weaverbirdllm/famma · Datasets at Hugging Face

300

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nan

Based on Exhibit 1 and the notes following the exhibit, Arcadia is least likely in compliance with the GIPS standards with regard to the:

[ "A. performance presentation.", "B. measure of internal dispersion.", "C. performance record." ]

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C

Answer = C. Arcadia is required by the GIPS standards to present five years of performance because the composite has been in existence for that period. The small-cap composite was started on 31 December 2007. For each composite presented to be GIPS compliant, the Standards require that firms show at least 5 years of annual performance (less if the firm or composite has been in existence for a shorter period) and then the performance record must be extended each year until 10 years of results have been presented.

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multiple-choice

portfolio management

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nan

Regarding the notes to Exhibit 1, the GIPS standards would most likely imply that:

[ "A. Notes 1 and 7 are required and Note 2 is recommended.", "B. Notes 3 and 8 are required and Note 6 is recommended.", "C. Notes 1 and 2 are required and Note 7 is recommended." ]

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A

Answer = A . Note 1 is required. It describes the definition of the firm used to determine the total firm assets. Note 2 is recommended because the firm is encouraged but not required to provide a list of the firms contained within the parent company. Note 7 is required because firms must disclose which dispersion measure is presented.

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multiple-choice

portfolio management

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The Ptolemy Foundation was established to provide financial assistance for education in the field of astronomy. Tom Fiske, the foundation’s chief investment officer, and his staff of three analysts use a top-down process that begins with an economic forecast, assignment of asset class weights, and selection of appropriate index funds. The team meets once a week to discuss a variety of topics ranging from economic modeling, economic outlook, portfolio performance, and investment opportunities, including those in emerging markets. At the start of the meeting, Fiske asks the analysts, Len Tuoc, Kim Spenser, and Pier Poulsen, to describe The Ptolemy Foundation was established to provide financial assistance for education in the field of astronomy. Tom Fiske, the foundation’s chief investment officer, and his staff of three analysts use a top-down process that begins with an economic forecast, assignment of asset class weights, and selection of appropriate index funds. The team meets once a week to discuss a variety of topics ranging from economic modeling, economic outlook, portfolio performance, and investment opportunities, including those in emerging markets. At the start of the meeting, Fiske asks the analysts, Len Tuoc, Kim Spenser, and Pier Poulsen, to describe and justify their different approaches to economic forecasting. They reply as follows. Tuoc: I prefer econometric modeling. Robust models built with detailed regression analysis can help predict recessions well because the established relationships among the variables seldom change. Spenser: I like the economic indicators approach. For example, the composite of leading economic indicators is based on an analysis of its forecasting usefulness in past cycles. They are intuitive, simple to construct, require only a limited number of variables, and third-party versions are also available. Poulsen: The checklist approach is my choice. This straightforward approach considers the widest range of data. Using simple statistical method, such as time-series analysis, an analyst can quickly assess which measures are extreme. This approach relies less on subjectivity and is less time-consuming.” The team then discusses what the long-term growth path for US GDP should be in the aftermath of exogenous shocks because of the financial crisis that began in 2008. They examine several reports from outside sources and develop a forecast for aggregate trend growth using the simple labor-based approach and appropriate data chosen from the items in Exhibit 1. <image_1> Upon a review of the portfolio and his discussion with the investment team, Fiske determines a need to increase US large-cap equities. He prefers to forecast the average annual return for US large-cap equities over the next 10 years using the Grinold–Kroner model and the data in Exhibit 2. <image_2> The analysts think that adding to US Treasuries would fit portfolio objectives, but they are concerned that the US Federal Reserve Board is likely to raise the fed funds rate soon. They assemble the data in Exhibit 3 in order to use the Taylor rule (giving equal weights to inflation and output gaps) to help predict the Fed’s next move with respect to interest rates. <image_3> To assess the attractiveness of emerging market equities, Fiske suggests that they use the data in Exhibit 4 and determine the expected return of small-cap emerging market equities using the Singer–Terhaar approach. <image_4> Finally, after examining data pertaining to the European equity markets, the investment team believes that there are attractive investment opportunities in selected countries. Specifically, they compare the recent economic data with long-term average trends in three different countries, shown in Exhibit 5. <image_5>

Regarding the approaches to economic forecasting, the statement by which analyst is most accurate

[ "A. Poulsen", "B. Tuoc", "C. Spenser" ]

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C

Answer = C. Spenser's statement is most accurate. In the economic indicators approach, for example, the composite of leading economic indicators is based on an analysis of its forecasting usefulness in past cycles. The indicators are intuitive, simple to construct, require only a limited number of variables, and third-party versions are also available.

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multiple-choice

economics

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nan

Using the data in Exhibit 1 and the labor-based method chosen by the team, the most likely estimate for the 10-year annual GDP growth is:

[ "A. 3.5%.", "B. 3.6%.", "C. 3.0%." ]

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C

Answer = C. The simplest way to analyze an economy's aggregate trend growth is to split it into growth from changes in employment (growth from labor inputs), and growth from changes in labor productivity. For longer-term analysis, growth from changes in employment is broken down further into growth in the size of the potential labor force and growth in the actual labor force participation rate. <ans_image_1>

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multiple-choice

economics

english

180

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nan

Using the data in Exhibit 2 and Fiske's preferred approach, the estimated expected annual return for US large-cap equities over the next 10 years is closest to

[ "A. 7.9%.", "B. 7.6%.", "C. 7.4%." ]

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B

Answer = B <ans_image_2>

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multiple-choice

economics

english

180

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nan

Using the data in Exhibit 3 and the investment team's approach to predict the Fed's next move, the new fed funds rate will most likely be:

[ "A. 2.9%.", "B. 2.1%.", "C. 2.6%." ]

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B

Answer = B <ans_image_3>

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multiple-choice

economics

english

180

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nan

Using the data in Exhibit 4 and Fiske's suggested approach, the forecast of the expected return for small-cap emerging market equities is closest to:

[ "A. 9.5%.", "B. 8.9%.", "C. 9.9%." ]

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A

Answer = A. The Singer–Terhaar approach for determining the expected return on an asset class involves determining the risk premium arising from systematic risk as a weighted average of the risk premiums arising from a fully integrated market and fully segmented market, where the weights for the fully integrated market are the degree of integration of the markets. <ans_image_4> <ans_image_5>

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multiple-choice

economics

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180

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nan

Among the three countries examined by the investment team, which is in the most attractive phase of the business cycle for equity returns

[ "A. Hungary", "B. Ireland", "C. Spain" ]

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A

Answer = A. The most favorable phases when considering equity returns are initial recovery and early upswing whereas the late upswing, slowdown, and recession phases carry the greater risk for equities. Hungary has the combination of factors consistent with the initial recovery/early upswing phases of the business cycle – increasing production, low inflation, improving confidence, stimulatory fiscal/monetary policies, and abundant capacity. These indicators point to strongly rising stock prices and therefore most attractive for equity returns.

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multiple-choice

economics

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Andres Rioja is the treasurer of Empresas Crianza. His duties have recently been expanded to include oversight of the firm’s pension fund. Given his limited experience in overseeing investments, he is relying on an outside consultant. Rioja prepares a number of questions for his first meeting with the consultant, Manolo Priorat of Consulta Jerez. Priorat starts the meeting by summarizing for Rioja the status of the defined benefit pension plan and makes the following statement: The pension liability has a duration of 14 years and a present value of $4 billion. The liabilities are discounted using the spot rate on high-quality long-term corporate bonds. Presently, the asset portfolio covers 87.5% of these liabilities and is invested entirely in fixed-income assets. The plan assets have fallen short of the pension liabilities over the past five years because their durations are not properly matched. I am concerned that Crianza has selected the wrong benchmark for the pension plan. The current benchmark is a weighted average of the benchmarks for the various strategies used in the investment of pension assets. I believe the appropriate benchmark should be the liability itself. Priorat and Rioja review the fixed-income funds in which the pension assets are currently invested. Portfolio managers have been given the mandate to meet or exceed their respective benchmarks based on their investment styles. Details of the various portfolios are provided in Exhibit 1. <image_1> Rioja updates Priorat on Crianza’s current plans for the pension plan. Rioja states: “Crianza will make a $500 million contribution to fully fund the plan and invest the funds in Treasury STRIPs. In addition, we would like to completely reallocate pension investments away from the fund that presents the greatest contingent claim risk and into the long corporate bond fund.” Rioja then asks Priorat, “I would like to understand the risk profile of each index benchmark we have assigned to the portfolio managers. What measures are available to do this?” Priorat responds, There are several key measures that come to mind. Effective duration measures the sensitivity of the index’s price to a relatively small parallel shift in interest rates. For large non-parallel changes in interest rates, a convexity adjustment is used to improve the accuracy of the index’s estimated price change. Key rate duration measures the effect of shifts in key points along the yield curve. Key rate durations are particularly useful for determining the relative attractiveness of various portfolio strategies, such as bullet strategies versus barbell strategies. Spread duration describes how a non-Treasury security’s price will change as a result of the widening or narrowing of the spread contribution. Rioja then asks about the rationale for active managers to do secondary market trades. Priorat responds, Secondary market trades should be evaluated in a total return framework. The exception is the yield or spread pickup trade, which should be evaluated in the context of additional yield. Credit-upside trades provide an opportunity for managers to capitalize on unexpected upgrades. Curve-adjustment trades are yet another example of investors expressing their interest rate views in the credit markets in anticipation of interest rate changes. Finally, Priorat offers further explanation of how active managers can add value. He notes, Structural analysis of corporate bonds is an important part of active management. Credit bullets in conjunction with long-end Treasury structures are used in a barbell strategy. Callable bonds provide a spread premium that can be valuable to an investor during periods of high interest rate volatility. Put structures will provide investors with some protection in the event that interest rates rise sharply but not if the issuer has an unexpected credit event.”

Is Priorat's statement with regard to selecting a benchmark for the pension plan most likely correct

[ "A. No, because Crianza should select a high-quality long-term corporate bond index as the benchmark", "B. Yes", "C. No, because the current benchmark is appropriate to measure each strategy's performance" ]

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B

Answer = B. The investor with liabilities will measure success by whether the portfolio generates the funds necessary to pay the cash outflows associated with the liabilities. In other words, meeting the liabilities is the investment objective; as such, it also becomes the benchmark for the pension plan. Although Crianza should use the pension liabilities as the benchmark, this does not preclude managers of the various asset portfolios from being assigned an appropriate asset benchmark to manage against.

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multiple-choice

fixed income

english

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nan

For which portfolio in Exhibit 1 is a sampling approach most likely to be used in an attempt to match the primary index risk factors?

[ "A. Treasury STRIPs", "B. Emerging market bond fund", "C. Mortgage-backed securities fund" ]

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C

Answer = C. The mortgage-backed securities fund strategy uses enhanced indexing. This management style uses a sampling approach in an attempt to match the primary index risk factors and achieve a higher return than under full replication.

easy

multiple-choice

fixed income

english

181

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nan

If Rioja rebalances the portfolio as he proposes in his statement to Priorat, the dollar duration of the assets relative to the dollar duration of the liabilities is most likely to:

[ "A. fall well short.", "B. be far exceeded.", "C. be nearly matched." ]

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C

Answer = C. The portfolio has to be rebalanced to match the dollar duration of the liabilities. The liabilities have dollar duration of $4,000,000 (thousands) × 14 = $56,000,000 (thousands). The mortgage-backed securities fund is the asset class that poses contingent claim risk, so it is being liquidated, and the $700,000 thousand is being invested in the long corporate bond fund. The new $500,000 thousand contribution is invested in Treasury STRIPs. The reallocated assets have dollar durations nearly identical to the liabilities as calculated in the following table:<ans_image_1>

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multiple-choice

fixed income

english

181

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nan

In Priorat’s response to Rioja regarding the explanation of key measures of an index’s profile, he is most likely correct regarding

[ "A. key rate duration and incorrect regarding convexity adjustment.", "B. spread duration and incorrect regarding effective duration.", "C. convexity adjustment and incorrect regarding key rate duration." ]

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A

Answer = A. Priorat’s explanation of key rate duration is accurate, whereas his explanation of convexity adjustment is incorrect. A convexity adjustment is used to improve the accuracy of the index’s estimated price change for large parallel changes in interest rates. A convexity adjustment is an estimate of the change in price that is not explained by duration.

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multiple-choice

fixed income

english

181

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nan

With regard to evaluating secondary market trades, Priorat is least likely correct with respect to

[ "A. credit-upside trades.", "B. yield/spread pickup trades.", "C. curve-adjustment trades" ]

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B

Answer = B. Yield/spread pickup trades should be evaluated in a total return framework. In a total return framework, both yield and spread, as well as price appreciation or depreciation, should be considered. A bond that offers higher yield may pose the potential for a capital loss if it is riskier than a lower-yielding security.

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multiple-choice

fixed income

english

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nan

Priorat is most likely correct with regard to which structural trade

[ "A. Putables", "B. Bullets", "C. Callables" ]

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B

Answer = B. Front-end bullets (i.e., bullet structures with one-year to five-year maturities) have great appeal for investors who pursue a barbell strategy in which both the short and long end of the barbell are US Treasury securities. There are “barbellers” who use credit securities at the front or short end of the curve and Treasuries at the long end of the yield curve.

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multiple-choice

fixed income

english

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William Gatchell, is an investment analyst with the Sonera Endowment Fund. Sonera is considering hiring a new equity investment manager. In preparation, Gatchell meets with Anjou Lafite, another analyst at the fund, to review a relevant part of the endowment’s investment policy statement: Funds will be invested in the most efficient vehicle that meets the investment objective. Each manager must demonstrate the efficiency with which the tracking error they use delivers active return. In addition, each manager must consistently adhere to his or her stated style. Gatchell is given the task of reviewing three investment managers and selecting a manager that is most likely to adhere to Sonera’s investment policy statement. Information about the investment managers is shown in Exhibit 1. <image_1> Gatchell is reviewing the fee structures proposed by the three investment managers. He finds the following reference in Sonera’s investment policy statement: The fee structure must be easy to understand and avoid undue complexity wherever possible. Also, the fee structure must be predictable, so Sonera can reasonably forecast these costs on a yearly basis as an input to the annual budgeting process. He understands there are many different fee structures, and he wants to make sure he chooses the most appropriate one for the Sonera. Gatchell prepares a recommendation for the investment policy committee regarding the most appropriate fee structure. Sonera has followed an active investment style for many years. Gatchell would like to recommend to the investment policy committee that a portion of the funds be invested using a passive investment style. His research shows there are a number of methods used to weight the stocks in an index, each having its own characteristics. The one key feature he believes is important is that the method chosen not be biased toward small-capitalization stocks. Gatchell is also examining different ways to establish passive equity exposure. He states to Lafite: There are a number of ways to get passive equity exposure; we can invest in an equity index mutual fund, a stock index futures contract, or a total return equity swap. Stock index futures and equity swaps are low-cost alternatives to equity index mutual funds; however, a drawback of stock index futures is that they have to be rolled over periodically. One advantage of investing in equity mutual funds is that shares can be redeemed at any point during the trading day. Gatchell is reviewing the performance of another investment manager, Far North, which uses a value-oriented approach and specializes in the Canadian market. Gatchell would like to recommend to the investment policy committee that the fund diversify geographically. The information for Far North and the related returns are shown in Exhibit 2. <image_2> The investment policy committee reviews the information in Exhibit 2 and is not familiar with the terms “true active return” and “misfit active return.” Gatchell responds with the following statement: The true active return is the return Far North made above its normal benchmark return. The misfit active return is the return Far North made above the investor’s benchmark return. The term “investor’s benchmark” refers to the benchmark the investor uses to evaluate performance for a given portfolio or asset class.

Based on Exhibit 1, which investment manager most likely meets the criteria established in the endowment's investment policy statement?

[ "A. Manager B", "B. Manager C", "C. Manager A" ]

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A

Answer = A. Manager B has a positive information ratio, demonstrating that he has been able to deliver active returns relative to his level of tracking error. Manager B's investment style is consistent with a value investment style, with a higher beta for the two value indices—the small-cap value index and the large-cap value index.

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multiple-choice

equity

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nan

Based on Exhibit 1, is there sufficient information for Gatchell to create and interpret the results of a style box?

[ "A. No, because additional holdings data are required", "B. Yes", "C. No, because additional index data are required" ]

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A

Answer = A. Holdings data are required to create a style box and interpret the results. Gatchell is given the styles and the assets under management but not each individual investment or holding that each investment manager has selected.

easy

multiple-choice

equity

english

182

2

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nan

Which fee structure is most appropriate for Sonera, based on the criteria in the investment policy statement

[ "A. An ad valorem fee structure", "B. A performance-based fee structure with a high-water mark", "C. A performance-based fee structure with a fee cap" ]

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A

Answer = A. Ad valorem fee structures are both simple and predictable. The ad valorem fee structure is calculated by multiplying the value of the assets by a percentage.

easy

multiple-choice

equity

english

182

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nan

If the investment policy committee decides to accept Gatchell's recommendation to also use passive investing, the index structure that least likely meets Gatchell's requirement is

[ "A. a price-weighted index.", "B. an equal-weighted index.", "C. a value-weighted index." ]

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B

Answer = B. An equal-weighted index is biased toward small-capitalization stocks.

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multiple-choice

equity

english

182

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nan

In his statement to Lafite, Gatchell is least likely correct with respect to:

[ "A. periodic rollover.", "B. redemption.", "C. cost." ]

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B

Answer = B. Gatchell is correct that stock index futures and equity swaps are low-cost alternatives to equity index mutual funds. He is also correct that a drawback of stock index futures is that they have to be rolled over periodically. He is incorrect about the pricing of mutual funds: They are priced once daily

hard

multiple-choice

equity

english

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nan

Is Gatchell's statement regarding true active return and misfit active return correct

[ "A. Yes", "B. No, he is incorrect about misfit active return", "C. No, he is incorrect about true active return" ]

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B

Answer = B. The definition of misfit active return is incorrect. Misfit active return is the difference between the normal benchmark and the investor's benchmark.

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multiple-choice

equity

english

182

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Anna Lehigh, is a portfolio manager for Brown and White Capital Management (B&W), a US-based institutional investment management firm whose clients include university endowments. Packer College is a small liberal arts college whose endowment is managed by B&W. Lehigh is considering a number of derivative strategies to tactically adjust the Packer portfolio to reflect specific investment viewpoints discussed at a meeting with Packer’s investment committee. At the meeting, the committee reviews Packer’s current portfolio, whose characteristics are shown in Exhibit 1. <image_1> Kemal Gulen, a member of the investment committee, asks Lehigh how she manages the risk exposure of the call options investment. Lehigh responds by stating that she ensures that her call option positions are delta hedged. She notes, however, that in some instances, at an option’s expiration, the option gamma is very high and maintaining a delta hedged position becomes very difficult. Lehigh intends to synthetically modify the duration of the corporate bond component of the portfolio to a target of 3.0 in anticipation of rising interest rates. Interest rate swap data are provided in Exhibit 2. <image_2> Lehigh notes the holding of Mountain Hawk common stock. The shares were recently donated by an alumnus who mandated that they not be sold for three years. Lehigh provides three potential options strategies to use in order to benefit from changes in Mountain Hawk’s stock price, which is presently $100.00. Options strategies are provided in Exhibit 3. <image_3> Lehigh tells the committee she believes US large-cap stocks will perform well over the next year. The committee agrees and wants B&W to adjust the beta of the US large-cap part of the portfolio to a target of 1.10 by purchasing large-cap futures contracts. Lehigh proposes purchasing 15 contracts. For each contract, the beta is 1.00 and the price is $100,000. The committee is concerned that Europe’s sovereign debt crisis may lead to volatility in European stock markets and the euro currency. It considers the hedging strategies outlined in Exhibit 4 <image_4> Finally, Lehigh discusses B&W’s market view that over the next 24 months, mid-cap stocks will underperform small-cap stocks and the Libor rate will be less than the percentage increase in the small-cap index but greater than the percentage change in the mid-cap index. She recommends executing a swap transaction in order to alter the stock and bond allocation and thus capture the economic benefit of B&W’s market view. The investment committee considers the swap strategies outlined in Exhibit 5. <image_5>

Lehigh's response to Gulen is most likely correct when the option is:

[ "A. out of the money.", "B. in the money.", "C. at the money." ]

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C

Answer = C. At expiration, at-the-money call options move very rapidly to a delta of 1 or 0. At this point, the gamma is the highest and it is very difficult to maintain a delta-hedged position.

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multiple-choice

derivatives

english

183

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nan

Based on the data in Exhibit 2, modifying the duration of the fixed-income allocation to its target will require an interest rate swap that has notional principal closest to:

[ "A. $11,030,000.", "B. $17,777,000", "C. $9,412,000." ]

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A

Answer = A. <ans_image_1>

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multiple-choice

derivatives

english

183

2

1

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nan

If the price of Mountain Hawk stock declines to $88.00, which options strategy will most likely have the highest value at expiration?

[ "A. Bull spread", "B. Straddle", "C. Bear spread" ]

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C

Answer = C. The bear spread strategy will have a value of $10. A bear (put) spread entails buying the put with the higher exercise price ($100) and selling the put with the lower exercise price ($90). Value at expiration = max(0, 100 – 88) – max(0, 90 – 88) = 10.

easy

multiple-choice

derivatives

english

183

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nan

Will Lehigh's purchase of US large-cap futures contracts most likely result in the committee's beta objective for the US large-cap investment being attained

[ "A. No, because the beta will be above the target", "B. Yes", "C. No, because the beta will be below the target" ]

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C

Answer = C. Purchasing 15 futures contracts increases the beta to 1.00, not 1.10. Purchasing 45 futures contracts is necessary to attain the beta target. <ans_image_2>

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multiple-choice

derivatives

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nan

Given the committee's view about the sovereign debt crisis, which hedging strategy is most likely to result in Packer earning the US risk-free rate of return

[ "A. Strategy 3", "B. Strategy 1", "C. Strategy 2" ]

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C

Answer = C. Shorting European stock market futures, selling euros, and buying US dollars will result in the Packer endowment fund earning the US risk-free rate.

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multiple-choice

derivatives

english

183

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nan

Which of the following swaps will least likely capture the greatest economic benefit, based on the committee's 24-month market view

[ "A. Swap 1", "B. Swap 3", "C. Swap 2" ]

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C

Answer = C. Receiving the underperforming index (mid cap) and paying the outperforming index (small cap) will result in a net negative payment.

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derivatives

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Manuel Silva is a principal at Raintree Partners, a financial advisory firm, and a specialist in providing advice on risk management and trading strategies using derivatives. Raintree’s clients include high-net-worth individuals, corporations, banks, hedge funds, and other financial market participants. One of Silva’s clients, Iria Sampras, is meeting with Silva to discuss the use of options in her portfolio. Silva has collected information on S&P 500 Index options, which is shown in Exhibit 1. <image_1> At the beginning of the meeting, Sampras states: “My investment in Eagle Corporation stock has increased considerably in value, and I would like suggestions on options strategies I can use to protect my gains.” Silva responds: There are two strategies that you may want to consider: covered calls or protective puts. Covered calls provide a way to protect your gains in Eagle Corporation stock. Adding a short call to your long position in Eagle stock will provide protection against losses on the stock position, but it will also limit upside gains. A protective put also provides downside protection, but it retains upside potential. Unlike covered calls, protective puts require an upfront premium payment. At the end of the meeting, Sampras asks Silva to provide a written analysis of the following option strategies: Strategy A: A butterfly spread strategy using the options information provided in Exhibit 1. Strategy B: A straddle strategy using the options in Exhibit 1 with an exercise price of $1,125. Strategy C: A collar strategy using the options information in Exhibit 1. On 16 March 2012, First Citizen Bank (FCB) approached Silva for advice on a loan commitment. At that time, FCB had committed to lend $100 million in 30 days (on 15 April 2012), with interest and principal due on 12 October 2012, or 180 days from the date of the loan. The interest rate on the loan was 180-day Libor + 50 bps, and FCB was concerned about interest rates declining between March and April. Silva advised FCB to purchase a $100 million interest rate put on 180-day Libor with an exercise rate of 5.75% and expiring on 15 April 2012. The put premium was $25,000. Libor rates on 16 March 2012 and 15 April 2012 were 6% and 4%, respectively. The option was exercised on 15 April 2012, and the payoff was received on 12 October 2012. FCB has asked for a written evaluation of the success of the strategy. On 15 October 2013, another client, Short Hills Corporation (SHC), indicates it expects to take out a $25 million dollar loan on 15 December 2013. The loan rate is 90-day Libor + 100 bps. Interest and principal will be paid on 15 March 2014, 90 days after the loan is made on 15 December 2013. SHC is concerned about rising interest rates and has approached Silva for recommendations on addressing this issue. On Silva’s advice, SHC purchases a $25 million interest rate call on 90-day Libor with an exercise rate of 3.5%. The option premium is $45,000, and it expires in 61 days, on 15 December 2013. If the option is exercised on 15 December 2013, the payoff will be received on 15 March 2014. SHC has asked Silva to provide a report on possible outcomes relative to potential interest rate scenarios.

Is Silva's response to Sampras regarding reducing exposure to Eagle Corporation stock most likely correct

[ "A. No, he is incorrect about covered calls", "B. No, he is incorrect about protective puts", "C. Yes" ]

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Answer = A. Silva is incorrect about covered calls. Covered calls do not provide protection against downside losses. They do limit upside gains.

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Based on the information in Exhibit 1, the maximum profit per contract for Strategy A is closest to:

[ "A. $9,015.", "B. $5,855.", "C. $2,545." ]

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C

Answer = C. In the butterfly spread, using calls the investor goes long the $1,100 and $1,150 strikes and short two of the $1,125 strike. The maximum profit is when the index is at $1,125. The maximum profit per contract = Profit on long $1,100 + Profit on two short $1,125 + Profit on long $1,150 = ($1,125 – $1,100) – $95.85 + (2 × $80.50) – $64.70 = $25.45. The profit per contract = $25.45 × $100 = $2,545.

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Based on the information presented in Exhibit 1, the maximum loss per contract for Strategy B is closest to:

[ "A. $20,900.", "B. $10,350.", "C. $12,850." ]

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C

Answer = C. The straddle consists of a long call and a long put at a strike price of $1,125. The maximum loss occurs when the index is at $1,125, when the call and put are at the money. The maximum loss = Call premium + Put premium = $80.50 + $48.00 = $128.50. Per the contract, the loss is $100 × $128.50 = $12,850.

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The expected volatility of the S&P 500, relative to market expectations, is least likely to be a factor in the decision to implement

[ "A. Strategy", "B. B. Strategy", "C. C. Strategy" ]

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B

Answer = B. Strategy C is a collar, which is a directional strategy; that is, its performance is dependent on the direction of the movement of the underlying (in this instance, the S&P 500). The performance of Strategy A (butterfly spread) and Strategy B (straddle) are based on the expected volatility (relative to the rest of the market) of the S&P 500.

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Based on Silva's advice, the effective annual interest rate for First Citizen Bank's loan is closest to:

[ "A. 5.75%.", "B. 4.56%.", "C. 6.38%." ]

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C

Answer = C. <ans_image_1>

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Assuming Silva's advice is followed and Libor rates are 5% and 6% on 15 October 2013 and 15 December 2013, respectively, the effective annual interest rate on Short Hills Corporation's loan is closest to:

[ "A. 3.50%.", "B. 5.42%.", "C. 4.64%." ]

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B

Answer = B. The effective annual rate is calculated as follows: Future value of call premium on 15 December <ans_image_2>

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Kamiko Watanabe, is a portfolio adviser at Wakasa Bay Securities. She specializes in the use of derivatives to alter and manage the exposures of Japanese equity and fixed-income portfolios. She has meetings today with two clients, Isao Sato and Reiko Kondo. Sato is the manager of the Tsushima Manufacturing pension fund, which has a target asset allocation of 60% equity and 40% bonds. The fund has separate equity and fixed-income portfolios, whose characteristics are provided in Exhibits 1 and 2. Sato expects equity values to increase in the coming two years and, in order to avoid substantial transaction costs now and in two years, would like to use derivatives to temporarily rebalance the portfolio. He wants to maintain the current beta of the equity portfolio and the current duration of the bond portfolio. <image_1> <image_2> In order to rebalance the pension fund to its target allocations to equity and bonds, Watanabe recommends using Nikkei 225 Index futures contracts, which have a beta of 1.05 and a current contract price of ¥1,525,000, and Nikko Bond Performance Index futures, which have a duration of 6.90 and a current contract price of ¥4,830,000. She assumes the cash position has a duration of 0.25. Sato wants to know if other derivatives could be used to rebalance the portfolio. In response, Watanabe describes the characteristics of a pair of swaps that, together, would accomplish the same rebalancing as the proposed futures contracts strategy. Kondo manages a fixed-income portfolio for the Akito Trust. The portfolio’s market value is ¥640 million, and its duration is 6.40. Kondo believes interest rates will rise and asks Watanabe to explain how to use a swap to decrease the portfolio’s duration to 3.50. Watanabe proposes a strategy that uses a pay-fixed position in a three-year interest rate swap with semi-annual payments. Kondo decides he wants to use a four-year swap to manage the portfolio’s duration. After some calculations, Watanabe tells him a pay-fixed position in a four-year interest rate swap with a duration of –2.875 would require a notional principal of ¥683 million (rounded to the nearest million yen) to achieve his goals. Kondo asks Watanabe whether it would be possible to cancel the swap prior to its maturity. Watanabe responds with three statements: Statement 1: If you purchase a swaption from the same counterparty as the original swap, it is common to require the payments of the two swaps be netted or cash settled if the swaption is exercised. Statement 2: You could purchase a payer swaption with the same terms as the original swap. This approach would protect you from falling fixed swap rates but at the cost of the premium you would pay to the swaption counterparty. Statement 3: During the life of the swap, you could enter into a new pay-floating swap with the same terms as the original swap, except it would have a maturity equal to the remaining maturity of the original swap. However, the fixed rate you receive might be lower than the fixed rate you are paying on the original swap.

The number of Nikko Bond Performance Index futures Sato must sell to rebalance the Tsushima pension fund to its target allocation is closest to

[ "A. 743.", "B. 149.", "C. 1,594." ]

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A

Answer = A. <ans_image_1>

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The number of Nikkei 225 Index futures Sato must buy to rebalance the Tsushima pension fund to its target allocation is closest to:

[ "A. 4,148.", "B. 3,293.", "C. 3,950." ]

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C

Answer = C. <ans_image_2>

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Which of these is most likely to be a characteristic of one of the two swaps Watanabe describes to Sato

[ "A. Receive return on Nikko Bond Performance Index", "B. Pay return on Nikkei 225 Index", "C. Receive Libor" ]

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C

Answer = C. One of the swaps would be pay Nikko Bond Performance Index return and receive Libor.

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The duration of the swap in Watanabe's first proposal to Kondo is closest to:

[ "A. –1.75.", "B. –2.00.", "C. –2.75." ]

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B

Answer = B. A pay-fixed (receive-floating) position in an interest rate swap is similar to issuing a fixed-rate bond and buying a floating-rate bond with the proceeds. The duration of the fixed-rate bond is approximately 75% of the maturity, and the swap is short this duration. The duration of the floating-rate bond is approximately half its repricing frequency, and the swap is long this duration. Therefore, the duration of the three-year swap with semi-annual payments is (0.5 × 0.5) – (0.75 × 3) = –2.00.

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Is the notional principal of the swap Watanabe recommends to Kondo most likely correct

[ "A. No, it is too high", "B. Yes", "C. No, it is too low" ]

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A

Answer = A. <ans_image_3>

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Which of Watanbe's three statements to Kondo is least likely correct

[ "A. Statement 3", "B. Statement 1", "C. Statement 2" ]

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C

Answer = C. The original swap is pay-fixed, implying that the offsetting swap would be pay-floating. A receiver swaption provides its owner with the right to enter a pay-floating (receive-fixed) in a swap at the exercise fixed rate, whereas a payer swaption provides the right to enter the swap in a pay-fixed position.

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REDD Partners specializes in forecasting and consulting in particular sectors of the equity market. Minglu Li is an analyst for REDD and specializes in the consumer credit industry. Last year (2012), Li and her team gathered data to determine the expected return for the industry, shown in Exhibit 1. <image_1> After considering a number of approaches, Li and her team decided to use the bond-yield-plus-risk-premium method. The method had worked well in 2012, but a new assignment presented to Li’s team the previous week posed a new challenge. A new consumer credit mechanism was being tested on a small scale using a smartphone application to pay for items instead of the traditional credit card. The application had proved successful in the use of microloans in developing countries and was now being applied to a much broader consumer base. The new challenge for Li’s team is to develop a model for the expected return for these new consumer credit companies, which are called “smart credit” companiesbecause they combine the consumer credit industry and what had traditionally been considered the telecommunications industry. Although smart credit company returns data are sparse, a five-year monthly equally weighted index called the “Smart Credit Index” (SCI) was created from the existing companies’ returns data. The number of companies in the index at a given time varies because of firms failing and also merging over time. The SCI risk premium, equal to the SCI return minus the risk-free rate, denoted as SCIRP, is used as the dependent variable in a two-factor regression in which the independent variables are index returns minus the risk-free rate for the consumer credit industry (CCIRP) and the telecommunications industry (TELIRP). The regression results are in Exhibit 2. <image_2> Although volatility information is available from the SCI data and correspondingly for the SCIRP, Li’s team wants to determine the statistical relationship between the SCIRP and both the CCIRP and the TELIRP because forecasting the CCIRP and TELIRP is much less difficult than forecasting the SCIRP. After some discussion, the team believes that the volatility measure for the SCIRP data based on the volatility of CCIRP and TELIRP through the regression should be adjusted to incorporate a correlation coefficient of 0.25 between the CCIRP and TELIRP. Although the two index risk premiums were uncorrelated in the past and within the regression, Li’s team believes the two technologies will become more correlated in the future. Li’s team also examined survey data within the consumer credit and telecommunications industries over the same time period for which the actual data were collected. They found that projections in the surveys of the CCI and TELI tended to be more volatile than the actual data. However, Li’s team has decided not to make any adjustments because a definitive procedure could not be determined. Given the effect of short-term interest rates on consumer credit, Li’s team then decided to determine what the short-term interest rate is expected to be in the future. The central bank’s last official statement identified 2.5% as the appropriate rate, assuming no other factors. Li’s team then estimates potential factors that may make the central bank behave differently from the 2.5% rate in the statement, shown in Exhibit 3. <image_3> Based on Taylor’s rule, with an assumption of equal weights applied to forecast versus trend measures, the short-term rate is expected to increase from the current 1.23%, and the yield curve is expected to flatten. For further insight, Li decides to consult an in-house expert on central banking, Randy Tolliver. Tolliver states that a flat yield curve is consistent with tight monetary policies and tight fiscal policies.

Based on Exhibit 1 and the method used by Li's team, the expected return for the consumer credit industry in 2012 was closest to

[ "A. 12.8%.", "B. 12.2%.", "C. 12.4%." ]

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B

Answer = B. The bond-yield-plus-risk-premium method sets the expected return to the yield to maturity on a long-term government bond plus the equity risk premium (12.2% = 3.8% + 8.4%).

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The SCI data most likely exhibits which type of bias?

[ "A. Survivorship", "B. Data-mining", "C. Time-period" ]

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A

Answer = A. The SCI data is an index that is not composed of the same number of firms each period because of firm failures and combinations through time, which is indicative of a survivorship bias.

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Based on the correlation that Li's team believes to exist between the CCIRP and TELIRP, the new volatility for the SCIRP is closest to:

[ "A. 56.4%.", "B. 31.8%.", "C. 49.1%." ]

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A

Answer = A. <ans_image_1>

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A comparison between the survey data containing projections of the CCI and TELI and the actual CCI and TELI most likely exhibits

[ "A. a status quo trap.", "B. ex post risk being a biased measure of ex ante risk.", "C. a recallability trap." ]

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B

Answer = B. As stated, the projections in the survey data tended to be more volatile than the actual outcomes over the same time period. This result indicates that the ex-post risk (i.e., the volatility of the actual data) tends to have a downward bias relative to the ex ante risk displayed by the survey data. This tendency is evidence of ex post risk being a biased measure of ex ante risk.

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Based on how the Taylor rule is applied by Li's team, the central bank's estimated optimal short-term rate is closest to:

[ "A. 2.8%.", "B. 1.5%.", "C. 2.0%." ]

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C

Answer = C. The Taylor rule sets the optimal short-term rate as Neutral rate + 0.5 × (GDP growth forecast – GDP growth trend) + 0.5 × (Inflation forecast – Inflation target). Applying numbers from Exhibit 3, 2.0% = 2.5% + 0.5 × (2.0% ‒ 1.0%) + 0.5 × (1.5% ‒ 3.5%).

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Tolliver's statement regarding the yield curve is most likely:

[ "A. incorrect with regard to fiscal policy.", "B. incorrect with regard to monetary policy.", "C. correct." ]

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A

Answer = A. A flat yield curve is consistent with tight monetary policy and loose fiscal policy, which means that Tolliver’s statement is incorrect with regard to fiscal policy.

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Brian O'Reilly is a capital markets consultant for the Tennessee Teachers' Retirement System (TTRS). O'Reilly is meeting with the TTRS board to present his capital market expectations for the next year. Board member Kay Durden asks O'Reilly about the possibility that data measurement biases exist in historical data. O'Reilly responds: Some benchmark indexes suffer from survivorship bias. For example, the returns of failed or merged companies are dropped from the data series, resulting in an upward bias to reported returns. This bias may result in an overly optimistic expectation with respect to future index returns. Another bias results from the use of appraisal data in the absence of market transaction data. Appraisal values tend to be less volatile than market determined values for identical assets. The result is that calculated correlations with other assets tend to be biased upward in absolute value compared with the true correlations, and the true variance of the asset is biased downward. Board member Arnold Brown asks O'Reilly about the use of high-frequency (daily) data in developing capital market expectations. O'Reilly answers, "Sometimes it is necessary to use daily data to obtain a dataseries of the desired length. High-frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce higher correlation estimates." Board member Harold Melson notes he recently read an article on psychological traps related to making accurate and unbiased forecasts. He asks O'Reilly to inform the board about the anchoring trap and the confirming evidence trap. O'Reilly offers the following explanation: The anchoring trap is the tendency for forecasts to be overly influenced by the memory of catastrophic or dramatic past events that are anchored in a person's memory. The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports a preferred viewpoint than to evidence that contradicts it. The board asks O'Reilly about using a multifactor model to estimate asset returns and covariances among asset returns. O'Reilly presents the factor covariance matrix for global equity and global bonds shown in Exhibit 1 and market factor sensitivities and residual risk shown in Exhibit 2. <image_1> Finally, the board asks about forecasting expected returns for major markets, given that price earnings ratios are not constant over time and that many companies are repurchasing shares instead of increasing cash dividends. O'Reilly responds that the Grinold–Kroner model accounts for those factors and then makes the following forecasts for the European equity market: • The dividend yield will be 1.95%. • Shares outstanding will decline 1.00%. • The long-term inflation rate will be 1.75% per year. • An expansion rate for P/E multiples will be 0.15% per year. • The long-term corporate earnings growth premium will be 1% above GDP growth. • GDP growth will be 2.5% per year. • The risk-free rate will be 2.5%.

With respect to his explanation of survivorship bias, O'Reilly most likely is:

[ "A. correct.", "B. incorrect, because survivorship bias results in an overly pessimistic view of expected returns.", "C. incorrect, because survivorship bias results in a downward bias to reported returns." ]

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A

Answer = A.

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With respect to his explanation of appraisal data bias, O'Reilly most likely is

[ "A. correct.", "B. incorrect, because calculated correlations with other assets tend to be biased downward in absolute value.", "C. incorrect, because the true variance of the asset is biased upward." ]

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B

Answer = B. O'Reilly's explanation of appraisal data bias is incorrect because calculated correlations with other assets tend to be smaller in absolute value compared with the true correlations. O'Reilly is correct in that appraisal values tend to be less volatile than market-determined values for identical assets, and the true variance (and standard deviation) of the asset is biased downward.

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With respect to his answer to Brown's question, O'Reilly most likely is

[ "A. incorrect, because high-frequency data tend to produce lower correlation estimates.", "B. incorrect, because high-frequency data are less sensitive to asynchronism.", "C. correct." ]

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Answer = A. O'Reilly's answer is incorrect with respect to correlation estimates. High-frequency data are more sensitive to asynchronism across variables and, as a result, tend to produce lower correlation estimates.

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Is O'Reilly's explanation of the anchoring trap most likely correct

[ "A. No, because the anchoring trap is the tendency for the mind to give a disproportionate weight to the first information it receives on a topic", "B. No, because the anchoring trap is the tendency to temper forecasts so that they do not appear extreme", "C. Yes" ]

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A

Answer = A. O'Reilly's explanation of the anchoring trap is incorrect. The anchoring trap is the tendency of the mind to give disproportionate weight to the first information it receives on a topic. Initial impressions, estimates, or data anchor subsequent thoughts and judgments.

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Given the data in Exhibits 1 and 2, the covariance between Market 1 and Market 2 is closest to:

[ "A. 0.0225.", "B. 0.0243.", "C. 0.0027." ]

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B

Answer = B. The covariance between Market 1 and Market 2 is calculated as follows: M12 = (1.20 × 0.90 × 0.0225) + (0 × 0 × 0.0025) + [(1.20 × 0) + (0 × 0.90)] × 0.0022 = 0.0243.

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Given O'Reilly's forecasts for the European market, the expected long-term equity return using the Grinold–Kroner model is closest to

[ "A. 6.35%.", "B. 8.35%.", "C. 7.35%." ]

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B

Answer = B. <ans_image_1> <ans_image_2>

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McMorris Asset Management (MCAM) is an investment adviser based in Atlanta, Georgia. Tom Morris manages the active equity portfolios. Dan McKeen manages the semiactive equity portfolios and the semiactive derivatives portfolios. They are preparing to meet with Maggie Smith, the chief investment officer of Philaburgh Capital, who is considering hiring MCAM to replace one of its current managers. At the meeting, Morris and McKeen discuss MCAM’s investment approaches with Smith and present her with the risk and return characteristics detailed in Exhibit 1. <image_1> Smith asks if MCAM’s active equity strategy is long only. McKeen responds that MCAM uses market-neutral long–short strategies for several reasons. He indicates that long–short strategies: Reason 1: enhance portfolio performance by increasing the beta. Reason 2: generate alpha by identifying undervalued or overvalued securities. Reason 3: benefit from events that give rise to price changes, which are more prevalent on the short side than on the long side. Smith considers each approach listed in Exhibit 1 but is uncertain about what would be an optimal investment strategy. She makes the following comments about market efficiency: Comment 1: A firm’s stock price does not reflect all publicly available company information, and good research can uncover sound investment opportunities. Comment 2: Philaburgh’s mandate is for managers to limit volatility around the benchmark return while providing incremental returns that exceed management costs. Smith states, “In order to ensure investment discipline, Philaburgh uses two methods to evaluate an investment manager’s style.” She then reviews the current characteristics of MCAM’s active equity approach using the first method, as presented in Exhibit 2. <image_2> Smith then selects three benchmarks—value, blend, and growth—in addition to the normal benchmark to assess the manager’s style using the second method, as presented in Exhibit 3. <image_3> Smith indicates that Philaburgh’s performance measurement is compliant with the Global Investment Performance Standards. In considering investment performance, Morris identifies three risks that may prevent MCAM’s active equity approach from generating incremental returns: Risk 1: Overestimating a stock’s earnings per share growth. Risk 2: Deciding incorrectly that a stock’s earnings multiple would not contract. Risk 3: Misjudging whether a stock’s undervaluation will correct within the investor’s investment horizon. Smith concludes by telling Morris that she is impressed by MCAM’s track record in adding alpha in the US stock market. However, she believes that the European equity markets are likely to outperform the US equity markets over the next five years. She asks whether MCAM can structure a portfolio to capture both opportunities. Morris offers to combine his long–short active equity strategy with a EURO STOXX 50 Index strategy.

Based on Exhibit 1, the approach that is least likely efficient with respect to delivering active returns for a given level of tracking risk is:

[ "A. active equity.", "B. semiactive derivatives.", "C. semiactive equity" ]

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A

Answer = A. The active equity strategy has the lowest information ratio and is thus least efficient in delivering active returns. Information ratio = Active return (Portfolio – Benchmark)/Tracking risk. The information ratio is 0.5%, which is the lowest of the three.

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Based on Exhibits 2 and 3, what can Smith most likely determine about MCAM's investment style over time? MCAM's style has:

[ "A. drifted from value to growth.", "B. not drifted.", "C. drifted from growth to value" ]

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C

Answer = C. The active equity strategy was not value oriented because the returns-based style analysis indicates a growth orientation given a 0.65 coefficient of determination with respect to growth returns. The current holdings, however, depict a value orientation when compared with the manager's normal benchmark given the differences in dividend yield and P/E. MCAM's style has drifted over time from growth to value.

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Which of the risks Morris identifies with respect to MCAM's active equity strategy is least likely applicable to a growth-oriented investor?

[ "A. Risk 3", "B. Risk 1", "C. Risk 2" ]

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Answer = A. The main risk for a value-oriented investor rather than a growth-oriented investor is misinterpreting a stock's cheapness within the investor's time horizon.

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The type of portfolio that Morris recommends to Smith to take advantage of both US and European equity market opportunities is most likely a(n):

[ "A. completeness fund.", "B. core satellite.", "C. alpha and beta separation." ]

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C

Answer = C. Alpha and beta separation involve combining an index strategy with a market-neutral active strategy in order to earn a desired beta + alpha outcome. Smith's objective is to realize returns from the European market (beta) + MCAM's active return (alpha). In this case, by using the EURO STOXX 50 index strategy, MCAM is able to offer both strategies combined into an alpha and beta separation strategy for Smith.

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Aina Monts, is a fixed-income portfolio manager at Girona Advisors. She has been awarded the management of a €150 million portfolio for Fondo de Pensiones Lerida, a pension fund based in Barcelona, Spain. The previous manager was fired for underperforming the benchmark by more than 100 bps in each of the last three years. Lerida’s primary objective is to immunize its liabilities, which have a duration of 4.40 years, while achieving a total rate of return in excess of the Barclays Capital Global Aggregate Bond Index. The benchmark’s duration is currently 4.42 years. At Girona’s portfolio review meeting, Monts makes the following statement: Statement 1: We will invest the €150 million in a multi-sector portfolio with a yield to maturity of 6.75%. This rate is higher than Lerida’s required rate of return of 6.25%. The duration of the portfolio will be equal to the duration of the liabilities, and we will manage the portfolio with an expectation of beating the Barclays Capital Global Aggregate Bond Index. Exhibit 1 presents key characteristics of Lerida’s portfolio for the current period compared with one year ago. Because rates have shifted over this period, Monts informs Lerida that an additional investment must be made to rebalance the portfolio and reestablish the original dollar duration. Monts plans to rebalance using the existing security proportions. <image_1> Monts will rebalance the portfolio by investing in securities that her research group has identified as providing the most attractive total return potential. Sector allocations for her portfolio and the benchmark are presented in Exhibit 2. <image_2> Monts will rebalance the portfolio by investing in securities that her research group has identified as providing the most attractive total return potential. Sector allocations for her portfolio and the benchmark are presented in Exhibit 2. Monts also uses security selection in addition to sector rotation as sources of alpha and is evaluating several new trades. At the portfolio review meeting, Monts makes the following statements: Statement 2: I am concerned that certain types of securities in the portfolio pose a risk of not providing sufficient cash flow to pay liabilities when they are due. The allocation to mortgage-backed securities in the portfolio, for instance, exposes us to contingent claims risk. We should thus increase the allocation to non-callable fixed-rate corporate bonds, which do not expose us to contingent claims risk. Statement 3: Our research team anticipates that the credit fundamentals of most issuers will deteriorate over the coming months as the economy contracts. The market consensus is not in line with our view yet, and spreads do not reflect the proper valuation. Statement 4: Structural analysis of corporate bonds is a key part of our research process. Given Girona’s view that interest rates are in secular decline, we expect callable bonds to outperform bullets. In the event that interest rates rise sharply, put structures will provide investors with some protection.

Based on Monts's Statement 1, the extension of classical immunization theory that Monts will use to meet Lerida's investment objective is best described as:

[ "A. symmetrical cash flow matching.", "B. multiple liability immunization.", "C. contingent immunization." ]

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C

Answer = C. An extension of classical immunization is to integrate immunization strategies with elements of active management strategies. The difference between the 6.75% yield to maturity and 6.25% required rate is the cushion spread. As long as there is a spread cushion, the manager can actively manage part of or the entire portfolio.

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Based on Exhibit 1, the cash required to rebalance the Lerida portfolio is closest to

[ "A. €12,027,000.", "B. €533,000.", "C. €3,331,000." ]

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A

Answer = A. The portfolio has to be rebalanced to the initial level of dollar duration. The portfolio market value and dollar duration are provided for both periods. First calculate dollar duration as: Market value × Duration × 0.01. <ans_image_1>

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nan

Based on the data in Exhibit 2, Mont’s positioning of the portfolio would suggest that the sector that poses the most tracking error relative to the benchmark is

[ "A. Treasuries.", "B. corporate bullets.", "C. MBS." ]

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B

Answer = B. Contribution to spread duration is the key measure that provides the relative sensitivity to movements in spreads for a particular sector. The portfolio has an overweight to Treasuries on a contribution to overall duration but it is not a spread sector; a neutral position in mortgages and an underweight in corporate bonds (2.13 years in the portfolio versus 2.37 years in the benchmark). The equal weight on a nominal basis in corporate bonds implies the duration of those bonds in the portfolio is shorter than the bonds in the index, which will be less sensitive to changes in spread movement.

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Is Monts’s Statement 2 mostly likely correct

[ "A. No, she is incorrect about corporate bonds", "B. No, she is incorrect about mortgage-backed securities", "C. Yes" ]

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C

Answer = C. When securities have a contingent claim provision, explicit or implicit, there is an associated risk. In a falling-rate scenario, the manager may have higher coupon payments halted and receive principal, as is the case with mortgage-backed securities. Mortgage-backed securities thus have contingent claims risk. Fixed-rate corporate bullet bonds do not have contingent claims risk.

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The strategy that is most likely to benefit from the environment described by Monts in Statement 3 is to:

[ "A. rotate from consumer non-cyclical to consumer cyclical sectors.", "B. increase exposure to the crossover sector.", "C. shift the portfolio’s positions to shorter duration corporate bonds." ]

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C

Answer = C. Curve-adjustment trades take place when the portfolio manager expects credit spreads will widen (either overall or in a particular sector). The specific strategy is to shift the portfolio’s exposure to shorten spread duration by selling longer maturity corporate bonds and buying shorter maturity bonds, which lowers the contribution to spread duration.

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Is Monts’s Statement 4 most likely correct

[ "A. No, because callable bonds would underperform", "B. No, because putable bonds would not provide protection", "C. Yes" ]

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A

Answer = A. Callable bonds significantly underperform non-callable bonds when interest rates decline because of their negative convexity. When the bond market rallies, callable structures do not fully participate given the upper boundary imposed by call prices.

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WM’s current allocation to alternative investments is presented in Exhibit 1. Quest states the justification for the allocation: “I believe that the alternative investments we have provide good liquidity and strong portfolio diversification for the remainder of the portfolio, which consists of equities and fixed income.” <image_1> DPAM is the manager of a managed futures fund that seeks to achieve a positive absolute return. DPAM’s chief investment officer, Randall Duke, is preparing a report for his first meeting with WM’s investment committee. Knowing that WM’s investment committee is less familiar with real assets than with equities and fixed income, he includes the following exhibits. Exhibit 2 shows information on DPAM’s portfolio positions in Canadian dollars (C$). <image_2> Exhibit 3 provides information on current delivery month prices of selected commodity contracts. <image_3> Duke calls Quest to ensure that his report addresses any questions the committee may have. Quest tells him, There are a few questions we would like you to address in your report: Question 1. Could you explain why using managed futures is more beneficial to us than using an unleveraged exchange-listed commodity index fund? Question 2. The endowment has to support WM’s long-term operation, which has seen its costs rising steadily over the past decade. In view of that, would it not be better for our managed futures portfolio to have a larger weighting in energy commodities, such as the crude oil position, and to eliminate agricultural commodities, such as wheat? Question 3. Some of the committee members are considering adding commodities and other alternative investments to their own personal portfolios. We know you are knowledgeable about the institutional investment due diligence process. From the perspective of private investors, what due diligence questions would our members have in common with the WM endowment? Duke answers: My report already answers your first question. In answer to Question 2, I believe the retention of agricultural commodities in the portfolio can be justified as follows: Justification 1: Agricultural commodities can increase expected return relative to a portfolio composed of only traditional investments. Justification 2: Agricultural commodities typically provide an expected offset to losses in such assets as conventional debt instruments in times of unexpected inflation. Justification 3: Agricultural commodities are a natural source of return, reflecting economic fundamentals over the long term. If the committee members want to personally invest in alternative investments, the following are due diligence considerations that must be evaluated by both institutional and private investors: Consideration 1: Market opportunity Consideration 2: Determine suitability Consideration 3: Potential for decision risk.

Quest's justification for the alternative investments in the WM portfolio is most likely correct with respect to

[ "A. private equity.", "B. real estate.", "C. hedge funds." ]

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B

Answer = B. The real estate investment is in REITs, which are publicly traded securities and liquid. REITs can also provide diversification benefits when included in a portfolio of traditional investments, such as stocks and bonds. Private equity investments have low liquidity and provide low diversification benefits. Hedge funds provide strong diversification benefits but have low liquidity.

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nan

Based on Exhibit 2, which position most likely represents an indirect commodity investment?

[ "A. Position 1", "B. Position 2", "C. Position 3" ]

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B

Answer = B. Position 2 is an indirect commodity investment. The Global Energy Equity Index Fund, although correlated with commodity price movements, is not a direct exposure to commodities because it is made up of stocks.

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Based on Exhibits 2 and 3, assuming a 5% increase in prices for each underlying asset in the next 12 months, DPAM will most likely obtain the largest roll return from:

[ "A. Position 5.", "B. Position 3.", "C. Position 4." ]

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B

Answer = B. Position 3 would provide the largest roll return. A long position in backwardation will produce a greater roll return than a position in contango if the price increases. In backwardation, futures prices with a longer time to maturity are lower than the current spot price. In contango, the futures price is greater than the spot price. The backwardation in the wheat futures is greater than that in Australian dollars and thus has a greater roll return.

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nan

Duke's response to Question 1 would least likely include that

[ "A. managed futures have a low cost structure.", "B. the index fund only earns the risk-free rate minus costs in the long term.", "C. managed futures take advantage of rising and falling markets." ]

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A

Answer = A. Managed futures do not have a low cost structure. The compensation arrangement for managed futures is similar to hedge funds. Thus, it is not true to say that they have a low cost structure compared with index funds.

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nan

When justifying the inclusion of agricultural commodities in the portfolio, Duke is least likely correct in

[ "A. Justification 1.", "B. Justification 3.", "C. Justification 2." ]

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A

Answer = A. Agricultural commodities do not necessarily increase the expected portfolio return. Although somewhat less so for agricultural commodities than for energy, one of the principal roles that have been suggested for commodities in portfolios is as an inflation hedge during times of unexpected inflation and as a source of natural return over the longer term. The ability of commodities to increase expected return relative to a portfolio of traditional and other alternative investments is ambiguous.

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nan

Which of Duke's three due diligence items would more likely be evaluated by an individual investor rather than by an institutional investor

[ "A. Consideration 1", "B. Consideration 3", "C. Consideration 2" ]

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B

Answer = B. Consideration 3 would be more likely to be evaluated by an individual investor. Decision risk is the risk of changing strategies at the point of maximum loss. Private clients can be acutely sensitive to positions of loss at stages prior to an investment policy statement's stated time horizon. Although the determination of suitability can be more complex for a private investor, it must be done for both, just as the market opportunity must also be determined.

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Beatriz Anton is the chief compliance officer at Long Pond Advisers, an asset management firm catering to institutional investors. Long Pond is not currently GIPS compliant, but Anton would like to market the firm as being compliant as soon as possible. To assist Anton in achieving compliance, she hires Ana Basco from Nantucket Advisers to provide guidance on achieving compliance. At their initial meeting to discuss a framework for the implementation of GIPS standards, Anton asks Basco what she believes the fundamentals of GIPS compliance encompass. Basco responds, A good starting point is input data because the Standards rely on the integrity of input data to accurately calculate results. Portfolios must be valued in accordance with the definition of fair value, not cost or book values. In fact, fair value supersedes market value. Transactions are reflected in the portfolio at settlement when the exchange of cash, securities, and paperwork involved in a transaction is completed. Accrual accounting is used for fixed-income securities and all other assets that accrue interest income; dividend-paying equities accrue dividends on the ex-dividend date. Basco then asks Anton about Long Pond’s policies for return calculation methodologies. Anton responds that she has recently implemented the following polices: Policy 1: Total return is calculated for portfolios using time-weighted rates of return computed by geometrically linking the periodic returns. Both realized and unrealized gains and losses are used in the calculation. Policy 2: Large- and mid-cap equity portfolios are revalued on the date when capital equal to 10% or more of current market value is contributed or withdrawn. Small-cap and fixed-income portfolios use a 5% threshold. Policy 3: Cash and cash equivalents are excluded in total return calculations. Custody fees are not considered direct transaction costs. Returns are calculated after deduction of trading expenses. Their conversation turns to the construction of composites and composite return calculations. Anton tells Basco: Long Pond calculates composite returns by asset weighting the individual portfolio returns using beginning-of-period values. For periods beginning 1 January 2010, we calculate composite returns by asset weighting the individual portfolio returns quarterly. All actual fee-paying, discretionary portfolios are included in at least one composite. Non-fee-paying discretionary portfolios are also included in a composite, and appropriate disclosures are provided. Client portfolios that restrict the purchase of certain securities are excluded if this restriction hinders the portfolio manager’s ability to execute the investment strategy. We consider a hierarchical structure of criteria for composite definition that promotes primary and secondary strategy characteristics, such as asset classes, styles, benchmarks, and risk/return characteristics. The composites are not always defined according to each level of the hierarchy. Anton then provides Basco with a recent presentation to a prospective client for Long Pond’s mid-capitalization composite. Details of this presentation are found in Exhibit 1. <image_1> Notes: 1. Long Pond is an independent investment firm founded in May 1998 and has a single office in Seattle, WA. The firm manages portfolios in various equity, fixed-income, and real estate strategies. 2. The composite has an inception date of 31 December 2001. A complete list and description of firm composites is available on request. 3. The composite includes all fee-paying discretionary, non-taxable portfolios that follow a mid-cap strategy. The composite does not include any non-fee-paying portfolios. 4. First quarter 2013 (1Q13) data are not annualized. 5. Valuations are computed and performance reported in US dollars. 6. Internal dispersion is calculated using the equal-weighted standard deviation of all portfolios that were included in the composite for the entire year. 7. Gross-of-fees performance returns are presented before management and custodial fees but after all trading expenses. The management fee schedule is as follows: 1.00% on first $25 million; 0.60% thereafter. Net-of-fees performance returns are calculated by deducting the management fee of 0.25% from the monthly gross composite return. Anton concludes by describing Long Pond’s real estate composite valuation practices to Basco: Since 1 January 2011, Long Pond uses fair value for real estate holdings calculated annually and has an external expert value the properties every 36 months. For periods before 1 January 2011, however, we used market values. We calculate income returns and capital returns separately using geometrically linked time-weighted rates of return and composite returns by asset-weighting the individual portfolio returns at least quarterly.

In her statement regarding input data, Basco is least likely correct with respect to:

[ "A. fair value.", "B. settlement date accounting.", "C. accrual accounting." ]

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B

Answer = B. The GIPS standards require that firms use trade-date accounting for the purpose of performance measurement for periods beginning 1 January 2005 (Provision I.1.A.5). The principle behind requiring trade-date accounting is to ensure that no significant lag occurs between a trade's execution and its reflection in the portfolio's performance.

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Based on Exhibit 1 and the notes following the table, Long Pond is least likely in compliance with GIPS standards with regard to the:

[ "A. measure of internal dispersion.", "B. length of performance record.", "C. presentation of 1Q13 performance." ]

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B

Answer = B. Long Pond is required by the GIPS standards to present five years of performance because the composite has been in existence for that period. The mid-cap composite was started on 31 December 2001; therefore, performance for 2008 must be presented. After presenting 5 years of performance, the firm should present additional annual performance up to 10 years.

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Regarding the disclosures contained in Exhibit 1, the GIPS standards would most likely

[ "A. require Columns 3 and 7 and recommend Column 6.", "B. require Column 6 and recommend Columns 4 and 7.", "C. require Columns 2 and 5 and recommend Column 1." ]

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C

Answer = C. The presentation of firm assets (or percentage of firm assets represented by the composite) is required. Firms are required to present either net-of-fees performance or gross-of-fees performance. If one or the other is presented, then it is recommended that the remaining also be presented. For example, if net-of-fees performance is disclosed, then it is recommended that gross-of-fees performance also be disclosed.

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Rebecca Mayer is an asset management consultant for institutions and high-net-worth individuals. Mayer meets with Sebastian Capara, the newly appointed Investment Committee chairman for the Kinkardeen University Endowment (KUE), a very large tax-exempt fund. Capara and Mayer review KUE’s current and strategic asset allocations, which are presented in Exhibit 1. Capara informs Mayer that over the last few years, Kinkardeen University has financed its operations primarily from tuition, with minimal need of financial support from KUE. Enrollment at the University has been rising in recent years, and the Board of Trustees expects enrollment growth to continue for the next five years. Consequently, the board expects very modest endowment support to be needed during that time. These expectations led the Investment Committee to approve a decrease in the endowment’s annual spending rate starting in the next fiscal year. <image_1> As an additional source of alpha, Mayer proposes tactically adjusting KUE’s asset-class weights to profit from short-term return opportunities. To confirm his understanding of tactical asset allocation (TAA), Capara tells Mayer the following: Statement 1 The Sharpe ratio is suitable for measuring the success of TAA relative to SAA. Statement 2 Discretionary TAA attempts to capture asset-class-level return anomalies that have been shown to have some predictability and persistence. Statement 3 TAA allows a manager to deviate from the IPS asset-class upper and lower limits if the shift is expected to produce higher expected risk-adjusted returns. Capara asks Mayer to recommend a TAA strategy based on excess return forecasts for the asset classes in KUE’s portfolio, as shown in Exhibit 2. <image_2> Following her consultation with Capara, Mayer meets with Roger Koval, a member of a wealthy family. Although Koval’s baseline needs are secured by a family trust, Koval has a personal portfolio to fund his lifestyle goals. In Koval’s country, interest income is taxed at progressively higher income tax rates. Dividend income and long-term capital gains are taxed at lower tax rates relative to interest and earned income. In taxable accounts, realized capital losses can be used to offset current or future realized capital gains. Koval is in a high tax bracket, and his taxable account currently holds, in equal weights, high-yield bonds, investment-grade bonds, and domestic equities focused on long-term capital gains. Koval asks Mayer about adding new asset classes to the taxable portfolio. Mayer suggests emerging markets equity given its positive short-term excess return forecast. However, Koval tells Mayer he is not interested in adding emerging markets equity to the account because he is convinced it is too risky. Koval justifies this belief by referring to significant losses the family trust suffered during the recent economic crisis. Mayer also suggests using two mean–variance portfolio optimization scenarios for the taxable account to evaluate potential asset allocations. Mayer recommends running two optimizations: one on a pre-tax basis and another on an after-tax basis.

Based on Exhibits 1 and 2, to attempt to profit from the short-term excess return forecast, Capara should increase KUE’s portfolio allocation to:

[ "A. developed markets equity and decrease its allocation to infrastructure", "B. emerging markets equity and decrease its allocation to investment-grade bonds", "C. developed markets equity and increase its allocation to private real estate equity" ]

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A

A is correct. The forecast for expected excess returns is positive for developed markets equity and negative for infrastructure. Therefore, to attempt to profit from the short-term excess return forecast, KUE can overweight developed markets equity and underweight infrastructure. These adjustments to the asset-class weights are within KUE’s lower and upper policy limits.

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Given Koval’s current portfolio and the tax laws of the country in which he lives, Koval’s portfolio would be more tax efficient if he reallocated his taxable account to hold more

[ "A. high-yield bonds", "B. investment-grade bonds", "C. domestic equities focused on long-term capital gain opportunities." ]

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C

C is correct. As a general rule, the portion of a taxable asset owner’s assets that are eligible for lower tax rates and deferred capital gains tax treatment should first be allocated to the investor’s taxable accounts. Assets that generate returns mainly from interest income tend to be less tax efficient and in Koval’s country are taxed at progressively higher rates. Also, the standard deviation (volatility) of after-tax returns is lower when equities are held in a taxable account. Therefore, Koval’s taxable account would become more tax efficient if it held more domestic equities focused on long-term capital gain opportunities.

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Aline Nuñes, a junior analyst, works in the derivatives research division of an international securities firm. Nuñes’s supervisor, Cátia Pereira, asks her to conduct an analysis of various option trading strategies relating to shares of three companies: IZD, QWY, and XDF. On 1 February, Nuñes gathers selected option premium data on the companies, presented in Exhibit 1. <image_1> Nuñes considers the following option strategies relating to IZD: Strategy 1: Constructing a synthetic long put position in IZD Strategy 2: Buying 100 shares of IZD and writing the April €95.00 strike call option on IZD Strategy 3: Implementing a covered call position in IZD using the April €97.50 strike option Nuñes next reviews the following option strategies relating to QWY: Strategy 4: Implementing a protective put position in QWY using the April €25.00 strike option Strategy 5: Buying 100 shares of QWY, buying the April €24.00 strike put option, and writing the April €31.00 strike call option Strategy 6: Implementing a bear spread in QWY using the April €25.00 and April €31.00 strike options Finally, Nuñes considers two option strategies relating to XDF: Strategy 7: Writing both the April €75.00 strike call option and the April €75.00 strike put option on XDF Strategy 8: Writing the February €80.00 strike call option and buying the December €80.00 strike call option on XDF

Based on Exhibit 1, Nuñes should expect Strategy 2 to be least profitable if the share price of IZD at option expiration is:

[ "A. less than €91.26", "B. between €91.26 and €95.00", "C. more than €95.00" ]

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A

A is correct. Strategy 2 is a covered call, which is a combination of a long position in shares and a short call option. The breakeven point of Strategy 2 is €91.26, which represents the price per share of €93.93 minus the call premium received of €2.67 per share (S0 – c0). So, at any share price less than €91.26 at option expiration, Strategy 2 incurs a loss. If the share price of IZD at option expiration is greater than €91.26, Strategy 2 generates a gain.

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Based on Exhibit 1, the breakeven share price of Strategy 3 is closest to:

[ "A. €92.25", "B. €95.61", "C. €95.82" ]

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A

A is correct. Strategy 3 is a covered call strategy, which is a combination of a long position in shares and a short call option. The breakeven share price for a covered call is the share price minus the call premium received, or S0 – c0. The current share price of IZD is €93.93, and the IZD April €97.50 call premium is €1.68. Thus, the breakeven underlying share price for Strategy 3 is S0 – c0 = €93.93 – €1.68 = €92.25.

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Based on Exhibit 1, the maximum loss per share that would be incurred by implementing Strategy 4 is:

[ "A. €2.99", "B. €3.99", "C. unlimited" ]

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B

B is correct. Strategy 4 is a protective put position, which is a combination of a long position in shares and a long put option. By purchasing the €25.00 strike put option, Nuñes would be protected from losses at QWY share prices of €25.00 or lower. Thus, the maximum loss per share from Strategy 4 would be the loss of share value from €28.49 to €25.00 (or €3.49) plus the put premium paid for the put option of €0.50: S0 – X + p0 = €28.49 – €25.00 + €0.50 = €3.99.

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Based on Exhibit 1, Strategy 5 offers:

[ "A. unlimited upside", "B. a maximum profit of €2.48 per share", "C. protection against losses if QWY’s share price falls below €28.14" ]

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B

B is correct. Strategy 5 describes a collar, which is a combination of a long position in shares, a long put option, and a short call option. Strategy 5 would require Nuñes to buy 100 QWY shares at the current market price of €28.49 per share. In addition, she would purchase a QWY April €24.00 strike put option contract for €0.35 per share and collect €0.32 per share from writing a QWY April €31.00 strike call option. The collar offers protection against losses on the shares below the put strike price of €24.00 per share, but it also limits upside to the call strike price of €31.00 per share. Thus, the maximum gain on the trade, which occurs at prices of €31.00 per share or higher, is calculated as (X2 – S0) – p0 + c0, or (€31.00 – €28.49) – €0.35 + €0.32 = €2.48 per share.

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Based on Exhibit 1, the breakeven share price for Strategy 6 is closest to:

[ "A. €22.50", "B. €28.50", "C. €33.50" ]

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B

B is correct. Strategy 6 is a bear spread, which is a combination of a long put option and a short put option on the same underlying, where the long put has a higher strike price than the short put. In the case of Strategy 6, the April €31.00 put option would be purchased and the April €25.00 put option would be sold. The long put premium is €3.00 and the short put premium is €0.50, for a net cost of €2.50. The breakeven share price is €28.50, calculated as XH – (pH – pL) = €31.00 – (€3.00 – €0.50) = €28.50.

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Based on Exhibit 1, the maximum gain per share that could be earned if Strategy 7 is implemented is:

[ "A. €5.74", "B. €5.76", "C. unlimited" ]

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B

B is correct. Strategy 7 describes a short straddle, which is a combination of a short put option and a short call option, both with the same strike price. The maximum gain is €5.76 per share, which represents the sum of the two option premiums, or c0 + p0 = €2.54 + €3.22 = €5.76. The maximum gain per share is realized if both options expire worthless, which would happen if the share price of XDF at expiration is €75.00.

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Based on Exhibit 1, the best explanation for Nuñes to implement Strategy 8 would be that, between the February and December expiration dates, she expects the share price of XDF to:

[ "A. decrease", "B. remain unchanged", "C. increase" ]

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C

C is correct. Nuñes would implement Strategy 8, which is a long calendar spread, if she expects the XDF share price to increase between the February and December expiration dates. This strategy provides a benefit from the February short call premium to partially offset the cost of the December long call option. Nuñes likely expects the XDF share price to remain relatively flat between the current price €74.98 and €80 until the February call option expires, after which time she expects the share price to increase above €80. If such expectations come to fruition, the February call would expire worthless and Nuñes would realize gains on the December call option.

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Stanley Kumar Singh is the risk manager at SKS Asset Management. He works with individual clients to manage their investment portfolios. One client, Sherman Hopewell, is worried about how short- term market fluctuations over the next three months might impact his equity position in Walnut Corporation. Although Hopewell is concerned about short- term downside price movements, he wants to remain invested in Walnut shares because he remains positive about its long- term performance. Hopewell has asked Singh to recommend an option strategy that will keep him invested in Walnut shares while protecting against a short- term price decline. Singh gathers the information in Exhibit-1 to explore various strategies to address Hopewell’s concerns. Another client, Nigel French, is a trader who does not currently own shares of Walnut Corporation. French has told Singh that he believes that Walnut shares will experience a large move in price after the upcoming quarterly earnings release in two weeks. French also tells Singh, however, that he is unsure which direction the stock will move. French asks Singh to recommend an option strategy that would allow him to profit should the share price move in either direction. A third client, Wanda Tills, does not currently own Walnut shares and has asked Singh to explain the profit potential of three strategies using options in Walnut: a long straddle, a bull call spread, and a bear put spread. In addition, Tills asks Singh to explain the gamma of a call option. In response, Singh prepares a memo to be shared with Tills that provides a discussion of gamma and presents his analysis on three option strategies: Strategy 1: A long straddle position at the $67.50 strike option Strategy 2: A bull call spread using the $65 and $70 strike options Strategy 3: A bear put spread using the $65 and $70 strike options <image_1>

Based on Exhibit 1, Strategy 1 is profitable when the share price at expiration is closest to:

[ "A. $63.00", "B. $65.24", "C. $69.49" ]

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A

A is correct. The straddle strategy consists of simultaneously buying a call option and buying a put option at the same strike price. The market price for the $67.50 call option is $1.99, and the market price for the $67.50 put option is $2.26, for an initial net cost of $4.25 per share. Thus, this straddle position requires a move greater than $4.25 in either direction from the strike price of $67.50 to become profitable. So, the straddle becomes profitable at $67.50 – $4.26 = $63.24 or lower, or $67.50 + $4.26 = $71.76 or higher. At $63.00, the profit on the straddle is positive.

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Based on Exhibit 1, the maximum profit, on a per share basis, from investing in Strategy 2, is closest to:

[ "A. $2.26", "B. $2.74", "C. $5.00" ]

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A

A is correct. The bull call strategy consists of buying the lower-strike option and selling the higher-strike option. The purchase of the $65 strike call option costs $3.65 per share, and selling the $70 strike call option generates an inflow of $0.91 per share, for an initial net cost of $2.74 per share. At expiration, the maximum profit occurs when the stock price is $70 or higher, which yields a $5.00 per share payoff ($70 – $65) on the long call position. After deduction of the $2.74 per share cost required to initiate the bull call spread, the profit is $2.26 ($5.00 – $2.74).

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Based on Exhibit 1, and assuming the market price of Walnut’s shares at expiration is $66, the profit or loss, on a per share basis, from investing in Strategy 3, is closest to:

[ "A. $2.36", "B. $1.64", "C. $2.64" ]

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B

B is correct. The bear put spread consists of buying a put option with a high strike price ($70) and selling another put option with a lower strike price ($65). The market price for the $70 strike put option is $3.70, and the market price for the $65 strike put option is $1.34 per share. Thus, the initial net cost of the bear spread position is $3.70 – $1.34 = $2.36 per share. If Walnut shares are $66 at expiration, the $70 strike put option is in the money by $4.00, and the short position in the $65 strike put expires worthless. After deducting the cost of $2.36 to initiate the bear spread position, the net profit is $1.64 per contract.

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Based on the data in Exhibit 1, Singh would advise Tills that the call option with the largest gamma would have a strike price closest to:

[ "A. $ 55.00", "B. $ 67.50", "C. $ 80.00" ]

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B

B is correct. The $67.50 call option is approximately at the money because the Walnut share price is currently $67.79. Gamma measures the sensitivity of an option’s delta to a change in the underlying. The largest gamma occurs when options are trading at the money or near expiration, when the deltas of such options move quickly toward 1.0 or 0.0. Under these conditions, the gammas tend to be largest and delta hedges are hardest to maintain.

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Anneke Ngoc is an analyst who works for an international bank, where she advises high-net- worth clients on option strategies. Ngoc prepares for a meeting with a US-based client, Mani Ahlim. Ngoc notes that Ahlim recently inherited an account containing a large Brazilian real (BRL) cash balance. Ahlim intends to use the inherited funds to purchase a vacation home in the United States with an expected purchase price of US$750,000 in six months. Ahlim is concerned that the Brazilian real will weaken against the US dollar over the next six months. Ngoc considers potential hedge strategies to reduce the risk of a possible adverse currency movement over this time period. Ahlim holds shares of Pselftarô Ltd. (PSÔL), which has a current share price of $37.41. Ahlim is bullish on PSÔL in the long term. He would like to add to his long position but is concerned about a moderate price decline after the quarterly earnings announcement next month, in April. Ngoc recommends a protective put position with a strike price of $35 using May options and a $40/$50 bull call spread using December options. Ngoc gathers selected PSÔL option prices for May and December, which are presented in Exhibit 1. <image_1> Ahlim also expresses interest in trading options on India’s NIFTY 50 (National Stock Exchange Fifty) Index. Ngoc gathers selected one-month option prices and implied volatility data, which are presented in Exhibit 2. India’s NIFTY 50 Index is currently trading at a level of 11,610. <image_2> Ngoc reviews a research report that includes a one-month forecast of the NIFTY 50 Index. The report’s conclusions are presented in Exhibit 3. <image_3> Based on these conclusions, Ngoc considers various NIFTY 50 Index option strategies for Ahlim.

Based on Exhibit 1, the maximum loss per share of Ngoc’s recommended PSÔL protective put position is:

[ "A. $0.60", "B. $2.41", "C. $4.22" ]

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C

C is correct. Ngoc recommends a protective put position with a strike price of $35 using May options. The maximum loss per share on the protective put is calculated as Maximum loss per share of protective put = S0 − X + p0. Maximum loss per share of protective put = $37.41 − $35.00 + $1.81 = $4.22. In summary, with the protective put in place, Ahlim is protected against losses below $35.00. Thus, taking into account the put option purchase price of $1.81, Ahlim’s maximum loss occurs at the share price of $33.19, resulting in a maximum loss of $4.22 per share (= $37.41 – $33.19). A is incorrect because $0.60 reflects incorrectly subtracting (rather than adding) the put premium in the calculation of the maximum loss of protective put (i.e., $37.41 − $35.00 − $1.81 = $0.60). B is incorrect because $2.41 does not include the put premium in the calculation but only reflects the difference between the current share price ($37.41) and the put exercise price ($35.00).

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Based on Exhibit 1, the breakeven price per share of Ngoc’s recommended PSÔL protective put position is:

[ "A. $35.60", "B. $36.81", "C. $39.22" ]

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C

C is correct. Ngoc recommends a protective put position with a strike price of $35 using May options. The breakeven price per share on the protective put is calculated as Breakeven price per share of protective put = S0 + p0. Breakeven price per share of protective put = $37.41 + $1.81 = $39.22. In summary, Ahlim would need PSÔL’s share price to rise by the price of the put option ($1.81) from the current price of $37.41 to reach the breakeven share price—the price at which the gain from the increase in the value of the stock offsets the purchase price of the put option. A is incorrect because $35.60 represents incorrectly subtracting (rather than adding) the put premium in the calculation of the protective put breakeven price: $37.41 − $1.81 = $35.60. B is incorrect because $36.81 represents incorrectly adding the put premium to the strike price (not the current share price): $35.00 + $1.81 = $36.81.

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Based on Exhibit 1, the maximum profit per share of Ngoc’s recommended PSÔL bull call spread is:

[ "A. $2.25", "B. $7.75", "C. $12.25" ]

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B

B is correct. Ngoc recommends a $40/$50 bull call spread using December options. To construct this spread, Ahlim would buy the $40 call, paying the $6.50 premium, and simultaneously sell the $50 call, receiving a premium of $4.25. The maximum gain or profit of a bull call spread occurs when the stock price reaches the high exercise price ($50) or higher at expiration. Thus, the maximum profit per share of a bull call spread is the spread difference between the strike prices less the net premium paid, calculated as Maximum profit per share of bull call spread = (XH – XL) – (cL – cH). Maximum profit per share of bull call spread = ($50 – $40) – ($6.50 – $4.25). Maximum profit per share of bull call spread = $7.75. A is incorrect because $2.25 represents only the net premium and does not include the spread difference. C is incorrect because $12.25 represents the net premium being incorrectly added (rather than subtracted) from the spread difference.

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Based on Exhibit 1, the breakeven price per share of Ngoc’s recommended PSÔL bull call spread is:

[ "A. $42.25", "B. $47.75", "C. $52.25" ]

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A

A is correct. Ngoc recommends a $40/$50 bull call spread using December options. To construct this spread, Ahlim would buy the $40 call, paying a $6.50 premium, and simultaneously sell the $50 call, receiving a $4.25 premium. The breakeven price per share of a bull call spread is calculated as Breakeven price per share of bull call spread = XL + (cL – cH). Breakeven price per share of bull call spread = $40 + ($6.50 – $4.25). Breakeven price per share of bull call spread = $42.25. In summary, in order to break even, the PSÔL stock price must rise above $40 by the amount of the net premium paid of $2.25 to enter into the bull call spread. At the price of $42.25, the lower $40 call option would have an exercise value of $2.25, exactly offsetting the $2.25 cost of entering the trade. B is incorrect because $47.75 represents the net premium being incorrectly subtracted from the high exercise price (rather than being added to the low exercise price): $50 – ($6.50 – $4.25) = $47.75. C is incorrect because $52.25 represents the net premium being added to the high exercise price (rather than the low exercise price): $50 + ($6.50 – $4.25) = $52.25.

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Based on Exhibit 2, the NIFTY 50 Index implied volatility data most likely indicate a:

[ "A. risk reversal", "B. volatility skew", "C. volatility smile" ]

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B

B is correct. When the implied volatility decreases for OTM (out-of- the- money) calls relative to ATM (at-the- money) calls and increases for OTM puts relative to ATM puts, a volatility skew exists. Put volatility is higher, rising from 16.44 ATM to 17.72 OTM, likely because of the higher demand for puts to hedge positions in the index against downside risk. Call volatility decreases from 12.26 for ATM calls to 11.98 for OTM calls since calls do not offer this valuable portfolio insurance. A is incorrect because a risk reversal is a delta-hedged trading strategy seeking to profit from a change in the relative volatility of calls and puts. C is incorrect because a volatility smile exists when both call and put volatilities, not just put volatilities, are higher OTM than ATM.

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Based on Exhibit 3, which of the following NIFTY 50 Index option strategies should Ngoc recommend to Ahlim?

[ "A. Buy a straddle", "B. Buy a call option", "C. Buy a calendar spread" ]

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A

A is correct. The research report concludes that the consensus forecast of the implied volatility of index options is too low and anticipates greater-than- expected volatility over the next month. Given the neutral market direction forecast, Ngoc should recommend a long straddle, which entails buying a one-month 11,600 call and buying a one-month put with the same exercise price. If the future NIFTY 50 Index level rises above its current level plus the combined cost of the call and put premiums, Ahlim would exercise the call option and realize a profit. Similarly, if the index level falls below the current index level minus the combined cost of the call and put premiums, Ahlim would exercise the put option and realize a profit. Thus, Ahlim profits if the index moves either up or down enough to pay for the call and put premiums. B is incorrect because the strategy to buy a call option would be reasonable given an increase in expected implied volatility with a bullish NIFTY 50 Index forecast, not a neutral trading range. C is incorrect because a long calendar spread is based on the expectation that implied volatility will remain unchanged, not increase, until the expiry of the shorter-term option.

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Guten Investments GmbH, based in Germany and using the EUR as its reporting currency, is an asset management firm providing investment services for local high net worth and institutional investors seeking international exposures. The firm invests in the Swiss, UK, and US markets, after conducting fundamental research in order to select individual investments. Exhibit 1 presents recent information for exchange rates in these foreign markets. <image_1> In prior years, the correlation between movements in the foreign-currency asset returns for the USD-denominated assets and movements in the exchange rate was estimated to be +0.50. After analyzing global financial markets, Konstanze Ostermann, a portfolio manager at Guten Investments, now expects that this correlation will increase to +0.80, although her forecast for foreign-currency asset returns is unchanged. Ostermann believes that currency markets are efficient and hence that long-run gains cannot be achieved from active currency management, especially after netting out management and transaction costs. She uses this philosophy to guide hedging decisions for her discretionary accounts, unless instructed otherwise by the client. Ostermann is aware, however, that some investors hold an alternative view on the merits of active currency management. Accordingly, their portfolios have different investment guidelines. For these accounts, Guten Investments employs a currency specialist firm, Umlauf Management, to provide currency overlay programs specific to each client’s investment objectives. For most hedging strategies, Umlauf Management develops a market view based on underlying fundamentals in exchange rates. However, when directed by clients, Umlauf Management uses options and a variety of trading strategies to unbundle all of the various risk factors (the “Greeks”) and trade them separately. Ostermann conducts an annual review for three of her clients and gathers the summary information presented in Exhibit 2. <image_2>

Based on Exhibit 1, the domestic-currency return over the last year (measured in EUR terms) was higher than the foreign-currency return for:

[ "A. USD-denominated assets", "B. GBP-denominated assets", "C. CHF-denominated assets" ]

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C

C is correct. The domestic-currency return is a function of the foreign-currency return and the percentage change of the foreign currency against the domestic currency. Mathematically, the domestic-currency return is expressed as: $R_DC = (1 + R_FC)(1 + R_FX) – 1$ where $R_DC$ is the domestic-currency return (in percent), $R_FC$ is the foreign-currency return, and $R_FX$ is the percentage change of the foreign currency against the domestic currency. Note that this RFX expression is calculated using the investor’s domestic currency (the EUR in this case) as the price currency in the P/B quote. This is different than the market-standard currency quotes in Exhibit 1, where the EUR is the base currency in each of these quotes. Therefore, for the foreign currency (USD, GBP, or CHF) to appreciate against the EUR, the market-standard quote (USD/EUR, GBP/EUR, or CHF/EUR, respectively) must decrease; i.e. the EUR must depreciate. The Euro-Swiss (CHF/EUR) is the only spot rate with a negative change (from 1.2175 to 1.2080), meaning the EUR depreciated against the CHF (the CHF/ EUR rate decreased). Or put differently, the CHF appreciated against the EUR, adding to the EUR-denominated return for the German investor holding CHF-denominated assets. This would result in a higher domestic-currency return (RDC), for the German investor, relative to the foreign-currency return (RFC) for the CHF-denominated assets. Both the Euro-dollar (USD/EUR) and Euro-sterling (GBP/EUR) experienced a positive change in the spot rate, meaning the EUR appreciated against these two currencies (the USD/EUR rate and the GBP/EUR rate both increased). This would result in a lower domestic-currency return (RDC) for the German investor relative to the foreign-currency return (RFC) for the USD- and GBP-denominated assets.

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Based on Exhibit 2, the currency overlay program most appropriate for Braunt Pensionskasse would:

[ "A. be fully passive", "B. allow limited directional views", "C. actively manage foreign exchange as an asset class" ]

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B

B is correct. Braunt Pensionskasse provides the manager with limited discretion in managing the portfolio’s currency risk exposures. This would be most consistent with allowing the currency overlay manager to take directional views on future currency movements (within predefined bounds) where the currency overlay is limited to the currency exposures already in the foreign asset portfolio. It would not be appropriate to use a fully-passive hedging approach since it would eliminate any alpha from currency movements. Further, a currency overlay program, which considers “foreign exchange as an asset class”, would likely expose Braunt’s portfolio to more currency risk than desired given the given primary performance objectives.

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Based on Exhibit 2, the client most likely to benefit from the introduction of an additional overlay manager is:

[ "A. Adele Kastner", "B. Braunt Pensionskasse", "C. Franz Trading GmbH" ]

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C

C is correct. The primary performance objective of Franz Trading GmbH is to add alpha to the portfolio, and thus has given the manager discretion in trading currencies. This is essentially a “foreign exchange as an asset class” approach. Braunt Pensionskasse and Kastner have more conservative currency strategies, and thus are less likely to benefit from the different strategies that a new overlay manager might employ. A is incorrect because Franz Trading GmbH is more likely to benefit from the introduction of an additional overlay manager. Kastner is more likely to have a fully passive currency overlay program. B is incorrect because Franz Trading GmbH is more likely to benefit from the introduction of an additional overlay manager. Braunt is more likely to have a currency overlay program where the manager takes a directional view on future currency movements.

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Cécile is a junior analyst for an international wealth management firm. Her supervisor, Margit, asks Cécile to evaluate three fixed-income funds as part of the firm’s global fixed-income offerings. Selected financial data for the funds Aschel, Permot, and Rosaiso are presented in Exhibit 1. In Cécile’s initial review, she assumes that there is no reinvestment income and that the yield curve remains unchanged. <image_1> After further review of the composition of each of the funds, Cécile makes the following notes: Note 1 Aschel is the only fund of the three that uses leverage. Note 2 Rosaiso is the only fund of the three that holds a significant number of bonds with embedded options. Margit asks Cécile to analyze liability-based mandates for a meeting with Villash Foundation. Villash Foundation is a tax-exempt client. Prior to the meeting, Cécile identifies what she considers to be two key features of a liability-based mandate. Feature 1 It can minimize the risk of deficient cash inflows for a company. Feature 2 It matches expected liability payments with future projected cash inflows. Two years later, Margit learns that Villash Foundation needs $5 million in cash to meet liabilities. She asks Cécile to analyze two bonds for possible liquidation. Selected data on the two bonds are presented in Exhibit 2. <image_2>

Based on Exhibit 1, which fund provides the highest level of protection against inflation for coupon payments?

[ "A. Aschel", "B. Permot", "C. Rosaiso" ]

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B

B is correct. Permot has the highest percentage of floating-coupon bonds and inflation-linked bonds. Bonds with floating coupons protect interest income from inflation because the reference rate should adjust for inflation. Inflation-linked bonds protect against inflation by paying a return that is directly linked to an index of consumer prices and adjusting the principal for inflation. Inflation-linked bonds protect both coupon and principal payments against inflation. The level of inflation protection for coupons equals the percentage of the portfolio in floating-coupon bonds plus the percentage of the portfolio in inflation-linked bonds: Aschel = 2% + 3% = 5%. Permot = 34% + 28% = 62%. Rosaiso = 17% + 21% = 38%. Thus, Permot has the highest level of inflation protection, with 62% of its portfolio in floating-coupon and inflation-linked bonds.

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Based on Exhibit 1, the rolling yield of Aschel over a one-year investment horizon is closest to: <image_3>

[ "A. –2.56%", "B. 0.54%", "C. 5.66%" ]

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B

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Based on Exhibit 2, the optimal strategy to meet Villash Foundation’s cash needs is the sale of:

[ "A. 100% of Bond 1", "B. 100% of Bond 2", "C. 50% of Bond 1 and 50% of Bond 2" ]

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A

A is correct. The optimal strategy for Villash is the sale of 100% of Bond 1, which Cécile considers to be overvalued. Because Villash is a tax-exempt foundation, tax considerations are not relevant and Cécile’s investment views drive her trading recommendations.

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Serena is a risk management specialist with Liability Protection Advisors. Trey, CFO of Kiest Manufacturing, enlists Serena’s help with three projects. The first project is to defease some of Kiest’s existing fixed-rate bonds that are maturing in each of the next three years. The bonds have no call or put provisions and pay interest annually. Exhibit 1 presents the payment schedule for the bonds. <image_1> The second project for Serena is to help Trey immunize a $20 million portfolio of liabilities. The liabilities range from 3.00 years to 8.50 years with a Macaulay duration of 5.34 years, cash flow yield of 3.25%, portfolio convexity of 33.05, and basis point value (BPV) of $10,505. Serena suggested employing a duration-matching strategy using one of the three AAA rated bond portfolios presented in Exhibit 2. <image_2> Serena explains to Trey that the underlying duration-matching strategy is based on the following three assumptions. 1 Yield curve shifts in the future will be parallel. 2 Bond types and quality will closely match those of the liabilities. 3 The portfolio will be rebalanced by buying or selling bonds rather than using derivatives. The third project for Serena is to make a significant direct investment in broadly diversified global bonds for Kiest’s pension plan. Kiest has a young workforce, and thus, the plan has a long-term investment horizon. Trey needs Serena’s help to select a benchmark index that is appropriate for Kiest’s young workforce. Serena discusses three benchmark candidates, presented in Exhibit 3. <image_3> With the benchmark selected, Trey provides guidelines to Serena directing her to (1) use the most cost-effective method to track the benchmark and (2) provide low tracking error. After providing Trey with advice on direct investment, Serena offered him additional information on alternative indirect investment strategies using (1) bond mutual funds, (2) exchange-traded funds (ETFs), and (3) total return swaps. Trey expresses interest in using bond mutual funds rather than the other strategies for the following reasons. Reason 1 Total return swaps have much higher transaction costs and initial cash outlay than bond mutual funds. Reason 2 Unlike bond mutual funds, bond ETFs can trade at discounts to their underlying indexes, and those discounts can persist. Reason 3 Bond mutual funds can be traded throughout the day at the net asset value of the underlying bonds.

Based on Exhibit 1, Kiest’s liabilities would be classified as:

[ "A. Type I", "B. Type II", "C. Type III" ]

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A

A is correct. Type I liabilities have cash outlays with known amounts and timing. The dates and amounts of Kiest’s liabilities are known; therefore, they would be classified as Type I liabilities.

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Based on Exhibit 2, the portfolio with the greatest structural risk is:

[ "A. Portfolio A", "B. Portfolio B", "C. Portfolio C" ]

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C

C is correct. Structural risk arises from the design of the duration-matching portfolio. It is reduced by minimizing the dispersion of the bond positions, going from a barbell structure to more of a bullet portfolio that concentrates the component bonds’ durations around the investment horizon. With bond maturities of 1.5 and 11.5 years, Portfolio C has a definite barbell structure compared with those of Portfolios A and B, and it is thus subject to a greater degree of risk from yield curve twists and non-parallel shifts. In addition, Portfolio C has the highest level of convexity, which increases a portfolio’s structural risk.

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Which portfolio in Exhibit 2 fails to meet the requirements to achieve immunization for multiple liabilities?

[ "A. Portfolio A", "B. Portfolio B", "C. Portfolio C" ]

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A

A is correct. The two requirements to achieve immunization for multiple liabilities are for the money duration (or BPV) of the asset and liability to match and for the asset convexity to exceed the convexity of the liability. Although all three portfolios have similar BPVs, Portfolio A is the only portfolio to have a lower convexity than that of the liability portfolio (31.98, versus 33.05 for the $20 million liability portfolio), and thus, it fails to meet one of the two requirements needed for immunization.

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Based on Exhibit 2, relative to Portfolio C, Portfolio B:

[ "A. has higher cash flow reinvestment risk", "B. is a more desirable portfolio for liquidity management", "C. provides less protection from yield curve shifts and twists" ]

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A

B is correct. Portfolio B is a laddered portfolio with maturities spread more or less evenly over the yield curve. A desirable aspect of a laddered portfolio is liquidity management. Because there is always a bond close to redemption, the soon-to- mature bond can provide emergency liquidity needs. Barbell portfolios, such as Portfolio C, have maturities only at the short-term and long-term ends and thus are much less desirable for liquidity management.

hard

multiple-choice

fixed income

english

198

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nan

The global bond benchmark in Exhibit3 that is least appropriate for Kiest to use is the:

[ "A. Global Aggregate Index", "B. Global High Yield Index", "C. Global Aggregate GDP Weighted Index" ]

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B

B is correct. Kiest has a young workforce and thus a long-term investment horizon. The Global Aggregate and Global Aggregate GDP Weighted Indexes have the highest durations (7.73 and 7.71, respectively) and would be appropriate for this group. Global High Yield is the least appropriate due to its relatively shorter duration.

hard

multiple-choice

fixed income

english

198

5

0

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english_199_1_r1

A Sydney-based fixed-income portfolio manager is considering the following Commonwealth of Australia government bonds traded on the ASX (Australian Stock Exchange): <image_1> The manager is considering portfolio strategies based upon various interest rate scenarios over the next 12 months. She is considering three long-only government bond portfolio alternatives, as follows: Bullet: Invest solely in 4.5-year government bonds Barbell: Invest equally in 2-year and 9-year government bonds Equal weights: Invest equally in 2-year, 4.5-year, and 9-year bonds

The portfolio alternative with the highest modified duration is the:

[ "A. bullet portfolio", "B. barbell portfolio", "C. equally weighted portfolio" ]

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B

B is correct. The modified duration of a fixed-income portfolio is approximately equal to the market value-weighted average of the bonds in the portfolio, so the barbell has a modified duration of 5.049, or (1.922 + 8.175)/2), which is larger than that of either the bullet (4.241) or the equally weighted portfolio (4.779, or (1.922 + 4.241 + 8.175)/3.

easy

multiple-choice

fixed income

english

199

1

0

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