Question 1

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 2

Smiler Industries is a U.S. manufacturer of machine tools and other capital goods. Dat Ng, the CFO of Smiler,

feels strongly that Smiler has a competitive advantage in its risk management practices. With this in mind, Ng

hedges many of the risks associated with Smiler's financial transactions, which include those of a financial

subsidiary. Ng's knowledge of derivatives is extensive, and he often uses them for hedging and in managing

Srniler's considerable investment portfolio.

Smiler has recently completed a sale to Frexa in Italy, and the receivable is denominated in euros. The

receivable is €10 million to be received in 90 days. Srniler's bank provides the following information:

Smiler borrows short-term funds to meet expenses on a temporary basis and typically makes semiannual

interest payments based on 180-day LIBOR plus a spread of 150 bp. Smiler will need to borrow S25 million in

90 days to invest in new equipment. To hedge the interest rate risk on the loan, Ng is considering the purchase

of a call option on 180-day LIBOR with a term to expiration of 90 days, an exercise rate of 4.8%, and a premium

of 0.000943443 of the loan amount. Current 90-day LIBOR is 4.8%.

Smiler also has a diversified portfolio of large cap stocks with a current value of $52,750,000, and Ng wants to

lower the beta of the portfolio from its current level of 1.25 to 0.9 using S&P 500 futures which have a multiplier

of 250. The S&P 500 is currently 1,050, and the futures contract exhibits a beta of 0.98 to the underlying.

Because Ng intends to replace the short-term LIBOR-based loan with long-term financing, he wants to hedge

the risk of a 50 bp change in the market rate of the 20-year bond Smiler will issue in 270 days. The current

spread to Treasuries for Smiler's corporate debt is 2.4%. He will use a 270-day, 20-year Treasury bond futures

contract ($100,000 face value) currently priced at 108.5 for the hedge. The CTD bond for the contract has a

conversion factor of 1.259 and a dollar duration of $6,932.53. The corporate bond, if issued today, would have

an effective duration of 9.94 and has an expected effective duration at issuance of 9.90 based on a constant

spread assumption. A regression of the YTM of 20-year corporate bonds with a rating the same as Smiler's on

the YTM of the CTD bond yields a beta of 1.05.

If Ng purchases the interest rate call, and 180-day LIBOR at option expiration is 5.73%, the annualized effective

rate for the 180-day loan is closest to:

Options :

A : 6.6982%.

B : 6.5346%.

C : 6.3785%

Answer: A

Question 3

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 4

Andre Hickock, CFA, is a newly hired fixed income portfolio manager for Deadwood Investments, LLC. Hickock

is reviewing the portfolios of several pension clients that have been assigned to him to manage. The first

portfolio, Montana Hardware, Inc., has the characteristics shown in Figure 1.

Hickock is attempting to assess the risk of the Montana Hardware portfolio. The benchmark bond index that

Deadwood uses for pension accounts similar to Montana Hardware has an effective duration of 5.25. His

supervisor, Carla Mity, has discussed bond risk measurement with Hickock. Mity is most familiar with equity risk

measures, and is not convinced of the validity of duration as a portfolio risk measure. Mity told Hickock, "I have

always believed that standard deviation is the best measure of bond portfolio risk. You want to know the

volatility, and standard deviation is the most direct measure of volatility."

Hickock is also reviewing the bond portfolio of Buffalo Sports, Inc., which is comprised of the following assets

shown in Figure 2.

The trustees of the Buffalo Sports pension plan have requested that Deadwood explore alternatives to reduce

the risk of the MBS sector of their bond portfolio. Hickock responded to their request as follows:

"I believe that the current option-adjusted spread (OAS) on the MBS sector is quite high. In order to reduce your

risk, I would suggest that we hedge the interest rate risk using a combination of 2-year and 10-year Treasury

security futures. I would further suggest that we do not take any steps to hedge spread risk at this time."

In assessing the risk of a portfolio containing both bullet maturity corporate bonds and MBS, Hickock should

always consider that:

Options :

A :

the duration of MBS securities will increase as the level of interest rates declines.

B :

MBS values will benefit from higher convexity as interest rates decline.

C :

MBS values will be more sensitive to changes in the shape of the yield curve than bullet maturity corporate

bonds.

Answer: C

Question 5

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

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