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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: Apr 23, 2025
  • Rated: 4.9 |
  • Online Users: 730
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  • Question 1
    • 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 2
    • 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
      Regarding their statements concerning current and future credit risk, determine whether Cramer and McNally
      are correct or incorrect.

      Answer: B
  • Question 3
    • Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from a
      prestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-western
      university in the United States. Northern provides investment advice for pension funds, foundations,
      endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.
      They are currently scrutinizing the performance of several portfolio managers who work for the Thompson
      University endowment.
      Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,
      the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000
      that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $
      17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer and
      Seagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states that
      the advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that the
      money-weighted return is, however, a better measure of the manager's performance.
      Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for the
      most recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) for
      Thompson is the 4.5% spending rate on the endowment, which the endowment has determined using a
      geometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI World
      Index was used as the market index. The World index had a return of 9% in dollar terms with a standard
      deviation of 23% and a beta of 1.0.
      CFA-Level-III-page476-image50
      The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performance
      of managers. The alternatives discussed that day are manager universes, broad market indices, style indices,
      factor models, and custom benchmarks. Mercer states that manager universes have the advantage of being
      measurable but they are subject to survivor bias. Seagram states that manager universes possess only one
      quality of a valid benchmark.
      Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes in
      exploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engage
      in providing foreign currency hedges to small firms in emerging markets when deemed profitable. This most
      commonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a large
      position in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firm
      in Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into a
      currency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.
      Regarding their statements about manager universes, determine whether Mercer and Seagram are correct or
      incorrect.

      Answer: C
  • Question 4
    • Walter Skinner, CFA, manages a bond portfolio for Director Securities. The bond portfolio is part of a pension
      plan trust set up to benefit retirees of Thomas Steel Inc. As part of the investment policy governing the plan and
      the bond portfolio, no foreign securities are to be held in the portfolio at any time and no bonds with a credit
      rating below investment grade are allowable for the bond portfolio. In addition, the bond portfolio must remain
      unleveraged. The bond portfolio is currently valued at $800 million and has a duration of 6.50. Skinner believes
      that interest rates are going to increase, so he wants to lower his portfolio's duration to 4.50. He has decided to
      achieve the reduction in duration by using swap contracts. He has two possible swaps to choose from:
      1. Swap A: 4-year swap with quarterly payments.
      2. Swap B: 5-year swap with semiannual payments.
      Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. For
      analysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity.
      Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing a
      dual currency bond issued by an American holding company with significant operations in Japan. The bond
      makes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S.
      dollars five years from now. Skinner originally purchased the bond to take advantage of the strengthening
      relative position of the yen. The result was an above average return for the bond portfolio for several years.
      Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in the
      Japanese economy to accelerate over the next few years. Knowing Skinner's situation, one of his colleagues,
      Bill Michaels, suggests the following strategy:
      "You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dual
      currency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bond
      portfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. The
      swap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure of
      the portfolio."
      Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his expectations
      for the bond portfolio. Mann has also provided some advice to Skinner in the following comment:
      "1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rate
      shift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the call
      features of any callable bonds in your portfolio by purchasing a payer interest rate swaption."
      After his lung conversation with Director Securities' senior economist, Orval Mann, Skinner has completely
      changed his outlook on interest rates and has decided to extend the duration of his portfolio. The most
      appropriate strategy to accomplish this objective using swaps would be to enter into a swap to pay:

      Answer: B
  • Question 5
    • Harold Chang, CFA, has been the lead portfolio manager for the Woodlock Management Group (WMG) for the last five years. WMG runs several equity and fixed income portfolios, all of which are authorized to use derivatives as long as such positions are consistent with the portfolio's strategy. The WMG Equity Opportunities Fund takes advantage of long and short profit opportunities in equity securities. The fund's positions are often a relatively large percentage of the issuer's outstanding shares and fund trades frequently move securities prices. Chang runs the Equity Opportunities Fund and is concerned that his performance for the last three quarters has put his position as lead manager in jeopardy. Over the last three quarters, Chang has been underperforming his benchmark by an increasing margin and is determined to reduce the degree of underperformance before the end of the next quarter. Accordingly, Chang makes the following transactions for the fund: Transaction 1: Chang discovers that the implied volatility of call options on GreenCo is too high. As a result, Chang shorts a large position in the stock options while simultaneously taking a long position in GreenCo stock, using the funds from the short position to partially pay for the long stock. The GreenCo purchase caused the share price to move up slightly. After several months, the GreenCo stock position has accumulated a large unrealized gain. Chang sells a portion of the GreenCo position to rebalance the portfolio. Richard Stirr, CFA, who is also a portfolio manager for WMG, runs the firm's Fixed Income Fund. Stirr is known for his ability to generate excess returns above his benchmark, even in declining markets. Stirr is convinced that even though he has only been with WMG for two and a half years, he will be named lead portfolio manager if he can keep his performance figures strong through the next quarter. To achieve this positive performance, Stirr enters into the following transactions for the fund: Transaction 2: Stirr decides to take a short forward position on the senior bonds of ONB Corporation, which Stirr currently owns in his Fixed Income Fund. Stirr made his decision after overhearing two of his firm's investment bankers discussing an unannounced bond offering for ONB that will subordinate all of its outstanding debt. As expected, the price of the ONB bonds falls when the upcoming offering is announced. Stirr delivers the bonds to settle the forward contract, preventing large losses for his investors. Transaction 3: Sitrr has noticed that in a foreign bond market, participants are slow to react to new information relevant to the value of their country's sovereign debt securities. Stirr, along with other investors, knows that an announcement from his firm regarding the sovereign bonds will be made the following day. Stirr doesn't know for sure, but expects the news to be positive, and prepares to enter a purchase order. When the positive news is released, Stirr is the first to act, making a large purchase before other investors and selling the position after other market participants react and move the sovereign bond price higher. Because of their experience with derivatives instruments, Chang and Stirr are asked to provide investment advice for Cherry Creek, LLC, a commodities trading advisor. Cherry Creek uses managed futures strategies that incorporate long and short positions in commodity futures to generate returns uncorrelated with securities markets. The firm has asked Chang and Stirr to help extend their reach to include equity and fixed income derivatives strategies. Chang has been investing with Cherry Creek since its inception and has accepted increased shares in his Cherry Creek account as compensation for his advice. Chang has not disclosed his arrangement with Cherry Creek since he meets with the firm only during his personal time. Stirr declines any formal compensation but instead requests that Cherry Creek refer their clients requesting traditional investment services to WMG. Cherry Creek agrees to the arrangement. Three months have passed since the transactions made by Chang and Stirr occurred. Both managers met their performance goals and are preparing to present their results to clients via an electronic newsletter published every quarter. The managers want to ensure their newsletters are in compliance with CFA Institute Standards of Professional Conduct. Chang states, "in order to comply with the Standards, we are required to disclose the process used to analyze and select portfolio holdings, the method used to construct our portfolios, and any changes that have been made to the overall investment process. In addition, we must include in the newsletter all factors used to make each portfolio decision over the last quarter and an assessment of the portfolio's risks." Stirr responds by claiming, "we must also clearly indicate that projections included in our report are not factual evidence but rather conjecture based on our own statistical analysis. However, I believe we can reduce the amount of information included in the report from what you have suggested and instead issue more of a summary report as long as we maintain a full report in our internal records." Determine whether Chang's comments regarding the disclosure of investment processes used to manage WMG's portfolios and the disclosure of factors used to make portfolio decisions over the last quarter are correct.

      Answer: C
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