CFA II Questions and Answers 3

Q. Devon Ltd. common shares sell at US$40 a share, and their estimated price-to-earnings ratio (P/E) is 32. If Devon borrows funds to repurchase shares at its after-tax cost of debt of 5%, its EPS is most likely to: A. increase. B. decrease. C. remain the same. Solution B is correct. If the P/E is 32. the earnings-to-price ratio (earnings vield or E/P) is 1/32 = 3.125%. When the cost of capital is greater than the earnings yield, earnings dilution will result from the buyback. Q. Another MD joins the interview and mentions that an analyst on her team estimated a regression to explain a cross-section of returns on assets of companies using a regulation dummy variable (REG = 1 if regulated, O otherwise), market share (MKTSH), and an interaction term, REG_MKTSH, the product of REG and MKTSH. She notes the resulting model is RET = 0.50 - 0.5REG + 0.4MKTSH - 0.2REG_MKTSH and asks you to do the following: Identify which of the following statements is correct regarding interpretation of the regression results (indicate all that apply). A. The average return for a regulated firm is 0.5% lower than for a non-regulated firm, holding the market share constant. B. Non-regulated companies with larger market shares have lower ROAs than regulated companies. C. For each increase in market share, a regulated firm has a 0.3 lower return on assets than a non-regulated firm. Solution A and C are correct. A is correct because the coefficient on REG is -0.5. C is correct because the sum of coefficients is -0.3 = -0.5 REG + (0.4MKTSH + -0.2REG_MKTSH). Q. Robert Chan comments to Leslie Singer that Converted Industries' eX- _ cted dividend growth rate is 5.0%, dividend payout ratio (g) is 45%, and required return on equity (n) is 10%. Based on a justified trailing P/E ratio compared to the stock's trailing P/E ratio at market of 9.0, Converted Industries is most likely. A) overvalued. B) undervalued. C) correctly valued. Explanation Justified trailing P/E = payout ratio * (1 + g) / (r - g). When the expected dividend growth is 5.0%, the justified trailing P/E = 0.45 * (1 + 0.05) / (0.10 - 0.05) = 9.45. This is greater than the market P/E of 9.0. Q. When describing the APT, Park is least likely correct with regard to A. Assumption 1. B. Assumption 3. C. Assumption 2. Solution C is correct. The assumptions under the APT are as follows: 1. A factor model describes asset returns. 2. There are many assets, so investors can form well-diversified portfolios that eliminate asset-specific risk, not factor risk. 3. No arbitrage opportunities exist among well-diversified portfolios. The absence of an arbitrage opportunity indicates a condition of financial market equilibrium. Q. Which of the following statements least accurately explains the relationship between the residual income (RI) model, the dividend discount model (DDM), and free cash flow to equity (FCFE): A) All the models discount future cash flows or income at the required rate of return. B) RI models use an equity value from the balance sheet plus the present value of expected future residual income. C) FCFE models use historical cash flows. Explanation In theory, the same value or total present value should be derived using expected dividends, expected FFE, or book value plus expected residual income if the underlying assumptions are the same. However, the recognition of value is different because FCFE and DDM models forecast future cash flows, while residual income models start with a balance sheet measure of equity and add the present value of expected future residual income. A residual income model can be used along with other models to assess the consistency of results. Q. 1. Adjust financial leverage to the optimal level. 2. Implement efficiencies in administrative functions. 3. Reduce research and development (R&D) expenses. As a final question, Kim's supervisor asks him why he prefers the residual income model to other approaches. Q. Which of management's three strategic goals will /east likely result in a higher EVA for DongSun? A. Goal 1 B. Goal 2 C. Goal 3 Solution c is correct. By definition, EVA = NOPAT - (C% × TC), where NOPAT is the net operating profit after taxes, C% is the cost of capital, and TC is the total capital employed. Efficiencies in the administrative functions will decrease operating expenses, increase NOPAT, and thus increase EVA. Adjusting financial leverage to the optimal level will decrease the cost of capital and thus increase EVA. R&D costs are added back to NOPAT when calculating EVA. Therefore, decreasing R&D will serve to lower NOPAT and thus lower EVA. Q. For an option-free bond trading at par, it is least likely that: A) The rate durations for all the rates other than the maturity-matched rate are zero. B)The spot rate for the maturity of the bond is least important rate affecting the value of the bond. C) Its maturity key rate duration is the same as its effective duration. Explanation If an option-free bond is trading at par, the bond's maturity-matched rate (or the spot rate applicable to its maturity) is the only rate that affects the bond's value. Its maturity key rate duration is the same as its effective duration, and all other key rate durations are zero. Q. Based on Exhibit 1, the trailing P/E for Centralino as of 1 January 2020, ignoring any business-cycle influence, is closest to: A. 8.3. B. 8.9. C. 9.9. Solution B is correct. The trailing P/E is calculated as follows: Stock's current price/Most recent four quarters' EPS =€50/€5.64 = 8.9. Q. The current service cost is closest to: A. $14,152. B. $15,758. C. $17,907. Solution A is correct. Current service cost is the present value of annual unit credit earned in the current period Annual unit credit (benefit) per service year = Value at retirement / Years of service. Years of service = 15 (vested years of past service) + 7 (expected years until retirement) = 22. Annual unit credit = $393,949 / 22 = $17,906.77. Current service cost (for 1 year) = Annual unit credit/ (1 + Discount rate) Years until retirement at the end or Year 1) = $17,906.77/(1 + 0.04)^6 = $14, 151.98 Q. "Even if investors require compensation for holding longer-term bonds, the yield curve can slope downward- for example, if there is an expectation of severe deflation. Regarding forward rates, it can be helpful to understand yield curve dynamics by calculating implied forward rates. To see what I mean, we can use Exhibit 1 to calculate the forward rate for a two-year Country C loan beginning in three years." Q. When government budget deficits fall, fiscal supply-side effects are most likely to result in: A. higher bond yields. B. a steeper yield curve C. lower bond yields. Solution C is correct. When government budget deficits fall, fiscal supply-side effects are most likely to result in lower bond yields Q. Regarding options on a stock without dividends, it is: A) never worthwhile to exercise puts or calls early. B) sometimes worthwhile to exercise puts early but not calls. C) sometimes worthwhile to exercise calls early but not puts. Explanation After early exercise of a put, and in particular a deep in-the-money put, the sale proceeds can be invested at the risk-free rate and may earn interest worth more than the time value of the put option. The same is not true for call options: early exercise of call options on non-dividend-paying stock is never optimal. 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 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. 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. 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 × -1 × -8.7 × 0.333). There is no impact from curvature, since the curve did not "twist." Q. The sensitivity of a corporate bond's spread to changes in the business cycle is most likely to be: A. uncorrelated with the level of cyclicality in the company's business. B. positively correlated with the level of cyclicality in the company's business. C. negatively correlated with the level of cyclicality of the company's business. Solution B is correct. The sensitivity of a corporate bond's spread to changes in the business cycle and the level of cyclicality tend to be positively correlated. The greater the level of cyclicality, the greater the sensitivity of the bond's spread to changes in the business cycle Q. Using the crude oil futures prices in Exhibit 1, who would most likely account for the lowest roll return until March? A. An airline hedging fuel costs B. The QA Energy Commodities Fund C. A crude oil producer hedging production Solution C is correct. A crüde oil producer would be short futures to hedge the risk of future falling prices. For example, falling prices would decrease future sales and income. Crude oil futures are in backwardation, causing successive futures contracts to be sold at lower prices and causing roll yield to be negative. Q. Another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that Delta Corporation may make an unsolicited bid at a premium to the market price for all of the publicly traded shares of Zega, Inc. Zega's market capitalization and capital structure are comparable to Delta's; both firms are highly levered. It is anticipated that Delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. Q. A profitable equity-versus-credit trade involving Delta and Zega is to: A. short Zega shares and buy protection on Delta using the 10-year CDS. B. go long Zega shares and buy protection on Delta using 5-year CDS. C. go long Delta shares and buy protection on Delta using 5-year CDS. Solution B is correct. The shares of Zega can be sold at a higher price as a result of the unsolicited bid in the market. If Delta Corporation issues significantly more debt, there is a higher probability that it may default. If the Fund sells protection on Delta now, the trade will realize a profit as credit spreads widen. An equity-versus-credit trade would be to go long (buy) the Zega shares and buy protection on Delta Q. Based on the regression results in Exhibit 1, the original time series of exchange rates: A. has a unit root. B. exhibits stationarity. C. can be modeled using linear regression. Solution A is correct. If the exchange rate series is a random walk, then the first-differenced series will yield b, = 0 and b, = 0 and the error terms will not be serially correlated. The data in Exhibit 1 show that this is the case: Neither the intercept nor the coefficient on the first lag of the first-differenced exchange rate in Regression 2 differs significantly from zero because the -statistics of both coefficients are less than the critical t-statistic of 1.98. Also, the residual autocorrelations do not differ significantly from zero because the -statistics of all autocorrelations are less than the critical t-statistic of 1.98. Therefore, because all random walks have unit roots, the exchange rate time series used to run Regression 1 has a unit root. Q. Based on Exhibit 1 and Note 4 in Exhibit 2, the total intangible assets on Ngcorp's balance sheet as of 31 December 2016 are closest to: A. FB12.54 million. B. FB12.71 million. C. FB13.04 million. Solution B is correct. Because Ngcorp has a functional currency that is different from Amble's presentation currency, the intangible assets are translated into Norvoltian kroner using the current rate method. The current FB/NVK exchange rate is 4.2374 as of 31 December 2016. Thus, the intangible assets on Ngcorp's 2016 balance sheet are NVK3 million × FB4.2374/NVK = FB12.71 million. Q. Based on Exhibits 2 and 3, as well as Holmstead's assumption about future health care inflation, the debt-to-equity ratio calculated by Rickards for XYZ should be closest to: A. 2.69. B. 2.71. C. 2.73. Solution c is correct. To calculate the debt-to-equity ratio, both liabilities and total equity need to be adjusted for the estimated impact of a 100-bp increase in health care costs. The proposed increase in health care costs will increase total liabilities and decrease equity by the same amount. Consequently, the debt-to-equity ratio changes as follows: Sensitivity of benefit obligation to 100-bp increase = $93 Adjusted liabilities = $17,560 + $93 = $17,653 Adjusted equity = $6,570 - $93 = $6,477 Adjusted debt-to-equity ratio = $17,653/$6,477 = 2.7255 = 2.73 Consequently, a 100-bp increase in health care costs increases the debt-to-equity ratio to approximately 2.73. Q. The market price of Bond B2 is €1,090. If the bond is purchased at this price and there is a default on Date 3, the rate of return to the bond buyer would be closest to: A. -28.38%. B. -41.72% C. -69.49%. Solution A is correct. If default occurs on Date 3, the rate of return can be obtained by solving the following equation for internal rate of return (IRR): €1090=€60/(1+IRR) +€60/(1+IRR)^2 +€326.74/(1+IRR)^3 . In this equation, €60 is the amount of coupon received at Dates 1 and 2 prior to default at Date 3. The amount €326.74 is the recovery at Time 3 (from the CVA table in the solution to the previous question). The solution to the foregoing equation can be obtained using the cash flow IRR function on your calculator. Q. With regard to the credit risk of the sovereign debt issued by country governments, which of the following statements is correct? The credit risk premium on such debt is: A. zero because governments can print money to settle their debt. B. negligibly small because no country has defaulted on sovereign debt. C. a non-zero and positive quantity that varies depending on a country's creditworthiness Solution C is correct. Credit premiums have been an important component of the expected return on bonds issued by countries (sovereign debt). The credit premium varies from country to country depending on how creditworthy investors consider it to be. The fact that countries have both printed money to pay back debt and defaulted on it gives rise to a non-zero credit risk premium. Q. Following the investment committee's approval, Patterson references the updated risk management policy in her quarterly letter to investors. She states, "At Citadel, we take risk management very seriously. In response to recent investor concerns about volatility in our multi-asset fund, we have implemented a new policy. We limit fund losses to 2% of assets with a 99% level of confidence, with additional measures to limit total losses to 3% over a rolling 30-day period. Q. Patterson's comments to Citadel's investors are least likely accurate with regard to her: A. use of confidence levels. B. discussion of limiting losses. C. implied percentage declines from dollar VaR limits.Solution B is correct. VaR is an expression of a minimum loss. It is incorrect for Patterson to state that the policy will limit fund losses to 2% ($10 million/$500 million) over a five-day period. In practice, the maximum loss possible in an unleveraged portfolio is the portfolio's entire value. Q. A bond will be overvalued if the expected spot rate is: A. equal to the current forward rate. B. lower than the current forward rate. C. higher than the current forward rate. Hide Solution Solution to 2: C is correct. If the expected discount rate is higher than the forward rate, then the bond will be overvalued. The expected price of the bond is lower than the price obtained from discounting using the forward rate. 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. Solution A is correct. Using the expectations approach, the risk-neutral probability of an up move is п = [FV(1) - d]/(u - d) = (1.03 - 0.800)/(1.300 - 0.800) = 0.46. An American-style put can be exercised early. At Time Q. Based on the regression results in Exhibit 1, the original time series of exchange rates: A. has a unit root. B. exhibits stationarity. C. can be modeled using linear regression. Solution A is correct. If the exchange rate series is a random walk, then the first-differenced series will yield b, = 0 and b, = 0 and the error terms will not be serially correlated. The data in Exhibit 1 show that this is the case: Neither the intercept nor the coefficient on the first lag of the first-differenced exchange rate in Regression 2 differs significantly from zero because the -statistics of both coefficients are less than the critical t-statistic of 1.98. Also, the residual autocorrelations do not differ significantly from zero because the -statistics of all autocorrelations are less than the critical t-statistic of 1.98. Therefore, because all random walks have unit roots, the exchange rate time series used to run Regression 1 has a unit root. Q. Porter also analyzes Government-guaranteed mortgage backed securities (MBS). He considers the appropriate method to value those MBS, and the interest rate term structure model he should use to generate interest rates. Porter decides to use a model that avoids the generation of negative rates. Q. Which of the following methods is most appropriate for valuing the government-guaranteed MBS that Porter is examining? A. Pathwise valuation based on a binomial tree B. Pathwise valuation based on Monte Carlo Simulation C. Backward induction valuation based on a binomial tree B is correct. Q. As a final question, Kim's supervisor asks him why he prefers the residual income model to other approaches. Q. Which of the following is the most appropriate response Kim can make to his supervisor's final question? A. The analyst need not adjust the book value of common equity for non-recurring items. B. The analyst need not adjust book value of common equity for off-balance-sheet items. C. The interest expense in the residual income model correctly captures the cost of debt capital. Solution A is correct. Although it is important to adjust income for non-recurring items, these adjustments do not need to be made to the book value because they are already reflected in the value of the assets. Q. Franco's description of the Black model's approach to valuation of Eurodollar futures options used for hedging is: A. correct. B. incorrect, because he is describing a call option. C. incorrect, because he is describing a put option. Solution B is correct. Franco is incorrect because he describes a long call option, which according to the Black model can be viewed as the futures component minus the bond component. Long put options hedge against rising interest rates. The Black model evaluates put options as the bond component minus the futures component. Q. NinMount's long-term debt to equity ratio on 31 December 2018 most likely will be lowest if the results of the acquisition are reported using: A. the equity method. B. consolidation with full goodwill c. consolidation with partial goodwill Solution A is correct. Using the equity method, long-term debt to equity = £600/£1 430 = 0.42 Using the consolidation method, long-term debt to equity - long-term debt/equity = §1, 000/£1 750 = 0 57 Equity includes the 5320 noncontroling interest under either consolidation. It does not matter if the full or partial goodwill method is used since there is no goodwill. Q. Based on Exhibits 2 and 3, as well as Holmstead's assumption about future health care inflation, the debt-to-equity ratio calculated by Rickards for XYZ should be closest to A. 2.69. B. 2.71 C. 2.73. Solution C is correct. To calculate the debt-to-equity ratio, both liabilities and total equity need to be adjusted for the estimated impact of a 100-bp increase in health care costs. The proposed increase in health care costs will increase total liabilities and decrease equity by the same amount. Consequently, the debt-to-equity ratio changes as follows Sensitivity of benefit obligation to 100-bp increase = $93 Adjusted liabilities = $17,560 + $93 = $17.653 Adjusted equity = $6,570 - $93 = $6.477 Adjusted debt-to-equity ratio = $17,653/56,477 = 2.7255 = 2.73 Q. The valuation inputs used by Lee to price a call reflecting Solomons interest fate Views Shroud include all underlying FRA rate of. A. 0.60% with six months to expiration. B. 0.75% with nine months to expiration. C. 0.75% with six months to expiration Solution C is correct. Solomon's forecast is for the three-month MRR to exceed 0.85% in six months. The correct option valuation inputs use the six-month FRA rate as the underlying, which currently has a rate of 0.75%. Q. Identify the type of error and its impacts on regression Model A indicated by the data in Exhibit 2. A. Serial correlation, invalid coefficient estimates, and deflated standard errors. B. Heteroskedasticity, valid coefficient estimates, and deflated standard errors. C. Serial correlation, valid coefficient estimates, and inflated standard errors. Solution A is correct. The Breusch-Godfrey (BG) test is for serial correlation, and for Model A, the BG test statistic exceeds the critical value. In the presence of serial correlation, if the independent variable is a lagged value of the dependent variable, then regression coefficient estimates are invalid and coefficients' standard errors are deflated, so t-statistics are inflated. Q. Yang asks Whitney to explain the calculation of the fixed swap rate in a floating-for-fixed interest rate swap. Whitney outlines three possible methods for Yang to consider: Method 1 The swap rate is the difference between MR and the fixed interest rate on the bond. Method 2 The swap rate is the rate that sets the value of the fixed-rate bond equal to the notional principal of the swap. Method 3 The swap rate is the rate that sets the initial value of the swap equal to zero. Q. Which method described by Whitney is most likely correct? A. Method 3 B. Method 2 C. Method 1 Solution A is correct. The swap rate in a fixed-for-floating swap is the fixed rate that sets the initial value of the swap equal to zero. This is accomplished by setting the value of the fixed side equal to that of the floating side. Q. Determine using Exhibit 2 which one of the following statements is most likely to be correct. Monthly seasonality in the firm's portfolio is A. highly likely B. highly unlikely C. not able to be determined from the given data Solution B is correct. Monthly seasonality in the firm's portfolio is highly unlikely. The variance explained by the model (R-squared) is only 10.3%, and after adjusting for the number of independent variables (adjusted R-squared), it becomes negative. Also, the insignificant F-statistic indicates a 56.3% chance that all variable coefficients are zero. Finally, t-statistics and associated -values indicate that all the variable coefficients are insignificant (i.e., not significantly different from zero). Consequently, monthly seasonality is highly unlikely to exist in this portfolio. Q. If the one-year forward exchange rate is DC/FC 2 and the spot rate is DC/FC 1.9 when the foreign rate of return is 12% and the domestic return is 10%, which of the following statements would be most accurate? A) The arbitrage possibilities cannot be determined with the data given. B) Arbitrage is possible here, investors should borrow foreign, lend domestic. C) Arbitrage is possible here, investors should borrow domestic, lend foreign C is correct. Q. Which of Martin's statements relating to the introduction of electronic markets is correct? A. Statement 1 B. Statement 2 C. Statement 3 Solution A is correct. Once built, electronic systems are indeed cheaper to operate than floor-based trading systems. They require less physical space than do trading floors, and in contrast to floor-based trading systems, they do not require exchange officials to record and report prices. Furthermore, the widespread use of electronic trading systems significantly decreased trading costs for buy-side traders. Costs fell as exchanges obtained greater cost efficiencies from using electronic matching systems instead of floor-based manual trading systems. These technologies also decreased costs and increased efficiencies for the dealers and arbitrageurs who provide much of the liquidity offered at exchanges. Competition forced them to pass along much of the benefits of their new technologies to buy-side traders in the form of narrower spreads quoted for larger sizes. New electronic buy-side order management systems also decreased buy-side trading costs by allowing a smaller number of buy-side traders to process more orders and to process them more efficiently than manual traders. Q. Is his response to Scahill's question regarding the impact of changes in interest rate volatility on the OAS of callable and putable bonds, Morgan is most likely: A. incorrect about callable and putable bonds. B. correct about callable bonds and incorrect about putable bonds. C. correct about putable bonds and incorrect about callable bonds. Solution A is correct. Morgan's response to Scahill is incorrect. As interest rate volatility declines, the embedded call option becomes cheaper; thus, the higher the arbitrage-free value (or model value) of the callable bond. Callable bond value = Value of straight bond - Value of call option A higher value for the callable bond means that a higher spread needs to be added to one-period forward rates to make the arbitrage-free bond value equal to the market price (i.e., the OAS is higher). For putable bonds as interest rate volatility declines, the value of the put option declines as does the arbitrage-free value of the putable bond. Putable bond value = Value of straight bond + Value of put option This implies that a lower spread needs to be added to one-period forward rates to make the arbitrage free bond value equal to the market price. Thus, in this instance, the OAS is lower. Q. Based on Exhibit 4 and Gillette's forecast regarding Raffarin's share price, the return on the RI bond over the next year is most likely to be: A. lower than the return on Raffarin's common shares. B. the same as the return on Raffarin's common shares. C. higher than the return on Raffarin's common shares. Solution A is correct. Over the next year, Gillette believes that Raffarin's share price will continue to increase toward the conversion price but not exceed it. If Gillette's forecast becomes true, the return on the RI bond will increase but at a lower rate than the increase in Raffarin's share price because the conversion price is not expected to be reached. Q. Supreme Healthcare recently announced it had formed a special purpose entity through which it plans to sell up to $100 million of its accounts receivable. Supreme Healthcare has no voting interest in the SPE, but it is expected to absorb any losses that it may incur. Ohalin wants to estimate the impact this will have on Supreme Healthcare's consolidated financial statements. Q. If Supreme Healthcare sells its receivables to the SPE, its consolidated financial results will least likely show: A. a higher revenue for 2018. B. the same cash balance at 31 December 2018. C. the same accounts receivable balance at 31 December 2018 Solution A is correct. Revenue will not be higher for 2018 because Supreme Healthcare controls the SPE and thus eliminates intra-entity transactions and balances in consolidation. Consolidated revenue will thus present the results as if this transaction did not occur. Q. Franco's description of the Black model's approach to valuation of Eurodollar futures options used for hedging is: A. correct. B. incorrect, because he is describing a call option. C. incorrect, because he is describing a put option. Solution B is correct. Franco is incorrect because he describes a long call option, which according to the Black model can be viewed as the futures component minus the bond component. Long put options hedge against rising interest rates. The Black model evaluates put options as the bond component minus the futures component. Q. In presenting Investment 1, using Shire Gate Advisers' interest rate outlook, Smith could show that riding the yield curve provides a total return that is most likely. A. lower than the return on a maturity-matching strategy. B. equal to the return on a maturity-matching strategy. C. higher than the return on a maturity-matching strategy. Solution C is correct. When the spot curve is upward sloping and its level and shape are expected to remain constant over an investment horizon (Shire Gate Advisers' view), buying bonds with a maturity longer than the investment horizon (i.e., riding the yield curve) will provide a total return greater than the return on a maturity-matching strategy. Q. The multiple of expected proceeds at exit to invested funds for JRR's Stoneham LBO investment is closest to: A. 2.77. B. 2.89. C. 2.98. Solution B is correct. The investment exit value is $15 million. The expected payoff to JRR is calculated as follows (all amounts in millions): Expected exit value: $15.00 Debt remaining at exit: ($6.0 - 2.8) 3.20 Preference shares: [$3.60 × (1.15)5 8.33 Common equity: ($15 exit - 3.2 debt - 8.33 preference) 3.47 Initial investment: $3.6 (preference) + 0.9 × $0.4 (common) = $3.96. Proceeds at exit: $8.33 (preference) + 0.9 × $3.47 (common) = $11.45. Multiple of expected proceeds to invested funds: $11.45 exit value/$3.96 initial investment = 2.89×. Q. You have a portfolio 100% allocated to a manager with an ex post, active risk at 8.0%. You choose to allocate a 75% position to the active manager and 25% to the benchmark to bring the portfolio back to your target active risk of 6.0%. If the manager's information ratio is 0.50, what happens to the information ratio of the portfolio after the reallocation? A. The information ratio increases because the lower active risk reduces the denominator of the ratio. B. The information ratio remains unchanged because allocations between the active portfolio and the benchmark don't affect the information ratio. C. The information ratio decreases because allocating some of the portfolio to the benchmark means that the external manager generates less active return. Solution B is correct. The information ratio is unaffected by rebalancing the active portfolio and the benchmark portfolio. In this case, the active return and active risk are both reduced by 25% and the information ratio will be unchanged. Q. In Exhibit 2, the bond whose effective duration might lengthen if interest rates rise is: A. Bond #3. B. Bond #4. C. Bond #5. Solution B is correct. Effective duration indicates the sensitivity of a bond's price to a 100 bps parallel shift of the benchmark yield curve assuming no change in the bond's credit spread. The effective duration of an option-free bond, such as Bond #3, goes down as interest rates rise. As interest rates rise, a call option moves out of the money, which increases the value of the callable bond and lengthens its effective duration. In contrast, as interest rates rise, a put option moves into the money, which limits the price depreciation of the putable bond and shortens its effective duration. Thus, the bond whose effective duration might lengthen if interest rates rise is the callable bond (i.e., Bond #4). Q. The rate implicit in the lease for new stores is closest to: A) 8.14%. B) 8.53% C) 9.58%. C is correct. Explanation PV = -10.6, N = 20, PMT = 1.08, and FV = 4.6. CPT I/Y = 9.58%. (Module 17.1, LOS 17.e) Q. The forecasted item described in Reason 3 will most likely affect: A. earnings per share. B. dividends per share. C. book value per share. Solution C is correct. Other comprehensive income bypasses the income statement and goes directly to the statement of stockholders' equity (which is a violation of the clean surplus relationship). Therefore, book value per share for PTU will be affected by forecasted OCI. Q. Carter works for Invest Today, a local asset management firm. A broker that provides Carter with proprietary research through client brokerage arrangements is offering a new trading service. The broker is offering low-fee, execution-only trades to complement its traditional full-service, execution-and-research trades. To entice Carter and other asset managers to send additional business its way, the broker will apply the commissions paid on the new service toward satisfying the brokerage commitment of the prior full-service arrangements. Carter has always been satisfied with the execution provided on the full-service trades, and the new low-fee trades are comparable to the fees of other brokers currently used for the accounts that prohibit soft dollar arrangements. A. Carter can trade for his accounts that prohibit soft dollar arrangements under the new low-fee trading scheme. B. Carter cannot use the new trading scheme because the commissions are prohibited by the soft dollar restrictions of the accounts. C. Carter should trade only through the new low-fee scheme and should increase his trading volume to meet his required commission commitment. Solution Answer A is correct. The question relates to Standard I||(A) Loyalty, Prudence, and Care. Carter believes the broker offers effective execution at a fee that is comparable with those of other brokers, so he is free to use the broker for all accounts. Q. When discussing the Leighton Family Trust, does Telline violate any CFA Institute Standards of Professional Conduct? A. No. B. Yes, relating to duties to clients. C. Yes, relating to misrepresentation. Solution B is correct. Telline has a duty to preserve the confidentiality of current, former, and prospective clients. Telline violates Standard III(E) Preservation of Confidentiality when he reveals information about the Leighton Family Trust. Q. Rose, a portfolio manager for a local investment advisory firm, is planning to sell a portion of his personal investment portfolio to cover the costs of his child's academic tuition. Rose wants to sell a portion of his holdings in Household Products, but his firm recently upgraded the stock to "strong buy." Which of the following describes Rose's options under the Code and Standards? A. Based on his firm's "buy" recommendation, Rose cannot sell the shares because he would be improperly prospering from the inflated recommendation. B. Rose is free to sell his personal holdings once his firm is properly informed of his intentions. C. Rose can sell his personal holdings but only when a client of the firm places an order to buy shares of Household. Solution The correct answer is B. Standard VI(B)-Priority of Transactions does not limit transactions of company employees that differ from current recommendations as long as the sale does not disadvantage current clients. Q. Recall from the reading that each node is represented by both a time element and a rate change component. Which of the following statements about the missing data in Exhibit 3 I correct? A. Node 3-2 can be derived from Node 2-2. B. Node 4-1 should be equal to Node 4-5 multiplied by e^0.4, C. Node 2-2 approximates the implied one-year forward rate two years from now. Solution C is correct. Because Node 2-2 is the middle node rate in Year 2, it will be close to the implied one-year forward rate two years from now (as derived from the spot curve). Node 4-1 should be equal to the product of Node 4-5 and e^0.8 Lastly, Node 3-2 cannot be derived from Node 2-2; it can be derived from any other Year 3 node; for example, Node 3-2 can be derived from Node 3 4 (equal to the product of Node 3-4 and e^4q). 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 × -1 × -8.7 × 0.333). There is no impact from curvature, since the curve did not "twist." Q. Based on Exhibit 5, which single time-series model would most likely be appropriate for Busse to use in predicting the future stock price of Company 3? A. Log-linear trend model B. First-differenced AR(2) model C. First-differenced log AR(1) model Solution C is correct. As a result of the exponential trend in the time series of stock prices for Company 3, Busse would want to take the natural log of the series and then first-difference it. Because the time series also has serial correlation in the residuals from the trend model, Busse should use a more complex model, such as an autoregressive (AR) model.