CFA 2018 level 3 schweser practice exam v2 exam 2 afternoon answers

Question #1 of 60 Questions 1-6 relate to Ethical and Professional Standards Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Horizon Fund BIC is an asset management firm headquartered in Holland with regional offices in several other European countries After accepting the position, Bair received a letter from the three principals of BIC The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations Among other things, the letter stated the following: "Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund It is your responsibility to obtain this knowledge and comply with appropriate regulations This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully You will likely need to arrange for our sister companies to buy and sell Horizon Fund shares between themselves and at no risk over the first month of operations This will artificially support the price of the shares to allow the fund to trade closer to its net asset value, giving the perception that our fund is more desirable than other small-cap closed-end funds." Bair heeded the advice from her firm's principals and collected information from qualified advisors on the laws and regulations of three countries: N, S, and D Assume all of the investors in the Horizon Fund will be from these areas Based on her research, Bair has determined:    N allows crossing trades in the fund between firm clients even though this is prohibited between clients in D BIC will internally match buy and sell orders between clients in N whenever possible, but not in D This will reduce costs for clients in N whose orders are crossed and lower total fund expenses for all clients, which will benefit the fund's overall performance For clients located in D, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by D's securities regulators Clients in N will only receive such reports quarterly as consistent with that country's requirements For clients located in S, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment This policy is consistent with the laws and regulations in N D's securities regulations not cover this type of situation Three months after the inception of the fund, its market value has grown from $200 million to $300 million, and Bair's performance has earned her a quarter-end bonus It is now the end of the quarter, and Bair is participating in conference calls with companies in her fund Bair calls into the conference number for Sunrise Petroleum The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Sunrise discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter The restatement will not be announced until the year's end, six days from now Bair does not remind the officers that she can hear their conversation Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call The investment bankers then proceed to sell their personal holdings of Sunrise Petroleum stock After her meeting, Bair sells the Horizon Fund's holdings of Sunrise Petroleum stock Do the suggestions in the letter from the principals of BIC violate any CFA Institute Standards of Professional Conduct? A) Yes, the principals are pressuring Bair to perform B) Yes, the suggested trades are intended to manipulate market data in order to attract investors for the fund C) No, even though Bair is responsible for knowing the laws, the compliance officer is responsible for making sure the firm is in compliance Explanation Standard II(B) Market Manipulation prohibits members and candidates from manipulating securities price or volume with the intent to mislead BIC's principals have suggested to Bair that she artificially inflate the Horizon Fund's price to alter the market's perception of demand for the fund and mislead investors The fact the principals have informed Bair they will watch her performance is normal course of business for any employee/employer situation and not a violation If the employers were to create an environment that encourages unethical or illegal actions, that would be a violation; there is no such indication here Even though Bair may delegate supervisory duties to a compliance officer, it does not relieve Bair of making sure laws, rules, regulations, firm policies, and the Code and Standards are being followed For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #2 of 60 With regard to the treatment of clients in N and D, the policies that Bair has selected regarding crossing trades and client statements for the Horizon Fund violate any CFA Institute Standards of Professional Conduct? N A) No B) Yes C) No Explanation D Yes No No Standard I(A) Knowledge of the Law requires members and candidates to know and comply with rules, laws, and regulations that apply to their professional activities If there is a conflict, members and candidates are expected to adhere to the stricter of applicable laws, rules, and regulations or the Code and Standards By seeking qualified advice, Bair meets this requirement if she then acts on that advice Clients in each country are receiving the required service Note that this is not a case of BIC establishing different levels of service That is not unethical, though it must be disclosed so that clients can select the level of service they are willing and able to pay for In this case, these are not levels of service the clients can select but BIC adherence to differing regulations Most important, there is no group of clients being disadvantaged by BIC The crossing actually benefits all clients by improving total fund performance For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #3 of 60 With regard to the treatment of clients in S, does the policy that Bair has selected regarding levels of service for the Horizon Fund violate any CFA Institute Standards of Professional Conduct? A) Yes, Bair's policy will violate Standard III(B) Fair Dealing B) No, because disclosure in S would disadvantage clients residing in other countries C) No, because disclosure in any country would break the confidentiality that Bair owes to her clients Explanation According to Standard III(B) Fair Dealing, members and candidates are allowed to offer different levels of service but must disclose the existence of different levels of service and allow clients and prospects to choose the desired level By not disclosing the levels of service to investors in S, Bair is adhering to local law, which is less strict than the Code and Standards This is in violation of Standard I(A) Knowledge of the Law, which requires she adhere to the stricter of the two She also violated Standard III(B) by not disclosing the service levels For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #4 of 60 After her conference call with Sunrise Petroleum, Bair should have: A) included the information in a research report to make it public before selling the holdings from the Horizon Fund B) attempted to have Sunrise publicly disclose the earnings restatement before informing the compliance officer of the information C) informed the compliance officer and then publicly disclosed the information in a research report before selling the Sunrise stock Explanation According to Standard II(A) Material Nonpublic Information, the member or candidate cannot act on material, nonpublic information It is recommended the member or candidate attempt to have the subject company disclose the information publicly themselves If this is not possible, then the appropriate supervisor and/or compliance officer should be made aware of the situation For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #5 of 60 By selling their personal holdings of Sunrise Petroleum, did the employees of BIC's investment banking division violate any CFA Institute Standards of Professional Conduct? A) Yes, because they breached their fiduciary duty and were disloyal to Sunrise B) Yes, because they were front running the information by trading for their own benefit before BIC's clients C) Yes, because they knowingly traded on information that, if it had been publicly known, would have affected the price of Sunrise stock Explanation Standard II(A) Material Nonpublic Information prohibits acting on material nonpublic information The investment bankers should have known that the information was material and nonpublic and have violated Standard II(A) by trading on the information Because the information cannot be used for account management, it cannot be considered front running ahead of the accounts There is also no indication Sunrise is a client of the investment banking group and, therefore, no fiduciary duty to Sunrise For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #6 of 60 By selling the Horizon Fund's shares of Sunrise Petroleum, did Bair violate any CFA Institute Standards of Professional Conduct? A) Yes, Bair violated Standard II Integrity of Capital Markets B) No, because she ensured public dissemination of the earnings restatement information before she traded the shares C) Yes, because waiting to trade the stock would severely disadvantage investors in her fund and would have violated her duty of loyalty to her clients Explanation The large earnings restatement is certainly material information Disclosing the information before the conference call does not make the information public even if several analysts overheard the information Disclosing the information to her compliance officer also does not make the information public Therefore, Bair has traded on the basis of material nonpublic information and is in violation of Standard II(A) For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #7 of 60 Questions 7-12 relate to Ethical and Professional Standards Johnny Bracco, CFA, is a portfolio manager in the trust department of Canada National (CNL) in Toronto CNL is a financial conglomerate with many divisions In addition to the trust department, the firm sells financial products and has a research department, a trading desk, and an investment banking division Part of the company's operating procedures manual contains detailed information on how the firm allocates shares in oversubscribed stock offerings Allocation is effected on a pro rata basis based upon factors such as the size of a client's portfolio, suitability, and previous notification to participate in IPOs Additionally, company policy discloses to clients that any trade needs to meet a minimum transaction size in an effort to control trading costs and to comply with best execution procedures One of Bracco's trust accounts is the Carobilo family trust, which contains a portion of nondiscretionary funds managed by Stephen Carobilo Carobilo has a friend who runs a brokerage firm called First Trades, to which Carobilo tells Bracco to direct trades from the nondiscretionary accounts Bracco has learned that First Trades charges a slightly higher trading fee than other brokers providing comparable services, and he discloses this to Carobilo Due to high prices and limited supplies of oil, Bracco has been following companies in the energy sector He believes this area of the economy is in turmoil and should present some mispricing opportunities One company he has been researching is the Stiles Corporation, which is working on a new type of hydrogen fuel cell that uses fusion technology to create energy To date, no one has been able to successfully sustain a fusion reaction for an extended period of time Bracco has been in close contact with Stiles' pubic relations department, has toured their laboratories, and has thoroughly researched fusion technology and Stiles' competitors Bracco is convinced from his research, based upon various public sources, that Stiles is on the verge of perfecting this technology and will be the first firm to bring it to the marketplace Jerry McNulty, CFA and vice president of the investment banking division of CNL, has been working with Stiles to raise new capital via a secondary offering of Stiles common shares One day Bracco happened to be in a stall in the bathroom when McNulty and a colleague came in and discussed the fact that Stiles had perfected the fuel-cell technology, which will greatly increase the price of Stiles' stock A routine audit by the quality control department at CNL discovered trading errors in several of Bracco's accounts involving an oversubscribed IPO Some accounts received shares they should not have and others did not receive shares they should have Bracco and his supervisor Jaime Gun, CFA, are taking responsibility to reverse the incorrect trades Bracco told Gun, "I'll correct the trades based on our clients' investment policy statements, previous notification of intent, and according to the company's formula for allocating shares on a pro rata basis In so doing, we will fairly allocate shares so even small accounts that did not meet minimum size requirements will receive some shares of the IPO." Gun adds that we must go further and credit short-term interest back to the accounts that should not have received the shares That evening, Bracco and his wife attended the company holiday party for CNL employees and their spouses Jerry McNulty, whose wife was ill and could not come to the party, arrived drunk from a meeting with Stiles' upper management During the party McNulty made inappropriate advances toward many of the female employees and joked about the inadequacies of Stiles' managers While cleaning up after the party, a janitor found McNulty's pocket notebook that he apparently dropped accidentally during the party In the notebook, McNulty wrote the recommended amount and date of the secondary offering as well as several details on the nature of the new product Not knowing exactly what to with the notebook, the janitor gave it to Burt Sampson, CFA, a trader at CNL Later that night, Sampson called many of his relatives and friends and told them about the upcoming offering First thing the following Monday morning, McNulty submitted an order to buy the stock for his personal portfolio Has Bracco violated any soft dollar standards regarding the Carobilo family trust? Bracco has: A) violated soft dollar standards because he did not satisfy the requirement of best execution B) violated the soft dollar standards because client brokerage is to be used only for research purposes to benefit the client C) not violated any soft dollar standards since Carobilo requested that the trades be sent to a specific broker Explanation Commissions belong to the client and this is an example of client-directed brokerage where the client, in this case Stephen Carobilo, is allowed to direct the investment manager to use a specific broker to execute trades Under the AMC, if the manager believes the trades are not providing best execution, he should inform the client The client has the right to make the decision in this case For Further Reference: Study Session 2, LOS 4.c SchweserNotes: Book 1, p.48 CFA Program Curriculum: Vol.1 p.244 Question #8 of 60 If after overhearing McNulty's conversation in the bathroom Bracco placed trades to purchase shares of the Stiles Corporation for some of his clients, would Bracco have violated any of the Standards of Professional conduct? A) No, because the information regarding the Stiles Corporation was not acquired in a breach of confidence B) No, because he did not base the trade solely on the information he overheard C) Yes, because he is not allowed to trade on material, nonpublic information Explanation Bracco is in violation of Standard II(A) Material Nonpublic Information, which states that members and candidates cannot trade or cause others to trade based on material nonpublic information that could affect the value of an investment Even though Bracco has performed his own research and the information he acquired from McNulty and his colleague was an accident, it was nonetheless material nonpublic information and therefore cannot be traded upon For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #9 of 60 Regarding the statements made by Bracco and Gun on how to correct the trading errors: A) only Gun's statement is correct B) only Bracco's statement is correct C) both are correct or both are incorrect Explanation Gun is correct Accounts who incorrectly received shares also lost interest on the funds during the period they held the shares The underlying principal is accounts should be made whole for the firm's mistake, in this case, with the lost interest The CFA text is silent on whether the accounts who did not receive the shares initially can keep any interest they incorrectly earned during the period until they are correctly allocated the shares Ethically it can be removed to "make them whole," although to avoid upsetting clients, the firm may decide to let them keep the interest In any case, the firm must bear all costs for the firm's mistake Accounts that not meet the minimum transaction amount as described in the company's policies and procedures should not receive shares of the IPO, making Bracco's statement incorrect For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #10 of 60 Did McNulty's behavior at the holiday party violate the: Code of Ethics? A) B) C) Yes No Yes Standards of Professional Conduct? Yes Yes No Explanation McNulty has violated both the Code of Ethics and the Standards of Professional Conduct The Code of Ethics states in part that members of CFA Institute must act with integrity, competence, diligence, respect, and in an ethical manner with employees and colleagues in the investment profession The inappropriate behavior has violated the Code The unethical behavior also violates Standard I(D) Misconduct The Standard states in part that members and candidates must not commit any act that reflects adversely on their professional reputation, integrity, or competence His inappropriate behavior, especially drinking heavily with Stiles' management, has violated this Standard For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #11 of 60 Based solely on the information provided in the last paragraph, determine whether McNulty and/or Sampson violated the Code and Standards A) B) C) McNulty Sampson No Yes No No Yes Yes Explanation The information in the notebook is clearly material and non-public, as its public release will affect Stiles' stock price As such, McNulty should have taken steps to protect it His drinking and behavior at the party are the obvious blame for his accidentally losing the notebook, but the reasons for losing it are not the point here Whether he intentionally or accidentally lost the notebook, McNulty has violated Standard III(E), Duties to Clients, by not taking steps to preserve the confidentiality of his client's planned offering Sampson violated Standard II(A) by sharing material, non-public information with others and trading on it For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #12 of 60 Under the provision of the Asset Manager Code (AMC), in order to minimize the likelihood of some of the recent problems, CNL must all of the following except: A) establish written policies to ensurer fair and equitable trade allocation B) appoint a qualified compliance officer C) prohibit employees from trading in securities in which the firm has positions or investment banking relationships Explanation Under the AMC, there must be traded allocation policies in place and disclosed to clients Any policies that are not documented (written) not effectively exist A qualified compliance officer must be in place While the AMC and the Standards of Professional Conduct both require disclosure of actual and potential conflicts of interest, neither require that firm employees be prohibited from trading in securities in which the firm has an interest For Further Reference: Study Session 2, LOS 4.c, d SchweserNotes: Book 1, p.48 CFA Program Curriculum: Vol.1 p.244 Question #13 of 60 Questions 13-18 relate to Behavioral Finance Krista Duchene, CFA, is an investment advisor for U.S clients Below, she summarizes some recent conversations with her clients Jonathan: Jonathan faces mandatory retirement from his unionized job in five years He has a relatively small portfolio and will be highly dependent on it in retirement His only other asset will be a modest pension He wants to avoid all international equities in his portfolio because he read in a few online news stories that many of them have performed poorly in the past year, despite having performed well for many years before that Jonathan's portfolio consists primarily of investment grade bonds that he inherited from his father He feels that his father was a knowledgeable investor, so it will be good to hold the bonds Duchene plans to apply behaviorally modified asset allocation (BMAA) to Jonathan's situation Seth: Seth attended his bachelor party in Las Vegas last week where he gambled and lost $5,000 Afraid to come home and share the news with his future spouse, he accepted a proposal with a 50% chance of losing another $5,100 (therefore, losing $10,100 in total) or a 50% chance of winning $5,000 (therefore, losing $0 in total) Being sure his luck would turn, he won and ended up breaking even overall Leah: Leah played a coin tossing game with her son They tossed a quarter 10 times and it came up heads every time Given that the long-term mean must be 50% heads and 50% tails, Leah said that the probability of tails turning up on the 11th loss is much more likely than heads Micah: After careful analysis, Micah purchased 200 shares of Ruby Corp (Ruby) several months ago at $25 per share The share price fell shortly thereafter due to an unexpected antitrust court ruling that increased competition in Ruby's industry The current share price is $20 and reliable analyst reports suggest that price properly reflects the new situation Micah says he may consider selling his shares when the price rises above $25 Stacey: Stacey owns 6% of the outstanding voting common stock of a private company She has no involvement in the company and has considered selling the shares in the past but has not found the time to so Also, because Stacey is independently wealthy, she would have no need for the funds anyways In applying BMAA to Jonathan's situation and his desire to avoid international equity and hold the bonds, the most appropriate action would be to: A) mitigate both his requests and have him invest in international equity and sell the investment grade bonds B) accommodate his request to hold the investment grade bonds C) accommodate his request not to invest in international equities Explanation  Jonathan has relatively low wealth and high standard of living risk (SLR), suggesting we mitigate (change his behavior) But he is also emotional and we will likely have to accommodate some of his biases The desire to hold the investment grade bonds his father bought is an emotional (endowment) bias, but it makes sense that he retains significant fixed income, given his lower overall risk tolerance and the fact that he is approaching retirement We can more reasonably accommodate that bias and retain the bonds Totally avoiding international equity ignores the potential to lower his portfolio risk through diversification as well as potentially improve his return Both are important given his significant SLR It makes more sense to work with him and mitigate that bias For Further Reference: Study Session 3, LOS 6.a, b, c, d SchweserNotes: Book p.108, 109 CFA Program Curriculum: Vol.2 p.51, 52, 81 Question #14 of 60 Seth's behavior in accepting the 50/50 proposal is best described as: A) risk averse B) risk neutral C) risk seeking Explanation The loss that has already occurred, cannot be changed, and should not rationally affect his next decision The proposal has an expected payoff of losing $50 (50% chance of making $5,000 and 50% chance of losing $5,100) but the payoff is clearly uncertain A risk averse investor would not accept the proposal A risk averse investor would not even accept a fair wager with an expected payoff Accepting a negative payoff event is risk seeking Seth is so averse to emotionally accepting he has already lost 5,000, he will take a proposal with a negative payoff For Further Reference: Study Session 3, LOS 5.a SchweserNotes: Book p.79 CFA Program Curriculum: Vol.2 p.7 Question #15 of 60 Leah's description of the coin toss is best described by which of the following cognitive errors? A) Anchoring and adjustment bias B) Confirmation bias C) Gambler's fallacy Note that calculating active risk follows the normal portfolio standard deviation formula, but correlation makes the last part of the calculation For Further Reference: Study Session 12, LOS 25.p, q SchweserNotes: Book p.26, 28 CFA Program Curriculum: Vol.4 p.303, 306 Question #40 of 60 Which of the three strategies presented to Suresh is most clearly a form of alpha and beta separation? A) Strategy B) Strategy C) Strategy Explanation Alpha and beta separation is any investment strategy where some portion of the portfolio or management efforts are devoted to generating value added (alpha) and the rest to (passive) market exposure (beta) Strategy has no beta A market neutral strategy balances long and short positions such that market direction is not expected to affect the portfolio The long and short positions are intended to exploit under and overvalued securities to add value (alpha) In strategy 2, the 130/30 short extension strategy is not alpha and beta separation as the alpha and beta components are not managed separately but integrated together The 130 are long positions that provide both market exposure and alpha (by emphasizing the selection of undervalued securities) The 30 are short positions that allow some exploitation of overvalued securities but leave the total portfolio 100% long Strategy is alpha and beta separation It combines strategy (alpha only) with equity futures contracts which provide market (beta) return For Further Reference: Study Session 12, LOS 25.t SchweserNotes: Book p.34 CFA Program Curriculum: Vol.4 p.313 Question #41 of 60 If Suresh states that he requires full exposure to the benchmark and a portfolio beta near 1, which of the three strategies will least likely meet this constraint? A) Strategy B) Strategy C) Strategy Explanation See the previous answer explanation Market neutral has a target beta of The other strategies target full market exposure, beta of For Further Reference: Study Session 12, LOS 25.n SchweserNotes: Book p.22 CFA Program Curriculum: Vol.4 p.299 Question #42 of 60 The true information ratio of the SSCO composite is: A) -0.23 B) -0.33 C) -0.43 Explanation True active return = portfolio return - manager's normal portfolio return = 12.8% - 13.7% = -0.9% For Further Reference: Study Session 12, LOS 25.s SchweserNotes: Book p.32 CFA Program Curriculum: Vol.4 p.311 Question #43 of 60 Questions 43-48 relate to Fixed Income Portfolio Management Rebecca Bradley is a fixed-income specialist at Boyds Bank with particular experience in devising liability funding strategies It is October 2018, and she is meeting with Jeremy Wilson of Qual-Mart plc Qual-Mart is a major supermarket chain, and due to an extensive expansion of their stores across the United Kingdom, Qual-Mart has a large amount of debt outstanding Wilson is concerned this is depressing the stock price The company's liabilities are in various forms and maturity For ease of discussion, Bradley has set up groups of liabilities so they can discuss potential strategies to deal with the debt Group is GBP12 million market value of liabilities that will be due for payment between and 10 years from now Some key features of these liabilities are detailed in Exhibit 1: Exhibit 1: Qual-Mart Liabilities Cash flow yield: 2.92% Basis point value (BPV): 7,496 Duration: 6.34 Convexity: 47.75 Bradley has identified four possible AAA-rated portfolios that might be used to immunize these liabilities Details of the immunizing portfolios are given in Exhibit The first block of data for each portfolio discloses the bonds in that portfolio For example, portfolio P is made up of bonds due in five years with a coupon of 2.6% and bonds due in eight years with a coupon of 3.6% Exhibit 2: Potential Immunizing Portfolios Portfolio: P Q R S Bonds (term, coupon) years, 2.6% years, 2.4% 3.5 years, 2.3% years, 2.1% years, 3.6% 6.5 years, 3% years, 3.5% 13.5 years, 5% 10 years, 4.1% 11 years, 4.6% Cash flow yield 3.20% 3.26% 3.59% 3.02% BPV 7,476 7,215 7,474 7,471 Duration 6.33 6.11 6.34 6.32 Convexity 46.03 47.60 47.89 68.34 Group of Qual-Mart's liabilities has already been immunized Due to a recent reshaping of the yield curve, the BPV of the immunizing portfolio has decreased from 31,678 to 29,324, while the liability BPV fell to 31,207 Bradley suggests that bond futures contracts could be used to close this duration gap She determines that the CTD bond for the long gilt future (a futures contract on U.K government bonds) has a BPV of 90.57 per contract (100,000 par), with a conversion factor of 1.1346 Qual-Mart's treasury department has reported to Wilson that the company's cash holdings are so sufficiently large that some debt liabilities could be retired Wilson has identified a group of liabilities where this would be possible, but he believes it will be more cost effective to defease these liabilities by purchasing U.K government bonds Both the liabilities and the bonds purchased could be removed from the reported balance sheet The company's accountants have determined that this will require a cash flow matching strategy to cover the principal and interest payments on the liabilities Exhibit details the payments due on these group liabilities: Exhibit 3: Debt Payments to be Defeased March 2019 2,470,000 September 2019 1,780,000 March 2020 3,150,000 September 2020 2,675,000 March 2021 2,980,000 Exhibit lists the U.K gilts that are being considered for purchase The gilts pay interest semiannually in September and March It can be assumed that the payment dates for the gilts fall on or before the payments due on the debt to be defeased and that this is acceptable to qualify for balance sheet defeasement Exhibit 4: Gilts Available for Purchase Annual Coupon Maturity 1.98% March 2019 2.05% September 2019 2.25% March 2020 2.48% September 2020 2.70% March 2021 Finally, Wilson seeks advice regarding a GBP22 million of fixed-to-floating rate note issued by Qual-Mart one year ago The notes were issued with a 10-year maturity, paying a quarterly coupon of 4.1% for the first three years, then LIBOR plus 1.1% over the remaining period to maturity Of the immunizing portfolios in Exhibit 2, which has the greatest structural risk relative to the liabilities in Exhibit 1? A) Portfolio P B) Portfolio R C) Portfolio S Explanation Structural risk exists when the distribution of the asset cash flows does not match that of the liabilities This can lead to a differential in performance of the assets versus liabilities when there are large or non-parallel shifts in the yield curve This risk is reduced by minimizing the dispersion of cash flows in the portfolio relative to the liabilities Convexity is related to cash flow dispersion, and if the asset's convexity is set slightly larger than the liability convexity, the structural risk is minimized Portfolio P's convexity is slightly too low R is the best situation with convexity slightly greater than that of the liabilities S's convexity is well above the liability convexity of 47.75 Therefore, S has the greatest structural risk For Further Reference: Study Session 10, LOS 22.c, d, e SchweserNotes: Book p.253, 259, 265 CFA Program Curriculum: Vol.4 p.64, 78, 88 Question #44 of 60 Which of the portfolios in Exhibit would be most appropriate to immunize the liabilities in Exhibit 1? A) Portfolio P B) Portfolio Q C) Portfolio R Explanation The first requirement for immunization is to match the BPV of the assets and liabilities Q has insufficient BPV and is not acceptable In addition, asset convexity should slightly exceed that of the liabilities P's convexity is slightly too low R meets the condition of slightly more convexity than the convexity of the liabilities R is the acceptable choice (R also has the highest yield, which is also desirable.) For Further Reference: Study Session 10, LOS 22.c, d, e SchweserNotes: Book p.253, 259, 265 CFA Program Curriculum: Vol.4 p.64, 78, 88 Question #45 of 60 Assume that the Exhibit liabilities were immunized by an investment in portfolio S and that 6.32 is the modified duration If the portfolio is fully funded with GBP12 million to match the present value of the liabilities, what is the effect on the surplus (asset PV - liability PV) of an immediate 1.5 percentage point decrease in all yields? A) There will be no change in the surplus B) The surplus will turn positive C) The surplus will turn negative Explanation Percent change in value can be estimated as: [-MD ì Yield] + [ẵ ì Convexity × (∆Yield)2] Where MD is modified duration We know the initial surplus is zero (PVA = PVL) We can calculate the estimated % change in value to the assets and liabilities to determine the change in value of the surplus For a 1.5% decline in yields: %∆Liabilities = [-6.34 × -0.015] + [ẵ ì 47.75 ì (-0.015)2] = +10.05% %Portfolio S = [-6.32 ì -0.015] + [ẵ ì 68.34 ì (-0.015)2] = +10.25% Portfolio S's value rises by more than the liability, so the surplus turns from zero to positive For Further Reference: Study Session 10, LOS 22.c, d, e SchweserNotes: Book p.253, 259, 265 CFA Program Curriculum: Vol.4 p.64, 78, 88 Question #46 of 60 How many long gilt futures contracts must be purchased to eliminate the duration gap in the immunized group liabilities? A) 18 B) 21 C) 24 Explanation Asset BPV is now below liability BPV, and therefore, bond contracts must be purchased The duration gap is: 31,207 - 29,324 = GBP1,883 We will need the BPV of the contract, which is: BPV of CTD / CF of CTD: 90.57 / 1.1346 = 79.8255 Buy: 1,883 / 79.8255 = 24 contracts For Further Reference: Study Session 10, LOS 22.c, d, e SchweserNotes: Book p.253, 259, 265 CFA Program Curriculum: Vol.4 p.64, 78, 88 Question #47 of 60 If a cash matching portfolio is built using the gilts in Exhibit to defease the debt payments in Exhibit 3, which of the following is closest to the par value that will be purchased of the September 2020 gilt? A) 2.675 million B) 2.642 million C) 2.603 million Explanation This is a recursive calculation You must start with the longest liability and work to the next longest In each calculation, buy sufficient amount of the bond that par plus all coupons available are sufficient to pay the liability The March 2021 liability is 2,980,000 To fully fund this, we will need to buy the amount of par value of the March 2021 bond such that par + final coupon = 2,980,000, so: parMar21 = 2,980,000 ÷ (1 + (0.027/2)) = 2,940,306 The coupon on this bond will be 2,940,306 × (0.027 / 2) = 39,694 The Sept 2020 coupon on this bond will pay off part of the Sept 2020 liability, leaving 2,675,000 - 39,694 = 2,635,306 to be funded The par value bought of the Sept 2020 bond will thus be: ParSept20 = 2,635,306 ÷ (1 + (0.0248/2)) = 2,603,028 This answers the question We need 2,603,028 To illustrate the process, we can show the calculation for the third longest liability as well: The coupon on the September 2020 bond will be 2,603,028 × (0.0248 / 2) = 32,278 The March 2020 coupons on the September 2020 and March 2021 bonds will total 32,278 + 39,694 = 71,972, which means that 3,150,000 - 71,972 = 3,078,028 of the March 2020 liability must still be funded The par value bought of the March 2020 bond will be: ParMar20 = 3,078,028 ÷ (1 + (0.0225/2)) = 3,043,785 For Further Reference: Study Session 10, LOS 22.c, d, e SchweserNotes: Book p.253, 259, 265 CFA Program Curriculum: Vol.4 p.64, 78, 88 Question #48 of 60 Bradley should classify the Qual-Mart fixed-to-floating rate notes as: A) type I liabilities B) type II liabilities C) type III liabilities Explanation The classification scheme is: Amount of Cash Timing of Cash Outlay Outlay I Known Known II Known Uncertain III Uncertain Known IV Uncertain Uncertain This bond pays a fixed rate for the first three years and then converts to floating It was issued one year ago, so it will remain fixed for two more years and then convert to floating That means that all the future amounts are not known, but the future payment dates are known That is a type III liability Liability Type For Further Reference: Study Session 10, LOS 22.a SchweserNotes: Book p.244 CFA Program Curriculum: Vol.4 p.48 Professor's Note: I consider this a useless question It is pure memorization of infrequently used and arbitrary terminology You have taken at least two CFA exams If you have found this kind of question to be frequent on the exam, memorize everything in the text I find it uncommon By the way, the only substantive point in this classification discussion is that type I liabilities are the easiest to model; the others involve greater uncertainty Question #49 of 60 Questions 49-54 relate to Execution of Portfolio Decisions: Monitoring and Rebalancing Somerset Investment Limited is a Singapore-based money management firm that is conducting an appraisal of its investment performance Cameron Li, CFA, has been charged with conducting the appraisal and is to report back to upper management with his findings Li is convinced that trade executions play a substantial role in overall portfolio performance, particularly for funds that have a relatively high level of turnover during the year As a result, he is seeking methods that will allow him to evaluate the quality of trade executions He knows that the firm's traders use both market and limit orders, and he is wondering if a framework can be developed to ensure that the best order type is used under the specific circumstances for each trade When he consults with the firm's head trader, Rick Gleeson, Gleeson tells him that market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty According to Gleeson, rebalancing and liquidity-motivated trades should use limit orders while valuemotivated and information-motivated trades should use market orders Li knows that bid-ask spreads are a major component of trading costs and asks Gleeson for some recent trade data that he can use for analysis and presentation to management He receives the following data relating to a series of buy trades for Sumatra Natural Resources (SNR), with all currency values in Singapore dollars: Trades of Sumatra Natural Resources Execution Shares Time Bid Price Ask Price Price Bought 10:30 $22.18 $22.36 $22.33 900 11:15 $22.23 $22.43 $22.43 600 13:45 $22.29 $22.48 $22.47 700 15:00 $22.37 $22.63 $22.65 800 Gleeson also tells Li that the portfolio manager had originally made the decision to purchase 5,000 SNR at 10:00 a.m when the price was $22.36 The closing price for the day was Gleeson's last trade at $22.65, at which point the order for the remaining 2,000 shares was cancelled Which of the following correctly summarizes Gleeson's comments concerning the differences between market and limit orders? A) He is correct concerning the nature of uncertainty; he is correct concerning when the order types should be used B) He is correct concerning the nature of uncertainty; he is incorrect concerning when the order types should be used C) He is incorrect concerning the nature of uncertainty; he is correct concerning when the order types should be used Explanation Gleeson is correct concerning the nature of uncertainty Market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty However, he is incorrect concerning when these order types should be used In most cases, information-motivated and liquidity-motivated trades should use market orders to ensure that execution takes place, while value-motivated and rebalancing trades should use limit orders because price is typically more important than the speed of execution For Further Reference: Study Session 16, LOS 31.a SchweserNotes: Book 5, p.1 CFA Program Curriculum: Vol.6 p.7 Question #50 of 60 Concerning the Sumatra Natural Resources price and execution data, the average effective spread and weighted average effective spread are closest to: Average effective spread A) B) C) 0.1957 0.0971 0.1975 Weighted average effective spread 0.1975 0.0908 0.1957 Explanation The quoted spread for the first trade = 22.36 - 22.18 = 0.18 The quoted spreads for the remaining three trades are 0.20, 0.19, and 0.26, so the average quoted spread = (0.18 + 0.20 + 0.19 + 0.26) / = 0.2075 The mid-quote for the first trade = (22.36 + 22.18) / = 22.27, and the effective spread = (22.33 - 22.27) × = 0.12 The effective spreads for the remaining three trades are 0.20, 0.17, and 0.30, so the average effective spread = (0.12 + 0.20 + 0.17 + 0.30) / = 0.1975 The weighted average effective spread = (900 / 3,000) × 0.12 + (600 / 3,000) × 0.20 + (700 / 3,000) × 0.17 + (800 / 3,000) × 0.30 = 0.1957 For Further Reference: Study Session 16, LOS 31.b SchweserNotes: Book 5, p.2 CFA Program Curriculum: Vol.6 p.10 Question #51 of 60 Assume that the four trades in Sumatra Natural Resources are the only trades in the security for the day Determine which of the following statements concerning the volume weighted average price (VWAP) is most correct A) The VWAP for the day is 22.470, and the trader's goal would be to have an average cost that is less than the VWAP B) The VWAP for the day is 22.468, and the trader's goal would be to have an average cost that is greater than the VWAP C) The VWAP for the day is 22.468, and the trader's goal would be to have an average cost that is less than the VWAP Explanation The VWAP for the day = (900 / 3,000) × 22.33 + (600 / 3,000) × 22.43 + (700 / 3,000) × 22.47 + (800 / 3,000) × 22.65 = 22.468, and the trader's goal would be to have an average cost that is less than the VWAP if they are buying For Further Reference: Study Session 16, LOS 31.e SchweserNotes: Book 5, p.8 CFA Program Curriculum: Vol.6 p.22 Question #52 of 60 Calculate the implementation shortfall assuming total commissions paid by Gleeson when he purchased the 3,000 SNR were $210 A) 0.303% B) 0.996% C) 2.027% Explanation The benchmark price and decision price at the time the decision to trade is made is 22.36, and the benchmark quantity is 5,000, so the benchmark investment = 22.36 × 5,000 = $111,800 The terminal benchmark value at the cancellation price of 22.65 is 22.65 × 5,000 = $113,250, and the benchmark gain = 113,250 - 111,800 = $1,450 The actual portfolio cost at the various execution prices is (900 × 22.33) + (600 × 22.43) + (700 × 22.47) + (800 × 22.65) = 67,404 With commissions of 210, this is a total cost of $67,614 The actual portfolio terminal value = 22.65 × 3,000 = $67,950, and the actual gain = 67,950 - 67,614 = $336 The implementation shortfall = (1,450 - 336) / 111,800 = 0.00996 or 0.996% For Further Reference: Study Session 16, LOS 31.f SchweserNotes: Book 5, p.9 CFA Program Curriculum: Vol.6 p.24 Question #53 of 60 Which of the following statements concerning implementation shortfall and VWAP is incorrect? A) Implementation shortfall is greater than zero if any portion of the original order goes unfilled and is cancelled B) For small trades in non-trending markets, VWAP is more appropriate than implementation shortfall C) Implementation shortfall can be adjusted to accurately account for movements in the general market Explanation In general, implementation shortfall will be positive (i.e., profits will be foregone) if prices are rising when the trader is attempting to buy, or if prices are falling when the trader is attempting to sell, and all of the order is not completed Cancellation of a buy order prior to a fall in price, or cancellation of a sell order prior to a rise in price will give rise to a negative implementation shortfall (i.e., the trader will be made better off by the cancellation) For Further Reference: Study Session 16, LOS 31.e SchweserNotes: Book 5, p.8 CFA Program Curriculum: Vol.6 p.22 Question #54 of 60 Determine which of the following statements concerning an algorithmic trading strategy is most incorrect An algorithmic trading strategy: A) ensures that the portfolio does not become over-concentrated (in specific assets or sectors) because it is based on quantitative rules B) involves the use of automated processes based on quantitative measures, such as the ratio of the trade size to average daily volume, to guide trading decisions C) known as simple logical participation, breaks trades into small pieces to avoid detection and to minimize market impact costs Explanation Because an algorithmic trading strategy involves mechanical rules to guide trading, one of the concerns is that the portfolio can become over-concentrated For example, the portfolio could become over-concentrated in sectors that are more liquid and easier to trade when buying, and the opposite problem could occur when selling (i.e., the most liquid assets are sold first, leaving the portfolio over-concentrated in illiquid securities) For Further Reference: Study Session 16, LOS 31.l SchweserNotes: Book 5, p.18 CFA Program Curriculum: Vol.6 p.45 Question #55 of 60 Questions 55-60 relate to Risk Management Application of Derivatives Suzanne Sheffield is the head of risk management at Elm Court Advisors (Elm) Elm is an investment management firm headquartered in Burlington, Vermont She is meeting with George Harris, a portfolio manager at Elm In preparation for the meeting, Sheffield prints out the information in Exhibit for options on BIM stock BIM is a major financial software consultancy The stock is trading at USD154.10 and the tables show a range of option expirations and strike prices for both calls and puts The put data includes each option's price and its delta Harris has two large clients Sheffield wants to discuss Both are retired senior executives of BIM He has consulted with Elm's compliance group and determines neither client is considered an insider Also, both insiders are free to trade in the stock or its options without legal restriction Client has a favorable view of BIM and holds a large block of the stock with a large unrealized capital gain Harris is considering two strategies for client In both strategies he is ignoring the long position in the stock which the client wants to retain and looking only at the performance of the options Strategy A: This is a speculative single option position to generate additional profits if the stock appreciates before the year's end (December) He will buy an at-the-money 154 December option Strategy B: Harris wants to take a position that will generate premium income if the stock price is stable for the next 14 days but without substantial downside risk in the option position Client has sold his shares of BIM and has a very negative opinion on the stock Strategy C: Harris will use a bear spread constructed with September 150 and 158 calls Exhibit 1: Options Data for BIM Inc (all values in USD1) Calls (premium) June September December (14 days) (105 days) (196 days) Strike price: 150 6.15 12.95 17.26 152 4.88 11.87 16.21 154 3.79 10.85 15.21 156 2.87 9.89 14.26 158 2.12 9.00 13.35 Puts (premium, and associated deltas) Expiration: June September December (14 days) (105 days) (196 days) Strike price: 150 1.80, -0.324 7.01, -0.435 9.73, -0.453 152 2.53, -0.408 7.90, -0.467 10.64, -0.477 154 3.43, -0.496 8.85, -0.500 11.60, -0.501 156 4.51, -0.583 9.87, -0.532 12.60, -0.524 158 5.76, -0.665 10.95, -0.563 13.65, -0.547 The current price of BIM stock is $154.10 Expiration: Harris has another client (client 3) where he has been using option strategies for a couple of years The client recently observed that it appears more of the strategies have involved long rather than short positions Harris responds that is often true and that it is just human nature that we all like positive skew and buying options can have a large payoff with limited down side risk The client asked how that can work "Doesn't there have to be an option seller?" Harris admitted he was stumped by this and now asks Sheffield to explain it Sheffield states that dealers will take the other side of the trade and typically accumulate net short positions in the options Then, they use delta hedging to offset the risk For example, a dealer might accumulate a short position in September puts on 10,000 shares of BIM at a strike price of 152 The dealer can hedge this with shares of BIM It then it gets complicated because the hedge must be rebalanced and there are second order issues that can affect the performance of the hedge Sheffield promises to follow up with Harris and provide more details later Right now, Harris wants help with a more immediate problem Client is a large retail enterprise with extensive money market investments and is considering making a loan to one of its suppliers It will be a 180-day loan at LIBOR plus 3.6% All principal and interest will be repaid at the end of the 180 days The problem is that the loan won't be made for another 60 days, and the client wants to hedge the risk that LIBOR can decline before the loan is made Sheffield says it can be done with a put on LIBOR at a strike rate of 4.5%, the current level of LIBOR The client will still benefit if LIBOR goes up but will have a floor on the effective annual rate (EAR) it will earn on the loan After the meeting, Harris realizes he forgot to ask the obvious question, "What is that EAR"? The breakeven stock price for the option in strategy A is closest to: A) 15.21 B) 154.00 C) 169.21 Explanation To capture stock price appreciation, Harris will buy the December 154 call at a cost of 15.21 per share The instructions are to ignore the stock holding This is a simple, naked long call The total initial investment is 15.21 The max loss occurs when the stock is at the strike price of 154 The option is worthless and the 15.21 premium is lost From 154, the stock must increase to reach breakeven It must increase to 154 + 15.21 = 169.21 For Further Reference: Study Session 15, LOS 29.a SchweserNotes: Book p.170 CFA Program Curriculum: Vol.5 p.286 Question #56 of 60 The most appropriate option position to achieve Strategy B is: A) a September straddle using only the 154 strike price B) a June butterfly using strike prices of 150, 154, and 158 C) a December reverse butterfly using strike prices of 152, 154, and 156 Explanation Harris wants to profit (by generating premium income) from low volatility in BIM for the next 14 days The June butterfly is the obvious strategy He will sell ATM (154 strike) calls and puts He will buy out-of-the-money puts and calls to truncate his downside risk Choosing 150 and 158 or 152 and 154 as the OTM strike prices is a choice-either set of strike prices works The narrower 152 and 154 strike prices would have provided greater downside protection, but they will cost more The September straddle is wrong for two reasons It has unlimited downside risk, a fundamental mistake A more minor issue is that it is for 105, not the desired 14 days The reverse butterfly is also wrong for three reasons The fundamental issues are that it is designed to profit from higher volatility and it is a net premium expenditure The minor issue is, again, it is not for 14 days For Further Reference: Study Session 15, LOS 29.b SchweserNotes: Book p.175 CFA Program Curriculum: Vol.5 p.293 Question #57 of 60 The max gain for the bear spread using call options in strategy C is closest to: A) 3.95 B) 4.05 C) 12.95 Explanation To construct the September bear spread using calls, Harris will sell the September 150 and buy the September 158 call He will receive 12.95 and pay 9.00 for a net receipt of 3.95 His max gain occurs if the stock declines to 150 Both options expire worthless and he keeps the 3.95 as his max gain For Further Reference: Study Session 15, LOS 29.b SchweserNotes: Book p.175 CFA Program Curriculum: Vol.5 p.293 Question #58 of 60 The initial shares of BIM required to hedge the 10,000 short September puts with a strike price of 152 is closest to: A) short 4,080 share B) long 4,670 shares C) short 4,670 shares Explanation The dealer will lose on the short put position if BIM declines A short position in the stock will produce offsetting gains The number of shares is delta × number of options The September 152 put delta is 0.467, therefore 10,000 × 0.467 = 4,670 shares are required The sign on delta is irrelevant to our analysis as option fundaments dictate we must be short shares because a short put produces loses as the underlying declines and a short position in the stock would produce offsetting gains For Further Reference: Study Session 15, LOS 29.e SchweserNotes: Book p.199 CFA Program Curriculum: Vol.5 p.333 Question #59 of 60 Rebalancing the hedge on the 10,000 short September puts with a strike price of 152 is most likely to produce an immediate net profit if the: A) BIM stock price increases and expected volatility decreases B) BIM stock price increases and expected volatility increases C) BIM stock price decreases and expected volatility increases Explanation Delta hedging a short put position requires continually rebalancing the number of shares for the hedge As the stock price changes, delta will change and shares will have to be bought or sold to maintain the hedge One of the practical problems of delta hedging a short option position (be it puts or calls) is that you will have to buy shares if they have gone up and sell shares if they have gone down There is an immediate loss on the rebalancing transaction in either direction A decline in volatility is the only way it is possible there could be a gain A decline in volatility lowers the value of both call and put options That drop in value (price) is a gain to the short put (or short call) position For Further Reference: Study Session 15, LOS 29.e SchweserNotes: Book p.199 CFA Program Curriculum: Vol.5 p.333 Question #60 of 60 Ignoring any differences in day count or compounding conventions for various types of interest rates, the minimum EAR for client 4's future loan transaction is: A) 8.1% B) less than 8.1% C) more than 8.1% Explanation The client will buy a 60-day put on 180-day LIBOR with a strike price of 4.5% If LIBOR is less than 4.5% when the client lends the money in 60 days, the client will receive on the put (at loan expiration) and that will offset any decline on the rate they can charge for the loan Ignoring the cost of the put, the client locks in the strike rate of 4.5% plus the loan spread of 3.6% for 8.1% The complicating issue in EAR calculation is that the option requires an immediate expenditure When that premium cost is considered, the minimum EAR the client can earn must be less than 8.1% For Further Reference: Study Session 15, LOS 29.c SchweserNotes: Book p.187 CFA Program Curriculum: Vol.5 p.312 ... years, 2. 6% years, 2. 4% 3. 5 years, 2 .3% years, 2. 1% years, 3. 6% 6.5 years, 3% years, 3. 5% 13. 5 years, 5% 10 years, 4.1% 11 years, 4.6% Cash flow yield 3. 20 % 3. 26 % 3. 59% 3. 02% BPV 7,476 7 ,21 5 7,474... Annual Coupon Maturity 1.98% March 20 19 2. 05% September 20 19 2. 25% March 20 20 2. 48% September 20 20 2. 70% March 20 21 Finally, Wilson seeks advice regarding a GBP 22 million of fixed-to-floating rate... (0. 027 /2) ) = 2, 940 ,30 6 The coupon on this bond will be 2, 940 ,30 6 × (0. 027 / 2) = 39 ,694 The Sept 20 20 coupon on this bond will pay off part of the Sept 20 20 liability, leaving 2, 675,000 - 39 ,694