CFA Level III Mock Exam 3 - Solutions (PM)

CFA Level III Mock Exam 3 – Solutions (PM)
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CFA Level III Mock Exam 3
June, 2018
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FinQuiz.com – 3rd Mock Exam 2018 (PM Session)
Questions Topic Minutes

1-12 Ethical and Professional Standards 36
13-18 Alternative Investments 18
19-30 Risk Management 36
31-36 Risk Management Application of Derivatives 18
37-42 Portfolio Execution 18
43-48 Equity Investments 18
49-54 Global Investment Performance Standards 18
55-60 Fixed Income 18
Total 180

Questions 1 through 6 relate to Ethical and Professional Standards
GemStar Associates Case Scenario
GemStar Associates, a U.S. based firm, provides investment advisory services to

domestic and international private wealth and institutional clients. It houses two portfolio
management teams, A and B, comprising of three managers each. Team A manages
traditional investment vehicles while Team B manages alternative investments. This year,
one of the firm’s objectives is to gain full compliance with the Global Investment
Performance Standards (GIPS).
Susan Marcus, CFA, is a member of Team A who is exploring small-cap high growth
equities in the emerging market country of Lipa. To aid her selection process, she is using
a statistical model, which uses factor-based models and regression analysis. In her
monthly communication with clients she describes the model.
Description: To aid the selection of equity securities in Lipa, a statistical model is being
used which employs complex methodologies. Details on the model are
available on request.
Damien Rupert is another portfolio manager and member of Team A. He is following

Mono Corporation, a manufacturer of skin care products, the owner of which is a close
friend of Rupert’s. During a casual lunch, Monroe’s friend shares his long-term business
plans. He intends to launch a line of organic skin care products; the launch will depend
on Mono’s success following the IPO. Following their meeting, Rupert purchases Mono
stock for a majority of his clients’ portfolios. To avoid any conflict of interest, he does
not invest in the stock for his personal portfolio.
Rupert devotes some of his time to charities as a volunteer. At some charities, he

participates in the policy making progress while at others he serves as a junior volunteer.
He has not disclosed these involvements to GemStar.
Terry Peters is GemStar’s senior portfolio manager and member of Team B. Due to his
successful performance record and significant expertise with alternative investments, he
has been invited by Abascus Associates, a newly incorporated investment advisory firm,
to offer wealth management guidance to its portfolio managers. His meeting with the
firm’s CEO is scheduled at an offsite company lodge. Upon arriving at the lodge, the
CEO invites Peters to a famous skiing spot, which he accepts. Although he had notified
his employer about the visit to the lodge, he reports the remaining trip details upon his
return.

In order to bring GemStar into compliance with the GIPS standards, senior compliance
officer Jerry Walsh plans to undertake verification for its equity composites, which have
recently been brought into compliance, from Tray Inc, a firm providing verification
services. Walsh intends to take the following actions to further comply with the
standards:
Action 1: Present each account’s performance net of trading expenses. The amount of
trading expenses will be disclosed upon request.
Action 2: Include terminated accounts within the relevant composite’s historical

performance record for a three year period with details of termination dates
clearly disclosed.
1. By providing a description of the model she employs, has Marcus violated any
CFA Institute Standards of Professional Conduct?
A. No.
B. Yes, she has not described the model adequately.
C. Yes, she has not used an adequate communication channel.
Correct Answer: B
Reference:
CFA Level III, Volume 1, Study Session 1, Reading 2.
Marcus has violated Standard V (B) Communication with Clients and Prospects
by not describing the model adequately. The standard requires members and
candidates to use reasonable judgment in identifying which factors are important
to their investment analysis and include those factors in the communications with
their clients. Merely stating that she uses a model, which employs complex
methodologies, does not qualify as an adequate description.
Communication can be in written or oral firm. By describing the model in the

monthly newsletter, she has not violated any standards.

2. Has Rupert violated any standards by purchasing Mono’s stock for his clients’
portfolios?
A. No.
B. Yes, he has acted on material nonpublic information.
C. Yes, he has not determined the suitability of the investment.
Correct Answer: A
Reference:
Rupert has not violated any standards by purchasing Mono’s stock for his clients’
portfolios. Although Rupert has acted upon the discovery of his friend’s business
plans, the plan has yet been finalized and is contingent upon Mono’s success.
Based on Standard II (A) Material nonpublic information, information is material
if it impacts the price of a security or if investors would want to have access to the
information before making a decision; information which is uncertain/ambiguous
in terms of its effects on a security’s price does not qualify as material
information even if it is nonpublic.
There is no information to indicate that Rupert has failed to determine the

suitability of the investment.
3. Has Rupert violated Standard IV (A) Loyalty by failing to disclose his charity
involvements to GemStar?
A. Yes, with respect to his role as policy maker.

B. Yes, with respect to his role as policy maker and junior volunteer.
C. No.
Correct Answer: C
Reference:

Rupert has not violated the Loyalty standard by failing to disclose his
involvement with charities to GemStar. According to the Loyalty standard,
‘Practice’ means any service the employee makes available for remuneration
while undertaking independent practice means engaging in competitive business.
Rupert’s involvement with charities as a policy maker and as a junior volunteer is
entirely voluntary and does not compete with GemStar. Therefore, his
involvement does not qualify as independent practice, which requires disclosure.
4. Has Peters violated any Professional Conduct Standards during his trip?
A. Yes, by visiting the offsite company lodge.

B. Yes, by visiting the skiing spot.
C. No.
Correct Answer: C
Reference:
Peters has not violated any standards by visiting the offsite company lodge or
visiting the skiing spot. He informed his employer about the trip to the offsite
company lodge but did not have any knowledge about the visit to the skiing spot
at the time of accepting the trip offer. By informing his employer about the
remaining trip details upon his return he has complied with Standard IV (B)
Additional Compensation Arrangements.
5. Walsh’s decision to undertake verification is:
A. appropriate.
B. inappropriate, verification must be firm wide.
C. Inappropriate, with respect to the independence of the verifier.
Correct Answer: B
Reference:

Walsh’s decision to undertake verification is inappropriate because verification

must be undertaken on a firm-wide basis rather than for the equity composites
only.
Additionally, verification must be undertaken by an independent third party.

Given that Tray Inc is an independent third party verifier, Walsh’s decision is not
inappropriate in this regard.
6. Which of the following actions violate the CFA Institute Standards of

Professional Conduct?
A. Action 1.
B. Action 2.
C. Both Actions 1 and 2.
Correct Answer: C
Reference:
Action 1 violates the CFA Institute Standards of Professional Conduct.

Disclosures related to fees must not be made available on request but should be
included with the performance presentation.
Action 2 violates the CFA Institute Standards of Professional Conduct.

Terminated accounts should be included as part of performance history with a
clear indication of when the accounts were terminated. Although the firm will
provide details on the terminated accounts, a policy of including terminated
accounts for a three year period does not comply with the standards.

Questions 7 through 12 relate to Ethical and Professional Standards
Martinez Advisory Case Scenario
Martinez Advisory is a U.S. based multinational investment management firm founded

by the Martinez brothers, Jose and Juan. Its U.K. division, Holton Advisory (HA),
currently manages a £45 million investment fund and is being headed by Jeremy Walsh,
CFA. Portfolio investments include U.K. Treasuries, corporates, gilts, municipals, hedge
funds, private equity, and emerging and developed market equities.
A strong believer of maintaining good relationships with clients, Walsh instructs HA’s
portfolio managers to report hedge fund performance on a semi-annual basis and the
performance of the other asset classes on a quarterly basis. To justify the difference in the
reporting policies, HA’s performance report includes a disclosure to clients.
Disclosure: All our hedge fund investments are structured with lock-up periods; therefore
their performance cannot be ascertained with 100% accuracy before the scheduled
reporting date. Therefore, it is HA’s utmost responsibility to ensure reported performance
is fair, accurate and complete.
HA’s private wealth clients are of various financial backgrounds. To ensure equitable
dealings with clients, portfolio managers allocate trades based on needs assessment.
Trades are first allocated to those accounts which management believe require immediate
allocation. Any remaining portion of the trade is allocated to the accounts of those clients
expressing an interest.
HA’s risk management head, Harold White, has retired after serving a 30 year period.
Upon his retirement he recommends Jack Lee, senior risk manager, for his position. After
lengthy discussions and decision making by the board, Lee is appointed as the risk
management head. Upon his appointment, Lee formulates a plan to automate HA’s
centralized risk management system. The system will have the added function of
generating automated performance reviews of the firm’s portfolio managers.
To ensure performance being reported to clients complies with HA’s policies, the most
experienced portfolio managers undertake a review of individual client account
information. Due to the complexity of institutional accounts, a joint audit is undertaken
by HA’s internal audit department head and a renowned external audit firm.
Valuing private equity holdings has been a challenge for HA’s portfolio managers. To aid
its portfolio managers, Walsh has introduced a self-developed valuation model whereby

fund investments are valued using statistical methodologies. With the exception of hedge
funds investments and emerging market equities, which are valued using a ad hoc error
approach, all other asset classes are valued using the most recent asset prices.
7. Are HA’s performance reporting policies consistent with both the required and
recommended standards of the CFA Institute Asset Manager Code of Professional
Conduct?
A. Yes.
B. No, the procedures regarding hedge funds are not.
C. No, the procedures regarding all asset classes are not.
Correct Answer: B
Reference:
HA’s performance reporting policies regarding hedge funds are not consistent
with the Asset Manager Code while those regarding other asset classes are
consistent.
The Code encourages Managers to report to clients at least quarterly and such
reporting should be provided within 30 days after the end of the quarter. Even if
hedge funds have lock-up periods, a semi-annual reporting schedule is not
consistent with the Code’s recommendations.
8. Is HA’s trade allocation policy consistent with both the required and
recommended standards of the Asset Manager Code?
A. Yes.
B. No, trades should be allocated based on suitability.
C. No, trades should not be allocated to the accounts of clients expressing an
interest.

Correct Answer: B
Reference:
HA’s current trade allocation policy violates the requirements of the Asset
Manager Code.
Managers are required to fairly place trades for client accounts. When placing
trades, Managers must ensure that some client accounts are not routinely traded
first or receive preferential treatment. In HA’s case, this implies that Managers
need to allocate trades to the accounts of those clients who have not expressed an
interest, but for which the trades are suitable, as well as the accounts of those
clients expressing an interest for which the trades are suitable.
9. In order to adhere to the requirements and recommendations of the Asset Manager

Code with respect to the changes at the risk management department, HA’s best
course of action is to:
A. do nothing.
B. disclose to clients details regarding the risk management head replacement
only.
C. disclose to clients details regarding the risk management head replacement
and the automation of the risk management system.
Correct Answer: C
Reference:
HA must disclose details regarding the risk management head replacement as well
as the automation of the risk management system.
The Code requires Managers to disclose material changes to the risk management
process. A change in the risk management head as well as a system automation
both qualify as material changes.

10. Are HA’s performance review policies consistent with requirements and
recommendations of the Asset Manager Code?
A. No.
B. Only with respect to private wealth client accounts.
C. Only with respect to institutional client accounts.
Correct Answer: A
Reference:
HA’s performance review policies are inconsistent with the Code’s requirements
and recommendations.
When reviewing portfolio information, the Code requires Managers to undertake

an independent third-party confirmation or review. The confirmation of the
portfolio information may take the form of an audit.
With respect to individual client accounts, review must not be undertaken by

portfolio managers as they lack independence. In the case of institutional
accounts, reviews should have been undertaken solely by the external audit firm.
11. Which of the following asset classes are valued using a methodology, which is
inconsistent with the Asset Manager Code?
A. Private equity.
B. All other asset classes.
C. Hedge funds investments and emerging market equities.
Correct Answer: C
Reference:
Hedge fund investments and emerging market equities are valued using a
methodology, which is inconsistent with the Asset Manager Code.
Using an ad hoc approach does not reflect an appropriate methodology for valuing
portfolio holdings. An internal valuation model and the most recent asset price
represent valuation methodologies, which are consistent with the Code.

12. Which of the following statements is most likely correct with respect to the CFA
Institute Code of Ethics? Members and candidates:
A. are encouraged to adhere to the Code.

B. are required to respect client confidentiality.
C. are required to respect their fellow investment professionals.
Correct Answer: C
Reference:
Members and candidates are required to adhere to the Code of Ethics. Under the
Code, members and candidates are required to act respectfully with colleagues,
amongst others, in the investment profession. The requirement to respect client
confidentiality is a requirement of the CFA Institute Standards of Professional
Conduct.

Questions 13 through 18 relate to Alternative Investments
Caroline King Case Scenario
Caroline King is the chief investment officer for the Ray Foundation (RF), a small-sized
recently established foundation. RF’s portfolio is invested 60% in equity and 40% in
bonds. King has selected Jeremy Brown, a consultant, for recommending the addition of
alternative investments to RF’s portfolio.
To hire Brown, King had conducted a lengthy search process which was based on several
key criteria. According to King, “Such criteria ensure that we select the best advisor”.
During his first meeting with King, Brown proposes that RF allocate its portfolio to
indirect real estate, particularly REITs. He justifies his proposal with the following
statement:
Statement 1: “Given RF’s limited funds and small size, investing in REITs is more
appropriate compared to a direct real estate investment.”
King responds by stating that she has heard that the evaluation of REIT investments is
complicated by the low volatility bias often associated with the NAREIT index. Brown
assures King that he intends to use a benchmark corrected for this bias.
After their meeting concludes, Brown decides to explore commodity investments. He is

particularly interested in the diversification potential the asset class can bring to RF’s
portfolio. He has read in an article that this potential arises from the low correlation
between commodities and stock and bond returns.
For RF’s portfolio, Brown would like to invest in commodity futures. He has chosen
futures over an indirect investment in the commodity producing companies with the
intention of providing maximum exposure to the underlying commodities. He collects
data on three 3-month oil futures contracts with different expiration dates (Exhibit 1).
Brown notices that many oil producers participating in the futures market hold real
production options.

Exhibit 1
Oil Futures Contract Prices ($)
Contract Futures Price as Futures Price as of Change in spot

Maturity of May 2011 April 2011 price
June 2011 45.10 44.71 0.80
September 2011 46.55 45.88 0.80
December 2011 46.99 46.02 0.80
Finally, King requests Brown to consider hedge funds for RF’s portfolio. King identifies
three conditions which need to be satisfied before making a final selection:
Condition 1: Enhance risk-adjusted portfolio returns

Condition 2: Minimize the momentum effect in returns
Condition 3: Sensitivity of the index to the direction of the underlying stock and bond
markets should be minimal.
Brown collects data on three hedge fund indices (Exhibit 2). The funds underlying each
index are collectively managed using a distinct strategy. The Treasury bill rate is 4.0%.
Exhibit 2
Data Concerning Three Hedge Fund Indices
Annual Correlation
Annual Correlation Value/
Standard with the
Index Return with the Equal
Deviation Lehman
(%) S&P 500 Weighted
(%) Gov./Corp
Equity Hedge 9.5 7.8 0.65 0.10 Equal
Equity market
11.2 10.7 0.04 0.24 Equal
neutral
Long-only 14.4 12.1 0.26 0.30 Value

13. Which of the following criteria is least important in the process used by King to
evaluate advisors?
A. The lenders providing financial support to the advisor.

B. The advisor’s communication skills with respect to clients.
C. Whether the market environment will continue to support the advisor’s
investment strategy.
Correct Answer: B
Reference:
When selecting a potential advisor, clients should evaluate the advisor’s service
providers. Among the service providers, King will evaluate the lenders providing
financial support to its advisors. This is an important criterion used by
institutional clients in the selection of their advisors.
King will most likely evaluate whether the market will continue to support its
advisor’s investment strategy in the future. This is an important criterion used by
institutional clients in the selection of their advisors.
The ability of a manager to communicate with their clients is a factor more

relevant in the due diligence process concerning private wealth clients. Thus, this
criterion is the least important.
14. Based on Brown’s statement, his recommendation is most likely:
A. justified.
B. not justified; REITs are restricted to wealthy investors.
C. not justified; direct real estate tends to offer higher risk-adjusted returns.
Correct Answer: A
Reference:

Brown’s recommendation is justified. REITs permit smaller investors to gain real

estate exposure. Exchange traded funds, mutual funds and traded closed-end
investment companies allow investors to obtain a professionally managed and
diversified portfolio for a small initial outlay.
Given RF’s small size and limited funds, an indirect investment class is more
suitable relative to a direct one. The latter requires investors to invest a significant
amount of funds as parcels of real estate are not easy to divide into small pieces.
While physical real estate offers the opportunity to earn high-risk adjusted returns
to those investors who can obtain the necessary information, the large investment
required makes this asset class currently unsuitable for RF’s portfolio.
15. With respect to King’s concerns and Brown’s response concerning the NAREIT
index, which individual is most likely correct?
A. King
B. Brown
C. Neither King nor Brown.
Correct Answer: C
Reference:
Neither King nor Brown is correct. The index used for direct real estate, NCREIF,
suffers from a low volatility bias. This is because the volatility of the underlying
property values is often underestimated.
16. Which of the following statements least likely justify the low correlation observed
between commodities and stock and bonds?
A. Commodity prices tend to rise during weak economies due to their

inflation hedging capability.
B. Commodities have a positive correlation whereas stocks and bonds have a
negative correlation with inflation.
C. Commodity future prices are affected by short-term expectations while
equity and bonds are affected by long-term expectations.
Correct Answer: A

Reference:
There are three reasons why commodity returns have been weakly correlated with
bond and stock returns.
i. Commodity prices tend to decline during weak economies.

ii. Commodities have a positive correlation whereas stocks and bonds have a
negative correlation with inflation.
iii. Commodity future prices are affected by short-term expectations while
equity and bonds are affected by long-term expectations.
17. Using the data in Exhibit 1, what is the roll return on the September contract and
will oil producers exercise their real options?
Roll return: Exercise?

A. –$0.13 Yes
B. –$0.13 No
C. $0.80 Yes
Correct Answer: B
Reference:
Roll return = ΔFutures price –ΔSpot price

= ($46.55 –$45.88) – $0.80 = –$0.13
The real options held by oil producers will only be exercised when spot prices
begin to rise. These real options will be used to determine whether production
should be done or not. Production will only occur when futures prices are below
the current spot price, i.e. a downward sloping term-structure of forward prices.
Given the information in Exhibit 1, the term structure of forward prices is upward
sloping; December contract prices are higher than September contract prices
which in turn are higher than June prices. Oil producers will not exercise their
production options when futures markets are in contango.
18. Considering Conditions 2 and 3 only, which index will Brown most likely select?
A. Long-only
B. Equity hedge
C. Equity market neutral

Correct Answer: C
Reference:
Brown will most likely select an equity market neutral index. This index is an
equal-weighted index unlike the long-only index. One of the shortcomings of the
value-weighted index is that successful, top-performing funds tend to dominate
the index. These top-performing funds tend to grow from new inflows and high
returns while poorly performing funds are closed. As a result, indices that are
value-weighted may suffer from popularity bias, which creates a momentum
effect in returns and difficulty in tracking an index. Because equal-weighted
indices weigh each underlying fund in an equal proportion they do not suffer from
this bias. Thus, an equal-weighted index satisfies Condition 2.
The equity market neutral index will better satisfy Condition 3. Traditional long-
bias funds are affected by the direction of the stock and bond markets whereas the
former fund is less sensitive. Given that the equity hedge index has a higher
correlation with the S&P 500, the index will be more sensitive to the direction of
the stock market. In conclusion, the equity hedge index will not satisfy this
condition and therefore the equity market neutral index is the most appropriate
choice.

Questions 19 through 24 relate to Risk Management
William Pearson Case Scenario
William Pearson is a head of risk governance at Everest Investment Management (EIM).

His firm follows a centralized risk governance structure, also known as the Enterprise
Risk Management System. A recently hired subordinate, James Stephen, is concerned
about how companies manage risk. Pearson responds to Stephen as follows:
Statement 1: “Companies manage their risk which means that when they perceive a
competitive advantage, they bring their risk exposures to the minimum
level.”
Although Stephen does have knowledge about the two types of risk governance
structures, he is still confused about their peculiar characteristics. Pearson explains:
Statement 2: “In contrast to the decentralized structure, companies using a centralized

governance structure take into account total risk exposures and thereby
increase their overall need to hedge.”
Stephen has listed down various types of risk categories. The list is as follows.
A. Financial risks
i. Liquidity risk
ii. Credit risk
iii. Commodity price risk
iv. Equity price risk
v. Exchange rate risk
vi. Interest rate risk
B. Nonfinancial risks
i. Operations risk
ii. Model risk
iii. Settlement risk
iv. Regulation risk
v. Legal risk
vi. Taxes
vii. Accounting risk

Stephen states “only regulated markets are exposed to regulation risk”.
Davis Marshall, CFA, a portfolio manager at EIM, is managing the investment portfolio
of a large mining company, Shining Stones (SS). The portfolio is specifically designed to
help the company hedge its risk associated with commodity prices and foreign exchange
rate risk. The company has entered into various OTC forwards and option contracts.
Marshall is concerned about managing liquidity risk associated with investing in various
OTC derivatives which are of large trade sizes. His assistant has been charged with
measuring this liquidity risk. Marshall explains to his assistant that due to large trade
sizes, it is not useful to use bid-ask quotations; rather, it is better to use the illiquidity
ratio.
In addition, SS holds an exchange-traded credit derivative instrument and entered into a

forward contract with a specific counterparty. When the settlement was due on the
forward contract, in spite of no change in credit worthiness of the counterparty, the
counterparty failed to settle the contractual obligations due to financial difficulties
resulting from activities of a rogue-trader.
EIM also manages a hedge fund, which has two strategies managed independently by two
separate portfolio managers, James Joe and Emmy Gide. Joe generated 10% gain whereas
Gide generated 0% gain. In the hedge fund, an asymmetric incentive fee contract exists.
On analyzing the performance of the two managers, Blain Lee, an analyst at EIM, made
the following statements:
Statement 3: “The hedge fund is exposed to performance nettingassociated losses.”
Statement 4: “Settlement netting risk arises due to the absence of a netting

arrangement.”
19. With regard to Pearson’s response to Stephen which of the following is most
likely correct?
A. Statement 1 is correct; Statement 2 is incorrect.

B. Statement 1 is incorrect; Statement 2 is correct.
C. Statement 1 is incorrect; Statement 2 is incorrect.

Correct Answer: C
Reference:
• Statement 1 is incorrect. Companies manage their risk exposures, increasing it

when they perceive a competitive advantage and decreasing it when they
perceive a competitive disadvantage.
• Statement 2 is incorrect. Due to the offsetting effects of risks, centralization
reduces the overall need to hedge.
20. Which of the following risk is least likely linked to market supply and demand?
A. Liquidity risk
B. Currency risk
C. Interest rate risk
Correct Answer: A
Reference:
Only market risk i.e. interest rate, currency, stock prices and commodity price risk
are linked to supply and demand in various marketplaces.
21. What does the illiquidity ratio measure; and is Marshall correct in using this ratio
to measure the liquidity risk of OTC derivatives?
A. Illiquidity ratio measures price impact per $1 million trades in a day;

Marshall is incorrect.
B. Illiquidity ratio measures total trading cost per $1 million trades in a day;
Marshall is incorrect.
C. Illiquidity ratio measures trade size relative to average daily trading
volume; Marshall is correct.

Correct Answer: A
Reference:
Illiquidity ratio measures price impact per $1 million trades in a day. Marshall is
incorrect in using illiquidity ratio for OTC derivative because no explicit
transaction volume is available for many OTC instruments.
22. With respect to the exchange-traded credit derivative instrument, SS is most likely
exposed to:
A. Market risk
B. Credit risk
C. Settlement risk
Correct Answer: A
Reference:
Shining stones is exposed to market risk. Without the probability of default

changing, a company could suffer a loss as a result of a short-term supply demand
imbalance because the credit instrument is traded. Exchange-traded derivatives
are guaranteed against credit losses and are not exposed to credit risk.
Furthermore, since the instruments trade on centralized exchanges, all
transactions take place between the exchange member and the central
counterparty removing settlement risk from the transaction.
23. With respect to the forward contract, SS is most likely exposed to which of the
following risks and how can this risk be reduced?
A. Operational risk; using insurance.

B. Settlement risk; using a netting arrangement.
C. Credit risk; using a credit derivative instrument.

Correct Answer: A
Reference:
When settlement fails due to operational problems, despite the counterparty being
credit-worthy, the resulting risk is operational risk. Operational risk is managed
using insurance not derivatives.
24. With regard to Statement 3 and 4, which of the following is most likely incorrect?
A. Statement 3 is correct; Statement 4 is correct

B. Statement 3 is correct; Statement 4 is incorrect.
C. Statement 3 is incorrect; Statement 4 is correct.
Correct Answer: A
Reference:
Statement 3 is incorrect. Performance netting risk manifests only when individual

portfolio managers within a jointly managed product generate actual losses, not
zero performance, over the course of a fee-generating cycle.
Statement 4 is incorrect. Settlement netting risk does not arise due to the absence
of a netting arrangement, rather due to a netting arrangement which is susceptible
to legal challenge.

Questions 25 through 30 relate to Risk Management
Mark Paul Case Scenario
Mark Paul, CFA, is a portfolio manager at a small investment management firm, Galaxy
Inc. Galaxy advises a variety of clients on risk management issues. Mark Paul prefers to
use value at risk (VAR) for measuring and managing key risk exposures associated with
his clients’ investment portfolios. Paul discusses the use of VAR with a recently hired
risk manager at Galaxy, Carol Mike. During their discussion, Paul makes the following
statements:
Statement 1: “VAR can be easily used to measure market risk under all market
conditions.”
Statement 2: “Portfolio A has a VAR of $2 million for one day with a probability of
5%. Portfolio B has a VAR of $2.5 million for 5 days with a probability of
5%. Portfolio A’s VAR suggests that there is a 5% chance that portfolio A
will lose at least $2 million whereas portfolio B’s VAR suggests it will
lose $2.5 million. Hence, portfolio A is preferred over portfolio B.”
Statement 3: “The higher the turnover in the portfolio, the longer the time periods
chosen for VAR.”
Statement 4: “The higher the probability selected, the lower the VAR.”
Mike adds that there are three methods used to estimate VAR. He makes the following
statements:
Statement 5: “The three methods used to estimate VAR are analytical, historical and
Monte Carlo method. A variant of the historical method is the historical
simulation method which is based on the simulation of past returns.”
Statement 6: “If a portfolio contains several bonds maturing in the year 2020, then to
estimate VAR using the historical method, we will use otherwise identical
bonds maturing in 2019 as proxies rather than bonds maturing in year
2020.”

Mike is contemplating the application of one of the VAR techniques to analyze risk in
more detail. Mike has collected portfolio information concerning one of Galaxy’s clients
(Exhibit 1).
Exhibit 1
Overview of Client’s Portfolio
Asset class A Asset class B Portfolio

Weight 0.70 0.30 1
Expected Annual Return, E(R) 0.13 0.06 0.109
Standard Deviation, σ 0.24 0.08 0.173
Correlation between A and B 0.14
Portfolio value $25 million
Probability 5%
Mike suggests that Paul consider using the various extensions of VAR to identify
exposures to potential losses. These extensions include incremental VAR (IVAR), total
VAR (TVAR), cash flow at risk (CFAR) and earnings at risk (EAR). He summarizes
relevant data for a client’s portfolio which he intends to use in further analyzing these
extensions (Exhibit 2).
Exhibit 2
Data Concerning VAR Extensions
VAR of total portfolio including asset A $1.5 million
VAR of portfolio excluding asset A $1.3 million
VAR of asset A $0.8 million
One of Galaxy’s clients, Bright Chemicals, has entered into a forward contract by taking
a long position. The current underlying asset price, at the time of contract initiation, is
$105 and the risk-free rate is 4%. The forward contact will expire in one year. After 3
months, the value of underlying asset is $108.50.
Ryan Anderson, CFA, is an analyst at Galaxy Inc. He is analyzing various possible

impacts of credit risk and different ways of managing credit risk. He is working with his
subordinate to create a handbook on credit risk.

He explains to his subordinate that credit risk is difficult to measure relative to market
risk because credit events are rare and recovery rates are hard to estimate. Nevertheless,
credit risk can easily be controlled using credit VAR. His subordinate asks him whether
credit risk associated with options is unilateral or bilateral.
25. With regard to the statements made by Paul, which of the following is most likely
correct?
A. Statements 1 and 4 are correct.

B. Statements 1 and 2 are incorrect.
C. Statements 3 and 4 are correct.
Correct Answer: B
Reference:
• Statement 1 is incorrect because VAR can be used only under normal market
conditions.
• Statement 2 is incorrect because VAR has a time element and cannot be
compared directly unless they share the same time interval.
• Statement 3 is incorrect because higher portfolio turnover will require daily
VAR e.g. hedge funds.
• Statement 4 is correct. With a higher level of probability, the VAR measure
decreases.
26. With regard to Statements 5 and 6, respectively, which of the following is most
likely correct?
A. Statement 5 is correct; Statement 6 is correct.

B. Statement 5 is correct; Statement 6 is incorrect.
C. Statement 5 is incorrect; Statement 6 is correct.
Correct Answer: C
Reference:

Statement 5 is incorrect. Historical simulation method is the same as historical

method. It is based on historical data, not on simulation of the past returns.
Statement 6 is correct. The historical VAR calculation must consider the tendency
of bonds to behave differently during their lives. This can be taken into account
by adjusting current bond/derivative pricing parameters to simulate their current
characteristics across the period of analysis.
27. Using the data provided in Exhibit 1, which of the following is most likely
incorrect?
A. VAR is $4.4125 million.

B. Daily VAR is – 0.011163.
C. There is 5% chance that a portfolio will lose at least 17.65% in a year.
Correct Answer: B
Reference:
Annual VAR in % = 0.109 – 1.65 (0.173) = – 0.1765

Annual VAR in $ = 17.65% × $25 million = $4.4125 million
Daily E (R) = 0.109 / 250 = 0.000436
Daily σ= 0.173 / (250) 1/2 = 0.010941
Daily VAR in $ = 0.000436 – 1.65 (0.010941) = – 0.017617.
28. Using the data given in Exhibit 2, which of the following is most likely correct
regarding IVAR and TVAR?
IVAR is equal to: TVAR is equal to:

A. $0.70 million VAR – expected loss in excess of VAR
B. $0.20 million VAR + expected loss in excess of VAR
C. $0.20 million VAR – expected loss in excess of VAR
Correct Answer: B
Reference:
• IVAR = VAR of Total Portfolio – VAR of Portfolio excluding asset A

= $1.5 million – $1.3 million = $0.2 million.
• TVAR = VAR + expected loss in excess of VAR.

29. Which of the following statements is most likely correct with respect to the
forward contract involving Bright Chemicals?
A. Bright faces current credit risk amounting to $2.465.

B. If Bright defaults, it will hold an asset worth $2.465.
C. The counterparty faces potential credit risk amounting to $2.465.
Correct Answer: B
Reference:
Forward price = 105 × (1.04) = $109.20
Value to long = 108.50 – [109.20 / (1.04)0.75] = $108.50 – $106.0346

= $2.465.
Since the value to the long is positive, Bright (not the counterparty) faces credit
risk amounting to $2.465. This credit risk is potential and not current. In case the
party holding the long position defaults, it will hold an asset worth $2.465.
30. With respect to his comments on credit risk and Anderson’s response to his
subordinate’s question, respectively, which of the following is most likely correct?
A. Ryan is incorrect; credit risk is bilateral.

B. Ryan is correct; credit risk is one-sided.
C. Ryan is incorrect; credit risk is one-sided.
Correct Answer: C
Reference:
Ryan is incorrect because due to asymmetric nature of credit risk, it cannot be

easily controlled using VAR or standard deviation. Credit risk associated with
options is unilateral while forward contracts and swaps have bilateral default risk.

Questions 36 through 41 relate to Risk Management Application of Derivatives
Gregory Sparks Case Scenario
Gregory Sparks, CFA, is a derivatives specialist at a large investment bank. He is

currently addressing the demands of three clients. He will be required to determine the
optimal options strategy for each client.
Client 1: Frontal Pension Plan (FPP)

The plan’s chief investment officer has requested that the policy portfolio’s exposure to
Delta Corp’s stock be synthetically reduced. Sparks explores a covered call strategy.
Exercise prices and premium per option data have been compiled by Sparks (Exhibit 1).
Sparks determines that FPP will need to sell 20,000 call options to implement the
strategy. The current stock price is $45 and FPP owns 100,000 shares of Delta Corp.
Exhibit 1
Call Option Exercise Prices and Premiums (in $)
Option Exercise Price Premium
1 60 12.25
2 55 13.15
3 40 14.25
When describing the strategy to the investment officer, Sparks makes the following
statements:
Statement 1: “The strategy will help reduce overall risk exposure at the expense of
reducing overall expected returns.”
Statement 2: “The maximum loss will occur when the underlying stock price declines
to zero.”
Client 2: Sue Mackintosh

Mackintosh has approached Sparks after reading an article which speculates that small-
cap stocks are expected to decline. She would like to profit from this decline and has
asked Sparks to present a solution. Sparks recommends a bear put strategy with the
underlying options based on the S&P 600 index. The current index price is $125. Details
on the index options have been collected by Sparks (Exhibit 2).

Exhibit 2
S&P 600 Index Options
Exercise Prices And Premiums (in $)
Option Exercise Price Premium

1 145 60
2 125 52
Client 3: Hanver Corporation (HC)

HC has come to Sparks in search of a unique solution. HC is not much of a risk taker and
would like the specialist to recommend a strategy which would benefit from a lower than
market expectation of volatility. Spark feels that either a box spread or butterfly strategy
will be suitable for the client and collects 1-month call and put exercise price and
premium data (Exhibit 3). The one-month annualized risk-free rate is 1.50%.
Exhibit 3
1-month Call and Put Exercise Prices and Premiums (in $)
Option Call Exercise Price Premium Put Exercise Price Premium
1 70 11.45 70 22.80
2 60 12.45 60 14.25
After serving his clients, Sparks resumes his work on an article he is writing for an
investment newsletter. His article explains option strategies in detail. He intends to
include the following two statements in his article:
Statement 3: Collars are similar to bull spreads in their performance.
Statement 4: In contrast to the put-call parity, the box spread strategy is cheaper and
requires the binomial model to hold during high market volatility.

31. If the stock price rises to $55, the profit on the covered call strategy with the
highest initial inflow is closest to:
A. $945,000
B. $985,000
C. $1,000,000
Correct Answer: B
Reference:
The option strategy with the highest initial inflow is option 3; FPP will be able to
earn the highest possible premium on this strategy.
Profit = ST – S0 – max (0,ST – X) + c0

Profit = (55 – 45)(100,000) – [max(0,55 – 40) – 14.25](20,000)
= $985,000
32. Is Sparks correct with respect to the statements made to the investment officer?
A. Yes.
B. Only with respect to Statement 1.
C. Only with respect to Statement 2.
Correct Answer: A
Reference:
Sparks is correct with respect to Statements 1 and 2. Selling a call on a position in

the underlying reduces the risk of that position. By selling the covered call
strategy, the writer will miss out on gains during bull markets. Therefore, selling a
covered call as a strategy reduces risk at the expense of reducing expected returns.
The maximum loss on a covered call strategy will occur when the underlying
declines to zero.

33. The breakeven asset price of Mackintosh’s proposed strategy is closest to:
A. $133.
B. $137.
C. $153.
Correct Answer: B
Reference:
Breakeven price = ST* = 145 – 60 + 52 = $137
34. In light of HC’s expectations, Sparks is correct with respect to his proposal
concerning:
A. the butterfly strategy only.

B. the box spread strategy only.
C. neither of the two strategies.
Correct Answer: A
Reference:
Spark is correct with respect to his proposal concerning the butterfly strategy
only. When the market expects a lower level of volatility relative to market
expectations, it should engage in a butterfly strategy.
A box spread strategy is a risk-free strategy generating an identical outcome,

regardless of the direction of the market. Such a strategy is not suitable given
HC’s market expectations.
35. Should Sparks implement a box spread strategy for HC, he will most likely
conclude that the box spread is:
A. overpriced.
B. fairly priced.
C. underpriced.

Correct Answer: C
Reference:
Sparks will conclude that the box spread is underpriced. In order to determine
whether this spread is fairly priced or not, the cost and the present value of the
payoff need to be determined.
Cost of the spread = c1 – c2 + p2 – p1

= 12.45 – 11.45 + 22.80 – 14.25 = 9.55
Present value of the payoff = (70 – 60)/(1.015)1/12 = 9.99
The box spread should be worth $9.99 but costs $9.55; it is underpriced.
36. With regard to the two statements to be included in his article, Sparks is most
likely incorrect with respect to:
A. both statements.
B. Statement 3 only.
C. Statement 4 only.
Correct Answer: C
Reference:
Sparks is correct with respect to Statement 3 but incorrect with respect to

Statement 4.
Collars perform similarly to bull spreads. They put a cap on the gain and floor on
the loss. Bull spreads limit the upside profit potential similar to collars. The only
difference between the two strategies is that the bull strategy does not involve
holding the underlying.
Unlike the put-call parity, a box spread does not require the binomial or Black-
Scholes-Merton model to hold and requires no estimation of volatility. The latter
strategy has the advantage of lower transaction costs.

Questions 42 through 47 relate to Portfolio Execution
David Miller Case Scenario
David Miller, CFA, works as an analyst with U.S based ZM Asset Management Firm.
Miller is currently exploring how portfolio execution costs can be minimized when
fulfilling trade orders.
Miller is considering various price benchmarks with the intention of selecting the most
appropriate benchmark. Various price benchmarks are available such as quotation mid-
point, volume weighted average price (VWAP), opening price, closing price and
implementation shortfall. Miller selects VWAP because he considers it a more
satisfactory benchmark compared to quotation mid-point.
William Banner is another analyst at ZM. He agrees with Miller with respect to the use of
VWAP. However, he makes the following statements regarding the limitations of
VWAP.
Statement 1: “VWAP is not free from limitations because it can be ‘gamed’.”
Statement 2: “To deal with the gaming problem associated with VWAP, a more reliable
measure of VWAP can be obtained by measuring VWAP over multiple
days instead of a single day.”
Banner is evaluating market quality. He gathers necessary information and observes that
quoted and effective spreads are high and investors do not have easy access to accurate
and reliable information about quotes and trades. In addition, parties to trades do not
stand behind their quotes. Based on this information, he concludes that the market has
low quality. Based on this conclusion, Banner decides to use implementation shortfall as
a price benchmark due to its various advantages over other price benchmarks.
Banner mentions two advantages of implementation shortfall.
Advantage 1: Implementation shortfall incorporates both explicit and implicit costs and
is not vulnerable to gaming.
Advantage 2: Implementation shortfall can be used for all types of assets due to its
inherent quality of capturing all elements of transaction costs.

Miller is analyzing a transaction involving Saving Life Drugs Company (SDC) (Exhibit
1).
Exhibit 1
Saving Life Drugs Company Transaction (SDC)
Benchmark Price:
On Monday, April 2nd, SDC closed at $23.05 a share.
Tuesday Morning:
Before market opens, a portfolio manager at ZM decides to buy 1,100 shares of SDC
using a limit order at $22.95.
Tuesday Close of Trading:
• Price of SDC does not fall below $23.00 and no part of the order is filled on
Tuesday, it expires.
• It closes at $23.10.
Wednesday:
• Limit order is revised to a new limit of $23.11.
• The order is partially filled on Wednesday, buying 750 shares incurring
commission costs of $15.
• The stock closes at $23.15 and order for the remaining 350 shares is cancelled.
After analyzing various trades, Miller concludes that the implementation shortfall is
always positive for buy orders. Banner is analyzing a trade of Angels Clothing Company
(ACC). He has computed an implementation shortfall of 23%. The expected return on
ACC’s stock is 25%.
Miller is also managing a separate fund for a client. His client is very concerned about
minimizing trading costs. Therefore, Miller decides to discuss the issue with head of the
trading desk, Abraham Ryan. Ryan makes the following two comments:
Comment 1: Both explicit and implicit costs are part of total trading costs and explicit
costs constitute a major part of total trading cost.
Comment 2: Trading aggressively often leads to the most expensive trade due to higher
market impact. Therefore, trading costs can be reduced by avoiding
aggressive trades.

37. With respect to the use of VWAP as a price benchmark and the two statements
made by Banner, which of the following is most likely correct?
A. Banner is correct in agreeing with Miller; Banner is incorrect with respect

to both Statements 1 and 2.
B. Banner is correct in agreeing with Miller; Banner is correct with respect to
both Statements 1 and 2.
C. Banner is correct in agreeing with Miller; Banner is correct with respect
to Statement 1 only.
Correct Answer: C
Reference:
Banner is correct in agreeing with Miller because VWAP is a more satisfactory

benchmark compared to quotation mid-point. Statement 1 is correct; VWAP can
easily be gamed. Statement 2 is incorrect because measuring VWAP over
multiple days does not provide a reliable measure because the cost of measuring
VWAP over a longer time frame is that there is less accuracy in estimating trading
costs.
38. With regard to Banner’s conclusion regarding market quality and use of
implementation shortfall as a price benchmark, which of the following is most
likely correct?
A. Banner is correct with respect to market quality and correct with respect to
the use of implementation shortfall.
B. Banner is incorrect with respect to market quality and incorrect with
respect to the use of implementation shortfall.
C. Banner is correct with respect to market quality but incorrect with respect
to the use of implementation shortfall.
Correct Answer: C
Reference:

Market quality is low when quoted and effective spreads are high; investors do
not have easy access to accurate and reliable information about quotes and trades
and parties to trades do not stand behind their quotes.
Banner is incorrect with respect to the use of implementation shortfall (IS)

because using IS as a price benchmark is not preferred when a market lacks
transparency.
39. With regard to the two advantages of implementation shortfall:
A. Advantage 1 is correct; Advantage 2 is incorrect.

B. Advantage 1 is correct; Advantage 2 is correct.
C. Advantage 1 is incorrect; Advantage 2 is correct.
Correct Answer: A
Reference:
Advantage 1 is correct because it correctly states an advantage of IS. Advantage 2

is incorrect because IS is not useful for assets that trade infrequently (e.g.
alternative investments).
40. Using the data provided in Exhibit 1, the implementation shortfall and delay costs
are, respectively, closest to:
implementation
shortfall: delay costs:
A. 0.373% 0.446%
B. 0.375% 0.148%
C. 0.316% 0.069%
Correct Answer: B
Reference:

Implementation shortfall (IS) = (paper portfolio gain – real portfolio gain) /

Paper portfolio investment
Paper portfolio gain = 1,100 (23.15) – 1,100 (23.05) = 110

Real portfolio gain = 750 (23.15) – [(750 × 23.11) + 15] = 15
Paper portfolio investment = 1,100 × 23.05 = 25,355
IS = (110 – 15) / 25,355 = 0.375%
!"#$%&'( *+, -.&(%/0 1"%-# – 3#/-45+"6 1"%-# 74+"#( 1'"-4+(#*

Delay costs = 3#/-45+"6 1"%-#
× (4+"#( &"*#"#*
$9:.<=>$9:.=? @?=
= $9:.=?
× <<==
= 0.148%.
41. With respect to Miller's conclusion regarding implementation shortfall and

Banner's analysis of the adjusted implementation shortfall (IS) measure for ACC,
respectively, which of the following is most likely correct?
Miller is: The adjusted IS is:

A. Incorrect – 2%
B. Correct + 2%
C. Correct – 2%
Correct Answer: A
Reference:
Miller is incorrect because IS may not always be positive if the effect of the
market is removed.
Adjusted IS = 23% – 25% = –2%.
42. With regard to the comments made by Ryan on trading costs, which of the
following is most likely correct?
A. Comment 1 is correct; Comment 2 is incorrect.

B. Comment 1 is correct; Comment 2 is correct.
C. Comment 1 is incorrect; Comment 2 is incorrect.
Correct Answer: C

Reference:
• Comment 1 is incorrect. Implicit not explicit costs constitute a major part of

total trading cost.
• Comment 2 is incorrect. The trade that is never completed is often the most
expensive trade; not the trade that is competed aggressively.

Questions 43 through 48 relate to Equity Investments
Amanda Gary and Harrod Dickson Case Scenario
Amanda Gary, CFA and Harrod Dickson, CFA are senior analysts at Wealth
Management Associates (WM). WM provides portfolio management services and
investment advice to wealthy individuals and institutional clients.
Gary and Dickson discuss the fundamental law of active management and its application
in evaluating managers’ performances. During their discussion, Gary makes two
statements.
Statement 1: “In the fundamental law of active management, investor’s breadth

represents the number of independent active decisions made each year.
This implies that the greater the size of the investor’s research universe,
the greater the breadth and consequently the greater the information ratio.”
Statement 2: “A manager’s style of investing can be identified using two approaches

with one based on analyzing the characteristics of overall individual
security holdings while the other based on analyzing the characteristics of
the overall portfolio.”
Dickson has gathered some data on three portfolio managers at WM.
1. Macklin holds a long position in S&P 500 Futures contracts and a cash position. He
focuses on generating alpha by altering the duration of his cash position. Correlation
between Macklin’s forecasted returns and actual returns is 0.04.
2. Carter holds a long-short portfolio which involves 500 stocks in the S&P 500 index
and uses a stock-based semi-active strategy to generate active returns. Correlation
between Carter’s forecasted returns and actual returns is 0.07.
3. Bernard holds a long-only portfolio consisting of 500 stocks of the S&P 500 index
and focuses on generating active returns through over- or under weighting individual
stocks based on his expectations for those stocks. Correlation between Bernard’s
forecasted returns and actual returns is 0.04.
Walter Tobler, Dickson’s subordinate, is concerned about the effects of a long-only

constraint on investing activities. In response to those concerns, Dickson states:
Statement 3: “A long-only constraint only limits an investor’s ability to take advantage

of negative information. This indicates that in case of a long-only
constraint, the investor has an asymmetric opportunity set.”

On hearing that, Tobler asks Dickson about the types of risks long-only investors are
exposed to.
James Chan, WM’s client, indicates that he might invest a total of USD 100 million.
While having a discussion with Robert Andrew, CFA, a portfolio manager at WM, Chan
says:
Statement 4: “Although I am highly risk averse, I am interested in taking a systematic

risk exposure along with the opportunity to earn skill-based active
returns.”
In response to Chan, Andrew says the strategy that best serves Chan’s interest is an
equitized market neutral long-short strategy.
Andrew is also analyzing different funds to pursue a core-satellite approach for Chan.
Relevant data on these funds is given in Exhibit 1.
Exhibit 1
Potential Funds for the a Core-Satellite Approach
Fund A Fund B Fund C Fund D Fund E
Expected α 0% 5% 0% 3% 2%
Expected
0% 9% 0% 6% 5%
Tracking Risk
Total
$50 million $10 million $15 million $40 million $45 million
Investment
Andrew is also working with another client, Rainbow Foundation (RF). RF seeks to
achieve two specific objectives.
Objective 1: To earn skill-based active returns along with beta exposure but without
altering the strategic asset allocation of our portfolio.
Objective 2: To capture value added from active management along with matching
overall portfolio’s risk to its benchmark.

43. Is Gary correct with regard to Statement 1 and with regard to Statement 2: which
style analysis would result in greater need for buffering?
A. Yes; holdings-based analysis.

B. No; composition-based analysis.
C. No; return-based analysis.
Correct Answer: B
Reference:
• Gary is incorrect because number of independent active decisions does not

necessarily increase with size of research universe.
• Holdings-based analysis is also known as composition-based analysis. It
detects style changes more quickly than return-based analysis. Thus, it makes
buffering more necessary in order to avoid unnecessary high turnover with the
index.
44. With regard to the data provided on the three portfolio managers, which of the
following statements is most likely incorrect?
A. Macklin will have a higher information ratio than Bernard.

B. Carter will have a higher information ratio than Bernard.
C. Macklin will have a lower information ratio than Carter.
Correct Answer: A
Reference:

• Both Macklin and Bernard have same information coefficient. However,

Macklin follows a derivative based semi-active strategy which has lower
breadth than the stock-based semi-active strategy which is followed by
Bernard. Thus, Macklin will have a lower information ratio than Bernard.
• Macklin follows a derivative based semi-active strategy which has lower
breadth than the stock-based semi-active strategy which is followed by Carter.
In addition, Carter has higher information coefficient. Thus, Macklin will
have a lower information ratio than Carter.
• Although both Carter and Bernard have the same breadth (500 stocks),
Carter’s information coefficient is greater than Bernard’s. Carter will have a
higher information ratio than Bernard.
45. With regard to Statement 3 and Dickson’s response to Tobler, respectively, which
of the following is most likely correct?
A. Statement 3 is correct; long-only investors are exposed to both systematic

and unsystematic risk.
B. Statement 3 is incorrect; long-only investors are exposed to both
systematic and unsystematic risk.
C. Statement 3 is incorrect; long-only investors are exposed to systematic risk
only.
Correct Answer: B
Reference:
Statement 3 is incorrect because a long-only constraint limits an investor’s ability

to exploit both negative and positive information.
A long-only investor is exposed to both systematic and unsystematic risk.
46. Is Andrew’s proposed strategy appropriate for Chan?
A. Yes.
B. No; the most appropriate strategy is an alpha-beta separation strategy.
C. No; the most appropriate strategy is a short extension strategy.
Correct Answer: C
Reference:

Chan is highly risk averse; thus, the most appropriate strategy to satisfy Chan’s
needs would be a short-extension strategy because it involves only a partial
relaxation of long-only constraint in order to control risk associated with complete
relaxation of long-only constraint (e.g. in market-neutral long-short strategies).
47. Based on Exhibit 1 and Statement 4, in order to pursue the core-satellite approach,
which of the following funds would be most appropriate for Chan as a core
investment?
A. Fund A.
B. Fund C.
C. Fund E.
Correct Answer: A
Reference:
Both Fund A and C represent core investments since both have expected alpha
and tracking risk of zero. However, Chan mentioned that he is highly risk averse.
The lower the risk tolerance, the greater the core allocation will be. Therefore,
Chan might prefer Fund A as core investment to Fund C.
48. In order to meet RF’s objectives, the most appropriate investment approach is:
A. short-extension strategy for objective 1; completeness fund for objective 2.

B. equitized market neutral long-short strategy for objective 1; bias control
fund for objective 2.
C. short-extension strategy for objective 1; portfolio indexed to broad market
for objective 2.
Correct Answer: B
Reference:
For objective 1, the most appropriate strategy is equitized market neutral long-
short strategy as it facilitates to earn market return from one source and alpha
from another source without the need to adjust the strategic asset allocation.
For objective 2, the most appropriate strategy is completeness fund which is also
known as bias control fund.

Questions 49 through 54 relate to Global Investment Performance Standards
Eleanor Moser Case Scenario
Eleanor Moser, portfolio manager at Boise Securities, an asset management firm, has
been hired by Adrian Gustov. Gustov represents Maritime Corp’s pension plan’s
investment portfolio and has approached Moser based on Boise’s advertised claim of
compliance to the Global Investment Performance Standards (GIPS).
During her first meeting with Gustov, Moser states,
“Compliance with the GIPS standards is entirely voluntary. Once a firm claims
compliance, it must apply the standards with the goal of full disclosure and fair
representation.”
Gustov is particularly interested in Boise’s international equity composite and asks Moser
to demonstrate how the composite’s performance complies with the standards. Moser
responds by stating,
“All composite returns are calculated by multiplying individual portfolio returns by the
beginning composite assets held in each portfolio and summing the results.”
Next, Moser collects data concerning the international equity composite’s assets and
related external cash flow activity (Exhibit 1).
Exhibit 1
International Equity Composite
Assets and External Cash Flows
Cash flow Portfolio ($ 000)

weighting factor A B C
Beginning assets (March 31) 91.5 124.8 140.0
External Cash flows
2 April 0.933 –4.0 + 5.0 + 2.0
10 April 0.667 + 3.8 + 6.0 + 4.0
27 April 0.100 + 5.0 –1.2 + 3.6
Ending assets (April 30) 96.9 135.0 150.8
*The composite has a beginning total assets and weighted cash flows of $400,000

Boise’s international equity composite was constructed on January 1, 2006. Composite

policies did not meet the requirements of the GIPS standards at that time. Boise’s chief
compliance officer, Ramon Martin, drafted three policies on December 31, 2006. These
policies were intended to ensure that composites fairly and accurately reflected the
performance of the underlying portfolios.
Policy 1: All foreign emerging and developed market equities are included in the
composite. To capture active returns, the former category is managed using a
core-satellite approach while the latter is managed using a short-extension
strategy.
Policy 2: If a portfolio’s total asset value falls by at least $2 million for two consecutive
periods, it will be removed from the composite along with its performance
record.
Portfolio B belongs to a risk-averse client who exhibits home bias with respect to his
investments. His entire portfolio is invested in foreign equities. The client has requested
Moser to dispose his foreign stock allocation and avoid further foreign trades.
49. With respect to the statement made during her meeting with Gustov, Moser is
most likely:
A. correct.
B. incorrect, compliance with the GIPS standard is compulsory.
C. incorrect, full disclosure cannot be made in performance situations where
a standard does not exist.
Correct Answer: A
Reference:
Compliance with the GIPS is voluntary. Firms that choose to comply with the
standards must apply them with the goal of full disclosure and fair representation.
When performance situations arise on which the Standards are silent or open to
interpretation, disclosures other than those required may be necessary.

50. Is Boise’s composite return calculation policy in compliance with the

requirements of the GIPS standards?
A. Yes.
B. No, composite returns must be time-weighted.
C. No, composite returns must be weighted according to beginning asset
values and external cash flows.
Correct Answer: A
Reference:
Boise’s composite return calculation policy is in compliance with the GIPS

standards. The Standards require composite returns to be calculated by asset-
weighting the individual portfolio returns using beginning-of-period values or a
method that reflects both beginning-of-period values and external cash flows.
Either of the two methods can be used.
When the former method is used, the composite return can be calculated by
multiplying the individual portfolio returns by the percentage of composite
beginning assets held in each portfolio and summing the products.
51. Using the data in Exhibit 1, the proportion of portfolio B relative to the
composite’s beginning assets and weighted cash flows is closest to:
A. 31.20%
B. 33.34%
C. 35.89%
Correct Answer: B
Reference:

Portfolio B’s total beginning assets and weighted cash flows is calculated using
the following formula:
𝑉! = 𝑉= + D(𝐶𝐹% × 𝑤% )
%K%
Where CFi represents the portfolio cash flows and wi represents the weights
assigned to these cash flows.
V Portfolio B = 124.8 + (5 × 0.933) + (6.0 × 0.667) + (─ 1.2 × 0.10) = 133.347
When expressed as a percentage of composite beginning total assets and weighted

cash flows of $400,000, the proportion of portfolio B is 33.34% (133.347/400)
52. With respect to Policy 1, has Boise complied with the GIPS standards by
including developed and emerging equities in one composite?
A. Yes.
B. No, they each represent distinct geographical segments.
C. No, they are each managed using a distinct investment strategy.
Correct Answer: C
Reference:
Boise has not complied with the GIPS standards by including developed and
emerging equities in one composite. This violation does not arise because the two
equity segments belong to different geographical segments. However, since the
two segments are each managed using a distinct investment strategy, Boise cannot
include them in one composite.
Under the GIPS standards, composites must be defined according to similar

investment objectives and/or strategies. Firms are not permitted to include
portfolios with different investment mandates, objectives or strategies in the same
composite.

53. Is Policy 2 consistent with the GIPS standards?
A. Yes.
B. No, the historical performance record must not be removed.
C. No, portfolios falling below the minimum threshold should be withdrawn
at the end of the first period.
Correct Answer: B
Reference:
Policy 2 is inconsistent with the GIPS standards. For firms which define a
minimum asset level for a composite, the Guidance Statement recommends that
they consider establishing a valuation threshold and a minimum time period for
applying the policy.
A policy which mandates removing a portfolio which falls below the minimum
asset level for two consecutive periods complies with this Standard. However, the
historical performance of the portfolio must remain in the composite. Policy 2
violates the Standards in this regard.
54. In order to comply with the GIPS standards, Boise’s best course of action with
respect to client B’s portfolio is to:
A. remove the portfolio from the composite.

B. transfer the portfolio to a more suitable composite.
C. retain the portfolio but provide adequate disclosure.
Correct Answer: B
Reference:

With respect to portfolio B, Boise’s best course of action is to transfer the

portfolio to a more suitable composite. The GIPS standards prohibit the inclusion
of non-discretionary portfolios in a firm’s composite (I.3.A.1). The Standards go
on to state that if a portfolio is not discretionary, in must not be included in any
composite. However if an investor merely restricts the portfolio manager to
domestic equities, the portfolio can still be managed; it does not lose its
discretionary status.
By prohibiting Moser from purchasing international equities, the client is not

completely imposing restrictions on her freedom to make investment decisions.
Moser can continue to purchase domestic equities for B’s portfolio.
Because the portfolio is not non-discretionary, simply removing the portfolio

from the international equity composite is not an appropriate course of action; it
must be transferred to another composite. Additionally, the portfolio no longer
meets the international equity definition. Therefore, retaining the portfolio in the
international composite by providing adequate disclosure is not an appropriate
course of action.

Questions 55 through 60 relate to Fixed Income
Defense Insurance Providers (DIP) Case Scenario
Defense Insurance Providers (DIP) is a life and casualty insurance firm based in
Wisconsin, USA. The firm not only provides life insurance, but also protection against
most risks to property including fire, weather damage, and theft. DIP manages its risk at
an enterprise level by diversifying its liabilities over a large client base, and by offering
specialized insurance including flood insurance, earthquake insurance and fire insurance.
Nathan Bowen heads the risk management and finance department at the firm, which
includes a team of risk managers, portfolio managers, research and finance analysts, and
economists. Bowen has instructed Alyson Moore, a fixed-income analyst, to manage a
cash liability of $7.5 million due in five years. Moore has constructed three bond
portfolios to immunize this liability. Exhibit 1 displays the features and characteristics of
each of these portfolios.
Exhibit 1: Bond Portfolios

Portfolio A Portfolio B Portfolio C
Macaulay Duration 4.98 4.99 5.03
PV $7.50 $7.60 $7.65
Convexity 55.69 64.21 69.20
Cash flow yield 3.55% 3.57% 3.60%
In addition to this, Bowen also assigns Moore the task of immunizing a set of liabilities
with a value of $20,029,650 and a cash flow yield of 4.520%, stated on a semiannual
basis. The duration and convexity of the debt portfolio are 7 years and 56.90 respectively.
The dispersion equals 9.55. Moore presents Bowen with the following four portfolios as
options for this purpose.

Exhibit 2: Multiple Liability Immunization Bond Portfolios

Portfolio A Portfolio B Portfolio C Portfolio D
Cash Flow Yield 4.53% 3.79% 3.88% 4.99%
PV $20.029648 $20.890129 $20.030333 $20.000120
Convexity 58.00 56.32 57.00 57.03
Dispersion 11.40 10.90 12.10 8.20
Macaulay
7.01 6.98 6.80 7.00
Duration
When talking to Bowen about the attractiveness of each portfolio, Moore makes the
following comments:
Comment 1: “Since the present value of Portfolio B is greater than the present value of
the liability portfolio, we will have considerable surplus to pursue
contingent immunization.”
Comment 2: “To immunize with Portfolio C, we would need to go long a certain number
of futures contracts. The greater these contracts are spread out across the
yield curve, the lower the structural risk.”
During the discussion, Bowen inquired about how model risk could affect the ultimate
effectiveness of the immunization strategy. Moore agreed that such a risk is always
inherent in these situations especially if portfolio duration is measured using a weighted
average of the individual durations of the bonds. He added that using futures contracts
would also add spread risk to the liability driven investment strategy. Bowen decided to
further this discussion the next day.
55. Which of the bond portfolios given in Exhibit 1 is most likely the correct
immunizing portfolio for the single liability?
A. Portfolio A.
B. Portfolio B.
C. Portfolio C.
Correct Answer: A

Reference:
CFA Level III, Volume 4, Study Session 10, Reading 22
To immunize the single liability of $7.5 million Portfolio A would be the best
option. The present value of the portfolio equals that of the liability and the
duration is very close. Even though Portfolio B’s duration is closer and yield is
higher, the difference is very minute. In addition, Portfolio A’s convexity is much
lower than that of Portfolio B. In immunization, lower convexity is a desirable
property because it reduces structural risk. Portfolio C has the highest convexity
and a deviated duration, so it is the least favorable option of the three.
56. Which of the bond portfolios given in Exhibit 2 is most likely the correct
immunizing portfolio for the set of liabilities?
A. Portfolio A.
B. Portfolio B.
C. Portfolio C.
Correct Answer: A
Reference:
BPV of debt portfolio : 7 × 20,029,650 × 0.0001 = $14,020.75

BPV of:
Portfolio A: 7.01/(1+(0.0453/2)) × 20,029,648 × 0.0001 = $13,729
Portfolio B: 6.98/(1+(0.0379/2)) × 20,890,129 × 0.0001 = $14,310.13
Portfolio C: 6.80/(1+(0.0388/2)) × 20,030,333 × 0.0001 = $13,361.41
Portfolio D: 7.00/(1+(0.0499/2)) × 20,000,120 × 0.0001 = $13,659.28
The BPVs of Portfolios A and B are closest to the BPV of the debt portfolio.
Although lower convexity is a desirable property, it is subject to the condition that
the convexity of the assets is greater than the convexity of the liabilities. This is
true only for Portfolio A. The same is true for dispersion. Between Portfolio A
and Portfolio B, dispersion is slightly greater for Portfolio A. Although Portfolio
D’s convexity statistic is appropriate, its BPV has a greater deviation from the
BPV of the liabilities.
For all these reasons, Portfolio A is the best option.

57. In Exhibit 2, structural risk will most likely be highest for:
A. Portfolio B.
B. Portfolio C.
C. Portfolio D.
Correct Answer: C
Reference:
All three portfolios have convexity greater than the convexity of the liabilities,
other than Portfolio B. However, the convexity is only slightly lower, but
dispersion is much greater. For portfolio D, dispersion is much smaller than the
dispersion of liabilities. Hence, structural risk is highest for Portfolio D.
58. Moore is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. Both comments 1 and 2.
Correct Answer: B
Reference:
Comment 1 is inaccurate. Portfolio B’s greater value of assets is due to the fact
that the cash flow yield on the assets is smaller than the cash flow yield on the
liabilities. The assets would grow at a lower rate, and, therefore, need to start at a
higher level. If there is any surplus over and above that, only then it would permit
contingent immunization.
Comment 2 is correct. The BPV of Portfolio C is less than the BPV of the
liabilities. Hence, we would need to go long futures contracts. Also, the greater
the diversification (contracts spread across other segments of the yield curve) the
lower the structural risk.

59. Moore’s concern about model risk will least likely be mitigated if:
A. the underlying yield curve is flat.

B. future cash flows are concentrated in a particular segment of the yield
curve.
C. cash flow yield is used to discount the future coupon and principal
payments.
Correct Answer: B
Reference:
Model risk arising from using an approximate value of the asset portfolio duration
measured as the weighted average of the individual durations of the component
bonds will be minimized if the yield curve is flat or if cash flows are concentrated
in the flattest segment of the curve. A better approach to use is to discount future
cash flows using the cash flow yield.
60. Spread risk in derivatives overlay liability driven investing most likely arises
from:
A. a large duration gap between the asset portfolio and the liability portfolio.
B. Not incorporating short-term rates and accrued interest in the
determination of the futures BPV.
C. The fact that yields on high-quality bonds are less volatile than on more-
liquid government bonds.
Correct Answer: C
Reference:
The higher volatility on more liquid Treasuries relative to high quality corporates
introduces spread risk in a derivatives LDI strategy. Since they would not move in
concurrence in response to a change in yields, this would introduce spread risk in
the hedging strategy.

CFA Level III Mock Exam 3 - Solutions (PM)

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FinQuiz.com – 3rd Mock Exam 2018 (PM Session)

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

GemStar Associates Case Scenario

GemStar Associates, a U.S. based firm, provides investment advisory services to

Damien Rupert is another portfolio manager and member of Team A. He is following

Rupert devotes some of his time to charities as a volunteer. At some charities, he

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Action 2: Include terminated accounts within the relevant composite’s historical

Communication can be in written or oral firm. By describing the model in the

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There is no information to indicate that Rupert has failed to determine the

A. Yes, with respect to his role as policy maker.

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A. Yes, by visiting the offsite company lodge.

5. Walsh’s decision to undertake verification is:

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Walsh’s decision to undertake verification is inappropriate because verification

Additionally, verification must be undertaken by an independent third party.

6. Which of the following actions violate the CFA Institute Standards of

Action 1 violates the CFA Institute Standards of Professional Conduct.

Action 2 violates the CFA Institute Standards of Professional Conduct.

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Questions 7 through 12 relate to Ethical and Professional Standards

Martinez Advisory Case Scenario

Martinez Advisory is a U.S. based multinational investment management firm founded

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9. In order to adhere to the requirements and recommendations of the Asset Manager

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When reviewing portfolio information, the Code requires Managers to undertake

With respect to individual client accounts, review must not be undertaken by

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A. are encouraged to adhere to the Code.

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Questions 13 through 18 relate to Alternative Investments

Caroline King Case Scenario

After their meeting concludes, Brown decides to explore commodity investments. He is

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Contract Futures Price as Futures Price as of Change in spot

Condition 1: Enhance risk-adjusted portfolio returns

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A. The lenders providing financial support to the advisor.

The ability of a manager to communicate with their clients is a factor more

14. Based on Brown’s statement, his recommendation is most likely:

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Brown’s recommendation is justified. REITs permit smaller investors to gain real

A. Commodity prices tend to rise during weak economies due to their

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i. Commodity prices tend to decline during weak economies.

Roll return: Exercise?

Roll return = ΔFutures price –ΔSpot price

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Questions 19 through 24 relate to Risk Management

William Pearson Case Scenario

William Pearson is a head of risk governance at Everest Investment Management (EIM).

Statement 2: “In contrast to the decentralized structure, companies using a centralized

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