Question 1

Robert Keith, CFA, has begun a new job at CMT Investments as Head of Compliance. Keith has just completed a review of all of CMT's operations, and has interviewed all the firm's portfolio managers. Many are CFA charterholders, but some are not. Keith intends to use the CFA Institute Code and Standards, as well as the Asset Manager Code of Professional Conduct, as ethical guidelines for CMT to follow. In the course of Keith's review of the firm's overall practices, he has noted a few situations which potentially need to be addressed. Situation 1: CMT Investments' policy regarding acceptance of gifts and entertainment is not entirely clear. There is general confusion within the firm regarding what is and is not acceptable practice regarding gifts, entertainment and additional compensation. Situation 2: Keith sees inconsistency regarding fee disclosures to clients. In some cases, information related to fees paid to investment managers for investment services provided are properly disclosed. However, a few of the periodic costs, which will affect investment return, are not disclosed to the clients. Most managers are providing clients with investment returns net of fees, but a few are just providing the gross returns. One of the managers stated "providing gross returns is acceptable, as long as I show the fees such that the client can make their own simple calculation of the returns net of fees." Situation 3: Keith has noticed a few gaps in CMT's procedure regarding use of soft dollars. There have been cases where "directed brokerage" has resulted in less than prompt execution of trades. He also found a few cases where a manager paid a higher commission than normal, in order to obtain goods or services. Keith is considering adding two statements to CMT's policy and procedures manual specifically addressing the primary issues he noted. Statement 1: "Commissions paid, and any corresponding benefits received, are the property of the client. The benefit(s) must directly benefit the client. If a manager's client directs the manager to purchase goods or services that do not provide research services that benefit the client, this violates the duty of loyalty to the client.” Statement 2: "In cases of "directed brokerage," if there is concern that the client is not receiving the best execution, it is acceptable to utilize a less than ideal broker, but it must be disclosed to the client that they may not be obtaining the best execution." Situation 4: Keith is still evaluating his data, but it appears that there may be situations where proxies were not voted. After completing his analysis of proxy voting procedures at CMT, Keith wants to insert the proper language into the procedures manual to address proxy voting. Situation 5: Keith is putting into place a "disaster recovery- plan," in order to ensure business continuity in the event of a localized disaster, and also to protect against any type of disruption in the financial markets. This plan includes the following provisions: • Procedures for communicating with clients, especially in the event of extended disruption of services provided. • Alternate arrangement for monitoring and analyzing investments in the event that primary systems become unavailable. • Plans for internal communication and coverage of crucial business functions in the event of disruption at the primary place of business, or a communications breakdown. Keith is considering adding the following provisions to the disaster recovery plan in order to properly comply with the CFA Institute Asset Manager Code of Professional Conduct: Provision 1: "A provision needs to be added incorporating off-site backup for all pertinent account information." Provision 2: "A provision mandating testing of the plan on a company-wide basis, at periodical intervals, should be added." Situation 6: Keith is spending an incredible amount of time on detailed procedures and company policies that are in compliance with the CFA Institute Code and Standards, and also in compliance with the CFA Institute Asset Manager Code of Professional Conduct. As part of this process, he has had several meetings with CMT senior management, and is second-guessing the process. One of the senior managers is indicating that it might be a

better idea to just formally adopt both the Code and Standards and the Asset Manager Code of Conduct, which would make a detailed policy and procedure manual redundant. Keith wants to assure CMT's compliance with the requirements of the CFA Institute Code and Standards of Professional Conduct. Which of the following statements most accurately describes CMT's responsibilities in order to assure compliance?

Options :

A : CMT must adopt the Asset Manager Code of Conduct, as required by the CFA Institute Code and Standards. The policy manual is acceptable, but not necessary.

B : Although adoption of the CFA Institute Asset Manager Code of Conduct is not a requirement, the Standards of Practice encourage firms to adopt this Code. CMT must adopt supplemental policies and procedures as part of a policy manual in order to properly implement the CFA Institute guidelines

C : The Standards of Practice do not require CMT to adopt the Asset Manager Code of Conduct, nor is there a requirement to publish a detailed procedural manual. Disclosure of policies is required, and any changes or updates to policies must be immediately disseminated.

Answer: B

Question 2

Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios which

have just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints,

as welt as an initial strategic asset allocation. However, Draper has found that all of the portfolios have

experienced changes in asset values. As a result, the current allocations have drifted away from the initial

allocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with their

proposed asset allocation targets.

Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing. During their conversation,

Sterling made the following comments:

Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatility

of the asset classes in the portfolio.

Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to more

frequent rebalancing.

Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing,

but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As an

example, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.

Draper has been reviewing Madison files on four high net worth individuals, each of whom has a $1 million

portfolio. He hopes to gain insight as to appropriate rebalancing strategies for these clients. His research so far

shows:

Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerance

drops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook,

which is for a long-term bull market with few reversals.

Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees with

the Madison stock market outlook.

Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio.

She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked by

numerous reversals, over the coming months.

In selecting a rebalancing strategy for his clients, Draper would most likely select a constant mix strategy for:

Options :

A : Client A.

B : Client B.

C : Client C.

Answer: C

Question 3

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 4

John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management. In one of his client portfolios, Rawlins currently holds the following positions:

The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.

In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he has

regressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient for

this regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedging

calculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futures

contracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).

In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond management

by moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in his

portfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-hold

strategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervalued

bond issues. Although Tejada has recently graduated from a prestigious university with a master's degree in

finance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approach

needs further evaluation over a period of both falling and rising interest rates, as well as in different credit

environments.

Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, a

U.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by Bergamo

Metals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. The

holding period for either bond is three months.

The characteristics of the bonds are as follows:

3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejada

will hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.

Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacom

bond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro is

at a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because the

net return advantage for the Dynacom bond is 0.5% over the next three months.

Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has a

yield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heard

rumors that the chief executive and the chairman of the board at Dynacom are both being investigated by the

U.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to the

exercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident could

be damaging to Dynacom's bond price.

Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes that

news of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states that

he would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bond

stays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative of

Tejada's efforts, the analysis relies on an approximation.

Suppose that the original dollar duration for a 100 basis point change in interest rates was $4,901,106 and that

the bond prices remain constant during the year. Based upon the durations one year from today, and assuming

a proportionate investment in each of the three bonds, the amount of cash that will need to be invested to

restore the average dollar duration to the original level is closest to:

Options :

A : $5,885,167.

B : $10,888,662.

C : $12,793,588.

D :

Answer: C

Question 5

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,

which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in

the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,

foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,

Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking

error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus

reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian

region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments

in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are

expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by

finding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on

the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing

outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option

adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted

spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative

attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity

from the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts that

interest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of business

investment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low in

order to stimulate the economy. Although she sees the level of yields declining, she believes that the spread on

risky securities will increase due to the decline in business prospects. She therefore has reallocated her bond

portfolio away from high-yield bonds and towards investment grade bonds.

Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.

As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a

7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated Quincy

Corporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhanced

his annual income, which he considers quite favorable given the declining yields in the market.

Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, she

expects that the yields on mortgages will decline. As a result, she has reallocated the portion of Northern

Capital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to

7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in price

more than the higher coupon mortgages. She identifies this trade as a structure trade.

Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:

Which of the following best describes the relative value analysis used in the Northern Capita! Emerging market

bond fund? It is a:

Options :

A : top-down approach.

B : bottom-up approach.

C : combination of a top-down approach and a bottom-up approach.

Answer: B

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