2013 level III sample exam version 2

2013 Level III Sample Exam Version 2
Laredo Case Scenario
Tyler Austin is a fixed-income portfolio manager at Laredo Advisors. He manages a
USD ($) l billion fund that opportunistically seeks the best ideas across fixed-income
markets. He meets daily with Odessa Houston, the fund's senior analyst, to discuss
trade ideas that might be implemented that day. Austin has identified six ideas that he
would like Houston to evaluate in more detail for potential inclusion in the fund.
Austin notes that the current low level of interest rates is limiting the potential
absolute return the fund generates. He asks Houston to evaluate the use of leverage to
enhance returns. He can borrow 25% of the fund's value at an annual interest rate of
1.50% and earn a rate of return of 5% per year on the invested funds.
Austin tells Houston that he is concerned about the potential for rates to rise and
wants to explore how the fund's duration can be changed using the futures market.
The fund currently has duration of 5, and he would like to eliminate all interest rate
risk. Houston uses the data in Exhibit 1 for her analysis.

Austin is intrigued by the incremental yield he could earn by buying an Italian
sovereign bond. A dealer provides a quote at a spread of 350 basis points over U.S.
Treasuries for a 5% coupon, 10-year maturity Italian Buoni Del Tesoro Poliennali
(BTP) bond with duration of 6.75. He asks Houston to assess how much this bond
spread could widen over the six-month period he intends to hold the bond before the
yield advantage relative to Treasuries would be eliminated.
Austin asks Houston whether the euro-denominated bonds they buy should be hedged
back to the U.S. dollar, the fund's domestic currency. Houston responds that they
should hedge back to the U.S. dollar because short-term interest rates are 2.50% in the
eurozone and 0.25% in the U.S. and her forecast shows that she expects the euro to
depreciate by 1.75% relative to the U.S. dollar.


There are U.S.-denominated and euro-denominated bonds in the fund; therefore,
Austin wonders whether the fund's duration is still simply an average of the durations

of each bond. Houston comments, "International interest rates are not perfectly
correlated. Currently, the fund has 80% of the portfolio in U.S. issuers with average
duration of 5.5 and the remainder in German issuers with average duration of 3.5.
Historically, the country beta of Germany - i.e., for German rates relative to U.S. rates
- is estimated to be 0.62."
Finally, Austin tells Houston that his models are showing mortgage securities as
having the most attractive spread relative to other fixed-income sectors. He believes
there are certain risks associated with mortgages and would like to hedge them. He
asks Houston to identify the risks and possible ways to hedge them. Houston replies
with the following statements:
Statement 1: Option-adjusted spread (OAS) is the risk premium for holding
mortgage securities; therefore, you don't want to hedge this spread risk.
If you do hedge against the spread widening, you'll also give up the
benefit from the spread narrowing. If you believe yield spreads are
wide, try to capture the OAS over time by increasing the allocation to
mortgage securities.
Statement 2: The durations of mortgage securities change in an undesirable way
when interest rates change. You can effectively manage this negative
convexity by buying options or by hedging dynamically. Hedging
dynamically with futures requires lengthening duration after rates have
declined and shortening it after rates have risen. The cost associated
with dynamically managing negative convexity is forgoing part of the
spread over Treasuries.
Statement 3: You can manage volatility risk by buying options or by hedging
dynamically. When the volatility implied in option prices is higher than
you believe future realized volatility will be, you should hedge by
purchasing options. When you believe future volatility will be higher
than implied volatility, you should hedge dynamically.

1. If Austin utilizes leverage as he proposes, the rate of return on the portfolio's
equity
funds
will
be
closest
to:
A.
B.
C.

4.70%.
5.88%.
6.25%.

2. Based on Exhibit 1, the number of futures contracts Austin needs to sell in
order to eliminate all interest rate risk in the portfolio is closest to:
A.
B.
C.

9,038.
10,574.
12,372.

3. Given Austin's time horizon, the amount by which spreads for BTPs could
widen before their yield advantage relative to Treasuries would be eliminated
is
closest
to:

A.
B.
C.

26
37
52

bps.
bps.
bps.

4. Based on Houston's forecast for the EUR relative to the USD and assuming
interest rate parity holds, should Austin most likely hedge the portfolio's EUR
exposure
using
forward
contracts?
A. Yes.
B. No, because the euro is expected to depreciate by less than implied by the
forward contracts.
C. No, because the euro is expected to depreciate by more than implied by
the
forward
contracts.


5. Based on Houston's comment regarding international interest rates, the
contribution to the portfolio's overall duration from German bonds is closest
to:

A.
B.
C.

0.43.
0.68.
2.17.

6. Houston is least likely correct about hedging risks of mortgage securities in:
A.
B.
C.

Statement
Statement
Statement

1.
2.
3.


McMorris Asset Management Case Scenario
McMorris Asset Management (MCAM) is an investment adviser based in Atlanta,
Georgia. Tom Morris manages the active equity portfolios. Dan McKeen manages the
semiactive equity portfolios and the semiactive derivatives portfolios. They are
preparing to meet with Maggie Smith, the chief investment officer of Philaburgh
Capital, who is considering hiring MCAM to replace one of its current managers.
At the meeting, Morris and McKeen discuss with Smith MCAM's investment
approaches and present her with the risk and return characteristics detailed in Exhibit

1.

Smith asks if MCAM's active equity strategy is long only. McKeen responds that
MCAM uses market-neutral long-short strategies for several reasons. He indicates
that long-short strategies:
Reason 1: Enhance portfolio performance by increasing the beta.
Reason 2: Generate alpha by identifying undervalued or overvalued securities.
Reason 3: Benefit from events that give rise to price changes, which are more
prevalent on the short side than the long side.
Smith considers each approach listed in Exhibit 1 but is uncertain as to an optimal
investment strategy. She makes the following comments about market efficiency:
Comment 1: A firm's stock price does not reflect all publically available company
information, and good research can uncover sound investment
opportunities.
Comment 2: Our mandate is for managers to limit volatility around the benchmark
return while providing incremental returns which exceed management


costs.
Smith states, "In order to ensure investment discipline, Philaburgh uses two methods
to evaluate an investment manager's style." She then reviews the current
characteristics of MCAM's active equity approach as presented in Exhibit 2.

Smith then selects three benchmarks - value, blend, and growth - in addition to the
normal benchmark to assess the manager's style, as presented in Exhibit 3.

Smith indicates that Philaburgh's performance measurement is compliant with the
Global Investment Performance Standards. In considering investment performance,
Morris identifies three risks that may prevent MCAM's active equity approach from
generating incremental returns:

Risk 1:

Misjudging that a stock's earnings multiple will not contract.

Risk 2:

Incorrectly estimating a stock's earnings per share growth vs. consensus
expectation.

Risk 3:

Misjudging whether a stock's undervaluation will correct within the
investor's investment horizon.

Smith concludes, by telling Morris that she is impressed by MCAM's track record in
adding alpha in the U.S. stock market. However, she believes that the European equity
markets are likely to outperform the U.S. equity markets over the next five years. She
asks whether MCAM can structure a portfolio to capture both opportunities. Morris
offers to combine his long-short active equity strategy with a Euro Stoxx 50 index


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

active
semiactive

semiactive

equity.
equity.
derivatives.

8. McKeen's response to Smith's question about MCAM's active equity style is
least
likely
correct
with
respect
to:
A.
B.

Reason
Reason

1.
2.

C.

Reason

3.

9. Smith's Comment 1 and Comment 2 respectively are most likely consistent
with

an
investment
style
that
is:
Comment 1

Comment 2

A.

active

active

B.

semiactive

active

C.

active

semiactive

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

B.
C.

not
drifted
drifted

from
from

growth
value

to
to

drifted.
value.
growth.

11. Which of the risks Morris identifies with respect to his active equity strategy
is
least
likely
applicable
to
a
growth-oriented
investor?
A.

B.
C. Risk 3

Risk
Risk

1
2


12. The type of portfolio that Morris recommends to Smith to take advantage of
both U.S. and European equity market opportunities is most likely:
A.
B.
C.

alpha

completeness
and

beta

core-satellite.
fund.
separation.


Mary Bing Case Scenario
Mary Bing is a senior portfolio manager at NMS Advisors (NMSA), an investment

and wealth management firm with offices in Boston and Chicago. NMSA provides
investment advisory and asset allocation services to private and institutional clients.
Bing is an expert in the use of derivatives to manage portfolios. Bing is assisted by
two analysts, Rakesh Sharma and Hernando Torres. Bing is performing a review of
client portfolios. She has collected the stock and bond index futures information that
is presented in Exhibit 1. Futures prices are shown after accounting for the multiplier.
Bing also notes that risk-free bonds with one year to maturity yield 1.5%.

Bing manages a portfolio invested in U.S. small-cap stocks for the Wellington
Academy Endowment. The portfolio has a current market value of $321 million. Bing
and her team believe that small-cap stocks will perform well over the next three
months. After consulting with the trustees of the endowment, Bing decides to raise the
beta of the portfolio from 0.8 to 1.2 for the next three months. Bing has also been
informed that the endowment has received a $15 million cash donation that is to be
invested in small caps. Bing and her team decide to use futures to equitize the new
cash inflow for a period of three months.
Another one of Bing's clients is KP McLane Incorporated (KPM Inc.), a U.S.-based
manufacturer of men's apparel. The current market value of KPM Inc.'s pension
portfolio is $950 million with a 65% allocation to U.S. midcap stocks and a 35%
allocation to U.S. bonds. The stock allocation has a beta of 1.45, and the bond
allocation has a modified duration of 5.3. Bing's research indicates that midcap stocks
are likely to underperform over the near term. Accordingly, she decides to reduce the
allocation to midcap stocks to 60% and increase the bond allocation to 40%.
KPM Inc. exports a significant portion of its products to eurozone countries. KPM
Inc. expects the dollar to rise against the euro and is concerned that this could lead to
a decline in sales in the eurozone. KPM Inc. asks Bing for advice on how to manage
this risk exposure.


TCMS is a medical college that is a client of NMSA. TCMS currently has a two-year

loan outstanding with a 5.5% fixed annual interest rate. Bing expects a decline in
interest rates and advises TCMS to enter into a two-year interest rate swap where
TCMS would pay LIBOR+0.5% and receive a 5.5% fixed rate. From TCMS's
perspective, the duration of a two-year fixed rate loan is -1.5 years and the duration of
a floating rate loan is -0.125. Bing asks Torres, "Can you comment on the overall
impact of the interest rate swap on TCMS?"
Torres responds, "The net effect of entering the swap is to reduce the interest rate
sensitivity of the overall loan plus swap posit ion relative to the loan by itself;
however, if the swap is added, it will be harder for TCMS to predict cash flows, and
from this perspective, the swap does not serve as a good hedge."
Bing asks Sharma, "We adjusted the asset allocation of the KPM Inc. pension fund
using futures. Could we have used swaps to carry out the change?"
Sharma responds, "Yes, we could have used a combination of a fixed-income swap on
the Barclays US Aggregate Bond Index and an equity swap on the S&P 400 MidCap
Index, where the notional value is $47.5 million."
13. In order to adjust the beta of the $321 million Wellington Academy
Endowment portfolio, the number of small-cap futures contracts Bing would
need
to
buy
is
closest
to:
A.
B.
C.

54.
467.
1,402.

14. In order for Bing to equitize the $15 million cash inflow received by the
Wellington Academy Endowment, the number of small-cap futures purchased
and the amount invested in risk-free bonds, respectively, are closest to:


15. In order to carry out the proposed adjustment to the KPM Inc. pension
portfolio, the number of S&P 400 MidCap futures Bing would need to sell
and the number of Barclays US Aggregate Bond Index futures she would
need
to
buy,
respectively,
are
closest
to:

16. The type of exchange rate risk that KPM Inc. faces is best described as:
A.
B.

economic
translation

exposure.
exposure.

C.

transaction

exposure.

17. Is

Torres'

response

to

Bing

most

likely

correct?

A.
Yes.
B. No, he is incorrect about hedging ability of the swap.
C. No, he is incorrect about the sensitivity of the overall position.
18. The

pair

of

swaps

Sharma

should

most

likely

describe

are:


Ng Case Scenario
Katherine Ng, a Global Investment Performance Standards (GIPS) specialist, has been
hired as a consultant to assist Rune Managers in becoming a GIPS-compliant firm.
Rune is a global asset manager with several divisions around the world that invest in
both stock and bond strategies. James Arnott, a performance specialist at Rune, is
responsible for the project. In their first meeting, Ng and Arnott discuss the GIPS
standards and the steps Rune will need to take to become compliant.
Ng recommends starting with the definition of the firm. She tells Arnott how the firm
is defined will affect the process for compliance and that the Standards recommend
the firm be defined as broadly as possible. Arnott replies that Rune managers have
been discussing the firm definition and they want their definition to include all Rune
divisions except their European division, Rune Europe. Rune Europe has its own
strategies and management team that are distinct from the rest of Rune. Ng replies
that the Rune Europe division should be included in the definition of the firm because
the division markets itself as part of Rune Managers.
Ng then asks about Rune's policies for the inclusion of portfolios in composites.

Arnott responds that Rune has the following policies for all composites:
Policy 1: All new accounts funded with cash or securities on or before the 10th day of
the month are added to the composite at the beginning of the following month. Those
funded after the 10th day of the month are added at the beginning of the 2nd month
after funding or at the beginning of the calendar month after the proceeds have been
substantially invested in the appropriate strategy. Policy 2: All portfolios are deemed
"nondiscretionary" on the date the notice of termination of the management
relationship is received and removed from the composite at the end of the month of
notification.
The discussion then moves on to a new composite Rune is constructing. Arnott tells
Ng that the marketing department has decided to target domestic Swiss investors and
would like to carve out the Swiss portion of international and global accounts for the
period of 1 January 2006 through 1 January 2011 and allocate cash to each carve-out
segment to create a Swiss franc (CHF) composite. Ng responds that this new
composite will comply with the standards, but Rune will be required to disclose the
percent of composite assets that are carve-outs for each annual period end and the
policy used to allocate cash to the carve-out segments.


Arnott interjects that the marketing department is looking forward to claiming GIPS
compliance in advertisements. He is meeting with the marketing department and asks
Ng what they need to be aware of regarding the GIPS standards in advertising. Ng
responds that there are several requirements in the GIPS Advertising Guidelines.
Specifically, the following must be disclosed in the advertisements: the firm
description, composite and benchmark descriptions, and the number of accounts in the
composite.
Arnott and Ng then move on to discuss one of Rune's GIPS-compliant performance
presentations, which is provided in Exhibit 1.

Rune Managers claims compliance with the Global Investment Performance

Standards (GIPS®) and has prepared and presented this report in compliance with the
GIPS standards. Rune Managers has not been independently verified.
Notes:
1.

2.

3.

4.
5.

Rune Managers is an investment manager registered with the SEC. Rune
Managers has divisions in Europe, Asia, and the United States that invest in
various equity and bond strategies.
The Rune Mid-Capitalization Equity Composite includes all institutional
portfolios that invest in mid-capitalization U.S. equities with the goal of
providing long-term capital growth and steady income from dividends by
investing in low price-to-earnings, undervalued securities.
A complete list and description of Rune Managers composites as well as policies
for valuing portfolios and preparing compliant presentations are available upon
request.
The composite was created on 30 November 2005.
Leverage, derivatives, and short posit ions are not used by this strategy.


6.

Performance is expressed in U.S. dollars. The returns include the reinvestment of
all income. Gross-of-fees returns are presented before management and custodial

fees but after all trading expenses. Net-of-fees returns are calculated by deducting
the actual fees of the accounts from the gross composite return.
7. The management fee schedule is as follows: 0.80% on the first 510 million,
0.55% on the next 540 million, and 0.40% on assets over 550 million.
8. This presentation is not required to conform to any laws or regulations that
conflict with the GIPS standards.
9. Internal dispersion is calculated using the asset-weighted standard deviation of
annual gross returns of those portfolios that were included in the composite for
the entire year.
10. The three-year annualized standard deviation measures the variability of the
composite and the benchmark returns over the preceding 36-month period. The
standard deviation is not presented for 2006 through 2010 because monthly
composite and benchmark returns were not available and it is not required for
periods prior to 2011.
19. In their discussion of the Rune Europe division, which of the following is
most
likely
correct?
A. Arnott's analysis, because of how the strategies are run
B. Ng's analysis, because of how the division markets itself
C. Arnott's analysis, because of how the division is managed
20. Which policy on the inclusion of portfolios in composites is most likely
compliant
with
the
GIPS
standards?
A.
B.
C.

Policy
Policy
Policy

1

and

Policy

1
2
2

21. In the discussion of carve-outs, Ng is least likely correct in her statement
regarding
the:
A.
B.
C.

compliance
of
the
composite.
disclosure
of
the
cash

allocation
policy.
disclosure
of
the
percent
of
composite
assets.


22. In the discussion of the GIPS Advertising Guidelines, Ng is most likely
correct
in
her
statement
regarding
the
disclosure
of:
A.
B.
C.

the
composite
the
number

firm

and
benchmark
of
accounts
in

the

description.
descriptions.
composite.

23. Regarding the disclosures contained in Notes to Exhibit 1, the notes most
likely
required
are:
A.
B.
C.

1,
2,
6,

5
7
7

and
and

and

6.
8.
9.

24. Regarding Exhibit 1, which item is least likely an error in the presentation?
A.
B.
C.

Note
Three-year
Composite
percentage

standard
of

firm

#3
deviation
assets


Duke Case Scenario
The Woodberry Museum (WM) invests in a number of alternative investments as part
of its endowment. John Quest, WM's chief investment officer, oversees several direct
investments as well as outside managers for the asset class. WM's investment

committee is currently evaluating one of the outside managers, Duke Partners Asset
Management (DPAM).
WM's current allocation to alternative investments is presented in Exhibit 1. Quest
states the justification for it: "I believe that the alternative investments we have
provide good liquidity and strong portfolio diversification to the remainder of the
portfolio, which consists of equities and fixed income."

DPAM is the manager of a managed futures fund that seeks to achieve a positive
absolute return. DPAM's chief investment officer, Randall Duke, CFA, is preparing a
report for his first meeting with WM's investment committee. Knowing that WM's
investment committee is less familiar with real assets than with equities and fixed
income, he includes Exhibits 2 and 3. Exhibit 2 shows information on DPAM's
portfolio positions, and Exhibit 3 provides information on selected futures contracts.


Duke calls Quest to ensure that his report addresses any quest ions the committee may
have.
Quest tells him, "There are two questions we would like you to address:
Question 1: Could you explain why using managed futures is more beneficial to us
than using an unlevered exchange-listed commodity index fund?
Question 2: Recently, there has been no clear trend in the commodity markets. It
seems you could increase returns by selling long term options against
your positions. Wouldn't that improve the Sharpe ratio?"
Duke replies: "I will be prepared to explain why I believe neither the use of an index
fund nor an option writing strategy will benefit the portfolio. In addition, we expect to
be maintaining our short gold position for only another three months. Thereafter, we
will seek an entry point to establish a long position in gold."
Quest comments: "After exiting your gold futures position, I would suggest buying
physical gold rather than futures."
Duke answers: "Under certain conditions, we might want to follow your suggestion. I

will address that in my comments to the committee."


25. Quest's justification for the alternative investments in the WM portfolio is
most
likely
correct
with
respect
to:
A.
B.
C.

real
hedge
private

estate.
funds.
equity.

26. Based on Exhibit 2, which position most likely represents an indirect
commodity
investment?
A.
B.
C.

Position

Position
Position

1
2
3

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

Position
Position
Position

3.
4.
5.

28. Duke's response to Question 1 would least likely include that:
A.
managed
futures
have
a
low

cost
structure.
B. managed futures take advantage of rising and falling markets.
C. the index fund only earns the risk-free rate less costs, in the long term.
29. When addressing Question 2, Duke's reasoning for not implementing Quest's
suggestion
would
least
likely
include
a
discussion
of:
A.
B.
C.

the
the
the

maturity
skewness
moneyness

of
of
of

the

the
the

options.
options.
options.


30. After exiting his short gold position, Duke would be motivated to follow
Quest's final suggestion if the amount of the lease rate is:
A. less
than
the
amount
of
the
storage
cost.
B. more than the amount of the storage cost.
C. more than the difference between the discount rate and expected price
growth rate.