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CFA Society Boston

CFA Level II – 2018 Practice Exam Morning MULTIPLE CHOICE RESPONSE FORM

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CFA Society Boston Level II

2018 Practice Exam

Morning Session

9:00AM – 12:00PM

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The CFA Society Boston Level II 2018 Practice Exam may be updated with an addendum to be provided at a later date only at www.cfaboston.org. Any addendum will be provided to CFA Society Boston Practice Exam purchasers free of charge. It is your sole responsibility to log onto the CFA Society Boston website to determine if any addendum has been posted, and CFA Society Boston will not send out any notification that an addendum has been posted. Any addendum is governed by the Terms and Conditions described herein.

The morning session of the CFA Society Boston Level II 2018 Practice Exam has 10 item sets. The item set format consists of a vignette or a short case followed by six multiple choice

questions based on the vignette. Each item set is allocated 18 minutes for a total of 180 minutes.

Item Set Topic Questions Minutes

1 Ethical and Professional Standards 1-6 18 2 Quantitative Methods 7-12 18 3 Economics 13-18 18 4 Financial Reporting and Analysis 19-24 18 5 Corporate Finance 25-30 18 6 Equity Valuation 31-36 18 7 Equity Valuation 37-42 18 8 Fixed Income 43-48 18 9 Derivative Instruments 49-54 18 10 Portfolio Management 55-60 18 Total 60 180

ITEM SET 1: ETHICAL AND PROFESSIONAL STANDARDS Questions 1 through 6 are allocated 18 minutes.

Balmoral Asset Management, LLC (Balmoral) is a regional multi-purpose investment company. Neal Huff, CFA, is one of Balmoral’s equity analysts. Huff estimates that Steel Furniture

Industries (SFI) will increase its dividend by USD2.00 a share next year due to pending federal tax legislation. The proposed federal tax legislation will give SFI a lower corporate tax rate if passed. A governmental lobbyist used by Balmoral recently briefed all the equity analysts, saying that the prospects for passage of the tax legislation were favorable. Huff concludes his latest SFI research report with the following statement:

Statement 1: We conclude that Steel Furniture Industries’ stock price will rise by USD10.00 by

the end of the year because the dividend will increase by USD2.00 which will give investors a total return on the stock of over 20%.

A discretionary account managed by Huff is the Bear Aid Corporation (Bear Aid). Naomi

Faulds, Bear Aid’s CEO, asks Huff to vote the shares of the Bear Aid’s employee profit-sharing plan in favor of the slate of directors nominated by Bear Aid’s management and not the directors nominated by disgruntled group of Bear Aid’s shareholders. Bear Aid directs all of its trades through a broker that provides Huff with useful research about tax-exempt strategies that is not of value to Bear Aid. The brokerage firm provides the best execution and the lowest cost for trades. Huff investigates the board of directors issue and concludes that the management-nominated directors are better for Bear Aid and votes accordingly.

Ahmed Chaudry, CFA, is Huff’s supervisor and oversees his company-required quarterly reports of personal securities holdings and trading. Chaudry notices that Huff uses the same broker that Balmoral uses for other investors and portfolio accounts. Chaudry also notices that Huff trades in some of the same securities that Balmoral does for its clients. Huff provides Chaudry with his personal securities holdings only when he has no trading activity.

Karen Caouette, CFA, works for Balmoral and is approached by a broker that provides Caouette with proprietary research through Balmoral’s existing full-service brokerage arrangements. The broker offers Caouette a new, low-fee, execution-only trading deal that will complement the traditional full-service execution and research service. To encourage Caouette to send additional business its way, the broker will apply the commissions paid on the new service toward

satisfying the brokerage commitment on the full-service arrangements. Caouette has always been satisfied with the execution provided on the full-service trades, and she notices the new low-fee trade proposal is similar to that of other brokers that Balmoral uses for accounts that prohibit soft dollar arrangements.

Lisa Larsen, CFA, a member of Balmoral’s senior investment management team, has been asked to be a keynote speaker at an upcoming investment conference in Boston, Massachusetts. The event is hosted by one of the brokerage firms currently used by Balmoral. The firm offers to cover all the travel and conference costs for Larsen and will make attendance free for two additional members of Balmoral’s senior investment management team. The host firm has

arranged for an exclusive cruise the day after the event to entice Larsen and other speakers to attend the conference.

Huff was recently elected to the board of directors of an inner-city charity that targets

disadvantaged youth by providing a summer camp experience for at-risk teenagers. This charity is the local chapter of a national not-for-profit organization. Huff believes many of his clients are interested in making donations to charity. In his next investment letter to clients, he mentions the current fund-raising campaign being conducted by the charity and his position on its board of directors. 1. With respect to Huff’s SFI research report and Statement 1:

A. Huff violated the Standards because he used material inside information. B. Huff violated the Standards because he failed to separate opinion from fact. C. Huff violated the Standards by basing his research on uncertain predictions of

future government actions. 2. Did Huff violate the Standards with respect to the Bear Aid board of directors’ vote and

the directed brokerage? Board of Directors vote Directed brokerage

A. Yes No B. No Yes C. No No 3. With respect to Huff’s personal securities trading and Chaudry’s oversight, which of the

following is most likely to be a violation of the Code and Standards?

A. Huff failed to disclose to Chaudry his personal transactions. B. Chaudry allows Huff to own the same securities as those of Balmoral’s clients. C. Chaudry allows Huff to use the same broker as Balmoral for his trading. 4. What action by Caouette is most likely correct?

A. Caouette can trade for her accounts that prohibit soft dollar arrangements under

the new low-fee trading system.

B. Caouette cannot use the new trading system because the commissions are

prohibited by the soft dollar restrictions of the accounts.

C. Caouette should trade only through the new low-fee system and should increase

her trading volume to meet her required commission commitment.

Which action by Larsen is least likely to violate the Standards? A.

Larsen may accept the offer to have her conference-related expenses paid by the host firm.

B. Larsen may accept the offer to have her conference-related expenses paid and may attend the cruise at the expense of the host firm.

Larsen may accept the entire package of incentives offered to speak at the conference.

6. With respect to Huff’s investment letter mentioning the non-profit’s fund-raising campaign:

A. Huff violated the Standards by soliciting donations from his clients through his

investment letter.

B. Huff violated the Standards by not obtaining approval from Balmoral before soliciting his clients.

Huff did not violate the Standards.

ITEM SET 2: QUANTITATIVE METHODS Questions 7 through 12 are allocated 18 minutes.

Zihao Lin, CFA, has been assigned to predict the monthly operating costs, expressed in USD, for a battery factory, given the level of production of three types of batteries. The batteries are

manufactured at a small factory that is being tested to see if economies of scale would justify an investment in a “giga-factory” to bring costs down. Lin has been asked to estimate the operating costs of production of Products A, B and C, using a multiple regression analysis of nineteen months of data from the test factory.

Lin made the following statements, after examining the regression output:

Statement 1: Multicollinearity occurs when no correlation exists between independent

variables.

Statement 2: Regarding the slope coefficients, a classic symptom of multicollinearity is a high

R2 with significant F-statistic and t-statistics.

Statement 3: Interpreting regression output becomes problematic when multicollinearity is

present.

Exhibit 2-1

Monthly Factory Operating Costs

and Production Volumes of Product A, Product B and Product C Units Produced

Month Operating Cost Product A Product B Product C 1 $44,439 515 541 928 2 $43,936 929 692 711 3 $44,464 800 710 824 4 $41,533 979 675 758 5 $46,343 1165 1147 635 6 $44,922 651 939 901 7 $43,203 847 755 580 8 $43,000 942 908 589 9 $40,967 630 738 682 10 $48,582 1113 1175 1050 11 $45,003 1086 1075 984 12 $44,303 843 640 828 13 $42,070 500 752 708 14 $44,353 813 989 804 15 $45,968 1190 823 904 16 $47,781 1200 1108 1120

17 $43,202 731 590 1065 18 $44,074 1089 607 1132 19

$44,610 786 513 839

Exhibit 2-2

Descriptive Statistics of Product A, Product B and Product C Product A Product B Product C Mean 884.68 809.32 844.32 Standard error 50.52 48.28 39.53 Median 847.00 752.00 828.00 Mode #N/A #N/A #N/A Standard

deviation

220.19 210.43 172.31

Sample variance 48,483.89 44,281.67 29,689.34 Kurtosis -0.9504 -1.0558 -0.9581 Skewness -0.1796 0.4465 0.1667 Range 700.00 662.00 552.00 Minimum 500.00 513.00 580.00 Maximum 1,200.00 1,175.00 1,132.00 Sum 16,809.00 15,377.00 16,042.00 Count 19 19 19

Exhibit 2-3 Regression Statistics

Regression Statistics Multiple R 0.8034 R-squared

0.6454 Adjusted R-squared 0.5745 Standard error 1,252.7639 Observations

Exhibit 2-4 Regression Output

Coefficients Standard Error t -Statistics

Intercept 35,102.9004 1,837.2269 19.1065 Product A 2.0660 1.6650 1.2408 Product B 4.1764 1.6813 2.4841 Product C

4.7906 1.7893

2.6774

Exhibit 2-5

Regression Output Analysis of Variance

df SS MS

Regression 3 42,856,230 14,285,410 Residual 15 23,541,261 1,569,417 Total 18 66,397,491

Exhibit 2-6 Correlation Table

Product A Product B Product C Product A 1.0000 Product B 0.5433 1.0000 Product C 0.2681 0.0582 1.0000

Exhibit 2-7

Table of the Student's t-Distribution

One-Tailed Probabilities

df p = 0.10 p = 0.05 p = 0.025 p = 0.01 p = 0.005 3 1.638 2.353 3.182 4.541 5.841 4 1.533 2.132 2.776 3.747 4.604 14 1.345 1.761 2.145 2.624 2.977 15 1.341 1.753 2.131 2.602 2.947 19

1.328 1.729 2.093 2.539

2.861

7. The calculated F-statistic of this regression is closest to:

A. 9.1024 B. 11.6024 C.

14.1024

The 95% confidence interval for the slope coefficient for Product C is closest to: A. B. C.

0.667, 8.917 0.978, 8.604 1.463, 8.119

When testing the null hypothesis, H0, that the Product A and Product B coefficients are 0 against the alternative hypothesis, Ha, that the Product A and Product B coefficients are different from 0, at a 0.05 significance level, Lin would most likely conclude that: A. B. C.

she cannot reject the null hypothesis for Product A, but she can reject the null hypothesis for Product B in favor of the alternative hypothesis for Product B.

she can reject the null hypothesis for both Product A and Product B in favor of the alternative hypothesis for Product A and Product B.

she cannot reject the null hypothesis for both Product A and Product B.

10.

Which statement by Lin regarding the regression exhibiting symptoms of multicollinearity is true? A. B. C.

Statement 1. Statement 2. Statement 3.

11.

The least likely type of heteroskedasticity for which Lin would test is: A. B. C.

conditional heteroskedasticity. unconditional heteroskedasticity. generalized heteroskedasticity.

12.

The predicted operating cost, given the mean values for Product A, Product B and Product C, is closest to: A. B. C.

$44,355 $44,514 $44,539

ITEM SET 3: ECONOMICS

Questions 13 through 18 are allocated 18 minutes.

Neil Brome is a new employee on the foreign exchange (FX) desk, supporting Sandra Williams, a senior trader. Williams begins the day with an overview of FX market structure and makes the following statements:

Statement 1: The National Futures Association (NFA) is a self-funded, non-profit organization that oversees and represents its members within U.S. FX markets. Membership in the NFA is mandatory for all market participants and the organization has been granted recognition and authority by the CFTC, a government agency.

Statement 2: Some academics have voiced concern that regulation, while designed to promote

fairness and stability across markets, may instead serve the interests of the regulated entities, given the entities’ close working relationships with regulators.

As markets open, Williams provides Brome with a binder containing the U.S. dollar (USD), euro (EUR) and Canadian dollar (CAD) market data found in Exhibit 1. Just before accepting a client’s call, Williams explains the need for market consistency on a cross-currency basis and leaves Brome to review the information. On the call, a client asks Williams for help establishing the mark-to-market value of a forward contract with a settlement date in six months. The client initiated the contract three months ago by selling USD 15,000,000 forward against the euro at a rate of 0.8025 EUR/USD. Williams consults data in Exhibit 1 before responding.

Exhibit 1

Dealer Quote EUR/USD 6M Libor (annualized)

Pair Bid/Offer Forward Points Currency Rate CAD/USD 1.2637/1.2639 1 Month -15 / -14 EUR 0.10% EUR/USD 0.8103/0.8104 3 Months -52/ -51 USD 2.78%

Interbank Quote 6 Months -109 / -107 CAD 1.62% CAD/EUR 1.5588/1.5592 9 Months -169 / -167 12 Months -233 / -230

Later, Williams and several colleagues discuss fundamental drivers of exchange rates with Brome. During the conversation, Brome carefully makes note of several statements for later review:

Statement 3: The International Fisher Effect provides a useful framework for analyzing

exchange rate movements, but relies on several key parity conditions, only one of which is enforceable by arbitrage.

Statement 4: By focusing solely on aggregate demand and assuming sufficient slack in the economy, the Mundell-Fleming model suggests that, under conditions of high capital mobility, a country with expansionary monetary and fiscal policies would experience currency appreciation.

Following the meeting, Williams offers to meet with Brome the following day to review any questions. 13. Based on the information in Statement 1, the NFA is most likely categorized as:

A. an independent regulator only. B. a self-regulating organization (SRO) only. C. both an independent regulator and a SRO. 14. Statement 2 most likely refers to which form of regulatory interdependency? A. Regulatory arbitrage. B. Regulatory capture. C. Regulatory competition. 15. Using Exhibit 1, a participant with access to the interbank market seeking to establish a

triangular arbitrage using the CAD/EUR cross rate would most likely: A. be unable to generate an arbitrage profit. B. buy EUR in the interbank market and sell it to the dealer to profit 0.0002 CAD/EUR.

C. buy EUR from the dealer and sell it on the interbank market to net 0.0002

CAD/EUR. 16. The mark-to-market value of the client’s forward contract using Exhibit 1 is closest to: A. - EUR 65,412 B. + EUR 41,979 C. + EUR 46,477 17. The arbitrage-enforceable parity condition referenced in Statement 3 is most likely: A. absolute purchasing power parity. B. forward rate parity.

C. covered interest rate parity.

18. Statement 4, regarding the effects of expansionary monetary and fiscal policy under conditions of high capital mobility, is most likely:

A. correct; the domestic currency would appreciate. B. incorrect; the domestic currency would depreciate.

C. incorrect; the effect on the domestic currency is indeterminate.

ITEM SET 4: FINANCIAL REPORTING AND ANALYSIS Questions 19 through 24 are allocated 18 minutes.

Taylor plc is a UK-headquartered retail company that prepares its financial statements according to the IFRS standards. In 2014, Taylor held a 15% passive equity interest in CF plc, another retailer with operations in Wales. CF plc is classified as available for sale. During 2016, the value of its investment in CF fell by ₤2 million. In December 2016, Taylor plc announced that it would be increasing its stake in CF to 60%, allowing it to exercise significant influence over CF, effective 1 January 2017.

In addition to its investment in CF plc, Taylor has invested in the following bonds issued by three other UK companies at par. CN Rail BP Shipping TD Chemicals Classification Available for sale Held to maturity Held for trading Cost (000) ₤30,000 ₤45,000 ₤56,000 Market value, 31 Dec. 2016 ₤33,000 ₤42,000 ₤55,000 Market value, 31 Dec. 2017 ₤32,000 ₤51,000 ₤60,000

Below are the abbreviated financial statements for Taylor plc and CF plc.

Extracts from the financial statements for Taylor plc (₤ millions)

Year ending 31 December 2016 2017 Revenue 2,800 3,010 Operating income 250 290 Net income 125 140 Dividends 35 40

As of 31 December 2016 2017 Total assets 2,400 2,700 Shareholders’ equity 1,150 1,250 Extracts from the financial statements for CF plc (₤ millions)

Year ending 31 December 2016 2017 Revenue 1,900 2,100 Operating income 160 180 Net income 80 90 Dividends 30 45

As of 31 December 2016 2017 Total assets 1,600 1,700 Shareholders’ equity 900 945

19.

In 2016, the contribution from CF to Taylor’s earnings before tax is closest to: A. B. C.

₤0.3 million ₤2.0 million ₤4.5 million

20.

If Taylor classified its investment in CF as held for trading (instead of available for sale), the contribution from CF to Taylor’s earnings before tax in 2016 is closest to: A. B. C.

₤2.5 million ₤4.5 million ₤6.5 million

21.

The impact of the increase in equity interest in CF at the beginning of 2017 on Taylor’s 2017 net income will be an increase closest to: A. B. C.

₤0

₤41 million ₤54 million

22.

Following the increase in equity interest in CF and the consolidation of accounts, the operating margin of the combined entity in 2017 will most likely be: A. B. C.

lower. the same. higher.

23.

The balance sheet carrying value of Taylor’s investments in its bond portfolio at the end of 2017 is closest to: A. B. C.

₤129 million ₤133 million ₤137 million

24.

If the CFO of Taylor wants to report higher earnings before tax in 2017, the CFO would most likely: A. B. C.

reclassify CN investment as held for trading. reclassify BP investment as held for trading. reclassify TD investment as held to maturity.

ITEM SET 5: CORPORATE FINANCE

Questions 25 through 30 are allocated 18 minutes

Eco Touch Systems (ETS) develops, manufactures and markets a complete line of touch screen and touch monitor products for gaming and casino applications. Due to the worldwide decline in demand for gaming, ETS is scaling down its operations in gaming and expanding its

manufacturing of touch screen products for medical and healthcare applications. In order to

transition smoothly into this market segment, ETS is considering replacing a piece of its existing production equipment with a new and more technologically advanced unit. The company has commissioned a team of consultants to do a feasibility study for this replacement project, spending $300,000 for the study.

The existing machine was purchased five years ago at a cost of $12 million and has been

depreciated using the straight-line method over a ten-year period with zero salvage value. This machine could be sold today for $8 million.

The results of the feasibility study indicate that the firm must spend $20 million for the new equipment and an additional $2 million for modifying the new equipment to make it operational for touch screen products in medical applications. The new equipment has an expected useful life of 10 years. The consultants also estimate that the benefit to ETS from the new equipment will be substantially reduced after 5 years due to its rivals stepping up their own production in this market. Therefore, they suggest using a 5-year horizon for this capital budgeting project. The new equipment will be depreciated using the straight-line method over ten years with zero salvage value, and has an estimated sale price of $10 million at the end of five years. The

consultant's report predicts that the new machine will increase computer sales by $4 million per year, while operating costs will increase by $1.2 million per year. Because the new equipment is more efficient, ETS will need less work-in-progress in inventory, resulting initially in a saving of $400,000. The inventory account, however, will return to previous levels at the end of the

project. The marginal tax rate of ETS is 30%, and the project’s cost of capital is 14%. Assuming that the company purchases the new equipment at the end of 2018, the first year of operating the new equipment will be 2019, and the last year is 2023.

ETS is also considering acquiring a small rival company, Advanced Touch. An analyst has been assigned the task of estimating the fair market value of Advanced Touch using the discounted cash flow approach.

Advanced Touch has 2 million shares outstanding. The analyst has estimated current pre-merger free cash flow for Advanced Touch to be $1 million. Post-merger free cash flows for Advanced Touch are expected to increase by 25% for the next three years, after which the analyst expects cash flows will grow at a rate of 5% indefinitely. The analyst has determined that Advanced Touch WACC is 12%. The analyst presented the fair market value of Advanced Touch to the board of ETS. A board member makes the following two statements:

Statement 1: I believe that, using the comparable company analysis, we may come up with a

more accurate value for Advanced Touch than the discounted cash flow method,

as the takeover value is determined from values that are recently established in the market. The discounted cash flow method relies on too many assumptions and estimates.

Statement 2: We may also want to consider using the comparable transaction approach. The

advantage of this approach over the comparable company approach is that the value is based on the acquisition price and thus implicitly accounts for any

takeover premium. With the comparable company approach, we need to estimate the takeover premium.

25. ETS’s initial net investment outlay for this replacement project is closest to:

A. $14,200,000 B. $15,000,000 C. $16,000,000 26. ETS’ annual net incremental cash flows for years 1-4 and the total net cash flows for year 5 (including the disposition cash flows) are closest to:

Net CF Years 1-4 Net CF Year 5 A. $2,260,000 $13,310,000 B. $2,260,000 $12,510,000 C. $2,620,000 $12,880,000 27. The IRR and NPV of the company's replacement project, as well as the company’s budgeting decision, are most likely to be:

IRR NPV Decision A. 11.49% -$237,080 Reject B. 12.45% -$702,213 Reject C. 14.28% $123,395 Accept

28. Using the constant growth model, the terminal value for Advanced Touch in 3 years is

closest to:

A. $23.43 million B. $27.90 million C. $29.30 million

29.

The analyst’s current estimated value per share of Advanced Touch, using the discountedcash flow approach, is closest to:A.$10.79B.$11.80C.

$12.30

30.Regarding the board member's two statements about the three valuation methods:A.Both statements are correct.

B.Statement 1 is correct, but statement 2 is incorrect.C.

Statement 1 is incorrect, but statement 2 is correct.

ITEM SET 6: EQUITY VALUATION

Questions 31 through 36 are allocated 18 minutes.

HESC Investments’ equity analyst Fred Furtado initiated coverage on three micro-cap

technology firms last week. In preparing for an upcoming research meeting, Furtado summarized his research in the following notes:

•

COGS, Inc. profitability has varied from year to year, but the firm has material cashreserves. The management team has been stable and has demonstrated an ability toreact positively to the fast-changing industry environment. Management rightlyanticipated the recent demand shift and updated its software products appropriately.Indications are that this helped to ensure near-term profitability, but longer-termprofitability is not as stable.

Tech Ventures’ profitability is up for the fourth consecutive year, although only at a4% CAGR, which is below its peers. Return on assets is also below industry averageand its cash flow, while positive, is weak. Management was recently successful incompleting a significant line of credit agreement at market rates.

Octocog has been struggling since it was spun off by Oracle three years ago.Profitability has been negative, mainly because of some accelerated accountingcharges (which are now fully expensed). Cash flow is positive and growing, and hasbeen for past three years. Octocog has committed significant resources to artificialintelligence and has some promising product developments. However, it may bemissing out on the virtual reality segment.

•

At the research meeting, Furtado explained that COGS, Inc. was the only one of the three firms that had multiple divisions producing different products. Furtado explained that he intended to use HESC’s standard intrinsic value methodology for valuation work on COGS. In addition, Furtado was adamant that, in order to best value the company, he needed to assess the firm’s quality of earnings.

Furtado explained the balance sheet position of COGS, Inc.

Statement 1: COGS is in a strong position with $350 million of cash on its balance sheet, and

material, but manageable, leverage. The firm currently has 2,800,000 shares of common stock trading at $8.55 per share vs. our price target of $9.75. Also, last week, they sold 52,000 7-year bonds at $990. The firm tax rate is 35%. Furtado listed several criteria for selecting a valuation model for Octocog.

Statement 2: This firm’s future earnings are extremely difficult to predict and probably

unreliable. The valuation model to use should assign only a small portion of Octocog’s total present value to future earnings. Exhibit 6-1 shows a summary schedule of company data.

Exhibit 6-1

Summary of Company Data

COGS,

Tech

Octocog Inc.

Ventures

Inflation rate 1.25% 1.25% 1.25% 1-month T-bill rate 0.20% 0.20% 0.20% Risk-free rate 1.25% 1.25% 1.25% Adjusted beta 0.82 0.95 0.96 Equity risk

premium 6.25% 6.25%

6.25% Size beta -0.150 -0.200 -0.135 Size premium 1.15% 2.35% 1.80% Long-term debt, yield to maturity 10.55% 7.65% 8.25% (YTM) Value beta -0.250 -0.050 -0.125 Value premium 1.35% 0.55% 1.05% Liquidity beta 0.375 0.375

0.250

31. Based on Furtado’s summary of the three firms, the most likely going concerns are:

A. COGS, Inc. and Octocog only. B. Tech Ventures and Octocog only. C.

all three firms.

32. Intrinsic value is best defined as:

A. the value of a company to a specific buyer, taking into account all potential synergies and based on the investor’s requirements and expectations.

B. the value of a company if it were dissolved and its assets sold individually. C. the value of a company, given a hypothetically complete understanding of its

investment characteristics.

33. Based on Statements 1 and 2 at the research meeting concerning Octocog, the valuation model Furtado most likely will select is:

A. the residual income model. B. the dividend discount model.

the sum-of-the-parts valuation model.

34.

A higher quality of earnings would most likely result from: A. B. C.

recognizing revenue early, or classifying non-operating income or gains as part of operations.

recognizing ample reserves in the current year, such as valuation allowances against deferred tax assets.

accelerating expenses through the income statement, or using conservative estimates and assumptions, such as shorter depreciable lives.

35.

Using the Fama-French Multifactor Model and data shown in Exhibit 1 and a risk-free rate of 2.15%, the firm with the lowest required rate of return is: A. B. C.

COGS, Inc. Tech Ventures. Octocog.

36.

Based on Furtado’s summary of COGS, Inc.’s balance sheet information, COG’s weighted-average cost of capital is closest to: A. B. C.

4.5% 6.5% 6.7%

ITEM SET 7: EQUITY VALUATION

Questions 37 through 42 are allocated 18 minutes.

Matt Matthews, MacMillian Foundation CIO, was reviewing the Q4 2017 earnings report for Delos Corp. (NYSE: DEL). Matthews is considering adding the stock to the foundation’s portfolio. Delos’ financial statements are shown in Exhibits 1 through 4.1

Delos reported trailing 12-month EPS of $20.57, which included $0.45 per share of restructuring costs and $0.78 per share of amortization of intangibles arising from a recent acquisition.

Additionally, the firm experienced a one-time charge equal to $0.90 per share related to vacating certain real estate locations. Matthews expects the amortization charges to continue at these levels for the foreseeable future. Matthews is considering using the firm’s free cash flows in his valuation models.

Later, Matthews further analyzed Delos. In addition to noting that Delos’ closing stock price for Q4 2017 was $27.75 (with 205,000,000 shares outstanding), Matthews calculated several other key data points, including Delos’ cost of debt—7.0% before taxes and 4.9% after tax—and its cost of equity—11.2%.

Note: Numbers in Exhibits 1–4 may not add due to rounding.

37.

From 2016 to 2017, Delos Corporation’s free cash flow to the firm is most likely growing: A. B. C.

faster than its free cash flow to equity. slower than its free cash flow to equity.

at the same rate as its free cash flow to equity.

38.

Trailing 12-month EPS, based on underlying earnings, for Delos Corp. is closest to: A. B. C.

$18.45 $19.20 $20.10

39.

The advantage of using free cash flow in a valuation model versus other cash flow definitions or earnings-related measures is most likely that: A. B. C.

free cash flows are readily available data.

forecasting free cash flows is a relatively easy and straightforward exercise. free cash flows can be used directly in a DCF framework to value the firm, or to value equity.

40.

Based on results for 2017, EV/EBITDA is closest to: A. B. C.

11.90 13.55 15.20

41.

An advantage of using EV/EBITDA multiples is: A. B. C.

EBITDA ignores the effects of differences in revenue recognition policy on cash flow from operations.

EBITDA estimates cash flow from operations, even if working capital is contracting.

EBITDA is frequently positive when EPS is negative.

42.

Delos Corporation’s residual income for 2017 is closest to: A. B. C.

$160.5 million $176.6 million $228.0 million

ITEM SET 8: FIXED INCOME

Questions 43 through 48 are allocated 18 minutes.

Victoria Wynn, CFA, at Adelaide Co. is researching the underlying economic factors that she believes are affecting the shape of the yield curve. She believes that maturity preference is the driving force. She discusses this finding with a colleague, Harrison Lee, CFA, who provides three additional observations:

Statement 1: Supply and demand for maturities independently determine the yield for that maturity.

Statement 2: Investors are risk neutral.

Statement 3: Institutions are taking on additional risk to gain additional return.

Lee is also assisting the trading desk to identify arbitrage opportunities. He gathers the following information on a convertible, callable, putable bond: Value of convertible/callable/putable bond: $106

Value of issuer call option: $2.75 Value of call option on stock: $4.50 Value of investor put option: $0.50

Wendy Bay works for Adelaide’s high-yield fund. She has been tasked with evaluating a new company and determining if the company should hedge its default risk exposure. Based on similar competitors in the same market, Bay assumes a constant hazard rate of 3% for the first quarter.

Alan Ramirez, CFA, is a new credit analyst. He is responsible for monitoring the firm’s own internal credit risk models. He is verifying that Adelaide Company’s assumptions are consistent with the credit risk models being employed. His research leads to observations about the risk-free rate, option pricing models, and company debt as related to structural models versus reduced form models.

Jennifer Spicer, a research associate at Adelaide, is creating a binomial tree to evaluate several new callable issues that the firm has purchased. She has gathered implied volatility data and interest rate data from benchmark par yields. Her colleague, Harrison Lee, observes that the volatility data are derived from CDS market prices, and that the par yield curve is upward sloping, so the spot rates are higher than the par rates.

Craig Pfizter, CFA, is evaluating changes in spreads in order to understand recent market shifts. At the weekly market meeting, he comments:

Statement 4: Supply and demand conditions have changed substantially, as evidenced by the dramatic shift in the TED spread.

Statement 5: The 10-year swap spread has narrowed, indicating a large change in the risk and liquidity of money market securities.

Statement 6: Perceived credit risk in the economy is unchanged, since the LIBOR-OIS spread has stayed flat. 43. Which of Lee’s statements most likely supports Wynn’s research?

A. Statement 1. B. Statement 2. C. Statement 3.

44. In order that there to be no arbitrage opportunity, the value of a straight bond, similar to the convertible, callable, putable bond, is closest to:

A. $98.25 B. $103.75 C. $104.75

45. Based on Wendy’s assumption, the conditional probability of survival for the second quarter, and the probability of default during the first two quarters are closest to:

Conditional Probability Probability of Default A. 94.1% 3.0% B. 97.0% 3.0% C. 97.0% 5.9% 46. Ramirez’s research finding that is least likely consistent with reduced form models is

that:

A. the risk-free rate is stochastic. B. the Black-Scholes model should be used, since there is the equivalent of a European-style call option on the company’s assets. C. some of the company’s debt is tradable.

47.

Based on Lee’s observations of Spicer’s approach, was Spicer’s binomial tree constructed accurately? A. B. C. Yes, because implied volatility was calculated accurately and spot rates are higher than par rates when the par curve is upward sloping.

No, because implied volatility was calculated incorrectly and spot rates are lower than par rates when the par curve is upward sloping.

No, because implied volatility was calculated incorrectly, but spot rates are higher

than par rates when the par curve is upward sloping.

48. How many of Pfizter’s statements are true?

A. 0. B. 1. C.

ITEM SET 9: DERIVATIVE INSTRUMENTS Questions 49 through 54 are allocated 18 minutes.

Tom Miller, a successful hedge fund manager who specializes in derivatives, will receive a $10 million fund inflow in 30 days. He is concerned that after strong rallies in equities in a rising interest rates environment, a significant market correction may occur very soon. When the correction happens, the rise of short-term interest rates may stall, or even decline, before he receives the $10 million inflow.

To be better prepared for the new fund inflow, Miller decides to enter a $10 million notional amount 1x4 receive-fixed FRA priced at 1.75% that is advanced set, advanced settled. This FRA expires in 30 days and is based on 90-day US Dollar LIBOR. After 30 days, the 90-day US Dollar LIBOR rate is 1.523% and this rate is also used as the discount factor.

Miller also plans to review three positions that he is holding.

Position 1: Nine months ago (Time = 0), Miller initiated a one-year forward contract on the smart phone maker Orange Pad (ticker: OPAD) with a forward price: F0 (T) = $142. OPAD does not pay any dividends.

Position 2: Six months ago, Miller entered an equity swap with an annual reset as the receive-fixed, pay-equity (linked to the S&P 500 index) party. Exhibit 1 lists the relevant data. At the time this swap was initiated, the S&P 500 index was trading at 2,430. Today it is at 2,630.

Position 3: Miller has an over-weighted position in the online retailer Nozama (ticker: NZMA) whose price has appreciated significantly in the past two years. However, the rally of this volatile stock has stalled recently. Miller purchased some two-year, American-style NZMA at-the-money puts in an attempt to partially hedge potential corrections in the stock. The stock is currently trading at $1,160 per share. It does not pay a dividend (δ = 0), and it has an annualized volatility of σ = 22%. The risk-free interest rate is 1.70% on an annual basis.

Exhibit 9-1 Selected Data on Equity SwapSwap Notional Amount$20,000,000Original Swap TermFive years, with annual resetFixed Swap Rate3.75%Selected US Spot RatesMaturity (years)Spot Rate0.51.50%1.51.80%2.51.95%3.52.05%4.52.15% © 2018 CFA Society Boston

When a newly hired young research analyst, Bill Morgan, comes to Miller seeking advice on the at-the-money call options of the non-dividend-paying stock NZMA, Miller has a choice of three statements:

Statement 1: Since these call options are at-the-money, they tend to have high gamma values,

which can cause rapid changes in the delta; hence, you should definitely early-exercise the call options to acquire the stock to eliminate the high gamma risk.

Statement 2: Since the interest rate is very low, you should take advantage of cheap financing

to early-exercise the call options to capture their time values.

Statement 3: Since the stock does not pay dividends, it is not optimal to early-exercise the call

options.

49. The cash flow at the FRA settlement is closest to:

A. Miller pays the counterparty $115,630. B. Miller receives $5,650 from the counterparty. C. Miller receives $115,630 from the counterparty.

50. Today, at Time t = 0.75, OPAD is trading at $169.50 per share. The value of Miller’s forward contract (Position 1) is closest to:

A. $22.70 B. $25.40 C. $28.10

51. From Miller’s perspective (receive-fixed, pay-equity), the most accurate description of the equity swap (Position 2) is:

A. The fair value of the swap is -$141,600 and the S&P 500 must be trading at 2,410 for the current value of the swap to be zero. B. The fair value of the swap is $150,700 and the S&P 500 must be trading at 2,550 for the current value of the swap to be zero. C. The fair value of the swap is $163,100 and the S&P 500 must be trading at 2,650 for the current value of the swap to be zero.

52.

Based on the two-period binomial model, given the up factor u = 1.2461 and the down factor d = 0.8025, the early exercise premium of the NZMA at-the-money puts (Position 3) is closest to: A. B. C.

$0 $9.85 $229.10

53.

Which of the three possible statements of Miller to Morgan is correct? A. B. C.

Statement 1. Statement 2. Statement 3.

54.

Today, a two-year NZMA at-the-money call costs $160 when the stock is trading at $1,160 per share. The maximum profit at option expiration from a covered call strategy using this option is closest to: A. B. C.

$160 $1,000 Unlimited

ITEM SET 10: PORTFOLIO MANAGEMENT Questions 55 through 60 are allocated 18 minutes.

Sahar Hasan decides to review her personal investment portfolio. Hasan had selected 3 funds for her portfolio, based on her view of the portfolio managers and their skills. She had also chosen a policy benchmark portfolio similar to the overall US market, and had maintained reasonably constant weights throughout the period. Her allocation choices included: 2 large-cap funds (which she benchmarks to the S&P 500) and 1 small-cap fund (with the Russell 2000 as the benchmark). Hasan collects the data, summarized in Exhibit 10-1.

Exhibit 10-1 AUM # of

Ticker Portfolio Name ($mil) Stocks Return STD(R) SR TE WT LSGRX Loomis Sayles Growth 8,170 35 15.60% 11.80% 1.28 5.37% 40%

Columbia Disciplined

RDLFX Gr. 559 77 13.37% 10.90% 1.19 3.92% 40% S&P500 S&P 500 Index 11.41% 10.07% 1.09 90% JHancock Small Cap JCCIX Core 184 82 13.46% 13.80% 0.94 3.74% 20% R2000 Russell 2000 Index 9.96% 14.11% 0.67 10%

Notes: Returns, standard deviation (STD), Sharpe ratio (SR) and tracking error (TE) results are annualized. WT: for funds (LSGRX, RDLFX, JCCIX) WT is the fund weight in the active portfolio weight; for indices (S&P500, R2000) WT is the index weight in the benchmark portfolio.

Hasan notes that each of the funds has a 𝛽𝛽 (relative to that fund’s benchmark) close to 1.0.

Hasan also obtains data for these portfolios’ factor sensitivities in the Fama-French-Carhart four factor market risk model, and constructs the factor sensitivities for her active portfolio and her benchmark. These factor sensitivities and the factor returns for the last 3 years are given in Exhibit 10-2.

Exhibit 10-2

Factor Sensitivities

Market Size Value Momentum

Portfolio (RM−RF) (SMB) (HML) (WML)

1.01 -0.01 -0.28 -0.01 Active

1.00 -0.02 0.00 0.02 Benchmark

Factor Returns (Annualized) 10.74% 0.49% -1.88% 3.66%

The risk-free rate is expected to be 1.40%.

55.

Hasan is quick to recognize that her portfolio has outperformed her policy benchmark, and wonders whether her choice of fund weights (asset allocation) or the success of the fund managers (security selection) made the larger contribution to outperformance. Based on these data, she is most likely to conclude that:

A. asset allocation made the larger contribution. B. stock selection made the larger contribution. C. both effects contributed nearly equal amounts (within 10 basis points).

Which fund most likely has the largest information ratio (IR)?

A. LSGRX. B. RDLFX. C. JCCIX.

Hasan decides to apply the principles of the Fundamental Law of Active Management to these funds in order to estimate stock-picking skill. She first needs to determine the fund optimal tracking error (TE*), that is, the level of active risk that leads to the maximum Sharpe ratio. The value for TE* for the JHancock Small Cap Core fund (JCCIX) is closest to: A. B. C.

5.0% 10.0% 20.0%

Hasan determines which factor sensitivity had the greatest positive contribution to her active return over the last 3 years. The result is most likely to be: A. market (RM−RF). B. value (HML). C. momentum (WML).

Hasan also calculates TE* for Columbia Disciplined Growth (RDLFX), and uses the result to estimate the Transfer Coefficient (TC) for the Columbia fund to be TC = 0.847. She sees from the Sharpe ratio and the IR that RDLFX is generally performing well, and wonders whether or not that is evidence of strong stock-picking. If it is, she would expect a relatively high information coefficient (IC) for the fund. Using her estimated TC, she estimates the IC for RDLFX, with a result that is closest to: A. .10 B. .20 C. .50

56.

57.

58.

59.

60.

Turning to the Carhart risk model, Hasan is interested in estimating the expected returnsfor her active portfolio. Making the assumption that the expected factor risk premia willbe the same as the factor returns for the last three years, the expected active portfolioreturn will be closest to:A.11.5%B.12.0%C.

13.0%

END OF MORNING SESSION.

CFA Society Boston

CFA Level II – 2018 Practice Exam Afternoon MULTIPLE CHOICE RESPONSE FORM A B C 1.0 0 02.0 0 03.0 0 04.0 0 05.0 0 06.0 0 07.0 0 08.0 0 09.0 0 010.0 0 011.0 0 012.0 0 013.0 0 014.0 0 015.0 0 016.0 0 017.0 0 018.0 0 019.0 0 020.0 0 021.0 0 022.0 0 023.0 0 024.0 0 025.0 0 026.0 0 027.0 0 028.0 0 029.0 0 030.0 0 031.0 0 032.0 0 033.0 0 034.0 0 035.0 0 036.0 0 037.0 0 038.0 0 039.0 0 040.0 0 041.0 0 042.0 0 043.0 0 044.

0 0 0

A B C 45.0 0 046.0 0 047.0 0 048.0 0 049.0 0 050.0 0 051.0 0 052.0 0 053.0 0 054.0 0 055.0 0 056.0 0 057.0 0 058.0 0 059.0 0 060.

0 0 0

CFA Society Boston Level II

2018 Practice Exam

Afternoon Session

1:30PM – 4:30PM

CFA®

is a licensed service mark owned by CFA Institute.

Addendums to this Exam:

The afternoon session of the CFA Society Boston Level II 2018 Practice Exam has 10 item sets. The item set format consists of a vignette or a short case followed by six multiple choice

questions based on the vignette. Each item set is allocated 18 minutes for a total of 180 minutes.

Item Set Topic Questions Minutes

1 Ethical and Professional Standards 1-6 18 2 Quantitative Methods 7-12 18 3 Financial Reporting and Analysis 13-18 18 4 Financial Reporting and Analysis 19-24 18 5 Corporate Finance 25-30 18 6 Equity Valuation 31-36 18 7 Fixed Income 37-42 18 8 Derivative Instruments 43-48 18 9 Alternative Investments 49-54 18 10 Portfolio Management 55-60 18 Total 60 180

ITEM SET 1: ETHICAL AND PROFESSIONAL STANDARDS Questions 1 through 6 are allocated 18 minutes.

James Paul recently passed Level I of the CFA exam. Paul’s elation is tempered by the current uncertain economic environment. His firm, White Crest Capital Management (White Crest), is a manager for several pooled investment vehicles for institutional clients. Paul works in the high-yield loan group, which purchases and sells bank debt and other fixed income securities. Other groups within the firm include a growth and income fund, which buys and sells small-cap equities, and a real estate investment division.

White Crest began in 2000, offering a high-yield loan fund, a small-cap fund and a real estate fund. Paul joined the firm in 2003. White Crest encourages a culture of cooperation and rewards employees who help the firm prosper. Pamela Jean is the supervisor of the high-yield loan group and is not a CFA Institute member, nor a CFA candidate. Jean believes that, in order for the firm to prosper in these tumultuous times, it needs to report only the most favorable returns in the firm’s marketing materials. Jean requests that each employee calculate the returns for each investment vehicle as of December 31, 2017, for upcoming marketing presentations.

Paul estimates the performance of the high-yield loan group and determines that the performance is stronger if calculated since the inception of the fund in 2000 than if calculated since 2003, when he joined the group. Paul decides to report the performance of the high-yield loan fund since the fund’s inception. Paul is worried because the performance of the high-yield loan fund has been lower since he joined the firm.

At a professional networking event, Paul discusses the investment environment with William Blain, CFA, of Highland Bluff, LLC (Highland), an asset management firm located in the same city as White Crest. Paul describes to Blain the performance of the high-yield loan fund using investments that he recommended, but which were not approved by the White Crest investment committee. Blain does not know that the investment performance described by Paul is simulated. Blain is interested in Paul’s work and invites him to share his work over dinner.

A few days later, Paul meets Blain for dinner. Paul presents the simulated investment returns for the White Crest high-yield loan fund using the investments that Paul recommended, but which were not approved by the high-yield loan group’s investment committee. Paul states that the high-yield loan portfolio can be easily replicated by Highland by showing Blain all of the

investment positions, actual and simulated, held by the high-yield loan fund. Paul believes that investors seeking protection from loss should be attracted by the risk-adjusted returns that this portfolio of high-yield loans offers.

Blain is intrigued by Paul’s presentation and calls Jean the following day to discuss a potential joint marketing opportunity. Blain explains to Jean the previous night’s dinner with Paul. Blain does not want to interfere with White Crest and asks for Jean’s permission to use the investment information provided by Paul as a way to market the high-yield loan group’s investment vehicle to Highland’s existing clients. Since Jean is eager to attract new investors, she agrees to share the investment performance information with Blain.

Is Jean’s desire “to report only the most favorable returns in the firm’s marketing materials” in compliance with the Standards? A. Yes, because the Standards encourage full disclosure of investment performance

data to clients. B. No, because reporting only the most favorable returns does not provide a fair and

complete presentation of performance information. C. No, because the requirements of the Standards are limited to members and

candidates. Does Paul’s calculation of the high-yield loan group’s performance since the inception of the fund comply with the Standards? A. No, because ignoring the lower performance since Paul’s arrival does not provide

a fair and complete presentation of performance information. B. No, because the requirements of the Standards are limited to members and

candidates. C. Yes. Would Paul’s presentation to Blain of the high-yield loan group’s simulated investment performance be in compliance with the Standards? A. No, because reporting simulated returns does not provide a fair and complete

presentation of performance information. B. No, because the requirements of the Standards allow for simulated investment

results, as long as they are applied retroactively to investment performance. C. Yes. Is Paul’s use of high-yield loan group’s performance data in his discussion with Blain in compliance with the Standards? A. Yes, because Blain received permission from Jean to use the information. B. Yes, because the Standards allow for knowledge gained at one employer to be

used in discussions with other firms with the employer’s prior consent. C. No, because the information is the property of White Crest and Paul did not

obtain consent from his employer prior to meeting Blain.

Would Blain’s use of Paul’s performance information to market White Crest’s high-yield loan group to potential investors be in compliance with the Standards? A. Yes, because Blain received prior permission from Jean to use the information. B. Yes, because Paul actually recommended the investments included in the

performance data. C. No, because reporting simulated returns does not provide a fair and complete

presentation of performance information. If Blain offered Paul additional compensation for his work in the high-yield loan market, what would Paul need to do to be in compliance with the Standards? A. Paul cannot accept any additional compensation arrangements. B. Paul must obtain permission from Highland prior to accepting additional

compensation. C. Paul must obtain permission from White Crest prior to accepting additional

compensation.

ITEM SET 2: QUANTITATIVE METHODS Questions 7 through 12 are allocated 18 minutes.

Taeho Kim, CFA, is putting together an analysis of palm oil prices in an attempt to predict future prices, using historic time-series data. Palm oil is sold by the barrel. Kim does not know the best model for predicting palm oil prices, but believes that the current period value will be related to the previous period value. Kim decides to start out with a first-order autoregressive model:

AR(1): Palm Oilt = b0 + b1(Palm Oilt-1) + εt.

Exhibit 2-1 Regression Statistics

Regression Statistics R-squared 0.7748 Standard error 0.0420 Observations 62 Durbin-Watson 1.8464

Exhibit 2-2 Regression Output

Coefficients Standard Error t-Statistic Intercept 0.0843 0.0376 2.2420 Lag 1 0.8656 0.0621 13.9388

Exhibit 2-3

Autocorrelations of the Residual

Lag Autocorrelation Standard Error t-Statistic 1 0.0678 0.1270 0.5339 2 -0.1992 0.1270 -1.5685 3 0.0514 0.1270 0.4047 4 -0.1489 0.1270 -1.1724

Exhibit 2-4

Two-sided t-Distribution

Degrees of Freedom t.995 t.99 t.95 t.90 1 127.3 63.66 12.71 6.31 2 14.10 9.93 4.30 2.92 60 2.92 2.67 2.00 1.67

In addition, Kim runs a regression of the squared residuals from the autoregressive model which resulted in the following output:

Exhibit 2-5

Model of the Squared Residuals From the AR(1) Model

Regression Statistics R-squared 0.1385 Standard error 26.4294 Observations 59 Durbin-Watson 1.9216

Exhibit 2-6 Regression Output

Coefficient Standard Error t-Statistic Intercept 7.3014 1.6061 4.5460 Lag 1 0.4273 0.0589 7.2544

Exhibit 2-7 χ2 Distribution

Degrees of Freedom χ 2.995 χ 2.99 χ 2.975 χ 2.95 χ 2.90 1 7.88 6.63 5.02 3.84 2.71 2 10.60 9.21 7.38 5.99 4.61

7. Based on the t-statistics of the autocorrelation of the residuals in Exhibit 2-3, at the 0.05

significance level, Kim can most likely conclude:

Serial Correlation of

the Residuals t-statistic

Yes Significant A.

No Significant B.

No Not Significant C.

8. With the price of a barrel of palm oil equal to $82 last month, the model’s predicted price

of palm oil in the current month is closest to:

A. $69 B. $71 C. $79

The most likely reason Kim included the lags in his regression equation was to: A. B. C.

first difference the regression model. increase autocorrelation of the residuals. improve the R2.

10.

Based on the data from Exhibit 2-6 and Exhibit 2-7, at the 99th percent confidence level, Kim should most likely: A. B. C.

reject the null hypothesis of serial correlation.

reject the null hypothesis of no conditional heteroskedasticity. not reject the null hypothesis of serial correlation.

11.

If ARCH exists in Kim’s AR(1) model, the most likely consequence is that: A. B. C.

one or more of the lagged terms in the AR(1) equation is statistically significant. the variance of the error terms is the same for all observations. the standard errors of the regression coefficients are incorrect.

12.

A time series with a unit root: A. B. C.

is covariance-stationary.

tends to have a finite, mean-reverting level. is found in random walk time series.

ITEM SET 3: FINANCIAL REPORTING AND ANALYSIS Questions 13 through 18 are allocated 18 minutes.

CHS Industries, a US company, has a defined benefit pension plan for its employees. The

assumed discount rate the company uses to calculate the present value of its pension obligations is 6%. The expected rate of return on its plan assets is 7%. Below is the information on the CHS pension plan.

CHS Industries Defined Benefit Pension Plan

Change in benefit obligations

Benefit obligations at the beginning of the year Service cost Interest cost Benefits paid Actuarial loss Benefit obligations at the end of the year Change in plan assets Fair value of plan assets at the beginning of the year Actual return on plan assets Employer contributions Benefits paid Fair value of plan assets at the end of the year Funded status at the beginning of the year Funded status at the end of the year

2017 $million

36,400

298

1,994

(1,500)

(86)

37,106

31,508

1,932

954

(1,500)

32,894

(4,892)

(4,212)

13.

Net interest expense for 2017 is closest to: A. B. C.

$253 million $294 million $342 million

14.

Remeasurement for 2017 under IFRS is closest to: A. B. C.

- $187.5 million - $127.5 million - $44.5 million

15.

The components of retirement benefits paid during the year are best expressed as: A. B. C.

Pension benefits paid is calculated using the beginning obligation, interest costs, service costs and ending obligation.

Pension benefits paid is calculated using the beginning obligation, interest costs, actuarial gains or losses, and ending obligation.

Pension benefits paid is calculated using the beginning obligation, interest costs, service costs, actuarial gains or losses, and ending obligation.

16.

CHS is listed on the London Stock Exchange and the company reports its financial

statements using IFRS in Great Britain. The amount of periodic pension cost that would be reported in the income statement under IFRS is closest to: A. B. C.

$506 million $592 million $678 million

17.

CHS is also listed on the New York Stock Exchange and reports its financial statements using US GAAP in the US. Remeasurement according to US GAAP is closest to: A. B. C.

- $359.6 million - $284.5 million - $44.5 million

18. Which of the following is the most likely impact of a greater rate of compensation increase on CHS’ financial statements?

A. An increase in the rate of employee compensation would increase plan

obligations in the balance sheet and decrease the service cost element in the periodic cost.

B. An increase in the rate of employee compensation would increase plan obligations in the balance sheet and increase the service cost element in the periodic cost.

C. An increase in the rate of employee compensation would decrease plan obligations in the balance sheet and increase the service cost element in the

periodic cost.

ITEM SET 4: FINANCIAL REPORTING AND ANALYSIS Questions 19 through 24 are allocated 18 minutes.

Merv Hughes, CFA, is an equity portfolio manager. He is considering an investment in MOS Corporation, which has a subsidiary, Ferts plc, in the UK that was acquired on 31 December 2017. Ferts plc uses the US dollar (USD) as its functional currency.

Balance sheet for the year ending 31 December 2018

GBP million Cash GBP 155 Accounts receivable 168 Inventory 117 Net fixed assets 160 Total assets GBP 600

Accounts payable

GBP 142 Long-term debt 195 Common stock 172 Retained earnings 91 Total liabilities and shareholders' equity GBP 600

Exchange rates

USD/GBP Rate on December 31, 2017 1.32 Average rate 1.26 Rate on December 31, 2018 1.28

Ferts plc uses FIFO for inventory valuation. 19. As Hughes consolidates Ferts accounts with the holding company, MOS, inventory and long-term debt would be closest to:

A. inventory of USD 147.4 million and long-term debt of USD 249.6 million. B. inventory of USD 149.8 million and long-term debt of USD 249.6 million. C. inventory of USD 154.4 million and long-term debt of USD 245.7 million. 20. The translated value of the retained earnings is closest to:

A. USD 107.3 million B. USD 116.0 million C. USD 120.5 million

21.

Hughes is evaluating the possibility of Ferts plc operating as an entity with a high degree of autonomy. If Ferts is a self-contained, independent entity, its total assets will be closest to: A. B. C.

USD 768 million USD 772 million USD 784 million

22.

If the current rate method is used, the balance sheet foreign currency exposure of MOS Corp. would be closest to: A. B. C.

GBP 263 million USD 340 million GBP 405 million

23.

Hughes expects the GBP to strengthen and wants to evaluate the effect of a stronger GBP against the USD under both the current and temporal methods. Which of the following is most likely to be the correct interpretation? A. B. C.

Temporal Method, Net Monetary

Liability Exposure Higher shareholder equity, higher net income

Lower shareholder equity, lower net income

Temporal Method, Net Monetary Asset Exposure Higher shareholder equity, higher net income

Higher shareholder equity, higher net income

Current Rate Method

Higher shareholder equity, higher net income

Lower shareholder equity, lower net income

24.

Hughes is aware that MOS reports its financial statements under US GAAP and Ferts plc reports its financial statements under IFRS. Which of the following is most likely a disclosure requirement under US GAAP but not under IFRS? A. B. The amount of exchange differences reported in net income.

The amount of cumulative translation adjustment classified in a separate equity component.

The amount of translation adjustment transferred from stockholders’ equity.

ITEM SET 5: CORPORATE FINANCE

Questions 25 through 30 are allocated 18 minutes.

Jennifer MacMillan, CFA, is an analyst evaluating the capital structure and dividend policy of TaxAdvisors, a publicly-traded East Coast company with operations in Western Europe and Japan. The company provides accounting and legal services for small and medium-sized businesses. The company plans to expand its operations into the western United States, for which it needs to raise $100 million in new capital. TaxAdvisors is located in a jurisdiction that has a 40% corporate tax rate and 30% personal income tax on dividends. TaxAdvisors currently distributes 50% of its earnings in regular cash dividends to its shareholders.

A member of the board makes the following statements regarding the company’s capital structure and dividend policy:

Statement 1: We currently use a capital structure of 50% debt and 50% equity, and have $30

million of internally-generated funds available to use for our planned expansion. According to the pecking order theory, we should avoid issuing additional debt and finance the expansion with the $30 million of available funds and by issuing an additional $70 million in new shares of common stock.

Statement 2: Debt ratings do not affect our capital structure decision.

Statement 3: According to the bird-in-the-hand theory, paying dividends lowers our cost of

capital and increases the firm’s value.

Statement 4: Research shows that, while international factors still play key roles in the

differences between capital structures in developed and emerging markets, these differences are not statistically significant across developed countries due to the globalization of these economies.

MacMillan estimates the company’s earnings next year to be $80 million. The company has a target debt/equity ratio of 50/50. Its capital budget for next year is estimated to be $100 million. TaxAdvisors follows a residual dividend policy.

MacMillan computes the company’s dividend coverage ratio to assess the risk of a dividend cut.

MacMillan also calculates that the dividend coverage ratio for a peer group is 1.5x over a 10-year cycle. Based on these findings, MacMillan concludes that, all else being equal, there is a higher risk of TaxAdvisors cutting its dividends than of peer companies doing so.

Finally, MacMillan observes that TaxAdvisors’ current payout ratio of 50% is below its peer group’s ratio. She would like to incorporate the factors associated with relatively low payouts into her analysis.

25.

26.

27.

With respect to the board member’s first and second statements, MacMillan will most likely:

A. disagree with both Statement 1 and Statement 2.

B. disagree with Statement 1 but agree with Statement 2. C. agree with Statement 1 but disagree with Statement 2.

With respect to the board member’s third and fourth statements, MacMillan will most likely:

A. agree with Statement 3 and Statement 4.

B. disagree with Statement 3 but agree with Statement 4. C. agree with Statement 3 but disagree with Statement 4.

Given the current corporate and personal tax rates in TaxAdvisors’ jurisdiction, the effective tax rate on TaxAdvisors’ pretax income distributed as dividends is closest to:

A. 35% B. 55% C. 58%

28. Given MacMillan’s earnings projections, if TaxAdvisors follows a residual dividend policy and has a target equity/debt ratio of 50/50, its next year’s dividend payout ratio is closest to:

A. 12.5% B. 37.5% C. 50.0%

29. TaxAdvisors’ dividends coverage ratio and MacMillan’s conclusion regarding the risk of TaxAdvisors cutting its dividend are most likely:

Dividends Coverage Ratio MacMillan’s Conclusion A. 2.0x Correct B. 2.0x Incorrect C. 0.5x Correct

30. Regarding MacMillan’s observation on TaxAdvisors’ low dividend payout, the factor least associated with a low dividend payout ratio is:

A. low growth prospect.

B. high tax rates on dividends.

high flotation costs on new equity issues.

ITEM SET 6: EQUITY VALUATION

Questions 31 through 36 are allocated 18 minutes.

Steve Smith, CFA, is director of research at Cleopatra Investments. Smith is developing an investment recommendation on Riverbranch Inc. (NASDAQ: RVRB, current price: $38.00). Riverbranch is mid-sized energy firm focusing on the transportation and storage of refined petroleum products. Riverbranch is located in the United States, employs more than 6,500 employees, and operates over a dozen domestic pipelines.

Riverbranch management believes that current growth will decrease over the next few years. After a decade of increasing profitability and opportunity, industry competition is rapidly

increasing as exploration and production activity has slowed, resulting in mounting pressure on transportation charges and profit margins. For the next two years, the firm expects annual growth to remain high at 12.5%, but then slow to 10.0% for two years, and fall to 5.0% thereafter (in line with broader economic growth).

Smith was analyzing the latest research report his lead analyst provided. Smith noted several key items, including the data he needed as inputs for the Riverbranch equity valuation model. Specifically, Smith highlighted Riverbranch’s required rate of return of 9.8%.

Smith analyzed a summarized income statement and statement of cash flows for Riverbranch in Exhibits 1 and 21.

Note: Numbers in Exhibits 1 and 2 may not add exactly, due to rounding.

31. Using the three-stage DDM, a share of Riverbranch’s common stock trading in the market is most likely:

A. undervalued. B. fairly valued. C.

overvalued.

32. Based on Riverbranch’s net income, the firm’s FCFE for 2016 is closest to:

A. $1,490 B. $1,600 C.

$2,270

33. The business development phase of Riverbranch is most likely:

A. the growth phase. B. the transitional phase. C.

the mature phase.

34.

When valuing a levered firm, an analyst is most likely to select an FCFF model over a FCFE model when the firm being valued has: A. B. C.

a positive FCFE.

a changing capital structure.

a required rate of return that is less sensitive to changes in financial leverage than changes in the WACC.

35.

Based on the data contained in the statement of cash flows, Riverbranch’s FCFF for 2016 is closest to: A. B. C.

$2,540 $2,850 $3,065

36.

Under US GAAP, Riverbranch’s interest received and interest paid are most likely classified as cash flow from: A. B. C.

operating activities. investing activities. financing activities.

ITEM SET 7: FIXED INCOME

Questions 37 through 42 are allocated 18 minutes.

Pam Hamilton, CFA, a portfolio manager at Heuer Capital Management (Heuer), is evaluating a new issue from Natural Wonders GmbH. The issue matures in three years with a 4.25% annual coupon, callable at €100.00 in Year 1, callable at €100.25 in Year 2, and putable at €99.25 in Year 2.

Year 1 Year 2 Year 0

NUU

5.526%

NU 3.870% N0 NUD

2.500% 4.524%

3.168% NDD

3.704%

Hamilton’s colleague, Victor Nam, is analyzing convertible bonds. Believing that he has found a good investment, Nam presents his key findings to the CIO, James Akoo, CFA.

Premium over straight value: 1.98% Value of straight bond: 101

Following the presentation, Akoo reads a research paper that focuses on the use of partial durations. Reviewing the latest trades in Thomas Industries and NPTech, he observes that the sum of the partial durations for Thomas Industries equals the modified duration, but the sum of the partial durations for NPTech is less than the modified duration of NPTech.

Later in the day, the head of derivatives sales at the investment bank Iacono, Weetman & Co., Courtney Trautolo, makes a presentation to Rob Andover, Heuer’s chief risk officer. Trautolo’s firm makes a market in a CDS index where Andover has $5 million in unhedged credit exposure. The CDS index currently has 125 entities in it.

The following day, Andover wants to review the interest rate generation process with the risk team. The risk team recently made two changes to their Monte Carlo process.

1. It widened the mean reversion bounds on the cash flows along each interest rate path. 2. It adjusted the drift term being applied to the interest rates.

At the end of the week, the credit team at Heuer discovers that some bondholders would not be receiving interest payments on a securitized bond that Heuer owns, which is issued by Markham

LLC. However, the portfolio administration team determines that Heuer will be receiving the full expected interest payment. 37. Based on Hamilton’s tree, the value of the Natural Wonders issue is closest to:

A. €101.54 B. €101.65 C. €102.11 38. The value of the convertible bond and the value of the call option on the issuer’s stock that Nam is researching are closest to:

Convertible Bond Value Call option on issuer’s stock A. 103 2 B. 103 3 C. 104 2 39. Based on Akoo’s observations, which conclusion regarding the Thomas Industries and NPTech bonds is most likely correct?

A. The NPTech bond is undervalued relative to the Thomas Industries bond. B. The Thomas Industries bond is more sensitive to interest rate changes than the NPTech bond. C. The NPTech bond contains an embedded option and the Thomas Industries bond does not.

40. If Andover were to fully hedge the $5 million credit exposure, he would most likely:

A. purchase $500 million on the CDS index. B. purchase $5 million on a single-name CDS. C. short a single-name CDS with an upfront payment of $4 million.

41. Are both changes made to the Monte Carlo process by the risk team appropriate?

A. Yes, both changes are appropriate. B. No, both changes are inappropriate. C. No, one change is appropriate and one change is inappropriate.

42. What is the most likely scenario for the Markham LLC bond?

A. Heuer is a senior tranche holder.

B. The security is a special purpose entity. C.

The bond is highly rated.

ITEM SET 8: DERIVATIVE INSTRUMENTS Questions 43 through 48 are allocated 18 minutes.

Fund manager Mimi Taylor is reviewing her current positions in the S&P 500 index futures and options. She collects the data shown in Exhibit 8-1.

Exhibit 8-1 S&P 500 Index DataSpot index level2,630One-year risk free interest rate1.70%Index dividend yield (continuous compounding)1.90%Index volatility18.00%Index option styleEuropeanFutures contract time to expirationThree months

Taylor is concerned that, after a nine-year bull market that tripled major market indices, the US equity market may trade sideways or even experience cyclical declines in the next year or two. She considers writing the one-year S&P 500 index at-the-money calls to enhance the performance of her US equity portfolio.

Taylor proposes that her firm make a USD100 million investment in the UK financial market for one year to take advantage of the potential Brexit event. She also proposes to raise this

investment capital by issuing US-denominated bonds. The firm will then enter into a one-year currency swap with a large UK bank, Pubclays, with quarterly reset (30/360 day count) and the exchange of notional amounts at initiation and at maturity. Her proposals are approved and she is assigned to lead the investment.

Assume that both parties in the currency swap agree to a USD/GBP spot exchange rate of 1.35. Exhibit 2 lists the interbank spot rates today, at time = 0.

One of Taylor’s portfolios has a position in the stocks of the media company Xilften (ticker: XLFN). After the success of its TV series, Mansion of Dominos, subscriptions to the company’s online streaming service soared, its revenue jumped and its stock price responded bullishly.

Taylor believes the magnitude of the XLFN rally has been excessive and the risk of a significant downside correction has dramatically increased. In response, she intends to initiate a protective put strategy to protect the gain. Taylor would like to know the cost of two-year at-the-money calls on XLFN. Taylor uses a two-period binomial model to estimate this call’s price using the data shown in Exhibit 3.

Exhibit 8-3 Xilften DataCurrent Stock Price$200Time to expiration2 yearsInterest rate1.70%Dividend (δ)NoneVolatility (σ)40%Up factor (u)1.5Down factor (d)0.667

Exhibit 8-4 Standard Normal Curve Areasz-0.5-0.4-0.3-0.2-0.10.00.10.20.30.40.500.308540.344580.382090.420740.460170.500000.539830.579260.617910.655420.691460.010.312070.348270.385910.424650.464140.503990.543800.583170.621720.659100.694970.020.315610.351970.389740.428580.468120.507980.547760.587060.625520.662760.698470.030.319180.355690.393580.432510.472100.511970.551720.590950.629300.666400.701940.040.322760.359420.397430.436440.476080.515950.555670.594830.633070.670030.705400.050.326360.363170.401290.440380.480060.519940.559620.598710.636830.673640.708840.060.329970.366930.405170.444330.484050.523920.563560.602570.640580.677240.712260.070.333600.370700.409050.448280.488030.527900.567490.606420.644310.680820.715660.080.337240.374480.412940.452240.492020.531880.571420.610260.648030.684390.719040.090.340900.378280.416830.456200.496010.535860.575350.614090.651730.687930.72240 © 2018 CFA Society Boston

43.

The current price of the S&P 500 index is 2,630. The no-arbitrage futures price of the S&P 500 index futures contract that Taylor holds is closest to: A. B. C.

2,617 2,629 2,641

44.

The fixed quarterly payments in the currency swap will be closest to: A. B. C.

GBP 96,300 and USD 380,000 GBP 118,150 and USD 442,000 GBP 142,100 and USD 495,840

45.

Suppose the S&P 500 index dividend yield suddenly drops by 10%. Based on the Black-Scholes-Merton (BSM) model, which of the following statements regarding the price of a one-year at-the-money S&P 500 index call is most accurate? A. B. C.

The BSM model call price will remain the same because the model does not consider dividend contributions.

The BSM model call price will decrease because the index price is discounted less as its dividend yield drops, while everything else remains the same as before the dividend yield change.

The BSM model call price will change because the dividend yield change affects the adjusting factors for both the current index price and option strike price components.

46.

A protective put strategy is most likely equivalent to: A. B. C.

a long call and a bond.

a long call option and short the underlying. a long bond and short the underlying.

47.

For her covered call strategy, the price of an XLFN two-year at-the-money (X=200) call, using a two-period binomial model, is closest to: A. B. C.

USD32 USD43 USD54

48. Thomas Flint, the firm’s derivative strategist, found Taylor’s XFLN story fascinating and decided to execute a short-term trade: going long the 3-month at-the-money (X=200) calls and puts simultaneously. Flint’s strategy is best described as a:

A. collar.

B. bull spread. C.

straddle.

ITEM SET 9: ALTERNATIVE INVESTMENTS Questions 49 through 54 are allocated 18 minutes.

Sofia DePietro, formerly a REIT fund analyst in New York, recently moved to Milan to become a private real estate analyst in the Milan office of Euro Specialty Investments (ESI). Her first assignment is to evaluate and compare two private commercial real estate proposals: a multi-family building outside of Milan and an office building in Rome. One of her summary tables is shown below in Exhibit 1.

Exhibit 9-1

Property Type #1: Milan Multi-Family #2: Rome Office Building Occupancy 95% 90% Square meters or # of units 200 units 35,000 square meters Gross potential rent €3,100,000 €4,250,000 Expense reimbursement 0 300,000 Potential gross income 3,100,000 4,550,000 Vacancy loss (155,000) (455,000) Effective gross income 2,945,000 4,095,000 Property management fee (120,000) (200,000) Other operating expenses (1,500,000) (2,100,000) Net operating income (NOI) €1,325,000 €1,795,000

DePietro presents these results to her manager. The manager is intrigued by the potential for both properties, but business and labor forecasts for Rome are seen as especially attractive.

Accordingly, he asks for more detailed cash flow information on project #2. This requested information is shown in Exhibit 2 and Exhibit 3.

Exhibit 9-2

6-Year Net Operating Income Assumptions for Project #2 Year 1 € 1,795,000 Year 2 1,848,850 Year 3 1,904,316 Year 4 1,961,445 Year 5 2,020,288 Year 6 2,080,896

Exhibit 9-3

Discounted Cash Flow Assumptions

for Project # 2

Investment hold period: 5 Years Going in cap rate: 5.25% Terminal cap rate: 6.0% Discount rate: 7.25% Income value growth rate: Constant

For its private real estate investments, ESI can either make an all-cash purchase or undertake a partial debt financing through a major bank in Milan. The going rate on a five-year commercial mortgage loan is 5.75%. DePietro is told to ignore the financing decision for now.

49. Though DePietro has experience analyzing both private real estate investments and

REITs, ESI exclusively invests in private real estate. A potential benefit of private real estate investments to ESI is most likely:

A. liquidity. B. property control. C. diversification.

50. Both REIT investing and private real estate investing offer the chance to participate in

income-producing properties. The greatest opportunity for capital gains is more likely to come from:

A. REITs. B. private real estate. C. either; both investments offer similar potential for capital gains.

51. Based on Exhibit 3, the growth rate of property #2 is closest to:

A. 0.75% B. 1.25% C. 2.00%

52. DePietro’s valuation for property #2, using the discounted cash flow method, is closest

to:

A. € 35,476,122 B. € 36,432,856 C. € 42,412,442

53.

To further support her analysis, DePietro has been asked to provide a second valuation analysis. In addition to the discounted cash flow valuation approach, another commonly used private real estate valuation methodology is: A. B. C.

net asset value. sales comparison. price multiple.

54.

Assuming DePietro’s forecast is reasonably accurate, if ESI chooses to purchase property #2 using partial debt financing, the most likely result will be: A. B. C.

a lower return on equity. the same return on equity. a higher return on equity.

ITEM SET 10: PORTFOLIO MANAGEMENT Questions 55 through 60 are allocated 18 minutes.

The University of New England, a private university with a substantial endowment, is a client of Upside Consultants. Analyst Jermaine Grady of Upside is assigned to the relationship with the university’s endowment (UNEE). UNEE supports the goals and activities of the university principally by funding student financial aid. When the UNEE makes an award, it funds it fully and immediately, so that, while it endeavors to maintain a consistent level of spending from year to year, UNEE has no significant ongoing liabilities.

Grady has been assigned to the annual review of the UNEE investment policy statement. He notes several features of the IPS:

• The endowment is expected to operate in perpetuity.

• UNEE’s contributions to the university derive exclusively from investment returns; donor contributions are not to be spent.

• The return objective is to outperform the policy benchmark by an average of 1.0% per year, on a rolling 3-year basis.

• The policy benchmark consists of: 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index.

• The risk objective is to maintain expected tracking error of no more than 3.0% compared

to the policy benchmark.

• Approved investment asset classes include: US equities, US fixed income and absolute return strategies.

• Asset allocations are regularly reviewed and adjusted by the investment committee. • Portfolio managers for UNEE allocations have individual performance benchmarks and are selected and evaluated based on the Sharpe ratio of their results.

Grady also notes the following aspects of the investment environment:

• UNEE’s active equity managers have been outperforming their individual benchmarks. • UNEE’s fixed income managers have been performing in line with their benchmarks. • UNEE’s absolute return managers have been adding value modestly.

• The expected benchmark return is 10.40%, and the expected risk (standard deviation) is 5.80%.

• The expected risk-free rate is 1.40%.

• The market trend for equities has been for gradually rising P/E ratios.

• Investment-grade bond spreads in the US over the last 5 years are depicted in Exhibit 10-1.

Exhibit 10-1

55. Grady studies the way that managers are selected and evaluated according to the IPS. After consideration, his most likely conclusion is to:

A. suggest that manager selection and evaluation should be changed to focus on performance as measured by information ratios, rather than Sharpe ratios. B. suggest that manager selection and evaluation should be changed to focus on performance as measured by annualized returns, rather than Sharpe ratios. C. confirm that the current approach to manager selection and evaluation is appropriate.

56. Grady is most likely to consider the rise in equity P/E ratios to be caused by:

A. an increase in real interest rates. B. a decrease in the equity risk premium. C. an increase in expected inflation.

57. Grady is interested in determining a value of VaR for UNEE that is consistent with its risk and return objectives, given the current market expectations. Using the parametric approach, the estimated 5% one-week VaR is closest to:

A. 0.6% B. 1.3% C. 1.5%

58. Grady is concerned about possible indications of a recession. Based on the US fixed income spread data shown in Exhibit 1, his most likely conclusion is that:

A. fixed income spread trends are consistent with an expectation that a coming recession may be likely. B. fixed income spread trends are consistent with an expectation that a coming recession is not likely. C. fixed income spread trends are inconclusive as to whether a coming recession is likely or not.

59. One manager whom Grady is asked to evaluate uses a pairs trading strategy based on Eurozone stocks. In terms of a possible allocation of this manager for UNEE, the most appropriate asset class for this strategy is:

A. equity. B. absolute return. C. neither—this is not an approved asset class.

60. UNEE is large enough that it will be subject to the federal excise tax on endowment

investment income enacted into law in 2017, although it had never been subject to federal tax previously. The section of the Investment Policy Statement that will most likely be directly affected by this change is:

A. the risk objective. B. the return objective. C. neither the risk nor the return objective.

END OF AFTERNOON SESSION.

CFA Society Boston Level II

2018 Practice Exam

Answer Key

CFA®

is a licensed service mark owned by CFA Institute.

Addendums to this Exam: The CFA Society Boston Level II 2018 Practice Exam may be updated with an addendum to be provided at a later date only at www.cfaboston.org. Any addendum will be provided to CFA Society Boston Practice Exam purchasers free of charge. It is your sole responsibility to log onto the CFA Society Boston website to determine if any addendum has been posted, and CFA Society Boston will not send out any notification that an addendum has been posted. Any addendum is governed by the Terms and Conditions described herein.

LEVEL II MORNING SECTION – GUIDELINE ANSWERS

ITEM SET 1: ETHICAL AND PROFESSIONAL STANDARDS - Questions 1 through 6 1. B LOS: Study Session 1-2-a, b

This question relates to Standard V(B): Communication with Clients and Prospective Clients. Huff issued a research report stating that he expects the price of Steel Furniture Industries stock to rise by USD10 a share because the dividend will increase by USD2.00 per share. He has made this statement knowing that the dividend will increase only if the government enacts certain legislation, an uncertain prospect. By stating definitively and without qualification that the dividend will increase, Huff failed to separate fact from opinion. Reference: Reading 2, Guidance for Standards I–VII. 2. C LOS: Study Session 1-2-a, b

This question relates to Standard III(A): Loyalty, Prudence, and Care—specifically, a member's or candidate's responsibility for voting proxies and the use of client brokerage. According to the facts stated in the question, Huff did not violate Standard III(A). Although the company president asked Huff to vote the shares of the Bear Aid profit-sharing plan a certain way, Huff investigated the issue and decided, independently, on the best way to vote. Therefore, even though his decision conformed with the wishes of the company president, Huff is not in violation of his responsibility to be loyal and to provide care to his clients. In this case, the participants and the beneficiaries of the profit-sharing plan are the clients, not the company's management. In addition, because the brokerage firm provides the lowest commissions and best execution for securities transactions, Huff has met his obligations to the client in using this brokerage firm. It does not matter that the brokerage firm also provides research information that is not useful for the account generating the commission because Huff is not paying any more of the clients’ money for that information. Reference: Reading 2, Guidance for Standards I–VII. 3. A LOS: Study Session 1-2-a, b

Huff violated Standard I(D): Misconduct by failing to adhere to company policy and by hiding his personal transactions from his firm. Moreover, Chaudry violated Standard IV(C): Responsibilities of Supervisors. Although the company had requirements for regularly reporting personal trading, Chaudry failed to adequately enforce those requirements.

Reference: Reading 2, Guidance for Standards I–VII. A LOS: Study Session 1-2-a, b

The question relates to Standard III(A): Loyalty, Prudence, and Care. Caouette believes the broker offers effective execution at a fee that is comparable with those of other brokers; therefore, she is free to use the broker for all accounts.

Reference: Reading 2, Guidance for Standards I–VII. A LOS: Study Session 1-2-a, b

Standard I(B): Independence and Objectivity emphasizes the need for members and candidates to maintain their independence and objectivity. Best practices dictate that firms adopt a strict policy not to accept compensation for travel arrangements. Under some circumstances, however, accepting paid travel will not compromise one's independence and objectivity. 6.

Reference: Reading 2, Guidance for Standards I–VII. C LOS: Study Session 1-2-a, b

Huff has not provided any information about his clients to the leaders or managers of the inner-city charity; thus, he has not violated Standard III(E): Preservation of

Confidentiality. Providing contact information about his clients for a direct-mail solicitation would have been a violation.

Reference: Reading 2, Guidance for Standards I–VII.

ITEM SET 2: QUANTITATIVE METHODS—Questions 7 through 12 7. A LOS: Study Session 3-10-g

𝑀𝑀𝑀𝑀𝑀𝑀𝐹𝐹= 𝑀𝑀𝑀𝑀𝑀𝑀

Mean regression sum of squares: 14,285,410 Mean squared error: 1,569,417

Note: the mean squared error relates to the “Residual” row in the regression output Exhibit 2-5.

14,285,410𝐹𝐹= 1,569,417 = 9.1024 8.

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis, Section

2.3. B

LOS: Study Session 3-10-e

The formula for the confidence interval for a regression coefficient Product C is:

Which can be interpreted as:

Product C regression coefficient ± critical t-statistic * standard error of the Product C estimate.

Product C regression coefficient: 4.7906 [Exhibit 2-4] The standard error of the Product C regression coefficient: 1.7893 [Exhibit 2-4]

For the critical t-statistic, we need to select the right value from the t-statistic table in Exhibit 7:

Number of observations = 19 [Exhibit 2-3] Number of parameters estimated (3+1) = 4

(All the product coefficients A, B, C, plus the intercept) [Exhibit 2-4]

These values are crucial to determining the correct degrees of freedom.

Critical t-statistic at 95% confidence level is a two-tailed test; however, the table given in Exhibit 7 shows t-statistic values for one-tailed probabilities. Therefore, the column to choose is p = 0.025 (which, multiplied by two, equals the 0.05 significance level given).

The degrees of freedom is 15 (since the number of observations equals 19 and the

number of parameters estimated, including the intercept term, equals 4; the correct df row is 15 (19–4). Critical t-statistic: 2.131

df 3 4 14 15 19

The confidence interval is (rounded):

4.7906−(2.131)(1.7893) = 0.978 4.7906+(2.131)(1.7893) = 8.604

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis,

Sections 2–2.3. 9.

LOS: Study Session 3-10-c

The question asks for an evaluation of the hypothesis tests below:

Null H0: Product A = 0 Null H0: Product B = 0

Alternative Ha: Product A ≠ 0 Alternative Ha: Product B ≠ 0

Critical t-statistic at 95% confidence level is a two-tailed test. However, the table in Exhibit 7 shows t-statistic values for one-tailed probabilities. Therefore, the column to use is p = 0.025 (which, multiplied by two, equals the 0.05 significance level).

Number of observations = 19 [Exhibit 2-3] Number of parameters estimated (3+1) = 4

(All the product coefficients A, B, C, plus the intercept) [Exhibit 2-4]

The degrees of freedom column is the same as in the prior question. Since n equals 19 and the number of parameters estimated is 4, the correct df row is 15 (19–4). Critical t-statistic: 2.131

df 3 4

p = 0.10 1.638 1.533

p = 0.05 2.353 2.132

p = 0.025 3.182 2.776

p = 0.01 4.541 3.747

p = 0.005 5.841 4.604

p = 0.10 1.638 1.533 1.345 1.341 1.328

p = 0.05 2.353 2.132 1.761 1.753 1.729

p = 0.025 3.182 2.776 2.145 2.131 2.093

p = 0.01 4.541 3.747 2.624 2.602 2.539

p = 0.005 5.841 4.604 2.977 2.947 2.861

14 15 19

1.345 1.341 1.328 1.761 1.753 1.729 2.145 2.131 2.093 2.624 2.602 2.539 2.977 2.947 2.861

The t-statistics are already given for Product A and Product B in Exhibit 2-4:

Product A = 1.2408 Product B = 2.4841

Since the absolute value of the t-statistic for Product A |1.2408| is less than the critical t-statistic of 2.131, we cannot reject the null hypothesis that the Product A coefficient is zero.

Since the absolute value of the t-statistic for Product B |2.4841| is more than the critical t-statistic of 2.131, we can reject the null hypothesis that the Product B coefficient is zero in favor of the alternative hypothesis that the Product B coefficient is different than zero.

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis,

Sections 2–2.3.

10.

LOS: Study Session 3-10-l

Statement 3 is the only true statement regarding multicollinearity. Statement 1 is false; multicollinearity occurs when two or more independent variables are highly (but not perfectly) correlated with each other. Statement 2 is false; a classic symptom of

multicollinearity is a high R2 with significant F-statistic, even though the t-statistics on the estimated slope coefficients are not significant.

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis, Section

4.3.

11.

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis, Section

4.1.

12.

LOS: Study Session 3-10-e

Formula:

𝑌𝑌=𝑏𝑏0+𝑏𝑏1𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐴𝐴1+𝑏𝑏2𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐵𝐵1+𝑏𝑏3𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶1

The intercept bo and the coefficients of Products A, B and C are given in Exhibit 2-4: C

LOS: Study Session 3-10-k

“Generalized” is not a type of heteroskedasticity.

Intercept bo = 35,102.90 Product A b1 = 2.0660 Product B b2 = 4.1764 Product C b3 = 4.7906

The question asks for predicted values given the mean values of Product A and Product B and Product C, which are shown in Exhibit 2-2.

Product A mean value = 884.68 Product B mean value = 809.32 Product C mean value = 844.32

Y = 35,102.90 + 2.0660(884.68) + 4.1764(809.32) + 4.7906(844.32) = $44,355 (rounded)

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis, Section

ITEM SET 3: ECONOMICS—Questions 13 through 18

13. C LOS: Study Session 4-15-a

Independent regulators derive their authority from their recognition by a government body or agency. A key difference between government agencies and independent regulators is that the independent regulators are typically not funded through the

government. Self-regulating organizations are private, non-governmental organizations that both represent and regulate their members. Reference: Reading 15, Economics of Regulation, Section 2.1.

14. B LOS: Study Session 4-15-d

Regulators often have experience within the regulated industry, or aspire to work within the regulated entities. This interrelationship, combined with the significant industry knowledge and background of the regulated entities, may complicate the relationship between regulators and the entities they govern. These complications are referred to as regulatory capture. Reference: Reading 15, Economics of Regulation, Section 2.2.

15. B

LOS: Study Session 4-13-b

The bid-offer for the dealer CAD/EUR cross rate must first be calculated as:

11𝐵𝐵𝐵𝐵𝑃𝑃: 1.2637��=1.5594 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑃𝑃: 1.2639��=1.5598

0.81040.8103

The bid-offer for the interbank CAD/EUR cross rate was supplied as:

𝐵𝐵𝐵𝐵𝑃𝑃: 1.5588 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑃𝑃: 1.5592

The dealer cross rate bid is greater than the interbank cross rate offer, violating the

arbitrage constraint. A market participant may buy EUR at the interbank market offer and sell it at the dealer bid for a profit of 0.0002 CAD/EUR, calculated as:

1.5594−1.5592=0.0002

Reference: Reading 13, Currency Exchange Rates: Understanding Equilibrium Value,

Section 2.1.

16.

17.

LOS: Study Session 4-13-d

The client sold $15,000,000 USD forward against the euro at a forward rate of 0.8025 EUR/USD. To mark the position to market, the client would need to create a hypothetical offsetting forward transaction by buying $15,000,000 USD six months forward at the matching settlement date, so the USD amounts net to zero. For the offsetting transaction, the client will pay the offer for both the spot EUR/USD rate and the forward points for a forward rate of 0.8104-0.0107 = 0.7997.

At settlement, the client would receive EUR 12,037,500 from the initial contract:

𝑈𝑈𝑀𝑀𝑈𝑈 15,000,000 × 0.8025=𝑀𝑀𝑈𝑈𝑀𝑀 12,037,500

Against the offsetting cash outflow of EUR 11,995,500:

𝑈𝑈𝑀𝑀𝑈𝑈 15,000,000 × 0.7997=𝑀𝑀𝑈𝑈𝑀𝑀 11,995,500

For a net cash flow of +EUR 42,000:

12,037,500−11,995,500= 𝑀𝑀𝑈𝑈𝑀𝑀 42,000

This is a cash inflow because the client sold USD forward against the euro and the USD depreciated. This cash inflow will occur in six months and must be discounted back, using the six-month EUR Libor rate to reach the mark-to-market value:

42,000=𝑀𝑀𝑈𝑈𝑀𝑀 41,979 180�1 + 0.001�360��Reference: Reading 13, Currency Exchange Rates: Understanding Equilibrium Value,

Sections 2.2 & 2.3. C

LOS: Study Session 4-13-e

Covered interest parity is an international parity condition enforceable through riskless arbitrage between fully-hedged foreign and domestic currency money market instruments.

Reference: Reading 13, Currency Exchange Rates: Understanding Equilibrium Value,

Section 3.1. 18.

LOS: Study Session 4-13-k

According to the Mundell-Fleming model, under conditions of high capital mobility, the effect on the domestic currency of monetary and fiscal policies that are both expansionary, or both restrictive, is indeterminate.

Reference: Reading 13, Currency Exchange Rates: Understanding Equilibrium Value,

Section 6.1.

ITEM SET 4: FINANCIAL REPORTING AND ANALYSIS—Questions 19 through 24 19. C LOS: Study Session 5-16-a, c

As Taylor classifies its investment in CF plc as available for sale, Taylor would recognize a 15% share of the dividends paid by CF plc, to be included in its earnings before tax (EBT).

Total dividends by CF = ₤30 million Taylor’s share of CF dividends included in EBT = 15% × ₤30 million = ₤4.5 million.

Only Taylor’s share of the dividends paid by CF plc should be included in its EBT. Reference: Reading 16, Intercorporate Investments, Sections 2 & 3. 20. A LOS: Study Session 5-16-a, c

When an investment is classified as held for trading, it is reported at fair value with unrealized gains and losses included in income. In addition, the income statement includes dividends from a company classified as held for trading.

₤million

Decrease in value in the CF investment = 2.00

Share of dividends paid by CF = 4.50 15% × 30

Contribution to Taylor's EBT by CF = 2.50

Reference: Reading 16, Intercorporate Investments, Sections 2 & 3. 21. C LOS: Study Session 5-16-a, c

If Taylor is deemed to have significant influence over CF, it would use the equity method to record its investment in CF. Under the equity method, Taylor would add its share of CF’s net income to its own net income but dividends received are no longer part of its net income.

₤million Taylor's share of CF Net Income = 54.00 60% × 90

22.

Reference: Reading 16, Intercorporate Investments, Section 3.6. A

LOS: Study Session 5-16-a, c

Operating margin of Taylor (290/3,010) Operating margin of CF (180/2,100)

= =

9.63% 8.57%

As the operating margin of CF is lower than that of Taylor, the combined entity will have a lower operating margin. 23.

Reference: Reading 16, Intercorporate Investments, Section 3.6. C

LOS: Study Session 5-16-a, c

Investment in CN (available for sale, carried at market value) Investment in BP (held to maturity, carried at historical cost) Investment in TD (held for trading, carried at market value)

Available-for-sale and held-for-trading securities are both carried at market value, while held-to-maturity securities are carried at historical cost. 24.

Reference: Reading 16, Intercorporate Investments, Sections 3 & 4. B

LOS: Study Session 5-16-a, c

Unrealized gains and losses are included in income when securities are classified as held for trading. If the BP investment was reclassified as held for trading, instead of held to maturity, the CFO would be able to recognize an unrealized gain of ₤6 million.

In contrast, reclassifying CN as held for trading would result in an unrealized loss of ₤1 million in earnings and reclassifying TD as held to maturity would also decrease earnings from the non-recognition of the unrealized gain of ₤5 million.

Reference: Reading 16, Intercorporate Investments, Sections 3 & 4.

= = = =

₤million 32 45 60 137

ITEM SET 5: CORPORATE FINANCE—Questions 25 through 30 25. A LOS: Study Session 7-21-a

The net investment outlay is $14,200,000. The spreadsheet below shows the relevant calculations. 2012 2013-2016 2017 INVESTMENT CASH FLOWS

Cost of new equipment -$22,000,0000 Change in working capital $400,000 -$400,000 Sale of old equipment $8,000,000

Sale of new equipment $10,500,000 Tax on disposition of old

equipment

-$600,000

Tax credit on sale of new equipment $150,000

Investment cash flows -$14,200,000 $10,250,000

OPERATING CASH FLOWS Increase in revenues

Minus: change in expenses Minus: change in depreciation Change in taxable income Minus: change in taxes 30% Change in income after taxes Plus: change in depreciation Change in operating cash flows Net cash flows

Notes:

• Total cost of equipment = $20,000,000 new equipment + $2,000,000 modifications.

• The consultants’ fees of $300,000 are sunk cost, not incremental.

• Changes in depreciation = $2,200,000 – $1,200,000 = $1,000,000 per year. Note that the existing machine had a cost of $12 million and was depreciated using the straight-line method over 10 years with zero salvage value, and thus an annual depreciation allowance of $1.2 million. Similarly, the new machine will have annual depreciation of $2.2 million. This will give an incremental change in depreciation of $1 million per year.

• The book value of the existing equipment = $12,000,000 – $6,000,000

-$14,200,000

$4,000,000 $1,200,000 1,000,000 $1,800,000 $540,000 $1,260,000 $1,000,000 $2,260,000 $2,260,000

$4,000,000 $1,200,000 1,000,000 $1,800,000 $540,000 $1,260,000 $1,000,000 $2,260,000 $12,510,000

• • • •

26.

$6,000,000.

Tax on disposition of the existing equipment = 0.30(8,000,000 – 6,000,000) = $600,000.

- Change in Net Working Capital = $400,000

Book value of the new equipment in year 5 = $22,000,000 – $11,000,000 = $11,000,000.

Tax on disposition of the new equipment in year 5 = 0.30($10,500,000 – 11,000,000) = -$150,000 (tax credit).

Reference: Reading 21, Capital Budgeting, Sections 5 & 6. B

LOS: Study Session 7-21-a

The net cash flows for years 1–4 and year 5 are $2,260,000 and $12,510,000 respectively. The spreadsheet below shows the relevant calculations. 2012 2013-2016 2017 INVESTMENT CASH FLOWS

Cost of new equipment -$22,000,0000 Change in working capital $400,000 -$400,000 Sale of old equipment $8,000,000

Sale of new equipment $10,500,000 Tax on disposition of old

equipment

-$600,000

Tax credit on sale of new equipment $150,000

Investment cash flows -$14,200,000 $10,250,000

Increase in revenues

Minus: change in expenses Minus: change in depreciation Change in taxable income Minus: change in taxes

Change in income after taxes Plus: change in depreciation Change in operating cash flows Net cash flows

-$14,200,000

$4,000,000 $1,200,000 1,000,000 $1,800,000 $540,000 $1,260,000 $1,000,000 $2,260,000 $2,260,000

$4,000,000 $1,200,000 1,000,000 $1,800,000 $540,000 $1,260,000 $1,000,000 $2,260,000 $12,510,000

Notes:

• The consultants’ fees of $300,000 are sunk cost, not incremental.

• Changes in depreciation = $2,200,000 – $1,200,000 = $1,000,000 per year. • The book value of the existing equipment = $12,000,000 – $6,000,000 = $6,000,000.

• Tax on disposition of the existing equipment = 0.30(8,000,000 - 6,000,000) = $600,000.

• Change in net working capital = $400,000.

• Book value of the new equipment in year 5 = $22,000,000 – $11,000,000 = $11,000,000.

• Tax on disposition of the new equipment in year 5 = 0.30($10,500,000 – 11,000,000) = -$150,000 (tax credit).

27.

Reference: Reading 21, Capital Budgeting, Sections 5 & 6. A

LOS: Study Session 7-21-a

The IRR and NPV are 11.49% and -$237,080 respectively. 2,260,00012,510,000𝑁𝑁𝑃𝑃𝑁𝑁= −$14,200,000+ �+

(1.14)ⁿ(1.14)⁴

𝑛𝑛=14

28. 29.

NPV = -$237,080 IRR = 11.49%

Since the project's NPV is negative, the project should not be accepted. Also, the project's IRR is lower than the company's WACC, indicating that it is not a profitable project. Reference: Reading 21, Capital Budgeting, Sections 6 & 7. C

LOS: Study Session 8-26-i

Based on the constant growth model, the terminal value of Advanced Touch in three years is:

FCF3 = (1+.25)3 =1.9531

Terminal value in year 3 = FCF3 (1+g) = 1.9531(1.05) / (0.12 – 0.05) = $29.3 million. Reference: Reading 26, Mergers and Acquisitions, Section 7.1. C

LOS: Study Session 8-26-i

The value of Advanced Touch today = Total PV of FCF for the first three years + PV of the terminal value in year 3.

Estimated value of Advanced Touch = 1.25 / 1.12 + 1.5625 / (1.12)2 + 1.9531 / (1.12)3 + 29.3 / (1.12)3 = $24.60 million.

Estimated stock price = $24.60 million / 2 million shares = $12.30.

Reference: Reading 26, Mergers and Acquisitions, Section 7.1. 30. A

LOS: Study Session 8-26-h Both statements are correct.

Reference: Reading 26, Mergers and Acquisitions, Section 7.1.

ITEM SET 6: EQUITY VALUATION—Questions 31 through 36 31. C

LOS: Study Session 10-27-b

All firms exhibit going concern characteristics.

Reference: Reading 27, Equity Valuation: Applications and Processes, Section 2.1. 32.

LOS: Study Session 10-27-a

Intrinsic value is the value given to a hypothetically complete understanding of the asset’s investment characteristics.

Reference: Reading 27, Equity Valuation: Applications and Processes, Section 2.1. A

LOS: Study Session 10-27-f

Recognition of value in residual income models typically occurs earlier than in dividend discount models. Residual income models tend to assign a relatively small portion of a security’s total present value to the earnings that occur in later years.

Reference: Reading 27, Equity Valuation: Applications and Processes, Section 3.3. C

LOS: Study Session 10-27-c

Accelerating expenses through the income statement, or using conservative estimates and assumptions, such as shorter depreciable lives, are indicators of higher quality of earnings.

Reference: Reading 27, Equity Valuation: Applications and Processes, Section 3.1. A

LOS: Study Session 10-28-c

ri = RF + βimktRMRF+ βisizeSMB + βivalue HML

COGS Inc. = 2.15 + (0.82*1.25) + (-.150*1.15) + (-0.250*1.35) = 2.67 Tech Ventures = 2.15 + (0.95*1.25) + (-.200*2.35) + (-0.050*0.55) = 2.84 Octocog = 2.15 + (0.96*1.25) + (-.135*1.80) + (-0.125*1.05) = 2.98

Reference: Reading 28, Return Concepts, Section 4.2.

33.

34.

35.

36.

LOS: Study Session 10-28-g

Market value of equity $2,800,000 * $8.55 = $23,940,000 Market value of debt 52,000 * $990 = $51,480,000 Total market value of equity & debt 23,940,000 + 51,480,000 = $75,420,000 Weight of equity 23,940,000 / 75,420,000 = 31.7% Weight of debt 66,750,000 / 75,420,000 = 68.3%

Cost of Equity 1.25% + 0.82 × 6.25% = 6.375% (Rf

+ Adjusted Beta x Market Risk Premium)

Cost of Debt 10.55% × (1–35%) = 6.858% (YTM * (1- tax rate))

WACC = 31.7% × 6.375% + 68.3% × 6.858% =6.704% (Wt. of Eq. x Cost of Eq. + Wt. of Debt x Cost of Debt)

Reference: Reading 28, Return Concepts, Section 5.

ITEM SET 7: EQUITY VALUATION—Questions 37 through 42 37. B

LOS: Study Session 12-31-d

Reference: Reading 31, Free Cash Flow Valuation, Section 3.4. 38.

LOS: Study Session 12-32-e

Reference: Reading 32, Market-Based Valuation: Price and Enterprise Value Multiples,

Section 3.1. 39.

LOS: Study Session 12-31-a

Free cash flows can be used directly in a DCF framework to value the firm or to value equity. This is the main advantage of FCFF and FCFE relative to other cash-flow concepts. Free cash flows are computed from financial information that is not readily available. Moreover, forecasting future free cash flows is a rich and demanding exercise.

Reference: Reading 31, Free Cash Flow Valuation, Section 2.1. 40.

LOS: Study Session 11-32-n

Reference: Reading 32, Market-Based Valuation: Price and Enterprise Value Multiples,

Section 4.1. 41.

LOS: Study Session 11-32-n

EBITDA is frequently positive when EPS is negative. This is an advantage for using EV/EBITDA.

Reference: Reading 32, Market-Based Valuation: Price and Enterprise Value Multiples,

Section 4.1. A

LOS: Study Session 12-37-a

42.

Reference: Reading 37, Residual Income Valuation, Sections 3 & 3.1.

ITEM SET 8: FIXED INCOME—Questions 43 through 48 43. C

LOS: Study Session 12-35-j

Wynn is stating that she believes that the preferred habitat theory is the key theory. When institutions/investors are willing to take on additional risk for additional return, they are demonstrating the preferred habitat theory.

Statement 1 is a rationale for the segmented markets theory. Statement 2 is the main assumption of the unbiased expectations theory.

Reference: Reading 35, The Term Structure and Interest Rate Dynamics, Section 4.

44. B

LOS: Study Session 13-37-o

Value of convertible/callable/putable bond = Value of straight bond + value of call option on issuer’s stock – value of issuer call option + value of investor put option

106 = Value of straight bond + 4.50 – 2.75 + 0.50

Value of straight bond = 106 – 4.50 + 2.75 – 0.50 = 103.75

Reference: Reading 37, Valuation and Analysis: Bonds with Embedded Options,

Section 6.3.

45. C

LOS: Study Session 13-39-c

Single period probability of survival = 100% – hazard rate = 100% – 3% = 97%.

The conditional probability of survival in subsequent quarters is also 97% since the hazard rate is constant.

The probability of survival over each of the first two quarters is 97%. So the probability of survival for both periods is 97% * 97% = 94.1%.

So the probability of default is 100% – probability of survival = 100% – 94.1% = 5.9%.

Reference: Reading 39, Credit Default Swaps, Section 3.1.

46. B

LOS: Study Session 13-38-d, e, f

47.

48.

Two key assumptions of reduced form models are a stochastic risk-free rate of interest and that some of a company’s debt is tradable.

Structural models assume that modeling the company’s net assets is similar to a European call option that can be valued using Black-Scholes.

Reference: Reading 38, Credit Analysis Models, Sections 4 & 5. C

LOS: Study Session 12-36-c

In creating a binomial interest rate tree, volatility can be calculated in two ways: either using recent historical volatility data or by using implied volatility, observed via market prices of interest rate derivatives—interest rate swaps/swaptions, caps, floors, etc. CDS are credit derivatives and, therefore, are not good instruments to use to determine interest rate volatility.

In an upward sloping yield curve, spot rates will also be higher than par rates.

Reference: Reading 36, The Arbitrage-Free Valuation Framework, Sections 3.1 & 3.2.

LOS: Study Session 12-35-i

The TED spread is a measure of general credit risk in the market.

The 10-year swap spread is determined by supply and demand.

The LIBOR-OIS spread is a measure of risk and liquidity in money market securities.

Reference: Reading 35, The Term Structure and Interest Rate Dynamics, Section 3.5.

ITEM SET 9: DERIVATIVE INSTRUMENTS—Questions 49 through 54 49. B

LOS: Study Session 14-40-a, b

The notional amount NA = $10 million, and the 90-Day US Dollar LIBOR at expiration date, 30 days from now, is L30(90) = 1.523%. The discount factor D30(90) = L30(90) = 1.523% as stated. Also, h = 30, m = 90, FRA(0,h,m) = FRA(0,30,90) = 1.75%.

Hence, the settlement amount of the 1x4 FRA at h = 30, tm = 90/360 = 0.25 for receive-fixed is

NA*{[FRA(0,h,m) – Lh(m)]*tm}/[1+Dh(m)*tm]

= 10,000,000*{[0.0175 – 0.01523]*0.25}/(1+0.01523*0.25) = 5,675/1.0038 = 5,653.47 ≈ $5,650.

Reference: Reading 40, Pricing and Valuation of Forward Commitments, Section 3.4. 50. C

LOS: Study Session 14-40-a, b

Note that, based on F0(T) = $142, S0.75 = $169.50, r = 1.70%, and T – t = 0.25, the value of the existing forward contract entered at Time 0 valued at Time t will be

F0(T)0.25

Vt (T) = St – PVt,T(F0(T)) = St – (1+r = 169.50 – 142/(1.017) = 169.50 – 0.25)

141.40 = $28.10.

Reference: Reading 40, Pricing and Valuation of Forward Commitments, Sections 3.2

& 3.3.

51.

LOS: Study Session 14-40-c, d

Based on the given data in Exhibit 9-1, we construct the following table of the present value factors, fixed cash flows and the present value of the fixed cash flows. Maturity (years)Spot Rate0.51.50%1.51.80%2.51.95%3.52.05%4.52.15%TotalPV Factors0.9925560.9737100.9535590.9330530.911785Fixed Cash FlowPV(Fixed Cash Flow)750,000744,417750,000730,282750,000715,169750,000699,79020,750,00018,919,53521,809,194 The data in the first two columns were known. PV Factors = 1/[1 + {(Spot

Rate)*(Maturity)}]. Fixed Cash Flow = (Notional Amount $20,000,000)*(Fixed Swap Rate 3.75%). The last row in the Fixed Cash Flow column added back the Notional Amount $20,000,000. The last column PV(Fixed Cash Flow) = (PV Factors)*(Fixed Cash Flow).

The value of the equity leg of the swap is calculated as (2,630/2,430)*($20,000,000) = $21,646,090.

Therefore, the fair value of the equity swap, from the perspective of Miller (receive-fixed, pay-equity) is calculated as Vt = $21,809,194 – $21,646,090 = $163,104 ≈ $163,100.

The S&P 500 index level at which the swap’s fair value would be zero can be calculated by forcing the swap valuation formula equal to zero and solving for the price St*: [21,809,194/20,000,000 – (St*/St-1)] = 0.

Therefore, St* = 1.090460*2,430 = 2,649.82 ≈ 2,650.

Reference: Reading 40, Pricing and Valuation of Forward Commitments, Section 4.3. 52. B

LOS: Study Session 14-41-a, b

We are given the following information: S0 = X = 1,160, u = 1.2461, d = 0.8025, n = 2 years (and time steps), r = 1.70% (per period), volatility σ = 22%, and NZMA does not pay a dividend. (In fact, the up factor u and the down factor d can be calculated by using

1the formula u= eσ√∆t and d=u , where Δt = 2 years/2 periods = 1 year/period is the length of time leg in each move.) We can then calculate the probability of an up move π = [FV(1) – d]/(u – d) = [(1 + r) – d]/(u – d) = 0.4835. Two-Period Binomial American-Style Put OptionItemUnderlyingPutValue1801.140.00ItemUnderlyingPutHedge RatioValue1160106.48-0.41ItemUnderlyingPutHedge RatioValue1445.450.000.00ItemUnderlyingPutValue1160.000.00ItemValueUnderlying930.92Put209.69Hedge Ratio-1.00Without Early ExerciseItemUnderlyingPutValue747.08412.92 We calculate the underlying prices after up and down moves all the way to the last column, i.e., S+ = uS, S++ = u2S, S+- = udS, S- = dS, S-- = d2S ≈ 747; then we calculate the put prices in that column. Only the down-down leg has a non-zero value obtained by max(0, X-d2S) ≈ 413. Then we work backward to complete the middle column. Again, only the down leg has a non-zero put price, which is obtained by p- = 1/(1+r)*(1–π)*p-- = {[1/1.017]*(1–0.4835)}*413 ≈ 209.7. Finally, we calculate the present value of the put option:

p = [1/(1+r)]*(1–π)*p- ≈ 106.50.

Now, at Time step 1, the middle column, if we early exercise the put option, we would have a put value of 1160 – 930.90 = 229.10, which is higher than the value of the non-exercise case. So if we use this exercised value to recalculate the Time step 0 put price, we would have p = 1/(1+r)*(1–π)*(X-S-) ≈ 116.35.

Thus, there is an early exercise premium of 116.35 – 106.50 = $9.85 at Time 0 when a down move occurs. Two-Period Binomial American-Style Put Option with Early ExerciseItemUnderlyingPutValue1801.140.00ItemUnderlyingPutHedge RatioValue1160116.33-0.45ItemUnderlyingPutHedge RatioValue1445.450.000.00ItemUnderlyingPutValue1160.000.00ItemValueUnderlying930.92Put229.08Hedge Ratio-1.00With Early ExerciseItemUnderlyingPutValue747.08412.92

Reference: Reading 41, Valuation of Contingent Claims, Section 3.2. 53. C

LOS: Study Session 14-41-a, b, e, f, g, h, k

It is not optimal to early-exercise the no-dividend-paying stocks’ call options. This can be considered from the arbitrageur’s two fundamental rules: Rule 1 Do not use your own money. You must obtain a loan in order to exercise the options. Thus you must pay interest for the loan, which will reduce your profit, if there is any. Rule 2 Do not take any price risk. If you early-exercise the call option, you give up the implicit insurance property of the call, since you now own the stock. If the stock’s price subsequently drops below the exercise price, you have a loss.

If you hold the call option until the expiration date, you don’t need to borrow; therefore, there is no need to pay interest on a loan. Further, if the stock’s price declines, you do not exercise the option and all you lose is the option premium paid.

Reference: Reading 41, Valuation of Contingent Claims, Section 3.2.

54.

LOS: Study Session 14-42-b, c, d, e, f

We have the following data: S0 = X = $1,160, c0 = $160.

The profit/loss from writing a covered call is

PL = [ST – max(ST – X, 0)] – [S0 – c0]

S−ST+X−S0+c0=X−S0+c0=c0=160 for ST≥ X = �T ST −S0+c0= ST −X+c0Therefore, at option expiration, the maximum profit of this at-the-money covered call is PLmax = $160.

Reference: Reading 42, Derivatives Strategies, Section 4.1.

ITEM SET 10: PORTFOLIO MANAGEMENT—Questions 55 through 60 55. B

LOS: Study Session 17-51-a

The value added due to asset allocation is:

𝑀𝑀𝐴𝐴,𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴=𝛥𝛥𝑤𝑤𝑆𝑆&𝑃𝑃500𝑀𝑀𝑆𝑆&𝑃𝑃500+𝛥𝛥𝑤𝑤𝑅𝑅2000𝑀𝑀𝑅𝑅2000=(.4+.4−.9)11.41+(.2−.1)9.96 =−1.141+0.996=−0.15%.

The value added due to security selection is:

𝑀𝑀𝐴𝐴,𝑆𝑆𝑆𝑆𝐴𝐴𝑆𝑆𝐴𝐴𝑛𝑛=𝑤𝑤𝐿𝐿𝑆𝑆𝐿𝐿𝑅𝑅𝐿𝐿(𝑀𝑀𝐿𝐿𝑆𝑆𝐿𝐿𝑅𝑅𝐿𝐿−𝑀𝑀𝑆𝑆&𝑃𝑃500)+𝑤𝑤𝑅𝑅𝑅𝑅𝐿𝐿𝑅𝑅𝐿𝐿(𝑀𝑀𝑅𝑅𝑅𝑅𝐿𝐿𝑅𝑅𝐿𝐿−𝑀𝑀𝑆𝑆&𝑃𝑃500)+𝑤𝑤𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐿𝐿(𝑀𝑀𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐽𝐿𝐿

−𝑀𝑀𝑅𝑅2000)

=.4(15.60−11.41)+.4(13.37−11.41)+.2(13.46−9.96)=3.16%.

Reference: Reading 51, Analysis of Active Portfolio Management, Section 2.3. 56. C

LOS: Study Session 17-51-b

The information ratio (IR) is the ratio of the active return to the active risk: 𝐼𝐼𝑀𝑀=𝑀𝑀𝐴𝐴/𝑀𝑀𝑆𝑆𝑈𝑈(𝑀𝑀𝐴𝐴).

For each of the funds we have: LSGRX: IR = (15.60–11.41)/5.37 = .780 RDLFX: IR = (13.37–11.41)/3.92 = .500 JCCIX: IR = (13.46–9.96)/3.74 = .936

Reference: Reading 51, Analysis of Active Portfolio Management, Section 3.2. 57. C

LOS: Study Session 17-51-d

The optimal tracking error TE* is given by:

𝑆𝑆𝑀𝑀∗=(𝐼𝐼𝑀𝑀⁄𝑀𝑀𝑀𝑀𝐵𝐵)𝑀𝑀𝑆𝑆𝑈𝑈(𝑀𝑀𝐵𝐵)=.936/.67(14.11%)=19.71%, rounded to 20.0%.

Reference: Reading 51, Analysis of Active Portfolio Management, Sections 3.3 & 4.2. 58. B

LOS: Study Session 16-48-f

For the active factor sensitivities we have: RMRF: 𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀=1.01−(1.00)=.01 SMB: 𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀=−.01−(−.02)=.01 HML: 𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀=−.28−(.00)=−.28 WML: 𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀=−.01−(.02)=−.03

The resulting contribution to active return for each factor is the product of the active exposure times the factor risk premium (rounded):

RMRF: (𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀)(𝑀𝑀𝑀𝑀𝑀𝑀𝐹𝐹)=(.01)(10.74%)=.11% SMB: (𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀)(𝑀𝑀𝑀𝑀𝐵𝐵)=(.01)(.49%)=.00%

(𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀)(𝐻𝐻𝑀𝑀𝐻𝐻)=(−.28)(−1.88%)=.53% HML:

WML: (𝛽𝛽𝑃𝑃−𝛽𝛽𝑀𝑀)(𝑊𝑊𝑀𝑀𝐻𝐻)=(−.03)(3.66%)=−.11%

Reference: Reading 48, An Introduction to Multifactor Models, Section 5.1. 59.

LOS: Study Session 17-51-c

From the Fundamental Law 𝐼𝐼𝑀𝑀=(𝑆𝑆𝐶𝐶)(𝐼𝐼𝐶𝐶)√𝐵𝐵𝑀𝑀, and using the number of holdings N for the breadth BR, we can get the IC:

𝐽𝐽𝑅𝑅.500𝐼𝐼𝐶𝐶=𝑇𝑇𝐽𝐽𝑁𝑁=(.847)77=.067.

√

Reference: Reading 51, Analysis of Active Portfolio Management, Sections 3.3 & 4.2. 60.

LOS: Study Session 16-48-c

For the portfolio, we have:

𝑀𝑀(𝑀𝑀)=𝑀𝑀𝑅𝑅+𝛽𝛽1(𝑀𝑀𝑀𝑀𝑀𝑀𝐹𝐹)+𝛽𝛽2(𝑀𝑀𝑀𝑀𝐵𝐵)+𝛽𝛽3(𝐻𝐻𝑀𝑀𝐻𝐻)+𝛽𝛽4(𝑊𝑊𝑀𝑀𝐻𝐻).

Using the data given:

𝑀𝑀(𝑀𝑀)=1.40%+1.01(10.74%)−.01(.49%)−.28(−1.88%)−.01(3.66%) = 12.73%, rounded to 13.0%.

Reference: Reading 48, An Introduction to Multifactor Models, Section 3.

LEVEL II AFTERNOON SECTION – GUIDELINE ANSWERS

ITEM SET 1: ETHICAL AND PROFESSIONAL STANDARDS - Questions 1 through 6 1. B LOS: Study Session 1-2-a, b

Standard III: Duties to Clients, (D) Performance Presentation.

Standard III(D) requires members and candidates to provide credible performance information to clients and prospective clients and to avoid misstating performance or misleading clients and prospective clients about the investment performance of members or candidates or their firms. This standard encourages full disclosure of investment performance data to clients and prospective clients.

The requirements for this standard are not limited to members and candidates. Any time a member or candidate provides performance information for which the manager is

claiming responsibility, such as for pooled funds, the history must be accurate. Research analysts promoting the success or accuracy of their recommendations must ensure that their claims are fair, accurate, and complete.

If the presentation is brief, the member or candidate must make available to clients and prospects, upon request, the detailed information supporting that communication.

Jean’s desire to report only the most favorable returns and to ignore the complete investment performance of White Crest would not present a full and fair disclosure of investment performance. Reference: Reading 2, Guidance for Standards I–VII. 2. C LOS: Study Session 1-2-a, b

Standard III: Duties to Clients, (D) Performance Presentation.

Standard III(D) requires members and candidates to provide credible performance information to clients and prospective clients, and to avoid misstating performance or misleading clients and prospective clients about the investment performance of members or candidates, or their firms. This standard encourages full disclosure of investment performance data to clients and prospective clients.

Paul is in compliance with this standard by providing the fund’s performance since its inception. Reference: Reading 2, Guidance for Standards I–VII.

LOS: Study Session 1-2-a, b

Paul violated Standard III(D) by failing to clearly identify simulated performance results. Standard III(D) prohibits members and candidates from making any statements that

misrepresent the performance achieved by them or their firms and requires members and candidates to make every reasonable effort to ensure that performance information

presented to clients is fair, accurate, and complete. Use of the simulated results should be accompanied by full disclosure as to the source of the performance data. Paul did not disclose to Blain that the investment performance he discussed was simulated.

Reference: Reading 2, Guidance for Standards I–VII. C

LOS: Study Session 1-2-a, b

Except with the consent of their employer, which Paul did not obtain prior to his dinner with Blain, employees may not take employer property, which includes books, records, reports, and other materials, and may not interfere with their employer’s business opportunities. Taking any employer records, even those the member or candidate prepared, violates Standard IV(A).

Reference: Reading 2, Guidance for Standards I–VII. C

LOS: Study Session 1-2-a, b

Use of the performance data provided by Paul to Blain would violate Standard III(D) by failing to clearly identify simulated performance results. Standard III(D) prohibits

members and candidates from making any statements that misrepresent the performance achieved by them or their firms and requires members and candidates to make every reasonable effort to ensure that performance information presented to clients is fair, accurate, and complete. Use of the simulated results should be accompanied by full disclosure as to the source of the performance data.

Reference: Reading 2, Guidance for Standards I–VII. C

LOS: Study Session 1-2-a, b

Standard IV: Duties to Employers, (B) Additional Compensation Arrangements Standard IV(B) requires members and candidates to obtain permission from their

employer before accepting compensation or other benefits from third parties for services rendered to the employer, or for any services that might create a conflict of interest with their employer’s interest. Compensation and benefits include direct compensation by the client and any indirect compensation or other benefits received from third parties.

“Written consent” includes any form of communication that can be documented (for example, communication via e-mail that can be retrieved and documented).

Reference: Reading 2, Guidance for Standards I–VII.

ITEM SET 2: QUANTITATIVE METHODS—Questions 7 through 12 7. C LOS: Study Session 3-11-e

Number of observations = 62 [Exhibit 2-1] Number of parameters estimated (1+1) = 2 (The intercept and lag 1) [Exhibit 2-2]

Use the 60 degrees of freedom row (62 observations minus 2 parameters) and use the critical value of 2.00.

The t-distribution table in Exhibit 4

t.95

Degrees of Freedom t.995 t.99 t.90 1 127.3 63.66 12.71 6.31 2 14.10 9.93 4.30 2.92 60 2.92 2.67 2.00 1.67

Since none of the first 4 autocorrelations in Exhibit 3 has a t-statistic with an absolute value greater than the critical value of 2.00 at the 0.05 significance level, he can conclude:

1. There is no serial correlation at this level, and 2. t-statistics are not significant. 8.

Reference: Reading 11, Time-Series Analysis, Section 4.3. B

LOS: Study Session 3-11-a

Kim is using an AR(1) model with a 1 month lag.

𝑏𝑏0 = 0.0843 Intercept coefficient [Exhibit 2] 𝑏𝑏1 = 0.8656 Lag 1 coefficient [Exhibit 2] 𝑥𝑥𝑡𝑡−1 = $82 Given

xt = 0.0843 + 0.8656($82) = $71 (rounded)

Reference: Reading 11, Time-Series Analysis, Section 4.

LOS: Study Session 3-11-l

One of the goals of implementing lags is to improve the R2 of a regression. The other two choices are not goals of implementing seasonal lags. 10.

Reference: Reading 11, Time-Series Analysis, Section 7. B

LOS: Study Session 3-10-k

The test for conditional heteroskedasticity is distributed chi-squared (χ2 ) under the null hypothesis of no conditional heteroskedasticity.

The degrees of freedom used to find the critical value in the chi-squared distribution for this test is equal to the number of independent variables in the regression, not counting the intercept.

The degrees of freedom to use is 1 (the lag 1 independent variable) [Exhibit 2-6]

Exhibit 7 χ2 distribution:

χ 2.99 2

Degrees of Freedom χ.995 χ 2.975 χ 2.95 χ 2.90 1 7.88 6.63 5.02 3.84 2.71 2

10.60

9.21

7.38

5.99

4.61

The critical value is 6.63 in Exhibit 2-7. Since the t-statistic for the lagged variable is 7.3014 in Exhibit 2-6, exceeding the critical value of 6.63, he can reject the null hypothesis of no conditional heteroskedasticity.

Reference: Reading 10, Multiple Regression and Issues in Regression Analysis, Section

4.1.

11.

LOS: Study Session 3-11-m

Statement C is the only true statement regarding autoregressive conditional

heteroskedasticity (ARCH). If the variance of the errors is statistically significant, the test statistics in Exhibit 2-2 are not valid.

12.

Reference: Reading 11, Time-Series Analysis, Section 9. C

LOS: Study Session 3-11-j

Answer C is the only answer that describes a time series with a unit root. Reference: Reading 11, Time-Series Analysis, Section 5.2.

ITEM SET 3: FINANCIAL REPORTING AND ANALYSIS—Questions 13 through 18 13. B LOS: Study Session 5-17-a, b, c

Interest cost on the beginning net

Net interest expense = pension obligation Discount rate = 6%

6% × 4,892 =

Net interest expense = 294

Reference: Reading 17, Employee Compensation: Post-Employment and Share-Based,

Section 2.

14. C LOS: Study Session 5-17-a, b, c, d

Remeasurement

Actual return on plan assets Beginning plan assets × discount rate

Net return on plan assets Actuarial losses Remeasurement

Reference: Reading 17, Employee Compensation: Post-Employment and Share-Based,

Section 2. 15.

LOS: Study Session 5-17-b, c, d

Pension benefits paid is calculated using the beginning obligation, interest costs, service costs, actuarial gains or losses, and ending obligation.

Reference: Reading 17, Employee Compensation: Post-Employment and Share-Based, Section 2.

= = = = = = =

Net return on plan assets +/-Actuarial gains/losses

1,932

6% × 31508

1,890.5 41.52

(86.0) (44.5)

16.

LOS: Study Session 5-17-d, e, f

Under IFRS, the components of periodic pension cost that would be reported in the income statement are the service cost and the net interest expense or income.

Service cost Net interest expense Discount rate

Net interest expense

Periodic pension cost in the income statement under IFRS

Reference: Reading 17, Employee Compensation: Post-Employment and Share-Based, Section 2. 17.

LOS: Study Session 5-17-e, f

Under US GAAP, the calculation of remeasurement involves the net return but is

calculated using the expected return on plan assets (as opposed to the discount rate used in IFRS).

Remeasurement

Actual return on plan assets

Beginning plan assets × expected return

Net return on plan assets Actuarial losses

Remeasurement - US GAAP

= = = = = =

Net return on plan assets +/-Actuarial gains/losses

1,932 7% × 31508

2,205.6 (273.6)

(86.0) (359.6)

= = = = = =

298

Interest cost on the beginning net

pension obligation

6% × 4,892

294 592

Reference: Reading 17, Employee Compensation: Post-Employment and Share-Based, Section 2.2.

18.

LOS: Study Session 5-17-e, f

An increase in the rate of employee compensation would increase plan obligations in the balance sheet and increase the service cost element in the periodic cost.

Reference: Reading 17, Employee Compensation: Post-Employment and Share-Based, Section 2.3.

ITEM SET 4: FINANCIAL REPORTING AND ANALYSIS—Questions 19 through 24 19. B LOS: Study Session 5-18-a, d, e

Since USD is the functional currency, the temporal method is used to translate subsidiary accounts. Exchange rates, however, differ depending on the line item. Financial assets and liabilities are translated using current rates, and non-monetary assets are translated at historical rates. Because Ferts uses FIFO, ending inventory consists of the newest items and is translated at an average rate.

Inventory (translated at current rate of 1.28) 117 × 1.28 149.8 Long-term debt (translated at current rate of 1.28) 195 × 1.28 249.60

Reference: Reading 18, Multinational Operations, Sections 2.1 & 3.2. 20. B LOS: Study Session 5-18-a, d

GBP USD

million Rate million

Cash 155 1.28 198.4

Accounts receivable 168 1.28 215.04

Inventory 117 1.28 149.8

Net fixed assets 160 1.32 211.20 Total assets 600 774.4

Accounts payable 142 1.28 181.8

Long-term debt 195 1.28 249.6

Common stock 172 1.32 227.0 Retained earnings 91 Balance 116.0 Total liabilities and shareholders' equity GBP 600 USD774.4

Reference: Reading 18, Multinational Operations, Section 2.1. 21. A LOS: Study Session 5-18-e, f

If Ferts is a self-contained, independent entity, the current rate method should be used. Under that method, all assets are translated at the current rate (year-end rate).

Cash

Accounts Receivable Inventory Net fixed assets Total assets

22.

GBP million 155 168 117 160 GBP 600

USD Rate million 1.28 198.40

1.28 215.04

1.28 149.76

1.28 204.80

USD768.00

Reference: Reading 18, Multinational Operations, Section 2.1. A

LOS: Study Session 5-18-e, f

If the current rate method is used, MOS’ balance sheet exposure would be the net assets of Ferts plc.

GBP million

Total assets 600 Accounts payable -142 Long-term debt -195 Or (common stock + retained earnings) 263

23.

Reference: Reading 18, Multinational Operations, Section 2.1. B

LOS: Study Session 5-18-f, g Temporal Method, Net Monetary Liability Exposure

Lower net income

Lower shareholder equity

Temporal Method, Net Monetary Asset Exposure

Higher net income Higher shareholder equity

Current Rate Method Higher net income Higher shareholder equity

Reference: Reading 18, Multinational Operations, Section 3.3 & 3.4.

24.

LOS: Study Session 5-18-j

Only US GAAP requires a disclosure of the amount of translation adjustment transferred from stock holders’ equity.

Both choice A and choice B are required under US GAAP and IFRS.

Reference: Reading 18, Multinational Operations, Section 3.6.

ITEM SET 5: CORPORATE FINANCE –Questions 25 through 30 25. A LOS: Study Session 7-22-a, c

According to pecking order theory, internally generated funds are preferable to both new debt and equity. If internal financing is insufficient, managers prefer debt, then equity. This is due to the asymmetric information that exists between managers and investors. Managers choose methods with the least amount of potential information content. As for statement 2, as financial leverage rises, rating agencies tend to lower bond ratings, resulting in increased credit risk and higher costs of debt.

Reference: Reading 22, Capital Structure, Section 2.6. 26. C

LOS: Study Session 7-23-a, e

Statement 3 follows the argument that a given amount of dividends is less risky than the same amount of capital gains, and thus a company that pays dividends will have a lower cost of capital than a similar company that does not pay dividends. The bird-in-the-hand theory states that a firm's value will be maximized by setting a high dividend payout. Research shows that there are significant differences in the capital structures across developed countries as well as between developed and emerging markets.

Reference: Reading 23, Dividends and Share Repurchase: Analysis, Section 3.2. 27. B

LOS: Study Session 7-23-f

Corporate tax on a $1 earning is $1×0.4=0.4, and personal tax = 0.3×$0.50=0.15, so the total tax = 0.40 + 0.15 = 0.55 or a 55% effective tax rate.

Reference: Reading 23, Dividends and Share Repurchase: Analysis, Section 4.4. 28. B LOS: Study Session 7-23-b

Capital budget $100 million % from equity 50% Amount of equity required $50 million

Earnings $80 million Amount of equity required $50 million Dividend $30 million

Dividend payout next year = $30/$80 = 0.375. 29.

Dividend coverage ratio = 1/dividend payout ratio. For TaxAdvisors,

1𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑐𝑐𝑐𝑐𝐷𝐷𝐷𝐷𝑐𝑐𝑐𝑐𝑐𝑐𝐷𝐷 𝑐𝑐𝑐𝑐𝑟𝑟𝐷𝐷𝑐𝑐= 0.5=2.0. In general, higher dividend payout ratios (or lower dividend coverage ratios) constitute a risk factor for dividends being cut if earnings decline.

Reference: Reading 23, Dividends and Share Repurchase: Analysis, Section 8. 30.

Lack of growth opportunities typically mean high payout ratios for companies,

distributing funds to shareholders rather than retaining them and reinvesting them back into the companies.

Reference: Reading 23, Dividends and Share Repurchase: Analysis, Section 8.

LOS: Study Session 7-23-n

Reference: Reading 23, Dividends and Share Repurchase: Analysis, Section 5.3. B

LOS: Study Session 7-23-m

ITEM SET 6: EQUITY VALUATION—Questions 31 through 36 31. C

LOS: Study Session 10-30-b

DPS1 = ((1.2945 * 1.125) / (1.098)1 DPS2 = ((1.2945 * 1.1252) / (1.098)2

DPS3 = (1.2945 * 1.1252 * 1.10) / (1.098)3 DPS4 = (1.2945 * 1.1252 * 1.102) / (1.098)4

TV = [1.2945 * 1.1252 * 1.102 * 1.05 / (0.098 – 0.05)] / (1.098)4 ∑ = $35.2460

Three stage DDM result of $35.25 is 7.8% less than the current stock price of $38.00 = overvalued.

Reference: Reading 30, Discounted Dividend Valuation, Section 2.4. B

LOS: Study Session 11-31-d

32.

Reference: Reading 31, Free Cash Flow Valuation, Section 3.4. 33.

LOS: Study Session 10-30-j

The firm is fully in line with the definition of a firm in the transition phase: continued above average growth falling in the near term to average growth as competition pressures prices and profit margins.

Reference: Reading 30, Discounted Dividend Valuation, Section 5.

LOS: Study Session 11-31-a

FCFF is the model best applied in cases where a levered company has negative FCFE and for one in which the required rate of return is more sensitive to changes in financial leverage than changes in WACC (i.e., the use of a constant discount rate is difficult to

34.

justify). Additionally, an FCFF model is best applied to a levered company with a changing capital structure.

Reference: Reading 31, Free Cash Flow Valuation, Section 2.1.

35.

LOS: Study Session 11-31-d

Reference: Reading 31, Free Cash Flow Valuation, Section 3.2.

36.

LOS: Study Session 11-31-c

Under US GAAP, interest expense paid to providers of debt capital must be classified as part of cash flow from operations (as is interest income). The payment of dividends to providers of equity capital, however, is classified as a financing activity.

Reference: Reading 31, Free Cash Flow Valuation, Section 3.2.

ITEM SET 7: FIXED INCOME—Questions 37 through 42 37. B

LOS: Study Session 13-37-f

In year 3, the final values are all $100 par + $4.25 coupon.

Year 2:

Vuu = 104.25/1.05526 = 98.7908 (put – goes to 99.25) Vud = 104.25/1.04524 = 99.7379

Vdd = 104.25/1.03704 = 100.527 (called – goes to 100.25)

Year 1:

Vu = [ (99.25 + 4.25)/2 + (99.7379 + 4.25)/2] / 1.0387 = 99.8786

Vd = [ (100.25 + 4.25)/2 + (99.7379 + 4.25)/2] / 1.03168 = 101.0429 (called – goes to 100)

Year 0:

V0 = [ (99.8786 + 4.25)/2 + (100 + 4.25)/2] / 1.025 = 101.65

Reference: Reading 37, Valuation and Analysis: Bonds with Embedded Options,

Section 3.5.

38. A

LOS: Study Session 13-37-o

Premium over straight value = (Convertible bond price / straight value – 1)

Rearranging: Convertible bond price = (Premium over straight value + 1) * straight value

Convertible bond price = (1.98% + 1) * 101 Convertible price ≈ 103

Value of Convertible Bond = Value of Straight Bond + value of call option on issuer’s stock

103 = 101 + value of call option

Value of call option on issuer’s stock = 2

Reference: Reading 37, Valuation and Analysis: Bonds with Embedded Options,

Sections 6.2 & 6.3.

39. C

LOS: Study Session 12-35-l, 13-37-k

The sum of partial or key rate durations equals effective duration. Effective duration will equal modified duration when there is no optionality. Without any specific values, it

40.

41.

42.

cannot be determined which bond is over- or under-valued, nor which is more sensitive to changes in interest rates.

Reference: Reading 35, The Term Structure and Interest Rate Dynamics, Section 6.4;

Reading 37, Valuation and Analysis: Bonds with Embedded Options, Section 4.1.

LOS: Study Session 13-39-c

The simplest way to hedge credit risk is a through buying a single-name CDS in the notional amount that covers the notional value.

Standard CDS indexes are equally weighted, so a long position of $500 million in a CDS index is 500/125 = $4 million per component, which leaves $1 million unhedged.

Shorting a CDS is selling protection. Despite receiving an upfront payment, the existing risk will still be unhedged.

Reference: Reading 39, Credit Default Swaps, Section 2. C

LOS: Study Session 12-36-h

During a Monte Carlo simulation, mean reversion is done during the rate generation

process. Bounds are established on the random process that generates the interest rates. It is not done on the cash flow inputs, so this is not an appropriate adjustment.

Drift adjustment is done on the rate paths, so this is an appropriate adjustment.

Reference: Reading 36, The Arbitrage-Free Valuation Framework, Section 4. A

LOS: Study Session 13-38-i

Securitized bonds do not go into default when interest payments are missed. Since the payments are drawn from a pool of many assets, losses will not necessarily be passed to all holders. Receiving payment despite other parties incurring losses is likely due to being a more senior bondholder and receiving priority in the waterfall.

Special purpose entities (or vehicles) are the legal bodies that issue securitized bonds. Ratings are not a guarantee of soundness, and do not have any bearing on being paid in the event of a loss.

Reference: Reading 38, Credit Analysis Models, Section 7.

ITEM SET 8: DERIVATIVE INSTRUMENTS—Questions 43 through 48 43. B

LOS: Study Session 14-40-a, b

We have the spot index level S0 = 2,630, the annual compounded interest rate r = 1.70%, the three months remaining time Δt = 0.25 and the continuously compounded dividend yield γ = 1.9%.

We convert the annual compounding interest rate to the continuously compounded interest rate: rc = ln(1+r) = ln(1.0170) = 1.6857%.

The no-arbitrage futures price of the S&P 500 index futures contract will be

F0(T) = S0*e(rc-γ)*Δt = 2,630 * e(0.016857-0.019)*0.25 = 2,630 * 0.999464 = 2,628.59 ≈ 2,629.

Reference: Reading 40, Pricing and Valuation of Forward Commitments, Sections 3.2

& 3.3. 44.

LOS: Study Session 14-40-c, d

We first find the present value (PV) factors and solve for the fixed swap rates. The

1present value expression based on spot rates is PV0,ti(1)= 1+r, where rSpotiand NADi denote the spot interest rate and the number of accrued days during the payment period ti, and NTD = 360 is the total number of days during the year. Spot rates cover the entire period from 0 to ti.

Based on the data given, we construct the following present value data table. The calculations are shown to the sixth decimal place to minimize rounding error. Days to Maturity90180270360British Pound (£) Present Value US$ Spot Present Value (£ 1)Interest Rates(US$1)Spot Interest Rates0.520%0.9987021.52%0.9962140.585%0.9970841.70%0.9915720.678%0.9949411.85%0.9863150.770%0.9923592.00%0.980392Sum:3.983085Sum:3.954493 Spoti�

NADi�NTD We find the swap fixed rate for the British pound:

1− PV0,t4,GBP(1)1−0.992359rFIX,GBP= 4= =0.00191836 or 0.191836%

∑i=1PV0,ti,GBP(1)3.983085

and for the US dollar:

At the spot exchange rate of $1.35/£, we find the notional amount of British pound for $100 million to be $100 million/($1.35/£) = £74,074,074.07.

The fixed quarterly swap payments for each currency equal the periodic swap rate times the appropriate notional amount.

FS£ = £74,074,074.07 * 0.191836% = £142,100

FSUS$ = $100,000,000 * 0.495841% = $495,841.

Reference: Reading 40, Pricing and Valuation of Forward Commitments, Sections 4.1

& 4.2. 45.

46.

LOS: Study Session 14-42-f, g, h

A protective put strategy consists of a long put option and ownership of the underlying asset. Use the put-call parity relationship equation: p + S = c + X*e-rT.

The left side of the equation represents the protective put strategy. The right side of the equation is a long call while investing in (i.e., lending) a bond that matures on the

expiration date of the options with a notional amount of X. Based on this parity equation, a protective put strategy is equivalent to a long call and owning a bond.

Reference: Reading 42, Derivatives Strategies, Sections 4.1 & 4.3. 47.

LOS: Study Session 14-41-a, b

We are given the following information: S = X = $200, r = 1.7%, volatility σ = 40%, T = 2 years, u = 1.5, d = 0.667.

LOS: Study Session 14-41-f, g, h

According to BSM, the call price is modeled as c=S∙e−δT∙N(d1)−X∙e−rcT∙N(d2), in which δ is the dividend yield. Not only will the index price component S∙e−δT∙N(d1) change explicitly through the factor e−δT, but the strike price component X∙e−rcT∙N(d2) will also change implicitly through N(d1) and N(d2), where d1 and d2 are both functions of the dividend yield δ.

Reference: Reading 41, Valuation of Contingent Claims, Sections 4.1 & 4.3.

rFIX,USD

The probability of an up move is:

π = [FV(1) – d]/(u – d) = [(1 + r) – d]/(u – d) = (1.017–0.667)/(1.5–0.667) = 0.420

S+ = uS = 1.5*200 = 300, S++ = u2S = 1.52*200 = 450, S+- = S-+ = duS = 200, S- = dS = 0.667*200 = 133.4, S-- = d2S = 0.6672*200 ≈ 89. C++ = max(0, S++ – X) = 450 – 200 = 250

c+- = c-+ = max(0, S+- – X) = max(0, 200 – 200) = 0 c-- = max(0, S-- – X) = max(0, 89 – 200) = 0

Therefore,

c = PV(π2 c++ + 2π (1 – π) c+- + (1 – π)2 c--) = PV(π2 c++) = π2 c++ / (1+r)2 = 0.422 * 250/1.0172 = $42.7 ≈ $43.

Reference: Reading 41, Valuation of Contingent Claims, Section 3.2. 48.

LOS: Study Session 14-42-g, h, i, j

The strategy that Flint executed is a straddle, which is long both calls and puts, with the same exercise price and expiration date on the same underlying asset.

Reference: Reading 42, Derivatives Strategies, Section 5.3.

ITEM SET 9: ALTERNATIVE INVESTMENTS—Questions 49 through 54

49. B LOS: Study Session 15-44-b

Private real estate investments typically offer direct property control, but with inherently less liquidity and diversification. REIT investing offers more liquidity and diversification, but less direct ownership and control. Reference: Reading 44, Publicly Traded Real Estate Securities, Section 3.3.

50. B LOS: Study Session 15-44-c

Compared to REITs, private real estate investments are allowed to retain earnings and invest in and develop their properties to add value. In contrast, REITs are legally required to distribute most of their earnings to investors, so the growth opportunities are more limited. Reference: Reading 44, Publicly Traded Real Estate Securities, Section 3.3.

51. C LOS: Study Session 15-43-f

7.25% – 5.25% = 2.0%

The income growth rate is assumed to be constant. Therefore, by definition, the growth rate is the discount rate minus the going in cap rate. Reference: Reading 43, Private Real Estate Investments, Section 6.3.

52. C LOS: Study Session 15-43-g

NOI Discount Factor Discounted Value

Year 1 NOI € 1,795,000 1.0725 € 1,673,660 Year 2 NOI 1,848,850 1.0725^2 1,607,337 Year 3 NOI 1,904,316 1.0725^3 1,543,644 Year 4 NOI 1,961,445 1.0725^4 1,482,473 Year 5 NOI 2,020,288 1.0725^5 1,423,727 Terminal Year NOI 2,080,896 .06 34,681,600 DCF Value € 42,412,442

Reference: Reading 43, Private Real Estate Investments, Section 6.3.

53.

LOS: Study Session 15-43-i, 15-44-e, h

The sales comparison approach is commonly used by private real estate analysts to value properties in similar markets.

The net asset value and price multiple approaches are commonly used to evaluate publicly-traded real estate (and other) securities.

Reference: Reading 43, Private Real Estate Investments, Section 7.2; Reading 44,

Publicly Traded Real Estate Securities, Sections 5 & 6. 54.

LOS: Study Session 15-43-c, l

The quoted mortgage rate (5.75%) is less than the discount rate (7.25%). Assuming

DePietro’s forecast is reasonably accurate, the positive financial leverage would enhance financial returns to investors when compared to all-equity financing.

Reference: Reading 43, Private Real Estate Investments, Section 12.

ITEM SET 10: PORTFOLIO MANAGEMENT—Questions 55 through 60 55. A

LOS: Study Session 16-47-c

Since both the risk and return objectives of UNEE are relative, it is inconsistent to select and evaluate managers based on their absolute risk-adjusted performance as measured by the Sharpe ratio. Using a relative performance measure, such as the information ratio, is more appropriate and consistent with the objectives.

Reference: Reading 47, The Portfolio Management Process and the Investment Policy

Statement, Section 5.

56. B

LOS: Study Session 17-50-j

Increases in P/E ratios could be the result of several factors, including: • An increase in expected real earnings growth, • Falling real interest rates,

• A decline in inflation expectations, or

• A decline in the equity risk premium, consistent with option B.

Reference: Reading 50, Economics and Investment Markets, Section 6.4. 57. B

LOS: Study Session 16-49-c

Given the benchmark expected return and the return goal, the expected weekly return is:

𝐸𝐸(𝑅𝑅𝐵𝐵)+1.0%11.40%𝐸𝐸(𝑅𝑅𝑃𝑃)===0.2192%. 5252

The expected annual risk combines the expected benchmark risk and the goal tracking error:

𝜎𝜎𝑃𝑃,𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴=�(𝜎𝜎𝑃𝑃)2+(𝑇𝑇𝐸𝐸)2=√.05802+.032=6.53%.

And the weekly expected risk is then:

6.53%𝜎𝜎𝑃𝑃==0.9055%.

√52

For a 5% probability of loss, the VaR is then: 𝑉𝑉𝑐𝑐𝑅𝑅=|0.2392%−1.65(0.9055%)|=1.25%.

Reference: Reading 49, Measuring and Managing Market Risk, Section 2.2.

58.

LOS: Study Session 17-50-d, f

Term spreads are a measure of the steepness of the yield curve, and recessions are often preceded by a flattening (or even inversion) of the yield curve, as seen here. However, investment grade corporate bond credit spreads tend to rise in the lead up to a recession, which is not what is seen here.

Reference: Reading 50, Economics and Investment Markets, Section 4.5 and 5.1.

59.

LOS: Study Session 17-52-c

Pairs trading is a statistical arbitrage trading strategy that is designed to generate profits independent of the direction of the market, making it an absolute return strategy.

Reference: Reading 52, Algorithmic Trading and High-Frequency Trading, Section 2.2.

60.

LOS: Study Session 16-47-e

The requirement to pay a federal excise tax will directly affect the liquidity requirement and create the need for a section on tax concerns—both of which are included in the constraints section of the IPS. This new requirement may affect risk or return objectives, but it is not clear if they would, and in any case that is not a direct effect.

Reference: Reading 47, The Portfolio Management Process and the Investment Policy

Statement, Section 6.2.

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cfa 二级 考试复习资料

cfa 二级考试复习资料