CFA Institute CFA-Level-II CFA Level II Chartered Financial Analyst Exam Practice Test

Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.

Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.

After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:

"You should also know that I am quite bullish on the stock market for the near future. Therefore, as an alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.

If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes."

To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.

Evaluate, in light of the appropriate equity swap strategy for Jacobs's portfolio, Mr. Widby's comments regarding the credit risk and use of swaptions in Jacobs's portfolio.

Rock Torrey, an analyst for International Retailers Incorporated (IRI), has been asked to evaluate the firm's swap transactions in general, as well as a 2-year fixed for fixed currency swap involving the U .S . dollar and the Mexican peso in particular. The dollar is Torrey's domestic currency, and the exchange rate as of June 1,2009, was $0.0893 per peso. The swap calls for annua! payments and exchange of notional principal at the beginning and end of the swap term and has a notional principal of $100 million. The counterparty to the swap is GHS Bank, a large full-service bank in Mexico.

The current term structure of interest rates for both countries is given in the following table:

Torrey believes the swap will help his firm effectively mitigate its foreign currency exposure in Mexico, which sterns mainly from shopping centers in high-end resorts located along the eastern coastline. Having made this conclusion, Torrey begins writing his report for the management of IRI. In addition to the terms of the swap, Torrey includes the following information in the report:

* Implicit in the currency swap under consideration is a swap spread of 75 basis points over 2-year U .S . Treasury securities. This represents a 10 basis point narrowing of the spread as compared to this time last year. Thus, we can assume that the credit risk of the global credit market has decreased. Unfortunately, the decline provides no insight into the credit risk of the individual currency swap with GHS Bank, which could have increased.

* In order to decrease the counterparty default risk on the currency swap, we will need to utilize credit derivatives between the beginning and midpoint of the swap's life when this particular risk is at its highest. This is a significantly different strategy than we normally use with interest rate swaps. For interest rate swaps, counterparty default risk peaks at the middle of the swap's life, at which point we utilize credit derivative CQuntermeasures to offset the risk.

* Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from IRI.

Six months have passed (180 days) since Torrey issued his report to IRI's management team, and the current exchange rate is now $0,085 per peso. The new term structure of interest rates is as follows:

For the currency swap that Torrey is evaluating, calculate the annual payments that will be required of International Retailers Incorporated.

Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.

In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:

Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.

Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:

"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."

Which of the following correctly analyzes Grimell's comments regarding earning the risk-free rate by selling calls and buying puts, and regarding waiting for the option vegas to increase?

Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.

In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:

Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.

Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:

"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."

Given Mabry's assessment of the risks associated with BIC, which option strategy would be the most effective in delta-neutral hedging the risk of BIC stock?

Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.

In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:

Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.

Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:

"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."

If the premium on Put D on November 1 is $3.18, which of the following has most likely occurred?

Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.

Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.

Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.

Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.

Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.

Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.

* If a firm anticipates floating rate exposure from issuing floating rate bonds at some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.

* Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.

Are the comments about swaptions correct?

Erich Reichmann, CFA, is a fixed-income portfolio manager with Global Investment Management. A recent increase in interest rate volatility has caused Reichmann and his assistant, Mel O'Shea, to begin investigating methods of hedging interest rate risk in his fixed income portfolio.

Reichmann would like to hedge the interest rate risk of one of his bonds, a floating-rate bond (indexed to LIBOR). O'Shea recommends taking a short position in a Eurodollar futures contract because the Eurodollar contract is a more effective hedging instrument than a Treasury bill futures contract.

Reichmann is also analyzing the possibility of using interest rate caps and floors, as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio.

Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on $30 million principal value with annual payments. He values the 1-year floor at $90,000 and the 2-year floor at $285,000.

Reichmann has also heard about using interest rate collars to hedge interest rate risk, but is unsure how to construct a collar.

Finally, Reichmann is interested in using swaptions to hedge certain investments. He evaluates the following comments about swaptions.

* If a firm anticipates floating rate exposure from issuing floating rate bonds at some future date, a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan. It would be exercised if the yield curve shifted down.

* Swaptions can be used to speculate on changes in interest rates. The investor would buy a receiver swaption if he expects rates to fall.

What would be the most appropriate way for Reichmann to construct an interest rate collar to hedge the fixed-rate portion of the portfolio using the 2-year 6% floor and a 2-year 12% cap?