CFA 2018 level 3 schweser practice exam v2 exam 2 afternoon answers

For Further Reference: Study Session 1, LOS 1.b SchweserNotes: Book 1, p.2 CFA Program Curriculum: Vol.1 p.15 Question #4 of 60 After her conference call with Sunrise Petroleum, Bair s

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Question #1 of 60

Questions 1-6 relate to Ethical and Professional Standards

Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Horizon Fund BIC is an asset management firm headquartered in Holland with regional offices in several other European countries

After accepting the position, Bair received a letter from the three principals of BIC The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations Among other things, the letter stated the following:

"Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund It is your responsibility to obtain this knowledge and comply with appropriate regulations This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully You will likely need to arrange for our sister companies to buy and sell Horizon Fund shares between

themselves and at no risk over the first month of operations This will artificially support the price of the shares to allow the fund to trade closer to its net asset value, giving the perception that our fund is more desirable than other small-cap closed-end funds."

Bair heeded the advice from her firm's principals and collected information from qualified advisors on the laws and regulations of three countries: N, S, and D Assume all of the

investors in the Horizon Fund will be from these areas Based on her research, Bair has determined:

 N allows crossing trades in the fund between firm clients even though this is prohibited between clients in D BIC will internally match buy and sell orders between clients in N whenever possible, but not in D This will reduce costs for clients in N whose orders are crossed and lower total fund expenses for all clients, which will benefit the fund's overall performance

 For clients located in D, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis

as required by D's securities regulators Clients in N will only receive such reports

quarterly as consistent with that country's requirements

 For clients located in S, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment This policy is consistent with the laws and regulations in N D's securities regulations do not cover this type of situation

Three months after the inception of the fund, its market value has grown from $200 million to

$300 million, and Bair's performance has earned her a quarter-end bonus It is now the end of the quarter, and Bair is participating in conference calls with companies in her fund Bair calls into the conference number for Sunrise Petroleum The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Sunrise discussing

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the huge earnings restatement that will be necessary for the financial statement from the previous quarter The restatement will not be announced until the year's end, six days from now Bair does not remind the officers that she can hear their conversation

Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call The investment bankers then proceed to sell their personal holdings of Sunrise Petroleum stock After her meeting, Bair sells the Horizon Fund's

holdings of Sunrise Petroleum stock

Do the suggestions in the letter from the principals of BIC violate any CFA Institute

Standards of Professional Conduct?

A) Yes, the principals are pressuring Bair to perform

B) Yes, the suggested trades are intended to manipulate market data in order to attract investors for the fund

C) No, even though Bair is responsible for knowing the laws, the compliance officer is responsible for making sure the firm is in compliance

Explanation

Standard II(B) Market Manipulation prohibits members and candidates from manipulating securities price or volume with the intent to mislead BIC's principals have suggested to Bair that she artificially inflate the Horizon Fund's price to alter the market's perception of demand for the fund and mislead investors The fact the principals have informed Bair they will watch her performance is normal course of business for any employee/employer situation and not a violation If the employers were to create an environment that encourages unethical or illegal actions, that would be a violation; there is no such indication here Even though Bair may delegate supervisory duties to a compliance officer, it does not relieve Bair of making sure laws, rules, regulations, firm policies, and the Code and Standards are being followed

For Further Reference:

Study Session 1, LOS 1.b

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Standard I(A) Knowledge of the Law requires members and candidates to know and comply with rules, laws, and regulations that apply to their professional activities If there is a

conflict, members and candidates are expected to adhere to the stricter of applicable laws, rules, and regulations or the Code and Standards By seeking qualified advice, Bair meets this requirement if she then acts on that advice Clients in each country are receiving the required service Note that this is not a case of BIC establishing different levels of service That is not unethical, though it must be disclosed so that clients can select the level of service they are willing and able to pay for In this case, these are not levels of service the clients can select but BIC adherence to differing regulations Most important, there is no group of clients being disadvantaged by BIC The crossing actually benefits all clients by improving total fund performance

A) Yes, Bair's policy will violate Standard III(B) Fair Dealing

B) No, because disclosure in S would disadvantage clients residing in other countries

C) No, because disclosure in any country would break the confidentiality that Bair owes to her clients

Explanation

According to Standard III(B) Fair Dealing, members and candidates are allowed to offer different levels of service but must disclose the existence of different levels of service and allow clients and prospects to choose the desired level By not disclosing the levels of service

to investors in S, Bair is adhering to local law, which is less strict than the Code and

Standards This is in violation of Standard I(A) Knowledge of the Law, which requires she adhere to the stricter of the two She also violated Standard III(B) by not disclosing the service levels

SchweserNotes: Book 1, p.2

CFA Program Curriculum: Vol.1 p.15

After her conference call with Sunrise Petroleum, Bair should have:

A) included the information in a research report to make it public before selling the holdings from the Horizon Fund

B) attempted to have Sunrise publicly disclose the earnings restatement before informing the compliance officer of the information

C) informed the compliance officer and then publicly disclosed the information in a research report before selling the Sunrise stock

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According to Standard II(A) Material Nonpublic Information, the member or candidate cannot act on material, nonpublic information It is recommended the member or candidate attempt to have the subject company disclose the information publicly themselves If this is not possible, then the appropriate supervisor and/or compliance officer should be made aware

of the situation

By selling their personal holdings of Sunrise Petroleum, did the employees of BIC's

investment banking division violate any CFA Institute Standards of Professional Conduct? A) Yes, because they breached their fiduciary duty and were disloyal to Sunrise

B) Yes, because they were front running the information by trading for their own benefit before BIC's clients

C) Yes, because they knowingly traded on information that, if it had been publicly known, would have affected the price of Sunrise stock

Explanation

Standard II(A) Material Nonpublic Information prohibits acting on material nonpublic

information The investment bankers should have known that the information was material and nonpublic and have violated Standard II(A) by trading on the information Because the information cannot be used for account management, it cannot be considered front running ahead of the accounts There is also no indication Sunrise is a client of the investment

banking group and, therefore, no fiduciary duty to Sunrise

A) Yes, Bair violated Standard II Integrity of Capital Markets

B) No, because she ensured public dissemination of the earnings restatement information before she traded the shares

C) Yes, because waiting to trade the stock would severely disadvantage investors in her fund and would have violated her duty of loyalty to her clients

Explanation

The large earnings restatement is certainly material information Disclosing the information before the conference call does not make the information public even if several analysts overheard the information Disclosing the information to her compliance officer also does not

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make the information public Therefore, Bair has traded on the basis of material nonpublic information and is in violation of Standard II(A)

Questions 7-12 relate to Ethical and Professional Standards

Johnny Bracco, CFA, is a portfolio manager in the trust department of Canada National (CNL) in Toronto CNL is a financial conglomerate with many divisions In addition to the trust department, the firm sells financial products and has a research department, a trading desk, and an investment banking division

Part of the company's operating procedures manual contains detailed information on how the firm allocates shares in oversubscribed stock offerings Allocation is effected on a pro rata basis based upon factors such as the size of a client's portfolio, suitability, and previous notification to participate in IPOs Additionally, company policy discloses to clients that any trade needs to meet a minimum transaction size in an effort to control trading costs and to comply with best execution procedures

One of Bracco's trust accounts is the Carobilo family trust, which contains a portion of

nondiscretionary funds managed by Stephen Carobilo Carobilo has a friend who runs a brokerage firm called First Trades, to which Carobilo tells Bracco to direct trades from the nondiscretionary accounts Bracco has learned that First Trades charges a slightly higher trading fee than other brokers providing comparable services, and he discloses this to

Carobilo

Due to high prices and limited supplies of oil, Bracco has been following companies in the energy sector He believes this area of the economy is in turmoil and should present some mispricing opportunities One company he has been researching is the Stiles Corporation, which is working on a new type of hydrogen fuel cell that uses fusion technology to create energy To date, no one has been able to successfully sustain a fusion reaction for an

extended period of time Bracco has been in close contact with Stiles' pubic relations

department, has toured their laboratories, and has thoroughly researched fusion technology and Stiles' competitors Bracco is convinced from his research, based upon various public sources, that Stiles is on the verge of perfecting this technology and will be the first firm to bring it to the marketplace Jerry McNulty, CFA and vice president of the investment banking division of CNL, has been working with Stiles to raise new capital via a secondary offering

of Stiles common shares One day Bracco happened to be in a stall in the bathroom when McNulty and a colleague came in and discussed the fact that Stiles had perfected the fuel-cell technology, which will greatly increase the price of Stiles' stock

A routine audit by the quality control department at CNL discovered trading errors in several

of Bracco's accounts involving an oversubscribed IPO Some accounts received shares they should not have and others did not receive shares they should have Bracco and his supervisor Jaime Gun, CFA, are taking responsibility to reverse the incorrect trades Bracco told Gun,

"I'll correct the trades based on our clients' investment policy statements, previous

notification of intent, and according to the company's formula for allocating shares on a pro rata basis In so doing, we will fairly allocate shares so even small accounts that did not meet

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minimum size requirements will receive some shares of the IPO." Gun adds that we must go further and credit short-term interest back to the accounts that should not have received the shares

That evening, Bracco and his wife attended the company holiday party for CNL employees and their spouses Jerry McNulty, whose wife was ill and could not come to the party, arrived drunk from a meeting with Stiles' upper management During the party McNulty made

inappropriate advances toward many of the female employees and joked about the

inadequacies of Stiles' managers

While cleaning up after the party, a janitor found McNulty's pocket notebook that he

apparently dropped accidentally during the party In the notebook, McNulty wrote the

recommended amount and date of the secondary offering as well as several details on the nature of the new product Not knowing exactly what to do with the notebook, the janitor gave it to Burt Sampson, CFA, a trader at CNL Later that night, Sampson called many of his relatives and friends and told them about the upcoming offering First thing the following Monday morning, McNulty submitted an order to buy the stock for his personal portfolio Has Bracco violated any soft dollar standards regarding the Carobilo family trust? Bracco has:

A) violated soft dollar standards because he did not satisfy the requirement of best execution B) violated the soft dollar standards because client brokerage is to be used only for research

purposes to benefit the client

C) not violated any soft dollar standards since Carobilo requested that the trades be sent to a specific broker

Explanation

Commissions belong to the client and this is an example of client-directed brokerage where

the client, in this case Stephen Carobilo, is allowed to direct the investment manager to use a specific broker to execute trades Under the AMC, if the manager believes the trades are not providing best execution, he should inform the client The client has the right to make the decision in this case

Study Session 2, LOS 4.c

A) No, because the information regarding the Stiles Corporation was not acquired in a breach of confidence

B) No, because he did not base the trade solely on the information he overheard

C) Yes, because he is not allowed to trade on material, nonpublic information

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Bracco is in violation of Standard II(A) Material Nonpublic Information, which states that members and candidates cannot trade or cause others to trade based on material nonpublic information that could affect the value of an investment Even though Bracco has performed his own research and the information he acquired from McNulty and his colleague was an accident, it was nonetheless material nonpublic information and therefore cannot be traded upon

Regarding the statements made by Bracco and Gun on how to correct the trading errors:

A) only Gun's statement is correct

B) only Bracco's statement is correct

C) both are correct or both are incorrect

Explanation

Gun is correct Accounts who incorrectly received shares also lost interest on the funds during the period they held the shares The underlying principal is accounts should be made whole for the firm's mistake, in this case, with the lost interest The CFA text is silent on whether the accounts who did not receive the shares initially can keep any interest they incorrectly earned during the period until they are correctly allocated the shares Ethically it can be removed to "make them whole," although to avoid upsetting clients, the firm may decide to let them keep the interest In any case, the firm must bear all costs for the firm's mistake Accounts that do not meet the minimum transaction amount as described in the company's policies and procedures should not receive shares of the IPO, making Bracco's statement incorrect

Did McNulty's behavior at the holiday party violate the:

Code of Ethics? Standards of Professional Conduct?

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competence, diligence, respect, and in an ethical manner with employees and colleagues in the investment profession The inappropriate behavior has violated the Code The unethical behavior also violates Standard I(D) Misconduct The Standard states in part that members and candidates must not commit any act that reflects adversely on their professional

reputation, integrity, or competence His inappropriate behavior, especially drinking heavily with Stiles' management, has violated this Standard

by sharing material, non-public information with others and trading on it

Under the provision of the Asset Manager Code (AMC), in order to minimize the likelihood

of some of the recent problems, CNL must do all of the following except:

A) establish written policies to ensurer fair and equitable trade allocation

B) appoint a qualified compliance officer

C) prohibit employees from trading in securities in which the firm has positions or investment banking relationships

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Conduct both require disclosure of actual and potential conflicts of interest, neither require that firm employees be prohibited from trading in securities in which the firm has an interest

Study Session 2, LOS 4.c, d

Questions 13-18 relate to Behavioral Finance

Krista Duchene, CFA, is an investment advisor for U.S clients Below, she summarizes some recent conversations with her clients

Jonathan: Jonathan faces mandatory retirement from his unionized job in five years He has a relatively small portfolio and will be highly dependent on it in retirement His only other asset will be a modest pension He wants to avoid all international equities in his portfolio because he read in a few online news stories that many of them have performed poorly in the past year, despite having performed well for many years before that Jonathan's portfolio consists primarily of investment grade bonds that he inherited from his father He feels that his father was a knowledgeable investor, so it will be good to hold the bonds Duchene plans

to apply behaviorally modified asset allocation (BMAA) to Jonathan's situation

Seth: Seth attended his bachelor party in Las Vegas last week where he gambled and lost

$5,000 Afraid to come home and share the news with his future spouse, he accepted a

proposal with a 50% chance of losing another $5,100 (therefore, losing $10,100 in total) or a 50% chance of winning $5,000 (therefore, losing $0 in total) Being sure his luck would turn,

he won and ended up breaking even overall

Leah: Leah played a coin tossing game with her son They tossed a quarter 10 times and it came up heads every time Given that the long-term mean must be 50% heads and 50% tails, Leah said that the probability of tails turning up on the 11th loss is much more likely than heads

Micah: After careful analysis, Micah purchased 200 shares of Ruby Corp (Ruby) several months ago at $25 per share The share price fell shortly thereafter due to an unexpected anti-trust court ruling that increased competition in Ruby's industry The current share price is $20 and reliable analyst reports suggest that price properly reflects the new situation Micah says

he may consider selling his shares when the price rises above $25

Stacey: Stacey owns 6% of the outstanding voting common stock of a private company She has no involvement in the company and has considered selling the shares in the past but has not found the time to do so Also, because Stacey is independently wealthy, she would have

no need for the funds anyways

In applying BMAA to Jonathan's situation and his desire to avoid international equity and

hold the bonds, the most appropriate action would be to:

A) mitigate both his requests and have him invest in international equity and sell the investment grade bonds

B) accommodate his request to hold the investment grade bonds

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C) accommodate his request not to invest in international equities

We can more reasonably accommodate that bias and retain the bonds Totally avoiding international equity ignores the potential to lower his portfolio risk through diversification as well as potentially improve his return Both are important given his significant SLR It makes more sense to work with him and mitigate that bias

Study Session 3, LOS 6.a, b, c, d

Study Session 3, LOS 5.a

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Leah's description of the coin toss is an example of gambler's fallacy; in this case a mistaken belief that reversal to the mean dictates that the previous coin flips affect the next outcome With a coin, the next and every flip is independent of all other flips and a 50/50 proposition Anchoring and adjustment refers to being "anchored" to a previous data point Being

influenced by (anchored to) the previous forecast, the individual is not able to fully

incorporate or make an appropriate adjustment in her forecast to fully incorporate the effect

of new information It is not the same as inaccurately extrapolating past data into the future Confirmation bias refers to the tendency to view new information as confirmation of an original forecast

Study Session 3, LOS 7.f

SchweserNotes: Book 1 p.139

Which bias best describes Micah's actions with regard to his holdings of Ruby shares?

A) Anchoring and adjustment bias

"anchored" to his $25 initial purchase price

Study Session 3, LOS 6.a, b

B) Regret aversion bias

C) Status quo bias

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specifically tell us that Regret aversion bias is the fear of making a change and having it go badly, so the thought is that by doing nothing, one will never be responsible

Study Session 3, LOS 6.a, b

A) Behavioral asset pricing

B) Behavioral portfolio theory

C) Adaptive markets hypothesis

The adaptive markets hypothesis (AMH) assumes successful market participants apply

heuristics until they no longer work and then adjust them accordingly In other words, success

in the market is an evolutionary process Those who do not or cannot adapt do not survive AMH specifically assumes that investors satisfice rather than maximize utility

Holding a well-diversified portfolio as prescribed by traditional finance will maximize utility

in theory With behavioral portfolio theory, individuals construct a portfolio by layers Each layer reflects a different expected return and risk The end result does not maximize utility in theory, so there is an element of satisficing occurring Satisfice is described as investors gathering what they consider to be an adequate amount of information and apply heuristics to arrive at an acceptable decision (i.e., behavioral portfolio theory) The investor does not necessarily make the theoretically optimal decision from a traditional finance perspective

Study Session 3, LOS 6.a, b, c, d

SchweserNotes: Book 1 p.108, 109

CFA Program Curriculum: Vol.2 p.51, 52, 81

Questions 19-24 relate to Private Wealth Management and Asset Allocation

Michael Berkovsky, CFA, is a senior portfolio manager who has a wide range of institutional investment clients, including pension plans, foundations, property and casualty insurance, and life insurance He also maintains a few high net worth individual clients

One of those clients, Kathleen Penny, age 50, is a successful corporate lawyer Her son, Adam, age 15, will be going to college in a few years Kathleen established a separate college fund for him when he was born She selected a specific asset allocation at the time to

minimize the volatility of the fund The cost of tuition has been rising steadily for many years

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and is expected to be about $25,000 per year for four years when Adam is ready to attend Kathleen wants to be certain that his tuition costs will be fully covered by the college fund because the remainder of her funds have been set aside for retirement and philanthropic reasons

Kathleen is subject to marginal tax rates of 40%, 35%, and 25% on interest, dividends, and capital gains, respectively Her income tax rate is expected to decrease in the coming years as she gradually decreases her working hours to part-time in preparation for retirement Her total investment portfolio consists of taxable, tax-deferred and tax-exempt accounts Kathleen is interested in adding five-year coupon bonds to her investment portfolio, subject to the

maximum allowable amounts applicable to the accounts

Berkovsky's assistant is looking at circumstances in which asset allocations change when there are changes to investment objectives, constraints, or both She makes the following two statements:

Statement 1: A large cash inheritance that leads a client to accelerate retirement plans

will result in a change in constraints

Statement 2: Moving through the business cycle will usually trigger a change in goals

for both institutional and individual portfolios

One of Berkovsky's clients is a large foundation that awards annual scholarships to music students in need From time to time, he applies tactical asset allocation strategies to the

foundation's portfolio after examining data such as bond yields and credit spreads, GDP growth, and sentiment indicators for the past year

Another of Berkovsky's clients is an insurance company that uses the same asset allocation strategy in its employee pension plan assets as it does for its insurance assets The pension assets are invested 85% in investment grade bonds with a duration of 10.3 and 15% in

domestic and global equities The duration of the pension liabilities is about 17 years The pension plan is currently overfunded and the insurance company is capable of keeping it that way However, as part of a corporate cost-cutting strategy, the company has two objectives, (1) to reduce future cash contributions to the pension plan and (2) maintain minimal risk to the funded status In response, Berkovsky has formulated three proposals to attempt to meet the insurance company's objectives:

Proposal 1: Maintain the status quo on the asset allocation and the portfolio's

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as their primary source of liquidity to balance out the less liquid and larger loan portfolio, and therefore, portfolio assets need to be highly liquid

Which of the following asset allocations would Penny most likely have chosen for the college

fund for her son?

A) 100% equity

B) 100% bonds and cash

C) 60% equity and 40% bonds

Explanation

If her emphasis was low volatility of the fund, she selected all bonds and cash Given that she would have had about an 18-year time horizon, that may not have been optimal to balance return and risk, but her focus was low volatility All stock or 60/40 would have been more volatile

Also see Study Session 4, Reading 9

How many of the statements made by Berkovsky's assistant are most likely correct?

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Statement 2 is incorrect Individuals and institutions set their goals based on their needs Many individual's goals are longer term in nature and would not be affected by the business cycle Foundations and endowments are typically even more long term in nature Certainly the business cycle could affect some (particularly shorter term) goals for some clients A bank could certainly have varying liquidity needs through the business cycle An individual approaching retirement would often become more focused on shorter-term volatility Over all, the business cycle is not a major driver of goals for all situations (Note that someone focusing on tactical asset allocation may pay attention to the business cycle to deviate from their SAA, but the SAA is constant and driven by the goals The TAA is an effort to add value.)

Study Session 9, LOS 18.c

Which of the following tactical asset allocation approaches or strategies is Michael most

likely using for the foundation's portfolio?

Study Session 9, LOS 18.d

Which of the following asset allocation proposals for the insurance company's pension plan

is most appropriate for Berkovsky to consider?

A) Proposal 1

B) Proposal 2

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C) Proposal 3

Explanation

Adding equity should increase long run return, which would accomplish the goal of reducing future contributions However, in the short run, it makes the positive surplus (the plan is overfunded) more vulnerable to adverse market moves The surplus can be protected by increasing portfolio duration to immunize the plan liabilities You will see all of these

concepts explored throughout the Level III curriculum Knowing both goals can be

accomplished (given the positive surplus), the other choices cannot be optimal This is

essentially what can be called a two portfolio approach

Questions 25-30 relate to Asset Allocation - Currency Management

James Sanderson is an analyst with Barnard Capital Management (BCM), a U.K.-based investment management company All results are reported in GBP Many of the funds offered

by BCM include substantial foreign currency-denominated positions and Sanderson is

involved both in hedging decisions and in active currency position decisions

The BCM Global Alpha Fund takes aggressive currency bets based on a variety of active management approaches Different strategies are used at different times, depending on

perceived opportunities Sanderson is currently interested in opportunities for the Mexican peso He checks and finds six-month GBP and MXN interest rates are 0.29% and 6.71% The spot exchange rate is 23.6554 (MXN per GBP) He sees a potential advantage in undertaking

a carry trade

He has talked through his thoughts on the carry trade opportunity with Annette Fischer, a colleague at BCM, who has made two comments:

Comment 1: "I'm projecting low volatility for the MXN/GBP rate over the next six

months, and thus, the carry trade would be an appropriate strategy to undertake."

Comment 2: "My projection is that the Mexican peso will depreciate by no more

than 3% over the next six months, so your carry trade looks profitable (before trading costs)."

Sanderson is also considering a speculative position in the MXN only He checks his

technical indicators and sees the 10-day moving average of the exchange rate has just crossed and is now above the 200-day moving average of 23.5512 MXN per GBP

BCM's European Industrials Fund hedges its currency exposures The fund has just acquired Swiss franc-denominated stock in a manufacturing company, costing CHF1.5 million, and Sanderson plans to use a static forward contract-based hedge for the first six months that the stock is held, after which the position and the appropriateness of the hedge will be reviewed The GBP per CHF is 0.8095, while the six-month forward rate is 0.8143

The BCM Nordic Equity Fund invests in a number of Scandinavian markets Among the fund's holdings is a NOK11 million exposure to the OBX index (based on the 25 most liquid

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stocks on the Oslo stock exchange) Sanderson is concerned that a nạve currency hedge will ignore the potential implicit hedge between the market and the currency He believes a

minimum-variance hedge will deliver better performance Sanderson examines five years of historic data for the NOK and the stock index (the OBX) He concludes they are negatively correlated

Stephanie Swann, a client of BCM, is lunching with Andrew Baker, the portfolio manager who runs her account In the course of their conversation, Swann asks for some advice

regarding currency exposures faced by Swann Pacific, her U.K.-based import/export

business Swann mentions to Baker that she has heard that there is such a thing as a deliverable forward contract (NDF) She does not understand this and cannot see how these can be useful if there is no exchange of currency at maturity Baker confesses that he is not up-to-speed on NDFs, but calls in Sanderson, who spends five minutes explaining to Swann the basics of NDFs through an example

non-While Sanderson is in the room, Swann also asks about the use of forward contracts to hedge

a yen-denominated liability that she expects will be outstanding for about two months

Ideally, she would like Swann Pacific to be fully protected against adverse movements of the currency and retain the benefit from favorable movements Swann states that a forward contract would inflexibly remove both the costs and benefits deriving from the position, but that an option-based strategy could give Swann the two objectives she seeks

What is the best description of Fischer's comments on the carry trade between the peso and

sterling?

A) Both comments are accurate

B) Comment 1 is accurate, but comment 2 is inaccurate

C) Comment 1 is inaccurate, but comment 2 is accurate

Explanation

Comment 1 is accurate Low volatility is ideal for the carry trade because it is associated with

a stable currency or even appreciation of the higher interest rate (MXN) currency

Comment 2 is accurate The carry trade involves borrowing in the lower interest rate currency and lending in the higher interest rate currency Without getting into day count conventions (and none are provided in the case), the annual interest rate differential is 6.71 - 0.29 =

6.42% For a six-month carry trade there is an expected return of 3.21% As long as the MXN does not depreciate by more than 3.21%, the carry trade will be profitable (ignoring default and transaction costs) The prediction is for no more than 3% depreciation You may notice that the exchange rate quotes are given as indirect quotes (MXN/GBP), but we are working directly with interest rate differentials, so that is irrelevant to the correct analysis

Study Session 9, LOS 19.e

Based on the MXN/GBP moving average data, Sanderson would most likely:

A) close out his carry trade

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B) take long positions in the MXN

C) take short positions in the MXN

Explanation

In technical analysis, a shorter-term moving average crossing over a longer term moving average is considered a signal A simple way to keep the rule straight is that the shorter-term average signals the direction In this case, the shorter turn average for the MXN/GBP has moved above signaling the GBP will continue to appreciate In turn, shorting the MXN should be profitable, given that the question is premised on using a technical rule Notice that

in this question it was important to observe the quotes are given as direct prices of the the currency in the denominator You must then conclude that if the indicator suggests

GBP-appreciation in the GBP, it is signaling depreciation in the MXN That does not directly lead

to a need to close the carry trade from question 1 Recall that we have a substantial yield advantage in the carry trade

Study Session 9, LOS 19.e

B) buy CHF80,000 four months forward

C) sell CHF80,000 four months forward

Study Session 9, LOS 19.f, g

SchweserNotes: Book 3 p.180, 186

CFA Program Curriculum: Vol.3 p.409, 420

If Sanderson hedges the Nordic Equity Fund's NOK11 million exposure to the OBX using a

minimum-variance hedge ratio, the most likely short position in GBP/NOK futures is:

A) more than NOK11 million

B) NOK11 million

C) less than NOK11 million

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Study Session 9, LOS 19.i

Which of the following statements regarding NDFs is most accurate?

A) The credit risk of an NDF is typically lower than for a standard forward contract

B) The price of NDFs should be the same as for a standard forward contract

C) Selling the foreign currency forward using an NDF when the foreign currency depreciates will most likely result in a positive margin cash flow

Explanation

It is accurate to say the credit risk of an NDF is typically lower than for a standard forward contract This is because the principal sums in the NDF do not move Only a net gain or loss

at expiration are exchanged

NDFs are normally used because a capital restriction by one of the countries prohibits the cross-border movement of currency required to settle a standard forward currency contract The same restrictions disrupt the IRP arbitrage relationship that determines pricing of

standard forwards With arbitrage not practical, NDF pricing will be more affected by supply and demand factors As OTC forward contracts, there would be no margin flows even though the short position has a marked-to-market profit Note that if you want collateral or margin for an OTC instrument, you would have to specifically require that in the contract

Study Session 9, LOS 19.i

Regarding Swann Pacific's yen liability, the most appropriate strategy for Sanderson to

suggest using options on the currency would be buy:

A) 50-delta puts on the GBP

B) 50-delta calls on the GBP

C) 50-delta puts and sell 30-delta puts on the GBP

Explanation

Swann Pacific has a yen-denominated liability which means it will lose if the JPY

appreciates However, the options are on the GBP and it is equally correct to say they will lose if the GBP depreciates A protective put and buying the at-the-money 50-delta put on the

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GBP meets both objectives-removing the risk of adverse currency movement and retaining the benefit of favorable movement

Buying 50-delta puts and selling 30-delta puts on the GBP would only provide protection between the two strike prices, and that is not what was requested It does generate premium income, but again, is not what was requested A call on the GBP would give benefit if the GBP appreciates, not protection from depreciation

Study Session 9, LOS 19.h

Professor's Note: Overall, this was a rather tricky item set, but it is fair The math was not at

all excessive The issue is to know the currency relationships, pay attention to objectives, know how the data is presented, and think logically In other words, it is not hard if you do it correctly

Questions 31-36 relate to Alternative Investments for Portfolio Management

William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and

positions in physical commodities He is reviewing his operations and strategies to increase the return of the fund Bliss has just hired Joseph Cantori, CFA, to help him manage the fund because he realizes that he needs to increase his trading activity in futures and to engage in futures strategies other than passively managed positions Cantori is a registered commodity trading advisor (CTA) who generally uses a contrarian strategy to manage futures Bliss also hired Cantori because of Cantori's experience with swaps, which Bliss hopes to add to his choice of investment tools

Bliss explains to Cantori that his clients pay 2% on assets under management and a 20% incentive fee The incentive fee is based on profits after having subtracted the risk-free rate, which is the fund's basic hurdle rate, and there is a high water mark provision Bliss is hoping that Cantori can help his business because his firm did not earn an incentive fee this past year This was the case despite the fact that, after two years of losses, the value of the fund

increased 14% during the previous year That increase occurred without any new capital contributed from clients Bliss is optimistic about the near future because the term structure

of futures prices is particularly favorable for earning higher returns from long futures

positions

Cantori says he has seen research that indicates inflation may increase in the next few years

He states this should increase the opportunity to earn a higher return in commodities and suggests taking a large, margined position in a broad commodity index This would offer an enhanced return that would attract investors holding only stocks and bonds Bliss mentions that not all commodity prices are positively correlated with inflation, so it may be better to choose particular types of commodities in which to invest Furthermore, Bliss adds that commodities traditionally have not outperformed stocks and bonds either on a risk-adjusted

or absolute basis Cantori says he will research companies who do business in commodities because buying the stock of those companies to gain commodity exposure is an efficient and effective method for gaining indirect exposure to commodities

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