2013LevelIIIMockExam

The2013LevelIIICharteredFinancialAnalyst(CFA?)MockExaminationhas60questions.Tobestsimulatetheexamdayexperience,candidatesareadvisedtoallocateanaverageof18minutesperitemset(vignetteand6multiplechoicequestions)foratotalof180minutes(3hours)forthissessionoftheexam.

Questions

Topic

1–12

EthicalandProfessionalStandards

13-18

RiskManagement

19-24

EquityPortfolioManagement

25-30

PerformanceAttribution

31-36

FixedIncomePortfolioManagement

37-48

RiskManagementApplicationsofDerivatives

49-54

PortfolioManagementofGlobalBonds

55-60

GlobalInvestmentPerformanceStandards

Total:

180

Questions1to12relatetoEthicalandProfessionalStandards

SueKimCaseScenario

SueKim,CFA,isahedgefundmanagerwhospecializesinbiotechnologystocks.Kimhasspentmany

yearsinvestinginbiotechcompaniesandinthepast,workedasanequityportfoliomanagerforalargebankwithsubstantialresearchcapabilities.Twoyearsago,Kimstartedahedgefund,GreenNoteInvestments.Shemanagesaccountsforseveralwealthyindividuals.Nowthatshenolongerhastheresourcesofthebanktosupportherresearch,Kimreliesonanetworkofexpertstohelphersearchforprofitableinvestmentopportunitiesinthebiotechnologyarea.Theseexpertsincludelegal,business,andpoliticalcontacts.

Kimpurchasesinformationfromseveralbiotechnologycompanyemployees,noneofwhomareofficers

oftheirrespectivecompanies,whoperformworkoutsidetheirregularpositionsasbiotechnologyconsultantsorexperts.TheseconsultantsworkwithKimwithouttheknowledgeoftheiremployers,noneofwhichhasaprohibitiononoutsideemployment,andprovideherwithinformationaboutquarterlyearningsandotherconfidentialdatarelatedtotheircompanies’performance.Kimbasesherfinalinvestmentdecisiononthisinformationandencouragestheconsultantsandexpertssheworkswithtopubliclydisclosetheinformationthathasbeenpassedontoher.

InordertospreadthenewsaboutthepositivereturnsGreenNotehasachieved,Kimhiresapublic

relationsconsultant,TakehikoAkagi,CFA.AkagitellsKimthatforamarketingcampaigntobeeffective,sheneedsafive-yearreturnhistory.Kimtriestoretrieveherperformancehistoryfromthebankbutisdeniedthisrequest.Searchingherhomelaptopcomputer,Kimfindsherhistoricalbankperformancedata.Kimusesthisbankdatatorecreatethefirsttwoyearsoftherequestedfive-yearperformancehistory.ForthethirdyearshesimulatesherinvestmentperformancebyapplyingGreenNote’scurrentinvestmentstrategytohistoricaldata,whichshedisclosesinafootnotealongwithinformationaboutwhethertheperformanceisgrossornetoffees.Forthefinaltwoyears,KimusestheactualperformancehistoryofGreenNote.

Becausethemarketingcampaigntakeslongerthanexpectedtoaccomplishitsgoalofbringingnew

clientstothefund,KimasksAkagitoacceptarevisedfeearrangement.InsteadofpayingAkagiamonthlyfeeof$10,000forhisservicesmarketingthefund,Kimproposesaninvestmentmanagementfeesharingarrangement.ForeachclientAkagibringstoKimandwhomshesignsonasaninvestorinGreenNote,KimwillpayAkagiafeeof10%oftheinvestmentmanagementfeeshechargesthatclientforhisfirst24monthsinthefund.Akagiagreestothisarrangement,andKimmakessuretodisclosethistoprospectiveclientsbyverballytellingthemthatGreenNotecompensatesAkagiforhiseffortstofindinvestorsforthefund,whichisthefirsttimeclientsaremadeawareofthisarrangement.Akagialsodisclosestoeachclientthefeeheexpectstoearnfromthisarrangementonceaninvestmentmanagementagreementissigned.

Kim’sformeruniversityroommate,DonnaMiriam,isnowalegalexpertinmergersandacquisitions.

Miriamhasanumberofconnectionstoseniorassociateswhospecializeinthisareaoflawatlarge,well-knownlawfirms.MiriamupdatesKimwhenshehearsadealisabouttobecompleted.Kimusesthisinformationaspartofamosaicofinformationshegathersfromherownresearchandinformationfromotherexpertsinhernetwork.OnceKimhasdeterminedMiriam’sinformationislikelytobecorrect,Kim

tradesderivativesecuritiesoftheacquisitiontarget.Inthepast18months,hermergerandacquisition

investmentshaveresultedinprofitsof$10millionforthehedgefund.KimalsomanagesaseparateaccountforMiriam,whohasauthorizedKimtoreplicatethetradesintheacquisitiontargetsforheraccount.BecauseMiriamprovidesthisvaluableinformation,KimmakessureshetradesMiriam’saccountbeforeanyotherclienttrades.

JulianHuang,agovernmentlobbyist,isanotherkeymemberofKim’sexpertnetwork.Huangkeepsin

constantcontactwiththemanylobbyistsinvolvedinbiotechnologyissuesandhascloserelationswithmanylegislators.Recently,legislatorsproposedrestrictingbiotechnologyresearch.Ifthelegislationhadpassed,itwouldhavereducedvaluationsacrosstheboardforbiotechstocks.Kimledthehedgefundindustry’seffortstofightthischange.Shepersonallydonatedalargesumofmoneytosupporttheseeffortsandwasalsoverysuccessfulinraisingfundsfromthehedgefundcommunitytofightthepassingofthisproposedlegislation.

Kim’seffortstogrowherfundresultinnewclientsandrapidgrowthofassetsundermanagement.

Facedwithasignificantincreaseinherworkload,Kimrealizessheneedstochangeherinvestmentprocesstomeetthesenewdemands.Inordertobringspecializedexperiencetoherinvestmentdecision-makingprocess,Kimhiresseveralcompetentoutsideadviserstositonherinvestmentcommittee,usingherstandardizedcriteriaforadviserselection.Kimalsosubscribestoseveralwell-knownthird-partyresearchvendorsnotconsideredpreviouslybecauseoftheirhighexpense.Withincreasedfeesearnedfromadditionalassetsundermanagement,Kimcannowaffordtorequestinformationfromthesevendorsthatistailoredtoherspecificneeds.Becausethisresearchissospecializedanddetailed,andbecauseKimisconfidentthattheoutsideadvisersusediligenceandareasonablebasisintheirresearch,sheisabletousethereports,withafewminorchanges,asherown.Otherthanshowingoffhernewreports,Kimdoesnottellclientsofthechangesmadetoherinvestmentprocessandreports.

1.

ByKimexecutingtradesbasedontheinformationshereceivesfromthebiotechnology

consultantsemployees,sheleastlikelyviolatestheCFAInstituteStandardsofProfessionalConductconcerning:

A.

B.

C.

MarketManipulation.

DiligenceandReasonableBasis.MaterialNonpublicInformation.

Answer=A

GuidanceforStandardsI-VII,CFAInstitute

2013ModularLevelIII,Vol.1,StandardII(A)MaterialNonpublicInformation,Guidance,StandardII(B),MarketManipulation,Guidance,StandardV(A)DiligenceandReasonableBasis,Guidance

StudySession1–2–b

RecommendpracticesandproceduresdesignedtopreventviolationsoftheCodeofEthicsandStandardsofProfessionalConduct.

Aiscorrectbecausethehedgefundmanager’stradesdonotrepresentaviolationofStandardII

(B),MarketManipulation.Kimisnotengaginginpracticesthatdistortpricesorartificiallyinflatestradingvolumewiththeintenttomisleadmarketparticipants.Becausethetradesarebasedonmaterialnonpublicinformation,however,KimisinviolationofStandardII(A)MaterialNonpublicInformation.KimisalsoinviolationofStandardV(A)DiligenceandReasonableBasisbecauseshehasbasedherinvestmentdecisionsoninformationreceivedfromthirdpartiesandhasnotdeterminedifthisinformationissoundandtheprocessesandproceduresusedbythoseresponsiblefortheresearchwerevalid.

2.

WithregardtoGreenNotes’sfive-yearinvestmentperformancehistory,Kimisinconsistent

withtheCFAInstituteStandardsofProfessionalConductconcerningwhichofthefollowing?

A.

B.

C.

Performanceasahedgefundmanager

SimulatedperformanceofcurrentstrategyPerformancewhenshewasanequityportfoliomanager

Answer=C

GuidanceforStandardsI-VII,CFAInstitute

2013ModularLevelIII,Vol.1,StandardIII(D)PerformancePresentation,Guidance,StandardIV

(A)Loyalty,GuidanceStudySession1–2–a

DemonstrateathoroughknowledgeoftheCodeofEthicsandStandardsofProfessionalConductbyinterpretingtheCodeandStandardsinvarioussituationsinvolvingissuesofprofessionalintegrity.

Ciscorrectbecauseshowingpastperformanceoffundsmanagedatapriorfirmaspartofa

performancetrackrecordispermissibleunderStandardIII(D)PerformancePresentationonlyaslongasshowingthatrecordisaccompaniedbyappropriatedisclosuresaboutwheretheperformancetookplaceandtheperson’sspecificroleinachievingthatperformance,whichKimdidnotdo.Inaddition,thematerialusedtocreatethisperformancerecordisthepropertyofKim’sformeremployer,andinordertousethisrecordsheshouldhaveobtainedpermissiontodosobutdidnotasrequiredbyStandardIV(A)Loyalty.

3.

WithregardtoKim’sfeearrangementswithAkagi,whoseactionsareinconsistentwiththe

CFAInstituteStandardsofProfessionalConduct?

A.

B.

C.

Kim’s

Akagi’s

BothKimandAkagi’s

Answer=C

GuidanceforStandardsI-VII,CFAInstitute

2013ModularLevelIII,Vol.1,StandardIV(C)ResponsibilitiesofSupervisors,Guidance,StandardVI(C),ReferralFees,Guidance

StudySession1–2–a

DemonstrateathoroughknowledgeoftheCodeofEthicsandStandardsofProfessionalConductbyinterpretingtheCodeandStandardsinvarioussituationsinvolvingissuesofprofessionalintegrity.

Ciscorrectbecausedisclosurethatfullyexplainsthereferralfeearrangementhasnotbeen

properlyprovidedinviolationofStandardVI(C)ReferralFees.Akagiisrequiredtodiscloseinwriting,andpriortotheexecutionofanyagreement,referralfeeagreementsinplaceincludingthenatureandthevalueofthebenefit.KimisalsoinviolationofStandardIV(C)ResponsibilitiesofSupervisorsbecauseshehasaresponsibilitytooverseeAkagiandensuretheappropriatedisclosuresaremadeconcerningreferralfees.Inaddition,KimverballytellingclientsthatGreenNotecompensatesAkagiforhiseffortstofindinvestorsforthefundisnotsufficienttomeetthedisclosurerequirements.

4.

Kim’srelationshipwithMiriamisconsistentwiththeCFAInstituteStandardsofProfessional

Conductconcerning:

A.

B.

C.

FairDealing.

PriorityofTransaction.

MaterialNonpublicInformation.

Answer=B

GuidanceforStandardsI-VII,CFAInstitute

2013ModularLevelIII,Vol.1,StandardII(A)MaterialNonpublicInformation,Guidance,StandardIII(B)FairDealing,Guidance,StandardVI(B)PriorityofTransactions,GuidanceStudySession1–2–a

DemonstrateathoroughknowledgeoftheCodeofEthicsandStandardsofProfessionalConductbyinterpretingtheCodeandStandardsinvarioussituationsinvolvingissuesofprofessionalintegrity.

BiscorrectbecauseStandardVI(B)PriorityofTransactionsconcernsinvestmenttransactions

forclientsandemployershavingpriorityoverinvestmenttransactionsinwhichamemberorcandidateisthebeneficialowner.Becausethemanagerdoesnothavebeneficialownershipinsecuritiestradedinclientaccounts,thisStandardhasnotbeenviolated.BypurchasingsharesforMiriam’saccountbeforeotherclientaccounts,themanagerhasviolatedStandardIII(B)FairDealing,whichrequiresmembersandcandidatestotreatallclientsfairlywhentakinginvestmentactionwithregardtogeneralpurchases.Inaddition,becausethehedgefundmanager’stradesarebasedonmaterialnonpublicinformation,theyareinviolationofStandardII(A)MaterialNonpublicInformation.Themosaictheoryisnotapplicableherebecausethemanageruseditasawaytohideherreceiptofmaterialnonpublicinformation.

5.Withregardtobiotechlegislationlobbying,isKimconsistentwiththeCFAInstitute

StandardsofProfessionalConduct?

A.Yes

No,becauseofhereffortstoinfluencelegislation

No,becauseshemixedpersonalandhedgefunddonations

Answer=A

GuidanceforStandardsI-VII,CFAInstitute

2013ModularLevelIII,Vol.1,CodeofEthics,StandardI(A)KnowledgeoftheLaw,GuidanceStudySession1–2–b

RecommendpracticesandproceduresdesignedtopreventviolationsoftheCodeofEthicsandStandardsofProfessionalConduct.

AiscorrectbecauseKimhasnotviolatedtheCodeofEthicsandStandardI(A)Knowledgeofthe

Law.Hereffortstoinfluencethelegislativeprocess,includingherpersonaldonations,arelegalandnotaviolationofanystandard.

6.

WhichofKim’schangesmadeasaresultofhavingmoreassetsundermanagementis

consistentwiththeCFAInstituteStandardsofProfessionalConduct?

A.

B.

C.

Useofoutsideadvisors

ClientcommunicationsUseofthird-partyresearch

Answer=A

GuidanceforStandardsI-VII,CFAInstitute

2013ModularLevelIII,Vol.1,StandardI(C)Misrepresentation,Guidance,

StandardV(A)DiligenceandReasonableBasis,Guidance,StandardV(B)CommunicationwithClientsandProspectiveClients,Guidance

StudySession1–2–b

RecommendpracticesandproceduresdesignedtopreventviolationsoftheCodeofEthicsandStandardsofProfessionalConduct.

AiscorrectbecauseStandardV(A)DiligenceandaReasonableBasisrequiresmembersand

candidatestoensuretheirfirmshavestandardizedcriteriaforreviewingexternaladvisers,whichKimhasmet.KimisinviolationofStandardV(B)CommunicationwithClientsandProspectiveClientsbecauseshehasnotcommunicatedthechangesinherinvestmentprocesstoclients.Bypresentingthethird-partyresearchasherown,KimhasalsoviolatedStandardI(C)Misrepresentation.

AthenaCaseScenario

CaitlynWilson,CFA,recentlystartedherownassetmanagementcompany,AthenaInvestmentServices

(Athena).TheboardofdirectorsofAthenahasadoptedboththeCFACodeofEthicsandStandardsofPracticeandtheCFAInstituteAssetManagerCodetoinstitutionalizeethicalbehaviorwithinthefirm.Theboardalsoimplementedhalf-yearlystaffperformancereviews,includinganassessmentofeachmanager’sabilitytoensurehisdepartment’scompliancewiththeCode.

Sixmonthsintothefirstfinancialyear,Wilsonmeetswithallofhermanagerstoassesseach

department’scompliance.Wilsonaskshercomplianceofficer,MarkZefferman,CFA,tomakeanopeningstatementtosettherighttoneforthemeeting.Zeffermanstates,“Ataminimum,weareresponsibleforimplementingproceduresaddressingthegeneralprinciplesembeddedinthesixcomponentsoftheCode:Asstatedbelow,wemust:

Statement1:

Actwithskill,competenceanddiligencewhileexhibitingindependenceandobjectivity

whengivinginvestmentadvice;

Putourclients’interestsabovethefirm’swhenappropriateandactinaprofessionalandethicalmanneratalltimes;and

Communicatewithourclientsinatimelyandnon-misleadingmannerandobeyallrulesgoverningcapitalmarkets.”

Statement2:

Statement3:

Zeffermanadds,“Withregardtothelaststatement,pleasebeawarewemustimplementthenewAnti-

MoneyLaunderingRegulationsbeingintroducedbyourlocalregulatorwitheffectfromthefirstquarterofnextyear.I’vedoneananalysisofthenewregulationsandhavefoundthatallofthelocalrequirementsarepartofnewregulationsrecentlyintroducedinEurope,whereonlyafewofourclientsreside.WhenwestarttakingonnewclientsbasedinSingaporeinthesecondhalfofnextyear,wewillalsoneedtofollowthatcountry’santi-moneylaunderingregulations.Thelocalanti-moneylaunderinglegislationappearstobeembeddedintheSingaporeregulationsaswell.”

Wilsonstates,“IwouldlikeeachofyoutoexplainhowtheimplementationoftheAssetManagerCode

withinyourdepartmentisbeingsupervised.Let’sstartwithShenalMehta,ourclientservicemanager.”

Mehtastates,“WithrespecttotheAssetManagerCoderelatingtoclientservices,wehaveensuredwe

enforcethefollowingpolicies:Alldisclosuresareaccurateandcomplete,andourcalculationsareshown,nomatterhowcomplicated.Wealsoensuretheclientseessomesortofcommunicationfromuswhentheyrequestitandthatthemarketingmaterialsenttoclientsischeckedbythecompliancedepartmentforaccuracyandcompleteness.”

AndersPeterson,CFA,chiefinvestmentofficer,states,“InadditiontowhatMehtahassaid,Ihavethe

followingcomments:

Comment1:

Anycommunicationwithclientsiskeptconfidentialandisonlyaccessiblebyauthorized

personnel;

Onoccasion,weareabletoacquiresecuritiesweexpectwillbeparticularlystrongperformers,suchasoversubscribedinitialpublicofferings.Inordertoassurethatallclientsaretreatedfairly,eachclientportfolioisgiventhesamenumberofshares;and

Agiftandentertainmentpolicyisinplacetohelpensurethatourmanagersandanalystskeeptheirindependenceandobjectivity.”

Comment2:

Comment3:

RichardGilchrist,headofportfolioadministration,thenadds,“Ourportfoliopoliciescallforallassetsto

bevaluedatfairmarketpricesusingthird-partypricingservices.Whenasecuritypriceisnotavailablefromtheservice,acommitteewhosemembershaveexperienceinvaluingilliquidassetsusesthehierarchydictatedbyGIPStodeterminevalues.”

WilsonconcludesthemeetingbymentioningthatAthenamustdoevenmoretoensureitsclients

continuetohavefaithinAthena’sabilitytoprotectandgrowtheirassets.Sherecommendsthey

disclosetheirriskmanagementpractices,whichidentify,measure,andmanagethevariousriskaspects

ofthebusinesstoclientsandtheregulator.Sheadds,“Inaddition,weneedtocreateabusinesscontinuityplancoveringdatabackupandrecovery,alternatetradingsystemsiftheprimarysystemfails,andmethodstocommunicatetoemployees,criticalvendors,andsuppliersincaseofanemergencythatcoulddisruptnormalbusinessfunctions.”

7.WhichofZefferman’sopeningstatementsisinconsistentwiththeAssetManagerCodeof

ProfessionalConduct?

Statement1

Statement2

Statement3

Answer=B

“AssetManagerCodeofProfessionalConduct,”KurtSchacht,JonathanJ.Stokes,andGlenn

Daggett

2013ModularLevelIII,Vol.1,Reading6,GeneralPrinciplesofConductStudySession2–6–a

ExplaintheethicalandprofessionalresponsibilitiesrequiredbythesixcomponentsoftheAssetManagerCode.

BiscorrectbecauseZeffermanstatesthefirmisresponsibleforputtingclients’interestsabove

thefirm’swhenappropriate.TheGeneralPrinciplesofConductembeddedinthesixcomponentsoftheAssetManagerCodestatethatmanagershavetheresponsibilityofactingforthebenefitofclients.Thecodedoesnotstipulatethatthisresponsibilityisapplicableonlywhenappropriate.

8.Whichofthefollowinganti-money-launderinglawsmustAthenacurrentlycomplywithto

beconsistentwiththeCFAInstituteStandardsofProfessionalConduct?

Local

European

Singaporean

Answer=B

“GuidanceforStandardsI-VII,”CFAInstitute2013ModularLevelIII,Vol.1,Reading2

Section:StandardI(A)KnowledgeoftheLawStudySession1–2–c

RecommendpracticesandproceduresdesignedtopreventviolationsoftheCodeofEthicsandStandardsofProfessionalConduct.

BiscorrectbecauseZefferman,asaCFAcharterholder,willberesponsibleforensuringAthena

complieswiththestricteranti-moneylaunderinglawsofEurope,wheresomeofitsclientsreside,asperStandardI(A)KnowledgeoftheLaw.Europe’snewlaws,whichencompassand

exceedthelocalanti-money-launderingregulations,arealreadyinplace;therefore,theseare

theregulationsthatmustbecurrentlyfollowed.

9.WhichofMehta’sclientservicepoliciesisconsistentwiththeAssetManagerCode?

Typesofdisclosures

Communicationtiming

Marketingmaterialreviews

Answer=C

“AssetManagerCodeofProfessionalConduct,”KurtSchacht,JonathanJ.Stokes,andGlenn

Daggett

2012ModularLevelIII,Vol.1,Reading6

Sections:A.LoyaltytoClients,D.RiskManagement,ComplianceandSupport,andF.DisclosuresStudySession2–6–b

Determinewhetheranassetmanager’spracticesandproceduresareconsistentwiththeAssetManagerCode.

CiscorrectbecauseSectionD,RiskManagement,ComplianceandSupportoftheAsset

ManagerCodestatesthatportfolioinformationprovidedtoclientsshouldbereviewedbyanindependentthirdparty.Thecompliancedepartmentwouldbeconsideredanindependentthirdpartybecausecomplianceisnotinvolvedwithcompilingorpresentingtheinformationtoclients.AccordingtoSectionF,Disclosures,disclosuresshouldbetruthful,accurate,complete,andunderstandable.Itisunlikelyclientswouldeasilyunderstandcomplicatedcalculations.

SectionF,Disclosurescallsforcommunicationswithclientstobeonanongoingandtimelybasis.CommunicationtoclientsonlywhentheyaskforitwouldnotbeconsistentwiththeCode.Itisrecommendedcommunicationbeatleastonaquarterlybasis.

10.WhichofPeterson’scommentsisinconsistentwiththeAssetManagerCode?

Comment1

Comment2

Comment3

Answer=B

“AssetManagerCodeofProfessionalConduct,”KurtSchacht,JonathanJ.Stokes,andGlenn

Daggett

2012ModularLevelIII,Vol.1,Reading6

Sections:A.LoyaltytoClients,andD.RiskManagement,ComplianceandSupportStudySession2–6–b

Determinewhetheranassetmanager’spracticesandproceduresareconsistentwiththeAssetManagerCode.

BiscorrectbecauseSectionB(6)(b)requiresclientstobetreatedequitably,notequally.Clients

havedifferentinvestmentobjectivesandrisktolerances,sotreatingclientsequallywouldbeinconsistentwiththeAssetManagerCode.

11.AreGilchrist’scommentsregardingportfoliovaluationconsistentwiththeAssetManager

Code?

Yes

No,withregardtothird-partypricingservices

No,withregardtotheprocessusedtopriceilliquidsecurities

Answer=A

“AssetManagerCodeofProfessionalConduct,”KurtSchacht,JonathanJ.Stokes,andGlenn

Daggett

2012ModularLevelIII,Vol.1,Reading6

Sections:E.PerformanceandValuation,F.DisclosuresStudySession2–6–b

Determinewhetheranassetmanager’spracticesandproceduresareconsistentwiththeAssetManagerCode.

AiscorrectbecauseSectionEoftheAssetManagerCodecallsfortheuseoffair-marketvalues

sourcedbythirdpartieswhenavailable,andwhensucharenotavailable,thecodecallsfortheuseof“goodfaith”methodstodeterminefairvalue.Athena’spolicyappearsconsistentwiththisrequirement.Intermsofclientreporting,monthlyvaluationreportswouldbeconsistentwiththecallfortimelyreporting.

12.AreWilson’sclosingremarksconsistentwithrecommendedpracticesandprocedures

designedtopreventviolationsoftheAssetManagerCode?

Yes

No,withregardtothebusinesscontinuityplan

No,withregardtodisclosureofthefirm’sriskmanagementprocess

Answer=B

“AssetManagerCodeofProfessionalConduct,”KurtSchacht,JonathanJ.Stokes,andGlenn

Daggett

2012ModularLevelIII,Vol.1,Reading6,Appendix6-RecommendationsandGuidanceStudySession2–6–c

RecommendpracticesandproceduresdesignedtopreventviolationsoftheAssetManagerCode.

Biscorrectbecauseatminimum,SectionD.RiskManagement,ComplianceandSupportofthe

AssetManagerCoderecommendsabusinesscontinuityplantoincludeplansforcontactingandcommunicatingwithclientsduringaperiodofextendeddisruption.Wilson’scontinuityplanincludesnosuchstrategy.Herrecommendationfordisclosingthefirm’sriskmanagement

processgoesbeyondthecoderecommendationstodisclosetheriskmanagementprocessonly

toclients,nottoregulators.Wilsonrecommendstheydisclosetoboth.

Questions13to18relatetoRiskManagement

LauraHackettCaseScenario

LauraHackettisariskmanagementconsultantwhohelpsinvestmentcompaniesbuildandenhance

theirriskmanagementprocess.JardinsAdvisors,afinancialservicesfirmwithequity,fixedincome,andcommoditytradingdesks,recentlyhiredhertoevaluateandrecommendimprovementstotheirprocesses.Jardins’seniormanagementoutlinestheircurrentriskmanagementprocesstoHackettasfollows:“First,weestablishpoliciesandproceduresforriskmanagement.Next,weidentifythetypesofriskweface.Wethenmeasureourexposurestothoserisks.Finally,wedetermineourrisktoleranceandadjustlevelsofriskasappropriate.”Theyaskher,“Isthisprocessappropriate?”

AlphaAssetManagementInc.,anotherofHackett’sclients,hiredhertoidentifyandseparateits

financialriskexposuresintocategories.Alphawasincorporatedduringthecurrentyearandfocusesononeinvestmentstrategytogeneratereturns.Alphaissuesdebtwithamaturityoflessthanoneyearandinveststheproceedsinemergingmarketdebt.HackettcreatesalistofAlpha’sfinancialriskcategories.

HackettasksAnthonyMackenzie,arecentlyhiredassociate,toapplytheanalyticalmethodtoestimate

theVARforAlphaAssetManagement’sportfolio,whichisvaluedat$20million.Theportfoliohasanexpectedannualreturnof7.5%andastandarddeviationof22.4%.

AnotherofHackett’sclientsisBetaInvestmentAdvisors.Betainvestsinavarietyofassetclassesand

internationalmarkets.ItusesahistoricalsimulationapproachtomeasuretheVARofitsportfolio,basedontheprevious24monthsofmarketdata.BetaasksHacketttoevaluateitsapproachrelativetoothermethodsusedforestimatingportfolioVAR.

SigmaInvestmentManagementInc.isapotentialnewclientthatwishestomeasurethecreditriskofan

over-the-counterAmericancalloptiononasecurity.Thecalloptionhasastrikepriceof$65andwaspurchasedatapriceof$3.50peroption.Theoption’scurrentvalueis$8.50peroption.

Inadditiontomeasuringcreditrisk,SigmaasksHacketttoevaluateitsover-the-counterderivative

positionsandrecommendwaystodecreasecreditriskassociatedwiththesepositions.Sigmaprovidesathoroughexplanationofitscurrentprocess.Atleast20counterpartiesareused,eachislimitedto7%ofSigma’stotalderivativespositions,andeachmustmeetaminimumcreditratingthreshold.Thecontractshaveatypicaltermoftwoyears,atwhichtimetheyaremarkedtomarketandallpaymentsunderthecontractarenettedandgainsorlossessettled.

13.WhatresponsewouldHackettmostlikelymaketoJardinsAdvisors’seniormanagement?

Thefirmshould:

measureits