2009 l3 sample exam v2 qa

162 Study Session 1-2-a, b Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by interpreting the Code and Standards in various situations invol

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NEW-Level 3 Version 2 2009 Sample Exam

1

Jorge Peña Case Scenario

Jorge Peña is a broker and CFA Institute member who passed Levels I and II of the CFA® examination in 2006 and

2007 Because of a demanding work schedule, he did not enroll for the 2009 Level III exam He hopes to enroll for the 2010 Level III exam

In April 2009, Peña decides to apply for a broker position with regional brokerage firm Harvest Financial and updates his résumé (curriculum vitae) Peña did not earn a degree, so he details his academic experience by stating the four years he attended a prestigious university He prominently displays “CFA® candidate” and states that he “completed both Level I and Level II of the Chartered Financial Analyst Program.” Under the “Personal” section of his résumé, Peña lists “referee for regional football league” and “member of investment committee, Mueller School.”

During an interview with Peter Williams of Harvest Financial, Peña explains that he currently has more than 100 brokerage clients Based on relationships with those clients over the years, he feels confident that at least half of them will transfer their accounts to Harvest if he is employed there

Over lunch, Peña and Williams discuss his personal interests, including football Peña has been refereeing football games for five years It is a significant time commitment, but he explains that he enjoys the activity and that the fees

of $50 per game more than pay for his travel expenses Peña and Williams agree that $50 per game is not material They then discuss Peña’s role on the investment committee of the Mueller School The committee monitors and evaluates the performance of the school’s asset managers It is a volunteer position, but the school allows all

volunteers free use of the school’s athletic facilities, which Peña enjoys because the facilities are state-of-the-art Peñaand Williams agree that neither his refereeing nor his investment committee activities will interfere with his duties at Harvest

After lunch, Williams introduces Peña to an old colleague who happens to be a client of Peña's current employer and who also attended the same university as Peña The colleague asks, “In what area is your degree?” Peña replies, “I mostly studied finance I found the coursework to be very helpful preparation for the Chartered Financial Analyst program, which is a postgraduate program in finance I have completed both Levels I and II of the CFA Program.” He

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then adds, "You should leave your current broker There are rumors they are in trouble; that's why I want to leave."

One month later, Peña accepts an offer of employment from Harvest Financial On the first day in his new job, he

hangs a framed copy of the CFA Institute Code of Ethics on his wall and places a copy of the Standards of Practice

Handbook on his bookshelf for easy reference When his supervisor mentions the Code hanging on the wall, Peña

replies “I conduct my business affairs so that I comply with both the Code and the Standards of Professional

Conduct.” He does not explain the Standards to his supervisor or mention the Handbook Later that day, Peña uses public records to contact his clients He informs them of his new position and asks them to transfer their accounts to Harvest so that he can continue acting as their broker One month after starting his new job, only 25 of Peña’s clients have transferred their accounts to Harvest

At Harvest, Peña attends an educational seminar about a new tax-advantaged investment program available for clientssaving for college and university expenses The program offers families the opportunity to obtain growth and

distribution of earnings that are free from federal taxes More than 80 individual plans are available and more than one-quarter provide additional local tax benefits In the interest of time and for the sake of simplicity, the Harvest supervisor provides information on only one plan, which offers only federal tax benefits

During the seminar, the supervisor shows the federal tax savings available under the plan given a number of different scenarios He informs the brokers that the plan is subject to the same compliance and suitability requirements that apply to the sale of non-tax-advantaged products The supervisor then distributes the paperwork associated with the plan, along with the firm’s compliance and suitability requirements

At the end of the meeting, the supervisor states that he has already sold $400,000 worth of plans to his clients He encourages Peña and his colleagues to contact all their clients and share the information about the savings plans

Question #1

When listing himself as a CFA® candidate on his résumé (curriculum vitae), did Peña violate any CFA Institute Standards

of Professional Conduct?

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A No.

B Yes, because he may not refer to partial completion of the program.

C Yes, because he must be enrolled to take the next scheduled exam to claim candidacy in the CFA®

Program

Correct Answer = C

"Guidance" for Standards I — VII, CFA Institute

2009 Modular Level III, Vol 1, pp 103-105

Ethics in Practice, Philip Lawton, CFA

2009 Modular Level III, Vol 1, p 162

Study Session 1-2-a, b

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

Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.Peña violated Standard VII (B), Responsibilities as a CFA Institute Member or CFA Candidate: References to CFA Institute, the CFA Designation, and the CFA Program Peña is not a candidate for the CFA charter because he is not enrolled to sit for a specified examination

2 With respect to the fees he receives as a football referee, has Peña violated any CFA Institute Standards?

A No.

B Yes, because he failed to receive written consent from his employer.

C Yes, because he failed to receive written consent from all parties involved.

Correct Answer = A

2009 Modular Level III, Vol 1, p 75

Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.Disclosure of additional compensation arrangements is required in situations where consideration might reasonably be expected to create a conflict of interest with the employer's interest The fees in question are small and unrelated to Peña's professional activities They create no conflict of interest with the employer

3 According to CFA Institute Standards, after commencing employment with Harvest, is Peña required to make any additional disclosures regarding his relationship with Mueller School?

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A No, because his supervisor agreed that his involvement will not interfere with his professional duties at

Harvest

B Yes, because he must disclose in writing to his immediate supervisor that he is a member of the school's

investment committee

C Yes, because he must not accept the use of the school's athletic facilities unless he obtains written

consent from both Harvest and Mueller School

Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.Peña must disclose benefits he receives in exchange for his services on the committee According to Standard IV (B), Duties to Employers: Additional Compensation Arrangements, members must not accept benefits or consideration that competes with, or might reasonably be expected to create a conflict of interest with, their employer's interest unless they obtain written consent from all parties involved

4 During Peña's conversation with Williams' old colleague, which Standard below is least likely to have been violated?

A Loyalty.

B Misrepresentation.

C Reference to the CFA Program.

2009 Modular Level III, Vol 1, pp 29, 69, 103-107

Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards

In the conversation with Williams' old colleague, Peña did not violate Standard VII (B), Responsibilities as a CFA Institute Member or CFA Candidate: Reference to CFA Institute, the CFA Designation, and the CFA Program, because he did not call himself a candidate but explained his participation in the program and properly stated that he had passed Levels I and II

of the CFA Program

5 Based only on the information describing his first month of employment at Harvest, did Peña violate any CFA Institute

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Standards during that time?

A No.

B Yes, because he solicited clients from his previous employer.

C Yes, because he failed to inform his supervisor in writing of his obligation to comply with the Code and

Standards

Correct Answer = A

2009 Modular Level III, Vol 1, pp 15-17, 29-31, 69-71

Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards

No violation occurred Peña is free to solicit clients using public information Although Peña did not deliver as many clients

as he had hoped, he did not make any promises Finally, while encouraged to do so, he is not obligated to inform his supervisor in writing of his obligation to comply with the Code and Standards

6 Based on the information provided regarding the tax-advantaged savings plan, the Harvest supervisor is least likely to have

violated the Standard:

A relating to Suitability.

B relating to Independence and Objectivity.

C relating to Responsibilities of Supervisors.

Correct Answer = B

2009 Modular Level III, Vol 1, pp 21-23, 60-62, 76-78

Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards.The Standard regarding Independence and Objectivity requires members to use reasonable care to achieve independence and objectivity According to the Standard, members must not offer or accept any gifts or benefits that reasonably could be expected to compromise their independence Based on the information provided, the supervisor has not received any benefits that would compromise his independence Nevertheless, the supervisor failed to exercise thoroughness in analyzingthe various tax-advantaged plans and lacked a reasonable basis for suggesting one plan over the many others As a

supervisor, he failed to establish adequate compliance procedures for determining the suitability of tax-advantaged

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programs, instead using standard compliance procedures designed for non-tax-advantaged products Finally, when selling the plan to his own clients, he failed to consider the suitability of a plan offering only federal tax savings when other plans offered additional tax advantages

7

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 six 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 investors in 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:

Fan asks Mulloth to evaluate the sensitivity of a Ginnie Mae passthrough security in the portfolio to changes in the level of interest rates and the shape of the yield curve 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 two approaches both provide effective hedges Mulloth then prepares a presentation for Fan with his findings He first liststhe following assumptions he made in his analysis:

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

Statement 2: Yield curve risk is the exposure to changes in the shape of the yield curve that impact our investments

in Treasury securities, non-callable corporates, and mortgage securities Since the sum of all key rate durations approximate the portfolio's duration, the portfolio's effective duration provides an effective measure of our yield curve risk

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

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Mulloth calculates the results of price changes using the two hedging

methodologies and the mortgage passthrough security and prepares the data

in Exhibit 1 Mulloth compares the annual spread to Treasuries of 168 basis points earned for owning the Ginnie Mae to the hedging results in Exhibit 1

Exhibit 1 Price Changes for Mortgage Security and Hedges

Increase in Yield Decrease in Yield Flattening Steepening

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

comparable Treasuries and rendering the hedge ineffective

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

comparable Treasuries and rendering the hedge ineffective

Correct Answer = B

"Hedging Mortgage Securities to Capture Relative Value," Kenneth B Dunn, Roberto M Sella, and Frank J Fabozzi

Study Session 10-32-a

Demonstrate how a mortgage security's negative convexity will affect the performance of a hedge

Assumption 1: A typical steepening or flattening in the yield curve of 14 basis points, its historical average, in a

given month

Assumption 2: The average price change is an approximation of how the mortgage security price changes for a

significant change in interest rates

Assumption 3: Our proprietary prepayment model has proven to do a good job estimating how cash flows will

change when the yield curve changes

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The value of mortgage security = value of a Treasury security — value of the prepayment option If interest rates decline, the value of the prepayment option rises and mortgage security values rise by less than comparable Treasury securities, thereby rendering the hedge ineffective The basic principle of hedging is that changes in the value of the security being hedged are offset by changes in the value of the Treasury futures position

C No, because if interest rates fall, the price of the mortgage securities will not rise as much as a

comparable Treasury security

Demonstrate how a mortgage security's negative convexity will affect the performance of a hedge

Explain the risks associated with investing in mortgage securities and discuss whether these risks can be effectively hedged.The appropriate action to hedge interest rate risk is to sell Treasury futures However, matching the dollar duration of mortgage securities and Treasury futures will not provide an appropriate hedge This is because if interest rates fall, the negative convexity of mortgage securities means the value of the mortgage security will not rise by as much as a

comparable Treasury security The result is that changes in the value of the mortgage securities will not be correctly offset

by changes in the value of the Treasury futures position

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

A Yes.

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

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

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Study Session 10-32-b

Explain the risks associated with investing in mortgage securities and discuss whether these risks can be effectively hedged.Fan should not hedge against spread (OAS) widening The spread is a risk premium for holding mortgage securities and should not be hedged By doing so, she will give up any benefit from spread narrowing Instead Fan should invest in mortgage securities when spreads offer attractive relative value to other fixed income securities

C No, because in a twist of the shape of the yield curve, callable bond prices will be more sensitive

than bullet bond prices

Study Session 10-32-c

Contrast an individual mortgage security to a Treasury security with respect to the importance of yield curve risk

Yield curve risk measures the exposure that a fixed income portfolio has to a non-parallel change in the shape of the yield curve The impact of a change in the shape of the yield curve can be quantified using key rate durations However, individual Treasury securities and non-callable corporate bonds have bullet maturities (the entire principal is due at maturity) and are therefore sensitive to changes in the level of the yield curve, but not to changes in the shape of the yield curve Mortgage securities are amortizing securities and are sensitive to changes in the level of interest rates and to changes in the shape of the yield curve This is because the pattern of cash flows of mortgage securities can be impacted bychanges in the shape of the yield curve

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Study Session 10-32-d, e

Compare and contrast duration-based approaches versus interest rate sensitivity approaches to hedging mortgage securities

Contrast a two-bond hedge that takes account of yield curve level and twist changes with a duration hedge

The average price change is an approximation for a small, not a significant, change in interest rates

12

Based on the results in Exhibit 1, does Mulloth's analysis show that he is most likely receiving sufficient spread on

the Ginnie Mae 5.5 percent mortgage after hedging costs?

A No, because the cost for the duration hedge is not offset by the additional spread.

B Yes, because the maximum loss under either the two-bond or duration hedge is lower than the

additional spread

C Yes, because hedging costs for the two-bond hedge is covered by the additional spread.

Study Session 10-32-e

Contrast a two-bond hedge that takes account of yield curve level and twist changes with a duration hedge

The right hedging strategy to use for mortgage securities for both changes in the level and shape of the yield curve is the two-bond hedge The hedging cost is calculated by subtracting the changes in the Ginnie Mae with the two-bond hedge

The cost under the scenarios presented is —0.074 basis points The 168 basis spread offers a monthly carry advantage of

14 basis points (168 / 12), which more than offsets the hedging cost

13

Giles Morgan Case Scenario

Giles Morgan, a portfolio manager at Severn Capital, a British institutional asset manager, is meeting the investment committee for Cotswold Industries' pension plan Cotswold, based in the United Kingdom and a client of Severn, has

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traditionally been conservative, and the pension plan's portfolio is diversified among U.K and non-U.K country securities.

developed-Morgan states: "There are several benefits from having international securities in a portfolio These include:

 improved covariance relations across the portfolio's exposures, resulting in greater diversification benefits;

 a wider range of industry and company choices for portfolio construction purposes."

Jama Pillai, a committee member, states, "I think the best diversification vehicle is an asset with high volatility and negative correlation with our current portfolio."

Pillai then asks Morgan, "I understand that emerging markets can provide

attractive investment returns, but what are the risks?" Morgan responds to Pillai, "Yes, emerging markets can provide attractive returns and you should consider allocating a part of the pension portfolio to emerging markets

However, there are several significant sources of risk that must be

considered:

Statement 1: The distribution of emerging market stock returns are not symmetrical and standard deviation is not a good

measure of risk

Statement 2: During periods of international crises, correlations increase thereby negating some of the benefits of

investing in emerging markets

To illustrate the impact of exchange rates, Morgan provides the data in

Exhibit 1.

Exhibit 1 Mexican Equity Portfolio and Currency Data

Portfolio Value in Mexican Pesos (MXN) after one month 21,000,000

Standard Deviation of Mexican Equity Market Returns in Pesos 8.25%

Correlation between Mexican Equity Market Returns in Pesos and the Exchange Rate 0.15

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