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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)

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CFA Level II Mock Exam3
June, 2016

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

FinQuiz.com – 3rd Mock Exam 2016 (AM Session)

Questions Topic Minutes


1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-18 Economics 18
19-24 Corporate Finance 18
25-36 Financial Reporting and Analysis 36
37-48 Equity Investments 36
49-54 Fixed Income 18
55-60 Derivatives 18
Total 180

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Questions 1 through 6 relate to Ethical and Professional Standards

Django Limited Case Scenario

Django Limited (DL) is an investment management firm situated in the U.S. It provides
portfolio management as well as investment advisory services to private wealth and
institutional clients.

Ridley Jacob, CFA, is one of DL’s senior portfolio managers. Jacob has developed an
interest in foreign markets. A local Russian newsletter, published in multiple languages,
included a full-length article on the proposed merger between a Russian and German
steel manufacturer. The article included excerpts from several local research reports
strongly recommending the purchase of the Russian manufacturer’s stock. While the
news is still unheard of in the U.S. market, Jacob rushes to instruct DL’s broker to
purchase the Russian manufacturer’s stock for his U.S. clients’ portfolios.

Following the purchase, Jacob meets with his client, Travis Barnes. Barnes explains to
Jacob that he intends to construct a charity hospital and would like to liquidate $2 million
from his portfolio immediately. Jacob assures Barnes that he will sell Barnes’ corporate
bond holdings to generate the funds. Upon returning from his meeting, Jacob engages in a
discussion with DL’s fixed income portfolio manager. While careful not to reveal
Barnes’ identity, Jacob shares his bond strategy with the manager. The manager advises
Jacob to delay the sales until the announcement of the monetary policy, which is
expected shortly. He explains that by waiting Jacob can sell the bond holdings at
attractive prices. Jacob delays his disposal strategy accordingly.

Several of DL’s clients have expressed an interest in alternative investments. DL does not
have any experience with these asset classes and conducts a search for a potential
external advisor, with the selection criteria being primarily based on market popularity.

Camilla Jacob, Jacob’s sister resides in Brazil. She recently purchased the stock of
Energon-V, a local energy supplier, for her brother’s private account. A month later, the
supplier announces an IPO of its stock. Jacob allocates the supplier’s stock to the
accounts of clients expressing an interest; portfolio managers of those clients passing a
suitability test; and a senior manager’s private account paying the same fee rate as DL’s
clients.

Later that evening, Jacob attends an annual investment conference. At the conference
dinner he discusses his role at DL; the fact that he manages the accounts of private wealth

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

and institutional clients. When asked whether he manages Elaine Green’s account
(Jacob’s first cousin), he politely declines to share any further information.

All DL employees are required to sign a pre-clearance form prior to any personal trades.
Several of Jacob’s subordinates have purchased securities within thirty-six hours
following the dissemination of investment recommendations to clients from third party
research firms. Jacob has not taken any action in response to these trades.

1.   By instructing DL’s broker to purchase the Russian stock, has Jacob violated any
CFA Standards of Professional Conduct?

A.   No.
B.   Yes, he failed to share the information with DL.
C.   Yes, he acted on material nonpublic information.

Correct Answer: A

Reference:
CFA Level II, Volume 1,Study Session 1, Reading 2, LOS a

Jacob did not violate any CFA Standards of Professional Conduct when
purchasing the Russian stock for his clients’ portfolios. Standard II (A) Material
Nonpublic information prohibits members and candidates who possess material
nonpublic information that could affect the value of the investment from acting or
causing others to act on the information.

Although information on the proposed merger is material, it is also public as the


information has been published in a circulated newsletter. Even if the U.S. market
is currently unaware of the proposed merger, dissemination of the news via a
Russian newsletter does not make the information nonpublic. Furthermore, he has
not violated any standard by not sharing the information with DL.

2.   With respect to his discussion with the fixed income manager, Jacob has most
likely violated the Standard related to:

A.   fair dealing.
B.   loyalty, prudence, and care.
C.   preservation of client confidentiality.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a

Jacob has most likely violated the Standard related to loyalty, prudence, and care.
According to this standard, members and candidates have a duty of loyalty to their
clients and must act with reasonable care and exercise prudent judgment.
Members and candidates must act for the benefit of their clients and place their
clients’ interests before their employer’s or their own interests.

Barnes had expressly requested an immediate liquidation of a portion of his


portfolio. Furthermore, Jacob had assured Barnes that he would take immediate
action. By deciding to delay the disposal strategy so that he could profit from the
sale, he has placed his own interests ahead of Barnes’ and has violated this
standard.

Jacob has not violated the standard related to fair dealing, which requires
members and candidates to deal fairly and objectively with all clients during their
professional activities.

By sharing his strategy and not revealing Barnes’ identity to the fixed income
manager, Jacob has complied with the preservation of confidentiality standard.
Portfolio managers are permitted to seek advice on their investment actions as
long as they preserve their client’s confidentiality.

3.   In order to better comply with the CFA Institute Code and Standards, DL should
evaluate potential advisors based on their:

A.   cost structure only.


B.   skills in addition to popularity.
C.   skills, performance history, and cost structure.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS b

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Standard V(A) Diligence and reasonable basis provides guidance in the selection
of external advisers and sub-advisers. When selecting an external advisor,
members and candidates need to ensure that their firms have standardized criteria
for reviewing external advisors.

In order to better comply with the CFA Institute Code and Standards, DL should
evaluate potential investment advisors based on their skills, performance history,
and cost structure. Market popularity is not an adequate criterion.

4.   By purchasing Energon-V’s shares for client accounts, Jacob has least likely
violated the Standard related to:

A.   priority of transactions.
B.   disclosure of conflicts.
C.   loyalty, prudence, and care.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a

Jacob has least likely violated the Standard related to loyalty, prudence and care
when purchasing Energon-V’s shares for client accounts. Jacob has exercised
prudent judgment and acted with reasonable care to ensure that the trade is
allocated to the necessary accounts.

By not disclosing the ownership of Energon-V’s stock in his private account to


clients, Jacob has violated the standard related to disclosure of conflicts. This
standard requires members and candidates to make full and fair disclosures of all
matters that could reasonably be expected to impair their independence and
objectivity or interfere with their duties to their clients and prospects, among
others. Ownership of a stock, which is later allocated to client accounts constitutes
a potential conflict of interest, which may impair Jacob’s impartiality.

Jacob has also violated the Standard related to priority of transactions by


allocating the trade to a senior officer. He should have allocated the trade to the
officer’s account after allocating it to the respective client accounts.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

5.   At the annual investment conference, did Jacob violate any Standards of


Professional Conduct?

A.   No.
B.   Yes, by sharing information with respect to client types.
C.   Yes, by not sharing information with respect to his cousin’s account.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a

Option A is correct. Jacob has not violated any CFA Institute standard.

According to this Standard III (E) Preservation of Confidentiality, members and


candidates are required to keep information about current, former, and prospective
clients confidential unless the client permits it; the information concerns illegal
activities on part of the client; or disclosure is required by law.

Option B is not correct. Simply stating that he manages the accounts of individual
and institutional clients is not a violation of this standard. However, providing
information on the sizes of these client accounts constitutes a breach of client
confidentiality.

Option C is also incorrect. Elaine Green (Jacob’s first cousin) is his client and he
is allowed to keep information about his clients confidential just like his other
clients.

6.   By not taking any action on the personal trades, has Jacob violated any Standards
of Professional Conduct?

A.   No.
B.   Yes, by not enforcing a sufficient blackout period.
C.   Yes, by not adequately supervising his subordinates.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Jacob has not violated any standards by not taking action on his subordinates’
personal trading. By giving clients and prospects sufficient amount of time to act
upon the investment recommendation, his subordinates have not violated any
standards.

Since his subordinates have not violated any standards, Jacob has not violated the
responsibility of supervisors Standard, which requires members and candidates to
make reasonable efforts to detect and prevent violations.

Since employees are executing personal trades within a reasonable time period
following the dissemination of investment recommendations, Jacob has not
violated the priority of transactions standard by not enforcing a blackout period.
Blackout periods are intended to ensure employees do not front run their personal
trades ahead of client trades.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Questions 7 through 12 relate to Quantitative Methods

Lily Richards Case Scenario

Lily Richards, CFA, is a quantitative analyst serving Gateway Constructors (GC). GC


specializes in the construction of national highways.

For pricing its projects, GC presently holds a contract agreement with a third party
valuation firm. The contract is near expiration and GC is contemplating the development
of its own project price-forecasting model. It has tasked Richards with building the
model.

To develop the model, Richards intends to use linear regression. Each project is expected
to be priced by multiplying a margin percentage to net construction costs and adding a
base price; the base price is the minimum project price. The regression model will be
based on several projects’ prices over the years 2005 to 2010. She justifies her data
selection technique with the following statement:

Statement 1: “Industry conditions were significantly different during the pre-2005 era.”

Her regression model is as follows:

Forecasted project price = Base Price + Margin(Construction costs)

Two years following the implementation of her model, Richards conducts a variety of
tests. She gathers the following data for the purposes of analysis (Exhibits 1 and 2).

Exhibit 1
Regression Data and Analysis of Variance (ANOVA)
Multiple R 0.8821
R-squared 0.7651
Standard Error of Estimate 0.6347
Observations 62

Coefficients Standard Error

Base price 950 8.535


Margin 0.10 0.429

   

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

ANOVA
Sum of Squares
Df (SS)
Regression 1 0.1856
Residual 60 0.0268
Total 61 0.2124

Exhibit 2
Significance levels
df p = 0.10 p= 0.05 p= 0.025
2 1.886 2.920 4.303
60 1.296 1.671 2.000
70 1.294 1.667 1.994

Richards would like to determine the ability of her model to generate price forecasts. She
identifies three factors, which may be useful in developing a prediction interval.

Factor 1: Variance of mean construction costs = 27.9

Factor 2: Variance of mean forecasted project price = 18.35

Factor 3: Mean construction costs = 98.54

Factor 4: Correlation between mean construction costs and mean forecasted price =
0.75

Upon the completion of the regression tests, she engages in a discussion with fellow
manager Earl Matthews. The two employees arrive at the following conclusions with
respect to the regression analysis.

Conclusion 1: If the sample size is increased from 62 to 80 projects, the standard error of
estimate measure will increase. This will reduce the reliability of
regression results.

Conclusion 2: The standard error of estimate measures the standard deviation of the
residual term; its numerator is calculated as the difference between the
actual and predicted value of the independent variable.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

7.   Richards’ pricing-model is most likely constructed using:

A.   panel data.
B.   time series analysis.
C.   cross-sectional analysis.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS d

Richards is using price data over a number of years providing evidence of time
series analysis. Richards is using price data of several projects providing evidence
of cross sectional analysis. Therefore she is using a mix of the two methods; i.e.
panel data.

8.   The F-test statistic is closest to:

A.   114.44.
B.   415.52.
C.   885.00.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS j

!"#$  &"'&"(()*$  (+,  *-  (.+#&"(


F-test =
!"#$  (.+#&"/  "&&*&(

Mean regression sum of squares = 0.1856/1 = 0.1856


Mean squared errors = 0.0268/60 = 0.000447

0.2345
F-test = = 415.52
0.000667

9.   Which of the following factors will most likely be required to construct a


prediction interval?

A.   Factor 1
B.   Factor 2
C.   Factor 4

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS i.

In order to construct the prediction interval for her model, Richards will need the
following data:

•   Variance of mean construction costs = 27.9


•   Mean construction costs = 98.54
•   Squared standard error of estimate
•   Number of observations
•   The value of the independent variable used to predict the dependent
variable.

Thus factors 2 and 4 will not be required to construct a prediction interval.

10.  The standard deviation of the prediction error given independent variable equals
425 is closest to:

A.   5.063.
B.   25.636.
C.   41.093.

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS i

2 6=4@A3.46 B
The variance of the prediction error = 0.6347= 1 +   +  
5= 5=@2 =7.A
= 25.636

Standard deviation of the prediction error = 25.636 = 5.06

11.  Conclusion 1 is most likely:

A.   correct.
B.   incorrect, the standard error of estimate should decrease.
C.   incorrect, the standard error of estimate will remain constant.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS f

An increase in the size of the sample will decrease the sum of squared errors
(SSE) and simultaneously increase the denominator of the formula on the right
side (see below).

EEF
SEE =
$@G@2

12.  Conclusion 2 is most likely:

A.   correct.
B.   incorrect, the standard error of estimate is the standard deviation of the
actual values of the independent variable.
C.   incorrect, the numerator is calculated as the difference between the actual
and predicted value of the dependent variable.

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 3, Reading 9, LOS f

The standard error of estimate is the standard deviation of the residual term in the
regression. Its numerator is calculated as the difference between the actual and
predicted values of the dependent variable.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Questions 13 through 18 relate to Economics

Ian Joshlin, CFA, Case Scenario

Ian Joshlin, CFA is an economic analyst at a U.K. based research firm. Joshlin is
preparing an interactive presentation in which he will cover the following agenda:

•   Explain how interest rate and inflation differentials determine exchange rates
•   Demonstrate the return generated by a carry trade involving the GBP and AUD and
evaluate the sources of downside crash risk.

To achieve the first item on his agenda, Joshlin focuses on the domestic and foreign
Russian currency market. He collects LIBOR rates, inflation rates, current spot rate and
3-month forward rate data for the analysis (Exhibit 1).

Exhibit 1
Relevant RUB and GBP Economic Data

Current spot rate (RUB/GBP) 46.65


Current three-month forward rate (RUB/GBP) 41.89
Relative price level, (GBP)/(RUB) 1.2
Inflation rate (GBP) 1.0%
Inflation rate (RUB) 2.5%
Three month LIBOR (GBP)* 0.507%
Three-month LIBOR (RUB)* 0.346%
*In nominal terms

After collecting the necessary data, Joshlin poses the following questions to his team:

Question 1: “If the expected spot exchange rate in three months’ time is forecasted to
equal RUB/GBP 41.89, which parity conditions will be expected to hold?”

Question 2: “Based on interest rate parity conditions, for the investor to be indifferent
between owning a Russian and British Investment should the GBP
appreciate or depreciate and by how much?”

Question 3: “If the value of the GBP is expected to remain at its current level, will the
inflation differential influence the competitiveness of Russian and British
firms?”

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

At the conclusion of the presentation, Joshlin invites the participants to make comments.
Two of the comments, which he receives are:

Comment 1: “Keeping all else constant, if the RUB/GBP nominal exchange rate
increases, it will become less expensive for Russian consumers to
purchase U.K. products in real terms.”

Comment 2: “Absolute PPP will fail to hold in a country that imposes import quotas
and the same goods are consumed in different amounts in two countries.”

To achieve his second agenda, Joshlin demonstrates a carry trade, which involves
borrowing in GBP and investing in AUD at the 1-year LIBOR. Joshlin collects the
necessary data and would like to demonstrate the AUD yield level that would generate a
zero net return on the carry trade. He collects LIBOR rates and current and one-year spot
rates for the USD/AUD and GBP/USD currency pairs.

Exhibit 2
Data Relevant For Carry Trade
Today’s 1-Year Currency Pairs Spot Rate Today Spot Rate in One Year
LIBOR
AUD USD/AUD 1.0400 0.9956
5.0%
GBP GBP/USD 0.6611 0.7010
0.6%

13.  The most appropriate response to Question 1 is:

A.   international Fisher effect.


B.   uncovered interest rate parity.
C.   real interest rate parity condition.

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOSg

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

For the expected spot rate to equal to the forward rate, it is necessary for
uncovered interest rate parity and covered interest rate parity hold.
A is incorrect. If the international Fisher effect holds, the nominal yield spread
between domestic and foreign markets will equal the domestic/foreign expected
inflation differential.

C is incorrect. When the real interest rate parity condition holds the real interest
rate differential is equal to zero.

14.  The most appropriate response to Question 2 is:

Appreciate or Percentage
Depreciate? Change?
A.   Appreciate 0.346%
B.   Depreciate 0.161%
C.   Depreciate 1.020%

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS e

If the investor is indifferent between holding a British and Russian investment,


the expected return on the two investments must equal. That is, the domestic
currency must depreciate by 0.161%, see below:

i f − %ΔS e f d = id

0.346 – %ΔS e f d = 0.507%

%ΔS e f d = –0.161%

15.  The most appropriate response to Question 3 is that the:

A.   competitive environment is not affected.


B.   competitiveness of British companies will decline.
C.   competitiveness of Russian companies will decline.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS e

If the value of the exchange rate is expected to remain unchanged, the higher
Russian inflation rate will erode the competitiveness of Russian companies
relative to British companies.

16.  Which of the comments received by Joshlin is most likely correct?

A.   Comment 1 only
B.   Comment 2 only
C.   Both of the comments

Correct Answer: B

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS f.

Comment 1 is incorrect. Using the equation below, if the nominal value of GBP
increases while the relative foreign-domestic price level is kept constant, the real
value of GBP will increase. An increase in the real value of GBP means it will
become more expensive, in real terms, for Russian consumers to purchase British
products.

CPI d
qf d = Sf d ×
CPI f

Comment 2 is correct. Absolute PPP will fail to hold when trade barriers exist and
when foreign and domestic price indices do not include the same bundle of goods
and services or include the same bundle of goods and services but in different
weights.

17.  Assuming the GBP yield remains unchanged, the one year AUD LIBOR rate that
will produce a zero net return on the carry trade is closest to:

A.   0.99%.
B.   1.51%.
C.   2.12%.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Correct Answer: A

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS i

Current spot cross rate GBP/AUD = USD/AUD × GBP/USD


= 1.0400 × 0.6611
= 0.6875

Spot rate in one year GBP/AUD = 0.9956 × 0.7010


= 0.6979

For the net return to equal zero, the expression below should equal zero:

"$ 1 &$
# (1+ f ) ( Fd f) −1 '−d
%$ Sd f ($

{(1/0.6875)(1 + f)(0.6979) – 1} – 0.6% = 0


1.0151(1 + f) = 1.006
f = 0.991% or 0.99%

Therefore, the Australian 1-year LIBOR rate should equal 0.99% for the net
return on the carry trade to equal zero.

18.  Which of the following factors directly contributes to the downside risk of carry
trades?

A.   Overcrowding in high yield currencies


B.   Capital controls in high yield countries
C.   Skewed return distribution of carry trades

Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS i

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

C is correct. The return distribution of carry trades is peaked and has fatter tails
that are negatively skewed. The negative skew and fat tails indicate that carry
trades have tended to exhibit more losses than would have been experienced had
the distribution been normal.

A is incorrect. Overcrowding in high yield currencies will lead to unwinding of


carry trades and the encourage investors to invest in lower yield currencies. Thus,
overcrowding in a high yield currency by itself does not represent a source of
downside risk.

B is incorrect. A policy related danger of carry trades is that if the global search
for yield drives high yield currencies into overvaluation and in turn generates
negative consequences for economic activity, monetary authorities may be
compelled to restrict the flow of capital by imposing capital controls. Thus capital
controls represent a policy response to excess trading in overvalued currencies as
opposed to a source of the downside risk.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Questions 19 through 24 relate to Corporate Finance

Alpha & Beta Money Managers (A&B) Case Scenario

Alpha & Beta Money Managers (A&B) is an investment management firm established by
a group of eminent portfolio managers with considerable experience in asset
management. David Knox is the chief portfolio manager at A&B and has played a pivotal
role in developing and enhancing the firm’s reputation. Due to high success in its
industry, A&B recently decided to provide its services not only to private wealth clients
but also to institutional investors. The institutional wing at A&B has hired a number of
professional investment analysts and portfolio managers. As part of their stock-picking
process, James Mazzola, the head of the institutional wing, invited Knox over to discuss
international differences in capital structures of companies. Knox made the following
comments:

Statement 1: “The legal system can have important implications on the capital structure
of firms in a country. Generally, the more efficient the legal system of a
country is the more protection debt providers get, and the higher the
leverage of companies operating in the country. Also, firms in such
countries tend to use more long-term debt in their capital structures.”

Statement 2: “Countries with a common law tradition have stronger shareholder rights
than civil-law countries. Hence, firms in common-law countries use less
debt and more equity in their capital structure. However, even though
common-law countries are more market-based than bank-based, firms
within such countries tend to use longer debt maturity structures compared
to their peers in civil-law countries.”

After their meeting, Mazzola approached Knox to have an informal discussion on the
various theories of capital structure. As their conversation continued, Mazzola mentioned
the Modigliani and Miller Propositions without taxes, and inquired how the theory is
modified with the introduction of taxes. Knox made the following comment:

“According to MM Propositions without taxes, the cost of equity is increased as the use
of debt financing is increased. However, with taxes, the cost of equity and WACC
decreases as debt increases in the capital structure. This is true if financial distress and
bankruptcy costs are not considered.”

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Mazzola disagreed and stated:

“I believe that even if the costs of corporate taxes, financial distress and bankruptcy are
considered, it is possible in the Miller model for debt to add value, lower value or have
absolutely no effect on value.”

Mazzola is evaluating the expansion of Hexagon Enterprises (HXE), an all equity firm
with a current cost of capital of 15%. For the expansion, HXE would issue debt at a rate
of 11.5%, and doing so would increase it debt-to-equity ratio to 0.6. The corporate tax
rate is 35%. Mazzola is assessing how taxes would affect HXE’s cost of equity after the
issuance of debt.

After his evaluation of HXE’s expansion strategy, Mazzola proceeded with the regular
performance appraisal of a pension fund he manages. The fund invests 2% of its value in
the stock of Vivid Enterprises (VIE), a U.S. firm operating in the media industry. VIE
stock’s price has been fluctuating considerably over the past few quarters and Mazzola
believes that it is due to an ineffective corporate governance system at the firm. To assess
the quality of corporate governance at VIE, Mazzola gathered the following information:

1.   The supervisory board of directors consists of 12 members, 8 of whom are completely


independent of company management.
2.   VIE has a tiered hierarchy of boards.
3.   The supervisory board has the authority to hire outside consultants without
management intervention.

To discuss his evaluation of VIE’s governance quality, Mazzola talked to Knox about the
management compensation at VIE. After a thorough examination of the compensation
structure at VIE, Knox instructed Mazzola to assess the ‘share overhang’ in order to
adequately measure the impact of the compensation structure on shareholder value.

VIE is considering expanding its operations in other states of the United States. In
assessing the expansion strategy, upper management at VIE is analyzing the individual
impact on firm value of expansion in each of the desired States. Management is using a
14% firm WACC to determine the attractiveness of each project.

19.  Knox is most accurate with respect to:

A.   Statement 1 only.
B.   Statement 2 only.
C.   both statements 1 and 2.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Correct Answer: B

Reference:
CFA Level II,Volume 3, Study Session 8, Reading 24, LOS e

Statement 1 is incorrect. Companies operating in countries with an efficient legal


system tend to use more long-term debt than short-term debt and exhibit lower
leverage than comparable companies in countries with weaker legal systems.

Statement 2 is correct. Companies operating in common law countries tend to


have longer debt maturity structures compared to their peers in civil law countries
and use less debt in their capital structure.

20.  With respect to their comments regarding the MM Propositions, are Knox and
Mazzola most likely correct?

A.   Only Knox is correct.


B.   Only Mazzola is correct.
C.   Neither Knox nor Mazzola is correct.

Correct Answer: B

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 24, LOS a

Knox is incorrect. According to the MM model, when taxes are considered, the
cost of equity still increases as the amount of debt in the capital structure
increases, but the rise is not as fast as it is in the no-tax case.

Mazzola is correct. In the Miller model, whether or not adding debt in the capital
structure adds value depends on the corporate tax rate, the personal tax rate on
interest income and the personal tax rate on dividend income. If individuals face
different tax rates on dividend and interest income, it is possible for debt to add
value, lower value, or have no effect on value.

21.  Compared to the cost of equity without the consideration of taxes, HXE’s cost of
equity with taxes will most likely be:

A.   0.74% lower.
B.   5.98% lower.
C.   6.67% lower.

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Correct Answer: A

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 24, LOS a

Without taxes:
Re = 0.15 + [(0.15 – 0.115)(0.6)] = 17.1%

With taxes:
Re = 0.15 + [(0.15 – 0.115)(1– 0.35)(0.6)] = 16.365%

Difference: 0.735%

22.  Considering each independent of the others, which of the above points about
VIE’s corporate governance system most likely indicates high quality
governance?

A.   Points 1 and 3 only.


B.   Points 2 and 3 only.
C.   Points 1, 2, and 3.

Correct Answer: B

Reference:
CFA Level II, Volume 3, Study Session 9, Reading 26, LOS d & e

At a minimum, the majority of board members must be independent of


management. Global best practice recommends that at least three quarters of the
board members should be independent.VIE’s board should have at least 9
independent members whereas it only has 8. A tiered hierarchy of boards helps in
overcoming difficulties such as the lack of independence of board members or the
lack of independence of the chairman of the board. In such an approach, a
management board oversees the upper management, and a supervisory board
monitors the management board. Point 3 ensures the integrity of the board’s
independent oversight function.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

23.  Knox has suggested to assess the share overhang of VIE most likely because:

A.   VIE provides its management with large grants of stock options.


B.   VIE has seen a decrease in share price because of bonuses awarded to
upper management that reward them for achieving short-term non-
sustainable growth.
C.   managers at VIE are offered perquisite awards not shown on the
company’s financial statements.

Correct Answer: A

Reference:
CFA Level II, Volume 3, Study Session 9, Reading 26, LOS e

The share overhang is a measure to assess the stock options’ potential dilutive
effect on shareholders. The overhang is simply the number of shares represented
by the options, relative to the total amount of stock outstanding. Since Knox has
instructed Mazzola to measure the share overhang, VIE most likely provides its
management with large grants of stock options that might diminish the value of
shareholders’ holdings.

24.  In assessing the impact of its expansion strategy on firm value, VIE will most
likely:

A.   reject high-risk projects.


B.   accept low-risk projects.
C.   reject low-risk projects.

Correct Answer: C

Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS e

Since VIE is using its overall company WACC to assess expansion in each state,
it will most likely accept high risk projects (those that have a higher required
return than the company WACC) and reject low risk projects (those that have a
lower required return than the company WACC).

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Questions 25 through 30 relate to Financial Reporting and Analysis

Benjamin Gandy Case Scenario

Benjamin Gandy is a portfolio manager at Gateway Investments, an asset management


firm established in Louisiana, USA. Gandy is evaluating Prime-Cut Manufacturers, one
of USA’s leading manufacturers of office and home furniture. As part of his evaluation,
Gandy has gathered some financial information about the firm for the past two years.
Exhibits 1 and 2 display this information.

Exhibit 1
2012 2011
Years Ended 31 December
(in $ millions) (in $ millions)
Total Revenue 76,880 61,238
Cost of Goods Sold 47,920 38,339
Operating Profit 28,960 22,899
Net Profit 21,054 19,673

Exhibit 2
2012 2011
Years Ended 31 December
(in $ millions) (in $ millions)
Cash and short-term investments 5,898 4,983
Inventories 12,675 10,433
Total current assets 55,573 43,416
Total shareholder’s equity 23,569 18,875
Total liabilities 67,302 54,033

Further study of the financial statement notes by Gandy revealed the following:

•   Prime-Cut values inventory on a LIFO basis and reports inventories at the lower of
cost or market on the balance sheet.
•   The LIFO reserve equaled $7,819 for year 2012 and $7,106 for year 2011.
•   The company paid taxes of 35% in the year 2012 and 30% for every year before that.

After his analysis, Gandy made the following comments:

Statement 1: “Compared to a similar company that follows the FIFO method of


inventory accounting, Prime-cut Manufacturers will appear to be less
profitable, less liquid and less leveraged.”

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Statement 2: “If the company followed the FIFO method of inventory accounting it
would have reported total assets of $96,309 million in 2012 and its
cumulative gross profits would have been $7,819 higher as of the end of
the same year.”

Gandy is also assessing Crystal Enterprises (CE), a firm that produces optical equipment
since 2010. Exhibit 3 displays CE’s financial statement information under LIFO
inventory costing.

Exhibit 3
2010 2011 2012
Number of units purchased 15,000 15,000 15,000
Purchase cost per unit $60 $70 $85
Number of units sold 13,000 15,000 16,000
Sales price per unit $100 $115 $135
Cost of goods sold $780,000 $1,050,000 $1,335,000

Michael Westmore is a financial analyst at Gateway Investments. Westmore is currently


studying the effects of different accounting practices on the financial statements of
Perfect-Stitch Enterprises (PSE), a high-class fashion boutique in the USA. The firm
capitalized interest expense of $2.5 million in year 2010, $3.2 million in year 2011, and
none in year 2012. Also, in 2011, the firm reported total interest expense of $4.595
million and EBIT of $51.9475 million. The capitalized interest during the year increased
depreciation expense by $500 thousand. PSE reported net operating cash flow of $15,678
thousand in 2011 and $13,567 thousand in year 2012.

After his evaluation, Westmore invited Gandy over for lunch to discuss his conclusions.
During their conversation Westmore made the following comments:

Statement 3: “Under IFRS, for held-to-maturity debt investments that become impaired,
the amount of loss is measured as the difference between the security
carrying value and the PV of future cash flows discounted at the security’s
current market effective interest rate.”

Statement 4: “Under IFRS, impairment losses on available for sale debt and equity
securities cannot be reversed.”

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25.  If Prime-Cut Manufacturers had used the FIFO method of inventory costing
instead of the LIFO method, by what amount would the firm’s 2012 net cash flow
from operations and retained earnings change?

Net Cash flow from Operations Retained Earnings


A.   –$2,737 million $6,914 million
B.   –$249 million $5,438 million
C.   $317 million $5,082 million

Correct Answer: B

Reference:
CFA Level II,Volume 2, Study Session 5, Reading 16, LOS c

Increase in LIFO reserve is $713 million. This will reduce COGS, increase
operating profit and increase taxes by $249.55 million [713(0.35)]. Net operating
cash flow would decline by $249.55 million in year 2012.

The amount that would be added to retained earnings is 713(0.65)+7,106(0.70) =


$5,437.65 or $5,438 million.

26.  Gandy is most accurate with respect to:

A.   Statement 1 only.
B.   Statement 2 only.
C.   neitherStatement 1 nor Statement 2.

Correct Answer: B

Reference:
CFA Level II,Volume 2, Study Session 5, Reading 16, LOS c.

Statement 1 is incorrect. Since prices are rising, the company appears to be less
profitable, less liquid, and more leveraged under LIFO relative to a firm that
followed the FIFO inventory accounting method.

Statement 2 is correct. Under FIFO, total assets (23,569+67,302) + 7,819 –


(713(0.35)+7,106(0.30)) = $96,309 million. The cumulative gross profits would
be $7,819 higher as of the end of year 2012 if the firm had used the FIFO method.

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27.  The amount of CE’s 2012 gross profit due to LIFO liquidation is closest to:

A.   $10,000.
B.   $15,000.
C.   $25,000.

Correct Answer: C

Reference:
CFA Level II,Volume 2, Study Session 5, Reading 16,LOS b.

The reported gross profit equals: 135(16,000) – 1,335,000 = $825,000

The COGS under the LIFO method should have been 16,000(85) = $1,360,000
and the reported gross profit should have been 135(16,000) – 1,360,000 =
$800,000. Hence, the gross profit due to LIFO liquidation is $25,000 (825,000-
800,000) higher. This can also be found out as 1,000($25) = 25,000 (number of
extra units sold multiplied by the different in the purchase price and the historical
cost).

28.   If Perfect-Stitch Enterprises expensed the interest instead of capitalizing it, the
interest coverage ratio in 2011 would be closest to:

A.   6.60.
B.   6.73.
C.   7.25.

Correct Answer: B

Reference:
CFA Level II,Volume 2, Study Session 5, Reading 17, LOS a.

The interest coverage ratio is the EBIT divided by interest expense. After the
adjustment for previously capitalized interest, the interest coverage ratio will
equal:

(51,947,500 + 500,000)/(4,595,000 + 3,200,000) = 6.728

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29.   If Perfect-Stitch Enterprises expensed the interest instead of capitalizing it, the
change in operating cash flow from the year 2011-2012 would be:

A.   positive.
B.   less negative.
C.   more negative.

Correct Answer: A

Reference:
CFA Level II,Volume 2, Study Session 5, Reading 17, LOS a.

The change in operating cash flow would turn positive instead of negative if PSE
expenses the interest cost:

[13,567,000/(15,678,000 – 3,200,000)]–1 = 8.727% (which is currently –


13.465%)

30.   Westmore is most accurate with respect to:

A.   Statement 3 only.
B.   Statement 4 only.
C.   neither Statement 3 nor Statement 4.

Correct Answer: C

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 18, LOS a

Statement 3 is incorrect. The impairment loss is measured as the difference


between the security’s carrying value and the present value of its future cash
flows discounted at the security’s original effective interest rate (the effective
interest rate computed at initial recognition).

Statement 4 is incorrect. The IFRS allow impairment losses on available for sale
debt securities to be reversed. However, impairment losses on available-for-sale
equity securities cannot be reversed.

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Questions 31 through 36 relate Financial Reporting and Analysis

Ché Enterprises Case Scenario

Ché Enterprises is a U.S. based locomotive manufacturer with subsidiaries situated across
the world. KamlaRahul, CFA, is an equity analyst following the manufacturer. She is
particularly interested in one of its Asian subsidiaries, Chrome Ltd. The subsidiary is
situated in China and accounts for its inventory using the FIFO method and the lower of
cost or market rule.

Rahul has collected selected balance sheet and income statement information on the
subsidiary for the year ended December 31, 2011 (Exhibit 1). Chrome uses the Chinese
Yuan (CNY) to compile its financial statements. She has also collected relevant exchange
rate data (Exhibit 2). Ché uses the current method for translating Chrome’s financial
statements.

Exhibit 1
Selected Financial Information for Chrome Ltd
For the Year Ending December 31, 2011
CNY (‘000)
Cash 800
Inventory, measured at historical cost 300
Inventory, measured at market value 400
Accounts receivable 2,000
Noncurrent assets 4,500
Total assets 8,000
Total liabilities 2,200
Common Stock 2,600
Retained Earnings 3,200
Revenue 2,700
EBIT 1,989
Net Income 1,005

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Exhibit 2
Exchange rate data (US$ per CNY)
January 1, 2010 0.146
Rate when fixed assets were acquired 0.122
Rate when 2010 inventory was acquired 0.125
Rate when 2011 inventory was acquired 0.129
Average rate, 2010 0.148
December 31, 2011 0.150

31.   Chrome’s translated inventory balance is closest to (in $’000s):

A.   97.
B.   105.
C.   4,667.

Correct Answer: B

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 20, LOS e.

Under the current method, both inventory measured at historical cost and market
value is translated at current exchange rates.

Translated Inventory balance (in ‘000s) = CNY (300 + 400) × $/CNY 0.150
= $105

32.   If the CNY had depreciated from 0.150 ($ per CNY) to 0.146 rather than
appreciated, total translated assets (in $’000s) would have been:

A.   32 higher.
B.   32 lower.
C.   1,200 lower.

Correct Answer: B

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 20, LOS e.

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Total assets (based on current exchange rates, in $’000s) = CNY 8,000 × $/CNY
0.150 = $1,200
Total assets (based on assumed scenario, in $’000s) = CNY 8,000 × $/CNY 0.146
= $1,168

If the CNY had depreciated, total assets would have been $32,000 lower.

33.   Based on the data provided in Exhibits 1 and 2, upon translating Chrome's
financial statements, Ché will report a cumulative:

A.   positive translation adjustment, which is reported as a gain as part of net


income.
B.   negative translation adjustment, which is reported as a loss as part of net
income.
C.   positive translation adjustment, which is accumulated and presented as a
separate component of equity.

Correct Answer: C

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 20, LOS e.

Upon translating Chrome's financial statements, Ché will report a positive


translation adjustment. This is because of two reasons, 1) Ché's total assets
(8,000) exceed its liabilities (2,200) and 2) the CNY has appreciated relative to
the US$.

Given that Ché uses the current method, it will accumulate and present this
translation adjustment as a component of equity.

34.   If Ché uses the temporal method, Chrome's interest coverage will most likely be:

A.   higher.
B.   lower.
C.   the same.

Correct Answer: A

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 20, LOS f.

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The interest coverage ratio is calculated as EBIT/Interest expense. Interest


expense is translated at the average exchange rate using the current and temporal
method. The main difference lies in EBIT, which is higher under the temporal
method. Cost of goods sold (COGS) is converted at an historical rate under the
temporal method. Since CNY is appreciating, its historical rate will be lower
leading to a lower COGS and higher EBIT compared to the current method.

As the denominator in both the current and temporal method is the same, a higher
EBIT, in case of the temporal method, shall lead to a higher interest coverage
ratio.

35.   When translating Chrome's financial statements, Ché will most likely translate the:

A.   income statement and balance sheet first.


B.   balance sheet and statement of retained earnings first.
C.   income statement and statement of retained earnings first.

Correct Answer: C

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 20, LOS d.

Under the current method, the income statement and statement of retained
earnings is translated first followed by the balance sheet.

36.   Which of the following will most likely be higher under the temporal method?

A.   Quick ratio
B.   Common stock
C.   Fixed asset turnover

Correct Answer: C

Reference:
CFA Level II,Volume 2, Study Session 6, Reading 20, LOS f

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Fixed asset turnover will be higher under the temporal method. This is because
the assets will be translated at a historical (lower) rate under the temporal method.
In the case of an appreciating CNY, the historical rate will be lower relative to the
current rate. Under the current method, fixed assets will be translated at the
December 31, 201 rate and will be higher. Turnover is translated at an average
rate under both methods. Therefore, the denominator of the fixed asset turnover
will be lower under the temporal method, leading to a higher ratio.

Common stock will be translated at an historical rate under both methods and thus
will be identical. Cumulative translation adjustments, under the current method,
are reported as a separate component of stockholder’s equity.

The quick ratio is calculated as (current assets – inventory)/current liabilities.


Under both the current and temporal method, current assets (excluding inventory)
and current liabilities will be translated at the year-end rate. Since inventory has
been removed from the ratio, which will cause both ratios to differ, both ratios
will be identical.

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Questions 37 through 42 relate to Equity Investments

Matt Tonne Case Scenario

Matt Tonne is an equity specialist at a leading investment bank with considerable know-
how of financial modeling and financial statements analysis. Tonne specializes in the
automobile sector of the U.S. economy and is considered one of the most prestigious
research analysts for the sector. Recently, Fast-Tires Automobiles (FTA), a U.S. car
manufacturer, captured Tonne’s attention. FTA builds its cars for and markets its cars to
the female community, with its cars specially designed and customized to meet unique
female needs. Exhibit 1 shows some details found in FTA’s financial statements. The tax
rate is 40%.

Exhibit 1
Details Concerning FTA’s Financial Statements
Year Ending 31 December
(in thousands of dollars)
2011 2012
Net Income 135.98 156.45
Depreciation 53.21 62.67
Decrease (increase) in accounts receivable (23) 43
Decrease (increase) in inventory (11) 7
(Decrease) increase in trade payables (45) (58)
(Decrease) increase in accrued expenses 12 24
(Decrease) increase in other creditors 50 57
Purchases of property, plant and equipment 67 96
Borrowing (repayment) 39.96 46.38
*Cash paid for interest was $23,985 in 2011 and $27,104 in 2012. Cash paid for
taxes was $47,800 in 2011 and $53,098 in 2012.

After his analysis of FTA’s financial statements, Tonne made the following comments in
his research report:

Statement 1: “After scrutinizing the firm’s financial statements, I believe that the
change in the depreciation account from year 2011 to 2012 is positive for
future cash flow from operations but negative for future net income.”

Statement 2: “The changes in the working capital accounts in 2012 will all have a
positive effect on the firm’s free cash flow to equity except for the change
in the trade payables account.”

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Tonne is also reviewing the firm’s financial statements for the year 2010. Till 2010, FTA
followed the International Financial Reporting Standards (after which it followed the
U.S. GAAP) and classified its dividends received as an investing activity and interest
paid as a financing activity. Using the changes in the working capital accounts, Tonne
determined that FTA has a total CFO equal to $98,473. Interest expense for the year
equaled $18,900 and taxes paid equaled $41,009. The company paid a tax rate of 37.7%
during that year. Fixed capital expenditures equaled $59,000 for 2010 and depreciation
equaled $47,230. Tonne is determining the FCFF of FTA for 2010 and 2011.

Tonne’s investment bank has been hired by a large foundation for the management of its
equity portfolio. The foundation’s board is particularly interested in the stock of Haley
and Jones Incorporated (H&J), a well-established grocery chain in the U.S. Tonne’s
supervisor, Leesa Evans, has asked Tonne to research the company’s fundamentals for
the current year. After a few hours of thorough examination, Tonne determined that the
company spent $120,000 in cash on fixed capital. In addition, H&J incurred a cash
outflow of $78,000 for investments in working capital. Also, the financial statements
show a deferred tax liability of $34,569 due to different depreciation methods used for
financial reporting and for tax accounting. Tonne expects this amount to reverse in the
near future. H&J also shows a deferred tax asset of $15,209 formed due to restructuring
charges and H&J is expected to have these charges on a continual basis. Exhibit 2 shows
some other information related to H&J.

Exhibit 2
Information Relevant to H&J
Net Income $155,095
Depreciation $23,000
Amortization of long-term bond discounts $7,000
Loss on sale of equipment $12,000
Interest expense $23,957
Tax rate 35%

Evans has invested $200,000 in a manufacturing concern that just earned an EPS of
$3.45/share. Evans expects the future growth rate in dividends to equal 6.8%. After her
calculations, Evans estimated that the company’s value of growth equals $14.73/share.
The company has a beta of 1.4. The risk free rate is 5.5% and the market risk premium is
7.0%.

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Evans is also evaluating Energy Chemicals Inc. (ENERC). She has gathered the
following information about ENERC:

•   The current market price is $68.30.


•   The current dividend is $1.29.
•   Evans expects the dividend to grow by 16% over the coming two years.
•   Evans anticipates that ENERC will grow at a rate of 8% per year in the mature phase,
and it will take 12 years for the transition.
•   The required return for ENERC’s stock equals 11.5%.

Evans is valuing another firm, Eternal Enterprises (EE), using the FCFE approach. Evans
estimated the per share value of the firm using the single-stage H-model.

37.   Tonne is most accurate with respect to:

A.   Statement 1 only.
B.   Statement 2 only.
C.   both statements 1 and 2.

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 35, LOS c.

Statement 1 is correct. Depreciation expense increased from the year 2011 to


2012. If we project this increase in depreciation expense, it will be a negative for
future net income (because net income is reduced by the after tax depreciation
expense) but a positive for future CFO (because we add back depreciation in full
to net income to calculate CFO).

Statement 2 is correct. Decreases in inventory and accounts receivable result in


positive adjustments to net income. Increases in accrued expenses and “other
creditors” are also added back to net income and are sources of cash. However,
the decrease in trade payables means a cash outflow. Because CFO is a
component of FCFE, the items that had a positive effect on CFO also have a
positive effect on FCFE and vice versa.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

38.   Ignoring the accrued expenses and “other creditors” accounts, the FCFF of FTA
for the year 2010 and 2011 is closest to:

A.   $50,813 and $124,110, respectively.


B.   $39,473 and $57,581, respectively.
C.   $98,043 and $43,190, respectively.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 35, LOS d

Year 2010:
CFO + Int(1-Tax rate) – investment in FCInv

But since the firm followed the IFRS accounting rules, and classifies the interest
paid as a financing activity, we do not need to add back the interest expense, since
it is not included in CFO. So FCFF equals:

98,473 –59,000 = $39,473.

Year 2011:
CFO = 135.98 + 53.21 –23 –11–45 = $110.19
FCFF = 110,190 +23,985(1–0.40) – 67,000 = $57,581

39.   The FCFF of H&J for the current year is closest to:

A.   –$541.95.
B.   $34,027.05.
C.   $20,027.05.

Correct Answer: A

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

Reference:
CFA Level II,Volume 4, Study Session 12, Reading 35, LOS d

FCFF = NI + NCC +Int(1-Tax rate) – FCInv – WCInv


= 155,095 + 23,000–15,209+7,000+12,000 +[23,957(1-0.35)]-120,000-
78,000
= –$541.95

We will not add back the deferred tax liability since it is expected to reverse. The
deferred tax asset should be subtracted.

40.   Assuming that prices reflect value, the price to earnings multiple of the
manufacturing firm is closest to:

A.   10.534.
B.   10.805.
C.   18.709.

Correct Answer:A

Reference:
CFA Level II,Volume 4, Study Session 11, Reading 34, LOS e

R = 5.5% + 1.4(7%) = 15.3%


P/E = 1/0.153 + 14.73/3.68 = 10.534

41.   The total value of ENERC’s stock is closest to:

A.   $64.969.
B.   $77.367.
C.   $85.634.

Correct Answer:A

Reference:
CFA Level II,Volume 4, Study Session 11, Reading 34, LOS l.

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Evans is also evaluating Energy Chemicals Inc. (ENERC). She has gathered the
following information about ENERC:

•   The current market price is $68.30.


•   The current dividend is $1.29.
•   Evans expects the dividend to grow by 16% over the coming two years.
•   Evans anticipates that ENERC will grow at a rate of 8% per year in the mature
phase, and it will take 12 years for the transition.
•   The required return for ENERC’s stock equals 11.5%.

D1 = 1.29(1.16) = $1.4964, PV = $1.342


D2= 1.4964(1.16)= $1.7358, PV = $1.396

For the stage 2 and 3:

[1.7358(1.08)/0.115 – 0.08] +[1.7358(6)(0.16 – 0.08)/0.115 – 0.08]


= 53.562 + 23.805 = $77.367, PV = $62.231

Total = $64.969

42.   Eternal Enterprises is most likely in its:

A.   growth phase.
B.   transition phase.
C.   mature phase.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 11, Reading 34, LOS i.

Since Evans is using the H-model for valuation, the company is most likely in its
transition phase, with abnormal growth declining as competitors enter the industry
and profit margins decrease.

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Questions 43 through 48 relate to Equity Investments

Antoine Chaput Case Scenario

Antoine Chaput, CFA, is an independent equity analyst following Tavos Ltd, a U.S.
based steel manufacturer with international subsidiaries. Chaput is particularly interested
in valuing Tavos using residual income approaches. Tavos compiles and presents its
financial statements in accordance with U.S. GAAP. Selective financial information
relevant to the manufacturer is summarized in the Exhibit 1. Chaput intends to use this
information to formulate residual income forecasts.

Exhibit 1
Selective Financial Information Relevant to Tavos Ltd.
Forecast Horizon 3 years
Current share price, 2010 $47.50
Return on equity – Year 1, 2, and 3 25%; 23%; and 21%, respectively
Book value of equity as of December 2010 $15.50 per share
Book value of debt as of December 2010 $32 million
Forecasted Earnings per share (Year 1) $14.50
Forecasted Earnings per share – Years 2-3 Increases by 5% per annum
Earnings retention rate 100%
Cost of equity 11%
Number of shares 2,000,000

To make projections, Chaput will use either of the two assumptions:

Assumption 1: Return on equity will decay towards the cost of equity in 2014 and beyond
at a persistence factor of 0.66.

Assumption 2: Beginning January 1, 2010, Tavos will continue to earn earnings per share
of $14.50 indefinitely.

Laport and Davis Steel are two steel manufacturers operating in the same industry as
Tavos. Chaput is interested in determining the residual income persistence of the two
manufacturers. Information related to Laport, Davis Steel, and the steel industry is
summarized in the Exhibit 2.

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Exhibit 2
Analytical Information
Relevant to Laport, Davis Steel, and Industry Average
Laport Davis Steel Industry Average
Earnings Retention Rate 0.70 0.80 0.56
Average Net income
$45 million $122 million $80 million
(2006-2010)
Return on Equity Range
– 8% to +35% 16% to 20% 15% to 18%
(2006-2010)

During his analysis of Tavos, Chaput made the following observations:

Observation 1: Under Tavos’ sales policy, products are shipped to a third party
warehouse, which dispatches the orders to customers. Due to their limited
storage facilities, customers do not request orders to be shipped
immediately. Associated revenues are recognized two days following the
release of orders from Tavos’ factory site.

Observation 2: Translation gains and losses associated with subsidiaries’ financial


statements are reported in other comprehensive income. The recent
depreciation of foreign currencies relative to the dollar has generated net
translation losses producing a negative other comprehensive income
account balance.

43.   Using Exhibit 1, Tavos’ market value added (MVA) for the year 2010 is closest to
(in $ millions):

A.   32.
B.   63.
C.   95.

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Correct Answer: A

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS a.

Market value added = Market value of the company – Accounting book value of
total capital

Market value added = ($47.50 × 2,000,000)


– [($15.50 × 2,000,000) + 32,000,000]
= $32,000,000

44.   Using Assumption 1, the dollar equity capital charge (per share) in 2012 is closest
to:

A.   1.71.
B.   1.79.
C.   3.30.

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS h.

Book Value Capital Charge


Year Earnings per share ($)
($) (Cost of equity × BVPSt-1)
2010 15.5000
2011 30.0000 14.5000 1.7050
2012 45.2250 15.2250 3.3000

45.   Based on Assumption 1 and using the data in Exhibit 1, the present value of the
terminal value is closest to:

A.   $17.89.
B.   $21.65.
C.   $106.92.

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Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS h

Book Capital Charge


Earnings per Residual
Year Value (Cost of equity ×
share ($) income ($)
($) BVPSt-1)
2010 15.5000
2011 30.0000 14.5000 1.7050 12.7950
2012 45.2250 15.2250 3.3000 11.9250
2013 61.2113 15.9863 4.9748 11.0115

Given a retention rate of 100% and an ROE of 21%, the growth rate is 100% ×
21%= 21%.Therefore the residual income in 2014 is $13.3239 (11.0115 × 1.21).

The present value of the terminal value is calculated as follows:

𝐸I − 𝑟𝐵I@2 $13.3239
I@2
= 6@2
= $21.6496   ≈ $21.65
1+𝑟−𝜔 1+𝑟 1 + 0.11 − 0.66 1.11

46.   Based on Assumption 2, the Tavos stock is most likely:

A.   overvalued.
B.   undervalued.
C.   fairly valued.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS l.

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If Tavos will continue to earn earnings per share of $14.50, and given that it has a
100% retention rate, the book value of equity will remain at $15.50 per share.

Residual income per share = ET – rBT – 1 = $14.50 – ($15.50 × 0.11)


= $12.795

V0 = Book value + Present value of expected future per share residual income
= $15.50 + ($12.795/0.11)
= $131.82

The current share price is $47.50; therefore the Tavos stock is undervalued.

47.   Based on the information presented in Exhibit 2, Chaput will most likely conclude
that the residual income persistence of:

A.   Laport is higher.
B.   Davis Steel is higher.
C.   Laport and Davis Steel are equal.

Correct Answer: B

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS l.

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1) Residual income persistence is high if a company displays the following


characteristics:

•   Low dividend payout


•   High historical persistence in the industry

2) Residual income persistence is low if a company displays the following


characteristics:

•   Extreme ROE
•   Extreme levels of special items
•   Extreme level of accounting accruals

Relative to Laport, Davis Steel has a lower dividend payout rate (30% vs. 20%,
respectively). Also, the ROE range for Davis Steel over the last 5 years has been
less extreme relative to Laport. Given the industry average ROE range, Laport’s
ROE range exhibits an extreme trend. Therefore, Davis Steel has higher residual
income persistence.

48.   Which of the following most accurately highlights the impact of Observations 1
and 2 on residual income?

Observation 1: Observation 2:
A.   Overstated No impact
B.   Understated Understated
C.   Overstated Overstated

Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS k

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Observation 1 will lead to an overstatement of residual income. Tavos’ sales


practices reflect bill and hold sales. By recognizing the revenue two days
following the dispatch of orders from its factory site, Tavos is accelerating the
recognition of its revenues. Tavos should recognize the revenue when the product
is shipped to the final customer.

Observation 2 will lead to an overstatement of residual income. Items that


typically bypass the income statement but are recorded in equity include, amongst
others, foreign currency translation adjustments. In the case of Tavos, the foreign
currency translation losses are reflected accurately in the book value of equity but
not net income. Given that these translation losses have produced negative other
comprehensive income, net income should be reduced to reflect the translation
effects. Since this is not the case, residual income is overstated.

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Questions 49 through 54 relate to Fixed Income

Uptown Limited Case Scenario


Uptown Limited is a firm providing fixed-income security valuation services for a wide
range of clients. Sam Mendes is a senior manager at Uptown. Mendes is analyzing three
securities issued by Blake, Time & Sons (BTS). Details concerning the three issues are
summarized in an exhibit (Exhibit 1).

Exhibit 1: BTS Fixed-Income Security Issues

Coupon Effective Price per %


Type of Bond Rate (%) Duration of Par Value Maturity
Callable at par two
years from today* 8.5 6.5 102.80 31 December 2017
Option-free 8.5 8.0 100.00 31 December 2017
Putable at par one and
two years from today 8.5 7.0 98.50 31 December 2017
*Today is January 1, 2016

Based on the information collected in the Exhibit, Mendes attempts to answer the
following queries put forth by one of his subordinates, Carl Rodriguez:

Question 1: What is the effective duration of the callable bond relative to an option-free
bond when the embedded option is deep in the money?

Question 2: Which bond issue will experience the greatest percentage price decline in
response to a steepening of the yield curve?

Question 3: What is the impact of a flattening of the yield curve on the effective
convexity of callable and putable bond issues?

After attending to the subordinate’s queries, Mendes attempts to value BTS’s putable
issue using a binominal interest rate tree (Exhibit 2). He has used an interest rate
volatility of 15% to construct the tree.

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Exhibit 2: Binomial Interest Rate Tree for Valuing Putable Bond


Year 0 Year 1 Year 2
4.1550% 5.8113%
2.7855% 3.4536% 4.8097%
3.9896%

After constructing the tree, Mendes realizes that he must factor in an option-adjusted
spread (OAS) of 100 basis points prior to valuing the issue. He then proceeds to adjust
the tree. Rodriguez is asked to review the calculation of the bond’s value after
incorporating the OAS. Rodriguez conducts a scenario analysis for the purposes of
determining the impact of change in OAS on bond value. He summarizes the results of
his analysis in the following statement:

Statement: “The OAS should increase as interest rate volatility increases reflecting the
additional compensation required for higher risk. This holds true for both
callable and putable bonds.”

Mendes concludes his analysis by evaluating a convertible corporate bond issued by


BTS. He summarizes details concerning the issue in an exhibit:

Exhibit 3: BTS Convertible Issue


Issue price $109,000
Annual coupon rate 5.0%
Yield curve shape Flat at 4.0%
Current share price $25.00
Issuer common shares
received upon conversion 4,320
Current selling price of
convertible $101,000
Price of identical option-free
bond $102,000

49.  Using Exhibit 1, the most appropriate response to Question 1 and Question 2,
respectively, is:

Question 1: Question 2:
A.   closer to 8.0 callable.
B.   lower than 8.0 option-free.
C.   higher than 8.0 putable.

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Correct Answer: A

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS a & e

The most appropriate response to Question 1 is closer to 8.0. When the embedded
option is deep in the money, the effective duration of the bond resembles that of
the straight bond maturing on the first exercise date. Given that the callable bond
is first callable two years from today (on December 31, 2017), the effective
duration will be close to that of the option-free issue.

The most appropriate response to Question 2 is the callable bond issue. When the
yield curve steepens, long-term rates are higher than short-term rates. Therefore,
the one-period forward rates one-year from now are high and the opportunities to
call the bond are fewer.

50.  The most appropriate response to Question 3 is:

A.   The value of the embedded call option increases.


B.   The upside potential on a putable will be lower relative to a callable bond.
C.   The probability of the callable bond exhibiting positive convexity
increases.

Correct Answer: A

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS e

A is correct. A flattening of the yield curve will result in a decline in forward


rates. This will encourage issuers of callable bonds to exercise embedded options.
Therefore, the value of the embedded call option will increase.

B is incorrect. When interest rates decline, putable bonds will have a greater
upside potential relative to callable bonds. The latter will behave similarly to
option-free bonds whereas the greater value of the embedded put option will
increase the value of putable bonds relative to an option-free bond.

C is incorrect. When the yield curve flattens, there is a greater probability of the
yield declining below the coupon rate. However, the increase in the value of the

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embedded call option (see above) will limit the price appreciation of a callable
bond relative to an option-free issue. This illustrates a scenario where the callable
bond exhibits negative convexity.

51.  Using the data in Exhibits 1 and 2, the value of the putable bond (% of par value)
upon incorporating the OAS is closest to:

A.   $98.50.
B.   $110.244.
C.   $115.210.

Correct Answer: B

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS f & g

T=0 T=1 T=2 T=3


R = 5.1550% R = 6.8113%
R = 2.7855% + 100 C = 8.50 C = 8.50 C = 108.50
basis points = Value = $113.642 Value = $110.081
3.7855%
Value = $110.244
R = 4.4536% R = 5.8097%
C = 8.50 C = 8.50 C = 108.50
Value = $115.192 Value = $111.043

R = 4.9896%
C = 8.50 C = 108.50
Value = $111.844

C = 108.50

52.  Rodriguez’s statement concerning the impact of OAS on interest rate volatility is
most likely:

A.   correct.
B.   incorrect; the statement holds true for callable bonds only.
C.   incorrect; the probability of the embedded call being exercised increases
which increases interest rate risk.

Correct Answer: C

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Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS h
 
The OASs for callable and putable bonds decrease with an increase in interest rate
volatility. Rodriguez’s statement does not hold true for either callable or putable
bonds. The source of interest rate risk associated with an increase in interest rate
volatility for callable bonds is reinvestment risk. As interest rate volatility
increases, the value of the embedded call option increases. In addition, greater
interest rate volatility will increase the probability of the call option being
exercised as there is a greater chance of market yields declining below the coupon
rate. This gives rise to reinvestment risk for the bondholder who will need to
reinvest the proceeds of redeemed bonds at lower market rates.

53.  Using the data in Exhibit 3, Mendes will conclude that a current arbitrage
opportunity involving the convertible bond most likely:

A.   does not exist.


B.   exists and an arbitrage profit of $1,000 can be earned.
C.   exists and an arbitrage profit of $7,000 can be earned.

Correct Answer: C

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS p

An arbitrage opportunity will arise if the value of the convertible bond were lower
than the greater of the conversion value and the straight value or if the convertible
issue is selling at a price lower than its conversion value.

Minimum value = Maximum (Conversion value: Straight value)


Conversion value = 4,320 × $25.00 = $108,000
Minimum value = Max ($108,000:$102,000)

The minimum value of the convertible bond is $108,000. Based on the


information presented in the exhibit, the convertible bond is selling for an amount
which is lower than this value. The investor can buy the convertible bond, convert
it into 4,320 shares, and sell the shares at $25.00 each or $108,000. The
arbitrageur makes a profit equal to the difference between the convertible bond’s
current selling price of $101,000 and the minimum value of $108,000 or $7,000.
 

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54.  The premium (discount) which investors are required to pay when purchasing the
BTS convertible bond as opposed to its underlying common stock is closest to:

A.   – $1.62.
B.   – $1.39.
C.   + $1.62.

Correct Answer: A

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS o

To determine the premium or discount required when purchasing a convertible


bond rather than the underlying stock, the market conversion premium per share
should be calculated:

Market conversion premium per share = Market conversion price – Underlying


share price

Market conversion price = Convertible bond price/conversion ratio =


$101,000/4,320 = $23.3796 or $23.38

Market conversion premium per share = $23.38 – $25.00 = - $1.62

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Questions 55 through 60 relate to Derivatives

Forwards And Derivative Dealers (FDD) Case Scenario

Forwards And Derivative Dealers (FDD), is a firm that engages in derivative strategies
for institutional investors with either speculation or hedging motives. Shaun Evans is a
financial strategist at the firm, with considerable experience in the implementation of
derivative strategies. Mega-Cap Enterprises (MCE) has instructed Evans, to sell a stock
currently worth $154.87 in ten months time. MCE is concerned with the amount it would
receive at that time and wants to hedge this risk. Evans has advised MCE to enter into a
forward contract to achieve this purpose. After ten months, the price of the stock rises to
$155.99. The risk free rate is 7.645%. When MCE asked Evans about what rate of return
it earned over this time period, Evans made the following comment:

“If you entered the contract at a price of $164.675, the value of the forward contract to
you is $8.685, but the rate of return that you earn cannot be higher or lower than
7.645%.”

MCE is expected to receive British pounds from the sale of its subsidiary operating in
England. A large multinational firm established in Britain is likely to buy the subsidiary
in about one year’s time. To hedge the exchange rate risk associated with the
dollar/pound exchange rate, MCE has entered a forward contract at the no-arbitrage price.
The current spot exchange rate is $1.886/£. The U.S. risk free rate is 5.5% and the U.K.
risk free rate is 6.3%. After two months the exchange rate rose to $1.861/£. During a
meeting with Adrian Hill, MCE’s CEO, Evans stated that the value of the contract (per
unit) to MCE after the exchange rate movement is -$0.000715.

Evans will receive a performance-based bonus in 167 days and will use it to purchase the
stock of High-Class Entertainment Studios (HCES). The stock is currently selling for
$120.39 and is expected to pay a dividend of $1.36 in 65 days and another $1.03 in 135
days. The risk free rate is 5.0%. To lock in a fixed purchase price, Evans has decided to
go long a forward contract on the stock. 80 days later, the stock price rises to $125.79.

Hill held a meeting with Evans to understand the relative benefits of trading in futures
markets as well as the operations of suchmarkets. Evans made the following comments:

Statement 1: “A greater number of producers of a given asset relative to consumers will


most likely result in a situation called normal backwardation for the asset.”

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Statement 2: “Advantages of trading in the futures market over the forward market
include liquidity and transparency.”

HCES is establishing a division for marketing, research and development in Alabama.


The division will cost them $35 million and HCES plans to borrow this amount for 180
days, 60 days from now. To hedge the risk of interest rates rising, HCES is entering a
forward rate agreement. The term structure of LIBOR is given below.

Exhibit 1
60 day LIBOR 5.45%
120 day LIBOR 5.85%
180 day LIBOR 6.01%
240 day LIBOR 6.10%

FDD also specializes in trading strategies involving credit derivatives to enhance return
and manage risk. Joe Monks is a hedge fund manager at the firm who specializes in credit
derivative trading strategies. Monks and Evans discusstwo trades involving credit default
swaps (CDS) in which FDD has taken a position. The two individuals are attempting to
determine FDD’s stance on the underlying reference entity, to classify the type of
tradeand determine the implication of the trade on the shape of the associated credit
curve.Both transactions involve distinct reference entities.

Transaction 1: The reference entity’s bond trades at a yield of 2.5%. FDD has purchased
two-year duration CDS trading at 550 basis points and has sold eight-year
duration CDS trading at 300 basis points on the same entity. The
volatilities of both positions are identical.

Transaction 2: FDD has purchased a three-year CDS on a reference entity offering a


credit spread of 450 basis points. The underlying reference obligation has
a maturity of three years and offers a credit spread of 290 basis points.
FDD has additionally established a short position in the reference
obligation. The volatilities of both positions are identical.

Monks is pricing a futures contract with the spot price of the underlying equal to $67.
The contract expires in eighteen months. The underlying is expected to earn a positive
cash flow during this time period, and the future value of this cash flow is $1.3. The
future value of storage costs net of convenience yield is $1.83. The risk free rate is 8.0%.

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55.  Is Evans accurate with respect to the stock forward contract and currency forward
contract that Mega-Cap Enterprises entered into?

A.   Only with respect to the stock forward contract.


B.   Only with respect to the currency forward contract.
C.   Both with respect to the stock forward contract and the currency forward
contract.

Correct Answer: A

Reference:
CFA Level II, Volume 6, Study Session 16, Reading 47, LOS b & c.

Evans is correct with respect to the stock forward contract. If the transaction were
executed at the no-arbitrage forward price, it would be impossible to earn a return
higher or lower than the risk free rate. The no-arbitrage forward price is:

154.87(1.07645)0.8333= $164.675
Value of forward contract = 155.99 – 164.675 = –$8.685
Since MCE is short, so the value is positive 8.685

Evans is incorrect with respect to the currency forward contract. Since MCE will
receive pounds, it will go short the forward contract to hedge the exchange rate
risk (the time to maturity equals one year). The forward rate equals:

1.886(1.055)/1.063 = $1.872

Value of the forward contract to the long:

1.861/(1.063)10/12–1.872/(1.055)10/12 = –$0.0217

Since MCE is short, it gains $0.0217

56.  The value of the HCES stock forward contract to Evans after 80 days is closest to:

A.   $4.723.
B.   $5.026.
C.   $5.473.

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Correct Answer: C

Reference:
CFA Level II, Volume 6, Study Session 16, Reading 47, Pages26-29 LOS b.

Present value of dividends: 1.36/(1.05)65/365 + 1.03/(1.05)135/365 = $2.3598

Forward price = (120.39 – 2.3598)(1.05)167/365= $120.69

After 80 days, the first dividend has already been paid, and there are 55 days
remaining till the second dividend. Its present value is 1.03/1.0555/365 = $1.0224

Value = (125.79 – 1.0224) –120.69/(1.05)87/365 = $5.473

57.  Evans is most accurate with respect to:

A.   Statement 1 only.
B.   Statement 2 only.
C.   both statements 1 and 2.

Correct Answer: C

Reference:
CFA Level II, Volume 6, Study Session 16, Reading 48, LOS f.

Statement 1 is correct. A greater number of producers imply that there will be a


greater number of people wanting to hedge the price risk of the asset by going
short relative to those who want to go long. Hence, the futures price will be less
than the expected spot price (the holders of the asset must lower the price to a
level sufficient to compensate the futures trader for the risk he is taking on). This
situation is called normal backwardation.

Statement 2 is correct. Futures market provide an orderly, liquid trading platform


in which traders can open and close positions without worrying about holding
contracts to expiration. The clearinghouse provides an additional degree of
liquidity. The transparency of futures market arises from the open, standardized
and regulated nature of the market. Futures prices are closely monitored by
market participants and prices are widely disseminated to participants and the
general public.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

58.  The rate on the forward rate agreement that HCES is entering is closest to:

A.   4.155%.
B.   5.069%.
C.   6.260%.

Correct Answer: C

Reference:
CFA Level II, Volume 6, Study Session 16, Reading 47, LOS c.

The forward rate is equal to:


[1+0.0610(240/360)/1+0.0545(60/360) – 1](360/180) = 6.2598%

59.  Which of the following statements is most likely correct with respect to the CDS
transactions discussed by Monks and Evans?

A.   Transaction 1 is classified as a long/short trade.


B.   Concerning Transaction 2, FDD anticipates a shift in the term structure.
C.   Concerning Transaction 1, FDD anticipates long-term problems for the
reference entity.

Correct Answer:C

Reference:
CFA Level II, Volume 6, Study Session 17, Reading 52, LOS d.

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CFA  Level  II  Mock  Exam  3  –  Solutions  (AM)  

C is correct. Transaction 1 is classified as a curve trade. This is because FDD has


purchased two CDS with different maturities on the same reference entity. Since
FDD is long the short-term CDS (selling protection) and short the long-term CDS
(buying protection), it undertakes a curve-steepening trade; this trade implies that
the short-term outlook for the reference entity is better relative to the long-term
outlook.

A is incorrect. A long/short trade involves taking a long position in one CDS and
short position in another CDS; the two CDSs will involve different reference
entities.

B is incorrect. Transaction 2 is not taken in anticipation of a shift in the general


level of the curve. This is becausethe volatilities of the two positions are equal.
Since credit risk is cheaper in the bond market, FDD has chosen to exploit the
arbitrage opportunity by borrowing cheap in the bond market and going long in
the CDS market to earna high premium.

60.  The appropriate futures price for the future contract Monks is pricing is closest to:

A.   $74.829.
B.   $75.569.
C.   $75.729.

Correct Answer: C

Reference:
CFA Level II, Volume 6, Study Session 16, Reading 48, LOS d.

The futures price equals: 67(1.08)18/12–1.3+1.83 = $75.729.

We do not subtract the non-monetary benefit amount because the storage costs are
net of this benefit (storage costs are net of convenience yield, that is, this yield is
already subtracted).

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