. 7
( 12 .)


new agreement was announced. She believes that Rio National™s required rate of return (cost of eq-
uity) is 13.5 percent.
Calculate the present value of growth opportunities (PVGO) reflected in Rio National™s share
price after the agreement was announced. Show your calculations. [6 minutes]


1. CFA Examination Level III
Giselle Donovan is the newly appointed Chief Financial Officer of Bontemps International (BI), an
import/export firm conducting a worldwide trading business from its principal office in New York.
BI is a financially healthy, rapidly growing firm with a young workforce. All liabilities are denomi-
nated in U.S. dollars. Its ERISA-qualified defined-benefit pension plan is structured as follows:

Percent Prior Year
Allocation Total Return

Higher-Risk Asset Classes
U.S. equities (large capitalization) 35% 10.0%
U.S. equities (small capitalization) 10 12.0
International equities 5 7.0
Total equities 50%
Lower-Risk Asset Classes
U.S. Treasury bills (1-year duration) 10% 4.5
U.S. intermediates and mortgage-backed
securities (4-year duration) 39 1.0
U.S. long-term bonds (10-year duration) 1 19.0*
Total fixed income 50%
Total 100% 10.0%
Present value of plan liabilities $298 million
Market value of plan assets $300 million
Surplus $ 2 million
Duration of liabilities 10 years
Actuarial return assumption 7.0%
BI Board™s long-term total return objective 9.0%

*Income element 7.0%, gain element 12.0%.

The Board is concerned about the pension portfolio™s downside risk and wants to adopt a formal pol-
icy for rebalancing the plan™s assets in response to fluctuations in market values. Donovan asks you
to review the major strategies that the Board should consider. You are aware of three strategies used
05-152 Webpages pp2 12/5/05 9:14 AM Page 28

28 Web Problems

to reallocate between higher-risk and lower-risk assets: “Constant Mix,” “Constant Proportion,” and
“Buy and Hold.”
a. Describe the primary characteristics of each of these three strategies as they relate to changes in
market values. Identify the market environment in which each strategy should provide the best
relative performance.
b. Recommend one strategy for the Board™s consideration, taking their concerns into account. Justify
your choice.


1. CFA Examination Level II
The shape of the U.S. Treasury yield curve appears to reflect two expected Federal Reserve reduc-
tions in the Federal Funds rate. The first reduction of approximately 50 basis points (BP) is expected
six months from now, and the second reduction of approximately 50 BP is expected one year from
now. The current U.S. Treasury term premiums are 10 BP per year for each of the next three years
(out through the three-year benchmark.)
You agree that the two Federal Reserve reductions described will occur. However, you believe
that they will be reversed in a single 100 BP increase in the Federal Funds rate 21„2 years from now.
You expect term premiums to remain 10 BP per year for each of the next three years (out through
the three-year benchmark.)
a. Describe or draw the shape of the Treasury yield curve out through the three-year benchmark.
(Note to Candidates: Be sure to label your axes and relevant data points carefully.) [4 minutes]
b. State which term structure theory supports the shape of the U.S. Treasury yield curve described
in Part a. Justify your choice. [6 minutes]
Kent Lewis, an economist, also expects two Federal Reserve reductions in the Federal Funds
rate but believes that the market is too optimistic about how soon they will occur. Lewis believes
that the first 50 BP reduction will be made 1 year from now and that the second 50 BP reduction
will be made 11„2 years from now. He expects these reductions to be reversed by a single 100 BP
increase 21„2 years from now. He believes that the market will adjust to reflect his beliefs when
new economic data are released over the next two weeks.
Assume you are convinced by Lewis™s argument and are authorized to purchase either the two-
year benchmark U.S. Treasury or a Cash/three-year benchmark U.S. Treasury barbell weighted
to have the same duration as the two-year U.S. Treasury.
c. Select an investment in either the two-year benchmark U.S. Treasury (bullet) or the Cash/three-
year benchmark U.S. Treasury barbell. Justify your choice. [5 minutes]
2. CFA Examination Level III
Charles Investment Management, Inc., a fixed-income manager of U.S.-only portfolios, has pro-
vided significant excess returns for its clients through duration and sector management. The firm
defines sectors as either government bonds or corporate bonds. Several of the manager™s clients have
asked the firm about the possibility of investing in international fixed-income markets. These clients
mention the favorable performance of these markets, as exemplified by the “international fixed-
income aggregate index” in the accompanying table. The clients are asking Charles to transfer the
same management techniques that it has successfully applied in the U.S. market to international
fixed-income markets.


Bond Index One Year Five Years

International fixed-income aggregate index, unhedged 1.0% 15.9%
International fixed-income aggregate index, hedged 6.5 7.2
05-152 Webpages pp2 12/5/05 9:14 AM Page 29

Chapter 18

a. Infer from the preceding table the effect of changes in the U.S. dollar on international fixed-in-
come returns for U.S. investors in the past one-year and five-year periods. [6 minutes]
b. Explain why the firm™s techniques to generate excess returns through duration and sector man-
agement in U.S. fixed-income markets may not be transferrable to international fixed-income
markets. [6 minutes]
3. CFA Examination Level II
The following are the average yields on U.S. Treasury bonds at two different points in time:


Term to Maturity January 15, 19XX May 15, 19XX

1 year 7.25% 8.05%
2 years 7.50% 7.90%
5 years 7.90% 7.70%
10 years 8.30% 7.45%
15 years 8.45% 7.30%
20 years 8.55% 7.20%
25 years 8.60% 7.10%

a. Assuming a pure expectations hypothesis, define a forward rate. Describe how you would calcu-
late the forward rate for a three-year U.S. Treasury bond two years from May 15, 19XX, using
the actual term structure provided. [3 minutes]
b. Discuss how each of the three major term structure hypotheses could explain the January 15,
19XX, term structures shown. [6 minutes]
c. Discuss what happened to the term structure over the time period and the effect of this change on
U.S. Treasury bonds of 2 years and 10 years. [5 minutes]
d. Assume that you invest solely on the basis of yield spreads and, in January 19XX, acted upon the
expectation that the yield spread between 1-year and 25-year U.S. Treasuries would return to a
more typical spread of 170 basis points. Explain what you would have done on January 15,
19XX, and describe the result of this action based upon what happened between January 15,
19XX, and May 15, 19XX. [7 minutes]
4. CFA Examination Level III
Emily Maguire, manager of the actively managed nongovernment bond portion of PTC™s pension
portfolio, has received a fact sheet containing data on a new security offering. It will be a bond
issued by a U.S. corporation but denominated in Australian dollars (A$), with both principal and
interest payable in that currency.
The terms of the offering made in June 1992 are as follows:
• Issuer”Student Loan Marketing Association (SLMA”a U.S. government sponsored corpora-
• Rating”AAA
• Coupon Rate”8.5 percent payable quarterly
• Price”par
• Maturity”June 30, 1997 (noncallable)
• Principal and interest payable in Australian dollars (A$)
As an alternative, Maguire finds that five-year U.S. dollar pay notes issued by SLMA yield 6.75 percent.
She prepares an analysis directed at several specific questions, beginning with the following table
of economic data for Australia and the United States.
05-152 Webpages pp2 12/5/05 9:14 AM Page 30

30 Web Problems


Major Economic Indicators 1990 1991 1992E 1990 1991 1992E

20.5% 20.5%
Real GNP (annual change) 1.1% 2.2% 1.6% 3.0%
Consumer expenditures (annual change) 0.9% 0.0% 1.0% 1.1% 2.0%
Inflation (annual change) 5.4% 4.2% 3.4% 7.3% 3.2% 3.9%
Long-bond yield (end of year) 8.1% 7.2% 7.0% 9.8% 10.0% 10.2%
2100 283 280 230 220 275
Trade balance (U.S. $ billions)

Assuming that interest rates fall 100 basis points in both the U.S. and Australian markets over the
next year, identify which of these two bonds will increase the most in value, and justify your answer.
[7 minutes]
5. CFA Examination Level III
TMP is working with the officer responsible for the defined-benefit pension plan of a U.S. company.
She has come to the firm for advice on what she calls “the key elements of non-U.S. dollar fixed-
income investing.”
The following information, based on TMP™s assessment of the Italian market, has been developed
to illustrate the process by which market and currency expectations are integrated.


Expected Yield
Modified Current Current to Maturity in
Security Duration Price Yield to Maturity Three Months

Bill 0.25 100.00 12.50% 12.50%
Note 6.00 100.00 10.00% 9.00%


Expected Rate
Current Rate in Three Months

L1500/$1.00 (US) L1526/$1.00 (US)

Based on the information provided, calculate the expected return (in U.S. dollars) on each security
over the three-month period. [9 minutes]
6. CFA Examination Level I
During 1990, Disney issued $2.3 billion face value of zero coupon subordinated notes that resulted
in gross proceeds of $965 million. The notes
• mature in 2005;
• can be exchanged for cash by the note holder at any time for the U.S. dollar equivalent of the cur-
rent market value of 19.651 common shares of Euro Disney per $1,000 face value of notes; and
• are callable at any time at their issuance price plus accrued interest.
On March 11, 1993, Disney called the notes at a price of $483.50, which is equivalent to a yield to
maturity of 6 percent. On the call date, Euro Disney common stock traded at a price of 86.80 French
francs per share and the currency exchange rate for U.S. dollars ($US) to French francs (Ffr) was:


Exchange rate .1761 5.6786
05-152 Webpages pp2 12/5/05 9:14 AM Page 31

Chapter 18

a. Calculate, as of the call date,
(1) the price of a share of Euro Disney expressed in U.S. dollars; and
(2) the exchange value (conversion value) of a $1,000 face value note in U.S. dollars.
[6 minutes]


. 7
( 12 .)