2008 l3 sample exam v2 qa

Fan explains that in addition to interest rate risk and prepayment risk, the other major sources of risk faced by mortgage securities include: spread risk, yield curve risk, and volatili

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Online CFA Sample Exam Site

Don Rowan Case Scenario

Don Rowan, CFA, works for an investment bank that is advising a client about a potential acquisition of Martin Industries Although Rowan is not working on the Martin deal, Julia Carney, CFA, a colleague in the same department who is directly involved with the acquisition, telephones Rowan at home to ask for his advice about the acquisition

Rowan's wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, "She is a colleague in my department who is working on an important deal involving Martin and was simply seeking my advice." That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney

Two weeks later, Boyle, a research assistant at an asset management firm, reads an article about Martin Industries in the financial press After further reading and investigation, Boyle, who is a CFA candidate, hypothesizes that

the firm may be a prime takeover target She informs her supervisor of her hypothesis Her supervisor, a CFA ct holder and portfolio manager who emphasizes diligent research, tells Boyle to do more research and then write a report

Boyle collects the data needed for her report and gathers previously published research reports from reputable firms to assist in her analysis She conducts primary research and scrutinizes the reports including the assumptions, the timeliness, and the rigor of analysis During lunch, she observes that Martin's common stock price is starting to increase She completes her report and places a call to her father, a member of CFA Institute who is an advisor

at the firm where she holds her children’s education fund Boyle tells him, "I think Martin stock may be a good buy Buy 300 shares for the children's education fund." Her father immediately purchases the shares according to his daughter's instructions He then places an order to purchase a block of 5,000 shares of Martin stock, which he allocates among his client and personal accounts

Late the next day, Boyle gives her completed report to her supervisor She takes care to disclose in the report that "the author is a beneficial owner of Martin Industries common stock." The report, which references previously published reports as Boyle's main sources, recommends purchase of Martin stock for investors with above-average risk tolerance The supervisor reads the report immediately and is impressed with Boyle's work He questions Boyle about her research, her sources, and her recommendation Satisfied with Boyle's responses, he places an order to purchase a block of 25,000 shares to be allocated among his clients

e C Yes, relating only to fiduciary duty to employer

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Rowan's wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, "She is a colleague in my department who is working on an important deal involving Martin and was simply seeking my advice." That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney

c C Yes, only the Standard relating to fiduciary duty to employer

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Rowan's wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, "She is a colleague in my department who is working on an important deal involving Martin and was simply seeking my advice.” That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney

Question

When buying Martin Industries stock for her children's education fund, did Boyle violate any CFA Institute Standards?

c No

Yes, relating to reasonable basis

Yes, relating to priority of transactions

Yes, relating to material nonpublic information

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Rowan’s wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, "She is a colleague in my department who is working on an important deal involving Martin and was simply seeking my advice.” That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney

Two weeks later, Boyle, a research assistant at an asset management firm, reads an article about Martin Industries in the financial press After further reading and investigation, Boyle, who is a CFA candidate, hypothesizes that the firm may be a prime takeover target She informs her supervisor of her hypothesis Her supervisor, a CFA ct holder and portfolio manager who emphasizes diligent research, tells Boyle to do more research and then write a report

Boyle collects the data needed for her report and gathers previously published research reports from reputable firms to assist in her analysis She conducts primary research and scrutinizes the reports including the assumptions,

the timeliness, and the rigor of analysis During lunch, she observes that Martin's common stock price is starting to increase She completes her report and places a call to her father, a member of CFA Institute who is an advisor

Question

With respect to the block trade in Martin Industries stock, did Boyle's father violate any CFA Institute Standards?

| c A.No

Œ B Yes, relating only to reasonable basis

c

C Yes, relating only to material nonpublic information

¬ D Yes, relating to both reasonable basis and material nonpublic information

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Rowan’'s wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, "She is a colleague in my department who is working on an important deal involving Martin and was simply seeking my advice." That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney

Two weeks later, Boyle, a research assistant at an asset management firm, reads an article about Martin Industries in the financial press After further reading and investigation, Boyle, who is a CFA candidate, hypothesizes that the firm may be a prime takeover target She informs her supervisor of her hyp is Her supervisor, a CFA charterholder and portfolio manager who emphasizes diligent research, tells Boyle to do more research and then write a report

Question

When completing and submitting her report on Martin Industries, did Boyle violate any CFA Institute Standards?

c B Yes, because the report included other people's work

e C Yes, because she did not disclose the amount of her beneficial ownership

c ) Yes, because she did not attempt to disseminate the material nonpublic information

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Rowan’s wife, Joanne West, a nurse, overhears the telephone conversation between Carney and Rowan When West questions Rowan about why Carney called him at home, Rowan explains, "She is a colleague in my department who is working on an important deal involving Martin and was simply seeking my advice.” That evening, West tells her friend Ruth Boyle about the conversation between Rowan and Carney

Two weeks later, Boyle, a research assistant at an asset management firm, reads an article about Martin Industries in the financial press After further reading and investigation, Boyle, who is a CFA candidate, hypothesizes that the firm may be a prime takeover target She informs her supervisor of her hyp is Her supervisor, a CFA ct holder and portfolio manager who emphasizes diligent research, tells Boyle to do more research and then write a report

Boyle collects the data needed for her report and gathers previously published research reports from reputable firms to assist in her analysis She conducts primary research and scrutinizes the reports including the assumptions,

the timeliness, and the rigor of analysis During lunch, she observes that Martin's common stock price is starting to increase She completes her report and places a call to her father, a member of CFA Institute who is an advisor

Question

When trading in Martin Industries stock, did Boyle's supervisor violate any CFA Institute Standards?

c B Yes, because he did not have a reasonable basis

¢ C Yes, because he was trading on material nonpublic information

c Yes, because he purchased a single block rather than purchasing shares for individual client

\ccounts

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Yun Fan Case Scenario

Yun Fan manages a U.S.-based fixed-income portfolio for JF Asset Management The portfolio invests in Treasury securities, non-callable investment grade corporate bonds, and mortgage-backed securities (MBS), all with durations of about 6 years Fan is meeting with a junior portfolio manager, Raj Mulloth, to discuss investment strategies for the MBS portion of the portfolio

Mulloth begins by stating that because Treasuries and mortgage securities in the portfolio have similar durations, they both could be hedged against interest rate changes by using Treasury futures contracts Fan comments

that they both must be hedged by selling Treasury futures, and that the dollar duration of the mortgage securities must equal the dollar duration of the Treasury futures position

The discussion then turns to the other sources of risk faced by mortgage securities Fan explains that in addition to interest rate risk and prepayment risk, the other major sources of risk faced by mortgage securities include: spread risk, yield curve risk, and volatility risk Fan then makes the following statements:

Statement 1: "Spread risk should be hedged by selling Treasury futures contracts."

Statement 2: "Yield curve risk is a reference to the impact of changes on the shape of the yield curve on

bond prices An examination of key rate durations will show that our investments in

Treasury securities, non-callable corporates, and mortgage securities are all significantly impacted by changes in the shape of the yield curve."

Statement 3: “Mortgage securities have significant exposure to volatility risk Our expectation is that

current implied interest rate volatility will exceed future realized interest rate volatility

Therefore it would be appropriate to manage volatility risk by hedging dynamically or by using options.”

Mulloth asks if hedging mortgage securities using a duration-based approach is equivalent to an interest rate sensitivity or two-bond hedge approach Fan responds that these approaches are not equivalent because duration-

based hedging accounts only for likely changes in the level of interest rates whereas the two-bond hedge incorporates both likely changes in the level and shape of the yield curve Consequently, when interest rates change, the price change for mortgage securities is more closely matched to changes in the value of a duration hedge than the changes in the value of a two-bond hedge

Question

Assuming a decline in interest rates, is Mulloth correct with regard to using Treasury futures contracts to hedge the interest rate risk of JF Asset Management's fixed-income portfolio?

No, the value of the prepayment option rises, causing mortgage security values to rise by less

comparable Treasuries and rendering the hedge ineffective

No, the value of the prepayment option rises, causing mortgage security values to rise by more

No, the value of the prepayment option declines, causing mortgage security values to rise by less

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Mulloth begins by stating that because Treasuries and mortgage securities in the portfolio have similar durations, they both could be hedged against interest rate changes by using Treasury futures contracts Fan comments that they both must be hedged by selling Treasury futures, and that the dollar duration of the mortgage securities must equal the dollar duration of the Treasury futures position

bond prices An examination of key rate durations will show that our investments in Treasury securities, non-callable corporates, and mortgage securities are all significantly impacted by changes in the shape of the yield curve.”

Statement 3: "Mortgage securities have significant exposure to volatility risk Our expectation is that

Therefore it would be appropriate to manage volatility risk by hedging dynamically or by using options."

Question

Is Fan's comment to Mulloth regarding hedging mortgage securities correct or incorrect with respect to:

selling Treasury futures?

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Mulloth begins by stating that because Treasuries and mortgage securities in the portfolio have similar durations, they both could be hedged against interest rate changes by using Treasury futures contracts Fan comments

that they both must be hedged by selling Treasury futures, and that the dollar duration of the mortgage securities must equal the dollar duration of the Treasury futures position

Treasury securities, non-callable corporates, and mortgage securities are all significantly impacted by changes in the shape of the yield curve."

Question

In Statement 1, is Fan most likely correct with regard to hedging spread risk?

No, spread risk should be hedged only if spreads are expected to narrow

No, spread risk should be hedged only if spreads are expected to widen

No, the spread is a risk premium for holding mortgage securities and should not be hedged

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Treasury securities, non-callable corporates, and mortgage securities are all significantly impacted by changes in the shape of the yield curve.”

Question

In Statement 2, is Fan most likely correct or incorrect with regard to yield curve risk and key rate durations, respectively?

[| | Yield curve risk?

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test over

11 ||

bond prices An examination of key rate durations will show that our investments in Treasury securities, non-callable corporates, and mortgage securities are all significantly impacted by changes in the shape of the yield curve."

Question

Given the expected relation between implied interest rate volatility and expected future interest rate volatility (Statement 3), Fan's most appropriate action following a decline in interest rates would be to:

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Treasury securities, non-callable corporates, and mortgage securities are all significantly impacted by changes in the shape of the yield curve.”

- | Equivalence of the two | Ability of the two strategies to hedge price

hedging strategies movement in mortgage securities

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New-Level 3 Version 2 2008 Sample Exam-v6

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Question #13 out of 30 Time Remaining:

Rafael Herrera Case Scenario

Rafael Herrera, CFA, an investment advisor, is preparing for a meeting with one of his U.S.-based high-net-worth clients, Patricia Dunlap Dunlap's investment portfolio consists of long only positions in domestic equity and

fixed-income securities Herrera feels that hedge funds would be an appropriate investment for Dunlap because they offer the opportunity to enhance portfolio returns and reduce portfolio risk

Herrera begins by presenting a table that summarizes hedge fund strategies into broad categories and provides examples of each type of strategy This information is presented in Exhibit 1

Exhibit 1 Hedge Fund Strategies Strategy Examples

Event Driven Merger arbitrage and distressed securities Global Asset Allocators Global macro, emerging markets Herrera then proceeds to provide a brief description of the three major strategies listed:

"Relative value strategies involve the purchase of undervalued securities and the sale of overvalued securities Event driven strategies use long and short positions to take advantage of opportunities created by corporate events

such as mergers and bankruptcies Global asset allocator strategies take appropriate long and short positions in various financial and non-financial assets in domestic as well as international markets.”

The following conversation takes place:

Dunlap: "Can you explain the difference between equity market neutral and hedged equity relative value strategies?”

exposure that is as close to zero as possible The only difference is that hedged equity strategies use derivatives to obtain the short exposure.”

typical compensation structure of hedge fund managers?”

plus incentive fees of approximately 20% of profits In addition, a high-water mark (HWM) provision sets a minimum NAV that must be exceeded before incentive fees are paid to the manager The HWM is constructed so that it ratchets up over time.”

Dunlap states that she has read in a trade magazine that investing in hedge funds through a fund of funds (FOF) offers more diversification benefits She asks Herrera, "What are the advantages and disadvantages of investing in

an FOF as opposed to a particular hedge fund?"

Herrera: "One of the advantages of investing in an FOF is that the due diligence process is much

shorter, while the downside is that the lock-up period during which no funds can be withdrawn is much longer.”

The discussion then turns the evaluation of hedge fund performance Herrera cautions Dunlap that care must be exercised in the selection of a hedge fund benchmark index For example, survivorship bias causes historical

returns to be underestimated and the value weighting scheme used in index construction causes underperforming funds to be overrepresented The discussion continues:

Herrera: “When it comes to measuring risk in hedge fund performance, either the standard deviation

of returns or downside deviation measure can be used.”

funds?"

Instead, I recommend using the Sortino ratio."

Equity market Hedged equity

neutral strategy strategy

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Question #14 out of 30 Time Remaining:

Rafael Herrera, CFA, an investment advisor, is preparing for a meeting with one of his U.S.-based high-net-worth clients, Patricia Dunlap Dunlap's investment portfolio consists of long only positions in domestic equity and fixed-income securities Herrera feels that hedge funds would be an appropriate investment for Dunlap because they offer the opportunity to enhance portfolio returns and reduce portfolio risk

Exhibit 1 Hedge Fund Strategies

| Strategy Examples

| Relative Value Equity market neutral, hedged equity, and convertible arbitrage

| Event Driven Merger arbitrage and distressed securities

| Global Asset Allocators Global macro, emerging markets Herrera then proceeds to provide a brief description of the three major strategies listed:

“Relative value strategies involve the purchase of undervalued securities and the sale of overvalued securities Event driven strategies use long and short positions to take advantage of opportunities created by corporate events such as mergers and bankruptcies Global asset allocator strategies take appropriate long and short positions in various financial and non-financial assets in domestic as well as international markets.”

Dunlap: "Can you explain the difference between equity market neutral and hedged equity relative value strategies?"

Herrera: "They are very similar in that the objective in both strategies is to achieve a net market exposure that is as close to zero as possible The only difference is that hedged equity strategies use derivatives to obtain the short exposure.”

Dunlap: “Lunderstand that hedge fund managers charge high fees Can you tell me more about the typical compensation structure of hedge fund managers?"

Herrera: "Hedge fund managers receive a management fee that is 1% to 2% of net asset value (NAV) plus incentive fees of approximately 20% of profits In addition, a high-water mark (HWM) provision sets a minimum NAV that must be exceeded before incentive fees are paid to the manager The HWM is constructed so that it ratchets up over time.”

an FOF as opposed to a particular hedge fund?”

Herrera: "One of the advantages of investing in an FOF is that the due diligence process is much shorter, while the downside is that the lock-up period during which no funds can be withdrawn is much longer.”

The discussion then turns the evaluation of hedge fund performance Herrera cautions Dunlap that care must be exercised in the selection of a hedge fund benchmark index For example, survivorship bias causes historical returns to be underestimated and the value weighting scheme used in index construction causes underperforming funds to be overrepresented The discussion continues:

Herrera: "When it comes to measuring risk in hedge fund performance, either the standard deviation

of returns or downside deviation measure can be used."

Dunlap: "Would you use the Sharpe ratio to measure the risk adjusted performance of hedge funds?"

Herrera: "No, the Sharpe ratio is not an appropriate measure to evaluate hedge fund performance

Instead, I recommend using the Sortino ratio.”

@ B No, b blished, the HWM ins fixed time

e C.No, because the HWM provision sets a maximum NAV on which incentive fees are paid

D No, because the HWM provision establishes a minimum return level that must be exceeded

before incentive fees are paid

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Ñ 7 Online CFA Sample Exam Site NSTITUTE

Rafael Herrera, CFA, an investment advisor, is preparing for a meeting with one of his U.S.-based high-net-worth clients, Patricia Dunlap Dunlap's investment portfolio consists of long only positions in domestic equity and fixed-income securities Herrera feels that hedge funds would be an appropriate investment for Dunlap because they offer the opportunity to enhance portfolio returns and reduce portfolio risk

Exhibit 1 Hedge Fund Strategies

| Strategy Examples

| Relative Value Equity market neutral, hedged equity, and convertible arbitrage

| Global Asset Allocators Global macro, emerging markets

Herrera then proceeds to provide a brief description of the three major strategies listed:

"Relative value strategies involve the purchase of undervalued securities and the sale of overvalued securities Event driven strategies use long and short positions to take advantage of opportunities created by corporate events such as mergers and bankruptcies Global asset allocator strategies take appropriate long and short positions in various financial and non-financial assets in domestic as well as international markets.”

Dunlap: “Can you explain the difference between equity market neutral and hedged equity relative value strategies?”

Herrera: “They are very similar in that the objective in both strategies is to achieve a net market exposure that is as close to zero as possible The only difference i is that hedged equity strategies use derivatives to obtain the short exposure.”

Dunlap: “Lunderstand that hedge fund managers charge high fees Can you tell me more about the typical compensation structure of hedge fund managers?”

Herrera: “Hedge fund managers receive a management fee that is 1% to 2% of net asset value (NAV) plus incentive fees of approximately 20% of profits In addition, a high-water mark (HWM) provision sets a minimum NAV that must be exceeded before incentive fees are paid to the manager The HWM is constructed so that it ratchets up over time.”

an FOF as opposed to a particular hedge fund?"

shorter, while the downside is that the lock-up period during which no funds can be withdrawn is much longer."

The discussion then turns the evaluation of hedge fund performance Herrera cautions Dunlap that care must be exercised in the selection of a hedge fund benchmark index For example, survivorship bias causes historical

Herrera: “When it comes to measuring risk in hedge fund performance either the standard deviation

of returns or downside deviation measure can be us:

Dunlap: “Would you use the Sharpe ratio to measure the risk adjusted performance of hedge funds?"

Herrera: “No, the Sharpe ratio is not an appropriate measure to evaluate hedge fund performance

Instead, I recommend using the Sortino ratio.”

Question

With respect to Herrera's statement concerning the advantages and disadvantages of fund of funds, is he most likely correct or incorrect regarding the due diligence process and the lock-up period?

Due diligence process Lock-up period

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