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

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

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 nondollar, 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

Daniel Castillo and Ramon Diaz are chief investment officers at Advanced Advisors (AA), a boutique fixedincome 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:

1. "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. "

2. "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

Jacques Lepage, CFA, is a portfolio manager for MontBlanc Securities and holds 4 million shares of AirCon in

client portfolios. Lepage issues periodic research reports on AirCon to both discretionary and nondiscretionary

accounts. In his October investment report, Lepage stated, "In my opinion, AirCon is entering a phase, which

could put it 'in play' as a takeover target. Nonetheless, this possibility appears to be fully reflected in the market

value of the stock."

One month has passed since Lepage's October report and AirCon has just announced the firm's executive

compensation packages, which include stock options (50% of which expire in one year), personal use of

corporate aircraft (which can be used in conjunction with paid vacation days), and a modest base salary that

constitutes a small proportion of the overall package. While he has not asked, he believes that the directors of MontBlanc will find the compensation excessive and sells the entire position immediately after the news. Unbeknownst to Lepage, three days earlier an announcement was made via Reuters and other financial news services that AirCon had produced record results that were far beyond expectations. Moreover, the firm has established a dominant position in a promising new market that is expected to generate above-average firm growth for the next five years. A few weeks after selling the AirCon holdings, Lepage bought 2.5 million shares of Spectra Vision over a period of four days. The typical trading volume of this security is about 1.3 million shares per day, and his purchases drove the price up 9% over the 4-day period. These trades were designated as appropriate for 13 accounts of differing sizes, including performance-based accounts, charitable trusts, and private accounts. The shares were allocated to the accounts on a pro rata basis at the end of each day at the average price for the day. One of the investment criteria used in evaluating equity holdings is the corporate governance structure of the issuing company. Because Lepage has dealt with this topic extensively, he has been asked to present a talk of corporate governance issues to the firm's portfolio managers and analysts at the next monthly meeting. At the meeting, Lepage makes the following comments: "When evaluating the corporate governance policies of a company, you should begin by assessing the responsibilities of the company's board of directors. In general, the board should have the responsibility to set long-term objectives that are consistent with shareholders' interests. In addition, the board must be responsible for hiring the CEO and setting his or her compensation package such that the CEO's interests are aligned with those of the shareholders. In that way the board can spend its time on matters other than monitoring the CEO. A firm with good corporate governance policies should also have an audit committee made up of independent board members that are experienced in auditing and related legal matters. The audit committee should have full access to the firm's financial statements and the ability to question auditors hired by the committee." According to the CFA Institute Code and Standards, Lepage's ignorance of AirCon's press release to Reuters three days before he sold shares of the company:

Matrix Corporation is a multidivisional company with operations in energy, telecommunications, and shipping.

Matrix sponsors a traditional defined benefit pension plan. Plan assets are valued at $5.5 billion, while recent

declines in interest rates have caused plan liabilities to balloon to $8.3 billion. Average employee age at Matrix

is 57.5, which is considerably higher than the industry average, and the ratio of active to retired lives is 1.1. Joe

Elliot, Matrix's CFO, has made the following statement about the current state of the pension plan.

"Recent declines in interest rates have caused our pension liabilities to grow faster than ever experienced in our

long history, but I am sure these low rates are temporary. I have looked at the charts and estimated the

probability of higher interest rates at more than 90%. Given the expected improvement in interest rate levels,

plan liabilities will again come back into line with our historical position. Our investment policy will therefore be

to invest plan assets in aggressive equity securities. This investment exposure will bring our plan to an overfunded status, which will allow us to use pension income to bolster our profitability."