Question 1

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

Question 2

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 3

Joan Weaver, CFA and Kim McNally, CFA are analysts for Cardinal Fixed Income Management. Cardinal

provides investment advisory services to pension funds, endowments, and other institutions in the U.S. and

Canada. Cardinal recommends positions in investment-grade corporate and government bonds.

Cardinal has largely advocated the use of passive approaches to bond investments, where the predominant

holding consists of an indexed or enhanced indexed bond portfolio. They are exploring, however, the possibility

of using a greater degree of active management to increase excess returns. The analysts have made the

following statements.

• Weaver: "An advantage of both enhanced indexing by matching primary risk factors and enhanced indexing

by minor risk factor mismatching is that there is the potential for excess returns, but the duration of the portfolio

is matched with that of the index, thereby limiting the portion of tracking error resulting from interest rate risk."

• McNally: "The use of active management by larger risk factor mismatches typically involves large duration

mismatches from the index, in an effort to capitalize on interest rate forecasts."

As part of their increased emphasis on active bond management, Cardinal has retained the services of an

economic consultant to provide expectations input on factors such as interest rate levels, interest rate volatility,

and credit spreads. During his presentation, the economist states that he believes long-term interest rates

should fall over the next year, but that short-term rates should gradually increase. Weaver and McNally are

currently advising an institutional client that wishes to maintain the duration of its bond portfolio at 6.7. In light of

the economic forecast, they are considering three portfolios that combine the following three bonds in varying

amounts.

Weaver and McNally next examine an investment in a semiannual coupon bond newly issued by the Manix

Corporation, a firm with a credit rating of AA by Moody's. The specifics of the bond purchase are provided

below given Weaver's projections. It is Cardinal's policy that bonds be evaluated for purchase on a total return

basis.

One of Cardinal's clients, the Johnson Investment Fund (JIF), has instructed Weaver and McNally to

recommend the appropriate debt investment for $125,000,000 in funds. JIF is willing to invest an additional

15% of the portfolio using leverage. JIF requires that the portfolio duration not exceed 5.5. Weaver

recommends that JIF invest in bonds with a duration of 5.2. The maximum allowable leverage will be used and

the borrowed funds will have a duration of 0.8. JIF is considering investing in bonds with options and has asked

McNally to provide insight into these investments. McNally makes the following comments:

"Due to the increasing sophistication of bond issuers, the amount of bonds with put options is increasing, and

these bonds sell at a discount relative to comparable bullets. Putables are quite attractive when interest rates

rise, but, we should be careful if with them, because valuation models often fail to account for the credit risk of

the issuer."

Another client, Blair Portfolio Managers, has asked Cardinal to provide advice on duration management. One

year ago, their portfolio had a market value of $3,010,444 and a dollar duration of $108,000; current figures are

provided below:

The expected bond equivalent yield for the Manix Bond, using total return analysis, is closest to:

Options :

A : 5.92%.

B : 11.86%.

C : 12.12%.

Answer: B

Question 4

Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. The

funds are managed individually, but Pace has an investment committee that oversees all of the funds. This

committee is responsible for evaluating the performance of the funds relative to appropriate benchmarks and

relative to the stated investment objectives of each individual fund. During a recent investment committee

meeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of the

portfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee was

to review the performance of the manager responsible for each fund and dismiss those managers whose

performance had lagged substantially behind the appropriate benchmark.

The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with a

capitalization between S40 billion and $80 billion. A review of the operations of the fund found the following:

• The turnover of the fund was almost double that of other similar style mutual funds.

• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existing

holding.

• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutual

funds.

• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years of

financial information on that company, plus independent research reports from at least three different analysts.

• The portfolio manager refuses to increase her technology sector weighting because of past losses the fund

incurred in the sector.

• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. She

expects oil prices to fall back to the $40 to S50 per barrel range.

A committee member made the following two comments:

Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfolio

lacks recognizable companies. I believe that good companies make good investments."

Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. She

seems to sell stocks that appreciate, but hold stocks that have declined in value."

The supervisor of the Mid-Cap Mutual Fund portfolio manager made the following statements:

Statement 1: "The portfolio manager of the Mid-Cap Mutual Fund has engaged in quarter-end window dressing

to make her portfolio look better to investors. The portfolio manager's action is a behavioral trait known as overreaction."

Statement 2: "Each time the portfolio manager of the Mid-Cap Mutual fund trades a stock, she executes the

trade by buying or selling one-third of the position at a time, with the trades spread over three months. The

portfolio manager's action is a behavioral trait known as anchoring."

Indicate whether Statement 1 and Statement 2 made by the supervisor are correct.

Options :

A : Only Statement 1 is correct.

B : Only Statement 2 is correct.

C : Neither Statement is correct.

Answer: C

Question 5

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

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