Absolute Free CFA-Level-II Exam Practice for Comprehensive Preparation 

Tamara Ogle, CFA, and Isaac Segovia, CAIA, are portfolio managers for Luca's Investment Management (Luca's). Ogle and Segovia both manage large institutional investment portfolios for Luca's and are researching portfolio optimization strategies.

Ogle and Segovia begin by researching the merits of active versus passive portfolio management. Ogle advocates a passive approach, pointing out that on a risk-adjusted basis, most managers cannot beat a passive index strategy. Segovia points out that there will always be a need for active portfolio managers because as prices deviate from fair value, active managers will bring prices back into equilibrium. They determine that Treynor-Black models permit active management within the context of normally efficient markets.

Ogle decides to implement Treynor-Black models in her practice and starts the implementation process. In conversations with her largest client's risk manager, Jim King, FRM, she is asked about separation theorem in relation to active portfolio management. She responds that separation theorem more properly relates to asset prices deviating from and gravitating toward their theoretical fair price. King next asks Ogle about the differences between the Sharpe ratio and the information ratio and the difference between the security market line (SML) and the capital market line (CML).

After reallocating her client portfolios based on using the Treynor-Black model, Ogle discusses the results with Segovia. Ogle states that she is satisfied with the current methodology, but given her preference for passive management, she is still concerned about relying on analyst's forecasts. Segovia tells Ogle that he will research methods for modifying the Treynor-Black model to account for analyst forecasts.

The optimal risky portfolio determined by the Treynor-Black model has an allocation of 30% to the active portfolio and a Sharpe ratio of 0.45. Given that the risk-free rate is 3%, the standard deviation of the market (passive) portfolio is 20%, and the expected return on the optimal risky portfolio is 10%, the standard deviation of an investor's optimal portfolio that is allocated 70% to the risk-free asset is closest to:

James Kelley is the CFO of X-Sport Inc., a manufacturer of high-end outdoor sporting equipment. Using both debt and equity, X-Sport has been acquiring small competitor companies rather rapidly over the past few years, leading Kelley to believe that the firm's capital structure may have drifted from its optimal mix. Kelley has been asked by the board of directors to evaluate the situation and provide a presentation that includes details of the firm's capita! structure as well as a risk assessment. In order to assist with his analysis, Kelley has collected information on the current financial situation of X-Sport. He has also projected the financial information for alternative financing plans. This information is presented in Exhibit 1.

After carefully analyzing the data, Kelley writes his analysis and proposal and submits the report to Richard Haywood, the chairman and CEO of X-Sport Inc. Excerpts from the analysis and proposal follow:
* In selecting a re-financing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current Baa rating, causing our cost of debt to rise dramatically. This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest tax shield will be more than The marginal increase in the costs of financial distress. However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of X-Sport management with its shareholders.
* In the event that X-Sport decides to proceed with a recapitalization plan, I recommend Plan D since it is the most consistent with the shareholders' interests.
Haywood reviews the report and calls Kelley into his office to discuss the proposal. Haywood suggests that Flan B would be the most appropriate choice for adjusting X-Sport's capital structure. Before Kelley can argue, however, the two are interrupted by a previously scheduled meeting with a supplier.
Haywood takes Kelley's data and proposes to the board of directors that X-Sport pursue one of three alternatives to restructure the company. The first alternative is Plan B from Kelley's analysis. The second alternative involves separating GearTech, one of the companies acquired over the last few years, from the rest of the company by issuing new GearTech shares to X-Sport common shareholders. The third alternative involves creating a new company, Euro-Sport, out of the firm's European operations and selling 35% of the new Euro-Sport shares to the public while retaining 65% of the shares within X-Sport. After some persuading, Haywood convinces the seven-member board (two of whom were former executives at GearTech) to accept the second alternative, which he had favored from the beginning. The board puts together an announcement to its shareholders as well as the general public, detailing the terms and goals of the plan.
A group of shareholders, upset about the board's plan, submit a formal objection to X-Sport's board as well as to the SEC. In the objection, the shareholders state that the independence of the board has been compromised to the detriment of the company and its shareholders. The objection also states that:
* The value of X-Sport's common stock has been impaired as a result of the poor corporate governance system.
* The liability risk of X-Sport has increased due to the increased possibility of future transactions that benefit X-Sport's directors, without regard to the long-term interests of shareholders.
* The asset risk of X-Sport has increased due to the inability of investors to trust the GearTech financial disclosures necessary to value the division.
Which of the following best explains the difference between X-Sport's current cost of debt and the cost of debt associated with Plan A?

William Bow, CFA, is a risk manager for GlobeCorp, an international conglomerate with operations in the technology, consumer products, and medical devices industries. Exactly one year ago, GlobeCorp, under Bow's advice, entered into a 3-year payer interest rate swap with semiannual floating rate payments based on the London interbank offered rate (LIBOR) and semiannual fixed rate payments based on an annual rate of 2.75%. At the time of initiation, the swap had a value of zero and the notional principal was set equal to $150 million. The counterparty to GlobeCorp's swap is NVS Bank, a commercial bank that also serves as a swap dealer. Exhibit 1 below summarizes the current LIBOR term structure.

Upper management at GlobeCorp feels that the original swap has served its intended purpose but that circumstances have changed and it is now time to offset the firm's exposure to the swap. Because they cannot find a counterparty to an offsetting swap transaction, management has asked Bow to come up with alternative measures to offset the swap exposure. Bow created a report for the management team which outlines several strategies to neutralize the swap exposure. Two of his strategies are included in Exhibit 2.

After examining its long-term liabilities, NVS Bank has decided that it currently needs to borrow $100 million over the next two years to finance its operations. For this type of funding need, NVS generally issues quarterly coupon short-term floating rate notes based on 90-day LIBOR. NVS is concerned, however, that interest rates may shift upward and the LIBOR curve may become upward sloping. To manage this risk, NVS is considering utilizing interest rate derivatives. Managers at the bank have collected quotes on over-the-counter interest rate caps and floors from a well known securities dealer. The quotes, which are based on a notional principal of $100 million, are provided in Exhibit 3.

One of the managers at NVS Bank, Lois Green, has expressed her distrust of the securities dealer quoting prices on the caps and floors. In a memo to the CFO, Green suggested that NVS use an alternative but equivalent approach to manage the interest rate risk associated with its two-year funding plan. Following is an excerpt from Green's memo:
'Rather than using a cap or floor, NVS Bank can effectively manage its exposure to interest rates resulting from the 2-year funding requirement by taking long positions in a series of put options on fixed-income instruments with expiration dates that coincide with the payment dates on the floating rate note.'
'As a cheaper alternative, NVS can effectively manage its exposure to interest rates resulting from the 2-ycar funding requirement by creating a collar using long positions in a series of call options on interest rates and long positions in a series of call options on fixed income instruments all of which would have expiration dates that coincide with the payment dates on the floating rate note.'
GlobeCorp is concerned with its exposure to the interest rate swap initiated one year ago. Evaluate the strategies recommended by Bow in Exhibit 2.