CFA^® Exam Sample Questions

Level II of the CFA exam introduces vignettes. A vignette describes a business scenario in several paragraphs using a mix of text, tables, financial statements, and so on. (You can get more information about the Level II exam here.) As part of preparing for Level II, you must develop the ability to quickly scan through a vignette and pick out the pieces of data needed to answer a particular question. Let’s look at a sample vignette and its questions.

Level II Vignette: Holly Jameson, CFA

Holly Jameson has recently started a new role as a bond analyst at Holt Investment Management, LLC, based in Farland. Her team leader has provided her with up-to-date but incomplete data on the term structure of interest rates, summarized in Exhibit 1.

Exhibit 1: Farland Treasury Bond Rates

Holly has been asked to assess whether a specific treasury bond that Holt is considering recommending to its clients is fairly priced. The bond pays a 6% annual coupon, matures in three years’ time, and is trading at $108.30.

In a discussion in the staff dining room shortly after she joined the firm, Holly’s colleague, Doug Ross, made a confident assertion, “I really don’t know how some people find bond trading difficult. For each specific maturity, spot rates are always lower than forward rates, and forward rates are always lower than YTM. So, you can always achieve a higher return by riding the yield curve. I’ve been doing that since my first day on the job.”

Holt offers both domestic and international bonds to its clients to enable them to benefit from risk reduction through diversification. Holly has carried out some preliminary research on the Farland bond market and has found that the yield curve has an unexpected shape and does not seem to be driven by interest rate expectations.

She asks her team leader for advice, who tells her, “Things are strange in Farland. Rates are influenced simply by the supply and demand of bonds of specific maturities. Different types of investors want particular maturity bonds, and they never seem to deviate from their preferences. High demand for 5-year bonds has pushed prices up and yields down.”

Alex Allan, a bond analyst colleague of Holly, started another discussion with the group by stating, “I’m more interested in what happens to bond prices when the yield curve changes. I need to estimate how much prices will change when short-term yields increase but long-term yields stay constant.”

Question 1: The BBB-rated corporate bond being assessed by Holly is most likely:

A. Undervalued by $2.34.
B. Overvalued by $3.75.
C. Overvalued by $3.70.

Question 2: The comments made by Doug Ross are most likely:
A. Inaccurate in respect to the statement about spot rates, forward rates, and yields-to-maturity.
B. Inaccurate in respect to the statement about riding the yield curve.
C. Inaccurate in both respects.

Question 3: Holly’s team leader’s comments about interest rates in Farland most likely supports which theory of the term structure of interest rates?

A. Liquidity preference theory.
B. Segmented markets theory.
C. Local expectations theory.

Question 4: The most appropriate measure for Alex Allan to assess bond price sensitivity is:

A. Key rate duration.
B. Effective duration.
C. Macaulay duration.

Level II Answers

The answer to question 1 is C, the answer to question 2 is C, the answer to question 3 is B, and the answer to question 4 is A.

Level III Exam Questions

The CFA Level III exam introduces a type of essay question called constructed response to test your ability to apply judgment and also contains item set vignettes (you can learn more about the exam format and more here). These constructed response questions are open-ended. You must write your own answer; there are no options to choose from. Here is an example of a constructed response question related to fixed income.

Level III Constructed Response

Algonquin Enterprises is a US company that recently raised a substantial quantity of cash from the sale of a redundant factory site and would like to use this cash to retire a set of debt liabilities. Summary statistics for the liabilities, which range in maturity from five to eight years, are given in Exhibit 1-1:

Exhibit 1-1: Debt liabilities to be retired

Algonquin’s treasury department is considering three possible methods that could be used: a bond tender offer, whereby the liabilities are repurchased on the open market, which they hope will lead to an upgrade from the company’s current A- rating to AA. However, the tender offer would need to be at a price reflecting the improvement in rating; cash flow matching using government bonds, which would allow for defeasement of the assets and liabilities; or duration matching using high-quality corporate bonds.

A. Identify and explain one advantage and one disadvantage of the duration matching approach compared to the cash flow matching approach.

Three different portfolios of investment-grade corporate bonds, ranging in maturity from 3 years to 10 years, have been proposed for the duration matching approach. Each portfolio has a market value of $650 million, which will be adequate for the funding of the liabilities. Exhibit 1-2 shows relevant information for these portfolios:

Exhibit 1-2: Portfolios for Duration Matching Strategy

B. Identify and justify with two reasons which of the three portfolios (P, Q, or R) should be chosen if the duration matching strategy is adopted.

Algonquin is currently pursuing a contingent immunization strategy with another set of liabilities. These liabilities have a current market value of $78.96 million and a BPV of $36,374. The associated T-Note portfolio has a market value of $83.15 million and a BPV of $41,458. Additionally, 140 contracts of the five-year T-Note futures have been sold. The futures have a par value of $100,000 and an estimated BPV of $51.0745.

C. Assuming that any remaining duration gap is intentional, state with justification the likely view held by Algonquin’s treasury department on the future five-year T-Note interest rate.

Level III Answers