CFA Institute CFA-Level-III

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

Which of the following statements provides the best description of the advantage of using breakeven spread analysis? Breakeven spread analysis: 

John Green, CFA, is a sell-side technology analyst at Federal Securities, a large global investment banking and

advisory firm. In many of his recent conversations with executives at the firms he researches, Green has heard

disturbing news. Most of these firms are lowering sales estimates for the coming year. However, the stock

prices have been stable despite management's widely disseminated sales warnings. Green is preparing his

quarterly industry analysis and decides to seek further input. He calls Alan Volk, CFA, a close friend who runs

the Initial Public Offering section of the investment banking department of Federal Securities.

Volk tells Green he has seen no slowing of demand for technology IPOs. "We've got three new issues due out

next week, and two of them are well oversubscribed." Green knows that Volk's department handled over 200

IPOs last year, so he is confident that Volk's opinion is reliable. Green prepares his industry report, which is

favorable. Among other conclusions, the report states that "the future is still bright, based on the fact that 67%

of technology IPOs are oversubscribed." Privately, Green recommends to Federal portfolio managers that they

begin selling all existing technology issues, which have "stagnated," and buy the IPOs in their place.

After carefully evaluating Federal's largest institutional client's portfolio, Green contacts the client and

recommends selling all of his existing technology stocks and buying two of the upcoming IPOs, similar to the

recommendation given to Federal's portfolio managers. Green's research has allowed him to conclude that only

these two IPOs would be appropriate for this particular client's portfolio. Investing in these IPOs and selling the

current technology holdings would, according to Green, "double the returns that your portfolio experienced last

year."

Federal Securities has recently hired Dirks Bentley, a CFA candidate who has passed Level 2 and is currently

preparing to take the Level 3 CFA® exam, to reorganize Federal's compliance department. Bentley tells Green

that he may be subject to CFA Institute sanctions due to inappropriate contact between analysts and

investment bankers within Federal Securities. Bentley has recommended that Green implement a firewall to

rectify the situation and has outlined the key characteristics for such a system. Bentley's suggestions are as

follows:

1. Any communication between the departments of Federal Securities must be channeled through the

compliance department for review and eventual delivery. The firm must create and maintain watch, restricted,

and rumor lists to be used in the review of employee trading.

2. All beneficial ownership, whether direct or indirect, of recommended securities must be disclosed in writing.

3. 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 Standard 11(A) Material Nonpublic Information, when Green contacted Volk, he:

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

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.

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