CFA Level II Mock Exam 2 - Answers

Overview for Questions #1-4 of 88 Question ID: 1507374 TOPIC: QUANTITATIVE METHODS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Lena Pilchard, a research associate at Eiffel, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts. Additionally, Pilchard wants to develop an algorithm to create a custom index to use as a benchmark. Pilchard's supervisor, Edna Wilrus, recommends a portfolio allocation strategy that overweights neglected firms. Wilrus cites studies of the "neglected firm effect," in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilrus considers a company covered by three or fewer analysts to be "neglected." Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio: Ri = b0 + b1COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei where: Ri = the rate of return on stock i COVERAGEi = one if there are three or fewer analysts covering stock i, and equals zero otherwise LN(SIZEi) = the natural logarithm of the market capitalization (stock price times shares outstanding) for stock i, units in millions FORECASTi = the 1-year consensus earnings growth rate forecast for stock i Pilchard derives the following results from her cross-sectional regression: Exhibit 1: Results of Pilchard's Cross-Sectional Regression Variable Constant Coefficient t-Statistic 0.060 1.56 COVERAGE 0.050 3.20 LN(SIZE) –0.003 –2.50 FORECAST 0.200 2.85 The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400. The coefficient of determination of the regression model using the residuals as dependent variable and using the same set of independent variables is 0.07832. Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating. Exhibit 2: Coverage, Firm Size, and Earnings Growth Forecast for Eggmann Enterprises Number of analysts 5 Firm size $500 million Earnings growth forecast 50% Pilchard uses the following table to conduct some of her hypothesis tests. Exhibit 3: Critical Values for Chi-Square Distribution (Level of Significance = 5%) Degree of Freedom Critical Value 1 3.841 2 5.991 3 7.815 4 9.488 5 11.070 6 12.592 Question #1 of 88 Question ID: 1507375 To create the custom benchmark, Elwell would most appropriately use a: A) LASSO algorithm. B) KNN technique. C) random forest classifier. Explanation Least absolute shrinkage and selection operator (LASSO) is a popular penalized regression model that is useful in building parsimonious models through feature reduction. K-nearest neighbor (KNN) is used in classification and regression. This technique is used to classify an observation based on nearness to the observations in the training sample. Investment applications of KNN include predicting bankruptcy, assigning a bond to a ratings class, predicting stock prices, and creating customized indices. Random forest is a variant of classification trees whereby a large number of classification trees are trained using data bagged from the same data set. Investment applications of random forest include factor-based asset allocation, and prediction models for the success of an IPO. (Module 3.2, LOS 3.c) Question #2 of 88 Question ID: 1507376 Does the model exhibit evidence of conditional heteroskedasticity in residuals? A) Yes because the χ2 of 6.44 is less than the critical χ2 of 7.815. B) No because the χ2 statistic of 2.35 is less than the critical χ2 of 7.815. C) No because the data is cross-sectional. Explanation The calcualted chi-square statistic uses the R2 of the regression of residuals on the original independent variables (R2 is given as 0.07832). χ2 = n × R2 = 30 × 0.07832 = 2.35 Critical χ2 (dof = k = 3) = 7.815. Since the calculated χ2 is not greater than the critical value, we fail to reject the null hypothesis of no conditional heteroskedasticity. (Module 1.3, LOS 1.h) Question #3 of 88 Question ID: 1507377 Holding firm size and consensus earnings growth forecasts constant, the estimated average difference in stock returns between neglected and non-neglected firms equals: A) 1%. B) 3%. C) 5%. Explanation The slope on the dummy variable (COVERAGE), which is 0.05 or 5%, equals the change in average returns between neglected and non-neglected firms after controlling for SIZE and FORECAST. (Module 1.2, LOS 1.f) Question #4 of 88 Question ID: 1507378 Using the inputs for Eggmann Enterprises provided in Exhibit 2, the predicted stock return for Eggmann Enterprises is closest to: A) 4%. B) 9%. C) 14%. Explanation The estimated regression equation equals: return = 0.06 + 0.05Coverage − 0.003LN(SIZE) + 0.20Forecast where: coverage equals zero if number of analysts exceeds 3 Therefore, the predicted return for Eggmann Enterprises equals: return = 0.06 + 0 − 0.003LN(500) + 0.20(0.50) return = 14.14% (Module 1.2, LOS 1.f) Overview for Questions #5-8 of 88 Question ID: 1507389 TOPIC: ECONOMICS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Alfred Farias, fixed income analyst for BNF, Inc., is analyzing the economic prospects of Procken, Krosse, Weira, and Toban, four countries in the same region. He collects the following economic and demographic statistics for the countries: Procken Krosse Current real GDP (in $ billions) Weira Toban $250.00 $250.00 $4,500.00 $4,800.00 Projected real GDP in 5 years (in $ billions) based on potential GDP growth rate $306.00 $315.00 $5,262.00 $5,778.00 Long-term growth rate of capital 4.0% 4.2% 3.2% 3.8% Current capital base ($ billions) $782.9 $699.2 $18,750 $19,750 Imports (in $ billions) $30.00 $60.00 $1,500.00 $900.00 Exports (in $ billions) $32.00 $80.00 $1,000.00 $900.00 Population (in $ millions) 20.4 20.0 101.0 100.0 Labor growth rate 1.9% 2.9% 0.4% 0.8% Cost of capital relative to total factor cost 32.5% 35.0% 25.0% 22.5% 4.0% 4.7% 4.5% 3.8% Average real annual appreciation in equities (past five years) A GDP per capita below $25,000 is considered a developing country, and a GDP per capita greater than $25,000 is considered a developed country. Farias concludes that Weira and Toban have reached steady-state growth. In the latest round of trade negotiations, representatives from each country discussed their efforts to foster their countries' economic development and benefit from the growth of world trade. Procken's Representative: "We are wary of the potential for loss of domestic industries if we remove trade barriers. Given the state of our economy, I'm not certain that we can lower our trade barriers any further." Krosse's Representative: "We in Krosse are not investing enough in infrastructure and education to increase the level of productivity and technology in our economy. We also need foreign direct investment and hence we welcome foreign investors." Weira's Representative: "We are concerned about my country's negative trade balance. Weira needs more exports to sustain our growth." Toban's Representative: "We seem to be at a point in Toban where the growth rate of my country's labor force may be insufficient to support our GDP growth rate." Question #5 of 88 Which country is most likely to benefit from capital deepening? A) Weira. Question ID: 1507390 B) Krosse. C) Procken. Explanation Krosse is a developing nation with the highest α (share of capital in GDP) among all the countries. A high value of α indicates that the next unit of capital added will increase output almost as much as the previous unit of capital. Developing nations with a high α are more likely to benefit from capital deepening, which should result in an increase in productivity (at least in the short term). (Module 3.2, LOS 3.c) Question #6 of 88 Question ID: 1507391 For this question only, assume that the population growth rate is the same for Krosse and Procken. A possible cause for the difference in growth rate of labor is that relative to Procken, Krosse has: A) stricter immigration policies. B) a lower labor participation rate. C) experienced an increase in average hours worked. Explanation Krosse's labor growth rate is greater than that of Procken's. Labor growth can be accomplished by an increase in the labor force participation rate, an increase in average hours worked, additional supply of labor by immigration, or a higher population growth rate. We are told that the population growth rate is equal for the two countries. The only choice that allows for higher labor growth rate is then higher average hours worked. (Module 1.3, LOS 1.h) Question #7 of 88 The rental price of capital in Weira is closest to: A) 6%. B) 12%. C) 25%. Explanation Question ID: 1507392 It is stated in the vignette that Weira has reached steady-state. In steady state (i.e., in equilibrium), the marginal product of capital (MPK = αY/K) and marginal cost of capital (i.e., the rental price of capital, r) are equal; hence: αY/K = r. r = (0.25)(4,500) / (18,750) = 0.06 or 6% (Module 1.2, LOS 1.f) Question #8 of 88 Question ID: 1507393 Based on the information provided, which developing country is most likely to achieve convergence in growth rates and standard of living with their developed counterparts? A) Toban. B) Krosse. C) Procken. Explanation Based on the data in the vignette, Krosse and Procken are developing countries. The GDP per capita for Krosse is $250 billion divided by 20.0 million people, which is equal to $12,500. The GDP per capita for Procken is $250 billion divided by 20.4 million people, which is equal to $12,255. Krosse is more likely to achieve convergence because Krosse is showing more willingness toward opening up the economy to trade and financial flows than is Procken; Krosse's international trade as a proportion of GDP is higher than Procken's, and comments by Krosse's representative indicate that inflow of foreign capital would be welcome. Finally, comments by Procken's representative indicate an inward-oriented policy, which could hinder convergence. (Module 1.2, LOS 1.f) Overview for Questions #9-12 of 88 Question ID: 1508883 TOPIC: FINANCIAL STATEMENT ANALYSIS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS In 2009, Continental Supply Company was formed to provide drilling equipment and supplies to contractors and oilfield production companies located throughout the United States. At the end of 2013, Continental Supply created a wholly owned foreign subsidiary, International Oilfield Incorporated, to begin servicing customers located in the North Sea. International Oilfield maintains its financial statements in a currency known as the local currency unit (LCU). Continental Supply follows U.S. GAAP and its presentation currency is the U.S. dollar. For the years 2013 through 2016, the weighted-average and year-end exchange rates, stated in terms of local currency per U.S. dollar, were as follows: LCU/$US 2013 2014 2015 2016 Average 0.90 1.05 1.05 1.25 Year-end 1.00 1.10 1.00 1.50 International Oilfield accounts for its inventory using the lower-of-cost or market valuation method in conjunction with the first-in, first-out, cost flow assumption. All of the inventory on hand at the beginning of the year was sold during 2016. Inventory remaining at the end of 2016 was acquired evenly throughout the year. At the beginning of 2014, International Oilfield purchased equipment totaling LCU 975 million when the exchange rate was LCU 1.00 to $1. During 2015, equipment with an original cost of LCU 108 million was totally destroyed in a fire. At the end of 2015, International Oilfield received a LCU 92 million insurance settlement for the loss. On June 30, 2016, International Oilfield purchased equipment totaling LCU 225 million when the exchange rate was LCU 1.25 to $1. For the years 2015 and 2016, Continental Supply reported International Oilfield revenues in its consolidated income statement of $375 million and $450 million, respectively. There were no inter-company transactions. Following are International Oilfield's balance sheets at the end of 2015 and 2016: LCU in millions 2016 2015 Cash and receivables 120.0 216.0 Inventory 631.3 650.4 Equipment 820.7 693.6 Liabilities (all monetary) 600.0 600.0 Capital stock 350.0 350.0 Retained earnings 622.0 610.0 At the end of 2016, International Oilfield's retained earnings account was equal to $525 million and, to date, no dividends have been paid. All of International Oilfield's capital stock was issued at the end of 2013. Question #9 of 88 Question ID: 1507400 Assuming that International Oilfield's equipment is depreciated using the straight-line method over 10 years with no salvage value, calculate the subsidiary's 2016 depreciation expense under the temporal method. A) $95.7 million. B) $104.7 million. C) $114.7 million. Explanation International Oilfield is carrying 867 (i.e., 975 – 108) LCU original cost of equipment purchased in 2014 on their books. The 2015 losses due to fire and related insurance settlement do not affect depreciation in 2016 (other than depreciating fewer assets). The new equipment purchased during the year would be depreciated for a half year in 2016. Depreciation will be translated at the historical exchange rate under the temporal method. Equipment Calculation LCU Depreciation Historical Exchange Rate USD Depreciation Originally purchased in 2014 867 / 10 86.7 1 $86.70 1/2 × (225 /10) 11.25 1.25 $9.00 Purchased in 2016 (1/2 year) Total $95.70 (Module 10.3, LOS 10.d) Question #10 of 88 Question ID: 1507401 Compute the cumulative translation adjustment reported on Continental Supply's consolidated balance sheet at the end of 2016, assuming International Oilfield is a relatively self-contained and independent operation of Continental Supply. A) –$227 million. B) –$200 million. C) $298 million. Explanation Under the current rate method, gains and losses that occur as a result of the translation process do not show up on the income statement but are instead accumulated in a balance sheet account called the cumulative translation adjustment account (CTA). The translation gain or loss in each year is calculated and added to the account, acting like a running total of translation gains and losses. The CTA is simply an equity account on the balance sheet. To compute the CTA for Continental's balance sheet, force the accounting equation (A = L + E) to balance with the CTA; [(120 million cash and receivables + 631.3 million inventory + 820.7 million equipment − 600 million liabilities) / 1.50] − $350 million capital stock − $525 retained earnings = –$227 million. The LCU 350 capital stock was issued at the end of 2013 at an exchange rate of LCU 1 = $1. The $525 retained earnings figure was given in the text. (Module 10.4, LOS 10.d) Question #11 of 88 Question ID: 1507402 Compared to the temporal method, which of the following best describes the impact of the current rate method on International Oilfield's gross profit margin percentage for 2016 when stated in U.S. dollars? The gross profit margin would be: A) lower. B) higher. C) the same. Explanation Compared to the temporal method, the current rate method will result in a higher gross profit margin percentage (higher numerator) when the local currency is depreciating as is the case in this scenario (the exchange rate has risen from LCU 1 per $1 to LCU 1.25 per $1; thus, it costs more LCUs to buy $1 which is the result of a depreciating LCU). Under the temporal method, COGS is remeasured at the historic rate; thus, COGS is not impacted by the depreciating currency. Under the current rate method, COGS is translated at the average rate; thus, COGS is lower because of the depreciating currency. Lower COGS results in a higher gross profit margin percentage. (Module 10.4, LOS 10.e) Question #12 of 88 Question ID: 1507403 When remeasuring International Oilfield's 2016 financial statements into the presentation currency, which of the following ratios is not affected by changing exchange rates under the temporal method? A) Current ratio. B) Total asset turnover. C) Quick ratio. Explanation Both the numerator (cash + receivables) and denominator (current liabilities) of the quick ratio are remeasured at the current exchange rate under the temporal method. Inventories are ignored in the quick ratio. Since the same rate is used to remeasure both the numerator and denominator, the ratio does not change when stated in the presentation currency. (Module 10.3, LOS 10.e) Overview for Questions #13-16 of 88 Question ID: 1508884 TOPIC: EQUITY VALUATION THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Sampson Aerospace is a publicly traded U.S. manufacturer. Sampson supplies communication and navigation control systems to manufacturers of airplanes for commercial and government use. The company operates two divisions: (1) Commercial Operations, and (2) Government Operations. Revenues from the Government Operations division comprise 80% of Sampson's total company revenues. Revenues for other companies in the industry are also driven primarily by sales to the U.S. government. Sampson has gained a reputation for offering unique products and services. Sampson's market share has been increasing, and its net profit margin is among the highest in its industry. Sampson Aerospace recently announced that it is reducing its investment return assumption on its pension assets from 6% to 5%, and that it has entered negotiations to possibly acquire controlling equity interests in communications software firms, NavTech and Aerospace Communications. NavTech recently has decided to capitalize a significant portion of its research and development expense, and Aerospace Communications has restructured and reclassified many of its leases from operating to financial leases. Smith recently announced that Sampson had dropped out of negotiations with Knowledge Technologies, claiming it was likely not a sustainable business model. Consensus forecasts for NavTech and Aerospace Communications are presented in Exhibit 1. Exhibit 1: Selected Financial Data for NavTech and Aerospace Communications NavTech Aerospace Comm. Expected year-end dividend per share $1.07 $0.55 Expected year-end free cash flow to equity per share $0.80 $1.25 Weighted average cost of capital 10% 9% Required return on equity 12% 12% $21.40 $25 Current stock price Question #13 of 88 Question ID: 1507415 The most appropriate approach for Sampson Aerospace's valuation of NavTech and Aerospace Communications is: A) the dividend discount model. B) the free cash flow model. C) the relative value model. Explanation Sampson intends to make a purchase offer for controlling equity interests in the target companies. Cash flow models are more appropriate because a controlling interest allows Sampson to set the target company's financing, investment, and distribution policies. (Module 19.1, LOS 19.h) Question #14 of 88 Question ID: 1507416 Regarding the financial statement information provided in the analyst's report, the quality of financial statements has improved least for: A) Sampson. B) NavTech. C) Aerospace Communications. Explanation NavTech recently has decided to capitalize much of its research and development expense, thereby deferring much of its R&D expense (rather than immediately recognizing R&D as expense on the income statement). This is an example of aggressive accounting, especially if revenues cannot be matched directly with R&D expense. By reducing the investment return assumption on its pension investments, Sampson is moving to a more conservative approach. By capitalizing its leases (treating as finance leases rather than operating leases), Aerospace Communications more clearly reports its liabilities and assets. (Module 19.1, LOS 19.e) Question #15 of 88 Question ID: 1507417 By claiming that Knowledge Technologies is "not a sustainable business model," Sampson CEO Drew Smith would most likely estimate Knowledge Technologies's value using: A) balance sheet value. B) going concern value. C) liquidation value. Explanation If the company's business model is not sustainable, the liquidation value is more appropriate than its value as a going concern (which could be negative). Balance sheet value is an accounting concept, not a valuation concept. (Module 19.1, LOS 19.b) Question #16 of 88 Question ID: 1507418 Assuming that NavTech is valued according to the constant growth dividend model, the market expectation of dividend growth implied by NavTech's current stock price is closest to: A) 3%. B) 5%. C) 7%. Explanation Defining P0 as the current stock price, D1 as the expected year-end dividend, r as the required cost of equity, and g as the dividend growth rate, the present value formula for constant growth dividends is: D1 P0 = $21.40 = r−g $1.07 = 0.12−g $1.07 0.12 − g = $21.40 $1.07 g = 0.12 − $21.40 (Module 20.2, LOS 20.f) (Module 19.1, LOS 19.d) = 0.07 = 7% Overview for Questions #17-20 of 88 Question ID: 1507419 TOPIC: EQUITY VALUATION THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Ivan Johnson is reviewing the investment merits of BioTLab, a fast-growing biotechnology company. BioTLab has developed several drugs, which are being licensed to major drug companies. BioTLab also has several drugs in phase III trials (phase III trials are the last testing stage before FDA approval). Johnson notes that two drugs recently received approval which should provide BioTLab solid revenue growth and generate predictable cash flow well into the future. Based on the potential for the two drugs, BioTLab's estimated annual cash flow growth rate for the next two years is 25%, and long-term growth is expected to be 12%. Because of BioTLab's attractive investment opportunities, the company does not pay a dividend. BioTLab's current weighted average cost of capital is 15% and its stock is currently trading at $50 per share. The following is financial information for BioTLab for the most recent 12 months: Net working capital excluding cash increased from $7,460,000 to $9,985,000. Book value increased from $81,250,000 to $101,250,000. BioTLab currently has no debt. Research facilities and production equipment were purchased for $8,450,000. BioTLab held non-operating assets in the amount of $875,000. Net income for the 12 months was $20,000,000. BioTLab has a marginal tax rate of 40%. Noncash charges for depreciation and restructuring for the 12 months were $1,250,000. BioTLab's management has indicated an interest in establishing a dividend and will fund new drug research by issuing additional debt. Johnson also reviews a competitor to BioTLab, Groh Group, which has a larger segment operating in a highly cyclical business. The Groh Group has a debt to equity ratio of 1.0 and pays no dividends. In addition, Groh Group plans to issue bonds in the coming year. Question #17 of 88 Question ID: 1507420 Using a two-stage, free cash flow to the firm model, determine which of the following is closest to the value of BioTLab. A) $419 million. B) $436 million. C) $477 million. Explanation Free cash flow to the firm (FCFF) can be calculated in many ways but in this question, you are given enough information to calculate the measure in the following way: FCFF = net income + non-cash charges + interest (1 − t) − fixed capital investment − working capital investment FCFF0 = 20,000,000 + 1,250,000 + 0 − 8,450,000 − (9,985,000 − 7,460,000) = 10,275,000 The next step is to forecast the future FCFFs and the terminal value: FCFF1 = 10,275,000(1.25) = 12,843,750 FCFF2 = 12,843,750(1.25) = 16,054,688 terminal value = 16,054,688(1.12) / (0.15 – 0.12) = 599,375,000 Next, calculate the present value of the FCFFs and the terminal value: (16,054,688+599,375,000) 12,843,750 PVFCFs = 1.15 + (1.15) 2 = 476,521,739 If a firm has non-operating assets (e.g., land held for investment) on its balance sheet, the value of these assets must be added to the value of the operating assets (determined using the present value of the FCFFs and terminal value) to find the total firm value. total firm value = value of operating assets + value of non-operating assets total firm value = 476,521,739 + 875,000 = 477,396,739 (Module 21.5, LOS 21.k) Question #18 of 88 Question ID: 1507421 If BioTLab establishes a dividend and issues additional debt, the most likely effect on FCFF will be: A) no effect. B) a decrease in FCFF. C) an increase in FCFF. Explanation If BioTLab established a dividend there would be no impact on either FCFF or FCFE. Changing the company capital structure by increasing debt will not impact FCFF, although it will initially increase FCFE by the amount of debt issued and then reduce FCFE thereafter by the after-tax interest expense. (Module 21.5, LOS 21.f) Question #19 of 88 Question ID: 1507422 Which model would be most appropriate in valuing the Groh Group? A) FCFF model. B) FCFE model. C) Dividend Discount model. Explanation The FCFF model is better than the FCFE model in valuing debt laden, cyclical companies, and companies with a changing capital structure. Since Groh Group does not pay a dividend, the DDM model would be the least appropriate model to value the company. (Module 21.5, LOS 21.f) (Module 21.1, LOS 21.a) Question #20 of 88 Question ID: 1507423 Ten years have passed and BioTLab's drug pipeline has generated the expected growth. To support BioTLab's growth, the company levered its balance sheet to a debt-to-equity ratio of 35% by borrowing an additional $1.6 million during the last year, even as it paid total interest of $4 million. Still, the company generated $20 million in free cash flow to equity. The company's tax rate is 40% and pretax interest rate is 6%. The company's required rate of return on equity equals 13%. Using a single-stage FCFF model results in a value of $483,508,770. The expected growth rate in BioTLab's free cash flows is closest to: A) 6%. B) 8%. C) 10%. Explanation WACC = (0.35 / 1.35)(0.06)(1 − 0.40) + (1 / 1.35)(0.13) = 10.56% FCFF = FCFE + Int(1 − T) − net borrowing = 20,000,000 + 4,000,000(1 − 0.40) − 1,600,000 = 20,800,000 FCFF0 (1+g) firm value = WACC−g 20,800,000(1+g) 483,508,770 = 0.1056−g g = 0.06 (Module 21.5, LOS 21.k) Overview for Questions #21-24 of 88 Question ID: 1507429 TOPIC: FIXED INCOME THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corporation, Hardin's competitor, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%). Today Year 1 Year 2 9.324% 8.530% 7.250% 7.634% 6.983% 6.250% Also, assume that the appropriate spot rates for securities maturing in one, two, and three years are 7.25%, 7.5%, and 7.80%, respectively. Diffle believes he should begin his analysis with the option-free Bratton bonds. He decides to consider two different approaches to valuing the Bratton bonds—one that uses the current spot rate curve and another that uses the interest rate tree given above. To finish the analysis, Diffle would like to use his binomial model to evaluate the interest rate risk of both the Hardin bonds and the Bratton bonds. Diffle starts out with the benchmark interest rate tree and estimated OAS for both bonds. Then he shocks interest rates up and down by 25 basis points throughout the tree and adds the OAS estimated earlier. Using the tree and standard backward induction process, Diffle calculates values for the bonds. He plans to use these values as inputs into the following formulas for duration and convexity: Diffle's supervisor, Mark Zando, notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-themoney, the duration of one of the bonds will be lower than the other one. Question #21 of 88 Question ID: 1507430 Calculate the value of the Bratton bonds using the interest rate tree. A) 100.218. B) 100.378. C) 100.915. Explanation Interest rate tree: Discount maturity value back one year at different 1-year forward rates, then take the equally weighted average of those values discounted back to today at today's 1-year rate: V = 0.5 × [(108 / 1.08530) + 8] / 1.0725 + 0.5 × [(108 / 1.06983) + 8] / 1.0725 V = 0.5 × (99.512 + 8) / 1.0725 + 0.5 × (100.951 + 8) / 1.0725 V = 50.122 + 50.793 = 100.915 Today Year 1 Year 2 108 107.512 100.915 108 108.951 108 (Module 26.1, LOS 26.e) Question #22 of 88 Question ID: 1507431 Using the interest rate tree, and assuming that the bonds will be called at any node of the tree where the calculated value exceeds the call price, which of the following is closest to the value of the Hardin bonds? A) 100.472. B) 100.915. C) 101.358. Explanation Use the same method as in the previous problem, but remember that if the value at one node exceeds the call price, then the call price should be used for that node. In this case, the value at the lower node would be 108 / 1.06983 = 100.951. The assumption is that the bond would be called at the call price one year from now, or 100. V = 0.5 × (99.512 + 8) / 1.0725 + 0.5 × (100 + 8) / 1.0725 V = 50.122 + 50.350 = 100.472 (Module 27.2, LOS 27.f) Question #23 of 88 Question ID: 1507432 With regard to Zando's statement about comparability of duration of the two bonds, which of the following statements is most accurate? Bratton bonds' duration would be: A) lower than the duration of Hardin bonds under a rising interest rate scenario. B) C) lower than the duration of Hardin bonds under a declining interest rate scenario. higher than the duration of Hardin bonds under a declining interest rate scenario. Explanation Option-free Bratton bonds will have higher one-sided down duration compared to the callable Hardin bonds when the underlying option is at- or near-the-money. Due to the underlying call option, the appreciation of Hardin bonds in a declining interest rate scenario will be limited. (Module 27.6, LOS 27.k) Question #24 of 88 Question ID: 1507433 Which of the following statements is most accurate regarding Diffle's calculation of duration and convexity? A) B) C) The duration estimate will be inaccurate since it does not account for any change in cash flows due to the call option embedded in the Hardin bond. The duration estimate for the Bratton bonds will reflect the projected percentage change in price for a 100-basis-point change in interest rates. The estimates for both duration and convexity will be inaccurate because the OAS was not estimated again after the rate shock. Explanation The duration formula given will calculate the percentage change in price for a 100basis-point change in yield, regardless of the actual change in rates used to derive BV– and BV+. The standard backward induction process would ensure that the derived values of BV– and BV+ reflect any potential change in cash flows due to embedded options. (Module 27.5, LOS 27.i) Overview for Questions #25-28 of 88 TOPIC: DERIVATIVES Question ID: 1507449 THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention—Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. BIC is not expected to pay dividends in the foreseeable future. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing. In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock: Call A Call B Call C BIC Call Options BIC Put Options Strike Maturity Premium Strike Maturity Premium 40 October 3.51 50 October 1.98 60 October 1.42 Put D Put E Put F 30 November 2.31 40 November 4.14 50 November 9.21 Note: October options expire on the 21st of the month, while November options expire on the 18th. Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Question #25 of 88 Question ID: 1507450 Which of the following statements regarding the delta of the BIC options is correct? (Assume that the largest delta is defined as the delta furthest from zero.) A) Call C has the largest delta of all the BIC options. B) Put D has the smallest delta of all the BIC options. C) Put F has the largest delta of all the BIC options. Explanation An option that is deep in-the-money will have the largest delta. Call options that are deep in-the-money will have a delta close to one, while put options that are deep inthe-money will have a delta close to –1. Options that are out-of-the-money will have deltas close to zero. Put F is the option that is deepest in-the-money, and therefore has the largest delta (even though it is negative, the change in the price of Put F given a change in the price of BIC stock will be larger than any of the other options). Call C is the deepest out-of-the-money option, and thus has the smallest delta. (Module 31.7, LOS 31.k) Question #26 of 88 Question ID: 1507451 If the gamma of Put E is equal to 0.081, which of the following correctly interprets the option's gamma? A) The sensitivity of Put E’s price to changes in BIC’s stock price is very likely to change. B) A dynamic hedging strategy using Put E would require infrequent rebalancing. C) An increase in BIC's stock price of one dollar will increase Put E's premium by $0.081. Explanation An option's gamma measures the change in the delta for a change in the price of the underlying asset. The gamma of an option is highest when an option is at-themoney since the probability of moving in or out of the money is high. Put E is close to being at-the-money and because it has a gamma of greater than zero, the sensitivity of Put E's price to changes in BIC's stock price (i.e., the delta) is likely to change. The higher the gamma, the greater the change in delta given a change in stock price. (Module 31.7, LOS 31.l) Question #27 of 88 Question ID: 1507452 Assuming that on October 15, the closing price of BIC common stock is $40 per share, how would the delta of Put F have changed from June 1? A) The delta on Put F will move closer to –1. B) The delta on Put F will move closer to 0. C) The delta on Put F will move closer to 1. Explanation As the option moves further into the money and as the expiration date approaches, the delta of a put option moves closer to –1. (Module 31.7, LOS 31.k) Question #28 of 88 Question ID: 1507453 If the premium on Put D on November 1 is $3.18, which of the following has most likely occurred? A) The price of BIC stock has decreased to $26.82. B) BIC had a negative earnings surprise. C) Volatility of BIC stock has decreased. Explanation The premium on Put D has risen from $2.31 to $3.18 and there is still time left until expiration. Therefore, the increase in value must have come from either a decrease in stock price, an increase in volatility, or both of these events. Choice A would be correct if the option was at expiration and the $3.18 represented only intrinsic value. Since we are not yet at the expiration date, the stock price must be above $26.82. A negative earnings surprise would most likely cause a drop in the market price of the stock. Since there is no indication of the exact amount of the drop in price, the premium observed is a possibility. A decrease in BIC volatility would reduce the put premium, not increase it. (Module 31.7, LOS 31.k) Overview for Questions #29-32 of 88 Question ID: 1507454 TOPIC: ALTERNATIVE INVESTMENTS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Peter Lister, CFA, is an analyst with Rose Alternative Investments, LLC. Lister is evaluating investment opportunities in Buna, a developed country. Buna Commercial Real Estate Market Expectations Commercial real estate prices have experienced a moderate increase over the past year after a decade of unusually slow growth. Demand is expected to exceed supply over the next 10 years. The current average commercial mortgage rate of 3.75% is low by historical standards and is expected to stay relatively low for at least seven more years. Buna's economy is expected to enjoy an above average growth rate. Exhibit 1: Buna Economic Outlook Expected Annual Growth Relative to Other Developed Rate Countries Job 3.00% High Population 1.80% High Retail sales 1.50% Low Inflation 0.50% Low creation Three investment choices under consideration are: Choice 1: Investment in an equity REIT Choice 2: Purchase of an apartment building. Choice 3: Purchase of stock of a real estate operating company. Lister is also evaluating a new investment in the Targus Company. Targus is a start-up biotech company seeking $9 million of venture capital financing. Targus's founders believe that, based on the company's drug pipeline, a company value of $300 million is reasonable in seven years. Lister views Targus as a risky investment (15% risk of failure) and is using an ROI of 8x. Question #29 of 88 Question ID: 1507455 Based on the information in Exhibit 1, the REIT sector that represents the least desirable investment is: A) retail. B) office. C) apartments. Explanation For retail REITs, the most important factor affecting economic value is retail sales growth, which is expected to be low in Buna. The most important factor affecting economic value for apartment REITs are job creation and population growth, which are both expected to be high. For office properties, the most important factor is job creation, which is expected to be high. (Module 32.1, LOS 32.b) Question #30 of 88 Question ID: 1507456 The most appropriate reason to favor investing in Choice 2 over Choices 1 and 3 is that Choice 2 is likely to have the ability to: A) use higher leverage. B) provide greater tax advantages. C) avoid structural conflicts of interest. Explanation Choice 2 represents private investment in real estate, while Choices 1 and 3 entail investing through public securities. Tax advantages can be enjoyed by direct investments in real estate, as well as through public securities. Similarly, use of leverage can be pursued by all three choices. Choice 2 does not have the problem of structural conflicts of interest that may be present in REITs and REOCs. (Module 32.3, LOS 32.k) Question #31 of 88 Question ID: 1507457 Using the VC model, the post-money valuation of Targus Company is closest to: A) $26 million. B) $28 million. C) $37.5 million. Explanation post-money valuation = exit value / ROI exit value = $300 million; ROI = 8x post-money valuation = $300 million / 8 = $37.5 million (Module 33.1, LOS 33.d) Question #32 of 88 Question ID: 1507458 For this question only, assuming that the founders will hold 2.5 million shares, and the post money valuation is $90 million, the price per share for the venture capital investor is closest to: A) $32.40. B) $34.12. C) $36.00. Explanation PRE = POST – INV = $90 million − $9 million = $81 million Price-per-share (founders) = PRE / number of shares = $81 million / 2.5 million = $32.40 Price-per-share for the VC investor is the same value. Alternatively: The ownership proportion of the venture capital (VC) investor is f = INV / POST = $9,000,000 / 90,000,000 = 0.10 or 10%. sharesVC = sharesFounders(f / 1 − f) = 2,500,000 × (0.10 / 0.90) = 277,778 price = INV / sharesVC = $9,000,000 / 277,778 = $32.40 per share (Module 33.1, LOS 33.d) Overview for Questions #33-36 of 88 Question ID: 1507464 TOPIC: PORTFOLIO MANAGEMENT THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Samuel Edson, CFA, portfolio manager for Driver Associates, employs a multifactor model to evaluate individual stocks and portfolios. Edson examines several possible risk factors and finds two that are priced in the marketplace. These two factors are investor sentiment (IS) risk and business cycle (BC) risk. Edson manages equity Portfolio A and derives the following relationship for that portfolio, as well as for the S&P 500 stock market index: RA = 0.1750 + 2.0FIS + 1.5FBC RS&P = 0.1475 + 1.5FIS + 1.25FBC where: RA and = the returns for Portfolio A and the S&P 500 market index, RS&P respectively Portfolio A is well-diversified. FIS is the surprise in investor sentiment, and FBC is the surprise in the business cycle. Surprises in the risk factors are defined as the difference between the actual value and the predicted value. Driver Associates also provides Edson with the following multifactor equations on three additional portfolios (D, E, and Z): E(RD) = RF + 1.0FIS + 0.0FBC = 9% E(RE) = RF + 0.0FIS + 1.0FBC = 8% E(RZ) = RF + 1.5FIS + 1.25FBC = 14.75% Driver Associates uses a two-factor arbitrage pricing model to develop equilibrium expected returns for individual stocks and portfolios: E(R) = risk-free rate + b1λ1 + b2λ2 where: = sensitivity of the portfolio return to changes in risk b1 factor 1 = sensitivity of the portfolio return to changes in risk b2 factor 2 λ1 = risk premium associated with risk factor 1 λ2 = risk premium associated with risk factor 2 At the time of Edson's analysis, the long-term government bond yield was 5%. Question #33 of 88 Question ID: 1507465 Edson's supervisor, Rosemary Valry, asks Edson to interpret the intercept of the multifactor equation for Portfolio A (0.175). Edson should respond that the intercept equals: A) B) the expected return for Portfolio A, assuming no surprises in the macroeconomic variables. the expected return for Portfolio A, assuming the macroeconomic variables (investor sentiment and business cycle) equal zero. C) the expected abnormal return for Portfolio A. Explanation The intercept in a macroeconomic factor model equals the expected return for the portfolio examined in the model (assuming no surprises in the macroeconomic variables). The factors in the multifactor equations, FIS and FBC, are factor "surprises," which by definition are expected to equal zero (i.e., by definition, zero "surprise" is "expected"). So, by assumption, FIS and FBC are expected to equal zero. Therefore, the expected return for Portfolio A equals its intercept (17.5%). (Module 36.2, LOS 36.d) Question #34 of 88 Question ID: 1507466 Driver Associates uses portfolios D, E, and Z as part of their risk management strategies. Which of these portfolios are factor portfolios? A) Portfolios D and E. B) Portfolios D and Z. C) Portfolio Z only. Explanation A portfolio that has a sensitivity of 1.0 to one of the macroeconomic factors, and zero sensitivity to the remaining macroeconomic factors is called a factor portfolio. Portfolios D and E are factor portfolios. A portfolio that has factor sensitivities that equal the sensitivities of the benchmark is called a tracking portfolio. Portfolio Z has factor sensitivities that exactly match those of the S&P 500. (Module 36.3, LOS 36.e) Question #35 of 88 Question ID: 1507467 Valry instructs Edson to use the two-factor model to examine Driver Associates's welldiversified balanced Portfolio P, which has an Investor Sentiment factor sensitivity equal to 1.25 and a Business Cycle factor sensitivity equal to 1.10. According to Driver Associates's model, the expected return for Portfolio P equals: A) 8.3%. B) 10.8%. C) 13.3%. Explanation According to the Arbitrage Pricing Model, the expected return equals risk-free rate + b1RP1 + b2RP2, where RPi is the risk premium for factor i. Portfolio D is designed to have sensitivity equal to one to the investor sentiment risk factor and sensitivity equal to zero to the business cycle risk factor. Similarly, Portfolio E is a portfolio designed to have sensitivity equal to zero to the investor sentiment risk factor and sensitivity equal to one to the business cycle risk factor. Portfolios that have a sensitivity equal to 1.0 to one factor and zero sensitivity to the remaining factors are called factor portfolios. Therefore, Portfolio D is the investor sentiment factor portfolio, and Portfolio E is the business cycle factor portfolio. According to the multifactor equations, the expected return for the investor sentiment factor portfolio (D) equals 9% and for the business cycle factor portfolio (E) equals 8%. Risk premiums are defined as the difference between the expected return on the appropriate factor portfolio and the risk-free rate. The risk-free rate is 5% (the longterm government bond yield). Therefore, the investor sentiment risk premium equals 0.09 − 0.05 = 0.04. Similarly, the business cycle risk premium equals 0.08 − 0.05 = 0.03. Therefore, the expected return for Portfolio P equals 0.05 + 1.25(0.04) + 1.1(0.03) = 13.3%. (Module 36.2, LOS 36.d) Question #36 of 88 Question ID: 1507468 Assuming Driver Associates uses the S&P 500 Index as their performance benchmark, which of the following portfolios is expected to have the least active factor risk? A) Portfolio D. B) Portfolio E. C) Portfolio Z. Explanation Active factor risk is caused by deviations of a portfolio's factor sensitivities from the benchmark factor sensitivities. Deviations are quite large for both Portfolios D and E, but Portfolio Z's factor sensitivities match those of the S&P 500 benchmark (1.5 and 1.25). (Module 36.3, LOS 36.e) Overview for Questions #37-40 of 88 Question ID: 1507469 TOPIC: PORTFOLIO MANAGEMENT THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Gordon Stenton, CFA, works for a small investment management firm in the United States. Part of his role involves managing portfolios for high net worth individuals. Currently, Stenton is corresponding with Rachael Matten. Matten has withdrawn her assets from Altune, an asset management firm, and is considering allocating $2.5 million of those funds to Stenton's firm. Matten indicated that she was unhappy with the level of disclosure about trading methods and risk management that were employed at Altune. Matten has sent Stenton a list of questions to assess the policies at Stenton's firm. The first issue Matten wants clarification on pertains to the use of VaR. Among the documents that Altune sent Matten were two statements (shown in Exhibit 1). Matten was unsure of how to interpret either of these statements. Exhibit 1: VaR Statement 1: Your portfolio has a 5% monthly VaR of $225,000. VaR is calculated using a parametric methodology and an assumption of normality for all risk factors. Statement 2: The average loss once the VaR cutoff is exceeded is estimated to be $320,000. Matten indicates that in Statement 1, she understands that the $225,000 represents the minimum loss that will occur 5% of the time. She would also like to confirm her suspicion that the 1% VaR (loss) would be lower. To provide Matten the risk management process employed at his firm, Stenton intends to send Matten the description shown in Exhibit 2. Exhibit 2: Risk Management Measures Primary Risk Management Measure – Steps Step 1: Identify the top 10 exposures for the portfolio. Step 2: Design a hypothetical global event that would simultaneously adversely affect each of the exposures. Step 3: Assess the impact on the portfolio. Question #37 of 88 Question ID: 1507470 Which of the following statements regarding Statement 1 in Exhibit 1 is least accurate? A) The given monthly VaR indicates an annual VaR of $2.7 million. B) The fund will lose more than $225,000 in a month, 5% of the time. C) The methodology described is not applicable to portfolios containing option positions. Explanation A monthly VaR cannot be annualized by simply multiplying by 12. The monthly return and standard deviation would need to be annualized and VaR recalculated. An assumption of a normal distribution is invalid if options were in the portfolio. (Module 37.1, LOS 37.a) Question #38 of 88 Statement 2 in Exhibit 1 is most accurately described as: A) incremental VaR. B) conditional VaR. C) marginal VaR. Question ID: 1507471 Explanation The estimated loss under the condition that VaR has been exceeded is known as conditional VaR. (Module 37.2, LOS 37.e) Question #39 of 88 Question ID: 1507472 In her interpretation of VaR, Matten is most likely: A) correct regarding the $225,000 but incorrect regarding the 1% VaR. B) incorrect regarding the $225,000 but correct regarding the 1% VaR. C) incorrect regarding the $225,000 and the 1% VaR. Explanation The $225,000 is a minimum loss that will be exceeded 5% of the time. A 1% VaR corresponds to a greater loss than a 5% VaR. (Module 37.1, LOS 37.a) Question #40 of 88 Question ID: 1507473 The primary risk management measure discussed in Exhibit 2 is most accurately described as: A) sensitivity risk analysis. B) reverse stress testing. C) Monte Carlo simulation. Explanation The description is of reverse stress testing, which is a form of scenario analysis, not sensitivity analysis. A Monte Carlo simulation would run many repeated scenarios. (Module 37.3, LOS 37.h) Overview for Questions #41-44 of 88 Question ID: 1507474 TOPIC: ETHICAL AND PROFESSIONAL STANDARDS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Matteo Johansson, CFA, is a portfolio manager at Investment AB Framgang. Framgang is a Stockholm-based firm offering a variety of investment products and services. Johansson manages the Berglund Fund, a domestic equity fund specializing in small industrial stocks. Framgang has an investment banking department that is active in initial public offerings (IPOs). Anders Lindberg, CFA, is the senior manager of the IPO team. Lindberg approaches Johansson about Blomtronics, a new IPO being offered by Framgang. Blomtronics will open trading in two days. Framgang had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Johansson thinks Blomtronics would be a good fit for his fund; he expects Blomtronics to improve the Berglund Fund's performance in both the short and long term. Johansson is not aware of any information related to Blomtronics beyond that provided in the prospectus. Johansson asks to purchase 5% of the IPO, but Lindberg limits Berglund's share to 2%, explaining: "With Berglund Fund's reputation, any participation will make the unsold shares highly marketable. Further, we may need Berglund to acquire more Blomtronics shares at a later date if the price does not hold up." Johansson is disappointed in being limited to 2% of the offering and suggests to Lindberg in an email that, given the 2% limitation, Berglund will not participate in the IPO. Lindberg responded a few hours later with the following message: "I have just spoken with Ms. D, the CFO of Blomtronics. Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year's sales by 20% or more. I urge you to accept the 2%—you won't be sorry!" After reviewing Lindberg's email, Johansson agrees to the 2% offer. Finally, Investment AB Framgang has been appointed by Olandig AB to manage Olandig's pension fund. Question #41 of 88 Question ID: 1507475 By offering Berglund the opportunity to participate in the IPO of Blomtronics, Framgang Investments has violated CFA Institute Standards relating to: A) priority of transactions but not independence and objectivity. B) independence and objectivity but not priority of transactions. C) neither priority of transactions nor independence and objectivity. Explanation Johansson was not pressured to take the IPO, and he believed it was a good investment. Johansson received no confidential information. The IPO had been made available to all Framgang clients prior to Berglund. There is no evidence of a violation of either of these Standards. (Module 43.5, LOS 43.b) (Module 43.5, LOS 43.a) Question #42 of 88 Question ID: 1507476 Lindberg's arguments for limiting Berglund's share to 2% suggest that Framgang: A) B) C) may engage in a liquidity pumping strategy that would be acceptable given that Berglund is a related entity. may engage in transaction-based manipulation of Blomtronics in the future, in violation of Standards relating to market manipulation. is violating Standards related to priority of transactions by offering the IPO to Berglund before it is fully subscribed. Explanation By suggesting that Berglund might need to acquire more shares to support the price in the future, Lindberg is suggesting that Framgang would be willing to manipulate the market by creating false trading volume. This would be transaction-based manipulation, in violation of Standard II(B) Integrity of Capital Markets – Market Manipulation. (Module 43.3, LOS 43.b) (Module 43.5, LOS 43.a) Question #43 of 88 Question ID: 1507477 Based upon Johansson's acceptance of the 2% limitation after receiving the email from Lindberg: Johansson has violated the Standards relating to material nonpublic A) information, and Lindberg has violated the Standards relating to preservation of confidentiality. Johansson has not violated the Standards relating to material nonpublic B) information, but Lindberg has violated the Standards relating to preservation of confidentiality. Johansson has not violated the Standards relating to material nonpublic C) information, but Lindberg has violated the Standards relating to preservation of confidentiality and material nonpublic information. Explanation By changing his previous decision and accepting the 2% based on Lindberg's email, Johansson has violated the Standards related to material nonpublic information. He has acted based on inside information. Lindberg has violated the Standards related to both material nonpublic information and preservation of confidentiality. Lindberg violated Standard III(E) – Duties to Clients – Preservation of Confidentiality by revealing information he received based upon a special relationship with Blomtronics. By passing that information to another area of Framgang, Lindberg has violated Standard II(A) Integrity of Capital Markets – Material Nonpublic Information as well. (Module 43.6, LOS 43.b) (Module 43.5, LOS 43.a) Question #44 of 88 Question ID: 1507478 Regarding Olandig's pension fund, Framgang is least likely to owe a duty of loyalty, prudence, and care to Olandig's: A) shareholders and management team. B) pension plan participants. C) pension plan beneficiaries. Explanation Members and candidates that manage a firm's pension fund owe loyalty, prudence, and care to the participants and beneficiaries of the pension plan, rather than to the management team or the shareholders, according to Standard III(A)–Loyalty, Prudence, and Care. (Module 43.4, LOS 43.b) (Module 43.5, LOS 43.a) Overview for Questions #45-48 of 88 Question ID: 1507379 TOPIC: QUANTITATIVE METHODS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Song Hu is the quantitative analyst for Guangho Equity Partners. Hu has been busy over the past week modeling the macroeconomic data of an emerging market. The data for the past 24 months is shown in Exhibit 1: Time Series of Emerging Markets Data. Exhibit 1: Time Series of Emerging Markets Data Hu ponders how she can run a regression that will model the data for this country in the most appropriate way. She decides to regress the macroeconomic values against a time variable. The resulting plot of the residuals is shown in Exhibit 2: Residual Plot From Emerging Markets Data. Exhibit 2: Residual Plot From Emerging Markets Data Hu set up a meeting with Qianfan Li, senior analyst to discuss the progress on a model that Li was developing. The model is supposed to forecast return over the next month for a group of 100 midsize companies. A portfolio with a long position in 10 stocks with the highest forecasted return and a corresponding short position in 10 stocks with the lowest return is envisioned. Li mentions that he is collecting the relevant fundamental and technical variable data for the 100 companies. Li states that he would rather take the broad sample of 1,000 stocks with the highest trading volume and divide the sample into 10 groups of diverse characteristics. The intent is to select 1 stock from each group to long/short so as to diversify the portfolio composition and reduce risk. Question #45 of 88 Question ID: 1507380 To best model the emerging markets data using linear regression, Hu should use: A) an adjustment for multicollinearity. B) the natural log of the dependent variable. C) White’s correction for the standard errors. Explanation Hu should take the natural log of the dependent variable so that the data are transformed and can be better modeled using a linear regression. From the plot, it appears that the data follows a log-linear trend. If the natural log is taken of the dependent variable, the data will be more linear so that it is readily modeled in a regression. The transformed data will plot as follows: (Module 2.1, LOS 2.a) Question #46 of 88 Question ID: 1507381 The most likely problem in Hu's regression of the emerging market data and the most appropriate test for it in the regression is: Problem Test A) Serial correlation Durbin-Watson B) Serial correlation Dickey-Fuller C) Cointegrated variables Engle-Granger Explanation The most likely problem in Hu's regression of the emerging market data is that the error terms appear to be positively correlated in Exhibit 2: Residual Plot From Emerging Markets Data. The first few error terms are positive, then negative, and then positive. This indicates serial correlation, which is common in trend models. As Hu regresses the macroeconomic data against a time variable, she is using a trend model. In a linear trend model, the Durbin-Watson statistic can be used to detect serial correlation. (Module 1.3, LOS 1.i) Question #47 of 88 Question ID: 1507382 Which model would be most appropriate for Li to use in predicting returns? A) Penalized regression model. B) Clustering model. C) KNN Model. Explanation The objective of the model is to forecast monthly returns using a set of fundamental and technical variables (features). This is not a classification problem and hence clustering and KNN would be inappropriate. A penalized regression model tries to use a limited number of most important features that explain the variation in the dependent variable (the monthly return on 100 stocks). (Module 3.2, LOS 3.c) Question #48 of 88 Question ID: 1507383 Li's suggested diversification problem could be best addressed using the: A) principal component analysis (PCA). B) K-Means clustering. C) LASSO. Explanation LASSO is a feature-reduction algorithm; through optimization, LASSO automatically eliminates the least-predictive features. LASSO is not used for classification. Kmeans clustering partitions observations into k (k = 10 in this case) nonoverlapping clusters. PCA summarizes the information in a large number of correlated factors (features) into a much smaller set of uncorrelated factors and is used for dimension reduction and not for grouping or classification. (Module 3.3, LOS 3.d) Overview for Questions #49-52 of 88 Question ID: 1507384 TOPIC: ECONOMICS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Debbie Angle and Craig Hohlman are analysts for a large commercial bank, Arbutus National Bank. Arbutus has extensive dealings in both the spot and forward foreign exchange markets. Angle and Hohlman are providing a refresher course on foreign exchange relationships for its traders. Angle uses a three country example from North America to illustrate foreign exchange parity relations. In it, the Canadian dollar is expected to depreciate relative to the U.S. dollar and the Mexican peso. Nominal, 1-year interest rates are 7% in the United States and 13% in Mexico. From this data and using the uncovered interest rate parity relationship, Angle forecasts future spot rates. During their presentation, Hohlman discusses the effect of monetary and fiscal policies on exchange rates. He cites a historical example from the United States, where the Federal Reserve shifted to an expansionary monetary policy to stimulate economic growth. This shift was largely unanticipated by the financial markets because the markets thought the Federal Reserve was more concerned with inflationary pressures. Hohlman states that the effect of this policy was an increase in economic growth and an increase in inflation. The cumulative effect on the dollar was unchanged, however, because, according to the Mundell-Fleming model, an expansionary monetary policy would strengthen the dollar whereas under relative purchasing power parity, an increase in inflation would weaken the dollar. Regarding U.S. fiscal policies, Hohlman states that if these were unexpectedly expansionary, real interest rates would increase, which would produce an appreciation of the dollar. Hohlman adds that a sustained increase in the federal budget would attract foreign capital such that the long-run effect would be an increase in the value of the dollar. Hohlman makes the following statement about parity conditions: Statement: If relative purchasing power parity holds, we can say that uncovered interest rate parity also holds under certain conditions. Angle next discusses the foreign exchange expectations. While examining Great Britain and Japan, she states that it appears the 1-year forward rate, which is currently ¥200/£, is an accurate predictor of the expected future spot rate. Furthermore, she states that uncovered interest rate parity and relative purchasing power parity hold. In the example for her presentation, she uses the following figures for the two countries. Great Britain Japan Expected GDP growth 2.50% 1.80% Nominal 1-year interest rates 9.70% 6.40% Growth in exports 3.90% 5.70% Question #49 of 88 Question ID: 1507385 Using Angle's analysis, what is the nominal 1-year interest rate in Canada? A) Less than 7%. B) Between 7% and 13%. C) Greater than 13%. Explanation Angle uses the uncovered interest rate parity relationship to forecast future spot rates. If the Canadian dollar is expected to depreciate relative to the U.S. dollar and the Mexican peso, then nominal interest rates in Canada must be higher than those in the United States and Mexico. The 13% nominal interest rate in Mexico is higher than the nominal interest rate in the U.S., so the nominal interest rate in Canada must be greater than 13%. (Module 5.2, LOS 5.e) Question #50 of 88 Question ID: 1507386 Is Hohlman's statement regarding the effect of monetary policies on the dollar correct? A) Yes, it is correct. B) C) No, under the Mundell-Fleming model, expansionary monetary policy in the U.S. would weaken the dollar. No, the dollar value would be unchanged, but under the asset market model and not the Mundell-Fleming model. Explanation Hohlman is incorrect regarding the implications of an expansionary monetary policy in the U.S. under the Mundell-Fleming model, which predicts a depreciation of the dollar. The asset market approach focuses on fiscal policy—not monetary policy. (Module 5.3, LOS 5.k) Question #51 of 88 Question ID: 1507387 What additional condition must be satisfied for Hohlman's statement to be valid? A) Covered interest parity must hold. B) Fisher effect must hold. C) The international Fisher relation must hold. Explanation If relative purchasing power parity holds, then inflation differentials drive future exchange rates. If the international Fisher relationship holds, then inflation differentials will be equal to interest rate differentials. Hence, when both relative purchasing power parity and the international Fisher relationship hold, uncovered interest rate parity should also hold. Covered interest rate parity always holds (by arbitrage) and is not a necessary additional condition. Real interest rate parity links the Fisher effect to the international Fisher relationship. (Module 5.2, LOS 5.f) Question #52 of 88 Question ID: 1507388 Which of the following is closest to the current ¥/£ spot rate? A) ¥194/£. B) ¥200/£. C) ¥206/£. Explanation Angle assumes the forward rate is an accurate predictor of the expected future spot rate, so we will use ¥200/£ as the future spot rate. Angle states that uncovered interest rate parity holds. Given a quote structure of ¥/£, S0 (1 + Yen interest rate) / (1 + GBP interest rate) = E(S1) S0(1.064 / 1.097) = 200 S0 = 206.20 Notice that the exchange rate will move from ¥206/£ to ¥200/£. So it takes fewer yen to buy one pound (i.e., the yen has strengthened), which uncovered interest rate parity predicts because the Japanese interest rate is lower. (Module 5.2, LOS 5.f) (Module 5.2, LOS 5.e) Overview for Questions #53-56 of 88 Question ID: 1507394 TOPIC: FINANCIAL STATEMENT ANALYSIS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Engineered Packaging, Inc., (EPI) is a manufacturer of industrial and consumer packaging products. The company's products include composite and plastic rigid packaging, flexible packaging, as well as metal and plastic ends and closures. In January 2018, EPI entered into a joint venture with BMI Enterprises. EPI contributed ownership of five plants, while BMI contributed a new manufacturing technology. The joint venture is known as EP/BM LLC. EPI owns 50% of EP/BM LLC and uses the equity method to account for its investment. The following information for 2018 is provided: In Millions, Year-End 2018 EPI EP/BM LLC Revenue $3,115 $421 Cost of goods sold $2,580 $295 $316 $50 Interest expense $47 $8 Equity in earnings of EP/BM $22 SG&A Pretax income Income tax Net income In Millions, December 31, 2018 $194 $68 $60 $24 $134 $44 EPI EP/BM LLC Assets Cash $118 $13 Accounts receivable $390 $50 Inventory $314 $41 $1,007 $131 Property Investment Total Liabilities and Equity Accounts payable $38 $1,867 EPI $235 EP/BM LLC $274 $35 Long-term debt $719 $125 Equity $874 $75 $1,867 $235 Total Question #53 of 88 Question ID: 1507395 Had EPI used the proportionate consolidation method instead of the equity method to account for its investment, which of the following statements is the most accurate? A) Net profit margin would be the same. B) Return on assets would be the same. C) Return on equity would be the same. Explanation Total assets, liabilities, revenues, and expenses are higher under proportionate consolidation as compared to the equity method. However, net income and stockholders' equity are the same under either method. Accordingly, profit margin and return on assets are typically lower under proportionate consolidation than under the equity method. Return on equity will be same under either method. The following financial statements are provided for informational purposes only. The numbers in the acquisition method are derived as EPI + EP/BM LLC, except for the equity items. In Millions, Year End 2018 EPI EP/BM LLC Acquisition Method Revenue $3,115 $421 $3,536 Cost of goods sold $2,580 $295 $2,875 SG&A $316 $50 $366 EBIT $219 $76 $295 Interest expense $47 $8 $55 Equity in earnings of EP/BM $22 Pretax income Income tax N/A $194 $68 $240 $60 $24 $84 (–) Noncontrolling interest $22* Net income $134 In Millions, December 31, 2018 EPI $44 EP/BM LLC $134 Acquisition Method Assets Cash $118 $13 $131 Accounts receivable $390 $50 $440 Inventory $314 $41 $355 $1,007 $131 $1,138 Property Investment $38 Total $1,867 N/A $235 Liabilities and Equity Accounts payable $274 $35 $309 Long-term debt $719 $125 $844 Equity $874 Total $75 $911** $1,867 $235 $2,064 *50% of EP/BM LLC's net income of $44 **$874 + noncontrolling interest (50% of EP/LLC's equity of $75) (Module 8.1, LOS 8.a) $2,064 Question #54 of 88 Question ID: 1507396 Based on the acquisition method, EPI's current ratio at the end of 2018 (using the financial information provided) is closest to: A) 1.8. B) 2.6. C) 3.0. Explanation current ratio = current assets / current liabilities; (131 + 440 + 355) / 309 = 3.0. (Module 8.4, LOS 8.c) Question #55 of 88 Question ID: 1507397 Based on the acquisition method, EPI's interest coverage ratio for 2018 (using the financial information provided) is closest to: A) 3.6. B) 4.0. C) 5.4. Explanation interest coverage = EBIT / interest expense; 295 / 55 = 5.36. (Module 8.4, LOS 8.c) Question #56 of 88 Question ID: 1507398 Had EPI used the acquisition method instead of the equity method to account for its investment, EPI's long-term debt-to-equity ratio would have been: A) higher. B) lower. C) the same. Explanation Under Equity Method: Long-term debt to equity ratio = 719 / 874 = 0.82 Under Acquisition Method: Long-term debt to equity ratio = 844 / 911 = 0.93 (Module 8.4, LOS 8.a) Overview for Questions #57-60 of 88 Question ID: 1507404 TOPIC: FINANCIAL STATEMENT ANALYSIS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Matthew Jackson, CFA, has recently taken an analyst role at The Collins Group, an asset management firm based in New Jersey. As part of his job, Jackson has been asked to review the most recent unaudited financial statements from several private companies that have been identified as potential investments for the firm. Jackson is reviewing financial statements from Troth Health, a firm producing health and wellness products in the United Kingdom. Extracts from the pro forma financial statement recently released, along with 2019 and 2018 comparables, is shown in Exhibit 1. Exhibit 1: Troth Health Financial Statement (Extract) Headline Operating Profit: Quarter Ending 31 December 2020 (£000) 2020 2019 2018 Stockholders' equity 8,380 7,980 7,450 Revenue retail outlet sales 1,402.2 3,543.9 3,501.6 Online sales 3,086.2 398.9 389.4 Headline net income (Note A) 1,262.7 1,104.4 1,086.0 Note A:Headline net income excludes settlement costs and network costs. Settlement costs are one-off payments to settle legal procedures; these costs totaled (in £000) 20.0, 22.1, and 24.8 in 2018, 2019, and 2020, respectively. Network costs related to running the online business totaled (in £000) 202.0, 325.0, and 885.5 in 2018, 2019, and 2020, respectively. The financial accounts submitted to our bank in accordance with our loan covenants shows net income after charging both settlement and network costs in accordance with local GAAP. Jackson notes that the financial statements submitted to the firm's bankers did indeed report net income correctly in accordance with local GAAP. However, this figure was much less prominent than headline net income, as the GAAP income was disclosed only in the footnotes rather than on the face of the income statement. Jackson believes that the legal settlements are payments made to dissatisfied customers and are a normal part of business. Jackson also believes that the increase in network cost is consistent with Troth's increased focus on online operations. Troth's required return on stockholders' equity is 5%. Question #57 of 88 Question ID: 1507405 Which of the following statements is the least accurate regarding the Troth Health information shown in Exhibit 1? A) B) C) The financial statements submitted to analysts are not as decision-useful as they could be due to biased accounting choices. The financial statements submitted to the bank are not as decision-useful as they could be due to biased accounting choices. The financial statements submitted to the bank are decision-useful as they exhibit no evidence of biased accounting choices. Explanation Biased accounting choices are reflected not only in the numbers presented but also in the manner of disclosure of information. The lack of transparency of GAAPcompliant net income relative to the headline net income suggests that the financial statements are not very decision-useful. (Module 12.1, LOS 12.b) Question #58 of 88 Question ID: 1507406 Which of the following conclusions is Jackson most likely to draw about the earnings quality of Troth Health? 2020 net income after correctly including network and settlement costs shows: A) B) C) compound annual growth of over 7%, and earnings that are of high quality as they are correctly calculated under GAAP. negative compound annual growth of over 35%, and earnings that are of low quality. negative compound annual growth of over 35%, and earnings that are of high quality as they are correctly calculated under GAAP. Explanation 2020 Headline Net Income 2019 2018 1,262.7 1,104.4 1,086.0 Network costs (from note A) 885.5 325.0 202.0 Settlements (from note A) 24.8 22.1 20.0 Net Income 352.4 757.3 864.0 Net Income CAGR = [(352.4 / 864)1/2] − 1 = –0.36 = –36% Average stockholders' equity = (8,380 + 7,980) / 2 = 8,180 Return on stockholders' equity for 2020 = 352.4 / 8,180 = 4.31% Earnings quality refers not only to compliance with GAAP but also to the persistence and level of earnings. The GAAP-compliant net income does not satisfy the minimum return requirement; hence, earnings are low (and therefore of low quality). (Module 12.3, LOS 12.h) Question #59 of 88 Question ID: 1507407 Treating an investment as an investment in associate rather than in a subsidiary is least likely to: A) overstate net profit margins. B) understate fixed assets. C) understate net income. Explanation An investment in associates is accounted for using the equity method, while investment in a subsidiary is accounted for using the acquisition method. Using either method, net income will be the same. However, fixed assets and total revenue will be lower under the equity method. (Module 12.3, LOS 12.h) Question #60 of 88 Question ID: 1507408 If Jackson were to find that Troth has significant amounts of off-balance-sheet debt, the aspect of financial reporting quality that Troth Health's balance sheet is most likely to be lacking is: A) completeness. B) unbiased measurement. C) clear presentation. Explanation Balance sheets with significant amounts of off-balance-sheet debt lack the completeness aspect of financial reporting quality. (Module 12.5, LOS 12.j) Overview for Questions #61-64 of 88 Question ID: 1508604 Jared Sampson, CFA, is analyzing Gigatech, a large U.S.-based technology conglomerate. Sampson first starts out calculating economic value added (EVA) for Gigatech and notices that the firm uses last-in, first-out (LIFO) cost flow assumption. Sampson is also valuing the stock of Heritage Builders, a developer of luxury residential communities. Heritage reports in accordance with the IFRS. Heritage's current book value per share is €15. In prior years, Heritage has enjoyed high residual income. Going forward, Heritage's return on equity (ROE) of 15% is expected to converge to its required rate of return of 12%, with a persistence factor of 0.60. One of the concerns that Sampson has is the appropriateness of the residual income model of valuation for Heritage. He makes the following observations after analyzing Heritage's financial statements: 1. The firm's free cash flows have been negative in two of the last four years. 2. Heritage's pension plan shows remeasurement losses of €128 million. 3. Heritage does not pay any dividends. Finally, Sampson wonders what would lead to a higher estimate of the persistence factor. Question #61 of 88 Question ID: 1507425 Regarding the LIFO cost flow assumption, which of the following is the most accurate adjustment to calculate EVA for Gigatech? A) B) C) While there is no adjustment needed to the NOPAT, the change in the LIFO reserve should be added to the invested capital. While there is no adjustment to the invested capital, the LIFO reserve should be added to NOPAT. The LIFO reserve should be added to the invested capital, and the change in the LIFO reserve should be added to NOPAT. Explanation The correct adjustment is to add the LIFO reserve to the invested capital and add back the change in the LIFO reserve to NOPAT. (Module 23.1, LOS 23.a) Question #62 of 88 Question ID: 1507426 The estimate of value of Heritage stock using the residual income valuation is closest to: A) €16.67. B) €15.87. C) €15.22. Explanation V0 = current book value + PV of continuing residual income B0 (ROE−r) V 0 = B0 + [ (1+r−ω) ] 15(0.15−0.12) = 15 + [ ] = 15.87 (1+0.12−0.6) (Module 23.4, LOS 23.h) Question #63 of 88 Question ID: 1508605 Which observation regarding Heritage is problematic for use of the residual income valuation model? A) Observation 2 only. B) Observations 1 and 2. C) Observations 1 and 3. Explanation Observations 1 and 3 justify the use of residual income model over other models. Observation 2 would lead to a violation of the clean surplus relationship: pension remeasurements go through OCI rather than the income statement. (Module 23.5, LOS 23.j) (Module 23.5, LOS 23.k) Question #64 of 88 Question ID: 1507428 Which of the following would least likely lead to a higher persistence factor for Heritage? A) Heritage does not pay any dividends. B) Luxury residential builders have enjoyed a high persistence factor historically. C) Heritage has a high level of ROE as compared to its peers. Explanation Higher persistence factors will be associated with the following: Low dividend payouts Historically high residual income persistence in the industry Lower persistence factors will be associated with the following: High return on equity Significant levels of nonrecurring items High accounting accruals (Module 23.4, LOS 23.h) Overview for Questions #65-68 of 88 Question ID: 1508601 TOPIC: CORPORATE ISSUERS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Sentinel News is a publisher of more than 100 newspapers around the country, with the exception of the Midwestern states. The company's CFO, Harry Miller, has been reviewing a number of potential candidates (both public and private companies) that would provide Sentinel News entrance into the Midwestern market. Recently, the founder of Midwest News, a small, private newspaper company, passed away. The founder's family members are inclined to sell their 80% controlling interest. Miller noted that Midwest News does not pay a dividend, nor does the company have any debt. The most comparable publicly traded stock is Freedom Corporation. Freedom, however, has significant radio and television operations. Freedom is expected to maintain a payout ratio of 40%. Analysts are forecasting the company will earn $3.00 per share next year and grow their earnings by 6% per year. Freedom has a current market capitalization of $15 billion and 375 million shares outstanding. Freedom's current market value equals its intrinsic value. Miller's staff uses current expectations to develop the appropriate equity risk premium for Midwest News. Miller believes the best method to estimate the required return on equity of Midwest News is the build-up method. All relevant information to determine Midwest News's required return on equity is presented in Exhibit 1. Exhibit 1: Required Return Estimate Factors Risk-free rate 3.5% Equity risk premium 4.0% Small size premium 3.5% Specific-company premium 2.0% Beta Growth rate 1.2 3.0% Miller makes two statements concerning cost of capital as shown below: Statement 1: In some less-developed countries that lack corporate debt markets, businesses have to rely on bank lending known as the shadow banking system. Statement 2: Countries that follow common law–based legal systems offer lower risk premiums compared to countries with civil law– based legal systems. Miller is also looking into foreign media companies. Specifically, Miller is evaluating the valuation of Maura Ltd., a media house in an emerging economy. Question #65 of 88 Question ID: 1507410 The required rate of return estimate for equity of Freedom Corporation is closest to: A) 3%. B) 6%. C) 9%. Explanation year-ahead dividend required return estimate = + expected dividend growth rate market price ($3.00×0.40) required return estimate = ( $15,000 million /375 million ) + 0.06 = 0.09 Since Freedom Corporation has a dividend policy of paying 40% of earnings, dividend growth equals earnings growth. The assumption is that Freedom's stock is correctly valued (and is given in the vignette). (Module 17.2, LOS 17.e) Question #66 of 88 Question ID: 1507411 Using the build-up method, Midwest News's required return on equity is closest to: A) 13.0%. B) 13.8%. C) 15.8%. Explanation ri = risk-free rate + equity risk premium + size premiumi + specific-company premiumi ri = 3.5% + 4.0% + 3.5% + 2.0% = 13.0% (Module 17.2, LOS 17.e) Question #67 of 88 Question ID: 1508602 Miller has made two statements, the shadow banking system, and the other concerning the characteristics of common law-based and civil law-based legal systems. Are Miller's statements correct? A) Only Statement 1 is correct. B) Only Statement 2 is correct. C) Both Statements 1 and 2 are correct. Explanation Statement 1 is incorrect. Shadow banking system relies on unregulated, non-bank sources. Statement 2 is correct. Countries that follow common law–based legal systems offer stronger protection to investors, leading to lower risk premiums compared to countries with civil law–based legal systems. (Module 17.1, LOS 17.a) Question #68 of 88 Question ID: 1508603 Which of the following approaches would be least appropriate to measure the cost of capital of Maura Ltd.? A) Expanded CAPM. B) Extended CAPM. C) Country risk premium. Explanation Two approaches to estimating the cost of equity of a foreign company are (1) country risk premium model and (2) the extended CAPM. Expanded CAPM is used for domestic private companies where additional risk premia (above those applicable for public companies) are applicable. (Module 17.2, LOS 17.d) Overview for Questions #69-72 of 88 Question ID: 1508885 TOPIC: FIXED INCOME THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS CTT Credit Analysis provides fixed-income credit analysis to fund managers and high net worth individuals. Tam Lowenstadt, CFA, joined the firm recently; one of his first tasks is to provide a new client with an overview of the credit analysis models the firm uses. Lowenstadt makes the following statement regarding this analogy and how it can be used to value equity and debt: Statement 1: Holding the company's equity is economically equivalent to owning a European call option on the company's assets. CTT Credit Analysis always includes an illustration of the impact of credit migration on the price performance of corporate bonds. As an example, Lowenstadt demonstrates the impact of a credit downgrade of ZT bonds. ZT, Inc., has two bonds outstanding, identical in every respect except that one is callable while the other is not. CTT does not recommend the use of reduced form models of credit analysis to its clients. Lowenstadt defended this decision based on the firm's standard response as shown in Exhibit 1. Exhibit 1: CTT Firm View on Reduced Form Models Point 1: Unlike the structural model, reduced form models do not explain why default occurs. Point 2: A key input into the reduced form model is the default intensity, which is the probability of default over the next time period. Default intensity is estimated using option pricing models. Finally, Lowenstadt also discussed CTT's application of credit analysis to asset-backed securities. Lowenstadt is aware that the client has some collateralized debt obligations in her portfolio. His overview is shown in Exhibit 2. Exhibit 2: ABS Overview Section 1 − Collateral Short-term granular and homogenous structured finance vehicles are evaluated using a portfolio-based approach. Medium-term granular and homogenous obligations are evaluated using a statistical-based approach because the portfolio composition varies over time. Section 2 − Servicer Quality Counterparty risk. Operational risk. Section 3 − Structure Credit enhancement. Distribution waterfall. Question #69 of 88 Lowenstadt's Statement 1 is best described as: Question ID: 1507440 A) incorrect, as he should have instead stated American call option. B) incorrect, as he should have instead stated European put option. C) correct. Explanation European call on assets is the correct analogy for equity under the structural model for credit analysis. (Module 28.4, LOS 28.d) Question #70 of 88 Question ID: 1507441 Given Lowenstadt's scenario, relative to the price performance of the straight bond issued by ZT, Inc., the callable bond is most likely to have: A) equal or poorer price performance. B) equal or better price performance. C) the same price performance. Explanation Given Lowenstadt's scenario of a ratings downgrade, spreads should widen. Callable bonds have a duration that is lower than (or equal to) the duration of comparable straight bonds. Hence, the decline in price for a callable ZT bond will be less than (or equal to) the decline in price of an equivalent straight ZT bond. (Module 28.6, LOS 28.f) (Module 27.5, LOS 27.j) Question #71 of 88 Question ID: 1507442 Which of Lowenstadt's points in Exhibit 1 is correct? A) Only point 1 is accurate. B) Only point 2 is accurate. C) Neither point is accurate. Explanation While structural models provide economic rationale regarding why default occurs (i.e., when AT < K), reduced form models do not. Default intensity is typically estimated using regression models (not option pricing models). (Module 28.4, LOS 28.d) Question #72 of 88 Question ID: 1507443 Lowenstadt's overview of asset-backed securities in Exhibit 2 most likely contains an error in: Section 1, because short-term granular and homogenous structured finance A) vehicles are evaluated using a statistical-based approach, while medium-term granular and homogenous obligations are evaluated using a portfolio-based approach. B) Section 2, because counterparty risk is not relevant for servicer quality. C) Section 3, because credit enhancement is not relevant for asset-backed securities. Explanation Short-term granular and homogenous structured finance vehicles are evaluated using a statistical-based approach. Medium-term granular and homogenous obligations are evaluated using a portfolio-based approach because the portfolio composition varies over time. All other sections are correct. (Module 28.7, LOS 28.h) Overview for Questions #73-76 of 88 Question ID: 1507434 TOPIC: FIXED INCOME THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Ben Stamper, CFA, is evaluating callable bonds issued by Gardein, Inc. Stamper has decided to calculate the value of the Gardein bonds using a binomial interest rate tree. His assumption is that the bond will be called at any node of the tree where the calculated value exceeds the call price. Stamper summarizes the results of his bond valuation analysis in a memo to his supervisor, Luke Puldo. In this memo, Stamper makes the following statements: Statement 1: The value of the option embedded in the Gardein bonds can be derived by simply subtracting the interest rate tree value of the Gardein bonds from the interest rate tree value of the otherwise comparable straight bonds. Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Gardein bonds. After reviewing Stamper's analysis, Puldo notes that Stamper has not included any information on the option adjusted spread (OAS) for the Gardein bonds. Puldo suggests that Stamper should evaluate the OAS in order to get an idea of the liquidity risk of the Gardein bonds. Stamper counters that the OAS may not be very informative in this case, since he is uncertain as to the reliability of the interest rate volatility assumption. Stamper provides Puldo with the process used by the firm to evaluate credit risk as shown in Exhibit 1. Exhibit 1: Key Underlying Principles 1. The probability of default multiplied by the recovery rate given default is equal to the expected loss. 2. The sum of expected losses for each period is equal to the cumulative valuation adjustment. 3. Given the market price of a credit risky bond, the estimated risk-neutral probabilities of default and recovery rates are positively correlated. Stamper also provides an overview of the structural model approach to credit analysis. He starts off by explaining the basic approach of valuing the credit risk by using an option analogy. He makes the following observation: Observation: Owning the company's debt with a face value of K and a maturity of T is economically equivalent to owning a riskless bond with face value of K and maturity of T and simultaneously purchasing a European put option on the assets of the company with a strike price equal to K and maturing at time T. Question #73 of 88 Question ID: 1507435 Indicate whether the statements made by Stamper in his memo regarding the value of the embedded option and the effect of the volatility assumption are correct. A) Only the statement regarding the value of the embedded option is correct. B) Only the statement regarding the effect of the volatility assumption is correct. C) Both statements are correct. Explanation Statement 1 is correct. The value of the option would be the difference between the value calculated with no call feature and the value calculated assuming the bond is callable. Statement 2 is also correct. Increased volatility would increase the value of the option, thus lowering the value of the callable bond. (Module 27.1, LOS 27.b) Question #74 of 88 Question ID: 1507436 Which of the following most accurately critiques the OAS discussion between Stamper and Puldo? Puldo is: correct that the OAS will provide insight into the liquidity risk of the Gardein A) bonds, and Stamper is correct that different volatility assumptions would change the OAS. correct that the OAS will provide insight into the liquidity risk of the Gardein B) Bonds, but Stamper is incorrect since OAS implicitly adjusts for the volatility of interest rates. incorrect that the OAS will provide insight into the liquidity risk of the Gardein C) Bonds, but Stamper is correct that different volatility assumptions would change the OAS. Explanation The OAS accounts for compensation for credit and liquidity risk after the optionality has been removed (i.e., after the cash flows have been adjusted). Since in this case the credit risk of the bonds is similar, the OAS could prove helpful in evaluating the relative liquidity risk. OAS will be affected by different assumptions regarding the volatility of interest rates. (Module 27.4, LOS 27.g) Question #75 of 88 Question ID: 1507437 In Exhibit 1, which of the underlying principles outlined by Stamper is most accurate? A) Principle 1. B) Principle 2. C) Principle 3. Explanation The expected loss is (the probability of default) × (loss given default), not the recovery rate. Credit valuation adjustment (CVA) is the sum of the present value of the expected loss for each period. In general, given the market price (and hence the implied credit spread), the estimated risk-neutral probabilities of default and recovery rates are positively correlated. (Module 28.1, LOS 28.a) Question #76 of 88 Question ID: 1507438 Stamper's observation about the structural model is most likely: A) incorrect, as he should have instead stated purchasing a European call option. B) incorrect, as he should have instead stated selling a European put option. C) correct. Explanation The option analogy for debt states that a long position in risky debt is equivalent to a long position in a riskless bond plus a short European put on the company's assets. (Module 28.4, LOS 28.d) Overview for Questions #77-80 of 88 Question ID: 1507444 TOPIC: DERIVATIVES THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Simon Jackman, a junior analyst for Tucker Group Limited (TGL), has been asked to evaluate the firm's various swap transactions and interest rate option positions. TGL's counterparty for many of these derivatives is MBS Bank, a large full-service bank in Australia. Jackman begins writing his report for the management of TGL. In the report, Jackman makes the following statements about interest rate derivative instruments: Statement A payer swap can be replicated using a long receiver swaption and a 1: short payer swaption with the same exercise rates. If the exercise rate is set such that the premiums of the payer and receiver swaptions are equal, then the exercise rate must be equal to the market swap fixed rate. Statement A long callable bond can be replicated using a long option-free bond 2: plus a short receiver swaption. Jackman is also evaluating a two-year European interest rate call option with a strike rate of 5% and a notional principal of $2 million. Jackman wants to use a binomial tree as shown in Exhibit 1 to value the option. Exhibit 1: Two-Period Interest Rate Tree Question #77 of 88 Question ID: 1507445 Jackman's Statement 1 is most likely: A) correct. B) incorrect about long receiver swaption and short payer swaption. C) incorrect about the exercise rate being equal to the market swap fixed rate if the premiums of the two swaptions are equal. Explanation A payer swap can be replicated using a long payer swaption and short receiver swaption with the same exercise rates. Jackman's Statement 1 about how if the premiums of the two options are equal, the exercise rate must be equal to the market swap fixed rate is correct. (Module 31.6, LOS 31.j) Question #78 of 88 Jackman's Statement 2 is most likely: A) correct. B) incorrect about the long option free bond. C) incorrect about the short receiver swaption. Explanation Question ID: 1507446 Statement 2 is correct: being long a callable fixed-rate bond can be viewed as equivalent to being long a straight fixed-rate bond and short a receiver swaption. The embedded call feature is similar to a receiver swaption, in that the receiver swaption buyer will benefit when rates fall and the swaption is exercised. (Module 31.6, LOS 31.j) Question #79 of 88 Question ID: 1507447 The value of the two-year interest rate call option is closest to: A) $7,717. B) $15,434. C) $18,415. Explanation Given the exercise rate of 5%, the call option has a positive payoff for nodes C++ and C+–. The value of the option at node C++ can be calculated as: [Max (0, 0.083 − 0.05)] × $2,000,000 = $66,000 Similarly, the value at node C+– can be calculated as: [Max (0, 0.0504 − 0.05)] × $2,000,000 = $800 Value at node C+ = [(0.5 × 66,000) + (0.5 × 800)] / (1.0531) = $31,716 Value at node C– = [(0.5 × 800) + 0] / (1.0322) = $388 And the value at node C = [(0.5 × 31,716) + (0.5 × 388)] / (1.04) = $15,435 (Module 31.5, LOS 31.e) Question #80 of 88 Question ID: 1507448 In Jackman's binomial interest rate tree, the probability of an up movement is least likely to be equal to: A) exactly 50%. B) (1​+​Rf​− D) / (U​− D). C) 1 – the probability of a down move. Explanation For a binomial interest rate tree, the probability of an up movement = the probability of a down movement = 0.5. In a binomial stock price tree, the riskneutral probability of an up move can be calculated based on the risk-free rate, the size of an up movement, and the size of a down movement: πU = (1 + Rf − D) / (U − D). (Module 31.5, LOS 31.e) Overview for Questions #81-84 of 88 Question ID: 1507459 TOPIC: ALTERNATIVE INVESTMENTS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The Fund's total assets are valued at $3.5 billion. The investment policy uses a total return approach to meet the return objective that includes a spending rate of 5%. In addition, the policy constraints established make tax-exempt instruments an inappropriate investment vehicle. The Fund's current asset mix includes an 18% allocation to private equity. The private equity allocation is shown in Exhibit 1. Exhibit 1: IS University Endowment Fund's Private Equity Investments Private Equity Percentage Allocation Venture capital 12% Buyouts 56% Special situations 32% The private equity allocation is a mixture of funds with different vintages. For example, within the venture capital category, investments have been made in five different funds. Exhibit 2 provides details about the Alpha Fund with a vintage year of 2014 and committed capital of $195 million. The distribution waterfall calls for 20% carried interest when NAV before distributions exceeds committed capital. Exhibit 2: $195 Million Venture Capital Alpha Fund ($Millions) Year Called-Down Management Fees Operating Results 2014 $30 $0.45 –$10 2015 $25 $0.83 $55 2016 $75 $1.95 $75 Question #81 of 88 Question ID: 1507460 Which of the following risk factors will most likely impact the private equity portion of the IS University Endowment? A) Lack of diversification. B) Illiquid investments. C) Taxation risk. Explanation The risk that the private equity portion of the IS University's Endowment Fund would most likely suffer from is illiquidity. It can be difficult to trade the private equity investments because they are usually not listed on secondary securities markets. The private equity investments are diversified in terms of vintage and strategies. The IS endowment fund is exempt from taxation on capital gains or dividends. (Module 33.2, LOS 33.g) Question #82 of 88 Question ID: 1507461 Using Exhibit 2, calculate the 2016 percentage management fee of the Alpha Fund. A) 1.5%. B) 2.0%. C) 2.5%. Explanation Percentage management fee = management fee / paid-in capital paid-in capital = Σ called-down 2016 % management fee = 1.95 / (75 + 25 + 30) = 0.015 (Module 33.3, LOS 33.i) Question #83 of 88 Alpha Fund's 2016 dollar amount of carried interest is closest to: A) $0 million. B) $10 million. C) $20 million. Explanation Question ID: 1507462 $195 million Alpha Fund (all data in millions) Called- Management Operating NAV before Carried NAV after Year Down Fees Results Distributions Interest Distributions Distributions 2014 30 0.45 –10 19.55 0 2015 25 0.83 55 98.72 0 2016 75 1.95 75 246.77 10.35 0 2014 NAV before distributions = 30 – 0.45 + (–10) = 19.55 2015 NAV before distributions = 19.55 + 25 − 0.83 + 55 = 98.72 2016 NAV before distributions = 98.72 + 75 − 1.95 + 75 = 246.77 When NAV before distribution exceeds committed capital, the 20% carried interest is applied. (246.77 − 195) × 0.2 = 51.77 × 0.2 = 10.35 In years 2017 and beyond, the 20% carried interest is applied to the change in NAV before distributions. For example, if the 2017 NAV before distributions was 296.77, then the carried interest would equal (296.77 − 246.77) × 0.2 = 50 × 0.2 = 10. The NAV after distributions subtracts carried interest and distributions from NAV before distributions. (Module 33.3, LOS 33.i) Question #84 of 88 Question ID: 1507463 Which of the following is most likely a characteristic of a venture capital investment? A) The typical investment uses leverage. B) Measurable risk. C) Increasing capital requirements. Explanation Venture capital investments require considerable capital to develop and grow. Companies that require venture capital usually have significant cash burn as they develop new products. Venture capital investments are primarily funded through equity and utilize little or no debt. Risk measurement of venture capital investments is difficult because of their short operating history, and the required development of new markets and technologies. (Module 33.1, LOS 33.c) Overview for Questions #85-88 of 88 TOPIC: ETHICAL AND PROFESSIONAL STANDARDS Question ID: 1507479 236.42 THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Pat Wilson, CFA, is the chief compliance officer for Excess Investments, a global asset management and investment banking services company. Wilson is reviewing two investment reports written by Peter Holly, CFA, an analyst and portfolio manager who has worked for Excess for four years. Holly's first report under compliance review is a strong buy recommendation for BlueNote, Inc., a musical instrument manufacturer. The report states that the buy recommendation is applicable for the next 6 to 12 months with an average level of risk and a sustainable price target of $24 for the entire time period. Further, the report states that the risk analysis is based on 95% VaR (calculated using the parametric method) and that price declines over the investment horizon should thus be limited to 5% of the current price. Holly informs Wilson that he determined his conclusions primarily from an intensive review of BlueNote's filings with the SEC but also from a call to one of BlueNote's suppliers who informed Holly that their new inventory processing system would allow for more efficiency in supplying BlueNote with raw materials. Holly explains to Wilson that he is the only analyst covering BlueNote who is aware of this information and that he believes the new inventory processing system will allow BlueNote to reduce costs and increase overall profitability for several years to come. Wilson must also review Holly's report on BigTime, Inc., a musical promotion and distribution company. In the report, Holly provides a very optimistic analysis of BigTime's fundamentals. The analysis supports a buy recommendation for the company. Just before the report is issued, Holly mentions to Wilson that BigTime unknowingly disclosed to him and a few other analysts who were waiting for a conference call to begin that the company is planning to restructure both its sales staff and sales strategy and may sell one of its poorly performing business units next year. Three days after issuing his report on BigTime, which caused a substantial rise in the price of BigTime shares, Holly sells all of the BigTime shares out of both his performance fee-based accounts and flat-fee accounts and then proceeds to sell all of the BigTime shares out of his own account on the following day. Holly obtained approval from Wilson before making the trades. After speaking with the CEO of BlueNote, Holly constructs a letter that he plans to send by email to all of his clients and prospects with email addresses and by regular mail to all of his clients and prospects without email addresses. The letter details changes to an equity valuation model that Holly and several other analysts at Excess use to analyze potential investment recommendations. Holly's letter explains that the new model, which will be put into use next month, will utilize Monte Carlo simulations to create a distribution of stock values, a sharp contrast to the existing model which uses static valuations combined with sensitivity analysis. Relevant details of the new model are included in the letter, but similar details about the existing model are not included. The letter also explains that management at Excess has decided to exclude alcohol and tobacco company securities from the research coverage universe. Holly's letter concludes by stating that no other significant changes that would affect the investment recommendation process have occurred or are expected to occur in the near future. Question #85 of 88 Question ID: 1507480 According to CFA Institute Standards of Professional Conduct, which of the following statements is most accurate with regard to the investment report on BlueNote, Inc.? The report: A) complies with the Standards. B) should not have included a price target as it makes an implicit guarantee of investment performance. C) does not comply with the Standards due to improper risk analysis. Explanation Under Standard V(A), specification of a price target is acceptable as long as the risk is appropriately disclosed. A research report can specify VaR as an appropriate risk metric, but the report should clarify that the quality of the VaR estimate depends on the quality of model inputs. (Module 43.8, LOS 43.a) Question #86 of 88 Question ID: 1507481 Did Holly violate any CFA Institute Standards of Professional Conduct with respect to his report on BlueNote or BigTime, as it relates to potential use of material nonpublic information? A) B) C) Holly has violated Standard on material nonpublic information in the case of both reports. There is a violation regarding the BlueNote report, but no violation with the BigTime report. There is a violation regarding the BigTime report, but no violation with the BlueNote report. Explanation Standard II(A). Holly has utilized public information to conduct an intensive analysis of BlueNote and has also utilized information obtained from a supplier that, while nonpublic, is not by itself material. When combined with his knowledge of BlueNote's material public information, however, the information from the supplier allows Holly to make a significant and material conclusion that would not be known to the public in general. This situation falls under the Mosaic Theory. Holly is free to make recommendations based on her material nonpublic conclusion on BlueNote since the conclusion was formed using material public information combined with nonmaterial nonpublic information. Thus, the BlueNote report did not violate Standard II(A) Integrity of Capital Markets – Material Nonpublic Information, and since there appears to be a reasonable and adequate basis, does not appear to violate any other Standards either. Holly's report on BigTime, however, is based in part on a conversation that he overheard between executives at BigTime. The information he overheard related to the sale of one of BigTime's business units was both material and nonpublic. The fact that several other analysts overheard the conversation as well does not make the information public. Because Holly is in possession of material nonpublic information, he is prohibited by Standard II(A) from acting or causing others to act on the information. Therefore, his report on BigTime violates the Standard. (Module 43.3, LOS 43.a) (Module 43.3, LOS 43.b) Question #87 of 88 Question ID: 1507482 According to CFA Institute Standards of Professional Conduct, which of the following statements is most likely correct with regard to Holly's report and subsequent sale of his and his clients' shares of BigTime common stock? Holly has: A) B) C) violated the Standard by attempting to manipulate the market price of BigTime stock. not violated the Standard since he first obtained approval to make the trades from his compliance officer. not violated the Standard since he acted in the best interest of his clients by realizing gains on BigTime stock. Explanation Standard II(B) – Market Manipulation. Holly has issued a buy recommendation on BigTime stock. The analysis is based on a very optimistic analysis of the company's fundamentals. Yet, three days after issuing the report, Holly decides to sell all of his clients' holdings as well as his own holdings of BigTime stock after observing a rise in the price of the stock. Holly's report, which caused an increase in the price of BigTime stock, was intended to deceive market participants into believing the company was a good investment when, as indicated by his subsequent sale of the shares, Holly believed otherwise. The combination of actions indicates that Holly is likely attempting to manipulate the price of the stock for his clients', and his own, benefit. Thus, he has likely violated Standard II(B) – Integrity of Capital Markets – Market Manipulation. (Module 43.3, LOS 43.a) (Module 43.3, LOS 43.b) Question #88 of 88 Question ID: 1507483 In his letter to clients explaining the change in the valuation model, did Holly violate any CFA Institute Standards of Professional Conduct? A) No. B) Yes, because he did not treat all clients fairly in his dissemination of the letter. C) Yes, because he failed to include details of the current valuation model to contrast with the new model. Explanation Standard V(B) – Communication With Clients and Prospective Clients. Standard V(B) requires members and candidates to promptly disclose any changes that materially affect investment processes. Holly has provided a detailed description of the new valuation model that will be used to generate investment recommendations and has disclosed the new limitations on the investment universe (i.e., no alcohol or tobacco stocks). Therefore, it does not appear that he has violated Standard V(B). Holly also has not violated any other standards. It is acceptable for him to email those clients with email addresses and send his letter by regular mail to those who do not. Standard III(B) – Fair Dealing does not require that all clients receive investment recommendations or other communications at exactly the same time, only that the system treats clients fairly. (Module 43.8, LOS 43.b) (Module 43.8, LOS 43.a)