CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 10 derivatives and risk management questions

DERIVATIVES/RISK MANAGEMENT QUESTION 1 IS COMPOSED OF FOUR PARTS A, B, C, D FOR A TOTAL OF 14 MINUTES Judy Nakamura and John Lewis are consultants with Risk Assessment Associates RAA, a

DERIVATIVES/RISK MANAGEMENT

QUESTION 1 IS COMPOSED OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 14 MINUTES

Judy Nakamura and John Lewis are consultants with Risk Assessment Associates (RAA), a company that specializes in setting up and reviewing enterprise risk management (ERM) systems for asset management firms RAA has been hired by Bancroft Asset Management (Bancroft), an institutional money management firm Bancroft tried to implement an ERM system last year

Carrie Mollette, Bancroft’s CEO, has asked Nakamura and Lewis to assess the problems with Bancroft’s ERM system Nakamura and Lewis begin their review by asking Mollette for

Bancroft’s ERM goals Mollette hands them the document shown in Exhibit 1

Exhibit 1: Goals in Establishing Bancroft Asset Management's ERM System

Goal 1: Identify potential risk factors for the firm

Goal 2: Quantify the potential impact that risk factors may have on the firm

Goal 3: Minimize risk for the firm

A Explain which of the goals for Bancroft’s ERM system listed in exhibit 1 are most likely

appropriate or inappropriate

(3 minutes)

Lewis tells Mollette that in addition to market risks, Bancroft’s ERM system should explicitly identify non-financial risks faced by the firm Mollette states that the current Bancroft ERM plan document contains sections addressing nonfinancial risks, including 1) Herstatt risk, 2)

uncertainty concerning different regulations governing swaps and equities, 3) sensitivity of models to changes in risk factor correlations, and 4) the possibility of sustaining losses due to the inability to liquidate a position at a fair price

2

B Identify which of these four items are financial and which are nonfinancial risk factors

(4 minutes)

Nakamura and Mollette are discussing how Bancroft Asset Management measures market risk across the firm In the course of the discussion, they make several comments:

“The analytic method allows for modeling of the correlation between risks.”

“TVAR also measures the impact of unusual events that might not be captured in the VAR calculation.”

“I like using nominal position limits with derivatives because that gives the portfolio manager a set amount of capital to work with and measures the maximum amount that can be lost.”

C State whether or not the first and last of the comments made is/are correct Explain why

Answer Question C in the template provided

(4 minutes)

Template for Question C

Comment

Is the comment correct?

(circle one)

Explanation

“The analytic method

allows for the modeling of

the correlation of risks.”

Yes

No

“I like using nominal

position limits with

derivatives because that

gives the portfolio

manager a set amount of

capital to work with and

measures the maximum

amount that can be lost.”

Yes

No

D Explain whether or not TVAR (tail VAR) is an appropriate way to address comment 2

(3 minutes)

4

QUESTION 2 IS COMPOSED OF TWO PARTS (A, B) FOR A TOTAL OF 14 MINUTES

Zeta Investors Inc., (ZI) wants to begin using options or futures strategies to increase the returns

on its stock portfolios Three of the senior employees, Lawson Hewlett, Sandra Costakarios, and Ralph Dinara, are attending a seminar to investigate potential strategies

The instructor, Pam Watoaski, describes various ways options can be combined to create

different strategies She states, “A bull spread using call options can be created by selling a call with a low exercise price and buying a call with a high exercise price.”

At the end of the morning session, Watoaski gives the attendees the following problem to work

on during lunch based on exhibit 1 She plans to review it during the afternoon

Exhibit 1: Straddle Applications

An investor wants to execute a straddle using options on company Q’s stock Company Q’s stock

is trading at $46 Use the following table to construct a straddle

Call $2.50 $50

Call $1.25 $55

Call $0.50 $60

Put $5.25 $50

Put $2.25 $45

Put $0.75 $40

*All are European options with the same expiration date of September 201X

At lunch, Hewlett meets Dinara and Costakarios to discuss what they’ve learned Dinara says,

“You can use a long put on interest rates to place an upper limit on the effective interest earned

by a floating-rate lender.” Regarding the session she attended, Costakarios adds, “Gamma

measures how delta changes in response to a change in an asset’s price.”

A State whether or not each of the comments made is correct If incorrect, explain why

Answer Question A in the template provided

(6 minutes)

Template for Question A

Comment

Is the comment correct?

(circle one)

Explanation

“A bull spread using call options

can be created by selling a call

with a low exercise price and

buying a call with a high exercise

price.”

Yes

No

“You can use a long put on

interest rates to place an upper

limit on the effective interest

earned by a floating-rate lender.”

Yes

No

“Gamma measures how delta

changes in response to a change

in an asset’s price.”

Yes

No

6

B Using the options on company Q’s stock, calculate the maximum loss, breakeven stock

prices, and maximum profit for a straddle Show your work

(8 minutes)

QUESTION 3 HAS SIX PARTS (A, B, C, D E, F) FOR A TOTAL OF 23 MINUTES

Steve Simms is a derivatives specialist with Lean Asset Management (LAM) Jane Goodwell is one of LAM’s portfolio managers She manages an illiquid equity portfolio, and the stock

positions have taken considerable time to accumulate Goodwell is now expecting a sharp market decline She asks Simms for advice on a hedging transaction to lower the portfolio’s equity exposure by 10%

Simms gathers the following data:

 Portfolio size and beta: GBP157 million and 1.04

 6-month contract price, multiplier, and beta: GBP1,024, 500, and 0.97

Six months later, the contracts expire The market has declined 5.7%, the contract price is 973, and the unhedged portfolio value is GBP147,750,000

A. Calculate the number of contracts Simms will sell to meet Goodwell’s objective Show your

work

(3 minutes)

B. State the additional information required for Simms to make this hedge a synthetic position, and quantify what must be done at initiation of the synthetic position with contacts,

underlying securities, and cash equivalents

(5 minutes)

8

C. Assume Simms had made a different trade and sold 40 contracts, calculate the effective beta

achieved with the hedge

(4 minutes)

D At the end of the contract life, Goodwell observes that the effective beta is different from

what was expected State two reasons this may have happened Do not use contract rounding

as a reason No calculations are required

(4 minutes)

E. Explain how Goodwell could achieve comparable hedging results using an index-based

equity swap, and discuss two risks of using such a swap to meet her objectives

(4 minutes)

Goodwell manages another portfolio that includes foreign equity positions She assumes the foreign equity and derivatives markets are highly efficient

F Discuss the additional information needed to estimate the portfolio return if she hedges the

foreign equity market and currency risk

(3 minutes)