Question 1

Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping.

Matrix sponsors a traditional defined benefit pension plan. Plan assets are valued at $5.5 billion, while recent

declines in interest rates have caused plan liabilities to balloon to $8.3 billion. Average employee age at Matrix

is 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1.1. Joe

Elliot, Matrix's CFO, has made the following statement about the current state of the pension plan.

"Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in our

long history, but I am sure these low rates are temporary. I have looked at the charts and estimated the

probability of higher interest rates at more than 90%. Given the expected improvement in interest rate levels,

plan liabilities will again come back into line with our historical position. Our investment policy will therefore be

to invest plan assets in aggressive equity securities. This investment exposure will bring our plan to an overfunded status, which will allow us to use pension income to bolster our profitability."

Options :

A :

Critique Elliot-s statement with respect to investing Matrix-s plan assets by addressing the following three

points:

B : Behavioral characteristic exhibited.ii. Plan risk and return objectives.iii. Using pension plan income to bolster firm profitability.

C :

Based on the information provided, formulate a return objective and a risk objective for the Matrix

Corporation pension plan. (No calculations required.)Template for Question 2-B

D :

Based on the information provided, formulate an appropriate constraints section for the investment policy

statement for the pension fund.Template for Question 2-C

Answer: A

Question 2

Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investment

analysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout the

world. The firm specializes in the valuation of international bonds, with consideration of currency risk. IA

typically uses forward contracts to hedge currency risk.

Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm,

Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency

(NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higgins

suggests that they consider forward contracts with the same maturity as the investment holding period, which is

estimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona

(Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via a

one-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.

Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if the

Norwegian NKr and euro are positively correlated, then a forward contract should be entered into where euros

will be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates and

spot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.

Return on Bergen Petroleum bond in Norwegian NKr 7.00%

Risk-free rate in Norway 4.80%

Expected change in the NKr relative to the U.S. dollar -0.40%

Risk-free rate in United States 2.50%

Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.

• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, where

higher forward rates imply that a country's spot rate will increase in the future."

• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-year

U.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forward

premium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen.

Invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."

The following day, Higgins and Tyler discuss various emerging market bond strategies and make the following

statements.

• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagion

and the competitive devaluations that often accompany crises in emerging markets. When one country

devalues their currency, others often quickly follow and as a result the countries default on their external debt,

which is usually denominated in a hard currency."

• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging market

bond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emerging

country bonds outside of this region."

Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds:

a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by the

Horgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued by a firm based in

Switzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss the

relative attractiveness of each bond and, using a total return approach, which bond should be invested in,

assuming a 1-year time horizon.

Which of the following statements provides the best description of the advantage of using breakeven spread analysis? Breakeven spread analysis:

Options :

A : provides an estimate of exchange rate risk.

B : quantifies the change in spread needed to offset a foreign yield advantage.

C : assesses the risk of a foreign bond investment independent of the bond-s duration.

Answer: B

Question 3

Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has been

examining portfolio risk using traditional methods such as the portfolio variance and beta. He has ranked

portfolios from least risky to most risky using traditional methods.

Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount of

money clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solely

for Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using the

variance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviation

is expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (in

millions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000

scenarios). The following table provides the results of the simulation:

Figure 1: Monte Carlo Simulation Data

The top row (Percentile) of the table reports the percentage of simulations that had returns below those

reported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and

97.5% of the simulations provided a return of 20% or less.

Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfolio

management practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon to

justify his use of VAR methodology and explain why the estimated VAR varies depending on the method used

to calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client,

the York Pension Plan.

To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluating

portfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the York

Pension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Note

that the minimum acceptable return is the risk-free rate.

Figure 3: Performance Ratios for the York Pension Plan

Using the historical data over the past 100 days, the 1-day, 5% VAR for the Jude Fund is closest to:

Options :

A : $11 million.

B : $12 million.

C : $15 million.

Answer: B

Question 4

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety

of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management

techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,

its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the

creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other

institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).

Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit

risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,

which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable

difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the

Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in

default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims

before it could settle the agreement with Johnson Associates.

McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states

that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the

possibility of default on current obligations, while future credit risk relates to potential default on future

obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value

of current obligations and the present value of future obligations. Cramer adds that combining current and

potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a

reliable predictor of a borrower's potential credit risk.

As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with

forward agreements. Cramer states that long forward contracts gain in value when the market price of the

underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk

and forward contracts in the handbook. She offers the following:

A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.

The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds

were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He

writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral

from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a

discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives

represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in

their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the

holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap

dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash

flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like

protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus

3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond

issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is

considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the

economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond

and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The

characteristics of the forward contract are shown below.

Information on the Credit Spread Forward

Regarding their statements concerning current and future credit risk, determine whether Cramer and McNally

are correct or incorrect.

Options :

A : Only Cramer is correct.

B : Only McNally is correct.

C : Both are correct -OR- both are incorrect.

Answer: B

Question 5

Rowan Brothers is a full service investment firm offering portfolio management and investment banking services. For the last ten years, Aaron King, CFA, has managed individual client portfolios for Rowan Brothers, most of which are trust accounts over which King has full discretion. One of King's clients, Shelby Pavlica, is a widow in her late 50s whose husband died and left assets of over $7 million in a trust, for which she is the only beneficiary. Pavlica's three children are appalled at their mother's spending habits and have called a meeting with King to discuss their concerns. They inform King that their mother is living too lavishly to leave much for them or Pavlica's grandchildren upon her death. King acknowledges their concerns and informs them that, on top of her ever-increasing spending, Pavlica has recently been diagnosed with a chronic illness. Since the diagnosis could indicate a considerable increase in medical spending, he will need to increase the risk of the portfolio to generate sufficient return to cover the medical bills and spending and still maintain the principal. King restructures the portfolio accordingly and then meets with Pavlica a week later to discuss how he has altered the investment strategy, which was previously revised only three months earlier in their annual meeting. During the meeting with Pavlica, Kang explains his reasoning tor altering the portfolio allocation but does not mention the meeting with Pavlica's children. Pavlica agrees that it is probably the wisest decision and accepts the new portfolio allocation adding that she will need to tell her children about her illness, so they will understand why her medical spending requirements will increase in the near future. She admits to King that her children have been concerned about her spending. King assures her that the new investments will definitely allow her to maintain her lifestyle and meet her higher medical spending needs. One of the investments selected by King is a small allocation in a private placement offered to him by a brokerage firm that often makes trades for King's portfolios. The private placement is an equity investment in ShaleCo, a small oil exploration company. In order to make the investment, King sold shares of a publicly traded biotech firm, VNC Technologies. King also held shares of VNC, a fact that he has always disclosed to clients before purchasing VNC for their accounts. An hour before submitting the sell order for the VNC shares in Pavlica's trust account. King placed an order to sell a portion of his position in VNC stock. By the time Pavlica's order was sent to the trading floor, the price of VNC had risen, allowing Pavlica to sell her shares at a better price than received by King. Although King elected not to take any shares in the private placement, he purchased positions for several of his clients, for whom the investment was deemed appropriate in terms of the clients* objectives and constraints as well as the existing composition of the portfolios. In response to the investment support, ShaleCo appointed King to their board of directors. Seeing an opportunity to advance his career while also protecting the value of his clients' investments in the company, King gladly accepted the offer. King decided that since serving on the board of ShaleCo is in his clients' best interest, it is not necessary to disclose the directorship to his clients or his employer. For his portfolio management services, King charges a fixed percentage fee based on the value of assets under management. All fees charged and other terms of service are disclosed to clients as well as prospects. In the past month, however. Rowan Brothers has instituted an incentive program for its portfolio managers. Under the program, the firm will award an all-expense-paid vacation to the Cayman islands for any portfolio manager who generates two consecutive quarterly returns for his clients in excess of 10%. King updates his marketing literature to ensure that his prospective clients are fully aware of his compensation arrangements, but he does not contact current clients to make them aware of the newly created performance incentive. According to the CFA Institute Standards of Professional Conduct, which of the following statements is correct concerning King's directorship with ShaleCo?

Options :

A : King may not accept the directorship since it creates a conflict of interest

B : King may accept the directorship as long as it is disclosed to clients and prospects

C : King may accept the directorship as long as it is disclosed to his employer, clients, and prospects

Answer: C

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