2009 l3 sample exam v1 qa

With a new CEO, Twain, which adheres to the Asset Manager Code of Professional Conduct, experiences significant change during the year when management hires a compliance officer.. 75, 89

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NEW-Level III (Free) 2009 Sample exam

1

Frank Litman Case Scenario

Frank Litman, CFA, has recently been hired as a portfolio manager for Twain Investments, a small regional asset management firm For the past ten years, Litman has managed a limited number of accounts belonging to family and friends He started managing these accounts when he was enrolled in graduate school All the accounts are too small to meet Twain’s minimum balance requirement of $5 million, and they generate only modest fees for Litman Litman disclosed the arrangement to the Human Resources (HR) manager when he

interviewed for the position of portfolio manager The HR manager agreed that the accounts were too small and would probably never be large enough to meet Twain’s minimum

requirement Upon accepting the position with Twain, Litman met with each of his non-Twain clients and recommended that they find another financial advisor Each of them asked Litman

to continue managing their money as a personal favor, arguing that a different advisor would undoubtedly charge higher fees Following the meetings, Litman sent letters to both his Twain

HR manager and his non-Twain clients explaining his employment relationship to each

The following month, Litman updated the promotional material he shares with clients and prospects The material summarizes Litman’s portfolio trading strategy, which he developed

by analyzing 20 years of historical data In his analysis, Litman determined that his strategy, which invests in large-capitalization U.S stocks, would have outperformed the S&P 500 Index over the last 20 years—with an average annual return of 10.91 percent versus 10.42 percent for the S&P 500 The concluding paragraph of the brochure states, "Using this trading

strategy over the long term will lead to superior performance compared with the S&P 500." The brochure does not provide the supporting data, but it summarizes these results and includes a footnote in small print stating, “Simulated results Past performance cannot

guarantee future results.”

At Twain, Litman has discretionary authority over the portfolios of individual stocks and bondsfor about 30 clients His ten largest clients vary widely in age, occupation, and wealth For a variety of reasons, each of these accounts requires significant attention The remaining two-thirds of Litman’s clients are stable, long-term investors, all of whom are saving for

retirement Litman performs comprehensive quarterly reviews with the owners of the ten largest accounts and similar annual reviews with the remaining clients Recently, he made an

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exception to this rule when he learned that one of his smaller, less active clients had

unexpectedly inherited $600,000 from an aunt’s estate Litman met with the client and

performed a comprehensive review of the client’s financial situation even though only three months had passed since their last meeting

With a new CEO, Twain, which adheres to the Asset Manager Code of Professional Conduct, experiences significant change during the year when management hires a compliance officer The compliance officer immediately begins to update the firm's policies and procedures After

a thorough analysis, the firm decides to outsource its back-office operations and hires an independent consultant to review client portfolio information At the same time, they add several research and investment staff and upgrade the information management system They eliminate paper records in favor of electronic copies and develop a business-continuity plan based on current staffing

Eighteen months later, the compliance officer resigns Rather than hire externally,

management designates one of its senior portfolio managers as the new compliance officer The compliance officer reviews both firm and employee transactions and reports to the chief investment officer

Question 1

According to CFA Institute Standards, for Litman to comply with the Standards in regards to Twainand non-Twain clients, he must do which of the following?

Select exactly 1 answer(s) from the following:

A Inform his immediate supervisor.

B Obtain written consent from both Twain and his non-Twain clients.

C Nothing more as he has already informed Twain management and his non-Twain

clients explaining the relationship

Correct Answer = B

"Guidance" for Standards I — VII, CFA Institute

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2009 Modular Level III, Vol 1, pp 75, 89-91

Study Session 1-2-a

Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct byinterpreting the Code and Standards in various situations involving issues of professional integrity.According to Standard IV (B), Duties to Employers: Additional Compensation Arrangements, Litman must obtain written permission from all parties involved

2 According to CFA Institute Standards and Procedures for Compliance, which of the following

information in regards to Litman managing funds for his family and friends is least likely required

for him to comply with the Duty to Employer?

A The names of his non-Twain clients.

B The amount and type of compensation received.

C The duration of the investment management agreements.

Correct Answer = A

2009 Modular Level III, Vol 1, pp 67, 75

Study Session 1-2-a

Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations involving issues of professional integrity.According to the recommended Procedures for Compliance for Standard IV (B), Duties to Employers:Additional Compensation Arrangements, members should disclose the terms of any agreement under which a member will receive additional compensation Terms include the nature of the

compensation, the approximate amount of compensation, and the duration of the agreement

because such arrangement may affect loyalties and objectivity, thus creating a potential conflict of interest

According to Standard III (E), Duties to Clients: Preservation of Confidentiality, members must keepinformation about current and prospective clients confidential

3 In his promotional material about the performance of his portfolio trading strategy, is Litman

in compliance with CFA Institute Standards of Professional Conduct with respect to the

footnote?

A Yes.

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B No, because he doesn't state whether the results are net or gross of fees.

C No, because he should not be using simulated results to make a comparison.

2009 Modular Level III, Vol 1, pp 64- 65

Study Session 1-2-a

Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct

by interpreting the Code and Standards in various situations involving issues of professional integrity

The footnote is a standard disclaimer regarding the performance numbers presented (simulated)

as well as expectations of the future in that past results do not necessarily reflect future

performance The Code does not prohibit the use of simulated performance analysis as long as it

is clearly stated that the results are simulated

4 Did Litman violate any CFA Institute Standards in regards to his performance reviews?

A No.

B Yes, with respect to the frequency of reviews for his ten largest clients.

C Yes, with respect to his recent review for the client with the inheritance.

2009 Modular Level III, Vol 1, pp 60-62

Study Session 1-2-a

Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct

by interpreting the Code and Standards in various situations involving issues of professional integrity

According to Standard III (C), Duties to Clients: Suitability, members shall make a reasonable inquiry into a client or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendations or taking investment actionand must update this information regularly Such an inquiry should be repeated at least annually and prior to material changes to specific investment recommendations or decisions on behalf of the client

5 Are Twain's actions and procedures during the first year of the new CEO's tenure in compliance

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with the Asset Manager Code of Professional Conduct?

A Yes.

B No, because it outsourced its back-office operations.

C No, because by hiring an independent consultant it violates client confidentiality.

Asset Manager Code of Professional Conduct: Compliance and Support, including Appendix A

(CFA Institute, Centre for Financial Market Integrity, 2005)

2009 Modular Level III, Vol 1, pp 194-195, 203

6 With respect to its most recent compliance officer, are Twain's actions and procedures in

compliance with the recommendations and requirements of the Asset Manager Code of

Professional Conduct?

A Yes.

B No, because the compliance officer should not be an existing employee.

C No, because the compliance officer should not report to the chief investment officer Correct Answer = C

Asset Manager Code of Professional Conduct: Compliance and Support, including Appendix A (CFA

Institute, Centre for Financial Market Integrity, 2005)

Study Session 2-6-b

Interpret the Asset Manager Code in specific situations presenting issues of compliance,

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disclosure, or professional conduct.

According to the Code, the compliance officer should report directly to the CEO or board of

directors so that this person is independent from the investment personnel Depending on the sizeand complexity of the Manager's operations, some Managers may designate an existing employee

to also serve as the compliance officer

7

Dena Pearson Case Scenario

Dena Pearson is a recent hire at a large international bank She is currently working a

rotation in the Risk Management Group, where she has received several assignments

For her first assignment, Pearson must draft a response to an inquiry from a client seeking information about value at risk or VAR The client’s email stated:

“This month’s report states that using a 95 percent confidence level, the

portfolio has an average daily VAR of $1 million I need clarification on what

this means I would also like to understand what would happen to the VAR

measure if the confidence level was increased to 99 percent and the

frequency was changed from daily to monthly

In the notes, the report states that the VAR is based on the analytical or

variance-covariance method What are the key advantages and

disadvantages of this method? Why doesn't the bank use the historical

simulation method or the Monte Carlo simulation method?”

Pearson drafts a response to the client’s questions In her response, she states:

“Assuming 250 trading days in a year, the current VAR estimate indicates

that the daily portfolio loss will likely exceed $1 million approximately

twelve to thirteen times over a period of one year Switching to a 99

percent confidence level would provide a less conservative VAR estimate.”

Later in the response, she writes:

"Disadvantages of the historical simulation method include that the model:

1) is nonparametric,

2) relies completely on events of the past, and

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3) applies historical price changes to the current portfolio.

The chief disadvantage of the Monte Carlo method is that it relies on historical data to generate outcomes based on a normal probability distribution For these reasons, we prefer the analytical method."

Pearson's second assignment is to evaluate the credit risk of several positions, including:

1 A call option the bank purchased from a dealer for $30 The current market price of the option is $35

2 A short position in a one-year forward contract with a forward price of

$200 that has six months remaining until expiry The forward price was determined based on a risk-free rate of 5.5 percent The current spot price

of the underlying asset is $207

Question #7 out of 30

Pearson's draft response to the client clarifying the meaning of the current VAR measure is:

A correct.

B incorrect, because VAR represents a maximum loss that will not be exceeded.

C incorrect, because over a full year, the VAR will be larger than the amount for a single

day

"Risk Management," Don M Chance, Kenneth Grant, and John Marsland

Study Session 14-40-e, g

Interpret and compute value at risk (VAR) and explain its role in measuring overall and individual position market risk

Discuss the advantages and limitations of VAR and its extensions, including cash flow at risk, earnings at risk, and tail value at risk

Assuming 250 trading days per year, if daily VAR at 95 percent confidence level (violated 5

percent of the time) is $1 million, over one year a daily loss exceeding $1 million should occur approximately 5 percent of 250 days or 12.5 days

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8 To address the client's question regarding a shift from a daily to a monthly VAR measure,

Pearson's most accurate response would be that the VAR estimate for the portfolio would:

A increase.

B decrease.

C not change.

Study Session 14-40-e

Interpret and compute value at risk (VAR) and explain its role in measuring overall and individual position market risk

The longer the time period chosen, the greater the VAR number will be because the magnitude of potential losses varies directly with the time span over which they are measured

9 Pearson decides to expand her answer regarding the bank's method for estimating VAR to add discussion about the key advantages of the analytical method One of the key advantages of the analytical method that she could discuss is the:

A simplicity of the method.

B assumption that returns are normally distributed.

C ability to incorporate optionality into the analysis.

Study Session 14-40-f

Compare and contrast the analytical (variance-covariance), historical, and Monte Carlo methods for estimating VAR and discuss the advantages and disadvantages of each

The model for the analytical method uses readily available data and simple calculations

10 Are Pearson's three statements regarding the disadvantages of the historical method for estimating VAR correct?

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A Yes.

B No, the first statement is not a disadvantage.

C No, the third statement is not a disadvantage.

11 For the bank's long call option position, Pearson's most appropriate estimate of the amount at

risk of a credit loss is:

A $0.

B $30.

C $35.

Correct Answer = C

Study Session 14-40-i

Evaluate the credit risk of an investment position, including forward contract, swap, and option positions

The current failure (e.g., bankruptcy) of the option seller would mean the option holder (the bank)would lose the entire market value

12 For the forward contract position, Pearson's most appropriate estimate of the amount of

potential credit risk is:

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A $0.

B $1.53.

C $12.28.

Study Session 14-40-i

Evaluate the credit risk of an investment position, including forward contract, swap, and option positions

The value of the long position is +$12.28 = $207 — $200 / (1.055)0.5 This means the short(the bank) owes the long, so the short (the bank) has no credit risk

13

Bae Chung Case Scenario

Bae Chung, CFA, is the owner of Kyung Securities, a small boutique firm that manages

US$4.2 billion in leveraged fixed income portfolios for clients Chung has been meeting withmanagers of a pension fund that is interested in placing $500 million under Kyung's

management and is preparing a proposal for them

At a meeting with the pension fund's representatives, Chung was asked to explain Kyung's use of leverage Chung replied, "We use the repo market

to borrow against client assets and leverage up portfolio returns Our

mandate allows us to borrow between 0 and 75 percent of the equity of

the portfolio, depending on our market outlook." Bae then makes the

following statements:

Statement 1: "In the current market, our average client portfolio has an expected asset

return of 7.40 percent, our average portfolio leverage is 40 percent, and we pay 4.25 percent in the repo market."

Statement 2: "We place client assets that are used in these repurchase agreements in a

custodial account at our bank, rather than using wire transfer of title This delivery method results in lower delivery charges and lower repo rates."

The proposal that Chung is creating discusses Kyung's fixed income investment

philosophy: "We seek the highest risk-adjusted returns by purchasing bonds and other

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fixed income securities that our models indicate are underpriced with respect to credit risk characteristics Our investment policy requires that we purchase only investment grade (BBB-rated or higher) securities and sell any security that is downgraded to speculative grade Further, our policy requires that we use derivatives to hedge credit risk for any position rated below A We do not consider a client's target duration until after the portfolio is formed, at which time we use interest rate futures contracts to modify the duration of the portfolio, as necessary."

Chung develops an example of changing a portfolio's duration based on the data in Exhibit 1.

Exhibit 1 Bond Portfolio and Bond Futures Data

Conversion factor for cheapest to deliver bond 1.15

Based on earlier discussions with the pension fund's managers, Chung was prepared to recommend a model portfolio with a duration of 5.0 years, measured against U.S interest rates More recently, Chung was told that the pension fund owns $100 million worth of Australian bonds that must be included in the portfolio for the next year These bonds have a duration of 3.2 years and Chung estimates that Australia's country beta is 0.80 The expected (local currency) return on the bonds is 8.50 percent, and the 1-year risk-free yields are 1.3 percent in the U.S and 4.6 percent in Australia The spot

exchange rate is USD0.69/AUD and the one year forward rate is USD0.67/AUD

Chung's proposal includes a recommendation that the pension fund consider adding exposure to emerging markets The recommendation states that, "Many investors avoid emerging fixed income markets to their detriment On average, the returns earned in these markets exceed those earned in developed countries and downside risks are compensated with equally large upside potential."

The proposal concludes with a review of Kyung Securities' performance

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during the last three years It indicates that, on average, Kyung's

signature core-plus portfolio has produced alpha of 35 bps against fees of

22 bps with tracking error of 150 bps.

Question 13

Based on Statement 1, the expected return of Kyung's average client portfolio is closest to:

A 8.66%.

B 10.55%.

C 11.81%.

"Fixed-Income Portfolio Management — Part II," H Gifford Fong and Larry D Guin, CFA

Study Session 10-31-a

Evaluate the effects of leverage on portfolio returns

RP = rF + (B / E) × (rF — k), where RP = portfolio rate of return, where rF = return on funds

invested, B = amount of borrowed funds, E = amount of equity, and k = cost of borrowing

Assuming $100 invested, then,

14 Chung's Statement 2 regarding delivery of assets in repurchase agreements is most likely:

A correct.

B incorrect, because repo rates are lower for electronic (wire) transfer of title.

C incorrect, because delivery charges are lower for electronic (wire) transfer of

title

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15 Chung's proposal mentions the use of derivatives to hedge credit risk

Given Kyung's policy, which of the following instruments would most likely

be used?

A Binary credit options.

B Credit spread options.

C Credit spread forwards.

A credit spread option is inappropriate, because credit spreads can widen or tighten due to generalmarket conditions, rather than specific ratings changes A credit spread forward is even more inappropriate because it exposes the portfolio to losses if the spreads tighten, which will happen if Kyung's models are correct and the securities purchased are indeed undervalued

16 According to the data in Exhibit 1, the number of futures contracts that must be purchased

to meet the portfolio's target duration is closest to:

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