Mock sample exam CFA level III mock exam itemset questions 2009

Zhang provides wealth management services solely to high net worth individuals and has adopted the CFA Institute Standards and Asset Manager Code of Conduct.. Zhang has strict trade allo

2009 Level III Mock Exam

The 2009 Level III Chartered Financial Analyst® Mock Examination has 60 questions

To best simulate the exam day experience, candidates are advised to allocate an average

of 18 minutes per item set (vignette and 6 multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam

1-6 Ethical and Professional Standards 18

7-12 Ethical and Professional Standards 18

31-36 Fixed Income Portfolio Management 18

37-42 Risk Management Application of Derivatives 18

43-48 Risk Management Application of Derivatives 18

49-54 Portfolio Management of Global Bonds 18

Questions 1 through 6 relate to Ethical and Professional Standards

Weiying Shao Scenario

Weiying Shao, CFA, is an investment officer employed by Zhang Financial Services Zhang provides wealth management services solely to high net worth individuals and has adopted the CFA Institute Standards and Asset Manager Code of Conduct

Shao receives a request from a client asking for an itemized accounting of the actual fees and other costs charged to them for the year Shao sends the client a document itemizing management fees paid by the client along with an explanation as to how the fees were derived

Zhang has expanded its services recently to include proprietary mutual funds Two experienced and respected research analysts were promoted to manage the new mutual funds

Shao meets with Guohua Xu, a client who holds a diversified portfolio of funds

Traditionally, Shao has invested client assets in long-established funds with strong

performance and management continuity Because he has great respect for Zhang’s new products and their portfolio managers, Shao suggests investing a portion of Xu’s portfolio

in one of the new Zhang funds He recommends a fund with investment objectives

similar to those of Xu Shao provides performance data based on a simulated application

of the fund’s approach over the past 18 months He adds, “The new fund’s simulated performance is comparable to the performance of your current holdings over that period.” Several clients ask Shao about hedge funds After carefully screening for risk and return characteristics, Shao recommends selected hedge funds he finds appropriate for even conservative clients The funds have had excellent performance so Shao believes they are appropriate despite their three year lock out prevision He discusses his research and recommendations with a colleague who responds “I don’t believe hedge funds are

appropriate for any of our conservative clients, especially those with short-term liquidity needs.”

Periodically Shao reviews Zhang’s confidential proxy voting policy that is disclosed to clients only upon request The policy directs investment officers to be selective when reviewing proxies, and to avoid spending time reviewing and voting routine proxies In such cases, Zhang considers the cost involved for the client to be greater than the benefit that the client would receive

Zhang has strict trade allocation procedures developed in accordance with the CFA

Institute Standards and Asset Manager Code of Conduct The firm distributes copies of the procedures to clients annually Occasionally, Shao receives notice from the trading desk at the close of the day informing him that his block trades were only partially filled

Recently, when the trading desk could not execute the full $750,000 in stock that he had requested for two accounts, he allocated $100,000 of the stock to the $5 million dollar private account and the remaining $500,000 of stock to a $25 million dollar institutional account

During the next month, Zhang’s founder is accused by regulatory authorities of a number

of violations including misappropriation of client funds The same day, a team of senior portfolio managers leave Zhang to start their own firm Zhang instructs its personnel not

to discuss either of these developments with current or prospective clients

1 Are the fee disclosures made by Shao to his client consistent with the CFA Institute Asset Manager Code of Professional Conduct?

A No

B Yes, because Shao disclosed how fees are derived

C Yes, because Shao itemized the management fees paid on the client’s behalf

2 By recommending that Xu switch a portion of his portfolio to a new Zhang fund, does Shao violate any CFA Institute Standards of Professional Conduct?

A No

B Yes, because he has a conflict of interest as the new funds are proprietary

C Yes, because the fund data used in the performance comparison was

4 Is Zhang’s proxy voting policy consistent with the requirements and

recommendations of CFA Institute Standards and the Asset Manager Code of Conduct?

A Yes

B No, because the proxy voting policy should be disclosed to all clients

C No, because voting of all proxies is a part of the management of client

investments

5 When allocating the shares on the partially filled block order does Shao violate any CFA Institute Standards?

A No

B Yes, because he fails to disclose the firm’s trade allocation policies

C Yes, because he should allocate shares to client accounts only after the order

is completely filled

6 According to the CFA Institute Asset Manager Code of Conduct, Zhang must disclose the information regarding its:

A founder only

B team of senior portfolio managers only

C both the founder and the team of senior portfolio managers

Questions 7 through 12 relate to Ethical and Professional Standards

Anne Zawadi Case Scenario

A group of fund management professionals recently formed a self-regulating professional association, the Fund Managers’ Association (FMA), whose main objective is to increase the level of integrity of fund management in the country Membership in the FMA is restricted to fund management firms

The FMA wants to create a Code of Conduct to be used by all the firm members of the FMA To help in the creation of the Code, the FMA has hired Anne Zawadi, a CFA charterholder

In the first meeting between the Board of the FMA and Zawadi, the Chairman of the FMA Board states, “Our initial thoughts are to require all of our members to adopt the CFA Code of Ethics and Standards of Professional Conduct rather than create our own code If they fail to abide by the CFA Code, their membership will be revoked.”

Zawadi responds, “Perhaps it would be better to adopt the CFA Institute Asset Manager Code of Professional Conduct, as it is specific to asset management firms, not

individuals The Code lays out principles of conduct, including acting in a professional and ethical manner, acting for the benefit of clients at all times and with independence and objectivity, in addition to acting with skill, competence and diligence It also covers communication with clients It is so comprehensive there is no need to allow any

flexibility amongst your members However, it only covers some aspects of our capital markets regulations but it should be adopted without any further provisions.”

After Zawadi’s comments, the FMA Board agreed to adopt the CFA Asset Manager Code without any changes or additions, requiring all its members to strictly abide by it It also required its members to state in their marketing material that their clients could submit complaints regarding any member to the FMA’s Compliance Committee

One year later, the Compliance Committee of the FMA asks to meet with Zawadi to discuss a complaint against one of its members, Amani Asset Management The

complaint comes from a client who gave Amani full discretion and believes Amani violated the Asset Managers Code His opinion is based on the fact that he lost one third

of his portfolio value over the last year The client claims he was told by one of Amani’s managers that recently all of their clients’ asset allocations were heavily weighted to more speculative equity investments in order to enhance returns The manager is also alleged to have told the client his performance is really quite good as the market lost 50 percent

Along with his complaint, the client submitted his investment policy statement, prepared

by Amani Zawadi noted that the client’s risk tolerance in the statement was described as

“moderate” due to his conservative nature and poor investment experiences in the past

Amani’s client also indicates he heard that Amani had been fined a substantial amount of money by regulators for not complying with regulations regarding the handling of client funds The client also indicates that as a result of the disciplinary action, several top management personnel left the company The client enclosed Amani’s last bi-weekly newsletter in which Amani disclosed recent staff additions, new management fee

structures, and changes in handling client account procedures

As part of the FMA’s objective of improving standards in their industry, the FMA Board asks Zawadi to review the procedures they require of their members in regards to

Compliance and Support, Trading and Disclosure Zawadi finds the following existing procedures in place:

Compliance Members are required to ensure all their employees sign a statement and Support: acknowledging the firm’s mandatory compliance with the CFA Asset

Managers Code; appoint a Compliance Officer reporting to the CEO and Board of Directors; maintain records regarding investment decisions for a minimum of six years; and portfolio information must be checked by another department within the Member firm

Trading: Members are required to enforce procedures to ensure: clients’ interests

are first and foremost; trade allocations are distributed equally amongst all clients and best trade execution

Disclosure: Members are required to ensure all Members disclose: basis for valuation

methodology; potential conflicts of interest; and use of derivatives

After the review of the procedures she makes two recommendations as to how the FMA can further enhance integrity amongst its members:

Recommendation: Each member firm should require all of its employees to

declare on a quarterly basis, any investment actions taken

by themselves or anyone else living in their household to ensure the firms’ clients’ interests are being put before the employees of the firm

Recommendation: Member firms should restrict the use of performance fees

but solely charge clients on the basis of a percentage of assets under management so to ensure managers do not take excessive risk

7 Are Zawadi’s comments regarding the implementation and the ethical

responsibilities of the CFA Asset Manager Code of Professional Conduct

most likely accurate?

A No

B Yes, because she covers all aspects of the ethical responsibilities

C Yes, because she covers all aspects of the ethical responsibilities and mentions that the Code must be adopted without any changes

8 Did Amani’s client have a basis for making a complaint with regard to the Asset Manager Code against Amani?

9 Which of the FMA’s existing procedures regarding Compliance and Support least

likely meets the minimum Standards of the Asset Managers Code?

A Maintaining records

B Department confirmation

C Independent Compliance Officer

10 Which of the following disclosures would the FMA least likely require of their members to meet the minimum Standards of the Asset Managers Code?

A Use of leverage

B Fund audit results

C Remuneration of Professional Staff

11 Could Zawadi’s first recommendation be improved further to better meet the Standards of the Asset Manager Code and the CFA Standards of Professional Conduct?

A No, it already meets the requirements of both Codes

B Yes, disallow all employees to trade in investment securities

C Yes, require all employees to obtain permission prior to making a trade

12 Does Zawadi’s recommendation conform to the Asset Manager Code of

Standards?

A Yes

B No, Code does not forbid performance fees as long as the fee calculation is clearly disclosed

C No, Code does not forbid performance fees as long as each client’s

performance fee is calculated identically

Questions 13 through 18 relate to Risk Management

Lara Fraser Case Scenario

on my portfolio performance Can the VAR measure be adjusted to address this concern?

In addition, please explain the primary limitation of VAR.”

Fraser responds with the following statements:

Statement 1: VAR quantifies potential losses in simple terms

Statement 2: VAR often underestimates the magnitude and frequency of the worst

Galaxy & Co.’s senior management wants to be confident that the firm is managing and measuring credit risk in an appropriate manner They ask Fraser to provide a specific example of an investment instrument within the portfolio that may create credit risk Fraser chooses to illustrate the concept of credit risk with a swap example A portion of the firm’s portfolio is invested in floating rate notes Galaxy uses interest rate swaps to manage the interest rate risk exposure of this investment Specifically, the firm has

entered into a one year pay variable receive fixed interest rate swap The swap has a notional value of £1,000,000 The current market value of the swap to Galaxy is

-£47,000

Fraser is confident that the techniques she employs to mitigate credit risk are

comprehensive and follow industry best practice standards She drafts a description of the techniques used at Galaxy and includes the following statement:

“In keeping with industry standards, our primary means of managing credit risk is

requiring that our counterparties post collateral.”

Meanwhile, Wallace drafts a memo to Fraser with some of his initial thoughts:

“As an investment firm that manages international and domestic fixed income and equity portfolios, Galaxy & Co is exposed to both financial and non-financial risks Each of these broad topics will be addressed in turn.”

Wallace decides to initially add depth to the financial risks that the firm faces

13 Fraser’s most appropriate response to Client A’s question regarding the possibility

of adjusting the VAR measure is:

A an increase in the confidence interval will increase the magnitude of the VAR measure

B the VAR measure will decrease if the time frame of measurement is

C The historical method relies completely on events of the past, and the

probability distribution of the past may not hold in the future

16 With respect to the plain vanilla interest rate swap, which of the following most

accurately describes Galaxy’s exposure to credit risk?

A No current credit risk

18 As Wallace begins to add depth to the description of the initial source of risks

present at Galaxy & Co., which of the following will he least likely include:

A taxes

B liquidity

C interest rates

Questions 19 through 24 relate to Equity Portfolio Management

William Pugh Case Scenario

William Pugh is a portfolio manager for the pension plan of the FMJ Corporation Pugh

is evaluating portfolio managers for the pension plan

PMA Asset Management follows a passive investment strategy that is implemented using ETF’s rather than conventional mutual funds PMA proposes to offer a new index

portfolio that reflects the Russell 2000 small-cap value index PMA indicates that the technique used to construct the new index portfolio assumes that the factors used to explain stock returns are uncorrelated

ASM Partners is an active manager A common strategy that ASM implements is a pairs trade where they take equal long and short positions in two common stocks in a single industry These positions are constructed so that they have no correlation with equity market returns

CKI Financial Advisors also follows an active portfolio strategy A portfolio analysis for CKI is provided below in Exhibit 1

Exhibit 1 Portfolio Analysis for CKI

Pugh is also evaluating another active manager, the DCM Group Selected information for all three active managers as well as their normal and investor benchmarks are

presented in Exhibit 2

Exhibit 2 Active Portfolio Managers’ Characteristics

and Benchmark Information

Portfolio Manager Benchmark Benchmark Active Active

ASM 15.00% 11.25% 8.50% 6.05% 4.40%

CKI 13.20% 14.25% 7.50% 4.68% 3.40%

DCM 12.75% 15.00% 10.00% 5.50% 4.00%

Pugh proposes to construct a core-satellite portfolio with the following allocations: 45 percent in PMA, 15 percent in ASM, 20 percent in CKI and 20 percent in DCM The investment management committee for the pension plan has stated that it expects the core-satellite portfolio to achieve a total active return of at least 2.1 percent and have total active risk of no more than 1.8 percent Pugh assumes that the managers’ active returns are uncorrelated Furthermore, since PMA follows a passive strategy, he assumes that active return and active risk for PMA are 0 percent

19 A characteristic of PMA Asset Management’s investment strategy is that it:

A is more tax efficient

B has lower license fees

C has higher expenses due to fund level accounting

20 The most appropriate technique for constructing PMA’s new portfolio is:

A optimization

B full-replication

C stratified sampling

21 Relative to a long-only strategy, the expected alpha of ASM Partners’ investment

strategy is most likely:

23 Based on the information in Exhibit 2, does the portfolio proposed by Pugh meet the investment management committee’s stated thresholds of risk and return?

A Yes

B No, portfolio active risk is above the threshold

C No, portfolio active return is below the threshold

24 Based on the information presented in Exhibit 2, the “true” active risk for ASM

Partners is closest to:

A 1.65%

B 4.15%

C 6.05%

Questions 25 through 30 relate to Performance Attribution

Malcolm O’Kelly Case Scenario

Malcolm O’Kelly is a performance evaluation consultant working for the Board of Trustees of the Rutherford University (RU) Pension Fund The Board has asked O’Kelly

to conduct a macro attribution analysis for the pension fund O’Kelly gathered the data shown in Exhibit 1 and Exhibit 2 The one-month return on a U.S Treasury bill is 0.41 percent

Exhibit 1

RU Pension Fund Investment Policy Allocations and Benchmark Assignments

Exhibit 2

RU Pension Fund One-month Actual and Benchmark Returns

securities their analysts have identified as undervalued The Board asked O’Kelly to perform a micro attribution analysis of Cottonwood’s equity portfolio O’Kelly’s

analysis is shown in Exhibit 3

Exhibit 3 Micro Attribution Analysis for Cottonwood Equity Advisors Portfolio

Portfol

io Weight (%)

Sector Benchma

rk Weight (%)

Portfol

io Return (%)

Sector Benchma

rk Return (%)

Performance Attribution

Total Valu e- Adde

d

Economic

Sectors

Pure Sector Selecti

on

Allocatio n/

Selection Interacti

on

Within Sector Selecti

9.3 40.6 7.3 24.3 18.5 0.0

–3.60 1.92 0.37 2.92 2.00 0.14

–3.95 1.77 0.14 2.05 1.30

0.030 –0.029 –0.021 –0.005 0.004 –0.014

–0.002 –0.007 0.005 –0.004 0.014 0.002

0.033 0.061 0.017 0.211 0.130 0.000

0.061 0.025 0.001 0.202 0.147 –0.012 Buy/hold +

The discussion then turns to fixed-income attribution analysis Board member Carolyn

Tripp asks O’Kelly about the determinants of fixed-income portfolio returns O’Kelly

responds that fixed-income portfolio returns can be attributed to an external interest rate

effect and the management effect Then Tripp asks O’Kelly about analyzing the

management effect O’Kelly responds that the management effect can be decomposed

into the following components:

• Interest rate management effect

•

: indicates how well the manager predicts interest rate changes Each security must be priced as a default-free security Then the Treasury bill rate is added to the returns on the repriced securities to obtain the interest rate management effect

Sector/quality effect

•

: measures the manager’s ability to select outperforming sectors and quality groups The sector/quality return is estimated by repricing each security in the portfolio using the average yield premium in its respective category A gross return can be then calculated based on this price The return from the sector/quality effect is calculated by subtracting the external effect and the interest rate management effect from this gross return

Security selection effect: measures how the return on specific securities within a sector relates to the average performance of the sector The security selection effect for each security is the total return for that security less all the other components The portfolio’s security selection effect is the arithmetic average of all the individual security selection effects

• Trading activity: measures the effect of sales and purchases of securities and is calculated as the total portfolio return less all the other components

25 Based on a macro attribution analysis of the information given in Exhibits 1 and

2, the incremental return contribution attributed to the Asset Category investment

strategy is closest to:

A –0.09%

B 3.48%

C 3.89%

26 Based on a macro attribution analysis of the information given in Exhibits 1 and

2, the incremental return contribution attributed to misfit return (i.e., style bias) is

closest to:

A –0.09%

B 0.08%

C 0.32%

27 Based on a macro attribution analysis of the information given in Exhibits 1 and

2, the incremental return contribution attributed to the investment managers is

closest to:

A –0.09%

B 0.08%

C 0.49%

28 Based on the micro attribution analysis presented in Exhibit 3, which part or parts

of Cottonwood’s strategy most likely succeeded?

A Sector selection

B Securities selection

C Neither securities nor sector selection