Question 1

William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and positions in physical

commodities. He is reviewing his operations and strategies to increase the return of the fund. Bliss has just

hired Joseph Kanter, CFA, to help him manage the fund because he realizes that he needs to increase his

trading activity in futures and to engage in futures strategies other than fully hedged, passively managed

positions. Bliss also hired Kanter because of Kantcr's experience with swaps, which Bliss hopes to add to his

choice of investment tools.

Bliss explains to Kanter that his clients pay 2% on assets under management and a 20% incentive fee. The

incentive fee is based on profits after having subtracted the risk-free rate, which is the fund's basic hurdle rate,

and there is a high water mark provision. Bliss is hoping that Kanter can help his business because his firm did

not earn an incentive fee this past year. This was the case despite the fact that, after two years of losses, the

value of the fund increased 14% during the previous year. That increase occurred without any new capital

contributed from clients. Bliss is optimistic about the near future because the term structure of futures prices is

particularly favorable for earning higher returns from long futures positions.

Kanter says he has seen research that indicates inflation may increase in the next few years. He states this

should increase the opportunity to earn a higher return in commodities and suggests taking a large, margined

position in a broad commodity index. This would offer an enhanced return that would attract investors holding

only stocks and bonds. Bliss mentions that not all commodity prices are positively correlated with inflation so it

may be better to choose particular types of commodities in which to invest. Furthermore, Bliss adds that

commodities traditionally have not outperformed stocks and bonds either on a risk-adjusted or absolute basis.

Kanter says he will research companies who do business in commodities, because buying the stock of those

companies to gain commodity exposure is an efficient and effective method for gaining indirect exposure to

commodities.

Bliss agrees that his fund should increase its exposure to commodities and wants Kanter's help in using swaps

to gain such exposure. Bliss asks Kanter to enter into a swap with a relatively short horizon to demonstrate how

a commodity swap works. Bliss notes that the futures prices of oil for six months, one year, eighteen months,

and two years are $55, S54, $52, and $5 1 per barrel, respectively, and the risk-free rate is less than 2%.

Bliss asks how a seasonal component could be added to such a swap. Specifically, he asks if either the

notional principal or the swap price can be higher during the reset closest to the winter season and lower for the

reset period closest to the summer season. This would allow the swap to more effectively hedge a commodity

like oil, which would have a higher demand in the winter than the summer. Kanter says that a swap can only

have seasonal swap prices, and the notional principal must stay constanl. Thus, the solution in such a case

would be to enter into two swaps, one that has an annual reset in the winter and one that has an annual reset in

the summer.

Given the information, the most likely reason that Bliss's firm did not earn an incentive fee in the past year was

because:

Options :

A : the normal return was subtracted.

B : the 2% asset-under-management fee is greater than the risk-free rate.

C : of a high water mark provision, which states the value of the fund must exceed its previous high point before managers are paid an incentive fee.

Answer: C

Question 2

Sue Gano and Tony Cismesia are performance analysts for the Barth Group. Barth provides consulting and

compliance verification for investment firms wishing to adhere to the Global Investment Performance Standards

(GIPS ®). The firm also provides global performance evaluation and attribution services for portfolio managers.

Barth recommends the use of GIPS to its clients due to its prominence as the standard for investment

performance presentation.

One of the Barth Group's clients, Nigel Investment Advisors, has a composite that specializes in exploiting the

results of academic research. This Contrarian composite goes long "loser" stocks and short "winner" stocks.

The "loser' stocks are those that have experienced severe price declines over the past three years, while the

"winner" stocks are those that have had a tremendous surge in price over the past three years. The Contrarian

composite has a mixed record of success and is rather small. It contains only four portfolios. Gano and

Cismesia debate the requirements for the Contrarian composite under the Global Investment Performance

Standards.

The Global Equity Growth composite of Nigel Investment Advisors invests in growth stocks internationally, and

is tilted when appropriate to small cap stocks. One of Nigel's clients in the Global Equity Growth composite is

Cypress University. The university has recently decided that it would like to implement ethical investing criteria

in its endowment holdings. Specifically, Cypress does not want to hold the stocks from any countries that are

deemed as human rights violators. Cypress has notified Nigel of the change, but Nigel does not hold any stocks

in these countries. Gano is concerned that this restriction may limit investment manager freedom going forward.

Gano and Cismesia are discussing the valuation and return calculation principles for both portfolios and

composites, which they believe have changed over time. In order to standardize the manner in which

investment firms calculate and present performance to clients, Gano states that GIPS require the following:

Statement 1: The valuation of portfolios must be based on market values and not book values or cost. Portfolio

valuations must be quarterly for all periods prior to January 1, 2001. Monthly portfolio valuations and returns are

required for periods between January 1, 2001 and January 1, 2010.

Statement 2: Composites are groups of portfolios that represent a specific investment strategy or objective. A

definition of them must be made available upon request. Because composites are based on portfolio valuation,

the monthly requirement for return calculation also applies to composites for periods between January 1, 2001

and January 1, 2010.

The manager of the Global Equity Growth composite has a benchmark that is fully hedged against currency

risk. Because the manager is confident in his forecasting of currency values, the manager does not hedge to

the extent that the benchmark does. In addition to the Global Equity Growth composite, Nigel Investment

Advisors has a second investment manager that specializes in global equity. The funds under her management

constitute the Emerging Markets Equity composite. The benchmark for the Emerging Markets Equity composite

is not hedged against currency risk. The manager of the Emerging Markets Equity composite does not hedge

due to the difficulty in finding currency hedges for thinly traded emerging market currencies. The manager

focuses on security selection in these markets and does not try to time the country markets differently from the

benchmark.

The manager of the Emerging Markets Equity composite would like to add frontier markets such as Bulgaria,

Kenya, Oman, and Vietnam to their composite, with a 20% weight- The manager is attracted to frontier markets

because, compared to emerging markets, frontier markets have much higher expected returns and lower

correlations. Frontier markets, however, also have lower liquidity and higher risk. As a result, the manager

proposes that the benchmark be changed from one reflecting only emerging markets to one that reflects both

emerging and frontier markets. The date of the change and the reason for the change will be provided in the

footnotes to the performance presentation. The manager reasons that by doing so, the potential investor can

accurately assess the relative performance of the composite over time.

Cismesia would like to explore the performance of the Emerging Markets Equity composite over the past two

years. To do so, he determines the excess return each period and then compounds the excess return over the

two years to arrive at a total two-year excess return. For the attribution analysis, he calculates the security

selection effect, the market allocation effect, and the currency allocation effect each year. He then adds all the

yearly security selection effects together to arrive at the total security selection effect. He repeats this process

for the market allocation effect and the currency allocation effect.

What are the GIPS requirements for the Contrarian composite of Nigel Investment Advisors?

Options :

A : The composite can be formed and the composite must report all performance statistics.

B : The composite can be formed, however the number of portfolios and dispersion does not have to be reported.

C :

The composite cannot be formed because it has less than six portfolios in it, so there are no presentation

requirements.

Answer: B

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

Jerry Edwards is an analyst with DeLeon Analytics. He is currently advising the CFO of Anderson Corp., a

multinational manufacturing corporation based in Newark, New Jersey, USA. Jackie Palmer is Edwards's

assistant. Palmer is well versed in risk management, having worked at a large multinational bank for the last

ten years prior to coming to Anderson.

Anderson has received a $2 million note with a duration of 4.0 from Weaver Tools for a shipment delivered last

week. Weaver markets tools and machinery from manufacturers of Anderson's size. Edwards states that in

order to effectively hedge the price risk of this instrument, Anderson should sell a series of interest rate calls.

Palmer states that an alternative hedge for the note would be to enter an interest rate swap as the fixed-rate

payer.

As well as selling products from a Swiss plant in Europe, Anderson sells products in Switzerland itself. As a

result, Anderson has quarterly cash flows of 12,000,000 Swiss franc (CHF). In order to convert these cash

flows into dollars, Edwards suggests that Anderson enter into a currency swap without an exchange of notional

principal. Palmer contacts a currency swap dealer with whom they have dealt in the past and finds the following

exchange rate and annual swap interest rates:

Exchange Rate (CHF per dollar) 1.24

Swap interest rate in U.S. dollars 2.80%

Swap interest rate in Swiss franc 6.60%

Discussing foreign exchange rate risk in general, Edwards states that it is transaction exposure that is most

often hedged, because the amount to be hedged is contractual and certain. Economic exposure, he states, is

less certain and thus harder to hedge.

To finance their U.S. operations, Anderson issued a S10 million fixed-rate bond in the United States five years

ago. The bond had an original maturity often years and now has a modified duration of 4.0. Edwards states that

Anderson should enter a 5-year semiannual pay floating swap with a notional principal of about $11.4 million to

take advantage of falling interest rates. The duration of the fixed-rate side of the swap is equal to 75% of its

maturity or 3.75 (= 0.75 x 5). The duration of the floating side of the swap is 0.25. Palmer states that Anderson's

position in the swap will have a negative duration.

For another client of DeLeon, Edwards has assigned Palmer the task of estimating the interest rate sensitivity

of the client's portfolios. The client's portfolio consists of positions in both U.S. and British bonds. The relevant

information for estimating (he duration contribution of the British bond and the portfolio's total duration is

provided below.

U.S. dollar bond $275,000

British bond $155,000

British yield beta 1.40

Duration of U.S. bond 4.0

Duration of British bond 8.5

When discussing portfolio management with clients, Edwards recommends the use of emerging market bonds

to add value to a core-plus strategy. He explains the characteristics of emerging market debt to Palmer by

stating:

1. "The performance of emerging market debt has been quite resilient over time. After crises in the debt

markets, emerging market bonds quickly recover after a crisis, so long-term returns can be poor."

2. "Emerging market debt is quite volatile due in part to the nature of political risk in these markets. It is

therefore important that the analyst monitor the risk of these markets. I prefer to measure the risk of emerging

market bonds with the standard deviation because it provides the best representation of risk in these markets."

Regarding his two statements about the characteristics of emerging market debt, is Edwards correct?

Options :

A :

Only statement 1 is correct.

B :

Only statement 2 is correct.

C :

Both statements are incorrect.

Answer: A

Question 5

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

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