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Level III CFA® Program Question of the Day

Please Note: the dates below are based on the North American Central Time Zone.

September 27 | Answer: B




The use of appraisal data, relative to actual returns, results in correlations that are biased downwards and standard deviations that are biased downwards. The reason is that price fluctuations are masked by the use of appraised data.

September 26 | Answer: A




Most bond trading is done OTC through dealers, unlike stock traded on exchanges. Capital requirements have increased for dealers post-2008. The higher capital cost has reduced dealers' willingness to hold large bond inventories and increased the bid-ask spread charged by dealers. The result is that bond market liquidity has declined.
Fixed-income markets are much larger than equity markets – more bond issues are outstanding and the characteristics of individual bonds vary widely. This generally makes full replication impractical.
Outside of the U.S., many bond transactions that do occur are not publicly reported, making reliable price and volume data more difficult to obtain. In contrast, public equities are traded on exchanges so all transactions must be publicly reporting, making reliable price and volume easier to obtain.

September 25 | Answer: B




Given that the trader is looking to take advantage of an increase in volatility with uncertain direction, a long straddle with at-the-money calls and puts is most appropriate. This is an expensive strategy but would be beneficial if the volatility is high.
A short straddle is a neutrality play and would result in potentially large losses under highly volatile share prices. A bull call spread does not allow the trader to benefit from a decline in share price.

September 24 | Answer: A




The ability of plan participants to switch or take early withdrawals from the plan increases the plan's liquidity needs. Liquidity needs are high for pension plans with older workers because they will require greater cash flows to pay retirees.

September 23 | Answer: A




The risk-adjusted TAA portfolio's effectiveness is best assessed by plotting its realized risk and return against the risk and return of the portfolios along the SAA portfolio's efficient portfolio. Even if the TAA portfolio had better Sharpe and information ratios than the SAA portfolio, it could still be less optimal than other portfolios along the SAA's efficient frontier.

September 22 | Answer: C




As a CFA Institute member, Feldman is bound, under Standard I(A), not to "knowingly participate or assist in any violation of such laws, rules, or regulations." Since it should be clear that releasing bogus financial information is in contravention of laws, rules, and regulations, and since he knows that the data is purposely distorted, he must not release the data to the public. Doing so places him in violation of the Code and Standards.

September 21 | Answer: A




With an employee stock ownership plan (ESOP), Nelita would sell all of her shares to the ESOP, which in turn would sell the shares to the company employees. With over 500 employees, the total purchase price is spread over many individuals which makes her realization of the full proceeds more likely. Therefore, the ESOP would most likely provide Nelita with the necessary funds to fully retire and she would have no future commitments to the company.
With an initial public offering (IPO), Nelita would sell a portion of her shares to the public and transform the remaining shares into liquid public shares. Generally, IPO purchasers will expect the owner to retain a significant ownership stake and continue to manage the business, which are both completely against Nelita's objective of obtaining access to all her funds and fully retiring.
A personal line of credit could be provided to Nelita whereby she borrows the funds from the bank and pledges her company stock as collateral. Although it may provide her access to most or all of her desired amount, she still owns the company shares and would still be responsible for managing the company, which is against her objective of fully retiring.

September 20 | Answer: C




First determine the new target beta by multiplying the current beta of the portfolio which is
0.95 by 1.4 to achieve a new target beta that is 40% greater than the current portfolio beta: (0.95)(1.4) = 1.33
Then use the equation:

[(BetaT - Betap) / Betaf][Vp / (Pf × multiplier)]
[(1.33 - 0.95) / 1](78,000,000) / (856)(250) = (0.38)(364.49) = 138.50, rounded to 139

September 19 | Answer: B




Shortening maturity is the correct strategy since credit premiums have been shown to be especially generous at the short end of the curve. Increasing the maturities of credit risky bonds would go against the empirical evidence about term and credit premiums. Moving from AA to AAA bonds would not be an effective way to take on increasing credit risk because that would be a move towards safer investments and away from the expertise of the fund.

September 18 | Answer: C




A pension is a non-marketable financial asset because the (vested portion of the) pension belongs to the individual who earned it. Inherently pensions are not traded assets (though it may be possible under some conditions to assign the future cash flows to another). In contrast the other two items are traded assets. Collectables have elements of personal consumption and utility but are considered marketable in that the value of such assets is set by auction markets or specialized dealers. Private equity is a business asset and although it may be relatively illiquid, it is considered a marketable asset.

September 17 | Answer: A




When markets are falling, it is better to hold cash and therefore, cash drag actually benefits the fund.
The benchmark is assumed to be fully invested, therefore, it is not subject to cash drag.
The use of futures contracts is an example of a derivatives strategy that can be used to provide equity exposure to a portfolio. That will avoid or reduce cash drag compared to if the portfolio were simply invested in cash.

September 16 | Answer: B




Look ahead bias occurs when using information that was unknown at the time to explain stock returns. In this case the market did not know in April of the earnings revision that was to come later in the year, hence stock returns for April should be regressed against the EPS that was known at the time, that being the $2 initially reported in March.

September 15 | Answer: C




As of now, the only purpose of verification is to give the GIPS compliant firm a competitive edge. Prospective clients will have more confidence in the claim of GIPS compliance.

September 14 | Answer: B




Quanta most likely would recommend buying put options on gold futures or credit default swaps (CDS) to execute a tail risk hedge.

September 13 | Answer: C




Standard III(A) Loyalty, Prudence, and Care requires members acting as advisors to make a reasonable inquiry into the client's investment experience, risk and return objectives, and financial constraints before making investment recommendations. Investment decisions must be made based on a total portfolio approach, rather than the quality of an individual investment in isolation. Some members are not acting as investment advisors and may only have a duty to provide best execution of client orders.

September 12 | Answer: C




The collateral for a CDO is frequently corporate bonds, so there is little diversification benefits for a corporate bond portfolio manager to include CDOs in their portfolio.

September 11 | Answer: C




When an owner sells his position to the existing employees of a company, generally the buyers will only purchase at a discount.
The buyers may lack financial resources and expect the existing owner to finance a significant portion of the purchase with a loan or promissory note. The promissory note is often contingent on future performance of the business with no assurance current employees or managers are capable of running the business and making the payments.

September 10 | Answer: C




At the trough of the business cycle, analysts should recommend an increase to equity exposure since equities tend to perform well as business conditions improve. With interest rates expected to rise, an analyst should recommend reducing portfolios' bond exposures and durations since bonds tend to underperform when interest rates rise. Analysts may recommend a barbell strategy (increase short-term and long-term bond exposure and reduce intermediate maturities).

September 9 | Answer: C




A coupon-paying bond will have a Macaulay duration less than the term. Therefore, the duration in this case is less than the investment horizon. When duration is less than investment horizon, an increase in interest rates will benefit the portfolio due to reinvestment at the higher rate, resulting in a realized return that is greater than initially expected.

September 8 | Answer: B




There are only two requirements that are needed to achieve immunization for multiple liabilities. The money duration (BPV) of the assets and the liabilities must match and the convexity of the assets must be larger than the convexity of the liabilities.

September 7 | Answer: A




Standard VI(C) says that a member must reveal information both on fees she receives for referring clients to other professionals and those she pays for having clients referred to her before a prospect becomes a client. This allows the prospect to evaluate any partiality of a recommendation and the full cost of the services.

September 6 | Answer: B




The present value of future expected outflows due to lifestyle expenses would likely be the largest liability on an economic 'holistic' balance sheet for most individuals. The younger person may or may not have explicit debts such as student loans or a mortgage, but even if they do the PV of other future living expenses for their remaining life would likely be larger.

September 5 | Answer: B




Relative to other hedge fund strategies, distressed debt takes a long time to work out as legal proceedings grind through the system. Distressed debt can generate spectacular investment returns or complete losses.

September 4 | Answer: A




Having the Platinum account is a benefit from her managing the endowment, which led to the relationship with Advisors. Members should report to their employers any additional compensation or benefits they receive for their services. This must be in writing. Doing
$2,500 in business alone will not negate her obligation unless she explicitly tells Advisors that she is willing to accept whatever penalties accompany a Platinum account when a client does less business.

September 3 | Answer: B




Consistency over various time horizons is referred to as intertemporal consistency. Cross- sectional consistency refers to consistency across asset classes.

September 2 | Answer: A




A carry trade is a form of leverage. In a stable downward-sloping curve, rates are falling as time/term increases. Therefore, an appropriate strategy would be to borrow at lower longer- term rates to invest at higher shorter-term rates.

September 1 | Answer: A




Stimulative monetary policy will result in lower short-term rates. Restrictive fiscal policy will slow economic activity, thus likely reducing rates in the future. The net result is a moderately steep yield curve. If both were stimulative, the yield curve would rise sharply and be very steep. An inverted yield curve is normally the result of restrictive monetary and fiscal policy.

August 31 | Answer: A




According to behavioral finance, investors will diversify the portfolio for their defined contribution pension using 1/n diversification. In 1/n diversification, an employee puts an equal amount in each fund on the employer's defined contribution pension plan menu. For example, if there are eight mutual funds available, the employee will put one-eighth of their contribution in each fund. Note that in the U.S., an employer cannot force an employee to put more than 10% of their retirement funds in company stock.

August 30 | Answer: C




UIP states that exchange rate changes between countries should equal the differences in their nominal interest rates. Successful carry trades are violations of UIP. A carry trade involves borrowing in a low interest rate currency and lending in a high interest rate currency.

August 29 | Answer: C




Assets subject to the highest rates of tax should be first allocated to tax advantaged accounts. Interest on high yield bonds is typically taxed at a higher rate than dividend income which in turn is taxed at a higher rate than capital gains. Vustings should therefore allocate high-yield bonds first to the retirement account, and leave the high growth equity in the taxable account.

August 28 | Answer: B




Equities tend to do well from a point when the economy is at a trough because future economic expansion positively impacts returns. An increase in integration will reduce the risk of the equity market, thus reducing required returns. The reduction in required returns will increase equity prices and result in higher returns over the period of increased integration.

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