CFA Level III Mock Exam 4 - Questions (PM)

CFA Level III Mock Exam 4 – Questions (PM)
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CFA Level III Mock Exam 4
June, 2018
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FinQuiz.com – 4th Mock Exam 2018 (PM Session)
Questions Topic Minutes
1-6 Ethical and Professional Standards 18
7-12 Ethical and Professional Standards 18
13-18 Economic Analysis 18
19-24 Economic Analysis 18
25-30 Risk Management Application of Derivatives 18
31-36 Risk Management Application of Derivatives 18
37-42 Equity Portfolio Management 18
43-48 Fixed-Income Portfolio Management 18
49-54 Alternative Investments 18
55-60 Alternative Investments 18
Total 180

Questions 1 through 6 relate to Ethical & Professional Standards
A&J Case Scenario
Matt Beckner is a chemical engineer who works for an oil exploration firm in Ohio, USA.
Beckner is 55 years old and has an investment portfolio worth $75,000 consisting of
stocks, bonds and T-bills. In the past, Beckner has been managing his portfolio himself.
However, he now believes that getting professional expertise and financial advice for his
portfolio’s management would be prudent. Consequently, he selects Alfred & Jack
Associates (A&J) to be his capital management firm. During his visit at the firm, Beckner
meets Robin Flynn, an investment analyst at A&J. As part an introductory presentation to
Beckner, Flynn presents him with the performance of a number of A&J’s internally
managed funds. Beckner observes that many of these funds, especially the ones that
relied on complex derivative strategies, lacked an associated benchmark presentation. In
addition, when presenting the value of the firm’s real estate investments, Flynn states that
independent, third party valuations were used since fair values were not easily available.
He provides Beckner with a list of third party firms that were hired. Beckner notices that
in the past two years, A&J switched among ten firms for obtaining valuations for their
real estate investments.
While presenting to Beckner, Flynn also displays a list of the funds that the firm offered
its clients and prospects. Beckner discovers that the firm offered a total of fifteen funds
ranging from completely conservative, to very aggressive. The presentation then makes
the following comment:
“A&J has achieved excellent returns for its investors. The Aggressive Growth Fund, for
example, has had returns that exceeded its peer group benchmark by more than 12% for
the past fifteen years.”
Beckner was satisfied with the performance history of A&J’s funds. He now wanted to
know about the procedures and methods used by the managers at the firm for stock
picking. In seeking such information, Beckner approaches Gina Melton, the chief
portfolio manager at A&J. Melton tells Beckner that A&J paid a firm that served as an
intermediary in connecting analysts and investors with market experts. Many of these
experts have followed a single industry for over five to seven years, and are thus, privy to
much of the industry’s internal workings. Melton adds that A&J uses the insights of such
experts in making investment choices. He then makes the following comment:

“Whenever a portfolio manager is uncertain about the appropriate course of action with
respect to a specific client, the manager makes the decision as if it were affecting him/her.
If in doubt, the manager discloses the matter to the client and obtains client approval.”
Beckner then asks Melton about the trading procedures at A&J and the related policies in
place. Melton states that many a times they get unsolicited trade requests from clients that
are unsuitable for them. In such cases, the manager updates the client’s investment policy
statements so that he or she can clearly understand the potential effect of the requested
trade on his or her current goals.
After meeting with several other portfolio managers and employees at the firm, Beckner
is satisfied with his decision to opt for A&J to manager his portfolio. Before his
departure, Melton provides Beckner with the ID of his facebook account that she
maintained only for professional purposes. She states that this makes it easier for her to
separate her personal contacts from her professional ones.
1. In Flynn’s presentation, which of the following is most likely a red flag with
regards to a violation of the CFA Institute Standards of Professional Conduct?
A. The lack of benchmarks.

B. The third party valuations.
C. Both the lack of benchmarks and the third party valuations.
2. In his comment about The Aggressive Growth Fund, has Flynn most likely
violated the CFA Institute Standards of Professional Conduct?
A. Yes.
B. No, since Flynn is allowed to state outperformance as long as it is correct.
C. No, since Flynn has stated a fact and used a sufficiently long time horizon
to justify its accuracy.
3. In using the services of the intermediary firm, A&J has most likely:
A. not violated any Standards.

B. violated the Standards, since it is requesting or acting on confidential
information.
C. violated the Standard, since the compensation provided may result in a
conflict of interest.

4. With regards to Melton’s comment, are the managers at A&J most likely in
compliance with the CFA Institute Standards of Professional Conduct?
A. Yes.
B. No, since clients are not financial experts and decisions should not be
based on their approval.
C. No, since managers are required to seek approval from their compliance
department first.
5. With regards to the handling of unsolicited trade requests, to be in compliance

with the Standards, portfolio managers should adopt A&Js policy:
A. under no circumstances.
B. only for clients agreeing with the policy.
C. only for trades that have a material impact on the portfolio.
6. If Melton decides to leave A&J and join another firm, to be in compliance with
the CFA Institute Standards of Professional Conduct, before leaving she should
most likely:
A. delete her professional facebook account or transfer it.

B. keep her facebook accounts since they are her property.
C. keep her facebook accounts only if A&J approves of it.

Questions 7 through 12 relate to Ethical & Professional Standards
DIM Case Scenario
Delta Investment Management (DIM) is a capital management firm in New York, USA.
DIM initiated its operations as a small firm comprising of only a few portfolio managers.
With hard work and disciplined efforts, DIM has managed to increase its investable asset
base considerably. To ensure that asset managers within the firm fulfill their ethical
responsibilities with respect to the management of client assets, Brad Lowman, the CEO
of DIM is considering compliance with the Asset Manager Code of Professional Conduct.
Lowman plans to work in alliance with a team of ethical experts headed by Thomas Hahn
to research the procedures within DIM and determine the ones that need to be altered for
assuring compliance. At their first meeting, Lowman makes the following comment:
“As part of holding clients’ interest paramount, at DIM, we have established policies that
guide portfolio managers with regards to the acceptance of gifts from clients. Our policy
limits the acceptance of cash gifts by specifying the amount per time period per vendor.
Usually the items accepted are of minimal value.”
He continued with the following comment:
“Also, to preserve independence and objectivity, the managers at DIM are not allowed to
maintain multiple business relationships with a client as it can result in significant
conflicts of interests.”
As their discussion continued, Lowman mentioned that DIM offered certain financial
products that were made available only to certain qualifying clients. Also, additional
services were provided to only those clients who expressed an interest in getting them
and paid additional fees. In addition, managers at DIM engaged in ‘tag-along’
arrangements with certain clients for whom the opportunity was suitable.
Hahn was interested in knowing about the financial products offered by DIM. One such
product, The International Growth Investment Fund, particularly caught his attention. The
Fund earned a return of more than 18% last year, which was very impressive given the
performance of similar funds. On further research, Hahn discovered that the Manager of
the fund would occasionally diverge slightly from the stated strategy to take advantage of
changing financial circumstances. This was disclosed to clients in the course of normal
client reporting.

When researching the policies regarding the allocation of initial public offerings, Hahn
was surprised to learn that the firm allowed employees to participate in IPOs for their
personal accounts. In justifying this policy, Lowman stated that all employees who
wished to invest in IPOs for their personal accounts needed to seek prior approval and
were not allowed to forerun client trades. In addition, employees were required to provide
the compliance officer with copies of trade confirmations each quarter, along with a
statement of personal holdings.
As Lowman talked about the various risks faced by Managers at DIM, Hahn inquired a
little further about the risk management processes at DIM. Lowman stated that all risk
management activities were outsourced because a separate risk management firm was not
cost-effective or feasible. Hahn was confused how the managers at DIM ensured that risk
management complemented the investment management processes at DIM instead of
competing with it.
Before the meeting concluded, Hahn scrutinized the performances of DIM’s private
wealth accounts. Hahn noticed that when presenting the performance of their accounts,
portfolio managers at DIM disclosed the actual management fees, incentive fees, and
other costs charged to them. However, since future trading expenses, including
commissions and bid/ask spreads were uncertain, estimated or expected expenses were
not disclosed to prospective clients. The firm did, however, mention in all presentations
to prospects, that fees and other costs would be assessed to investors.
7. With respect to the comments made by Lowman, are DIM’s policies regarding the
acceptance of gifts and multiple business relationships most likely in compliance
with the Asset Manager Code of Professional Conduct?
A. No.
B. Yes.
C. Only with respect to multiple business relationships.

8. In offering additional services and products to only a few clients, and engaging in
tag-along arrangements, has DIM violated the Asset Manager Code of
Professional Conduct?
A. Yes.
B. Only with respect to tag-along arrangements and not with respect to
additional services and financial products.
C. No, as long as the arrangements are disclosed and made available to all
clients and opportunities are fairly allocated.
9. With regards to the International Growth Investment Fund, DIM has most likely:
A. violated the Asset Manager Code of Professional Conduct.

B. not violated the Asset Manager Code of Professional Conduct.
C. not violated the Asset Manager Code of Professional Conduct, only if the
divergence occurs less than twice a year.
10. Is Hahn’s concern about the participation by DIM’s employees in IPOs for their
personal accounts most likely valid?
A. No, because the justifications provided Lowman assure compliance.

B. No, as long as the statements of personal holdings are provided annually
instead of quarterly.
C. Yes, because to ensure best practice, firms should prohibit employees
from participating in IPOs for their personal accounts.
11. To be in compliance with the Asset Manager Code of Professional Conduct, can
DIM outsource the risk management functions?
A. Yes.
B. No, since risk needs to be analyzed and managed as part of a
comprehensive risk management process for portfolios, investment
strategies, and the firm.
C. No, because risk management functions involve the use of confidential
information about specific portfolios that can and should not be shared
with outside consultants.

12. With regards to performance presentation, has DIM violated the Asset Manager
Code of Professional Conduct?
A. Yes.
B. No, because actual, and not estimated, expenses are to be disclosed.
C. No, because the Code instructs such presentations to be made only to
clients and not to prospects.

Questions 13 through 18 relate to Economic Analysis
AGIA Case Scenario
The Analytical Group of Investment Advisors (AGIA) is a small, U.S. based financial
advisory firm that offers research and investment services covering a wide range of
domestic and international asset classes. Ryan Porter is a finance manager at AGIA and is
currently working with Douglas Bell, a research analyst, to set capital market
expectations for the coming future. Bell has researched and collected the data displayed
in Exhibit 1.
Exhibit 1:
Asset Class (U.S. Real Estate)
Standard deviation 18.50%
Correlation with the GIM Portfolio 0.55
Lock-up period 5 years
MPSR @ ICAPM required return of 14% 0.20
MPSR @ expected return of 23% 0.32
In addition, Bell also provides Porter with the following correlation matrix:
Exhibit 2:
Correlation Matrix
Correlation U.S. Equities Real Estate GIM
U.S. Equities 1.0
Real Estate - 1.0
GIM 0.75 0.55 1.0

He concludes his data gathering with the following facts and estimates:
• The Sharpe ratio of GIM is estimated to be 0.32.

• The standard deviation of the GIM is estimated to be 8.5%.
• The risk-free rate of interest is 4.0%.
• The standard deviation of U.S. equities is 22.5%.
• U.S. equities are estimated to be 80% integrated and US real estate is estimated to
be 65% integrated.
Porter reviews the data compiled by Bell and adds the following forecasts:
• Given the fiscal and monetary conditions, the yield spread is expected to narrow.
• Due to the large output gap putting downward pressure on prices, the rate of
inflation is expected to decelerate to a low level and deflation might occur.
Bell disagreed with Porter’s estimates. He believed that, to bring the economy back to its
equilibrium level, monetary policy would be tight in the near future. However, on a
parallel note, the government would cut taxes and increase spending.
While developing capital market expectations for the US, Bell also researched the
economic outlooks of two international economies. He gathered the data given in Exhibit
3.
Exhibit 3:
Growth Data for Two Economies
Economy A Economy B
Trend growth in GDP 8.0% 8.0%
Growth in labor force 2.5% 3.0%
Growth in labor force

2.75% 1.4%
participation rate
He also estimated that TFP growth accounted for 50% of the growth from labor
productivity for both the economies.

13. The Singer-Terhaar risk premium estimate for US real estate is closest to:
A. 4.18%.
B. 4.58%.
C. 13.18%.
14. The covariance between US equities and US real estate is closest to:
A. 171.69.
B. 314.50.
C. 376.30.
15. The expected return on US real estate is closest to:
A. 8.18%.
B. 8.58%.
C. 17.18%.
16. Given Porter’s outlook of the future economic conditions, an investor should most
likely invest in:
A. Real assets.
B. Short-term bonds.
C. Long-term bonds.
17. Given Bell’s forecasts of the economic scenario, the yield curve will tend to be:
A. Flat.
B. Inverted.
C. Moderately Steep.
18. Considering only the data provided in the vignette, which economy’s equities
would offer better future returns to an investor?
A. Economy A.
B. Economy B.
C. Both economies would offer equivalent returns.

Questions 19 through 24 relate to Economic Analysis
Larry Winer Case Scenario
Larry Winer is the Chief Research Analyst (CRA) at Kelly & Associates Financial
Advisory Firm (K&A), Minneapolis, USA. Winer is considering the addition of real
estate to the K&A Growth Fund. To make sure that expanding the investment universe of
the fund would add value, Winer estimated some key values for the asset class as a
whole. Using publicly traded proxies, Winer accumulated the data presented in Exhibit 1.
Exhibit 1:
Real Estate Characteristics
Expansion Recession
Risk-free rate 3.0% 3.0%

Expected return
15% 5%
on market
Β 0.7 1.30
α 0% 0%
*An expansion and recession is equally likely.
After his analysis, Winer was convinced of the diversification benefits of real estate as an
asset class. However, he was not sure how significantly the returns to equity investments
were correlated to the returns to real estate. Winer’s research suggested that investing in
direct real estate held the most benefits. However, he was unsure why the returns to
equity were positively correlated to the returns to direct real estate. For further research,
Winer regressed the returns to real estate on returns to equities and past inflation rates. In
addition, he performed a time-series analysis by regressing the returns to real estate on
lagged values of itself and lagged values of equity returns and inflation rates. He used the
results of his regression to generate an accurate conclusion about the interaction of the
two asset classes in consideration.
Given his extensive knowledge and experience with investing globally, Winer was
advised by his supervisor to determine the correlation between two international markets:
Market ABC and Market XYZ. To keep his preliminary analysis simple, Winer assumed
two risk factors that drove the returns to all assets: A global equity factor and a global
bonds factor. He also gathered the following data:

• Variance of global equity is 0.0199.

• Variance of global bonds is 0.0023.
• Correlation of global equity and global bonds is 0.40.
• The factor sensitivities of Market ABC and Market XYZ to the global equity
factor are 1.25 and 1.10 respectively.
• The factor sensitivities of Market ABC and Market XYZ to the global bond
factors are both zero.
While making notes about his findings, Winer wrote the following on his drafting pad:
“The following holds for the Markets under consideration:
1. Markets ABC and XYZ are both equity markets.

2. The zero sensitivity of both the markets to the global bonds factor shows that they
are uncorrelated with this risk factor.
3. The zero sensitivity also shows that global bonds are not one of the return drivers
for both the markets.”
Winer is also concerned with the performance of U.S. equities relative to U.S. bonds in
the near future. For this, Winer forecasted the variables given in Exhibit 2.
Exhibit 2:
Equity Market Data
P/E ten years ago 15.1
P/E as of now 33.0
Forecasted dividend yield 1.5%
GDP growth estimate 3.0%
Excess corporate growth 0.7%
Expected inflation 2.0%
Repurchase yield -2.5%
In addition to the above data, Winer also determined that the YTM on a long-term
government bond equaled 6.5%. A public economic survey report forecasted an equity
risk premium of 3.0% for equities.

19. Using Exhibit 1, the unconditional expected return using the unconditional beta
shows that real estate as an asset class:
A. fairly rewards risk.

B. adequately rewards risk.
C. inadequately rewards risk.
20. In determining the interaction of equities and real estate, Winer is trying to
establish the:
A. existence of an exogenous variable.

B. Existence of an underlying causal link.
C. Effects of partial correlation.
21. The covariance between Markets ABC and XYZ is closest to:
A. 0.0109.
B. 0.0274.
C. 0.4274.
22. Winer is least accurate with respect to:
A. Point 2 only.
B. Points 2 and 3 only.
C. neither Points 1, 2 or 3.
23. According to the Grinold-Kroner model, using the information in Exhibit 2, the
expected capital gains return on equities is closest to:
A. 11.83%.
B. 12.83%.
C. 13.83%.
24. Using the data in the vignette, the estimate of the expected return on equities is
higher using:
A. the Grinold-Kroner model.

B. the bond-yield-plus-risk-premium method.
C. either the Grinold-Kroner model or bond-yield-plus-risk-premium method,
since both estimate equivalent returns.

Questions 25 through 30 relate to Risk Management
INPI Case Scenario
Investment Planners Incorporated (INPI) has just established a new wing that specializes
in capital management strategies involving derivatives and leverage. Tony Sereno, the
head of the wing, has considerable experience with the execution of unconventional
return generation strategies. Sereno is anticipating a change in the outlook of the U.S.
automobile industry. To corroborate his finding, Sereno requested the research
department to provide him with a detailed analysis of the industry. Based on the
information provided to him, Sereno got quotations on options of an automobile stock
currently trading at a price of $250/share. Exhibit 1 provides the details.
Exhibit 1:
Options on an Automobile Stock
Strike Time to
Options Price
Rate Expiration
C0 $260 6 months $16.79
C1 $230 6 months $22.90
P0 $240 8 months $17.50
P1 $220 8 months $13.50
While reading the research report provided to him, Sereno highlighted the following
paragraph:
“The firms within the industry have reported earnings with an average standard deviation
of 22.0%. Given the structural changes that have occurred during the past few years, and
the increased bargaining power of suppliers, the earnings volatility is expected to increase
even more. External factors like government regulation have also contributed to
automobile stocks being more volatile than the overall market.”
Although Sereno found the report to be current, relevant and useful, he disagreed with
this particular piece of information. Apart from call option C0, Sereno found the dealer
quotations to be relatively overpriced. So he decided to construct a strategy that involved
using call option C0 to benefit from a decrease in the value of the stock. However, he
wanted the strategy to have minimum upfront investment. Sereno got the following
additional quotations:

Exhibit 2:
Options with the Same Underlying and Time to Expiration as C0
Put Options Strike Rate Price
Option A $260 $22.00
Option B $225 $16.50
Option C $200 $12.50
Sereno contemplated the maximum return he could gain on his strategy. He also
researched other strategies that were similar to the one he just constructed and the payoffs
to them under different scenarios.
After careful analysis of the quotations he had in hand, Sereno thought of using a box
spread to exploit an arbitrage opportunity. He got one additional quotation: A put option
with an exercise price of $230 that was selling for $17.00.
25. Given the information in Exhibit 1, if Sereno wants to take benefit of a rising
automobile market, the maximum profit of an appropriate strategy involving
options would be closest to:
A. $16.00.
B. $23.89.
C. $36.11.
26. Given Sereno’s opinion about the industry analysis in the research report, the most
appropriate strategy to use will be to go:
A. long a straddle.
B. long a butterfly spread.
C. short a butterfly spread.

27. The maximum return that Sereno could gain on his risk reversal strategy is closest
to:
A. 4.0%.
B. 10.0%.
C. 12.0%.
28. Which of the following strategies is least like the strategy that Sereno
constructed?
A. Bull spread.
B. Butterfly spread.
C. Interest rate collar.
29. Which of the following strategies is least likely based on the volatility of the
underlying?
A. Collars.
B. Straddles.
C. Butterfly spreads.
30. Assuming that all options that Sereno got quotations of expire at the same time,
and the risk free rate is 5.00%, the profit to a box spread will be closest to:
A. $18.89.
B. $22.63.
C. $31.05.

Questions 31 through 36 relate to Risk Management
UBEM Case Scenario
Unique Bond and Equity Management (UBEM) is a group of portfolio managers that
specialize in return generation strategies involving derivatives and non-traditional asset
classes. Although the firm initiated with only a few clients, it now has a considerable
client base. Ryan McGill is a portfolio manager at the firm who is reviewing the
performance of a $50 million institutional fund under his forecasted interest rate
scenarios. Based on his research, McGill deems it appropriate to reduce the duration of
the $35 million fixed-income portion from 7.5 to 4.6. McGill plans to use a futures
contract priced at $275,000 for this purpose. The contract has an implied modified
duration of 5.5 and a yield beta of 1.35. After the duration change, the yield changes such
that the bond portfolio increases in value by 2.0% and the futures price increases to
$280,000.
UBEM also offers its clients investment in a fund that replicates the performance of a
diversified portfolio of U.S. stocks as represented by the S&P 500 Index. McGill is the
brains behind creating this new product and believes it best to synthetically create the
position. The position consists of an investment of $100 million in the S&P 500. The
index has a dividend yield of 2.75% and the U.S. risk free rate is 5.5%. McGill uses
futures contracts priced at $3,500 with a multiplier of 10 to construct the synthetic index.
Every six months, the position is renewed with a new futures contract.
Liam Dunn is one of the private wealth clients of UBEM who wishes to invest in the
synthetic stock position. However, he is concerned with the accuracy of the replication
process and the exact returns that would be captured. McGill assures him of the strategy
and states that since the futures market and the risk-free bond market are fairly liquid,
executing the strategy would be easy and relatively accurate.
In addition to the above concern, Dunn posed the following question:
“If instead of creating a synthetic stock position, UBEM holds an actual investment in
U.S. stocks and uses a futures contract priced at $35,000 to convert the stock position to
cash, what will be the number of units of stock being effectively converted to cash?”

McGill performs certain calculations to determine an appropriate response to Dunn’s

query. After he concludes his computations, Dunn talks about the opportunities that
existed for managing risk using futures and forwards. He knew that there were a number
of differences between forwards and futures that made one or the other more appropriate
in certain situations. McGill makes Dunn note the following pointers:
1. Forward contracts are the preferred vehicle for the risk management of foreign
currency because of the deep liquidity in the forward market.
2. The Eurodollar futures contract is one of the most active of all futures contracts
even though most corporations do not use this market to hedge their floating-rate
loans.
3. The risk of equity portfolios tends to be managed using futures rather than
forwards.
Before his meeting with McGill concludes, Dunn tells him that he holds a position in the
stock of Ticker Products Incorporated. Dunn expects a fall in the price of his stock
holding and wanted to hedge this risk. McGill provides him with the options given in
Exhibit 1.
Exhibit 1:
Call Options
Call Options Exercise Call Price
Price
Call A $125 $55.50
Call B $115 $57.80
Call C $105 $61.00
Dunn asks McGill to structure a strategy that would give him more room for gain on the
upside. The current stock price equals $100.
31. The overall return on the $35 million fixed income portion of institutional fund
after the yield change is closest to:
A. 0.70%.
B. 1.50%.
C. 1.75%.

32. For the synthetic index fund, the money that UBEM is synthetically depositing in
risk-free bonds is closest to:
A. $100,000,000.
B. $100,011,495.
C. $100,104,398.
33. Which of the following best describes the underlying concern of Dunn regarding
the synthetic stock position?
A. The transaction will not capture the dividends that would be earned if one
held the underlying stocks directly.
B. The futures contract could expire later than the desired date.
C. The futures contract may not be correctly priced.
34. Assuming the conversion is for six months, the best response to Dunn’s question
is that the number of stocks would be closest to:
A. 2,856.
B. 2,857.
C. 2,895.
35. With respect to the differences between the use of forwards and futures for risk
management purposes, McGill is most accurate with respect to:
A. Point 2 only.
B. Points 2 and 3 only.
C. Points 1, 2 and 3.
36. If McGill structures an appropriate strategy involving Dunn’s holding of Ticker

Products Inc. stock, the maximum profit to his position will be closest to:
A. $66.00.
B. $72.80.
C. $80.50.

Questions 37 through 42 relate to Equity Portfolio management
Tom Holzinger Case Scenario
Tom Holzinger, an equity portfolio manager and advisor, is responsible for overseeing
the performance of the equity portion of three large pension funds managed by his
investment firm. In reviewing their annual performance, Holzinger gathers information
about the expected alphas and tracking risk of the pension funds’ managers. Exhibit 1
displays this data.
Exhibit 1:
Portfolio Managers’ Characteristics
Pension Fund X Pension Fund Y Pension Fund Z
Expected Expected Expected
Allocation Allocation Allocation
Alpha Alpha Alpha
Manager
22% 0% 0% 0% 35% 0%
A
Manager
10% 0.5% 54% 0.5% 0% 0.5%
B
Manager
30% 2% 26% 2% 40% 2.5%
C
Manager
38% 4% 20% 4% 25% 4.0%
D
As he continued with his review Holzinger discovered that for the most recent year
Pension Fund X reported the highest active return. To confirm the accuracy of the
reported figures, Holzinger collected the following additional facts:
• Manager C is a growth oriented manager.

• The MSCI World ex-US Index, the MSCI World ex-US growth index and
Manager C earned a return of 15%, 19% and 17% respectively.
• Manager C’s risk relative to the MSCI World ex-US Index is 6.5%. The
manager’s ‘misfit’ risk is 4% annually.
Holzinger was also concerned with the risk factors that the pension funds were exposed
to. To properly understand the risk exposures, Holzinger planned to perform an absolute
and a relative analysis of the risk biases inherent in the portfolios. He unfolded the details
given in Exhibit 2.

Exhibit 2:
Funds’ Risk Exposures (Historical)
Pension
Pension Fund Y Pension Fund Z
Fund X
Portfolio
20% 24% 22%
return
Stock
Selection Bottom up Top down Bottom up
Process
Misfit risk 0% 0% 2%
Overall style
0% 3% 5%
return
After a comprehensive performance appraisal, Holzinger concluded that a few of the

pension fund managers needed to be replaced due to below average performance and
inferior stock picking capabilities. In his attempt to replace an equity manager for
Pension Fund Z, Holzinger shortlisted three equity portfolio managers. Exhibit 3 displays
data about the managers’ performance.
Exhibit 3: Manager Details

Manager A Manager B Manager C
Historical Alpha 2.5% 1.2% 3.5%
Tracking Risk 3.5% 2.7% 6.5%
IC 0.04 0.09 0.06

Number of stocks
290 250 300
followed
In addition to the above information, Holzinger also found out the following:
• Managers A and B attempt to pick up active return through equity insights.

• Manager B evaluates every investment relative to the benchmark. Manager A
carries out absolute analysis.
• Manager C generates active return from investments other than equity. He also
follows changes in the yield curve very closely.
Holzinger also found out that Manager A invested some of the funds in a tracking
portfolio to gain exposure to a specific segment of the market. In addition, he also

invested in a long-short portfolio to generate alpha. Holzinger found this strategy very
interesting and easy to use.
37. Which of the portfolios mentioned in Exhibit 1 most likely represents the structure
of a core satellite portfolio?
A. Pension Fund X.
B. Pension Fund Y.
C. Pension Fund Z.
38. Using an appropriate measure of the manager’s stock selection ability, Manager
C’s information ratio will be closest to:
A. 0.31.
B. -0.39.
C. -1.00.
39. Using the information given in the vignette, which of the following pension funds
is most likely utilizing a completeness fund?
A. Pension Fund X only.

B. Pension Fund X and Y only.
C. Pension Fund X and Z only.
40. Which of the following managers should Holzinger most likely select to manage
the pension fund?
A. Manager A.
B. Manager B.
C. Manager C.
41. Which of the following managers most likely follows a stock-based semiactive
strategy?
A. Manager A.
B. Manager B.
C. Manager C.

42. Manager A is most likely managing his portfolios using the:
A. short-extension strategy.
B. alpha and beta separation strategy.
C. equitizing a long-short portfolio strategy.

Questions 43 through 48 relate to Fixed Income Portfolio management
Amy Wulfing Case Scenario

Amy Wulfing is a portfolio analyst who manages a fifteen million dollar fixed-income
portfolio invested in US-based corporate bonds. Wulfing manages credit risk separately
from interest rate risk and uses the Z-spread as a close approximation of the credit spread
of a security. Wulfing is currently evaluating the attractiveness of four corporate bonds
each with a different credit rating. Exhibits 1 and 2 display relevant information for all
the four bonds.
Exhibit 1: Expected Credit Loss

Expected Expected probability
Yield
recovery rate of default
Bond A 60% 0.55% 4.5%
Bond B 45% 1.38% 5.7%
Bond C 25% 5.77% 9.5%
Bond D 35% 2.90% 6.4%
Exhibit 2: Bond Characteristics

Z-spread (at the
Spread Z-Spread
end of the Holding period
Duration (today)
holding period)
Bond A 3 2.5% 2.75% 3 months
Bond B 4 2.7% 3.00% 6 months
Bond C 7 4.4% 4.90% 6 months
Bond D 5 3.5% 3.70% 6 months
Wulfing derives the following conclusions from her appraisal of the corporate bonds:
Conclusion 1: “The evaluation of spread risk and credit migration risk will bear more
importance in the assessment of Bond A than the assessment of Bond C.”
Conclusion 2: “If interest rates rise in the near future, Bond C is likely to experience the
highest % change in its price.”

Conclusion 3: “If default losses are expected to be low, and credit spreads to be relatively
tight, Bond C’s interest rate sensitivity is likely to increase.”
Wulfing is planning to construct a portfolio composed of bonds that span a broad range of
the credit spectrum. The ratings of the bonds will vary from Aaa to Caa2. In addition, the
portfolio’s mandate will emphasize a focus on long-term returns, so only intermediate to
long-term bonds will be a part of the asset allocation. To accurately assess the credit
quality of this portfolio, Wulfing will use the following approaches:
1. The arithmetical weighting of each credit rating category assigned.

2. A market-value weighted OAS of each of the component bond’s individual OAS.
Even though this portfolio would include only domestic bonds, Wulfing is evaluating the
possibilities of expanding the investment universe to include international bonds. After a
comprehensive analysis, Wulfing has shortlisted European Corporates as a plausible
option. Using these bonds, Wulfing develops the following two investment strategies:
Strategy 1: Buying credit securities in the European market and selling credit securities in
the US market.
Strategy 2: Borrowing in the euro market and investing in the US market.
Wulfing bases these strategies on the following market expectations:
Expectation 1: “Euro interest rates are expected to fall and US interest rates are
expected to rise.”
Expectation 2: “Euro bond prices are expected to rise more than the rise in US bond
prices.”
Expectation 3: “The euro/dollar exchange rate is expected to fall.”
Wulfing is also using the G-spread to estimate the price change of a bond issued by The
Eon Group (TEG). The bond has an interest rate of 6.94% and a duration of 8.0.

43 Which bond is most likely to experience the greatest credit loss?
A. Bond A.
B. Bond B.
C. Bond D.
44. Which of the following conclusion(s) is (are) most accurate?
A. Conclusion 1 only.
B. Conclusions 1 and 3 only.
C. Conclusions 1, 2 and 3.
45. Wulfing’s suggested methods of assessing the credit quality of the bond portfolio
are most likely to:
A. Overestimate credit quality.

B. Underestimate credit quality.
C. One method will overestimate credit quality, whereas the other will
underestimate it.
46. Which of the following market expectations are most likely to affect Strategy 2
negatively?
A. Expectations 2 and 3 only.

B. Expectation 1 and 2 only.
C. Expectations 1, 2 and 3.
47. Which of the following market expectations are most likely to affect Strategy 1
positively?
A. Expectation 3 only.
B. Expectations 2 and 3 only.
C. Expectations 1, 2 and 3.
48. What advantage would Wulfing gain, if instead of the G-spread, she uses the I-
spread to measure the price change of the TEG bond?
A. The I-spread more accurately reflects supply and demand.

B. The swap curve is less disjointed than the government bond curve.
C. The I-spread more accurately represents a credit risk-free rate.

Questions 49 through 54 relate to Alternative Investments
Connon Carey Case Scenario
Connon Carey is a wealthy entrepreneur who holds an investment portfolio worth ten
million US dollars. Carey’s portfolio is invested in US stocks, US corporate bonds, and
T-bills. During a recent meeting with Kasey Kreft, his portfolio manager, Carey informed
her about an expected influx of $100,000 in cash in the coming six months. Keeping the
probability of receiving this inflow in mind, Kreft recommended Carey to invest a certain
portion of his portfolio in alternative investments. She presented the following options:
1. Equity market neutral hedge funds.

2. Systematic managed futures.
3. Hedged equity hedge funds.
4. Event driven hedge funds.
5. Fixed-income arbitrage.
Carey agreed with the suggestion to add alternative investments to his portfolio but was
still contemplating which investment would be most appropriate for him, given his
circumstances. He was particularly interested in hedge funds but was also concerned with
the issues in selecting and using hedge fund indices. Kreft shared his concern, and stated
that survivorship bias was often raised as a major concern for investors in hedge funds.
However, she added that such a bias could be reduced by conducting superior due
diligence. In addition, Kreft mentioned the following additional concerns related to the
creation of hedge fund indices:
• Age effects make it difficult to compare the performance of hedge funds.

However, as the time horizon increases, age effects generally decrease in
importance.
• Lack of security trading leads to the stale price bias which causes volatility to be
understated and measured correlations to be lower than expected.
• Value-weighted indices overweigh the performance of the best-performing hedge
funds over a given time period.
As their discussion on hedge funds continued, Carey mentioned the difficulties in

appraising the performance of a hedge fund investment. Kreft stated that the most
extensively used measure for hedge fund appraisal has been the Sharpe Ratio. However,
she added that such a ratio could easily be gamed. In trying to further elucidate her point,
Kreft presented the following examples:

Example 1:
Many hedge funds take on excessive amounts of exposure to a specific risk factor to
improve the mean or standard deviation of a particular investment.
Example 2:
A hedge fund can enter a total return swap where it pays the best and worst returns for its
benchmark index each year, and the counterparty pays a fixed cash flow.
Example 3:
Many FOFs combine funds in such a way that reduces negative skewness. For example,
global macro funds with high volatility and kurtosis are often combined with equity
market-neutral funds that tend to act as volatility and kurtosis reducers.
When the discussion concluded, Kreft altered Carey’s portfolio’s asset allocation by
investing 10% of the portfolio in hedge funds. While reviewing his portfolio’s revised
asset allocation, Carey instructed Kreft to diversify his alternative investments by
including another asset class. Kreft advised Carey to invest in distressed securities, given
the economic forecasts and expected long-term financial trends. Carey agreed, though he
stated some conditions as expressed in the following comment:
“I do not want to take on an influential position by becoming the target’s major creditor
or by owning most of its stock. In addition, I would like to gain certain protection under
either scenario: the target’s prospects worsening, or the target’s prospects improving.”
Carey then posed the following question:
“Which risk should I be least worried about when investing in distressed securities?”
49. In order to achieve maximum diversification, which of the following fund options
presented by Kreft should Carey least likely invest in?
A. hedged equity and event driven hedge funds.

B. fixed-income arbitrage and systematic managed futures.
C. systematic managed futures and event driven hedge funds.

50. To minimize the concern of survivorship bias, Carey should least likely invest in:
A. Currency funds.
B. Hedged equity.
C. Funds of funds.
51. Kreft is most accurate with respect to which of the following concerns regarding
hedge funds?
A. Age effects and value-weighting effect only.

B. Stale price bias and value-weighting effect only.
C. Age effects, stale price bias and value-weighting effect.
52. Which of the examples given by Kreft least likely represents a gaming of the
Sharpe ratio?
A. Example 1.
B. Example 2.
C. Example 3.
53. Given Carey’s conditions as presented in his comment, the most appropriate
distressed investment strategy for him would be:
A. private Equity.
B. prepackaged Bankruptcy.
C. distressed Debt Arbitrage.
54. The most appropriate response to Carey’s question is:
A. event risk.
B. market risk.
C. market liquidity risk.

Questions 55 through 60 relate to Alternative Investments
Ted Smith Case Scenario
Ted Smith, a portfolio manager and research analyst, owns and operates an investment
management firm in the U.S. Smith’s firm specializes and deals mainly in the more
traditional asset classes, that is, stocks and bonds. However, recently, Smith hired a group
of financial managers who were experts in managing funds in non-traditional asset
classes; ones that had risk and return characteristics very different from those of stock
and bond investments. This branch of Smith’s firm attracted many high-net worth private
wealth clients as well as institutional funds. Martha Long is the head of this department
and is contemplating investment in a small private firm for a large pension fund. Long
estimates the market value of the firm’s equity to be $800 million. After careful
deliberation, Long determines that an investment representing 5.0% of the firm’s equity
is appropriate for the pension fund. A minority interest discount and a marketability
discount relating to the investment have been estimated to equal 25% and 20%
respectively.
After making the investment, Long met with Bruce Will, the head of the pension fund’s
board. Will was not completely satisfied with the idea of investing in alternative
investments. To mitigate his concerns, Long presented him with the information given in
Exhibit 1.
Exhibit 1:
Correlation of Alternative Investments with Traditional Asset Classes
Private
Stocks NCREIF NAREIT Bonds
Equity
Stocks 1.0
Private
-0.12 1.0
Equity
NCREIF -0.09 0.35 1.0
NAREIT 0.45 0.55 0.53 1.0
Bonds 0.23 0.05 0.13 0.19 1.0

After studying the figures, Will got convinced about the benefits of investing in more
non-traditional asset classes. He asked Long to provide him with the details of
commodity investments and their risk and return characteristics. Since Will showed an
interest in commodities, Long attempted to explain to him the return components to a
commodity index using the data provided in Exhibits 2 and 3.
Exhibit 2:
Commodity Futures
Futures
Futures Change in Convenience
Contract Maturity Price
Price (May) Spot Price Yield
(July)
August $150.55 $151.60 $0.60 15%
September $147.90 $149.00 $0.60 22%
Exhibit 3:
Commodity Index Return Components (to a long position)
Roll
Year Collateral Yield Spot Return
Return
1980 7.5% 11.0% 5.5%
2010 8.5% -11.0% 36.0%
Will was still confused about the factors contributing to commodity returns. While
talking to Long about it, he stated the following:
“I have heard that physical commodities are exposed to event risk. How true is that?”
Will’s query made Long ponder over the effect of the unique characteristics of this asset
class on the -returns earned in the commodity markets.

55. The value of the equity investment of the pension fund in the private equity firm
is closest to:
A. $22 million.
B. $24 million.
C. $20 million.
56. Which of the values given in the correlation matrix seems most inaccurate?
The correlation between:
A. stocks and NAREIT.

B. NCREIF and NAREIT.
C. private equity and stocks.
57.Given the data in Exhibit 2, the roll return is most likely:
A. positive, but is likely to decrease.

B. negative, but is likely to increase.
C. positive, and is likely to increase.
58. The most appropriate response to Will’s question is that physical commodities are
exposed to:
A. positive event risk.

B. negative event risk.
C. event risk only with respect to changes in the business cycle.
59. For the year 2010, the data in Exhibit 3 least likely implies that the:
A. market is in contango.
B. market supply is less than the market demand.
C. convenience yield has followed an increasing trend.
60. The existence of real options in the commodity market will most likely result in:
A. a downward-sloping term structure of futures prices.

B. an upward-sloping term structure of futures prices.
C. commodities being an excellent inflation hedge.

CFA Level III Mock Exam 4 - Questions (PM)

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FinQuiz.com – 4th Mock Exam 2018 (PM Session)

Questions Topic Minutes

1-6 Ethical and Professional Standards 18

7-12 Ethical and Professional Standards 18

13-18 Economic Analysis 18

19-24 Economic Analysis 18

25-30 Risk Management Application of Derivatives 18

31-36 Risk Management Application of Derivatives 18

37-42 Equity Portfolio Management 18

43-48 Fixed-Income Portfolio Management 18

49-54 Alternative Investments 18

55-60 Alternative Investments 18

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Questions 1 through 6 relate to Ethical & Professional Standards

A&J Case Scenario

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A. The lack of benchmarks.

A. not violated any Standards.

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5. With regards to the handling of unsolicited trade requests, to be in compliance

A. delete her professional facebook account or transfer it.

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Questions 7 through 12 relate to Ethical & Professional Standards

DIM Case Scenario

He continued with the following comment:

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A. violated the Asset Manager Code of Professional Conduct.

A. No, because the justifications provided Lowman assure compliance.

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Questions 13 through 18 relate to Economic Analysis

AGIA Case Scenario

Correlation with the GIM Portfolio 0.55

Lock-up period 5 years

MPSR @ ICAPM required return of 14% 0.20

MPSR @ expected return of 23% 0.32

Correlation U.S. Equities Real Estate GIM

U.S. Equities 1.0

Real Estate - 1.0

GIM 0.75 0.55 1.0

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• The Sharpe ratio of GIM is estimated to be 0.32.

Growth in labor force

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15. The expected return on US real estate is closest to:

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Questions 19 through 24 relate to Economic Analysis

Larry Winer Case Scenario

Risk-free rate 3.0% 3.0%

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• Variance of global equity is 0.0199.

1. Markets ABC and XYZ are both equity markets.

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A. fairly rewards risk.

A. existence of an exogenous variable.

22. Winer is least accurate with respect to:

A. the Grinold-Kroner model.

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Questions 25 through 30 relate to Risk Management