CFA Society Boston Level III

2021 Practice Exam

Afternoon Session

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© 2021 CFA Society

Boston
The afternoon session of the CFA Society Boston Level III 2021 Practice Exam has 10 item sets.
The item set format consists of a vignette or a short case followed by four or six multiple choice
questions based on the vignette. Each item set is allocated either 12 minutes or 18 minutes for a
total of 132 minutes.

Item Set Topic Questions Minutes

1 Ethics 1–4 12 2/4=50%
2 Ethics 5–8 12 2/4=50%
3 Capital Market Expectations 9–14 18 3/6=50%
4 Asset Allocation 15–18 12 3/4=75%
5 Derivatives and Currency Management 19–22 12 3/4=75%
6 Derivatives and Currency Management 23–26 12 4/4=100%
7 Fixed-Income Portfolio Management 27–30 12 2/4=50%
8 Fixed-Income Portfolio Management 31–34 12 3/4=75%
9 Alternative Investments for Portfolio Management 35–40 18 4/6=66.7%
10 Trading, Performance Evaluation, and Manager Selection 41–44 12 4/4=100%

Total 44 132 30/44=68%

© 2021 CFA Society Boston 2

ITEM SET 1: ETHICS
Questions 1 through 4 are allocated 12 minutes.

Mary Lee Vincenzo, CFA, is a fixed income portfolio manager who oversees the operations of
GLL Investments, a major financial institution in Germany.

Vincenzo observes what she believes to be a violation of the Code of Ethics and Standards of
Professional Conduct by one of the managers in another department. She approaches the
manager with her concerns and recommends that the manager cease the improper activity. These
direct discussions with the manager are, however, unsuccessful. Vincenzo believes the Code and
Standards compel her to take the following actions:

Action 1: Bring the violation to the attention of the manager’s supervisor or the firm’s
compliance department.

Action 2: Step away and dissociate from the activity.

Action 3: Report the violation to the relevant governmental or regulatory organization.

Gertrude Shultz, CFA, an analyst with GLL, approaches Vincenzo with a concern. Shultz was
accused of professional misconduct. Shultz tells Vincenzo that she is innocent and will not
accept the charges nor the proposed sanction levied against her.

Shultz explains that she was accused of accepting outside compensation in violation of Standard
IV(B)–Additional Compensation Arrangements. She states that she discussed all pertinent details
with her managing director at a meeting one month before she accepted the outside
compensation. At that meeting, Shultz notified the director of her intention to do independent
outside work, the nature and duration of the services she intended to provide, and the total
compensation she expected. The director nodded her approval and shook Shultz’s hand, wishing
her good luck with the endeavor.

At an industry conference on ethics, Vincenzo makes the following three statements regarding
what it means to be a CFA charterholder:

Statement 1: Soft dollars cannot be used when managing client accounts.

for clients OK
Statement 2: Conflicts of interest are sometimes permissible.
OK if disclosed
Statement 3: Whistleblowing is always allowed.
whistleblowing for self-gain NOT allow
Vincenzo would like GLL to adopt the Asset Manager Code of Professional Conduct (AMC),
but she recognizes that it will take time before it is fully implemented at the firm. She wonders
how GLL can achieve this goal in phases.

© 2021 CFA Society Boston 3

1. Vincenzo’s understanding of the Code and Standards is most likely:

Action 1 Action 2 Action 3

A. Correct Incorrect Incorrect
B. Correct Correct Incorrect
C. Correct Correct Correct You DON’t have to report to

2. Shultz’s refusal to accept the charge and proposed sanction will most likely be referred to:

A. a volunteer committee. Yep volunteer disciplinary commitee

B. the CFA Institute Board of Governors.
C. a disciplinary panel elected by CFA Institute members.

3. Vincenzo’s statement at the conference that is most likely correct is:

A. Statement 1. soft dollars CAN be used if APPROVED by clients

B. Statement 2. Conflicts of Interest permissible if disclosed
C. Statement 3. whistleblowing NOT always allowed, esp if self-benefit

4. Over time, Vincenzo’s firm, GLL, may:

A. claim full compliance with parts of the AMC.

B. only claim compliance with the entire AMC.
C. claim general compliance with the AMC, citing any compliance deficiencies.

© 2021 CFA Society Boston 4

ITEM SET 2: ETHICS
Questions 5 through 8 are allocated 12 minutes.

Dorothy Bray, CFA, is an analyst at Sadosky & Bray (S&B), a global investment counseling
firm headquartered in Vancouver, British Columbia. Bray is very pleased that the firm, after a
thorough internal review, can claim compliance with the CFA Institute’s Asset Manager Code of
Professional Conduct (AMC). In the marketing materials she develops for the firm, Bray writes
that the company is proud to attain the level of professional and ethical compliance with the
AMC that is granted by the CFA Institute. She points out that very few Canadian firms have
attained this achievement.

Bray issues a report on the Canadian shale oil industry. The report contains S&B proprietary
research, industry data from subscription services, and raw statistical economic data prepared by
the Canadian and Alberta governments. Bray identifies S&B’s own in-house research and
adequately references the sources of the industry (verified) and government (unverified) data.

S&B’s Director of Research, Elizabeth Donovan, CFA, holds a firm-wide (35 individuals)
meeting to alert all personnel that the firm will be making significant revisions to its “buy, sell,
hold” recommendations in three weeks and that confidentiality of this information is critical. In
the past, changes in the firm’s assessments of investment attractiveness leaked out before their
scheduled announcement. Donovan hopes to avoid such leakage this time.

Bray advises a group of newly hired portfolio managers, making the following statement:

Statement 1: Those of you who have just passed Level III of the CFA program and are now
about to become CFA charterholders will now be required to comply with the
CFA Institute’s:
• Code of Ethics,
• Standards of Professional Conduct, and
• Asset Manager Code of Professional Conduct (AMC).

Donovan engages in online chat rooms where investment ideas are discussed. She is careful not
to reveal any S&B material nor propriety information and acts primarily as an observer. When
she does post a comment, Donovan uses a fictitious name and does not identify herself as a CFA
charterholder. She notes that three other chat room participants regularly refer to themselves as:

• a past CFA charterholder,

• an inactive CFA candidate, and
• a CFA charterholder who passed each of the three levels on her first try.

In order to assist all S&B portfolio managers in the construction of client portfolios, Donovan’s
research group maintains an extensive list of securities, referred to as the Approved List, that
were thoroughly researched and likely to exhibit favorable future performance. S&B associates
believe that the research department develops this list using a reasonable and adequate basis and
that its process is both independent and objective. S&B permits portfolio managers to use

© 2021 CFA Society Boston 5

securities from the list in any client portfolio, unless an expressed restriction in the client’s IPS
applies.

5. In her marketing materials and oil industry report, Bray has most likely improperly
communicated:

S&B’s Use of Unverified

AMC Compliance Government Data
A. No No No the CFA does not issue AMC compliance
B. Yes No
C. Yes Yes Yes you can use unverified government
data

6. In order to reduce the probability of information leakage, Donovan would least likely:

A. limit the number of people possessing the assessment information.

B. have all employees sign an anti-disclosure and confidentiality agreement. People break NDA’s
C. shorten the time between the new assessment decisions and dissemination.anyway

7. With regard to the requirements cited in Statement 1, Bray is most likely:

Ethics Standards AMC

A. Correct Correct Correct
B. Correct Correct Incorrect Already comply as a candidate
C. Incorrect Incorrect Incorrect so NOT “now” suddenly
And AMC is firm level not individual

8. Did the following chat room participants, in the manner in which they referenced
themselves, most likely violate Standard VII(B)–Reference to CFA Institute, the CFA
Designation, and the CFA Program?

Past CFA Inactive CFA CFA Passed

Charterholder Candidate on First Try
A. No No No
B. No Yes Yes
C. Yes Yes Yes
Past CFA no longer needs to comply, he can say
whatever he wants
Inactive cfa candidate can also say whatever
because he’s inactive
Passed on first try is fine to say

© 2021 CFA Society Boston 6

ITEM SET 3: CAPITAL MARKET EXPECTATIONS
Questions 9 through 14 are allocated 18 minutes.

Joseph Dawson, CFA, is a portfolio manager for Dunsby & Hillman, an investment firm that
invests in US and non-US assets. One of his clients, Mary Reid, has a well-diversified portfolio
with investments in various asset classes and in different countries worldwide. The investments
are in five specific countries, referred to below as countries A through E.

Reid closely follows her portfolio. She notices several economic events occurring in the markets
in which she has investments. She expresses concern to Dawson about the possible effects these
events may have on her portfolio.

As part of the annual review for his clients, Dawson meets with Linda Gonzalez, a member of
the investment strategy committee in his firm. Gonzalez monitors relevant global financial
events and their possible effects on the financial markets.

Dawson asks Gonzalez for insights and information regarding the countries where Reid has
investments. Gonzalez provides information for those countries, which is summarized in Exhibit
1.

For Country A, Dawson questions whether the allocation of equities in that country should be
increased in Reid’s portfolio. Among other factors, Gonzalez states that Country A has
an expansion rate of 0.35% per year for P/E multiples. In addition, Gonzalez has also monitored
the annual long-term corporate earnings growth rate, the rate of net share repurchases for
equities, and the dividend yield.

Gonzalez informs Dawson that the equities in Country B, an emerging market, have become
more fully integrated with the global investment market. As a result, Gonzalez believes that
Country B has a lower required rate of return. Her research also shows that Country B’s overall
volatility will decrease. Gonzalez has also compiled previous and new estimates of the financial
aspects of Country B as shown in Exhibit 1.

While further exploring options for his clients, Dawson learns of the Taylor rule and asks
Gonzalez about it. Gonzalez states that the investment strategy committee compiles data that
may be needed to determine the Taylor rule for a particular country, including:

1) the real policy rate that would be targeted if growth is expected to be at trend and
inflation on target,
2) the expected and target inflation rates, and
3) the expected and trend nominal and real GDP growth rates.

© 2021 CFA Society Boston 7

 Exhibit 1
Country Information
1) Expansion rate for P/E multiples of 0.35% per year.
2) Based on a 1 percentage point premium for corporate
earnings growth over Gonzalez’s expected Country A
(nominal) GDP growth rate of 4.5%, the annual long-term
Country A corporate earnings growth rate is 5.5%.
3) The rate of net share repurchases for Country A equities is
1.5%.
4) Based on the country’s main stock index, equities have a
2.75% dividend yield.

2020 2021
Estimated Projected
Category/Parameter Data Data
Country B Volatility 17% 21%
Correlation with global market 0.6 0.5
Degree of integration 0.65 0.55
Sharpe ratio (global and segmented markets) 0.25 0.25

1) The economy is in early expansion stage.

2) The front section of the yield curve is increasingly sloping
upward.
Country C
3) The back half of the yield curve is a flat curve.
4) The central bank is deemphasizing its quantitative easing
program and is purchasing fewer government bonds.

Country D Secularly rising current account surplus.

Country E Secularly rising current account deficit.

Gonzalez’s research shows that the economy of Country C (in which Reid has an equity
investment) is in an early expansion stage. The front section of Country C’s yield curve is
increasingly sloping upward, while the back half exhibits a flat curve. Additionally, Country C’s
central bank is deemphasizing its quantitative easing program and is purchasing fewer
government bonds.

Gonzalez has also examined the national savings and investment totals for Countries D and E.
Reid understands that a country’s current account balance is the difference between national
saving and investment. However, she is unsure about how a current account surplus or current
account deficit might impact the allocation of investments between Countries D and E. When
asked by Dawson, Gonzalez stated that her research shows that Country D has a secularly rising
current account surplus while Country E has a secularly rising current account deficit.

© 2021 CFA Society Boston 8

9. Using Exhibit 1, which of the following statements is least likely to have an impact
regarding reallocation of investments in Reid’s portfolio?
cap account balance trend sustainability are
not mentioned
A. Capital account balances are trending and sustainable. degree of integ decreased impacts
B. Markets are becoming more or less globally integrated.
RP and return estimate
C. Monetary and fiscal policies are consistent with long-term stability and the phases
of the business cycle.
central bank deemphasizing easing impacts
rates and allocation decisions
10. Based on the information provided by Gonzalez, the expected rate of return for Country
A’s equities is closest to:

A. 9.3% E(R)=D/P-Change Shares+Earnings Change+P/E change

B. 9.8%
C. 10.1%

11. Using the Singer-Terhaar model for the Country B investment, the net impact of the
changes on the risk premium estimate for this market will be closest to:
RPg=SharpeRatio*StdDev*Corr
A. 43 bps.
RPp=SharpeRatio*StdDev
B. 66 bps.
RP=degree of integration*RPg+(1-degree)*RPp
C. 79 bps.
RP2021-RP2020=change

12. Which of the following information provided by Gonzalez is least likely required for a
calculation of the Taylor rule?
i*=Rn+inf*+.5(realGDPg*-realGDPgtrend)+.5(inf*-inf_target)
A. Expected and target inflation rates.
B. Expected and trend nominal GDP growth rates. real gdp growth not nominal!
C. The real policy rate that would be targeted if growth is expected to be at trend and
inflation on target.

13. For Country C, which of the following trends is most likely to occur for current money
market rates and those in the short-term future?

A. Declining; pace may be expected to accelerate.

B. Moving up; pace may be expected to accelerate.
C. Above average and rising; expectations tempered by eventual peak/decline.

© 2021 CFA Society Boston 9

14. Based on the information presented, the preferred reallocation of Reid’s portfolio assets
between Country D and Country E is most likely:

A. to Country D, since a secularly rising current account surplus generally puts

downward pressure on asset prices in order to induce a lower saving rate in the
surplus country to lessen the narrowing surplus.
B. to Country E, since a secularly rising current account deficit generally puts
downward pressure on asset prices in order to induce a lower saving rate in the
surplus country to mitigate the narrowing surplus.
C. to Country E, since a secularly rising current account deficit generally puts
upward pressure on real required returns in order to induce a higher saving rate in
the deficit country and to attract the increased flow of capital from abroad
required to fund the deficit.

preferred reallocation of assets to E, E has a CAPITAL account DEFICIT

With DEFICIT -> upward pressure on REAL RETURN up-> higher
SAVINGS rate up->increased INFLOW of CAPITAL up to fund the deficit

© 2021 CFA Society Boston 10

ITEM SET 4: ASSET ALLOCATION
Questions 15 through 18 are allocated 12 minutes.

Sammiah Kumar is a seasoned consultant at Delphi Consulting. Delphi serves more than 200
high-net-worth clients with aggregate assets in excess of $5 billion. The firm has substantial staff
resources in market and manager research.

Kumar is meeting with his new clients, Manuel and Kelly Garcia. The Garcias are married, both
are healthy and both are 55 years old. Manuel is employed at a regional utility company as an
executive overseeing renewable energy development. He plans to retire in about five years.
Kelly recently retired from her teaching job to take care of their only child, Spencer, age 20, who
has physical limitations from a car accident that occurred in the previous year.

The Garcias have both taxable and tax-advantaged investment portfolios worth a combined total
of $2,500,000. They are considering adding new asset classes to their current portfolio. Possible
additions are shown in Exhibit 1.

Exhibit 1
Possible Additions Composition
Equity Global public equity and global private equity
Fixed Income Global investment-grade bonds and global high-yield bonds
Alternatives Direct real estate investments and Bitcoin

Kumar states that, for purpose of asset allocation, the following criteria should be met:

• asset classes should be diversifying,

• asset classes should be mutually exclusive, and
• assets within an asset class should be relatively homogenous.

The Garcias own real estate valued at $1,000,000, with a $500,000 outstanding mortgage loan.
They plan to set up a special needs trust for Spencer with a present value of $2 million to be
funded in five years. Kumar estimates Manuel’s pre-retirement earnings from the utility
company have a present value of $1,500,000. He estimates the Garcias’ future expected
consumption expenditures have a total present value of $2,000,000. In addition, the Garcias
expect to receive a tax-free inheritance within the coming year, which has an estimated present
value of $1,000,000. Kumar uses this information to prepare an economic balance sheet for the
Garcias.

Kumar recognizes the Garcias’ very strong desire to fund a trust for their son. Kumar
recommends the Garcias use a goals-based approach to achieve this goal and offers three
possible portfolios for consideration. Selected data on the three portfolios are presented in
Exhibit 2.

© 2021 CFA Society Boston 11

 Exhibit 2
Possible Portfolio Allocations
Global Global Diversifying
Cash Bonds Equities Strategies*
Portfolio A 10% 20% 50% 20%
Portfolio B 20% 40% 30% 10%
Portfolio C 30% 60% 10% 0%

*Diversifying strategies consist of hedge funds, managed futures and private equity.

Kumar prepares an Investment Policy Statement (IPS) for the Garcias’ review. Kelly notes the
following statement in the IPS:

Statement 1: Clients agree to delegate full authority to Delphi Consulting to manage their
investment portfolio as specified in this IPS, which includes selections of active
and passive managers for each of the main and sub-asset classes, among others.

15. With regard to asset allocation, which of the possible asset classes shown in Exhibit 1 is
most likely to meet the three criteria Kumar mentioned?

A. Equity. Pub and private equity have very different characteristics so not EQ
B. Fixed Income. Investment grade and high yield Bonds, can be quite similar, just quality diff
C. Alternatives. Real Estate and Bit Coin are very different-> not homogenous

16. Using the economic balance sheet approach, the Garcias’ economic net worth is closest
to:

A. $500,000
B. $1,500,000
C. $5,000,000

17. Based on Exhibit 2, which portfolio best meets the Garcias’ goal to fund a special needs
trust for their son?

A. Portfolio A.
B. Portfolio B.
C. Portfolio C.

© 2021 CFA Society Boston 12

18. Regarding Statement 1, which factor is least likely to influence Kumar’s decisions to
select passive or active strategies for the Garcias’ investment portfolio?

A. Tax status.
B. Risk budgeting.
C. Beliefs concerning market informational efficiency.

© 2021 CFA Society Boston 13

ITEM SET 5: DERIVATIVES AND CURRENCY MANAGEMENT
Questions 19 through 22 are allocated 12 minutes.

Hudson Kelly, CFA, is an options strategy analyst at Quant Analytics, Inc., focusing on
managing the portfolios of high-net-worth clients. Kelly is reviewing the IPSs for several clients
to devise strategies to meet their short- and long-term objectives.

Kelly meets with Noah Jacobs, a client whose portfolio is concentrated in a single stock,
Brookline Corporation (BKLN). Jacobs is confident about the long-term performance of the
stock and does not want to sell any shares. Using the BKLN shares, Jacobs wants to generate an
immediate cash flow of $100,000 to pay for his son’s college tuition. Kelly is tasked to come up
with an option strategy that does not use naked option positions. Three-month option contract
prices and Greeks for BKLN are shown in Exhibit 1.

Exhibit 1
Three-Month Option Contract Prices & Greeks for BKLN
Call Call Exercise Put Put
Call Vega Delta Premium Price Premium Delta Put Vega
0.198 0.761 23.05 490 2.82 –0.346 0.198
0.214 0.651 15.55 500 5.26 –0.421 0.214
0.320 0.506 9.70 510 9.22 –0.514 0.320
0.225 0.382 5.75 520 15.65 –0.612 0.225
0.190 0.272 3.40 530 22.80 –0.745 0.190
0.175 0.213 2.51 540 31.30 –0.891 0.175
BKLN current stock price = $510.40

Liz McPherson, a high-net-worth client, is following BKLN and is tracking its earnings history
for the last few quarters. McPherson is expecting the revenue of BKLN to peak due to
advancements in technology. Although the overall stock market is performing well and rising,
there could be a potential downside for BKLN’s industry. Kelly recommends that McPherson
establish an at-the-money (ATM) straddle strategy to benefit from possible extreme movements
in the BKLN stock price.

Kelly meets with Anusha Bandla, another high-net-worth client, who expects very little price
movement in BKLN. Bandla evaluates the options strategies to take advantage of BKLN’s
volatility and makes the following three statements:

Statement 1: For a 1% move in the options volatility, the value of an ATM straddle would
change by $0.506.

Statement 2: A short volatility strategy can be established by implementing an ATM straddle.

Statement 3: To protect downside risk, a collar strategy can be implemented by adding a long
put to a covered call position.

© 2021 CFA Society Boston 14

19. The number of BKLN covered call contracts with an exercise price of $540 required to
generate the needed cash flow is closest to:

A. 104
B. 295
C. 399

20. The percentage change in BKLN’s share price for the straddle strategy to breakeven is
closest to:

A. 1.90%
B. 3.71%
C. 6.12%

21. Given the information in Exhibit 1, the minimum cost of implementing a bullish seagull
strategy, using strike prices of $490 and $530, is closest to:

A. $16.83
B. $22.47
C. $23.63

22. Which of Bandla’s statements is least likely correct?

A. Statement 1.
B. Statement 2.
C. Statement 3.

© 2021 CFA Society Boston 15

ITEM SET 6: DERIVATIVES AND CURRENCY MANAGEMENT
Questions 23 through 26 are allocated 12 minutes.

Evelyn Weismann, a CFA Level I candidate, is a research analyst at Bay Area Investments,
which specializes in derivatives and currency management. Bluerock Holdings, a US-based firm
and an institutional client of Bay Area, is looking to increase its footprint in international
markets. Bluerock is in the process of conducting due diligence to acquire Concord Associates,
which is domiciled in London. Concord Associates has overall holdings amounting to GBP 400
million. Liam Mason, CEO of Bluerock, meets with Weismann and expresses his intention to
mitigate the GBP currency risk before closing on the acquisition of Concord. Weismann makes
the following three recommendations:

Recommendation 1: Implement an ATM call option on GBP/USD to protect the exposure

against appreciation of the base currency.

Recommendation 2: Implement a risk reversal strategy by buying an ATM GBP/USD call

option and buying an OTM GBP/USD put option.

Recommendation 3: Use a knock-in/knock-out option to receive an all-or-none asymmetric

payoff when the exchange rate touches a pre-specified level.

Exhibit 1
Portfolio Return and Risk Details
Total Portfolio Expected Return Standard Deviation σ Correlation ρUSD/GBP
United States 3.65% 4.6%
United Kingdom 2.16% 2.5% 0.25

Rocky Brothers LLC, a client of Bay Area, has a portfolio of CAD 200 million 6% fixed rate
bonds that pay a semiannual coupon with an average modified duration of 6.5. Interest rates
started to increase in Canada a few months after the initial purchase. Rocky Brothers wants to
reduce the modified duration of the portfolio to 5.6, using an interest rate swap that has an
estimated modified duration of –1.5.

Bay Area has been hired by Nate Alternatives, a global investment firm, as derivatives and risk
management consultants to help mitigate the risk and to identify opportunities in the derivatives
markets. Nate Alternatives holds a limited partnership in a German private equity firm and is
expecting to receive a capital call of EUR 5,000,000 in six months. The current USD/EUR
exchange rate is 1.22, and the euro is expected to appreciate over the next six months. Weismann
recommends the following three strategies to mitigate the risk of euro appreciation:

Strategy 1: A six-month USD/EUR put option with a strike price of USD/EUR 1.30

Strategy 2: A six-month USD/EUR call option with a strike price of USD/EUR 1.23

Strategy 3: A six-month EUR/USD call option with a strike price of USD/EUR 1.30

© 2021 CFA Society Boston 16

23. Which of Weismann’s recommendations is most likely correct?

A. Recommendation 1.
B. Recommendation 2.
C. Recommendation 3.

24. Using the information in Exhibit 1, which position would best implement Bluerock’s
minimum-variance hedge against Concord Associates’ exposure?

A. Short a GBP/USD forward contract with a notional size of GBP 184 million.
B. Go long a USD/GBP forward contract with a notional size of USD 184 million.
C. Go long a GBP/USD forward contract with a notional size of GBP 184 million.

25. The notional principal of the interest rate swap Rocky Brothers LLC can use to reduce
the modified duration is closest to:

A. CAD 120 million.

B. CAD 200 million.
C. CAD 333 million.

26. Which of Weismann’s strategies should most likely be implemented for Nate Alternatives
to mitigate possible euro appreciation?

A. Strategy 1.
B. Strategy 2.
C. Strategy 3.

© 2021 CFA Society Boston 17

ITEM SET 7: FIXED-INCOME PORTFOLIO MANAGEMENT
Questions 27 through 30 are allocated 12 minutes.

Brad Stevens, CFA, is the director of Fixed Income at Pinehurst Capital. He has been hired to
manage a portfolio of fixed income bonds for Yankee Inc., a client of Pinehurst. Stevens has
been asked to determine a strategy to retire Yankee’s debt liabilities over the next ten years. The
liabilities have a market value of USD 750 million, a modified duration of 6.25 years and a BPV
of USD 468,750. Yankee has just finalized a small asset sale and received USD 775 million of
net proceeds to fund the new mandate. Stevens builds a portfolio of US government bonds to
immunize the liabilities with a modified duration of 6.5 years and a BPV of USD 503,750.
Pinehurst allows Stevens to use five-year Treasury futures to close the duration gap. The five-
year Treasury note has a BPV per 100,000 in par value of 50.28 and a conversion factor of 0.77.

Stevens established Pinehurst’s enhanced index strategy division in an effort to attract private
wealth investors seeking a diversified bond market exposure at low cost. He is meeting with a
prospective client, Jared Dudley, to discuss Pinehurst’s product offerings. Dudley has described
himself as risk averse and sensitive to large price fluctuations in his portfolio. Stevens brings the
prospectus for each of the firm’s top three strategies, which are summarized in Exhibit 1.

Exhibit 1
Average Modified
Strategy Description Quality Duration Yield
1 US Government/Credit Treasury, Agency and credit AA 7.64 1.18%
securities with maturities from 1
to 30 years
2 Long US Treasury US Treasury obligations with AAA 19.02 1.72%
maturities no less than 20 years
3 Intermediate US Investment US corporate debt with minimum A– 4.58 1.35%
Grade Corporate Index average quality of BBB–and
maturities from 1 to 10 years

Dudley reviews each prospectus and favors investment in the Intermediate US Investment Grade
Corporate Index. To avoid tracking error, he asks Stevens to purchase every bond in the index.
Stevens explains that pursuing a pure indexing strategy is not practical and makes the following
statements:

Statement 1: By matching the portfolio’s overall option-adjusted duration and key rate duration
exposure to the index, we can significantly reduce the portfolio’s tracking error in
the event of changes in the level of interest rates and shifts in the yield curve.

Statement 2: We will remove tracking error arising from idiosyncratic risk by matching the
portfolio’s market percentage weights by sector and quality to that of the index.

Statement 3: Trading costs in the credit markets are higher than in the Treasury market. An
enhanced indexing approach will lower the costs related to rebalancing.

© 2021 CFA Society Boston 18

Burt Snow is a global bond portfolio manager at Pinehurst with a focus on emerging markets
sovereign debt. Snow expects recent headlines surrounding social unrest and weak economic
projections to result in higher interest rate volatility in Brazil. He arranges a meeting with Sally
Cole, Pinehurst’s Latin American economist, to discuss altering the overall convexity of his
portfolio. Cole explains that market consensus is for the Brazilian economy to slow, forcing the
government to provide a large stimulus package in order to improve economic conditions. In
contrast to market expectations, Cole believes that growth will be steady for at least one year and
does not expect yields to move from current levels.

27. The number of five-year Treasury futures contracts required to close the duration gap for
the Yankee portfolio is closest to:

A. buy 478 contracts.

B. sell 536 contracts.
C. sell 696 contracts.

28. Which strategy is least likely to be suitable for Dudley?

A. Strategy 1.
B. Strategy 2.
C. Strategy 3.

29. The statement that is least likely to be correct is:

A. Statement 1.
B. Statement 2.
C. Statement 3.

30. Based on Cole’s view of Brazil, the best strategy to achieve higher returns is most likely
to:

A. buy call options on Brazilian government bonds.

B. buy put options on Brazilian government bonds.
C. sell put options on Brazilian government bonds.

© 2021 CFA Society Boston 19

ITEM SET 8: FIXED-INCOME PORTFOLIO MANAGEMENT
Questions 31 through 34 are allocated 12 minutes.

Dwight Newman and Julia Jones are portfolio managers for Bonita Investment Advisors. Both
manage their credit portfolios against the Bloomberg US Investment Grade Corporate Index,
which has an effective duration of 8.50 years. Newman believes that high-yield bond spreads
will tighten more than investment-grade spreads. He allocates 5% of his portfolio to corporate
bonds with Caa ratings. Jones is less optimistic on the economic environment and holds only
investment-grade bonds in her portfolio. Newman and Jones use interest rate futures to manage
duration. At the beginning of the year, their portfolios have an effective duration of 8.50 years.

With the US corporate index spreads close to all-time historic lows, Newman discusses adding
exposure to emerging markets corporates for those portfolios that allow for their inclusion from
prospectus guidelines. Newman makes the following statements in favor of emerging markets
corporate bonds within the context of the current environment:

Statement 1: Commodity prices should rise and support the credit profiles of emerging markets
corporates more than US corporates, all else being equal.

Statement 2: Trading liquidity in emerging markets corporate bonds is improving, and

investors are being compensated for this risk with the additional spread.

Statement 3: The higher degree of government ownership in emerging markets corporations

provides downside protection for international bondholders in the event that
defaults rise.

Newman and Jones believe that global interest rates will remain stable over the next six months
and are discussing inter-market carry trades in the sovereign debt market as a way to augment
portfolio performance for their US clients. Bonita’s trading desks provide the data shown in
Exhibit 1.

Exhibit 1
Swap Rates 2-Year 5-Year 10-Year
BRL 5.01% 5.11% 5.39%
COP 2.62% 3.84% 5.57%
USD 0.22% 0.44% 1.08%
BRL = Brazilian real
COP = Colombia peso

Jones makes the following statements regarding inter-market trades:

Statement 4: Given the lack of credibly fixed exchange rates across markets,
default-free yield differentials are unlikely to perfectly converge over time.

Statement 5: Given today’s domestic rate environment, even if there is volatility in spread

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 levels or rates, the most important driver of the expected returns for US investors
entering into an inter-market trade will be the carry advantage.

Statement 6: For clients who do not want to accept currency exposure, we can eliminate that
risk by rolling 3-month forwards until we unwind the trade.

31. All else being equal, will Newman’s or Jones’ portfolio most likely have a significant
empirical duration gap compared to the benchmark?

A. Jones’ portfolio.
B. Newman’s portfolio.
C. Neither, both portfolios should have empirical durations close to the index.

32. Which statement is least likely to support a decision to buy emerging markets corporate
debt?

A. Statement 1.
B. Statement 2.
C. Statement 3.

33. Based on data in Exhibit 1, which inter-market trade is most likely to result in the best
carry return over one year?

A. Pay 2-year USD/receive 5-year BRL.

B. Pay 10-year USD/receive 10-year COP.
C. Pay 2-year USD/receive 10-year COP.

34. Which of Jones’ statements is most likely to be correct regarding inter-market trades?

A. Statement 4.
B. Statement 5.
C. Statement 6.

© 2021 CFA Society Boston 21

ITEM SET 9: ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGEMENT
Questions 35 through 40 are allocated 18 minutes.

Herman Clark, CFA, has recently been hired by Castle Advisors, an investment consulting firm
providing services to small and medium-sized institutions. Clark has extensive experience in
hedge fund due diligence.

Many of Castle’s clients expect that there will be an increase in monetary policy support from
the central bank. However, concerned about recent market volatility and tail risk events, several
of Castle’s clients have been inquiring about uncorrelated strategies that could be added to their
portfolios. To address these concerns, Clark considers three hedge fund strategies that may be
appropriate additions for these clients: short-biased, global macro, and life settlements. Clark
decides to prepare a presentation that will summarize the key characteristics of each strategy.

Clark makes three statements in the presentation:

Statement 1: Short-biased managers focus on short equity beta through index shorting.

Statement 2: Use of options by global macro strategies often adds convexity to the returns.

Statement 3: Life settlements can provide liquidity to the original policyholder.

After reviewing the materials, one of Castle’s clients asks for more information on short-biased
strategies and requests a specific fund recommendation. Clark recommends the Tech-No Fund,
which has a strong track record in identifying market mispricings. To demonstrate the fund
manager’s expertise, Clark creates a conditional risk factor model and presents the statistics in
Exhibit 1.

Exhibit 1
Coefficient Estimate t-Statistic
Normal Times
Intercept 0.007 0.97
USD 0.075 0.23
CREDIT 0.016 0.01
SNP500 –0.461 –10.23
VIX 0.123 4.23
Crisis Times
DUSD 0.231 1.23
DCREDIT 0.009 0.02
DSNP500 –0.123 –3.54
DVIX –0.234 –3.33

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35. Which of the strategies identified by Clark is most likely to be impacted immediately by a
change in central bank support?

A. Global macro.
B. Life settlements.
C. Short-biased.

36. What other strategy most likely addresses the concerns of Castle Advisors’ clients?

A. Merger arbitrage.
B. Managed futures.
C. Convertible arbitrage.

37. Which of Clark’s statements is least likely to be accurate?

A. Statement 1.
B. Statement 2.
C. Statement 3.

38. Which of the following is least likely to be a reason to use a conditional risk factor model
when evaluating hedge fund returns?

A. Hedge fund returns may exhibit serial correlation.

B. Hedge funds may have dynamic trading strategies.
C. Hedge funds may have unexpected exposures to systemic risks.

39. During times of crisis, Tech-No Fund’s volatility exposure is best described as:

A. short.
B. neutral.
C. increasing.

40. The negative factor loading on VIX during times of crisis implies that the Tech-No Fund
is most likely:

A. selling puts.
B. buying VIX futures.
C. holding more cash than usual.

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ITEM SET 10: TRADING, PERFORMANCE EVALUATION, AND
MANAGER SELECTION
Questions 41 through 44 are allocated 12 minutes.

Alan Treetop, CFA, works for Bicycle Investment Advisors (BIA), where he manages a fixed
income portfolio consisting of US bonds with different credit ratings. Treetop uses a proprietary
factor model to select specific bonds within each rating group. Treetop’s benchmark is the
Barclays US Aggregate Bond Index, and his objective is to outperform that benchmark by 100
bps.

BIA has provided an attribution analysis of Treetop’s performance to present to both current and
prospective clients. The analysis is summarized in Exhibit 1 and Exhibit 2.

Treetop makes the following two statements regarding the attribution policy:

Statement 1: BIA utilizes a returns-based attribution because it is the most accurate

performance attribution method.

Statement 2: A holdings-based attribution is not appropriate because BIA’s portfolios have

high turnover.

Exhibit 1
Portfolio and Benchmark Allocations
Bond
Credit Treetop Benchmark Treetop Benchmark
Rating Weight Weight Duration Duration
Group
Low 35.00% 30.00% 7.4 6.5
Medium 30.00% 30.00% 7.5 7.4
High 35.00% 40.00% 5.7 7.5

Exhibit 2
Treetop’s Return Attribution Results
(relative to benchmark)
Total
Interest Credit Rating
Bond Credit Duration Curve Rate Group Bond
Rating Group Effect Effect Allocation Allocation Selection Total
Low 1.45% –0.23% 1.22% –0.53% –0.47% 0.22%
Medium 0.10% 0.04% 0.14% –0.03% –0.36% –0.25%
High 0.32% 0.33% 0.65% –0.26% –0.22% 0.17%

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41. Which of Treetop’s statements regarding attribution methodologies is most likely correct?

A. Statement 1.
B. Statement 2.
C. Neither Statement 1 nor Statement 2.

42. Using the data in Exhibit 1, Treetop’s portfolio will most likely outperform the
benchmark in which of the following scenarios?
A. Credit spreads narrow.
B. Credit spreads don’t change.
C. Credit spreads widen.

43. Which risk attribution approach is most appropriate to evaluate Treetop’s portfolio?

A. Marginal contribution to total risk.

B. Marginal contribution to tracking risk.
C. Factor’s marginal contributions to total risk and specific risk.

44. Based on the data in Exhibit 2, Treetop’s total return relative to his benchmark is closest
to:

A. –1.05%
B. 0.14%
C. 1.05%

END OF AFTERNOON SESSION

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