CFA Level II Mock Exam 4 - Answers

Overview for Questions #1-4 of 88 Question ID: 1509426 TOPIC: QUANTITATIVE METHODS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Joan Fisher and Kim Weatherford are economists responsible for modeling security returns for Quincy Portfolio Managers, which is located in the southwestern United States. Fisher is the firm's chief economist and Weatherford is her assistant. In addition to financial assets, Quincy Portfolio Managers also recommends the use of commodities as a portfolio diversifier. Weatherford has been examining price indices for silver in an attempt to determine whether silver returns are predictable. As an initial step, she uses an autoregressive first-order regression model on daily price data for silver over the past two years. The plot of the raw data and the results of the regression are shown in Exhibit 1: Time Series of Silver Prices and Exhibit 2: Silver Price Regression Results. Exhibit 1: Time Series of Silver Prices Exhibit 2: Silver Price Regression Results Regression Statistics Multiple R 0.99 R-Square 0.98 Adjusted R-Square 0.98 Standard Error 123.81 Observations 522.00 Durbin-Watson 2.39 ANOVA df Regression Residual SS MS F 1.00 365,730,065 365,730,065 23,859.63 520.00 7,970,771 15,328 Significance F 0.00 Total 521.00 373,700,837 Coefficients Standard Error t-Stat P-value Intercept 21.00 Slope 11.56 0.99 1.82 0.07 0.01 154.47 0.00 Fisher and Weatherford later discuss fluctuations in gold prices. Although the arithmetic and geometric mean returns for gold were negative for much of the 1980s and 1990s, Fisher and Weatherford believe that gold should perform better in the future due to higher expected inflation. After appropriate transformation of the data, they use an autoregressive first-order regression model to examine the characteristics of gold returns, the results of which are shown in Exhibit 3: Gold Price Regression Results. Exhibit 3: Gold Price Regression Results Regression Statistics Multiple R 0.09 R-Square 0.01 Adjusted R-Square 0.01 Standard Error 123.95 Observations 520.00 ANOVA Regression df SS MS 1.00 66,742 66,742 4.34 Residual 518.00 7,958,144 15,363 Total 519.00 8,024,887 F Significance F 0.04 Coefficients Standard Error t-Stat P-value Intercept Slope 2.00 –0.09 5.44 0.37 0.71 0.04 –2.08 0.04 Question #1 of 88 Question ID: 1509427 Is the use of the Durbin Watson statistic in Weatherford's silver regression appropriate and, if so, how should it be interpreted? A) No. B) Yes, and it appears that the error terms are serially correlated. C) Yes, and it appears that the error terms are not serially correlated. Explanation The use of the Durbin-Watson statistic is inappropriate in an autoregressive regression, which is what Weatherford is using. The Durbin-Watson statistic is appropriate for trend models, but not autoregressive models. To determine whether the errors terms are serially correlated in an autoregressive model, the significance of the autocorrelations should be tested using the t-statistic. (Module 2.2, LOS 2.e) Question #2 of 88 Question ID: 1509428 Which of the following are the most likely problem in Weatherford's silver regression and the most appropriate test for it? Problem Test A) Multicollinearity Breusch-Pagan B) Multicollinearity Dickey-Fuller C) Nonstationary data Dickey-Fuller Explanation Weatherford is using an autoregressive first-order regression model in which this period's silver price is regressed on the previous period's price. The regression is of the form: Xt = b0 + b1Xt–1 The most likely problem in this regression is that the data is not covariance stationary. In the plot of the data, the mean of the data does not appear to be constant (it is much higher in the middle period). The estimate of the lag one slope coefficient is close to 1.0, which also suggests that the data is nonstationary. To definitively test this, the Dickey-Fuller test should be used, where the null hypothesis is that b1 – 1 is equal to zero. If the null hypothesis is not rejected, we say that the data has a unit root and is nonstationary. (Module 2.3, LOS 2.j) Question #3 of 88 Question ID: 1509429 To best model the silver price data using an autoregressive first-order regression model, Weatherford should use: A) first differences of the data. B) the actual silver price levels. C) the predicted silver price levels. Explanation Weatherford should use the first differences of the data in the regression. That is, instead of using the actual price levels, she should use the change in the data rather than levels: Yt = Xt – Xt–1 Then, the appropriate regression will be: Yt = b0 + b1Yt–1 The transformed time series data will have a mean-reverting level and be covariance stationary. (Module 2.3, LOS 2.j) Question #4 of 88 Question ID: 1509430 Using the data for the gold regression, what is the mean-reverting level and what is the two-step-ahead forecast if the current value of the independent variable is –0.80? Two-step-ahead Mean-reverting level forecast A) 1.83 1.75 B) 1.83 1.81 C) 2.07 1.75 Explanation To determine the mean-reverting level, we divide the intercept by one minus the slope coefficient: b0 mean-reverting level = 1−b1 2.00 = 1−(−0.09) = 1.83 The one-step-ahead predicted value is calculated by substituting the current value into the regression equation: ŷt+1 = b0 + b1 (yt ) = 2.00 + (−0.09) (−0.80) = 2.072 The two-step-ahead predicted value is then calculated by substituting the one-stepahead predicted value into the regression equation: ŷ t+2 = b0 + b1 (ŷ t+1 ) = 2.00 + (−0.09) (2.072) = 1.81 (Module 2.2, LOS 2.d) Overview for Questions #5-8 of 88 TOPIC: ECONOMICS Question ID: 1509436 THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities. However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data: Spot JPY/USD exchange rate = 120. Spot EUR/USD exchange rate = 0.7224. U.S. risk-free interest rate = 7%. Eurozone risk-free rate = 9.08%. Japanese risk-free rate = 3.88%. Yield curves in all three currencies are flat. In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the most lucrative opportunities. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements. Several bank customers have engaged in a carry trade with Bundovian Bunco (BU) as the investment currency and the USD as the funding currency. The bank will provide risk management advice to customers as it pertains to their FX carry trades. Wilson obtains the following data from the econometrics department: JPY/USD spot rate one year ago = 116. EUR/USD spot rate one year ago = 0.7200. Anticipated and historical U.S. annual inflation = 3%. Anticipated and historical Japanese annual inflation = 0%. Anticipated and historical eurozone annual inflation = 5%. One of the bank's major customers has significant business interests in Japan and in the eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from longterm currency exposure. Question #5 of 88 Question ID: 1509437 According to relative purchasing power parity, the expected JPY/EUR spot rate two years from now is closest to: A) 150. B) 158. C) 183. Explanation We must start by calculating the JPY/EUR spot rate. This is a simple algebra problem. We know that the JPY/USD spot rate is 120 and the EUR/USD spot rate is 0.7224. Dividing JPY/USD by EUR/USD leaves us with JPY/EUR. Plugging in the numbers, we get a JPY/EUR spot rate of 166.113 (= 120 / 0.7224). Next, we estimate the JPY/EUR spot rate two years from now using the relative PPP formula (for two years), given that EUR inflation is expected to be 5% higher (per year) than JPY inflation: E(S1) = S0 × (1 – 0.05)2 = 166.113(0.95)2 = 149.92 (Module 5.2, LOS 5.g) Question #6 of 88 Question ID: 1509438 Are the Japanese and eurozone inflation forecasts provided by the econometrics department consistent with the inflation rates implied by the international Fisher relation, given a U.S. inflation rate of 3%? A) Both forecasts are consistent. B) Neither forecast is consistent. C) One forecast is consistent and the other is not. Explanation Using the international Fisher relation, we can solve for the inflation forecasts in Japan and Europe, given interest rate differentials and the U.S. inflation forecast: R nominalA – R nominalB = E(inflationA) – E(inflationB) For Japan: 7.00% – 3.88% ≠ 3% – 0% For eurozone: 9.08% – 7.00% ≠ 5% – 3% Both implied inflation rates are inconsistent with the forecasts from the econometrics department. (Module 5.2, LOS 5.e) Question #7 of 88 Question ID: 1509439 According to the uncovered interest rate parity, in 12 months, the JPY/USD exchange rate would most likely be closest to: A) 116. B) 118. C) 124. Explanation Uncovered interest rate parity forecast: U.S. interest rate is higher by 7% – 3.88% = 3.12% 120 × (1 – 0.0312) = 116.26 (Module 5.2, LOS 5.g) Question #8 of 88 Question ID: 1509440 Based on the assumption that international parity conditions will hold in the long run, should the JPY and euro currency exposures of the bank's major customer be left unhedged? A) Both currencies should be left unhedged. B) Neither currency should be left unhedged. C) One currency should be left unhedged and the other should not. Explanation This question requires you to look at deviations from international parity conditions and then determine whether those deviations will tend to work to the advantage of the customer. In this problem, you are given the necessary information to examine parity conditions using relative purchasing power parity (RPPP). For the JPY, RPPP tells us that, because the spot rate one year ago was 116 and U.S. inflation was 3% higher than Japan's, the spot rate today should be: Stoday(assuming RPPP held) = Slast year (1 − 0.03) = 116(0.97) = 112.52 Because the expected spot rate today, based on RPPP (i.e., 112.52), is not equal to the actual spot rate today (i.e., 120), RPPP did not hold over the past year. Because the actual rate is higher than the rate forecast by RPPP, the long-term trend based on deviations from international parity conditions will be for the rate to fall and the JPY to appreciate. Hence, using deviations from parity conditions as indicators of future currency movements, the bank should recommend that the JPY exposure be left unhedged. Using the same RPPP process for the EUR exposure, we can calculate an RPPP spot rate today of 0.7340 (given that the rate was 0.72 one year ago and that U.S. inflation was lower by 2%): Stoday(assuming RPPP held) = Slast year (1 + 0.02) = 0.72(1.02) = 0.7344 Again, RPPP did not hold (i.e., the actual rate today, 0.7224, is not equal to the RPPP rate that should exist today given the inflation rates). However, for the EUR case, the RPPP expected spot is higher than the actual spot, indicating that the EUR may be currently overvalued and, thus, more likely to depreciate in the future. EUR exposure should be hedged. (Module 5.2, LOS 5.g) Overview for Questions #9-12 of 88 TOPIC: FINANCIAL STATEMENT ANALYSIS Question ID: 1509441 THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor, Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc. (Wayland), a manufacturer of components for high quality optic transmission systems. Mao also inquires about the impact of any unconsolidated investments. On December 31, 2017, Wayland purchased a 35% ownership interest in a strategic new firm called Optimax for $300,000 cash. The pre-acquisition balance sheets of both firms are found in Exhibit 1: Pre-Acquisition Balance Sheets for Wayland and Optimax. Exhibit 1: Pre-Acquisition Balance Sheets for Wayland and Optimax Balance Sheets as of Dec. 31, 2017 in Thousands Wayland Optimax Assets Cash $710 $100 Marketable securities 2,550 – Inventory 2,000 400 Accounts receivable 3,000 500 Property, plant, and equipment 2,450 1,000 $10,710 $2,000 $3,310 400 Long-term debt 5,000 1,000 Equity 2,400 600 $10,710 $2,000 Total assets Liabilities Accounts payable Total liabilities and equity On the acquisition date, all of Optimax's assets and liabilities were stated on its balance sheet at their fair values except for its property, plant, and equipment (PP&E), which had a fair value of $1.2 million. The remaining useful life of the PP&E is 10 years with no salvage value. Both firms use the straight-line depreciation method. For the year ended 2018, Optimax reported net income of $250,000 and paid dividends of $100,000. During the first quarter of 2019, Optimax sold goods to Wayland and recognized $15,000 of profit from the sale. At the end of the quarter, half of the goods purchased from Optimax remained in Wayland's inventory. Wayland currently uses the equity method to account for its investment in Optimax. Rathbun also notes that Wayland owns shares in Vanry, Inc. (Vanry). Rathbun gathers the data in Exhibit 2: Share Transaction Data, Vanry, Inc. from Wayland's financial statements. The year-end portfolio value is the market value of all Vanry shares held on December 31. All security transactions occurred on July 1, and the transaction price is the price that Wayland actually paid for the shares acquired. Vanry pays a cash dividend of $1 per share at the end of each year. Wayland expects to sell its investment in Vanry in the near term and accounts for it as fair value through profit or loss security. Exhibit 2: Share Transaction Data, Vanry, Inc. Year-End Portfolio Year-End Year-End Transaction Price Value Shares Held Share Price (July 1) 2017 $1,875,000 25,000a $75 $85 2018 $2,280,000 30,000 $76 $78 Year aPurchased on July 1, 2017. Question #9 of 88 Question ID: 1509442 The amount of goodwill resulting from Wayland's acquisition of Optimax is closest to: A) $20,000. B) $70,000. C) $90,000. Explanation The excess of purchase price over the pro rata share of the book value of Optimax is allocated to PP&E. The remainder is goodwill. Purchase price (in thousands) $300 Less: Pro rata share of Optimax 210 Excess of purchase price 90 Less: Excess allocated to PPE 70 Acquisition goodwill $20 [$600 Optimax book value × 35%] [($1,200 fair value − $1,000 book value) × 35%] (Module 8.3, LOS 8.a) Question #10 of 88 Question ID: 1509443 The amount that Wayland should report in its balance sheet at the end of 2018 as a result of its investment in Optimax is closest to: A) $345,500. B) $352,000. C) $380,500. Explanation Under the equity method, Wayland recognizes its pro rata share of Optimax's net income, less the additional depreciation that resulted from the increase in fair value of Optimax's PP&E. Pro rata share of Optimax's net income $87,500 [$250,000 × 35%] 7,000 [($200,000 / 10 years) × 35%] Less: Additional depreciation from PPE Equity income $80,500 Wayland's investment account on the balance sheet increased by its equity income and decreased by the dividends received from the investment. Beginning investment account $300,000 Equity income from Optimax 80,500 Less: Dividends received 35,000 [$100,000 dividends × 35%] Ending investment account $345,500 (Module 8.1, LOS 8.b) Question #11 of 88 Question ID: 1509444 Considering Wayland's intercompany sales transaction for the quarter ended March 31, 2019, the amount by which Wayland should reduce its equity income is closest to: A) $2,625. B) $7,500. C) $15,000. Explanation Because all of the profit from the intercompany transaction is included in Optimax's net income, Wayland must reduce its equity income of Optimax by the pro rata share of the unconfirmed profit. Because half of the goods remain, half of the profit is unconfirmed. Thus, Wayland must reduce its equity income by $2,625 [($15,000 total profit × 50% unconfirmed) × 35% ownership interest]. (Module 8.4, LOS 8.b) Question #12 of 88 Question ID: 1509445 As a result of its investment in Vanry, the amount of profit that Wayland should recognize in its income statement for the year ended 2018 is closest to: A) $15,000. B) $25,000. C) $45,000. Explanation The change in market value for the period and dividends received from the investment are recognized in the income statement for fair value through profit or loss securities. In 2018, there was a $25,000 unrealized gain on the original 25,000 shares [25,000 shares × ($76 – $75)] and a $10,000 unrealized loss on the shares purchased in 2018 [5,000 shares × ($76 – $78)]. Wayland received $30,000 in dividends from Vanry (30,000 shares × $1 per share). For 2018, the income statement impact is a $45,000 profit ($25,000 unrealized gain on original shares – $10,000 unrealized loss on increase in shares + $30,000 dividends received). (Module 8.2, LOS 8.a) Overview for Questions #13-16 of 88 Question ID: 1509451 TOPIC: FINANCIAL STATEMENT ANALYSIS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Ota L'Abbe, a supervisor at an investment research firm, has asked one of the junior analysts, Andreas Hally, to draft a research report dealing with various accounting issues. Excerpts from the request are as follows: "There's an exciting company that we're starting to follow these days. It's called Snowboards and Skateboards, Inc. They are a multinational company with operations and a head office based in the resort town of Whistler in western Canada. However, they also have a significant subsidiary located in the United States." "Look at the subsidiary and deal with some foreign currency issues, including the specific differences between the temporal and current rate methods of translation, as well as the effect on financial ratios." "The attached file contains the September 30, 2018, financial statements of the U.S. subsidiary. Translate the financial statements into Canadian dollars in a manner consistent with U.S. GAAP." Snowboards and Skateboards, Inc. (U.S.) Balance Sheet as of 9/30/2018 (U.S. Dollars) Cash and accounts receivable 775,000 Inventory 600,000 Property, plant, and equipment (PP&E) – net 730,000 Total assets 2,105,000 Accounts payable 125,000 Long-term debt 400,000 Common stock 535,000 Retained earnings 1,045,000 Total liabilities and shareholders' equity 2,105,000 Income statement for the year ended 9/30/2018 Sales 1,352,000 Cost of goods sold (1,205,000) Depreciation (140,000) Net income 7,000 Other information to be considered: Exchange rates (CAD/USD) Fiscal 2017 (average) 1.44 Fiscal 2018 (average) 1.35 October 1, 2014 1.50 September 30, 2017 1.48 June 30, 2018 1.37 September 30, 2018 1.32 Beginning inventory for fiscal 2018 had been purchased evenly throughout fiscal 2017. The company uses the FIFO inventory value method. Dividends of USD 25,000 were declared on June 30, 2018. All of the remaining inventory at the end of fiscal 2018 was purchased evenly throughout fiscal 2018. All of the PP&E was purchased, and all of the common equity was issued at the inception of the company on October 1, 2014. No new PP&E has been acquired, and no additional common stock has been issued since then. However, they plan to purchase new PP&E starting in fiscal 2019. The beginning retained earnings balance for fiscal 2018 was CAD 1,550,000. The accounts payable on the fiscal 2018 balance sheet were all incurred on June 30, 2018. The U.S. subsidiary's operations are highly integrated with the main operations in Canada. The remeasured inventory for 2018 using the temporal method is CAD 810,000. Costs of goods sold under the temporal method in 2018 is CAD 1,667,250. Question #13 of 88 Question ID: 1509452 Compared to the temporal method, which of the following financial statement elements of the parent are lower under the current rate method? A) Cash and accounts receivable. B) Depreciation expense and cost of goods sold. C) Common stock and dividends paid. Explanation Depreciation expense and COGS are remeasured at the historical rate under the temporal method. Under the current rate method, depreciation and COGS are translated at the average rate. Because the U.S. dollar is depreciating, depreciation expense and COGS are lower under the current rate method. (Module 10.5, LOS 10.e) Question #14 of 88 Question ID: 1509453 Using the appropriate translation method, which of the following best describes the effect of changing exchange rates on the parent's fiscal 2018 financial statements? A) An accumulated loss of CAD 242,100 is reported in the shareholders’ equity. B) A loss of CAD 31,200 is recognized in the income statement. C) A gain of CAD 27,400 is recognized in the income statement. Explanation Because the subsidiary's operations are highly integrated with the parent, the temporal method is used. Accordingly, a loss of CAD 31,200 is recognized in the parent's income statement (see balance sheet and income statement worksheet next). However, no calculations are actually necessary to answer this question. The parent has a net monetary asset position in the subsidiary (monetary assets > monetary liabilities). Holding net monetary assets when the foreign currency is depreciating will result in a loss. Under the temporal method, the loss is reported in the income statement. Only choice B satisfies this logic. The Canadian dollar is the functional currency because the subsidiary is highly integrated with the parent. Therefore, the temporal method applies. Step 1: Remeasure the balance sheet using the temporal method. 2018 (USD) Rate 2018 (CAD) Cash and account receivables 775,000 1.32 1,023,000 Inventory (given in Item 9) 600,000 Given 810,000 PP&E (net) 730,000 1.50 1,095,000 Total assets 2,105,000 2,928,000 Accounts payable 125,000 1.32 165,000 Long-term debt 400,000 1.32 528,000 Common stock 535,000 1.50 802,500 Retained earnings 1,045,000 Total liabilities and shareholders' equity 2,105,000 (a) 1,432,500 2,928,000 (a) Retained earnings is a plug figure that makes the accounting equation balance CAD 2,928,000 assets − CAD 165,000 accounts payable − CAD 528,000 long-term debt − CAD 802,500 common stock = CAD 1,432,500. Step 2: Derive net income from the beginning and ending balances of retained earnings and dividends paid as follows: CAD Beginning retained earnings 1,550,000 Given Item 6 Net income (83,250) Calculate Dividends paid in the year (34,250) (25,000 × 1.37 historical rate) Ending retained earnings Step 3: 1,432,500 From Step 1 Remeasure the income statement using the temporal method. 2018 (USD) Sales Cost of goods sold (given Item 11) Depreciation expense Remeasurement loss Net income Rate 2018 (CAD) 1,352,000 1.35 1,825,200 (1,205,000) Given (1,667,250) (140,000) 1.50 (210,000) (b) (31,200) 7,000 From Step 2 (83,250) (b) The remeasurement loss is a plug that is equal to the difference in net income of −CAD 83,250 and income before remeasurement of –CAD 52,050 (CAD 1,825,200 sales − CAD 1,667,250 COGS − CAD 210,000 depreciation). (Module 10.5, LOS 10.e) Question #15 of 88 Question ID: 1509454 As compared to the temporal method, the parent's fixed asset turnover for fiscal 2018 using the current rate method is: A) higher. B) lower. C) the same. Explanation The local currency (the USD) is depreciating, so the historical rate will be higher than the current rate. Fixed asset turnover (sales divided by net PP&E) will be higher under the current rate method. Net PP&E will be translated at the lower current rate, and because sales are the same under both methods, the ratio will be higher. If you want to do the calculations, net PP&E under the current rate method is USD 730,000 × 1.32 CAD/USD = CAD 963,600, and fixed asset turnover is CAD 1,825,200 / CAD 963,600 = 1.9 times. Fixed asset turnover under the temporal method is CAD 1,825,200 / CAD 1,095,000 = 1.7 times. (Module 10.3, LOS 10.d) Question #16 of 88 Question ID: 1509455 Suppose the parent uses the current rate method to translate the subsidiary for fiscal 2018. Will return on assets and net profit margin in U.S. dollars before translation be the same as, or different than, the translated Canadian dollar ratios? Return on assets Net profit margin A) Same Different B) Different Different C) Different Same Explanation Return on assets prior to translation will be different than the ratio after translation because the numerator (net income) is translated at the average rate, and the denominator (assets) is translated at the current rate using the current rate method. Net profit margin will be the same because both the numerator (net income) and the denominator (sales) are translated at the average rate using the current rate method. (Module 10.6, LOS 10.f) Overview for Questions #17-20 of 88 TOPIC: CORPORATE ISSUERS Question ID: 1511531 THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Alertron is a retail pharmacy chain with approximately $3.5 billion in annual sales. After rapid expansion into new geographical markets, Alertron's same-store sales have been shrinking, and the firm's nonpharmacy business has been a drag on the company's bottom line. Alertron stopped making dividend payments last quarter, and the company's stock is trading at a multiyear low of $11. New accounting standards will impact the way Alertron reports leases on the company's brick-and-mortar stores. These changes will reduce the company's fixedcharge coverage ratio below the level specified in the company's debt covenants. The market price and the ratings on the company's debt have accordingly dropped. Analysis of the individual lease terms for new stores reveals that a building with a fair value of $10.2 million (including the lessor's initial costs) is leased for 20 years for annual payments of $1.08 million. The value of the building after 20 years is estimated to be $4.6 million. Alertron's corporate tax rate is 15%. Phillip Margos, CEO of the company, is preparing for a tough meeting with Alertron's board of directors. One of the items that Margos drafts is a list of potential corporate restructuring actions. Question #17 of 88 Question ID: 1511532 Which of the following would be the most appropriate approach for estimating Alertron's cost of equity? A) Gordon growth model. B) CAPM. C) Exapnded CAPM. Explanation We are given that the company's stock trades; hence, we should be able to estimate the company's beta and apply CAPM to calculate the cost of equity. The Gordon growth model is not appropriate here because the company has stopped making dividend payments (and growth may not be constant, given the significant corporate restructuring that may occur). Expanded CAPM is used for privately held companies. (Module 17.2, LOS 17.d) Question #18 of 88 The most appropriate cost of debt for Alertron is: A) the YTM on the longest-maturity straight debt outstanding. B) the interest rate on a new bank loan. C) the RIIL. Question ID: 1511533 Explanation If the company's debt is traded, then the yield to maturity on the longest-maturity straight debt should be used as the estimate of cost of debt. The rate on new bank loans is only used for companies that rely on bank loans (not given in this case). The rate implicit in the lease (RIIL) provides an estimate of the cost of lease obligations. (Module 17.1, LOS 17.b) Question #19 of 88 Question ID: 1511534 The rate implicit in the lease for new stores is closest to: A) 8.14%. B) 8.53%. C) 9.58%. Explanation PV = -10.6, N = 20, PMT = 1.08, and FV = 4.6. CPT I/Y = 9.58%. (Module 17.1, LOS 17.e) Question #20 of 88 Question ID: 1511535 Which of the following corporate restructuring actions would be least appropriate for Margos to include in his presentation to the board? A) Acquisition. B) Divestiture. C) Cost restructuring. Explanation Alertron is facing potential violation of debt covenants. In a divestiture, Alertron would sell a segment of the company (or group of assets) to an acquirer for cash, which would allow Alertron to reallocate capital to debt reduction. A cost restructuring could similarly help to fend off violations in debt covenants. An acquisition, on the other hand, would involve expending scarce corporate resources, which is likely to be inappropriate for Alertron at this time. (Module 18.1, LOS 18.a) Overview for Questions #21-24 of 88 Question ID: 1509461 TOPIC: EQUITY VALUATION THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. De Jong is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2019, and De Jong is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week. Following an acquisition of a major competitor in 2002, O'Connor went public in 2003 and paid its first dividend in 2009. Dividends are paid at the end of the year. After 2018, dividends are expected to grow for three years at 11%: $2.13 in 2019, $2.36 in 2020, and $2.63 in 2021. The average of the arithmetic and compound growth rates are given in Exhibit 1: O'Connor Textiles Dividend History. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts. O'Connor's annual dividend history is shown in Exhibit 1: O'Connor Textiles Dividend History. Exhibit 1: O'Connor Textiles Dividend History Year Dividend ($) % Change 2009 0.76 2010 0.76 0.000 2011 0.76 0.000 2012 0.82 7.895 2013 0.91 10.976 2014 1.03 13.187 2015 1.16 12.621 2016 1.34 15.517 2017 1.52 13.433 2018 1.92 26.316 2009–2018 Arithmetic mean growth = 11.1% 2009–2018 Compound growth = 10.9% De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model. Charles Wang, De Jong's colleague, is of the opinion that O'Connor's growth rate will be 11% but will decline linearly to a long-term growth rate of 4% over the next six years. Wang also feels that the required rate of return for O'Connor should be 9.5%. ​ Question #21 of 88 Question ID: 1509462 For this question only, assume that De Jong's estimate of the value of O'Connor stock using a two-stage DDM is $75. Assuming the market has also applied a two-stage DDM, and the market's consensus estimate of dividend growth and required return are the same as De Jong's, the market's consensus estimate of the duration of the high-growth period is most likely: A) less than three years. B) equal to three years. C) greater than three years. Explanation De Jong's estimate of value of $75 (based on a high-growth period of three years) is greater than the market's consensus of $70, which means the market's consensus high-growth duration must be less than three years, all else equal. (Module 20.1, LOS 20.b) Question #22 of 88 Question ID: 1509463 In what situation is it most appropriate for De Jong to employ these models? Dividend discount model FCFE model A) Noncontrol perspective FCFE aligned with profitability B) Control perspective FCFE aligned with profitability C) Noncontrol perspective FCFE aligned with dividend policy Explanation For the dividend discount model to produce a reasonable estimate of share price, the investor should have a noncontrol perspective. For the FCFE model to be appropriate, there should be a link between FCFE and profitability. (Module 20.1, LOS 20.a) Question #23 of 88 Question ID: 1509464 The value of O'Connor stock using Wang's assumptions is closest to: A) $43.64. B) $48.75. C) $52.35. Explanation H = 6 / 2 = 3, D0 = 1.92, r = 0.095, gS = 0.11, gL = 0.04 D0 (1+g ) D0 ×H×(g −g ) L P0 = (r−g ) s + L + (0.095−0.04) (r−g ) L 1.92(1.04) = L 1.92×3×0.07 = $43.64 (0.095−0.04) (Module 20.3, LOS 20.n) Question #24 of 88 Question ID: 1509465 For this question only, assume that the market price of O'Connor stock is $48.00 and the linearly declining high-growth period is five years. The required rate of return implicit in the market price is closest to: A) 8.86%. B) 9.22%. C) 10.81%. Explanation D0 r = [( P0 ) × [(1 + gL ) + [H × (gS − gL )]]] + gL 1.92 = [( 48 ) × [(1.04) + (2.5 × 0.07)]] + 0.04 = 0.0886 (Module 20.3, LOS 20.i) Overview for Questions #25-28 of 88 Question ID: 1509476 TOPIC: FIXED INCOME THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Ted Thompson, CIO for Aplius Insurance Company, is evaluating the credit risk management models for the company's fixed income portfolio. Thompson meets with Nambi Musa, who is the head of Aplius's credit risk analysis department. Musa assures Thompson that his team has updated the credit risk analysis models over recent years and that these updated models have performed well over the past 12 months. Thompson, however, is not pleased with the losses incurred on Aplius's municipal bond holdings in the last quarter. Musa mentions that while the credit risk analysis department continues to use credit ratings, they are also evaluating other analytical tools including structural models. He specifically mentions credit valuation adjustment and expected loss as other credit risk measures currently being used. Musa makes the following two statements: "Company credit ratings are based on senior secured debt Statement 1: issued by the company. Ratings on other issues by the same company are adjusted by a process known as notching." "The credit valuation adjustment on a bond is the maximum Statement 2: amount an investor would be willing to pay to an insurer to bear the credit risk of that security." Musa further discusses the credit analysis metrics that are newly developed. As an example, he illustrates the valuation conducted on 3-year, 5% Zeta Corp. $100 par, senior unsecured bonds. Exhibit 1: Valuation of 3-Year, 5% Zeta Corp. Bond shows the report. Exhibit 1: Valuation of 3-Year, 5% Zeta Corp. Bond Period Cash Flow LGD POD DF 1 5.00 32.648 1.500% 0.971 2 5.00 32.083 1.478% 0.943 3 105.00 31.500 1.455% 0.915 Thompson then tells Musa that the credit analysis department should focus on reduced-form models. Thompson states that, "reduced-form models perform better than structural models as they tend to impose assumptions on the outputs of the structural model. However, reduced-form models require a specification of the company's balance sheet composition." Question #25 of 88 Question ID: 1509477 Musa's Statement 1 is most likely: A) correct. B) C) incorrect because the process of adjusting ratings on issues by same issuer is not called notching. incorrect because corporate credit ratings are based on senior unsecured debt of the issuer. Explanation Statement 1 is incorrect. Issuer rating for a company is typically based on its senior unsecured debt. Ratings on other classes of debt by the same issuer may be notched. (Module 28.3, LOS 28.b) Question #26 of 88 Question ID: 1509478 Musa's Statement 2 is most likely: A) correct. B) incorrect as the statement only considers credit risk. C) incorrect as the statement should refer to expected loss and not to credit valuation adjustment. Explanation Statement 2 is correct. Credit valuation adjustment is the compensation an investor receives for bearing the credit risk and is the maximum amount the investor would be willing to pay to insure against credit risk losses. (Module 28.1, LOS 28.a) Question #27 of 88 Question ID: 1509479 Using information in Exhibit 1: Valuation of 3-Year, 5% Zeta Corp. Bond, the credit valuation adjustment for the Zeta Corp. bond is closest to: A) $1.34. B) $1.86. C) $2.72. Explanation Period Cash Flow LGD Prob. of Default Expected Loss Discount Factor PVEL 1 5.00 32.648 1.500% 0.490 0.971 0.475 2 5.00 32.083 1.478% 0.474 0.943 0.447 3 105.00 31.500 1.455% 0.458 0.915 0.420 CVA = 1.3418 (Module 28.1, LOS 28.a) Question #28 of 88 Question ID: 1509480 Thompson's statement about reduced-form models relative to structural model is most likely: A) correct. B) incorrect regarding assumptions imposed. C) incorrect regarding specification of balance sheet composition being required. Explanation While Thompson's statement about reduced-form models imposing assumptions on the output of structural models is correct, Thompson is incorrect about balance sheet composition being required—reduced-form models do not require a specification of the company's balance sheet structure. (Module 28.4, LOS 28.d) Overview for Questions #29-32 of 88 Question ID: 1509496 TOPIC: DERIVATIVES THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Jonathan Adams, CFA, is doing some scenario analysis on swaps ands forward contracts. The process involves pricing the contracts and then estimating their values based on likely scenarios provided by the firm's forecasting and strategy departments. The contracts with which Adams is most concerned are those on interest rates. The MRR spot curve is as follows: 30-day: 3.12% 60-day: 3.32% 90-day: 3.52% 120-day: 3.72% 150-day: 3.92% 180-day: 4.12% Adams determines the price of a 2×5 FRA from the spot yield curve using the following calculation: Thirty months ago, Adams entered into a $1 million notional, 3-year, semiannual settlement, 3% fixed-rate payer swap. Question #29 of 88 Question ID: 1509497 How many of the following terms are correct in the calculation of the FRA price: 0.0352, 0.0332, 60/360, 90/360? A) Two. B) Three. C) Four. Explanation Adams used the 90-day rate (0.0352) and the time period (90/360) in the numerator instead of the 150-day rate (0.0392) and the 150-day time period (150/360). The denominator is correct, so two out of the four terms are used correctly. The correct calculation is: ⎡ 1+0.0392( ⎢ ⎢ ⎢ ⎣ 1+0.0332( 150 360 60 360 ) ) ⎤ ⎥ − 1⎥ ( ⎥ 360 90 1.01633 ) = [ 1.00553 − 1] (4) = 4.30% ⎦ (Module 30.4, LOS 30.c) Question #30 of 88 Question ID: 1509498 After 30 days, Adams wants to value a $10 million short position in the 2×5 FRA. The 90-day forward rate in 30 days is now 4.14%, and the original price of the FRA was 4.30%. 120-day MRR has changed to 3.92%. The current value of the $10 million FRA to the short position under this scenario is closest to: A) $15,794. B) $3,948. C) –$15,794. Explanation (0.0430 – 0.0414) × $10 million × 90 / 360 = $4,000 (expected payoff in 120 days) $4,000 PV of payoff is = $3, 948 1+0.0392( 120 360 ) (Module 30.5, LOS 30.c) Question #31 of 88 Question ID: 1509499 Immediately after the fifth settlement, the value of the swap to Adams is closest to: A) $5,487. B) $5,600. C) $11,076. Explanation Original swap tenor is 3 years, semiannual. After 30 months, there is only one settlement remaining. Hence: SFRnew = MRR corresponding to that settlement = 4.12% DF (180-day) = 1 / (1 + 0.0412 × (180 / 360)) = 0.9798 valuepayer = ΣZ × (SFRnew ​− S​FRold) × (days / 360) × notional principal = 0.9798 × (0.0412 – 0.03) × (180 / 360) × 1,000,000 = $5,487 (Module 30.6, LOS 30.e) Question #32 of 88 Question ID: 1509500 Suppose that Adams entered into the FRA as a short party and now wants to hedge that exposure. The most appropriate way to achieve that hedge would be to take on exposure to: A) a long interest rate call and short interest rate put. B) a short interest rate call and long interest rate put. C) a receiver swap. Explanation A short FRA position can be hedged by a long position in an equivalent FRA. Long FRA = long IR call + short IR put (Module 31.6, LOS 31.j) Overview for Questions #33-36 of 88 Question ID: 1509501 TOPIC: ALTERNATIVE INVESTMENTS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Julie Mariluz is a real estate analyst with Young Family Trust (YFT), a family investment office. Aside from investment in equities and bonds, YFT makes direct investment in diverse real estate properties. Mariluz has been asked to evaluate three potential investment properties shown in Exhibit 1: Property Description Exhibit 1: Property Description Property 1: A multi-family residential building with high occupancy and in a desirable location. Property 2: An older office building with dated architectural features and in an area that is undergoing significant improvements. Property 3: A shopping mall with two anchor tenants. Question #33 of 88 Question ID: 1509502 Which property valuations are most likely to be heavily influenced by their unique characteristics? A) Property #1 and Property #2. B) Property #1 and Property #3. C) Property #2 and Property #3. Explanation While almost any private equity real estate investment will be unique (if for no other reason than that they must be in different locations), residential properties tend to have the fewest unique characteristics. This is why transactions-based indices tend to be more useful for residential commercial property benchmarking than for nonresidential commercial properties due to the large amount of data required for many properties and the unique features of many nonresidential commercial properties. (Module 32.1, LOS 32.c) Question #34 of 88 Question ID: 1509503 Which approach would an appraiser most likely use for valuing Property #2? A) Cost approach. B) Income approach. C) Sales comparison approach. Explanation Property #2 is an older office building with unique characteristics that could not be easily reproduced using current architectural designs and materials. Therefore, the cost approach would be less appropriate than the income approach as a basis for appraisal. The sales comparison approach would also be less suitable as the property is relatively unique. (Module 32.2, LOS 32.g) Question #35 of 88 Question ID: 1509504 One of the partners at YFT asks Mariluz how she would go about estimating the value of an owner-occupied, 45-year-old single family home. The most appropriate response that Mariluz could provide is: A) the income approach. B) the cost approach. C) the sales comparison approach. Explanation The sales comparison approach estimates a property's value based on what comparable properties are currently selling for in the market. The cost approach is less applicable because of the difficulty in estimating depreciation and obsolescence of an older property. The income approach is not appropriate because an owneroccupied property does not generate income. (Module 32.2, LOS 32.f) Question #36 of 88 Question ID: 1509505 YFT is considering the use of an index as a benchmark for measuring the performance of the firm's private real estate investments. Compared to a transaction-based real estate index, an appraisal-based real estate index is most likely to have higher: A) lag. B) volatility. C) correlation with other asset classes. Explanation Appraisal-based indices tend to lag transaction-based indices, and will appear to have lower correlation with other asset classes and lower volatility compared to transaction-based indices. (Module 32.1, LOS 32.e) Overview for Questions #37-40 of 88 Question ID: 1509526 TOPIC: ETHICAL AND PROFESSIONAL STANDARDS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Mike Zonding, CFA, is conducting a background check on CFA candidate Annie Cooken, a freshly minted MBA who applied for a stock-analysis job at his firm, Khasko Financial. Zonding does not like to hire anyone who does not adhere to the Code and Standards' professional conduct requirements. The background check reveals the following: (i) While doing a full-time, unpaid internship at Kale Investments, Cooken was reprimanded for working a 30-hour-a-week night job as a waitress. (ii) As an intern at Lammar Corp., Cooken was fired after revealing to the FBI that one of the principals was embezzling from the firm's clients. (iii) Cooken performed 40 hours of community service in relation to a conviction on a misdemeanor drug possession charge when she was 16 years old. (iv) On her resume, Cooken writes, "Recently passed Level II of the CFA exam, a test that measures candidates' knowledge of finance and investing." During the interview, Zonding asks Cooken several questions on ethics-related issues, including questions about the role of a fiduciary and Standard III(E) Preservation of Confidentiality. He asks her about her internship at Kale Investments, specifically about the working hours. Cooken replies that the internship turned out to require more time than she originally planned, up to 65 hours per week. Zonding subsequently hires Cooken and functions as her supervisor. On her third day at the money management boutique firm, portfolio manager Steven Clarrison hands her a report on Mocline Tobacco and tells her to revise the report to reflect a buy rating. Cooken is uncomfortable about revising the report. Zonding prepared a research report with a buy rating on Orlando Stores, a discount clothing chain. Khasko's investment banking department has completed transactions for Orlando in the past 12 months and currently is working with Orlando to evaluate a secondary offering; Khasko has a policy in place that separates the activities of investment banking and research departments. In the report, Zonding disclosed that Khasko has an investment banking relationship with Orlando and that his wife holds Orlando shares. However, he forgot to comment on the risk profile and suitability of investing in Orlando shares. Zonding just entered into a brokerage agreement with Zeta Services. According to that agreement, in exchange for client referrals from Zeta, Khasko would give Zeta its brokerage business. Khasko advised its clients about the nature and extent of this relationship in writing. Question #37 of 88 Question ID: 1509527 In the context of the Code and Standards, which of the items from the background check would most likely indicate that Zonding should not have hired Cooken? A) Item i. B) Item ii. C) Item iii. Explanation Item (i) is a likely violation of the Code and Standards. Working as a waitress is not a conflict of interest for an investment analyst, but Cooken's employer can reasonably assume that a 30-hour-a-week side job could be tiring, depriving the company of her skills and ability during her internship, which would violate Standard IV(A) Loyalty (to employer). Cooken's description of the CFA exam is accurate, and she takes no liberties with a title. Thus she has not violated Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program. One conviction as a teenager before working as an investment professional is not a violation of Standard I(D) Misconduct. Standard IV(A) Loyalty (to employer) does not hold when illegal activities are involved, and Cooken's willingness to talk to the FBI would most likely not be considered a violation. The Standards do suggest, however, that the member consult with his employer's compliance personnel or outside counsel before disclosing any confidential client information. (Module 43.7, LOS 43.a) Question #38 of 88 Question ID: 1509528 Which of the following statements provides the least appropriate justification for Cooken's caution about revising the report on Mocline Tobacco? A) Cooken knows next to nothing about Mocline stock. B) Cooken’s uncle, George Whates, is the CFO of Mocline. C) In college, Cooken worked for Mocline, but never declared the income on her taxes. Explanation While Cooken's tax avoidance may represent a professional-conduct issue, it has no bearing on her ability to write a report on Mocline. While Clarrison may be an expert on Mocline, Cooken does not know enough about the stock to write about it without taking the risk of being in violation of Standard V(A) Diligence and Reasonable Basis. Because of Cooken's relationship to the CFO of Mocline and ownership of Mocline stock, her objectivity might be questioned. (Module 43.8, LOS 43.a) Question #39 of 88 Question ID: 1509529 Was Zonding in compliance with CFA Institute Standards of Professional Conduct with regard to the Orlando Stores research report? A) B) C) No, because Zonding neglected to discuss Orlando’s suitability as an investment. No, because Zonding failed to disclose Orlando’s plans to announce a secondary offering in the near future. Yes, because Zonding disclosed his firm’s relationship with Orlando, his wife’s ownership of the shares, and the availability of his Orlando report. Explanation Zonding's research report failed to include sufficient information be included for investors to assess the appropriateness of the investment for their own personal risk profile violating Standard V(B) Communication with Clients and Prospective Clients. (Module 43.8, LOS 43.a) Question #40 of 88 Question ID: 1509530 Did Zonding and Khasko follow the recommended procedures of the CFA Institute Standards of Professional Conduct with respect to the brokerage arrangement with Zeta? A) Yes, because Khasko disclosed this arrangement to their clients. B) No, because Khasko did not preserve confidentiality of their agreement with Zeta. C) No, because the agreement inappropriately creates a conflict of interest. Explanation Zonding complied with Standard VI(A) in making disclosure about Khasko's relationship with Zeta. Standard III(E) Preservation of Confidentiality is not applicable here because Zeta is not a client. (Module 43.9, LOS 43.b) Overview for Questions #41-44 of 88 Question ID: 1509531 TOPIC: ETHICAL AND PROFESSIONAL STANDARDS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Brandon Ratlieff, CFA, is a partner at Global Asset Management (GAM). CFA program candidate Sarah Gunderson just completed her first year at GAM. Ratlieff is going over Gunderson's annual evaluation completed by her supervisor Peter Jackson, CFA. To supplement the meager income from her entry-level stock-analysis job, Gunderson took a part-time position working three hours each Friday and Saturday night tending bar at a sports bar and grill downtown. Gunderson did not inform her supervisor or HR about the job. During her first week, Gunderson has lunch with her former classmates, including Taira Basch, CFA, who works for the compliance officer at a large investment bank in town. Basch arrives late, explaining, "What a day, it's only noon and already I have worked on the following requests: 1. A federal regulator called and wanted information on potentially illegal activities related to one of the firm's key clients. 2. A rival company's employee wanted information regarding employment opportunities at the firm. 3. A potential client contacted an employee and wanted detailed performance records of client accounts so he can decide whether to invest with the firm." One of GAM's clients is Bluestar Inc. Several months ago, Ratlieff filed several documents with regulators concerning Bluestar's IPO. A Bluestar official later provided Ratlieff information that suggested that the financial statements GAM filed with the regulator overstate the issuer's earnings. Ratlieff seeks the advice of GAM's general counsel, who states that because Ratlieff was not aware of the irregularity at the time of the filing, it would be difficult for the regulator to prove that GAM has been involved in any wrongdoing. GAM provides research coverage for ASE, a European retailer. Gunderson's mother owns 30,000 ASE shares. As part of her estate planning, Gunderson's mother informs Gunderson that she has created a trust in Gunderson's name, into which she has placed 2,000 shares of ASE. The trust is structured so that Gunderson will not receive control of the assets for three years. Gunderson is due to update the research coverage of ASE within the next two weeks. Question #41 of 88 Question ID: 1509532 By not telling her employer about the bartending position, Gunderson has most likely violated: A) no Standards. B) Standard IV(B) Additional Compensation Arrangements. C) Standard IV(A) Loyalty (to employer) and Standard IV(B) Additional Compensation Arrangements. Explanation Standard IV(A) Loyalty (to employer) requires that members and candidates act for the benefit of their employer and not deprive the employer of their skills and abilities. In addition, members and candidates must not cause harm to their employers. It's safe to say that a bar does not compete with a stock analysis/asset management company, and a six-hours-a-week part-time job should not interfere with her ability to perform analysis duties. Standard IV(B) Additional Compensation Arrangements relates to additional compensation related to an employee's services to the employer. The part-time work is not related to her analysis job and, as such, does not violate the Standard. There is nothing inherently unethical about working as a bartender, and working as a barkeeper does not compromise Gunderson's professional reputation, integrity, or competence. Thus, Standard I(D) Misconduct has not been violated. (Module 43.7, LOS 43.a) Question #42 of 88 Question ID: 1509533 Which of the requests, if fulfilled, is most likely to place Basch in violation of Standard III(E) Preservation of Confidentiality? A) Request 1. B) Request 2. C) Request 3. Explanation Request 3 is a likely violation. Potential clients are not entitled to performance data beyond what the company chooses to disclose. Providing data, particularly clientspecific data, could be a violation of the clients' confidentiality. Members and candidates must answer questions asked by CFA Institute's Professional Conduct Program. Members and candidates may report illegal activities (and in some cases may have a legal obligation to report such activities) on the part of clients without fear of violating Standard III(E) Preservation of Confidentiality, so Request 1 is not likely a violation. And unless the firm's policy requires silence about job openings, answering questions about them is ethical, if not always wise, so Request 2 is not likely a violation. (Module 43.6, LOS 43.a) Question #43 of 88 Question ID: 1509534 With respect to the information about Bluestar, Ratlieff's most appropriate course of action would be to: A) treat the information received from the company official as confidential. B) seek independent legal counsel about his obligations under the law. C) report the information to the regulator. Explanation Although it is recommended that members and candidates seek the advice of legal counsel, the reliance on such advice does not absolve a member or candidate from his responsibilities under Standard I(A) – Knowledge of Law. Ratlieff should recognize that the recommendation of the firm's general counsel was not in compliance with the law. There is no requirement under the Standards to report violations to governmental authorities. (Module 43.1, LOS 43.a) Question #44 of 88 Question ID: 1509535 With regard to research reports on ASE, Gunderson should most appropriately: A) B) advise her supervisor that she is not able to issue research recommendations on ASE. disclose her holdings in the report, though she need not notify her supervisor because the shares are held in trust and are not within her direct control. C) disclose the situation to her supervisor and, if then asked to prepare a report, also disclose the situation in the report. Explanation Standard VI(A) – Disclosure of Conflicts requires members to make all conflicts of interests known to their employers and to comply with any restrictions placed on members by their employers. Furthermore, members should also disclose these conflicts in their reports to the firm's clients so that clients can fully evaluate the report in the context of the conflict. (Module 43.9, LOS 43.a) Overview for Questions #45-48 of 88 Question ID: 1509446 TOPIC: FINANCIAL STATEMENT ANALYSIS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Andrew Carson is an equity analyst employed at Lee Vincent and Associates, an investment research firm. Carson is responsible for following Samilski Enterprises (Samilski), a publicly traded firm that produces motorcycles and associated mechanical parts. Samilski reports under U.S. GAAP. Exhibit 1: Selected Pension Plan Information for FY 20X9 shows selected financial data pertaining to Samilski's employee pension plan. Exhibit 1: Selected Pension Plan Information for FY 20X9 $ Millions Current service cost Past service cost 118 36 Beginning PBO 1,022 Ending PBO 1,198 Interest cost 82 Actual return on plan assets 214 Employer contribution 102 Beginning plan assets 896 During fiscal year 20X9, a change in actuarial assumptions regarding employee life expectancy resulted in an actuarial loss of $128 million. Average employee service life is estimated to be 20 years. The discount rate and expected return on plan assets are 8% and 10% respectively. Carson believes that rate of compensation increase will be 5% as opposed to the 4% assumed by the plan. Question #45 of 88 Question ID: 1509447 The amount of benefits paid during the year is closest to: A) $76 million. B) $132 million. C) $188 million. Explanation Benefits paid can be determined by reconciling ending PBO to beginning PBO: Beginning PBO + Current service cost 1,022 118 + Past service cost 36 + Interest cost 82 + Actuarial loss 128 (–) Benefit paid 188 (=) Ending PBO 1,198 (Module 9.2, LOS 9.b) Question #46 of 88 Question ID: 1509448 The ending fair value of plan assets is closest to: A) $1,024 million. B) $1,128 million. C) $1,412 million. Explanation The ending fair value of plan assets = beginning fair value + contributions + actual return – benefits paid = 896 + 102 + 214 – 188 = $1,024 million (Module 9.2, LOS 9.b) Question #47 of 88 The total periodic pension cost is closest to: A) $62 million. B) $76 million. C) $150 million. Question ID: 1509449 Explanation Total periodic pension cost = employer contributions – change in funded status = employer contributions – [ending funded status – beginning funded status] = 102 – [(1,024 – 1,198) – (896 – 1,022)] = $150 million or total periodic pension cost = current service cost + past service cost + interest cost + actuarial loss – actual return on plan assets = 118 + 36 + 82 + 128 – 214 = $150 million. (Module 9.4, LOS 9.c) Question #48 of 88 Question ID: 1509450 The amount of periodic pension cost reported in P&L if Samilski reported under IFRS would be closest to: A) $144 million. B) $152 million. C) $166 million. Explanation Under IFRS, periodic pension cost reported in P&L would consist of current and past service cost plus/minus net interest expense/income. Net interest income is computed as the discount rate multiplied by beginning funded status (adjusted for past service cost). periodic pension cost in P&L = 118 + 36 – 0.08[896 – 1,022 – 36] = 166.96 Note that because the beginning funded status is negative, there is a net interest cost. (Module 9.4, LOS 9.c) Overview for Questions #49-52 of 88 Question ID: 1511526 TOPIC : QUANTITATIVE METHODS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Henke Malfoy, CFA, is an analyst with Alpha Securities. He is interested in forecasting dividend increases in large-cap U.S. stocks. Malfoy starts out with a database of 500 stocks in the S&P 500 Index and formulates the following model: div = b0 + b1 ΔFCFE + b2 growth + b3 D/E where: Div = 1 if the dividend increase, else = 0 ΔFCFE = % change in FCFE from prior year Growth = growth rate in EPS over the past five years D/E = debt-to-equity ratio Exhibit 1: Regression Results shows the results of the model for the year 20X2. Exhibit 1: Regression Results Coefficient P-Value Intercept -2.03 0.02 ΔFCFE -3.112 0.04 Growth -3.13 0.01 -1.118 0.01 D/E Malfoy's colleague, Beth Griner, comments that the usefulness of the output is dependent on proper model specification. Griner is particularly concerned that improper model specification may lead to biased and inconsistent model parameters. Malfoy wants to use advanced algorithms to parse through MD&A in company 10-Q reports to predict dividend increases. Malfoy starts by removing numbers, punctuation, blank spaces, and HTML tags from the text data. Question #49 of 88 Question ID: 1511527 What is the change in probability of an increase in dividends when the growth rate in EPS increases by 1%? A) 3.13%. B) 4.19%. C) 4.37%. Explanation The change in ln(odds) for a 1% increase in growth rate = –3.13. The change in odds = e-3.13 = 0.0437. The change in probability = 0.0437 / (1 + 0.0437) = 0.0419, or 4.19%. (Module 1.4, LOS 1.l) Question #50 of 88 Question ID: 1511528 Griner is most likely concerned with the model misspecification of: A) inappropriate transformation. B) data that is improperly pooled. C) the omission of important independent variables. Explanation We are given that Griner is concerned with biased and inconsistent model parameters. The omission of important variables could lead to biased and inconsistent regression parameters. It may also lead to serial correlation or heteroskedasticity in residuals. Improperly pooled data may lead to serial correlation or heteroskedasticity in residuals. Inappropriate transformation may lead to heteroskedasticity in residuals. (Module 1.3, LOS 1.g) Question #51 of 88 Question ID: 1511529 The most appropriate machine learning algorithm for Malfoy to use to analyze MD&A is: A) principal components analysis. B) support vector machine. C) random forest. Explanation Support vector machine can (among other uses) be applied to classify text from documents into categories useful for investors. Principal components analysis is used for unsupervised learning (where there is no target variable; here, we have a qualitative target variable). A random forest is used with a continuous (rather than categorical) target variable. (Module 3.2, LOS 3.c) Question #52 of 88 Question ID: 1511530 The step taken by Malfoy to transform the textual data would most appropriately be called: A) text preprocessing. B) data wrangling. C) text cleansing. Explanation The procedure described would most accurately be called text cleansing. Text cleansing typically involves removing HTML tags, punctuation, white spaces, and most numbers. The data wrangling (also called preprocessing) task performs transformations on cleansed data to ready it for model training. Data wrangling or preprocessing may include dealing with outliers, extracting useful variables, and scaling the data. (Module 4.1, LOS 4.g) Overview for Questions #53-56 of 88 Question ID: 1509471 TOPIC: EQUITY VALUATION THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Lorenz Kummert is a junior equity analyst who is following Schubert, Inc. (Schubert), a small publicly traded company in the United States. His supervisor, Markus Alter, CFA, has advised him to use the residual income model to analyze Schubert. Kummert has determined Schubert's cost of equity, cost of debt, and weighted average cost of capital (WACC) to be 12.8%, 8.4%, and 11.9%, respectively. Book value of long-term debt and equity was $6,200,000 and $3,281,000 respectively on January 1, 2018. The stock price on December 31, 2018, is $36 per share and there are 130,000 shares outstanding. The relevant tax rate is 30%, and return on equity (ROE) is expected to be 14%. Summarized financial information about Schubert for 2018 is provided in Exhibits 1 and 2. Exhibit 1: Schubert, Inc., Balance Sheet on December 31, 2018 Cash Accounts receivable $125,000 Accounts payable $426,000 975,000 Accrued liabilities 774,000 Inventory 1,215,000 Fixed assets (net) 9,277,000 Total assets $11,592,000 Long-term debt 6,211,000 Common shares 2,100,000 Retained earnings 2,081,000 Total liabilities and equity $11,592,000 Exhibit 2: Schubert, Inc., Income Statement for the Year Ended December 31, 2018 Sales $9,423,000 Cost of sales 4,580,000 Selling, general, and administrative 1,230,000 Depreciation 1,745,000 Interest expense 522,000 Income tax expense 403,800 Net income $942,200 Based on his analysis of several years of financial statements, Kummert notes that 2018 was an exceptionally profitable year for Schubert, and that its dividend payouts are usually low because the funds are mainly reinvested in the firm to promote growth. Furthermore, there are very few nonrecurring items on the income statement. Upon review of Kummert's preliminary report, Alter concurs with his analysis of the financial statements but reminds him that Schubert's long-term debt is currently trading at 95% of its book value. He also cautions Kummert that violations of the clean surplus relation can bias the results of the residual income model. The consensus annual EPS estimate for 2019 is $4.50, and the dividend payout ratio for 2019 is estimated at 5%. Question #53 of 88 Question ID: 1509472 Which of the following amounts is the most appropriate forecast of Schubert's book value per share and residual income, respectively, for 2019? Book value per share Residual income A) $36.43 $0.38 B) $38.00 $2.32 C) $36.43 $2.32 Explanation Beginning book value = Total Equity = Common shares + Retained earnings = 2,100,000 + 2,081,000 = $4,181,000 Beginning book value (Bt–1) $32.16 ($4,181,000 / 130,000) Earnings per share forecast (Et) $4.50 (given) Dividend forecast (Dt = Et × payout ratio) $0.23 ($4.50 × 5%) Forecast book value per share (Bt–1 + Et − Dt) $36.43 Equity charge per share (r × Bt–1) $4.12 (0.128 × $32.16) Per share RIt[(Et − (r × Bt–1)] $0.38 ($4.50 − $4.12) (Module 23.2, LOS 23.c) Question #54 of 88 Question ID: 1509473 Which of the following amounts are closest to Schubert's economic value added (EVA) for fiscal year 2018 and market value added (MVA) as of fiscal year-end 2018, respectively? EVA MVA A) $179,361 $188,450 B) $23,455 $369,500 C) ($70,900) $369,500 Explanation Economic value added (EVA) is calculated as follows: $WACC = WACC × total capital (beginning of 2018) = 0.119 × ($6,200,000 + $3,281,000) = $1,128,239 Note that total capital = net working capital + net fixed assets OR book value of longterm debt + book value of equity EVA = NOPAT − $WACC = EBIT(1 − t) − $WACC = $1,868,000(1 − 0.30) − $1,128,239 = $179,361 market value of the company (year-end 2018) = market value of the equity + market value of the debt = ($36 × 130,000) + (0.95 × 6,211,000) = $10,580,450 market value added (MVA) = market value − total capital = $10,580,450 − ($6,211,000 + $2,100,000 + $2,081,000) = $188,450 (Module 23.1, LOS 23.a) Question #55 of 88 Question ID: 1509474 Which of the following amounts is closest to Schubert's implied growth rate in residual income? A) 0.34%. B) 2.75%. C) 12.63%. Explanation [B0 ×(ROE−r)] g = r − V0 −B0 B0 = [(2,100,000 + 2,081,000)] / 130,000 = $32.16 r = cost of equity = 12.8% [32.16×(0.14−0.128)] g = 0.128 − 36−32.16 = 0.0275 = 2.75% (Module 23.3, LOS 23.g) Question #56 of 88 Question ID: 1509475 Regarding Alter's caution about violations of the clean surplus relationship, examples of items that can violate this relationship are most likely to include: A) foreign currency gains and losses under the current rate method. B) changes in the market value of debt and equity held as trading securities. C) changes in net working capital. Explanation The clean surplus relationship (i.e., ending book value = beginning book value + net income – dividends) may not hold when items bypass the income statement and affect equity directly. Foreign currency gains and losses under the current rate method bypass the income statement and are reported under shareholders' equity as CTA. Changes in the market value of trading securities are included in net income and do not violate the clean surplus relationship. Changes in working capital do not bypass the income statement. [Usually, changes in working capital do not affect the income statement. When they do (e.g., inventory write-offs, bad debts, etc.), the income statement will not be bypassed.] (Module 23.5, LOS 23.k) Overview for Questions #57-60 of 88 Question ID: 1509466 TOPIC: EQUITY VALUATION THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources. Ferguson Department Stores, Inc. FDS went public in 1979 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the onestop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1. At the end of 2018, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings-per-share forecast for 2019 of $0.90. He set a 12-month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18. Exhibit 1: Summary Income Statement, Ferguson Department Stores, Inc. (U.S. $ millions, except per share data and shares outstanding) 2018 2017 $6,435.9 $6,322.7 6,007.9 5,875.9 148.7 146.6 59.8 59.5 189.1 5.0 Earnings before tax 30.4 235.7 Income taxes—current 49.3 7.5 Income taxes—future (71.1) 93.5 (21.8) 101.0 Net earnings for the year $52.2 $134.7 Earnings per share: Basic $0.49 $1.26 Fully diluted $0.49 $1.26 Sales Cost of goods sold, operating, administrative, and selling expenses Depreciation and amortization Interest expense Unusual items—expense Weighted average shares outstanding 106,530,610 106,530,610 In 2018, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs. Exhibit 2: Selected Industry Information for 2018 Estimated earnings growth rate 0.10 Mean trailing price/earnings (P/E) ratio 22.50 Mean price/sales (P/S) ratio 0.50 Question #57 of 88 Question ID: 1509467 The value of one share of FDS using the H-model is closest to: A) $14.50. B) $16.50. C) $19.33. Explanation According to the H-model: D0 H(g –g ) D0 (1+g ) L V0 = r–g S + r–g L $1×(1+0.04) L = L 0.12–0.04 $1×3×(0.08–0.04) + 0.12–0.04 (Module 20.3, LOS 20.n) Question #58 of 88 Question ID: 1509468 Assuming that the cost of equity for FDS does not change, the present value of growth opportunities in the share price following the announcement that the company would be expanding its retail operations, using Emery's 2019 earnings forecast, is closest to: A) $9.00. B) $10.50. C) $12.50. Explanation The relationship we need to evaluate is V E1 0 = r This expression can be rewritten as E1 PVGO = V0 – r $0.90 = $18 − (Module 20.2, LOS 20.g) 0.12 = $10.50. + PVGO. = $14.50 Question #59 of 88 Question ID: 1509469 Assuming a tax rate of 34%, the underlying earnings per share (EPS) for FDS in 2018 is closest to: A) $0.19. B) $0.73. C) $1.36. Explanation Earnings must be adjusted to reflect the nonrecurring extraordinary item restructuring costs and asset write downs. Adjusted 2018 earnings before tax = $30,400,000 + $189,100,000 = $219,500,000. Adjusted 2018 after-tax earnings = $219,500,000 × (1 – 0.34) = $144,870,000. 2018 underlying EPS = $144,870,000 / 106,530,610 = $1.36 (Module 22.4, LOS 22.e) Question #60 of 88 Question ID: 1509470 According to FDS's price-to-sales ratio for 2018, based on the post-expansion announcement stock price, FDS is: A) underpriced relative to the industry. B) overpriced relative to the industry. C) properly priced relative to the industry. Explanation FDS has a price-to-sales ratio in 2018 of: $18 ( $6,435,900,000 106,530,610 $18 = ) = 0.30. $60.41 Because its price-to-sales ratio is less than the industry average of 0.50, FDS is relatively underpriced. (Module 22.2, LOS 22.l) Overview for Questions #61-64 of 88 Question ID: 1509486 TOPIC: FIXED INCOME THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Sally Soikins, CFA, Chief Investment Officer at Greenvalley is reviewing the bank's policies about credit risk management with Esha Leone, a senior analyst managing the bank's fixed income portfolio. Two years ago, when benchmark rates were flat at 4%, Greenvalley bank purchased $3 million par of 7-year, 5% annual-pay coupon Newspace Inc. bonds. At the time of the purchase, Leone had calculated the CVA on the bond as $7.71 per $100 par. A 5.76-year duration, 5% standardized coupon CDS on those bonds was available at that time but was not purchased by the bank. Since the investment, the credit spread on the bonds has widened by 80bps and the duration of the CDS has changed to 4.31 years. Soikins observes that credit investment grade credit curves seem to be steepening. Leone makes the following two statements about credit curves: Statement 1: Lower rated sectors tend to have flatter credit curves due to their higher sensitivity to the business cycle and greater uncertainty. Statement 2: When a company refinances a maturing debt with a new longer-dated issue, the credit curve for that issuer may experience an inversion due to higher liquidity of the new issue. Question #61 of 88 Question ID: 1509487 If Greenvalley bank had bought protection on their investment in Newspace bonds, their upfront cash flow would have been closest to: A) a receipt of 4.6% of notional. B) a payment of 18.2% of notional. C) a receipt of 21.3% of notional. Explanation The following steps illustrate the computation of the credit spread on Newspace bonds: 1. Calculate the value of the corporate bond assuming no default (VND): N = 7, PMT = 5, I/Y = 4, FV = 100, PV = 106.00 = VND Given CVA = 7.71, Bond price = 106 – 7.71 = 98.29 2. Calculate the yield to maturity (YTM) of the bond: N = 7, PMT = 5, FV = 100, PV = −98.29, I/Y = 5.30% 3. Credit spread = 5.30% − 4% = 1.30% Upfront payment (from protection buyer) = (credit spread – coupon) × duration = (1.3% – 5%) × 5.76 = −21.31% (Module 29.2, LOS 29.c) Question #62 of 88 Question ID: 1509488 If Greenvalley bank had purchased CDS protection on their investment in Newspace bonds upon acquisition, the gain/loss on the CDS would have been closest to: A) a gain of $103,440. B) a loss of $344,800. C) a gain of $413,760. Explanation The profit for protection buyer ≈ change in spread × duration × notional principal = +0.008 × 4.31 × 3,000,000 = $103,440. (Module 29.2, LOS 29.c) Question #63 of 88 Question ID: 1509489 Leone's Statement 1 about credit curves is best described as: A) accurate. B) inaccurate regarding the shape of the credit curve for the lower rated sector. C) inaccurate regarding sensitivity to the business cycle. Explanation Statement 1 is correct about lower-rated sectors having higher sensitivity to the business cycle and greater uncertainty. However, Statement 1 is incorrect about the shape of the credit curve: lower rated sectors tend to have steeper credit curves. (Module 28.6, LOS 28.g) Question #64 of 88 Question ID: 1509490 Leone's Statement 2 on credit curves is best described as: A) accurate. B) inaccurate about higher liquidity of the new issue. C) inaccurate about inversion of the curve. Explanation Statement 2 is correct. Due to low liquidity in most corporate issues, the credit curves are most influenced by more-heavily-traded bonds. Because newly issued bonds are generally more liquid, when an issuer refinances a near-dated bond with a longer-term bond, the spread may appear to narrow for the longer maturity (possibly leading to an inverted credit spread curve). (Module 28.6, LOS 28.g) Overview for Questions #65-68 of 88 Question ID: 1509481 TOPIC: FIXED INCOME THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Nayna Shah, CFA, leads the fixed income department at Rodney Partners (RP). Shah has recently hired Susan Reynolds, a new economics graduate. During a previous meeting with Reynolds, Shah had mentioned purchasing a $12 million CDS on Welby, Inc., bonds that is currently part of the RP's portfolio. While Welby has not declared bankruptcy, it recently missed a coupon payment. Shah asks Reynolds to provide details of RP's position and planned course of action. Exhibit 1: Welby Inc. provides some of the information that Reynolds has collected. Exhibit 1: Welby Inc. RP's position: $12 million par, 6% senior unsecured maturing in five years. CDS Protection buyer, standardized coupon of 5% Current market prices of Welby bonds: 6% senior unsecured 55% of par 5% subordinated unsecured debentures 40% of par 5% senior unsecured 50% of par Shah notes that RP has also purchased $10 million notional, index CDS position in CDX-HY and that Welby is one of the 125 constituents in that index. While discussing credit risk analysis, Reynolds makes the following two statements: Statement 1: One of the assumptions of the structural models of credit analysis is that the company has no off-balance sheet debt. Statement 2: In the case of an ABS, credit analysis focuses on the credit quality of the servicer. Question #65 of 88 Question ID: 1509482 Was there a credit event for Welby, and if so what settlement method is Rodney Partners most likely to prefer? A) Yes; cash settlement. B) Yes; physical settlement. C) No. Explanation Under the ISDA terms, a credit event occurs when the issuer fails to make a scheduled coupon payment. RP would prefer a cash settlement because the cheapest-to-deliver bond is the 5% senior unsecured bonds trading at 50% of par. The bank would, therefore, receive 50% of notional (or $6 million) as cash settlement and sell their holdings at 55% of par (or $6.60 million) for a total of $12.60 million. Under physical settlement, the bank would tender its holdings of $12 million par bonds and receive a settlement of $12 million. (Module 29.1, LOS 29.b) Question #66 of 88 Question ID: 1509483 Assuming a default for Welby, the notional for RP's CDX-HY index CDS would be adjusted to an amount closest to: A) $9.92 million. B) $9.99 million. C) $10.00 million. Explanation The original notional would be reduced by 1/125th of the notional principal of $10 million or $80,000. New notional = $10,000,000 – $80,000 = $9,920,000. (Module 29.1, LOS 29.a) Question #67 of 88 Question ID: 1509484 Reynolds's Statement 1 is most likely: A) correct. B) incorrect as structural models can incorporate the risk of off-balance sheet debt as long as the assets of the company trade. C) incorrect because off-balance sheet debt is a zero-coupon liability. Explanation Statement 1 is correct. Structural models assume a simple balance sheet. When companies have off balance sheet debt, the default barrier under the structural model (i.e., "K") would be inaccurate and therefore lead to inaccurate estimates of credit risk. (Module 28.4, LOS 28.d) Question #68 of 88 Reynold's Statement 2 is most likely: Question ID: 1509485 A) correct. B) C) incorrect as credit analysis of ABS focuses on the quality of the collateral pool and the structure of the ABS and not on servicer quality. incorrect as credit analysis of ABS focuses on the quality of the collateral pool, the structure of the ABS, and servicer quality, and not on servicer credit quality. Explanation Statement 2 is incorrect. Credit analysis of ABS is based on analysis of the collateral pool, the structure of the ABS and servicer quality. (Module 28.7, LOS 28.h) Overview for Questions #69-72 of 88 Question ID: 1509491 TOPIC: DERIVATIVES THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Trent Black is a government fixed-income portfolio manager, and on January 1, he holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering into a 2-year, $30 million semi-annual pay interest rate swap as the fixed-rate payer. He must first determine the swap rate. Black notes the term structure shown in Exhibit 1: Term Structure of MRR (USD and CHF) on January 1: Exhibit 1: Term Structure of MRR (USD and CHF) on January 1 Term (Days) CHF MRR USD Discount Factor MRR Discount Factor 180 –0.65% 1.0033 3.25% 0.9840 360 –0.55% 1.0055 3.35% 0.9676 540 –0.20% 1.0030 3.60% 0.9488 720 0.10% 0.9980 3.85% 0.9285 900 0.30% 0.9926 4.00% 0.9091 1,080 0.55% 0.9838 4.10% 0.8905 1,260 0.88% 0.9701 4.25% 0.8705 Black is also evaluating a USD fixed for CHF fixed, 3-year, semiannual currency swap on a notional of USD 10 million. The current exchange rate is CHF/USD 0.97. On July 1, immediately after the first settlement, Black observes that the 18-month semiannual swap fixed rate is 4.62%. The term structure of MRR is given in Exhibit 2: USD MRR Term Structure on July 1. Exhibit 2: USD MRR Term Structure on July 1 Days Annual Rate (%) Discount Factor 60 3.31 0.9945 180 3.66 0.9820 360 4.21 0.9596 480 4.69 0.9411 540 4.74 0.9336 720 5.00 0.9091 Question #69 of 88 Question ID: 1509492 The annualized fixed rate for the $30 million swap on January 1 is closest to: A) 3.73%. B) 3.80%. C) 3.91%. Explanation The semi-annual fixed payment is calculated as: 1−0.9285 0.9840+0.9676+0.9488+0.9285 = 0.01867 When annualized, this works out to 3.73%. (Module 30.6, LOS 30.e) Question #70 of 88 Question ID: 1509493 For this question only, assume the annualized fixed rate on the $30 million swap is 3.80%. The amount of the first net payment due on this swap is closest to: A) $82,500. B) $165,000. C) $285,000. Explanation The floating rate applicable for the first settlement was determined at the inception of the swap (i.e., 3.25%). The net amount owed by the fixed rate payer of the swap would be (0.0380 – 0.0325) / 2 × $30,000,000 = $82,500. (Module 30.6, LOS 30.e) Question #71 of 88 Question ID: 1509494 For this question only, assume that the original 2-year $30 million notional swap was entered into at a fixed rate of 4.0%. Based on the information in the case and Exhibit 2: USD MRR Term Structure on July 1, the value of the swap on July 1 to Black is closest to: A) $267,390. B) $270,000. C) $346,572. Explanation After the first settlement date, there are three more settlements remaining, at 180, 360, and 540 days. The sum of the discount factors for those three dates = 0.9820 + 0.9596 + 0.9336 = 2.8752. We are told that the original swap fixed rate is 4.0%, and the new swap fixed rate is given as 4.62%. Value to the payer = ΣDF × (SFRnew – SFRold) × (days / 360) × notional principal = 2.8752 × (0.0462 – 0.04) × (180 / 360) × $30,000,000 = $267,394. (Module 30.6, LOS 30.e) Question #72 of 88 Question ID: 1509495 The CHF fixed payment to be made periodically by the USD receiver is closest to: A) CHF 26,200. B) CHF 52,381. C) CHF 54,000. Explanation CHF notional = 0.97 × 10,000,000 = CHF 9,700,000 (1−0.9838) CHF fixed rate = (1.0033+1.0055+1.0030+0.9980+0.9926+0.9838 Periodic CHF payment = (0.00541) × (180 / 360) × 9.7 million ≈ CHF 26,200 (Module 30.7, LOS 30.f) Overview for Questions #73-76 of 88 TOPIC: ALTERNATIVE INVESTMENTS Question ID: 1509506 360 × ( 180 ) = 0.541% THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS The Gould Organization, founded in 1923 as E. Gould & Son, is a group of approximately 200 business entities of which Jacob Gould is the principal owner. The Gould Organization has interests in real estate investment, development, and management. Gould has expressed an interest in acquiring the Five Falls Apartments, a 99 unit complex housed on 213 acres of land outside Stamford in Fairfield County, Connecticut. This property was constructed in 1995 at a cost of $9 million. It is one of the most desirable rental buildings in the area. Gould's team collects the following data for Five Falls: Appraised value $40 million Net operating income $3.2 million (and forecast to be level) The Gould Organization has typically focused on residential real estate but is now considering investing in other kinds of properties as well. Recently, Gould's human resources team interviewed Samantha Watkins, a recent MBA graduate and CFA Level II candidate, for an open analyst position with the firm. To test her knowledge of real estate finance, Gould's HR staff asks Watkins questions about how she would value various types of real estate property. Question #73 of 88 Question ID: 1509507 Gould expects to finance his firm's acquisition of the Five Falls apartments at its appraised value using a loan. Suppose that Primeco Bank is willing to make the Gould Organization an interest-only loan at a 5% interest rate as long as the DSCR is at least 2.0 and loan to value ratio is not more than 85%. The maximum amount of loan that Gould can obtain is closest to: A) $32 million. B) $34 million. C) $36 million. Explanation Based on a DSCR of 2.0 and Five Falls's NOI of $3.2 million, the maximum debt service would be $3,200,000/2.0 = $1,600,000. For an interest only loan at 5% interest, this corresponds to a loan amount of 1,600,000/0.05 = $32,000,000. The 85% loan to value ratio corresponds to a maximum loan of $40,000,000 × 0.85 = $34,000,000. Because this value is higher than the limit based on DSCR, the DSCR limit is the maximum loan amount that can be obtained. (Module 32.2, LOS 32.j) Question #74 of 88 Question ID: 1509508 Suppose that the Gould Organization purchases Five Falls at its appraised value, partially financed using an interest-only mortgage in the amount of $34 million at 5% interest. The equity dividend rate (i.e., the cash-on-cash return) for the first year would be closest to: A) 4%. B) 15%. C) 25%. Explanation The first-year cash flow is the NOI less the mortgage payment. NOI $3,200,000 Debt Service (= 5% of $34 million) $1,700,000 Cash flow $1,500,000 The amount of equity invested is the purchase price less the loan amount: Purchase Price $40,000,000 Mortgage $34,000,000 Equity $6,000,000 Equity yield rate = cash flow / equity = $1,500,000 / $6,000,000 = 25% (Module 32.2, LOS 32.j) Question #75 of 88 Question ID: 1509509 Suppose that rather than taking out a loan, the Gould Organization purchases the property today for its appraised value on an all-cash basis. Then, after five years, the property is sold by Gould for $48 million. The IRR for this unleveraged (all-cash) investment in the property would be closest to: A) 11% B) 16%. C) 21%. Explanation For their initial investment of $40 million, the Gould Organization will receive the NOI ($3.2 million per year), plus (later) all of the cash flow from the sale ($48 million). Using a financial calculator and working in millions of dollars: PV = −40 PMT = 3.2 n=5 FV = 48 Compute I/Y = 11.2% This is the IRR based on an unleveraged (all-cash) investment in the Five Falls property. (Module 32.2, LOS 32.j) Question #76 of 88 Question ID: 1509510 Imagine that rather than purchasing Five Falls for cash, Gould Organization takes out an interest-only $32 million loan requiring debt service of $1.6 million. Suppose that the property is sold by Gould after five years for $48 million. Ignoring taxes, the IRR of the Gould Organization's investment is closest to: A) −11%. B) 21%. C) 31%. Explanation The cash flow received by the Gould Organization from the sale will be the sale price less the mortgage balance, or $48 million – $32 million = $16 million. The upfront cash payment by the Gould Organization to purchase the property is the purchase amount of $40 million minus the mortgage amount of $32 million, or $8 million. Cash flow annually after debt service = NOI – interest = $3.2 million – $1.6 million = $1.6 million. Using a financial calculator and working in millions of dollars: PV = −8 PMT = 1.6 n=5 FV = 16 Compute I/Y = 30.9% This is an IRR based on the equity the Gould Organization invested in the Five Falls property. The difference between this IRR and the lower IRR of an all-cash investment reflects positive financial leverage. The property earns 11.2% before adding a loan, and the loan is at 5 percent interest, so the investor is benefiting from the spread between 11.2% and 5%. (Module 32.2, LOS 32.j) Overview for Questions #77-80 of 88 Question ID: 1509511 TOPIC: PORTFOLIO MANAGEMENT THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Neil Cernan set up his own investment management firm in 2005. Cernan Investment Management LLC (CIM) is headquartered in Kansas City, MO, with eight offices across the U.S. Midwest and East coast. While initial growth of the firm was relatively slow, over the last six quarters assets under management have increased at their fastest rate since inception. Cernan now feels that the time is right to expand overseas to help sustain the pace of the firm's growth. CIM's board has narrowed the expansion down to two possible countries: Pangia and Isopia. Cernan has historically tried to avoid investing in any country with low real GDP growth or low interest rates, or inflation rates that are too high or volatile. He intends to follow the same rules for CIM. Cernan's proposed screening process is shown in Exhibit 1: Screening Criteria. Exhibit 1: Screening Criteria A country will not be considered a candidate for CIM's expansion if: 1. Forecast real GDP growth for the coming year is less than 1.5% 2. The real risk-free rate is less than 1.0% 3. Forecast inflation is greater than 1.5% Cernan has gathered some information on Pangia because he is concerned that that economy may not pass the screening process. The data gathered is shown in Exhibit 2: Pangia Data and Next Period Forecast. Exhibit 2: Pangia Data and Next Period Forecast 1-year, zero-coupon government bond price (£100 par) £97.20 Forecast inflation rate 1.2% Forecast premium for inflation uncertainty 0.4% Forecast nominal GDP growth rate 2.4% In addition to assessing macroeconomic data in each candidate country, CIM has also researched potential investment managers. In Isopia, CIM staff have identified three potential investment managers with the required skill set and experience. Cernan presents this information to the board, including a definition of the information ratio, plus key performance data for two of the managers as shown in Exhibit 4: Information Ratio Definition and Isopian Candidate Data. Exhibit 4: Information Ratio Definition and Isopian Candidate Data Information Ratio Defined: The ex post information ratio is the actual correlation between active returns and expected active returns and may be positive or negative. Candidate Data Manager A Manager B Transfer coefficient 0.70 0.50 Information coefficient 0.025 0.034 Information Ratio (constrained) 0.192 0.123 All three candidates work with constrained portfolios due to local laws and regulations. However, Cernan intends to assess the managers by calculating their information ratio had the portfolios been unconstrained. Cernan's screen calls for a minimum unconstrained information ratio of 0.25. A third candidate, Manager X, had an information ratio of 2.99. Although impressive, this IR seemed too high to Cernan and hence Cernan does not consider Manager X. When the CIM board asks Cernan why he did not consider this candidate, Cernan provides the following two reasons why Manager X's information ratio may be too high: Reason 1: Manager X's information ratio suffers from cross-sectional interdependence, whereby each decision made is not independent. Manager X's information ratio suffers from time-series Reason 2: dependence, whereby decisions taken on securities may be correlated over time. Question #77 of 88 Question ID: 1509512 Using the data in Exhibit 2: Pangia Data and Next Period Forecast, and the screening process outlined in Exhibit 1: Screening Criteria, Pangia is most likely to: A) fail only the screening criterion related to the real GDP growth rate. B) fail only the screening criterion related to the real risk-free rate. C) pass both the real GDP growth and real risk-free rates criteria. Explanation Pangia Data and Next Period Forecast: Risk-free zero-coupon government bond price (£100 face) £97.20 Forecast inflation rate 1.2% Forecast premium for inflation uncertainty 0.4% Forecast nominal GDP growth rate 2.4% Nominal risk-free rate as implied by the one-year zero-coupon government bond: (100.00 / 97.20) − 1= 2.88% Real risk-free rate = nominal rate – forecast inflation – premium for inflation uncertainty = 2.88% − 1.2% − 0.4% = 1.28% (>1%; passes real risk-free rate screen) Real GDP growth rate = nominal GDP growth rate – inflation forecast = 2.4% − 1.2% = 1.2% (<1.5%; fails real GDP growth rate screen) (Module 39.1, LOS 39.d) Question #78 of 88 Question ID: 1509513 In Exhibit 4: Information Ratio Definition and Isopian Candidate Data, Cernan's definition of the information ratio is best described as: A) correct. B) incorrect because the information ratio cannot be negative. C) incorrect because it defines the information coefficient instead. Explanation The information coefficient measures the correlation between active returns and expected active returns. When the information coefficient is multiplied by the transfer coefficient and the square root of breadth, we get the information ratio. (Module 40.3, LOS 40.c) Question #79 of 88 Question ID: 1509514 Which of the candidates in Exhibit 4: Information Ratio Definition and Isopian Candidate Data is most likely to pass Cernan's IR screen? A) Only Manager A. B) Only Manager B. C) Neither Manager A nor Manager B. Explanation Manager A Manager B Transfer coefficient 0.70 0.50 Information coefficient 0.025 0.034 Information ratio (constrained) 0.192 0.123 IR (unconstrained) = IRc / TC 0.192 / 0.7 = 0.274 0.123/0.5 = 0.246 As the IR screen specifies an unconstrained IR of at least 0.25, only Manager A would be considered. (Module 40.3, LOS 40.c) Question #80 of 88 Question ID: 1509515 Which of Cernan's reasons for not relying on Manager X's information ratio are based on actual limitations of the fundamental law? A) Reason 1 only. B) Reason 2 only. C) Both reasons are limitations. Explanation Both cross-sectional dependence and time-series dependence may inflate the information ratio. (Module 40.4, LOS 40.f) Overview for Questions #81-84 of 88 Question ID: 1509516 TOPIC: PORTFOLIO MANAGEMENT THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Steve Mason, CFA, is an analyst with Alpha Developers. Mason is advising a client regarding trading algorithms. Mason revealed that he has some concerns over the trading methods carried out by market participants. His analysis revealed several instances of high frequency trading that he was uncomfortable with because they may invite regulatory scrutiny. While showing a screenshot of orders, Mason makes the following statement: Statement The pattern of trading by Trader [B] over the period 8th June to 12th 1: June suggests strongly that Trader [B] may be wash trading. While discussing backtesting, Mason states, "I am always skeptical when someone shows me a strategy that has performed well based on past data. Did they find this strategy by sifting through many different models and selecting the one based on how good it looked statistically?" Another client is concerned with longer term trends in Ruritania, a country where the client has significant investments. A recent paper on consumption trends and that country's position in the business cycle left the client with doubts about both Ruritanian interest rates and bond performance. The relevant extract from the paper is shown in Exhibit 1: Longer Term Macroeconomic Forecasts for Ruritania – Extract Exhibit 1: Longer Term Macroeconomic Forecasts for Ruritania – Extract "Two distinct trends have emerged in the Ruritanian economy over the last 10 quarters. First, the level of wealth per capita has increased, and this increase is only expected to accelerate over the next four years. Compared to today, the average family can expect to increase their wealth at an average of 0.5% per year over this period. In addition, the reduction of restrictions on capital flows and international trade under the current political regime (which is expected to remain in power for at least four years) is expected to continue, leading to an increase in both GDP and the volatility of GDP growth." Mason draws two conclusions from the extract: Conclusion The expected trend in personal wealth will decrease the utility of future 1: consumption relative to consumption today, reduce the inter-temporal rate of substitution, and reduce the real interest rate. Conclusion The increase in GDP growth is expected to increase real interest rates, 2: but this effect be offset by the impact of the increase in the volatility of that growth. Question #81 of 88 Question ID: 1509517 The activity described in Statement 1 is most likely to involve: A) placing a legitimate trade on one side of the market and several illegitimate orders at different prices on the other side. B) executing simultaneous buy and sell orders on the same financial instrument. C) entering large quantities of fictitious orders into the market and instantaneously canceling them. Explanation Wash trading is a kind of market manipulation where the investor buys and sells the same financial instrument simultaneously, in order to simulate demand in the instrument by boosting trading volume. Placing a legitimate trade on one side of the market and several bogus orders on the other side of the market is known as layering. Entering large quantities of fictitious orders into the market and instantaneously canceling them is known as quote stuffing. (Module 41.4, LOS 41.j) Question #82 of 88 Question ID: 1509518 Based on Mason's statement about backtesting, he is most likely to be concerned about: A) data snooping. B) statistical anomalies. C) survivorship bias. Explanation Data snooping is the practice of backtesting numerous strategies and then selecting the best performing one, rather than constructing a portfolio based on sound theory. A strategy chosen by data snooping is unlikely to deliver the same promising results in later periods when the strategy is actually deployed. (Module 38.3, LOS 38.d) Question #83 of 88 Question ID: 1509519 Mason's Conclusion 1, in response to the extract in Exhibit 3 is least accurate regarding the effect on: A) the utility of future consumption relative to consumption today. B) the inter-temporal rate of substitution. C) the real interest rate. Explanation An increase in wealth will reduce the marginal utility of future consumption relative to consumption today. As a result, the inter-temporal rate of substitution (ut/u0) will also decrease. The price of a risk-free inflation-indexed bond is the expected intertemporal rate of substitution, hence it will fall and real interest rates will rise. (Module 39.1, LOS 39.c) Question #84 of 88 Question ID: 1509520 Mason's Conclusion 2, in response to the extract in Exhibit 3 is most likely: A) incorrect, as both growth and volatility would increase real interest rates. B) incorrect, as both growth and volatility would decrease real interest rates. C) correct. Explanation High GDP growth reduces the utility of future consumption and, hence, the intertemporal rate of substitution, so real interest rates should be higher. Increased volatility of growth, leading to uncertainty, will require a higher premium and, hence, also increase rates. (Module 39.1, LOS 39.c) Overview for Questions #85-88 of 88 Question ID: 1509521 TOPIC: ETHICAL AND PROFESSIONAL STANDARDS THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS Andrea Vrbenic, CFA, was recently promoted to supervisory analyst at Banke Gjigante, a large brokerage firm that has investment banking and asset management departments. Vrbenic will report to Tom Sheffield, a senior manager and director at the firm. Currently, Vrbenic manages the investment account of Bill Stallwell, a single retiree who lives off his portfolio and is relatively risk averse. Stallwell's account has been with the firm for over fifteen years. Last year, Vrbenic added a stock with a beta of 1.5 to Stallwell's portfolio. Since then, Vrbenic has also sold call options on these shares as part of a covered call strategy for Stallwell's portfolio. Sheffield passes on to Vrbenic a request from Amica Biotech, one of the firm's clients, to write a research report on Amica. The research will be paid for by Amica, with a flat fee plus a fixed bonus if Amica's IPO is fully subscribed. Mike Callingly, CFA, a senior portfolio manager at Banke Gjigante, routinely distributes performance reports on composite of portfolios managed by him. He claims that the performance reports are GIPS compliant, except that the returns are equally-weighted and not asset-weighted. As part of communication with her clients, Vrbenic sends out a quarterly performance report comparing the performance of clients' portfolios to the performance of a broad-based market index. While doing some analysis, Vrbenic notes that her performance would look more attractive if she used a target-date index fund for comparison purposes. She also notes that the risk profile of her client portfolios is more closely tracked by target-date funds than by the broad-based market index. Starting with the first quarter of the current year, Vrbenic updates her client communications, replacing the broad-based market index with target-date funds for comparison purposes. Question #85 of 88 Question ID: 1509522 With respect to Bill Stallwell's portfolio, Vrbenic has most likely: A) B) C) violated the Standards, both by buying the high-beta stock and by selling the calls. violated the Standards by selling the options but not by purchasing the highbeta stock. not violated the Standards because overall portfolio risk needs to be evaluated for the purpose of judging suitability. Explanation Standard III(C) – Suitability requires members to judge the suitability of investments in the context of the client's total portfolio. (Module 43.5, LOS 43.a) Question #86 of 88 Question ID: 1509523 With regards to the research report on Amica, Vrbenic will most likely: A) B) C) not be in violation of the Standards as long as the fact that the research is issuer-funded is disclosed. not be in violation of the Standards as long as both the source of the funding and the nature of the compensation is disclosed. be in violation of the Standards even if both the funding source and the nature of the compensation are disclosed. Explanation Issuer-paid research is fraught with potential conflicts. Analysts' compensation for preparing such research should be limited, and the preference is for a flat fee without regard to conclusions or the report's recommendations. As such, the arrangement with Amica Biotech is a violation under Standard I(B) – Independence and Objectivity. (Module 43.1, LOS 43.a) Question #87 of 88 Question ID: 1509524 With regards to performance presentation, Callingly's performance report is most likely: A) a violation of Standard III(D) – Performance Presentation. B) not a violation. C) a violation of Standard I(D) – Professional Misconduct. Explanation Callingly is in violation of Standard (III)D – Performance Presentation by claiming GIPS® compliance even though one of the requirements of GIPS® is not complied with. There is no partial GIPS® compliance. (Module 43.6, LOS 43.a) Question #88 of 88 Question ID: 1509525 With respect to Vrbenic's changes to quarterly performance reports for clients, Vrbenic is most likely: A) not in violation of the Standards because the change has a reasonable basis. B) C) in violation of Standard III(D) because changes to an established performance benchmark are prohibited. not in violation of the Standards if she discloses the change in performance presentation to her clients. Explanation Under Standard III(D) – Performance Presentation, members are required to promptly disclose any changes in benchmarks used in performance presentation. To avoid a violation of the Standard, the member must disclose this change to existing and new clients. Vrbenic should explain the reasons for changing the benchmark and present the performance reports using both the old and new methodologies so that clients may compare them. (Module 43.6, LOS 43.a)