CFA II Questions and Answers

Q. Using the data in Exhibit 3, Raman's estimate of the contribution that the terminal value of the residual income stream in 5 years will contribute to the current value of equity (in S millions) is closest to. A. $48.82 B. $61.91 C. $42.25 Solution A is correct. Using a multi-stage residual income model and the data in Exhibit 3. Q. Based on Exhibit 2, Vasileva should compute the: A coefficient of determination to be 0.4689. B 95% confidence interval for the intercept to be -0.0037 to 0.0227. C 95% confidence interval for the slope coefficient to be 0.0810 to 0.3898. Solution C is correct. Q. When comparing his two trades to the WWAP benchmark using all trades through the completion of his purchase, Varga would most likely conclude the price of the: A. first trade was less costly. B. second trade was less costly. C. average execution price was less costly than either single trade. Solution A is correct. The VWAP benchmark is the sum total dollar value of the benchmark trades divided by the total quantity of the trades. The WWAP transaction cost estimate formula for buy orders is as follows: Trade size × (Trade VWAP-VWAP benchmark). Q. Based on Exhibit 1, Varden's best answer to Quinni's question about the F-statistic is: A. both independent variables are significant at the 0.05 level. B. neither independent variable is significant at the 0.05 level. C. at least one independent variable is significant at the 0.05 level. Solution C is correct. Exhibit 1 indicates that the F-statistic of 4.161 is significant at the 0.05 level. A significant F-statistic means at least one of the independent variables is significant. BSM Model Assumptions Q. Which is the correct pair of statements? The BSM model assumes: A the return on the underlying has a normal distribution. The price of the underlying can jump abruptly to another price. B brokerage costs are factored into the BSM model. It is impossible to trade continuously. C volatility can be predicted with certainty. Arbitrage is non-existent in the marketplace. Solution: C is correct. All four of the statements in A and B are incorrect within the BSM model paradigm. We turn now to a careful examination of the BSM model. Q. A stock is priced at $100.00 and follows a one-period binomial process with an up move that equals 1.05 and a down move that equals 0.97. If 1 million Bernoulli trials are conducted, and the average terminal stock price is $102.00, the probability of an up move (p) is closest to: A. 0.375. B. 0.500. C. 0.625. Solution: C is correct. Calculate Rf from the 102 and 100 use probability of up move formula to calculate you will get (1.02 - 0.97)/(1.05 - 0.97) = 0.625 Q. Which REIT subgroup is Susan least likely to recommend based on the economic forecast presented by the macro strategist? A. Office. B. Industrial. C. Multi-family Solution: B is correct. Q. Which of the following would Messer most likely conclude from the implied volatility data in Exhibit 2 if he excludes the effects of moneyness and time to expiration? A. Using out-of-the-money options to hedge is more expensive than establishing a long position with out-of- the-money options. B. Using out-of-the-money options to establish a long position is more expensive than stablishing a short position using out-of-the-money options. C. Using out-of-the-money options to establish either long or short positions is more expensive than using at-the-money options Solution A is correct. Implied volatility is higher for lower strike prices than for higher strike prices, therefore, out of. the-money put options will generally be more expensive than out-of-the-money call options. Implied volatilities of options with lower strike prices are higher than those with higher strike prices Q. In Statement 2, Kynnersley implies that the portfolio: A. is at risk of losing $4,500 each trading day. B. value is expected to decline by $90,000 or more once in 20 trading days. C. has a 5% chance of falling in value by a maximum of $90,000 on a single trading day Solution B is correct. Value at risk is the minimum loss that would be expected a certain percentage of the time over a certain period of time. Statement 2 implies that there is a 5% chance the portfolio will fall in value by $90,000 (=$6,000,000 × 1.5%) or more in a single day. If VaR is measured on a daily basis and a typical month has 20-22 business days, then 5% of the days equates to about 1 day per month or once in 20 trading days. Q. 7 Did Kirabo most likely violate the CFA Institute Code and Standards by pur-chasing additional shares of Mtume? A Yes. B No, because the information that Kirabo learned from Moroka was not definite. C No, because his decision was based on the output from the analyst's revised model. A is correct. Kirabo was in violation of Standard II(A): Integrity of Capital Markets-Material Nonpublic Information. Members and candidates who possess material nonpublic information that could affect an investment's value must not act or cause others to act on the information. Information is "material" if its disclosure would probably affect the price of a security or if reasonable investors would want to know the information before making an investment decision. In addition to the substance and specificity of the information, the source or relative reliability of the information also determines materiality. In this case, factual information from a corporate insider regarding the purchase of a subsidiary is likely to be material. Although the offer is not definite or officially accepted by the board, its source, substance, and specificity are enough to make the information material. The output from the analyst's revised model was affected by the insider information. Q. If the price of Gl stock approaches $75 over the next 30 days, which of the following changes in option parameter measures will most likely be observed? A. Decreases in vega and the absolute value of theta B. Increases in vega and the absolute value of theta C. A decrease in vega and an increase in the absolute value of theta Solution B is correct. Typically, theta is negative for options. The speed of the option value decline increases, however, as time to expiration decreases. Vega is high when options are at or near the money. During the next 30 days, the options will approach expiration and approach being at the money. Q. Which of the following would Messer most likely conclude from the implied volatility data in Exhibit 2 if he excludes the effects of moneyness and time to expiration? A Using out-of-the-money options to hedge is more expensive than establishing a long position with out-of. the-money options. B. Using out-of-the-money options to establish a long position is more expensive than establishing a short position using out-of-the-money options. C. Using out-of-the-money options to establish either long or short positions is more expensive than using at-the-money options. Solution A is correct. Implied volatility is higher for lower strike prices than for higher strike prices, therefore, out-of-the-money put options will generally be more expensive than out-of-the-money call options. Implied volatilities of options with lower strike prices are higher than those with higher strike prices. Q. Which of the following is (or are) the likely result of a horizontal merger for the merged entity? a) Increase in Market Share b) Decrease in Market Competition c) Higher Bargaining power vis-a-vis Suppliers d) Higher Bargaining power vis-a-vis Customers e) All of the above Solution E is correct. Q. Assuming rates change as described by Akron and based on Exhibit 3, the impact on the portfolio as outlined in Module 6 would be most likely be a loss in value from changes in: A. level and a loss from changes in steepness. B. level and a gain from changes in steepness. C. steepness and a gain from changes in curvature. Solution A is correct. A parallel shift of the yield curve would result in a loss across each key rate duration given a sensitivity of 1. For example, a 100 basis point (b) parallel shift would generate an approximately 4.7% loss in value. A flattening of the yield curve in the long end would result in a loss given a sensitivity of -1. For example, a 100 bp decline in the 30-year key rate duration would result in a loss of approximately 2.9% (-100 x -1 x -8.7 × 0.333). There is no impact from curvature, since the curve did not "twist." Q. A floor on a floating rate note, from the bondholder's perspective, is equivalent to: A) owning a series of puts on fixed income securities. B) owning a series of calls on fixed income securities. C) writing a series of interest rate puts. Explanation B is correct. A floor, which puts a minimum on floating rate interest payments is equivalent to owning calls on fixed income securities which will pay when interest rates fall. Owning interest rate puts, rather than writing them, would be equivalent to the floor. Puts on fixed income securities pay when interest rates increase. Q. Is Kwon most likely accurate in his comments regarding how the portfolios have performed? A. Yes. B. No, with regard to his comment on Daegu's portfolio C. No, with regard to his comment on Gangwon's portfolio. Solution A is correct. Kwon correctly interprets the performance of the various portfolios from the information compiled in Exhibit 2 Kwon is correct that Daegu's portfolio has the highest active return. The information ratio is defined as active return divided by active risk or tracking error. Daegu has by far the largest active risk, and although it has à lower information ratio than Ulsan, its information ratio is 83% as high with an active risk that is 3.1 times larger (square root of Daegu active risk squared divided by square root of Ulsan active risk squared). As a result, Daegu must have the largest active return. Kwon is also correct that Gangwon's portfolio appears to have the highest contribution of active risk from stock selection; 75% of Gangwon's active risk comes from active specific risk, which means security specific risk. Even when considering Daegu's higher active total risk, only 10% of Daegu's active risk comes from active specific versus active factor sources, indicating the most secunty specific (stock selection) risk from Gangwon. Q. Tim Herndon, CFA, is a senior analyst working with Brad Welch, CFA. They work for a large brokerage firm and co-author all their research reports. Herndon believes Welch is in violation of the CA Institute Standards of Professional Conduct concerning reasonable basis for a company under their coverage. Herndon has had several discussions with Welch, as his supervisor, and has discussed the issue with the firm's compliance department. Both Welch and the compliance department appear to have dismissed his concerns. Which of the following actions should Herndon most likely take to avoid being in violation of the CFA Institute Standards of Professional Conduct? A. Threaten to leave the firm. B. Continue discussing the matter with Welch. C. Have his name removed from further research reports. Solution C is correct. To avoid violating the CA Institute Standards of Professional Conduct, Herndon should have his name removed from further research reports. If a member or candidate has reasonable grounds to believe his or her employer's activities are illegal or unethical, the member or candidate must dissociate, or separate, from the activity. Inaction combined with continuing association with those involved in the unethical conduct may be construed as participation or assistance in the unethical behavior. Q. Meshack Bradovic, CFA, was recently hired as a credit analyst at a credit rating agency whose major clients include publicly listed companies on the local stock exchange. One of the clients is currently preparing to issue a new bond to finance a major factory project. Analysts are speculating that without the new factory the company will not survive the onslaught of competition from increasing imports; therefore, the company is counting on an upgraded credit rating to enhance the subscription level of the issue. Bradovic's research suggests that the creditworthiness of the company has severely deteriorated over the last year due to negative operating cash flows. Without conducting extensive research, Bradovic's boss puts pressure on him to upgrade the credit rating to an investment grade rating. Bradovic reports this to the firm's compliance department where he is encouraged to follow his boss's advice. What course of action is most appropriate for Bradovic to prevent any violation of the CA Institute Code or Standards? A. Quit his position with the firm B. Upgrade the rating but note his objections in writing C. Disassociate with the credit rating report, the bond issue and the client Solution A is correct as the boss' insistence that the credit rating be given an investment grade rating irrespective of the analysis undertaken indicates a systemic disregard for due diligence, reasonable basis, and true representation. This shows a total disregard for the Standards, in particular Standard V(A)-Diligence and Reasonable Basis. Bradovic's best course of action consequently is to resign as the company's current practice of giving false credit ratings is likely to continue. Q. The value of the American-style put option on Beta Company shares is closest to: A. 4.53. B. 5.15 C. 9.32. Practico ProNe Solution A is correct. Using the expectations approach, the risk-neutral probability of an up move is 77 = (FV (1) - a/(u - d) = (1.03 - 0.800)(1.300 - 0.800) = 0.46. An American-style put can be exercised early. At Time Step 1, for the up move, p* is 0.2517 and the put is out of the money and should not be exercised early (X < S, 40 < 49.4). However, at Time Step 1, p' is 8.4350 and the put is in the money by 9.60 (X - S = 40 - 30.40). So, the put is exercised early, and the value of early exercise (9.60) replaces the value of not exercising early (8.4350) in the binomial tree. The value of the put at Time Step 0 is now /ro = PV[/pi*/ro^+ (1-/pi)*/ro^-]= [1/(1.03)1/0.46(0.2517) + 0.54(9.60)] = 5.1454 Q. There were no sales of PP&E during the year; depreciation expense wag $300. Calculate Airbrush's FCInv for 2017. Answer: FCInv = capital expenditures = ending net PP&E - beginning net PP&E + depreciation = $3, 500 - $2, 950 + $300 = $850 Q. Calculating FCInv with long-term asset sales Suppose that Air Brush reports capital expenditures of $1,400, long tem asset sales of $600, and depreciation expense of $850. The long-term assets sold were fully depreciated. Calculate Airbrush's revised FCInv for 2017. Answer: revised FCInv = capital expenditures - proceeds from sales of long-term as = $1.400 - $600 = $800 Q. After 180 days, the swap is marked to market when the 180, 360-, and 540-day annualized LIBOR rates are 4.5%, 5%, and 6%, respectively. The present value factors, respectively, are 0.9780, 0.9524, and 0.9174. What is the market value of the swap per $1 notional principal, and which of the two counterparties (the fixed rate payer or the fixed-rate receiver) would make the payment to mark the swap to market? Market value A. $0.01166 B. $0.04290 C. $0.01166 C is correct. \[\begin{align*} &PV_{\text{Fixed}} = (0.045 \times \frac{180}{360} \times 0.9780) + (0.05 \times \frac{180}{360} \times 0.9524) + (0.06 \times \frac{180}{360} \times 0.9174) \\ &PV_{\text{Floating}} = (0.045 \times \frac{180}{360} \times 0.9780) + (0.05 \times \frac{180}{360} \times 0.9524) + (0.06 \times \frac{180}{360} \times 0.9174) \\ &\text{Market Value} = PV_{\text{Fixed}} - PV_{\text{Floating}} \end{align*}\] Performing the calculations: \[\begin{align*} &PV_{\text{Fixed}} \approx 0.0429 \\ &PV_{\text{Floating}} \approx 0.03124 \\ &\text{Market Value} \approx PV_{\text{Fixed}} - PV_{\text{Floating}} \approx 0.01166 \end{align*}\] Q. Assume a flat yield curve of 6%. A three-year £100 bond is issued at par paying an annual coupon of 6%. What is the portfolio manager's expected return if he predicts that the yield curve one year from today will be a flat 7%? A. 4.19% B. 6.00% C. 8.83% A is correct. Q. When an accusate pander and dalsaces to create or redeem ElF shares, the related costs are ultimately borne: A. solely by the ETF sponsor. B. solely by the AP. C. proportionally by all existing ETF shareholders. B is correct. Q. Suppose we entered a receive-floating 6 x 9 FRA at a rate of 0.86%, with notionalnamount of C$10,000,000 at Time 0. The six-month spot Canadian dollar (C$) Libor was 0.628%, and the nine-month C$ Libor was 0.712%, Also, assume the 6 x 9 FRA rate is quoted in the market at 0.86%. After 90 days have passed, the three-month C$ Libor is 1.25% and the six-month C$ Libor is 1.35%, which we will use as the discount rate to determine the value at g. We have h = 180 and m = 90. Assuming the appropriate discount rate is CS Libor, the value of the original receive-floating 6 x 9 FRA will be closest to: A C$14,500. B C$14,625. C C$14,651. Solution: C is correct. Initially, we have Lo(h) - Lo(180) - 0.628%, Lo(h + m) - Lo(270) - 0.712%, and FRA(0,180,90) = 0.86%. After 90 days (g = 90), we have Lg(h - g) - Lop(90) = 1.25% and Lg(h + m - g) = log(180) = 1.35%. Interest rates rose during this period; hence, the FRA likely has gained value because the position is receive-floating. First, we compute the new FRA rate at Time g and then esti- mate the fair FRA value as the discounted difference in the new and old FRA rates. The new FRA rate at Time g, denoted FRA(g.h - g.m) = FRA (90,90,90), is the rate on day 90 of an FRA to expire in 90 days in which the underlying is 90-day Libor. That rate is found as FRA(g.h - g.m) = FRA(90,90,90) = ([1 + L,Ch + m - 8)th-m-gl/|1 + L, (h - 8)4-g) - 11/4m and based on the information in this example, we have FRA(90,90,90) = ([1 + Leo (180 + 90 0)(180/360)]/[1 + Leo(180 - 90) (90/360)] - 11/(90/360). Substituting the values given in this problem, we find FRA(90,90,90) = ([1 + 0.0135(180/360)]/[1 + 0.0125(90/360)] - 1}/(90/360) = |(1.00675/1.003125) - 1]4 = 0.0145, or 1.45%. Therefore, V (0,h,m) = Voo (0,180,90) = 10,000,000 (0.0145 - 0.0086)(90/360)1/[1 + 0.0135(180/360 = 14.651 Again, floating rates rose during this period; hence, the FRA enjoyed a gain. Notice that the FRA rate rose by roughly 59 bps (= 145 - 86), and 1 bp for 90- day money and a 1,000,000 notional amount is 25. Thus, we can also estimate Q. If the binomial tree of the three-year IED Bank callable bond has node i_2hh =6.75%, then the value of the bond according to the yield curve in Exhibit 2 at i_2hh is closest to: A. 93.677. B. 95.012. C. 98.595. Solution C is correct. The three-year bond matures at T_3 and will generate a cash flow of 105.25 according to the par rate for the three-year bond (5.25 coupon plus 100 maturity). All branches of the binomial tree will have a value of 105.25 at T_3. The price of the bond at izm is calculated as 105.25 ÷ 1.0675 = 98.595 Q. Which of the following trades is most likely appropriate on the basis of the information in Statement 3 and Exhibit 1? Go long: A. Company B five-year CDS and short Company B five-year bonds. B. Company A five-year CDS and short Company A five-year bonds. C. Company A five-year bonds and CDS and go short Company B five-year bonds and CDSs. Solution: B is correct. Q. Assuming rates change as described by Akron and based on Exhibit 3, the impact on the portfolio as outlined in Module 6 would be most likely be a loss in value from changes in: A level and a gain from changes in steepness. B steepness and a gain from changes in curvature. C level and a loss from changes in steepness. Solution. C is correct. Q. Andy Rock, CFA, is an analyst at Best Trade Co. The company is going to announce a sell recom-mendation on Biomed stock in one hour. Rock was a member of the team who reached the decision on Biomed. Rock's wife has an account at Best Trade Co. that contains Biomed stock. According to the Code and Standards, trading on Rock's wife's account can begin: A) only after the recommendation is announced to the general public only after Rock, as a beneficial owner, has given an appropriate amount of B) time for clients and his employer to act. C) as soon as the information is disseminated to all clients. Q. Barolo is least likely correct with regard to which aspect of the strength and limitations of the fundamental law of active management? A. The strength B. First limitation C. Second limitation Solution C is correct. Barolo provides Moscato with several strengths and limitations of the fundamental law of active management, although her list is not exhaustive. Her comment regarding the strengths are correct as is the first point regarding covariances in calculating breadth. Her comment regarding the inability to measure ex ante value added is not correct; the model can measure both ex ante and ex post value added. Q. Barolo is least likely correct with regard to which aspect of the strength and limitations of the fundamental law of active management? A. The strength B. First limitation C. Second limitation Solution C is correct. Barolo provides Moscato with several strengths and limitations of the fundamental law of active management, although her list is not exhaustive. Her comment regarding the strengths are correct as is the first point regarding covariances in calculating breadth. Her comment regarding the inability to measure ex ante value added is not correct; the model can measure both ex ante and ex post value added. Q. The current all-in bid rate for delivery of GBP against the CHF in three months is: A. 1.49136 B. 1.49150 C. 1.49164 Solution A is correct. Q. Based on the data in Exhibit 1, the expected net investment return on a one-year carry trade based on the JPY/EUR currency pair, measured in JPY terms, is closest to: A. 2.86%. B. 3.10%. C. 3.01%. Solution A is correct. In a carry trade, an investor will borrow in the low interest rate currency, the JPY, at 0. 15% and invest in the high interest rate currency, the EUR, at 1.40% Calculate the current and one-year-later JPY/EUR cross-rates. 1. Borrow JPY and buy USD for JPY 117.66 (offer); then use USD to buy EUR for USD1 0873 (offer). This generates a cross-rate of 117.66 × 1.0873 = 127 932 = 127 93JPY/EUR. 2. The one-year-later cross-rate for the JPY/EUR is calculated as 118 32 × 1 0984 = 129 963 = 129 96. The net investment return for the unhedged EUR deposit, measured in JPY is calculated as Q. A current account deficit is most likely to decrease as a result of an increase in' A. domestic savings. B. private investment. C. the fiscal budget deficit. Solution A is correct. Q. Suppose all three managers claim to be good at forecasting returns. According to the expanded fundamental law of active management, which manager is the best at efficiently building portfolios by anticipating future returns? A. Manager 1 B. Manager 2 C. Manager 3 Solution C is correct. The proper statistic to calculate is the information coefficient, and it is defined as follows: A manager is a good forecaster if his or her ex ante, active return expectations (forecasts) are highly correlated with the realized active returns. The information coefficient requires that these forecasts and realtzed returns be risk-weighted. When this is done for the three managers, the risk-weighted forecasts and realized returns are: Risk-Weighted Forecasts Manager 1 Manager 2 Manager 3 Realized Security 1 0.176 0.235 0.147 0.353 Security 2 0.400 0.100 0.150 0.700 Security 3 0.417 0.000 0.042 0.333 Security 4 0.240 0.080 0.060 0.080 Q. The estimated profit (in AUD millions) from Adamant's CDS price change immediately after the credit event the first month is closest to A. 10 B. 16 c. 20 Solution A is correct because "the percentage price change is estimated as the change in spread ((400] bps) multiplied by the duration (4), or [16]%. The profit to the investor is [16]% times the notional ([AUD100] million), or (AUD16] million. Q. Based on Gelblum's estimates, and holding the size of Zimt's ownership stake in Oxbow constant, Zimt's net income in 2018 will most likely be A. highest if Zimt is deemed to have control of Oxbow. B. highest if Zimt is deemed to have significant influence over Oxbow C. independent of the accounting method used for the investment in Oxbow. Solution C is correct. Net income is not affected by the accounting method used to account for active investments in other companies. "One-line consolidation" and consolidation result in the same impact on net income; it is the disclosure that differs. Q. The equilibrium 10-year Treasury note quoted futures contract price is closest to A. 147.94. B. 148.89. C. 149.78. Solution A is correct. The equilibrium 10-year quoted futures contract price based on the carry arbitrage model is calculated as Q_0 = (1/CF) × [FV(B, + Alo) - Al, - FVCI] CF = 0.7025 B_0 = 104.00. Al_0 = 0.17. Al_r = (120/180 × 0.02/2) = 0.67. FVCI = 0. Q. Smith decides to examine the following three investment options for Mathews: Buy a government security that would have an annualized return that is nearly risk free. Smith is Investment 1: considering two possible implementations: a two-year investment or a combination of two one-year investments. investment 2: Buy a four-year, zero-coupon corporate bond and then sell it after two years. Smith illustrates the returns from this strategy using the swap rate as a proxy for corporate yields. Investment 3; Buy a lower-quality, two-year corporate bond with a coupon rate of 4 15% and a 2-spread of 65 bps Whon Smith meets with Mathews to present these choices. Mathews tells him that she is somewhat confused by the various spread measures. She is curious to know whether there is one spread measure that could be Used as a good indicator of the risk and liquidity of money market securities during the recent past. Q. In presenting Investment 2, Smith should show an annual return closest to A. 4.31%. B. 5.42% C. 6.53%. Solution C is correct. The swap spread is a common way to indicate credit spreads in a market. The four-year swap rate (fixed leg of an interest rate swap) can be used as an indication of the four-year corporate yield. Riding the yield curve by purchasing a four-year zero-coupon bond with a yield of 4.75% (1.0., 4.05% + 0.70%, |P, = 100/1 + 0.0475)' = 83.058]) and then selling it when it becomes a two-year zero-coupon bond with a yield of 3.00% (i.e., 2.70% + 0.30%, (P, = 100/(1 + 0.0300)? = 94.260) produces an annual return of 6.53%: (94.260/83.058) 1.0 = 0.0653. Q. Perley & Sons is an investment advisor company that just signed a contract with full discretionary power for the management of assets for Bright Future, a charitable fund. Without consultation, portfolio manager Martin Brown, (FA, decides to trade the funds' assets through a brokerage firm that provides, as an additional benefit, research reports for companies in the microchip industry. These companies represent the main investment interest for most of the Perley & Sons clients. The Bright Future portfolio does not hold any equities in the microchip industry, and, because of its risk profile, is unlikely to ever do so. Which of the following activities represents a possible breach with the CFA Institute standards? A) Lack of action in consulting with the client before choosing the brokerage firm. B) Exercising a selection principle that does not comply with the idea of best trade price and execution. C) Accepting research reports from the brokerage firm that do not benefit client portfolios. Solution: B is correct. Q. One interpretation of an upward sloping yield curve is that the returns to short-dated bonds are: A. uncorrelated with bad times. B. more positively correlated with bad times than are returns to long-dated bonds. C. more negatively correlated with bad times than are returns to long-dated bonds. Solution C is correct. One interpretation of an upward-sloping yield curve is that returns to short-dated bonds are more negatively correlated with bad times than are returns to long-dated bonds. This interpretation is based on the notion that investors are willing to pay a premium and accept a lower return for short-dated bonds if they believe that long-dated bonds are not a good hedge against economic "bad times. Q. An analyst gathered the following information about a company: Number of shares outstanding 10 million Earnings per share US$2.00 PIE 20 Book value per share US$30 If the company repurchases 1 million shares at the prevailing market price, the resulting book value per share will be closest to A. US$26. B. US$27. C. US$29. Solution C is correct. The prevailing market price is US$2.00(20) = US$40.00 per share; thus, the buyback would reduce equity by US$40 million. Book value of equity before the buyback is US$300 million. Q. Risk-averse investors demanding a large equity risk premium are most likely expecting their future consumption outcomes and equity returns to be: A. uncorrelated. B. positively correlated. C. negatively correlated. Solution B is correct. If investors demand high equity risk premiums, they are likely expecting their future consumption and equity returns to be positively correlated. The positive correlation indicates that equities will exhibit poor hedging properties, because equity returns will be high (i.e., pay off) during "good times" and will be low (i.e., not pay off) during *bad times." In other words, the covariance between risk-averse investors' inter-temporal rates of substitution and the expected future prices of equities is highly negative, resulting in a positive and large equity risk premium. This is the case because in good times, when equity returns are high, the marginal value of consumption is low. Similarly, in bad times, when equity returns are low, the marginal value of consumption is high. Holding all else constant, the larger the magnitude of the negative covariance term, the larger the risk premium. Q. Given Hamilton's finding regarding heteroskedasticity, the most appropriate conclusion is that the variance of the error term is correlated with: A. the independent variables only. B. both the dependent and independent variables. C. the dependent variable only. Solution A is correct. Hamilton's test confirmed the presence of conditional heteroskedasticity, which means that the variance of the error term is correlated with the values of the independent variables. Q. Identify the trading strategy that will generate the payoffs of taking a long position in a put option within a single period binomial framework? A. Short Sell - HR = - (P^+ - P^-) / (S^+ + S&-) units of underlying and financing of - Pv (-HR x S^- + P^-) B. Buy - HR = (P^+ - P^-) / (S^+ - S^-) units of underlying and financing of - Pv (-HR x S^- + P^-) C. Short Sell HR = (P^+ - P^-) / (S^+ - S^-) units of underlying and financing of Pv (-HR x S^- + P^-) Therefore, a put option can be replicated with the underlying and financing. Specifically, the put option is equivalent to a short position in the underlying with financing in the form of lending. A is correct. Q. The BIG Industrial income statement reflects a profitable 49% unconsolidated equity investment. Webster calculates the return on sales of BIG Industrial based on the reported income statement. Dodd notes that industry peers consolidate similar investments. Dodd asks Webster to use a comparable method of calculating the return on sales for BIG Industrial. Q. In response to Dodd's request, Webster's recalculated return on sales will most likely. A decrease. B. remain the same. C. increase. Solution A is correct. The use of unconsolidated joint ventures or equity-method investees may reflect an overstated return on sales ratio, because the parent company's consolidated financial statements include its share of the investee's profits but not its share of the investee's sales. An analyst can adjust the reported amounts to better reflect the combined amounts of sales. Reported net income divided by the combined amount of sales will result in a decrease in the net profit margin. Q. Which of the following is not part of the nine major sections of the GPS® standards? A. Performance Fees B. Input Data C. Disclosure Solution B is correct. The major sections of the GIPS standards do not include performance fees or disclosure. The major sections are fundamentals of compliance, input data, and calculation methodology, composite and pooled fund maintenance, composite time-weighted return report, composite money-weighted return report, pooled fund time-weighted return report, pooled fund money-weighted return report, and GIPS advertising guidelines. Q. Intern 1 Intern 2 Required rate of return Growth rate, first four years Growth rate, beyond first four years 8.3% 5.0% 3.6% 7.8% 4.8% 4.0% Q. Based on Exhibit 4 and intern 1's analysis, Xavier Corporation's sustainable dividend payout ratio is closest to: A. 43.4%, B. 44.6%. C. 56.6%. Solution C is correct. because it is based on the sustainable growth rate and the required rate of return Sustainable growth rate = (b in mature phase) × (Return on equity) = (1 - Dividend payout) × (Return on equity) 0.036 = (1 - Dividend payout) × 0.083 Solving for the dividend payout ratio, the dividend payout = 56.627% *56.6%. Q. Based on Santos's revenue growth rate estimate, the shares of Phoenix are most likely: A. undervalued. B. fairly valued. C. overvalued. Solution C is correct. If the revenue growth rate Inferred by the market price exceeds the growth rate that the firm could reasonably expect, Santos should conclude that the market price is too high and thus that the firm is overvalued Q. The estimated profit (in AUD millions) from Adamant's CDS price change immediately after the credit event in the first month is closest to: A. 10. B. 16. C. 20. Solution A is correct because "the percentage price change is estimated as the change in spread ((400] bps) multiplied by the duration (4), or [16]%. The profit to the investor is [16]% times the notional (IAUD100] million), or [AUD16] million."