CFA Level III Mock Exam 2 June, 2018 Revision 1

FinQuiz.
com
CFA Level III Mock Exam 2
June, 2018
Revision 1
Copyright © 2010-2018. FinQuiz.com. All rights reserved. Copying, reproduction

or redistribution of this material is strictly prohibited. [email protected].
CFA Level III Mock Exam 2 – Solutions (PM)
FinQuiz.com –2nd Mock Exam 2018 (PM Session)
Questions Topic Minutes

1-12 Ethical and Professional Standards 36
13-18 Alternative Investments 18
19-24 Risk Management 18
25-30 Risk Management Application of Derivatives 18
31-36 Equity Investments 18
37-42 Fixed Income 18
43-48 Monitoring and Rebalancing 18
49-54 Risk Application of Swap Strategies 18
55-60 Global Investment Performance Standards 18
Total 180
FinQuiz.com © 2018 - All rights reserved. 2

Questions 1 through 6 relate to Ethical and Professional Standards
Wilshire Investment Case Scenario
Wilshire Investment (WI) is a U.S. based investment management firm providing wealth
management services to institutional clients. The firm primarily invests in traditional
asset classes such as equity and fixed income.
Holme’s Trust Foundation (HTF) is WI’s institutional client. Its portfolio is being
managed by Tony Monroe. Monroe is evaluating commodity futures in Rigea, an Eastern
European country, for HTF’s investment portfolio. WI does not have expertise with
commodity futures. Therefore, Monroe has made arrangements with an external portfolio
manager, Raul Davis. Under the arrangement Davis and WI will share any commissions
generated.
In addition to their agreement, Davis has invited Monroe to Rigea. As a signal of good
gesture, Davis’s firm has offered Monroe to pay for commercial transport and hotel
accommodation. Monroe has declined the hotel accommodation offered but has not
responded to the transport offer.
Jean Lowe is a research analyst serving WI’s research wing. Lowe is currently analyzing
hedge funds in Rigea. Monroe has asked Lowe to avoid hedge funds in Rigea because he
believes they will not generate attractive returns. Lowe remains convinced that the hedge
funds are attractive investment opportunities. After thorough research and analysis, Lowe
recommends the assets class and compels Monroe to invest his clients’ funds. Six months
later, the investment generates a strong alpha.
Prior to serving WI, Monroe served another portfolio management firm at which he was
extremely popular. In order to generate the same level of popularity at WI, Monroe
decides to contact a fellow portfolio manager at his previous workplace to provide
contact details of clients who are no longer invested with the firm. The firm continues to
store client details on its database.
After his successful yet uncertain venture into hedge funds, Monroe contemplates
increasing client portfolio allocations to modern alternative investment classes,
particularly buyout funds and venture capital funds. In describing the new investment
opportunity to his clients, he states:

Statement: “Buyout fund investments are virtually risk-free as the associated funds
are established companies; the latter category is highly risky but will
generate substantial returns if the associated venture survives.”
Octavia Richards, CFA, is a broker serving East End Brokers (EEB). On behalf of EEB,
she is forming an arrangement whereby any requested research will be directed to EEB in
exchange for providing new clients to Monroe. The commission charged by Richards is
higher than average; however, he believes doing business through Richards will allow WI
to gain access to investment funds with very high investment requirements and improve
client accounts’ results as well as meet their investment needs. He intends to disclose the
arrangement to clients if successful.
Curious about the success of the hedge fund, Monroe decides to investigate the source of
the outperformance. During his analysis and discussions with local analysts, Monroe
comes to the conclusion that the fund may be victim to survivorship bias. He presses fund
management who refuse to provide any information on the matter.
1. In response to the commercial transport offer made by Davis’s firm, Monroe’s

best course of action would be to:
A. accept the offer without any disclosure to his supervisor.

B. accept the offer with disclosure to his supervisor.
C. decline the offer.
Correct Answer: C
Reference:
CFA Level III, Volume 1, Study Session 1, Reading 2.
Standard I (B) Independence and Objectivity requires members and candidates to

avoid gifts, benefits, and compensation arrangements that compromise their own
or another’s independence and objectivity.
Best practice dictates that members and candidates use commercial transportation
rather than accept paid travel arrangements from an outside company. Should
commercial transportation be unavailable, members and candidates may accept
modest travel arrangements. Given that commercial transportation is available,
Monroe’s best course of action would be to decline the offer.

2. By issuing the research report, has Lowe violated any Standards of Professional
Conduct?
A. No.
B. Yes, she has violated IV (A) Loyalty by not respecting Monroe’s
instructions.
C. Yes, she has violated VI (A) Disclosure of conflicts by failing to disclose
the difference in opinion.
Correct Answer: A
Reference:
CFA Level III, Volume 1,Study Session 1, Reading 2.
Lowe has not violated any standards by issuing the research report. Standard I (B)
requires analysts to engage in thorough, independent and unbiased analysis.
Furthermore, analysts should ensure that the research reflects their independent
and objective judgment.
Given that there are no conflicts of interest, Lowe is not required to provide any
disclosures; standard VI (A) has not been violated.
3. By requesting access to client records, has Monroe violated any Standards of

Professional Conduct?
A. No.
B. Yes, he has violated IV (A) Loyalty.
C. Yes, he has violated III (E) Preservation of Confidentiality.
Correct Answer: B
Reference:
CFA Level III, Volume 1,Study Session 1, Reading 2. .
Standard IV (A) Loyalty requires members and candidates to act for the benefit of
their employer and not divulge confidential information, amongst other actions.
Departing employees must not engage in the misappropriation of clients or client

lists without their employer’s consent. By requesting access to client records,
which continues to remain stored in the firm’s database, Monroe has violated the
loyalty standard. Even if the clients are no longer invested with the firm, Monroe
is in violation of this standard as the records are a property of the firm.

4. In describing the proposed investment classes to his clients, Monroe has most
likely violated:
A. I (C) Misrepresentation.
B. III (D) Performance Presentation.
C. V (B) Communication with Clients and Prospective Clients.
Correct Answer: A
Reference:
Standard I (C) Misrepresentation requires members and candidates to not

knowingly make any misrepresentations relating to investment analysis,
recommendations, actions, or other professional activities. The standard prohibits
members and candidates from guaranteeing a rate of return on volatile
investments. Monroe has violated this standard by disclosing to clients that
buyout funds are risk-free. Although these funds are less risky in contrast to
venture capital funds, they cannot be classified as risk-free.
Standard III (D) Performance Presentation requires members and candidates to

make reasonable efforts to ensure investment performance information is fair,
accurate, and complete. Given that Monroe is not presenting investment
performance to his clients, he is not in violation of this standard.
Standard V (B) Communication with Clients and Prospective Clients requires

members and candidates to disclose the basic format and general process of the
investment process used to select securities; use reasonable judgment in
identifying which factors are important to their investment analysis,
recommendations, or actions; and distinguish between fact and opinion is the
presentation of investment analysis and recommendation. Monroe is not in
violation of this standard.
5. By undertaking the brokerage arrangement with EEB and Richards, Monroe has:
A. violated standard III (A) Loyalty, Prudence and Care.

B. violated standard III (C) Suitability.
C. not violated any Standards of Professional Conduct.

Correct Answer: A
Reference:
Standard III (A) Loyalty, Prudence and Care requires members and candidates to
act with reasonable care and exercise prudent judgment. Members and candidates
have a duty of loyalty to their clients and must act for their benefit and place their
interests before their own. By paying high commissions, Monroe will gain access
to investment opportunities not otherwise available. In this regard, he has not
violated the standards. However, by failing to disclose the arrangement to client
accounts, he is in violation.
Standard III (C) Suitability requires members and candidates to determine the
suitability of an investment to the client’s financial situation. Given that the
investment opportunity will help improve account performance, he is not in
violation of this standard.
6. Based on Monroe’s suspicions regarding the hedge fund, his best course of action
would be to:
A. consult his supervisor.

B. consult WI’s whistleblowing policy.
C. discontinue his investment arrangement with the hedge fund.
Correct Answer: A
Reference:
Monroe’s best course of action would be to consult his supervisor. Given that the
hedge fund has engaged in performance misrepresentation (by artificially inflating
performance), Monroe should consult WI’s whistleblowing policies if
consultation with the supervisor is unsuccessful.
In an extreme scenario, Monroe may consider discontinuing his investment

arrangement with the hedge fund.

Questions 7 through 12 relate to Ethical and Professional Standards
Alliance Limited Case Scenario
Alliance Limited (AL) is an asset advisory firm situated in Chicago, providing

investment advisory services to private wealth clients. To improve its standing in the
national market, senior officer Ali Reza has recommended AL adopt the CFA Institute
Asset Manager Code. He has drafted compliance policies in three different areas which
will assist the firm in gaining compliance.
Personal Trading: Any employee intending to trade a security on AL’s watch list must
seek prior approval from the compliance officer if the trade exceeds the $1,000 limit.
Backup records: To ensure the safety of account information, all pertinent information
will be stored on a backup computer system in electronic form only.
The system will be located in AL’s headquarters; an offsite system is
currently not within the firm’s budget.
Fee Disclosures: All managers are encouraged to disclose all actual gross- and net-of-
fees performance results as well as an itemization of charges. The
procedure used to determine contingent fees must be disclosed upon
request.
After drafting the policies, Reza engages in a discussion with AL’s senior portfolio
manager, Rob Martin. Martin manages the account of Martha Flower, a wealthy real
estate developer who is operating in Florida. Martin has long suspected Flower of
embezzling her clients’ funds. After thorough investigation, Martin is now certain and
fears a substantial portion of her portfolio may be funded with these funds. He is
uncertain of what action to take.
Sylvia Bath, CFA, a portfolio manager serving AL, manages the investment account of
Peter Blake. Blake is one year away from retirement and will depend entirely on his
retirement income to provide for his modest lifestyle. His investment portfolio has a
current equity allocation of 10%, comprising entirely of domestic large-cap value stocks,
with the remainder in fixed income securities. Due to the current cyclicality of the U.S.
economy and to protect her client’s portfolio, Bath has decided to sell the value stocks
and purchase large-cap growth stocks in the same proportion. Since this action was taken
to protect Blake’s portfolio, she does not believe informing Blake was necessary.

Later that evening, Bath receives an invitation to attend a charitable event from Blake.
Among the invitees include professionals from the investment industry. Believing that the
event will provide the opportunity to bring more business to AL, she accepts the
invitation after informing her supervisor in writing. At the event, the attendees engage in
various activities for cash prizes. Blake wins two cash prizes worth $50 each, which she
intends to disclose to her supervisor.
The following day Bath has been asked to review the performance record and resume of
Ramos Davis, a candidate applying for the position of computer systems technician.
Davis was fired from Cappa Inc., a large investment bank, after being wrongly accused of
negligent supervision of the bank’s backup computer system, which subsequently led to
its destruction in a site fire.
7. Which of the following policies is most likely consistent with both the required
and recommended standards of the CFA Institute Asset Manager Code? The
policy concerning:
A. Personal trading only.

B. Backup records only.
C. neither personal trading nor backup records.
Correct Answer: B
Reference:
The policy concerning Backup records is consistent with the Asset Manager Code
while that concerning Personal trading is not. The CFA Institute Asset Manager
Code recommends that employers place restricted securities on a restricted or
watch list. Any employees wishing to trade securities should be required to seek
prior approval. However the Code does not specify a dollar amount.
The CFA Institute Manager Code requires each firm to establish a disaster
recovery system; the size, nature and complexity of which depends on the size of
the organization. Managers should consider having adequate backup records,
preferably offsite, for all account information. Given that an offsite system is not
within AL’s budget, an on-site system is consistent with the Code’s
recommendations. Furthermore, storing account information in electronic form is
consistent with the Code.

8. Which of the following statements is most likely correct with respect to the Fee
Disclosures policy?
A. The procedure used to determine contingent fees must be disclosed

regardless of client request.
B. Managers should be encouraged to disclose either gross- or net-of-fees
results but not both.
C. The policy is in compliance with the required and recommended standards
of the Asset Manager Code.
Correct Answer: A
Reference:
With respect to fee disclosures, Managers should disclose both gross- and net-of-
fees returns. Managers are required to disclose the procedures for determining
contingent fees regardless of client request.
9. In order to adhere with the requirements and recommendations of the Asset

Manager Code, Martin’s best course of action with respect to his knowledge on
Flower’s activities is to:
A. inform his supervisor.

B. inform local authorities.
C. keep any information gained during the investigation confidential.
Correct Answer: A
Reference:
A Manager’s duty to keep client information confidential does not override

his/her duty to report illegal activities concerning client accounts to the
appropriate authorities. Because he is not completely certain of whether Flower’s
portfolio is funded using the stolen funds, Martin’s best course of action would be
to inform his supervisor. Together, they can determine the best course of action.

10. By diverting Blake’s funds to large-cap growth stocks, has Bath violated the
Asset Manager Code?
A. No.
B. Yes, she should have informed Blake after implementing the change.
C. Yes, she should have informed Blake of the proposed change before
taking investment action.
Correct Answer: C
Reference:
Bath should have informed Blake of the proposed change before diverting his
funds to large-cap growth stocks. According to the Asset Manager Code,
Managers must provide adequate information to clients before any material
change. If the Manager makes a material change in investment strategy or style,
clients should be given enough time to consider the proposed changes. Regardless
of the justification, a shift from value to growth stocks reflects a change in
investment style which requires disclosure.
11. With respect to informing her supervisor of the invitation and accepting the cash
prizes, are Bath’s actions consistent with the Asset Manager Code?
A. No.
B. Yes.
C. Only with respect to the cash prizes.
Correct Answer: B
Reference:
Bath is not in violation of the Code when informing her supervisor of the
invitation and accepting the cash prizes. The Asset Manager Code prohibits
Managers from accepting any gifts or entertainment that could impair their
independence, objectivity or loyalty to clients. Cash gifts are prohibited.
By informing her supervisor in writing of the charitable event invitation, she is

not in violation of the Code. Furthermore, she received the cash prizes due to her
participation in the activities at the event. Since she has earned the cash prizes,
she in not in violation of the Code.

12. When hiring Davis as systems technician, which of the following actions will be
required by AL to comply with the Asset Manager Code?
A. Ensure Davis is qualified.

B. Consider another candidate for the position.
C. Provide disclosure of the details of his employment termination to clients.
Correct Answer: A
Reference:
AL is required to ensure Davis is qualified enough to handle its computer

systems. Davis has not demonstrated any actions or engaged in activities
adversely affecting his professional integrity during the incident at Cappa Inc.;
therefore AL will not be required to disclose the details surrounding his
employment termination to clients.

Questions 13 through 18 relate to Alternative Investments
Victor Moreno Case Scenario
Victor Moreno, CFA, is an alternative investment analyst recently hired by Northbay

Asset Management (NAM), a U.S. based firm. NAM primarily deals with equity and
fixed income. Its equity securities are benchmarked to the S&P 500 index while fixed
income securities use the Lehman Aggregate Bond Index as benchmark. Moreno is
exploring commodities, private equity and real estate as potential asset classes for client
portfolios.
Dmitri Anderson, portfolio manager at NAM, asks Moreno to justify each of the three
proposed asset classes. Moreno shares the following knowledge with Anderson:
Real estate: Although both types of real estate investments, direct and indirect, offer
diversification benefits, direct real estate is a suitable asset class for both
the informational advantaged and disadvantaged investor.
Commodities: When the inflation outlook is poor, cyclical commodities provide an

effective inflation hedge.
Private equity: They are similar to seasoned public equity as they exhibit similar return
dispersion and help enhance long-term return.
Anderson has heard that private equity investments can be direct or indirect. He asks
Moreno to describe the indirect venture capital form to him. Moreno responds by
describing the structure, process and drawbacks of the asset class to Anderson.
Structure: Indirect venture capital investments can be structured as limited liability

companies or limited partnerships with life extension options.
Process: Investors deposit their funds in a centralized pool which are subsequently
deployed by a managing director for investments.
Drawbacks: Partners suffer from limited liability and double taxation.
Anderson has also heard of dividend recapitalization often being associated with buyout
funds. He asks Moreno what is meant by the term.

After concluding his discussion with Anderson, Moreno analyzes an investment in

Decorum Limited (DL), a furniture manufacturer. DL is a recently established private
venture which has managed to receive financing from two external parties. It intends to
use the funds to develop its products. DL will commence commercial manufacturing in
two days time. It has sold product samples to a selected number of customers, who are
extremely pleased with their design and quality.
Moreno estimates that if DL were publically traded, its value would have been $320
million. On behalf of NAM, Moreno intends to acquire a 15% non-marketable minority
stake in DL. A minority interest and a marketability discount of 28% and 36%,
respectively, are deemed appropriate for the manufacturer.
Larry Armstrong is a junior portfolio manager with some knowledge on alternative

investments. He is exploring an exchange traded fund (ETF) which utilizes a futures
trading strategy to manage exposure to the petroleum industry. Armstrong believes that
NAM client portfolios should benefit from participation in the commodity ETF.
13. Based on the justifications provided for the three asset classes, Moreno is most
likely accurate with respect to:
A. commodities only.
B. real estate and commodities only.
C. neither of the three asset classes.
Correct Answer: A
Reference:

Moreno is not accurate with respect to the justifications provided on real estate
and private equity but is accurate with respect to commodities
Although real estate as an asset class provides diversification to a stock/bond

portfolio, direct real estate investments are only suitable for the informational
advantaged investor. Direct real estate investments have low information
transparency.
Storable commodities that are directly linked to the intensity of the economic
activity such as energy have superior inflation-hedging capabilities.
Private equity has a greater return dispersion relative to seasoned public equity;
therefore there are more risky relative to the latter asset class. Private equity does
serve as a long-term return enhancer but the former statement invalidates the
justification.
14. When describing indirect venture capital funds, Moreno is correct with respect to
their:
A. structure.
B. process.
C. drawbacks.
Correct Answer: A
Reference:
Moreno has correctly described the structure of private equity funds. Private
equity funds can be structured as limited partnerships (LP) or limited liability
companies (LLC) with an expected life of 7-10 years and an option to extend the
life for another 1-5 years.
Monroe has incorrectly described the investment process of private equity funds.
Limited partners commit a specific investment to the general partner (the
managing director) who subsequently calls the capital to make investments.
Private equity funds usually do not maintain a pool of uninvested capital.
Monroe has incorrectly described the drawbacks of investing in private equity

funds. An advantage of investing in LPs or LLCs is that investors avoid double
taxation and do not bear any liabilities beyond the amount of their investments.
That is, they enjoy having limited liability.

15. With respect to Anderson’s query, the most appropriate response is that dividend
recapitalizations:
A. enable buyout funds to recoup their acquisition costs in a few years time.
B. allow for the restructuring of operations and improvement of management.
C. are used as an exit route for private equity funds, buyout and venture
capital.
Correct Answer: A
Reference:
A dividend recapitalization is used as an exit route for buyout funds only.

Dividend recapitalization allows buyout funds to recoup most or all of the cash
used to acquire companies in two to four years.
16. Based on the information provided on DL, the private equity firm is most likely in
its:
A. seed stage.
B. early stage.
C. second stage.
Correct Answer: B
Reference:
DL is in its early stage of development in general and the start-up stage in

particular. Companies at this stage are moving into production and earn their
initial revenues. Since DL will enter into commercial production shortly and has
sold its initial product samples to customers, its stage of development can be
categorized as early. Companies in the start-up stage require financing for product
development and initial marketing.

17. The value of the marketability discount applied to NAM’s minority stake in DL is
closest to (in $ millions):
A. 12.44.
B. 13.44.
C. 17.28.
Correct Answer: A
Reference:
All calculations are in millions.

Marketable controlling interest position = 15% × $320 = $48
Minority interest discount = 28% × $48 = $13.44
Marketable minority interest = $48 – $13.44 = $34.56
Marketability discount = $34.56 × 36% = $12.44
18. Which of the following does not reflect an advantage of Armstrong’s proposed
ETF investment?
A. Effective exposure to global energy prices.

B. Investors need not bear physical storage costs.
C. Small investors can gain exposure to commodities.
Correct Answer: A
Reference:
A commodity ETF reflects an indirect commodity investment. The drawback

associated with this type of investment is that they do not provide effective
exposure to the underlying commodity. This is because many corporations hedge
a major portion of their commodity risk thereby partially or fully eliminating
exposure.
An advantage of indirect commodity investments is that investors can avoid

physical storage costs, which are incurred when physically holding a commodity
(direct commodity investments).

An advantage particularly associated with commodity ETFs is that small investors

can participate and access the commodity market.

Questions 19 through 24 relate to Risk Management
Selena Roberts Case Scenario
Selena Roberts, CFA, is the risk management head at RX Associates, a U.S. based asset
management firm. Roberts has currently three tasks on hand.
1. Analyzing the risks associated with an investment in Swami, a Northern African

emerging market country.
2. Analyzing the impact of currency movements associated with the Swami investment
on client portfolio risk and return and ascertaining the emphasis and degree of
currency hedging based on RX’s expertise.
3. Determining the most appropriate methodology to use for allocating capital to RX’s
derivatives specialist, Paul Rodriguez.
Task 1: Analyzing the Risks Associated with the Swami Investment
Swami exports lumber and cotton on a global scale. Roberts is particularly interested in
Rivia Ltd., a local cotton exporter. A majority of Rivia’s local sales are on credit while
50% of its foreign sales are on credit. Rivia does not believe in credit financing and its
assets and supplies are purchased using cash. To hedge it foreign currency exposures,
Rivia engages in currency swaps and utilizes currency options traded on informal trading
platforms. Swami’s debt to foreign currency reserves is currently 2:1 and the country has
a significant level of foreign debt outstanding.
Task 2: Analyzing the Impact of the Investment on Portfolio Risk and Return and
Determining the Degree/Emphasis of Currency Hedging
For her analysis of the impact of the investment on portfolio risk and return, Roberts
collects information concerning a hypothetical portfolio held by a U.S. investor. The
portfolio’s performance is measured in terms of the Swami Pound (SWP) and the
portfolio comprises 40% of the SWP-denominated asset and 60% of the USD
denominated asset. The firm has little expertise in managing currency exposures. To
ascertain the degree/emphasis of currency hedging, Roberts has devised two alternative
strategies:
Strategy 1: Select a benchmark which has no foreign exchange exposure and if the
manager holds a view concerning the SWP, allow currency exposure to drift
±15% from the benchmark. If the manager lacks market conviction, avoid
currency exposures.

Strategy 2: Add alpha to client portfolios by taking currency risks and avoid
maintaining neutral currency exposures for extensive time periods.
Exhibit 1
Performance of a Hypothetical Portfolio Comprising
40:60 Swami- and US-Denominated Assets
Expected (Next
Current Year)
SWP/USD 85.60 82.90
SWP-denominated asset value* 45.60 50.20
USD-denominated asset value* 10.00 8.50
s (RFX ) 3% 4%
s (RFC ) 2% 1%
P[s (RFX ), s (RFC )] 0.4 0.4
*In tens of thousands of units of foreign currency
After evaluating the two strategies, she joins Jeremy Watson, specialist at RX, for lunch
and discusses the second one with him. Watson makes the following comment:
Comment: I believe we are better leaving out exposure to the SWP unhedged. This is
because adding unhedged foreign currency exposure should not affect
portfolio returns in the long run.
Task 3: Allocating Capital to Rodriguez
Rodriguez often takes positions in options and specializes in creating synthetic products.
In response to Rodriguez’s impressive performance, Roberts has decided to increase the
specialist’s capital allocation. She will utilize either notional position limits or VAR-
based position limits for the task. However, she is concerned that the two methodologies
may not be suitable for Rodriguez.
19. By investing in Rigia, RX will least likely be exposed to:
A. sovereign risk.
B. settlement risk.
C. interest rate risk.
Correct Answer: C
Reference:

By investing in Rigia, RX will be exposed to sovereign risk and settlement risk

but not interest rate risk.
Swami’s government is currently maintaining a debt to foreign reserves ratio of

2:1. This suggests its ability to take risk is low. Furthermore, foreign investors
may start to pull their investments out of Swami if the situation deteriorates. Thus
RX is exposed to sovereign risk.
RX is exposed to settlement risk. This is because Rigia engages in currency swaps

which do not feature netting arrangements. In addition, over-the-counter currency
options are exposed to settlement risk.
There is no information to indicate that RX will be exposed to interest rate risk.
20. Using Exhibit 1, the expected return on the hypothetical portfolio is closest to:
A. – 3.53%.
B. + 6.62%
C. + 13.67%.
Correct Answer: A
Reference:
CFA Level III, Volume, Study Session 9, Reading 19.
Expected domestic return = {0.40[1/(82.90 ÷ 85.60)](50.20/45.60) +

0.60(8.50/10.00)} – 1 = – 0.0353 or – 3.53%
21. Using Exhibit 1, the expected risk of the domestic currency return associated with
the Swami investment is closest to:
A. 2.00%.
B. 4.22%.
C. 4.49%.
Correct Answer: C
Reference:
CFA Level III, Volume, Study Session 9, Reading 19.
s 2 (RDC ) = (0.04) 2 + (0.01) 2 + 2(0.04 )(0.01)(0.4)

s (RDC ) = 0.0449 or 4.49%

22. Strategy 1 describes a strategic decision comprising:
A. discretionary hedging only.

B. a combination of discretionary and passive hedging.
C. a combination of discretionary hedging and active currency management.
Correct Answer: A
Reference:
Strategy 1 describes a discretionary hedging strategy. This strategy permits

limited discretion allowing the hedge ratio to drift to exploit currency exposures.
However, if the manager lacks any market conviction the market neutral position
for this type of hedger is to have no meaningful currency exposures.
Passive hedging attempts to keep portfolio currency risk exposures close to the
benchmark and keep these exposures as neutral as possible. While active currency
managers exercise discretional opinion to exploit market views adding alpha
through successive trading, leaving actual portfolio exposures near zero for
extended periods is inconsistent with this strategy.
23. Watson’s comment is least likely based on:
A. mean reversion.
B. regret minimization.
C. purchasing power parity (PPP).
Correct Answer: B
Reference:

Watson’s comment is based on PPP which asserts that adding unhedged currency
exposures should not affect portfolio returns in the long run as currencies
demonstrate a tendency to mean revert to a fair value equilibrium level or
historical average.
Watson’s comment is not based on regret minimization which is the dilemma

between hedging and missing out on an advantageous currency movement or
leaving a foreign currency-asset position unhedged and incurring a foreign
currency loss.
24. Which of the following statements least accurately explains why the
methodologies selected by Roberts are unsuitable for Rodriguez?
A. Rodriguez trades options rendering VAR-based position limits unsuitable.

B. Notional position limits are not a suitable standalone capital allocation
methodology.
C. VAR-based position limits will not effectively capture the effects of
offsetting risks related to synthetic products.
Correct Answer: C
Reference:
VAR-based risk measures generally assume normality. Therefore, they are not
suitable for evaluating the riskiness of instruments with non-normal return
distributions such as options. Allocating capital based on VAR is inappropriate
given the types of instruments traded by Rodriguez.
Notional position limits are seldom a sufficient capital allocation method because
individuals may be able to work around the limits using other assets to replicate a
position (in Rodriguez’s case, his use of synthetic transactions renders this
measure of little use on a standalone basis).
As mentioned above, notional position limits will not help effectively capture the
effects of offsetting risks with respect to the synthetic transactions undertaken.

Questions 25 through 30 relate to Risk Management Application of Derivatives
Monica Jose Case Scenario
Monica Jose, CFA, is a risk manager at Alpha&Ceta Wealth Management (ACWM). She
is currently addressing the concerns of four clients, Dallas Inc.; Walsh & Peters
Associates (WPA); Tamara Berg; and Frank O’Conner.
1. Dallas Inc. is a multinational manufacturer of home flooring. To finance its Japanese

operations it has issued a three-year dual currency bond with a face value of ¥450
million or $5.625 million with a coupon rate of 5.0%. To exploit arbitrage
opportunities, Jose has purchased a US$ denominated bond issued by a U.S.
manufacturer with a coupon rate of 5.25% and a face value of $5.625 million. It has
also engaged in a currency swap with yen and US$ swap rates of 5.0% and 4.5%,
respectively and notional principals of ¥450 million and US$5.625 million. The
current exchange rate is ¥80/US$.
2. WPA is a consultancy firm managing its own defined benefit pension plan. In light of
the plan’s strong overfunded position, Donna Marshall, the plan’s investment officer,
has expressed an interest in international equities. After extensive research, Jose
drafts a proposal to Marshall.
Proposal: I strongly recommend purchasing at-the-money calls and puts on Russian

stocks. Currently the Russian market is steady. According to my forecasts
all that can change if the government announces a restrictive monetary
policy. Although such a policy change is presently unanticipated by
investors, I strongly believe the policy will be implemented increasing
market volatility beyond expectations.
3. Tamara Berg is a wealthy entrepreneur. She has expressed her desire for exposure to
securities with inverse feature. Jose recommends investment in an inverse floater with
a coupon rate of 15% – Libor. Berg is concerned about the possibility of a rise in
interest rates resulting in a zero cash flow. In response to Berg’s concerns, Jose makes
the following comments:
Comment 1: By purchasing at-the-money calls, your portfolio’s exposure to negative

interest rates will be significantly reduced.

Comment 2: If you want to ensure that the interest rate you receive is positive at all
times, the 15% rate on the floater will need to be reduced to a lower
level.
4. Frank O’Conner is the owner of a national tire manufacturing business. To fund

business expansion, he has received a 4-year $12 million loan from a local bank.
Interest will be paid semi-annually at a rate of 200 basis points over the current
LIBOR. O’Conner is wary of rising interest rates and has come to Jose for a solution.
Jose recommends the purchase of a series of 6-month caplets with expiration dates of 15
October and 15 April for the next year, and so on for the next five years, and an exercise
rate of 11%. The number of days in and LIBOR during the first three settlement periods
has been compiled by Jose (Exhibit 1). Current LIBOR is 10% and the cap premium is
$65,000.
Exhibit 1
Number of Days in Settlement Period
And LIBOR Term Structure
LIBOR
Settlement Period Number of Days
(%)
15 October 183 9.25
15 April 182 11.50
15 October 183 11.80
25. Under the currency swap, Dallas Inc. will pay interest of (in millions):
A. ¥0 and receive interest of $0.30.

B. $0.25 and receive interest of ¥22.50.
C. ¥22.50 and receive interest of $0.25.
Correct Answer: B
Reference:

Since Dallas Inc. is paying interest in Yen on the dual currency bond, it will need
to receive yen interest on the currency swap. Therefore, it will pay US$ interest.
Interest paid = $5.625 million × 4.50% = $0.25 million.
Interest received = ¥450 million × 5.0% = ¥22.5 million
26. Dallas Inc. is concerned that the transaction will increase its exposure to credit
risk. Which of the following parties will expose the manufacturer to credit risk?
A. The swap dealer only.

B. The party issuing the dollar-denominated bond only.
C. The swap dealer and the party issuing the dollar-denominated bond.
Correct Answer: C
Reference:
Dallas Inc. is exposed to credit risk with regard to the swap dealer and the
party issuing the dollar-denominated bond; either of the two parties can
default. The latter party is a manufacturer and is unlikely to be default-free.
27. One year into the dual currency bond agreement, the Yen starts to rise sharply.
Dallas Inc. would like to exit its position using a synthetic transaction. The exit
transaction will most likely involve:
A. the sale of a dual currency bond paying interest in dollars and principal in
Yen.
B. the purchase of a yen denominated bond and the purchase of a currency
swap.
C. the purchase of a dollar denominated bond and the purchase of a currency
swap.
Correct Answer: C
Reference:

Dallas Inc. is currently short the dual currency bond. In order to terminate its
position, it will need to enter into an offsetting position. The exit transaction will
involve the purchase of a dollar-denominated bond and the purchase of a currency
swap requiring payments in dollars and paying Dallas Inc. interest in yen.
28. The options strategy being recommended to WPA is most likely known as a:
A. collar.
B. straddle.
C. butterfly spread.
Correct Answer: B
Reference:
The options strategy being recommended to WPA is known as a straddle. A

straddle strategy involves the purchase of calls and puts at the same exercise price
with the same time to expiration. These strategies are used to exploit greater than
expected market volatility. The proposed monetary policy change as well as her
forecasts of market volatility differs considerably from investor views.
Butterfly spreads are used by investors when expectations for volatility are low.
Collars are not used in this context.
29. Are the comments made by Jose most likely correct?
A. Yes.
B. Only with respect to Comment 1.
C. Only with respect to Comment 2.
Correct Answer: A
Reference:
Jose is correct with respect to Comments 1 and 2. In order to protect the lender
from rising interest rates associated with inverse floaters, an interest rate cap will
need to be purchased by the lender. However, the cost of the cap will reduce the
interest received on the note. Thus, the lender will need to accept a rate lower than
15%.

30. The effective interest due on the first caplet payoff date is closest to:
A. $564,250.
B. $682,500.
C. $712,833.
Correct Answer: B
Reference:
The first caplet expires on October 15 but will make a payment on April 15.
Loan interest = $12,000,000 × (9.25% + 200 basis points) × 182/360

= $682,500
Caplet payoff = $12,000,000 × max(0,9.25% ─ 11.00%) × 182/360 = 0
Effective interest = $682,500

Questions 31 through 36 relate to Equity Investments
Joyce Walker Case Scenario

Joyce Walker is a portfolio manager at South-March Associates, an asset advisory firm.
Walker is managing the equity portion of Lakehouse Limited Endowment’s (LLE) policy
portfolio. The portfolio is currently invested in international ex-US equities and is being
managed by four individuals – Gina Eco, Blake Morris, Carl Smith, and Mehmet Akhtar.
Exhibit 1 displays details concerning the funds managed by the individuals.
Exhibit 1:
Equity Portion of LLE’s Policy Portfolio
Eco Smith Morris Akhtar
Asset under management ($ millions) 5.0 2.5 3.5 2.0
Expected alpha 0.0 5.5% 7.2% 10.1%
Expected tracking risk 0.0 3.6% 6.5% 8.1%
Dividend yield 0.0 2.1 1.3 1.6
P/E 16 10 14 25
P/B 6.0 4.3 0.7 15.8
5-year consensus expected earnings growth 5.0% 3.1% 6.8% 10.5%
Annualized manager’s return 15.1% 22.1% 12.7% 17.0%
Annualized manager’s normal benchmark
return* 15.1% 18.0% 13.7% 16.1%
Annualized investor benchmark return* 15.1% 12.1% 11.6% 17.3%
Equity investment style N/A Value Value Growth
*All returns are gross of management fees
Walker’s colleague, Levin Alexei, is reviewing the allocation presented in Exhibit 1. He

tells Walker that a true/misfit distinction between portfolio risk and returns is crucial. He
supports his statement by providing the following justifications:
Justification 1: The true/misfit distinction will allow for an optimized allocation to

managers such that misfit risk is eliminated and true active returns are
maximized.
Justification 2: The distinction allows for the performance appraisal of active managers.

Following Alexei’s advice, Walker compiles details concerning the benchmarks used for
each of the four managers (Exhibit 2).
Exhibit 2:
Portfolio and Investor Benchmarks
Eco Smith Morris Akhtar
MSCI US MSCI World MSCI World
Manager’s normal Broad Market ex-US Value ex-US Value MSCI World
benchmark Index Index index ex-US index
Investor’s benchmark MSCI US MSCI World
Broad Market MSCI World MSCI World ex-US
Index ex-US index ex-US index Growth index
Following his analysis of the equity allocation, Walker holds a meeting with LLE’s chief
executive. During the meeting the executive entrusts Walker with the management of $10
million which the fund has received from a wealthy donor. The executive shares his
desire for an active equity exposure to emerging market equities. However Walker has
little expertise with respect to this equity category.
Walker is of the opinion that exposure to the U.S. equity market can be highly profitable
and devises a strategy to manage the $10 million by undertaking a long futures position
in the S&P500 equity index. For the emerging market equity allocation, he narrows down
his selection to Octavia Wilde, an active manager benchmarked to the MSCI Emerging
Markets Index (EMI). Wilde undertakes a short futures position in the MSCI EMI.
31. Based on the information presented in Exhibit 1, Morris’s value investment style
can most likely be classified as:
A. low P/E.
B. contrarian.
C. high dividend yield.
Correct Answer: B
Reference:

Morris’s value investment style is classified as contrarian as his portfolio’s P/B

ratio is below 1.0 and the lowest relative to those of the three equity managers. A
contrarian investor will search for stocks which are subject to problems and are
trading at low P/Bs, frequently below 1.0. Furthermore, a low P/B ratio is
consistent with a value bias.
32. The information ratio earned on LIE’s equity allocation is closest to:
A. 0.9.
B. 1.2.
C. 2.0.
Correct Answer: C
Reference:
To determine the information ratio earned on LIE’s equity allocation, a weighted

average information ratio is calculated. To calculate this ratio, the weights
assigned to each manager, portfolio active return, and active risk must be
determined.
All $ calculations are in millions.
Total assets under management ($) = 5.0 + 2.5 + 3.5 + 2.0 = 13.0
Weight assigned to Eco = 5.0/13.0 = 0.384615

Weight assigned to Smith = 2.5/13.0 = 0.192308
Weight assigned to Morris = 3.5/13.0 = 0.269231
Weight assigned to Akhtar = 2.0/13.0 = 0.153846
Portfolio active return = (0.384615)(0) + (0.192308)(5.5) + (0.269231)(7.2) +

(0.153846)(10.1) = 4.550002%
Portfolio active risk = [(0.384615)2(0)2 + (0.192308)2(3.6)2 + (0.269231)2(6.5)2 +

(0.153846)2(8.1)2]0.5= 2.257143%
Information ratio = 4.550002%/2.257143% = 2.015824 or 2.0.

33. Using the information presented in Exhibit 1, which manager has outperformed
his or her asset class benchmark by the highest margin?
A. Smith
B. Morris
C. Akhtar
Correct Answer: A
Reference:
To determine which manager has outperformed his or her asset class benchmark
by the highest margin, misfit active return must be calculated and compared.
Misfit active return = Manager’s normal benchmark – investor’s benchmark
Smith = 18.0% - 12.1% = 5.9%

Morris = 13.7% - 11.6% = 2.1%
Akhtar = 16.1% - 17.3% = - 1.2%
We can conclude that Morris has outperformed his asset class benchmark by the
highest margin.
34. With respect to the benefits of a true/misfit distinction, Alexei is least accurate
with respect to:
A. Justification 1 only.
B. Justification 2 only.
C. both of his justifications.
Correct Answer: A
Reference:

Alexei is least accurate with respect to Justification 1. Distinguishing between

true and misfit active risk and returns allows for the creation of optimal solutions
which maximizes active return at every level of active risk and allows for an
optimal level of misfit risk. A nonzero amount of misfit risk is desirable because a
high level of true active return may more than compensate for this type of risk.
35. Based on the information provided in Exhibits 1 and 2 and the vignette, Alexei
has correctly defined the normal benchmark for:
A. Eco.
B. Smith.
C. Akhtar.
Correct Answer: B
Reference:
All four managers are overseeing foreign (non-US) equity stocks. This calls for
the use of an international ex-US equity index for the manager’s normal
benchmark, which is further classified according to his or her investment style.
Alexei has incorrectly defined Eco’s normal benchmark as the benchmark does
not represent her investment universe, non-US international equities.
Smith’s normal benchmark represents his investment style and universe and is
thus appropriate.
Akhtar’s normal benchmark does not represent his investment style (growth) and
is not well-defined.
36. The strategy employed by Walker to manage the $10 million entrusted by LLE’s
chief executive is most likely classified as:
A. completeness fund
B. equitized market neutral.
C. alpha and beta separation.
Correct Answer: C

Reference:
Walker has adopted an alpha beta separation approach by gaining exposure to the
U.S. equity markets via the long futures position. Investors will obtain their active
exposure to emerging markets by allocating their funds to Wilde.
B is incorrect. An equitized market neutral strategy is a purely alpha strategy with

no beta exposure. Given that Walker’s strategy aims to obtain market (beta)
exposure (via a long futures position in the S&P500), his strategy is not classified
as equitized market neutral.
A is incorrect. A completeness fund complements a core satellite approach by

producing an overall portfolio with the same risk exposures as the investor’s
overall equity benchmark when added to active managers’ positions. Walker is
not employing this strategy.

Questions 37 through 42 relate to Fixed Income
Chat and Dine (C&D) Case Scenario

Brenda Cross is part of the portfolio management team that manages the investment
portfolio of Chat and Dine (C&D), a food chain with fourteen branches within New
York, USA. C&D started off as a bakery around five years ago but has now diversified its
business by incorporating coffee houses and restaurants as a part of their chain. Owing to
an enhanced variety of products, C&D has incorporated the latest technologies to
augment the effectiveness of their supply chain and reduce the transit time of perishable
items. It has, thus, taken on a series of debt obligations to cover its technological
investments. Cross has been advised to manage the firm’s investment portfolio in
accordance with the firm’s debt portfolio which consists of cash outflows at regular
intervals for a period of 15 years. While talking to Brown Smith, C&D’s CEO, about the
appropriate investment strategy, Cross suggests two approaches:
Fund A: “A portfolio that has a duration that equals the duration of the debt portfolio.
The matching would be achieved by using Treasury zeros, each maturing at the
dates of respective cash outflows. At the current interest rate of 7.5%, the
present value of the investment portfolio will slightly exceed that of the debt
portfolio. “
Fund B: “A portfolio consisting of interest rate futures and bonds that mature at dates that
precisely match the dates of the future liability payouts. Cash inflows precisely
equal cash outflows.”
The firm’s CEO seems more comfortable with Fund B’s investment mandate and
instructs Cross to structure the investment portfolio accordingly. In doing so, Cross
shortlists three bonds to include in the fund. The characteristics of the bonds are given in
Exhibit 1.

Exhibit 1: Bond Characteristics

Bond A Bond B Bond C
Issue Size $35 million $40 million $50 million
Time to Maturity 7 years 8 years 11 years
Credit Rating AA AAA BBB
Time since issuance New issue 3 months 6 months

Issuer’s issuing
Moderate Moderate Frequent
frequency
Short-term capital
33% 25% 30%
gains tax(< 2 years)
Long-term capital
21% 17% 19%
gains tax (>2 years)
Total Issuance
$1.20 billion $1.75 billion $0.89 billion
Outstanding
The bond selected would be used to cover liabilities that would be due in five quarters
from now. Smith states that liquidity is of a prime concern.
C&D owns commercial real estate that it does not use in the normal course of its
business. While talking to Cross about it, Smith expresses the desire to invest the locked
up real estate value in a fixed-income fund. Since the focus is to enhance returns, Cross
recommends using leverage to invest part of the value in fixed-income securities. She
suggests investing $15 million for five years in a bond portfolio worth $22 million. Cross
believes that this investment would earn them a return premium of 9.5%. A loan, taken
for five years, costs 11.5% before taxes, and the risk-free rate equals 5.5%. Smith is not
sure if this investment would add to the returns especially because of the additional risk
added by the loan. He is also unsure whether taking a loan would be the most suitable
approach. This is because he anticipates interest rates to decrease by 2-4% in the coming
years and by 90 bps in the coming month.
Cross states that, to take advantage of the rate decrease, the firm could invest $2 million
in a corporate bond using a repurchase agreement. C&D would have to buy back the
position in 1 day at a price of $2.0836 million and keep collateral worth $2.0257 million
with the lender. Smith is still contemplating whether the profit on the short sale warrants
the costs incurred.

37. With regards to the immunization of the single liability, which of the following is
most accurate about the risks involved in the two strategies?
A. Fund A has no reinvestment risk but price risk is present.

B. Fund B has no price but reinvestment risk is present.
C. Neither fund has either price risk or reinvestment risk.
Correct Answer: C
Reference:
CFA Level III, Volume 4, Study Session 10, Reading 21
Fund A is a duration matching approach using Treasury zeros. Because the bonds
are held to maturity and are designed to match liability cash flows, there are no
interim cash flows and thus, no price risk and no reinvestment risk.
Fund B is a cash flow matching approach. Since cash inflows exactly match cash
outflows, there is no reinvestment risk or price risk.
38. Which of the following about the effectiveness of the immunization strategy of
the funds is most accurate?
A. Unlike Fund B, Fund A would only work in case of parallel yield curve
shifts.
B. Unlike Fund A, Fund B would only work in case of parallel yield curve
shifts.
C. Both funds would work regardless of the type of yield curve change.
Correct Answer: C
Reference:
Although duration matching approaches work only in the case of parallel yield
curve shifts only, in this case, the portfolio is duration matched using Treasury
zeros that exactly match liability cash flows. Also, each security is held to
maturity. Therefore, the effect of interest rate changes on price is irrelevant and
there are no cash flows to invest.
Fund B is a cash flow matched portfolio, and hence, has no yield curve
assumption.

39. Using only the information given in Exhibit 1, which of the following bonds
should Cross add to the fund?
A. Bond A.
B. Bond B.
C. Bond C.
Correct Answer: B
Reference:
Since Fund B is a cash flow matched fund, securities that are highly liquid should
be added to the fund (as stated by the firm’s CEO). Bond B would be most
appropriate. With a larger issue size and higher credit rating than Bond A, and
only a slightly longer maturity, it seems to be the best option. Total issuance size
is also larger than that of Bond A, even though time passed since issuance is
slightly greater. Since the bond is to be sold in five quarters, short-term capital
gains tax would apply, which is much lower for Bond B than Bond A. Bond C is
not an option because of a much lower credit rating and issuance size, and a much
large time to maturity. Time passed since issuance is also larger. All these
override the fact that issue size is large and issuance frequency is high.
40. How much value is Cross’s suggestion to use leverage to invest in the bond
portfolio likely to add in percentage terms?
A. 1.63%.
B. -0.93%.
C. 1.03%.
Correct Answer: A
Reference:
Return on invested funds: 9.5+5.5 = 15%

Levered portfolio return:
0.15 × (15 million + $7 million) – (7 million ×0.115)/15 million
16.6333%
This is 1.6333% more than the return on invested funds.

41. Based on Smith’s expectations of interest rate movements, the least appropriate
way of adding leverage to the fixed-income portfolio would be to:
A. be the fixed-rate receiver in a swap agreement.

B. Go long an inverse floater.
C. Go long interest rate futures.
Correct Answer: C
Reference:
If the expectation is for interest rates to fall, going long interest rate futures would
result in losses. Going long an inverse floater or entering a swap as a fixed-rate
receiver would prove profitable.
42. The size of the credit protection in the repurchase agreement is closest to:
A. 1.284%.
B. 2.209%.
C. 4.178%.
Correct Answer: A
Reference:
The credit protection, or haircut, is the difference in the collateral’s value and the
repo principal amount. In this case, it equals: [$2.0257 million - $2 million]/$2
million = 1.284%

Questions 43 through 48 relate to Monitor and Rebalancing
George Pena Case Scenario
George Pena, CFA, is a portfolio manager at Aqua Wealth Management (AWM), LLC.
Pena has extensive experience with managing private wealth accounts. Karen Lawrence
and Joseph Smith are Pena’s newest clients. With respect to each client’s portfolio, Pena
has a task on hand.
Task A: Determine the optimal rebalancing strategy for Lawrence’s portfolio.
Task B: Determine the optimal corridor width for each asset class in Smith’s portfolio.
Task A: Optimal Rebalancing Strategy
Lawrence has recently inherited $300,000 from her deceased father’s estate. She is 35
years old and practices dentistry privately. Last year, Lawrence’s house was destroyed in
a domestic fire. 15% of the inheritance amount as well as insurance claims have enabled
her to seek new accommodation. Despite the incident, her living expenses are being
comfortably met.
During a meeting with Lawrence, she shares with Pena her desire to maintain a minimum
cash balance during economic downturns. However, she would like to maximize
portfolio returns when the opportunity arises and is willing to utilize her cash balance to
increase equity exposure.
Upon the conclusion of their meeting, Pena collects data from several economic reports
each of which forecast a sustained upward trend in equity markets. Pena estimates that
Lawrence’s stocks will generate a return of 5%. Her portfolio value and stock/cash
allocation, prior to any changes, is $2 million and 55/45, respectively.
Lewis Wise is an intern at AWM. He is being trained by Pena and is assisting him in the
management of Lawrence’s portfolio. During his training session, he asks the following
questions:
Question 1: The graphical representations of the constant proportion portfolio

insurance (CPPI) and constant-mix strategies are mirror images of each
other. Is this true?

Question 2: Is it correct to state that the buy-and-hold strategy is consistent with a risk
tolerance which has a positive relation to wealth at all levels of stock
return?
Task B: Optimal Corridor Width
For this task, Pena compiles volatility, return, transaction cost, and correlation data on the
three asset classes held in Smith’s (Exhibit 1) portfolio.
Exhibit 1
Expected Return, Volatility, Transaction Cost, and Correlation Data
Volatility
Expected
(Annualized Transaction Correlation with the
Asset Class Return
Standard Costs rest of the portfolio
(Annualized)
Deviation)
Domestic Equity 12.5% 14.2% 0.20% 0.25
Domestic Bonds 7.8 11.8 0.45 0.18
Commodities 11.3 11.9 0.19 0.09
Mildred Jones, CFA, is AWM’s Human Resource Manager. She has recently
implemented a policy which mandates firing any underperforming managers. Some
managers have complained that the policy is too stringent and has resulted in the
company losing promising managers which have underperformed due to uncontrollable
external factors.
43. Considering economic forecasts and Lawrence’s requirements, which of the

following rebalancing strategies is most appropriate for Lawrence’s portfolio?
A. CPPI
B. Buy-and-hold
C. Constant-mix
Correct Answer: A
Reference:

The most appropriate rebalancing strategy for Lawrence is CPPI. Her risk
tolerance is above average; her home purchase is being easily met with the
inheritance as well as insurance proceeds and her liquidity needs are minimal. In
fact, her ability to tolerate risk has increased with the inheritance. Furthermore her
desire for increasing equity exposure during positive economic conditions and for
protection during economic downturns makes this strategy appropriate for the
client. In conclusion, the CPPI strategy will generate the best performance for the
portfolio in the forecasted upwards trending market.
44. Assuming expectations are realized, Lawrence’s revised stock/cash allocation

under a buy-and-hold strategy is closest to:
A. 53.5/46.5
B. 55.0/45.0
C. 56.2/43.8
Correct Answer: C
Reference:
Current stock value = $2,000,000 × 0.55 = $1,100,000
Current cash value = $2,000,000 × 0.45 = $900,000
Portfolio return = Percent in stocks × Return on stocks

= 0.55 × 5% = 2.75%
New portfolio value = $2,000,000 × 1.0275 = $2,055,000
New stock value = $1,100,000 × 1.05 = $1,155,000
Revised stock allocation = 1,155,000/2,055,000 = 56.2%
Revised cash allocation = 900,000/2,055,000 = 43.8%
45. The most appropriate responses to Wise’s questions are:
Question 1 Question 2
A. No No
B. No Yes
C. Yes No

Correct Answer: C
Reference:
The response to Question 1 is a yes and to Question 2 is a no. For the constant
mix strategy, the relationship between portfolio and stock returns is concave. On
the other hand, the CPPI strategy is convex. The graphical representations of these
strategies are mirror images of each other.
For the buy-and-hold strategy, the investor’s risk tolerance is positively related to
wealth and stock returns. However, the risk tolerance is zero if stock returns or
value declines to zero.
46. Based only on the transaction cost and volatility information presented in Exhibit
1, which asset classes will have the narrowest corridor width?
A. Commodities
B. Domestic bonds
C. Domestic equity
Correct Answer: C
Reference:
Domestic equity should have the narrowest corridor width because it has the
highest volatility (14.2%) and second lowest transaction costs (0.2%). A given
percentage move away from a highly volatile asset class is more harmful for the
portfolio because it has a greater chance of a further large move away from the
target.
The more expensive it is to trade an asset, the wider the corridor should be so that
the marginal costs of rebalancing at least equal the marginal benefits and vice-
versa.
Although the transaction costs of domestic equity are higher relative to

commodities, the impact of higher volatility associated with the former asset class
is more harmful for the portfolio and dictates a relatively narrow corridor.

47. Considering the correlation data in isolation, Pena will conclude that the asset
class with the narrowest corridor width is:
A. Commodities
B. Domestic bonds
C. Domestic equity
Correct Answer: A
Reference:
Commodities have the lowest correlation with the rest of the portfolio (0.09)
relative to domestic bonds (0.18) and domestic equity (0.25). Therefore, it should
have the narrowest corridor width as chances of further divergences from target
allocations become less likely.
48. Jones’ policy characterizes a (n):
A. Type I error.
B. Type II error.
C. adequate manager continuation policy.
Correct Answer: B
Reference:
Jones’ policy characterizes a Type II error. Her policy is resulting in skilled

managers being fired from AWM even though the underperformance may not be
in their control. This represents an inadequate manager continuation policy.

Questions 49 through 54 relate to Risk Application of Swap Strategies
TSM Derivatives Trading (TSMDT) Case Scenario
TSM Derivatives Trading (TSMDT) is a derivatives trading group situated in London,

U.K. Amongst the derivative contracts it executes, the group locates interest rate, equity,
and commodity swap counterparties by acting as a dealer to parties seeking to hedge their
positions. In addition to solely offering dealership services, the group routinely
undertakes the dual role of derivatives dealer for and acts as swap counterparty to its
customers for an additional fee.
Kyote Inc. is one of TSMDT’s customers. Kyote Inc. is a wholesale manufacturer

producing cornmeal and other corn-based edible products. For the purposes of producing
these products, the manufacturer regularly purchases raw corn. Kyote Inc.’s finished
products are distributed to retailers to be further sold to individual retail customers.
To secure the purchase price of raw corn, Kyote Inc. plans to enter into a derivative
contract. TSMDT’s senior derivatives trader, Josef Silos, recommends the manufacturer
enter into a three year commodity swap contract on corn. The 1-year, 2-year, and 3-year
corn forward prices are £125, £150, and £165, respectively. The 1-year, 2-year, and 3-
year interest rates are 7.5%, 8.0%, and 9.5%, respectively.
During an initial meeting with Kyote Inc.’s head of risk management, Silos makes the
following statements:
Statement 1: “Entering into the commodity swap contract on corn will give your firm
(Kyote Inc.) a position equivalent to three forward contracts.
Statement 2: “Another way to look at it is, by entering into the commodity swap
contract, your firm will effectively be making a 2-year loan to TSMDT.”
Statement 3: “The benefit of entering into a commodity swap contract is that your firm’s
counterparty credit risk becomes virtually non-existent.”
The head of risk management responds to Silos’ statements by asking the following two
questions.
Question 1: “If forward prices and interest rates change following contract initiation,
will it have an impact on the value of our firm’s swap contract?”
Question 2: “If, in the future, our demand for corn needs to be increased (decreased) to
accommodate an unexpected demand rise (fall) for cornmeal and we are
met with seasonally high corn prices, is there a way to accommodate corn
price and demand changes when pricing commodity corn swap contracts?”

49. If Kyote Inc. decides to enter into the three-year commodity swap contract on corn, it
will most likely:
A. make a fixed payment and receive a floating payment on the swap

B. make a floating payment and receive a fixed payment on the swap.
C. make a fixed payment on the swap only.
Correct Answer: A
Reference:
Since Kyote Inc. is a regular purchase of raw corn the manufacturer will be hurt by corn
price rises and by volatile corn prices. Thus the manufacturer will enter into a commodity
swap contract where it will pay the fixed swap price and receive the floating spot price.
50. The effective unit price on the 3-year swap is closest to:
A. £119.51/bushel
B. £145.56/bushel
C. £165.55/bushel
Correct Answer: B
Reference:
The effective swap price on the three-year corn commodity swap is £145.56/bushel. This is
calculated as follows:
• Firstly, the present value of the cost per bushel is calculated:

125 150 165
+ + = 370.5528
(1.075) (1.08) (1.095)3
2
The swap price per bushel is then obtained by solving:
x x x
+ + = 370.5528
1.075 (1.08 ) (1.095)3
2
x = £145.5562 ≈ £145.56

51. TSMDT has entered into a three-year swap contract with Kyote Inc. as a dealer and
swap counterparty. Assuming TSMDT hedge corn price risk on the swap contract by
entering into three forward contracts, the derivative group’s net cash flow position
on the swap and forward contract in the second year is closest to:
A. – £4.44
B. + £4.44
C. + £15.55
Correct Answer: A
Reference:
Since Kayote Inc. is paying fixed and receiving floating on the swap, the dealer is in a
position opposite to the manufacturer (i.e. receiving fixed and paying floating). Because
the dealer is paying floating, the dealer is exposed to the risk of an increase in corn prices
and consequentially having to make greater £ sterling floating payments. In order to
hedge this corn price risk, the dealer should enter into three forward contracts by
undertaking a long position, one contract for each year of the swap. The payoffs received
under the swap are depicted in column 2 whereas the payoffs received under the forward
contracts are depicted in column 3 with the aggregate net cash flow position in column 4.
Year Net Swap Payment Long Forwards Net Position

1 S1 − £145.5562* S1 − £125 + 20.5562
2 S1 – £145.5562 S1 – £150 − 4.4438
3 S1 – £145.5562 S1 – £165 − 19.4438
* See the solution to previous question
52. In context of the statements made by Silos to Kyote Inc.’s head of risk management,
which of the following statements is most likely incorrect?
A. All three statements.

B. 1 and 3 only.
C. 2 only.
Correct Answer: B
Reference:

Statement 1:
From the prospective of Kyote In. (the corn buyer), entering into a commodity swap
contract is equivalent to entering into three forward contracts plus an agreement to lend
money at the implied forward rate. Thus statement 1 fails to correctly equate swaps to
forward contracts and a lending contract.
Statement 2:
By entering into the swap, Kyote Inc. is effectively lending TSMDT (the counterparty)
money for two years beginning in a year’s time. Thus statement 2 correctly states this
fact.
Statement 3:
A commodity swap which calls for physical delivery exposes the buyer of the prepaid
swap to credit risk should the counterparty fail to deliver the commodity.
A commodity swap which calls for financial settlement has an initial credit risk of zero as
either party does not pay anything to enter into the swap. However during the life of the
swap, credit risk may go back and forth between the swap buyer and seller as the value of
the swap changes.
Thus, irrespective of Kyote Inc.’s mode of settlement, which has not been mentioned in
the case, a commodity swap will entail credit risk for the manufacturer. Statement 3
incorrectly asserts the fact that commodity swaps facilitate an elimination of credit risk.
53. The most appropriate response to the risk management head’s first question is:
A. there will be no impact on the value of the swap contract.

B. the value of the swap contract will change, increase or decrease, only in
response to a change in corn forward prices.
C. the value of the swap contract will change, increase or decrease, in
response to a change in the value of either of the two variables, corn
forward prices and forward interest rates.
Correct Answer: C
Reference:
When a commodity buyer enters into a commodity swap, its market value is zero.
However, once the swap is struck its market value no longer remains zero:
• as forward prices for the commodity (in this case, corn) and interest rates change;
• due to implicit borrowing and lending (which changes the value of the swap
despite forward prices and interest rates remaining constant).

54. The most appropriate response to the question 2 is:
A. Yes.
B. No, commodity swap contracts may only accommodate forward price
changes.
C. No, commodity swap contracts may not be able to accommodate either
variable commodity demand or forward prices.
Correct Answer: A
Reference:
Swaps can take into account the tendency of commodity prices to exhibit seasonality.
That is, the swap can take into account circumstances where a commodity’s demand and
its price are seasonally varying. This is done by including a varying price and quantity
component in the swap agreement.

Questions 55 through 60 relate to Global Investment Performance Standards
Brooks Wealth Management Case Scenario
Brooks Wealth Management (BWM) is an asset advisory firm situated in Brooklyn, New
York. BWM manages the accounts of individual clients. Its subsidiary, Thuraiya
Associates, handles institutional client accounts. Each firm has its own team of portfolio
managers, trading desks, and marketing staff. Managers from both departments base their
investment decisions on research reports issued by a centralized in-house research
department. Access to this department is shared.
BWM is currently in the process of seeking compliance with the Global Investment
Performance Standards (GIPS). Three of its policies are believed to comply with the
requirements of these standards.
Large External Cash Flows: Portfolios belonging to the developed market equity
composite are revalued when capital equal to 10% of the fair value is contributed or
withdrawn. Portfolios belonging to the emerging market equity composite are revalued
when capital equal to 30% of the fair value is contributed or withdrawn. This policy is
documented.
Portfolio Valuation: The beginning value of investments is measured at cost. Subsequent

to initial recognition, investments are valued at fair value.
Valuation Frequency: Due to the illiquid nature of emerging market investments,

portfolios belonging to the emerging market equity composite are revalued semi-
annually. Liquid investments are revalued on the last day of the calendar month.
James Marco, BWM’s client, has requested BWM to demonstrate how his account’s
performance is calculated in accordance with the GIPS standards. Dmitri Solvang, CFA,
Marco’s portfolio manager, compiles relevant portfolio information (Exhibit 1).

Exhibit 1
Marco’s Portfolio Activity for the
Month of January, 2011 (in $)
January 1 (Beginning value) 180,000
External cash flows:
12 January + 4,500
27 January ─ 3,450
Value on 12 January* 197,500
Value on 27 January* 220,000
January 31, 2010 (Ending value) 222,000
*Portfolio values include the relevant cash flows
When presenting performance to clients, Solvang believes it is necessary to report

internal dispersion of returns earned by individual portfolios in the composite. Such
information will enable users to evaluate how consistently the firm was able to achieve its
strategy across individual portfolios. To measure internal dispersion, BWM reports an
annual VAR for all measured portfolios on an annual basis.
Gene Davis is another client of BWM. Her contract with the firm expires on August 31,
2011. Unsatisfied with her account’s performance, she instructs her portfolio manager to
cease trading and liquidate her holdings with immediate effect on August 12. Her
account’s performance is calculated on a monthly basis.
55. Which of the following entities meets the definition of a firm as outlined by the
GIPS standards?
A. both entities.
B. BWM only.
C. Thuraiya Associates only.
Correct Answer: A
Reference:

In order to comply with the GIPS standards, a firm must be an investment

management firm, subsidiary or department held out to clients as a distinct
business entity. A distinct business entity is defined as a “unit, division,
department or office that is organizationally and functionally segregated from
other units, divisions, departments or offices and that retains discretion over the
assets it manages and that should have autonomy over the investment decision-
making process.”
BWM and Thuraiya Associates are functionally and organizationally distinct

entities. Even if they share access to the research division, investment decisions
are made independently by the two entities.
56. BWM’s Large External Cash Flows policy most likely satisfies the requirements
of the GIPS standards with respect to:
A. both composites.
B. the developed market equity composite only.
C. the emerging market equity composite only.
Correct Answer: A
Reference:
The standards state that for periods beginning on or after 1 January 2010,
portfolios must be valued on the date of all large external cash flows (I.1.A.3-4)
and that firms must define large cash flows for each composite to determine when
the portfolios in the composite are valued. The standards require firms to define
portfolio- or composite-specific amounts or percentages that constitute large
external cash flows.
By defining what constitutes ‘large external cash flows’ and valuing portfolios in
the two composites accordingly, BWM’s large external cash flows policy satisfies
this requirement with respect to both composites.

57. Do BWM’s policies concerning portfolio valuation and valuation frequency,

respectively, satisfy the requirements of the GIPS standards?
Portfolio Valuation
Valuation Frequency
A. No No
B. No Yes
C. Yes No
Correct Answer: C
Reference:
The use of fair value represents a method consistent with the GIPS standards.
Although the standards prohibit the use of cost for valuation purposes, cost is
applicable to performance measurement as long as it reflects an investment’s
beginning value (I.1.A.2). By recording the beginning value of investments at cost
and subsequent value at fair value, BWM’s portfolio valuation policy satisfies the
standard’s requirements.
For periods prior to January 1, 2001 portfolios must be valued at least quarterly;
for periods beginning on or after January 1, 2001 portfolios must be valued at
least monthly; and for periods on or after January 1, 2010 portfolios must valued
on the last date of each calendar or business month (II.1.A.3-4). Although BWM’s
valuation frequency policy is consistent with these requirements with respect to
liquid investments, its semi-annual valuation policy is not.
58. The true time-weighted rate of return on Marco’s portfolio is closest to:
A. 13.1%.
B. 18.6%.
C. 22.4%.
Correct Answer: C
Reference:

The true time-weighted rate of return is calculated by chain linking the returns at
each cash flow date.
Return Period 1 = (197,500 – 4,500) – 180,000/180,000 = 7.22%

Return Period 2 = [(220,000 – (– 3,450)] – 197,500/197,500 = 13.14%
Return Period 3 = (222,000 – 220,000)/220,000 = 0.91%
Time-weighted rate of return = (1.0722)(1.1314)(1.0091) – 1 = 22.41%
59. Does BWM’s internal dispersion policy satisfy the GIPS standards?
A. Yes.
B. No, firms are required to report VAR on a monthly basis.
C. No, VAR is not an acceptable measure of internal dispersion.
Correct Answer: C
Reference:
The standards mandate reporting for each annual period a measure of internal
dispersion of the returns earned by individual portfolios in the composite
(I.5.A.1.i). The GIPS Glossary contains several acceptable methods such as
high/low, range, and the equal-weighted or asset-weighted standard deviation of
portfolio returns. Using VAR as a measure for internal dispersion of portfolio
returns is inconsistent with these acceptable methods.
60. In order to comply with the requirements of the standards, BWM’s best course of
action with respect to Davis’s account at a minimum, is to:
A. retain her performance record up to July 31, 2011.

B. retain her performance record up to August 12, 2011.
C. transfer her performance record to her new asset advisor.
Correct Answer: A
Reference:

The GIPS standards require firms to include a portfolio’s historical performance

in the composite up to the last full measurement period that the portfolio was
under management (I.3.A.6).
Given that BWM calculates Davis’s account performance on a monthly basis, it

must at a minimum, retain her performance record up to July 31, 2011.

CFA Level III Mock Exam 2 June, 2018 Revision 1

Uploaded by

Copyright:

Available Formats

CFA Level III Mock Exam 2 June, 2018 Revision 1

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA Level III Mock Exam 2 June, 2018 Revision 1

Uploaded by

Copyright:

Available Formats

FinQuiz.

Copyright © 2010-2018. FinQuiz.com. All rights reserved. Copying, reproduction

FinQuiz.com –2nd Mock Exam 2018 (PM Session)

Questions Topic Minutes

FinQuiz.com © 2018 - All rights reserved. 2

Questions 1 through 6 relate to Ethical and Professional Standards

Wilshire Investment Case Scenario

FinQuiz.com © 2018 - All rights reserved. 3

1. In response to the commercial transport offer made by Davis’s firm, Monroe’s

A. accept the offer without any disclosure to his supervisor.

Standard I (B) Independence and Objectivity requires members and candidates to

FinQuiz.com © 2018 - All rights reserved. 4

3. By requesting access to client records, has Monroe violated any Standards of

Departing employees must not engage in the misappropriation of clients or client

FinQuiz.com © 2018 - All rights reserved. 5

Standard I (C) Misrepresentation requires members and candidates to not

Standard III (D) Performance Presentation requires members and candidates to

Standard V (B) Communication with Clients and Prospective Clients requires

A. violated standard III (A) Loyalty, Prudence and Care.

FinQuiz.com © 2018 - All rights reserved. 6

A. consult his supervisor.

In an extreme scenario, Monroe may consider discontinuing his investment

FinQuiz.com © 2018 - All rights reserved. 7

Questions 7 through 12 relate to Ethical and Professional Standards

Alliance Limited Case Scenario

Alliance Limited (AL) is an asset advisory firm situated in Chicago, providing

FinQuiz.com © 2018 - All rights reserved. 8

A. Personal trading only.

FinQuiz.com © 2018 - All rights reserved. 9

A. The procedure used to determine contingent fees must be disclosed

9. In order to adhere with the requirements and recommendations of the Asset

A. inform his supervisor.

A Manager’s duty to keep client information confidential does not override

FinQuiz.com © 2018 - All rights reserved. 10

By informing her supervisor in writing of the charitable event invitation, she is

FinQuiz.com © 2018 - All rights reserved. 11

A. Ensure Davis is qualified.

AL is required to ensure Davis is qualified enough to handle its computer

FinQuiz.com © 2018 - All rights reserved. 12

Questions 13 through 18 relate to Alternative Investments

Victor Moreno Case Scenario

Victor Moreno, CFA, is an alternative investment analyst recently hired by Northbay

Commodities: When the inflation outlook is poor, cyclical commodities provide an

Structure: Indirect venture capital investments can be structured as limited liability

Drawbacks: Partners suffer from limited liability and double taxation.

FinQuiz.com © 2018 - All rights reserved. 13

After concluding his discussion with Anderson, Moreno analyzes an investment in

Larry Armstrong is a junior portfolio manager with some knowledge on alternative

FinQuiz.com © 2018 - All rights reserved. 14

Although real estate as an asset class provides diversification to a stock/bond

Monroe has incorrectly described the drawbacks of investing in private equity

FinQuiz.com © 2018 - All rights reserved. 15

A dividend recapitalization is used as an exit route for buyout funds only.

DL is in its early stage of development in general and the start-up stage in

FinQuiz.com © 2018 - All rights reserved. 16

All calculations are in millions.

A. Effective exposure to global energy prices.

A commodity ETF reflects an indirect commodity investment. The drawback

An advantage of indirect commodity investments is that investors can avoid