on the S&P 400 MidCap Index, where the notional value is $47.5 million." 13 In order to adjust the beta of the $321 million Wellington Academy Endowment portfolio, the number of small-cap futures contracts Bing would need to buy is closest to: A 54 B 467 C 1,402 14 In order for Bing to equitize the $15 million cash inflow received by the Wellington Academy Endowment, the number of small-cap futures purchased and the amount invested in risk-free bonds, respectively, are closest to: 15 In order to carry out the proposed adjustment to the KPM Inc pension portfolio, the number of S&P 400 MidCap futures Bing would need to sell and the number of Barclays US Aggregate Bond Index futures she would need to buy, respectively, are closest to: 16 The type of exchange rate risk that KPM Inc faces is best described as: A economic exposure B translation exposure C transaction exposure 17 Is Torres' response to Bing most likely correct? A Yes B No, he is incorrect about hedging ability of the swap C No, he is incorrect about the sensitivity of the overall position 18 The pair of swaps Sharma should most likely describe are: Ng Case Scenario Katherine Ng, a Global Investment Performance Standards (GIPS) specialist, has been hired as a consultant to assist Rune Managers in becoming a GIPS-compliant firm Rune is a global asset manager with several divisions around the world that invest in both stock and bond strategies James Arnott, a performance specialist at Rune, is responsible for the project In their first meeting, Ng and Arnott discuss the GIPS standards and the steps Rune will need to take to become compliant Ng recommends starting with the definition of the firm She tells Arnott how the firm is defined will affect the process for compliance and that the Standards recommend the firm be defined as broadly as possible Arnott replies that Rune managers have been discussing the firm definition and they want their definition to include all Rune divisions except their European division, Rune Europe Rune Europe has its own strategies and management team that are distinct from the rest of Rune Ng replies that the Rune Europe division should be included in the definition of the firm because the division markets itself as part of Rune Managers Ng then asks about Rune's policies for the inclusion of portfolios in composites Arnott responds that Rune has the following policies for all composites: Policy 1: All new accounts funded with cash or securities on or before the 10th day of the month are added to the composite at the beginning of the following month Those funded after the 10th day of the month are added at the beginning of the 2nd month after funding or at the beginning of the calendar month after the proceeds have been substantially invested in the appropriate strategy Policy 2: All portfolios are deemed "nondiscretionary" on the date the notice of termination of the management relationship is received and removed from the composite at the end of the month of notification The discussion then moves on to a new composite Rune is constructing Arnott tells Ng that the marketing department has decided to target domestic Swiss investors and would like to carve out the Swiss portion of international and global accounts for the period of January 2006 through January 2011 and allocate cash to each carve-out segment to create a Swiss franc (CHF) composite Ng responds that this new composite will comply with the standards, but Rune will be required to disclose the percent of composite assets that are carve-outs for each annual period end and the policy used to allocate cash to the carve-out segments Arnott interjects that the marketing department is looking forward to claiming GIPS compliance in advertisements He is meeting with the marketing department and asks Ng what they need to be aware of regarding the GIPS standards in advertising Ng responds that there are several requirements in the GIPS Advertising Guidelines Specifically, the following must be disclosed in the advertisements: the firm description, composite and benchmark descriptions, and the number of accounts in the composite Arnott and Ng then move on to discuss one of Rune's GIPS-compliant performance presentations, which is provided in Exhibit Rune Managers claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards Rune Managers has not been independently verified Notes: Rune Managers is an investment manager registered with the SEC Rune Managers has divisions in Europe, Asia, and the United States that invest in various equity and bond strategies The Rune Mid-Capitalization Equity Composite includes all institutional portfolios that invest in mid-capitalization U.S equities with the goal of providing long-term capital growth and steady income from dividends by investing in low price-to-earnings, undervalued securities A complete list and description of Rune Managers composites as well as policies for valuing portfolios and preparing compliant presentations are available upon request The composite was created on 30 November 2005 Leverage, derivatives, and short posit ions are not used by this strategy 6 Performance is expressed in U.S dollars The returns include the reinvestment of all income Gross-of-fees returns are presented before management and custodial fees but after all trading expenses Net-of-fees returns are calculated by deducting the actual fees of the accounts from the gross composite return The management fee schedule is as follows: 0.80% on the first 510 million, 0.55% on the next 540 million, and 0.40% on assets over 550 million This presentation is not required to conform to any laws or regulations that conflict with the GIPS standards Internal dispersion is calculated using the asset-weighted standard deviation of annual gross returns of those portfolios that were included in the composite for the entire year 10 The three-year annualized standard deviation measures the variability of the composite and the benchmark returns over the preceding 36-month period The standard deviation is not presented for 2006 through 2010 because monthly composite and benchmark returns were not available and it is not required for periods prior to 2011 19 In their discussion of the Rune Europe division, which of the following is most likely correct? A Arnott's analysis, because of how the strategies are run B Ng's analysis, because of how the division markets itself C Arnott's analysis, because of how the division is managed 20 Which policy on the inclusion of portfolios in composites is most likely compliant with the GIPS standards? A Policy B Policy C Policy and Policy 21 In the discussion of carve-outs, Ng is least likely correct in her statement regarding the: A compliance of the composite B disclosure of the cash allocation policy C disclosure of the percent of composite assets 22 In the discussion of the GIPS Advertising Guidelines, Ng is most likely correct in her statement regarding the disclosure of: A the firm description B composite and benchmark descriptions C the number of accounts in the composite 23 Regarding the disclosures contained in Notes to Exhibit 1, the notes most likely required are: A 1, and B 2, and C 6, and 24 Regarding Exhibit 1, which item is least likely an error in the presentation? A Note #3 B Three-year standard deviation C Composite percentage of firm assets Duke Case Scenario The Woodberry Museum (WM) invests in a number of alternative investments as part of its endowment John Quest, WM's chief investment officer, oversees several direct investments as well as outside managers for the asset class WM's investment committee is currently evaluating one of the outside managers, Duke Partners Asset Management (DPAM) WM's current allocation to alternative investments is presented in Exhibit Quest states the justification for it: "I believe that the alternative investments we have provide good liquidity and strong portfolio diversification to the remainder of the portfolio, which consists of equities and fixed income." DPAM is the manager of a managed futures fund that seeks to achieve a positive absolute return DPAM's chief investment officer, Randall Duke, CFA, is preparing a report for his first meeting with WM's investment committee Knowing that WM's investment committee is less familiar with real assets than with equities and fixed income, he includes Exhibits and Exhibit shows information on DPAM's portfolio positions, and Exhibit provides information on selected futures contracts Duke calls Quest to ensure that his report addresses any quest ions the committee may have Quest tells him, "There are two questions we would like you to address: Question 1: Could you explain why using managed futures is more beneficial to us than using an unlevered exchange-listed commodity index fund? Question 2: Recently, there has been no clear trend in the commodity markets It seems you could increase returns by selling long term options against your positions Wouldn't that improve the Sharpe ratio?" Duke replies: "I will be prepared to explain why I believe neither the use of an index fund nor an option writing strategy will benefit the portfolio In addition, we expect to be maintaining our short gold position for only another three months Thereafter, we will seek an entry point to establish a long position in gold." Quest comments: "After exiting your gold futures position, I would suggest buying physical gold rather than futures." Duke answers: "Under certain conditions, we might want to follow your suggestion I will address that in my comments to the committee." 25 Quest's justification for the alternative investments in the WM portfolio is most likely correct with respect to: A real estate B hedge funds C private equity 26 Based on Exhibit 2, which position most likely represents an indirect commodity investment? A Position B Position C Position 27 Based on Exhibits and 3, assuming a 5% rise in prices for each underlying asset in the next 12 months, DPAM will most likely obtain the largest roll return from: A Position B Position C Position 28 Duke's response to Question would least likely include that: A managed futures have a low cost structure B managed futures take advantage of rising and falling markets C the index fund only earns the risk-free rate less costs, in the long term 29 When addressing Question 2, Duke's reasoning for not implementing Quest's suggestion would least likely include a discussion of: A the maturity of the options B the skewness of the options C the moneyness of the options 30 After exiting his short gold position, Duke would be motivated to follow Quest's final suggestion if the amount of the lease rate is: A less than the amount of the storage cost B more than the amount of the storage cost C more than the difference between the discount rate and expected price growth rate  ... 5.88% C 6 .25 % Based on Exhibit 1, the number of futures contracts Austin needs to sell in order to eliminate all interest rate risk in the portfolio is closest to: A 9,038 B 10,574 C 12, 3 72 Given... deviation is not presented for 20 06 through 20 10 because monthly composite and benchmark returns were not available and it is not required for periods prior to 20 11 19 In their discussion of... number of accounts in the composite 23 Regarding the disclosures contained in Notes to Exhibit 1, the notes most likely required are: A 1, and B 2, and C 6, and 24 Regarding Exhibit 1, which item