CFA LEVELIII, PRACTICE SOLUTIONS (LOS # 27) Question - #91779 Your answer: A was correct! Since the asset manager cannot know the future value of the equity position, it is impossible to perfectly hedge the position with only currency contracts This question tested from Session 15, Reading 27, LOS g Question - #91447 Your answer: B was correct! The manager would want to short the forward contracts to hedge depreciation of the foreign currency To prevent hedging too much, over-hedging, the manager would hedge an amount less than the equity position because that position may decline in value from the equity risk This question tested from Session 15, Reading 27, LOS g Question - #92301 Your answer: B was correct! Number of contracts = -16 = (0 − beta) × (16 × futures price) / (beta × futures price) This question tested from Session 15, Reading 27, LOS a Question - #91799 Your answer: B was incorrect The correct answer was A) “long” the currency and should short the forward contract on the foreign currency In hedging foreign exchange risk, anticipating a receipt (payment) of a currency is like being long (short) the currency To hedge the associated risk, a manager should take the opposite position in the forward contract This question tested from Session 15, Reading 27, LOS f Question - #91565 Your answer: B was correct! NOTE – on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material from derivatives as tactical asset allocation can be accomplished by selling assets, or with a derivative overlay Stuart should disagree with both of Swemba’s statements Although Stuart’s goal of reducing the duration could be accomplished by selling bonds in the portfolio, doing so would likely incur significant transaction costs Also, since the duration of each bond in the portfolio is likely different, specific bonds would have to be selected in order to accomplish Stuart’s goal, making the process more difficult A derivative overlay, accomplished by using futures contracts, would be much easier and cost effective Swemba is also incorrect with respect to the number of futures contracts that would need to be sold The correct number of futures contracts to be sold is: (1.0)[(2.2 – 4.4) / 8.2]($12,000,000 / $102,000) = -31.56 ≈ -32 futures contracts The minus sign means that 32 contracts should be sold to achieve the desired duration in the portfolio This question tested from Session 15, Reading 27, LOS d Question - #91570 Your answer: B was incorrect The correct answer was A) the risk free rate is not zero The risk free rate does not enter into the formulas for determining the strategy for synthetically adjusting a stock/bond portfolio Although the risk free rate may play a role in some futures strategies to synthetically adjust a portfolio, the effectiveness of the strategy would not depend upon its value This question tested from Session 15, Reading 27, LOS d Question - #92351 Your answer: B was incorrect The correct answer was C) Short 69 contracts Number of contracts = -69.26 = (0.5 − 0.9) × ($20,000,000) / (1.1 × $105,000), and this rounds down to 69 (absolute value) Since the goal is to decrease beta, the manager should go short which is also indicated by the negative sign This question tested from Session 15, Reading 27, LOS a Question - #92304 Your answer: B was incorrect The correct answer was A) 564 The negative sign indicates the need to take a short position This question tested from Session 15, Reading 27, LOS c Question - #92225 Your answer: B was incorrect The correct answer was C) called pre-investing This is the definition of pre-investing using futures contracts, and it is not illegal This question tested from Session 15, Reading 27, LOS e Question 10 - #92404 Your answer: B was correct! Futures + Cash = Security, therefore, buy the corresponding futures contract and invest in a T-bill This question tested from Session 15, Reading 27, LOS b Question 11 - #91569 Your answer: B was correct! This should be obvious because a decline in the equity position is bad and the short position in a forward currency contract hurts when the foreign currency appreciates If the equity position falls short of the contracted amount, in addition to the loss from the decline in asset prices, then the manager will suffer a loss equal to the difference in the hedged amount and the actual equity value times the difference in the spot and contracted forward rate This question tested from Session 15, Reading 27, LOS g Question 12 - #91762 Your answer: B was correct! The exchange-rate dimension generally adds risk The two hedging strategies utilized by global portfolio managers to manage the risk of a foreign-denominated portfolio involve selling forward contracts on the foreign market index (to manage market risk) and selling forward contracts on the foreign currency (to manage the currency risk) They can choose to hedge one or the other, both, or neither This question tested from Session 15, Reading 27, LOS g Question 13 - #91571 Your answer: B was incorrect The correct answer was C) both equity risk and foreign exchange risk The position will have both equity and foreign exchange risk This makes the position, in isolation, more risky than a domestic equity portfolio This question tested from Session 15, Reading 27, LOS g Question 14 - #93166 Your answer: C was incorrect The correct answer was B) Sell 176 First determine the new target beta by multiplying the current beta of the portfolio which is 1.23 by to achieve a new target beta that is 30% less than the current portfolio beta: (1.23)(.7) = 0.861 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] [(0.861-1.23)/1](150,000,000)/(1260)(250) = (-.369)(476.19) = -175.71, rounded to -176 This question tested from Session 15, Reading 27, LOS a Question 15 - #91672 Your answer: B was incorrect The correct answer was C) Buy 804 contracts The number of futures contracts required to double the portfolio beta is computed as follows: Number of contracts = [(target beta - portfolio beta)/futures beta] x (Portfolio value / Futures contract value) = [(2.4 - 1.2) / 1] x [$100 million / (596.90 × $250)] = 804 contracts To double the portfolio beta we buy 804 contracts This question tested from Session 15, Reading 27, LOS a Question 16 - #91573 Your answer: B was correct! This move will accomplish the goal by reducing the exposure to equity and increasing the exposure to bonds This question tested from Session 15, Reading 27, LOS d Question 17 - #92002 Your answer: B was incorrect The correct answer was A) Transaction exposure The three types of exchange-rate risk are transaction exposure, economic exposure, and translation exposure Futures are most often used to hedge transaction exposure, which is the risk that exchange rates will change the real value (in the domestic currency) of the contracted price This question tested from Session 15, Reading 27, LOS f Question 18 - #92054 Your answer: B was correct! Expecting to make a payment is like being short the currency The firm would want to take a long forward position If the currency appreciates and there is no hedge, the firm would pay more With the hedge, the overall cost in domestic currency is locked in (cost increases will be offset by gains on the forward contract) Of course, the forward contract will result in a loss if the foreign currency actually depreciates, but this will be offset by a decrease in the cost of the underlying transaction This question tested from Session 15, Reading 27, LOS f Question 19 - #92286 Your answer: B was correct! The number of futures contracts required for the 100% risk-minimizing hedge (or to reduce the beta to zero) is computed as follows: Number of contracts = Portfolio value / Futures contract value × beta $80 million / (596.70 × $250) × 1.1 = 590 contracts Therefore, to reduce the by 50% we simply use half this number of contracts or 295 contracts This question tested from Session 15, Reading 27, LOS a Question 20 - #92801 Your answer: B was incorrect The correct answer was A) 673 contracts Number of contracts = 673.3 = $175,000,000 × (1.02)0.5/(1050 × 250) This question tested from Session 15, Reading 27, LOS b Question 21 - #92428 Your answer: C was incorrect The correct answer was B) To synthetically create the risk/return profile of an underlying common equity security, buy the corresponding futures contract, sell the common short, and invest in a T-bill To synthetically create the risk/return profile of an underlying common equity security, buy the corresponding futures contract and invest in a T-bill This question tested from Session 15, Reading 27, LOS b Question 22 - #92525 Your answer: B was incorrect The correct answer was C) Long contracts Number of contracts = 6.80 = (1.1 − 0.9) × ($10,000,000) / (1.2 × $245,000), and this rounds up to seven Since the goal is to increase beta, the manager should go long This question tested from Session 15, Reading 27, LOS a Question 23 - #91572 Your answer: B was incorrect The correct answer was C) both currency forwards and equity futures Forwards are most often used for currency risk and futures are most often used for equity risk The manager would have to use both contracts to completely hedge all the risk This question tested from Session 15, Reading 27, LOS g Question 24 - #91999 Your answer: B was correct! Economic exposure is the loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency That is, if the euro/dollar exchange rate increases, a U.S exporter to Europe would see a fall in revenue as the European buyers purchase fewer U.S exports that have effectively increased in price from the dollar appreciation This question tested from Session 15, Reading 27, LOS f Question 25 - #92172 Your answer: B was incorrect The correct answer was A) long position in 22 of the stock futures and 25 of the bond futures The goal is to create a $7 million equity position with a beta of 0.8 and a $3 million bond position with a duration of 5: number of stock futures = 21.8 = (0.8 − 0) × ($7,000,000) / (1.1 × $233,450) number of bond futures = 25.13 = (5 − 0) × ($3,000,000) / (6 × $99,500) The manager should take a long position in 22 of the stock index futures and 25 of the bond index futures This question tested from Session 15, Reading 27, LOS e Question 26 - #91683 Your answer: B was incorrect The correct answer was A) Short 85 bond futures and go long 33 stock index futures Since the manager wishes to increase the equity position and decrease the bond position by $10 million (10% of $100 million), the correct strategy is to take a short position in the bond futures and a long position in the stock index futures: number of bond futures = -85.03 = [(0 − 5) / 6]($10,000,000 / $98,000) number of stock futures = 32.82 = [(1 − 0) / 1.1]($10,000,000 / $277,000) This question tested from Session 15, Reading 27, LOS d Question 27 - #92463 Your answer: B was correct! The position created by risk-minimizing hedging is essentially the creation of a synthetic T-Bill The number of futures contracts required for the risk-minimizing hedge is computed as follows: Number of contracts = Portfolio value / Futures contract value × beta $100 million / (596.70 × $250) × 1.1 = 737 contracts Therefore, the investor has to sell 737 S&P 500 futures contracts short This question tested from Session 15, Reading 27, LOS b Question 28 - #92057 Your answer: B was incorrect The correct answer was A) $10,800,000 On the day the order comes in, the firm effectively has a long position in pounds; therefore, it should take a short position in a forward contract This contract would obligate the firm to deliver the pounds that it will receive for dollars The contract would be to exchange ₤8 million for: $10,800,000 = (₤8,000,000) × $1.35/₤ This question tested from Session 15, Reading 27, LOS f Question 29 - #92033 Your answer: B was correct! Translation exposure refers to the fact that multinational corporations might see a decline in the value of their assets that are denominated in foreign currencies when those foreign currencies depreciate When the consolidated balance sheet is composed, changing exchange rates will introduce variation in account values from year to year This question tested from Session 15, Reading 27, LOS f Question 30 - #92440 Your answer: B was correct! Payoff of futures plus T-bill = 886 × $250 × (1,120 − 1,100) + $240,000,000 × 1.03 0.25 Payoff of futures plus T-bill = $246,210,097 This question tested from Session 15, Reading 27, LOS b Question 31 - #91845 Your answer: B was incorrect The correct answer was A) Buy 218 contracts In order to be hedged against stock price increases, S&P 500 futures contracts have to be purchased The quantity of contracts to buy is computed as follows: # contracts = (beta)(Portfolio value) ÷ (futures price)(contract multiplier) = (1)(60,000,000) ÷ (1100)(250) @ 218.18 = 218 contracts This question tested from Session 15, Reading 27, LOS d Question 32 - #92361 Your answer: B was incorrect The correct answer was C) take a short position in 152 contracts The negative sign indicates the need to take a short position This question tested from Session 15, Reading 27, LOS c Question 33 - #92382 Your answer: B was correct! The trader can buy stock index futures and hold them in conjunction with T-Bills to mimic a stock portfolio So we have: Synthetic stock portfolio = T-Bills + stock index futures This question tested from Session 15, Reading 27, LOS b Question 34 - #91834 Part 1) Your answer: B was correct! The loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to the foreign currency is economic exposure The risk that contracted future cash flows become less valuable in terms of the domestic currency or that planned purchases become more expensive is known as transaction exposure Derivatives are primarily used to hedge transaction exposure (Study Session 15, LOS 36.f) This question tested from Session 15, Reading 27, LOS f Part 2) Your answer: B was incorrect The correct answer was A) sell 15 million in exchange for $18.75 million The day the freight cars are sold, Jackson is effectively long Euros so the optimal solution is to sell the Euro forward contract in exchange for $18,750,000 (15,000,000 / $0.80) If the company did not hedge, two months from now the sale would net only $16,666,667 (15,000,000 / $0.90) (Study Session 15, LOS 36.f) This question tested from Session 15, Reading 27, LOS f Part 3) Your answer: B was correct! Jackson wants to “lock in” the price of $6,390,977 (8,500,000 / $1.33) for the Canadian steel now by buying Canadian dollars with a forward contract (Study Session 15, LOS 36.f) This question tested from Session 15, Reading 27, LOS f Part 4) Your answer: B was correct! Being long the currency means holding or expecting to receive a foreign currency, therefore to hedge this foreign currency exposure you must sell forward contracts (deliver foreign currency and receive domestic currency at the expiration of the contract) Being short the currency indicates either an expectation to pay the foreign currency or the future obligation to deliver foreign currency which has already been sold To hedge this foreign currency exposure it is necessary to buy forward contracts (deliver home currency and receive foreign currency at the expiration of the contract) (Study Session 15, LOS 36.g) This question tested from Session 15, Reading 27, LOS f Part 5) Your answer: B was incorrect The correct answer was C) Statement Futures contracts trade on an exchange so they are required to be more regulated than forward contracts, and thus have lower default risk (Study Session 15, 36.a) This question tested from Session 15, Reading 27, LOS f Part 6) Your answer: B was incorrect The correct answer was A) the manager gets a leverage effect with futures because the only required “investment” is the margin deposit The point of a hedge is not to leverage a position If the investor is speculating, or even if they are preinvesting or turning cash into synthetic equity or debt, there may be a leverage advantage to futures rather than buying the underlying However, with respect to hedging, leverage is not the desired outcome The main advantages to using futures and forwards rather than adjusting the underlying security positions are cost, less disruption, and greater liquidity (Study Session 15, LOS 36.g) This question tested from Session 15, Reading 27, LOS f Question 35 - #91936 Your answer: B was correct! We should recall our formula for altering beta, number of contracts = ({target beta − Bportfolio} × V) / (Bfutures × futures price) In this case, for the first step where we convert the mid-cap position to cash, V=$15 million, and the target beta is The current beta is 1.0, and the futures beta is 1.05: -54.95 = (0 − 1) × ($15,000,000) / (1.05 × $260,000) The manager should short 55 of the futures on the mid-cap index Then the manager should take a long position in the following number of contracts on the small-cap index: 72.00 = (1.6 − 0) × ($15,000,000) / (1.5 × $222,222) Thus, the manager should take a long position in 72 of the contracts on the small-cap index This question tested from Session 15, Reading 27, LOS e Question 36 - #92159 Your answer: B was incorrect The correct answer was A) go long both stock and bond futures Since the original portfolio is long in both stocks and bonds, the manager will go long both stock and bond futures contracts This question tested from Session 15, Reading 27, LOS e Question 37 - #92559 Your answer: B was correct! First determine the new target beta by multiplying the current beta of the portfolio which is 95 by 1.4 to achieve a new target beta that is 40% greater than the current portfolio beta: (.95)(1.4) = 1.33 Then use the equation: [(BetaT - Betap)/Betaf][Vp/(Pf x multiplier)] [(1.33-.95)/1](78,000,000)/(856)(250) = (.38)(364.49) = 138.50, rounded to 139 This question tested from Session 15, Reading 27, LOS a Question 38 - #93144 Part 1) Your answer: B was incorrect The correct answer was C) $21,710, with Kaufman paying the bank the settlement = 20,000,000 × [(0.0485 – 0.05) × (270 / 360)] / [1 + ((0.0485)(270 / Settlement payment 360)] = 20,000,000 × (-0.001125 / 1.036375) = $21,710.29 Since the realized rate at the time of the loan, 4.85%, is lower than the contract rate of 5%, Kaufman would want to pay to get out of the FRA so that he can borrow at the prevailing lower rate (Study Session 14, LOS 34.i) This question tested from Session 15, Reading 27, LOS a Part 2) Your answer: B was correct! In this case use the modified duration of the bond portfolio, 6.3 to find the value of the portfolio given a 25 basis point increase in rates: New value = $40,000,000 × (1 - (6.3 × 0.0025)) = $39,370,000 (Study Session 9, LOS 23.g) This question tested from Session 15, Reading 27, LOS a Part 3) Your answer: B was correct! Contracts = (Yield Beta) [(MDTarget – MDP) / MDF][VP / (Pf(Multiplier))] Contracts = 1.1 × [(5 – 6.3) / 4.2] × ($40,000,000 / $245,000) = -55.59 To reduce the duration of the portfolio, take a short position in the futures contract Note that we must round the number of contracts up to 56 since partial contracts cannot be traded (Study Session 15, LOS 36.d) This question tested from Session 15, Reading 27, LOS a Part 4) Your answer: B was correct! Number of Contracts = (Target Beta – Portfolio Beta / Beta on Futures) × (Value of the portfolio / Price of the futures × the multiplier) Number of Contracts = [(1.4 – 1.25) / 0.90] × ($60,000,000 / $335,000) = 29.85 contracts The positive sign indicates that we should take a long position in the futures to “leverage up” the position If that is Kaufman’s goal, he must be expecting an increase in the market (Study Session 15, LOS 36.a) This question tested from Session 15, Reading 27, LOS a Part 5) Your answer: B was incorrect The correct answer was C) Sell approximately 121 contracts [$60,000,000 × (1.02)0.50] / (2000 × $250) = 121.19 contracts Kaufman would need to sell the contracts to create the synthetic cash (zero equity) position If he were converting cash to a synthetic equity position, he would of course buy contracts (Study Session 15, LOS 36.c) This question tested from Session 15, Reading 27, LOS a Part 6) Your answer: B was incorrect The correct answer was C) buy 22 bond futures contracts and buy 13 stock futures contracts Take the existing portfolio weights, 40% debt and 60% equity and apply them to the new money that is coming in Also, “mirror” the duration and beta of the original portfolios Number of bond futures = 1.05 × [(6.3 - 0) / 6.2] × [(6,000,000 × 0.40) / 115,460] = 22.18 contracts Number of stock futures = [(1.25 – 0) / 1.10] × [(6,000,000 × 0.60) / 315,650] = 12.96 Kaufman Co would take a long position in both the stock index and bond futures contracts because it is synthetically creating an existing portfolio until the actual $6 million is received and can be invested (Study Session 15, LOS 36.e) This question tested from Session 15, Reading 27, LOS a Question 39 - #92256 Your answer: B was incorrect The correct answer was C) 69 The negative sign indicates the need to take a short position This question tested from Session 15, Reading 27, LOS c Question 40 - #92389 Your answer: B was incorrect The correct answer was A) the fewer the number of needed contracts The formula is: Number of contractsUnrounded = (V × (1 + risk free rate)T) / (futures price × multiplier) As the multiplier increases, the number of needed contracts declines This question tested from Session 15, Reading 27, LOS b Question 41 - #92423 Your answer: B was correct! Security – Futures = Cash, therefore, buy the common equity and sell short the corresponding futures contract This question tested from Session 15, Reading 27, LOS b Question 42 - #91460 Your answer: B was incorrect The correct answer was C) long position in contracts We should recall our formula for altering beta, number of contracts = ({target beta − Bportfolio} × V) / (Bfutures × futures price) the provided information gives: number of contracts = = 0.5 × 10 × (futures price) / (1 × futures price) This question tested from Session 15, Reading 27, LOS e Question 43 - #93174 Your answer: B was incorrect The correct answer was C) Buy 175 equity futures contracts NOTE – on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material from derivatives as tactical asset allocation can be accomplished by selling assets, or with a derivative overlay Because Corser wants to increase the beta of his portfolio, he should buy futures contracts The appropriate number of contracts to buy is calculated as: [(1.25 − 0.85) / 1.03] × ($140,000,000 / $310,000) = 175.38 ≈ 175 contracts This question tested from Session 15, Reading 27, LOS a  ... answer was C) Buy 175 equity futures contracts NOTE – on the exam, it is very likely for material on tactical asset allocation to be tested in conjunction with material from derivatives as tactical... price of $6 ,39 0,977 (8,500,000 / $1 .33 ) for the Canadian steel now by buying Canadian dollars with a forward contract (Study Session 15, LOS 36 .f) This question tested from Session 15, Reading 27,... contracts trade on an exchange so they are required to be more regulated than forward contracts, and thus have lower default risk (Study Session 15, 36 .a) This question tested from Session 15, Reading