CFA Level III Mock Exam 5 June, 2018 Revision 1

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CFA Level III Mock Exam 5
June, 2018
Revision 1
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CFA Level III Mock Exam 5 – Solutions (PM)
FinQuiz.com – 5th 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 Equity Investments 18
25-30 Fixed-Income Portfolio Management 18
31-36 Fixed-Income Portfolio Management 18
37-42 Alternative Investments 18
43-48 Performance & Evaluation 18
49-54 Derivatives 18
55-60 Global Investment Performance Standards 18
Total 180
FinQuiz.com © 2018 - All rights reserved. 2

Questions 1 to 6 relate to Ethical and Professional Standards
Sun Davidson, CFA, Case Scenario
Sun Davidson, CFA, is a sell side energy research analyst. Davidson maintains an equity
investment blog which is actively followed by over 5,000 investors spread across
numerous countries. The investors are from various financial backgrounds with differing
risk appetites.
In the current year, Davidson decides to change the layout of the blog. Instead of placing
announcements concerning investment recommendations at the bottom of the screen, as
has been the case since she started the blog, recommendations can now be accessed by
clicking on a highlighted (in bold) ‘Recommendations’ tab located at the top left of the
screen. Davidson does not feel it is necessary to make any announcement with respect to
the change.
For her next entry, Davidson will be preparing an investment recommendation on Energy
Fund, a hedge fund which undertakes long and short positions in equity securities from
the energy sector. Due to her limited expertise with the alternative asset class, Davidson
seeks the advice of Earl Ramos, a leading hedge fund manager at Carlton, a hedge fund
management firm.
During their initial meeting, Ramos informs Davidson that, with the knowledge of his
employer, he is invested in the Energy Fund (EF) and maintains a working relationship
with the fund’s manager from whom he has learnt that the fund will be expanding to
include highly risky energy stocks issued in less developed countries. Upon Ramos’s
advice, Davison issues a buy recommendation but does not disclose Ramos’s holding in
EF or his relationship with the fund manager.
Pleased with their professional relationship, Davidson invites Ramos to become a regular
contributor to the blog which he accepts. Ramos’s compensation will be in the form of
commission generated for the recommendations he issues. However, he will not be paid
by Davidson. Ramos informs his supervisor of the offer after acceptance and has decided
to contribute to the blog during the weekends so as not to disrupt his routine work
activities.

The same evening, both professionals attend an investment conference at which Ramos
collides into Wilson Clark. Clark maintains an investment in the Carlton hedge fund
along with his brother, Ridley. Wilson praises Ramos for his exemplary performance
results achieved during the current year on both their holdings. Wilson invites Ramos to
vacation with him in Morocco.
Upon the conclusion of their conversation, Ramos shares the details of the offer with
Davidson stating, “I manage the hedge fund investments of the Clark brothers and both
are equally pleased with my performance. This calls for a celebration.”
1. By changing the layout of the blog Davidson is in violation of the CFA Institute
Standards of Professional Conduct with respect to:
A. loyalty to clients.
B. diligence and reasonable basis.
C. communication with clients and prospects.
Correct Answer: C
Reference:
CFA Level III, Volume 1, Study Session 1, Reading 2, LOS a
C is correct. Davidson is in violation of Standard V (B) Communication with Clients and

Prospective Clients by failing to disclose the change in layout to investors following the
blog. Communicating the change in the location of the recommendation section is crucial.
Moreover it is not sufficient to highlight the tab in bold and assume investors will readily
be able to locate it. Davidson should have made an announcement on his blog and by not
doing so she has violated this standard which requires members and candidates to
promptly disclose any changes which materially affect investment processes.
A is incorrect. There is no evidence which indicates that Davidson has placed her
personal interests before those of investors or otherwise acted in a manner inconsistent
with the interests of investors.
B is incorrect. The standard relating to diligence and reasonable basis has not been
violated.

2. By issuing the purchase recommendation, Davidson is in violation of the CFA

Institute Standards of Professional Conduct because she has failed to:
A. conduct a suitability analysis.

B. disclose that she has employed the expertise of Ramos.
C. disclose her reliance on material nonpublic information.
Correct Answer: B
Reference:
B is correct. Prior to engaging Ramos, Davidson generated investment

recommendations using her skills and expertise. Therefore, employing the
services of Ramos to help her make the hedge fund investment recommendation is
a material change to her investment process and one which will require disclosure
according the standard concerning Communication with Clients and Prospective
Clients [Standard V (B)].
A is incorrect. The investor base following the blog is characterized by a variety

of risk appetites. Therefore, it is highly unlikely that the highly risky hedge fund
investment will be inappropriate for all investors.
C is incorrect. Davidson has violated the CFA Institute Standards of Professional

Conduct by relying on material nonpublic information. Information regarding a
proposed change in fund mandate is material information and basing a
recommendation on it constitutes a violation. That being said, disclosure of a
violation is not a solution to the wronged action.
3. In order to avoid violation of the CFA Institute Standards of Professional

Conduct, Davidson is required to disclose to investors:
A. Ramos’s investment in the EF only.

B. Ramos’s relationship with the manager of the EF only.
C. Both Ramos’s investment in and relationship with the manager of the EF.
Correct Answer: C
Reference:
CFA Level III, Volume 1, Study Session 1, Reading 2, LOS b

According to the Standard VI (A) Disclosure of Conflicts members and

candidates are required to disclose all actual and potential conflicts of interest
which can impair their objectivity or interfere with their respective duties to their
clients and employers. Ramos’s relationship with the hedge fund manager has
given him access to material nonpublic information. Therefore his relationship
with the manager indicates the existence of actual and potential conflict of
interests which mandate disclosure. Furthermore, Ramos’s investment in the
hedge fund which he recommends for investment represents a source of potential
conflict of interest requiring disclosure. Investors may view his recommendation
as an attempt to improve the value of his investment.
4. By accepting Davidson’s offer to contribute to the blog, is Ramos in violation?
A. No, he will not be disrupting the activities of his employer.

B. Yes, he should have sought permission prior to acceptance.
C. Yes, he has not disclosed the commission income which he will earn.
Correct Answer: B
Reference:
B is correct. Standard V (A) Employer Loyalty requires members and candidates

to abstain from competitive activity that could conflict with the interests of their
employer. The standard does not preclude members and candidates from entering
into an independence practice agreement for compensation while still employed,
prior approval must be sought. Therefore, even if his participation in blog as
hedge fund analyst will not interfere with his duties at Carlton, Ramos is in
violation by not seeking prior permission.
C is incorrect. Although Ramos is required to disclose details of the offer to his

employer, he must seek approval prior to acceptance and by not doing so, he is in
violation.
5. Ramos’s best course of action with respect to Clark’s offer is to:
A. decline the offer.

B. disclose the offer to his employer only.
C. disclose the offer to his clients and employer.

Correct Answer: B
Reference:
According to Standard I (B) Independence and Objectivity, members and

candidates may accept gifts and benefits from their employer as long as they
either notify employers prior to or after accepting the gift, whichever is possible.
However, the standards do not mandate disclosure to clients.
6. With respect to the statement made to Davidson at the investment conference, is

Ramos in violation of the CFA Institute Standards of Professional Conduct?
A. No.
B. Yes, by mentioning that he manages Ridley’s portfolio only.
C. Yes, by mentioning that he manages the investment portfolios of the Clark
brothers.
Correct Answer: A
Reference:
Standard III (E) Preservation of Client Confidentiality requires members and

candidates to preserve the confidentiality of the information communicated to
them by their clients. However, information concerning client names is not
considered confidential information and its communication does not constitute a
violation.

Questions 7 to 12 relate to Ethical and Professional Standards
Riverside Asset Management Case Scenario
Riverside Asset Management (RAM) is a privately owned, small-scaled investment

advisory firm. The firm’s client base exclusively includes institutional clients. Roger
Marquez, the firm’s compliance officer, has made necessary modifications to RAM’s
policies and procedures to ensure they are consistent with the Asset Manager Code.
Once he is reasonably satisfied with RAM’s level of compliance, Marquez sends an

investment letter to clients and prospective clients which includes the compliance
statement, “RAM claims compliance with the CFA Institute Asset Manager Code of
Professional Conduct. This claim has not been verified by the CFA Institute.”
Thomas Nash manages RAM’s global equity fund which in benchmarked to the MSCI
global equity index. Nash employs a passive mandate for the global equity allocation of
Aero Inc’s defined benefit pension plan’s portfolio, which is consistent with the client’s
funding objectives. In the current year, the sponsor reports a surplus following a
profitable financial year. Nash decides to modify his investment strategy and employ a
semi-active approach which will allow him to increase the portfolio’s opportunity to earn
higher returns. He intends to inform the sponsor of the change in their next quarterly
meeting.
Victoria Reed is a junior portfolio manager reporting to Nash. Reed is managing the
investment portfolio of the Legend Foundation. As instructed by the foundation’s chief
executive, Reed allocates 1,000 of Hower Inc’s shares to the portfolio which has
undertaken an IPO. Reed simultaneously purchases 2,000 shares for her personal
investment portfolio. She discloses the amount and quantity of her purchase in a quarterly
trade confirmation and an annual statement of personal holdings which she will email to
Marquez on the respective dates.
Marquez is soon to retire and has been asked by RAM’s chief investment officer to
nominate a successor. Marquez evaluates two candidates one of whom is his brother who
is well-informed on the Code’s compliance policies and procedures. The second
candidate is an investment manager who overlooks RAM’s emerging market equity fund.

Several of the fund’s clients have requested an allocation to commodities. However,

RAM lacks expertise and has selected Fairhole Associates, a commodity trading
specialist to manage the allocation. Upon making the allocation, a letter is sent to clients
which states, “RAM has appointed Fairhole Associates to manage commodity
investments. Fairhole Associates retains liability for the performance of these
investments.”
At the end of the performance year, Nash prepares a performance presentation for the
global equity fund. Although the fund has been in operation for the past eight years, he
decides to present the annual performance for the recent most five years as they represent
its most successful years. He presents gross- and net-of-fees returns and provides a
breakdown of fees charged as management fees, incentive fees and commission. His
disclosure purposely omits a contingent fee component which he deems as too complex
for the understanding of clients.
7. Is RAM’s claim of compliance statement consistent with the Asset Manager

Code?
A. No.
B. Yes, the CFA Institute cannot verify actual compliance with the Code.
C. Yes, the CFA Institute can only verify the Manager’s claim of compliance.
Correct Answer: B
Reference:
RAM’s claim of compliance is consistent with the Asset Manager Code. The CFA
Institute does not verify either the Manager’s claim of compliance or actual
compliance with the Code.
8. By modifying his strategy, is Nash in violation of the Asset Manager Code?
A. No.
B. Yes, he has not undertaken a suitability analysis.
C. Yes, he has not made disclose to clients prior to the change.
Correct Answer: C

Reference:
C is correct. Nash is in violation of the Asset Manager Code because he has not
provided disclosure to clients prior to converting to a semi-active fund mandate.
Managers are required to provide this information well in advance of the change
so that clients should be given enough time to consider the change and take any
actions as necessary.
B is incorrect. A semi-active fund mandate is appropriate in light of the surplus

reported by the fund. A fund surplus accompanied by improved financial
performance translates will increase the plan’s risk tolerance.
9. With respect to the purchase of Hower Inc.’s shares, is Reed in violation of the
Asset Manager Code?
A. No.
B. Yes, she did not seek prior approval.
C. Yes, she did not delay the purchase of shares
Correct Answer: B
Reference:
B is correct. Reed is in violation of the Asset Manager Code by not seeking

approval prior to purchasing shares for his personal portfolio. The Code requires
Managers to require employees to receive approval prior to any personal
investments in initial public offerings or private placements.
C is incorrect. Reed is not in violation by purchasing shares for her account

concurrently with those for Legend Foundation’s portfolio. Reed has fulfilled the
foundation’s request to purchase 1,000 shares and by purchasing 2,000 shares for
her personal portfolio, her actions do not adversely affect her client’s interests.

10. Which candidate best fits the role of compliance officer in accordance with the
Asset Manager Code?
A. Marquez’s brother
B. The emerging market fund manager.
C. Neither of the two individuals.
Correct Answer: C
Reference:
Neither of the two individuals are suitable candidates for the role of compliance
officer. The recommendation and subsequent appointment of his brother may give
rise to potential conflict of interest situations. Furthermore, the familial
relationship between Marquez and the proposed candidate might call into question
the latter’s independence.
The emerging market fund manager is not a suitable candidate as he is not

independent from the investment personnel. The Asset Manager Code
recommends managers to appoint a compliance officer who is independent from
operations and investment personnel.
11. Is the allocation of client trades to Fairhole Associates consistent with the
requirements and recommendations of the Asset Manager Code?
A. Yes.
B. No, RAM cannot outsource work.
C. No, RAM must retain liability for the outsourced work.
Correct Answer: C
Reference:
The Asset Manager Code does not prohibit Managers from outsourcing the work
of certain functions. However, it is important that the Manager retain
responsibility and liability for any outsourced work. Limiting liability with respect
to outsourced work reflects an action which is inconsistent with the Asset
Manager Code.

12. Which of the following statements least likely indicates why Nash’s performance
presentation is inconsistent with the requirements and recommendations of the
Asset Manager Code? Nash:
A. has distorted the performance presented.

B. has not explained the commission component.
C. need only present gross- or net-of-fees returns but not both.
Correct Answer: C
Reference:
C is correct. At a minimum, the Asset Manager Code recommends managers to

disclose gross- and net-of-fees returns as well as any unusual expenses. By
disclosing both these returns, Nash is in compliance with the Code.
A is incorrect. Under the Code, Managers have a duty to present performance that
is a fair representation of their record and should not misrepresent their track
record. Nash is cherry picking the investment performance to present and by
doing so he is in violation of the Code.
B is incorrect. With respect to fees, the Code requires Managers disclose what
costs are included in the fees and the methodology for determining fees.
Therefore, it is essential that Nash disclose the methodology for determining the
commission component, along with others. By not doing so, he is in violation of
the Code.

Questions 13 to 18 relate to Economics
Dianne Fernandez Case Scenario
Dianne Fernandez is a junior economic analyst serving Thompson Ace (TA), a research
firm providing advisory services to institutions. Fernandez covers emerging markets. TA
has been engaged by Blake Asset Management (BAM), a U.S. based asset advisory firm,
to analyze the firm’s asset allocation and recommend changes based on capital market
projections.
Fernandez will be responsible for developing capital market projections for the country of
Rica with currency RIC. Rica is currently enjoying a period of strong economic growth.
Fernandez, however, projects that this economic strength will accelerate inflation in the
months to come. Based on preliminary economic analysis, Fernandez learns that bond
investors expect the central bank to maintain its inflation target by raising short-term
rates. BAM has allocated a total of 30% of client funds to securities (fixed income and
equity) issued in Rica (Exhibit 1).
Exhibit:
BAM’s Current Asset Allocation
Allocation
Asset Class (%)
Domestic equities 35
Emerging market equities 10
Long-term government bonds - Rica 15
U.S. Treasuries 10
AA-rated Domestic Corporate Bonds 25
Real estate 5
Total 100
Next, Fernandez meets with BAM’s senior investment officer who informs her that 40%
of the holdings to long-term government bonds belong to those investors with a short-
term time horizon while the remaining 60% has a long-term holding period.
Gillian Moore, a senior emerging market analyst serving TA, evaluates Fernandez’s
findings and suspects that the analyst’s projections as well as market expectations with
respect to inflation may be conservative.

After discussing her forecasts with the analyst, Moore urges Fernandez to analyze Rica’s
economy in more detail paying specific attention to long-term growth forecasts. Paying
heed to Moore’s advice, Fernandez decomposes long-term GDP growth into four factors
and develops projections for each. She compares her findings with another analyst who
has decomposed GDP growth into three factors and summarizes both sets of projections
in an Exhibit for her research report (Exhibit 2).
Exhibit 2:
Decomposition of Rica’s Long-term GDP Growth Forecast
Fernandez’s Analyst’s
Projections Projections
(%) (%)
Growth in potential labor force size 3.4 3.0

Growth from capital inputs 2.1
Growth in actual labor force participation rate 0.5
Growth from labor inputs 4.8
TFP growth 5.2
Growth from labor productivity 8.4
Fernandez then reads an article on the current state of Rica’s economy which is titled as,
‘Rica’s Economy – Today and Tomorrow’. She is analyzing the implications of the
following excerpt on BAM’s holding of the country’s equities:
Excerpt: “Rica’s rapid rate of economic growth has been due to a surge in capital
investments.”
Fernandez concludes her analysis by evaluating the current value of the RIC/USD
exchange rate. She would like to determine whether the RIC is correctly valued based on
the purchasing power parity. She has collected data relevant for her analysis in an exhibit
(Exhibit 3).
Exhibit 3:
Data Relevant for Analysis of RIC’s Value
Current RIC/USD exchange rate 70.52
1-year Rica risk-free rate 13.00%
1-year U.S. risk-free rate 2.50%
Expected inflation rate – Rica 5.00%
Expected inflation rate – U.S. - 0.02%

13. In light of Fernandez’s original economic projections of Rica, he will most likely
advise a reduction of an allocation to 30-year government bonds for investors
with:
A. short-term time horizons only.

B. long-term time horizons only.
C. short- and long-term time horizons.
Correct Answer: C
Reference:
CFA Level III, Volume 3, Study Session 7, Reading 14, LOS o
Investors with short- and long-term time horizons should reduce their allocation to
30-year government securities.
When buying and selling long-term bonds over a shorter time horizon, the
emphasis will be on how bond yields react to changes in the business cycle and
changes in short-term rates. Given that bond investors in Rica expect the central
bank to maintain its inflation objectives, bond yields will respond only to changes
in the short-term rate. An expected rise in short-term rates will make the 30-year
government bonds unattractive for investors with a short-term holding horizon.
For investors with long-term horizons, an increase in anticipated inflation will

serve to increase nominal yields on bonds as investors demand higher premiums.
This, in turn, will result in the decline of the par value of bonds making 30-year
government bonds unattractive for investors with a long-term horizon as market
yields rise.
14. Based on Moore’s findings with respect to inflation projections and expectations,
the senior analyst will most likely conclude that the total allocation (both short-
and long-term investors) to 30-year government bonds should be:
A. reduced.
B. increased.
C. held constant.
Correct Answer: A

Reference:
Because Moore believes that the acceleration of inflation will be higher than
expected by the market and that Fernandez has underestimated future inflation,
30-year government bonds will be very unattractive for BAM’s clients, regardless
of their individual time horizons. This is because nominal bond yields will not
compensate for this higher inflation rate resulting in the decline in the value of
bonds below par as market yields decline.
15. Using the data in Exhibit 2, relative to the analyst’s projections, Fernandez’s long-
term economic growth forecast is:
A. 0.2% higher.
B. 0.9% higher.
C. 0.7% lower.
Correct Answer: A
Reference:
CFA Level III, Volume 3, Study Session 7, Reading 14, LOS j
Long-term economic growth is represented by the trend growth in GDP, which

represents the sum of the following:
• Growth from labor inputs, comprising

o growth in potential labor force size
o growth in actual labor force participation, plus
• Growth from labor productivity, comprising

o growth from capital inputs and
o TFP growth
Fernandez’s GDP trend growth rate = 4.8% + 2.1% + 5.2% = 12.1%

Analyst’s GDP trend growth rate = 3.0% + 0.5% + 8.4% = 11.9%
Fernandez’s estimate is 0.2% (12.1% – 11.9%) higher.

16. In context of the data presented in Exhibit 2 and considering Fernandez’s

projections in isolation, she least likely expects that:
A. the death rate to decline.

B. number of immigrants will increase.
C. Rica’s government will encourage competition in the private sector.
Correct Answer: A
Reference:
A is correct. A reduced death rate will translate into a larger population and a rise
in the number of retirees who are living longer. Thus, a reduction in death rate
will not result in a corresponding growth in potential labor force size.
B is incorrect. An increase in the number of immigrants may contribute to a rise

in potential labor force size, a component of the trend growth in GDP.
C is incorrect. Competition will drive companies to become more efficient and

boost productivity growth, which in turn will boost trend GDP growth through
labor productivity in general and TFP growth in particular.
17. Based on the excerpt in the news article, which of the following conclusions most
likely represents a valid implication?
A. TFP growth will be boosted.

B. Labor productivity will remain unaffected.
C. BAM will need to reduce its allocation to Rican equities.
Correct Answer: C
Reference:

C is correct. The rapid growth in capital investment will drive down returns on
invested capital. With weaker stock market returns, BAM will need to reduce its
allocation to Rica’s stocks to avoid declines in their investment values.
A is incorrect. TFP growth results from increased efficiency in using capital

inputs and is not affected by the rate of capital investments.
B is incorrect. Growth from labor productivity is broken into two components,

growth from capital inputs and TFP growth. Therefore, an increase in capital
investment will boost labor productivity.
18. Using the data in Exhibit 3, Fernandez will conclude that the RIC is:
A. overvalued
B. undervalued
C. fairly valued.
Correct Answer: A
Reference:
CFA Level III, Volume 3, Study Session 7, Reading 14, LOS l
Inflation in Rica is expected to be 5.02% [5.00% – (- 0.02%)] higher than the U.S.
Therefore, the RIC will need to approximately depreciate by 5.02% according to
PPP. The RIC/USD exchange rate according to the PPP is 74.06 (1 +
5.02%)(70.52).
Comparing the current exchange rate to the level defined by PPP, the RIC appears
to be overvalued.

Question 19 to 24 relate Equity Investments
Trone Wealth Advisory Case Scenario
Trone Wealth Advisory’s (TRA) is an asset management firm with an institutional client
base. The Start Endowment Fund (SEF) is one of TRA’s clients and the equity portion of
its investment portfolio solely holds US equities and is being managed by Fran Davis, a
senior TRA equity manager. Davis has learned that SEF has received a further $20
million in donations in the current year which it intends to invest. SEF’s chief executive
officer (CEO) requests Davis to add active exposure to its portfolio using developed
market foreign equities and has specified an equal-weighted global index comprising
2,000 foreign equities as a benchmark. The CEO has instructed Davis to add exposure in
a way which does not require adjusting the strategic asset allocation. Davis maintains
strong negative and positive views with respect to the index’s stocks.
The CEO asks Davis to demonstrate how an equal-weighted index is valued. Davis
demonstrates the calculation using a hypothetical index comprising five stocks and a
valuation period starting on January 1, 2013 and ending on January 1, 2014. He estimates
the price change of the constituent stocks between the two dates and presents the data in
the exhibit below (Exhibit 1).
Exhibit 1:
Hypothetical Equal-Weighted Index
Stocks Price Change (%)
A 30.8
B - 12.7
C 9.3
D 2.1
E 20.5
The CEO has heard that there are certain drawbacks in using an equal-weighted index as
a benchmark. He asks Davis which of these drawbacks SEF should be most concerned
about given its foreign equity mandate.

The policy portfolio of Green Inc is being managed by Lance Young, one of TRA’s
wealth advisors. The equity portion of the portfolio is being managed using a value
approach and is benchmarked to the Russell 3000 index, a large-cap index. Young has
received a request by the plan sponsor to sell $2 million of Proctor and Gamble (P&G)
shares, a pharmaceutical, from the policy portfolio for the purposes of raising cash for
fund expansion. Young will implement a valuation-level sell discipline for executing the
transaction.
Details concerning Green Inc.’s portfolio and P&G holding prior to the sales transaction
are summarized in the exhibit below (Exhibit 2).
Exhibit 2:
Green Inc.’s Policy Portfolio and P&G Holding Information
P/E multiple at the time of P&G stock purchase 8.6
Current P/E multiple of P&G stock 12.5
Historical average P/E multiple of P&G stock 12.5
Actual dividend yield of P&G stock 5%
Average industry dividend yield of pharmaceutical stocks 3%
Purchase price $125.00
Current market price $150.00
Average annual portfolio turnover 135%
Proportion of consumer discretionary equities in portfolio 60%
TRA’s management has decided to devise a formal equity securities selection policy for
its global equity fund. It has tasked Carl Douglas, TRA’s senior global fund manager, to
devise the policy. Douglas sets to work by drafting the following policy:
“Above average earnings growth, P/E ratios in the lowest quartile, strong dividend paying
ability, and sound environmental conservation policies are the four factors used to screen
issuers of global equities. Companies passing the screen will be subject to further
evaluation in light of collected financial information. From the list of screened
companies, an investment will be made in the shares of those with strong corporate
governance practices.”

19. In light of the information provided on SEF and Davis, which of the following
strategies will most likely be used to add active exposure?
A. Long-only
B. Short extension
C. Equitized market neutral long-short
Correct Answer: C
Reference:
CFA Level III, Volume 4, Study Session 12, Reading 25, LOS m & n
C is correct. An equitized market neutral long-short strategy should be used to add

active exposure. This is because the source of active exposure (developed market
foreign equities) is distinct from the source of market return (U.S stocks). With a
long-short equitized long-short market neutral strategy, it is possible to earn the
market return from one source and alpha from another source. This feature will
allow SEF to pursue alpha in any developed equity market without having to
adjust its strategic asset allocation.
A is incorrect. A long-only strategy will only allow Davis to exploit his positive
views on the constituent stocks. However, negative insights cannot be fully
exploited in a long-only context. The maximum short position will be limited by
the stock’s index weight.
B is incorrect. A short extension strategy is undesirable because it earns its alpha

and market return from the same source. Therefore, should Davis implement this
strategy, he will be unable to earn market returns from US equities and seek active
exposure (alpha) from foreign equities.
20. Assuming initial value of a hypothetical index is 100, using the information in
Exhibit 1, the value of the index on January 1, 2014 is closest to:
A. 110.0.
B. 150.0.
C. 153.5.
Correct Answer: A

Reference:
CFA Level III, Volume 4, Study Session 12, Reading 25, LOS d
The base value of each index component on Jan. 1, 2013 is 100.

Value of components on Jan. 1, 2014:
% change in index value = [0.308 - 0.127 + 0.093 + 0.021 + 0.205] = 0.50/5 =

10%
Index value = 100 x (1+ 10%) = 110
21. Which of the following represents a valid concern when using an equal-weighted
index as benchmark specifically for the foreign equity portion of SEF’s portfolio?
A. Small-company bias
B. High rebalancing costs
C. Illiquidity of index constituent securities
Correct Answer: A
Reference:
CFA Level III, Volume 4, Study Session 12, Reading 25, LOS d
A is correct. Out of the three limitations of equal-weighted indexes presented,

small-company bias is a potential concern when using this weighting scheme.
This is because these indexes tend to include many more small-cap companies
than large-cap companies.
Both options B and C are incorrect; these represent valid concerns for indexers
using equal-weighted indexes as benchmarks. However, they should not represent
a concern to SEF as the $2 million will be managed actively.

22. Using the information in Exhibit 2, a decision to sell the P&G holding will be
made as the:
A. dividend yield exceeds the average industry yield.

B. P/E multiple has reached its average historical level.
C. current market price has declined by more than 15% below purchase price.
Correct Answer: B
Reference:
B is correct. A valuation-level sell discipline will sell a previously purchased low

P/E stock if it has reached its historical average level. Given that the current P/E
multiple of the P&G stock has reached this level, Young will sell the holding.
A is incorrect. Sell disciplines do not use dividend yields as a guide for executive
sale transactions.
C is incorrect. The statement reflects a decision based on the down-from-cost sell

discipline.
23. Which of the following factors presented in Exhibit 2 is least consistent with the
style being used to manage Green Inc.’s policy portfolio?
A. Portfolio turnover
B. Dividend yield of P&G stock
C. Proportion of consumer discretionary equities
Correct Answer: A
Reference:
CFA Level III, Volume 4, Study Session 12, Reading 25, LOS i

A is correct. Annual turnover levels for a value investor are relatively low and
range from 20% to 80%. Growth investors, on the other hand, have higher annual
portfolio turnover, in line with the greater frequency of earnings announcements.
Green Inc’s average annual portfolio turnover is quite high considering that
Young has employed a value investment style.
B is incorrect. Value investment styles are characterized by high dividend yields.

A dividend yield which exceeds the industry average corresponds with Young’s
investment style.
C is incorrect. Consumer discretionary stocks represent cyclical stocks. Different

investors will be attracted to these stocks depending on the stage of the business
cycle. Therefore, without any information on the current stage, a definite
conclusion cannot be made as to whether Young is correct in allocating 60% of
client funds to this category.
24. The drafted security selection policy most likely represents:
A. the top-down approach.

B. the bottom-up approach.
C. a combination of the top-down and bottom-up approach.
Correct Answer: B
Reference:
CFA Level III, Volume 4, Study Session 12, Reading 25, LOS v
B is correct. The drafted security selection represents the bottom-up approach.

The manager is focusing on company-specific fundamentals such as earnings, P/E
ratios, dividends, and soundness of environmental policies to initially screen
companies and then financial information to further shortlist the selected
companies. The policy pays little attention to the state of economy or other macro
factors and focuses on building a portfolio of stocks using company-specific
information.
A is incorrect. Using the top-down approach, analysts build a portfolio of stocks

by focusing on macroeconomic factors. Given that the policy lacks these insights,
it does not reflect a top-down approach.

Question 25 to 30 relate to Fixed Income
Link-up Communications Network (LUCN) Case Scenario
Link-up Communications Network (LUCN) is a nation-wide, telecom firm with

headquarters in New York USA. LUCN has more than fifteen branches and benefits from
a large client base and huge economies of scale. Over five years ago, LUCN offered its
employees a defined benefit pension plan in an attempt to retain skillful human resource.
This helped in retention of employees and so, the company has no immediate disposition
of closing the defined plan. The current balance sheet shows a projected benefit
obligation of $27.403953 million, estimated by using a discount rate of 5.5%. The
accumulated benefit obligation, using the same discount rate, is $19.504931 million. To
actively manage its pension liabilities, LUCN’s board of directors has hired Unified Fund
Managers (UFM), a licensed financial firm, proficient in institutional fund management.
Kylie Jack, a financial analyst at UFM, is heading the pension management team of
LUCN. Jack determines that the market value of pension plan assets is $27.603920. Even
though the plan is currently overfunded, Jack is concerned how movements in interest
rates could change the funded status of the plan. She requests her colleague to measure
the effective duration of the pension liabilities by raising and lowering the yield curve in
the valuation model and recalculating the present values. The estimated effective duration
is calculated to be 9.5.
Kylie has asked the research department at her firm to prepare a report on the future
outlook of market interest rates. The final report declares that unemployment is expected
to decrease, sales to rise, and inventories to build up. As the economy lifts up, spreads are
expected to tighten, as credit quality improves and default rates decrease. After reading
the report, Kylie becomes particularly concerned with how this interest rate scenario
could alter the funded status as reported on LUCN’s current balance sheet. Even though
the asset portfolio has only a 35% allocation to bonds, Kylie, nonetheless, anticipates an
adverse effect on plan assets, since their duration equals 6.0. The effective durations of
the remaining allocations to equity and alternative investments are assumed to be zero.
After careful deliberation and a comprehensive discussion with the portfolio management
team, Kylie suggests to the board of LUCN to consider the use of a derivatives overlay
strategy to manage the difference in durations between the assets and liabilities. In a
meeting with the board, she elaborates the following four derivative options:
Strategy 1: “The use of a 10-year Treasury futures contract with a BPV of $11,055
estimated using the cheapest to deliver bond.”

Strategy 2: “A 25-year, swap contract that has a fixed rate of 4.50% against three-month
Libor. The swap’s effective duration is 17.88. The BPV is calculated per
$100 of notional principal.”
Strategy 3: “A swaption with a strike rate of 3.75% and a premium of $75,000. The
swaption gives the right to enter into the swap described in strategy 2 and
expires on a date that coincides with LUCN’s next financial reporting date.”
Strategy 4: “A swaption collar that involves the swaption in strategy 3 as well as an

additional one with a strike rate of 5.50%. The swaption premium on this
swaption equals that of the previous one.”
As further clarification, Kylie states that a hedging ratio of 100% would not be feasible
even though it would completely eliminate the duration gap. She suggests that a ratio of
60% is a practical approach to managing the interest rate risk of the portfolio.
25. To actively hedge the pension liabilities using a derivatives overlay, LUCN
should least likely:
A. enter the swap as a floating-rate payer.

B. Buy a payer swaption.
C. Buy a receiver swaption and write a payer swaption.
Correct Answer: B
Reference:
CFA Level III, Volume 4, Study Session 10, Reading 22
The BPV of PBO (ABO will not be used since LUCN is a going concern) =
$27.403953 million × 9.5 × 0.0001 = $26,033.755
The BPV of assets: $27.603920 × (0.35× 6) ×0.0001 = $5,796.823
Since the BPV of assets is considerably lower than that of the liabilities, LUCN is
at the risk of a fall in interest rates that could raise liabilities and cause the plan to
be underfunded. To hedge this, LUCN should enter a receive-fixed pay floating
swap, or buy a receiver swaption. Option C describes a collar to reduce cost.

26. The notional principal of the swap in strategy 2 will be closest to:
A. $11.32 million.
B. $6.79 million.
C. $5.30 million.
Correct Answer: B
Reference:
BPV of swap: 17.88 /100 = 0.1788

Notional principal of swap:
5,796.823 +[NP ×0.1788/100] = 26,033.755 = $11,318,194.63
60% hedging ration NP: $6,790,916.779
27. Given that LUCN takes the right side of the swap, if Kylie anticipates interest
rates to be higher than the research department has estimated, the optimal hedging
ratio is most likely to:
A. decrease.
B. Increase.
C. Remain unchanged.
Correct Answer: A
Reference:
A receive-fixed pay-floating swap would benefit if rates fall. If rates, in fact, rise,
Kylie should reduce the hedging ratio.
28. Given that LUCN takes the right hedging position, if swap rates are expected to
equal 4.3%, which of the following strategies would be preferred?
A. Strategy 1.
B. Strategy 2.
C. Strategy 3.
Correct Answer: B

Reference:
If rates are expected to be at or below the swap rate of 4.50%, the receive-fixed
swap would be preferred. Its gains would be higher than the swaption. Futures
would not be preferred because of the daily market-to-market requirement.
29. Given that LUCN takes the right hedging position and considering that the swap
is annual-pay, if swap rates rise to 5.65% which of the following strategies would
most likely be the preferred option?
A. Strategy 2.
B. Strategy 3.
C. Strategy 4.
Correct Answer: B
Reference:
Since the rate is above the swap rate, it is not a preferred option.
Loss on Strategy 4 which is a collar: (0.0565-0.0550) × 6,790,916.779 =
10,186.375
The PV of a 25 year annuity discounted at 5.65% means that loss equals:

134,661.58
Since the premium paid is $75,000 and this is less than the loss on the collar, the
receiver swaption would be preferred.
30. Assuming that the swap is semi-annual pay, if rates are expected to equal 4.35%,
the gain or loss on Strategy 2 will be closest to:
A. $5093.
B. $8,535.
C. -$9,209.
Correct Answer: A

Reference:
Loss: (0.045-0.0435) × 0.5 × 6,790,916.779 = $5093.1875

Questions 31 to 36 relate to Fixed Income
Martin Alexander Case Scenario
Martin Alexander works for a renowned credit rating agency as a security appraiser &
research analyst. Alexander has worked with his colleagues in the bond appraisal of
numerous US-based, as well as international issuers. Consequently, he has become adept
at performing a comprehensive analysis of the factors that influence the financial
standing of a firm. For his latest assignment, Alexander is studying how a country’s
interest rate is affected by currency exchange rate changes. In particular, he is assessing
the following:
§ Changes in the level of long-term interest rates relative to short-term rates as

expressed in the yield curve.
§ The correlation between economic growth and defaults, and between defaults and
credit spreads.
§ The relationship of total debt as a multiple of EBITDA for different market
sectors of interest.
Alexander uses this method to determine how investment-grade bonds would perform
relative to high-yield bonds. He gathers the data presented in Exhibit 1 to perform an
accurate comparative analysis. The data describes the two sectors as a whole, and does
not focus on any one particular issue.
Exhibit 1: Investment grade vs. High-yield Bonds (for the year ended 2015)
Investment Grade
High-Yield Bonds
Bonds
Assets Under Management $55.95 billion $43 billion
Total US$ withdrawn $11.29 billion $10.32 billion
Spread before withdrawal 8.5% 4.5%
Spread after withdrawal 9.3% 5.7%
Bid-ask spread in bps

(measured in $price for high-
14 16
yield bonds and determined
an equivalence in bps)

Expected rise in net

33% 41%
debt/EBITDA
After gathering this data, Alexander also made the following observations about the US
fixed-income market:
Observation 1: “Heterogeneity in market views and assumptions has increased

significantly. Over the past few years, individual as well as institutional
investors have shown varying interest in fixed-income issuers.”
Observation 2: “Total assets under management, of both high yield and investment grade
bonds, decreased reasonably over the same time period.”
Observation 3: “The balance sheet size of any one particular issue on dealers’ balance
sheets decreased considerably.”
Observation 4: “Risk-averseness amongst market makers decreased.”
In addition to the US fixed-income market, Alexander is also aware about the benefits of
including emerging market bonds to a US bond portfolio. For this, he is considering three
emerging markets. He has accumulated some preliminary information about the structure
of their credit markets using data of their respective popular fixed-income indices.
Exhibit 2 expresses these details.
Exhibit 2: Emerging Market Data

Market A Market B Market C
% of government
ownership of bond 55% 23% 65%
issuers
Highest % of bonds
in the index w.r.t BBB BB CCC
credit rating
Increase in supply
High Low High
of corporate bonds
Average interest
4.0% 7.0% 9.0%
rates

As a continuation to the data gathered, Alexander also jotted down the following
expectations:
Expectation 1: The market will be bullish in all three countries.
Expectation 2: Debt restructuring will remain low.
While Alexander is concerned about the performance of these markets, and the risks
involved, he is somewhat at ease with investing in the US market because he believes that
interest rate volatility will remain low in the coming future. To offset the risks taken in
international bonds, Alexander wants to invest locally such, that liquidity is high and
default risk is low.
31. The most prominent drawback of the analytical approach used by Alexander is
that:
A. a sizable portion of credit returns may not be identified.

B. A semi-strong form efficient market would erode any competitive
advantage.
C. The effect of financial indicators on security prices will be difficult to
measure.
Correct Answer: B
Reference:
Alexander is using the top down approach to credit analysis, because his analysis
is based on interest rates, spread changes and overall leverage used. The main
advantage of this approach is that a sizable portion of credit returns can be
attributed to macro factors. However, since such factors are closely examined by
market participants, and are publicly available, they are reasonably reflected in
market prices. Hence, in a semi-strong form efficient market, informational
advantage would be difficult to gain.

32. Based on the data given in Exhibit 1, which sector of the fixed-income market
appears to be more liquid?
A. High-Yield.
B. Investment Grade.
C. Either high-yield or investment grade.
Correct Answer: A
Reference:
Spread sensitivity:
High yield bonds: 11.29/55.95 = 20.178% (outflow)
Spread widening: 80 bps
80/20.178 = 3.96
Investment grade: 10.32/43 = 24%

Spread widening 120bps
120/24 = 5
Based on spread widening, high-yield bonds are more liquid.

Bid-ask spreads are also lower for high-yield bonds indicating better liquidity.
Leverage as measured by net debt/EBITDA is also lower for high-yield bonds,
indicating higher liquidity.
From the data given in the exhibit, high-yield bonds appear to be more liquid.
33. Which of the following observations made by Alexander are most likely to
indicate an increase in liquidity in the fixed-income market?
A. Observations 1 and 4 only.

B. Observation 2, 3 and 4 only.
C. Observations 1, 3 and 4 only.
Correct Answer: A
Reference:

Increase in heterogeneity, reduced concentration and decreased risk averseness

increases liquidity in credit markets. The other two observations would decrease
liquidity.
34. Assuming an unhedged position, using the data in Exhibit 2, the most attractive
investment for a US investor will be:
A. corporate bonds in Market C.

B. Investment-grade bonds in Market A and investment-grade bonds in
Market B.
C. Investment-grade bonds in Market C and corporate bonds in Market A.
Correct Answer: A
Reference:
High government ownership protects credit investors from an adverse financial

situation of a company. Given that debt restricting is expected to remain low, the
risk of government ownership also decreases. Also, since the market is bullish,
CCC bonds will outperform BB or BBB bonds. A high supply of corporates is
likely to decrease the demand for investment grade bonds and lead to their
underperformance. All these factors indicate that an investment in corporate
bonds in Market C is most appropriate.
35. Assuming all other factors are the same, currency risk will be highest for:
A. Market A.
B. Market B.
C. Market C.
Correct Answer: A
Reference:
Currency risk will be highest for Market A because interest rates there are the
lowest. Any expected return can easily be wiped out by currency depreciation.

36. In the US market, the most appropriate investment given Alexander’s expectations
will be:
A. Corporate bonds.
B. Agency MBS.
C. Investment grade bonds.
Correct Answer: B
Reference:
In addition to diversification benefits offered by MBS, the default risk of agency

MBS will be low and liquidity will be high (relative to corporate bonds). In
addition, MBS are attractive when interest rate volatility is expected to decrease.

Questions 37 to 42 relate to Alternative Investments
Howard Corp Case Scenario
The board of trustees of Howard Corp’s defined benefit pension plan is seeking to expand
the $200 million investment portfolio which is currently allocated to Russell 3000 equity
index stocks and the Lehman Corporate Bond Index. The board is particularly interested
in an allocation to commodities due to their inflation hedging potential and low
correlation with existing portfolio holdings. The board is seeking the advice of Diego
Miller, an investment manager, serving a wealth management firm.
Miller deems that a direct exposure to futures based on the GSCI is suitable for HC’s
portfolio. To justify his choice of asset class, Miller collects historical performance on the
commodity index performance. He breaks down the performance of the index into four
components (Exhibit).
Exhibit:
Components of the GSCI Return Index (2000-2014)
GSCI Total GSCI Collateral GSCI Roll GSCI Spot
Annual Return Yield Return/Yield Annual Return
Year (%) (%) (%) (%)
1 25.1 4.5 ? 14.8
2 ? 18.8 12.7 6.1
Jill Travis is a board trustee representative at Howard Corp. She is concerned about the
limitations associated with an investment in GSCI futures. She asks Miller whether her
concerns are valid.
Miller proceeds to forecast the future performance of commodity index futures if Howard
Corp decides to undertake the investment. He reads an analyst’s report which presents
forecasts concerning the future economic outlook. Miller focuses on two forecasts:
Forecast 1: Economic and business conditions are likely to worsen.
Forecast 2: Due to a decline in the profitability of businesses, in general, inventory levels

will be reduced to cut down costs thereby increasing the supply of
commodities in the market.

Miller discusses these forecasts with Travis emphasizing on what they imply for spot
returns. Travis asks Miller whether Forecast 2 signals that Howard Corp will be exposed
to positive event risk.
While the GSCI futures investment will provide a passive long-only exposure to the
portfolio, Miller determines that the pension plan’s characteristics provide room for risk
taking. The manager proceeds to explore an active program using managed futures. He
prepares a report for Howard Corp.’s board proposing the investment strategy. In his
report, Miller presents the investment characteristics of managed futures:
Characteristic 1: Seek active returns from inefficiencies in the pricing of individual stocks
and bonds.
Characteristic 2: Investment requires a stringent due diligence process.
Characteristic 3: Are absolute return strategies as returns depend on the skill and/or
strategy of the individual trader.
37. Using the data in the Exhibit, which of the following reasons least likely explains
the roll return observed in Year 2?
A. Market volatility has decreased.

B. Convenience yields have increased.
C. There is an excess supply of commodities.
Correct Answer: A
Reference:
CFA Level III, Volume 5, Study Session 13, Reading 26, LOS n

A is correct. Convenience yields tend to increase during periods of increased

market volatility because of the higher impact of supply and demand shocks. The
effects of this are more pronounced for nonperishable storable commodities. An
increase in convenience yield will result in higher roll returns. It is highly possible
that the increase in convenience yield (Year 1 to Year 2 in the exhibit) is a result
of increased market volatility.
B is incorrect. An increase in the convenience yield should lead to futures markets

offering higher roll returns. The collateral yield has increased from 4.5% to
18.8%.
C is incorrect. An excess supply of commodities will reduce commodity prices

and decrease spot return which in turn will increase roll returns. Spot returns have
decreased from 14.8% to 6.1%.
38. Based on the data in the Exhibit, the roll return in Year 1 is closest to:
A. 5.8%.
B. 10.3%.
C. 12.7%.
Correct Answer: A
Reference:
Roll return (%) = Total annual return % - Collateral yield % - Spot return %
= 25.1% – 4.5% – 14.8% = 5.8%
39. The most appropriate response to Travis is that an investment in the GSCI futures
will:
A. increase liquidity risk.

B. increase rebalancing costs.
C. decrease the degree of investability.
Correct Answer: B
Reference:
CFA Level III, Volume 5, Study Session 13, Reading 26, LOS m

B is correct. The GSCI is an arithmetic measure of the performance of actively

traded, dollar-denominated nearby futures contracts. Investors attempting to
replicate the GSCI must rebalance their portfolios monthly to maintain constant
dollar weights thereby increasing their rebalancing costs.
A is incorrect. The GSCI is a widely used contract and receives considerable open
interest. Therefore, liquidity risk associated with the market for these futures
contracts will be low.
C is incorrect. The GSCI is considered investable.
40. The implication of Forecast 1 and 2 on projected spot returns respectively is:
Forecast 1: Forecast 2:
A. positive negative.
B. negative no effect.
C. no effect positive.
Correct Answer: A
Reference:
In periods of financial and economic distress, commodity prices tend to increase

in value.
An expected increase in the supply of commodities will lead to a decrease in

commodity prices and spot returns and business will reduce their inventory levels
(commodities) Therefore, Forecast 2 has a negative impact on spot returns.
41. The most appropriate response to Travis’ query concerning Forecast 2 implying
high positive event risk for the pension plan is a:
A. no.
B. yes, there is an excess supply of commodities.
C. yes, the volatility of commodity prices will increase.
Correct Answer: A

Reference:
A is correct. The most appropriate response to Travis’ query is a ‘no’. Physical

commodities have positive event risk. This risk is associated with events which
reduce the current supply and cause prices to rise. The expectation of an increase
in commodities supply indicates an absence of this risk.
42. In context of his research report covering managed futures, Miller is least accurate
with respect to Characteristic:
A. 1.
B. 2.
C. 3.
Correct Answer: A
Reference:
CFA Level III, Volume 5, Study Session 13, Reading 26, LOS t
Miller is not correct with respect to A. Managed futures trade market-based

futures and options contracts on a broader or more generic basket of assets
relative to hedge funds, which trade in individual securities; therefore, managed
futures will look for return opportunities in macro index stock and bond markets.
Hedge funds, in contrast, concentrate on inefficiencies in micro (security) stock
and bond markets.
B is correct. Miller is accurate with respect to Characteristic 2. Because managed

futures use derivatives and leverage in their investment strategy, investors should
conduct a higher level of due diligence compared to a commodity futures
investment.
C is correct. Managed futures are absolute return strategies because they require
no direct and comparable benchmark portfolios. They are also referred to as skill-
based strategies as these strategies obtain returns from the unique skill or strategy
of the trader.

Question 43 to 48 relate to Performance and Evaluation
Vault Corp Case Scenario
The equity portion of Vault Corp’s investment portfolio is being managed by Reliable
Financials (RF), a brokerage firm with a trust department. Vault’s CEO, Carla Smith, has
recently fired their investment advisor because he failed to outperform his performance
benchmark for two consecutive years.
Judith Spencer, CFA, is an investment advisor at RF who will be managing the ex-North
American developed equity market segment of VC’s portfolio. These securities are issued
in Europe, Australasia and the Far East (EAFE). Under the previous advisor the portfolio
was managed with a long-only active, market-oriented, large-cap equity mandate. The
current performance benchmark is a returns-based index with an equal allocation to large-
cap growth and large-cap value EAFE equities.
Spencer is of the opinion that the existing benchmark is inappropriate and is seeking to
replace it with one which is valid. The portfolio will continue to be managed under its
original mandate.
One year after assigning a suitable performance benchmark, Spencer’s supervisor, Eric
Daniels, tests the benchmark’s quality by collecting relevant information concerning
VC’s investment portfolio (P), benchmark (B), and the broad MSCI EAFE market index
(M) in an exhibit (Exhibit). After carefully examining the performance results of the
portfolio, Daniels notes that Spencer has maintained strong negative and positive views
concerning the EAFE securities.

Exhibit:
Testing Spencer’s Benchmark Quality
Volatility of E* σE 18.7%
Volatility of Active Return σA 9.5%
Correlation Coefficient between - 0.5
S and E pS,E
Correlation Coefficient between 0.0
A and B pA, B
B* – M* Positive
Benchmark turnover 10.5x
Benchmark coverage 0.7
Average annual active position - 0.8%
*E = Account performance (P) – Market index performance (M)
S = Return attributable to manager’s style
B = Benchmark performance
A small portion of VA’s investment portfolio is invested in a hedge fund employing a

long-short equity strategy with respect to stocks included in the Russell 2,000 index.
Smith would like to evaluate the performance of the fund over the most recent
performance year. She is evaluating three different options:
!"# $!"%
Option 1: Compute the fund’s rate of return ( !"%
) over the performance period.
Option 2: Compare the hedge fund’s Sharpe ratio to a universe of hedge funds with a
long/short investment mandate.
Option 3: Evaluate the fund’s performance relative to a custom-based benchmark by

combining separate long and short equity benchmarks.
Based on limited knowledge on hedge funds, Smith concludes that option 1 can lead to
nonsensically extreme returns; the Sharpe ratio relevant to the hedge fund universe
identified in option 2 is not measurable as the investment strategy includes a high degree
of skewness; and option 3 will produce a benchmark which lacks transparency.

43. The most likely implication of Smith’s decision to fire the previous investment
advisor is that:
A. Type I error will decrease.

B. Type I error will increase.
C. Type II error will decrease.
Correct Answer: A
Reference:
CFA Level III, Volume 6, Study Session 17, Reading 33, LOS t
A is correct. The decision to fire an underperforming manager, who has failed to

generate value-added returns, reflects a reduction in Type I error. This error arises
from retaining managers with zero value-added. The null hypothesis, which states
that the managers under evaluation are zero value-added managers, is not rejected
as it stands correct. Therefore, Smith has recognized that the firm retains zero
value-added managers which need to be replaced.
B is incorrect. The decision reflects an effort to reduce a Type I error. See above.
C is incorrect. Type II errors will decrease if the firm decides to retain (or,
alternatively, not fire) managers generating positive value-added returns.
44. One limitation of the benchmark based on the returns-based index is that:
A. it is ambiguous.
B. it is not investable.
C. tracking error is increased.
Correct Answer: C
Reference:
CFA Level III, Volume 6, Study Session 17, Reading 33, LOS f

A limitation of VA’s portfolio benchmark being based on the specified returns-

based index is that tracking error will increase. This is because an equal allocation
to large-cap growth and large-cap value indexes does not fully replicate the
performance of a portfolio with a market-oriented large-cap equity mandate.
Therefore, the risk exposure of the portfolio will not match that of its benchmark.
Options A and B are incorrect. Benchmarks based on return-based indexes are

unambiguous as they are investable.
45. The most appropriate benchmark for VA’s EAFE segment is a:
A. style index.
B. broad market index.
C. custom security-based index.
Correct Answer: C
Reference:
CFA Level III, Volume 6, Study Session 17, Reading 33, LOS f & g
C is correct. It is highly unlikely that a benchmark covering EAFE market-

oriented large-cap equities exists. Therefore, to replicate the performance of these
stocks, the most appropriate strategy would be to custom design a benchmark to
reflect the manager’s unique weighting approach.
A is incorrect. Style indexes are widely available indexes reflecting distinct

investment styles such as 1) large-capitalization growth, 2) large-capitalization
value, 3) small-capitalization growth, and 4) small-capitalization value. Style
indexes do not exist for a market-oriented large-cap investment strategy.
B is incorrect. Broad market indexes are unsuitable as benchmarks for the simple
reason that the constituent securities will not reflect the portfolio’s investment
mandate thus violating the appropriateness criterion.

46. Based on the data in the Exhibit and considering each factor in isolation, Daniels
will conclude that the benchmark is of low quality based on the fact that the:
A. the proportion of active positions is low.

B. benchmark is not reflective of Spencer’s investment style.
C. benchmark bears little resemblance to the opportunity set of Spencer’s
investment process.
Correct Answer: A
Reference:
A is correct. The active mandate of VA’s portfolio is long-only. Based on this

mandate, Spencer will be expected to hold positive active positions. An overall
negative average active position indicates that the benchmark poorly represents
the manager’s investment approach.
B is incorrect. Tracking error is defined as the volatility of A. Given that the

volatility of the account’s return versus the benchmark (σA = 9.5%) is lower
relative to the account’s return versus the market index (σP – M = σE*= 18.7%), the
benchmark is “good” as it reduces tracking error or noise in the performance
evaluation process. This will indicate that the benchmark is capturing important
aspects of the manager’s investment style.
C is incorrect. The chosen benchmark is of high quality based on benchmark

coverage, which is a measure of the benchmark’s relationship, on a security level,
with the opportunity set generated by the manager’s investment process.
47. Using the correlation data in the Exhibit, Spencer will conclude that systematic
bias in the benchmark relative to the account is:
A. minimal based on correlation coefficient of E and M (pE,M).

B. minimal based on correlation coefficient of A and B (pA,B).
C. significant based on correlation coefficient of E and M (pE,M).
Correct Answer: C
Reference:

C is correct. An account will demonstrate systematic bias when the correlation

between A = (P – B) and S = (B – M) is statistically different from zero or when
there is not a statistically significant positive correlation between S and E.
The correlation between S and E is negative. Therefore, even though Spencer’s

investment style is in favor relative to the market (as B – M is positive), Daniels
should expect either the benchmark or portfolio or neither of the two to
outperform the market index. This will introduce systemic biases in the
benchmark relative to the portfolio and reduce benchmark quality.
48. Regarding hedge fund performance evaluation, Smith is most accurate regarding
her conclusions with respect to:
A. 2 only.
B. 1 and 2 only.
C. all three options.
Correct Answer: C
Reference:

C is incorrect. Spencer is accurate with respect to her conclusions concerning all

three options.
Her conclusion concerning Option 1 is accurate as the net assets of long-short

positions may start out as positive, due to various margins and administrative
requirements, but may approach zero as net asset values get smaller. The
account’s return may, in turn, become nonsensically extreme (either positive or
negative infinity).
Her conclusion concerning Option 2 is accurate because, although the technique is

similar to manager universes, hedge funds are not required to report their
performance results and therefore report their performance on a less frequent basis
in comparison to other asset classes. This low frequency of reporting will, in turn,
reduce the measurability of the technique identified in Option 2 as the Sharpe
ratio cannot be calculated on a regular basis for the hedge funds under analysis.
Furthermore, most hedge funds incorporate a high degree of skewness
complicating performance evaluation using Sharpe ratios.
Her conclusion concerning Option 3 is accurate. One issue with custom security-
based benchmarks is that they are not composed of published indexes and
therefore a lack of transparency may be a valid concern.

Question 49 to 54 relate to Derivatives
Gus Weaver Case Scenario
Gus Weaver holds a $30 million portfolio invested in Arc Limited’s shares of a stock
which is indexed to the DJIA 30. Weaver would like to reduce his exposure to the shares
in anticipation of a profit squeeze which is forecasted to decrease Arc’s share price over
the course of the coming months. Weaver asks his portfolio manager, Eric Cox, to devise
a suitable strategy which does not involve liquidating his holding.
Cox designs two alternative strategies using DJIA 30 equity index futures contracts and
options, respectively. The strategies he has devised include:
Strategy 1: Synthetically reducing the exposure using 1-month DJIA 30 equity index
futures
Strategy 2: Employing equity call and/or put options written on the Arc Limited stock
Cox explains to Weaver that should Strategy 1 be implemented, the position will need to
be rolled over each month until protection is no longer desired. He collects details with
respect to the instruments used for the strategy (Exhibit 1).
Exhibit 1:
Details Concerning Strategy 1
Current market price per share $51.50
Futures price 1,860.50
Multiplier 25.00
Index dividend yield 0.50%
One- month risk-free rate 2.30%
After studying the strategy, Weaver asks Cox how an alternative strategy involving the
liquidation of portfolio holdings and subsequent investment of the proceeds in a risk-free
asset would compare to Strategy 1 in terms of relative liquidity, transaction costs, and
success in reducing portfolio beta to zero.

Next, Cox proceeds to explore Strategy 2. He collects details relevant to three one-month
put options (Exhibit 2) written on the Arc Limited stock. He expects the stock to be worth
$51.80 at option expiration. The designed strategy will greatly depend on whether
Weaver would like to:
i. maximize loss protection or

ii. retain upside potential but hedge losses.
Exhibit 2:
One-Month Put-Option Prices
Option 1 2 3
Exercise price ($) 49.70 51.00 54.30
Option price ($) 1.10 1.70 2.40
Cox believes that a protective put strategy will be most suitable if Weaver decides to
maximize loss protection and selects the 54.30 put to achieve this purpose.
Cox concludes his analysis by exploring the most suitable option structure should Weaver
choose to retain upside potential. Cox strongly believes that market volatility will remain
low over the next three months and intends to incorporate this projection in his selection
decision.
49. The number of futures contracts required to be sold and the effective amount of
money needed to be invested in risk-free bonds to implement Strategy 1 is,
respectively, closest to:
number of futures effective investment

contracts to be in risk-free bonds:
sold:
A. 645 $29,998,096.00.
B. 646 $29,990,190.99.
C. 646 $29,999,940.12.
Correct Answer: B
Reference:
CFA Level III, Volume 5, Study Session 15, Reading 28, LOS c

Because Weaver wants to effectively liquidate his Arc Limited holding, futures
contracts will need to be sold on the DJIA 30 index. The number of contracts
required to be sold (Nf) is approximately equal to 646.
V (1 + r ) $30,000,000(1.023)
T 1 12
- Nf = = = -646.21
qf ($25 ´ 1,860.50)
Selling 646 futures contracts is equivalent to selling contracts on stock worth
646(1,860.50 ´ $25)
= $29,990,190.99
(1.023)1 12
And is equivalent of investing $29,990,190.99 in risk-free bonds.
50. In order to establish an effective hedge using Strategy 1, Cox must ensure that
relative to the index beta, portfolio beta is:
A. lower.
B. higher.
C. identical.
Correct Answer: C
Reference:
Since the index underlying the futures contract is to be used to represent the
performance of the Arc Limited stock holding, it is essential that the betas of the
two are identical; this will enable Cox to implement a precise hedge. Furthermore,
this will enable the futures price and stock price to have the same sensitivity to
market movements thereby resulting in an effective hedge.
51. Cox’s most appropriate response to Weaver’s query concerning the comparison of
Strategy 1 to a liquidation of and reinvestment of portfolio proceeds in the context
of liquidity and success of eliminating beta exposure is that:
A. neither of the two strategies will guarantee a zero beta exposure.

B. strategy 1 will be more effective in guaranteeing a zero beta exposure.
C. investing the liquidation proceeds in risk-free securities is the more liquid
alternative.

Correct Answer: A
Reference:
A is correct. Neither of the two strategies can guarantee that beta will be reduced
to zero.
C is incorrect. Executing transaction in derivatives is generally a more liquid

alternative compared to buying risk-free assets from liquidation proceeds.
52. Using the data in Exhibit 2 and assuming the share price expectation is realized,
the value of the protective put strategy, on a per share basis, is closest to:
A. $0.00.
B. $51.90.
C. $54.30.
Correct Answer: C
Reference:
Value at expiration = VT = ST + max(0, X – ST) = $51.80 + max(0, $54.30 –

$51.80) = $54.30
53. Using the data in Exhibits 1 and 2, the breakeven price per share on the proposed
protective put strategy is closest to:
A. $49.10.
B. $51.90.
C. $53.90.
Correct Answer: C
Reference:
Breakeven = ST* = S0 + p0 = $51.50 + $2.40 = $53.90

54. Which of the following strategies is most suitable for maximizing upside potential
on the Arc stock position?
A. Straddle
B. Long position in a butterfly spread
C. Bear spread using put options 2 and 3
Correct Answer: C
Reference:
Given that Cox is highly certain that volatility will be lower than expected, he
should consider going either long the butterfly spread, which involves selling put
option 2 and buying put options 1 and 3, or a bear spread using put options 2 and
3.
C is correct. The maximum profit on a bear spread using put options 2 and 3 is
higher relative to the maximum profit of a butterfly spread. A bear spread using
put options 2 and 3 will generate a maximum profit of $2.60.
Maximum profit on bear spread = X3 – X2 – p3 + p2 = $54.30 – $51.00 – $2.40 +
$1.70 = $2.60
B is incorrect. The maximum profit on a long butterfly spread position is lower

relative to the specified bear spread position.
Maximum profit = X2 – X1 – (p1 – 2p2 + p3) = $51.00 – $49.70 – [$1.10 – 2($1.70)
+ $2.40] = $1.20
A is incorrect. A straddle strategy is inappropriate given Cox’s low volatility

expectations. The straddle strategy benefits from high volatility expectations.

Questions 55 to 60 relate to Global Investment Performance Standards
Walk Associates Case Scenario
Walk Associates (WA) is a firm providing brokerage and asset management services. The
firm is seeking to present its financial statements in compliance with the requirements
and recommendations of the Global Investment Performance Standards (GIPS). Clarence
Long is WA’s senior compliance officer who will be overseeing the conversion process.
Long evaluates the performance presentation of WA’s large-cap equity composite whose
equity holdings are benchmarked to the Russell 3000 index (Exhibit 1). The composite
commenced on January 1, 2010. The presentation has been prepared by a senior equity
fund manager and includes note disclosures. During his evaluation of the presentation,
Long identifies numerous inconsistencies which require rectification.
Exhibit 1:
Large-Cap Equity Composite Performance Presentation and Note Disclosures
Composite Benchmark Value of Value of
Gross-of- Gross-of- Total Cash Non- Composite
Fees Fees Firm Holdings Discretionary Downside
Returns Returns Assets ($ Assets Deviation
Year (%) (%) ($ Millions) ($ millions) (%)
Millions)
2010 8.9 7.8 2.5 0.1 0.1 - 4.5%
2011 9.1 9.0 2.8 0.2 0.1 - 8.8%
2012 9.5 9.5 3.4 0.1 0.3 - 2.2%
2013 9.0 9.8 3.0 0.3 0.2 - 7.1%
2014 8.9 9.8 3.1 0.3 0.4 - 12.0
Note 1: Gross-of-fees returns represent a return net of an all-in-fee comprising advisory,

custody and administrative fees. The portion of advisory fees including actual
trading expenses has been omitted from return calculations as these expenses are
highly variable and an estimate for trading expenses cannot otherwise be derived
with a reasonable degree of accuracy.
Note 2: Total firm assets include discretionary fee- and non-fee paying portfolios.

Note 3: Cash holdings represent investments in Treasury bills which are being managed
by a client-designated external fixed-income specialist firm. Returns from cash
holdings have been included in portfolio return calculations.
Note 4: The firm routinely employs option strategies such as protective put and bear
spreads to provide downside protection on its equity holdings.
Note 5: Due to the existence of embedded options for hedging purposes, the firm has
elected to present downside deviation as an additional risk measure to standard
deviation, which assumes normal distribution and is thus inappropriate for
evaluating the performance of a skewed return distribution.
Note 6: Non-discretionary portfolios include those managed with an active mandate but
are prohibited by portfolio holders from participating in small-cap equities.
Long would like to evaluate how composite portfolio returns are calculated and thus
breaks down the performance of one portfolio in terms of cash flow activity and market
values for the 1st quarter of 2015 (Exhibit 2).
Exhibit 2:
Portfolio Valuation and External Cash Flow Activity
(January 1st 2015 to March 31st 2015)
Market Value
Market value Large External Including Cash
Portfolio Date ($) Cash Flows ($) Flows ($)
1 January 2015 242,000
31 January 2015 250,000
25 February 2015 275,000 - 2,000 273,000
28 February 2015 282,000
16 March 2015 262,000 +12,000 274,000
31 March 2015 295,000

55. WA’s fee presentation policy presented in Note 1 is inconsistent with the
requirements of the GIPS standards and requires modification. Which of the
following statements represents an appropriate adjustment?
A. Trading expenses should be included even if they cannot be estimated with

accuracy.
B. Administrative fees must be excluded as they are generally not within the
control of a firm.
C. The portion of advisory fees including actual trading expenses must
represent the sole deduction from gross-of-fees returns.
Correct Answer: C
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS d & k
C is correct. For actual trading expenses which cannot be broken out of bundled
fees, the gross-of-fees returns must be reduced by the entire amount of bundled
fees or that portion which includes actual trading expenses. The use of estimated
trading expenses is prohibited (I.2.A.5.a-b). Given that the portion of advisory
fees including trading expenses has been identified, only that portion should have
been deducted from the gross-of-fees returns.
A is incorrect. The use of estimated trading expenses is prohibited.
B is incorrect. The GIPS standards recommend the exclusion of administrative

expenses because they are generally not within the control of the firm. However,
this is a recommendation and not a requirement (I.5.B.1.a).
56. Are Note 2 and Note 3 consistent with the requirements and recommendations of
the GIPS standards?
Note 2? Note 3?
A. Consistent Inconsistent
B. Inconsistent Consistent
C. Inconsistent Inconsistent

Correct Answer: B
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS b & d
Note 2 is inconsistent with the GIPS standards which require firms to include
discretionary, non-discretionary, fee-paying and non-fee paying portfolios for
which a firm has investment management responsibility as part of total firm assets
(I.0.A.13). WA manages non-discretionary portfolios, as evidenced in Exhibit 1
and Note 6; therefore the firm is required to present its non-discretionary
portfolios as part total firm assets.
Note 3 is consistent with the GIPS standards. Cash and cash equivalents must be
included in total return calculations even if the cash is not actually invested by the
same group or person. By including returns on cash holding in portfolio return
calculations, the firm has complied with the GIPS standards.
57. Note 4 is inconsistent with the requirements and recommendations of the GIPS
standards with respect to WA’s use of derivatives instruments. Which of the
following has been omitted by the disclosure and represents a violation?
A. presence.
B. characteristics.
C. frequency of use.
Correct Answer: B
Reference:
Note 4 is inconsistent with the GIPS standards as it fails to address the

characteristics of the hedging strategies and instruments used to provide downside
protection. For instance, the protective put strategy provides downside protection
while the bear spread strategy can be used to make money based on movements in
the prices of the underlying stock.
By indicating the presence of option strategies as well as managing the frequency,

being ‘frequently’, with which the underlying derivatives instruments are being
used WA is in compliance with the GIPS standards in this regard.

58. Is the firm’s decision to include downside deviation as a measure of internal

dispersion appropriate (Note 5)?
A. Yes.
B. No, the firm may only present standard deviation as a measure of risk.
C. No, the GIPS glossary does not define downside deviation as a measure of
risk.
Correct Answer: A
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS m
A is correct. When standard deviation is not an appropriate risk measure, as is the

case with the large-cap equity composite whose returns distribution is skewed due
to the presence of embedded options, the standards require firms to present an
additional three-year ex post measure of risk for the composite and benchmark;
that is, in addition to standard deviation. WA has identified this measure as
downside deviation which is appropriate.
B is incorrect. See above.
C is correct. Although the GIPS glossary does not specifically identify downside
deviation as a risk measure, this does not mean that the use of this measure is
inappropriate.
59. Has the firm appropriately classified its non-discretionary portfolios (Note 6)?
A. Yes.
B. No, the restriction does not impede the investment process.
C. No, client restrictions on the portfolio manager do not render a portfolio as
non-discretionary.
Correct Answer: A
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS f

By precluding a manager with an active mandate from investing in small-cap

stocks, which represent a potential source of active returns, the flexibility of the
investment manager is reduced as the constraint will restrict the manager’s
freedom in making investment decisions to achieve portfolio objectives and
executing his or her strategy in line with the mandate.
60. Using the data in Exhibit 2, calculate the rate of return for the portfolio for the 1st
quarter of 2015 using revaluing the large cash flow methodology.
A. 6.21%.
B. 16.32%.
C. 17.42%.
Correct Answer: C
Reference:
CFA Level III, Volume 6, Study Session 18, Reading 34, LOS e
The true time-weighted return (rtwr) will be calculated for each period and
geometrically be linked to produce an overall portfolio return for the 1st quarter
2015.
250, 000 − 242, 000

r31 Jan = = 0.0331
242, 000
275, 000 − 250, 000
r1-24 Feb = = 0.100
250, 000
282, 000 − 273, 000
r25-28 Feb = = 0.0330
273, 000
262, 000 − 282, 000
r1-15 March = = −0.0709
282, 000
295, 000 − 274, 000
r16-31 March = = 0.0766
274, 000
1st Quarter 2016

rtwr = [(1+ 0.0331) (1 + 0.100) (1 + 0.033) (1 - 0.0709) (1+ 0.0766)] – 1
= 17.42%

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FinQuiz.com – 5th 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 Equity Investments 18

25-30 Fixed-Income Portfolio Management 18

31-36 Fixed-Income Portfolio Management 18

37-42 Alternative Investments 18

43-48 Performance & Evaluation 18

55-60 Global Investment Performance Standards 18

FinQuiz.com © 2018 - All rights reserved. 2

Questions 1 to 6 relate to Ethical and Professional Standards

Sun Davidson, CFA, Case Scenario

FinQuiz.com © 2018 - All rights reserved. 3

C is correct. Davidson is in violation of Standard V (B) Communication with Clients and

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2. By issuing the purchase recommendation, Davidson is in violation of the CFA

A. conduct a suitability analysis.

B is correct. Prior to engaging Ramos, Davidson generated investment

A is incorrect. The investor base following the blog is characterized by a variety

C is incorrect. Davidson has violated the CFA Institute Standards of Professional

3. In order to avoid violation of the CFA Institute Standards of Professional

A. Ramos’s investment in the EF only.

FinQuiz.com © 2018 - All rights reserved. 5

According to the Standard VI (A) Disclosure of Conflicts members and

4. By accepting Davidson’s offer to contribute to the blog, is Ramos in violation?

A. No, he will not be disrupting the activities of his employer.

B is correct. Standard V (A) Employer Loyalty requires members and candidates

C is incorrect. Although Ramos is required to disclose details of the offer to his

5. Ramos’s best course of action with respect to Clark’s offer is to:

A. decline the offer.

FinQuiz.com © 2018 - All rights reserved. 6

According to Standard I (B) Independence and Objectivity, members and

However, the standards do not mandate disclosure to clients.

6. With respect to the statement made to Davidson at the investment conference, is

Standard III (E) Preservation of Client Confidentiality requires members and

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Questions 7 to 12 relate to Ethical and Professional Standards

Riverside Asset Management Case Scenario

Riverside Asset Management (RAM) is a privately owned, small-scaled investment

Once he is reasonably satisfied with RAM’s level of compliance, Marquez sends an

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Several of the fund’s clients have requested an allocation to commodities. However,

7. Is RAM’s claim of compliance statement consistent with the Asset Manager

8. By modifying his strategy, is Nash in violation of the Asset Manager Code?

FinQuiz.com © 2018 - All rights reserved. 9

B is incorrect. A semi-active fund mandate is appropriate in light of the surplus

B is correct. Reed is in violation of the Asset Manager Code by not seeking

C is incorrect. Reed is not in violation by purchasing shares for her account

FinQuiz.com © 2018 - All rights reserved. 10

The emerging market fund manager is not a suitable candidate as he is not

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A. has distorted the performance presented.

C is correct. At a minimum, the Asset Manager Code recommends managers to

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Questions 13 to 18 relate to Economics

Dianne Fernandez Case Scenario

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Growth in potential labor force size 3.4 3.0

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