CFA Institute CFA Level II Chartered Financial Analyst Exam

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.

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Michelle Norris, CFA, manages assets for individual investors in the United States as well as in other countries. Norris limits the scope of her practice to equity securities traded on U .S . stock exchanges. Her partner, John Witkowski, handles any requests for international securities. Recently, one of Norris's wealthiest clients suffered a substantial decline in the value of his international portfolio. Worried that his U .S . allocation might suffer the same fate, he has asked Norris to implement a hedge on his portfolio. Norris has agreed to her client's request and is currently in the process of evaluating several futures contracts. Her primary interest is in a futures contract on a broad equity index that will expire 240 days from today. The closing price as of yesterday, January 17, for the equity index was 1,050. The expected dividends from the index yield 2% (continuously compounded annual rate). The effective annual risk-free rate is 4.0811%, and the term structure is flat. Norris decides that this equity index futures contract is the appropriate hedge for her client's portfolio and enters into the contract.

Upon entering into the contract, Norris makes the following comment to her client:

"You should note that since we have taken a short position in the futures contract, the price we will receive for selling the equity index in 240 days will be reduced by the convenience yield associated with having a long position in the underlying asset. If there were no cash flows associated with the underlying asset, the price would be higher. Additionally, you should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."

Sixty days after entering into the futures contract, the equity index reached a level of 1,015. The futures contract that Norris purchased is now trading on the Chicago Mercantile Exchange for a price of 1,035. Interest rates have not changed. After performing some calculations, Norris calls her client to let him know of an arbitrage opportunity related to his futures position. Over the phone, Norris makes the following comments to her client:

"We have an excellent opportunity to earn a riskless profit by engaging in arbitrage using the equity index, risk-free assets, and futures contracts. My recommended strategy is as follows: We should sell the equity index short, buy the futures contract, and pay any dividends occurring over the life of the contract. By pursuing this strategy, we can generate profits for your portfolio without incurring any risk."

Which of the following best describes the movement of the futures price on the 240-day equity index futures contract as the contract moves toward the expiration date?

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Lauren Jacobs, CFA, is an equity analyst for DF Investments. She is evaluating Iron Parts Inc. Iron Parts is a manufacturer of interior systems and components for automobiles. The company is the world's second largest original equipment auto parts supplier, with a market capitalization of $1.8 billion. Based on Iron Parts's low price-to-book value ratio of 0.9* and low price-to-sales ratio of 0.15x, Jacobs believes the stock could be an interesting investment. However, she wants to review the disclosures found in the company's financial footnotes. In particular, Jacobs is concerned about Iron Parts's defined benefit pension plan. The following information for 2007 and 2008 is provided.

Iron Parts has adopted SFAS No. 158, Employers' Accounting for Defined Benefit Pensions and Other Postretirement Plans.

Jacobs wants to fully understand the impact of changing pension assumptions on Iron Parts's balance sheet and income statement. In addition, she would like to compute Iron Parts's economic pension expense.

As of December 31, 2008, the funded status of Iron Parts's pension plan was:

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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.

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Michelle Norris, CFA, manages assets for individual investors in the United States as well as in other countries. Norris limits the scope of her practice to equity securities traded on U .S . stock exchanges. Her partner, John Witkowski, handles any requests for international securities. Recently, one of Norris's wealthiest clients suffered a substantial decline in the value of his international portfolio. Worried that his U .S . allocation might suffer the same fate, he has asked Norris to implement a hedge on his portfolio. Norris has agreed to her client's request and is currently in the process of evaluating several futures contracts. Her primary interest is in a futures contract on a broad equity index that will expire 240 days from today. The closing price as of yesterday, January 17, for the equity index was 1,050. The expected dividends from the index yield 2% (continuously compounded annual rate). The effective annual risk-free rate is 4.0811%, and the term structure is flat. Norris decides that this equity index futures contract is the appropriate hedge for her client's portfolio and enters into the contract.

Upon entering into the contract, Norris makes the following comment to her client:

"You should note that since we have taken a short position in the futures contract, the price we will receive for selling the equity index in 240 days will be reduced by the convenience yield associated with having a long position in the underlying asset. If there were no cash flows associated with the underlying asset, the price would be higher. Additionally, you should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."

Sixty days after entering into the futures contract, the equity index reached a level of 1,015. The futures contract that Norris purchased is now trading on the Chicago Mercantile Exchange for a price of 1,035. Interest rates have not changed. After performing some calculations, Norris calls her client to let him know of an arbitrage opportunity related to his futures position. Over the phone, Norris makes the following comments to her client:

"We have an excellent opportunity to earn a riskless profit by engaging in arbitrage using the equity index, risk-free assets, and futures contracts. My recommended strategy is as follows: We should sell the equity index short, buy the futures contract, and pay any dividends occurring over the life of the contract. By pursuing this strategy, we can generate profits for your portfolio without incurring any risk."

Sixty days after the inception of the futures contract on the equity index, Norris has suggested an arbitrage strategy. Evaluate the appropriateness of the strategy. The strategy is:

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