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1. “The GIPS general provisions for real estate and for private equity require that both income and capital gains are included in the calculation and presentation of returns."

Of the three scenarios (see Figure 2) presented to the Beeman Enterprises executives, which would represent the appropriate reaction to increasing the pension plan allocation to equity, if management wishes to maintain its current equity beta?

2. Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Quaker Fund. BIC is an asset management firm headquartered in Holland with regional offices in several other European countries.

After accepting the position, Bair received a letter from the three principals of BIC. The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations.

Among other things, the letter stated the following:

"Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund. It is your responsibility to obtain this knowledge and comply with appropriate regulations. This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully. You will likely need to arrange for our sister companies to quietly buy and sell Quaker Fund shares over the first month of operations. This will provide sufficient price support to allow the fund to trade closer to its net asset value than other small-cap closed-end funds. Because these funds generally trade at a discount to net asset value, if our fund trades close to its net asset value, the market may perceive it as more desirable than similar funds managed by our competitors."

Bair heeded the advice from her firm's principals and collected information on the laws and regulations of three countries: Norway, Sweden, and Denmark. So far, all of the investors expressing interest in the Quaker Fund are from these areas. Based on her research, Bair decides the following policies are appropriate for the fund:

Note: Laws mentioned below are assumed for illustrative purposes.

• For clients located in Norway the fund will institute transaction crossing, since, unlike in Holland, the practice is not prohibited by securities laws or regulations. The process will involve internally matching buy and sell orders from Norwegian clients whenever possible. This will reduce brokerage fees and improve the fund's overall performance.

• For clients located in Denmark, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by Denmark's securities regulators, even though the laws in Holland only require such reports to be generated on a quarterly basis.

• For clients located in Sweden, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment. This policy is consistent with the laws and regulations in Holland. Sweden's securities regulations do not cover this type of situation.

Three months after the inception of the fund, its market value has grown from $200 million to $300 million and Bair's performance has earned her a quarter-end bonus. Since it is now the end of the quarter, Bair is participating in conference calls with companies in her fund. Bair calls into the conference number for Swift Petroleum. The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Swift discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter. The restatement will not be announced until the year's end, six months from now. Bair does not remind the officers that she can hear their conversation. Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call. Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call. The investment bankers then proceed to sell their personal holdings of Swift Petroleum stock. After her meeting, Bair sells the Quaker Fund's holdings of Swift Petroleum stock.

With regard to the treatment of clients in Sweden, does the policy that Bair has selected for the Quaker Fund violate any CFA Institute Standards of Professional Conduct?

3. Gabrielle Reneau, CFA, and Jack Belanger specialize in options strategies at the brokerage firm of Damon

and Damon. They employ fairly sophisticated strategies to construct positions with limited risk, to profit from future volatility estimates, and to exploit arbitrage opportunities. Damon and Damon also provide advice to outside portfolio managers on the appropriate use of options strategies. Damon and Damon prefer to use, and recommend, options written on widely traded indices such as the S&P 500 due to their higher liquidity.

However, they also use options written on individual stocks when the investor has a position in the underlying stock or when mispricing and/or trading depth exists.

In order to trade in the one-year maturity puts and calls for the S&P 500 stock index, Reneau and Belanger contact the chief economists at Damon and Damon, Mark Blair and Fran Robinson. Blair recently joined Damon and Damon after a successful stint at a London investment bank. Robinson has been with Damon and Damon for the past ten years and has a considerable record of success in forecasting macroeconomic activity. In his forecasts for the U.S. economy over the next year, Blair is quite bullish, for both the U.S. economy and the S&P 500 stock index. Blair believes that the U.S. economy will grow at 2% more than expected over the next year. He also states that labor productivity will be higher than expected, given increased productivity through the use of technological advances. He expects that these technological advances will result in higher earnings for U.S. firms over the next year and over the long run.

Reneau believes that the best S&P 500 option strategy to exploit Blair's forecast involves two options of the same maturity, one with a low exercise price, and the other with a high exercise price. The beginning stock price is usually below the two option strike prices. She states that the benefit of this strategy is that the maximum loss is limited to the difference between the two option prices.

Belanger is unsure that Blair's forecast is correct. He states that his own reading of the economy is for a continued holding pattern of low growth, with a similar projection for the stock market as a whole. He states that Damon and Damon may want to pursue an options strategy where a put and call of the same maturity and same exercise price are purchased. He asserts that such a strategy would have losses limited to the total cost of the two options.

Reneau and Belanger are also currently examining various positions in the options of Brendan Industries. Brendan Industries is a large-cap manufacturing firm with headquarters in the midwestern United States. The firm has both puts and calls sold on the Chicago Board Options Exchange. Their options have good liquidity for the near money puts and calls and for those puts and calls with maturities less than four months. Reneau believes that Brendan Industries will benefit from the economic expansion forecasted by Mark Blair, the Damon and Damon economist. She decides that the best option strategy to exploit these expectations is for her to pursue the same strategy she has delineated for the market as a whole. Shares of Brendan Industries are currently trading at $38. The following are the prices for their exchange-traded options.





As a mature firm in a mature industry, Brendan Industries stock has historically had low volatility.

However, Belanger's analysis indicates that with a lawsuit pending against Brendan Industries, the volatility of the stock price over the next 60 days is greater by several orders of magnitude than the implied volatility of the options. He believes that Damon and Damon should attempt to exploit this projected increase in Brendan Industries1 volatility by using an options strategy where a put and call of the same maturity and same exercise price are utilized. He advocates using the least expensive strategy possible.

During their discussions, Reneau cites a counter example to Brendan Industries from last year. She recalls that Nano Networks, a technology firm, had a stock price that stayed fairly stable despite expectations to the contrary. In this case, she utilized an options strategy where three different calls were used. Profits were earned on the strategy because Nano Networks' stock price stayed fairly stable. Even if the stock price had become volatile, losses would have been limited.

Later that week, Reneau and Belanger discuss various credit option strategies during a lunch time presentation to Damon and Damon client portfolio managers. During their discussion, Reneau describes a credit option strategy that pays the holder a fixed sum, which is agreed upon when the option is written, and occurs in the event that an issue or issuer goes into default. Reneau declares that this strategy can take the form of either puts or calls. Belanger states that this strategy is known as either a credit spread call option strategy or a credit spread put option strategy.

Reneau and Belanger continue by discussing the benefits of using credit options. Reneau mentions that

credit options written on an underlying asset will protect against declines in asset valuation. Belanger says that credit spread options protect against adverse movements of the credit spread over a referenced benchmark.

Regarding their comments concerning the credit option strategy that pays the holder a fixed sum, are Reneau and Belanger correct or incorrect?

4. Mary Rolle and Betty Sims are portfolio managers for RS Global Investments, located in Toronto, Canada. RS specializes in seeking undervalued stocks and bonds throughout the North American, Asian, and European markets. RS has clients throughout North America, however, the majority are Canadian institutional investors. RS has traditionally managed currency risk in their portfolios by assigning it to their portfolio managers. The manager is allowed discretion for hedging currency risk within the confines of the investor's investment policy statement.

Rolle and Sims are currently deciding whether to hedge the currency risk of a portfolio of Japanese stocks. Rolle explores the possibility of using three different currency hedges. Each is an option contract on the yen-Canadian dollar exchange rate.





RS has a portfolio of European stocks and would like to change its equity risk. They can enter into futures contracts on the Eurostoxx index of large European stocks. The information below provides the characteristics of the futures contract and the portfolio.

Portfolio value in euros 2,000,000

Desired beta value 1.80

Current portfolio beta 0.60

Beta of futures contract 1.02

Value of one futures contract in euros 110,000

RS is also invested in British and Argentine stocks. RS has taken a position in two main sectors of the British economy. The first sector consists of manufacturers who derive a great deal of their business from exporting to the United States and Canada. The other sector consists of British service firms who are largely immune from international competition, because most of their business is localized and cannot be provided by foreign firms. The main investment in the Argentine stocks consists of firms who provide cellular phone service to Argentine consumers. Rolle and Sims discuss which currency positions RS should hedge.

RS occasionally invests in mortgage-backed securities sold in the United States. The growth in these securities has increased tremendously over the past three decades as firms have used securitization to remove the risk of these securities from their balance sheet. RS holds a mortgage security issued by CWC International. This mortgage security has a coupon rate higher than newly issued mortgage securities. Sims discusses the return for this security when hedged with a short position in Treasury bond futures. Rolle and Sims further discuss how to hedge the risk of mortgage securities. Rolle states that two Treasury bond futures contracts are typically used instead of just one. Sims states that a hedge becomes more important if the volatility of interest rates increases.

Regarding the currency hedge of the British and Argentine stocks, which of the following would RS least likely hedge?

5. Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk, its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).

Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost, which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims before it could settle the agreement with Johnson Associates. McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the possibility of default on current obligations, while future credit risk relates to potential default on future obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value of current obligations and the present value of future obligations. Cramer adds that combining current and potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a reliable predictor of a borrower's potential credit risk.

As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with forward agreements. Cramer states that long forward contracts gain in value when the market price of the underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk and forward contracts in the handbook.

She offers the following:

A forward contract sold by Palmer Securities has six months until the delivery date and a contractprice of 50. The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus 3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The characteristics of the forward contract are shown below.

Information on the Credit Spread Forward





Regarding their statements concerning controlling credit risk, determine whether Cramer and McNally are correct or incorrect.

6. Bartholomew Hope, CFA, is the chief investment officer of Children's Trust Foundation (CTF), a foundation that supports a wide variety of child-related causes. CTFs total assets total $2.3 billion. The foundation's current asset mix is 55% stocks, 35% bonds, and 10% cash (T-bills earn 3.5%). The foundation provides $126.5 million annually for a variety of programs for children, which is forecasted to remain more or less constant in real terms. Hope does not envision any major capital expenditures for the foreseeable future. CTF's investment portfolio has underperformed its benchmark over the past three years. Hope believes corrective action is needed to address the issue of poor performance. Hope wants to evaluate the possibility the portfolio's risk to reward profile. Hope's staff generates Exhibit 1, which reviews the relevant necessary metrics to make the asset mix decision. The overall cost of investing the assets is 75 basis points.

Exhibit 1: Expected Returns, Risk, and Correlations for Asset under Consideration





One of the members of Hope's staff, Rene Meyer, includes a report on the key attributes of investing in venture capital funds.

The report includes the following sections:

Structure: "Indirect venture capital investments are achieved by pooling the funds of multiple investors into a limited partnership (LP). The investors are limited partners who allow a general partner to control the investments for a period of 7 to 10 years. The general partner also invests capital, earning a management fee of 1.5% to 2.5% of invested capital and a carried interest fee, which is generally 20% of the fund profits, after the fund's hurdle rate has been met."

Strategy: "Because initial public offerings are a primary exit strategy of venture capital investing, the correlation between public equity markets and returns on venture capital investments are positive. Therefore, the primary focus of any venture capital investment undertaken by Glendale should be long-term return enhancement rather than significant diversification. In addition, Glendale must make sure that all of the committed capital is available for the required up front cash distribution to the general partner at the beginning of the investment period."

Hope recognizes there are several unique strategies within the hedge fund group that have very different risk to reward trade-offs. Hope identifies three hedge funds as potential investment opportunities for the CTF. Exhibit 2 lists the funds under consideration and their most recent securities transactions.

Exhibit 2: Hedge Fund Transactions





While Clark presents the hedge funds, Hope comments that he is concerned with the potential difficulties in measuring hedge fund manager performance. Glendale's charter has strict requirements regarding the performance assessment of investment managers who control the assets of the foundation. Hope believes the performance of alternative investments presented may be difficult to evaluate against a benchmark index as required by Glendale's charter.

One of Hope's staff members has written a report on the proposed private equity investment. State whether the comments in the report related to the structure and strategy of CTFs private equity investment are correct.

7. Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has been examining portfolio risk using traditional methods such as the portfolio variance and beta. He has ranked portfolios from least risky to most risky using traditional methods.

Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount of money clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solely for Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using the variance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviation is expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (in millions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000 scenarios). The following table provides the results of the simulation:

Figure 1: Monte Carlo Simulation Data





The top row (Percentile) of the table reports the percentage of simulations that had returns below those reported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and 97.5% of the simulations provided a return of 20% or less.

Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfolio management practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon to justify his use of VAR methodology and explain why the estimated VAR varies depending on the method used to calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client, the York Pension Plan.





To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluating portfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the York Pension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Note that the minimum acceptable return is the risk-free rate.

Figure 3: Performance Ratios for the York Pension Plan





Using the performance evaluation information compiled by Dennon, determine which of the following statements is most likely correct with regard to the York Pension Plan. Over the last three years, the:

8. Johnny Bracco, CFA, is a portfolio manager in the trust department of Canada National (CNL) in Toronto. CNL is a financial conglomerate with many divisions. In addition to the trust department, the firm sells financial products and has a research department, a trading desk, and an investment banking division. Part of the company's operating procedures manual contains detailed information on how the firm allocates shares in oversubscribed stock offerings. Allocation is effected on a pro rata basis based upon factors such as the size of a client's portfolio, suitability, and previous notification to participate in IPOs. Additionally, company policy discloses to clients that any trade needs to meet a minimum transaction size in an effort to control trading costs and to comply with best execution procedures.

One of Bracco's trust accounts is the Carobilo family trust, which contains a portion of nondiscretionary funds managed by Stephen Carobilo. Carobilo has a friend who runs a brokerage firm called First Trades, to which Carobilo tells Bracco to direct trades from the nondiscretionary accounts. Bracco has learned that First Trades charges a slightly higher trading fee than other brokers providing comparable services, and he discloses this to Carobilo.

Due to high prices and limited supplies of oil, Bracco has been following companies in the energy sector. He believes this area of the economy is in turmoil and should present some mispricing opportunities. One company he has been researching is Stiles Corporation, which is working on a new type of hydrogen fuel cell that uses fusion technology to create energy. To date, no one has been able to successfully sustain a fusion reaction for an extended period of time. Bracco has been in close contact with Stiles' pubic relations department, has toured their laboratories, and has thoroughly researched fusion technology and Stiles' competitors. Bracco is convinced from his research, based upon various public sources, that Stiles is on the verge of perfecting this technology and will be the first firm to bring it to the marketplace. Jerry McNulty, CFA and vice president of the investment banking division of CNL, has been working with Stiles to raise new capital via a secondary offering of Stiles common shares. One day Bracco happened to be in a stall in the bathroom when McNulty and a colleague came in and discussed the fact that Stiles had perfected the fuel-cell technology, which will greatly increase the price of Stiles1 stock.

Stiles Corporation's board of directors includes Dr. Elaine Joachim, who is a physics professor at the University of Toronto. She also works part-time for Stiles Corporation as a consultant in their fusion technology laboratory. Her husband is a materials engineer who recently started performing consulting work for Stiles.

A routine audit by the quality control department at CNL discovered trading errors in several of Bracco's accounts involving an oversubscribed IPO. Some accounts received shares they should not have and others did not receive shares they should have. Bracco and his supervisor Jaime Gun, CFA, are taking responsibility to reverse the incorrect trades. Bracco told Gun, "I'll correct the trades based on our clients' investment policy statements, previous notification of intent, and according to the company's formula for allocating shares on a pro rata basis. In so doing, we will fairly allocate shares so even small accounts that did not meet minimum size requirements will receive some shares of the IPO." Gun replied to Bracco by saying, "I'll credit short-term interest back to the accounts that should not have received the shares and subtract interest from the accounts that should have received the shares."

That evening, Bracco and his wife attended the company holiday party for CNL employees and their spouses. Jerry McNulty, whose wife was ill and could not come to the party, arrived drunk from a meeting with Stiles' upper management. During the party McNulty made inappropriate advances toward many of the female employees and joked about the inadequacies of Stiles' managers.

Has Bracco violated any soft dollar standards regarding the Carobilo family trust? Bracco has:

9. Powerful Performance Presenters (PPP) is a performance attribution and evaluation firm for pension consulting firms and has recently been hired by Stober and Robertson to conduct a performance attribution analysis for TopTech. Tom Harrison and Wendy Powell are the principals for PPP. Although performance attribution has come under fire lately because of its shortcomings, Stober believes PPP provides a needed service to its clients. Robertson shares Stober's view of performance attribution analysis.

Stober and Robertson request that Harrison and Powell provide a discussion of performance measures.

During a conversation on complements to attribution analysis, Harrison notes the uses of the Treynor ratio. He states that the Treynor ratio is appropriate only when the investor's portfolio is well diversified. Powell states that the Sharpe ratio and the Treynor ratio will typically yield the same performance rankings for a set of portfolios.

Stober requests that PPP do some performance attribution calculations on TopTech's managers.

In order to facilitate the analysis, Stober provides the information in the following table:





Harrison states one of PPP's services is that it will determine if TopTech has chosen a valid benchmark. Stoher volunteers that indeed his firm's benchmark possesses the properties of a valid benchmark and describes its composition.

The benchmark has the following characteristics:

• It uses the top 10% of U.S. portfolio managers each year in each asset class as the benchmark for TopTech managers;

• TopTech is very careful to make sure that its managers are familiar with the securities in each benchmark asset class;

• The identities and weights of various securities in the TopTech benchmark are clearly defined.

During a presentation to Stober, Robertson, and other TopTech executives, Harrison and Powell describe how macro attribution analysis can decompose an entire fund's excess returns into various levels. In his introduction, Robertson delineates the six levels as net contributions, risk-free return, asset categories, benchmarks, investment managers, and allocations effects.

Robertson states that TopTech has performed impressively at the investment managers level tor three years in a row. Harrison and Powell then describe the levels in greater detail. Harrison describes the benchmark level as the difference between active managers' returns and their benchmark returns. Powell states that the investment managers' level reflects the returns to active management on the part of the fund's managers, weighted by the amount actually allocated to each manager.

At the request of Stober, Harrison and Powell explore alternatives to the benchmark TopTech is currently using for its small-cap value manager.

After some investigation of the small-cap value manager’s emphasis, Harrison and Powell derive four potential custom benchmarks and calculate two measures to evaluate the benchmarks:

(1) the return to the manager’s active management or A = portfolio return - benchmark return; and (2) the return to the manager's style or S = benchmark return - broad market return.

The following characteristics are presented below for each benchmark:

(1) the beta between the benchmark and the small-cap value portfolio;

(2) the tracking error (i.e., the standard deviation of A);

(3) the turnover of the benchmark;

and (4) the correlation between A and S.





Harrison and Powell evaluate the benchmarks based on the four measures.

Of the three benchmarks, determine which would be most appropriate for the small cap value manager.

10. Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has been examining portfolio risk using traditional methods such as the portfolio variance and beta. He has ranked portfolios from least risky to most risky using traditional methods.

Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount of money clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solely for Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using the variance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviation is expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (in millions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000 scenarios). The following table provides the results of the simulation:

Figure 1: Monte Carlo Simulation Data





The top row (Percentile) of the table reports the percentage of simulations that had returns below those reported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and 97.5% of the simulations provided a return of 20% or less.

Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfolio management practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon to justify his use of VAR methodology and explain why the estimated VAR varies depending on the method used to calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client, the York Pension Plan.





To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluating portfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the York Pension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Note that the minimum acceptable return is the risk-free rate.

Figure 3: Performance Ratios for the York Pension Plan





Which of the following correctly assesses Dennon's comment regarding the Monte Carlo Simulation method of estimating VAR?

11. Stephanie Mackley is a portfolio manager for Durango Wealth Management (DWM), a regional money manager catering to wealthy investors in the southwestern portion of the United States. Mackley's clients vary widely in terms of their age, net worth, and investment objectives, but all must have at least $1 million in net assets before she will accept them as clients.

Many of Mackley’s clients are referred to her by Kern & Associates, an accounting and consulting firm. DWM does not provide any direct compensation to Kern & Associates for the referrals, but Mackley’s who is the president of her local CFA Society, invites Kern & Associates to give an annual presentation to the society on the subject of tax planning and minimization strategies that Kern & Associates provides for its clients. Kern & Associates' competitors have never received an invitation to present their services to the society. When Mackley receives a referral, she informs the prospect of the arrangement between DWM and Kern & Associates.

DWM maintains a full research staff that analyzes and recommends equity and debt investments. All of the in-house research is provided to the firm's portfolio managers and their clients. In addition, DWM provides a subscription service to outside investors and portfolio managers. Aaron Welch, CFA, a private contractor, researches and reports on high-tech firms in the U.S. and other developed countries for several portfolio management clients. One of his latest reports rated InnerTech Inc., a small startup that develops microscopic surgical devices, as a strong buy. After reviewing the report carefully, Mackley decides to purchase shares of InnerTech for clients with account values over $6 million. She feels that accounts with less than this amount cannot accept the risk level associated with InnerTech stock.

Two days after purchasing InnerTech for her clients, the stock nearly doubles in value, and the clients are ecstatic about the returns on their portfolios. Several of them give her small bouquets of flowers and boxes of chocolates, which she discloses to her supervisor at DWM. One client even offers her the use of a condo in Vail, Colorado for two weeks during ski season, if she can reproduce the results next quarter. Mackley graciously thanks her clients and asks that they refer any of their friends and relatives who are in need of asset management services. She provides brochures to a few clients who mention that they have friends who would be interested. The brochure contains a description of Mackley's services and her qualifications. At the end of the brochure, Mackley includes her full name followed by "a Chartered Financial Analyst" in bold font of the same size as her name Following is An excerpt from the brochure: "DWM can provide many of the investment services you are likely to need. For those services that we do not provide directly, such as estate planning, we have standing relationships with companies that do provide such services. 1 have a long history with DWM, serving as an investment analyst for six years and then in my current capacity as a portfolio manager for twelve years. My clients have been very satisfied with my past performance and will likely be very satisfied with my future performance, which I attribute to my significant investment experience as well as my participation in the CFA Program. I earned the right to use the CFA designation thirteen years ago. All CFA charter-holders must pass a series of three rigorous examinations that cover investment management and research analysis."

Two weeks later, some of Mackley's clients request that she provide supporting documentation for the research report on InnerTech, so they can familiarize themselves with how DWM analyzes investment

opportunities. Mackley asks Welch for the documents, but Welch is unable to provide copies of his supporting research since he disposed of them, according to the company's policy, one week after issuing and distributing the report. Mackley informs Welch that obtaining the supporting documents is of the utmost importance, since one of the clients requesting the materials, Craig Adams, is about to inherit S20 million and as a result will be one of the firm's most important clients. Welch agrees to recreate the research documents in order to support the firm's relationship with Adams.

Does the arrangement between Mackley and Kern & Associates violate any CFA Institute Standards of Professional Conduct?

12. Shirley Riley, CFA, has just been promoted, from vice president of trading to chief investment officer (CIO) at Crane & Associates, LLC (CA), a large investment management firm. Riley has been with CA for eight years, but she has much to learn as she assumes her new duties as CIO. Riley has decided to hire Denny Simpson, CFA, as the new compliance officer for CA, Riley and Simpson have been reviewing procedures and policies throughout the firm and have discovered several potential issues.

Communications with Clients

Portfolio managers are encouraged to communicate with clients on a regular basis. At a minimum,

managers are expected to contact clients on a quarterly basis to review portfolio performance. Each client

must have an investment policy statement (IPS) created when their account is opened, specifying the

objectives and constraints for their portfolio. IPSs are reviewed at client request at any time. Any time

market conditions dictate a change in the investment style or strategy of a client portfolio, the client is

notified immediately by phone or email.

Employee Incentive Program

CA offers several incentive programs to employees. One of the most popular of these programs is the CA IPO program. Whenever CA is involved in an initial public offering (IPO), portfolio managers are allowed to participate. The structure is simple―for every 100 shares purchased on behalf of a client, the manager is awarded five shares for his own account. The manager is thus rewarded for getting an IPO sold and at the same time is able to share in the results of the IPO. Any-time shares are remaining 72 hours before the IPO goes public, other employees are allowed to participate on a first-come, first-serve basis. Employees seem to appreciate this opportunity, but CA does not have exact numbers on employee participation in the program.

Private Equity Fund

CA has a private equity fund that is internally managed. This fund is made available only to clients with more than $5 million in assets managed by CA, a policy that is fully disclosed in CA's marketing materials. Roughly one-third of the fund's assets are invested in companies that are either very small capitalization or thinly traded (or both). The pricing of these securities for monthly account statements is often difficult. CA support staff get information from different sources―sometimes using third party services, sometimes using CA valuation models. In some instances, a manager of the private equity fund will enter an order during the last trading hour of the month to purchase 100 shares of one of these small securities at a modest premium to the last trade price. If the trade gets executed, that price can then be used on the account statements. The small size of these trades does not significantly affect the fund's overall position in any particular company holding, which is typically several thousand shares.

Soft Dollar Usage

Several different managers at CA use independent research in developing investment ideas. One of the more popular research services among CA managers is "Beneath the Numbers (BTN)," which focuses on potential accounting abuses at prominent companies. This service often provides early warnings of problems with a stock, allowing CA managers the opportunity to sell their clients' positions before a negative surprise lowers the price. Stocks covered by BTN are typically widely held in CA client accounts. Managers at CA have been so happy with BTN that they have also subscribed to a new research product provided by the same authors―"Beneath the Radar (BTR)." BTR recommends small capitalization securities that are not large enough to attract much attention from large institutional investors. The results of BTR's recommendations are mixed thus far, but CA managers are willing to be patient.

As they discuss these issues, Riley informs Simpson that she is determined to bring CA into full compliance with the CFA Institute's "Asset Manager Code of Professional Conduct." The following questions should be answered with the Asset Manager Code as a guide.

Participation in CA's private equity fund is limited to clients with $5 million under management. This policy:

13. 0%, a floating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6 months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given its interest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, an underlying swap rate of 6.0%, and a floating rate based on LIBOR.

MIA is considering investing in the debt of Rio Corp, a Brazilian energy company. The investment would be in Rio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest rate decline in Brazil over the short term.

Determine whether the MIA analysts' comments regarding the duration of the Worth Inc. swap and the effects of the swap on the company's balance sheet are correct or incorrect.

14. Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has been examining portfolio risk using traditional methods such as the portfolio variance and beta. He has ranked portfolios from least risky to most risky using traditional methods.

Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount of money clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solely for Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using the variance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviation is expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (in millions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000 scenarios). The following table provides the results of the simulation:

Figure 1: Monte Carlo Simulation Data





The top row (Percentile) of the table reports the percentage of simulations that had returns below those reported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and 97.5% of the simulations provided a return of 20% or less.

Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfolio management practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon to justify his use of VAR methodology and explain why the estimated VAR varies depending on the method used to calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client, the York Pension Plan.





To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluating portfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the York Pension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Note that the minimum acceptable return is the risk-free rate.

Figure 3: Performance Ratios for the York Pension Plan





Evaluate Dennon's comments regarding the VAR estimates provided by the historical and analytical VAR methods. Dcnnon is:

15. John Rawlins is a bond portfolio manager for Waimea Management, a U.S.-based portfolio management firm. Waimea specializes in the management of equity and fixed income portfolios for large institutional investors such as pension funds, insurance companies, and endowments. Rawlins uses bond futures contracts for both hedging and speculative positions. He frequently uses futures contracts for tactical asset allocation because, relative to cash instruments, futures have lower transactions costs and margin requirements. They also allow for short positions and longer duration positions not available with cash market instruments. Rawlins has a total of approximately $750 million of assets under management.

In one of his client portfolios, Rawlins currently holds the following positions:





The dollar duration of the cheapest to deliver bond (CTD) is $10,596.40 and the conversion factor is 1.3698.

In a discussion of this bond hedge, Rawlins confers with John Tejada, his assistant. Tejada states that he has regressed the corporate bond's yield against the yield for the CTD and has found that the slope coefficient for this regression is 1.0. He states his results confirm the assumptions made by Rawlins for his hedging calculations. Rawlins states that had Tejada found a slope coefficient greater than one, the number of futures contracts needed to hedge a position would decrease (relative to the regression coefficient being equal to one).

In addition to hedging specific bond positions, Rawlins tends to be quite active in individual bond management by moving in and out of specific issues to take advantage of temporary mispricing. Although the turnover in his portfolio is sometimes quite high, he believes that by using his gut instincts he can outperform a buy-and-hold strategy. Tejada on the other hand prefers using statistical software and simulation to help him find undervalued bond issues. Although Tejada has recently graduated from a prestigious university with a master's degree in finance, Rawlins has not given Tejada full rein in decision-making because he believes that Tejada's approach needs further evaluation over a period of both falling and rising interest rates, as well as in different credit environments.

Rawlins and Tejada are evaluating two individual bonds for purchase. The first bond was issued by Dynacom, a U.S. telecommunications firm. This bond is denominated in dollars. The second bond was issued by Bergamo Metals, an Italian based mining and metal fabrication firm. The Bergamo bond is denominated in euros. The holding period for either bond is three months.

The characteristics of the bonds are as follows:





3-month cash interest rates are 1% in the United States and 2.5% in the European Union. Rawlins and Tejada will hedge the receipt of euro interest and principal from the Bergamo bond using a forward contract on euros.

Rawlins evaluates these two bonds and decides that over the next three months, he will invest in the Dynacom bond. He notes that although (he Bergamo bond has a yield advantage of 1% over the next quarter, the euro is at a three month forward discount of approximately 1.5%. Therefore, he favors the Dynacom bond because the net return advantage for the Dynacom bond is 0.5% over the next three months.

Tejada does his own analysis and states that, although he agrees with Rawlins that the Dynacom bond has a yield advantage, he is concerned about the credit quality of the Dynacom bond. Specifically, he has heard rumors that the chief executive and the chairman of the board at Dynacom are both being investigated by the U.S. Securities and Exchange Commission for possible manipulation of Dynacom's stock price, just prior to the exercise of their options in the firm's stock. He believes that the resulting fallout from this alleged incident could be damaging to Dynacom's bond price.

Tejada analyzes the potential impact on Dynacom's bond price using breakeven analysis. He believes that news of the incident could increase the yield on Dynacom's bond by 0.75%. Under this scenario, he states that he would favor the Bergamo bond over the next three months, assuming that the yield on the Bergamo bond stays constant. Rawlins reviews Tejada's breakeven analysis and states that though he is appreciative of Tejada's efforts, the analysis relies on an approximation.

The manager wants to completely hedge Bond Q for an expected 80 basis point change in interest rates.

The number of futures contracts required is closest to:

16. Somerset Investment Limited is a Singapore-based money management firm that is conducting an appraisal of its investment performance. Cameron Li, CFA, has been charged with conducting the appraisal, and is to report back to upper management with his findings.

Li is convinced that trade executions play a substantial role in overall portfolio performance, particularly for funds that have a relatively high level of turnover during the year. As a result, he is seeking methods that will allow him to evaluate the quality of trade executions.

He knows that the firm's traders use both market and limit orders, and he is wondering if a framework can be developed to ensure that the best order type is used under the specific circumstances for each trade. When he consults with the firm's head trader, Rick Gleeson, Gleeson tells him that market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty. According to Gleeson, rebalancing and liquidity-motivated trades should use limit orders while value-motivated and information-motivated trades should use market orders.

Li knows that bid-ask spreads are a major component of trading costs, and asks Gleeson for some recent trade data that he can use for analysis and presentation to management. He receives the following data relating to a series of buy trades for Sumatra Natural Resources (SNR), with all currency values in Singapore dollars:

Trades of Sumatra Natural Resources





Gleeson also tells Li that the portfolio manager had originally made the decision to purchase 5,000 SNR at 10:00 a.m. when the price was $22.36. The closing price for the day was Leeson's last trade at $22.65, at which point the order for the remaining 2,000 shares was cancelled.

Which of the following statements concerning implementation shortfall and VWAP is incorrect?

17. Jerry Edwards is an analyst with DeLeon Analytics. He is currently advising the CFO of Anderson Corp., a multinational manufacturing corporation based in Newark, New Jersey, USA. Jackie Palmer is Edwards's assistant. Palmer is well versed in risk management, having worked at a large multinational bank for the last ten years prior to coming to Anderson.

Anderson has received a $2 million note with a duration of 4.0 from Weaver Tools for a shipment delivered last week. Weaver markets tools and machinery from manufacturers of Anderson's size. Edwards states that in order to effectively hedge the price risk of this instrument, Anderson should sell a series of interest rate calls. Palmer states that an alternative hedge for the note would be to enter an interest rate swap as the fixed-rate payer.

As well as selling products from a Swiss plant in Europe, Anderson sells products in Switzerland itself. As a result, Anderson has quarterly cash flows of 12,000,000 Swiss franc (CHF). In order to convert these cash flows into dollars, Edwards suggests that Anderson enter into a currency swap without an exchange of notional principal.

Palmer contacts a currency swap dealer with whom they have dealt in the past and finds the following exchange rate and annual swap interest rates:

• Exchange Rate (CHF per dollar) 1.24

• Swap interest rate in U.S. dollars 2.80%

• Swap interest rate in Swiss franc 6.60%

Discussing foreign exchange rate risk in general, Edwards states that it is transaction exposure that is most often hedged, because the amount to be hedged is contractual and certain. Economic exposure, he states, is less certain and thus harder to hedge.

To finance their U.S. operations, Anderson issued a S10 million fixed-rate bond in the United States five years ago. The bond had an original maturity often years and now has a modified duration of 4.0. Edwards states that Anderson should enter a 5-year semiannual pay floating swap with a notional principal of about $11.4 million to take advantage of falling interest rates. The duration of the fixed-rate side of the swap is equal to 75% of its maturity or 3.75 (= 0.75 x 5). The duration of the floating side of the swap is 0.25. Palmer states that Anderson's position in the swap will have a negative duration.

For another client of DeLeon, Edwards has assigned Palmer the task of estimating the interest rate

sensitivity of the client's portfolios. The client's portfolio consists of positions in both U.S. and British bonds.

The relevant information for estimating (he duration contribution of the British bond and the portfolio’s total duration is provided below.

U.S. dollar bond $275,000

British bond $155,000

British yield beta 1.40

Duration of U.S. bond 4.0

Duration of British bond 8.5

When discussing portfolio management with clients, Edwards recommends the use of emerging market bonds to add value to a core-plus strategy.

He explains the characteristics of emerging market debt to Palmer by stating:

• "The performance of emerging market debt has been quite resilient over time. After crises in the debt markets, emerging market bonds quickly recover after a crisis, so long-term returns can be poor."

• "Emerging market debt is quite volatile due in part to the nature of political risk in these markets. It is therefore important that the analyst monitor the risk of these markets. I prefer to measure the risk of emerging market bonds with the standard deviation because it provides the best representation of risk in these markets."

If Anderson enters a properly structured currency swap to convert the CHF 12,000,000 to dollars, the amount they will receive is closest to:

18. Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a candidate for the Level 1 CFA exam.

Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain. He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£. Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The current 1-year forward rate is C$1.60/£.

Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United States.





Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also decide whether or not to hedge the currency exposure.

Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His reason for choosing the yen is that it is positively correlated with the won.

One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an interest rate floor as a hedge.

Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is contemplating using either a covered call or a protective put on a T-bond futures contract.

What must the 1-year forward exchange rate be between the CS and Great Britain's currency (£) so that no arbitrage opportunities are available?

19. Jack Thomas and Tim Bentley are analysts for Bond Analytics (BA). BA provides bond analysis for mutual fund managers, hedge fund managers, and institutional money managers in the United States. BA specializes in the valuation of international bonds and callable bonds, using intrasector analysis to find undervalued bonds. In addition to valuing the bonds, they also advise clients on whether to hedge currency risk for international bonds. Thomas has been a particularly strong advocate of hedging the currency risk of international bonds, especially in emerging markets, using forward contracts when they are available. At a morning meeting, Thomas and Bentley are trying to decide whether to hedge the currency risk of a large issue of bonds from a Thai manufacturer of pressed steel, Nakhon Metals. The client considering purchasing the bonds is a large U.S. mutual fund, Epsilon Funds. Epsilon has started to explore the possibility of earning higher returns through currency management using forward contracts. Thomas and Bentley discuss the various hedges of currency risk for the Nakhon Metals bond. One possibility is using a forward hedge position on the Thai baht. A second possibility is using forward contracts where the baht is delivered for Korean won. Thomas states that the second hedge would be pursued if the won was expected to appreciate more against the U.S. dollar than the baht. In the second hedge, the manager would sell won for dollars at the future spot rate.

Thomas and Bentley gather the following information on the expected changes in the various currencies, the 1-year cash rates in the respective countries, and the expected return on the Nakhon bond.





Additionally, the Nakhon Metals bond has a duration of 7.30 and is being compared against a bond denominated in U.S. dollars, issued by Powhatan Industries. The Powhatan bond has a duration of 4.2 and a yield of 4.50%.

Whichever bond is purchased will be held for the next year. Thomas projects that the yield for the Nakhon Metals bond is expected to increase by I 5 basis points while the yield on the Powhatan Industries bond is expected to stay constant.

The following day, Thomas and Bentley discuss the market for and valuation of callable and long duration bonds. They believe that interest rates are temporarily low and for this reason want to be careful about their bond investments. Although they could hedge interest rate risk, they prefer not to because they believe it reduces the ultimate long-term return.

Thomas says that due to secular changes in the bond market, bonds with structures are expected to become more scarce. He says that the problem with callable bonds has been that they typically trade at a premium due to their scarcity. Bentley states that bonds with long durations also trade at a premium because they are scarce as well.

Thomas states that the performance of callables and non-callables may differ when interest rates change due to the inherent call risk.

He discusses the relative performance under two scenarios:

• Scenario A: Interest rates are near coupon rates and fall for both callables and non-callables by the same amount.

• Scenario B: Interest rates are historically very low and rise for both callables and non-callables by the same amount.

The second hedge that Thomas recommends for the Nakhon Metals bond is most likely an example of which of the following currency hedging strategies?

20. Mark Rolle, CFA, is the manager of the international bond fund for the Ryder Investment Advisory. He is responsible for bond selection as well as currency hedging decisions. His assistant is Joanne Chen, a candidate for the Level 1 CFA exam.

Rolle is interested in the relationship between interest rates and exchange rates for Canada and Great Britain. He observes that the spot exchange rate between the Canadian dollar (C$) and the British pound is C$1.75/£. Also, the 1-year interest rate in Canada is 4.0% and the 1-year interest rate in Great Britain is 11.0%. The current 1-year forward rate is C$1.60/£.

Rolle is evaluating the bonds from the Knauff company and the Tatehiki company, for which information is provided in the table below. The Knauff company bond is denominated in euros and the Tatehiki company bond is denominated in yen. The bonds have similar risk and maturities, and Ryder's investors reside in the United States.





Provided this information, Rolle must decide which country's bonds are most attractive if a forward hedge of currency exposure is used. Furthermore, assuming that both country's bonds are bought, Rolle must also decide whether or not to hedge the currency exposure.

Rolle also has a position in a bond issued in Korea and denominated in Korean won. Unfortunately, he is having difficulty obtaining a forward contract for the won on favorable terms. As an alternative hedge, he has entered a forward contract that allows him to sell yen in one year, when he anticipates liquidating his Korean bond. His reason for choosing the yen is that it is positively correlated with the won.

One of Ryder's services is to provide consulting advice to firms that are interested in interest rate hedging strategies. One such firm is Crawfordville Bank. One of the loans Crawfordville has outstanding has an interest rate of LIBOR plus a spread of 1.5%. The chief financial officer at Crawfordville is worried that interest rates may increase and would like to hedge this exposure. Rolle is contemplating either an interest rate cap or an interest rate floor as a hedge.

Additionally, Rolle is analyzing the best hedge for Ryder's portfolio of fixed rate coupon bonds. Rolle is contemplating using either a covered call or a protective put on a T-bond futures contract.

Assuming Rolle uses forward contracts to hedge the currency risk of the bond investment, determine which bond is the better investment.

21. Lucy Sakata, CFA and Gary Lowenstein, CFA are portfolio managers for the Murray Funds, a provider of investment funds to institutional and wealthy individual investors. Murray frequently indexes in developed markets, but uses full blown active management in less efficient markets and when they think their analysts have a particular expertise. The vast majority of Murray's clients attempt to minimize tracking error.

One of the Murray's funds invests in a Hong Kong index and is marketed as a way for investors to participate in the growth of the Asian economies. The index represents the best known Hong Kong stocks and Murray uses a full replication strategy for the fund. The index is a market cap-weighted index and ten firms represent over 70% of the index's total market cap_Sakata would like to market the Hong Kong fund to institutions with a required minimum investment of $50 million. Many potential clients are institutions who

outsource their foreign equity management and are subject to maximum holdings on individual stocks. Murray also has a Canada fund that invests in an index which represents the 25 largest cap stocks in Canada. It is marketed as a way for investors to exploit the growth in demand for commodities. The index adjusts for stock splits and repurchases as necessary. Most of the index's return has come from capital gains, rather than dividends, due to the tremendous increase in global demand for commodities. To encourage long-term holding, Murray places a back-end load of 3% on fund redemptions that are made within two years of initial investment.

Sakata and Lowenstein discuss the fundamental law of active management and how it applies to three hypothetical managers who invest against the broad large-cap U.S. market, as represented by the S&P 500 index.

• Manager A under-weights and over-weights the 500 individual stocks of the S&P 500 index as she sees appropriate, keeping industry exposures similar to those of the index. She has an information coefficient of 0.05 and is restricted to long-only positions.

• Manager B holds cash and long S&P 500 futures. He tries to generate excess returns by altering the duration of the cash position and has an information coefficient of 0.05.

• Manager C has an information coefficient of 0.07, and she uses a long-short strategy for the 500 stocks in the S&P 500 index.

Sakata is consulting with the trustees of the Powell Foundation. The foundation has a position in the three Murray funds described in Exhibit 1 below.

Exhibit 1: Powell Foundation Holdings





Murray has a value fund that invests in stocks in the U.S. Lowenstein is considering several equity style index providers as a benchmark for the fund. The characteristics of the index providers and the methodologies they use to construct equity style indices are described in Exhibit 2 below.

Exhibit 2: Comparison of Index Providers





In regard to the index providers, Lowenstein makes the following statements:

Statement 1: "I would like to use the indices from either provider in a returns-based style analysis. Based on the information in the table, I believe that if I regress a value manager's returns against Provider B's indices, the manager's selection return will appear artificially large."

Statement 2: "If an index provider uses buffering rules, a fund tracking that index will experience lower transactions costs."

Determine which of the three managers will most likely have the highest information ratio.

22. Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixed-income firm based in the United States. AA employs numerous quantitative models to invest in both domestic and international securities.

During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.

Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned, however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy.

In response, Castillo explains the factors that affect the repo rate and makes the following statements:

• "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral, and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is usually quite low.”

• "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the collateral is limited, the repo rate will be higher."

Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the $200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The expected return on the portfolio is 8% and the cost of borrowed funds is 3%. The next day, the chief investment officer for the Washington Investment Fund expresses her concern about the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios.

In response, Diaz distinguishes between the standard deviation and downside risk measures, making the following statements:

• ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it considers all returns over the entire distribution, variance and the resulting standard deviation are artificially inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios, managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns below a given return, such as the mean or a hurdle rate."

• "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall risk is a more appropriate measure, because it provides the probability of not meeting a target return."

AA has a corporate client, Shaifer Materials with a 20,000,000 bond outstanding that pays an annual fixed coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.

Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year.

The terms of each instrument are provided below:

Payer swaption fixed rate7.90%

Receiver swaption fixed rate7.60%

Current Euribor7.20%

Projected Euribor in one year5.90%

Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.

Calculated in bond equivalent yield terms, Michacls's return over the next year, if interest rates change as expected, is closest to:

23. Garrison Investments is a money management firm focusing on endowment management for small colleges and universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocations to high quality long-term foreign government bonds. Garrison's largest account, Point University, has a market value of $800 million and an asset allocation as detailed in Figure 1.

Figure 1: Point University Asset Allocation





*Bond coupon payments are all semiannual.

Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value.

Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move.

Managers at Garrison have put together the following proposal for the reallocation:

To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2.

Figure 2: Mid-cap index and European Index Futures Data





Three months after proposing the international diversification plan, Garrison was able to persuade Point University to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japanese electronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of its production in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigate exchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HI has one remaining purchase of Australian gold that will occur in nine months. The company has hedged the purchase with a long 12-month futures contract on the Australian dollar (AUD). Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about the impact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decided to use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the local currency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of changes in the USD/Yen spot rate is 0.92.

Which of the following is closest to the notional principal on a swap that would allow Point University to hedge the currency risk of the interest payments from their U.K. bond holdings?

24. Eugene Price, CFA, a portfolio manager for the American Universal Fund (AUF), has been directed to pursue a contingent immunization strategy for a portfolio with a current market value of $100 million. AUF's trustees are not willing to accept a rate of return less than 6% over the next five years. The trustees have also stated that they believe an immunization rate of 8% is attainable in today's market. Price has decided to implement this strategy by initially purchasing $100 million in 10-year bonds with an annual coupon rate of 8.0%, paid semiannually.

Price forecasts that the prevailing immunization rate and market rate for the bonds will both rise from 8% to 9% in one year.

While Price is conducting his immunization strategy he is approached by April Banks, a newly hired junior analyst at AUF. Banks is wondering what steps need to be taken to immunize a portfolio with multiple liabilities. Price states that the concept of single liability immunization can fortunately be extended to address the issue of immunizing a portfolio with multiple liabilities. He further states that there are two methods for managing multiple liabilities. The first method is cash flow matching which involves finding a bond with a maturity date equal to the liability payment date, buying enough in par value of that bond so that the principal and final coupon fully fund the last liability, and continuing this process until all liabilities are matched. The second method is horizon matching which ensures that the assets and liabilities have the same present values and durations.

Price warns Banks about the dangers of immunization risk. He states that it is impossible to have a portfolio with zero immunization risk, because reinvestment risk will always be present. Price tells Banks, "Be cognizant of the dispersion of cash flows when conducting an immunization strategy. When there is a high dispersion of cash flows about the horizon date, immunization risk is high. It is better to have cash flows concentrated around the investment horizon, since immunization risk is reduced."

Price has stated that, because of the need to reinvest coupons, it is impossible to totally eliminate immunization risk. He has also stated that an increased dispersion of asset maturities around the horizon date increases immunization risk. Determine which of these statements is (are) correct.

25. Bartholomew Hope, CFA, is the chief investment officer of Children's Trust Foundation (CTF), a foundation that supports a wide variety of child-related causes. CTFs total assets total $2.3 billion. The foundation's current asset mix is 55% stocks, 35% bonds, and 10% cash (T-bills earn 3.5%). The foundation provides $126.5 million annually for a variety of programs for children, which is forecasted to remain more or less constant in real terms. Hope does not envision any major capital expenditures for the foreseeable future. CTF's investment portfolio has underperformed its benchmark over the past three years. Hope believes corrective action is needed to address the issue of poor performance. Hope wants to evaluate the possibility the portfolio's risk to reward profile. Hope's staff generates Exhibit 1, which reviews the relevant necessary metrics to make the asset mix decision. The overall cost of investing the assets is 75 basis points.

Exhibit 1: Expected Returns, Risk, and Correlations for Asset under Consideration





One of the members of Hope's staff, Rene Meyer, includes a report on the key attributes of investing in venture capital funds.

The report includes the following sections:

Structure: "Indirect venture capital investments are achieved by pooling the funds of multiple investors into a limited partnership (LP). The investors are limited partners who allow a general partner to control the investments for a period of 7 to 10 years. The general partner also invests capital, earning a management fee of 1.5% to 2.5% of invested capital and a carried interest fee, which is generally 20% of the fund profits, after the fund's hurdle rate has been met."

Strategy: "Because initial public offerings are a primary exit strategy of venture capital investing, the correlation between public equity markets and returns on venture capital investments are positive. Therefore, the primary focus of any venture capital investment undertaken by Glendale should be long-

term return enhancement rather than significant diversification. In addition, Glendale must make sure that all of the committed capital is available for the required up front cash distribution to the general partner at the beginning of the investment period."

Hope recognizes there are several unique strategies within the hedge fund group that have very different risk to reward trade-offs. Hope identifies three hedge funds as potential investment opportunities for the CTF. Exhibit 2 lists the funds under consideration and their most recent securities transactions.

Exhibit 2: Hedge Fund Transactions





While Clark presents the hedge funds, Hope comments that he is concerned with the potential difficulties in measuring hedge fund manager performance. Glendale's charter has strict requirements regarding the performance assessment of investment managers who control the assets of the foundation. Hope believes the performance of alternative investments presented may be difficult to evaluate against a benchmark index as required by Glendale's charter.

Which of the following is least likely to be a reason for Hope's concern over the ability to track hedge fund manager performance against a benchmark index as required by the Glendale Foundation charter?

26. Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy.

One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis.

Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity.

Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around."

The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year.

Using Stober's 5% probability level, the minimum amount by which TopTech's plan will be underfunded next year is closest to:

27. Jack Thomas and Tim Bentley are analysts for Bond Analytics (BA). BA provides bond analysis for mutual fund managers, hedge fund managers, and institutional money managers in the United States. BA specializes in the valuation of international bonds and callable bonds, using intrasector analysis to find undervalued bonds. In addition to valuing the bonds, they also advise clients on whether to hedge currency risk for international bonds. Thomas has been a particularly strong advocate of hedging the currency risk of international bonds, especially in emerging markets, using forward contracts when they are available. At a morning meeting, Thomas and Bentley are trying to decide whether to hedge the currency risk of a large issue of bonds from a Thai manufacturer of pressed steel, Nakhon Metals. The client considering purchasing the bonds is a large U.S. mutual fund, Epsilon Funds. Epsilon has started to explore the possibility of earning higher returns through currency management using forward contracts. Thomas and Bentley discuss the various hedges of currency risk for the Nakhon Metals bond. One possibility is using a forward hedge position on the Thai baht. A second possibility is using forward contracts where the baht is delivered for Korean won. Thomas states that the second hedge would be pursued if the won was expected to appreciate more against the U.S. dollar than the baht. In the second hedge, the manager would sell won for dollars at the future spot rate.

Thomas and Bentley gather the following information on the expected changes in the various currencies, the 1-year cash rates in the respective countries, and the expected return on the Nakhon bond.





Additionally, the Nakhon Metals bond has a duration of 7.30 and is being compared against a bond denominated in U.S. dollars, issued by Powhatan Industries. The Powhatan bond has a duration of 4.2 and a yield of 4.50%.

Whichever bond is purchased will be held for the next year. Thomas projects that the yield for the Nakhon Metals bond is expected to increase by I 5 basis points while the yield on the Powhatan Industries bond is expected to stay constant.

The following day, Thomas and Bentley discuss the market for and valuation of callable and long duration bonds. They believe that interest rates are temporarily low and for this reason want to be careful about their bond investments. Although they could hedge interest rate risk, they prefer not to because they believe it reduces the ultimate long-term return.

Thomas says that due to secular changes in the bond market, bonds with structures are expected to become more scarce. He says that the problem with callable bonds has been that they typically trade at a premium due to their scarcity. Bentley states that bonds with long durations also trade at a premium because they are scarce as well.

Thomas states that the performance of callables and non-callables may differ when interest rates change due to the inherent call risk.

He discusses the relative performance under two scenarios:

• Scenario A: Interest rates are near coupon rates and fall for both callables and non-callables by the same amount.

• Scenario B: Interest rates are historically very low and rise for both callables and non-callables by the same amount.

Which of the following best describes the relative performance of callables and non-callables under the two scenarios?

28. Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk, its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).

Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost, which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims before it could settle the agreement with Johnson Associates. McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the possibility of default on current obligations, while future credit risk relates to potential default on future obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value of current obligations and the present value of future obligations. Cramer adds that combining current and potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a reliable predictor of a borrower's potential credit risk.

As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with forward agreements. Cramer states that long forward contracts gain in value when the market price of the underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk and forward contracts in the handbook.

She offers the following:

A forward contract sold by Palmer Securities has six months until the delivery date and a contractprice of 50. The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus 3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The characteristics of the forward contract are shown below.

Information on the Credit Spread Forward





Determine which of the following is most likely responsible for the difficulty Cramer faced when transacting with the firm Johnson Associates.

29. Donaghy Management Company (DMC) manages several funds only available to high net worth individuals. In preparation for an upcoming meeting, the firm has circulated among its managers the information in Figure 1 on objectives and market expectations relevant to each of three funds.

Figure 1: Fund Strategies and Market Expectations





The manager of Fund A has collected data on put and call options on the broad market index underlying his strategy. The option data are presented in Figure 2. All options presented have the same expiration date.

Figure 2: Option Data for the Broad Market Index

During the meeting, the manager of Fund B states that in order to enhance returns for the fund, he intends to implement a box-spread strategy. The manager explains the strategy by stating, "The ending price of the asset underlying the box-spread strategy has no impact on the payoff of the strategy.

Thus, if the market price of the strategy implies a rate of return greater than the risk-free rate, an arbitrage opportunity exists."

Also during the meeting, DMC's president questioned the manager of Fund C about the mechanics of his hedging strategy.

The manager explained the strategy with the following comments:

Comment 1: "The hedge position is established to reduce the exposure to certain equity positions by writing call options on those equity positions. The necessary number of short option positions per share of stock held is calculated as the inverse of the option delta."

Comment 2: "The hedge position only requires adjusting in the event of a price or volatility change in the underlying and is effective for small changes in the price of the underlying security."

Which of the following option strategies would be most beneficial in terms of potential payoff for Fund A given its objectives and market expectations?

30. Mary Thomas works for Kershaw-Ross, a large investment bank located in London. Kershaw-Ross provides advice to portfolio managers, securities dealers, and hedge funds. Jack Bentley is Thomas assistant.

Washington Capital Management, one of Thomas' clients, has a $5 million position in fixed-rate U.S. Treasury bonds. The firm would like to hedge this position using calls on Treasury bonds. The calls each cover $100,000 par value of bonds, have a delta of 0.4, and are out-of-the-money. To hedge this position, Thomas recommends that Washington Capital Management calculate the delta for the call options written on these Treasury bonds.

Later that week, Thomas discusses the particulars of option hedges with Francis Steele, Vice President at Washington Capital Management. Thomas describes how using gamma, the change in delta relative to the change in the underlying asset price, can increase the precision of the hedge. She states that this would be particularly true if the bond portfolio used calls that were at-the-money. Bentley adds that given the uncertainty surrounding U.S. Federal Reserve monetary policy, Kershaw-Ross has been advising clients to carefully monitor their bond positions for price changes. Bentley states that in Washington Capital Management's case, if the price of the underlying bond increases by 1% due to a yield curve shift, the calf hedge should be decreased because delta would have increased.

Thomas is analyzing the portfolio for one of his investors, Canopy Managers. Last year the portfolio had a market value of $4,881,000 and a dollar duration of $157,200.

The current figures for the portfolio are provided below:





Canopy would like to alter the current dollar duration of the portfolio to last year's duration, and they would like to do so with the least amount of cash possible and a controlling position in one of the bonds.

Canopy Managers has also contracted to take out a 9-month loan for $5 million in three months at LIBOR. Canopy's chief financial officer has become concerned that interest rates might increase and has asked Thomas to investigate the possibility of hedging the position with a forward rate agreement. Thomas finds a forward rate agreement is available with the same maturity as Canopy's loan at a rate of 4.40%. The risk free rate is 3.8% and LIBOR is projected to be 4.60% at the inception of the loan.

The next week, Thomas and Bentley visit the headquarters of Capital Pension Management, one of Kershaw-Ross's largest clients. Capital is using contingent immunization to immunize a liability, but management is concerned about a possible rise in interest rates. Thomas states that if she were to recommend the most effective strategy to Capital, she would recommend that they use bonds with high yields because immunization will be cheaper. Bentley interjects that the risk from nonparallel shifts in the yield curve can be minimized by concentrating the cash flows around the horizon date.

Due to their tremendous success, Kershaw-Ross has outgrown their current headquarters and is going to expand their current building. Thomas's team has been charged with securing financing tor the renovations. They currently are considering a remodeling and addition that would cost approximately £5,000,000.

Thomas has secured the financing necessary for the renovations at a floating interest rate of LIBOR plus 150 basis points, with payments made quarterly over three years. Thomas believes that Kershaw-Ross should be able to complete the renovation of the building and close on the loan in one year. She is concerned, however, that interest rates will increase in the interim and has obtained a swaption to hedge the loan. She states that Kershaw-Ross should use a payer swaption to hedge the loan.

Bentley evaluates the forecasts for future swap fixed rates as well as the current terms of various swaptions, which are provided below:

Fixed rate for a 1 -year payer swaption = 8.50%

Fixed rate for a 1-year receiver swaption = 8.60%

Projected swap fixed rate in one year = 9.30%

Fixed rate for a 4-year payer swaption - 9.40%

Fixed rate for a 4-year receiver swaption = 9.70%

Projected swap fixed rate in four years = 9.80%

Regarding their statements concerning the strategy of Capital Asset Management, determine whether Thomas and Bentley are correct or incorrect.

31. Cindy Hatcher, CFA, has spent the last ten years as a portfolio manager with Bernhardt Capital. While working for Bernhardt, Hatcher was responsible for maintaining and improving the company's code of ethics and guidelines for ethical money management. As a result of Hatcher's efforts, Bernhardt saw a dramatic decline in the number of complaints received from their individual and institutional customers. One of Bernhardt's direct competitors, Smith Investments, is keenly aware of Hatcher's reputation for ethical business practices and has offered her a job as their compliance officer. Hatcher has been apprised of several potential ethical problems at Smith that she will be directly responsible for fixing through implementation of policies and procedures that will prevent ethical dilemmas. The management at Smith is willing to grant Hatcher the authority to construct and implement policies to eliminate the ethical problems at the company.

Hatcher agrees to accept the position with Smith and resigns from employment with Bernhardt. As her first initiative with the company, Hatcher distributes to all employees at Smith a survey intended to acquaint her with the company's common business practices. Her goal is to identify those factors that are most likely to interfere with Smith's compliance with the CFA Institute's Code of Ethics and Standards of Practice. After collecting and analyzing the anonymous responses to the survey, Hatcher has identified the following four issues as the most frequently cited questionable business practices:

• Many Smith employees have relatives who are clients of the firm. For relatives* accounts where the Smith employee does not have beneficial ownership, trades are generally executed in conjunction with trades for other discretionary accounts held at the firm. Only in accounts where the Smith employee has beneficial ownership are trades delayed until all discretionary account trading is completed.

• Many of Smith's employees either personally own or maintain, through a family member, beneficial ownership of stocks that are also held in accounts for many of the firm's clients. While the company maintains a strict disclosure policy to the firm of such beneficial ownership and an "at will" disclosure policy to its clients, employees are not barred from trading these securities for their personal benefit even if their clients also own or have a direct or indirect financial interest in the same securities.

• Account managers meet weekly to discuss the issues and concerns of the client portfolios managed at the firm. During the meetings it is not unusual for individual clients to be identified and discussed. Information regarding the client's holdings and investment strategy is discussed as well as persona! needs related to the client's portfolio. The meetings are held in order to provide guidance and continuing education to all of the firm's account managers.

• At the suggestion of fixed-income analysts at the firm, most of the portfolio managers working for Smith have been adding B-rated corporate fixed-income securities to their portfolios. Analysts originally made (and continue to make) the suggestion due to the attractive yield potential offered by this class of investments. Smith's portfolio managers were thrilled with the idea since the returns on many of the portfolios' equity positions have been stifled by high profile accounting scandals.

Management at Smith Investments has been pleased with Hatcher's efforts so far but is concerned about the firm's ability to maintain compliance with the CFA Institute's Global Investment Performance Standards (GIPS®). The managing director of the firm, Erich Prince, has made the following comments to Hatcher: "I am concerned that we will not be able to claim compliance with GIPS at the end of the year since our new information system has inhibited our ability to include terminated portfolios in the historical record up to the last full measurement period before they were terminated. Also, we are unable to regroup portfolios that utilize hedging into separate composites from those that do not utilize hedging. These portfolios are currently grouped according to traditional value and growth strategies based on the capitalization of portfolio holdings (i.e., large vs. small)."

Hatcher eases Prince's mind by telling him she will "ensure full compliance with GIPS by the end of the quarter."

Which of the following best describes a policy that Hatcher could implement to eliminate violations of the CFA Institute Code and Standards in conjunction with trades placed for relatives of the employees of Smith Investments?

32. Swap B: 5-year swap with semiannual payments.

Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. For analysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity. Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing a dual currency bond issued by an American holding company with significant operations in Japan. The bond makes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S. dollars five years from now. Skinner originally purchased the bond to take advantage of the strengthening relative position of the yen. The result was an above average return for the bond portfolio for several years. Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in the Japanese economy to accelerate over the next few years.

Knowing Skinner’s situation, one of his colleagues, Bill Michaels, suggests the following strategy:

"You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dual currency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bond portfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. The swap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure of the portfolio."

Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his expectations for the bond portfolio.

Mann has also provided some advice to Skinner in the following comment:

"1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rate shift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the call features of any callable bonds in your portfolio by purchasing a payer interest rate swaption."

Skinner has been consulting with Dwayne Barter, a client of Director Securities and CFO of a large corporation. Barter is interested in using interest rate swaps to convert his firm's floating rate debt to fixed rate debt. Barter is planning to enter into a swap to pay a fixed rate and receive a floating rate in exchange.

Which of the following is the most accurate statement Skinner could make regarding such a transaction? The swap would:

33. Eugene Price, CFA, a portfolio manager for the American Universal Fund (AUF), has been directed to pursue a contingent immunization strategy for a portfolio with a current market value of $100 million. AUF's trustees are not willing to accept a rate of return less than 6% over the next five years. The trustees have also stated that they believe an immunization rate of 8% is attainable in today's market. Price has decided to implement this strategy by initially purchasing $100 million in 10-year bonds with an annual coupon rate of 8.0%, paid semiannually.

Price forecasts that the prevailing immunization rate and market rate for the bonds will both rise from 8% to 9% in one year.

While Price is conducting his immunization strategy he is approached by April Banks, a newly hired junior analyst at AUF. Banks is wondering what steps need to be taken to immunize a portfolio with multiple liabilities. Price states that the concept of single liability immunization can fortunately be extended to address the issue of immunizing a portfolio with multiple liabilities. He further states that there are two methods for managing multiple liabilities. The first method is cash flow matching which involves finding a bond with a maturity date equal to the liability payment date, buying enough in par value of that bond so that the principal and final coupon fully fund the last liability, and continuing this process until all liabilities are matched. The second method is horizon matching which ensures that the assets and liabilities have the same present values and durations.

Price warns Banks about the dangers of immunization risk. He states that it is impossible to have a portfolio with zero immunization risk, because reinvestment risk will always be present. Price tells Banks, "Be cognizant of the dispersion of cash flows when conducting an immunization strategy. When there is a high dispersion of cash flows about the horizon date, immunization risk is high. It is better to have cash flows concentrated around the investment horizon, since immunization risk is reduced."

The initial cushion spread for Price's strategy is closest to:

34. United Global Group (UGG) is a major property and casualty insurance company. UGG has a total investment portfolio of $25 billion. The portfolio is divided into S22 billion in bonds and $3 billion in equities. UGG's equity strategy employs enhanced indexing with the S&P 500 Index as the benchmark. UGG adjusts its equity portfolio by employing the 200-day moving average technical indicator. When more than 80% of the stocks are trading above their 200-day moving average, this indicator considers the equity market overbought―a bearish signal. In contrast, if less than 20% of the stocks are trading above their 200-day moving average, the market is considered oversold―a bullish signal that means investors should expect a positive correction. UGG management uses this indicator to move in and out of equities. Rather than actually selling their equities, UGG uses futures to create a synthetic cash position to execute any bearish trigger. Relevant data is shown in Figure 1.

Figure 1: Selected Data





UGG's management applied its technical indicator to the Japanese market and discovered that it is in an oversold situation. Based on this factor, management allocated half of UGG's equity portfolio, or 162,225,000,000 yen, to the Japanese market. Relevant data are shown in Figure 2.

Figure 2: Selected Data





UGG would like to fully hedge against a possible decline in the Japanese market. Using the data in Figure 2, the number of (short) contracts needed to hedge the yen-denominated portion of the equity portfolio is between:

35. Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investment analysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout the world. The firm specializes in the valuation of international bonds, with consideration of currency risk. IA typically uses forward contracts to hedge currency risk.

Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm, Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency (NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higgins suggests that they consider forward contracts with the same maturity as the investment holding period, which is estimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona (Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via a one-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.

Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if the Norwegian NKr and euro are positively correlated, then a forward contract should be entered into where euros will be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates and spot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.

Return on Bergen Petroleum bond in Norwegian NKr 7.00%

Risk-free rate in Norway 4.80%

Expected change in the NKr relative to the U.S. dollar -0.40%

Risk-free rate in United States 2.50%

Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.

• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, where higher forward rates imply that a country's spot rate will increase in the future."

• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-year U.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forward premium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen. invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."

The following day, Higgins and Tyler discuss various emerging market bond strategies and make the following statements.

• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagion and the competitive devaluations that often accompany crises in emerging markets. When one country devalues their currency, others often quickly follow and as a result the countries default on their external debt, which is usually denominated in a hard currency."

• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging market bond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emerging country bonds outside of this region."

Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds: a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by the Horgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued by a firm based in Switzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss the relative attractiveness of each bond and, using a total return approach, which bond should be invested in, assuming a 1-year time horizon.





Regarding their statements concerning the relationship between spot rates and forward rates, determine whether Higgins and Tyler are correct.

36. The firm must increase the level of review or restriction of proprietary trading activities during periods in which the firm has knowledge of information that is both material and nonpublic.

Bentley has identified two of Green's analysts, neither of whom have non-compete contracts, who are preparing to leave Federal Securities and go into competition. The first employee, James Ybarra, CFA, has agreed to take a position with one of Federal's direct competitors. Ybarra has contacted existing Federal clients using a client list he created with public records. None of the contacted clients have agreed to move their accounts as Ybarra has requested. The second employee, Martha Cliff, CFA, has registered the name Cliff Investment Consulting (CIC), which she plans to use for her independent consulting business. For the new business venture, Cliff has developed and professionally printed marketing literature that compares the new firm's services to that of Federal Securities and highlights the significant cost savings that will be realized by switching to CIC. After she leaves Federal, Cliff plans to target many of the same prospects that Federal Securities is targeting, using an address list she purchased from a third-party vendor. Bentley decides to call a meeting with Green to discuss his findings.

After discussing the departing analysts. Green asks Bentley how to best handle the disclosure of the following items: (1) although not currently a board member. Green has served in the past on the board of

directors of a company he researches and expects that he will do so again in the near future; and (2) Green recently inherited put options on a company for which he has an outstanding buy recommendation. Bentley is contemplating his response to Green.

According to CFA Institute Standards of Professional Conduct, which of the following statements regarding Green's recommendation to Federal Securities' clients is TRUE?

37. Harold Chang, CFA, has been the lead portfolio manager for the Woodlock Management Group (WMG) for the last five years. WMG runs several equity and fixed income portfolios, all of which are authorized to use derivatives as long as such positions are consistent with the portfolio's strategy. The WMG Equity Opportunities Fund takes advantage of long and short profit opportunities in equity securities. The fund's positions are often a relatively large percentage of the issuer's outstanding shares and fund trades frequently move securities prices. Chang runs the Equity Opportunities Fund and is concerned that his performance for the last three quarters has put his position as lead manager in jeopardy. Over the last three quarters, Chang has been underperforming his benchmark by an increasing margin and is determined to reduce the degree of underperformance before the end of the next quarter.

Accordingly, Chang makes the following transactions for the fund:

Transaction 1: Chang discovers that the implied volatility of call options on GreenCo is too high. As a result, Chang shorts a large position in the stock options while simultaneously taking a long position in GreenCo stock, using the funds from the short position to partially pay for the long stock. The GreenCo purchase caused the share price to move up slightly. After several months, the GreenCo stock position has accumulated a large unrealized gain. Chang sells a portion of the GreenCo position to rebalance the portfolio.

Richard Stirr, CFA, who is also a portfolio manager for WMG, runs the firm's Fixed Income Fund. Stirr is known for his ability to generate excess returns above his benchmark, even in declining markets. Stirr is convinced that even though he has only been with WMG for two and a half years, he will be named lead portfolio manager if he can keep his performance figures strong through the next quarter.

To achieve this positive performance, Stirr enters into the following transactions for the fund:

Transaction 2: Stirr decides to take a short forward position on the senior bonds of ONB Corporation, which Stirr currently owns in his Fixed Income Fund. Stirr made his decision after overhearing two of his firm's investment bankers discussing an unannounced bond offering for ONB that will subordinate all of its outstanding debt. As expected, the price of the ONB bonds falls when the upcoming offering is announced. Stirr delivers the bonds to settle the forward contract, preventing large losses for his investors. Transaction 3: Sitrr has noticed that in a foreign bond market, participants are slow to react to new information relevant to the value of their country's sovereign debt securities. Stirr, along with other investors, knows that an announcement from his firm regarding the sovereign bonds will be made the following day. Stirr doesn't know for sure, but expects the news to be positive, and prepares to enter a purchase order. When the positive news is released, Stirr is the first to act, making a large purchase before other investors and selling the position after other market participants react and move the sovereign bond price higher.

Because of their experience with derivatives instruments, Chang and Stirr are asked to provide investment advice for Cherry Creek, LLC, a commodities trading advisor. Cherry Creek uses managed futures strategies that incorporate long and short positions in commodity futures to generate returns uncorrelated with securities markets. The firm has asked Chang and Stirr to help extend their reach to include equity and fixed income derivatives strategies. Chang has been investing with Cherry Creek since its inception and has accepted increased shares in his Cherry Creek account as compensation for his advice. Chang has not disclosed his arrangement with Cherry Creek since he meets with the firm only during his personal time. Stirr declines any formal compensation but instead requests that Cherry Creek refer their clients requesting traditional investment services to WMG. Cherry Creek agrees to the arrangement.

Three months have passed since the transactions made by Chang and Stirr occurred. Both managers met their performance goals and are preparing to present their results to clients via an electronic newsletter published every quarter. The managers want to ensure their newsletters are in compliance with CFA Institute Standards of Professional Conduct. Chang states, "in order to comply with the Standards, we are required to disclose the process used to analyze and select portfolio holdings, the method used to construct our portfolios, and any changes that have been made to the overall investment process. In addition, we must include in the newsletter all factors used to make each portfolio decision over the last quarter and an assessment of the portfolio's risks." Stirr responds by claiming, "we must also clearly indicate that projections included in our report are not factual evidence but rather conjecture based on our own statistical analysis.

However, I believe we can reduce the amount of information included in the report from what you have suggested and instead issue more of a summary report as long as we maintain a full report in our internal records."

According to CFA Institute Standards of Professional Conduct, which of the following statements regarding

Stirr's arrangement with Cherry Creek, LLC is most accurate1} Stirr's arrangement:

38. Security analysts Andrew Tian, CFA, and Cameron Wong, CFA, are attending an investment symposium at the Singapore Investment Analyst Society. The focus of the symposium is capital market expectations and relative asset valuations across markets. Many highly-respected practitioners and academics from across the Asia-Pacific region are on hand to make presentations and participate in panel discussions. The first presenter, Lillian So, President of the Society, speaks on market expectations and tools for estimating intrinsic valuations. She notes that analysts attempting to gauge expectations are often subject to various pitfalls that subjectively skew their estimates. She also points out that there are potential problems relating to a choice of models, not all of which describe risk the same way. She then provides the following data to illustrate how analysts might go about estimating expectations and intrinsic values.





The next speaker, Clive Smyth, is a member of the exchange rate committee at the Bank of New Zealand. His presentation concerns the links between spot currency rates and forecasted exchange rates. He states that foreign exchange rates are linked by several forces including purchasing power parity (PPP) and interest rate parity (IRP). He tells his audience that the relationship between exchange rates and PPP is strongest in the short run, while the relationship between exchange rates and IRP is strongest in the long run. Smyth goes on to say that when a country's economy becomes more integrated with the larger world economy, this can have a profound impact on the cost of capital and asset valuations in that country.

The final speaker in the session directed his discussion toward emerging market investments. This discussion, by Hector Ruiz, head of emerging market investment for the Chilean Investment Board, was primarily concerned with how emerging market risk differs from that in developed markets and how to evaluate the potential of emerging market investments. He noted that sometimes an economic crisis in one country can spread to other countries in the area, and that asset returns often exhibit a greater degree of non-normality than in developed markets.

Ruiz concluded his presentation with the data in the tables below to illustrate factors that should be considered during the decision-making process for portfolio managers who are evaluating investments in emerging markets.





With regard to Ruiz's statements concerning emerging market risk, when an economic crisis spreads from one country to other countries in the area, this is known as:

39. Somerset Investment Limited is a Singapore-based money management firm that is conducting an appraisal of its investment performance. Cameron Li, CFA, has been charged with conducting the appraisal, and is to report back to upper management with his findings.

Li is convinced that trade executions play a substantial role in overall portfolio performance, particularly for funds that have a relatively high level of turnover during the year. As a result, he is seeking methods that will allow him to evaluate the quality of trade executions.

He knows that the firm's traders use both market and limit orders, and he is wondering if a framework can be developed to ensure that the best order type is used under the specific circumstances for each trade. When he consults with the firm's head trader, Rick Gleeson, Gleeson tells him that market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty. According to Gleeson, rebalancing and liquidity-motivated trades should use limit orders while value-motivated and information-motivated trades should use market orders.

Li knows that bid-ask spreads are a major component of trading costs, and asks Gleeson for some recent trade data that he can use for analysis and presentation to management. He receives the following data relating to a series of buy trades for Sumatra Natural Resources (SNR), with all currency values in Singapore dollars:

Trades of Sumatra Natural Resources





Gleeson also tells Li that the portfolio manager had originally made the decision to purchase 5,000 SNR at 10:00 a.m. when the price was $22.36. The closing price for the day was Leeson's last trade at $22.65, at which point the order for the remaining 2,000 shares was cancelled.

Which of the following correctly summarizes Gleeson’s comments concerning the differences between market and limit orders?

40. Cindy Hatcher, CFA, has spent the last ten years as a portfolio manager with Bernhardt Capital. While working for Bernhardt, Hatcher was responsible for maintaining and improving the company's code of ethics and guidelines for ethical money management. As a result of Hatcher's efforts, Bernhardt saw a dramatic decline in the number of complaints received from their individual and institutional customers. One of Bernhardt's direct competitors, Smith Investments, is keenly aware of Hatcher's reputation for ethical business practices and has offered her a job as their compliance officer. Hatcher has been apprised of several potential ethical problems at Smith that she will be directly responsible for fixing through implementation of policies and procedures that will prevent ethical dilemmas. The management at Smith is willing to grant Hatcher the authority to construct and implement policies to eliminate the ethical problems at the company.

Hatcher agrees to accept the position with Smith and resigns from employment with Bernhardt. As her first initiative with the company, Hatcher distributes to all employees at Smith a survey intended to acquaint her with the company's common business practices. Her goal is to identify those factors that are most likely to interfere with Smith's compliance with the CFA Institute's Code of Ethics and Standards of Practice. After collecting and analyzing the anonymous responses to the survey, Hatcher has identified the following four issues as the most frequently cited questionable business practices:

• Many Smith employees have relatives who are clients of the firm. For relatives* accounts where the Smith employee does not have beneficial ownership, trades are generally executed in conjunction with trades for other discretionary accounts held at the firm. Only in accounts where the Smith employee has beneficial ownership are trades delayed until all discretionary account trading is completed.

• Many of Smith's employees either personally own or maintain, through a family member, beneficial ownership of stocks that are also held in accounts for many of the firm's clients. While the company maintains a strict disclosure policy to the firm of such beneficial ownership and an "at will" disclosure policy to its clients, employees are not barred from trading these securities for their personal benefit even if their clients also own or have a direct or indirect financial interest in the same securities.

• Account managers meet weekly to discuss the issues and concerns of the client portfolios managed at the firm. During the meetings it is not unusual for individual clients to be identified and discussed. Information regarding the client's holdings and investment strategy is discussed as well as persona! needs related to the client's portfolio. The meetings are held in order to provide guidance and continuing education to all of the firm's account managers.

• At the suggestion of fixed-income analysts at the firm, most of the portfolio managers working for Smith have been adding B-rated corporate fixed-income securities to their portfolios. Analysts originally made (and continue to make) the suggestion due to the attractive yield potential offered by this class of investments. Smith's portfolio managers were thrilled with the idea since the returns on many of the portfolios' equity positions have been stifled by high profile accounting scandals.

Management at Smith Investments has been pleased with Hatcher's efforts so far but is concerned about the firm's ability to maintain compliance with the CFA Institute's Global Investment Performance Standards (GIPS®). The managing director of the firm, Erich Prince, has made the following comments to Hatcher: "I am concerned that we will not be able to claim compliance with GIPS at the end of the year since our new information system has inhibited our ability to include terminated portfolios in the historical record up to the last full measurement period before they were terminated. Also, we are unable to regroup portfolios that utilize hedging into separate composites from those that do not utilize hedging. These portfolios are currently grouped according to traditional value and growth strategies based on the capitalization of portfolio holdings (i.e., large vs. small)."

Hatcher eases Prince's mind by telling him she will "ensure full compliance with GIPS by the end of the quarter."

Evaluate Martin Prince's comments about Smith's ability to maintain compliance with the Global Investment Performance Standards (GIPS). Are Prince's statements regarding terminated portfolios and hedging strategies correct or incorrect?

41. Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors, which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies, foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark, Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by finding those bonds that have been overlooked by other developed world bond funds. The fund favors non-dollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity from the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts that interest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of business investment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low in order to stimulate the economy. Although she sees the level of yields declining, she believes that the spread on risky securities will increase due to the decline in business prospects. She therefore has reallocated her bond portfolio away from high-yield bonds and towards investment grade bonds.

Smith is less decided about the economy.

However, his trading strategy has been quite successful in the past. As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a 7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated Quincy Corporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhanced his annual income, which he considers quite favorable given the declining yields in the market.

Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, she expects that the yields on mortgages will decline. As a result, she has reallocated the portion of Northern Capital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to 7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in price more than the higher coupon mortgages. She identifies this trade as a structure trade.

Smith is examining the liquidity of three bonds.

Their characteristics are listed in the table below:





Regarding the bonds Smith is examining, which of the following is most likely to have the greatest liquidity?

42. Stephanie Mackley is a portfolio manager for Durango Wealth Management (DWM), a regional money manager catering to wealthy investors in the southwestern portion of the United States. Mackley's clients vary widely in terms of their age, net worth, and investment objectives, but all must have at least $1 million in net assets before she will accept them as clients.

Many of Mackley’s clients are referred to her by Kern & Associates, an accounting and consulting firm. DWM does not provide any direct compensation to Kern & Associates for the referrals, but Mackley’s who is the president of her local CFA Society, invites Kern & Associates to give an annual presentation to the society on the subject of tax planning and minimization strategies that Kern & Associates provides for its clients. Kern & Associates' competitors have never received an invitation to present their services to the society. When Mackley receives a referral, she informs the prospect of the arrangement between DWM and Kern & Associates.

DWM maintains a full research staff that analyzes and recommends equity and debt investments. All of the in-house research is provided to the firm's portfolio managers and their clients. In addition, DWM provides a subscription service to outside investors and portfolio managers. Aaron Welch, CFA, a private contractor, researches and reports on high-tech firms in the U.S. and other developed countries for several portfolio management clients. One of his latest reports rated InnerTech Inc., a small startup that develops microscopic surgical devices, as a strong buy. After reviewing the report carefully, Mackley decides to purchase shares of InnerTech for clients with account values over $6 million. She feels that accounts with

less than this amount cannot accept the risk level associated with InnerTech stock.

Two days after purchasing InnerTech for her clients, the stock nearly doubles in value, and the clients are ecstatic about the returns on their portfolios. Several of them give her small bouquets of flowers and boxes of chocolates, which she discloses to her supervisor at DWM. One client even offers her the use of a condo in Vail, Colorado for two weeks during ski season, if she can reproduce the results next quarter. Mackley graciously thanks her clients and asks that they refer any of their friends and relatives who are in need of asset management services. She provides brochures to a few clients who mention that they have friends who would be interested. The brochure contains a description of Mackley's services and her qualifications. At the end of the brochure, Mackley includes her full name followed by "a Chartered Financial Analyst" in bold font of the same size as her name Following is An excerpt from the brochure: "DWM can provide many of the investment services you are likely to need. For those services that we do not provide directly, such as estate planning, we have standing relationships with companies that do provide such services. 1 have a long history with DWM, serving as an investment analyst for six years and then in my current capacity as a portfolio manager for twelve years. My clients have been very satisfied with my past performance and will likely be very satisfied with my future performance, which I attribute to my significant investment experience as well as my participation in the CFA Program. I earned the right to use the CFA designation thirteen years ago. All CFA charter-holders must pass a series of three rigorous examinations that cover investment management and research analysis."

Two weeks later, some of Mackley's clients request that she provide supporting documentation for the research report on InnerTech, so they can familiarize themselves with how DWM analyzes investment opportunities. Mackley asks Welch for the documents, but Welch is unable to provide copies of his supporting research since he disposed of them, according to the company's policy, one week after issuing and distributing the report. Mackley informs Welch that obtaining the supporting documents is of the utmost importance, since one of the clients requesting the materials, Craig Adams, is about to inherit S20 million and as a result will be one of the firm's most important clients. Welch agrees to recreate the research documents in order to support the firm's relationship with Adams.

Does Mackley's signature at the end of her brochure violate any CFA Institute Standards of Professional Conduct?

43. Gabrielle Reneau, CFA, and Jack Belanger specialize in options strategies at the brokerage firm of Damon and Damon. They employ fairly sophisticated strategies to construct positions with limited risk, to profit from future volatility estimates, and to exploit arbitrage opportunities. Damon and Damon also provide advice to outside portfolio managers on the appropriate use of options strategies. Damon and Damon prefer to use, and recommend, options written on widely traded indices such as the S&P 500 due to their higher liquidity.

However, they also use options written on individual stocks when the investor has a position in the underlying stock or when mispricing and/or trading depth exists.

In order to trade in the one-year maturity puts and calls for the S&P 500 stock index, Reneau and Belanger contact the chief economists at Damon and Damon, Mark Blair and Fran Robinson. Blair recently joined Damon and Damon after a successful stint at a London investment bank. Robinson has been with Damon and Damon for the past ten years and has a considerable record of success in forecasting macroeconomic activity. In his forecasts for the U.S. economy over the next year, Blair is quite bullish, for both the U.S. economy and the S&P 500 stock index. Blair believes that the U.S. economy will grow at 2% more than expected over the next year. He also states that labor productivity will be higher than expected, given increased productivity through the use of technological advances. He expects that these technological advances will result in higher earnings for U.S. firms over the next year and over the long run.

Reneau believes that the best S&P 500 option strategy to exploit Blair's forecast involves two options of the same maturity, one with a low exercise price, and the other with a high exercise price. The beginning stock price is usually below the two option strike prices. She states that the benefit of this strategy is that the maximum loss is limited to the difference between the two option prices.

Belanger is unsure that Blair's forecast is correct. He states that his own reading of the economy is for a continued holding pattern of low growth, with a similar projection for the stock market as a whole. He states that Damon and Damon may want to pursue an options strategy where a put and call of the same maturity and same exercise price are purchased. He asserts that such a strategy would have losses limited to the total cost of the two options.

Reneau and Belanger are also currently examining various positions in the options of Brendan Industries. Brendan Industries is a large-cap manufacturing firm with headquarters in the midwestern United States. The firm has both puts and calls sold on the Chicago Board Options Exchange. Their options have good liquidity for the near money puts and calls and for those puts and calls with maturities less than four months. Reneau believes that Brendan Industries will benefit from the economic expansion forecasted by Mark Blair, the Damon and Damon economist. She decides that the best option strategy to exploit these expectations is for her to pursue the same strategy she has delineated for the market as a whole. Shares of Brendan Industries are currently trading at $38. The following are the prices for their exchange-traded options.





As a mature firm in a mature industry, Brendan Industries stock has historically had low volatility.

However, Belanger's analysis indicates that with a lawsuit pending against Brendan Industries, the volatility of the stock price over the next 60 days is greater by several orders of magnitude than the implied volatility of the options. He believes that Damon and Damon should attempt to exploit this projected increase in Brendan Industries1 volatility by using an options strategy where a put and call of the same maturity and same exercise price are utilized. He advocates using the least expensive strategy possible.

During their discussions, Reneau cites a counter example to Brendan Industries from last year. She recalls that Nano Networks, a technology firm, had a stock price that stayed fairly stable despite expectations to

the contrary. In this case, she utilized an options strategy where three different calls were used. Profits were earned on the strategy because Nano Networks' stock price stayed fairly stable. Even if the stock price had become volatile, losses would have been limited.

Later that week, Reneau and Belanger discuss various credit option strategies during a lunch time presentation to Damon and Damon client portfolio managers. During their discussion, Reneau describes a credit option strategy that pays the holder a fixed sum, which is agreed upon when the option is written, and occurs in the event that an issue or issuer goes into default. Reneau declares that this strategy can take the form of either puts or calls. Belanger states that this strategy is known as either a credit spread call option strategy or a credit spread put option strategy.

Reneau and Belanger continue by discussing the benefits of using credit options. Reneau mentions that credit options written on an underlying asset will protect against declines in asset valuation. Belanger says that credit spread options protect against adverse movements of the credit spread over a referenced benchmark.

If Belanger is correct regarding Brendan Industries’ volatility, and if the stock price at expiration is $45 and he pursues a lower cost strategy, his described strategy has a profit at expiration of:

44. Johnny Bracco, CFA, is a portfolio manager in the trust department of Canada National (CNL) in Toronto. CNL is a financial conglomerate with many divisions. In addition to the trust department, the firm sells financial products and has a research department, a trading desk, and an investment banking division. Part of the company's operating procedures manual contains detailed information on how the firm allocates shares in oversubscribed stock offerings. Allocation is effected on a pro rata basis based upon factors such as the size of a client's portfolio, suitability, and previous notification to participate in IPOs. Additionally, company policy discloses to clients that any trade needs to meet a minimum transaction size in an effort to control trading costs and to comply with best execution procedures.

One of Bracco's trust accounts is the Carobilo family trust, which contains a portion of nondiscretionary funds managed by Stephen Carobilo. Carobilo has a friend who runs a brokerage firm called First Trades, to which Carobilo tells Bracco to direct trades from the nondiscretionary accounts. Bracco has learned that First Trades charges a slightly higher trading fee than other brokers providing comparable services, and he discloses this to Carobilo.

Due to high prices and limited supplies of oil, Bracco has been following companies in the energy sector. He believes this area of the economy is in turmoil and should present some mispricing opportunities. One company he has been researching is Stiles Corporation, which is working on a new type of hydrogen fuel cell that uses fusion technology to create energy. To date, no one has been able to successfully sustain a fusion reaction for an extended period of time. Bracco has been in close contact with Stiles' pubic relations department, has toured their laboratories, and has thoroughly researched fusion technology and Stiles' competitors. Bracco is convinced from his research, based upon various public sources, that Stiles is on the verge of perfecting this technology and will be the first firm to bring it to the marketplace. Jerry McNulty, CFA and vice president of the investment banking division of CNL, has been working with Stiles to raise new capital via a secondary offering of Stiles common shares. One day Bracco happened to be in a stall in the bathroom when McNulty and a colleague came in and discussed the fact that Stiles had perfected the fuel-cell technology, which will greatly increase the price of Stiles1 stock.

Stiles Corporation's board of directors includes Dr. Elaine Joachim, who is a physics professor at the University of Toronto. She also works part-time for Stiles Corporation as a consultant in their fusion technology laboratory. Her husband is a materials engineer who recently started performing consulting work for Stiles.

A routine audit by the quality control department at CNL discovered trading errors in several of Bracco's accounts involving an oversubscribed IPO. Some accounts received shares they should not have and others did not receive shares they should have. Bracco and his supervisor Jaime Gun, CFA, are taking responsibility to reverse the incorrect trades. Bracco told Gun, "I'll correct the trades based on our clients' investment policy statements, previous notification of intent, and according to the company's formula for allocating shares on a pro rata basis. In so doing, we will fairly allocate shares so even small accounts that did not meet minimum size requirements will receive some shares of the IPO." Gun replied to Bracco by saying, "I'll credit short-term interest back to the accounts that should not have received the shares and subtract interest from the accounts that should have received the shares."

That evening, Bracco and his wife attended the company holiday party for CNL employees and their spouses. Jerry McNulty, whose wife was ill and could not come to the party, arrived drunk from a meeting with Stiles' upper management. During the party McNulty made inappropriate advances toward many of the female employees and joked about the inadequacies of Stiles' managers.

Regarding the statements made by Bracco and Gun on how to correct the trading errors:

45. Ethan Edwards, CFA, is a fixed income portfolio manager for Searcher Securities. Edwards has been reviewing the pension fund of Cicatrix Corp., a large account with $55 million in fixed income securities. He is considering proposing a contingent immunization strategy to the trustees of the Cicatrix pension fund. The average age of Cicatrix employees covered by the plan is 41. In a recent meeting, the trustees of the plan informed Edwards that a 6.0% return was an acceptable minimum for the next six years.

The Cicatrix pension bond portfolio was set up in a classical immunization strategy four years ago. At that time the objective was to fund a $75 million liability in 10 years. The allocation was a barbell strategy using zero-coupon bonds with half of the bonds maturing in 4 years and half maturing in 15 years. The 4-year bonds are now maturing, and Edwards is hoping to use the proceeds to create a contingent immunized portfolio. Edwards plans to once again use a barbell structure, with half of the portfolio invested in maturities shorter than the 6-year time horizon set by the trustees and the other half in the original 15-year bonds.

One of the trustees of the Cicatrix pension fund asked Edwards whether rebalancing the portfolio was a concern when using classical immunization strategies. Edwards responded by claiming that as the yield curve shifts and time passes, the portfolio will need to be rebalanced. Edwards also stated that the costs to rebalance are high but can be mitigated by limiting the investment universe to highly liquid securities. Another trustee asked Edwards to assess the feasibility of pursuing a multiple liability immunization strategy for the fund and report his findings.

Among other items, Edwards’ response contained the following information:

• Assuming parallel shifts in interest rates, multiple liability immunization is possible for the Cicatrix pension fund as long as the duration of the immunization portfolio is equal to the duration of the liability stream.

• As an alternative to multiple liability immunization, the Cicatrix pension fund could employ a cash flow matching strategy. A cash flow matching strategy would be free from immunization risk, and typically would require less capital to fund the pension liabilities.

Determine whether Edwards is correct with regard to his statement about the conditions requiring rebalancing to maintain an immunization strategy and his statement about reducing the costs of rebalancing.

46. Rowan Brothers is a full service investment firm offering portfolio management and investment banking services. For the last ten years, Aaron King, CFA, has managed individual client portfolios for Rowan Brothers, most of which are trust accounts over which King has full discretion. One of King's clients, Shelby Pavlica, is a widow in her late 50s whose husband died and left assets of over $7 million in a trust, for which she is the only beneficiary.

Pavlica's three children are appalled at their mother's spending habits and have called a meeting with King to discuss their concerns. They inform King that their mother is living too lavishly to leave much for them or Pavlica's grandchildren upon her death. King acknowledges their concerns and informs them that, on top of her ever-increasing spending, Pavlica has recently been diagnosed with a chronic illness. Since the diagnosis could indicate a considerable increase in medical spending, he will need to increase the risk of

the portfolio to generate sufficient return to cover the medical bills and spending and still maintain the principal. King restructures the portfolio accordingly and then meets with Pavlica a week later to discuss how he has altered the investment strategy, which was previously revised only three months earlier in their annual meeting.

During the meeting with Pavlica, Kang explains his reasoning tor altering the portfolio allocation but does not mention the meeting with Pavlica's children. Pavlica agrees that it is probably the wisest decision and accepts the new portfolio allocation adding that she will need to tell her children about her illness, so they will understand why her medical spending requirements will increase in the near future. She admits to King that her children have been concerned about her spending. King assures her that the new investments will definitely allow her to maintain her lifestyle and meet her higher medical spending needs.

One of the investments selected by King is a small allocation in a private placement offered to him by a brokerage firm that often makes trades for King's portfolios. The private placement is an equity investment in ShaleCo, a small oil exploration company. In order to make the investment, King sold shares of a publicly traded biotech firm, VNC Technologies. King also held shares of VNC, a fact that he has always disclosed to clients before purchasing VNC for their accounts. An hour before submitting the sell order for the VNC shares in Pavlica's trust account. King placed an order to sell a portion of his position in VNC stock. By the time Pavlica's order was sent to the trading floor, the price of VNC had risen, allowing Pavlica to sell her shares at a better price than received by King.

Although King elected not to take any shares in the private placement, he purchased positions for several of his clients, for whom the investment was deemed appropriate in terms of the clients* objectives and constraints as well as the existing composition of the portfolios. In response to the investment support, ShaleCo appointed King to their board of directors. Seeing an opportunity to advance his career while also protecting the value of his clients' investments in the company, King gladly accepted the offer. King decided that since serving on the board of ShaleCo is in his clients' best interest, it is not necessary to disclose the directorship to his clients or his employer.

For his portfolio management services, King charges a fixed percentage fee based on the value of assets under management. All fees charged and other terms of service are disclosed to clients as well as prospects. In the past month, however. Rowan Brothers has instituted an incentive program for its portfolio managers. Under the program, the firm will award an all-expense-paid vacation to the Cayman islands for any portfolio manager who generates two consecutive quarterly returns for his clients in excess of 10%. King updates his marketing literature to ensure that his prospective clients are fully aware of his compensation arrangements, but he does not contact current clients to make them aware of the newly created performance incentive.

In his statements to Pavlica after the reallocation, did King violate any CFA Institute Standards of Professional Conduct?

47. International Opportunity Investors (IOI) manages substantial euro-priced equity portfolios for two U.S.-based investors, Mark Taylor and Cindy Amsler. Taylor and Amsler have invested in European stocks because of recent media reports suggesting that, due to continued interest rate increases in the United States, European stocks will outperform U.S. stocks over the next few years. Their portfolios are well diversified and similar to the local index portfolio in capitalization weightings.

Ted Tavinsky, lOI's portfolio manager asks his assistant, Tim Treblehorn, to review the relationship between international asset returns and the level of currency risk assumed when investing in foreign securities. The findings, Tavinsky believes, will prove useful in marketing the fund to North American investors. Treblehorn relays two fundamental conclusions to Taylor. First, correlations between international markets have been increasing, and the result has been reduced diversification benefits for international investors. Second, currency risk is typically less than half that of foreign stock risk, but the actual risk assumed is much lower because currency returns and stock returns are not perfectly positively correlated.

Taylor however is very concerned that the U.S. downturn may spread to the global economy. He states that he would like to explore the possibility of investing in the RRIC countries (Brazil, Russia, India, and China). Tavinsky replies that the prospects for the BRIC countries are quite good. Relative to the current G6 countries (U.S., Japan, U.K., Germany, France, and Italy), the stronger economic growth for emerging markets should result in higher stock returns. Furthermore, the increased growth in these markets will increase the demand for capital, which should strengthen their currency values.

Amsler is a novice investor and has hesitantly invested in the overseas markets. In order to calm her fears, Tavinsky and Treblehorn investigate the possibility of hedging using futures contracts on an equity index as well as a euro forward contract. They have chosen futures contracts written on the Eurostoxx equity index for her portfolio because the price changes of the contract have a high correlation with the returns on Amsler's equity portfolio. Amsler's equity portfolio has a market value of 15,000,000 and a beta of 1.15 relative to the local underlying index.

Tavinsky and Treblehorn collect data for spot exchange rates, futures contract prices and betas, as well as U.S. and European interest rates. Tavinsky and Treblehorn are bearish on the European stock market over the next year as noted by their forecasted return for it.

The values are shown in the table below:





Tavinsky has told Amsler that he and Treblehom will calculate the value of her portfolio in hedged and

unhedged scenarios. Tavinsky states that if, at the beginning of the year, he were to fully hedge the systematic risk of Amsler's equity portfolio using the index futures, the appropriate futures position to accomplish this would be 125 contracts. Treblehorn states that if they decide to hedge the currency risk of the portfolio as well, the principal for the forward contract that will hedge the currency risk of the hedged equity position will be 15,000,000, using a ''hedging the principal" strategy.

Lastly, Tavinsky and Treblehorn calculate the forecasted return on the portfolio assuming that currency risk is hedged. Assuming that both equity and currency risk are hedged, Tavinsky calculates that the dollar return would be 8.8%. Treblehorn states that the forecasted spot U.S. dollar / euro exchange rate in one year of $1.12 should be used for the forward contract rate.

Which of the following is least accurate regarding the BR1C countries?

48. Kim Simpson, CFA, manages a $75 million multi-cap growth portfolio. Simpson utilizes a growth at a reasonable price (GARP) investment strategy and her investment universe consists of small, medium and large capitalization stocks. She turns the entire portfolio over once each year. Simpson is concerned about the amount of trading costs she has generated through the implementation of her investment strategy. Simpson decides to conduct a trade cost analysis with the cooperation of her trader, Janet Long, CFA. Simpson believes the results of the trading analysis can be used to improve trading performance and help to refine her investment strategy. The first trade they examine is a purchase of 2000 shares of Technology Company that was completed using a market order. Simpson remembers adding to her Technology Company position based on her analyst's recommendation that the company was going to generate earnings significantly above the consensus estimate in a soon to be released earnings report. The order was split into two trades as shown in Figure 1.

Figure 1: Technology Company buy order for 2000 shares



In conducting a comprehensive analysis of the trading markets, Simpson states that she is most concerned about market liquidity. Simpson defines a market with good liquidity as one with diversity of opinion, many buyers/sellers and relatively wide bid-ask spreads. In addition to reviewing market liquidity, Simpson believes that, in order to assess market quality, both the ease with which investors can obtain accurate information and the certainty that a trade will be completed must be evaluated.

Simpson and Long review their trade of Nano Corporation, a small biotechnology company. Simpson used a limit order because her analyst had established a specific buy target and she wanted to hold down transaction costs. To handle both explicit and implicit trading costs, Simpson measures execution costs using implementation shortfall.

The buy order for 100,000 shares of Nano stock has the following timeline:

• Nano stock price closes at $35.00 per share.

• Day one: Simpson places a limit order for 100,000 shares of Nano stock at $34.75 per share or better at the opening of trading.

However, Nano's stock never falls below $35.00 per share and closes at $36.50 per share.

• Day two: Simpson adjusts her limit order price to $37.00 per share or better. Long is able to fill 50,000 shares of the order at $36.75 per share. Nano's stock climbs to $38.00 per share during the day and Simpson moves the limit price to $40.00 per share or better. Long completes the purchase of the remaining 50,000 shares of Nano at $40.00 per share, which is also the closing price of Nano's stock.

• The commission for each block trade is $2,500.

Long suggests implementing the Best Execution concept as established by the CFA Institute in its Trade Management Guidelines. Long states best execution would accept a high portfolio turnover strategy provided the overall portfolio value is greater after trading costs. Long asserts that her professional relationships are integral to best execution.

The buy order for the Technology Company shares has an average effective spread closest to:

49. Richard Bateman is a successful businessman with a $5 million portfolio. Bateman wants his portfolio managed using a conservative approach, and he specifically states that no options or futures are to be used.

A current client, Stan North, has decided to retire. North would like to reduce his risk exposure from aggressive to conservative. CCM moves North's account, including its historical performance, to the conservative composite.

At the end of 2008, CCM reports the moderate portfolio composite performance but does not include the associated number of accounts.

CCM reported the 2008 returns on its conservative composite as shown in Figure 1:

Figure 1: CCM Conservative Composite Returns: Year Ending December 31, 2007





The data shown in Figure 2 relates to Moss portfolio transactions from the 2nd quarter of 2008.

Figure 2: CCM Equity Returns for the Second Quarter of 2008





CCM established three types of composites: aggressive, moderate, and conservative.

State whether CCM's composites are correctly defined according to GIPS?

50. Cindy Hatcher, CFA, has spent the last ten years as a portfolio manager with Bernhardt Capital. While working for Bernhardt, Hatcher was responsible for maintaining and improving the company's code of ethics and guidelines for ethical money management. As a result of Hatcher's efforts, Bernhardt saw a dramatic decline in the number of complaints received from their individual and institutional customers. One of Bernhardt's direct competitors, Smith Investments, is keenly aware of Hatcher's reputation for ethical business practices and has offered her a job as their compliance officer. Hatcher has been apprised of several potential ethical problems at Smith that she will be directly responsible for fixing through implementation of policies and procedures that will prevent ethical dilemmas. The management at Smith is willing to grant Hatcher the authority to construct and implement policies to eliminate the ethical problems at the company.

Hatcher agrees to accept the position with Smith and resigns from employment with Bernhardt. As her first initiative with the company, Hatcher distributes to all employees at Smith a survey intended to acquaint her with the company's common business practices. Her goal is to identify those factors that are most likely to interfere with Smith's compliance with the CFA Institute's Code of Ethics and Standards of Practice. After collecting and analyzing the anonymous responses to the survey, Hatcher has identified the following four issues as the most frequently cited questionable business practices:

• Many Smith employees have relatives who are clients of the firm. For relatives* accounts where the Smith employee does not have beneficial ownership, trades are generally executed in conjunction with trades for other discretionary accounts held at the firm. Only in accounts where the Smith employee has beneficial ownership are trades delayed until all discretionary account trading is completed.

• Many of Smith's employees either personally own or maintain, through a family member, beneficial ownership of stocks that are also held in accounts for many of the firm's clients. While the company maintains a strict disclosure policy to the firm of such beneficial ownership and an "at will" disclosure policy to its clients, employees are not barred from trading these securities for their personal benefit even if their clients also own or have a direct or indirect financial interest in the same securities.

• Account managers meet weekly to discuss the issues and concerns of the client portfolios managed at the firm. During the meetings it is not unusual for individual clients to be identified and discussed. Information regarding the client's holdings and investment strategy is discussed as well as persona! needs related to the client's portfolio. The meetings are held in order to provide guidance and continuing education to all of the firm's account managers.

• At the suggestion of fixed-income analysts at the firm, most of the portfolio managers working for Smith have been adding B-rated corporate fixed-income securities to their portfolios. Analysts originally made (and continue to make) the suggestion due to the attractive yield potential offered by this class of investments. Smith's portfolio managers were thrilled with the idea since the returns on many of the portfolios' equity positions have been stifled by high profile accounting scandals.

Management at Smith Investments has been pleased with Hatcher's efforts so far but is concerned about the firm's ability to maintain compliance with the CFA Institute's Global Investment Performance Standards (GIPS®). The managing director of the firm, Erich Prince, has made the following comments to Hatcher: "I am concerned that we will not be able to claim compliance with GIPS at the end of the year since our new information system has inhibited our ability to include terminated portfolios in the historical record up to the last full measurement period before they were terminated. Also, we are unable to regroup portfolios

that utilize hedging into separate composites from those that do not utilize hedging. These portfolios are currently grouped according to traditional value and growth strategies based on the capitalization of portfolio holdings (i.e., large vs. small)."

Hatcher eases Prince's mind by telling him she will "ensure full compliance with GIPS by the end of the quarter."

Smith's portfolio managers have been adding B-rated corporate fixed-income securities to their portfolios at the recommendation of the firm's fixed-income analysts. With regard to this situation, Smith's employees have violated the CFA Institute's Code and Standards for which of the following reasons?

51. 5%. The characteristics of the forward contract are shown below.

Information on the Credit Spread Forward





Regarding their statements concerning current and future credit risk, determine whether Cramer and McNally are correct or incorrect.

52. Swap B: 5-year swap with semiannual payments.

Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in exchange. For analysis, Skinner always assumes the duration of a fixed rate bond is 75% of its term to maturity. Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by purchasing a dual currency bond issued by an American holding company with significant operations in Japan. The bond makes semiannual fixed interest payments in Japanese yen but will make the final principal payment in U.S. dollars five years from now. Skinner originally purchased the bond to take advantage of the strengthening relative position of the yen. The result was an above average return for the bond portfolio for several years. Now, however, he is concerned that the yen is going to begin a weakening trend, as he expects inflation in the Japanese economy to accelerate over the next few years.

Knowing Skinner’s situation, one of his colleagues, Bill Michaels, suggests the following strategy:

"You need to offset your exposure to the Japanese yen by establishing a short position in a synthetic dual currency bond that matches the terms of the dual currency bond you purchased for the Thomas Steel bond portfolio. As part of the strategy, you will have to enter into a currency swap as the fixed-rate yen payer. The swap will neutralize the dual-currency bond position but will unfortunately increase the credit risk exposure of the portfolio."

Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his

expectations for the bond portfolio.

Mann has also provided some advice to Skinner in the following comment:

"1 know you expect a general increase in interest rates, but I disagree with your assessment of the interest rate shift. I believe interest rates are going to decrease. Therefore, you will want to synthetically remove the call features of any callable bonds in your portfolio by purchasing a payer interest rate swaption."

After his lung conversation with Director Securities' senior economist, Orval Mann, Skinner has completely changed his outlook on interest rates and has decided to extend the duration of his portfolio. The most appropriate strategy to accomplish this objective using swaps would be to enter into a swap to pay:

53. Lucy Sakata, CFA and Gary Lowenstein, CFA are portfolio managers for the Murray Funds, a provider of investment funds to institutional and wealthy individual investors. Murray frequently indexes in developed markets, but uses full blown active management in less efficient markets and when they think their analysts have a particular expertise. The vast majority of Murray's clients attempt to minimize tracking error.

One of the Murray's funds invests in a Hong Kong index and is marketed as a way for investors to participate in the growth of the Asian economies. The index represents the best known Hong Kong stocks and Murray uses a full replication strategy for the fund. The index is a market cap-weighted index and ten firms represent over 70% of the index's total market cap._Sakata would like to market the Hong Kong fund to institutions with a required minimum investment of $50 million. Many potential clients are institutions who

outsource their foreign equity management and are subject to maximum holdings on individual stocks. Murray also has a Canada fund that invests in an index which represents the 25 largest cap stocks in Canada. It is marketed as a way for investors to exploit the growth in demand for commodities. The index adjusts for stock splits and repurchases as necessary. Most of the index's return has come from capital gains, rather than dividends, due to the tremendous increase in global demand for commodities. To encourage long-term holding, Murray places a back-end load of 3% on fund redemptions that are made within two years of initial investment.

Sakata and Lowenstein discuss the fundamental law of active management and how it applies to three hypothetical managers who invest against the broad large-cap U.S. market, as represented by the S&P 500 index.

• Manager A under-weights and over-weights the 500 individual stocks of the S&P 500 index as she sees appropriate, keeping industry exposures similar to those of the index. She has an information coefficient of 0.05 and is restricted to long-only positions.

• Manager B holds cash and long S&P 500 futures. He tries to generate excess returns by altering the duration of the cash position and has an information coefficient of 0.05.

• Manager C has an information coefficient of 0.07, and she uses a long-short strategy for the 500 stocks in the S&P 500 index.

Sakata is consulting with the trustees of the Powell Foundation. The foundation has a position in the three Murray funds described in Exhibit 1 below.

Exhibit 1: Powell Foundation Holdings





Murray has a value fund that invests in stocks in the U.S. Lowenstein is considering several equity style index providers as a benchmark for the fund. The characteristics of the index providers and the methodologies they use to construct equity style indices are described in Exhibit 2 below.

Exhibit 2: Comparison of Index Providers





In regard to the index providers, Lowenstein makes the following statements:

Statement 1: "I would like to use the indices from either provider in a returns-based style analysis. Based on the information in the table, I believe that if I regress a value manager's returns against Provider B's indices, the manager's selection return will appear artificially large."

Statement 2: "If an index provider uses buffering rules, a fund tracking that index will experience lower transactions costs."

Determine which of the following is the most likely reason that the Hong Kong fund will be inappropriate for the institutional investors.

54. Jean Sims, CFA and Ellie Hayes, CFA are advisors for Eagle Fixed Income Investors. Eagle makes recommendations on bonds, mortgages, and other fixed income investments for wealthy individuals and institutions.

Eagle has a client, Parker Portfolio Managers, which has a large holding of mortgages. Due to a projected decline in the housing market in the United States, the yields on mortgages are expected to increase over the next year. The largest mortgage position for Parker is currently priced at 98.80. Given the projected increase in yields, Sims has calculated an expected price of the mortgage of 95.50 in one year. For the same magnitude of yield change, she projects a price of 101.20 if yields instead fall. Hayes states that Parker should hedge the mortgage by shorting a 10-year Treasury bond futures contract.

Discussing the performance of mortgages in general with Parker officers, Hayes states that they are market directional investments. Hayes's reasoning is that mortgages tend to follow the general direction of the fixed income market, where mortgages should be avoided when interest rates are expected to rise and favored when they are expected to fall.

Commenting on hedging mortgages in general, Sims states that a two Treasury bond futures hedge is usually more effective than a single Treasury bond futures hedge. Furthermore, she states, a mortgage can be hedged dynamically by adjusting the hedge through time, or by buying interest rate options. An option hedge would be used when its implied volatility is low, she states.

Examining the Parker portfolio in more detail, Sims gathers the following details on mortgages they hold.





Later that day Sims and Hayes discuss the appropriate hedging of mortgages and make the following statements:

• Sims: "To hedge the duration exposure of a mortgage and maintain a constant duration, the investor should sell Treasury bond futures when interest rates fall and buy Treasury bond futures when interest rates rise."

• Hayes: "Mortgage investors face model risk where using a poor model increases the investor's risk. For example, if prepayments increase faster than expected, the investor faces greater risk. Unfortunately, there is no easy way to hedge model risk."

Examining the properties of principal only (PO) and interest only (10) strips, Sims determines that the key rate durations for a client's PO strip are negative before year 8 but turn positive thereafter. The client's 10 strip has key rate durations that are positive up until year 10 but turn negative thereafter. Overall, the duration is positive for the PO strip and negative for the 10 strip. Sims is examining the effect of a yield curve change on the mortgages. Her assumption is that the short end of the yield curve increases while the Long end of the curve is unchanged.

Of the mortgages in Parker's portfolio, which of the following would be most appropriately hedged with a duration-based strategy?

55. Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Quaker Fund. BIC is an asset management firm headquartered in Holland with regional offices in several other European countries.

After accepting the position, Bair received a letter from the three principals of BIC. The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations.

Among other things, the letter stated the following:

"Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund. It is your responsibility to obtain this knowledge and comply with appropriate regulations. This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully. You will likely need to arrange for our sister companies to quietly buy and sell Quaker Fund shares over the first month of operations. This will provide sufficient price support to allow the fund to trade closer to its net asset value than other small-cap closed-end funds. Because these funds generally trade at a discount to net asset value, if our fund trades close to its net asset value, the market may perceive it as more desirable than similar funds managed by our competitors."

Bair heeded the advice from her firm's principals and collected information on the laws and regulations of three countries: Norway, Sweden, and Denmark. So far, all of the investors expressing interest in the Quaker Fund are from these areas. Based on her research, Bair decides the following policies are appropriate for the fund:

Note: Laws mentioned below are assumed for illustrative purposes.

• For clients located in Norway the fund will institute transaction crossing, since, unlike in Holland, the practice is not prohibited by securities laws or regulations. The process will involve internally matching buy and sell orders from Norwegian clients whenever possible. This will reduce brokerage fees and improve the fund's overall performance.

• For clients located in Denmark, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by Denmark's securities regulators, even though the laws in Holland only require such reports to be generated on a quarterly basis.

• For clients located in Sweden, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment. This policy is consistent with the laws and regulations in Holland. Sweden's securities regulations do not cover this type of situation.

Three months after the inception of the fund, its market value has grown from $200 million to $300 million and Bair's performance has earned her a quarter-end bonus. Since it is now the end of the quarter, Bair is participating in conference calls with companies in her fund. Bair calls into the conference number for Swift Petroleum. The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Swift discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter. The restatement will not be announced until the year's end, six months from now. Bair does not remind the officers that she can hear their conversation. Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call. Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call. The investment bankers then proceed to sell their personal holdings of Swift Petroleum stock. After her meeting, Bair sells the Quaker Fund's holdings of Swift Petroleum stock.

After her conference call with Swift Petroleum, Bair should have:

56. Garrison Investments is a money management firm focusing on endowment management for small colleges and universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocations to high quality long-term foreign government bonds. Garrison's largest account, Point University, has a market value of $800 million and an asset allocation as detailed in Figure 1.

Figure 1: Point University Asset Allocation





*Bond coupon payments are all semiannual.

Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value.

Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move.

Managers at Garrison have put together the following proposal for the reallocation:

To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2.

Figure 2: Mid-cap index and European Index Futures Data





Three months after proposing the international diversification plan, Garrison was able to persuade Point University to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japanese electronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of its production in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigate exchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HI has one remaining purchase of Australian gold that will occur in nine months. The company has hedged the purchase with a long 12-month futures contract on the Australian dollar (AUD). Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about the impact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decided to use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the local currency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of changes in the USD/Yen spot rate is 0.92.

With regard to Garrison's proposal to generate temporary exposure to European equities in the Point University portfolio, determine the appropriate position in the European equity index futures.

57. Jimena Mora, CFA and Jack Wieters, CFA are economists for Otterbein Forecasting. Otterbein provides economic consulting and forecasting services for institutional investors, medium-sized investment banks, and corporations. In order to forecast the performance of asset classes and formulate strategic asset allocations, Mora and Wieters are currently examining the capital market expectations for four developed countries: Alzano, Lombardo, Bergamo, and Linden. Wieters was hired in 2009 and Mora is his supervisor. Mora and Wieters use the Grinold and Kroner model to forecast equity market performance.

Macroeconomic forecasts and capital market expectations for three countries are given below:





Mora is also examining the return on federal government bills and bonds of various maturities for the country of Linden.

The data are provided below:





One of Otterbein Forecasting's largest clients is an institutional investor in Linden, the Balduvi Endowment.

The current and potential asset allocations for the endowment are shown below





Mora asks Wieters for his opinion on the future of the economy in Linden and the appropriate investment

for the Balduvi Endowment.

Mora has been asked by the Otterbein CEO to develop a model for explaining stock returns. In her master's degree training, Mora was instructed that the default risk premium has predictive power for stock returns, however the CEO has asked her to include other macroeconomic variables.

Mora examines the following data for the capital market history of Bergamo:

• Default risk premiums, which she measures as the difference in yields between high-yield bonds and government bonds;

• Maturity risk premiums, which she measures as the difference in yields between ten-year and one-year government bonds; and

• Lagged changes in the stock market.

Mora uses these variables to explain stock returns in the following year.

Using 40 years of data, she finds the following results for the significance of the variables in explaining stock returns:





Mora concludes from the correlation analysis that, of the three variables studied, the default risk premium has the most predictive power for stock returns.

As the most recent hire at Otterbein Forecasting, Wieters is well versed on the latest evidence on asset pricing and financial engineering.

However, Mora suspects that his limited experience results in erroneous forecasts.

For instance, during the credit crisis of 2007-2008, annual stock returns in Lombardo averaged -12.6%.

However, using the 80-year history of its capital market, annual stock returns in Lombardo have averaged 13.6%. For his clients' strategic asset allocations in 2010 and onward, Wieters projects Lombardo stock returns of 6.5%. As his supervisor, Mora questions him about this and she suggests that Wieters revise his projections upward.

Mora and Wieters are discussing the valuation and risk analysis of emerging market securities and economies. In their discussion, Mora makes the following comments:

Statement 1: "Emerging countries are dependent on foreign financing of growth, but it is important that a country not take on too much debt. A financial crisis can lead to currency devaluations and capital flight. Foreign debt levels greater than 50% of GDP or debt greater than 200% of current account receipts may indicate that a country is over-levered."

Statement 2: "In financial crises, emerging market debt is particularly susceptible, as currency devaluations will quickly reduce the principal and coupon value. Because most emerging debt is denominated in a domestic currency, the emerging government must have foreign currency reserves to defend its currency in the foreign exchange markets."

What does the bond data predict for the future of the economy in Linden?

58. Ethan Edwards, CFA, is a fixed income portfolio manager for Searcher Securities. Edwards has been reviewing the pension fund of Cicatrix Corp., a large account with $55 million in fixed income securities. He is considering proposing a contingent immunization strategy to the trustees of the Cicatrix pension fund. The average age of Cicatrix employees covered by the plan is 41. In a recent meeting, the trustees of the plan informed Edwards that a 6.0% return was an acceptable minimum for the next six years.

The Cicatrix pension bond portfolio was set up in a classical immunization strategy four years ago. At that time the objective was to fund a $75 million liability in 10 years. The allocation was a barbell strategy using zero-coupon bonds with half of the bonds maturing in 4 years and half maturing in 15 years. The 4-year bonds are now maturing, and Edwards is hoping to use the proceeds to create a contingent immunized portfolio. Edwards plans to once again use a barbell structure, with half of the portfolio invested in maturities shorter than the 6-year time horizon set by the trustees and the other half in the original 15-year bonds.

One of the trustees of the Cicatrix pension fund asked Edwards whether rebalancing the portfolio was a concern when using classical immunization strategies. Edwards responded by claiming that as the yield curve shifts and time passes, the portfolio will need to be rebalanced. Edwards also stated that the costs to rebalance are high but can be mitigated by limiting the investment universe to highly liquid securities. Another trustee asked Edwards to assess the feasibility of pursuing a multiple liability immunization strategy for the fund and report his findings.

Among other items, Edwards’ response contained the following information:

• Assuming parallel shifts in interest rates, multiple liability immunization is possible for the Cicatrix pension fund as long as the duration of the immunization portfolio is equal to the duration of the liability stream.

• As an alternative to multiple liability immunization, the Cicatrix pension fund could employ a cash flow matching strategy. A cash flow matching strategy would be free from immunization risk, and typically would require less capital to fund the pension liabilities.

In order to minimize immunization risk in the event of a nonparallel interest rate shift, determine which of the following portfolio structures is preferable (assuming the entire portfolio will be restructured).

59. Harold Chang, CFA, has been the lead portfolio manager for the Woodlock Management Group (WMG) for the last five years. WMG runs several equity and fixed income portfolios, all of which are authorized to use derivatives as long as such positions are consistent with the portfolio's strategy. The WMG Equity Opportunities Fund takes advantage of long and short profit opportunities in equity securities. The fund's positions are often a relatively large percentage of the issuer's outstanding shares and fund trades frequently move securities prices. Chang runs the Equity Opportunities Fund and is concerned that his performance for the last three quarters has put his position as lead manager in jeopardy. Over the last three quarters, Chang has been underperforming his benchmark by an increasing margin and is determined to reduce the degree of underperformance before the end of the next quarter.

Accordingly, Chang makes the following transactions for the fund:

Transaction 1: Chang discovers that the implied volatility of call options on GreenCo is too high. As a result, Chang shorts a large position in the stock options while simultaneously taking a long position in GreenCo stock, using the funds from the short position to partially pay for the long stock. The GreenCo purchase caused the share price to move up slightly. After several months, the GreenCo stock position has accumulated a large unrealized gain. Chang sells a portion of the GreenCo position to rebalance the portfolio.

Richard Stirr, CFA, who is also a portfolio manager for WMG, runs the firm's Fixed Income Fund. Stirr is known for his ability to generate excess returns above his benchmark, even in declining markets. Stirr is convinced that even though he has only been with WMG for two and a half years, he will be named lead portfolio manager if he can keep his performance figures strong through the next quarter.

To achieve this positive performance, Stirr enters into the following transactions for the fund:

Transaction 2: Stirr decides to take a short forward position on the senior bonds of ONB Corporation, which Stirr currently owns in his Fixed Income Fund. Stirr made his decision after overhearing two of his firm's investment bankers discussing an unannounced bond offering for ONB that will subordinate all of its outstanding debt. As expected, the price of the ONB bonds falls when the upcoming offering is announced. Stirr delivers the bonds to settle the forward contract, preventing large losses for his investors. Transaction 3: Sitrr has noticed that in a foreign bond market, participants are slow to react to new information relevant to the value of their country's sovereign debt securities. Stirr, along with other investors, knows that an announcement from his firm regarding the sovereign bonds will be made the following day. Stirr doesn't know for sure, but expects the news to be positive, and prepares to enter a purchase order. When the positive news is released, Stirr is the first to act, making a large purchase before other investors and selling the position after other market participants react and move the sovereign bond price higher.

Because of their experience with derivatives instruments, Chang and Stirr are asked to provide investment advice for Cherry Creek, LLC, a commodities trading advisor. Cherry Creek uses managed futures strategies that incorporate long and short positions in commodity futures to generate returns uncorrelated with securities markets. The firm has asked Chang and Stirr to help extend their reach to include equity and fixed income derivatives strategies. Chang has been investing with Cherry Creek since its inception and has accepted increased shares in his Cherry Creek account as compensation for his advice. Chang has not disclosed his arrangement with Cherry Creek since he meets with the firm only during his personal time. Stirr declines any formal compensation but instead requests that Cherry Creek refer their clients requesting traditional investment services to WMG. Cherry Creek agrees to the arrangement.

Three months have passed since the transactions made by Chang and Stirr occurred. Both managers met their performance goals and are preparing to present their results to clients via an electronic newsletter published every quarter. The managers want to ensure their newsletters are in compliance with CFA Institute Standards of Professional Conduct. Chang states, "in order to comply with the Standards, we are required to disclose the process used to analyze and select portfolio holdings, the method used to

construct our portfolios, and any changes that have been made to the overall investment process. In addition, we must include in the newsletter all factors used to make each portfolio decision over the last quarter and an assessment of the portfolio's risks." Stirr responds by claiming, "we must also clearly indicate that projections included in our report are not factual evidence but rather conjecture based on our own statistical analysis.

However, I believe we can reduce the amount of information included in the report from what you have suggested and instead issue more of a summary report as long as we maintain a full report in our internal records."

According to CFA Institute Standards of Professional Conduct, which of the following statements regarding

Chang's arrangement with Cherry Creek, LLC is most accurate*! Chang's arrangement:

60. Wealth Management's top economist, Frederick Milton, is an economic cycle forecaster- Milton's economic forecasts indicate an economic upswing that will impact all goods and services sectors. Milton presents his economic findings to the rest of Wealth Management's professionals at their monthly meeting. All are excited about Milton's forecast of an improving economic condition that should translate into a steadily rising stock market.

Nathaniel Norton and Timothy Tucker have confidence in Milton's capabilities and decide to meet with their clients. Their first meeting is with Elizabeth Mascarella to whom Norton recommends a dynamic asset allocation strategy to take advantage of Milton's forecast.

However, Mascarella is concerned because the somewhat persistent back-and-forth of economic activity has translated into an oscillating stock market. Mascarella questions Norton's recommendation and asks Tucker which strategy should be followed if the market continues as it has, instead of making such "wonderful" strides.

It is one year later and Frederick Milton's economic forecast has been correct, and the market has trended upward as expected. Mascarella's strategic allocation to equity, which was $600,000 of a total portfolio of $1,000,000, has increased 20%. Her overall portfolio, which contains equity, debt, and some cash, is now valued at $1,150,000. Tucker meets with Mascarella and indicates it may be time to rebalance her portfolio.

Which of the following would generally suggest a narrower tolerance band?

61. Hilda Olson covers the chemical industry for Bern Securities. Based on conversations with two executives of InterChem, a major producer of synthetic fabrics, she issues a generalized sector report claiming that "according to a survey of industry executives, rayon feedstocks will be in short supply for at least the next 12 months." In addition, Olson recommends Han Chemical, a major producer of rayon, which has routinely reported higher profits than its competitors and should be well positioned to gain further from reduced supply.

In her efforts to learn more about Han Chemical and support her recommendation, Olson scrambles to compile a research report on the firm. She reproduces financial data provided in a research report by Standard & Poor's (S&P) and the Bank of Korea (BOK), the Korean government's central bank. She also obtains two research reports from brokerage firms with operations in Korea, and incorporates portions of the text and charts from these reports into her research report.

Olson describes Han Chemical in her research report as "low risk," even though she knows that the operating risk of the chemical industry is above average and that Han has a higher debt-to-equity ratio than its average competitor. She justifies this to her supervisor by saying that since the market for rayon feedstocks is tight, an investment in Han has a very low risk of suffering a loss in the near term. Olson's supervisor accepts her explanation as valid and the report is issued to the firm's clients.

Shortly after issuing her research report, Olson visited Han Chemical's operations in New Jersey. During her conversation with the firm's vice president of operations, who is also one of Bern's personal trust clients, she was told in confidence that Han Chemical's profit margins are higher than its competitors, partly because they routinely discharge untreated chemical waste into the Delaware River in order to reduce production costs. Such action is a direct violation of U.S. environmental laws.

When Olson returns from her trip to New Jersey, Wolfgang Hundt, director of research at Bern Securities, requests a meeting. Hundt has developed a compliance procedure and has provided relevant written information to employees. Every quarter, he issues written reminders regarding the program to Olson and her peers, so when Olson tells Hundt of Han's chemical dumping, he immediately begins an investigation into the violation.

In her report on Han Chemical, Olson has also utilized two brokerage firms' reports. With regard to these sources, Olson is:

62. Hilda Olson covers the chemical industry for Bern Securities. Based on conversations with two executives of InterChem, a major producer of synthetic fabrics, she issues a generalized sector report claiming that "according to a survey of industry executives, rayon feedstocks will be in short supply for at least the next 12 months." In addition, Olson recommends Han Chemical, a major producer of rayon, which has routinely reported higher profits than its competitors and should be well positioned to gain further from reduced supply.

In her efforts to learn more about Han Chemical and support her recommendation, Olson scrambles to compile a research report on the firm. She reproduces financial data provided in a research report by Standard & Poor's (S&P) and the Bank of Korea (BOK), the Korean government's central bank. She also obtains two research reports from brokerage firms with operations in Korea, and incorporates portions of the text and charts from these reports into her research report.

Olson describes Han Chemical in her research report as "low risk," even though she knows that the operating risk of the chemical industry is above average and that Han has a higher debt-to-equity ratio than its average competitor. She justifies this to her supervisor by saying that since the market for rayon feedstocks is tight, an investment in Han has a very low risk of suffering a loss in the near term. Olson's supervisor accepts her explanation as valid and the report is issued to the firm's clients.

Shortly after issuing her research report, Olson visited Han Chemical's operations in New Jersey. During her conversation with the firm's vice president of operations, who is also one of Bern's personal trust clients, she was told in confidence that Han Chemical's profit margins are higher than its competitors, partly because they routinely discharge untreated chemical waste into the Delaware River in order to reduce production costs. Such action is a direct violation of U.S. environmental laws.

When Olson returns from her trip to New Jersey, Wolfgang Hundt, director of research at Bern Securities, requests a meeting. Hundt has developed a compliance procedure and has provided relevant written information to employees. Every quarter, he issues written reminders regarding the program to Olson and her peers, so when Olson tells Hundt of Han's chemical dumping, he immediately begins an investigation into the violation.

Olson is concerned that Hundt's compliance actions as director of the firm's research department are inconsistent with CFA Institute Standards.

Which of the following properly characterize Hundt's compliance activities? Hundt's actions are:

63. SIMULATION

The local bank trust department also custodies the Finnegans' taxable $1.5 million inheritance account, but for this account Sara Finnegan directs all the trades. Ms. Finnegan expresses her social priorities through her financial investments. She deliberately excludes tobacco, defense, oil and gas, and chemical companies from her universe of potential investments and she is obsessed with tax minimization. The Finnegans do not want to pay the government one dollar more than is required. Ms. Finnegan's portfolio allocation is shown in Exhibit 2.

Exhibit 2: Finnegan's Portfolio





Ms. Finnegan is passionate about animals. Her activism has led the Finnegans to become involved with the Spay Neuter Action Project (SNAP). The Finnegans are providing a charitable donation to SNAP. It is their intention to bequest the stock of Conglomerate Inc. to the organization. They also hope to use the growth in the portfolio's assets to make additional contributions of similar size as often as possible.

From the information provided, indicate one item that would affect Sara's ability to tolerate risk and one item that would affect her willingness to tolerate risk and explain each with one reason.

Template for Question

64. William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and positions in physical commodities. He is reviewing his operations and strategies to increase the return of the fund. Bliss has just hired Joseph Kanter, CFA, to help him manage the fund because he realizes that he needs to increase his trading activity in futures and to engage in futures strategies other than fully hedged, passively managed positions. Bliss also hired Kanter because of Kantcr's experience with swaps, which Bliss hopes to add to his choice of investment tools.

Bliss explains to Kanter that his clients pay 2% on assets under management and a 20% incentive fee. The incentive fee is based on profits after having subtracted the risk-free rate, which is the fund's basic hurdle rate, and there is a high water mark provision. Bliss is hoping that Kanter can help his business because his firm did not earn an incentive fee this past year. This was the case despite the fact that, after two years of losses, the value of the fund increased 14% during the previous year. That increase occurred without any new capital contributed from clients. Bliss is optimistic about the near future because the term structure of futures prices is particularly favorable for earning higher returns from long futures positions. Kanter says he has seen research that indicates inflation may increase in the next few years. He states this should increase the opportunity to earn a higher return in commodities and suggests taking a large, margined position in a broad commodity index. This would offer an enhanced return that would attract investors holding only stocks and bonds. Bliss mentions that not all commodity prices are positively correlated with inflation so it may be better to choose particular types of commodities in which to invest. Furthermore, Bliss adds that commodities traditionally have not outperformed stocks and bonds either on a risk-adjusted or absolute basis. Kanter says he will research companies who do business in commodities, because buying the stock of those companies to gain commodity exposure is an efficient and effective method for gaining indirect exposure to commodities.

Bliss agrees that his fund should increase its exposure to commodities and wants Kanter's help in using swaps to gain such exposure. Bliss asks Kanter to enter into a swap with a relatively short horizon to demonstrate how a commodity swap works. Bliss notes that the futures prices of oil for six months, one year, eighteen months, and two years are $55, S54, $52, and $5 1 per barrel, respectively, and the risk-free rate is less than 2%.

Bliss asks how a seasonal component could be added to such a swap. Specifically, he asks if either the notional principal or the swap price can be higher during the reset closest to the winter season and lower for the reset period closest to the summer season. This would allow the swap to more effectively hedge a commodity like oil, which would have a higher demand in the winter than the summer. Kanter says that a swap can only have seasonal swap prices, and the notional principal must stay constanl. Thus, the solution in such a case would be to enter into two swaps, one that has an annual reset in the winter and one that has an annual reset in the summer.

Kanter's comment concerning seasonal swaps is:

65. Dynamic Investment Services (DIS) is a global, full-service investment advisory firm based in the United States. Although the firm provides numerous investment services, DIS specializes in portfolio management for individual and institutional clients and only deals in publicly traded debt, equity, and derivative instruments. Walter Fried, CFA, is a portfolio manager and the director of DIS's offices in Austria. For

several years, Fried has maintained a relationship with a local tax consultant. The consultant provides a DIS marketing brochure with Fried's contact information to his clients seeking investment advisory services, and in return. Fried manages the consultant's personal portfolio and informs the consultant of potential tax issues in the referred clients' portfolios as they occur. Because he cannot personally manage all of the inquiring clients' assets, Fried generally passes the client information along to one of his employees but never discloses his relationship with the tax accountant. Fried recently forwarded information on the prospective Jones Family Trust account to Beverly Ulster, CFA, one of his newly hired portfolio managers.

Upon receiving the information, Ulster immediately set up a meeting with Terrence Phillips, the trustee of the Jones Family Trust. Ulster began the meeting by explaining DIS's investment services as detailed in the firm's approved marketing and public relations literature. Ulster also had Phillips complete a very detailed questionnaire regarding the risk and return objectives, investment constraints, and other information related to the trust beneficiaries, which Phillips is not. While reading the questionnaire, Ulster learned that Phillips heard about DIS's services through a referral from his tax consultant. Upon further investigation, Ulster discovered the agreement set up between Fried and the tax consultant, which is legal according to Austrian law but was not disclosed by either party Ulster took a break from the meeting to get more details from Fried. With full information on the referral arrangement, Ulster immediately makes full disclosure to the Phillips. Before the meeting with Phillips concluded, Ulster began formalizing the investment policy statement (IPS) for the Jones Family Trust and agreed to Phillips' request that the IPS should explicitly forbid derivative positions in the Trust portfolio.

A few hours after meeting with the Jones Family Trust representative, Ulster accepted another new referral client, Steven West, from Fried. Following DIS policy, Ulster met with West to address his investment objectives and constraints and explain the firm's services. During the meeting, Ulster informed West that DIS offers three levels of account status, each with an increasing fee based on the account's asset value. The first level has the lowest account fees but receives oversubscribed domestic IPO allocations only after the other two levels receive IPO allocations. The second-level clients have the same priority as third-level clients with respect to oversubscribed domestic IPO allocations and receive research with significantly greater detail than first-level clients. Clients who subscribe to the third level of DIS services receive the most detailed research reports and are allowed to participate in both domestic and international IPOs. All clients receive research and recommendations at approximately the same lime. West decided to engage DIS's services as a second-level client. While signing the enrollment papers, West told Ulster, "If you can give me the kind of performance I am looking for, I may move the rest of my assets to DIS." When Ulster inquired about the other accounts, West would not specify how much or what type of assets he held in other accounts. West also noted that a portion of the existing assets to be transferred to Ulster's control were private equity investments in small start-up companies, which DIS would need to manage. Ulster assured him that DIS would have no problem managing the private equity investments.

After her meeting with West, Ulster attended a weekly strategy session held by DIS. All managers were required to attend this particular meeting since the focus was on a new strategy designed to reduce portfolio volatility while slightly enhancing return using a combination of futures and options on various asset classes. Intrigued by the idea, Ulster implemented the strategy for all of her clients and achieved positive results for all portfolios. Ulster's average performance results after one year of using the new strategy are presented in Figure 1. For comparative purposes, performance figures without the new strategy are also presented.





At the latest strategy meeting, DIS economists were extremely pessimistic about emerging market economies and suggested that the firm's portfolio managers consider selling emerging market securities out of their portfolios and avoid these investments for the next 12 to 15 months. Fried placed a limit order to sell his personal holdings of an emerging market fund at a price 5% higher than the market price at the time. He then began selling his clients' (all of whom have discretionary accounts with DIS) holdings of the same emerging market fund using market orders. All of his clients' trade orders were completed just before the price of the fund declined sharply by 13%, causing Fried's order to remain unfilled.

Did Ulster violate CFA Institute Standards of Professional Conduct by accepting either Phillips or West as new clients?

66. Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios which have just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints, as welt as an initial strategic asset allocation.

However, Draper has found that all of the portfolios have experienced changes in asset values. As a result, the current allocations have drifted away from the initial allocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with their proposed asset allocation targets.

Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing.

During their conversation, Sterling made the following comments:

Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatility of the asset classes in the portfolio.

Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to more frequent rebalancing.

Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing, but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As an example, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.





Draper has been reviewing Madison files on four high net worth individuals, each of whom has a $1 million

portfolio. He hopes to gain insight as to appropriate rebalancing strategies for these clients.

His research so far shows:

Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerance drops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook, which is for a long-term bull market with few reversals.

Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees with the Madison stock market outlook.

Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio. She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked by numerous reversals, over the coming months.

Based on the information provided in Figure 1, which asset class of the Rogers pension plan should have the narrowest rebalancing corridor width?

67. Maurice Taylor, CFA, FRM, is responsible for managing risk in his firm's commodity portfolios. Taylor has extensive experience in the risk management field and as a result has been appointed the task of mentoring entry-level employees. Steven Jacobs is a newly hired Financial Analyst who has been assigned to research the company's risk management process. To verify the accuracy of his findings he consults Taylor. Taylor agrees to thoroughly review Jacobs* findings and volunteers to contribute his knowledge to enhance any part of the report that mentions Taylor's department.

A week later Jacobs, submits his report to his supervisor without reading Taylor's suggestions. Some

excerpts from the report are as follows;

• "Many portfolio managers use a ratio that compares the average alpha to the standard deviation of alpha to measure risk-adjusted performance. This ratio can be used to rank their ability to generate excess returns on a consistent basis."

"The main difference between risk governance and risk budgeting is that risk governance is concerned with policies and standards, whereas risk budgeting is concerned with allocating risk."

• "In an ERM system individual portfolio managers are charged with measuring, managing, and monitoring their portfolio risk as well as determining their optimal amount of capital at risk. With this information upper management gains a better overall picture of the firm's risk."

• "The two general categories of risk are financial and non-financial risks. Financial risks include market risk and credit risk. Non-financial risks include settlement risk, regulatory risk, model risk, liquidity risk, operations risk, and political risk."

Jacobs' supervisor thanks him for the report and assigns him the next task of researching the firm's VAR calculation methodologies. His supervisor is wondering if the firm should switch to the Monte Carlo Method from the Historical Method. Jacobs again decides to consult Taylor for his expertise. Taylor agrees that using the Monte Carlo Method would be useful since it incorporates returns distributions rather than single point estimates of risk and return- This may be appropriate for Taylor's portfolios since commodity returns can exhibit skewed distributions. Taylor, however, informs Jacobs that there are also advantages to using historical VAR including that it is based on modern portfolio theory (MPT).

Jacobs uses the firm's small cap value portfolio to illustrate the calculation of VAR. The value of the portfolio is $140 million and it has an annual expected return of 12.10%. The annual standard deviation of returns is 18.20%. Assuming a standard normal distribution, 5% of the potential portfolio values are more than 1.65 standard deviations below the expected return.

Jacobs completes his research report on VAR by adding an appendix section on extensions of VAR. He states that one extension that can be particularly valuable in risk management measures the impact of a single asset on the portfolio VAR. This measure captures the effects of the correlations of the individual assets on the overall portfolio VAR.

In the first statement in his research report, Jacobs is most likely describing the:

68. Kim Simpson, CFA, manages a $75 million multi-cap growth portfolio. Simpson utilizes a growth at a reasonable price (GARP) investment strategy and her investment universe consists of small, medium and large capitalization stocks. She turns the entire portfolio over once each year. Simpson is concerned about the amount of trading costs she has generated through the implementation of her investment strategy. Simpson decides to conduct a trade cost analysis with the cooperation of her trader, Janet Long, CFA. Simpson believes the results of the trading analysis can be used to improve trading performance and help to refine her investment strategy. The first trade they examine is a purchase of 2000 shares of Technology Company that was completed using a market order. Simpson remembers adding to her Technology Company position based on her analyst's recommendation that the company was going to generate earnings significantly above the consensus estimate in a soon to be released earnings report. The order was split into two trades as shown in Figure 1.

Figure 1: Technology Company buy order for 2000 shares





In conducting a comprehensive analysis of the trading markets, Simpson states that she is most concerned about market liquidity. Simpson defines a market with good liquidity as one with diversity of opinion, many buyers/sellers and relatively wide bid-ask spreads. In addition to reviewing market liquidity, Simpson believes that, in order to assess market quality, both the ease with which investors can obtain accurate information and the certainty that a trade will be completed must be evaluated.

Simpson and Long review their trade of Nano Corporation, a small biotechnology company. Simpson used a limit order because her analyst had established a specific buy target and she wanted to hold down transaction costs. To handle both explicit and implicit trading costs, Simpson measures execution costs using implementation shortfall.

The buy order for 100,000 shares of Nano stock has the following timeline:

• Nano stock price closes at $35.00 per share.

• Day one: Simpson places a limit order for 100,000 shares of Nano stock at $34.75 per share or better at the opening of trading.

However, Nano's stock never falls below $35.00 per share and closes at $36.50 per share.

• Day two: Simpson adjusts her limit order price to $37.00 per share or better. Long is able to fill 50,000 shares of the order at $36.75 per share. Nano's stock climbs to $38.00 per share during the day and Simpson moves the limit price to $40.00 per share or better. Long completes the purchase of the remaining 50,000 shares of Nano at $40.00 per share, which is also the closing price of Nano's stock.

• The commission for each block trade is $2,500.

Long suggests implementing the Best Execution concept as established by the CFA Institute in its Trade Management Guidelines. Long states best execution would accept a high portfolio turnover strategy provided the overall portfolio value is greater after trading costs. Long asserts that her professional relationships are integral to best execution.

Simpson discusses both the definition of market liquidity and how to assess market quality. Are her statements correct?

69. Theresa Bair, CFA, a portfolio manager for Brinton Investment Company (BIC), has recently been promoted to lead portfolio manager for her firm's new small capitalization closed-end equity fund, the Quaker Fund. BIC is an asset management firm headquartered in Holland with regional offices in several other European countries.

After accepting the position, Bair received a letter from the three principals of BIC. The letter congratulated Bair on her accomplishment and new position with the firm and also provided some guidance as to her new role and the firm's expectations.

Among other things, the letter stated the following:

"Because our firm is based in Holland and you will have clients located in many European countries, it is essential that you determine what laws and regulations are applicable to the management of this new fund. It is your responsibility to obtain this knowledge and comply with appropriate regulations. This is the first time we have offered a fund devoted solely to small capitalization securities, so we will observe your progress carefully. You will likely need to arrange for our sister companies to quietly buy and sell Quaker Fund shares over the first month of operations. This will provide sufficient price support to allow the fund to trade closer to its net asset value than other small-cap closed-end funds. Because these funds generally trade at a discount to net asset value, if our fund trades close to its net asset value, the market may perceive it as more desirable than similar funds managed by our competitors."

Bair heeded the advice from her firm's principals and collected information on the laws and regulations of three countries: Norway, Sweden, and Denmark. So far, all of the investors expressing interest in the Quaker Fund are from these areas. Based on her research, Bair decides the following policies are appropriate for the fund:

Note: Laws mentioned below are assumed for illustrative purposes.

For clients located in Norway the fund will institute transaction crossing, since, unlike in Holland, the practice is not prohibited by securities laws or regulations. The process will involve internally matching buy and sell orders from Norwegian clients whenever possible. This will reduce brokerage fees and improve the fund's overall performance.

For clients located in Denmark, account statements that include the value of the clients' holdings, number of trades, and average daily trading volume will be generated on a monthly basis as required by Denmark's securities regulators, even though the laws in Holland only require such reports to be generated on a quarterly basis.

For clients located in Sweden, the fund will not disclose differing levels of service that are available for investors based upon the size of their investment. This policy is consistent with the laws and regulations in Holland. Sweden's securities regulations do not cover this type of situation.

Three months after the inception of the fund, its market value has grown from $200 million to $300 million and Bair's performance has earned her a quarter-end bonus. Since it is now the end of the quarter, Bair is participating in conference calls with companies in her fund. Bair calls into the conference number for Swift Petroleum. The meeting doesn't start for another five minutes, however, and as Bair waits, she hears the CEO and CFO of Swift discussing the huge earnings restatement that will be necessary for the financial statement from the previous quarter. The restatement will not be announced until the year's end, six months from now. Bair does not remind the officers that she can hear their conversation. Once the call has ended, Bair rushes to BIC's compliance officer to inform him of what she has learned during the conference call. Bair ignores the fact that two members of the firm's investment banking division are in the office while she is telling the compliance officer what happened on the conference call. The investment bankers then proceed to sell their personal holdings of Swift Petroleum stock. After her meeting, Bair sells the Quaker Fund's holdings of Swift Petroleum stock.

With regard to the treatment of clients in Norway and Denmark, do the policies that Bair has selected for the Quaker Fund violate any CFA Institute Standards of Professional Conduct? Norway Denmark

70. LCG: a large-cap growth index.

Using the benchmarks, Reinhart obtains the following regression results:

Period 1: Rp = 0.02 + H0.01(SCV) + 0.02(SCG) + 0.36(LCV) + 0.61(LCG)

Period 2: Rp = 0.02 + 0.01(SCV) + 0.02(SCG) + 0.60(LCV) + 0.38(LCG)

Kiley's long-only portfolio is benchmarked against the S&P 500 Index. The Index's current sector allocations are shown in Exhibit 3.

Exhibit 3: S&P 500 Index Sector Allocations





GenM strives to select managers whose correlation between forecast alphas and realized alphas has been fairly high, and to allocate funds across managers in order to achieve alpha and beta separation. GenM gives Reinhart a mandate to pursue a core-satellite strategy with a small number of satellites each focusing on a relatively few number of securities.

In response to the core-satellite mandate, Reinhart explains that a Completeness Fund approach offers two advantages:

Advantage 1: The Completeness Fund approach is designed to capture the stock selecting ability of the active manager, while matching the overall portfolio's risk to its benchmark.

Advantage 2: The Completeness Fund approach allows the Fund to fully capture the value added from active managers by eliminating misfit risk.

Assuming Kiley feels that the Utilities Sector is overvalued now, the largest active weight that Kiley can apply to the Utilities sector is:

71. Andre Hickock, CFA, is a newly hired fixed income portfolio manager for Deadwood Investments, LLC.

Hickock is reviewing the portfolios of several pension clients that have been assigned to him to manage.

The first portfolio, Montana Hardware, Inc., has the characteristics shown in Figure 1.





Hickock is attempting to assess the risk of the Montana Hardware portfolio. The benchmark bond index that Deadwood uses for pension accounts similar to Montana Hardware has an effective duration of 5.25. His supervisor, Carla Mity, has discussed bond risk measurement with Hickock. Mity is most familiar with equity risk measures, and is not convinced of the validity of duration as a portfolio risk measure. Mity told Hickock, "I have always believed that standard deviation is the best measure of bond portfolio risk. You want to know the volatility, and standard deviation is the most direct measure of volatility."

Hickock is also reviewing the bond portfolio of Buffalo Sports, Inc., which is comprised of the following assets shown in Figure 2.





The trustees of the Buffalo Sports pension plan have requested that Deadwood explore alternatives to reduce the risk of the MBS sector of their bond portfolio. Hickock responded to their request as follows:

"I believe that the current option-adjusted spread (OAS) on the MBS sector is quite high. In order to reduce your risk, I would suggest that we hedge the interest rate risk using a combination of 2-year and 10-year Treasury security futures. I would further suggest that we do not take any steps to hedge spread risk at this time."

Under most circumstances, the most effective means of hedging the risk of a portfolio of MBS is to take an offsetting position in a:

72. Ellen Truxel is the principal at Truxel Investment Management. Her firm uses bonds for income enhancement as well as capital gains. She occasionally uses sector quality bets and yield curve positioning to exploit her beliefs on the relative changes in sector credit quality and the direction of interest rates. She has recently hired John Timberlake to assist her in preparing data for the analysis of bond portfolios. Timberlake is a recent graduate of an outstanding undergraduate program in finance.

Truxel is considering investing in international bonds, as this is an arena she has previously ignored. During conversations, Truxel says it is her understanding that changes in international bond markets have made it easier to manage the duration of an international bond portfolio. Timberlake notes that the European Monetary Union has increased the availability of corporate bonds, making it easier to rotate across sectors.

In the domestic arena, Truxel is considering constructing a portfolio that matches the index on quality, call, sector, and cash flow dimensions and tilts the portfolio duration small amounts to take advantage of predictions of yield curve shifts. She states that this would be referred to as enhanced indexing with minor mismatches. Timberlake tells her that the most important determinant of her performance relative to other bond managers will be her ability to perform credit analysis.

Truxel then tells Timberlake that before they venture into new areas, she wants him to prepare an analysis of their current positions. Timberlake obliges and presents the following data on Truxel’s current portfolio.





If the OAS for all bond sectors changes by 60 basis points while Treasury yields remain unchanged, the approximate percent change in the Truxel portfolio is closest to:

73. Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. The funds are managed individually, but Pace has an investment committee that oversees all of the funds. This committee is responsible for evaluating the performance of the funds relative to appropriate benchmarks and relative to the stated investment objectives of each individual fund. During a recent investment committee meeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of the portfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee was to review the performance of the manager responsible for each fund and dismiss those managers whose performance had lagged substantially behind the appropriate benchmark. The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with a capitalization between S40 billion and $80 billion.

A review of the operations of the fund found the following:

• The turnover of the fund was almost double that of other similar style mutual funds.

• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existing holding.

• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutual funds.

• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years of financial information on that company, plus independent research reports from at least three different analysts.

• The portfolio manager refuses to increase her technology sector weighting because of past losses the fund incurred in the sector.

• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. She expects oil prices to fall back to the $40 to S50 per barrel range.

A committee member made the following two comments:

Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfolio lacks recognizable companies. I believe that good companies make good investments."

Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. She seems to sell stocks that appreciate, but hold stocks that have declined in value."

The supervisor of the Mid-Cap Mutual Fund portfolio manager made the following statements:

Statement 1: "The portfolio manager of the Mid-Cap Mutual Fund has engaged in quarter-end window dressing to make her portfolio look better to investors. The portfolio manager's action is a behavioral trait known as over-reaction."

Statement 2: "Each time the portfolio manager of the Mid-Cap Mutual fund trades a stock, she executes the trade by buying or selling one-third of the position at a time, with the trades spread over three months. The portfolio manager's action is a behavioral trait known as anchoring."

A committee member suggested that the portfolio manager of the Mid-Cap Fund may be overconfident about her abilities.

Which of the following facts from the review of the Mid-Cap fund is least likely to suggest that the manager is overconfident?

74. Maurice Taylor, CFA, FRM, is responsible for managing risk in his firm's commodity portfolios. Taylor has extensive experience in the risk management field and as a result has been appointed the task of mentoring entry-level employees. Steven Jacobs is a newly hired Financial Analyst who has been assigned to research the company's risk management process. To verify the accuracy of his findings he consults Taylor. Taylor agrees to thoroughly review Jacobs* findings and volunteers to contribute his knowledge to enhance any part of the report that mentions Taylor's department.

A week later Jacobs, submits his report to his supervisor without reading Taylor's suggestions. Some excerpts from the report are as follows;

• "Many portfolio managers use a ratio that compares the average alpha to the standard deviation of alpha to measure risk-adjusted performance. This ratio can be used to rank their ability to generate excess returns on a consistent basis."

"The main difference between risk governance and risk budgeting is that risk governance is concerned

with policies and standards, whereas risk budgeting is concerned with allocating risk."

• "In an ERM system individual portfolio managers are charged with measuring, managing, and monitoring their portfolio risk as well as determining their optimal amount of capital at risk. With this information upper management gains a better overall picture of the firm's risk."

• "The two general categories of risk are financial and non-financial risks. Financial risks include market risk and credit risk. Non-financial risks include settlement risk, regulatory risk, model risk, liquidity risk, operations risk, and political risk."

Jacobs' supervisor thanks him for the report and assigns him the next task of researching the firm's VAR calculation methodologies. His supervisor is wondering if the firm should switch to the Monte Carlo Method from the Historical Method. Jacobs again decides to consult Taylor for his expertise. Taylor agrees that using the Monte Carlo Method would be useful since it incorporates returns distributions rather than single point estimates of risk and return- This may be appropriate for Taylor's portfolios since commodity returns can exhibit skewed distributions. Taylor, however, informs Jacobs that there are also advantages to using historical VAR including that it is based on modern portfolio theory (MPT).

Jacobs uses the firm's small cap value portfolio to illustrate the calculation of VAR. The value of the portfolio is $140 million and it has an annual expected return of 12.10%. The annual standard deviation of returns is 18.20%. Assuming a standard normal distribution, 5% of the potential portfolio values are more than 1.65 standard deviations below the expected return.

Jacobs completes his research report on VAR by adding an appendix section on extensions of VAR. He states that one extension that can be particularly valuable in risk management measures the impact of a single asset on the portfolio VAR. This measure captures the effects of the correlations of the individual assets on the overall portfolio VAR.

In Jacobs' list of non-financial risks in his fourth statement, all are non-financial except:

75. Jack Higgins, CFA, and Tim Tyler, CFA, are analysts for Integrated Analytics (LA), a U.S.-based investment analysis firm. JA provides bond analysis for both individual and institutional portfolio managers throughout the world. The firm specializes in the valuation of international bonds, with consideration of currency risk. IA typically uses forward contracts to hedge currency risk.

Higgins and Tyler are considering the purchase of a bond issued by a Norwegian petroleum products firm, Bergen Petroleum. They have concerns, however, regarding the strength of the Norwegian krone currency (NKr) in the near term, and they want to investigate the potential return from hedged strategies. Higgins suggests that they consider forward contracts with the same maturity as the investment holding period, which is estimated at one year. He states that if IA expects the Norwegian NKr to depreciate and that the Swedish krona (Sk) to appreciate, then IA should enter into a hedge where they sell Norwegian NKr and buy Swedish Sk via a one-year forward contract. The Swedish Sk could then be converted to dollars at the spot rate in one year.

Tyler states that if an investor cannot obtain a forward contract denominated in Norwegian NKr and if the Norwegian NKr and euro are positively correlated, then a forward contract should be entered into where euros will be exchanged for dollars in one year. Tyler then provides Higgins the following data on risk-free rates and spot rates in Norway and the U.S., as well as the expected return on the Bergen Petroleum bond.

Return on Bergen Petroleum bond in Norwegian NKr 7.00%

Risk-free rate in Norway 4.80%

Expected change in the NKr relative to the U.S. dollar -0.40%

Risk-free rate in United States 2.50%

Higgins and Tyler discuss the relationship between spot rates and forward rates and comment as follows.

• Higgins: "The relationship between spot rates and forward rates is referred to as interest rate parity, where higher forward rates imply that a country's spot rate will increase in the future."

• Tyler: "Interest rate parity depends on covered interest arbitrage which works as follows. Suppose the 1-year U.K. interest rate is 5.5%, the 1-year Japanese interest rate is 2.3%, the Japanese yen is at a one-year forward premium of 4.1%, and transactions costs are minimal. In this case, the international trader should borrow yen. invest in pound denominated bonds, and use a yen-pound forward contract to pay back the yen loan."

The following day, Higgins and Tyler discuss various emerging market bond strategies and make the following statements.

• Higgins: "Over time, the quality in emerging market sovereign bonds has declined, due in part to contagion and the competitive devaluations that often accompany crises in emerging markets. When one country devalues their currency, others often quickly follow and as a result the countries default on their external debt, which is usually denominated in a hard currency."

• Tyler: "Investing outside the index can provide excess returns. Because the most common emerging market bond index is concentrated in Latin America, the portfolio manager can earn an alpha by investing in emerging country bonds outside of this region."

Turning their attention to specific issues of bonds, Higgins and Tyler examine the characteristics of two bonds: a six-year maturity bond issued by the Midlothian Corporation and a twelve-year maturity bond issued by the Horgen Corporation. The Midlothian bond is a U.S. issue and the Horgen bond was issued

by a firm based in Switzerland. The characteristics of each bond are shown in the table below. Higgins and Tyler discuss the relative attractiveness of each bond and, using a total return approach, which bond should be invested in, assuming a 1-year time horizon.





Assume that both the Midlothian and Horgen bonds are being considered for purchase. Determine which of the following statements provides the best description of the appropriate strategy using breakeven spread analysis. If the yield for the Horgen bond:

76. Garrison Investments is a money management firm focusing on endowment management for small colleges and universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocations to high quality long-term foreign government bonds. Garrison's largest account, Point University, has a market value of $800 million and an asset allocation as detailed in Figure 1.

Figure 1: Point University Asset Allocation





*Bond coupon payments are all semiannual.

Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value.

Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move.

Managers at Garrison have put together the following proposal for the reallocation:

To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2.

Figure 2: Mid-cap index and European Index Futures Data





Three months after proposing the international diversification plan, Garrison was able to persuade Point University to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japanese electronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of its production in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigate exchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HI has one remaining purchase of Australian gold that will occur in nine months. The company has hedged the purchase with a long 12-month futures contract on the Australian dollar (AUD). Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about the impact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decided to use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the local currency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of changes in the USD/Yen spot rate is 0.92.

Which of the following types of exchange rate risk exposure has Haikuza hedged using currency futures?

77. 0%, a floating rate based on LIBOR, and a tenor of eight years. The firm now believes interest rates may increase in 6 months, but is not 100% confident in this assumption. To hedge the risk of an interest rate increase, given its interest rate uncertainty, the firm has sold a payer interest rate swaption with a maturity of 6 months, an underlying swap rate of 6.0%, and a floating rate based on LIBOR.

MIA is considering investing in the debt of Rio Corp, a Brazilian energy company. The investment would be in Rio's floating rate notes, currently paying a coupon of 8.0%. MIA's economists are forecasting an interest rate decline in Brazil over the short term.

Which of the following strategies would best hedge the risk of MlA's investment in the Rio Corp. floating rate notes?

78. Johnny Bracco, CFA, is a portfolio manager in the trust department of Canada National (CNL) in Toronto. CNL is a financial conglomerate with many divisions. In addition to the trust department, the firm sells financial products and has a research department, a trading desk, and an investment banking division. Part of the company's operating procedures manual contains detailed information on how the firm allocates shares in oversubscribed stock offerings. Allocation is effected on a pro rata basis based upon factors such as the size of a client's portfolio, suitability, and previous notification to participate in IPOs. Additionally, company policy discloses to clients that any trade needs to meet a minimum transaction size in an effort to control trading costs and to comply with best execution procedures.

One of Bracco's trust accounts is the Carobilo family trust, which contains a portion of nondiscretionary funds managed by Stephen Carobilo. Carobilo has a friend who runs a brokerage firm called First Trades, to which Carobilo tells Bracco to direct trades from the nondiscretionary accounts. Bracco has learned that First Trades charges a slightly higher trading fee than other brokers providing comparable services, and he discloses this to Carobilo.

Due to high prices and limited supplies of oil, Bracco has been following companies in the energy sector. He believes this area of the economy is in turmoil and should present some mispricing opportunities. One company he has been researching is Stiles Corporation, which is working on a new type of hydrogen fuel cell that uses fusion technology to create energy. To date, no one has been able to successfully sustain a fusion reaction for an extended period of time. Bracco has been in close contact with Stiles' pubic relations department, has toured their laboratories, and has thoroughly researched fusion technology and Stiles' competitors. Bracco is convinced from his research, based upon various public sources, that Stiles is on the verge of perfecting this technology and will be the first firm to bring it to the marketplace. Jerry McNulty, CFA and vice president of the investment banking division of CNL, has been working with Stiles to raise new capital via a secondary offering of Stiles common shares. One day Bracco happened to be in a stall in the bathroom when McNulty and a colleague came in and discussed the fact that Stiles had perfected the fuel-cell technology, which will greatly increase the price of Stiles1 stock.

Stiles Corporation's board of directors includes Dr. Elaine Joachim, who is a physics professor at the University of Toronto. She also works part-time for Stiles Corporation as a consultant in their fusion technology laboratory. Her husband is a materials engineer who recently started performing consulting work for Stiles.

A routine audit by the quality control department at CNL discovered trading errors in several of Bracco's accounts involving an oversubscribed IPO. Some accounts received shares they should not have and others did not receive shares they should have. Bracco and his supervisor Jaime Gun, CFA, are taking responsibility to reverse the incorrect trades. Bracco told Gun, "I'll correct the trades based on our clients' investment policy statements, previous notification of intent, and according to the company's formula for allocating shares on a pro rata basis. In so doing, we will fairly allocate shares so even small accounts that did not meet minimum size requirements will receive some shares of the IPO." Gun replied to Bracco by saying, "I'll credit short-term interest back to the accounts that should not have received the shares and subtract interest from the accounts that should have received the shares."

That evening, Bracco and his wife attended the company holiday party for CNL employees and their spouses. Jerry McNulty, whose wife was ill and could not come to the party, arrived drunk from a meeting with Stiles' upper management. During the party McNulty made inappropriate advances toward many of the female employees and joked about the inadequacies of Stiles' managers.

Did McNulty's behavior at the holiday party violate the:

Code of Ethics? Standards of Professional Conduct?

79. Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixed-income firm based in the United States. AA employs numerous quantitative models to invest in both domestic and international securities.

During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.

Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned, however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy.

In response, Castillo explains the factors that affect the repo rate and makes the following statements:

• "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral, and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is usually quite low.”

• "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the collateral is limited, the repo rate will be higher."

Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the $200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The expected return on the portfolio is 8% and the cost of borrowed funds is 3%. The next day, the chief investment officer for the Washington Investment Fund expresses her concern about the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios.

In response, Diaz distinguishes between the standard deviation and downside risk measures, making the following statements:

• ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it considers all returns over the entire distribution, variance and the resulting standard deviation are artificially inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios, managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns below a given return, such as the mean or a hurdle rate."

• "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the

expected return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall risk is a more appropriate measure, because it provides the probability of not meeting a target return."

• has a corporate client, Shaifer Materials with a 20,000,000 bond outstanding that pays an annual fixed coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.

Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year.

The terms of each instrument are provided below:

Payer swaption fixed rate7.90% Receiver swaption fixed rate7.60% Current Euribor7.20%

Projected Euribor in one year5.90%

Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.

Determine whether each of Castillo's statements about repos is correct or incorrect.

80. Wealth Management's top economist, Frederick Milton, is an economic cycle forecaster- Milton's economic forecasts indicate an economic upswing that will impact all goods and services sectors. Milton presents his economic findings to the rest of Wealth Management's professionals at their monthly meeting. All are excited about Milton's forecast of an improving economic condition that should translate into a steadily rising stock market.

Nathaniel Norton and Timothy Tucker have confidence in Milton's capabilities and decide to meet with their clients. Their first meeting is with Elizabeth Mascarella to whom Norton recommends a dynamic asset allocation strategy to take advantage of Milton's forecast.

However, Mascarella is concerned because the somewhat persistent back-and-forth of economic activity has translated into an oscillating stock market. Mascarella questions Norton's recommendation and asks Tucker which strategy should be followed if the market continues as it has, instead of making such "wonderful" strides.

It is one year later and Frederick Milton's economic forecast has been correct, and the market has trended upward as expected. Mascarella's strategic allocation to equity, which was $600,000 of a total portfolio of $1,000,000, has increased 20%. Her overall portfolio, which contains equity, debt, and some cash, is now valued at $1,150,000. Tucker meets with Mascarella and indicates it may be time to rebalance her portfolio.

Determine the preferred dynamic rebalancing strategy if the market is expected to be highly volatile, but more or less flat.

81. Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixed-income firm based in the United States. AA employs numerous quantitative models to invest in both domestic and international securities.

During the week, Castillo and Diaz consult with one of their investors, Sally Michaels. Michaels currently holds a $10,000,000 fixed-income position that is selling at par. The maturity is 20 years, and the coupon rate of 7% is paid semiannually. Her coupons can be reinvested at 8%. Castillo is looking at various interest rate change scenarios, and one such scenario is where the interest rate on the bonds immediately changes to 8%.

Diaz is considering using a repurchase agreement to leverage Michaels's portfolio. Michaels is concerned, however, with not understanding the factors that impact the interest rate, or repo rate, used in her strategy.

In response, Castillo explains the factors that affect the repo rate and makes the following statements:

• "The repo rate is directly related to the maturity of the repo, inversely related to the quality of the collateral, and directly related to the maturity of the collateral. U.S. Treasury bills are often purchased by Treasury dealers using repo transactions, and since they have high liquidity, short maturities, and no default risk, the repo rate is usually quite low.”

• "The greater control the lender has over the collateral, the lower the repo rate. If the availability of the

collateral is limited, the repo rate will be higher."

Castillo consults with an institutional investor, the Washington Investment Fund, on the effect of leverage on bond portfolio returns as well as their bond portfolio's sensitivity to changes in interest rates. The portfolio under discussion is well diversified, with small positions in a large number of bonds. It has a duration of 7.2. Of the $200 million value of the portfolio, $60 million was borrowed. The duration of borrowed funds is 0.8. The expected return on the portfolio is 8% and the cost of borrowed funds is 3%. The next day, the chief investment officer for the Washington Investment Fund expresses her concern about the risk of their portfolio, given its leverage. She inquires about the various risk measures for bond portfolios.

In response, Diaz distinguishes between the standard deviation and downside risk measures, making the following statements:

• ''Portfolio managers complain that using variance to calculate Sharpe ratios is inappropriate. Since it considers all returns over the entire distribution, variance and the resulting standard deviation are artificially inflated, so the resulting Sharpe ratio is artificially deflated. Since it is easily calculated for bond portfolios, managers feci a more realistic measure of risk is the semi-variance, which measures the distribution of returns below a given return, such as the mean or a hurdle rate."

• "A shortcoming of VAR is its inability to predict the size of potential losses in the lower tail of the expected return distribution. Although it can assign a probability to some maximum loss, it does not predict the actual loss if the maximum loss is exceeded. If Washington Investment Fund is worried about catastrophic loss, shortfall risk is a more appropriate measure, because it provides the probability of not meeting a target return."

AA has a corporate client, Shaifer Materials with a 20,000,000 bond outstanding that pays an annual fixed coupon rate of 9.5% with a 5-year maturity. Castillo believes that euro interest rates may decrease further within the next year below the coupon rate on the fixed rate bond. Castillo would like Shaifer to issue new debt at a lower euro interest rate in the future. Castillo has, however, looked into the costs of calling the bonds and has found that the call premium is quite high and that the investment banking costs of issuing new floating rate debt would be quite steep. As such he is considering using a swaption to create a synthetic refinancing of the bond at a lower cost than an actual refinancing of the bond. He states that in order to do so, Shaifer should buy a payer swaption, which would give them the option to pay a lower floating interest rate if rates drop.

Diaz retrieves current market data for payer and receiver swaptions with a maturity of one year.

The terms of each instrument are provided below:

Payer swaption fixed rate7.90% Receiver swaption fixed rate7.60% Current Euribor7.20%

Projected Euribor in one year5.90%

Diaz states that, assuming Castillo is correct, Shaifer can exercise a swaption in one year to effectively call in their old fixed rate euro debt paying 9.5% and refinance at a floating rate, which would be 7.5% in one year.

The return on the Washington Investment Fund portfolio is closest to:

82. Jean Sims, CFA and Ellie Hayes, CFA are advisors for Eagle Fixed Income Investors. Eagle makes recommendations on bonds, mortgages, and other fixed income investments for wealthy individuals and institutions.

Eagle has a client, Parker Portfolio Managers, which has a large holding of mortgages. Due to a projected decline in the housing market in the United States, the yields on mortgages are expected to increase over the next year. The largest mortgage position for Parker is currently priced at 98.80. Given the projected increase in yields, Sims has calculated an expected price of the mortgage of 95.50 in one year. For the same magnitude of yield change, she projects a price of 101.20 if yields instead fall. Hayes states that Parker should hedge the mortgage by shorting a 10-year Treasury bond futures contract.

Discussing the performance of mortgages in general with Parker officers, Hayes states that they are market directional investments. Hayes's reasoning is that mortgages tend to follow the general direction of the fixed income market, where mortgages should be avoided when interest rates are expected to rise and favored when they are expected to fall.

Commenting on hedging mortgages in general, Sims states that a two Treasury bond futures hedge is usually more effective than a single Treasury bond futures hedge. Furthermore, she states, a mortgage can be hedged dynamically by adjusting the hedge through time, or by buying interest rate options. An option hedge would be used when its implied volatility is low, she states.

Examining the Parker portfolio in more detail, Sims gathers the following details on mortgages they hold.





Later that day Sims and Hayes discuss the appropriate hedging of mortgages and make the following statements:

• Sims: "To hedge the duration exposure of a mortgage and maintain a constant duration, the investor should sell Treasury bond futures when interest rates fall and buy Treasury bond futures when interest rates rise."

• Hayes: "Mortgage investors face model risk where using a poor model increases the investor's risk. For example, if prepayments increase faster than expected, the investor faces greater risk. Unfortunately, there is no easy way to hedge model risk."

Examining the properties of principal only (PO) and interest only (10) strips, Sims determines that the key rate durations for a client's PO strip are negative before year 8 but turn positive thereafter. The client's 10 strip has key rate durations that are positive up until year 10 but turn negative thereafter. Overall, the duration is positive for the PO strip and negative for the 10 strip. Sims is examining the effect of a yield curve change on the mortgages. Her assumption is that the short end of the yield curve increases while the Long end of the curve is unchanged.

Are Sims's statements at Parker headquarters regarding hedging mortgages correct?

83. Toni Morrison, CFA, a manager for Sierra Fund, is investigating the use of relative value methodologies for global corporate bond portfolio management. As a recent college graduate, Bernard Tabler has been assisting Morrison in data gathering and analysis.

Morrison is a firm believer that corporate yield spreads have a tendency to revert to their historical mean values. Accordingly, Tabler has compiled relevant information for three corporate issues. Morrison and Tabler use the information below to conduct mean reversion analysis.





Note: All spreads are expressed in basis points.

Morrison's research has also included a study of the implications of secular and cyclical changes in the primary corporate bond market. As a result of her research, she states that the implication of both cyclical and secular changes in the primary corporate bond market for fixed-income portfolio management is that effective duration and aggregate interest rate risk will increase. Tabler adds that it also appears that credit-based derivatives will increasingly be used to achieve desired exposure to credit sectors, issuers, and structures.

During the presentation to a client, Morrison discusses corporate curve analysis. He states that corporate spread curves tend to change with the economic cycle, so in order to properly conduct this analysis the analyst must examine credit and yield curves carefully. Tabler adds that corporate spreads usually narrow during upturns and widen during downturns.

Morrison is also considering using repurchase agreements to fund some overnight investment activities. Watching the financial news, she observes that the Federal Reserve has increased the federal funds rate to combat potential inflation. She notes that this will increase the borrowing costs of investment strategies using repurchase agreements. Tabler chimes in that the strategy's interest cost could be reduced by using hot collateral such as on-the-run U.S. Treasuries.

Morrison is also providing advice to a client on the best way to hedge a floating rate loan using a swap. The client is paying 120 basis points over LIBOR. Morrison suggests that the client enter a 5-year LIBOR-based swap. The swap fixed rate is 100 basis points over the U.S. Treasury rate. The floating rate is LIBOR flat. LIBOR is 5.60% and the Treasury rate is 5.20% when this swap is being considered.

Based on the mean-reversion analysis only, which of the three bonds is the most attractive candidate for Morrison to purchase for the Sierra Fund?

84. Bartholomew Hope, CFA, is the chief investment officer of Children's Trust Foundation (CTF), a foundation that supports a wide variety of child-related causes. CTFs total assets total $2.3 billion. The foundation's current asset mix is 55% stocks, 35% bonds, and 10% cash (T-bills earn 3.5%). The foundation provides $126.5 million annually for a variety of programs for children, which is forecasted to remain more or less constant in real terms. Hope does not envision any major capital expenditures for the foreseeable future. CTF's investment portfolio has underperformed its benchmark over the past three years. Hope believes corrective action is needed to address the issue of poor performance. Hope wants to evaluate the possibility the portfolio's risk to reward profile. Hope's staff generates Exhibit 1, which reviews the relevant necessary metrics to make the asset mix decision. The overall cost of investing the assets is 75 basis points.

Exhibit 1: Expected Returns, Risk, and Correlations for Asset under Consideration





One of the members of Hope's staff, Rene Meyer, includes a report on the key attributes of investing in venture capital funds.

The report includes the following sections:

Structure: "Indirect venture capital investments are achieved by pooling the funds of multiple investors into a limited partnership (LP). The investors are limited partners who allow a general partner to control the investments for a period of 7 to 10 years. The general partner also invests capital, earning a management fee of 1.5% to 2.5% of invested capital and a carried interest fee, which is generally 20% of the fund profits, after the fund's hurdle rate has been met."

Strategy: "Because initial public offerings are a primary exit strategy of venture capital investing, the correlation between public equity markets and returns on venture capital investments are positive. Therefore, the primary focus of any venture capital investment undertaken by Glendale should be long-term return enhancement rather than significant diversification. In addition, Glendale must make sure that all of the committed capital is available for the required up front cash distribution to the general partner at the beginning of the investment period."

Hope recognizes there are several unique strategies within the hedge fund group that have very different risk to reward trade-offs. Hope identifies three hedge funds as potential investment opportunities for the CTF. Exhibit 2 lists the funds under consideration and their most recent securities transactions.

Exhibit 2: Hedge Fund Transactions





While Clark presents the hedge funds, Hope comments that he is concerned with the potential difficulties in measuring hedge fund manager performance. Glendale's charter has strict requirements regarding the performance assessment of investment managers who control the assets of the foundation. Hope believes the performance of alternative investments presented may be difficult to evaluate against a benchmark index as required by Glendale's charter.

Based on the data provided in Exhibit 1, determine whether adding venture capital or hedge funds to the CTF portfolio would allow the foundation to achieve a superior efficient frontier (Sharpe ratio calculations required).

85. Sue Gano and Tony Cismesia are performance analysts for the Barth Group. Barth provides consulting and compliance verification for investment firms wishing to adhere to the Global Investment Performance Standards (GIPS ®). The firm also provides global performance evaluation and attribution services for portfolio managers. Barth recommends the use of GIPS to its clients due to its prominence as the standard for investment performance presentation.

One of the Barth Group's clients, Nigel Investment Advisors, has a composite that specializes in exploiting the results of academic research. This Contrarian composite goes long "loser" stocks and short "winner" stocks. The "loser' stocks are those that have experienced severe price declines over the past three years, while the "winner" stocks are those that have had a tremendous surge in price over the past three years. The Contrarian composite has a mixed record of success and is rather small. It contains only four portfolios. Gano and Cismesia debate the requirements for the Contrarian composite under the Global Investment Performance Standards.

The Global Equity Growth composite of Nigel Investment Advisors invests in growth stocks internationally, and is tilted when appropriate to small cap stocks. One of Nigel's clients in the Global Equity Growth composite is Cypress University. The university has recently decided that it would like to implement ethical investing criteria in its endowment holdings. Specifically, Cypress does not want to hold the stocks from any countries that are deemed as human rights violators. Cypress has notified Nigel of the change, but Nigel does not hold any stocks in these countries. Gano is concerned that this restriction may limit investment manager freedom going forward.

Gano and Cismesia are discussing the valuation and return calculation principles for both portfolios and composites, which they believe have changed over time.

In order to standardize the manner in which investment firms calculate and present performance to clients, Gano states that GIPS require the following:

Statement 1: The valuation of portfolios must be based on market values and not book values or cost. Portfolio valuations must be quarterly for all periods prior to January 1, 2001. Monthly portfolio valuations and returns are required for periods between January 1, 2001 and January 1, 2010.

Statement 2: Composites are groups of portfolios that represent a specific investment strategy or objective. A definition of them must be made available upon request. Because composites are based on portfolio valuation, the monthly requirement for return calculation also applies to composites for periods between January 1, 2001 and January 1, 2010.

The manager of the Global Equity Growth composite has a benchmark that is fully hedged against currency risk. Because the manager is confident in his forecasting of currency values, the manager does not hedge to the extent that the benchmark does. In addition to the Global Equity Growth composite, Nigel Investment Advisors has a second investment manager that specializes in global equity. The funds under her management constitute the Emerging Markets Equity composite. The benchmark for the Emerging Markets Equity composite is not hedged against currency risk. The manager of the Emerging Markets Equity composite does not hedge due to the difficulty in finding currency hedges for thinly traded emerging market currencies. The manager focuses on security selection in these markets and does not try to time the country markets differently from the benchmark.

The manager of the Emerging Markets Equity composite would like to add frontier markets such as Bulgaria, Kenya, Oman, and Vietnam to their composite, with a 20% weight- The manager is attracted to frontier markets because, compared to emerging markets, frontier markets have much higher expected returns and lower correlations. Frontier markets, however, also have lower liquidity and higher risk. As a result, the manager proposes that the benchmark be changed from one reflecting only emerging markets to one that reflects both emerging and frontier markets. The date of the change and the reason for the change will be provided in the footnotes to the performance presentation. The manager reasons that by doing so, the potential investor can accurately assess the relative performance of the composite over time. Cismesia would like to explore the performance of the Emerging Markets Equity composite over the past two years. To do so, he determines the excess return each period and then compounds the excess return over the two years to arrive at a total two-year excess return. For the attribution analysis, he calculates the security selection effect, the market allocation effect, and the currency allocation effect each year. He then adds all the yearly security selection effects together to arrive at the total security selection effect. He repeats this process for the market allocation effect and the currency allocation effect.

What are the GIPS requirements for the Cypress University portfolio in the Global Equity Growth

composite of Nigel Investment Advisors?

86. Garrison Investments is a money management firm focusing on endowment management for small colleges and universities. Over the past 20 years, the firm has primarily invested in U.S. securities with small allocations to high quality long-term foreign government bonds. Garrison's largest account, Point University, has a market value of $800 million and an asset allocation as detailed in Figure 1.

Figure 1: Point University Asset Allocation





*Bond coupon payments are all semiannual.

Managers at Garrison are concerned that expectations for a strengthening U.S. dollar relative to the British pound could negatively impact returns to Point University's U.K. bond allocation. Therefore, managers have collected information on swap and exchange rates. Currently, the swap rates in the United States and the United Kingdom are 4.9% and 5.3%, respectively. The spot exchange rate is 0.45 GBP/USD. The U.K. bonds are currently trading at face value.

Garrison recently convinced the board of trustees at Point University that the endowment should allocate a portion of the portfolio into international equities, specifically European equities. The board has agreed to the plan but wants the allocation to international equities to be a short-term tactical move.

Managers at Garrison have put together the following proposal for the reallocation:

To minimize trading costs while gaining exposure to international equities, the portfolio can use futures contracts on the domestic 12-month mid-cap equity index and on the 12-month European equity index. This strategy will temporarily exchange $80 million of U.S. mid-cap exposure for European equity index exposure. Relevant data on the futures contracts are provided in Figure 2.

Figure 2: Mid-cap index and European Index Futures Data





Three months after proposing the international diversification plan, Garrison was able to persuade Point University to make a direct short-term investment of $2 million in Haikuza Incorporated (HI), a Japanese electronics firm. HI exports its products primarily to the United States and Europe, selling only 30% of its production in Japan. In order to control the costs of its production inputs, HI uses currency futures to mitigate exchange rate fluctuations associated with contractual gold purchases from Australia. In its current contract, HI has one remaining purchase of Australian gold that will occur in nine months. The company has hedged the purchase with a long 12-month futures contract on the Australian dollar (AUD). Managers at Garrison are expecting to sell the HI position in one year, but have become nervous about the impact of an expected depreciation in the value of the Yen relative to the U.S. dollar. Thus, they have decided to use a currency futures hedge. Analysts at Garrison have estimated that the covariance between the local currency returns on HI and changes in the USD/Yen spot rate is -0.184 and that the variance of

changes in the USD/Yen spot rate is 0.92.

Which of the following best describes the minimum variance hedge ratio for Garrison's currency futures hedge on the Haikuza investment?

87. Jack Thomas and Tim Bentley are analysts for Bond Analytics (BA). BA provides bond analysis for mutual fund managers, hedge fund managers, and institutional money managers in the United States. BA specializes in the valuation of international bonds and callable bonds, using intrasector analysis to find undervalued bonds. In addition to valuing the bonds, they also advise clients on whether to hedge currency risk for international bonds. Thomas has been a particularly strong advocate of hedging the currency risk of international bonds, especially in emerging markets, using forward contracts when they are available. At a morning meeting, Thomas and Bentley are trying to decide whether to hedge the currency risk of a large issue of bonds from a Thai manufacturer of pressed steel, Nakhon Metals. The client considering purchasing the bonds is a large U.S. mutual fund, Epsilon Funds. Epsilon has started to explore the possibility of earning higher returns through currency management using forward contracts. Thomas and Bentley discuss the various hedges of currency risk for the Nakhon Metals bond. One possibility is using a forward hedge position on the Thai baht. A second possibility is using forward contracts where the baht is delivered for Korean won. Thomas states that the second hedge would be pursued if the won was expected to appreciate more against the U.S. dollar than the baht. In the second hedge, the manager would sell won for dollars at the future spot rate.

Thomas and Bentley gather the following information on the expected changes in the various currencies, the 1-year cash rates in the respective countries, and the expected return on the Nakhon bond.





Additionally, the Nakhon Metals bond has a duration of 7.30 and is being compared against a bond denominated in U.S. dollars, issued by Powhatan Industries. The Powhatan bond has a duration of 4.2 and a yield of 4.50%.

Whichever bond is purchased will be held for the next year. Thomas projects that the yield for the Nakhon Metals bond is expected to increase by I 5 basis points while the yield on the Powhatan Industries bond is expected to stay constant.

The following day, Thomas and Bentley discuss the market for and valuation of callable and long duration bonds. They believe that interest rates are temporarily low and for this reason want to be careful about their bond investments. Although they could hedge interest rate risk, they prefer not to because they believe it reduces the ultimate long-term return.

Thomas says that due to secular changes in the bond market, bonds with structures are expected to become more scarce. He says that the problem with callable bonds has been that they typically trade at a premium due to their scarcity. Bentley states that bonds with long durations also trade at a premium because they are scarce as well.

Thomas states that the performance of callables and non-callables may differ when interest rates change due to the inherent call risk.

He discusses the relative performance under two scenarios:

• Scenario A: Interest rates are near coupon rates and fall for both callables and non-callables by the same amount.

• Scenario B: Interest rates are historically very low and rise for both callables and non-callables by the same amount.

Based on interest rate expectations and ignoring currency effects, determine whether the Nakhon Metals bond or Powhatan Industries bond should be more attractive over the one-year time horizon.

88. Mary Thomas works for Kershaw-Ross, a large investment bank located in London. Kershaw-Ross provides advice to portfolio managers, securities dealers, and hedge funds. Jack Bentley is Thomas assistant.

Washington Capital Management, one of Thomas' clients, has a $5 million position in fixed-rate U.S. Treasury bonds. The firm would like to hedge this position using calls on Treasury bonds. The calls each cover $100,000 par value of bonds, have a delta of 0.4, and are out-of-the-money. To hedge this position, Thomas recommends that Washington Capital Management calculate the delta for the call options written on these Treasury bonds.

Later that week, Thomas discusses the particulars of option hedges with Francis Steele, Vice President at Washington Capital Management. Thomas describes how using gamma, the change in delta relative to the change in the underlying asset price, can increase the precision of the hedge. She states that this would be particularly true if the bond portfolio used calls that were at-the-money. Bentley adds that given the uncertainty surrounding U.S. Federal Reserve monetary policy, Kershaw-Ross has been advising clients to carefully monitor their bond positions for price changes. Bentley states that in Washington Capital Management's case, if the price of the underlying bond increases by 1% due to a yield curve shift, the calf hedge should be decreased because delta would have increased.

Thomas is analyzing the portfolio for one of his investors, Canopy Managers. Last year the portfolio had a market value of $4,881,000 and a dollar duration of $157,200.

The current figures for the portfolio are provided below:





Canopy would like to alter the current dollar duration of the portfolio to last year's duration, and they would like to do so with the least amount of cash possible and a controlling position in one of the bonds. Canopy Managers has also contracted to take out a 9-month loan for $5 million in three months at LIBOR. Canopy's chief financial officer has become concerned that interest rates might increase and has asked Thomas to investigate the possibility of hedging the position with a forward rate agreement. Thomas finds a forward rate agreement is available with the same maturity as Canopy's loan at a rate of 4.40%. The risk free rate is 3.8% and LIBOR is projected to be 4.60% at the inception of the loan.

The next week, Thomas and Bentley visit the headquarters of Capital Pension Management, one of Kershaw-Ross's largest clients. Capital is using contingent immunization to immunize a liability, but management is concerned about a possible rise in interest rates. Thomas states that if she were to recommend the most effective strategy to Capital, she would recommend that they use bonds with high yields because immunization will be cheaper. Bentley interjects that the risk from nonparallel shifts in the yield curve can be minimized by concentrating the cash flows around the horizon date.

Due to their tremendous success, Kershaw-Ross has outgrown their current headquarters and is going to expand their current building. Thomas's team has been charged with securing financing tor the renovations. They currently are considering a remodeling and addition that would cost approximately £5,000,000.

Thomas has secured the financing necessary for the renovations at a floating interest rate of LIBOR plus 150 basis points, with payments made quarterly over three years. Thomas believes that Kershaw-Ross should be able to complete the renovation of the building and close on the loan in one year. She is concerned, however, that interest rates will increase in the interim and has obtained a swaption to hedge the loan. She states that Kershaw-Ross should use a payer swaption to hedge the loan.

Bentley evaluates the forecasts for future swap fixed rates as well as the current terms of various swaptions, which are provided below:

Fixed rate for a 1 -year payer swaption = 8.50%

Fixed rate for a 1-year receiver swaption = 8.60%

Projected swap fixed rate in one year = 9.30%

Fixed rate for a 4-year payer swaption - 9.40%

Fixed rate for a 4-year receiver swaption = 9.70%

Projected swap fixed rate in four years = 9.80%

The current credit risk to Canopy from the FRA agreement is closest to: