CFA II Questions and Answers 4

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. в. 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. 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. Q. Compared to accounting principles currently in use, the pooling method BetterCare used for its Statewide Medical acquisition has most likely caused its reported: A. revenue to be higher. B. total equity to be lower. C. total assets to be higher. Solution B is correct. Statewide Medical was accounted for under the pooling of interest method, which causes all of Statewide's assets and liabilities to be reported at historical book value. The excess of assets over liabilities generally is lower using the historical book value method than using the fair value method (this latter method must be used under currently required acquisition accounting). It would have no effect on revenue. Q. Based on the data in Exhibit 2, the spread the market is expecting for the credit and liquidity component of the yield to maturity for the ESB bond is closest to: A. 1.14 B. 0.59 C. 0.66 Solution C is correct. The swap spread represents the return that investors require for credit and liquidity. Since dealers are quoting the bond flat to swaps or swaps + 0 basis points there is no added spread to swaps. The swap spread is measured over the "on-the-run" or most recently issued government security, in this case the Bund. Simple interpolation is used to calculate the swap spread. First, calculate the Bund yield for the maturity: 0.41 + 0.86 × (0.50 - 0.41) = 0.49. Second, calculate the swap rate for the maturity: 1.05 + 0.86 × (1.16 - 1.05) = 1.14. Third, the difference represents the swap spread: 1.14 - 0.49 = 0.66. Q. The amount of periodic pension cost that would be reported in P&L under IFRS is closest to: A. 28. B. 538. C. 1,020. Solution B is correct. Under IFRS, the components of periodic pension cost that would be reported in P&L are the service cost (composed of current service and past service costs) and the net interest expense or income, calculated by Q. Based on the data presented in Exhibit 2, the candidate with the greatest skill at achieving active returns appears to be: A. Candidate A. B. Candidate B. C. Candidate C. Solution B is correct. The IR measures the consistency of active return generation. A higher ratio generally indicates better managerial skill at achieving active returns on a risk-adjusted basis. The IR for Candidate B (0.746) is higher than the IR for Candidate A (0.582) and Candidate C (0.723). Thus, Candidate B appears to have the greatest skill, as indicated by the highest IR of 0.746. Q. The best answer to Paul's question about the operating portion of the pension expense if (in $ thousands): A. 1,151. B. 1,423. C. 6,592. Solution A is correct. Conceptually speaking, only the current service cost component is considered an operating expense. Atlantic's 2017 current service cost is $1,151. Both the interest expense and asset returns components of pension expense are non-operating. Q. Are Excerpts 2 and 3 of Crawfood's compliance procedures consistent with the CFA Institute Standards of Professional Conduct? A. Yes. B. No, because Excerpt 2 applies only to officers and their direct reports. C. No, because Excerpt 3 does not require employees to achieve public dissemination. Solution B is correct. Excerpt 2 is inconsistent with CA Standards because it addresses only officers and only their directreports, that is, employees whom they directly supervise. Standard IV (C) states that "any investment professionals who have employees subject to their control or influence" exercise supervisory responsibility. Excerpt 3 is consistent with CFA Standards. It is based on a quote from the Standards of Practice Handbook stating that "if a member or candidate determines that information is material, the member . .. should make reasonable efforts to achieve public dissemination." Members are not required to achieve public dissemination and those bound by a duty of loyalty or a duty to preserve confidentiality would refrain from doing so because it would breach their duty. 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 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 (bp) 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. Which of Kreming's observations regarding actual and risk-neutral default probabilities is correct? A. Only Observation 1 B. Only Observation 2 C. Both Observation 1 and Observation 2 Solution B is correct. Observation 1 is incorrect, but Observation 2 is correct. The actual default probabilities do not include the default risk premium associated with the uncertainty in the timing of the possible default. loss. The observed spread over the yield on a risk-free bond in practice does include liquidity and tax considerations, in addition to credit risk. Q. Suppose all three managers claim to be efficient in portfolio construction. According to the expanded fundamental law of active management, which manager is the best at building portfolios to make full use of their ability to correctly anticipate returns? A. Manager 1 B. Manager 2 C. Manager 3 Solution B is correct. The proper statistic to calculate is the transfer coefficient, and it is defined as follows: TC = rho (mu_i / sigma_i), triangle w_i sigma_i. The TC is the cross-sectional correlation between the forecasted active security returns and the actual active weights, adjusted for risk. Q. Based on Exhibits 1 and 2, the translation adjustment for Triofind-B's liabilities into Triofind's presentation currency for the six months ended 31 December 2016 is: A. negative. B. zero. C. positive. Solution A is correct. The monetary balance sheet items for Triofind-B are translated at the current exchange rate, which reflects that the Borliand dollar weakened during the period relative to the Norvolt euro. The rate as of 30 June 2016 was BRD1.15/NER (or NER/BRD0.8696) and as of 31 December 2016 was BRD1.20/NER (or NER/BRD0.8333). Therefore, notes payable translates to NER416,667 (BRD500,000 × NER/BRD0.8333) as of 31 December 2016, compared with NER434,783 (BRD500,000 × ER/BRD0.8696) as of 30 June 2016. Thus, the translation adjustment for liabilities is negative Q. Suppose an options dealer offers to sell a three-month at-the-money call on the FTSE index option at 19% implied volatility and a one-month in-the-money put on Vodaphone (VOD) at 24%. An option trader believes that based on the current outlook, FTSE volatility should be closer to 25% and VOD volatility should be closer to 20%. What actions might the trader take to benefit from her views? A. Buy the FTSE call and the VOD put. B. Buy the FTSE call and sell the VOD put. C. Sell the FTSE call and sell the VOD puts. Hide Solution Solution: B is correct. The trader believes that the FTSE call volatility is understated by the dealer and that the VOD put volatility is overstated. Thus, the trader would expect FTSE volatility to rise and VOD volatility to fall. As a result, the FTSE call would be expected to increase in value and the VOD put would be expected to decrease in value. The trader would take the positions as indicated in B. 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. 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.