Question 1

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

Question 2

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 3

Harold Chang, CFA, has been the lead portfolio manager for the Woodlock Management Group (WMG) for the last five years. WMG runs several equity and fixed income portfolios, all of which are authorized to use derivatives as long as such positions are consistent with the portfolio's strategy. The WMG Equity Opportunities Fund takes advantage of long and short profit opportunities in equity securities. The fund's positions are often a relatively large percentage of the issuer's outstanding shares and fund trades frequently move securities prices. Chang runs the Equity Opportunities Fund and is concerned that his performance for the last three quarters has put his position as lead manager in jeopardy. Over the last three quarters, Chang has been underperforming his benchmark by an increasing margin and is determined to reduce the degree of underperformance before the end of the next quarter. Accordingly, Chang makes the following transactions for the fund: Transaction 1: Chang discovers that the implied volatility of call options on GreenCo is too high. As a result, Chang shorts a large position in the stock options while simultaneously taking a long position in GreenCo stock, using the funds from the short position to partially pay for the long stock. The GreenCo purchase caused the share price to move up slightly. After several months, the GreenCo stock position has accumulated a large unrealized gain. Chang sells a portion of the GreenCo position to rebalance the portfolio. Richard Stirr, CFA, who is also a portfolio manager for WMG, runs the firm's Fixed Income Fund. Stirr is known for his ability to generate excess returns above his benchmark, even in declining markets. Stirr is convinced that even though he has only been with WMG for two and a half years, he will be named lead portfolio manager if he can keep his performance figures strong through the next quarter. To achieve this positive performance, Stirr enters into the following transactions for the fund: Transaction 2: Stirr decides to take a short forward position on the senior bonds of ONB Corporation, which Stirr currently owns in his Fixed Income Fund. Stirr made his decision after overhearing two of his firm's investment bankers discussing an unannounced bond offering for ONB that will subordinate all of its outstanding debt. As expected, the price of the ONB bonds falls when the upcoming offering is announced. Stirr delivers the bonds to settle the forward contract, preventing large losses for his investors. Transaction 3: Sitrr has noticed that in a foreign bond market, participants are slow to react to new information relevant to the value of their country's sovereign debt securities. Stirr, along with other investors, knows that an announcement from his firm regarding the sovereign bonds will be made the following day. Stirr doesn't know for sure, but expects the news to be positive, and prepares to enter a purchase order. When the positive news is released, Stirr is the first to act, making a large purchase before other investors and selling the position after other market participants react and move the sovereign bond price higher. Because of their experience with derivatives instruments, Chang and Stirr are asked to provide investment advice for Cherry Creek, LLC, a commodities trading advisor. Cherry Creek uses managed futures strategies that incorporate long and short positions in commodity futures to generate returns uncorrelated with securities markets. The firm has asked Chang and Stirr to help extend their reach to include equity and fixed income derivatives strategies. Chang has been investing with Cherry Creek since its inception and has accepted increased shares in his Cherry Creek account as compensation for his advice. Chang has not disclosed his arrangement with Cherry Creek since he meets with the firm only during his personal time. Stirr declines any formal compensation but instead requests that Cherry Creek refer their clients requesting traditional investment services to WMG. Cherry Creek agrees to the arrangement. Three months have passed since the transactions made by Chang and Stirr occurred. Both managers met their performance goals and are preparing to present their results to clients via an electronic newsletter published every quarter. The managers want to ensure their newsletters are in compliance with CFA Institute Standards of Professional Conduct. Chang states, "in order to comply with the Standards, we are required to disclose the process used to analyze and select portfolio holdings, the method used to construct our portfolios, and any changes that have been made to the overall investment process. In addition, we must include in the newsletter all factors used to make each portfolio decision over the last quarter and an assessment of the portfolio's risks." Stirr responds by claiming, "we must also clearly indicate that projections included in our report are not factual evidence but rather conjecture based on our own statistical analysis. However, I believe we can reduce the amount of information included in the report from what you have suggested and instead issue more of a summary report as long as we maintain a full report in our internal records." Determine whether Chang's comments regarding the disclosure of investment processes used to manage WMG's portfolios and the disclosure of factors used to make portfolio decisions over the last quarter are correct.

Options :

A : Both of Chang-s comments are correct.

B : Neither of Chang-s comments is correct.

C : Only Chang-s comments regarding disclosure of investment processes are correct.

Answer: C

Question 4

John Green, CFA, is a sell-side technology analyst at Federal Securities, a large global investment banking and

advisory firm. In many of his recent conversations with executives at the firms he researches, Green has heard

disturbing news. Most of these firms are lowering sales estimates for the coming year. However, the stock

prices have been stable despite management's widely disseminated sales warnings. Green is preparing his

quarterly industry analysis and decides to seek further input. He calls Alan Volk, CFA, a close friend who runs

the Initial Public Offering section of the investment banking department of Federal Securities.

Volk tells Green he has seen no slowing of demand for technology IPOs. "We've got three new issues due out

next week, and two of them are well oversubscribed." Green knows that Volk's department handled over 200

IPOs last year, so he is confident that Volk's opinion is reliable. Green prepares his industry report, which is

favorable. Among other conclusions, the report states that "the future is still bright, based on the fact that 67%

of technology IPOs are oversubscribed." Privately, Green recommends to Federal portfolio managers that they

begin selling all existing technology issues, which have "stagnated," and buy the IPOs in their place.

After carefully evaluating Federal's largest institutional client's portfolio, Green contacts the client and

recommends selling all of his existing technology stocks and buying two of the upcoming IPOs, similar to the

recommendation given to Federal's portfolio managers. Green's research has allowed him to conclude that only

these two IPOs would be appropriate for this particular client's portfolio. Investing in these IPOs and selling the

current technology holdings would, according to Green, "double the returns that your portfolio experienced last

year."

Federal Securities has recently hired Dirks Bentley, a CFA candidate who has passed Level 2 and is currently

preparing to take the Level 3 CFA® exam, to reorganize Federal's compliance department. Bentley tells Green

that he may be subject to CFA Institute sanctions due to inappropriate contact between analysts and

investment bankers within Federal Securities. Bentley has recommended that Green implement a firewall to

rectify the situation and has outlined the key characteristics for such a system. Bentley's suggestions are as

follows:

1. Any communication between the departments of Federal Securities must be channeled through the

compliance department for review and eventual delivery. The firm must create and maintain watch, restricted,

and rumor lists to be used in the review of employee trading.

2. All beneficial ownership, whether direct or indirect, of recommended securities must be disclosed in writing.

3. The firm must increase the level of review or restriction of proprietary trading activities during periods in

which the firm has knowledge of information that is both material and nonpublic.

Bentley has identified two of Green's analysts, neither of whom have non-compete contracts, who are preparing

to leave Federal Securities and go into competition. The first employee, James Ybarra, CFA, has agreed to

take a position with one of Federal's direct competitors. Ybarra has contacted existing Federal clients using a

client list he created with public records. None of the contacted clients have agreed to move their accounts as

Ybarra has requested. The second employee, Martha Cliff, CFA, has registered the name Cliff Investment

Consulting (CIC), which she plans to use for her independent consulting business. For the new business

venture, Cliff has developed and professionally printed marketing literature that compares the new firm's

services to that of Federal Securities and highlights the significant cost savings that will be realized by switching

to CIC. After she leaves Federal, Cliff plans to target many of the same prospects that Federal Securities is

targeting, using an address list she purchased from a third-party vendor. Bentley decides to call a meeting with

Green to discuss his findings.

After discussing the departing analysts. Green asks Bentley how to best handle the disclosure of the following

items: (1) although not currently a board member. Green has served in the past on the board of directors of a

company he researches and expects that he will do so again in the near future; and (2) Green recently inherited

put options on a company for which he has an outstanding buy recommendation. Bentley is contemplating his

response to Green.

According to Standard 11(A) Material Nonpublic Information, when Green contacted Volk, he:

Options :

A : violated CFA Institute Standards

B : violated of CFA Institute Standards unless the contact was disclosed to his clients

C : did not violate CFA Institute Standards since he was conducting a legitimate research activity.

Answer: C

Question 5

Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Quaker Fund. BIC is an asset management firm headquartered in Holland with regional offices in several other European countries. After accepting the position, Bair received a letter from the three principals of BIC. The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations. Among other things, the letter stated the following: "Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund. It is your responsibility to obtain this knowledge and comply with appropriate regulations. This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully. You will likely need to arrange for our sister companies to quietly buy and sell Quaker Fund shares over the first month of operations. This will provide sufficient price support to allow the fund to trade closer to its net asset value than other small-cap closed-end funds. Because these funds generally trade at a discount to net asset value, if our fund trades close to its net asset value, the market may perceive it as more desirable than similar funds managed by our competitors." Bair heeded the advice from her firm's principals and collected information on the laws and regulations of three countries: Norway, Sweden, and Denmark. So far, all of the investors expressing interest in the Quaker Fund are from these areas. Based on her research, Bair decides the following policies are appropriate for the fund: Note: Laws mentioned below are assumed for illustrative purposes. • For clients located in Norway the fund will institute transaction crossing, since, unlike in Holland, the practice is not prohibited by securities laws or regulations. The process will involve internally matching buy and sell orders from Norwegian clients whenever possible. This will reduce brokerage fees and improve the fund's overall performance. • For clients located in Denmark, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by Denmark's securities regulators, even though the laws in Holland only require such reports to be generated on a quarterly basis. • For clients located in Sweden, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment. This policy is consistent with the laws and regulations in Holland. Sweden's securities regulations do not cover this type of situation.

Three months after the inception of the fund, its market value has grown from $200 million to $300 million and Bair's performance has earned her a quarter-end bonus. Since it is now the end of the quarter, Bair is participating in conference calls with companies in her fund. Bair calls into the conference number for Swift Petroleum. The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Swift discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter. The restatement will not be announced until the year's end, six months from now. Bair does not remind the officers that she can hear their conversation. Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call. Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call. The investment bankers then proceed to sell their personal holdings of Swift Petroleum stock. After her meeting, Bair sells the Quaker Fund's holdings of Swift Petroleum stock. By selling the Quaker Fund's shares of Swift Petroleum, did Bair violate any CFA Institute Standards of Professional Conduct?

Options :

A : Yes, Bair violated Standard II Integrity of Capital Markets

B : No, because she ensured public dissemination of the earnings restatement information before she traded the shares

C : Yes, because waiting to trade the stock would severely disadvantage investors in her fund and would have violated her duty of loyalty to her clients.

Answer: A