Overview for Questions #1-4 of 86 Question ID: 1749746

TOPIC: DERIVATIVES AND RISK MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Frank Federer is an investment manager in Switzerland. He is advising his client, Martina

Muller, on her investment portfolio, which is denominated in euros. Muller's liabilities
are in Swiss francs (CHF), so she is conscious of the potential impact of currency
fluctuations on the euro portfolio. The portfolio's current market value is EUR 1.75
million. Federer proposes a hedge employing three-month forward contracts, rolled
forward at maturity to match the changes in portfolio value, and gathers the information
in Exhibit 1 (currency rates are given as bid-offer spreads).

Exhibit 1: Relevant Data for the Muller Portfolio and CHF/EUR

Value of portfolio in EUR 1,750,000

CHF/EUR spot 0.9321/0.9327

3-month forward points –56/–50

Three months later, the equivalent values are as shown in Exhibit 2.

Exhibit 2: Relevant Data Three Months After Exhibit 1

Value of portfolio in EUR 1,742,000

CHF/EUR spot 0.9418/0.9423

3-month forward points –52/–47

Another client, Sieglinde Wagner, is a more active investor who aggressively seeks profit
opportunities. However, her level of financial sophistication is not high, so she regularly
seeks Federer's advice before putting her intuitions into action. Wagner has noted that,
while CHF interest rates are low (around 1.25%), currencies like the Brazilian real (BRL)
deliver rates in the region of 37%, and she asks why such differentials cannot easily be
exploited to produce guaranteed profits by borrowing in the low interest rate currency,
using the proceeds to buy and deposit in the high interest rate currency.
Federer explains that this is a standard technique of active currency management, with
an obvious weakness—namely, that the higher interest rate currency could depreciate to
a degree that wipes out the benefit of the differential. Wagner responds, "In that case,
why not hedge the currency risk?"

Question #1 of 86 Question ID: 1749747

Justify, with two reasons, Federer's choice of forward contracts, rather than futures
contracts, as the hedge instrument to use for Muller's euro portfolio.

Question #2 of 86 Question ID: 1749748

Assuming that the hedge was initiated as in Exhibit 1, calculate the net cash flow (in
CHF) required to maintain the hedge three months later.

Question #3 of 86 Question ID: 1749749

Discuss the effectiveness of the hedge over the first three months.

Question #4 of 86 Question ID: 1749750

Explain why hedging the currency risk would undermine the profitability of such a trade.

Overview for Questions #5-8 of 86 Question ID: 1749692

TOPIC: CAPITAL MARKET EXPECTATIONS

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Maria Gonzales is a trainee analyst with a large investment management firm. She is
currently working with the capital market forecasts teams, who generate expected
return and covariance projections for use in the asset allocation and stock selection
processes.

Gonzales has been comparing notes with Romola Roberts, who is a more experienced
member of this team, and in a conversation with her, Gonzales has made the following
statement: "The use of the shrinkage estimator approach to parameter estimation will
result in smaller values being used for the estimated covariances between markets than
the values observed in the historical covariance matrix."

Roberts explains to Gonzales the use of the Singer-Terhaar ICAPM-based approach to

the estimation of market-expected returns. She provides an illustration (for the purpose
of the exercise, the domestic risk free is assumed to be 2.5%):

Equities in the country of Zubrowka are predicted to have a standard

deviation of 22% per annum, and a correlation with the global investable
market of 0.63. The Zubrowka equity market has been estimated as 75%
integrated with the global market, and the risk-free rate in Zubrowka is
currently 4.3%. The global market Sharpe ratio can be assumed to be 0.32.

Pamela DeFreitas, Gonzales's sister, has a $3 million U.S. equity portfolio. She is
considering rebalancing the portfolio based on an assessment of the risk and return
prospects facing the U.S. economy. To help in the assessment, the information in Exhibit
1, pertaining to U.S. investment markets and the economy, has been provided by
Gonzales.

Exhibit 1: U.S. Capital Markets Data

10-Year Historical Current Expectations

Average 10-year
10-year government
government bond yield:
bond yield: 3.1%
5.3%

Average annual equity Year-over-year equity

return: 6.2% return: 2.4%
Average annual inflation Year-over-year
Expected annual inflation: 1.4%
rate: 2.4% inflation rate: 3.1%

Equity market P/E

Current equity Expected equity market P/E in one
(beginning of period):
market P/E: 13.2 year: 12.5
14.0

Average annual dividend Expected annual dividend return:

return: 2.2% 1.7%

Average annual real Expected annual real earnings

earnings growth: 5.8% growth: 4.8%

Expected annual change in shares

outstanding (due to net repurchases):
–0.5%

Question #5 of 86 Question ID: 1749693

State whether Gonzales's statement regarding shrinkage estimators is correct or

incorrect. If you chose incorrect, explain why

Question #6 of 86 Question ID: 1749694

Compute the expected percentage return from Zubrowka equities that should be
computed by Roberts based on the Singer-Terhaar financial equilibrium model.

Question #7 of 86 Question ID: 1749695

Calculate the historical U.S. equity risk premium using the bond yield plus risk premium
method.
Question #8 of 86 Question ID: 1749696

Calculate the expected annual U.S. equity return using the Grinold-Kroner model.

Overview for Questions #9-12 of 86 Question ID: 1750132

TOPIC: PORTFOLIO CONSTRUCTION

TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

The Astney Foundation (AF) was funded in 1951 by the heirs of a large brewing fortune.
The foundation's sole purpose is to support training for gifted young skiers in the United
States in perpetuity. Yearly grants are provided to children between the ages of 9 and 15
to cover training, living accommodations, and education at Astney Mountain School. The
$25 million portfolio is expected to generate a real return of 4% and cover operating
expenses of 0.75%. General inflation is estimated at 2.5%, while costs covered by the
foundation are expected to increase at 3.5%. The foundation is tax exempt, subject to no
minimum payout requirement, and the trustees have expressed a strong desire to
generate a 3% annual income return.

Question #9 of 86 Question ID: 1749727

State the return objectives of Astney Foundation.

Question #10 of 86 Question ID: 1749728

Calculate AF's required annual nominal rate of return.

Question #11 of 86 Question ID: 1749729

Calculate the dollar amount that can be distributed over the coming year that is
consistent with AF's long-term goals.

Question #12 of 86 Question ID: 1749730

Explain how three other factors from the case information directly affect AF's risk
objective.

Overview for Questions #13-16 of 86 Question ID: 1749701

TOPIC: ASSET ALLOCATION

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Janusz Kubiak is a taxable investor, with a marginal rate of tax of 34% across earned and
investment income. Kubiak has been saving via a tax-deferred retirement account and a
tax-exempt account for many years. He has recently inherited a sizeable taxable
portfolio from his uncle.

The local jurisdiction applies limits to contributions to tax-deferred and tax-exempt

accounts. The new administration in the jurisdiction has announced that they intend to
reduce the benefit of tax deductions in three months' time.

Three years have passed since Kubiak reviewed his original portfolios, as his wealth
manager has retired. He decides to meet with two potential wealth management firms,
Warsaw Capital Managers (WCM) and Katowice Investment Managers (KIM), to review his
investments.

Kubiak first meets with Zbigniew Suska from WCM. Suska asks Kubiak about his
retirement plans, and if it is likely that his tax rate will fall when he retires. Kubiak agrees
this is very likely. After collating Kubiak's financial details, Suska makes the following
recommendations to optimize the tax location of Kubiak's portfolios:
Recommendation
Equities should be allocated to the taxable account.
1:

Recommendation Expected liquidity needs should be allocated to the taxable

2: account.

Recommendation If the benefits of tax deductions are reduced, this will impact a tax-
3: exempt and tax-deferred account equally.

The next day, Kubiak meets with Jakub Jeglinski from KIM. Jeglinski focuses on Kubiak's
recently inherited taxable account. He explains that the current rebalancing corridor has
not been optimized for tax. The data is shown in Exhibit 1.

Exhibit 1: Kubiak Taxable Account

Asset Classes Target Weight Rebalancing Corridor

Equities 50% +/– 10%

Fixed income 45% +/– 5%

Cash 5% +/– 3%

Jeglinski also advises Kubiak that there are several advantages to a taxable account, one
of which is that the standard deviation of returns will be lower for him.

Question #13 of 86 Question ID: 1749702

Determine how many of Suska's recommendations are correct (1, 2, or 3). Justify your
answer.

Question #14 of 86 Question ID: 1749703

Assuming Kubiak has the choice of investing today in either the TEA or the TDA until his
intended retirement, recommend the most suitable asset location. Justify your answer.
Question #15 of 86 Question ID: 1749704

Assuming Jeglinski's proposal is implemented, determine the lower rebalancing weight

for equities in the taxable account.

Question #16 of 86 Question ID: 1749705

In relation to Jeglinski's statement about risk in Kubiak's taxable account, determine if

his statement is correct or incorrect. Justify your answer.

Overview for Questions #17-20 of 86 Question ID: 1749766

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

P3 Capital (P3C) is an investment management firm formed by three sisters: Prudence,

Piper, and Phoebe. The sisters specialize in index-based portfolios covering various
equity markets. Leo Turner, a long-standing client, has asked for clarification of how
tracking error and transactions costs interrelate for an index containing some relatively
illiquid stocks. The sisters discuss the issue, but they have different views:

There is a linear relationship between tracking error and transaction costs

Prudence:
as the number of stocks increases in the benchmark.

There is a U-shape relationship between tracking error and transaction

Piper:
costs as the number of stocks increases in the benchmark.

The relationship between tracking error and transaction costs as the

Phoebe: number of stocks increases is unique and may follow the relationship
described by either Prudence or Piper.

Turner also asks for confirmation of how the firm minimizes tracking error when
executing trades and measuring performance.
Darryl Morris is head of derivatives at P3C. Morris is asked to explain the rationale used
when selecting between equity-index futures, options, and swaps to replicate equity
indexes. Morris explains that there are many factors to consider, including the
characteristics of each specific equity index and tax considerations.

Question #17 of 86 Question ID: 1749767

Which of the sisters correctly describes the relationship between tracking error and
transaction costs as the number of stocks increases in the index?

A) Prudence.
B) Piper.
C) Phoebe.

Question #18 of 86 Question ID: 1749768

Which of the following prices should the sisters use to minimize tracking error when
executing trades to replicate an index?

A) Arrival price.
B) Market-on-close price.
C) Volume-weighted average price.

Question #19 of 86 Question ID: 1749769

Following the comments made by Morris, which derivative is most likely to cover the
widest range of equity indexes?

A) Equity index futures.

B) Equity index swaps.
C) Equity index options.
Question #20 of 86 Question ID: 1749770

Following the comments made by Morris, which derivative has the highest tax policy
risk?

A) Equity index futures.

B) Equity index swaps.
C) Equity index options.

Overview for Questions #21-24 of 86 Question ID: 1749751

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Garrett Keenan, CFA, is employed by Gold Standard Bank (GSB), in the capital markets
division. The GSB board of directors recently made two decisions: (1) a leveraged co-
invest fund is to be created for the benefit of senior-level employees of GSB, and (2) a
hedge fund is to be constructed that will be marketed to high-net-worth trust
department clients and prospects. Both new entities will be fund-of-funds (FoF) managed
on behalf of GSB by "third-party" managers that Keenan will select.

Keenan researched the pool of hedge fund managers and compiled a report that was
based primarily on historical performance record. The 60 managers selected for further
review were tiered into three groups according to their three-year track record. Of the 20
managers in the highest-performing tier, Keenan selected 15 managers for the
employee-leveraged co-invest FoF. The other five managers in the top tier were selected
along with the 20 hedge fund managers in the second tier for the FoF to be marketed to
high-net-worth trust clients.

While screening hedge fund managers, Keenan came across his college friend, John
Carmichael, one of the principals at the hedge fund management firm Bryson
Carmichael, Inc. (BC). Because BC's track record met Keenan's criteria for inclusion in one
of the FoFs, BC was selected. Carmichael called Keenan to express his appreciation, and
during that conversation, offered Keenan the use of Carmichael's mountain house.
Keenan subsequently spent several long weekends at the mountain house. In
appreciation for his stay, Keenan promised to take Carmichael's children to an
amusement park free of charge during their upcoming vacation. Carmichael accepted
the invitation, but was told by Keenan to keep the invitation confidential.

Another hedge fund manager being considered for inclusion was Barry Grant, LLC
(Grant). Grant had been actively soliciting investors for his hedge fund and offered to pay
Keenan a personal fee of $200 if Keenan accepted Grant's hedge fund into one of GSB's
FoFs. Because Grant's fund performance was within Keenan's acceptable guidelines,
Keenan refused to accept the fee. However, Keenan told Grant that if his fund were able
to beat the benchmark return by at least 1% during the first annual measurement
period, he would accept his one-time fee. Keenan later mentioned the arrangement to
his direct supervisor during their weekly meeting.

Keenan was then asked to provide a training seminar to the Trust Department's sales
force. In that training, Keenan stated the compensation that the hedge funds would
receive: (a) a 2% fee on assets under management, and (b) 20% of the returns over a
high-water mark. The sales force was instructed to inform prospective FoF clients that
"past performance is no guarantee of future results" and Keenan recommended that
they emphasize positive aspects of the fee earned on returns over the high-water mark.
Keenan said, "Your clients should not worry about the managers failing to outperform
each year because the profits on returns over the high-water mark are how they make
their real money."

Keenan also instructed the sales force to emphasize the combined number of CFA
charterholders on the management teams of the hedge funds in the FoF and to provide
a description of the basic requirements to become a CFA charterholder.

Question #21 of 86 Question ID: 1749752

During his initial selection of the managers for the two FoFs, which of the following
Standards did Keenan least likely violate?

A) Independence and Objectivity.

B) Performance Presentation.
C) Fair Dealing.
Question #22 of 86 Question ID: 1749753

By accepting the use of Carmichael's mountain house, Keenan:

A) violated the Diligence and Reasonable Basis Standard.

B) violated the Independence and Objectivity Standard.
C) did not violate any Standards.

Question #23 of 86 Question ID: 1749754

Assuming that Grant's fund beats the benchmark return by 1.5% the first year and
Keenan receives the $200 fee, the Additional Compensation Arrangement Standard was:

A) not violated because the amount of the one-time fee was not material.
B) not violated because Keenan disclosed the fee arrangement to his supervisor.
C) violated as Keenan failed to get the written consent from Grant and his supervisor.

Question #24 of 86 Question ID: 1749755

In his presentation to the bank's trust department sales force, Keenan:

violated the Misrepresentation Standard by describing the hedge funds’ fee structure
A)
as a mechanism for delivering better returns.
violated the Misrepresentation Standard by mentioning the number of CFA
B)
charterholders on the FoF management teams.
C) was in compliance with the Standards.

Overview for Questions #25-28 of 86 Question ID: 1750141

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Angela Gardiner runs an equity fund for Magna Mutuals (MM). She is forwarded a
research report that recommends the sale of a mid-cap stock, Evans Engineering
Incorporated (EEI). This stock is currently held in her portfolio, and she decides to reduce
the position.

The following sequence of events occurs:

On Wednesday, EEI closes at $14.30.

That evening, Gardiner reads the report and, given the attractive closing price,
decides to sell a portion of her existing holding.
The next morning, Gardiner directs MM's trading desk to sell 3,000 shares at
$14.35 per share, or better, good for the day.
The assigned trader is new on the desk and is not familiar with EEI stock. He needs
to review its characteristics (liquidity, trading patterns, etc.) and current market
conditions. He also needs to review the historical performance of brokers trading
similar orders, and decides the best broker for the order is broker RXD. The
trading desk eventually releases the order to this broker 50 minutes after receiving
it from Gardiner, at which point the market price for EEI is $14.32.
None of the limit order is filled on Thursday, and the order expires. EEI closes at
$14.16.
First thing on Friday, the trading desk instructs RXD with a new limit order to sell
3,000 shares at $14.00 per share, or better, good for the day.
During the day, 700 shares are sold at $14.12, and 1,400 are sold at $14.05.
Commissions and fees for the trades are $9 and $15, respectively.
Shares in EEI close at $14.01, and VWAP is $14.05 on Friday.
Gardiner cancels the remainder of her order.

The head trader at MM tells Gardiner that their trading was successful because they sold
both lots for no less than the day's VWAP of $14.05. Gardiner is unconvinced, given that
fewer shares were sold than she had planned and at a lower price than she originally
intended.

Question #25 of 86 Question ID: 1749796

Calculatethe total implementation shortfall for the EEI trades, both in absolute terms
and in basis points.

Question #26 of 86 Question ID: 1749797

Calculate the opportunity cost component of the implementation shortfall, expressed in

basis points.

Question #27 of 86 Question ID: 1749798

Calculate the delay cost component of the implementation shortfall, expressed in basis
points.

Question #28 of 86 Question ID: 1749799

Calculate the trading cost component of the implementation shortfall, expressed in

basis points.

Overview for Questions #29-32 of 86 Question ID: 1750133

TOPIC: PERFORMANCE MEASUREMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

The Wilbert Smith Foundation allocates 15% of their total fund to a portfolio of small cap
U.S. growth stocks. For several years they have used the S&P 500 index as the
benchmark for that portfolio, but the Foundation's investment subcommittee now
wishes to select a more appropriate benchmark. Their consultant has suggested three
alternatives:

Alternative 1: The trailing Treasury bill return plus 500 basis points
Alternative 2: A custom security index based on historical regression of portfolio
returns
Alternative 3: The median return of U.S. small cap growth managers

Some months later, the subcommittee is reviewing the return from the Foundation's
total equity allocation. The most recent quarterly return and risk information are given
(on an annualized basis) in Exhibit 1:

Exhibit 1 – Wilbert Smith Foundation total equity allocation performance statistics

Foundation Total Equity Foundation Total Equity S&P 500

Portfolio Benchmark Index

Average Return 6.1% 5.7% 8.2%

Beta 1.2 1.2 1.0

Standard
15.2% 12.6% 10.2%
Deviation

Risk-free return was 0.3%

A member of the subcommittee states that it should make no difference whether risk-
adjusted performance is assessed using the Sharpe or Treynor measures, since both will
give consistent results when portfolios are compared.

The subcommittee is also reviewing a Brinson-Fachler micro attribution analysis for

another of the Foundation's equity managers. Excerpts from that report are shown in
Exhibit 2:

Exhibit 2 – Wilbert Smith Foundation equity subportfolio #3 sector returns

Benchmark Manager Benchmark Manager

Sector:
Return Return Weight Weight

Basic Industries 5.89% 6.25% 10.7% 15.7%

Communications –0.23% –0.56% 12.5% 7.5%

Cyclicals 2.58% –1.29% 5.9% 10.9%

Defensive 5.99% 5.01% 15.7% 10.7%

Energy 7.41% 10.25% 9.8% 14.8%

Financial 6.98% 2.22% 10.1% 5.1%

Health Care –4.25% –2.54% 7.6% 12.6%

Other N/A N/A N/A N/A

The overall benchmark return was 3.77%

Question #29 of 86 Question ID: 1749732

With reference to the alternative benchmarks suggested by the consultant, state one
characteristic of a valid benchmark possessed by Alternative 3, and state two
characteristics of a valid benchmark possessed by Alternative 1 (These should both be
different from that given for Alternative 3).

Question #30 of 86 Question ID: 1749733

Using the data in Exhibit 1, compute the Sharpe ratio for the Wilbert Smith Foundation
total equity allocation, and determine whether the Foundation's total equity allocation
outperformed its benchmark based on the Sharpe ratio.

Question #31 of 86 Question ID: 1749734

State whether the subcommittee member's statement regarding the Sharpe and
Treynor measures is true or false, and explain why this is the case, with reference to the
foundation and its benchmark. (Do not simply state that the data from Exhibit 1 confirms
or contradicts the member's statement.)
Question #32 of 86 Question ID: 1749735

Using the data in Exhibit 2, identify one sector where the manager added value through
security selection, one sector where value was added through sector overweighting, and
one sector where value was added through sector underweighting.

Overview for Questions #33-36 of 86 Question ID: 1750138

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Martina Theroux, CFA, is a Canadian-based fixed income investment manager. She

currently has the view that yield curves will remain static and upward sloping over the
next six months and is looking to profit from her view. She consults with a yield curve
analyst, Josie Ford, regarding the optimal way to position her portfolio.

Ford suggests the following methods:

Method 1: Enter a long position in a futures contract on a long-dated

government bond.

Method 2: Engage in a repo carry trade as a securities lender to earn

coupon income plus rolldown return in excess of the repo rate.

Method 3: Extend the duration of the portfolio by using either longer-dated

bonds or by receiving the fixed leg under a swap contract.

Theroux decides to investigate Method 3 further. She asks Ford to collect relevant data
on government bonds and swap contracts that could be used to execute the trade. Ford
presents the following information:

10-year government bonds exist with a coupon of 1.50% paid semiannually, with a
yield to maturity of 2.50% and a current price of CAD 91.20.
10-year tenor swaps exist with a swap fixed leg of 2.00%. The six-month CAD
market reference rate (MRR) is currently 0.50%.

Theroux is interested in the expected returns under a stable yield curve scenario. She
also instructs Ford to carry out an analysis of both trades and to perform a breakeven
calculation.

Question #33 of 86 Question ID: 1749786

Which of the following statements, with respect to Method 1 and assuming a stable,
upward-sloping yield curve, is most accurate?

The expected return on the position is equal to the change in the price of the futures
A)
contract.
The expected return on the position is equal to the change in the price of the futures
B)
contract minus any margin cost.
The expected return on the position is equal to the change in the price of the futures
C) contract minus any margin cost plus the coupon income from the underlying
government bond.

Question #34 of 86 Question ID: 1749787

Which of the following statements, with respect to Method 2 and assuming a stable,
upward-sloping yield curve, is most accurate?

A) Ford is correct.
Ford is incorrect because the investment manager should engage in a repo carry trade
B)
as a securities borrower, not a securities lender.
Ford is incorrect because under a correctly structured repo trade, the manager will not
C)
earn coupon income during the time the bond is lent out as collateral.

Question #35 of 86 Question ID: 1749788

If the yield curve remains static over the next six months and assuming the yield curve is
flat between the 9.5-year and 10-year maturities, the total return from a CAD 10 million
par value position in the 10-year government bond is closest to:
A) CAD 39,000.
B) CAD 75,000.
C) CAD 114,000.

Question #36 of 86 Question ID: 1749789

The increase in annualized swap rates over the next six months that would cause mark-
to-market (MTM) losses to offset the positive swap carry on a swap contract with a
notional value of CAD 10 million is closest to:

A) 4.4 basis points.

B) 7.5 basis points.
C) 8.7 basis points.

Overview for Questions #37-40 of 86 Question ID: 1749761

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Vakka Corp. (Vakka) offers hybrid mutual funds as well as portfolio management
services. The firm has adopted the CFA Institute Asset Manager Code of Conduct (AMC).
Based on what he read about the AMC, Tyler Powers, a portfolio manager at Vakka,
decides to communicate with clients on a monthly basis.

Another manager, Oliver Apple, CFA, chooses to replace 15% of Vakka's passively
managed index funds with actively managed energy and pharmaceutical stocks.
Annually, Apple plans to send clients the new asset allocation, an initial description and
explanation of risks inherent in "high-beta micro-cap stocks," and the performance of
each portfolio.

As part of the annual compliance review, the firm reviews the fee disclosures provided to
prospective and current fund clients. The fee disclosure states the following:
 "Vakka charges a 0.5% asset-based management fee. In addition to the
management fee, clients may pay an incentive fee at the end of each year.
The incentive fee is equal to 20% of the account's net profit and unrealized
capital gains for the year.

We offer a high-water mark provision. That will ensure that a fund manager
gets incentive fees based on the highest net asset value previously attained
at the end of any prior fiscal year or based on gains representing actual
profits for each investor. Hence, clients will pay incentive fees based on the
fund offsetting all prior investment losses from its securities."

In the annual compliance review, Powers is asked about the nature and frequency of
Vakka's distribution of performance records to clients. Powers states the following:

Statement 1: Our policy is to provide clients with performance net-of-fees, as

that is the more relevant performance metric.

Statement 2: Because the industry standard is to report performance reports

quarterly, we make sure that, at a minimum, statements go out
the week after quarter-end.

Powers is also investigated during the review about Vakka's social media policies,
particularly its LinkedIn postings on Vakka's account. Powers answers:

Statement 3: Because all our LinkedIn postings are accurate and often fully
reiterate other postings made by large financial institutions, we
do not keep records of posts made by the firm.

The compliance review reveals several compensation agreements involving portfolio

managers who handle private client accounts. In one particular arrangement, the client
offered the portfolio manager an expensive plane ticket to an exotic island and
accommodation at a five-star hotel there if the portfolio return exceeds the appropriate
blended benchmark return by 3%. Apple justifies the arrangement by stating the
following:

Statement 4: Vakka's policy on additional compensation requires employees

to obtain consent before receiving any monetary gift or bonus
given by a client in exchange for meeting a performance goal.
However, in this case, the reward is not financial, and the value
of the tickets plus hotel accommodation can vary considerably.
 Therefore, the portfolio manager is not required to obtain the
firm's permission.

Question #37 of 86 Question ID: 1749762

Which of the following statements is most accurate?

The CFA Institute does not verify either the manager’s claim of compliance or actual
A)
compliance with the AMC.
To comply with the AMC, Powers must communicate with the clients on at least a
B)
monthly basis.
Apple is correct in describing and explaining the risks inherent in “high-beta micro-cap
C)
stocks” while including the performance of each portfolio annually.

Question #38 of 86 Question ID: 1749763

Concerning disclosure of the fund's fee structure and high-water mark provision, Vakka's
management most likely:

A) complies with the AMC.

B) violates the AMC regarding Vakka’s fee structure.
C) violates the AMC regarding Vakka’s high-water mark provision.

Question #39 of 86 Question ID: 1749764

Which of Powers's statements most likely complies with the AMC and CFA Institute Code
and Standards?

A) Statement 1.
B) Statement 2.
C) Statement 3.
Question #40 of 86 Question ID: 1749765

Apple's justification in Statement 4 regarding the arrangement at the exotic island most
likely violates which of the following Standards?

A) Standard VI(A)—Disclosure of Conflicts.

B) Standard I(B)—Independence and Objectivity.
C) Standard IV(B)—Additional Compensation Arrangements.

Overview for Questions #41-44 of 86 Question ID: 1750136

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Redwood Advisors Ltd. (Redwood) has managed fixed-income portfolios for its clients for
many years. The firm recently hired a team of three new equity managers to expand its
investing expertise into equities. Specifically, the firm would like to establish a hedge
fund that will allow its new equity managers to engage in pairs trading.

The new equity team decides early on that they should strive to minimize market impact
costs when trading. Each team member makes the following comments regarding the
best ways to accomplish that goal:

Jeff: "We should seek to grow our assets under management (AUM) as
much as possible and engage in high-turnover trading of small-
cap stocks."

Mary: "I agree with Jeff when it comes to the AUM, but I think we should
engage in low-turnover trading of large-cap stocks instead."

Karen: "I think we should pursue a more conservative AUM figure while
engaging in low-turnover trading of large-cap stocks."

When describing their hedge fund strategy to a sophisticated potential investor, the
team brings up the terms active share and active risk. They explain that, while pursuing
their chosen strategy, they will exhibit a certain type of active share/active risk
combination. They use Exhibit 1 to indicate the potential combinations to investors.

Exhibit 1: Active Risk/Active Share Combinations

Combination Active Risk Active Share

1 High High

2 Low High

3 Low Low

The team then turns their attention to generating consistent active returns for the hedge
fund. They decide that the manager with the highest expected active annual return
should lead the effort. They use Exhibit 2 and the fact that each manager will make 110
independent decisions per year to make that determination.

Exhibit 2: Equity Manager Characteristics

Manager Transfer Coefficient Information Coefficient Active Risk (%)

Jeff 0.45 0.2 6.25

Mary 0.5 0.15 6.75

Karen 0.55 0.1 6.25

Question #41 of 86 Question ID: 1749777

Which portfolio construction approach would be most appropriate for the hedge fund
that Redwood would like to establish?

A) Long only.
B) Short only.
C) Market neutral.

Question #42 of 86 Question ID: 1749778

Which manager is most accurate with respect to minimizing the market impact costs the
fund will realize when executing trades?

A) Jeff.
B) Mary.
C) Karen.

Question #43 of 86 Question ID: 1749779

Which combination of active risk and active share will the equity team most likely display
in the pursuit of the firm's chosen hedge fund strategy?

A) Combination 1.
B) Combination 2.
C) Combination 3.

Question #44 of 86 Question ID: 1749780

Which manager will most likely lead the team's effort to generate consistent active
returns within the new fund?

A) Jeff.
B) Mary.
C) Karen.

Overview for Questions #45-48 of 86 Question ID: 1749756

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Pinnacle Investment Management (Pinnacle) is a midsized operation based in New York,
New York that provides investment analysis and asset management for individuals. In
addition, the firm offers investment banking services for corporate clients and manages
assets for several mutual funds.

Michael Jenkins, CFA, has been hired by Pinnacle to develop, implement, and oversee the
firm's compliance department. His objective is to conform to the CFA Institute Code and
Standards. He starts by interviewing numerous Pinnacle employees to determine what
formal and informal policies currently exist at the firm. Based on his findings, he
develops a written compliance manual that will be distributed to all of the firm's
employees. The manual will delineate procedures for reporting violations and sanctions,
describe the supervision hierarchy and each supervisor's duties, and outline the steps to
monitor and evaluate the compliance program. Jenkins designates the firm's senior
investment officer, Nadine Jacobs, CFA, as the employee with ultimate responsibility for
the compliance procedures and their enforcement.

During his first few weeks with Pinnacle, Jenkins has lunch with a former colleague,
Henry Mullins, CFA, who works for the compliance officer at a large investment bank in
the same town. Mullins arrives late and explains why.

"What a day! It's only noon, and already I have worked on three requests:

Request A federal regulator called and wanted information on potentially illegal

1: activities related to one of the firm's key clients.

Request A rival company's employee wanted information regarding employment

2: opportunities at the firm.

Request A potential client contacted an employee and wanted detailed performance

3: records of client accounts so he can decide whether to invest with the firm."

Kevin Rivers, CFA, manages one of Pinnacle's larger mutual funds. Over the holidays,
Rivers learns from his sister-in-law that her employer, Tomahawk Sporting Goods
(Tomahawk), has seen a large increase in sales and profitability. Rivers then researches
sporting goods stores and settles upon Sling Sports (Sling), a small-cap sporting goods
store with a high profit margin and no debt. Over the next four days, Rivers purchases
100,000 shares of Sling for the fund he operates, using a volume-weighted average price
algorithm.

Several weeks later, Rivers spots the CEO of Tomahawk dining with the CEO of Sling at an
upscale Italian restaurant in SoHo. Rivers knows that Tomahawk has made several
acquisitions in the past year and concludes that Sling may be Tomahawk's newest target.
The next morning, Rivers places an order for 500,000 additional shares of Sling for the
fund he manages at Pinnacle.

Mya Rose, CFA, is an investment analyst at Pinnacle. Rose has just entered into a
brokerage agreement with Apex Services. According to the agreement, in exchange for
client referrals from Apex, Pinnacle would give Apex its brokerage business. Pinnacle
advised its clients about the nature and extent of this relationship in writing.

Question #45 of 86 Question ID: 1749757

Does the compliance program developed by Jenkins comply with CFA Institute Standards
of Professional Conduct?

A) Yes.
No, because authority to enforce the compliance program should rest with the
B)
compliance officer.
No, because assigning supervisory duties takes away the responsibility of all
C)
supervisors to detect all violations of the compliance procedures.

Question #46 of 86 Question ID: 1749758

Which of the requests, if fulfilled, is most likely to place Mullins in violation of Standard
III(E): Preservation of Confidentiality?

A) Request 1.
B) Request 2.
C) Request 3.
Question #47 of 86 Question ID: 1749759

Regarding Rivers's investment in shares of Sling, he most likely:

A) violated Standard II(A): Material Nonpublic Information.

B) violated Standard V(A): Diligence and Reasonable Basis.
C) did not violate any Standards of Professional Conduct.

Question #48 of 86 Question ID: 1749760

Did Rose and Pinnacle follow the recommended procedures of the CFA Institute
Standards of Professional Conduct regarding the brokerage arrangement with Apex?

A) Yes, because Pinnacle disclosed the arrangement to its clients.

B) No, because Pinnacle did not preserve confidentiality of its agreement with Apex.
C) No, because the agreement inappropriately creates a conflict of interest.

Overview for Questions #49-52 of 86 Question ID: 1750131

TOPIC: PORTFOLIO CONSTRUCTION

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Sandra Nguyen works as a senior analyst for an investment consulting company,

Hamilton Consultants, Inc. (Hamilton). Hamilton provides management services to
various types of institutional investors.

Hamilton recently hired a new analyst, William Lara. While explaining asset allocation
and sovereign wealth funds to Lara, Nguyen makes the following points:

Point 1: Savings funds, reserve funds, and pension reserve funds all invest
heavily in private equity and real assets because those funds all
have low liquidity needs.
Point 2: Savings funds generally have a lower allocation to alternative
investments than do reserve funds.

After studying the most common asset allocation strategies for institutional investors,
Lara writes a report that includes the following statements:

Statement 1: Norway's Sovereign Wealth Fund has the potential for market
outperformance due to a significant exposure to alternative
investments and many actively managed assets.

Statement 2: The main difference between the Canada Pension Plan and the
Yale University Endowment is that the latter manages its assets
internally.

Statement 3: The Yale University Endowment strategy includes a high

allocation to alternative investments and significant active
management, which gives it the potential for market
outperformance.

Statement 4: Liability-driven asset allocation explicitly recognizes liabilities as

part of the investment process, and focuses on managing
surplus volatility as well as on maximizing expected surplus.

Nguyen meets with Ana Barragan, who manages the corporate defined benefit pension
plan for an external client. Nguyen is seeking more clarity from Barragan on the factors
that impact the pension liability and makes the following observations:

Observation 1: Higher expected investment returns will reduce the pension

liability.

Observation 2: Higher employee turnover will reduce the pension liability.

Observation 3: The pension plan's investment horizon will become shorter with
an increasing proportion of beneficiaries in retirement.

George Fritz, another employee at Hamilton, specializes in consulting for university

endowments and private foundations. Fritz makes the following comments to his
supervisor:

Comment 1: Smaller foundations generally allocate a larger portion of assets

to alternative investments than larger foundations.
Comment 2: Mission-related (or impact) investing is becoming more common
among endowments; furthermore, it is more common for
endowments than for foundations.

Comment 3: Fundraising from donors reduces the net spending rate for
endowments, whereas foundations are generally required to
spend all donations in the year in which they are received.

Question #49 of 86 Question ID: 1749722

Which of Nguyen's points regarding asset allocation and sovereign wealth funds is most
accurate?

A) Point 1 only.
B) Point 2 only.
C) Neither Point 1 nor Point 2.

Question #50 of 86 Question ID: 1749723

How many of Lara's statements are accurate?

A) One.
B) Two.
C) Three.

Question #51 of 86 Question ID: 1749724

Which of Barragan's observations on factors impacting the pension liability is least

accurate?

A) Observation 1.
B) Observation 2.
C) Observation 3.

Question #52 of 86 Question ID: 1749725

Which of Fritz's comments on endowments and/or foundations is most accurate?

A) Comment 1.
B) Comment 2.
C) Comment 3.

Overview for Questions #53-56 of 86 Question ID: 1750135

TOPIC: DERIVATIVES AND RISK MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Ilias Chair works for a derivatives trading and advisory company. He is currently looking
at aircraft manufacturers with the view of implementing some derivative strategies.

Chair is analyzing the financial performance of Glowing Aeronautics, Inc. (Glowing). A

review of publicly available information reveals that Glowing is bidding for a very large
order of passenger aircraft for a national airline in the Middle East. Winning the order
would result in a dramatic rise to its earnings. Losing the order to its main competitor
(AirTaxi) would result in a dramatic decline to its earnings.

Chair is also looking at the implications of covered calls and protective puts on Glowing
to advise clients holding Glowing stock. The current stock price is $20. Further
information is provided in Exhibit 1: Glowing Aeronautics Traded Options Details

Exhibit 1: Glowing Aeronautics Traded Options Details

Option Type Strike Price Premium

Put $14 $2

Call $26 $2
One of Chair's clients holds the stock of AirTaxi, Inc. (AirTaxi), and is concerned about the
downside risk if the company was to lose the bid to Glowing. The client wishes to hedge
downside risk with minimal outlay. Chair seeks the advice of two colleagues, who make
the following statements:

Bright Samuel: "I would consider using a collar. A collar can be constructed by
taking a covered call and adding a long put option."

Connor Matterson: "A collar will hedge downside risk at the expense of capping
upside potential. A collar can be constructed by taking a
protective put and selling a call option."

Further information is provided in Exhibit 2: AirTaxi Traded Options Details.

Exhibit 2: AirTaxi Traded Options Details

Option Type Strike Premium Option Type Strike Premium

Call €26 €5.00 Put €26 €0.80

Call €30 €1.70 Put €30 €1.54

Call €34 €1.00 Put €34 €5.20

Chair has also set up a collar on AirTaxi stock, which currently trades at €30 per share;
the collar is set at €26 to €34.

Question #53 of 86 Question ID: 1749742

Using the data in Exhibit 1, which of the following statements is most accurate regarding
a covered call and a protective put position on Glowing?

The maximum gain of the covered call is equal to the maximum gain of the protective
A)
put.
The breakeven point of the covered call is higher than the breakeven point of the
B)
protective put.
The maximum gain of the covered call exactly offsets the maximum loss of the
C)
protective put.
Question #54 of 86 Question ID: 1749743

Which of the following strategies will best exploit Chair's market expectations on Glowing
regarding the potential Middle East order?

A) Bull spread.
B) Covered call.
C) Long straddle.

Question #55 of 86 Question ID: 1749744

Which of Chair's colleagues' comments regarding the collar is most accurate?

A) Samuel’s comment only.

B) Matterson’s comment only.
C) Both Samuel's and Matterson’s comments.

Question #56 of 86 Question ID: 1749745

Using the data in Exhibit 2, if Chair's goal was to minimize the potential loss on an AirTaxi
trading strategy, which of the following strategies would be most appropriate?

A) 26/34 bull call spread.

B) 26/34 bear put spread.
C) Long straddle with a strike of €30.

Overview for Questions #57-60 of 86 Question ID: 1749771

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Jessica Fletcher, Frank Dowling, and Philip Prestwick are now retired. They meet each
month for lunch at Au Cheval to discuss their post-retirement investment strategies.
Fletcher is a relative value investor, Dowling is a GARP investor, and Prestwick likes
strategies with a lower chance of downside risk.

The group review four stocks, shown in Exhibit 1.

Exhibit 1: Stocks

12-Month 3-Year EPS Growth Dividend Sector Average

Company Price
EPS Forecast Yield P/E

A 62 6 18% 1% 13

B 45 3 4% 2% 18

C 29 3 3% 4% 12

D 33 2 5% 3% 16

Dowling's sister, Stephanie, likes to invest in the latest trends; her husband, Charlie,
takes a contrarian view regarding investment decisions.

Question #57 of 86 Question ID: 1749772

Which stock—Stock A, Stock B, Stock C, or Stock D—is least likely to be chosen by

Fletcher? Justify your answer.

Question #58 of 86 Question ID: 1749773

Which stock—Stock A, Stock B, Stock C, or Stock D—is least likely to be chosen by

Dowling? Justify your answer.
Question #59 of 86 Question ID: 1749774

Which stock—Stock A, Stock B, Stock C, or Stock D—is most likely to be chosen by

Prestwick? Justify your answer.

Question #60 of 86 Question ID: 1749775

Determine, between Stephanie or Charlie, who is more in line with behavioral finance
principles in their investing approach. Justify your answer with one reason.

Overview for Questions #61-64 of 86 Question ID: 1750123

TOPIC: ASSET ALLOCATION

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Gofton Asset Management (GAM) is an investment firm based in the United States.

Maria Delgado, CFA, chief economic strategist at GAM, has been assigned the task of
conducting an economic analysis of the impact of monetary and fiscal policies on the
performance of U.S. real estate. In an attempt to offer some diversification benefits to its
clients, GAM has decided to consider the possibility of including real estate–based
products in its funds.

As part of her analysis, she has collected key economic information from the Federal
Reserve Bank's (FRB) most recent financial projections to forecast next year's Fed funds
rate as shown in Exhibit 1.

Exhibit 1: Selected Data from the Federal Reserve Bank

Neutral rate 2%

Inflation target 3%

Expected inflation 1%
Expected real gross domestic product (GDP) growth rate 4%

Real GDP growth trend 3.5%

Delgado notes that the FRB has adopted quantitative easing over the past decade.
Through open market operations, the FRB has tried to help stimulate the economy. With
inflation expectations remaining low, Delgado reads from the FRB's most recent press
release that a rate cut is very likely and Delgado is now concerned that interest rates
might soon become negative.

Delgado seeks advice from her colleague, John Henderson, CFA, an economist.
Henderson made the following comments:

Comment 1: With quantitative easing, there was an increase in the FRB's

balance sheet, bank reserves have dramatically declined, and
yields on government bonds have dropped.

Comment 2: Negative interest rates would encourage individuals to hold

currencies, which would eventually drain deposits and reserves
from the banking system.

Delgado observed that, "Given the current federal budget deficit, it is clear that the
government has chosen to adopt fiscal expansion with the intention of creating new jobs
across a range of industries."

Henderson further observes that, "Upon evaluating the federal budget deficit on a
standalone basis, we can conclude that the government will be expecting higher tax
receipts and increased federal spending in the future, all other things being equal."

Henderson then stated that monetary and fiscal strategies might support or conflict with
each other. With regard to their combining impact on the yield curve and the economic
environment, he made the following statements:

Statement 1: If monetary policy is expansionary and fiscal policy is restrictive,

the yield curve is moderately steep and the economic
implications are less clear.

Statement 2: If both monetary and fiscal policies are expansionary, the yield
curve is steep and the economy will likely expand.

Statement 3: If monetary policy is restrictive and fiscal policy is expansionary,

the yield curve is moderately inverted and the economic
 implications are less clear.

Question #61 of 86 Question ID: 1606310

Using the data provided in Exhibit 1 and the Taylor rule, the nominal short-term interest
rate target rate is closest to:

A) 2.25%.
B) 2.75%.
C) 3.75%.

Question #62 of 86 Question ID: 1606311

Which of the comments made by Henderson is most accurate regarding the impact of
quantitative easing and negative interest rates?

A) Comment 1.
B) Comment 2.
C) Neither Comment 1 nor Comment 2.

Question #63 of 86 Question ID: 1614300

Concerning the federal budget deficit, the least accurate observation was made by:

A) Henderson regarding tax receipts.

B) Delgado regarding fiscal expansion.
C) Henderson regarding federal spending.

Question #64 of 86 Question ID: 1606313

Which of Henderson's statements with respect to the impact of monetary and fiscal
policies on the yield curve is least accurate?

A) Statement 1.
B) Statement 2.
C) Statement 3.

Overview for Questions #65-67 of 86 Question ID: 1750137

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Jack Walsh manages the assets for a large European airline's defined benefit (DB)
pension plan. The DB plan is currently underfunded with a deficit of £3.5 billion. The DB
plan's projected benefit obligation (PBO) is currently £16 billion and has an estimated
duration of 12.

The plan assets are split into two portions: return seeking and liability matching. The
return-seeking assets (equity-based ETFs and alternative investments) are held to
generate returns in excess of risk-free assets and comprise 56% of the plan assets. The
liability-matching assets (U.K. government Treasury bonds [gilts] and investment-grade
corporate bonds) comprise the remaining 44% of plan assets and have a duration of 13.

Exhibit 1 provides futures pricing data.

Exhibit 1

UK Long Gilt Futures Specifications

Futures price £118.50

Futures contract size £100,000

CTD 2.50% coupon 19 years to redemption

CTD price £96.32

CTD conversion factor 0.8017

CTD modified duration 14.95

Walsh also considers eliminating the duration gap by using over-the-counter (OTC)
interest rate swaps, shown in Exhibit 2.

Exhibit 2

£Fixed vs. £LIBOR Interest Rate Swap

Fixed side duration 12.5

Floating side duration 0.5

Walsh believes that interest rates will rise. Ideally, he would hedge less than 100% of the
duration gap to benefit the DB plan if his belief about interest rates is correct. However,
the plan trustees require him to hedge 100% of the duration gap.

The plan trustees monitor the performance of the return-seeking portion of the portfolio
relative to predetermined indices. The trustees use two indices to monitor the
performance of the liability-matching portion: a U.K. investment-grade bond index and a
U.K. government bond index. Walsh aims to minimize tracking risk but believes it is more
difficult to do so in fixed-income markets compared to other major asset classes, such as
public equity.

Question #65 of 86 Question ID: 1749782

Calculate the number of futures contracts that Walsh must buy/sell to hedge the
duration gap (indicate a plus sign for buy or a minus sign for sell).

Question #66 of 86 Question ID: 1749783

Assuming Walsh fully hedges the duration gap, identify a derivative overlay that will
enable Walsh to benefit from his forecast change in interest rates while remaining fully
hedged if his forecast turns out to be incorrect. Explain how this product will allow him
to benefit from his forecast while remaining fully hedged.
Question #67 of 86 Question ID: 1749784

Identify two reasons why tracking risk is difficult to eliminate, even for fixed-income
portfolios that aim to fully replicate the index.

Overview for Questions #68-71 of 86 Question ID: 1750130

TOPIC: PORTFOLIO CONSTRUCTION

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Daniel Castillo and Ramon Diaz are senior investment officers at Advanced Advisors (AA),
a large U.S.-based firm. AA uses numerous quantitative models to invest in both
domestic and international fixed-income securities.

AA offers investment funds that take long-only positions in varying fixed-income styles.
For example, they offer both a low and high interest rate risk fund. Current statistics of
the funds are provided in Exhibits 1 to 3.

Exhibit 1: Bond Strategy Fund Details

Lower Duration Higher Duration

Strategy Strategy

Duration 2.57 7.32

Convexity 21.56 195.62

Expected annual return 3.55% 8.45%

Expected monthly standard

0.62% 1.13%
deviation (σ)

Exhibit 2: Lower Duration Strategy

Average coupon rate 3%

Portfolio value per $100 par $108.60

Projected portfolio value in one year (assuming static yield curve) $109.20
Exhibit 3: High Duration Portfolio: Spread Measures (Basis Points)

Yield spread 211.45

G-spread 209.95

I-spread 208.25

Z-spread 210.11

Option-adjusted spread 210.11

Question #68 of 86 Question ID: 1749712

Diaz realizes he also needs to consider downside risk in the longer-duration strategy. He
decides to analyze what will happen if there is an immediate 60 basis point increase in
interest rates. Using the data in Exhibit 1, the expected change in value of the longer-
duration portfolio is closest to:

A) −4.0%.
B) −4.4%.
C) +4.8%.

Question #69 of 86 Question ID: 1749713

Diaz has yet to complete his computation of expected return of the low duration
portfolio. Using the data in Exhibit 2, the rolling yield on this portfolio is closest to:

A) 0.55%.
B) 2.76%.
C) 3.31%.

Question #70 of 86 Question ID: 1749714

The data in Figure 9 shows various measures of credit spread. Which duration measure
uses a proportional percentage change in the credit spread, rather than an
absolute change?

A) Spread duration.
B) Duration times spread.
C) Portfolio dispersion.

Question #71 of 86 Question ID: 1749715

Advanced Advisors are most likely to follow which of the following fixed-income
mandates?

A) Liability-based.
B) Asset-only.
C) Contingent immunization.

Overview for Questions #72-74 of 86 Question ID: 1750124

TOPIC: ASSET ALLOCATION

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Martin Bradbury is an investment advisor. Eleanor Carter is a client with whom Bradbury
is in discussion with a view to developing an appropriate strategic asset allocation. Carter
has $1.25 million to invest, and Bradbury assesses that she has a below-average level of
risk tolerance (λ = 6).

Exhibit 1 presents key statistics on four possible strategic asset allocations for Carter (all
are efficient portfolios, derived using a mean-variance optimization technique). The
Sharpe ratios are calculated assuming a risk-free rate of 2.5% (and all return figures are
in pretax nominal terms).

Exhibit 1: Strategic Asset Allocations

 Asset Allocation A B C D

Expected return 3.8% 6.7% 9.6% 12.9%

Standard deviation 3.7% 5.9% 10.5% 16.8%

Sharpe ratio 0.351 0.712 0.676 0.619

MSCI World ex. USA weighting 4.7% 7.6% 13.5% 22.9%

Carter will need to make a loan payment of $40,000 in 12 months' time, which will
necessitate a withdrawal of funds from the portfolio at that point. Bradbury ascertains
that Carter's goal is that the real value of the portfolio, having made this payment,
should not fall below its current level—assuming an inflation rate of 2%. Withdrawals
from the portfolio will be taxed at 20%.

Bradbury also advises Frank Mosta, a childless widower who recently retired with total
assets of $12 million. Mosta has two goals that he wishes to achieve during his
retirement.

Goal 1: Mosta wishes to have a 90% chance of transferring $9 million to

his sister's children in 12 years.

Goal 2: Mosta wishes to have a 70% chance of being able to donate $18
million to a foundation in 20 years.

Bradbury recommends the adoption of a goals-based portfolio construction approach,

and he develops a set of modules (subportfolios) that are shown in Exhibit 2. Bradbury
suggests that any excess capital should be invested in Module W.

Exhibit 2: Subportfolio Modules Under Various Horizon and Probability Scenarios

Module W X Y Z

Expected return 5.2% 7.2% 8.6% 9.4%

Standard deviation 4.2% 6.1% 8.8% 11.4%

Annualized Minimum Expectation Returns

Time Horizon (Years): 12

W X Y Z

Required Success: 90% 3.7% 4.9% 5.3% 5.2%

 80% 4.2% 5.7% 6.5% 6.6%

70% 4.6% 6.3% 7.3% 7.7%

60% 4.9% 6.8% 8.0% 8.6%

Time Horizon (Years): 20

Required Success: 90% 4.0% 5.5% 6.1% 6.1%

80% 4.4% 6.1% 6.9% 7.3%

70% 4.7% 6.5% 7.6% 8.1%

60% 5.0% 6.9% 8.1% 8.8%

Question #72 of 86 Question ID: 1750125

Based on utility-adjusted expected returns for the asset allocations, identify which
allocation in Exhibit 1 Bradbury should recommend for Carter (A, B, C, or D). Justify your
choice of allocation.

Question #73 of 86 Question ID: 1750126

Identify which allocation in Exhibit 1 Bradbury should recommend for Carter to

minimize the likelihood that the portfolio fails to meet her goal regarding real value (A, B,
C, or D). Justify your choice and state any assumptions you have made, including
calculations.

Question #74 of 86 Question ID: 1749700

State and justify the overall asset allocation for Mosta, given his two goals and
Bradbury's suggestion for investing any excess capital. Your answer should be in terms
of the percentage of total assets invested in each module.
Overview for Questions #75-78 of 86 Question ID: 1750139

TOPIC: PORTFOLIO MANAGEMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Gemma Garnier is considering taking advantage of an opportunity that she believes

exists in relation to two similar-sized U.S. pharmaceutical companies, Moliere and
Racine. Her view is that Racine's credit spreads are likely to narrow relative to Moliere's,
and she wants to trade on this happening without exposing herself to general changes in
the level of spreads in the pharmaceutical sector. She decides that using credit default
swaps would be an efficient way of exploiting her view, and she gathers the information
in Exhibit 1.

Exhibit 1: Pharma Sector CDS Contracts

Issuer Credit Rating Tenor (Years) CDS Spread Effective Spread Duration

Moliere A 6 94 bps 5.73

Racine BBB 6 98 bps 5.58

Garnier determines that she will take a notional principal position of $16 million in each
of the contracts.

Before the trade is implemented, however, Garnier is in receipt of research that causes
her to doubt her view on the way the relative spreads of the two companies will likely
change. She decides to focus instead on Moliere in isolation, the creditworthiness of
which she expects to deteriorate. She enters into the appropriate $15 million notional
principal trade in the Moliere CDS. The Moliere CDS spread is 96 bps at that point, but
the effective spread duration is still as per Exhibit 1.

One year later, Moliere has been downgraded to an A– rating, and a five-year maturity
CDS for that issuer has a CDS spread of 121 bps, with an effective spread duration of
4.84. At that point, Garnier closes out her trade.

Garnier then turns her attention to the overall state of the economy. She strongly
believes that there will be a recovery in the near future and decides to use CDX contracts
on investment-grade and high-yield indexes to trade on this view.
Question #75 of 86 Question ID: 1749791

Describe and justify the position in CDSs that Garnier would have used to exploit her
initial view regarding Moliere and Racine.

Question #76 of 86 Question ID: 1750140

Compute the net premium that Garnier would have paid or received on entering into
the trade you described in the previous question. Identify whether this would have been
paid to, or paid by, Garnier.

Question #77 of 86 Question ID: 1749793

Calculate the net profit or loss on the actual trade that Garnier undertook based on her
revised view.

Question #78 of 86 Question ID: 1749794

Describe and justify the relative value trade that Garnier could implement, using CDX IG
and CDX HY index contracts, to exploit her view on the economy.

Overview for Questions #79-82 of 86 Question ID: 1750134

TOPIC: PERFORMANCE MEASUREMENT

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

The Magister Foundation (MF) has received a substantial donation and wants to invest it
in a managed fund which would be an addition to its existing portfolio of equity funds. A
fund under consideration is the EDZ Fund, whose marketing materials claim that it
maintains a diversified exposure to the market, while still benefitting from a proprietary
market timing strategy. Lauren Matthews is an analyst employed by MF and she is
investigating whether the EDZ Fund has been successful in its market timing. Fund and
benchmark returns over the past 8 years are given in Exhibit 1:

Exhibit 1: EDZ Fund and Benchmark Returns for Past 8 Years

Year 1 2 3 4 5 6 7 8

EDZ 7.3% 5.5% 11.8% 8.4% 4.2% 1.4% -2.5% 5.2%

Benchmark 6.5% 5.4% 12.2% 8.4% 3.8% 0.9% -2.2% 5.3%

From the data in Exhibit 1, Matthews has correctly computed that the EDZ fund achieved
an upside capture of 103.2%, and concludes that, relative to their benchmark, EDZ
displayed positive asymmetry, or a convex return profile, which is a desirable attribute.

It has been suggested that an alternative way of investing the donation would be to split
it evenly between a value manager and a growth manager, both of whom would select
stocks from the mid-cap segment of the domestic equity market ¬¬— an area that is
currently underrepresented in MF's equity exposures. Matthews considers managers
who have lengthy track records with mid-cap value and growth stocks. Based on an
analysis of the value added by three of these managers, she assesses them as having the
skill levels as shown in Exhibit 2:

Exhibit 2: Matthews' skills assessments

Manager Mid-cap Value stock skill level Mid-cap Growth stock skill level

AB Skilled Skilled

CD Skilled Unskilled

EF Unskilled Skilled

The MF board has indicated an interest in opportunistic funds, though they are
concerned that an extended period of losses would cause difficulties. Matthews analyzes
the returns for the BWV Fund, one of the funds that is on the MF board's shortlist.
Returns for the previous 12 months are shown in Exhibit 3:
Exhibit 3: BWV Fund Monthly Returns Previous 12 months

Month Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan

Return (%) 4.36 7.13 5.22 -2.45 -3.86 -7.14 5.12 4.24 3.35 3.47 1.18 4.02

The BWV Fund charges a monthly performance-based fee, but this is subject to a high-
water-mark provision whereby such a fee can only be charged once any losses have
been recouped.

Question #79 of 86 Question ID: 1749737

Is Matthews' conclusion that "EDZ displayed positive asymmetry, or a convex return

profile, which is a desirable attribute" correct or incorrect? It is:

A) correct
incorrect because the capture ratio indicates negative asymmetry of returns, thus an
B)
undesirable, concave, profile.
incorrect because, although the capture ratio does indicate positive asymmetry of
C)
returns, this is associated with a concave, not a convex, return profile.

Question #80 of 86 Question ID: 1749738

Assuming that Matthews' skill assessments in Exhibit 2 are correct, then MF would be
committing a Type I, but not a Type II, error if they were to:

A) Engage AB for value stocks, but not engage AB for growth stocks.
B) Not engage CD for value stocks, but engage CD for growth stocks.
C) Engage EF for value stocks, and engage EF for growth stocks.

Question #81 of 86 Question ID: 1749739

Based on the data in Exhibit 3, which of the following is closest to the maximum
drawdown for BWV in the period covered by the data?

A) 12.9%.
B) 13.45%.
C) 14.12%.

Question #82 of 86 Question ID: 1749740

Matthews realizes that the returns data for May-July in Exhibit 3 was inaccurate (for the
other months the data was fine), and that the maximum drawdown was actually 15%.
Assuming that the end of April was a high-water mark for the BWV fund, which is the first
month after April in which the fund would have been able to charge a performance-
based fee?

A) October.
B) November.
C) December.

Overview for Questions #83-86 of 86 Question ID: 1750127

TOPIC: TOPIC: PORTFOLIO CONSTRUCTION

TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Mari Fujimoto, CFA, is an equity portfolio manager. After a period of weak equity returns,
the current economic environment is now one of strong equity returns and rising
interest rates.

This morning, Fujimoto is meeting with a new client, Ken Liu. Liu does not believe in
market efficiency and is not overly concerned about management fees. Liu wants to
invest in only specific markets and avoid investing in stocks pertaining to alcohol and
tobacco.
Additionally, Fujimoto manages an index fund for an institutional client. The fund has a
diversified and stable holding of stocks. Fujimoto would like to begin engaging in
securities lending whereby the fund would lend some of its shares in exchange for cash
collateral and a lending fee. She feels it would be an excellent way to generate additional
portfolio income for the client.

Over time, Fujimoto engages in two general types of transactions for the index fund:

Transaction type 1: periodic reweighting of the stocks in the index

Transaction type 2: adding and deleting stocks in the index

Fujimoto is giving a presentation on the role of equities in a portfolio. One of her

colleagues has drafted the following two statements for her to review:

Statement 1: Over both short and long periods of time, dividends have
comprised a significant component of total returns for equity
investors.

Statement 2: During periods of market crisis, correlations across asset

classes and among equities themselves often decrease.

Question #83 of 86 Question ID: 1749707

State whether Liu's portfolio is likely to be passively or actively managed. Justify your
choice with two reasons.

Question #84 of 86 Question ID: 1749708

Identifythree additional factors that Fujimoto should consider before engaging in

securities lending.

Question #85 of 86 Question ID: 1750128

Identify whether Statement 1 is correct or incorrect. If you chose incorrect, justify why
the statement is incorrect.

Question #86 of 86 Question ID: 1750129

Identify whether Statement 2 is correct or incorrect. If you chose incorrect, justify why
the statement is incorrect.