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Free CFA Institute CFA-Level-III Exam Questions

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  • CFA Institute CFA-Level-III Exam Questions
  • Provided By: CFA Institute
  • Exam: CFA Level III Chartered Financial Analyst
  • Certification: CFA Level III
  • Total Questions: 365
  • Updated On: Sep 25, 2024
  • Rated: 4.9 |
  • Online Users: 730
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  • Question 1
    • Gabrielle Reneau, CFA, and Jack Belanger specialize in options strategies at the brokerage firm of Damon and
      Damon. They employ fairly sophisticated strategies to construct positions with limited risk, to profit from future
      volatility estimates, and to exploit arbitrage opportunities. Damon and Damon also provide advice to outside
      portfolio managers on the appropriate use of options strategies. Damon and Damon prefer to use, and
      recommend, options written on widely traded indices such as the S&P 500 due to their higher liquidity.
      However, they also use options written on individual stocks when the investor has a position in the underlying
      stock or when mispricing and/or trading depth exists.
      In order to trade in the one-year maturity puts and calls for the S&P 500 stock index, Reneau and Belanger
      contact the chief economists at Damon and Damon, Mark Blair and Fran Robinson. Blair recently joined Damon
      and Damon after a successful stint at a London investment bank. Robinson has been with Damon and Damon
      for the past ten years and has a considerable record of success in forecasting macroeconomic activity. In his
      forecasts for the U.S. economy over the next year, Blair is quite bullish, for both the U.S. economy and the S&P
      500 stock index. Blair believes that the U.S. economy will grow at 2% more than expected over the next year.
      He also states that labor productivity will be higher than expected, given increased productivity through the use
      of technological advances. He expects that these technological advances will result in higher earnings for U.S.
      firms over the next year and over the long run.
      Reneau believes that the best S&P 500 option strategy to exploit Blair's forecast involves two options of the
      same maturity, one with a low exercise price, and the other with a high exercise price. The beginning stock
      price is usually below the two option strike prices. She states that the benefit of this strategy is that the
      maximum loss is limited to the difference between the two option prices.
      Belanger is unsure that Blair's forecast is correct. He states that his own reading of the economy is for a
      continued holding pattern of low growth, with a similar projection for the stock market as a whole. He states that
      Damon and Damon may want to pursue an options strategy where a put and call of the same maturity and
      same exercise price are purchased. He asserts that such a strategy would have losses limited to the total cost
      of the two options.
      Reneau and Belanger are also currently examining various positions in the options of Brendan Industries.
      Brendan Industries is a large-cap manufacturing firm with headquarters in the midwestern United States. The
      firm has both puts and calls sold on the Chicago Board Options Exchange. Their options have good liquidity for
      the near money puts and calls and for those puts and calls with maturities less than four months. Reneau
      believes that Brendan Industries will benefit from the economic expansion forecasted by Mark Blair, the Damon
      and Damon economist. She decides that the best option strategy to exploit these expectations is for her to
      pursue the same strategy she has delineated for the market as a whole.
      Shares of Brendan Industries are currently trading at $38. The following are the prices for their exchangetraded options.
      CFA-Level-III-page476-image187
      As a mature firm in a mature industry, Brendan Industries stock has historically had low volatility. However,
      Belanger's analysis indicates that with a lawsuit pending against Brendan Industries, the volatility of the stock
      price over the next 60 days is greater by several orders of magnitude than the implied volatility of the options.
      He believes that Damon and Damon should attempt to exploit this projected increase in Brendan Industries1
      volatility by using an options strategy where a put and call of the same maturity and same exercise price are
      utilized. He advocates using the least expensive strategy possible.
      During their discussions, Reneau cites a counter example to Brendan Industries from last year. She recalls that
      Nano Networks, a technology firm, had a stock price that stayed fairly stable despite expectations to the
      contrary. In this case, she utilized an options strategy where three different calls were used. Profits were earned
      on the strategy because Nano Networks' stock price stayed fairly stable. Even if the stock price had become
      volatile, losses would have been limited.
      Later that week, Reneau and Belanger discuss various credit option strategies during a lunch time presentation
      to Damon and Damon client portfolio managers. During their discussion, Reneau describes a credit option
      strategy that pays the holder a fixed sum, which is agreed upon when the option is written, and occurs in the
      event that an issue or issuer goes into default. Reneau declares that this strategy can take the form of either
      puts or calls. Belanger states that this strategy is known as either a credit spread call option strategy or a credit
      spread put option strategy.
      Reneau and Belanger continue by discussing the benefits of using credit options. Reneau mentions that credit
      options written on an underlying asset will protect against declines in asset valuation. Belanger says that credit
      spread options protect against adverse movements of the credit spread over a referenced benchmark.
      Assume Reneau applies the options strategy used earlier for Nano Networks. Assuming there is a 3-month 45
      call on Brendan Industries trading at $1.00, calculate the maximum gain and maximum loss on this position.
      Max gain Max loss

      Answer: A
  • Question 2
    • Milson Investment Advisors (MIA) specializes in managing fixed income portfolios for institutional clients. Many
      of MIA's clients are able to take on substantial portfolio risk and therefore the firm's funds invest in all credit
      qualities and in international markets. Among its investments, MIA currently holds positions in the debt of Worth
      inc., Enertech Company, and SBK Company.
      Worth Inc. is a heavy equipment manufacturer in Germany. The company finances a significant amount of its
      fixed assets using bonds. Worth's current debt outstanding is in the form of non-callable bonds issued two
      years ago at a coupon rate of 7.2% and a maturity of 15 years. Worth expects German interest rates to decline
      by as much as 200 basis points (bps) over the next year and would like to take advantage of the decline. The
      company has decided to enter into a 2-year interest rate swap with semiannual payments, a swap rate of 5.8%,
      and a floating rate based on 6-month EURIBOR. The duration of the fixed side of the swap is 1.2. Analysts at
      MIA have made the following comments regarding Worth's swap plan:
      • "The duration of the swap from the perspective of Worth is 0.95."
      • "By entering into the swap, the duration of Worth's long-term liabilities will become smaller, causing the value
      of the firm's equity to become more sensitive to changes in interest rates."
      Enertech Company is a U.S.-based provider of electricity and natural gas. The company uses a large proportion
      of floating rate notes to finance its operations. The current interest rate on Enertech's floating rate notes, based
      on 6-month LIBOR plus 150bp, is 5.5%. To hedge its interest rate risk, Enertech has decided to enter into a
      long interest rate collar. The cap and the floor of the collar have maturities of two years, with settlement dates
      (in arrears) every six months. The strike rate for the cap is 5.5% and for the floor is 4.5%, based on 6-month
      LIBOR, which is forecast to be 5.2%, 6.1%, 4.1%, and 3.8%, in 6,12, 18, and 24 months, respectively. Each
      settlement period consists of 180 days. Analysts at MIA are interested in assessing the attributes of the collar.
      SBK Company builds oil tankers and other large ships in Norway. The firm has several long-term bond issues
      outstanding with fixed interest rates ranging from 5.0% to 7.5% and maturities ranging from 5 to 12 years.
      Several years ago, SBK took the pay floating side of a semi-annual settlement swap with a rate of 6.0%, a
      floating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6
      months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given its
      interest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, an
      underlying swap rate of 6.0%, and a floating rate based on LIBOR.
      MIA is considering investing in the debt of Rio Corp, a Brazilian energy company. The investment would be in
      Rio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest rate
      decline in Brazil over the short term.
      Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effects
      of the swap on the company's balance sheet are correct or incorrect.

      Answer: C
  • Question 3
    • Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety
      of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management
      techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,
      its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the
      creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other
      institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).
      Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit
      risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,
      which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable
      difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the
      Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in
      default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims
      before it could settle the agreement with Johnson Associates.
      McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states
      that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the
      possibility of default on current obligations, while future credit risk relates to potential default on future
      obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value
      of current obligations and the present value of future obligations. Cramer adds that combining current and
      potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a
      reliable predictor of a borrower's potential credit risk.
      As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with
      forward agreements. Cramer states that long forward contracts gain in value when the market price of the
      underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk
      and forward contracts in the handbook. She offers the following:
      A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.
      The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds
      were exchanged upfront.
      Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He
      writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral
      from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a
      discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives
      represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in
      their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the
      holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap
      dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash
      flows from the asset.
      A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like
      protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus
      3%. Weaver Trading prefers a cash settlement.
      Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond
      issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is
      considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the
      economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond
      and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The
      characteristics of the forward contract are shown below.
      Information on the Credit Spread Forward
      CFA-Level-III-page476-image200
      Determine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.

      Answer: B
  • Question 4
    • Geneva Management (GenM) selects long-only and long-short portfolio managers to develop asset allocation
      recommendations for their institutional clients.
      GenM Advisor Marcus Reinhart recently examined the holdings of one of GenM's long-only portfolios actively
      managed by Jamison Kiley. Reinhart compiled the holdings for two consecutive non-overlapping five year
      periods. The Morningstar Style Boxes for the two periods for Kiley's portfolio are provided in Exhibits 1 and 2.
      Exhibit 1: Morningstar Style Box: Long-Only Manager for Five-Year Period 1
      CFA-Level-III-page476-image326
      Exhibit 2: Morningstar Style Box: Long-Only Manager for Five-Year Period 2
      CFA-Level-III-page476-image325
      Reinhart contends that the holdings-based analysis might be flawed because Kiley's portfolio holdings are
      known only at the end of each quarter. Portfolio holdings at the end of the reporting period might misrepresent
      the portfolio's average composition. To compliment his holdings-based analysis, Reinhart also conducts a
      returns-based style analysis on Kiley's portfolio. Reinhart selects four benchmarks:
      1. SCV: a small-cap value index.
      2. SCG: a small-cap growth index.
      3. LCV: a large-cap value index.
      4. LCG: a large-cap growth index.
      Using the benchmarks, Reinhart obtains the following regression results:
      Period 1: Rp = 0.02 + H0.01(SCV) + 0.02(SCG) + 0.36(LCV) + 0.61(LCG)
      Period 2: Rp = 0.02 + 0.01(SCV) + 0.02(SCG) + 0.60(LCV) + 0.38(LCG)
      Kiley's long-only portfolio is benchmarked against the S&P 500 Index. The Index's current sector allocations are
      shown in Exhibit 3.
      Exhibit 3: S&P 500 Index Sector Allocations
      CFA-Level-III-page476-image327
      GenM strives to select managers whose correlation between forecast alphas and realized alphas has been
      fairly high, and to allocate funds across managers in order to achieve alpha and beta separation. GenM gives
      Reinhart a mandate to pursue a core-satellite strategy with a small number of satellites each focusing on a
      relatively few number of securities.
      In response to the core-satellite mandate, Reinhart explains that a Completeness Fund approach offers two
      advantages:
      Advantage 1: The Completeness Fund approach is designed to capture the stock selecting ability of the active
      manager, while matching the overall portfolio's risk to its benchmark.
      Advantage 2: The Completeness Fund approach allows the Fund to fully capture the value added from active
      managers by eliminating misfit risk.
      Which one of the following statements about Kiley's long-only portfolio is most correct1? Kiley's portfolio:

      Answer: C
  • Question 5
    • Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping.
      Matrix sponsors a traditional defined benefit pension plan. Plan assets are valued at $5.5 billion, while recent
      declines in interest rates have caused plan liabilities to balloon to $8.3 billion. Average employee age at Matrix
      is 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1.1. Joe
      Elliot, Matrix's CFO, has made the following statement about the current state of the pension plan.
      "Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in our
      long history, but I am sure these low rates are temporary. I have looked at the charts and estimated the
      probability of higher interest rates at more than 90%. Given the expected improvement in interest rate levels,
      plan liabilities will again come back into line with our historical position. Our investment policy will therefore be
      to invest plan assets in aggressive equity securities. This investment exposure will bring our plan to an overfunded status, which will allow us to use pension income to bolster our profitability."

      Answer: A
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