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d. Which structure would you recommend for XYZ?
e. What types of investors might be interested in acquiring a bear floater? If an investor™s motive
was to hedge exposure to LIBOR, what might its balance sheet look like?
3. CFA Examination Level III
On June 30, 1996, Help for Students (HFS) Foundation owns $10 million (face amount) of 6 per-
cent coupon SteelCo. bonds, currently priced at par, which it must hold to maturity on June 30,
1998, two years from now. John Ames, HFS™s fixed-income manager, expects that the yield curve,
now normal in shape (i.e., positively sloped), will undergo an upward shift and invert sometime prior
to maturity. He wishes to enter into a swap on the $10 million notional amount of the holding to take
advantage of this yield curve forecast. Assume that HFS™s policy permits such action.


Price Yield

September 1996 Eurodollar future 94.9 5.1%
2-year swap fixed rate n/a 5.5

a. Identify and explain an interest rate swap arrangement that could achieve Ames™s goal in this
particular instance. Base your response on the preceding data and assume quarterly cash flows.
b. Describe the direction and calculate the amount of the first quarterly cash flow (on September
30, 1996) under this arrangement. (Note: Assume that 90-day spot LIBOR on June 30, 1996,
equals the September 1996 Eurodollar futures contract settlement yield.)
c. Explain the effect of the interest rate swap created in Part a on the sensitivity of HFS™s portfolio
value to interest rate changes.
d. Describe the role of the Eurodollar forward rate curve in pricing the fixed-rate payment side of
the interest rate swap created in Part a.
e. Identify a strategy that would use options to replicate the position of a fixed-rate payer in a swap
and explain how this strategy would accomplish its purposes. (Assume no transaction costs.)
4. CFA Examination Level II (2002)
Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to manage the
company™s financial risks.
Two years ago, Rone is issued a $25 million (U.S.$), five-year floating rate note (FRN). The
FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-callable
and will be repaid at par at maturity.
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Scott expects interest rates to increase and she recognizes that Rone could protect itself against
the increase by using a pay-fixed swap. However, Rone™s Board of Directors prohibits both short
sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combi-
nation of capital market instruments.
A. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the required
B. Explain how the transactions in Part A are equivalent to using a pay-fixed swap.
5. CFA Examination Level II (2002)
Rich McDonald, CFA, is evaluating his investment alternatives in Ytel Incorporated by analyzing a
Ytel convertible bond and Ytel common equity. Characteristics of the two securities are given in
Exhibit 23-1.
A. Calculate, based on Exhibit 23-1, the:
i. Current market conversion price for the Ytel convertible bond
ii. Expected one-year rate of return for the Ytel convertible bond
iii. Expected one-year rate of return for the Ytel common equity
Note: Your responses should ignore taxes and transaction costs.
One year has passed and Ytel™s common equity price has increased to $51 per share. Also, over the
year, the interest rate on Ytel™s non-convertible bonds of the same maturity increased, while credit
spreads remained unchanged.
B. Name the two components of the convertible bond™s values. Indicate whether the value of each
component should decrease, stay the same, or increase in response to the:
i. Increase in Ytel™s common equity price
ii. Increase in interest rates

Exhibit 23.1 Ytel Incorporated Convertible Bond and Common Equity Characteristics

Characteristic Convertible Bond Common Equity

Par Value $1,000 ”-
Coupon (Annual Payment) 4% ”-
Current Market Price $980 $35 per share
Straight Bond Value $925 ”-
Conversion Ratio 25 ”-
Conversion Option At any time ”-
Dividend ”- $0
Expected Market Price in One Year $1,125 $45 per share


1. CFA Examination Level III (2002)
Maxwell Arnold recently joined Top-Mark Investments Inc. (TMI) as a senior analyst. TMI is a
conservative institution, which has invested only in equities and fixed income securities.
Recently, TMI™s returns have been lower than those of its competitors. A member of TMI™s In-
vestment Committee tells Arnold that alternative assets might be used to enhance TMI™s perfor-
mance. However, the Investment Committee has not changed its traditional aversion to risk. The
Committee asks Arnold to evaluate investing in hedge funds or controlled-risk equity strategies to
increase returns without excessive exposure to risk.
Arnold™s report to the Committee contains the following statements:
1. Classic hedge funds tend to use long and short positions in publicly traded securities, with
the primary goal of being market-neutral. This strategy allows such funds to focus on stock
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2. Like classic hedge funds, current hedge funds are privately organized, pooled investment
vehicles that use leverage. Unlike classic hedge funds, current hedge funds also take posi-
tions in derivatives on publicly traded securities.
3. Macro funds use forward and futures contracts to take investment positions in currency,
bond, and/or equity markets. Because the currencies and indexes in which macro funds trade
are closely correlated, these funds are able to use very high levels of leverage.
4. Hedge fund managers often use complicated computer models to manage their portfolios.
Errors in analyzing data or recording positions can lead on delta, gamma, and vega risks.
A. Indicate one inaccuracy in each of Arnold™s statements.
The Committee also asks Arnold to investigate potential risks inherent in hedge fund strategies:
Arnold focuses on three such risks:
• Liquidity risk
• “Herd” risk
• Redemption risk
In his report to the Committee, Arnold concludes that liquidity risk and “herd” risk are important
performance factors in hedge fund investing, but that redemption risk is not an important factor
because of the structure of hedge funds.
B. Indicate whether Arnold™s conclusion about the importance of each of the three risks is correct or
incorrect. Justify each of your responses with one reason.
2. CFA Examination Level III (2002)
Maxwell Arnold is also preparing a report about controlled-risk equity strategies for the Investment
Committee of Top-Mark Investments Inc. He decides to compare the use of long-only, long-short
(market-neutral), and equitized long-short strategies. Arnold knows that his report to the Committee
must address the following questions:
1. Is the long or the short side of a long-short strategy more likely to allow a manager to profit
from security mispricings, and why?
2. What is the manager™s value-added or payoff from a market-neutral strategy, and what are
the components of the payoff?
3. How do a long-only strategy and a long-short strategy differ with regard to the importance of
benchmark holdings if the investor is particularly concerned about the residual risk of each
4. How might a manager equitize a long-short strategy without disturbing current portfolio
5. How do risk levels differ between long-only and long-short management in terms of maxi-
mum potential losses?
6. When implementing international long-short strategies, are correlations between strategy
returns or country market returns more important to consider, and why?
Formulate one correct response to each of Arnold™s questions.


1. A fund had an overall performance value of “0.50 percent using the Fama performance technique.
Discuss whether the manager of this fund could have experienced a positive selectivity value and
under what conditions that value might have occurred.
2. A portfolio has an R2 with the market of 0.95 and a selectivity value of 2.5 percent. Would you
expect this portfolio to have a positive or a negative net selectivity value? Explain.
3. CFA Examination Level III
You have been asked to evaluate the performance of two portfolios: Good Samaritan Hospital™s
endowment assets and estate fund of the recently deceased Mrs. Mary Atkins, which has just been
transferred in a bequest to Good Samaritan. The existing Good Samaritan endowment assets
(excluding the Atkins estate) have been managed by an investment counseling firm with an income
objective of approximately 5 percent annually. The returns from this portfolio and from Mrs. Atkins™
portfolio are shown in the following table:
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50 Web Problems

Latest Fiscal Year Beta
Total Return

Good Samaritan existing endowment assets
”Equity only 11.8% 1.20
”Total portfolio 8.4
Mrs. Atkins™ portfolio
”Equity only 10.7% 1.05
”Total portfolio 5.1

S&P 500 Index 9.9%
Lehman Bond Index 3.4
90-day Treasury bills 7.8
Municipal Bond Index 1.4

a. Calculate the risk-adjusted return of each of the two equity-only portfolios. Compare these
returns to each other and to the S&P 500, and explain the significance of any differences.
b. List and briefly comment on three factors that could account for the difference in reported
performance between Mrs. Atkins™ and Good Samaritan™s total portfolios.


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