# Thread: Sample CFA Level 2 question bank for June 2013 exam

1. Item set for 25-March (Derivatives):

Alvaro Rosenbluth Case Scenario

Alvaro Rosenbluth, CFA, is a derivatives analyst in Copernicus Inc. Copernicus Inc. is a fund management company which primarily deals in derivatives to provide excess risk-adjusted returns to its clients. The company also provides consulting and management services to its clients.

One of the clients has come to the company for some advice. Alvaro is dealing with the client. The client, Paparica Drom, plans to enter into an interest rate swap. He has found one trustable counter party for the swap. The swap is for 1 year. Paparica would enter into the swap as fixed rate receiver and floating rate payer. The interest amount is to be paid quarterly. The total amount to be swapped is \$100 million.

Paparica will get 6% annual coupon rate from the fixed payer side. The floating rate has been decided as LIBOR plus 1.0% spread. The LIBOR rates are given in Exhibit 1.

Exhibit 1

 90 days LIBOR 4.5% 180 days LIBOR 5.0% 270 days LIBOR 5.5% 360 days LIBOR 6.0%

Paparica wants to know the value of swap. Alvaro explains that the value of swap at the beginning is zero if we calculate the swap rate which makes the payments equal to the payments from the floating rate party. However, in case the fixed interest rate is different than the swap rate, the swap will have some value to one of the party.

Paparica inquires about the other methods by which we can simulate the payoffs of a swap contract. Alvaro answers his query by stating the following statements:

Statement 1: The swap is a series of forward rate agreements.
Statement 2: We can simulate the payoffs of swap contract by entering into different forward rate agreements for each settlement period of the swap.
Statement 3: We can simulate each forward rate agreement by entering into the interest rate options. For example, if we are a fixed receiver and floating payer, we can long interest rate call option and short interest rate put option to simulate the payoffs.

Another client, Rose Edmund, is concerned about the future exchange rate of currency. She is expecting to receive GBP 2 million after 6 months. She is a US resident. The current exchange rate between the GBP and USD is 1.8USD/GBP. She wants to sell 6-month forward contracts on the currency so that she can lock in the exchange rate. The interest rates in USA and GBP are given in Exhibit 2.

Exhibit 2
 Currency 6-month interest rate (annual) GBP 2.8% USD 4.2%

Alvaro calculates the forward price for her and tells her the price. She takes position into the forward contract. At the end of 6 months, the exchange rate becomes 1.82USD/GBP.

Alvaro is managing portfolio of one of the clients. The client has advised him to take leveraged position by forwards and futures only. He looks at two stocks which are trading at the same price but the volatility and dividend payments are different for both the stocks. One stock (A) is expected to pay a dividend of \$2 per share after 200 days and other stock (B) is expected to pay a dividend of \$2.05 per share after 300 days. The risk free rate is 6% per annum. He wants to take a position into 6-month futures contract. The volatility of stock A is 30% per annum and that of stock B is 20% per annum.

1. What is the value of the swap to Paparica Drom at the initiation of the swap contract?
a) -\$773,947
b) \$56,256
c) \$142,020

2. What is the annual spread earned by Paparica on entering into the swap?
a) 0.15%
b) -0.80%
c) -0.85%

3. Which of the following statements is least accurate by Alvaro regarding the simulation of payoff of swap contract?
a) Statement 2
b) Statement 3
c) All statements are correct

4. What is the total gain/loss of Rose by entering into the currency forward contract?
a) -\$15,569.3
b) -\$64,266.0
c) \$9,027.2

5. Which of the futures contact of the stocks will have a higher price?
a) Stock A because it has higher volatility
b) Stock B because it has lower present value of dividends
c) Both will have the same futures price

6. What is the forward exchange rate locked in by Rose?
a) 1.7879 GBP/USD
b) 1.8122 GBP/USD
c) 1.8245 GBP/USD  Reply With Quote

2. The answer for 25th March :-

1. a
2. c
3. a
4. b
5. a
6. c  Reply With Quote

3. Originally Posted by Konvexity Institute Solutions to Item set for 24-March:

1. Correct Answer is C: Swap rate for dollar denominated loan = (1-z4)/ (z1+z2+z3+z4). z1=1/ (1+0.0350*180/360) = 0.9828. z2 = 1/ (1+0.038*360/360) = 0.9634. z3= 1/ (1+0.042*540/360) = 0.9407. z4=1/ (1+0.045*720/360) = 0.9174. Swap rate = 0.0217*360/180 = 4.34%.
For JPY denominated loan, z1=1/ (1+0.012*180/360) = 0.9940. z2=1/ (1+0.015*360/360) = 0.9852. z3=1/ (1+0.017*540/360) = 0.9751. z4= 1/ (1+0.02*720/360) = 0.9615.Swap rate = 0.0098*360/180 = 1.96%.
2. Correct Answer is B: Semi-annual coupon for dollar-denominated bond = 0.0217*500,000,000/92 = \$117,955. Semi-annual coupon for JPY denominated loan = JPY500, 000,000*0.009822= JPY 4910907. The value of dollar denominated bond = 117,955/ (1+0.052*90/360) + (500,000,000/92 + 117,955)/ (1+0.06*270/360) = \$5,430,066. The value of JPY denominated loan = 4,910,907/ (1+0.021*90/360) + (500,000,000 + 4,910,907)/ (1+0.023*270/360) = JPY501, 234,149 = \$501,234,149/88 = \$5,695,842.5. The value of swap to the company = 5,695,842.5 – 5,430,066 = \$265,776.5.
3. Correct Answer is A: At the end of the contract, the USD loan party has to pay \$500,000,000/92 + \$117,955 = \$5,552,738.2. The JPY loan party has to pay = JPY500, 000,000 + JPY4, 910,907 = JPY504, 910,907 = \$5,610,121.6. The value of swap to the company = 5,610,121.6 – 5,552,738.2 = \$57,383.4.
4. Correct Answer is C: The Company has a net liability exposure for floating interest rate payment i.e. it is floating rate payer. To lock-in the maximum fixed rate, the company can enter into the 1X5 payer swaption i.e. the company has the option to enter into the swap as the fixed rate payer and receive the floating rate.
5. Correct Answer is C: Statement 2 is correct.
6. Correct Answer is C: The currency swap contract is most likely to have a higher credit risk at the end of the contract because the most of the credit risk arises due to the change in the exchange rate.

Sir, please more explain pt 4 & 6.  Reply With Quote

4. I have been following this thread and I think Konvexity Institute is providing really good quality level 2 sample questions. It will be really useful to anyone preparing for CFA Level 2. Thanks a lot!   Reply With Quote

5. Solutions to Item set for 25-March:

1. Correct Answer is A: The value of floating rate bond = \$100 million. The quarterly coupon received by Paparica = 0.06*90/360*\$100 million = \$1.5 million. z1=1/ (1+0.055*90/360) = 0.9864. z2= 1/ (1+0.06*180/360) =0.9709. z3= 1/ (1+0.065*270/360) = 0.9535. z4=1/ (1+0.07*360/360) = 0.9346. Value of fixed rate bond = \$1.5 million*(0.9864+0.9709+0.9535+0.9346) + \$100 million*0.9346 = \$99,230,077. Note that we have used LIBOR+1% in our calculations. The value of swap for Paparica = 99,226,053 – 100,000,000 = -\$773,947.
2. Correct Answer is B: The swap rate = [(1-z4) / (z1 + z2 + z3 +z4)]*(360.90) = 6.80%. Paparica is receiving a fixed rate of 6%. The spread earned by him = 6.00-6.80 = -0.80%.
3. Correct Answer is B: Statement 3 is inaccurate. A fixed rate receiver and floating rate payer will simulate the swap payoff by taking a long position in interest rate put option and short position in interest rate call option.
4. Correct Answer is A: The exchange rate at the end of 6 months = 1.82 USD/GBP. The forward contract rate locked in by Rose = 1.8122 USD/GBP (check solution to the last question). Total loss = (1.8122-1.82)*2 million = \$15,569.3.
5. Correct Answer is C: Both will have the same futures price. The future price is not impacted by the volatility of the stocks, the option value is impacted. The dividends will impact only if the dividend payment dates are within the contract period.
6. Correct Answer is B: The forward exchange rate = 1.80*(1.042/1.028)0.5 = 1.8122 USD/GBP.  Reply With Quote

6. Item set for 26-March (Derivatives):

Glori Smith Case Scenario

Glori Smith is concerned about the movement of stock market in coming future. The movement of stocks will depend on the outcome of ECB (European Central Bank) quarterly meeting where they will discuss about the PIIGS nations and the steps to avoid the crisis in the European Union.

She has 100,000 shares of Maxeye Construction Company which is into construction business and is affected by the macroeconomic factors. She wants to protect her portfolio value. She asks her friend Rebecca Stewart who is a CFA level II candidate about the various positions which she can take to protect the value of her holdings.

Rebecca tells her that she could do it using futures, options or swaps.

She can short the futures contract having settle date beyond the meeting date of ECB which is after 55 days. After the passing of that date, she can accordingly take the position by studying the outcome of the meeting.

You can also protect your portfolio value by using covered call strategy where you can sell call options equal to the number of shares of the portfolio. You can also do the dynamic delta hedging to protect your portfolio value.

You can make a swap contract with some counter party which is ready to pay you fixed return on some stock and receive the return on your portfolio of stock.

Glori decides to enter into futures contract. She enters into 2 months contract. The price of the underlying stock and other details when she entered into the contract are given in Exhibit 1.

Exhibit 1

 Spot price \$12.00 Annual risk free rate 6.00% Initial Margin 20.00%

She shorts the futures contract. At the end of contract, the stock price moves to \$14.50 as the situation in Euro zone starts to improve.

She realized at the end of the period that she should have entered into a strategy which protects the downside movement without hindering the upside potential. On asking Rebecca about the same, she tells her that this could be possible by using options.

Glori also has a portfolio of fixed coupon bonds having exposure to PIIGS countries. She secured the portfolio of bond by buying CDS as advised by her friend Rebecca. She bought the CDS at 280 basis points. The CDS spread has now widened to 340 basis points. But the counter party of the CDS position defaults exposing her portfolio to credit risk.

Glori notices that the value of her bond portfolio has fallen because of the increase in interest rates. But she has not been compensated by the CDS party for the fall in this value. She now wants to enter into a position so that she could earn a floating interest rate and in turn can pay the change in her bond portfolio and the fixed rate to the other party.

On consulting her friend, she enters into a total return swap. In a total return swap, she would receive the floating rate payment on her portfolio and would pay the total return on her portfolio to the counter party.

1. Which of the ways told by Rebecca is least accurate for protecting the portfolio value?
a) Using futures
b) Using options
c) Using swaps

2. How much initial margin was paid by Glori to enter into the futures contract?
a) \$240,000
b) \$242,342
c) \$254,400

3. Which of the following options strategy would protect the downside movement without restricting the profits from the upside movement?
a) Covered call (Selling call options)
b) Condor (Selling call options and buying put options)
c) Protective put (Buying put options)

4. Which of the following risk has been taken care of in the total return swap?
a) Credit risk
b) Market risk
c) Both of the above

5. What kind of risk has been faced by Glori for her CDS position?
a) Double default risk
b) Replacement risk
c) Interest rate risk

6. What is the total profit/loss from the futures contract position taken by Glori?
a) Loss of \$238,289
b) Profit of \$238,289
c) Loss of \$250,000  Reply With Quote

7. Originally Posted by Prabir Bansal Sir, please more explain pt 4 & 6.
Dear Prabir,

Question 4: The company has a net liability exposure for floating interest rate which means that the company has to pay floating interest rate in the future. But the company is afraid that the interest rates might rise in the future. The company wants to lock-in the maximum interest rate and if the interest rate falls, then company can get benefited from that. So, the company will enter into swaptions rather than simple forward rate agreements. Remember that in swaptions, the company would have a right to enter into the swap and it would only enter when the swap would be profitable i.e. when the floating rate is high and fixed rate is less. The company will take a position into payer swaption where it has a right to enter into a swap as a fixed rate payer and floating rate receiver. The liabilities are for 4 years and will arise after one year. So, it has to enter into 1X5 payer swaption which means a payer swaption which would settle after 1 year and the underlying swap is of duration (5-1=) 4 years.

Question 6: In a currency swap, the currencies will be replaced at the end of the contract. In all other swap contracts (like interest rate swaps, equity swaps), nothing has to be exchanged at the end and thus there is little credit risk at the end of the period. But in case of currency swap, the currencies need to be replaced at the end of the contract. The currencies change in value during the swap period which leads to a high credit exposure for one party (the party in the profit). Thus, it is most likely to have a higher credit risk at the end of the swap period unlike other swap contracts which has higher credit risk during the middle of the swap period.  Reply With Quote

8. @Konvexity:- Nicely explained the solutions (Q-4 & 6). I must appreciate that the level of ur questions are extremely good.

1. b
2. c
3. b
4. a
5. c
6.a  Reply With Quote

9. Originally Posted by Konvexity Institute Dear Prabir,

Question 4: The company has a net liability exposure for floating interest rate which means that the company has to pay floating interest rate in the future. But the company is afraid that the interest rates might rise in the future. The company wants to lock-in the maximum interest rate and if the interest rate falls, then company can get benefited from that. So, the company will enter into swaptions rather than simple forward rate agreements. Remember that in swaptions, the company would have a right to enter into the swap and it would only enter when the swap would be profitable i.e. when the floating rate is high and fixed rate is less. The company will take a position into payer swaption where it has a right to enter into a swap as a fixed rate payer and floating rate receiver. The liabilities are for 4 years and will arise after one year. So, it has to enter into 1X5 payer swaption which means a payer swaption which would settle after 1 year and the underlying swap is of duration (5-1=) 4 years.

Question 6: In a currency swap, the currencies will be replaced at the end of the contract. In all other swap contracts (like interest rate swaps, equity swaps), nothing has to be exchanged at the end and thus there is little credit risk at the end of the period. But in case of currency swap, the currencies need to be replaced at the end of the contract. The currencies change in value during the swap period which leads to a high credit exposure for one party (the party in the profit). Thus, it is most likely to have a higher credit risk at the end of the swap period unlike other swap contracts which has higher credit risk during the middle of the swap period.
@Knovexity# Sir, u r gr8 U have very well explained the things. Sir, I sincerly request u to plz provide some lecture series... like notes/videos/articles etc

Regards,
Prabir Bansal.  Reply With Quote

10. The solu for 26th :-

1. C
2. A
3. C
4. B
5. A
6. B  Reply With Quote

cfa level 2 