Question 1

Walter Skinner, CFA, manages a bond portfolio for Director Securities. The bond portfolio is part of a pension

plan trust set up to benefit retirees of Thomas Steel Inc. As part of the investment policy governing the plan and

the bond portfolio, no foreign securities are to be held in the portfolio at any time and no bonds with a credit

rating below investment grade are allowable for the bond portfolio. In addition, the bond portfolio must remain

unleveraged. The bond portfolio is currently valued at $800 million and has a duration of 6.50. Skinner believes

that interest rates are going to increase, so he wants to lower his portfolio's duration to 4.50. He has decided to

achieve the reduction in duration by using swap contracts. He has two possible swaps to choose from:

1. Swap A: 4-year swap with quarterly payments.

2. Swap B: 5-year swap with semiannual payments.

Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. For

analysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity.

Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing a

dual currency bond issued by an American holding company with significant operations in Japan. The bond

makes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S.

dollars five years from now. Skinner originally purchased the bond to take advantage of the strengthening

relative position of the yen. The result was an above average return for the bond portfolio for several years.

Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in the

Japanese economy to accelerate over the next few years. Knowing Skinner's situation, one of his colleagues,

Bill Michaels, suggests the following strategy:

"You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dual

currency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bond

portfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. The

swap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure of

the portfolio."

Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his expectations

for the bond portfolio. Mann has also provided some advice to Skinner in the following comment:

"1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rate

shift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the call

features of any callable bonds in your portfolio by purchasing a payer interest rate swaption."

After his lung conversation with Director Securities' senior economist, Orval Mann, Skinner has completely

changed his outlook on interest rates and has decided to extend the duration of his portfolio. The most

appropriate strategy to accomplish this objective using swaps would be to enter into a swap to pay:

Options :

A :

fixed and receive floating.

B : floating and receive fixed.

C : floating and receive floating.

Answer: B

Question 2

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from a

prestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-western

university in the United States. Northern provides investment advice for pension funds, foundations,

endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.

They are currently scrutinizing the performance of several portfolio managers who work for the Thompson

University endowment.

Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,

the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000

that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $

17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer and

Seagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states that

the advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that the

money-weighted return is, however, a better measure of the manager's performance.

Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for the

most recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) for

Thompson is the 4.5% spending rate on the endowment, which the endowment has determined using a

geometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI World

Index was used as the market index. The World index had a return of 9% in dollar terms with a standard

deviation of 23% and a beta of 1.0.

The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performance

of managers. The alternatives discussed that day are manager universes, broad market indices, style indices,

factor models, and custom benchmarks. Mercer states that manager universes have the advantage of being

measurable but they are subject to survivor bias. Seagram states that manager universes possess only one

quality of a valid benchmark.

Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes in

exploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engage

in providing foreign currency hedges to small firms in emerging markets when deemed profitable. This most

commonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a large

position in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firm

in Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into a

currency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.

Regarding their statements about manager universes, determine whether Mercer and Seagram are correct or

incorrect.

Options :

A :

Only Mercer is correct.

B :

Only Seagram is correct.

C : Both are correct.

Answer: C

Question 3

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

Question 4

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 5

Joan Nicholson, CFA, and Kim Fluellen, CFA, sit on the risk management committee for Thomasville Asset

Management. Although Thomasville manages the majority of its investable assets, it also utilizes outside firms

for special situations such as market neutral and convertible arbitrage strategies. Thomasville has hired a

hedge fund, Boston Advisors, for both of these strategies. The managers for the Boston Advisors funds are

Frank Amato, CFA, and Joseph Garvin, CFA. Amato uses a market neutral strategy and has generated a return

of S20 million this year on the $100 million Thomasville has invested with him. Garvin uses a convertible

arbitrage strategy and has lost $15 million this year on the $200 million Thomasville has invested with him, with

most of the loss coming in the last quarter of the year. Thomasville pays each outside manager an incentive fee

of 20% on profits. During the risk management committee meeting Nicholson evaluates the characteristics of

the arrangement with Boston Advisors. Nicholson states that the asymmetric nature of Thomasville's contract

with Boston Advisors creates adverse consequences for Thomasville's net profits and that the compensation

contract resembles a put option owned by Boston Advisors.

Upon request, Fluellen provides a risk assessment for the firm's large cap growth portfolio using a monthly

dollar VAR. To do so, Fluellen obtains the following statistics from the fund manager. The value of the fund is

$80 million and has an annual expected return of 14.4%. The annual standard deviation of returns is 21.50%.

Assuming a standard normal distribution, 5% of the potential portfolio values are 1.65 standard deviations

below the expected return.

Thomasville periodically engages in options trading for hedging purposes or when they believe that options are

mispriced. One of their positions is a long position in a call option for Moffett Corporation. The option is a

European option with a 3-month maturity. The underlying stock price is $27 and the strike price of the option is

$25. The option sells for S2.86. Thomasville has also sold a put on the stock of the McNeill Corporation. The

option is an American option with a 2-month maturity. The underlying stock price is $52 and the strike price of

the option is $55. The option sells for $3.82. Fluellen assesses the credit risk of these options to Thomasville

and states that the current credit risk of the Moffett option is $2.86 and the current credit risk of the McNeill

option is $3.82.

Thomasville also uses options quite heavily in their Special Strategies Portfolio. This portfolio seeks to exploit

mispriced assets using the leverage provided by options contracts. Although this fund has achieved some

spectacular returns, it has also produced some rather large losses on days of high market volatility. Nicholson

has calculated a 5% VAR for the fund at $13.9 million. In most years, the fund has produced losses exceeding

$13.9 million in 13 of the 250 trading days in a year, on average. Nicholson is concerned about the accuracy of

the estimated VAR because when the losses exceed $13.9 million, they are typically much greater than $13.9

million.

In addition to using options, Thomasville also uses swap contracts for hedging interest rate risk and currency

exposures. Fluellen has been assigned the task of evaluating the credit risk of these contracts. The

characteristics of the swap contracts Thomasville uses are shown in Figure 1.

Fluellen later is asked to describe credit risk in general to the risk management committee. She states that

cross-default provisions generally protect a creditor because they prevent a debtor from declaring immediate

default on the obligation owed to the creditor when the debtor defaults on other obligations. Fluellen also states

that credit risk and credit VAR can be quickly calculated because bond rating firms provide extensive data on

the defaults for investment grade and junk grade corporate debt at reasonable prices.

Which of the following best describes the accuracy of the VAR measure calculated for the Special Strategies

Portfolio?

Options :

A : It is accurate but should be supplemented with scenario analysis.

B : It is accurate and provides a complete measure of the fund-s risk.

C : It is inaccurate and should be supplemented with comprehensive stress testing.

Answer: C

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