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Sample Level I Questions

These sample questions were developed to give candidates an indication of the question
formats
that would be experienced on the actual examination.
These questions were not intended to represent the actual exam with respect to topic
coverage,
level of difficulty, or time requirement. These questions were not intended to provide any
indication of candidates’ performance on the actual exam. Candidates should also note
that these
questions were based on old curriculum and/or learning outcome statements that may no
longer
be assigned. Also, format and writing style conventions used for questions have changed
over
time in keeping with “best practices”.
1. According to the AIMR Code of Ethics, members must practice, and encourage others
to
practice, in a professional and ethical manner that will:
A. reflect credit on members and their profession.
B. add value for clients, prospects, employers, and employees.
C. maintain the excellent reputation of AIMR and its members.
D. encourage talented and ethical individuals to enter the investments profession.
2. The AIMR Standards of Professional Conduct state that a financial analyst shall not,
when
presenting material to others, “copy or use in substantially the same form, material
prepared
by another person without acknowledging its use and identifying the name of the author
or
publisher of such material.” The analyst, however, may use information from other
sources
without acknowledgment if the information:
A. includes the analyst’s own conclusions.
B. is only being reported in a one-to-one client presentation.
C. is only being reported to the analyst’s employer or associates.
D. is factual information published in recognized financial and statistical reporting
services.
3. Beth Patrick, a fixed income analyst at a brokerage company, assists her company’s
traders
by developing in-house bond ratings to supplement those of the major bond rating
services.
The traders use disparities in the ratings to construct profitable investment strategies.
Patrick
makes inferences from nonmaterial private information and news events, which she
reflects
in her bond ratings. Patrick’s approach:
A. reflects the mosaic theory.
B. violates confidentiality rules.
C. violates insider trading rules.
D. reflects the misappropriation of information theory.
4. According to the AIMR Standards of Practice Handbook, AIMR members are
permitted to:
A. depend on coworkers, who are AIMR members, to fulfill the obligation of informing
employers of the Code and Standards.
B. use in research reports, without acknowledgement, materials prepared by an AIMR
member employed by another company.
C. be excused for a lack of knowledge of the laws and regulations of countries in which
they
provide investment services, but not of the country in which they live and work.
D. waive the requirement to inform their employer, in writing, that AIMR members are
obligated to comply with the Code and Standards, if the employer has acknowledged, in
writing, adoption of the Code and Standards.
5. An analyst gathered the following data:
63.5 96.9 112.3 134.1
66.4 98.3 116.2 138.5
75.6 99.5 116.9 139.8
77.5 100.7 118.3 140.7
84.4 102.0 122.0 143.0
87.6 105.5 122.2 153.9
89.9 108.4 124.5 155.5
In constructing a frequency distribution using five classes, if the first class is “60 up to
80,”
the class frequency of the third class is:
A. 4.
B. 5.
C. 6.
D. 8.
6. An analyst gathered the following information about the net profit margins of
companies in
two industries:
Net Profit Margin Industry K Industry L
Mean 15.0% 5.0%
Standard deviation 2.0% 0.8%
Range 10.0% 15.0%
Compared with the other industry, the relative dispersion of net profit margins is smaller
for
Industry:
A. L, because it has a smaller mean deviation.
B. L, because it has a smaller range of variation.
C. K, because it has a smaller standard deviation.
D. K, because it has a smaller coefficient of variation.
7. An individual deposits $10,000 at the beginning of each of the next 10 years, starting
today,
into an account paying 9 percent interest compounded annually. The amount of money in
the
account at the end of 10 years will be closest to:
A. $109,000.
B. $143,200.
C. $151,900.
D. $165,600.
8. An investor wants to have $1 million when she retires in 20 years. If she can earn a 10
percent annual return, compounded annually, on her investments, the lump-sum amount
she
would need to invest today to reach her goal is closest to:
A. $100,000.
B. $117,459.
C. $148,644.
D. $161,506.
9. In hypothesis testing, a Type II error is:
A. rejecting the null hypothesis when it is true.
B. rejecting the null hypothesis when it is false.
C. accepting the null hypothesis when it is true.
D. accepting the null hypothesis when it is false.
10. An investment promises to pay $100 one year from today, $200 two years from
today, and
$300 three years from today. If the required rate of return is 14 percent, compounded
annually, the value of this investment today is closest to:
A. $404.
B. $444.
C. $462.
D. $516.
11. According to new classical economists, financing a reduction in current taxes by
government
borrowing will most likely result in aggregate demand being:
A. decreased.
B. increased.
C. unaffected.
D. increased or reduced, depending on interest rate levels.
12. Which of the following is least likely to explain why government regulation is
usually a sub optimal
Response to monopolistic markets?
A. Regulatory agencies often reflect the views of special interests.
B. Owners of regulated companies can lack the incentive to operate at a low cost.
C. Regulatory agencies may lack information about the true costs and profits of
companies.
D. Regulatory agencies can typically enforce marginal cost pricing but not average cost
pricing.
13. The law of diminishing marginal utility states that the:
A. marginal return derived from making successive units of investment eventually
declines.
B. additional satisfaction derived from consuming successive units of a product
eventually
declines.
C. additional satisfaction derived from consuming successive units of a product is limited
by
the amount of disposable income.
D. additional satisfaction derived from consuming successive units of a product can be
increased by reducing the product price.
14. Which of the following statements best describes the relationship between the
amount of
accounting profits (assuming historical-cost-based accounting) and the amount of
economic
profits of a company?
A. Accounting profits and economic profits are similar.
B. Economic profits are greater than accounting profits.
C. Accounting profits are greater than economic profits.
D. No systematic relationship exists between accounting and economic profits.
15. If the effects are fully anticipated, what impact is expansionary monetary policy
most likely
to have on real economic activity?
A. Little or no impact.
B. Large expansionary impact.
C. Moderate expansionary impact.
D. Moderate contractionary impact.
Questions 16-20 assume U.S. GAAP (generally accepted
accounting principles) unless
otherwise noted.
16. An analyst should consider whether a company acquired assets through a capital lease
or an
operating lease because the company may structure:
A. operating leases to look like capital leases to enhance the company’s leverage ratios.
B. operating leases to look like capital leases to enhance the company’s liquidity ratios.
C. capital leases to look like operating leases to enhance the company’s leverage ratios.
D. capital leases to look like operating leases to enhance the company’s liquidity ratios.
17. A lease is most likely to be classified as an operating lease if the:
A. lease contains a bargain purchase option.
B. collectibility of lease payments by the lessor is unpredictable.
C. term of the lease is more than 75 percent of the estimated economic life of the leased
property.
D. present value of the minimum lease payments equals or exceeds 90 percent of the fair
value of the leased property.
18. In the Statement of Cash Flows, which of the following best describes whether
interest
received and interest paid, respectively, are classified as operating or investing cash
flows?
Interest received Interest paid
A. Operating Operating
B. Operating Investing
C. Investing Operating
D. Investing Investing
19. An analyst gathered the following information about a fixed asset purchased by a
company:
• Purchase price $12,000,000
• Estimated useful life 5 years
• Estimated salvage value $2,000,000
Using the double-declining-balance depreciation method, the company’s depreciation
expense in Year 2 will be closest to:
A. $2,000,000.
B. $2,400,000.
C. $2,880,000.
D. $7,680,000.
20. The following information applies to a company’s preferred stock:
• Current price $47.00 per share
• Par value $50.00 per share
• Annual dividend $3.50 per share
If the company’s marginal corporate tax rate is 34 percent, the after-tax cost of preferred
stock is closest to:
A. 4.62%.
B. 4.91%.
C. 7.00%.
D. 7.45%.
21. The divisor for the Dow Jones Industrial Average (DJIA) is most likely to decrease
when a
stock in the DJIA:
A. has a stock split.
B. has a reverse split.
C. pays a cash dividend.
D. is removed and replaced.
22. A silver futures contract requires the seller to deliver 5,000 Troy ounces of silver. An
investor sells one July silver futures contract at a price of $8 per ounce, posting a $2,025
initial margin. If the required maintenance margin is $1,500, the price per ounce at which
the
investor would first receive a maintenance margin call is closest to:
A. $5.92.
B. $7.89.
C. $8.11.
D. $10.80.
23. The current price of an asset is 100. An out-of-the-money American put option with
an
exercise price of 90 is purchased along with the asset. If the breakeven point for this
hedge is
at an asset price of 114 at expiration, then the value of the American put at the time of
purchase must have been:
A. 0.
B. 4.
C. 10.
D. 14.
24. An analyst gathered the following information about a company:
• 2001 net sales $10,000,000
• 2001 net profit margin 5.0%
• 2002 expected sales growth -15.0%
• 2002 expected profit margin 5.4%
• 2002 expected common stock shares outstanding 120,000
The company’s 2002 expected earnings per share is closest to:
A. $3.26.
B. $3.72.
C. $3.83.
D. $4.17.
25. An industry is currently growing at twice the rate of the overall economy. New
competitors
are entering the industry and the formerly high profit margins have begun to decline. The
life
cycle stage that best characterizes this industry is:
A. mature growth.
B. pioneering development.
C. rapid accelerating growth.
D. stabilization and market maturity.
26. The structure of an investment company is least likely to be characterized by:
A. a corporate form of organization.
B. investment of a pool of funds from many investors in a portfolio of investments.
C. an annual management fee ranging from 3 to 5 percent of the total value of the fund.
D. a board of directors who hires a separate investment management company to manage
the
portfolio of securities and to handle other administrative duties.
27. If an investor’s required return is 12 percent, the value of a 10-year maturity zero-
coupon
bond with a maturity value of $1,000 is closest to:
A. $312.
B. $688.
C. $1,000.
D. $1,312.
28. Which of the following is least likely to affect the required rate of return on an
investment?
A. Real risk free rate.
B. Asset risk premium.
C. Expected rate of inflation.
D. Investors’ composite propensity to consume.
29. An individual investor’s investment objectives should be expressed in terms of:
A. risk and return.
B. capital market expectations.
C. liquidity needs and time horizon.
D. tax factors and legal and regulatory constraints.
30. A U.S. investor who buys Japanese bonds will most likely maximize his return if
interest
rates:
A. fall and the dollar weakens relative to the yen.
B. fall and the yen weakens relative to the dollar.
C. rise and the dollar weakens relative to the yen.
D. rise and the yen weakens relative to the dollar.
31. Arbitrage pricing theory (APT) and the capital asset pricing model (CAPM) are
most similar
with respect to their assumption that:
A. security returns are normally distributed.
B. a mean-variance efficient market portfolio exists and contains all risky assets.
C. an asset’s price is primarily determined by its covariance with one dominant factor.
D. unique risk factors are independent and will be diversified away in a large portfolio.
32. Which of the following statements best reflects the importance of the asset
allocation
decision to the investment process? The asset allocation decision:
A. helps the investor decide on realistic investment goals.
B. identifies the specific securities to include in a portfolio.
C. determines most of the portfolio’s returns and volatility over time.
D. creates a standard by which to establish an appropriate investment time horizon.
Answers:
1. A.2. D.3. A.4. D.5. D.6. D.7. D.8. C.9. D.10. B.11. C.12. D.13. B.14. C.15. A.
2. 16. C.17.B.18. A.19. C.20. D.21. A.22. C.23. D.24. C.25. A.26. C.27. A.28. D.
29. A.30. A.31. D.32. C.
2003 Sample Level II Questions
These sample questions were developed in 2003 to give candidates an indication of the question
formats that would be experienced on the actual examination.
These questions were not intended to represent the actual exam with respect to topic coverage, level of
difficulty, or time requirement. These questions were not intended to provide any indication of
candidates’ performance on the actual exam. Candidates should also note that these questions were
based on old curriculum and/or learning outcome statements that may no longer be assigned. Also,
format and writing style conventions used for questions have changed over time in keeping with “best
practices”.
Item Set #1 (Ethics):
Superior Asset Management has offices and provides investment advisory services to clients living in
various countries. Each country has different securities laws and regulations and no prohibition exist
against using material nonpublic information:
• Home Country (HC) has no securities laws or regulations.
• Less Strict Country (LSC) has securities laws and regulations that are less strict than the
requirements of the AIMR Code and Standards and also states that the law of the locality where
business is conducted governs.
• More Strict Country (MSC) has securities laws and regulations that are more strict than the
requirements of the AIMR Code and Standards and states that the law of the locality where
clients reside governs.
Superior wants to ensure that its portfolio managers comply with the applicable laws, rules, and
regulations of the various countries where Superior does business. Specifically, Superior is concerned
about the activities of the following four portfolio managers:
• Diane Grant, an AIMR member, resides in LSC but does business in HC and LSC.
• Brenda Klein, a candidate in the CFA Program, resides in LSC and manages accounts for clients
who reside in either LSC or MSC. LSC law applies
• Chris Thompson, CFA, resides in MSC and does business in LSC with clients who are citizens of
LSC. MSC law applies.
• John Wilson, an AIMR member, resides in HC and does business in HC, LSC, and MSC. LSC and
MSC laws apply.
1. Which of the following best describes Grant’s responsibility under the AIMR Standards of
Professional Conduct? Grant may:
A. not use material nonpublic information for her HC clients, her LSC clients, or herself.
B. use material nonpublic information for her HC clients, LSC clients, and for herself.
C. use material nonpublic information for her HC clients but not for her LSC clients or herself.
D. use material nonpublic information for her HC clients and LSC clients but not for herself.
2. According to AIMR Standards Klein must adhere to:
A. AIMR Code and Standards for her LSC and MSC clients.
B. MSC laws and regulations for both LSC and MSC clients.
C. AIMR Code and Standards for her LSC clients and MSC laws and regulations for her MSC
clients.
D. LSC laws and regulations for her LSC clients and MSC laws and regulations for her MSC
clients.
3. Thompson also manages accounts for clients who reside in MSC. According to AIMR Standards
Thompson must adhere to:
A. MSC laws and regulations for her LSC and MSC clients.
B. AIMR Code and Standards for her LSC and MSC clients.
C. AIMR Code and Standards for her LSC clients and MSC laws and regulations for her MSC
clients.
D. LSC laws and regulations for her LSC clients and MSC laws and regulations for her MSC
clients.
4. According to AIMR Standards Wilson must adhere to:
A. AIMR Code and Standards for his HC, LSC, and MSC clients.
B. The laws and regulations of MSC for his HC, LSC, and MSC clients.
C. AIMR Code and Standards for his HC and LSC clients and the laws and regulations of MSC
for his MSC clients.
D. The laws and regulations of HC for his HC clients, the laws and regulations of LSC for his
LSC clients, and the laws and regulations for MSC for his MSC clients.
Item Set #1 Guideline Answers:
1. A is correct. Because applicable law is less strict than the AIMR Code and Standards, the member
must adhere to the Code and Standards, which say that material nonpublic information may not be
used under any circumstances.
2. C is correct. When AIMR Code and Standards impose a higher degree of responsibility than
applicable laws, the AIMR Code and Standards must be applied. This is the case for Klein’s
clients in LSC. If applicable law is more strict than the requirements of the Code and Standards,
however, members, CFA charterholders, and candidates in the CFA program must adhere to
applicable law. This is the case for Klein’s clients in MSC.
3. A is correct. An analyst or portfolio manager working in an international environment is required
to have knowledge of the laws of the country where he or she is working. When involved with
securities of a country with laws and regulations that are more strict than the AIMR Code and
Standards, the stricter laws and regulations of the analyst’s home country (in this case MSC)
prevail.
4. C is correct. If applicable law is more strict than the requirements of the AIMR Code and
Standards, members, CFA charterholders, and candidates in the CFA program must adhere to
applicable law. Thus, the Code and Standards apply to Wilson’s HC and LSC clients and the laws
and regulations of MSC apply to his MSC clients.
Item Set #2 (Quantitative Analysis)
Peggy Parsons, CFA, wants to forecast sales of BoneMax, a prescription drug for treating
osteoporosis. Parsons has developed the sales regression model shown in Exhibit 1 and supporting
data found in Exhibits 2 and 3 to assist in her sales forecast of BoneMax.
Exhibit 1
BoneMax Sales Regression Model
SALES = 8.530 + 6.078 (POP) + 5.330 (INC) + 7.380 (ADV)
t-values: (2.48) (2.23) (2.10) (2.75)
Unadjusted R2=0.804
Number of observations = 20 annual observations
Notes:
SALES = sales of BoneMax (US$ millions)
POP = population (millions) of U.S. women over age 60
INC = average income (US$ thousands) of U.S. women over
age 60
ADV = advertising dollars spent on BoneMax (US$ millions)
Exhibit 2
Variable Estimates for 2002
POP 34.7
INC 27.4
ADV 8.2
Exhibit 3
Critical Values for Students t Distribution
Area in Upper Tail Degrees of
Freedom 10% 5% 2.5%
16 1.3368 1.7459 2.1199
17 1.3334 1.7459 2.1098
18 1.3304 1.7341 2.1009
19 1.3277 1.7291 2.0930
20 1.3253 1.7247 2.0860
1. Using the regression model developed, the sales forecast in millions of U.S. dollars for 2002 is
closest to:
A. 215.
B. 280.
C. 417.
D. 426.
2. The unadjusted R2 indicates that the intercept and the independent variables together explain:
A. 80.4% of total BoneMax annual sales.
B. 80.4% of the variability of BoneMax annual sales.
C. 89.7% of the variability of BoneMax annual sales.
D. less than 20% of the variability of BoneMax annual sales.
3. At the 5 percent level of significance, is the regression coefficient of the average income of U.S.
women over the age of 60 (INC) significantly different from zero?
A. No, because 2.10 < 2.1199
B. Yes, because 2.10 > 1.7247
C. Yes, because 2.10 > 1.7459
D. Yes, because 2.10 > 2.0860
4. In testing the statistical significance of the regression coefficient of advertising dollars spent on
BoneMax, Parsons must know which of the following inputs?
5. The standard error of the estimated coefficient for advertising dollars spent on BoneMax (ADV)
is closest to:
A. 0.373.
B. 2.211.
C. 2.684.
D. 5.934.
Item Set #2, Guideline Answers
1. D is correct. 8.530 + (6.078 × 34.7) + (5.330 × $27.4) + (7.380 × $8.2) = $426.0 million.
2. B is correct.
3. A is correct because with df = 20 – (3+1) = 16 and a 2-tailed test = 2.5% area, the critical t-value
= 2.1199.
4. D is correct because both inputs are necessary to determine the statistical significance of an
individual regression coefficient.
5. C is correct. The standard error is equal to 7.380/2.75.
Degrees of
freedom
One-tailed or
two-tailed test
A. No No
B. No Yes
C. Yes No
D. Yes Yes
2003 Sample Level III Questions
These sample questions were developed in 2003 to give candidates an indication of the question
formats that would be experienced on the actual examination.
These questions were not intended to represent the actual exam with respect to topic coverage, level of
difficulty, or time requirement. These questions were not intended to provide any indication of
candidates’ performance on the actual exam. Candidates should also note that these questions were
based on old curriculum and/or learning outcome statements that may no longer be assigned. Also,
format and writing style conventions used for questions have changed over time in keeping with “best
practices”.
Item Set #1 (Ethics):
Emily Cassella is an investment manager in a bank trust department. She provides investment advice
to high-net-worth clients and has developed a computer model that successfully identifies emerging
market companies with the potential for earnings growth. Cassella is planning to leave the bank to
start her own investment advisory firm that will provide the same level of services as the bank but at
lower fees. After business hours, in a social context, she casually informs several of the bank’s clients
of her plans and suggests that they switch their accounts to her firm once it is established. Cassella
also contacts a number of potential clients that she had been actively soliciting for the bank to inform
them that she is planning to start her new firm. She then contacts prospective clients that the bank has
rejected as being too small. Several of the bank’s current clients, potential clients, and rejected
prospects agree to transfer their accounts to Cassella’s firm once it is established.
Two weeks prior to announcing her resignation, Cassella applies to the appropriate regulatory
authorities to ensure that she can complete and file the necessary registration documents so she can
begin operating her business on the day she announces her resignation. She informs both of her
research assistants at the bank that she will be resigning and asks them to help her start her new firm.
Neither agrees to follow Cassella to her new firm.
Just prior to announcing her resignation, Cassella takes home some of her work that she believes
will help her establish her new firm. This material includes sample marketing presentations that she
designed; research material on several companies that Cassella has been following; investment ideas
that were rejected by Cassella’s superiors at the bank; a list of her clients; a copy of the firm’s
compliance procedures; and her clients’ records, including their investment objectives and constraints.
1. Cassella is planning to start her own firm while still employed by the bank. According to the
AIMR Standards of Professional Conduct, which of the following best describes Cassella’s
obligations in this situation? She:
A. must disclose the potential change in her employment to the bank’s clients and prospects.
B. must disclose the potential change in her employment to her direct supervisor at the bank.
C. may not breach her duty of loyalty to the bank in preparing to leave her current position.
D. may not seek alternative employment that could place her in direct competition with the bank.
2. With regard to Cassella’s solicitation of the bank’s current clients, which of the following
statements is most accurate? Cassella:
A. has not violated the AIMR Standards if the solicited clients do not follow Cassella when she
resigns.
B. has not violated the AIMR Standards because the solicitation was made after business hours
and in a social setting.
C. has not violated the AIMR Standards because Cassella’s duty to inform the clients about the
potential for reduced fees takes priority over her duty of loyalty to her employer.
D. has violated the AIMR Standards by soliciting the bank’s investment clients.
3. With regard to the bank’s potential clients and rejected prospects, which of the following
statements is most accurate? Cassella:
A. has not violated the AIMR Standards if the potential clients are later rejected by the bank.
B. has not violated the AIMR Standards if potential clients’ fees are substantially lower at
Cassella’s new firm.
C. may solicit the rejected prospects while she is employed by the bank and the potential clients
after she starts her new firm.
D. may not solicit either group because both the potential clients and the rejected prospects
represent potential business opportunities for the bank.
4. With regard to Cassella’s removal of the sample marketing presentations and the research
materials, which of the following statements is most accurate? Cassella:
A. has violated the AIMR Standards because the research materials may include nonpublic
information.
B. has violated the AIMR Standards even if Cassella never uses either of them for the benefit of
her new firm.
C. may remove the sample marketing presentations if they do not include confidential
information about the bank or its clients.
D. may remove the research material if it is factual information published by recognized
financial and statistical reporting services.
5. With regard to Cassella taking the computer model and the rejected investment ideas from the
bank, which of the following statements is most accurate? Cassella:
A. may take the computer model solely for her personal use and the rejected investment ideas for
use by her new firm.
B. may not take the rejected investment ideas or the computer model because they remain the
property of the bank.
C. may take the rejected investment ideas, because the bank is not using them, but she may not
take the computer model because it is proprietary information.
D. may take both the computer model and the rejected investment ideas because she personally
developed both and they are her property.
6. With regard to Cassella’s removal of the compliance procedures from the bank, which of the
following statements is most accurate? Cassella:
A. has violated the AIMR Standards because Cassella developed them for use by the bank.
B. has not violated the AIMR Standards because AIMR requires adequate compliance
procedures at all member firms.
C. has not violated the AIMR Standards if they are copied directly from the AIMR Standards of
Professional Conduct.
D. has not violated the AIMR Standards if they are used solely to promote adherence to the
AIMR Code and Standards by Cassella and her new firm.
Guideline Answers:
1. C is correct. Cassella is not allowed to breach her duty of loyalty to the bank in preparing to leave.
However, she does not need to notify anyone of her pending departure and she is free to seek
other employment.
2. D is correct. Cassella may not solicit current or potential clients of the bank prior to her leaving
the bank whether in a social setting or any other setting. The reduced fee potential is not a
criterion for allowing her to solicit them. It does not matter whether the clients leave or not; the
act of soliciting them would be a violation.
3. C is correct. Cassella may solicit rejected prospects while she is still employed by the bank
because they do not represent competition with the bank. She must do this on her own time
however, so that she fullfills her duty to her current employer. Prior to leaving the bank, she may
not solicit potential clients, but once she leaves she is free to contact them. The reduced fee
potential is not a criterion for allowing her to solicit the potential clients as long as she works for
the bank. It does not matter whether the bank eventually rejects the potential clients; the act of
soliciting them would be a violation as long as they have not been rejected.
4. B is correct. Cassella may not remove the sample marketing presentations and research materials
from the bank. The fact that the materials are never used to benefit her new firm does not change
the fact that they are the property of the bank and may not be removed. If Cassella had written
permission, she could remove the materials without violation of the Standards. It does not matter
whether the materials contain confidential or nonpublic information or not; the act of removing
them would be a violation. It does not matter whether the materials are factual information or not;
they are the property of the bank because they were gathered on the bank’s time.
5. B is correct. Cassella may not remove the computer model and the rejected investment ideas from
the bank. The fact that she developed them does not change the fact that they are the property of
the bank and may not be removed. They are not her property and she may not use them.
6. A is correct. Cassella may not remove the compliance procedures from the bank. They are the
property of the bank and may not be removed. Their source and use do not change the situation.
Item Set #2 (Derivatives)
Joel Franklin is a portfolio manager responsible for derivatives. Franklin observes European-style put
options and call options on Abaco Ltd. common stock with the same strike price and time to
expiration. Selected information relevant to Abaco Ltd. stock and options is shown in Exhibit 1.
Exhibit 1
Abaco Ltd. Securities Selected Data
Closing price of Abaco common stock $43.00
Put and call option exercise price $45.00
Time to expiration One year
Price of the European-style put option $4.00
Price of the European-style call option
One-year risk-free rate, compounded
continuously 5.50%
Samantha Crowe, a colleague of Franklin, believes that Abaco stock is overpriced and she decides to
sell short the stock. However, her broker informs her that an adequate inventory of the stock may not
be available to sell short.
1. Based on a put-call parity, the value of the European-style call option is closest to:
A. $0.00.
B. $2.00.
C. $4.35.
D. $4.41.
2. If the volatility of Abaco’s stock price decreases, what is most likely to happen to the values of
the related call and put?
A. Both the call and the put will decrease in value.
B. Both the call and the put will increase in value.
C. The value of the call will increase while the value of the put will decrease.
D. The value of the call will decrease while the value of the put will increase.
3. Franklin considers buying a European-style put option with an exercise price of $40.00 and one
year to expiration. Based on the information provided in Exhibit 1 about the options with an
exercise price of $45.00, what should be the price of a put option with an exercise price of
$40.00?
A. Less than or equal to $1.00.
B. Greater than $1.00 but less than or equal to $3.00.
C. Greater than $3.00 but less than or equal to $9.00.
D. Greater than $9.00.
4. Which of the following actions, if executed by Crowe at the correct exercise prices, times to
expiration, and face values, will accomplish the same payoff as the original short sale strategy?
A. Buy a pure discount risk-free bond, buy a put option, buy a call option.
B. Short a pure discount risk-free bond, buy a put option, buy a call option.
C. Buy a pure discount risk-free bond, sell a put option, buy a call option.
D. Short a pure discount risk-free bond, buy a put option, sell a call option.
5. The Chief Economist at Franklin’s firm is forecasting a substantial decline in interest rates. To
help gain from this forecast while assuming limited risk, Franklin should take which of the
following actions with regard to the European-style options in Exhibit 1?
A. Buy the call option.
B. Buy the put option.
C. Sell the call option.
D. Sell the put option.
6. Franklin considers selling the European-style put option described in Exhibit 1. Ignoring time
value of money and given current prices, the maximum possible loss from this strategy is:
A. $39.00.
B. $41.00.
C. $45.00.
D. Unlimited.
Item Set #2 Guideline Answers
1. D is correct. c = S + p – Xe–r(T– t)
$4.408 = $43 + 4.00 – 45.00e–0.055×1
2. A is correct. The volatility of the stock is directly related to the price of the call option and the put
option. So a decrease in volatility will cause the price of both the call and the put to decrease.
3. B is correct. The price of the put option is its time value plus intrinsic value. The time value
should be about $2.00 (from the $45.00 exercise price) and the intrinsic value will be $0.00. This
will place the price of the put at about $2.00, depending upon the volatility of Abaco stock. Both
the options (exercise price of $40 and $45) have the same time to expiration and similar time
values, and both options are European.
4. D is correct. The put-call parity can be written as c = S + p – Xe–r(T– t)
This equation can be re-written as –S = – Xe–r(T– t) + p – c
The left-hand side can be stated as shorting a stock, and the right hand side of the equation can be
stated shorting a pure discount risk free bond, buying a put, and shorting a call.
5. B is correct. According to the Black-Scholes Option Pricing Model, the change in risk-free
interest rate (‘rho’) is directly related to the value of a call option and inversely related to the
value of a put option. A decrease in interest rates should cause the price of the call to fall and the
price of the put to increase. Buying a put and selling a call will both result in gains, but selling a
naked call is an unlimited risk strategy. Therefore, buying a put will be the most appropriate
choice.
6. B is correct because the upper boundary for a put option price is when the stock is worthless (S =
0). Here, the put holder will have the right to sell the stock for $45, when it is worth nothing in the
market. The put writer will lose ($45–$4) = $41.

2004 CFA® Level II Examination


Morning Session – Essay
Candidate Number:
_____ _____ _____ _____ _____ _____ _____
THIS BOOK IS THE PROPERTY OF:
Association for Investment Management and Research®
560 Ray C. Hunt Drive
Charlottesville VA 22903-0668
USA
Tel: 434-951-5499
© 2004 Association for Investment Management and Research. All rights reserved.
FOR AIMR USE ONLY
FOR AIMR USE ONLY
Page 1
The Morning Session of the 2004 CFA Level II Examination has 19
questions.
For grading purposes, the maximum point value for each question is equal to
the
number of minutes allocated to that question.
Question Topic Minutes
1 Asset Valuation 10
2 Asset Valuation 8
3 Asset Valuation 9
4 Asset Valuation 15
5 Corporate Finance 18
6 Asset Valuation 9
7 Asset Valuation 7
8 Asset Valuation 6
9 Asset Valuation 7
10 Asset Valuation 7
11 Asset Valuation 10
12 Asset Valuation 6
13 Asset Valuation 8
14 Asset Valuation 12
15 Asset Valuation 12
16 Asset Valuation 9
17 Asset Valuation 9
18 Portfolio Management 9
19 Portfolio Management 9
Total: 180
Page 2
Questions 1 through 5 relate to Dynamic Communication and
Wade Goods & Co. A total
of 60 minutes is allocated to these questions. Candidates
should answer these questions in
the order presented. Exhibits 1-1, 1-2, and 1-3 relate to
Questions 1 through 3.
QUESTION 1 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
Dynamic Communication is a U.S. industrial company with several electronics divisions.
The
company has just released its 2003 annual report. Exhibits 1-1 and 1-2 present a summary
of
Dynamic’s financial statements for the years 2002 and 2003. Selected data from the
financial
statements for the years 1999 to 2001 are presented in Exhibit 1-3.
Exhibit 1-1
Dynamic Communication
Summary Balance Sheets
as of 31 December
(U.S. $ millions)
2003 2002
Cash and Equivalents $149 $83
Accounts Receivable 295 265
Inventory 275 285
Total Current Assets $719 $633
Gross Fixed Assets 9,350 8,900
Accumulated Depreciation (6,160) (5,677)
Net Fixed Assets $3,190 $3,223
Total Assets $3,909 $3,856
Accounts Payable $228 $220
Notes Payable 0 0
Accrued Taxes and Expenses 0 0
Total Current Liabilities $228 $220
Long-term Debt $1,650 $1,800
Common Stock 50 50
Additional Paid-in Capital 0 0
Retained Earnings 1,981 1,786
Total Shareholders’ Equity $2,031 $1,836
Total Liabilities and Shareholders’ Equity $3,909 $3,856
Page 3
Exhibit 1-2
Dynamic Communication
Summary Statements of Income
Years Ended 31 December
(U.S. $ millions except for share data)
2003 2002
Total Revenues $3,425 $3,300
Operating Costs and Expenses 2,379 2,319
Earnings Before Interest, Taxes,
Depreciation and Amortization (EBITDA)
$1,046
$981
Depreciation and Amortization 483 454
Operating Income (EBIT) $563 $527
Interest Expense 104 107
Income Before Taxes $459 $420
Taxes (40%) 184 168
Net Income $275 $252
Dividends $80 $80
Change in Retained Earnings $195 $172
Earnings per Share $2.75 $2.52
Dividends per Share $0.80 $0.80
Number of Shares Outstanding (millions) 100 100
Exhibit 1-3
Dynamic Communication
Selected Data from Financial Statements
Years Ended 31 December
(U.S. $ millions except for share data)
2001 2000 1999
Total Revenues $3,175 $3,075 $3,000
Operating Income (EBIT) 495 448 433
Interest Expense 104 101 99
Net Income $235 $208 $200
Dividends per Share $0.80 $0.80 $0.80
Total Assets $3,625 $3,414 $3,230
Long-term Debt $1,750 $1,700 $1,650
Total Shareholders’ Equity $1,664 $1,509 $1,380
Number of Shares Outstanding (millions) 100 100 100
Page 4
A group of Dynamic shareholders has expressed concern about the zero growth rate of
dividends
in the last four years, and has asked for information about the growth of the company.
A. Calculate Dynamic’s sustainable growth rates in 2000 and 2003. Show your
calculations.
Note: Your calculations should use beginning-of-year balance sheet data.
(6 minutes)
B. Determine how the change in Dynamic’s sustainable growth rate (2003 compared
to
2000) was affected by changes in each of the following for Dynamic:
i. Retention ratio
ii. Financial leverage
Show your calculations.
Note: Your calculations should use beginning-of-year balance sheet data.
(4 minutes)
Page 8
QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 8
MINUTES.
Mike Brandreth, an analyst who specializes in the electronics industry, is preparing a
research
report on Dynamic Communication. A colleague suggests to Brandreth that he may be
able to
determine Dynamic’s implied dividend growth rate from Dynamic’s current common
stock
price, using the Gordon growth model. Brandreth believes that the appropriate required
rate of
return for Dynamic’s equity is 8 percent.
A. Calculate, given a current common stock price of $58.49, Dynamic’s implied
dividend
growth rate as of 31 December 2003, using the Gordon growth model. Show your
calculations.
(5 minutes)
The management of Dynamic has indicated to Brandreth and other analysts that the
company’s
current dividend policy will be continued.
B. Determine whether using the Gordon growth model to value Dynamic’s common
stock
is appropriate or inappropriate. Justify your response with one reason based on the
assumptions of the Gordon growth model.
(3 minutes)
Page 12
QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
Mike Brandreth is considering the free cash flow to equity model as a method of valuing
Dynamic Communication’s equity.
A. Calculate Dynamic’s free cash flow to equity for 2003. Show your calculations.
(5 minutes)
Brandreth also wants to value Dynamic’s equity with the free cash flow to the firm
(FCFF)
model, based on a single-stage approach that assumes a constant annual growth rate of
cash
flow. He has decided to use the following formula to value Dynamic’s equity (V0) as of
31
December 2003:
0
0
0 BVD
gr
) g 1 ( FCFF
V-
-

=
FCFF0 = free cash flow to the firm in 2003
g = constant annual growth rate of cash flow
r = required rate of return for equity
BVD0 = book value of debt as of 31 December 2003
B. Indicate whether Brandreth’s use of each of the following two variables in his
formula
for V0 is appropriate or inappropriate:
i. r
ii. BVD0
State, for any inappropriate variable, the variable that Brandreth should use in his
formula for V0.
Answer Question 3-B in the Template provided on page 14.
(4 minutes)
Page 14

Answer Question 3 on This Page


Template for Question 3-B
Two variables
Indicate whether
Brandreth’s use of each of
the following two variables
in his formula for V0 is
appropriate or
inappropriate
(circle one for each
variable)
State, for any inappropriate variable,
the variable that Brandreth should use
in his formula for V0
r
Appropriate
Inappropriate
BVD0
Appropriate
Inappropriate
Page 17
QUESTION 4 HAS ONE PART FOR A TOTAL OF 15 MINUTES.
Dynamic Communication dominates a segment of the consumer electronics industry. A
small
competitor in that segment is Wade Goods & Co. Wade has just introduced a new
product, the
Carrycom, which will replace the existing Wade product line and could significantly
affect the
industry segment.
Mike Brandreth is preparing an industry research update that focuses on Wade, including
an
analysis that makes extensive use of the five competitive forces identified by Porter. As
part of
his research, Brandreth attends the launch presentation of the Carrycom. Wade’s
President,
Toby White, makes the following statements:
• “Wade has an exclusive three-year production license for Carrycom technology
from the patent owners of the new technology. This will provide us a window of
opportunity to establish a leading position with this new product before
competitors enter the market with similar products.”
• “A vital component in all existing competitive products is pari-copper, an
enriched form of copper; production of pari-copper is limited and is effectively
controlled by Dynamic. The Carrycom is manufactured with ordinary copper,
thus overcoming the existing dependence on pari-copper. All other Carrycom
components can be purchased from numerous sources.”
• “Existing products based on pari-copper are designed to work in a single
geographic region that is pre-determined during the manufacturing process. The
Carrycom will be the only product on the market that can be reset by the user for
use in different regions. We expect other products within our industry segment to
incorporate this functionality at the end of our exclusive license period.”
• “The Carrycom and similar competitive products have recently added the function
of automatic language conversion. This elevates these products to a superior
position within the broader electronics market, ahead of personal digital
assistants, personal computers, and other consumer electronics. We expect that
the broader electronics market will not be able to integrate automatic language
conversion for at least one year.”
• “We intend to replace Dynamic as the market leader within the next three years.
We expect ordinary copper-based products with automatic language conversion to
be the industry standard in three years. This will result in a number of similar
products and limited pricing power after the three-year license expires.”
Brandreth has adequately researched two of Porter’s competitive forces—the bargaining
power
of buyers and the bargaining power of suppliers—and now turns his attention to the
remaining
competitive forces needed to complete his analysis of Wade.
Page 18
Identify the three remaining competitive forces. Determine, with respect to
each of the
remaining competitive forces, whether Wade’s position in the industry is likely to be
strong or
weak:
i. One year from now
ii. Five years from now
Justify each of your responses with reference to White’s statements.
Answer Question 4 in the Template provided on pages 19, 20,
and 21.
(15 minutes)

Answer Question 4 on This Page


Page 19
Template for Question 4
Identify the three
remaining
competitive forces
Determine, with respect to
each of the remaining
competitive forces,
whether Wade’s position
in the industry is likely to
be strong or weak
(circle strong or weak for
each time period)
Justify each of your responses with
reference to White’s statements
One year
from now
Strong
Weak
1.
Five years
from now
Strong
Weak
Template for Question 4 continued on pages 20 and 21
Page 20

Answer Question 4 on This Page


Template for Question 4 (continued)
Identify the three
remaining
competitive forces
Determine, with respect to
each of the remaining
competitive forces,
whether Wade’s position
in the industry is likely to
be strong or weak
(circle strong or weak for
each time period)
Justify each of your responses with
reference to White’s statements
One year
from now
Strong
Weak
2.
Five years
from now
Strong
Weak
Template for Question 4 continued on page 21

Answer Question 4 on This Page


Page 21
Template for Question 4 (continued)
Identify the three
remaining
competitive forces
Determine, with respect to
each of the remaining
competitive forces,
whether Wade’s position
in the industry is likely to
be strong or weak
(circle strong or weak for
each time period)
Justify each of your responses with
reference to White’s statements
One year
from now
Strong
Weak
3.
Five years
from now
Strong
Weak
Page 25
QUESTION 5 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18
MINUTES.
Mike Brandreth has just read an announcement from Wade Goods & Co. that the
Carrycom
was put into production at the beginning of 2004. The announcement includes the
information given in Exhibit 5-1.
Exhibit 5-1
Wade Goods & Co.
Carrycom Sales Forecasts
2004 2005 2006
Unit Sales 5,000,000 6,250,000 7,500,000
Sales Price per Unit (U.S. $) $100 $100 $100
Total Revenues (U.S. $ millions) $500 $625 $750
With respect to the Carrycom forecasts for 2004, Brandreth estimates that operating fixed
costs
will be $225 million and operating variable costs will be 27.5 percent of the sales price.
A. Calculate the Carrycom’s breakeven sales quantity (units) for 2004. Show your
calculations.
(3 minutes)
Six months later, Brandreth reviews industry data for the first half of 2004 that indicate a
slowing growth rate in sales. Brandreth has prepared revised projections for 2005 for both
Wade
and Dynamic Communication. Selected data from his revised projections for Wade are
given in
Exhibit 5-2. Brandreth is using his revised data to analyze the extent to which both Wade
and
Dynamic are using operating leverage and financial leverage. For Dynamic, he has
calculated
the degree of operating leverage in 2005 to be 2.41 and the degree of financial leverage to
be
1.17.
Exhibit 5-2
Wade Goods & Co.
Selected Data from Revised Projections
Year Ended 31 December 2005
(U.S. $ millions except for share data)
Total Revenues $590
Operating Variable Costs 210
Operating Fixed Costs 175
Operating Income (EBIT) $205
Interest Expense 82
Taxes 49
Net Income $74
Earnings per Share $7.40
Dividends per Share $0.18
Total Assets $975
Long-term Debt $820
Total Shareholders’ Equity $97
Number of Shares Outstanding (millions) 10
Page 26
B. i. Calculate the degree of operating leverage for Wade in 2005. Show your
calculations.
ii. Judge whether the operating income of Wade or Dynamic would be more
affected by a change in revenues in 2005. Justify your response with reference to
the degree of operating leverage in 2005 for each company.
(6 minutes)
C. i. Calculate the degree of financial leverage for Wade in 2005. Show your
calculations.
ii. Judge whether Wade or Dynamic would have more financial risk in 2005.
Justify your response with reference to the degree of financial leverage in 2005
for each company.
(6 minutes)
D. Calculate the degree of total leverage for Dynamic in 2005. Show your
calculations.
(3 minutes)
Page 31
Questions 6 through 14 relate to the Star Hospital Pension
Plan. A total of 72 minutes is
allocated to these questions. Candidates should answer these
questions in the order
presented.
QUESTION 6 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
Sandra Kapple is a fixed income portfolio manager who works with large institutional
clients,
including the Star Hospital Pension Plan. Kapple is meeting with consultant Maria
VanHusen to
discuss management of the approximately $100 million bond portion of the $250 million
Star
portfolio. The current bond portfolio is invested entirely in U.S. Treasury securities.
During the
meeting, VanHusen and Kapple discuss the current U.S. Treasury yield curve, given in
Exhibit
6-1. VanHusen concludes, “Based on the large differential between 2- and 10-year yields,
the
portfolio would be expected to experience a higher return over a 10-year investment
horizon by
buying 10-year Treasuries, rather than buying 2-year Treasuries and reinvesting the
proceeds
into 2-year Treasuries at each maturity.”
Exhibit 6-1
U.S. Treasury Yield Curve
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
2 5 10 30
Maturity (Years)
Yield (%)
A. Indicate whether VanHusen’s conclusion is correct or incorrect, based on the pure
expectations theory. Support your response with one reason.
(3 minutes)
VanHusen discusses with Kapple alternative theories to explain the term structure of
interest
rates and gives her the information in Exhibit 6-2.
Page 32
Exhibit 6-2
Estimated U.S. Treasury Liquidity Premiums
Maturity (years)
2 5 10 30
Liquidity Premium (basis points) 50 60 75 100
B. Determine, based on the additional information in Exhibit 6-2 where applicable,
what the
shape of the yield curve in Exhibit 6-1 implies about the direction of expected future
short-term interest rates, using the:
i. Liquidity theory
ii. Market segmentation theory
Justify each of your responses with one reason.
(6 minutes)
Page 36
QUESTION 7 HAS TWO PARTS (A, B) FOR A TOTAL OF 7
MINUTES.
Sandra Kapple presents Maria VanHusen with a description, given in Exhibit 7-1, of the
bond
portfolio held by the Star Hospital Pension Plan. All securities in the bond portfolio are
noncallable U.S. Treasury securities.
Exhibit 7-1
Star Hospital Pension Plan
Bond Portfolio
Price if Yields
Change
Par Value
(U.S. $) Treasury Security
Market
Value
(U.S. $)
Current
Price
Up
100
Basis
Points
Down
100
Basis
Points
Effective
Duration
48,000,000 2.375% due 2006 48,667,680 101.391 99.245 103.595 2.15
50,000,000 4.75% due 2031 50,000,000 100.000 86.372 116.887
98,000,000 Total Bond Portfolio 98,667,680 --- --- ---
A. Calculate the effective duration of each of the following:
i. The 4.75% Treasury security due 2031
ii. The total bond portfolio
Show your calculations.
(4 minutes)
VanHusen remarks to Kapple, “If you changed the maturity structure of the bond
portfolio to
result in a portfolio duration of 5.25, the price sensitivity of that portfolio would be
identical to
the price sensitivity of a single, noncallable Treasury security that has a duration of 5.25.”
B. Describe the yield scenario in which VanHusen’s remark would be correct.
(3 minutes)
Page 40
QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 6
MINUTES.
Sandra Kapple expects interest rates to rise and yield volatility to increase. She is
concerned
about the effects on the bond portfolio held by the Star Hospital Pension Plan. Maria
VanHusen
tells Kapple, “We can forecast future yield volatility using either historical volatility or
implied
volatility. There are problems, however, associated with either approach. Using historical
volatility, for example, assumes that past volatility levels will remain unchanged in the
future.”
A. i. Identify, with respect to the calculation of historical yield volatility, two inputs
that affect estimates of historical volatility used to forecast future yield volatility.
ii. State one assumption that is typically made in using implied volatility to forecast
future yield volatility.
(3 minutes)
Given her expectation of rising interest rates, Kapple is considering the purchase of
default-free
putable bonds for the Star bond portfolio. She asks VanHusen whether yield volatility is
relevant
to her purchase decision.
B. Determine whether the prices of default-free putable bonds are likely to change in
response to increasing yield volatility. Justify your response with one reason.
(3 minutes)
Page 45
QUESTION 9 HAS TWO PARTS (A, B) FOR A TOTAL OF 7
MINUTES.
Sandra Kapple is concerned that the Star Hospital Pension Plan’s bond portfolio will
decline in
value if interest rates rise as she expects. To protect the portfolio, Kapple is considering
the
purchase of a putable bond that has a three-year maturity and a 5 percent annual-pay
coupon, and
is putable in two years at 101. Using a binomial interest rate tree (contained in Exhibit 9-
1) that
assumes each path has an equal probability, she determines that the computed value today
of an
otherwise identical option-free bond is 104.32.
Exhibit 9-1
Binomial Interest Rate Tree
Valuation of an Option-free Bond
Three-year Maturity; 5.00% Annual-pay Coupon
(10% Volatility Assumed)
Kapple is now using a binomial interest rate tree to determine the computed value today
of the
putable bond she is considering. Exhibit 9-2 contains her partially completed binomial
interest
rate tree for the putable bond.
Node Contents
Computed value 100.00
Coupon 5.00
Short-term rate 99.47
5.00
101.17 5.564% 100.00
5.00 5.00
104.32 3.730% 100.43
2.500% 5.00
102.69 4.555% 100.00
5.00 5.00
3.054% 101.22
5.00
3.730% 100.00
5.00
Today Year 1 Year 2 Year 3
Page 46
Exhibit 9-2
Binomial Interest Rate Tree
Valuation of a Putable Bond
Three-year Maturity; 5.00% Annual-pay Coupon
Putable in Two Years at 101
(10% Volatility Assumed)
A. Determine, to reflect the value of the embedded put option in the putable bond
described
in Exhibit 9-2, the computed values in Year 2 for the:
i. Upper node
ii. Middle node
iii. Lower node
Answer Question 9-A in the Template provided on page 47.
(3 minutes)
B. Calculate the computed value today of the putable bond described in Exhibit 9-2.
Show
your calculations.
Answer Question 9-B in the Template provided on page 47.
(4 minutes)
Node Contents
Computed value 100.00
Coupon 5.00
Short-term rate ---
5.00
5.564% 100.00
5.00 5.00
--- 3.730% ---
2.500% 5.00
4.555% 100.00
5.00 5.00
3.054% ---
5.00
3.730% 100.00
5.00
Today Year 1 Year 2 Year 3

Answer Question 9 on This Page


Page 47
Template for Question 9-A
Determine, to reflect the value of the embedded put option
in the putable bond described in Exhibit 9-2, the computed
values in Year 2 for the:
Computed value:
Upper node
5.00
5.564%
Computed value:
Middle node
5.00
4.555%
Computed value:
Lower node
5.00
3.730%
Year 2
Template for Question 9-B
Calculate the computed value today of the putable bond
described in Exhibit 9-2
Computed value:
2.500%
Today
Show your calculations
Page 50
QUESTION 10 HAS TWO PARTS (A, B) FOR A TOTAL OF 7
MINUTES.
Sandra Kapple is analyzing commercial mortgage-backed securities (CMBS) as a way to
diversify the Star Hospital Pension Plan’s bond portfolio. She understands that CMBS
and U.S.
non-government agency, residential mortgage-backed securities (MBS) have different
loan
recourse provisions and is concerned about assessing the relative credit risk of CMBS
and MBS.
A. i. Contrast the loan recourse provision found in CMBS with the loan recourse
provision found in MBS.
ii. Explain how assessing the credit risk of CMBS versus MBS differs as a result of
the contrasting loan recourse provisions.
(4 minutes)
Kapple is particularly interested in CMBS because of the call protection available to a
CMBS
investor.
B. Describe, for a CMBS investor, one form of call protection that is available at the
loan
level.
(3 minutes)
Page 54
QUESTION 11 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
Maria VanHusen suggests to Sandra Kapple that using forward contracts on fixed income
securities can be used to protect the value of the Star Hospital Pension Plan’s bond
portfolio
against the rising interest rates that Kapple expects. VanHusen prepares the following
example
to illustrate for Kapple how such protection would work:
• A ten-year bond with a face value of $1,000 is issued today at par value. The
bond pays an annual coupon.
• An investor intends to buy this bond today and sell it in six months.
• The six-month risk-free interest rate today is 5.00% (annualized).
• A six-month forward contract on this bond is available, with a forward price of
$1,024.70. The contract is not an off-market forward contract.
• In six months, the price of the bond, including accrued interest, will be $978.40 as
a result of a rise in interest rates.
A. Based on VanHusen’s example:
i. State whether the investor should buy or sell the forward contract to protect the
value of the bond against rising interest rates during the holding period.
ii. Calculate the value of the forward contract for the investor at the maturity of the
forward contract. Show your calculations.
iii. Calculate the change in value of the combined portfolio (the underlying bond and
the appropriate forward contract position) six months after contract initiation.
Show your calculations.
(6 minutes)
Kapple tells VanHusen, “Your example does not address the credit risk that will exist at
the
expiration date of the forward contract.”
B. Determine if credit risk exists for each of the following parties in VanHusen’s
example:
i. Buyer of the forward contract
ii. Seller of the forward contract
Justify each of your responses with one reason.
(4 minutes)
Page 58
QUESTION 12 HAS ONE PART FOR A TOTAL OF 6 MINUTES.
Sandra Kapple asks Maria VanHusen about using futures contracts to protect the value of
the
Star Hospital Pension Plan’s bond portfolio if interest rates rise as Kapple expects.
VanHusen states:
• “Selling a bond futures contract will generate positive cash flow in a rising
interest rate environment prior to the maturity of the futures contract.”
• “The cost of carry causes bond futures contracts to trade for a higher price than
the spot price of the underlying bond prior to the maturity of the futures contract.”
Indicate whether each of VanHusen’s two statements is accurate or inaccurate.
Support each
of your responses with one reason.
Answer Question 12 in the Template provided on page 59.
(6 minutes)

Answer Question 12 on This Page


Page 59
Template for Question 12
VanHusen’s two
statements
Indicate whether
each of
VanHusen’s two
statements is
accurate or
inaccurate
(circle one for
each statement)
Support each of your responses with one
reason
“Selling a bond
futures contract will
generate positive cash
flow in a rising
interest rate
environment prior to
the maturity of the
futures contract.”
Accurate
Inaccurate
“The cost of carry
causes bond futures
contracts to trade for
a higher price than
the spot price of the
underlying bond prior
to the maturity of the
futures contract.”
Accurate
Inaccurate
Page 62
QUESTION 13 HAS ONE PART FOR A TOTAL OF 8 MINUTES.
To protect the value of the Star Hospital Pension Plan’s bond portfolio against the rising
interest
rates that she expects, Sandra Kapple enters into a one-year pay fixed, receive floating
U.S.
LIBOR interest rate swap, as described in Exhibit 13-1.
Exhibit 13-1
U.S. LIBOR Interest Rate Swap Terms
1-year Fixed Rate (annualized) 1.5%
90-day U.S. LIBOR Rate [L0(90)] (annualized) 1.1%
Notional Principal $1
Day Count Convention 90/360
Note: Li(m) is the m-day LIBOR on day i
Sixty days have passed since initiation of the swap and interest rates have changed.
Kapple is
concerned that the value of her swap has also changed. The U.S. LIBOR term structure
and
present value factors of interest rates are described in Exhibit 13-2.
Exhibit 13-2
U.S. LIBOR Term Structure and Present Value Factors
(60 days after swap initiation)
U.S. LIBOR Term Structure
(annualized) Present Value Factors
L60(30) = 1.25 percent 0.9990
L60(120) = 1.50 percent 0.9950
L60(210) = 1.75 percent 0.9899
L60(300) = 2.00 percent 0.9836
Note: Li(m) is the m-day LIBOR on day i
Calculate the dollar market value of the interest rate swap entered into by Kapple, at
60 days
after the initiation of the swap and using a $1 notional principal. Show your
calculations.
Note: Your calculations should be rounded to 4 decimal places.
(8 minutes)
Page 66
QUESTION 14 HAS TWO PARTS (A, B) FOR A TOTAL OF 12
MINUTES.
Several weeks later, in response to weaker economic data, Sandra Kapple is now less
certain that
interest rates will rise in the future. Her new goal is to protect the value of the Star
Hospital
Pension Plan’s bond portfolio should interest rates rise, while preserving the portfolio’s
upside
return potential if interest rates decline in the future.
A. Judge whether the purchase of each of the following derivative instruments would
accomplish Kapple’s goal:
i. Interest rate cap
ii. European put option on a bond
iii. European put option on an interest rate
Justify each of your responses with one reason based on the derivative instrument’s
payoff.
(9 minutes)
Kapple is considering possible advantages and disadvantages of American and European
put
options on bond forward contracts. All of the options she considers are equivalent with
respect
to premium, expiration date, underlying asset, and strike price.
B. State whether early exercise is an advantage of put options on bond forward
contracts.
Support your response with one reason.
(3 minutes)
Page 70
Questions 15 through 17 relate to Lin Semiconductor Inc. and
Warren Integrated Circuits
Inc. A total of 30 minutes is allocated to these questions.
Candidates should answer these
questions in the order presented. Exhibits 15-1 and 15-2 relate
to Questions 15 through 17.
QUESTION 15 HAS ONE PART FOR A TOTAL OF 12 MINUTES.
David Yam, CFA, is evaluating which of two companies in the same industry sector is a
more
attractive investment. Lin Semiconductor Inc., based in a Pacific Rim country where the
local
currency is the tig, is the largest company in the “merchant silicon” industry. Warren
Integrated
Circuits Inc., based in the U.S., is the second largest company in the industry. Both
companies
sell products globally.
Yam has gathered summary financial information, shown in Exhibit 15-1, for the two
companies,
as well as supplemental information, shown in Exhibit 15-2, for Lin.
Exhibit 15-1
Summary Financial Information
(all financial statement data in local currency unless otherwise
noted)
Lin
Semiconductor
Inc.
(Tig millions)
Warren
Integrated
Circuits Inc.
(U.S. $ millions)
Income Statement Data for the Year Ended 31 December 2003
Total Revenues 121,208 3,483
Earnings Before Interest and Taxes (EBIT) 29,833 984
Earnings Before Taxes 20,417 939
Net Income (presented according to local accounting principles) 16,208 746
Balance Sheet Data as of 31 December 2003
Total Assets 292,907 4,235
Total Shareholders’ Equity 221,890 2,378
Lin
Semiconductor
Inc.
Warren
Integrated
Circuits Inc.
Share Data as of 31 December 2003
Fully Diluted Number of Shares Outstanding (millions) 14,942 263
Market Price per Share (local currency) 95 24
Page 71
Exhibit 15-2
Lin Semiconductor Inc.
Supplemental Information
Warren is a U.S. GAAP-reporting firm, while Lin reports its financial statements in
accordance
with GAAP of the country in which it is based. Yam wants to compare price/earnings
(P/E)
ratios for Lin and Warren. He is deciding whether to adjust Lin’s income statements for
the
following three items related to the comparability of Lin’s P/E ratio to Warren’s P/E
ratio:
• Assets available-for-sale
• Investments held-to-maturity
• Unusual gain
During 2003, Lin acquired a small competitor for strategic reasons. Lin paid 1.4 billion
tigs
for 100 percent of the outstanding shares of the company. Goodwill was charged directly
to
shareholders’ equity. Lin continues to operate the company as a separate entity.
Details of the Acquisition
At the Date of Acquisition
(net of Goodwill)
Book Value
(Tig millions)
Fair Value
(Tig millions)
Total Assets Acquired 650 750
Total Liabilities Acquired 350 350
Accounting for Investments
As of 31 December 2003 Cost
(Tig millions)
Market
(Tig millions)
Assets Available-for-Sale
Portfolio Equity Investments 20,000 25,000
Investments Held-to-Maturity
Government-backed Bonds 31,500 30,000
All investments were acquired early in 2003. The company records all investments at the
lower of cost or market, with all resulting gains and losses being reported on the income
statement.
Unusual Gain
Included in Lin’s income for the year was an unusual gain in the amount of 5.0 billion
tigs.
The gain was related to the sale of a piece of land that had been purchased for a future
factory;
Lin has now abandoned its plans to build the factory. Lin has not had similar gains in the
past.
Page 72
Determine, for each of the three items related to the comparability of Lin’s P/E
ratio to
Warren’s P/E ratio:
i. Whether the item requires a positive adjustment, a negative adjustment, or no
adjustment
to Lin’s 2003 pre-tax income
ii. The amount of any required adjustment to Lin’s 2003 pre-tax income
iii. Why an adjustment is or is not required
Answer Question 15 in the Template provided on page 73.
(12 minutes)

Answer Question 15 on This Page


Page 73
Template for Question 15
Determine, for each of the three items related to the
comparability of Lin’s P/E
ratio to Warren’s P/E ratio:
Three items
Whether the item
requires a positive
adjustment, a negative
adjustment, or no
adjustment to Lin’s
2003 pre-tax income
(circle one for each
item)
The amount of
any required
adjustment to
Lin’s 2003
pre-tax income
Why an adjustment is or is not
required
Assets
availablefor-
sale
Positive Adjustment
Negative Adjustment
No Adjustment
Investments
held-to-
maturity
Positive Adjustment
Negative Adjustment
No Adjustment
Unusual gain
Positive Adjustment
Negative Adjustment
No Adjustment
Page 76
QUESTION 16 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
David Yam turns his attention to return on equity (ROE) and related measures for Warren
Integrated Circuits Inc. Yam uses year-end balance sheet values for all ratio calculations.
A. Calculate, using the DuPont model, each of the five components of Warren’s
ROE for
the year ended 31 December 2003. Show your calculations.
(5 minutes)
Yam observes that Warren’s ROE is substantially higher than the industry ROE. He notes
the
following two factors that may affect the level of Warren’s ROE in 2004:
• Floating-rate debt: Warren has a large amount of floating-rate debt on its balance
sheet. Interest rates are expected to increase dramatically in 2004.
• Debt reclassification: A portion of Warren’s term debt will be reclassified from
long-term liabilities to current liabilities in 2004 because the debt will be maturing
in 2005.
B. Identify, for each of the two factors noted by Yam, which one, if any, of the five
DuPont
components is most likely to be affected by the factor. Determine whether
Warren’s
ROE for 2004 is most likely to increase, decrease, or not change as a result of each of
the
two factors.
Note: Your response should consider each of the two factors independently.
Answer Question 16-B in the Template provided on page 78.
(4 minutes)
Page 78

Answer Question 16 on This Page


Template for Question 16-B
Note: Your response should consider each of the two factors independently.
Two factors
Identify, for each of the two
factors noted by Yam, which
one, if any, of the five DuPont
components is most likely to be
affected by the factor
Determine whether Warren’s
ROE for 2004 is most likely to
increase, decrease, or not
change as a result of each of
the two factors
(circle one for each factor)
Floating-rate
debt
Increase
Decrease
Not change
Debt
reclassification
Increase
Decrease
Not change
Page 80
QUESTION 17 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
David Yam’s supervisor has asked Yam to value the equity of Warren Integrated Circuits
Inc.
using a residual income model.
A. Describe two circumstances in which a residual income model is most
appropriate for
valuing the equity of a company.
(4 minutes)
Yam expects that Warren’s return on equity will average 15 percent in 2004 and beyond.
Using
the capital asset pricing model, he estimates the required rate of return for Warren’s
equity to be
11 percent. Yam believes that Warren will grow at 9 percent annually for the foreseeable
future.
B. Calculate the value per share of Warren’s equity as of 31 December 2003, using
the
single-stage residual income model. Show your calculations.
(5 minutes)
Page 84
QUESTION 18 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
Jonathan Lambini has decided to save €12,000 each year in a taxable savings account.
He wants
a balanced portfolio, with minimal turnover, that is composed of a mix of individual
equity
securities and corporate bonds. His financial advisor states:
“Now that you have specified the asset classes to be included in your portfolio, the
second step in the asset allocation process should be to find the optimal asset mix
utilizing your specified asset classes.”
A. Discuss whether the financial advisor’s statement about the second step in the asset
allocation process is correct or incorrect.
(3 minutes)
Six years later, Lambini’s annual income has increased substantially. He decides to invest
the
maximum allowable €100,000 this year in a tax-deferred retirement account. His taxable
savings
account now has a market value of €100,000. Lambini determines that a combined
portfolio
consisting of €120,000 in individual equity securities and €80,000 in corporate bonds is
optimal.
The current tax rate on both capital gains and income is 30 percent, and all cash
dividends are
taxed. Taxes on capital gains are payable when gains are realized.
B. i. Determine how the €120,000 in individual equity securities should be allocated
between Lambini’s taxable savings account and his tax-deferred retirement
account.
ii. Determine how the €80,000 in corporate bonds should be allocated between
Lambini’s taxable savings account and his tax-deferred retirement account.
iii. Justify your allocations in parts (i) and (ii) with one reason.
Answer Question 18-B in the Template provided on page 86.
(6 minutes)
Page 86

Answer Question 18 on This Page


Template for Question 18-B
Account
Determine how the
€120,000 in individual
equity securities
should be allocated
between Lambini’s
taxable savings
account and his taxdeferred
retirement
account
Determine how the
€80,000 in corporate
bonds should be
allocated between
Lambini’s taxable
savings account and
his tax-deferred
retirement account
Total
Taxable Savings € € €100,000
Tax-Deferred Retirement € € €100,000
Total €120,000 €80,000 €200,000
Justify your allocations
with one reason
Page 88
QUESTION 19 HAS ONE PART FOR A TOTAL OF 9 MINUTES.
The Board of Trustees for the defined benefit pension plan of Columbia Automotive, a
U.S.-
based company, is conducting its annual review of the plan. The Columbia workforce is
relatively young, and the company’s pension fund has more than enough assets to meet
its
liabilities. The fund’s investment policy statement (IPS), however, has not been reviewed
for a
number of years and is being updated. A consultant has suggested that the Board can use
other
institutions as a model for updating the IPS, particularly with respect to portfolio
constraints.
The consultant states:
• “The Columbia pension fund’s liquidity constraint should be similar to the
liquidity constraint of an endowment fund.”
• “The Columbia pension fund’s time horizon should be similar to the time horizon
of a loan portfolio held by a commercial bank.”
• “The Columbia pension fund’s tax considerations should be similar to the tax
considerations of a life insurance company.”
Indicate whether each of the consultant’s three statements is correct or incorrect.
Support each
of your responses with one reason.
Answer Question 19 in the Template provided on page 89.
(9 minutes)

Answer Question 19 on This Page


Page 89
Template for Question 19
Consultant’s
three statements
Indicate
whether each of
the consultant’s
three statements
is correct or
incorrect
(circle one for
each statement)
Support each of your responses with one reason
“The Columbia
pension fund’s
liquidity
constraint should
be similar to the
liquidity
constraint of an
endowment
fund.”
Correct
Incorrect
“The Columbia
pension fund’s
time horizon
should be similar
to the time
horizon of a loan
portfolio held by
a commercial
bank.”
Correct
Incorrect
“The Columbia
pension fund’s
tax
considerations
should be similar
to the tax
considerations of
a life insurance
company.”
Correct
Incorrect
2004 CFA® Level II Examination
Morning Session – Essay
IMPORTANT INSTRUCTIONS TO CANDIDATES
1. Write your candidate number in the spaces provided on the front cover of this
examination book.
2. Complete and sign the pledge attached to the front cover of this examination
book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.
3. Write your answers in blue or black ink on the designated answer pages in the
examination book.
4. Label each part of your answer (A, B, C, D or i, ii, iii, etc.).
5. Only answers written on the correct answer pages will be graded. You may
make
marks and notes on the question pages, but these marks will not be graded.
6. If you use all of the designated pages, check the box at the bottom of the last
page
of your answer and continue your answer on the unnumbered extra pages at the
back of the examination book. Label extra pages with the correct question
number.
7. Use only the Texas Instruments BAII Plus, Hewlett Packard 12C or 12C
Platinum
calculator. Use of any other calculator will result in the submission of a Violation
Report to AIMR.
8. You must stop writing immediately when instructed to do so at the conclusion
of
the examination.
9. Violation of any of AIMR’s examination rules will result in AIMR voiding your
examination results and may lead to a suspension or termination of your candidacy
in the CFA Program.
DO NOT OPEN THIS EXAMINATION BOOK
UNTIL INSTRUCTED TO DO SO BY THE
PROCTOR/INVIGILATOR.
DO NOT REMOVE ANY EXAMINATION MATERIALS
FROM THE TESTING ROOM.
2004 Level II Guideline Answers
Morning Session – Page 1
LEVEL II, QUESTION 1
Topic: Asset Valuation
Minutes: 10
Reading References:
12-1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R.
Robinson, Jerald
E. Pinto, and Dennis McLeavey (AIMR, 2002)
A. “Discounted Dividend Valuation,” Ch. 2
Purpose:
To test the candidate’s ability to calculate sustainable growth and interpret the effects of
financing policies on a firm’s growth.
LOS: The candidate should be able to
w) define sustainable growth rate and explain the underlying assumptions;
x) calculate the sustainable growth rate for a company.
Guideline Answer:
A. The sustainable growth rate of a company is equal to:
gs = retention ratio × return on equity = b × ROE
where
b = [Net Income – (Dividend per share × shares outstanding)]/Net Income
ROE = Net Income/Beginning of year equity
In 2000: b = [208 – (0.80 × 100)]/208 = 0.6154
ROE = 208/1380 = 0.1507
so that sustainable growth rate = 0.6154 × 0.1507 = 9.3%
In 2003: b = [275 – (0.80 × 100)]/275 = 0.7091
ROE = 275/1836 = 0.1498
so that sustainable growth rate = 0.7091 × 0.1498 = 10.6%
B. i. Sustainable growth was increased by an increasing retention ratio.
Retention ratio = (Net Income – (Dividend per share × shares outstanding)) / Net Income
Retention ratio increased from 0.615 (= 128/208) in 2000 to 0.709 (= 195/275) in 2003,
which directly increased sustainable growth, given that the retention ratio is one of the
two factors determining sustainable growth.
ii. Sustainable growth was reduced by decreasing leverage.
Financial leverage = (Total Assets/Beginning of year equity)
Financial leverage decreased from 2.34 (= 3230/1380) at the beginning of 2000 to 2.10 at
the beginning of 2003 (= 3856/1836), which directly decreased ROE (and thus
sustainable growth), given that financial leverage is one of the factors determining ROE
(and ROE is one of the two factors determining sustainable growth).
2004 Level II Guideline Answers
Morning Session – Page 2
LEVEL II, QUESTION 2
Topic: Asset Valuation
Minutes: 8
Reading References:
12-1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas. R.
Robinson, Jerald
E. Pinto, and Dennis McLeavey (AIMR, 2002)
A. “Discounted Dividend Valuation,” Ch. 2
Purpose:
To test the candidate’s ability to use and interpret the Gordon growth model for valuing a
firm’s
equity.
LOS: The candidate should be able to
j) calculate the value of a common stock using the Gordon growth model and explain the
underlying assumptions;
k) calculate the expected rate of return or implied dividend growth rate in the Gordon
growth
model, given the market price, the expected dividend, and either the expected rate of
return
or the dividend growth rate;
o) explain the strengths and limitations of the Gordon growth model, and justify the
selection of
the Gordon growth model to value a company, given the characteristics of the company
being valued.
Guideline Answer:
A. The formula for calculating the value of a common stock using the Gordon growth
model
is:
V0 = D0 × (1 + g)/(r – g)
where: D0 = actual amount of dividends at time of valuation
g = assumed annual growth rate of dividends
r = assumed required rate of return for equity
In the above formula, P0, the market price of the common stock, substitutes for
V0, then g becomes the dividend growth rate implied by the market. The formula
then becomes
P0 = D0 × (1 + g)/(r – g)
or
58.49 = 0.80 × (1 + g)/(0.08 – g)
or
58.49 × (0.08 – g) = 0.80 × (1 + g)
or
4.6792 – 58.49g = 0.80 + 0.80g
or
3.8792 = 59.29g
so that g = 6.54%
2004 Level II Guideline Answers
Morning Session – Page 3
Alternate approach:
r = D1/P0 + g = [(D0 × (1 + g)) / P0] + g
0.08 = [(0.80 × (1 + g))]/58.49] + g
[(0.80/58.49) + 1] × g = 0.08 – (0.80/58.49)
1.01368 × g = 0.06632
g = 0.06543 = 6.54%
B. Using the Gordon growth model would be inappropriate to value Dynamic’s
common stock.
1. The Gordon growth model assumes a set of relationships about the growth
rate of dividends, earnings, and stock values. Specifically, it assumes that
dividends, earnings, and stock values will grow at the same constant rate. In
Dynamic’s case the Gordon growth model is inappropriate because
management’s dividend policy has held dividends constant in dollar amounts
although earnings have grown, thus reducing the payout ratio. This policy is
inconsistent with the Gordon growth model assumption of a constant payout
ratio.
2. It could also be argued that using the Gordon growth model given Dynamic’s
current dividend policy violates one of the general conditions for suitability
of use, namely that a company’s dividend policy bears an understandable and
consistent relationship to the company’s profitability.
2004 Level II Guideline Answers
Morning Session – Page 4
LEVEL II, QUESTION 3
Topic: Asset Valuation
Minutes: 9
Reading References:
12-1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas. R.
Robinson, Jerald
E. Pinto, and Dennis McLeavey (AIMR, 2002)
B. “Free Cash Flow Valuation,” Ch. 3
Purpose:
To test the candidate’s ability to value the equity of a company using free cash flow to
equity and
free cash flow to the firm.
LOS: The candidate should be able to
a) define and interpret free cash flow to the firm (FCFF) and free cash flow to equity
(FCFE);
b) describe the FCFF and FCFE approaches to valuation and contrast the appropriate
discount
rates for each model;
f) calculate FCFF and FCFE given a company’s financial statements prepared according
to U.S.
Generally Accepted Accounting Principles or International Accounting Standards.
Guideline Answer:
A. FCFE = Net income + Non-cash charges – Investments in fixed capital
– Investments in working capital + Net borrowing
= 275 + 483 – (9,350 – 8,900) – [(295 – 265) + (275 – 285) – (228 – 220)]
+ (1650 – 1800)
= 275 + 483 – 450 – 12 – 150
= 146
Alternatively:
FCFE = Cash flow from operations – Investments in fixed capital + Net
borrowing
= [275 + 483 – (295 – 265) + (228 – 220) – (275 – 285)] – (9,350 –
8,900) + (1,650 – 1,800)
= 146
2004 Level II Guideline Answers
Morning Session – Page 5
B.
Two variables
Indicate whether Brandreth’s
use of each of the following two
variables in his formula for V0
is appropriate or inappropriate
(circle one for each input)
State, for any inappropriate
variable, the variable that
Brandreth should use in his
formula for V0
r
Appropriate
Inappropriate
Weighted average cost of
capital should be used.
BVD0
Appropriate
Inappropriate
The market value of debt
should be used.
2004 Level II Guideline Answers
Morning Session – Page 6
LEVEL II, QUESTION 4
Topic: Asset Valuation
Minutes: 15
Reading References:
11-1. “Competitive Strategy: The Core Concepts,” Ch. 1 Competitive Advantage:
Creating and
Sustaining Superior Performance, Michael E. Porter (The Free Press, 1985, 1998)
Purpose:
To test the candidate’s ability to apply Porter’s competitive forces in analyzing the
relative
strengths and weaknesses of a company within its industry.
LOS: The candidate should be able to
a) analyze the competitive advantage and competitive strategy of a company and the
competitive forces that affect the profitability of a company.
Guideline Answer:
Identify the three
remaining
competitive forces
Determine, with respect to each of the
remaining competitive forces, whether
Wade’s position in the industry is likely to
be strong or weak:
i. One year from now
ii. Five years from now
(circle strong or weak for each time period)
Justify each of your
responses with
reference to White’s
statements
1. Substitutes
One year from now
Strong
Weak
Currently the
Carrycom and other
products in their
industry segment have
automatic language
conversion
functionality and
geographic region
flexibility. This
market segment is
currently in a strong
position.
2004 Level II Guideline Answers
Morning Session – Page 7
Five years from now
Strong
Weak
White expects other
products in the
broader consumer
electronics industry
such as PDAs, PCs,
and other consumer
electronics will
eventually be able to
incorporate both
functionalities and so
therefore diminish the
strength of this force
for Carrycom and
other products in their
market segment.
One year from now
Strong
Weak
Wade has no threat of
entrants into its
market for the next
three years because
a) Wade has the
exclusive ability to
manufacture with
ordinary copper,
while other potential
entrants do not have
access to pari-copper
and b) Potential
entrants do not have
access to the
exclusive production
license for Carrycom
technology.
2. Threat of New (or
Potential) Entrants
Five years from now
Strong
Weak
However, beyond the
next three years the
threat is high. White
expects competitors to
market copper-based
products, eliminating
Carrycom’s unique
competitive
advantage. In
addition, the threeyear
exclusive
production license
expires.
2004 Level II Guideline Answers
Morning Session – Page 8
One year from now
Strong
Weak
Wade will experience
only modest rivalry
for three years as it
has an exclusive
production license for
the next three years,
which limits the
availability of similar
products. However,
the broader
electronics market
may be integrating the
automatic language
conversion feature
into their products
after one year.
3. Intensity of Rivalry
Five years from now
Strong
Weak
After the license
expires in three years
White expects other
competitors to
produce a number of
similar products
which will limit their
pricing power. This
demonstrates a high
intensity of rivalry.
2004 Level II Guideline Answers
Morning Session – Page 9
LEVEL II, QUESTION 5
Topic: Corporate Finance
Minutes: 18
Reading References:
8-1. Fundamentals of Financial Management, 8th edition, Eugene F. Brigham
and Joel F.
Houston (Dryden, 1998)
E. “Capital Structure and Leverage,” Ch. 13, including Appendix 13A
Purpose:
To test the candidate’s ability to calculate and interpret various measures of operating
leverage,
financial leverage, and total leverage.
LOS: The candidate should be able to
c) discuss business risk and financial risk, and discuss factors that influence each;
e) explain how operating leverage affects a project’s or company’s expected rate of
return;
f) calculate the breakeven quantity of sales and determine the company’s gain or loss at
various
sales levels;
h) describe how changes in the use of debt can cause changes in the company’s earnings
per
share and in the stock price;
n) calculate degree of operating leverage, degree of financial leverage, and degree of total
leverage (Appendix 13A).
Guideline Answer:
A. Break-even point = Fixed cost/(Sales price per unit – Variable cost per unit)
= $225,000,000/($100 – $27.50)
= 3,103,448.276 units
B. i. Degree of operating leverage = (Sales – Variable costs)/(Sales – Variable costs –
Fixed costs)
= (590 – 210)/(590 – 210 – 175)
= 1.85366
ii. Dynamic’s operating income would be more affected by a change in revenue in 2005,
because its degree of operating leverage (2.41) is substantially higher than Wade’s degree
of operating leverage (1.85).
C. i. Degree of financial leverage = EBIT/(EBIT – Interest Expense)
= 205/(205 – 82)
= 1.66667
ii. Wade would have more financial risk in 2005, because its degree of financial leverage
(1.67) is substantially higher than Dynamic’s degree of financial leverage (1.17).
D. Dynamic’s degree of total leverage is 2.8197 (= 2.41 × 1.17).
2004 Level II Guideline Answers
Morning Session – Page 10
LEVEL II, QUESTION 6
Topic: Asset Valuation
Minutes: 9
Reading References:
14-1. Fixed Income Analysis for the Chartered Financial Analyst®
Program, Frank J. Fabozzi
(Frank J. Fabozzi Associates, 2000)
C. “The Term Structure and the Volatility of Interest Rates,” Level II, Ch. 1
Purpose:
To test the candidate’s understanding of various theories of the term structure of interest
rates.
LOS: The candidate should be able to
d) explain the various theories of the term structure of interest rates (i.e., pure
expectations,
liquidity, preferred habitat, and market segmentation) and the implications of each theory
for
the shape of the yield curve.
Guideline Answer:
A. VanHusen’s conclusion is incorrect using the pure expectations theory. According to
this
theory, the expected return over any time horizon would be the same, regardless of the
maturity strategy employed.
B. i. According to the liquidity theory, the shape of the yield curve implies that short-term
interest rates are expected to rise in the future. This theory asserts that forward rates
reflect expectations about future interest rates plus a liquidity premium that increases
with maturity. Given the shape of the yield curve and the liquidity premiums in the
Exhibits 1 and 2, the yield curve would still be positively sloped after subtracting the
respective liquidity premiums (e.g.,
1.25% = 1.75% – 0.50%
2.90% = 3.50% – 0.60%
3.50% = 4.25% – 0.75%
3.75% = 4.75% – 1.00%).
ii. According to the market segmentation theory, the slope of the yield curve implies
nothing
about the direction of future short-term interest rates. This theory asserts that the slope of
the yield curve implies higher demand and lower supply of short-term securities relative
to long-term securities. “The market segmentation theory assumes that neither investors
nor borrowers are willing to shift from one maturity sector to another to take advantage
of opportunities arising from differences between expectations and forward rates.”
Fabozzi, p. 309
2004 Level II Guideline Answers
Morning Session – Page 11
LEVEL II, QUESTION 7
Topic: Asset Valuation
Minutes: 7
Reading References:
14-1. Fixed Income Analysis for the Chartered Financial Analyst
Program, Frank J. Fabozzi
(Frank J. Fabozzi Associates, 2000)
B. “Introduction to the Measurement of Interest Rate Risk,” Level I, Ch. 7
Purpose:
To test the candidate’s ability to calculate the duration of a security and a portfolio.
LOS: The candidate should be able to
e) compute the duration of a bond, given information about how the bond’s price will
increase
and decrease for a given change in interest rates;
i) compute the duration of a portfolio, given the duration of the bonds comprising the
portfolio,
and discuss the limitations of portfolio duration.
Guideline Answer:
A. i. The formula for effective duration is as follows:
Effective Duration = (V– – V+)/[2(V0)(.y)]
= Price if yields decline Price if yields rise
2 (Initial price) (Change in yield in decimal)
-
××
The effective duration of the 4.75% Treasury issue due 2031 is calculated as follows:
Effective duration = 116.887 86.372
2 100.00 0.01
-
××
= 15.2575 = 15.26
ii. A portfolio’s duration can be obtained by calculating the weighted average of the
duration of the bonds in the portfolio. Stated in mathematical terms:
Portfolio Duration = w1D1 + w2D2 + w3D3 … + wKDK
where
wi = market value of bond i/market value of the portfolio
Di = duration of bond i
K = number of bonds in the portfolio
The effective duration of the total bond portfolio is calculated as follows:
(48,667,680/98,667,680) × 2.15 = 0.4932 × 2.15 = 1.06
(50,000,000/98,667,680) × 15.26 = 0.5068 × 15.26 = 7.73
= 8.79
2004 Level II Guideline Answers
Morning Session – Page 12
B. A small, parallel shift in yields is the yield scenario in which VanHusen’s remarks
would
be correct. Duration is a first (linear) approximation for only small changes in yield. For
larger changes in yields, the convexity measure is needed to approximate the change in
price that is not explained by duration. Additionally, portfolio duration assumes that all
yields change by the same number of basis points (parallel shift), so any non-parallel shift
in yields would result in a difference in the price sensitivity of the portfolio versus a
single security having the same duration.
2004 Level II Guideline Answers
Morning Session – Page 13
LEVEL II, QUESTION 8
Topic: Asset Valuation
Minutes: 6
Reading References:
14-1. Fixed Income Analysis for the Chartered Financial Analyst
Program, Frank J. Fabozzi
(Frank J. Fabozzi Associates, 2000)
C. “The Term Structure and the Volatility of Interest Rates,” Level II, Ch. 1
D. “Valuing Bonds with Embedded Options,” Level II, Ch. 2
17-2. Analysis of Derivates for the CFA® Program, Don Chance (AIMR, 2003)
A. “Option Markets and Contracts,” Ch. 4, pp. 195-242
Purpose:
To test the candidate’s understanding of: (1) historical and implied yield volatility, and
(2) how
putable bonds are valued.
LOS: The candidate should be able to
“The Term Structure and the Volatility of Interest Rates”
g) distinguish between historical yield volatility and implied yield volatility;
h) explain how yield volatility is forecasted.
“Valuing Bonds with Embedded Options”
d) explain the relationship among the values of a callable (putable) bond, the
corresponding
option-free bond, and the embedded option;
e) explain the effect of volatility on the arbitrage-free value of an option.
“Option Markets and Contracts”
j) demonstrate the methods for estimating the future volatility of the underlying asset
(i.e., the
historical volatility and the implied volatility methods).
Guideline Answer:
A. i. Estimates of historical yield volatility can vary according to the following inputs:
• The time periods chosen
• The number of observations used
• The weighting of observations
ii. The use of implied volatility to forecast future yield volatility commonly makes two
assumptions:
1. Implied volatility is based on option pricing models, which typically assume that
volatility remains constant over the life of the option.
2. Implied volatility assumes that the option pricing model is correct.
B. Yes, putable bond prices are likely to change. If yield volatility increases, the value of
the
put option portion of the putable bond will increase.
2004 Level II Guideline Answers
Morning Session – Page 14
LEVEL II, QUESTION 9
Topic: Asset Valuation
Minutes: 7
Reading References:
14-1. Fixed Income Analysis for the Chartered Financial Analyst
Program, Frank J. Fabozzi
(Frank J. Fabozzi Associates, 2000)
D. “Valuing Bonds with Embedded Options,” Level II, Ch. 2
Purpose:
To test the candidate’s ability to value a putable bond using a binomial interest rate tree.
LOS: The candidate should be able to
a) explain the backward induction valuation methodology within the binomial interest
rate tree
framework;
h) compute the value of a putable bond, using an interest rate tree.
Guideline Answer:
Template for Question 9-A
Determine, to reflect the value of the embedded put option
in the putable bond described in Exhibit 9-2, the
computed values in Year 2 for the:
Computed value: 101.00
Upper node
5.00
5.564%
Computed value: 101.00
Middle node
5.00
4.555%
Computed value: 101.22
Lower node
5.00
3.730%
Year 2
Supporting information:
i. Upper node computed value = 101.00. Because the option-free bond price is below 101
in
the upper node in Year 2, the 101 putable bond value would replace the option free bond
price.
2004 Level II Guideline Answers
Morning Session – Page 15
ii. Middle node computed value = 101.00. Because the option-free bond price is below
101
in the middle node in Year 2, the 101 putable bond value would replace the option free
bond price.
iii. Lower node computed value = 101.22. Because the original option-free bond price is
above 101 in the lower node in Year 2, it is retained.
Template for Question 9-B
Calculate the computed value today of the putable bond
described in
Exhibit 9-2
Computed value: 104.956
2.500%
Today
Show your calculations
The computed value in the upper node of Year 1 is:
0.5 × [(106/1.03730) + (106/1.03730)] = 102.19
The computed value in the lower node of Year 1 is:
0.5 × [(106/1.03054) + (106.22/1.03054)] = 102.97
The computed value of the putable bond today is calculated as follows:
0.5 × [(107.19/1.0250) + (107.97/1.0250)] = 104.956
where 102.19 + 5.00 = 107.19 and 102.97 + 5.00 = 107.97
2004 Level II Guideline Answers
Morning Session – Page 16
LEVEL II, QUESTION 10
Topic: Asset Valuation
Minutes: 7
Reading References:
15-2. “Commercial Mortgage-Backed Securities,” Fixed Income Analysis for the
Chartered
Financial Analyst® Program, 2nd edition, Frank J. Fabozzi (Frank J. Fabozzi
Associates,
forthcoming)
Purpose:
To test the candidate’s understanding of CMBS, MBS, and the implications of
differences
between the two securities.
LOS: The candidate should be able to
b) contrast CMBS to residential mortgage-backed securities with respect to loan
characteristics
and approaches to assessing credit risk;
c) explain the basic structure of a CMBS and discuss the ways in which a CMBS investor
may
realize call protection at the loan level and by means of the CMBS structure;
d) define balloon risk for a CMBS and explain why such risk is important to a CMBS
investor.
Guideline Answer:
A. i. Commercial mortgage loans collateralizing a CMBS are non-recourse loans. This
means
if a CMBS loan defaults, the lender can only look to the income from re-lease of the
property or from proceeds from the sale of the property to repay the loan, and has no
recourse to the borrower for any unpaid balance.
By contrast, MBS are recourse loans, based on the fact that in the case of
residential mortgage loans, the lender has recourse if a borrower defaults.
ii. The contrasting recourse provisions give rise to a substantial difference in assessing
credit risk. CMBS loans are evaluated on a loan-by-loan basis and examined as an
individual business to determine each loan’s credit risk. Residential MBS loans are
typically lumped into buckets based on certain loan characteristics and then default rates
are assumed regarding each bucket.
B. A CMBS investor has four different forms of call protection at the loan level:
1. Prepayment lockout: a contractual agreement prohibiting any principal prepayments
during a specified period of time (usually 2 to 5 years).
2. Defeasance: a borrower provides sufficient funds to invest in a portfolio of U.S.
Treasury securities to pay the principal and interest of the CMBS instead of prepaying
the loan. This substitution of U.S. Treasuries to pay cash flow replaces the required
principal and interest payments from the borrower. There is no early distribution to
the CMBS investor but the bond’s cash flows now have a higher credit quality
because they are paid from a portfolio of U.S. Treasuries.
2004 Level II Guideline Answers
Morning Session – Page 17
3. Prepayment penalty points: percentage points a borrower pays as a premium over the
outstanding balance of the loan to prepay it; usually a prepayment penalty is in the
form of 5-4-3-2-1 price premium points that decline over time from loan origination.
4. Yield maintenance charge [also known as a make-whole charge]: the borrower pays
additional funds to the CMBS holder equal to the difference between the current
market loan rate and the rate on an outstanding loan collateralizing the CMBS. With
this extra charge or premium paid, it becomes uneconomical for the borrower to
refinance the mortgage solely to obtain a lower interest rate.
2004 Level II Guideline Answers
Morning Session – Page 18
LEVEL II, QUESTION 11
Topic: Asset Valuation
Minutes: 10
Reading References:
16-1. Analysis of Derivatives for the CFA® Program, Don Chance (AIMR,
2003)
A. “Forward Markets and Contracts,” Ch. 2, pp. 37-66
Purpose:
To test the candidate’s: (1) ability to value forward contracts, and (2) understanding of
how
forward contracts on fixed income securities can enhance a portfolio’s performance in a
rising
interest rate environment.
LOS: The candidate should be able to
b) explain how the value of a forward contract is determined at initiation, during the life
of the
contract, and at expiration;
c) define an off-market forward contract and explain how it differs from the more
standard type
of forward contract;
e) calculate the price and the value of 1) a forward contract on a fixed income security, 2)
a
forward rate agreement (FRA), and 3) a forward contract on a currency;
f) explain how credit risk arises in a forward contract and how market value is a measure
of the
credit risk to a party in a forward contract.
Guideline Answer:
A. i. The investor should sell the forward contract to hedge the bond in VanHusen’s
example
against rising interest rates. Because there is a long position in the underlying asset, the
hedge will require a short position in the derivative instrument.
ii. The value of the forward contract on expiration date is equal to the spot price of the
underlying asset on expiration date minus the forward price of the contract:
VT(0,T) = ST – F(0,T) = $978.40 – $1,024.70 = –$46.30
where VT(0,T) is the value at expiration date “T” of the forward contract (initiated at time
“0”), ST is the spot price of the underlying bond on expiration date, and F(0,T) is the
forward price of the contract. The contract has a negative value. However, this is the
value to the holder of a long position in the forward contract. In this example, the investor
should be short the forward contract; the value to this investor would be +$46.30,
because this is the cash flow the investor expects to receive.
iii. The value of the combined portfolio at the end of the six month holding period is
$978.40
+ $46.30 = $1,024.70, and the change in the value of the combined portfolio during this
six month period is $24.70.
2004 Level II Guideline Answers
Morning Session – Page 19
Supporting information:
The value of the combined portfolio is the sum of the market value of the bond and the
value of the short position in the forward contract. At the start of the six-month holding
period the bond is worth $1,000 (it was sold at par, as given in VanHusen’s assumptions)
and the forward contract has a value of zero (because this is not an off-market forward
contract no money changed hands at initiation). Six months later the bond has a value of
$978.40 (given in VanHusen’s assumptions) and the value of the short position in the
forward contract is $46.30 (calculated in part ii).
That the combined value of the long position in the bond and the short position in
the forward contract at the forward contract’s maturity date is exactly equal to the
forward price on the forward contract at its initiation date is not a coincidence. By going
long the underlying asset and short the forward contract, the investor has created a fully
hedged and hence risk-free position, and should earn the risk-free rate of return. This
sixmonth
risk-free rate of return is 5.00% (annualized), which translates into a return of
$24.70 over a six-month period [$1,000 × (1.05)1/2 – $1,000 = .02470 = 2.470% return].
These results support VanHusen’s statement that selling a forward contract on the
underlying bond will protect the portfolio during a period of rising interest rates. The loss
in the value of the underlying bond during the six month holding period is offset by the
cash payment made at expiration date to holder of the short position in the forward
contract. Put otherwise, a short position in the forward contract protects (hedges) the long
position in the underlying asset.
B. i. Credit risk does not exist for the buyer. Given the assumptions in VanHusen’s
example,
the buyer of the contract is expected to make a payment to settle the obligation, as the
spot price of the underlying bond is less than the previously agreed-to forward price of
the bond. Hence, the buyer of this forward contract is not exposed to any credit risk.
ii. Credit risk does exist for the seller. Because the spot price of the underlying bond has
declined, the seller of the forward contract expects to receive a payment of $46.30 for
each $1,000 face value of the underlying bond sold. This is the maximum amount of
credit risk that the seller is exposed to (from counterparty default).
2004 Level II Guideline Answers
Morning Session – Page 20
LEVEL II, QUESTION 12
Topic: Asset Valuation
Minutes: 6
Reading References:
16-1. Analysis of Derivatives for the CFA Program, Don Chance (AIMR, 2003)
A. “Forward Markets and Contracts,” Ch. 2, pp. 37-66
B. “Futures Markets and Contracts,” Ch. 3, pp. 103-142
Purpose:
To test the candidate’s understanding of how futures contracts on fixed income securities
can
enhance a portfolio’s performance in a rising interest rate environment.
LOS: The candidate should be able to
“Forward Markets and Contracts”
f) explain how credit risk arises in a forward contract and how market value is a measure
of the
credit risk to a party in a forward contract.
“Futures Markets and Contracts”
b) explain how to determine the value of a futures contract;
c) explain how forward and futures prices differ;
e) identify the different types of monetary and non-monetary benefits and costs
associated with
holding the underlying asset, and explain how they affect the futures price;
f) define backwardation and contango;
g) discuss whether futures prices equal expected spot prices.
Guideline Answer:
Kapple’s two statements
Indicate
whether each of
Kapple’s two
statements is
accurate or
inaccurate
(circle one for
each statement)
Support each of your responses with
one reason
1. Selling a bond futures
contract will generate
positive cash flow in a rising
rate environment prior to the
maturity of the futures
contract.
Accurate
Inaccurate
Futures contracts are marked to market
daily. Holding a short position on a bond
futures contract during a period of rising
interest rates (declining bond prices) will
generate positive cash inflow from the
daily mark to market.
If the holder of a futures contract has a
long position when the price of the
2004 Level II Guideline Answers
Morning Session – Page 21
underlying asset is increasing, then the
daily mark to market will generate a
positive cash inflow that can be
reinvested. Forward contracts only settle
at expiration date and do not generate
any cash flow prior to expiration.
2. The cost of carry causes
bond futures contracts to
trade for a higher price than
the spot price of the
underlying bond prior to the
maturity of the futures
contract.
Accurate
Inaccurate
According to the cost of carry model, the
futures contract price is adjusted upward
by the cost of carry for the underlying
asset. Bonds (and other financial
instruments), however, do not have any
significant storage costs. Moreover, the
cost of carry is reduced by any coupon
payments paid by the bond during the
life of the futures contract. If there were
any “convenience yield” from holding
the underlying bond, this too would
reduce the cost of carry. As a result, the
cost of carry for a bond is likely to be
negative.
2004 Level II Guideline Answers
Morning Session – Page 22
LEVEL II, QUESTION 13
Topic: Asset Valuation
Minutes: 8
Reading References:
17-2. Analysis of Derivatives for the CFA Program, Don Chance (AIMR, 2003)
B. “Swap Markets and Contracts,” Ch. 5, pp. 285-318
Purpose:
To test the candidate’s ability to value an interest rate swap.
LOS: The candidate should be able to
a) distinguish between the pricing and valuation of swaps;
e) determine the fixed rate on a plain vanilla interest rate swap and the market value of
the swap
during its life.
Guideline Answer:
Calculating the swap’s dollar market value 60 days after the swap is initiated can be
broken into
three steps, namely calculation of the
• present value of the fixed pay rate
• present value of the variable receive rate
• dollar market value of the swap
Step 1: To calculate the present value of the fixed rate, we must first convert the quoted
annual
interest rate to a quarterly equivalent interest rate using the day count convention. The
quarterly
interest rate for the fixed payment is thus 0.015 × (90/360) = 0.00375.
Next the series of discount factors from Exhibit 2 are applied to calculate the value of the
fixed rate payment, which is the present value of the quarterly fixed interest rate
payments plus
the present value of one dollar at the end of the swap: This is as follows:
0.00375 × (0.9990 + 0.9950 + 0.9899 + 0.9836) + 1 × (0.9836) = $0.99848
per $1.00 notional principal
or
(0.00375 × 0.9990) + (0.00375 × 0.9950) + (0.00375 × 0.9899) + (0.00375 × 0.9836) +
(1 × 0.9836) = $0.99848 per $1.00 notional principal
Note: If 0.00375 is rounded to 0.0038, the result is $0.9987.
Step 2: The present value of the receive variable interest rate payment is equal to
discounting the
first 90-day period variable rate over the remaining 30 days to payment. There is no other
discounting because we do not know what the new 90-day rates will be for the next
periods
First, the period interest rate for the variable swap must be determined.
The quarterly interest rate for the variable swap interest rate is 0.011 × (90/360) =
0.00275.
2004 Level II Guideline Answers
Morning Session – Page 23
Next we calculate its present value 60 days after the swap is initiated using the first
discount
factor from Exhibit 2:
1.00275 × 0.9990 = 1.00175
Note: If 0.00275 is rounded to 0.0028, the result is 1.0018.
Step 3: To find the market value of the swap, we net the values of the pay fixed and
receive
variable and multiply by the notional value of the swap.
The present value of the receive variable rate minus the present value of the pay fixed
rate times notional value equals:
($1.00175 – $0.99848) × $1.00 = $0.00327 or $0.0033
Note: Alternate results resulting from rounding include
($1.00175 – $0.9987) × $1.00 = $0.00305
($1.00175 – $0.9985) × $1.00 = $0.00325
($1.0018 – $0.99848) × $1.00 = $0.00332
($1.0018 – $0.9987) × $1.00 = $0.00310
($1.0018 – $0.9985) × $1.00 = $0.00330
2004 Level II Guideline Answers
Morning Session – Page 24
LEVEL II, QUESTION 14
Topic: Asset Valuation
Minutes: 12
Reading References:
17-1. “Interest Rate Derivative Instruments,” Level II, Ch. 7, pp. 578-586, Fixed
Income
Analysis for the Chartered Financial Analyst® Program, Frank Fabozzi,
(Frank J.
Fabozzi Associates, 2000)
17-2. Analysis of Derivatives for the CFA® Program, Don Chance (AIMR,
2003)
A. “Option Markets and Contracts,” Ch. 4, pp. 195-242
Purpose:
To test the candidate’s understanding of options and how options can be used to reduce
portfolio
risk in a rising interest rate environment.
LOS: The candidate should be able to
“Interest Rate Derivative Instruments”
b) explain an interest rate cap, floor, and collar, and describe the relationship between
caps and
floors and options;
d) contrast options on interest rates and options on fixed income securities.
“Option Markets and Contracts”
f) explain how an option price, as represented by the Black-Scholes-Merton model, is
affected
by each of the input values (the option Greeks);
j) demonstrate the methods for estimating the future volatility of the underlying asset
(i.e., the
historical volatility and the implied volatility methods);
l) compare and contrast American options on forwards and futures with European options
on
forwards and futures.
Guideline Answer:
A. i. The purchase of an interest rate cap would accomplish Kapple’s goal to hedge the
bond
portfolio against rising interest rates. The payoff on an interest rate cap is equal to the
difference between the reference rate and the strike rate (or “cap” rate) of the cap on
settlement date, multiplied by the notional principal amount of the cap, then divided by
the number of times a year that there is settlement on the cap. This derivative instrument
makes a payoff if interest rates are above the strike rate on the settlement date.
ii. The purchase of a European put option on a bond would accomplish Kapple’s goal to
hedge a bond portfolio against rising interest rates. The payoff on a European put option
on a bond is equal to the excess (if any) of the strike price of the option over the spot
price of the underlying bond at the expiration date. This instrument makes a payoff on the
expiration date if interest rates increase enough that the reference bond’s price drops
below the strike price.
iii. The purchase of a European put option on interest rates would not accomplish
Kapple’s
goal to hedge a bond portfolio against rising interest rates. The payoff on a European put
option on interest rates is equal to the excess (if any) of the strike interest rate over the
2004 Level II Guideline Answers
Morning Session – Page 25
reference interest rate at the expiration date. This instrument makes a payoff on the
expiration date only if interest rates decline, not increase.
B. No, early exercise is not an advantage. A forward contract only makes a payoff at the
expiration date. Early exercise does not affect the cash flows; therefore nothing is gained
by early exercise of the American option.
2004 Level II Guideline Answers
Morning Session – Page 26
LEVEL II, QUESTION 15
Topic: Asset Valuation
Minutes: 12
Reading References:
5-2. The Analysis and Use of Financial Statements, 3rd edition, Gerald I.
White, Ashwinpaul
C. Sondhi, and Dov Fried (Wiley, 2003), in 2004 CFA Level II Candidate
Readings
A. “Analysis of Intercorporate Investments,” Ch. 13
B. “Analysis of Business Combinations,” Ch. 14
13-1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R.
Robinson, Jerald
E. Pinto, and Dennis W. McLeavey (AIMR, 2002)
A. “Market-Based Valuation: Price Multiples,” Ch. 4
Purpose:
To test the candidate’s understanding of price multiples and adjustments needed to
improve
comparability of multiples.
LOS: The candidate should be able to
“Analysis of Intercorporate Investments”
b) compute the effect of debt-security and equity-security classification on the financial
statements and financial ratios.
“Analysis of Business Combinations”
e) describe goodwill and discuss its treatment for purposes of financial analysis according
to
IASB GAAP and U.S. GAAP.
“Market-Based Valuation: Price Multiples”
e) define and calculate each price multiple and dividend yield;
f) define underlying earnings, and calculate underlying earnings given earnings per share
(EPS)
and nonrecurring items in the income statement;
g) define normalized EPS, discuss the methods of normalizing EPS, and calculate
normalized
EPS by each method;
j) calculate the justified value price-to-earnings ratio (P/E), price-to-book ratio (P/B), and
priceto-
sales ratio (P/S) for a stock, based on forecasted fundamentals;
r) discuss the sources of differences in cross-border valuation comparisons.
2004 Level II Guideline Answers
Morning Session – Page 27
Guideline Answer:
Template for Question 15
Determine, for each of the three items related to the
comparability of
Lin’s P/E ratio to Warren’s P/E ratio:
Three items
Whether the item
requires a positive
adjustment, a negative
adjustment, or no
adjustment to Lin’s 2003
pre-tax income
(circle one for each item)
The amount of
any required
adjustment to
Lin’s 2003
pre-tax income
The justification for
why an adjustment is
or is not required
Assets available-forsale
Positive Adjustment
Negative Adjustment
No Adjustment
0 Tigs
or blank
Under U.S. GAAP,
assets available-for-sale
are marked to market,
and mark to market
gains on assets
available-for-sale are
reported directly to
equity. Lin’s LOCOM
also does not recognize
the unrealized gains in
the income statement so
no adjustment is
necessary.
Investments held-to-
maturity
Positive Adjustment
Negative Adjustment
No Adjustment
1.5 billion Tigs
Investments held-to-
maturity are not marked
to market under U.S.
GAAP. Therefore the
loss on the long-term
investments included in
pre-tax income must be
removed.
Unusual gain
Positive Adjustment
Negative Adjustment
No Adjustment
5.0 billion Tigs
Nonrecurring items need
to be removed from the
calculation of pre-tax
income before
evaluating against
comparables.
2004 Level II Guideline Answers
Morning Session – Page 28
LEVEL II, QUESTION 16
Topic: Asset Valuation
Minutes: 9
Reading References:
7-3. “Analysis of Financial Statements,” Chapter 12, Investment Analysis and
Portfolio
Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000)
10-2. International Investments, 5th edition, Bruno Solnik and Dennis McLeavey
(Addison
Wesley, 2003)
B. “Equity: Concepts and Techniques,” Ch. 6
Purpose:
To test the candidate’s: (1) ability to calculate ROE using the Dupont model, and (2)
understanding of how financial statement items may affect the return on equity
calculations,
especially in an international context.
LOS: The candidate should be able to
“Analysis of Financial Statements”
d) calculate financial ratios in the following categories: common size, internal liquidity,
operating efficiency, operating profitability, business risk, financial risk, growth, and
external
liquidity;
e) compute return on equity (ROE) using the DuPont system and the extended DuPont
system;
g) prepare, using financial ratios, a comparative analysis of a company over time and
relative to
its industry or to the market.
“Equity: Concepts and Techniques”
f) demonstrate how to conduct global financial analysis, including duPont analysis.
Guideline Answer:
A. The five components of ROE are calculated as follows:
Net Income/EBT = 746/939 = 0.794
EBT/EBIT = 939/984 = 0.954
EBIT/Sales = 984/3,483 = 0.283
Sales/Assets = 3,483/4,235 = 0.822
Assets/Equity = 4,235/2,378 = 1.781
Supplemental information to check the calculations:
ROE = NI/Equity = 746/2,378 = 0.314
ROE = NI/EBT × EBT/EBIT × EBIT/Sales × Sales/Assets × Assets/Equity
= 0.794 × 0.954 × 0.283 × 0.822 × 1.781
= 0.314
A. Alternate answer based on Reilly and Brown 6th ed.
Components:
EBIT/Sales = 984/3,483 = 0.283
2004 Level II Guideline Answers
Morning Session – Page 29
Sales/total assets = 3,483/4,235 = 0.822
Interest expense/total assets = 45/4,235 = 0.011
Total assets/common equity = 4,235/2,378 = 1.781
1– income taxes/EBT = 1 – 193/939 = 1 – 0.205 = 0.795
Supplemental information to check the calculations:
ROE = NI/Equity = 746/2,378 = 0.314
ROE = [(EBIT/Sales) × (Sales/total assets) – (interest expense/total assets)]
× (Total assets/common equity) × (1 – income taxes/net before taxes)
= [(0.283 × 0.822) – 0.011] × 1.781 × 0.795
= 0.221 × 1.781 × 0.795
= 0.314
B.
Two factors
Identify, for each of the two
factors noted by Yam, which
one, if any, of the five DuPont
components is most likely to be
affected by the factor
Determine whether Warren’s ROE
for 2004 is most likely to increase,
decrease, or not change as a result of
each of the two factors
(circle one for each factor)
Floating rate
debt
Interest burden
(EBT/EBIT)
Increase
Decrease
Not change
Debt
reclassification
None
Increase
Decrease
Not change
2004 Level II Guideline Answers
Morning Session – Page 30
B - Alternate answer based on Reilly and Brown 6th ed.
Two factors
Identify, for each of the two
factors noted by Yam, which one,
if any, of the five DuPont
components is most likely to be
affected by the factor
Determine whether Warren’s
ROE for 2004 is most likely to
increase, decrease, or not change
as a result of each of the two
factors
(circle one for each factor)
Floating rate
debt
Interest Expense Rate
(Interest Expense/Total Assets)
Increase
Decrease
Not change
Debt
reclassification
None
Increase
Decrease
Not change
2004 Level II Guideline Answers
Morning Session – Page 31
LEVEL II, QUESTION 17
Topic: Asset Valuation
Minutes: 9
Reading References:
13-1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R.
Robinson, Jerald
E. Pinto, and Dennis W. McLeavey (AIMR, 2002)
B. “Residual Income Valuation,” Ch. 5
Purpose:
To test the candidate’s (1) understanding of residual income models, and (2) ability to
value the
equity of a company using a residual income model.
LOS: The candidate should be able to
a) define and calculate residual income;
c) discuss the uses of residual income models;
e) calculate the intrinsic value of a share of common stock using the residual income
model;
h) justify the choice of the residual income model for equity valuation given
characteristics of
the company being valued.
Guideline Answer:
A. A residual income model is most appropriate for valuing the equity of a company in
any
of three circumstances:
1. the company does not pay dividends or its dividends are not predictable;
2. the company’s expected free cash flows are unpredictable or negative within the
analyst’s comfortable forecast horizon; or
3. there is great uncertainty in forecasting terminal values using an alternative present
value approach.
B. The single stage (e.g. constant growth) residual income model formula for the value of
equity (V0) is:
V0 = B0 + {[(ROE – r)/(r – g)] × B0}
where:
V0 = value per share
B0 = book value at t=0
ROE = expected ROE
r = required return for equity
g = constant growth rate
B0 = $2,378/263 = $9.04, so:
V0 = $9.04 + {[(0.15 – 0.11)/(0.11 – 0.09)] × $9.04} = $27.12
2004 Level II Guideline Answers
Morning Session – Page 32
LEVEL II, QUESTION 18
Topic: Portfolio Management
Minutes: 9
Reading References:
18-2. “The Process of Portfolio Management,” Ch. 26, Investments, 5th edition, Zvi
Bodie,
Alex Kane, and Alan J. Marcus (McGraw-Hill, 2002)
Purpose:
To test the candidate’s understanding of: (1) the steps in the asset allocation process, and
(2) tax
effects on asset allocation decisions for an individual investor.
LOS: The candidate should be able to
c) explain the steps in the process of asset allocation and discuss how taxes and tax
deferral may
affect asset allocation.
Guideline Answer:
A. The financial advisor’s statement is incorrect. After specifying the asset classes to be
included in his portfolio, Lambini’s second step should be to specify capital market
expectations; the third step would be to derive the efficient portfolio frontier. The step
indicated by the advisor is actually the last of four steps in the asset allocation process.
B.
Account
Determine how the
€120,000 in individual
equity securities should
be allocated between
Lambini’s
taxable savings account
and his tax-deferred
retirement account
Determine how the
€80,000 in corporate
bonds should be
allocated between
Lambini’s taxable
savings account and
his tax-deferred
retirement account Total
Taxable
Savings
€100,000 €0 €100,000
Tax-Deferred
Retirement
€20,000 €80,000 €100,000
Total €120,000 €80,000 €200,000
2004 Level II Guideline Answers
Morning Session – Page 33
Justify your
allocations
with one
reason
Justification emphasizing equity securities:
The €120,000 in equity securities should be allocated €100,000 to the
taxable account (maximum permitted by the €100,000 constraint) and
€20,000 to the taxable account (required by the €100,000 constraint).
Because a greater portion of the equity return is from capital
appreciation than is the case for bonds, equities will be less taxdisadvantaged
than bond investments in the taxable account. Unlike
current income, capital gains are compounded on a gross basis and
taxed only when realized. The €80,000 in corporate bonds should be
allocated by default to the tax-deferred account.
or
Justification emphasizing corporate bonds:
The €80,000 in corporate bonds should be allocated to the tax-deferred
account. This allocation is most likely to maximize the after-tax returns
of the bond portfolio, which relative to the equity portfolio is generating
a greater portion of current income and thus a higher current tax burden.
The remainder of the tax-deferred account must be filled by €20,000 in
equity securities, as dictated by the overall €100,000 constraint. It
should be noted that this allocation should consist of the equities with
the highest dividend yields, which could experience a tax-deferral
benefit potentially similar to that experienced by bonds. The remaining
€100,000 in equity securities should be allocated by default to the
taxable account.
2004 Level II Guideline Answers
Morning Session – Page 34
LEVEL II, QUESTION 19
Topic: Portfolio Management
Minutes: 9
Reading References:
18-2. “The Process of Portfolio Management,” Ch. 26, Investments, 5th edition, Zvi
Bodie,
Alex Kane, and Alan J. Marcus (McGraw-Hill, 2002)
Purpose:
To test the candidate’s understanding of portfolio constraints for various institutional
investors.
LOS: The candidate should be able to
b) discuss portfolio objectives and the common types of portfolio constraints for
individual and
institutional investors.
Guideline Answer:
Consultant’s
three statements
Indicate whether
each of the
consultant’s
three statements
is correct or
incorrect
(circle one for
each statement)
Support each of your responses with one reason
The Columbia
pension fund’s
liquidity constraint
should be similar
to the liquidity
constraint of an
endowment fund.
Correct
Incorrect
An endowment fund has low liquidity constraints, as it
is not required to pay out its capital in the near future.
Similarly a pension fund with a young work force
such as Columbia does not require liquidity for a
number of years, as the pension plan members have a
number of years before their retirement. As such the
liquidity constraint of the Columbia defined benefit
fund is low.
The Columbia
pension fund’s
time horizon
should be similar
to the time horizon
of a loan portfolio
held by a
commercial bank.
Correct
Incorrect
A commercial bank has a short time horizon when it
invests, as it requires cash to fund its business
activities. Conversely, a young pension plan has a
long time horizon to invest, as there are a number of
years before the plan matures.
2004 Level II Guideline Answers
Morning Session – Page 35
The Columbia
pension fund’s tax
considerations
should be similar
to the tax
considerations of a
life insurance
company.
Correct
Incorrect
A life insurance company like other businesses pays
taxes on its profits, unlike a pension fund, which is
entitled to earn profits on its investments without the
need to pay taxes.

2003 CFA® Level II Examination


Morning Session – Essay
Candidate Number:
_____ _____ _____ _____ _____ _____
THIS BOOK IS THE PROPERTY OF:
Association for
Investment Management
and Research®
560 Ray C. Hunt Drive
Charlottesville VA 22903-0668
USA
Tel: 434-951-5499
© 2003 Association for Investment Management and Research. All rights
reserved.
FOR AIMR USE ONLY
FOR AIMR USE ONLY
The following list contains the command words used on the Morning
Session of
the 2003 Level II examination. Candidates may want to refer to this list as
they
formulate their answers.
Calculate: To ascertain or determine by mathematical processes.
Cite: To quote by way of evidence, authority, or proof.
Compute: To determine, especially by mathematical means.
Define: To set forth the meaning of; specifically, to formulate a definition of.
Determine: To come to a decision as the result of investigation or reasoning; to settle
or
decide by choice among alternatives or possibilities.
Describe: To transmit a mental image, an impression, or an understanding of the
nature
and characteristics of.
Discuss: To discourse about through reasoning or argument; to present in detail.
Estimate: To judge the value, worth, or significance of.
Explain: To give the meaning or significance of; to provide an understanding of; to
give
the reason for or cause of.
Identify: To establish the identity of; to show or prove the sameness of.
Indicate: To point out or point to with more or less exactness; to show or make
known
with a fair degree of certainty.
Justify: To prove or show to be valid, sound, or conforming to fact or reason; to
furnish grounds or evidence for.
List: To enumerate.
Select: To choose from a number or group–usually, by fitness, excellence, or other
distinguishing factor.
Show: To set forth in a statement, account, or description; to make evident or clear.
State: To express in words.
The Morning Session of the 2003 CFA Level II Examination has 17
questions.
For grading purposes, the maximum point value for each question is equal to
the
number of minutes allocated to that question.
Question Topic Minutes
1 Economics 6
2 Asset Valuation 9
3 Economics 12
4 Financial Statement Analysis 18
5 Asset Valuation 16
6 Asset Valuation 20
7 Asset Valuation 8
8 Asset Valuation 12
9 Asset Valuation 10
10 Asset Valuation 6
11 Asset Valuation 12
12 Asset Valuation 6
13 Asset Valuation 10
14 Asset Valuation 10
15 Asset Valuation 8
16 Portfolio Management 6
17 Portfolio Management 11
Total: 180
Questions 1 through 4 relate to Vacations Unlimited Inc.,
Yucatan Resorts, and Catalina
Resorts. A total of 45 minutes is allocated to these questions.
Candidates should answer
these questions in the order presented.
QUESTION 1 HAS TWO PARTS (A, B) FOR A TOTAL OF 6
MINUTES.
Vacations Unlimited Inc. (VU), a U.S.-based tourism company, has a majority stake in
Yucatan
Resorts, a Mexican firm that owns and operates luxury resorts along Mexico’s Caribbean
coast.
Because most of its client base consists of U.S. tourists, Yucatan Resorts’ revenues are
denominated in U.S. dollars. Yucatan Resorts converts all U.S. dollar receipts into
Mexican
pesos through the foreign exchange market. Yucatan Resorts’ operating costs are all
denominated in pesos and assumed to increase in line with the Mexican inflation rate, and
the
firm’s assets and liabilities are all denominated in pesos. Yucatan Resorts’ shares trade on
the
Mexican stock exchange and are also denominated in pesos.
George Davies, VU’s Chief Financial Officer, is considering increasing VU’s investment
in
Yucatan Resorts. He is aware, however, that the Mexican inflation rate has been higher
than the
inflation rate in the U.S. and that the Mexican peso has been depreciating against the U.S.
dollar.
Davies is concerned that a continuation of these trends might reduce Yucatan Resorts’
profitability. He asks Iris Hamson, a financial analyst at VU, to investigate the
relationship
between Yucatan Resorts’ share price, nominal exchange rates between the peso and the
dollar,
and inflation rates in Mexico and the U.S.
Hamson states:
“Based on Yucatan Resorts’ sources of revenues and costs, and given that purchasing
power parity is unlikely to hold, I conclude that Yucatan Resorts’ local currency
exposure will be characterized by a negative correlation between Yucatan’s share price
(measured in pesos) and the value of the peso.”
A. Define local currency exposure.
(3 minutes)
B. State whether Hamson’s conclusion about Yucatan Resorts’ local currency
exposure is
correct or incorrect. Justify your response with one reason.
(3 minutes)
QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
Iris Hamson is evaluating international fixed income investments for Vacations
Unlimited Inc.
She notes that Standard & Poor’s (S&P) assigns separate and distinct credit ratings to
each
national government’s local currency debt and foreign currency debt.
A. State whether a national government’s local currency debt credit rating or foreign
currency debt credit rating is generally lower. Justify your response with one reason
why the default risk is higher on the type of debt that is generally lower-rated.
(3 minutes)
S&P uses several risk factor categories in determining sovereign credit ratings. Hamson
contends that three S&P risk factor categories are most important: 1) income and
economic
structure, 2) fiscal flexibility, and 3) price stability. Based on her country research, she
has
compiled the following list of characteristics of Mexico:
1. National, regional, and local governments that generally possess competitive tax
structures and the ability to control spending
2. A strong banking sector that reflects conservative lending practices and generally
high asset quality
3. A history of prudent monetary and exchange-rate policies pursued by an
independent central bank
4. An external balance sheet that is conservatively structured and an excellent track
record of timely debt service payments
5. A recent Presidential election that was marked by wide voter participation in
response to a popular platform of economic reforms
6. Favorable trends in foreign direct investment and export growth that appears to be
sufficient to lessen any potential balance-of-payments pressures in the future
7. A market economy that exhibits average wealth levels overall but a concentration
of wealth that results in a large difference between the rich and the poor
B. Select from Hamson’s list the characteristic of Mexico that most directly relates to
each
of the three S&P risk factor categories.
Note: Your selections should NOT include any characteristic more than once; only the
characteristic reference numbers (1 through 7) are needed for your selections.
Answer Question 2-B in the Template provided on page 8.
(6 minutes)

Answer Question 2 on This Page


Template for Question 2-B
Note: Your selections should NOT include any characteristic more
than once; only the characteristic reference numbers (1 through 7) are
needed for your selections.
Three S&P risk factor categories
Select from Hamson’s list the
characteristic of Mexico that
most directly relates to each of
the three S&P risk factor
categories
Income and Economic Structure
Fiscal Flexibility
Price Stability
QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12
MINUTES.
After studying Iris Hamson’s credit analysis, George Davies is considering whether he
can
increase the holding period return on Yucatan Resort’s excess cash holdings (which are
held in
pesos) by investing those cash holdings in the Mexican bond market. Although Davies
would be
investing in a peso-denominated bond, the investment goal is to achieve the highest
holding
period return, measured in U.S. dollars, on the investment.
Davies finds the higher yield on the Mexican one-year bond, which is considered to be
free of
credit risk, to be attractive but he is concerned that depreciation of the peso will reduce
the
holding period return, measured in U.S. dollars. Hamson has prepared selected economic
and
financial data, given in Exhibit 3-1, to help Davies make the decision.
Exhibit 3-1
Selected Economic and Financial Data
U.S. and Mexico
Expected U.S. Inflation Rate 2.0% per year
Expected Mexican Inflation Rate 6.0% per year
U.S. One-year Treasury Bond Yield 2.5%
Mexican One-year Bond Yield 6.5%
Nominal Exchange Rates
Spot 9.5000 Pesos = U.S. $ 1.00
One-year Forward 9.8707 Pesos = U.S. $ 1.00
Hamson recommends buying the Mexican one-year bond and hedging the foreign
currency
exposure using the one-year forward exchange rate. She concludes:
“This transaction will result in a U.S. dollar holding period return that is equal to the
holding period return of the U.S. one-year bond.”
A. Calculate the U.S. dollar holding period return that would result from the
transaction
recommended by Hamson. Show your calculations. State whether Hamson’s
conclusion about the U.S. dollar holding period return resulting from the transaction is
correct or incorrect.
(4 minutes)
After conducting his own analysis of the U.S. and Mexican economies, Davies expects
that both
the U.S. inflation rate and the real exchange rate will remain constant over the coming
year.
Because of favorable political developments in Mexico, however, he expects that the
Mexican
inflation rate (in annual terms) will fall from 6.0 percent to 3.0 percent before the end of
the year.
As a result, Davies decides to invest Yucatan Resorts’ cash holdings in the Mexican one-
year
bond but not to hedge the currency exposure.
B. Calculate the expected exchange rate (pesos per dollar) one year from now.
Show your
calculations.
Note: Your calculations should assume that Davies is correct in his expectations about
the real exchange rate and the Mexican and U.S. inflation rates.
(4 minutes)
C. Calculate the expected U.S. dollar holding period return on the Mexican one-year
bond.
Show your calculations.
Note: Your calculations should assume that Davies is correct in his expectations about
the real exchange rate and the Mexican and U.S. inflation rates.
(4 minutes)
QUESTION 4 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18
MINUTES.
Vacations Unlimited Inc. (VU) owns Catalina Resorts, located in the Caribbean country
of Costa
Guda. This 75-room hotel is a popular vacation destination for North American tourists.
The
majority of operating and financing decisions are made by Catalina management in Costa
Guda,
although Catalina relies on VU’s managerial and technological expertise. The local
currency is
the guda (G); recent annual inflation rates for Costa Guda are given in Exhibit 4-1.
Exhibit 4-1
Inflation Rates for Costa Guda
Year Annual Inflation Rate
2000 20%
2001 25%
2002 30%
A. Identify the appropriate functional currency that Vacations Unlimited should have
used
in 2002 to account for its investment in Catalina Resorts. Justify your response with
one
reason.
(3 minutes)
B. Identify the appropriate functional currency that Vacations Unlimited should use in
2003
to account for its investment in Catalina Resorts, if Costa Guda’s annual inflation rate in
2003 is 50 percent. Justify your response with one reason.
(3 minutes)
Catalina Resorts’ balance sheet and relevant exchange rates for the guda and the U.S.
dollar are
shown in Exhibits 4-2 and 4-3, respectively.
Exhibit 4-2
Catalina Resorts
Balance Sheet
31 December 2001
(guda millions)
Cash 25
Accounts Receivable 50
Current Assets 75
Gross Fixed Assets 425
Accumulated Depreciation (100)
Net Fixed Assets 325
Total Assets 400
Short-term Debt 100
Current Liabilities 100
Common Stock 25
Retained Earnings 275
Total Shareholders’ Equity 300
Total Liabilities and Shareholders’ Equity 400
Exhibit 4-3
Exchange Rates
Guda (G) and U.S. Dollar (U.S. $)
2001 2002
Year-end G 1.06 = U.S. $ 1.00 G 1.20 = U.S. $ 1.00
Average G 0.98 = U.S. $ 1.00 G 1.13 = U.S. $ 1.00
Historical
Fixed Assets G 0.75 = U.S. $ 1.00
C. Determine the translation effect (gain, loss, or no change) for 2002 on Vacation
Unlimited’s investment in Catalina Resorts using each of the following two translation
methods:
i. All current method
ii. Temporal method
Justify your response with one reason for each method.
Answer Question 4-C in the Template provided on page 21.
(6 minutes)
D. Identify the translation method (all current, temporal, or neither) that will result in
each
of the following two ratio effects for Catalina Resorts:
i. A higher asset turnover ratio (in U.S. $ terms)
ii. A higher current ratio (in U.S. $ terms)
Justify your response with one reason for each ratio effect.
Note: No calculations are required.
Answer Question 4-D in the Template provided on page 22.
(6 minutes)

Answer Question 4 on This Page


Template for Question 4-C
Translation method
Determine the
translation effect for
2002 on Vacation
Unlimited’s
investment in
Catalina Resorts
using each of the two
translation methods
(circle one for each
method)
Justify your response with one reason for
each method
i. All current method
gain
loss
no change
ii. Temporal method
gain
loss
no change

Answer Question 4 on This Page


Template for Question 4-D
Note: No calculations are required.
Two ratio effects
Identify the
translation method
that will result in
each of the two ratio
effects for Catalina
Resorts
(circle one for each
ratio effect)
Justify your response with one reason for
each ratio effect
i. A higher asset
turnover ratio (in
U.S. $ terms)
all current method
temporal method
neither
ii. A higher current
ratio (in U.S. $ terms)
all current method
temporal method
neither
Questions 5 through 10 relate to Rio National Corp. A total of
72 minutes is allocated to
these questions. Candidates should answer these questions in
the order presented. Exhibits
5-1 through 5-5 relate to Rio National.
Rio National Corp. is a U.S.-based company and the largest competitor in its industry.
Exhibits
5-1 through 5-4 present the financial statements, which are prepared according to U.S.
Generally
Accepted Accounting Principles (U.S. GAAP), and related information for the company.
Exhibit
5-5 presents relevant industry and market data.
Exhibit 5-1
Rio National Corp.
Summary Balance Sheets
on 31 December
(U.S. $ millions)
2002 2001
Cash $13.00 $5.87
Accounts Receivable 30.00 27.00
Inventory 209.06 189.06
Current Assets $252.06 $221.93
Gross Fixed Assets 474.47 409.47
Accumulated Depreciation (154.17) (90.00)
Net Fixed Assets 320.30 319.47
Total Assets $572.36 $541.40
Accounts Payable $25.05 $26.05
Notes Payable 0.00 0.00
Current Portion of Long-term Debt 0.00 0.00
Current Liabilities $25.05 $26.05
Long-term Debt 240.00 245.00
Total Liabilities $265.05 $271.05
Common Stock 160.00 150.00
Retained Earnings 147.31 120.35
Total Shareholders’ Equity $307.31 $270.35
Total Liabilities and Shareholders’ Equity $572.36 $541.40
Exhibit 5-2
Rio National Corp.
Summary Income Statement
for the Year Ended 31 December 2002
(U.S. $ millions)
Revenue $300.80
Total Operating Expenses (173.74)
Operating Profit 127.06
Gain on Sale 4.00
Earnings Before Interest, Taxes,
Depreciation & Amortization (EBITDA)
131.06
Depreciation and Amortization (71.17)
Earnings Before Interest & Taxes (EBIT) 59.89
Interest (16.80)
Income Tax Expense (12.93)
Net Income $30.16
Exhibit 5-3
Rio National Corp.
Supplemental Notes for 2002
Note 1: Rio National had $75 million in capital expenditures during the year.
Note 2: A piece of equipment that was originally purchased for $10 million was sold for
$7
million at year-end, when it had a net book value of $3 million. Equipment sales are
unusual for Rio National.
Note 3: The decrease in long-term debt represents an unscheduled principal repayment;
there
was no new borrowing during the year.
Note 4: On 1 January 2002, the company received cash from issuing 400,000 shares of
common
equity at a price of $25.00 per share.
Note 5: A new appraisal during the year increased the estimated market value of land
held for
investment by $2 million, which was not recognized in 2002 income.
Exhibit 5-4
Rio National Corp.
Common Equity Data for 2002
Dividends Paid (U.S. $ millions) $3.20
Weighted Average Shares Outstanding during 2002 16,000,000
Dividend per Share $0.20
Earnings per Share $1.89
Beta 1.80
Note: The dividend payout ratio is expected to be constant.
Exhibit 5-5
Industry and Market Data
31 December 2002
Risk-free Rate of Return 4.00%
Expected Rate of Return on Market Index 9.00%
Median Industry Price/Earnings (P/E) Ratio 19.90
Expected Industry Earnings Growth Rate 12.00%
QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 16
MINUTES.
The portfolio manager of a large mutual fund comments to one of the fund’s analysts,
Katrina
Shaar:
“We have been considering the purchase of Rio National Corp. equity shares, so I would
like you to analyze the value of the company. To begin, based on Rio National’s past
performance, you can assume that the company will grow at the same rate as the
industry.”
A. Calculate the value of a share of Rio National equity on 31 December 2002, using
the
Gordon growth model and the capital asset pricing model. Show your calculations.
(6 minutes)
B. Calculate the three components of Rio National’s return on equity for the year
2002,
using the DuPont model. Show your calculations.
Note: Your calculations should use 2002 beginning-of-year balance sheet values.
(6 minutes)
C. Calculate the sustainable growth rate of Rio National on 31 December 2002.
Note: Your calculations should use 2002 beginning-of-year balance sheet values.
(4 minutes)
QUESTION 6 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 20
MINUTES.
While valuing the equity of Rio National Corp., Katrina Shaar is considering the use of
either
cash flow from operations (CFO) or free cash flow to equity (FCFE) in her valuation
process.
A. State two adjustments that Shaar should make to cash flow from operations to
obtain free
cash flow to equity. Explain why it is necessary to make each of the two adjustments
when valuing the equity of a firm.
Note: No calculations are required.
(4 minutes)
Shaar decides to calculate Rio National’s FCFE for the year 2002, starting with net
income.
B. Determine, for each of the five supplemental notes given in Exhibit 5-3:
i. Whether a net positive adjustment, a net negative adjustment, or no adjustment
should be made to net income to calculate Rio National’s free cash flow to equity
for the year 2002
ii. The dollar amount of the adjustment, if any
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template
for Question 6-B.
Answer Question 6-B in the Template provided on page 36.
(10 minutes)
C. Calculate Rio National’s free cash flow to equity for the year 2002. Show your
calculations.
Note: Your calculations should start with net income.
(6 minutes)

Answer Question 6 on This Page


Template for Question 6-B
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template.
Five supplemental notes
given in Exhibit 5-3
Determine, for each of the
five supplemental notes,
whether a net positive
adjustment, a net
negative adjustment, or
no adjustment should be
made to net income to
calculate Rio National’s
free cash flow to equity
for the year 2002
(circle one for each note)
Determine the dollar
amount of the
adjustment, if any
Note 1: Rio National had $75 million
in capital expenditures during the
year.
Positive
Negative
No Adjustment
$
Note 2: A piece of equipment that
was originally purchased for $10
million was sold for $7 million at
year-end, when it had a net book
value of $3 million. Equipment sales
are unusual for Rio National.
Positive
Negative
No Adjustment
$
Note 3: The decrease in long-term
debt represents an unscheduled
principal repayment; there was no
new borrowing during the year.
Positive
Negative
No Adjustment
$
Note 4: On 1 January 2002, the
company received cash from issuing
400,000 shares of common equity at
a price of $25.00 per share.
Positive
Negative
No Adjustment
$
Note 5: A new appraisal during the
year increased the estimated market
value of land held for investment by
$2 million, which was not recognized
in 2002 income.
Positive
Negative
No Adjustment
$
QUESTION 7 HAS TWO PARTS (A, B) FOR A TOTAL OF 8
MINUTES.
In the process of gathering data to value the equity of Rio National Corp. using a price-
multiple
approach, one of Katrina Shaar’s associates has suggested that the earnings per share
(EPS)
reported by Rio National may need to be converted to normalized (underlying) earnings.
A. Determine, for each of the supplemental notes 2 through 5 given in Exhibit 5-3,
the
dollar amount of the adjustment, if any, that should be made to pretax income to calculate
Rio National’s normalized (underlying) net income for the year 2002.
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template
for Question 7-A. Note 1 in the Template for Question 7-A is completed as an example.
Answer Question 7-A in the Template provided on page 41.
(4 minutes)
Shaar has revised slightly her estimated earnings growth rate for Rio National and, using
normalized (underlying) EPS, now wants to compare the current value of Rio National’s
equity
to that of the industry, on a growth-adjusted basis. Selected information about Rio
National and
the industry is given in Exhibit 7-1.
Exhibit 7-1
Selected Information
Rio National Corp. and Industry
Rio National
Estimated Earnings Growth Rate 11.00%
Current Share Price $25.00
Normalized (underlying) EPS for 2002 $1.71
Weighted Average Shares Outstanding during 2002 16,000,000
Industry
Estimated Earnings Growth Rate 12.00%
Median Price/Earnings (P/E) Ratio 19.90
B. State whether, compared to the industry, Rio National’s equity is overvalued or
undervalued on a P/E-to-growth (PEG) basis, using normalized (underlying) earnings per
share. Justify your response with one reason. Show your calculations.
Note: Your response should assume that the risk of Rio National is similar to the risk of
the industry.
(4 minutes)

Answer Question 7 on This Page


Template for Question 7-A
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template.
Note 1
in the Template is completed as an example.
Five supplemental notes
given in Exhibit 5-3
Determine, for each of the
supplemental notes 2 through 5
given in Exhibit 5-3, the dollar
amount of the adjustment, if any,
that should be made to pretax
income to calculate Rio National’s
normalized (underlying) net income
for the year 2002
Example: Example:
$ No adjustment Note 1: Rio National had $75 million in capital
expenditures during the year.
$
Note 2: A piece of equipment that was originally
purchased for $10 million was sold for $7 million at
year-end, when it had a net book value of $3 million.
Equipment sales are unusual for Rio National.
$
Note 3: The decrease in long-term debt represents an
unscheduled principal repayment; there was no new
borrowing during the year.
$
Note 4: On 1 January 2002, the company received cash
from issuing 400,000 shares of common equity at a
price of $25.00 per share.
$
Note 5: A new appraisal during the year increased the
estimated market value of land held for investment by
$2 million, which was not recognized in 2002 income.
QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 12
MINUTES.
As part of her valuation process, Katrina Shaar has collected the following comparative
information about Rio National Corp. and its primary competitor.
1. Rio National’s gross margin is 57 percent, up from 55 percent a year ago.
Management attributes this improvement to cost reductions from continuous
efforts to achieve manufacturing efficiencies.
2. Rio National is the largest company in the industry. The next largest competitor
is Gracemoor Inc., which has positioned itself as having high quality products and
excellent customer service. Gracemoor’s gross margin is 62 percent, which is the
highest gross margin in the industry.
3. Rio National’s customer base is:
Large volume retailers 45%
Ready to assemble product manufacturers 32%
Other 23%
Although Rio National is the largest company in the industry, it has relatively few
customers. Gracemoor is a substantially smaller company than Rio National but
has several times the number of customers.
4. Rio National’s management noted that most of Rio’s customers are highly price
sensitive, so Rio has found it quite difficult to increase prices. These customers,
however, have consistently purchased in large volumes. Rio’s management
believes that Rio’s average selling price is 20 percent below Gracemoor’s average
selling price.
A. Identify the competitive strategy being employed by Rio National and Gracemoor,
respectively. Cite two facts about each company that are consistent with that
company’s
identified strategy.
Answer Question 8-A in the Template provided on page 47.
(8 minutes)
A few weeks later, Shaar is reviewing several current e-mail newsletters that focus on
this
industry. One of the newsletters contains a press release entitled “Gracemoor Inc.
Announces
Merger with Remalco Corporation.” An extract from this press release is shown in
Exhibit 8-1.
Exhibit 8-1
Extract from Gracemoor Inc. Press Release
“Gracemoor Inc. Announces Merger with Remalco Corporation”
Jeff Fedor, President of Gracemoor Inc., and John Rutt, President of Remalco
Corporation, are
pleased to announce that the firms have reached an agreement to merge operations. The
combined entity, GraceMalco, will have over $250 million in annual revenues and will
employ
1,500 people in three locations.
“The merger of the operations will allow us to reorganize and update manufacturing
operations,
resulting in substantial manufacturing cost reductions. GraceMalco will continue the high
level
of customer and technical support that has been integral to Gracemoor’s prior success but
the
new company will also be able to expand the lower margin, high volume consumer
markets that
have been Remalco’s focus over the last three years,” said Fedor, the new president of
GraceMalco.
After reading the press release, Shaar calls both Rio National and GraceMalco for more
details
and obtains the following comments:
• From Rio National’s Vice President of Investor Relations:
“We believe that the market is large and there is room for more than one
company to pursue the strategy that we have chosen.”
• From the new President of GraceMalco:
“Our merged firm will be able to pursue multiple strategies and compete
more effectively against Rio National.”
B. Discuss one threat each that the merger may pose to the sustainability of the
competitive
strategies of the following two companies:
i. Rio National
ii. GraceMalco
(4 minutes)

Answer Question 8 on This Page


Template for Question 8-A
Identify the competitive
strategy being employed
by Rio National and
Gracemoor, respectively
(circle one for each
company)
Cite two facts about each company that are
consistent with that company’s identified
strategy
1.
Rio National
Cost Leadership
Cost Focus
Differentiation
Differentiation Focus
Buyer Bargaining Power
2.
1.
Gracemoor
Cost Leadership
Cost Focus
Differentiation
Differentiation Focus
Buyer Bargaining Power
2.
QUESTION 9 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
The management of Rio National Corp. has now announced the signing of a new
marketing
agreement that will allow the company to sell its products in Southeast Asia. Sophie
Delourme,
an analyst at Euro-International Co., is analyzing the effect of this announcement on her
estimated value of Rio National’s equity. She uses the H-model in her valuation process
and has
identified the following inputs:
• Rio National’s earnings growth rate is expected to be 30.0 percent in 2003,
declining over a five-year period to a constant growth rate of 12.0 percent in 2008
and thereafter.
• Because of the change in risk, the required rate of return (cost of equity) for Rio
National is expected to be 13.5 percent.
• The dividend per share for 2002 was $0.20.
• The dividend payout ratio is expected to be constant.
A. Calculate the estimated value of a share of Rio National’s equity on 31 December
2002,
using the H-model. Show your calculations.
(6 minutes)
Delourme presents her analysis to her supervisor and concludes:
“Except in rare circumstances, the H-model’s estimated value will be a close
approximation to estimated values generated by multi-stage dividend growth models that
explicitly forecast dividends each year.”
B. State whether Delourme’s conclusion is correct or incorrect. Justify your
response with
one reason.
(4 minutes)
QUESTION 10 HAS ONE PART FOR A TOTAL OF 6 MINUTES.
After Rio National Corp. announced the new marketing agreement to sell its products in
Southeast Asia, several analysts revised their 2003 outlook for Rio National. Reflecting
the new
marketing agreement, the current consensus 2003 earnings per share is $2.19 and the
current
consensus 12-month target share price is $50.00.
Sophie Delourme observes that Rio National’s share price rose from $25.00 to $37.00
after the
new agreement was announced. She believes that Rio National’s required rate of return
(cost of
equity) is 13.5 percent.
Calculate the present value of growth opportunities (PVGO) reflected in Rio
National’s share
price after the agreement was announced. Show your calculations.
(6 minutes)
QUESTION 11 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12
MINUTES.
Janet Meer is a fixed income portfolio manager. Noting that the current shape of the yield
curve
is flat, she considers the purchase of a newly issued, option-free corporate bond priced at
par; the
bond is described in Exhibit 11-1.
Exhibit 11-1
7% Option-free Bond
Maturity = 10 years
Change in Yields
Up 10 Basis Points Down 10 Basis Points
Price 99.29 100.71
Convexity Measure 35.00
Convexity Adjustment 0.0035
A. Calculate the duration of the bond described in Exhibit 11-1. Show your
calculations.
(4 minutes)
Meer is also considering the purchase of a second newly issued, option-free corporate
bond,
which is described in Exhibit 11-2. She wants to evaluate this second bond’s price
sensitivity to
an instantaneous, downward parallel shift in the yield curve of 200 basis points.
Exhibit 11-2
7.25% Option-free Bond
Maturity = 12 Years
Original Issue Price Par value,
to yield 7.25%
Modified Duration (at original price) 7.90
Convexity Measure 41.55
Convexity Adjustment (yield change of 200 basis points) 1.66
B. Estimate the total percentage price change for the bond described in Exhibit 11-2
if the
yield curve experiences an instantaneous, downward parallel shift of 200 basis points.
Show your calculations.
(4 minutes)
Meer asks her assistant to analyze several callable bonds, given the expected downward
parallel
shift in the yield curve. Meer’s assistant argues that if interest rates fall enough, both
modified
convexity and effective convexity for a callable bond will become negative.
C. State whether the assistant’s argument is correct or incorrect. Justify your
response with
one reason.
(4 minutes)
QUESTION 12 HAS TWO PARTS (A, B) FOR A TOTAL OF 6
MINUTES.
Hiromi Sato is evaluating the effects of yield curve risk on the three bond portfolios she
manages. Key rate durations for the three portfolios are given in Exhibit 12-1.
Exhibit 12-1
Key Rate Durations
Three Bond Portfolios
Key Rate Durations Key Rate Maturities Portfolio A Portfolio B
Portfolio C
2-year 0.89 1.23 0.10
3-year 0.89 1.23 0.11
5-year 0.81 0.70 0.08
7-year 0.85 0.04 2.70
10-year 0.83 0.05 2.66
20-year 0.84 0.09 0.20
30-year 0.89 2.66 0.15
Portfolio Effective Duration 6.00 6.00 6.00
A. Determine which of the three portfolios in Exhibit 12-1 will experience the best
price
performance if the 2-year spot rate increases 25 basis points while rates for all other
maturities in Exhibit 12-1 remain unchanged. Justify your selection with one reason.
(3 minutes)
B. Determine which of the three portfolios in Exhibit 12-1 will experience the best
price
performance if 10-, 20-, and 30-year spot rates each decrease 10 basis points while rates
for all other maturities in Exhibit 12-1 remain unchanged. Justify your selection with
one reason.
(3 minutes)
QUESTION 13 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
Sebastian Lee is planning to purchase one of the three collateralized mortgage obligation
(CMO)
tranches described in Exhibit 13-1. The three tranches—a Planned Amortization Class
(PAC)
Bond, a Scheduled Bond, and a Support Bond—are the only three tranches for this
particular
CMO issue.
Exhibit 13-1
Selected Data
Three Federal Home Loan Mortgage Corporation (FHLMC) CMO
Tranches
Tranche Coupon
Stated
Maturity
M/D/Y
Yield
Spread
(basis
points)
Original
Duration
(years)
Current
Duration
(years)
Current
Effective
Principal
Payment Collar
(PSA
prepayment
assumptions)
PAC Bond 6.50% 5/15/27 170 5.98 4.60 109 – 244
Scheduled Bond 6.50% 1/15/31 200 5.98 2.56 146 – 213
Support Bond 6.75% 8/15/31 248 4.88 1.65 ---
A. Indicate which of the three CMO tranches described in Exhibit 13-1 has first,
second,
and third priority, respectively, to receive principal payments. Explain how the priority
to receive principal payments is established for each of the three tranches.
Answer Question 13-A in the Template provided on page 73.
(6 minutes)
Lee is investing to meet a two-year time horizon and has decided to purchase the Support
Bond,
based on its yield spread and duration. Exhibit 13-2 provides duration and principal pay
down
window information for the three tranches. Lee is currently using a 350 PSA prepayment
assumption.
Exhibit 13-2
Duration and Principal Pay Down Window Information
Three Federal Home Loan Mortgage Corporation (FHLMC) CMO
Tranches
Interest Rate Change +100 basis points 0 basis points –100 basis points
PSA Prepayment Assumption 125 350 650
Tranche Duration and Principal Pay Down Window
PAC Bond
5.90 years
August 2009 –
September 2010
4.60 years
October 2007 –
June 2008
2.85 years
July 2005 –
November 2005
Scheduled Bond 7.48 years
October 2010 –
May 2015
2.56 years
April 2005 –
September 2007
1.45 years
November 2003 –
June 2005
Support Bond 11.48 years
June 2003 –
June 2026
1.65 years
June 2003 –
March 2005
0.94 years
June 2003 –
November 2003
B. Identify and describe, using only the information in Exhibit 13-2, the one risk
that Lee
will take if he purchases the Support Bond.
Note: Your response should NOT address reinvestment risk.
(4 minutes)

Answer Question 13 on This Page


Template for Question 13-A
Priority to
receive
principal
payments
Indicate which of the
three CMO tranches
described in Exhibit
13-1 has first, second,
and third priority,
respectively (circle
one for each priority)
Explain how the priority to receive principal
payments is established for each of the three
tranches
First priority
PAC Bond
Scheduled Bond
Support Bond
Second priority
PAC Bond
Scheduled Bond
Support Bond
Third priority
PAC Bond
Scheduled Bond
Support Bond
QUESTION 14 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
Takeda Development Corporation has issued a $100 million floating rate note (FRN) that
will
mature in three years. The FRN has quarterly coupons equal to three-month LIBOR,
payable in
arrears and due on the first business day of each quarter. Anne Yelland, Takeda
Development’s
Treasurer, wants to hedge against an increase in three-month LIBOR during the
remaining term
to maturity of the FRN. To implement the hedge, she realizes she can use either of two
alternatives: An interest rate cap or a package of over-the-counter (OTC) call options on
interest
rates.
A. State whether, to correctly implement the hedge using each of the two
alternatives,
Yelland should:
i. Buy or sell an interest rate cap
ii. Buy or sell a package of over-the-counter (OTC) call options on interest rates
Discuss one requirement that both alternatives must meet for Yelland’s hedge to be
effective.
(4 minutes)
Yelland decides to implement the hedge using an interest rate cap with the following
characteristics:
• The reference rate on the interest rate cap is three-month LIBOR.
• The cap rate (strike rate) is 5.50 percent.
• The length of the agreement is for the remaining three-year life of the FRN.
• The notional principal of the cap is $100 million.
• There is quarterly settlement of the cap, payable in arrears.
Exhibit 14-1 shows the three-month annualized LIBOR observed on the first business day
of
each quarter during the first year of the cap.
Exhibit 14-1
Three-month Annualized LIBOR
Beginning of Each Quarter
Quarter
Three-month
Annualized
LIBOR
1 4.50%
2 6.50%
3 7.50%
4 7.00%
B. Compute the payoff (in dollars) to the interest rate cap at the beginning of each of
the
following two quarters:
i. Quarter 2
ii. Quarter 3
(6 minutes)
QUESTION 15 HAS TWO PARTS (A, B) FOR A TOTAL OF 8
MINUTES.
Michael Weber, CFA, is analyzing several aspects of option valuation, including the
determinants of the value of an option, the characteristics of various models used to value
options, and the potential for divergence of calculated option values from observed
market
prices.
A. State, and justify with one reason for each case, the expected effect on the
value of a call
option on common stock if each of the following changes occurs:
i. The volatility of the underlying stock price decreases
ii. The time to expiration of the option increases
(4 minutes)
Using the Black-Scholes option-pricing model, Weber calculates the price of a three-
month call
option and notices the option’s calculated value is different from its market price. A
colleague
verifies that Weber’s methodology and results are correct.
B. With respect to Weber’s use of the Black-Scholes option-pricing model, and given that
his methodology and results are correct:
i. Discuss one reason why the calculated value of an out-of-the-money European
option may differ from that same option’s market price.
ii. Discuss one reason why the calculated value of an American option may differ
from that same option’s market price.
(4 minutes)
Questions 16 and 17 relate to Carlton Inc. A total of 17 minutes
is allocated to these
questions. Candidates should answer these questions in the
order presented.
QUESTION 16 HAS ONE PART FOR A TOTAL OF 6 MINUTES.
Carlton Inc. has decided to expand the benefits provided for employees by establishing a
retirement plan and has retained a consultant to assist in designing and implementing
either a
defined contribution plan or a defined benefit plan.
Carlton has four objectives in establishing a retirement plan:
1. Reward long-term employees for their years of service to Carlton, regardless of
the investment returns of the plan.
2. Reward those employees who save for their own retirement, by matching amounts
that employees pay into the plan.
3. Simplify the accounting requirements resulting from the plan.
4. Fully fund the plan at all times.
Indicate whether a defined contribution plan or a defined benefit plan is more
likely to meet
each of Carlton’s four objectives. Justify each of your responses with one reason.
Note: Your response should address each objective independently. Objective 1 in the
Template
for Question 16 is completed as an example.
Answer Question 16 in the Template provided on pages 87 and
88.
(6 minutes)

Answer Question 16 on This Page


Template for Question 16
Note: Your response should address each objective independently. Objective 1 in the
Template
is completed as an example.
Carlton’s four
objectives
in establishing a
retirement plan
Indicate whether a
defined contribution
plan or a defined benefit
plan is more likely to
meet each of Carlton’s
four objectives
(circle one for each
objective)
Justify each of your responses with one
reason
Example: Example: Example:
1. Reward long-term
employees for their
years of service to
Carlton, regardless of
the investment returns
of the plan.
Defined Contribution Plan
Defined Benefit Plan
In a defined benefit plan, the pension
benefit is generally determined by a
formula that associates greater pension
benefits with more years of employment
service, independent of the plan’s
investment results. A defined contribution
plan only rewards long-term participants if
investment results are good.
2. Reward those
employees who save
for their own
retirement, by
matching amounts
that employees pay
into the plan.
Defined Contribution Plan
Defined Benefit Plan
Template for Question 16 continued on page 88

Answer Question 16 on This Page


Template for Question 16 (continued)
Carlton’s four
objectives
in establishing a
retirement plan
Indicate whether a
defined contribution
plan or a defined benefit
plan is more likely to
meet each of Carlton’s
four objectives
(circle one for each
objective)
Justify each of your responses with one
reason
3. Simplify the
accounting
requirements resulting
from the plan.
Defined Contribution Plan
Defined Benefit Plan
4. Fully fund the plan
at all times.
Defined Contribution Plan
Defined Benefit Plan
QUESTION 17 HAS TWO PARTS (A, B) FOR A TOTAL OF 11
MINUTES.
The consultant tells Carlton Inc. that effective implementation of the proposed retirement
plan
requires a formal investment policy statement for the plan’s investment portfolio.
A. List the following components of a complete investment policy statement:
i. Two objectives
ii. Five constraints
(7 minutes)
After preparing the investment policy statement, the consultant has been working to
establish an
appropriate asset allocation for the investment portfolio of Carlton’s proposed retirement
plan.
First, she identified the specific asset classes to be considered for inclusion in the
portfolio. In
the second step of the process, she determined specific capital market expectations (risk,
return,
and correlations) for each of these asset classes.
B. Identify and explain the additional two steps that the consultant should perform
to
complete the process of determining an appropriate asset allocation for the retirement
plan’s investment portfolio.
(4 minutes)
2003 CFA® Level II Examination
Morning Session – Essay
IMPORTANT INSTRUCTIONS TO CANDIDATES
1. Write your candidate number in the spaces provided on the front cover of this
examination book.
2. Complete and sign the pledge attached to the front cover of this examination
book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.
3. Write your answers in blue or black ink on the designated answer pages in the
examination book.
4. Label each part of your answer (A, B, C, D or i, ii, iii, etc.).
5. Only answers written on the correct answer pages will be graded. You may
make
marks and notes on the question pages, but these marks will not be graded.
6. If you use all of the designated pages, check the box at the bottom of the last
page
of your answer and continue your answer on the unnumbered extra pages at the
back of the examination book. Label extra pages with the correct question
number.
7. Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C
calculator.
Use of any other calculator will result in the submission of a Violation Report to
AIMR.
8. You must stop writing immediately when instructed to do so at the conclusion
of
the examination.
9. Violation of any of AIMR’s examination rules will result in AIMR voiding your
examination results and may lead to a suspension or termination of your candidacy
in the CFA Program.
DO NOT OPEN THIS EXAMINATION BOOK
UNTIL INSTRUCTED TO DO SO BY THE
PROCTOR/INVIGILATOR.
DO NOT REMOVE ANY EXAMINATION MATERIALS
FROM THE TESTING ROOM.
2003 CFA® Level II Examination
Morning Session – Essay
Candidate Number:
_____ _____ _____ _____ _____ _____
THIS BOOK IS THE PROPERTY OF:
Association for
Investment Management
and Research®
560 Ray C. Hunt Drive
Charlottesville VA 22903-0668
USA
Tel: 434-951-5499
© 2003 Association for Investment Management and Research. All rights
reserved.
FOR AIMR USE ONLY
FOR AIMR USE ONLY
The following list contains the command words used on the Morning
Session of
the 2003 Level II examination. Candidates may want to refer to this list as
they
formulate their answers.
Calculate: To ascertain or determine by mathematical processes.
Cite: To quote by way of evidence, authority, or proof.
Compute: To determine, especially by mathematical means.
Define: To set forth the meaning of; specifically, to formulate a definition of.
Determine: To come to a decision as the result of investigation or reasoning; to settle
or
decide by choice among alternatives or possibilities.
Describe: To transmit a mental image, an impression, or an understanding of the
nature
and characteristics of.
Discuss: To discourse about through reasoning or argument; to present in detail.
Estimate: To judge the value, worth, or significance of.
Explain: To give the meaning or significance of; to provide an understanding of; to
give
the reason for or cause of.
Identify: To establish the identity of; to show or prove the sameness of.
Indicate: To point out or point to with more or less exactness; to show or make
known
with a fair degree of certainty.
Justify: To prove or show to be valid, sound, or conforming to fact or reason; to
furnish grounds or evidence for.
List: To enumerate.
Select: To choose from a number or group–usually, by fitness, excellence, or other
distinguishing factor.
Show: To set forth in a statement, account, or description; to make evident or clear.
State: To express in words.
The Morning Session of the 2003 CFA Level II Examination has 17
questions.
For grading purposes, the maximum point value for each question is equal to
the
number of minutes allocated to that question.
Question Topic Minutes
1 Economics 6
2 Asset Valuation 9
3 Economics 12
4 Financial Statement Analysis 18
5 Asset Valuation 16
6 Asset Valuation 20
7 Asset Valuation 8
8 Asset Valuation 12
9 Asset Valuation 10
10 Asset Valuation 6
11 Asset Valuation 12
12 Asset Valuation 6
13 Asset Valuation 10
14 Asset Valuation 10
15 Asset Valuation 8
16 Portfolio Management 6
17 Portfolio Management 11
Total: 180
Questions 1 through 4 relate to Vacations Unlimited Inc.,
Yucatan Resorts, and Catalina
Resorts. A total of 45 minutes is allocated to these questions.
Candidates should answer
these questions in the order presented.
QUESTION 1 HAS TWO PARTS (A, B) FOR A TOTAL OF 6
MINUTES.
Vacations Unlimited Inc. (VU), a U.S.-based tourism company, has a majority stake in
Yucatan
Resorts, a Mexican firm that owns and operates luxury resorts along Mexico’s Caribbean
coast.
Because most of its client base consists of U.S. tourists, Yucatan Resorts’ revenues are
denominated in U.S. dollars. Yucatan Resorts converts all U.S. dollar receipts into
Mexican
pesos through the foreign exchange market. Yucatan Resorts’ operating costs are all
denominated in pesos and assumed to increase in line with the Mexican inflation rate, and
the
firm’s assets and liabilities are all denominated in pesos. Yucatan Resorts’ shares trade on
the
Mexican stock exchange and are also denominated in pesos.
George Davies, VU’s Chief Financial Officer, is considering increasing VU’s investment
in
Yucatan Resorts. He is aware, however, that the Mexican inflation rate has been higher
than the
inflation rate in the U.S. and that the Mexican peso has been depreciating against the U.S.
dollar.
Davies is concerned that a continuation of these trends might reduce Yucatan Resorts’
profitability. He asks Iris Hamson, a financial analyst at VU, to investigate the
relationship
between Yucatan Resorts’ share price, nominal exchange rates between the peso and the
dollar,
and inflation rates in Mexico and the U.S.
Hamson states:
“Based on Yucatan Resorts’ sources of revenues and costs, and given that purchasing
power parity is unlikely to hold, I conclude that Yucatan Resorts’ local currency
exposure will be characterized by a negative correlation between Yucatan’s share price
(measured in pesos) and the value of the peso.”
A. Define local currency exposure.
(3 minutes)
B. State whether Hamson’s conclusion about Yucatan Resorts’ local currency
exposure is
correct or incorrect. Justify your response with one reason.
(3 minutes)
QUESTION 2 HAS TWO PARTS (A, B) FOR A TOTAL OF 9
MINUTES.
Iris Hamson is evaluating international fixed income investments for Vacations
Unlimited Inc.
She notes that Standard & Poor’s (S&P) assigns separate and distinct credit ratings to
each
national government’s local currency debt and foreign currency debt.
A. State whether a national government’s local currency debt credit rating or foreign
currency debt credit rating is generally lower. Justify your response with one reason
why the default risk is higher on the type of debt that is generally lower-rated.
(3 minutes)
S&P uses several risk factor categories in determining sovereign credit ratings. Hamson
contends that three S&P risk factor categories are most important: 1) income and
economic
structure, 2) fiscal flexibility, and 3) price stability. Based on her country research, she
has
compiled the following list of characteristics of Mexico:
1. National, regional, and local governments that generally possess competitive tax
structures and the ability to control spending
2. A strong banking sector that reflects conservative lending practices and generally
high asset quality
3. A history of prudent monetary and exchange-rate policies pursued by an
independent central bank
4. An external balance sheet that is conservatively structured and an excellent track
record of timely debt service payments
5. A recent Presidential election that was marked by wide voter participation in
response to a popular platform of economic reforms
6. Favorable trends in foreign direct investment and export growth that appears to be
sufficient to lessen any potential balance-of-payments pressures in the future
7. A market economy that exhibits average wealth levels overall but a concentration
of wealth that results in a large difference between the rich and the poor
B. Select from Hamson’s list the characteristic of Mexico that most directly relates to
each
of the three S&P risk factor categories.
Note: Your selections should NOT include any characteristic more than once; only the
characteristic reference numbers (1 through 7) are needed for your selections.
Answer Question 2-B in the Template provided on page 8.
(6 minutes)

Answer Question 2 on This Page


Template for Question 2-B
Note: Your selections should NOT include any characteristic more
than once; only the characteristic reference numbers (1 through 7) are
needed for your selections.
Three S&P risk factor categories
Select from Hamson’s list the
characteristic of Mexico that
most directly relates to each of
the three S&P risk factor
categories
Income and Economic Structure
Fiscal Flexibility
Price Stability
QUESTION 3 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12
MINUTES.
After studying Iris Hamson’s credit analysis, George Davies is considering whether he
can
increase the holding period return on Yucatan Resort’s excess cash holdings (which are
held in
pesos) by investing those cash holdings in the Mexican bond market. Although Davies
would be
investing in a peso-denominated bond, the investment goal is to achieve the highest
holding
period return, measured in U.S. dollars, on the investment.
Davies finds the higher yield on the Mexican one-year bond, which is considered to be
free of
credit risk, to be attractive but he is concerned that depreciation of the peso will reduce
the
holding period return, measured in U.S. dollars. Hamson has prepared selected economic
and
financial data, given in Exhibit 3-1, to help Davies make the decision.
Exhibit 3-1
Selected Economic and Financial Data
U.S. and Mexico
Expected U.S. Inflation Rate 2.0% per year
Expected Mexican Inflation Rate 6.0% per year
U.S. One-year Treasury Bond Yield 2.5%
Mexican One-year Bond Yield 6.5%
Nominal Exchange Rates
Spot 9.5000 Pesos = U.S. $ 1.00
One-year Forward 9.8707 Pesos = U.S. $ 1.00
Hamson recommends buying the Mexican one-year bond and hedging the foreign
currency
exposure using the one-year forward exchange rate. She concludes:
“This transaction will result in a U.S. dollar holding period return that is equal to the
holding period return of the U.S. one-year bond.”
A. Calculate the U.S. dollar holding period return that would result from the
transaction
recommended by Hamson. Show your calculations. State whether Hamson’s
conclusion about the U.S. dollar holding period return resulting from the transaction is
correct or incorrect.
(4 minutes)
After conducting his own analysis of the U.S. and Mexican economies, Davies expects
that both
the U.S. inflation rate and the real exchange rate will remain constant over the coming
year.
Because of favorable political developments in Mexico, however, he expects that the
Mexican
inflation rate (in annual terms) will fall from 6.0 percent to 3.0 percent before the end of
the year.
As a result, Davies decides to invest Yucatan Resorts’ cash holdings in the Mexican one-
year
bond but not to hedge the currency exposure.
B. Calculate the expected exchange rate (pesos per dollar) one year from now.
Show your
calculations.
Note: Your calculations should assume that Davies is correct in his expectations about
the real exchange rate and the Mexican and U.S. inflation rates.
(4 minutes)
C. Calculate the expected U.S. dollar holding period return on the Mexican one-year
bond.
Show your calculations.
Note: Your calculations should assume that Davies is correct in his expectations about
the real exchange rate and the Mexican and U.S. inflation rates.
(4 minutes)
QUESTION 4 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18
MINUTES.
Vacations Unlimited Inc. (VU) owns Catalina Resorts, located in the Caribbean country
of Costa
Guda. This 75-room hotel is a popular vacation destination for North American tourists.
The
majority of operating and financing decisions are made by Catalina management in Costa
Guda,
although Catalina relies on VU’s managerial and technological expertise. The local
currency is
the guda (G); recent annual inflation rates for Costa Guda are given in Exhibit 4-1.
Exhibit 4-1
Inflation Rates for Costa Guda
Year Annual Inflation Rate
2000 20%
2001 25%
2002 30%
A. Identify the appropriate functional currency that Vacations Unlimited should have
used
in 2002 to account for its investment in Catalina Resorts. Justify your response with
one
reason.
(3 minutes)
B. Identify the appropriate functional currency that Vacations Unlimited should use in
2003
to account for its investment in Catalina Resorts, if Costa Guda’s annual inflation rate in
2003 is 50 percent. Justify your response with one reason.
(3 minutes)
Catalina Resorts’ balance sheet and relevant exchange rates for the guda and the U.S.
dollar are
shown in Exhibits 4-2 and 4-3, respectively.
Exhibit 4-2
Catalina Resorts
Balance Sheet
31 December 2001
(guda millions)
Cash 25
Accounts Receivable 50
Current Assets 75
Gross Fixed Assets 425
Accumulated Depreciation (100)
Net Fixed Assets 325
Total Assets 400
Short-term Debt 100
Current Liabilities 100
Common Stock 25
Retained Earnings 275
Total Shareholders’ Equity 300
Total Liabilities and Shareholders’ Equity 400
Exhibit 4-3
Exchange Rates
Guda (G) and U.S. Dollar (U.S. $)
2001 2002
Year-end G 1.06 = U.S. $ 1.00 G 1.20 = U.S. $ 1.00
Average G 0.98 = U.S. $ 1.00 G 1.13 = U.S. $ 1.00
Historical
Fixed Assets G 0.75 = U.S. $ 1.00
C. Determine the translation effect (gain, loss, or no change) for 2002 on Vacation
Unlimited’s investment in Catalina Resorts using each of the following two translation
methods:
i. All current method
ii. Temporal method
Justify your response with one reason for each method.
Answer Question 4-C in the Template provided on page 21.
(6 minutes)
D. Identify the translation method (all current, temporal, or neither) that will result in
each
of the following two ratio effects for Catalina Resorts:
i. A higher asset turnover ratio (in U.S. $ terms)
ii. A higher current ratio (in U.S. $ terms)
Justify your response with one reason for each ratio effect.
Note: No calculations are required.
Answer Question 4-D in the Template provided on page 22.
(6 minutes)

Answer Question 4 on This Page


Template for Question 4-C
Translation method
Determine the
translation effect for
2002 on Vacation
Unlimited’s
investment in
Catalina Resorts
using each of the two
translation methods
(circle one for each
method)
Justify your response with one reason for
each method
i. All current method
gain
loss
no change
ii. Temporal method
gain
loss
no change

Answer Question 4 on This Page


Template for Question 4-D
Note: No calculations are required.
Two ratio effects
Identify the
translation method
that will result in
each of the two ratio
effects for Catalina
Resorts
(circle one for each
ratio effect)
Justify your response with one reason for
each ratio effect
i. A higher asset
turnover ratio (in
U.S. $ terms)
all current method
temporal method
neither
ii. A higher current
ratio (in U.S. $ terms)
all current method
temporal method
neither
Questions 5 through 10 relate to Rio National Corp. A total of
72 minutes is allocated to
these questions. Candidates should answer these questions in
the order presented. Exhibits
5-1 through 5-5 relate to Rio National.
Rio National Corp. is a U.S.-based company and the largest competitor in its industry.
Exhibits
5-1 through 5-4 present the financial statements, which are prepared according to U.S.
Generally
Accepted Accounting Principles (U.S. GAAP), and related information for the company.
Exhibit
5-5 presents relevant industry and market data.
Exhibit 5-1
Rio National Corp.
Summary Balance Sheets
on 31 December
(U.S. $ millions)
2002 2001
Cash $13.00 $5.87
Accounts Receivable 30.00 27.00
Inventory 209.06 189.06
Current Assets $252.06 $221.93
Gross Fixed Assets 474.47 409.47
Accumulated Depreciation (154.17) (90.00)
Net Fixed Assets 320.30 319.47
Total Assets $572.36 $541.40
Accounts Payable $25.05 $26.05
Notes Payable 0.00 0.00
Current Portion of Long-term Debt 0.00 0.00
Current Liabilities $25.05 $26.05
Long-term Debt 240.00 245.00
Total Liabilities $265.05 $271.05
Common Stock 160.00 150.00
Retained Earnings 147.31 120.35
Total Shareholders’ Equity $307.31 $270.35
Total Liabilities and Shareholders’ Equity $572.36 $541.40
Exhibit 5-2
Rio National Corp.
Summary Income Statement
for the Year Ended 31 December 2002
(U.S. $ millions)
Revenue $300.80
Total Operating Expenses (173.74)
Operating Profit 127.06
Gain on Sale 4.00
Earnings Before Interest, Taxes,
Depreciation & Amortization (EBITDA)
131.06
Depreciation and Amortization (71.17)
Earnings Before Interest & Taxes (EBIT) 59.89
Interest (16.80)
Income Tax Expense (12.93)
Net Income $30.16
Exhibit 5-3
Rio National Corp.
Supplemental Notes for 2002
Note 1: Rio National had $75 million in capital expenditures during the year.
Note 2: A piece of equipment that was originally purchased for $10 million was sold for
$7
million at year-end, when it had a net book value of $3 million. Equipment sales are
unusual for Rio National.
Note 3: The decrease in long-term debt represents an unscheduled principal repayment;
there
was no new borrowing during the year.
Note 4: On 1 January 2002, the company received cash from issuing 400,000 shares of
common
equity at a price of $25.00 per share.
Note 5: A new appraisal during the year increased the estimated market value of land
held for
investment by $2 million, which was not recognized in 2002 income.
Exhibit 5-4
Rio National Corp.
Common Equity Data for 2002
Dividends Paid (U.S. $ millions) $3.20
Weighted Average Shares Outstanding during 2002 16,000,000
Dividend per Share $0.20
Earnings per Share $1.89
Beta 1.80
Note: The dividend payout ratio is expected to be constant.
Exhibit 5-5
Industry and Market Data
31 December 2002
Risk-free Rate of Return 4.00%
Expected Rate of Return on Market Index 9.00%
Median Industry Price/Earnings (P/E) Ratio 19.90
Expected Industry Earnings Growth Rate 12.00%
QUESTION 5 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 16
MINUTES.
The portfolio manager of a large mutual fund comments to one of the fund’s analysts,
Katrina
Shaar:
“We have been considering the purchase of Rio National Corp. equity shares, so I would
like you to analyze the value of the company. To begin, based on Rio National’s past
performance, you can assume that the company will grow at the same rate as the
industry.”
A. Calculate the value of a share of Rio National equity on 31 December 2002, using
the
Gordon growth model and the capital asset pricing model. Show your calculations.
(6 minutes)
B. Calculate the three components of Rio National’s return on equity for the year
2002,
using the DuPont model. Show your calculations.
Note: Your calculations should use 2002 beginning-of-year balance sheet values.
(6 minutes)
C. Calculate the sustainable growth rate of Rio National on 31 December 2002.
Note: Your calculations should use 2002 beginning-of-year balance sheet values.
(4 minutes)
QUESTION 6 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 20
MINUTES.
While valuing the equity of Rio National Corp., Katrina Shaar is considering the use of
either
cash flow from operations (CFO) or free cash flow to equity (FCFE) in her valuation
process.
A. State two adjustments that Shaar should make to cash flow from operations to
obtain free
cash flow to equity. Explain why it is necessary to make each of the two adjustments
when valuing the equity of a firm.
Note: No calculations are required.
(4 minutes)
Shaar decides to calculate Rio National’s FCFE for the year 2002, starting with net
income.
B. Determine, for each of the five supplemental notes given in Exhibit 5-3:
i. Whether a net positive adjustment, a net negative adjustment, or no adjustment
should be made to net income to calculate Rio National’s free cash flow to equity
for the year 2002
ii. The dollar amount of the adjustment, if any
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template
for Question 6-B.
Answer Question 6-B in the Template provided on page 36.
(10 minutes)
C. Calculate Rio National’s free cash flow to equity for the year 2002. Show your
calculations.
Note: Your calculations should start with net income.
(6 minutes)

Answer Question 6 on This Page


Template for Question 6-B
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template.
Five supplemental notes
given in Exhibit 5-3
Determine, for each of the
five supplemental notes,
whether a net positive
adjustment, a net
negative adjustment, or
no adjustment should be
made to net income to
calculate Rio National’s
free cash flow to equity
for the year 2002
(circle one for each note)
Determine the dollar
amount of the
adjustment, if any
Note 1: Rio National had $75 million
in capital expenditures during the
year.
Positive
Negative
No Adjustment
$
Note 2: A piece of equipment that
was originally purchased for $10
million was sold for $7 million at
year-end, when it had a net book
value of $3 million. Equipment sales
are unusual for Rio National.
Positive
Negative
No Adjustment
$
Note 3: The decrease in long-term
debt represents an unscheduled
principal repayment; there was no
new borrowing during the year.
Positive
Negative
No Adjustment
$
Note 4: On 1 January 2002, the
company received cash from issuing
400,000 shares of common equity at
a price of $25.00 per share.
Positive
Negative
No Adjustment
$
Note 5: A new appraisal during the
year increased the estimated market
value of land held for investment by
$2 million, which was not recognized
in 2002 income.
Positive
Negative
No Adjustment
$
QUESTION 7 HAS TWO PARTS (A, B) FOR A TOTAL OF 8
MINUTES.
In the process of gathering data to value the equity of Rio National Corp. using a price-
multiple
approach, one of Katrina Shaar’s associates has suggested that the earnings per share
(EPS)
reported by Rio National may need to be converted to normalized (underlying) earnings.
A. Determine, for each of the supplemental notes 2 through 5 given in Exhibit 5-3,
the
dollar amount of the adjustment, if any, that should be made to pretax income to calculate
Rio National’s normalized (underlying) net income for the year 2002.
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template
for Question 7-A. Note 1 in the Template for Question 7-A is completed as an example.
Answer Question 7-A in the Template provided on page 41.
(4 minutes)
Shaar has revised slightly her estimated earnings growth rate for Rio National and, using
normalized (underlying) EPS, now wants to compare the current value of Rio National’s
equity
to that of the industry, on a growth-adjusted basis. Selected information about Rio
National and
the industry is given in Exhibit 7-1.
Exhibit 7-1
Selected Information
Rio National Corp. and Industry
Rio National
Estimated Earnings Growth Rate 11.00%
Current Share Price $25.00
Normalized (underlying) EPS for 2002 $1.71
Weighted Average Shares Outstanding during 2002 16,000,000
Industry
Estimated Earnings Growth Rate 12.00%
Median Price/Earnings (P/E) Ratio 19.90
B. State whether, compared to the industry, Rio National’s equity is overvalued or
undervalued on a P/E-to-growth (PEG) basis, using normalized (underlying) earnings per
share. Justify your response with one reason. Show your calculations.
Note: Your response should assume that the risk of Rio National is similar to the risk of
the industry.
(4 minutes)

Answer Question 7 on This Page


Template for Question 7-A
Note: The five supplemental notes given in Exhibit 5-3 are reproduced in the Template.
Note 1
in the Template is completed as an example.
Five supplemental notes
given in Exhibit 5-3
Determine, for each of the
supplemental notes 2 through 5
given in Exhibit 5-3, the dollar
amount of the adjustment, if any,
that should be made to pretax
income to calculate Rio National’s
normalized (underlying) net income
for the year 2002
Example: Example:
$ No adjustment Note 1: Rio National had $75 million in capital
expenditures during the year.
$
Note 2: A piece of equipment that was originally
purchased for $10 million was sold for $7 million at
year-end, when it had a net book value of $3 million.
Equipment sales are unusual for Rio National.
$
Note 3: The decrease in long-term debt represents an
unscheduled principal repayment; there was no new
borrowing during the year.
$
Note 4: On 1 January 2002, the company received cash
from issuing 400,000 shares of common equity at a
price of $25.00 per share.
$
Note 5: A new appraisal during the year increased the
estimated market value of land held for investment by
$2 million, which was not recognized in 2002 income.
QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 12
MINUTES.
As part of her valuation process, Katrina Shaar has collected the following comparative
information about Rio National Corp. and its primary competitor.
1. Rio National’s gross margin is 57 percent, up from 55 percent a year ago.
Management attributes this improvement to cost reductions from continuous
efforts to achieve manufacturing efficiencies.
2. Rio National is the largest company in the industry. The next largest competitor
is Gracemoor Inc., which has positioned itself as having high quality products and
excellent customer service. Gracemoor’s gross margin is 62 percent, which is the
highest gross margin in the industry.
3. Rio National’s customer base is:
Large volume retailers 45%
Ready to assemble product manufacturers 32%
Other 23%
Although Rio National is the largest company in the industry, it has relatively few
customers. Gracemoor is a substantially smaller company than Rio National but
has several times the number of customers.
4. Rio National’s management noted that most of Rio’s customers are highly price
sensitive, so Rio has found it quite difficult to increase prices. These customers,
however, have consistently purchased in large volumes. Rio’s management
believes that Rio’s average selling price is 20 percent below Gracemoor’s average
selling price.
A. Identify the competitive strategy being employed by Rio National and Gracemoor,
respectively. Cite two facts about each company that are consistent with that
company’s
identified strategy.
Answer Question 8-A in the Template provided on page 47.
(8 minutes)
A few weeks later, Shaar is reviewing several current e-mail newsletters that focus on
this
industry. One of the newsletters contains a press release entitled “Gracemoor Inc.
Announces
Merger with Remalco Corporation.” An extract from this press release is shown in
Exhibit 8-1.
Exhibit 8-1
Extract from Gracemoor Inc. Press Release
“Gracemoor Inc. Announces Merger with Remalco Corporation”
Jeff Fedor, President of Gracemoor Inc., and John Rutt, President of Remalco
Corporation, are
pleased to announce that the firms have reached an agreement to merge operations. The
combined entity, GraceMalco, will have over $250 million in annual revenues and will
employ
1,500 people in three locations.
“The merger of the operations will allow us to reorganize and update manufacturing
operations,
resulting in substantial manufacturing cost reductions. GraceMalco will continue the high
level
of customer and technical support that has been integral to Gracemoor’s prior success but
the
new company will also be able to expand the lower margin, high volume consumer
markets that
have been Remalco’s focus over the last three years,” said Fedor, the new president of
GraceMalco.
After reading the press release, Shaar calls both Rio National and GraceMalco for more
details
and obtains the following comments:
• From Rio National’s Vice President of Investor Relations:
“We believe that the market is large and there is room for more than one
company to pursue the strategy that we have chosen.”
• From the new President of GraceMalco:
“Our merged firm will be able to pursue multiple strategies and compete
more effectively against Rio National.”
B. Discuss one threat each that the merger may pose to the sustainability of the
competitive
strategies of the following two companies:
i. Rio National
ii. GraceMalco
(4 minutes)

Answer Question 8 on This Page


Template for Question 8-A
Identify the competitive
strategy being employed
by Rio National and
Gracemoor, respectively
(circle one for each
company)
Cite two facts about each company that are
consistent with that company’s identified
strategy
1.
Rio National
Cost Leadership
Cost Focus
Differentiation
Differentiation Focus
Buyer Bargaining Power
2.
1.
Gracemoor
Cost Leadership
Cost Focus
Differentiation
Differentiation Focus
Buyer Bargaining Power
2.
QUESTION 9 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
The management of Rio National Corp. has now announced the signing of a new
marketing
agreement that will allow the company to sell its products in Southeast Asia. Sophie
Delourme,
an analyst at Euro-International Co., is analyzing the effect of this announcement on her
estimated value of Rio National’s equity. She uses the H-model in her valuation process
and has
identified the following inputs:
• Rio National’s earnings growth rate is expected to be 30.0 percent in 2003,
declining over a five-year period to a constant growth rate of 12.0 percent in 2008
and thereafter.
• Because of the change in risk, the required rate of return (cost of equity) for Rio
National is expected to be 13.5 percent.
• The dividend per share for 2002 was $0.20.
• The dividend payout ratio is expected to be constant.
A. Calculate the estimated value of a share of Rio National’s equity on 31 December
2002,
using the H-model. Show your calculations.
(6 minutes)
Delourme presents her analysis to her supervisor and concludes:
“Except in rare circumstances, the H-model’s estimated value will be a close
approximation to estimated values generated by multi-stage dividend growth models that
explicitly forecast dividends each year.”
B. State whether Delourme’s conclusion is correct or incorrect. Justify your
response with
one reason.
(4 minutes)
QUESTION 10 HAS ONE PART FOR A TOTAL OF 6 MINUTES.
After Rio National Corp. announced the new marketing agreement to sell its products in
Southeast Asia, several analysts revised their 2003 outlook for Rio National. Reflecting
the new
marketing agreement, the current consensus 2003 earnings per share is $2.19 and the
current
consensus 12-month target share price is $50.00.
Sophie Delourme observes that Rio National’s share price rose from $25.00 to $37.00
after the
new agreement was announced. She believes that Rio National’s required rate of return
(cost of
equity) is 13.5 percent.
Calculate the present value of growth opportunities (PVGO) reflected in Rio
National’s share
price after the agreement was announced. Show your calculations.
(6 minutes)
QUESTION 11 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 12
MINUTES.
Janet Meer is a fixed income portfolio manager. Noting that the current shape of the yield
curve
is flat, she considers the purchase of a newly issued, option-free corporate bond priced at
par; the
bond is described in Exhibit 11-1.
Exhibit 11-1
7% Option-free Bond
Maturity = 10 years
Change in Yields
Up 10 Basis Points Down 10 Basis Points
Price 99.29 100.71
Convexity Measure 35.00
Convexity Adjustment 0.0035
A. Calculate the duration of the bond described in Exhibit 11-1. Show your
calculations.
(4 minutes)
Meer is also considering the purchase of a second newly issued, option-free corporate
bond,
which is described in Exhibit 11-2. She wants to evaluate this second bond’s price
sensitivity to
an instantaneous, downward parallel shift in the yield curve of 200 basis points.
Exhibit 11-2
7.25% Option-free Bond
Maturity = 12 Years
Original Issue Price Par value,
to yield 7.25%
Modified Duration (at original price) 7.90
Convexity Measure 41.55
Convexity Adjustment (yield change of 200 basis points) 1.66
B. Estimate the total percentage price change for the bond described in Exhibit 11-2
if the
yield curve experiences an instantaneous, downward parallel shift of 200 basis points.
Show your calculations.
(4 minutes)
Meer asks her assistant to analyze several callable bonds, given the expected downward
parallel
shift in the yield curve. Meer’s assistant argues that if interest rates fall enough, both
modified
convexity and effective convexity for a callable bond will become negative.
C. State whether the assistant’s argument is correct or incorrect. Justify your
response with
one reason.
(4 minutes)
QUESTION 12 HAS TWO PARTS (A, B) FOR A TOTAL OF 6
MINUTES.
Hiromi Sato is evaluating the effects of yield curve risk on the three bond portfolios she
manages. Key rate durations for the three portfolios are given in Exhibit 12-1.
Exhibit 12-1
Key Rate Durations
Three Bond Portfolios
Key Rate Durations Key Rate Maturities Portfolio A Portfolio B
Portfolio C
2-year 0.89 1.23 0.10
3-year 0.89 1.23 0.11
5-year 0.81 0.70 0.08
7-year 0.85 0.04 2.70
10-year 0.83 0.05 2.66
20-year 0.84 0.09 0.20
30-year 0.89 2.66 0.15
Portfolio Effective Duration 6.00 6.00 6.00
A. Determine which of the three portfolios in Exhibit 12-1 will experience the best
price
performance if the 2-year spot rate increases 25 basis points while rates for all other
maturities in Exhibit 12-1 remain unchanged. Justify your selection with one reason.
(3 minutes)
B. Determine which of the three portfolios in Exhibit 12-1 will experience the best
price
performance if 10-, 20-, and 30-year spot rates each decrease 10 basis points while rates
for all other maturities in Exhibit 12-1 remain unchanged. Justify your selection with
one reason.
(3 minutes)
QUESTION 13 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
Sebastian Lee is planning to purchase one of the three collateralized mortgage obligation
(CMO)
tranches described in Exhibit 13-1. The three tranches—a Planned Amortization Class
(PAC)
Bond, a Scheduled Bond, and a Support Bond—are the only three tranches for this
particular
CMO issue.
Exhibit 13-1
Selected Data
Three Federal Home Loan Mortgage Corporation (FHLMC) CMO
Tranches
Tranche Coupon
Stated
Maturity
M/D/Y
Yield
Spread
(basis
points)
Original
Duration
(years)
Current
Duration
(years)
Current
Effective
Principal
Payment Collar
(PSA
prepayment
assumptions)
PAC Bond 6.50% 5/15/27 170 5.98 4.60 109 – 244
Scheduled Bond 6.50% 1/15/31 200 5.98 2.56 146 – 213
Support Bond 6.75% 8/15/31 248 4.88 1.65 ---
A. Indicate which of the three CMO tranches described in Exhibit 13-1 has first,
second,
and third priority, respectively, to receive principal payments. Explain how the priority
to receive principal payments is established for each of the three tranches.
Answer Question 13-A in the Template provided on page 73.
(6 minutes)
Lee is investing to meet a two-year time horizon and has decided to purchase the Support
Bond,
based on its yield spread and duration. Exhibit 13-2 provides duration and principal pay
down
window information for the three tranches. Lee is currently using a 350 PSA prepayment
assumption.
Exhibit 13-2
Duration and Principal Pay Down Window Information
Three Federal Home Loan Mortgage Corporation (FHLMC) CMO
Tranches
Interest Rate Change +100 basis points 0 basis points –100 basis points
PSA Prepayment Assumption 125 350 650
Tranche Duration and Principal Pay Down Window
PAC Bond
5.90 years
August 2009 –
September 2010
4.60 years
October 2007 –
June 2008
2.85 years
July 2005 –
November 2005
Scheduled Bond 7.48 years
October 2010 –
May 2015
2.56 years
April 2005 –
September 2007
1.45 years
November 2003 –
June 2005
Support Bond 11.48 years
June 2003 –
June 2026
1.65 years
June 2003 –
March 2005
0.94 years
June 2003 –
November 2003
B. Identify and describe, using only the information in Exhibit 13-2, the one risk
that Lee
will take if he purchases the Support Bond.
Note: Your response should NOT address reinvestment risk.
(4 minutes)

Answer Question 13 on This Page


Template for Question 13-A
Priority to
receive
principal
payments
Indicate which of the
three CMO tranches
described in Exhibit
13-1 has first, second,
and third priority,
respectively (circle
one for each priority)
Explain how the priority to receive principal
payments is established for each of the three
tranches
First priority
PAC Bond
Scheduled Bond
Support Bond
Second priority
PAC Bond
Scheduled Bond
Support Bond
Third priority
PAC Bond
Scheduled Bond
Support Bond
QUESTION 14 HAS TWO PARTS (A, B) FOR A TOTAL OF 10
MINUTES.
Takeda Development Corporation has issued a $100 million floating rate note (FRN) that
will
mature in three years. The FRN has quarterly coupons equal to three-month LIBOR,
payable in
arrears and due on the first business day of each quarter. Anne Yelland, Takeda
Development’s
Treasurer, wants to hedge against an increase in three-month LIBOR during the
remaining term
to maturity of the FRN. To implement the hedge, she realizes she can use either of two
alternatives: An interest rate cap or a package of over-the-counter (OTC) call options on
interest
rates.
A. State whether, to correctly implement the hedge using each of the two
alternatives,
Yelland should:
i. Buy or sell an interest rate cap
ii. Buy or sell a package of over-the-counter (OTC) call options on interest rates
Discuss one requirement that both alternatives must meet for Yelland’s hedge to be
effective.
(4 minutes)
Yelland decides to implement the hedge using an interest rate cap with the following
characteristics:
• The reference rate on the interest rate cap is three-month LIBOR.
• The cap rate (strike rate) is 5.50 percent.
• The length of the agreement is for the remaining three-year life of the FRN.
• The notional principal of the cap is $100 million.
• There is quarterly settlement of the cap, payable in arrears.
Exhibit 14-1 shows the three-month annualized LIBOR observed on the first business day
of
each quarter during the first year of the cap.
Exhibit 14-1
Three-month Annualized LIBOR
Beginning of Each Quarter
Quarter
Three-month
Annualized
LIBOR
1 4.50%
2 6.50%
3 7.50%
4 7.00%
B. Compute the payoff (in dollars) to the interest rate cap at the beginning of each of
the
following two quarters:
i. Quarter 2
ii. Quarter 3
(6 minutes)
QUESTION 15 HAS TWO PARTS (A, B) FOR A TOTAL OF 8
MINUTES.
Michael Weber, CFA, is analyzing several aspects of option valuation, including the
determinants of the value of an option, the characteristics of various models used to value
options, and the potential for divergence of calculated option values from observed
market
prices.
A. State, and justify with one reason for each case, the expected effect on the
value of a call
option on common stock if each of the following changes occurs:
i. The volatility of the underlying stock price decreases
ii. The time to expiration of the option increases
(4 minutes)
Using the Black-Scholes option-pricing model, Weber calculates the price of a three-
month call
option and notices the option’s calculated value is different from its market price. A
colleague
verifies that Weber’s methodology and results are correct.
B. With respect to Weber’s use of the Black-Scholes option-pricing model, and given that
his methodology and results are correct:
i. Discuss one reason why the calculated value of an out-of-the-money European
option may differ from that same option’s market price.
ii. Discuss one reason why the calculated value of an American option may differ
from that same option’s market price.
(4 minutes)
Questions 16 and 17 relate to Carlton Inc. A total of 17 minutes
is allocated to these
questions. Candidates should answer these questions in the
order presented.
QUESTION 16 HAS ONE PART FOR A TOTAL OF 6 MINUTES.
Carlton Inc. has decided to expand the benefits provided for employees by establishing a
retirement plan and has retained a consultant to assist in designing and implementing
either a
defined contribution plan or a defined benefit plan.
Carlton has four objectives in establishing a retirement plan:
1. Reward long-term employees for their years of service to Carlton, regardless of
the investment returns of the plan.
2. Reward those employees who save for their own retirement, by matching amounts
that employees pay into the plan.
3. Simplify the accounting requirements resulting from the plan.
4. Fully fund the plan at all times.
Indicate whether a defined contribution plan or a defined benefit plan is more
likely to meet
each of Carlton’s four objectives. Justify each of your responses with one reason.
Note: Your response should address each objective independently. Objective 1 in the
Template
for Question 16 is completed as an example.
Answer Question 16 in the Template provided on pages 87 and
88.
(6 minutes)

Answer Question 16 on This Page


Template for Question 16
Note: Your response should address each objective independently. Objective 1 in the
Template
is completed as an example.
Carlton’s four
objectives
in establishing a
retirement plan
Indicate whether a
defined contribution
plan or a defined benefit
plan is more likely to
meet each of Carlton’s
four objectives
(circle one for each
objective)
Justify each of your responses with one
reason
Example: Example: Example:
1. Reward long-term
employees for their
years of service to
Carlton, regardless of
the investment returns
of the plan.
Defined Contribution Plan
Defined Benefit Plan
In a defined benefit plan, the pension
benefit is generally determined by a
formula that associates greater pension
benefits with more years of employment
service, independent of the plan’s
investment results. A defined contribution
plan only rewards long-term participants if
investment results are good.
2. Reward those
employees who save
for their own
retirement, by
matching amounts
that employees pay
into the plan.
Defined Contribution Plan
Defined Benefit Plan
Template for Question 16 continued on page 88

Answer Question 16 on This Page


Template for Question 16 (continued)
Carlton’s four
objectives
in establishing a
retirement plan
Indicate whether a
defined contribution
plan or a defined benefit
plan is more likely to
meet each of Carlton’s
four objectives
(circle one for each
objective)
Justify each of your responses with one
reason
3. Simplify the
accounting
requirements resulting
from the plan.
Defined Contribution Plan
Defined Benefit Plan
4. Fully fund the plan
at all times.
Defined Contribution Plan
Defined Benefit Plan
QUESTION 17 HAS TWO PARTS (A, B) FOR A TOTAL OF 11
MINUTES.
The consultant tells Carlton Inc. that effective implementation of the proposed retirement
plan
requires a formal investment policy statement for the plan’s investment portfolio.
A. List the following components of a complete investment policy statement:
i. Two objectives
ii. Five constraints
(7 minutes)
After preparing the investment policy statement, the consultant has been working to
establish an
appropriate asset allocation for the investment portfolio of Carlton’s proposed retirement
plan.
First, she identified the specific asset classes to be considered for inclusion in the
portfolio. In
the second step of the process, she determined specific capital market expectations (risk,
return,
and correlations) for each of these asset classes.
B. Identify and explain the additional two steps that the consultant should perform
to
complete the process of determining an appropriate asset allocation for the retirement
plan’s investment portfolio.
(4 minutes)
2003 CFA® Level II Examination
Morning Session – Essay
IMPORTANT INSTRUCTIONS TO CANDIDATES
1. Write your candidate number in the spaces provided on the front cover of this
examination book.
2. Complete and sign the pledge attached to the front cover of this examination
book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.
3. Write your answers in blue or black ink on the designated answer pages in the
examination book.
4. Label each part of your answer (A, B, C, D or i, ii, iii, etc.).
5. Only answers written on the correct answer pages will be graded. You may
make
marks and notes on the question pages, but these marks will not be graded.
6. If you use all of the designated pages, check the box at the bottom of the last
page
of your answer and continue your answer on the unnumbered extra pages at the
back of the examination book. Label extra pages with the correct question
number.
7. Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C
calculator.
Use of any other calculator will result in the submission of a Violation Report to
AIMR.
8. You must stop writing immediately when instructed to do so at the conclusion
of
the examination.
9. Violation of any of AIMR’s examination rules will result in AIMR voiding your
examination results and may lead to a suspension or termination of your candidacy
in the CFA Program.
DO NOT OPEN THIS EXAMINATION BOOK
UNTIL INSTRUCTED TO DO SO BY THE
PROCTOR/INVIGILATOR.
DO NOT REMOVE ANY EXAMINATION MATERIALS
FROM THE TESTING ROOM.
2002 CFA® Level II Examination
Morning Session – Essay
Candidate Number:
_____ _____ _____ _____ _____ _____
THIS BOOK IS THE PROPERTY OF:
Association for
Investment Management
and Research®
560 Ray C. Hunt Drive
Charlottesville VA 22903-0668
USA
Tel: 434-951-5499
© 2002 Association for Investment Management and Research. All rights reserved.
FOR AIMR USE ONLY
FOR AIMR USE ONLY
The following list contains the command words used on the Morning
Session of
the 2002 Level II examination. Candidates may want to refer to this list as
they
formulate their answers.
Calculate: To ascertain or determine by mathematical processes.
Contrast: To compare in respect to differences.
Define: To set forth the meaning of; specifically, to formulate a definition of.
Describe: To transmit a mental image, an impression, or an understanding of the nature
and characteristics of.
Discuss: To discourse about through reasoning or argument; to present in detail.
Explain: To give the meaning or significance of; to provide an understanding of; to give
the reason for or cause of.
Identify: To establish the identity of; to show or prove the sameness of.
Indicate: To point out or point to with more or less exactness; to show or make known
with a fair degree of certainty.
Justify: To prove or show to be valid, sound, or conforming to fact or reason; to
furnish grounds or evidence for.
Name: To mention or identify by name.
Recommend: To bring forward as being fit or worthy; to indicate as being one’s choice
for
something or as otherwise having one’s approval or support.
Show: To set forth in a statement, account, or description; to make evident or clear.
State: To express in words.
Support: To provide with verification, corroboration, or substantiation.
The Morning Session of the 2002 CFA Level II Examination has 16
questions.
For grading purposes, the maximum point value for each question is equal to
the
number of minutes allocated to that question.
Question Topic Minutes
1 Asset Valuation 14
2 Asset Valuation 16
3 Asset Valuation 11
4 Asset Valuation 11
5 Asset Valuation 12
6 Asset Valuation 8
7 Asset Valuation 12
8 Portfolio Management 7
9 Portfolio Management 15
10 Portfolio Management 6
11 Portfolio Management 6
12 Asset Valuation 9
13 Asset Valuation 17
14 Asset Valuation 12
15 Asset Valuation 12
16 Asset Valuation 12
Total: 180
Questions 1 through 6 relate to Jones Group Inc. A total of 72 minutes is allocated to
these
questions. Candidates should answer these questions in the order presented. Exhibits
1-1, 1-
2, and 1-3 relate to Jones Group and its subsidiaries.
Exhibit 1-1
Jones Group Inc.
Corporate Structure
Jones Group Inc.
Bill Jones, Chief Executive Officer
Midwest Pipeline Inc.
100% Owned Subsidiary
Sarah Smith, Chief Executive Officer
DCom Corp.
100% Owned Subsidiary
Tom Anderson, Chief Executive Officer
Exhibit 1-2
Jones Group Inc.
Summary Income Statement and Balance Sheet
(U.S.$ millions, except per share data)
December 31
2000 2001 2002 2003
Summary Income Statement (for the year) Actual Projection Projection Projection
Total Revenue $1,270.00 $1,425.00 $1,609.50 $1,833.45
Total Operating Expenses 461.45 519.77 590.02 676.43
Earnings Before Interest, Taxes,
Depreciation & Amortization (EBITDA)
$808.55 $905.23 $1,019.48 $1,157.02
Depreciation and Amortization 504.00 654.00 751.50 849.00
Earnings Before Interest & Taxes (EBIT) $304.55 $251.23 $267.98 $308.02
Interest Expense 134.10 124.20 132.75 132.75
Pre-tax Income $170.45 $127.03 $135.23 $175.27
Income Tax Expense 51.14 38.11 40.57 52.58
Net Income $119.31 $88.92 $94.66 $122.69
2000 2001 2002 2003
Summary Balance Sheet (year end) Actual Projection Projection Projection
Total Current Assets $549.92 $234.25 $347.43 $599.35
Net Fixed Assets 2,456.00 2,802.00 2,700.50 2,501.50
Total Assets $3,005.92 $3,036.25 $3,047.93 $3,100.85
Total Current Liabilities $101.60 $228.61 $132.29 $150.69
Long-term Debt 1,490.00 1,380.00 1,475.00 1,475.00
Total Liabilities $1,591.60 $1,608.61 $1,607.29 $1,625.69
Common Stock 560.00 560.00 560.00 560.00
Retained Earnings 854.32 867.64 880.64 915.16
Total Shareholders’ Equity 1,414.32 1,427.64 1,440.64 1,475.16
Total Liabilities and Equity $3,005.92 $3,036.25 $3,047.93 $3,100.85
Dividends $70.00 $75.60 $81.65 $88.18
Dividends per share $1.75 $1.89 $2.04 $2.20
Capital Expenditures $1,000.00 $650.00 $650.00
Changes in Working Capital ($3.92) ($15.16) ($18.41)
(excluding cash and short-term debt)
Exhibit 1-3
DCom Corp.
Summary Income Statement and Balance Sheet
(U.S.$ millions, except per share data)
December 31
2000 2001 2002 2003
Summary Income Statement (for the year) Actual Projection Projection Projection
Total Revenue $70.00 $105.00 $157.50 $236.25
Total Operating Expenses 30.45 45.68 68.51 102.77
Earnings Before Interest, Taxes,
Depreciation & Amortization (EBITDA)
$39.55 $59.32 $88.99 $133.48
Depreciation and Amortization 69.00 129.00 136.50 144.00
Earnings Before Interest & Taxes (EBIT) ($29.45) ($69.68) ($47.51) ($10.52)
Interest Expense 44.10 79.20 87.75 87.75
Pre-tax Income ($73.55) ($148.88) ($135.26) ($98.27)
Income Tax Expense (22.07) (44.66) (40.58) (29.48)
Net Income ($51.48) ($104.22) ($94.68) ($68.79)
2000 2001 2002 2003
Summary Balance Sheet (year end) Actual Projection Projection Projection
Total Current Assets $113.12 $130.93 $222.07 $253.75
Net Fixed Assets 391.00 662.00 575.50 481.50
Total Assets $504.12 $792.93 $797.57 $735.25
Total Current Liabilities $5.60 $8.63 $12.95 $19.42
Long-term Debt 490.00 880.00 975.00 975.00
Total Liabilities $495.60 $888.63 $987.95 $994.42
Common Stock 60.00 60.00 60.00 60.00
Retained Earnings (51.48) (155.70) (250.38) (319.17)
Total Shareholders’ Equity 8.52 (95.70) (190.38) (259.17)
Total Liabilities and Equity $504.12 $792.93 $797.57 $735.25
Dividends $0.00 $0.00 $0.00 $0.00
Capital Expenditures $400.00 $50.00 $50.00
Changes in Working Capital $5.19 ($4.32) ($6.47)
(excluding cash and short-term debt)
QUESTION 1 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES.
Jones Group Inc. is the parent company of Midwest Pipeline Inc., a mature, stable natural
gas
transmission pipeline company in the United States. In 1998, Jones Group established
DCom
Corp., a 100 percent owned subsidiary whose mandate is to install and commercialize a
long-
haul data communications network.
Tom Anderson, Chief Executive Officer of DCom, hires Vala and Associates to provide
additional insight into capital markets and corporate finance issues. During the initial
meeting in
December 2000 with Jim Vala, CFA, Anderson comments:
“I do not believe the full value of DCom is reflected in the market price of Jones Group
equity. I think DCom’s full value can be determined using the free cash flows to the firm
model.”
Vala has the following notes from his initial meeting with Anderson:
• The data communications network was built on existing property alongside
Midwest Pipeline’s transmission pipelines.
• The major network construction is nearing completion and DCom’s sales force is
now in place.
• Network data traffic is expected to grow at a rate of 50 percent annually through
2003 and 15 percent annually thereafter.
• Beginning in 2004, DCom’s free cash flows to the firm are expected to grow at a
sustainable rate of 15 percent annually.
• The weighted average cost of capital for DCom is 17 percent.
• The appropriate tax rate for DCom is 30 percent.
A. Calculate the total firm value of DCom at the end of year 2000, using the free cash
flows
to the firm (FCFF) model.
(10 minutes)
B. State whether total firm value as determined by the FCFF model is appropriate to
assess
the value that DCom should contribute to the market price of Jones Group equity.
Support your response with one reason.
(4 minutes)
QUESTION 2 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES.
Later in the December 2000 meeting with Tom Anderson, Jim Vala asks why customers
buy
from DCom Corp. Among Anderson’s responses are the following:
1. The company’s target market is corporate customers who have very large data
traffic demands. These customers perceive their communications networks to be
critical components of their businesses.
2. The recent penetration of the Internet into the home and corporate markets has
greatly increased the demands placed on the communications infrastructure.
3. Network data traffic is expected to grow at a rate of 50 percent annually through
2003 and 15 percent annually thereafter.
4. DCom offers a service level, or “up time,” guarantee of 99.999 percent that
translates into allowable network downtime of just minutes per year. The
established service providers have not had the network architecture that allows
them to provide this kind of guarantee.
5. Much of the sales and marketing strategy is based on the reputation of Jones
Group Inc. (the parent company) and the personal relationships established by the
sales people with customers.
A. Identify the competitive strategy being used by DCom and describe two
characteristics
of that strategy. Identify two of Anderson’s responses that support that strategy.
Answer Question 2-A in the Template provided on page 13.
(8 minutes)
After the meeting with Anderson, Vala is concerned about the long-haul data
communications
industry and wonders if DCom’s business model is viable in the long term. He contacts
David
Blume, a partner at Communication Consulting Group, who specializes in this industry.
In their
conversation, Blume makes the following observations:
1. Long-haul data communications market revenues are $23 billion per year.
2. From the supply perspective, network growth (measured in kilometers of
installed fiber) will increase by 75 percent in total over the next two years, driven
mainly by start-up carriers attempting to compete on quality of service.
3. New data traffic technology virtually eliminates capacity issues in long-haul
networks by allowing more data to flow over the same lines. As a result, the
marginal cost of carrying data traffic for an established service provider with an
existing network is very low.
4. Demand for data traffic will grow at a rate of 60 percent annually over the next
two years because of decentralization of computing resources, the rise of
telecommuting, and Internet traffic.
5. Until recently, established service providers had been prevented from competing
effectively against start-up carriers because of government price regulation.
B. Identify the competitive strategy most likely to be used by traditional telephone
companies in the long-haul data communications industry and describe two
characteristics of that strategy. Identify two of Blume’s observations that support that
strategy.
Answer Question 2-B in the Template provided on page 14.
(8 minutes)

Answer Question 2 on This Page


Template for Question 2-A
Identify the competitive
strategy being used by
DCom
1. Describe two characteristics
of that strategy
2.
Identify two of Anderson’s
responses that support
that strategy
(circle two numbers)
12345

Answer Question 2 on This Page


Template for Question 2-B
Identify the competitive
strategy most likely to be
used by traditional
telephone companies in the
long-haul data
communications industry
1. Describe two characteristics
of that strategy
2.
Identify two of Blume’s
observations that support
that strategy
(circle two numbers)
12345
QUESTION 3 HAS THREE PARTS FOR A TOTAL OF 11 MINUTES.
After meeting with Tom Anderson and contacting David Blume, Jim Vala next meets with
Bill
Jones, the Chief Executive Officer of Jones Group Inc. During this meeting, Jones
comments:
“The DCom business plan projects heavy capital spending in 2001 as DCom completes
the network construction. To finance this expenditure, DCom plans to issue a substantial
amount of debt. The company expects to experience rapid revenue growth, but also
expects to be unprofitable for several years as it builds customer base. I want to be sure
that the parent company, Jones Group, will have a balance sheet capable of sustaining its
growth afterwards.”
A. Calculate the projected sustainable growth rate of Jones Group at the end of year
2003.
(3 minutes)
Jones states that analysts expect Jones Group to achieve an annual growth rate in
revenues of 12
percent in year 2004 and beyond.
B. Recommend two potential policy changes that Jones Group management can
implement
to increase the likelihood of meeting the analysts’ expectations.
(4 minutes)
In addition, Vala notes:
“Projected capital expenditures are reduced dramatically in the last two years of the
Jones Group projections, yet revenue growth is expected to continue.”
Jones explains:
“That is because DCom will have substantially completed the network construction at the
end of year 2001. There will be significant excess capacity at that time. As a result, the
marginal cost of transporting additional data will be virtually zero.”
Vala concludes:
“Based on that explanation, I am not concerned that the projected short-term growth rate
might be different from the sustainable growth rate.”
C. Support Vala’s conclusion by discussing the implications of excess capacity for:
i. Profit margin
ii. Asset turnover
Note: No calculations are required.
(4 minutes)
QUESTION 4 HAS THREE PARTS FOR A TOTAL OF 11 MINUTES.
In March 2001, Jones Group Inc. announces its intentions to divest DCom Corp. Crispin
Tooley,
Director of Research at Heywood & Co., asks one of Heywood’s analysts, Fred
Richardson,
CFA, to estimate the value of DCom as a separate entity.
Richardson reaches the following conclusions:
• DCom is a high risk–high growth company.
• Revenue growth will determine DCom’s success or failure.
• Capturing market share will determine DCom’s revenue growth.
Richardson’s scenario analysis of DCom, shown in Exhibit 4-1, estimates the
probabilities of
DCom achieving the indicated revenue growth rates over the next three years, based on
whether
DCom gains, maintains, or loses market share.
Exhibit 4-1
DCom Corp.
Scenario Analysis
Market Share Revenue Growth
Rate
Estimated
Probability
Gain 120% 0.50
Maintain 50% 0.05
Lose 10% 0.45
After studying Exhibit 4-1, Tooley instructs Richardson to calculate the expected value of
DCom’s revenue growth rate and to use the resulting expected value in his valuation
model for
DCom.
A. Discuss why the shape of the probability distribution in Exhibit 4-1 could cause the
expected value of the revenue growth rate to be inappropriate for valuing DCom.
Note: No calculations are required.
(3 minutes)
Tooley questions the value of using scenario analysis to analyze DCom, stating that the
only
advantage of scenario analysis is the ability to look at various alternative outcomes.
B. Identify two advantages of Richardson’s scenario analysis of DCom in addition to the
advantage stated by Tooley.
(4 minutes)
Richardson forecasts that the long-haul data communications industry’s high growth rate
will last
for four years, then growth will decline to a stable rate of 13 percent per year.
C. Discuss two implications for valuation in the industry if the fade rate is lower than
Richardson forecasts.
Note: No calculations are required.
(4 minutes)
QUESTION 5 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES.
At midyear 2001, Jones Group Inc. has $80 million of publicly traded fixed-rate debt
maturing in
30 days and is considering its refinancing alternatives. Jones Group believes that one of
the two
alternatives provided in Exhibit 5-1 can be used.
Exhibit 5-1
Jones Group Inc.
Refinancing Alternatives
Alternative Description
1 A one-year maturity bank loan with a variable interest rate equal
to three-month LIBOR + 250 basis points.
2 A sale of assets through the issuance of asset-backed securities.
A. Explain two effects on Jones Group’s credit worthiness if Alternative 1 in Exhibit 5-1
is
used to refinance the maturing debt.
(4 minutes)
B. Explain two issues relating to the sale of assets that Jones Group management should
consider if Alternative 2 in Exhibit 5-1 is used to refinance the maturing debt.
(4 minutes)
Prior to 2000, Jones Group had been generating stable after-tax return on equity (ROE)
while
operating income was declining.
C. Explain two possible reasons Jones Group was able to maintain a stable after-tax ROE
despite its declining operating income.
(4 minutes)
QUESTION 6 HAS ONE PART FOR A TOTAL OF 8 MINUTES.
In mid-December 2001, Jim Vala has another meeting with Bill Jones.
During the meeting, Jones says:
“As you know, Jones Group has recently divested DCom. At the time of that transaction,
we signed a 20-year lease that gives DCom access to our pipeline property. We have just
been informed that, as a result of current market conditions, DCom will default on the
lease payments. We need that cash to service the debt that was retained by Jones Group
at the time of the divestiture.”
Jones continues:
“We should consider a new dividend policy to conserve cash. Dividends per share will
total $1.85 in 2001. I think we should reduce our dividend by 60 percent and maintain
that lower level for 2002 and 2003 to allow us to pay off some debt. In 2004, we will
increase our dividend back to $1.85, then grow the dividend at 8 percent annually
thereafter.”
The required rate of return on Jones Group equity is 11 percent for the foreseeable future.
Calculate, using a dividend discount model (DDM) approach, the expected share price of
Jones
Group equity on January 1, 2002, given the new dividend policy described by Jones.
Show your
calculations.
(8 minutes)
QUESTION 7 HAS ONE PART FOR A TOTAL OF 12 MINUTES.
Monica Brown, CFA, asks Jon Rutherford, her research assistant, to investigate how
minority
discounts are determined when valuing private companies. After concluding his research,
Rutherford makes the following statements to Brown:
1. A common approach to valuing minority interests uses a “bottom up” valuation
method, which is similar to valuing publicly traded common stocks using the
dividend discount model.
2. Statutes enacted by some sovereign entities that increase the rights of minority
shareholders usually serve to increase the magnitude of the minority discount.
3. Of the “top down,” “horizontal,” or “bottom up” methods of valuing minority
interests, both the “top down” and “horizontal” methods require an estimate of
value for the total enterprise.
4. In general, market control premiums are lower for strategic acquisitions than for
financial acquisitions.
Indicate whether each of Rutherford’s statements is correct or incorrect and, if incorrect,
justify
your response with one reason.
Answer Question 7 in the Template provided on page 41.
(12 minutes)

Answer Question 7 on This Page


Template for Question 7
Statement
Indicate
whether each
of
Rutherford’s
statements is
correct or
incorrect
(circle one)
Justify your response with one reason
(if incorrect)
1. A common approach to
valuing minority interests uses a
“bottom up” valuation method,
which is similar to valuing
publicly traded common stocks
using the dividend discount
model.
Correct
Incorrect
2. Statutes enacted by some
sovereign entities that increase
the rights of minority
shareholders usually serve to
increase the magnitude of the
minority discount.
Correct
Incorrect
3. Of the “top down,”
“horizontal,” or “bottom up”
methods of valuing minority
interests, both the “top down”
and “horizontal” methods require
an estimate of value for the total
enterprise.
Correct
Incorrect
4. In general, market control
premiums are lower for strategic
acquisitions than for financial
acquisitions.
Correct
Incorrect
QUESTION 8 HAS TWO PARTS FOR A TOTAL OF 7 MINUTES.
Shawn Ritenour, CFA, has a client who plans to retire in ten years. Ritenour meets with
the
client to begin the process of creating a portfolio to address the client’s return
requirement and
risk tolerance. During the meeting, the client states:
“My current portfolio is not very risky because over the past five years I never lost more
than 10 percent in any one year, and in my best year I earned 25 percent.”
A. Identify the measure of risk that is most consistent with the client’s statement.
Explain
one weakness of that measure of risk.
(3 minutes)
When asked about his investment objective, the client explains:
“I am basically a risk-averse person. If I were to earn 12 or 15 percent, that would be
fine, but the key is earning at least an 8 percent average annual return to achieve my
retirement goals.”
Based on the client’s explanation, Ritenour proposes the two alternative portfolios shown
in
Exhibit 8-1.
Exhibit 8-1
Characteristics of Proposed Alternative Portfolios
Characteristic Portfolio A Portfolio B
Holding Period 1 Year 10 Years 1 Year 10 Years
Expected Return 10.75% 10.75% 8.50% 8.50%
Standard Deviation 11.57% 3.66% 7.50% 2.37%
Probability of Actual Average
Annual Return < 0% 17.95% 0.17% 12.56% 0.00%
Probability of Actual Average
Annual Return < 8% 42.28% 27.54% 48.71% 45.92%
B. Recommend the portfolio in Exhibit 8-1 that is most likely to achieve the client’s
objective. Justify your response by referring to the appropriate values in Exhibit 8-1.
(4 minutes)
QUESTION 9 HAS THREE PARTS FOR A TOTAL OF 15 MINUTES.
John Wilson is a portfolio manager at Austin & Associates, which specializes in
providing
advice to clients about their overall asset allocation strategy. For all of his clients, Wilson
manages portfolios that lie on the Markowitz efficient frontier.
Wilson asks Mary Regan, CFA, a managing director at Austin, to review the portfolios of
two of
his clients, the Eagle Manufacturing Company and the Rainbow Life Insurance Co. The
expected returns of the two portfolios are substantially different. Using the assumptions
of
capital market theory, Regan determines that the Rainbow portfolio is the market
portfolio and
concludes that the Rainbow portfolio is superior to the Eagle portfolio.
A. State whether you agree or disagree with Regan’s conclusion that the Rainbow
portfolio
is superior to the Eagle portfolio. Justify your response with one reference to the Capital
Market Line.
(3 minutes)
Wilson remarks that the Rainbow portfolio has a higher expected return because it has
greater
unsystematic risk than Eagle’s portfolio.
B. Define unsystematic risk. State whether you agree or disagree with Wilson’s remark
and
justify your response with one reason.
(4 minutes)
Wilson is evaluating the expected performance of two common stocks, Furhman Labs
Inc. and
Garten Testing Inc. He has gathered the following information:
• The risk-free rate (RFR) is 5 percent.
• The expected return on the market portfolio (RM) is 11.5 percent.
• The beta of Furhman stock is 1.5.
• The beta of Garten stock is 0.8.
Wilson’s own forecasts of the returns on the two stocks are 13.25 percent for Furhman
stock and
11.25 percent for Garten stock.
C. Calculate the required rate of return for Furhman Labs stock and for Garten Testing
stock. Indicate whether each stock is undervalued, fairly valued, or overvalued.
Answer Question 9-C in the Template provided on page 51.
(8 minutes)

Answer Question 9 on This Page


Template for Question 9-C
Common
Stock
Calculate the required rate of return
Indicate whether each
stock is undervalued,
fairly valued, or
overvalued
(circle one)
Furhman
Labs
Undervalued
Fairly Valued
Overvalued
Garten
Testing
Undervalued
Fairly Valued
Overvalued
QUESTION 10 HAS TWO PARTS FOR A TOTAL OF 6 MINUTES.
Joan McKay is a portfolio manager for a bank trust department. McKay meets with two
clients,
Kevin Murray and Lisa York, to review their investment objectives. Each client expresses
an
interest in changing his or her individual investment objectives. Both clients currently
hold welldiversified
portfolios of risky assets. Security markets are considered efficient and in
equilibrium at this time.
Murray wants to increase the expected return of his portfolio.
A. State what action McKay should take to achieve Murray’s objective. Justify your
response in the context of the Capital Market Line.
(3 minutes)
York wants to reduce the risk exposure of her portfolio, but does not want to engage in
borrowing or lending activities to do so.
B. State what action McKay should take to achieve York’s objective. Justify your
response
in the context of the Security Market Line.
(3 minutes)
QUESTION 11 HAS ONE PART FOR A TOTAL OF 6 MINUTES.
Bart Campbell, CFA, is a portfolio manager who has recently met with a prospective
client, Jane
Black. After conducting a Security Market Line (SML) performance analysis using the
Dow
Jones Industrial Average as her market proxy, Black claims that her portfolio has
experienced
superior performance.
Campbell uses the Capital Asset Pricing Model as an investment performance measure
and finds
that Black’s portfolio plots below the SML. Campbell concludes that Black’s apparent
superior
performance is a function of an incorrectly specified market proxy, not superior
investment
management.
Justify Campbell’s conclusion by addressing the likely effects of an incorrectly specified
market
proxy on:
i. Beta
ii. The slope of the SML
(6 minutes)
QUESTION 12 HAS TWO PARTS FOR A TOTAL OF 9 MINUTES.
Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to
manage the
company’s financial risks.
Two years ago, Rone issued a $25 million (U.S.$), five-year floating rate note (FRN).
The FRN
pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-
callable
and will be repaid at par at maturity.
Scott expects interest rates to increase and she recognizes that Rone could protect itself
against
the increase by using a pay-fixed swap. However, Rone’s Board of Directors prohibits
both
short sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap
using
a combination of capital market instruments.
A. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe
the
required transactions.
(6 minutes)
B. Explain how the transactions in Part A are equivalent to using a pay-fixed swap.
(3 minutes)
QUESTION 13 HAS FOUR PARTS FOR A TOTAL OF 17 MINUTES.
Donna Donie, CFA, has a client who believes the common stock price of TRT Materials
(currently $58 per share) could move substantially in either direction in reaction to an
expected
court decision involving the company. The client currently owns no TRT shares, but asks
Donie
for advice about implementing a strangle strategy to capitalize on the possible stock price
movement. Donie gathers the TRT option pricing data shown in Exhibit 13-1.
Exhibit 13-1
TRT Materials
Option Pricing Data
(U.S.$)
Characteristic Call Option Put Option
Price $5 $4
Strike Price $60 $55
Time to
Expiration
90 days
from now
90 days
from now
A. Recommend whether Donie should choose a long strangle strategy or a short strangle
strategy to achieve the client’s objective. Justify your recommendation with one reason.
(4 minutes)
B. Indicate, at expiration for the appropriate strangle strategy in Part A, the:
i. Maximum possible loss per share
ii. Maximum possible gain per share
iii. Breakeven stock price(s)
Note: Your responses should ignore taxes and transaction costs.
(6 minutes)
The delta of the call option in Exhibit 13-1 is 0.625 and TRT common stock does not pay
any
dividends.
C. Calculate the approximate change in price for the call option in Exhibit 13-1 if TRT’s
stock price immediately increases to $59.
(3 minutes)
D. Define gamma and state whether gamma for the put option in Exhibit 13-1 would
decrease, stay the same, or increase if TRT’s stock price immediately decreases to $57.
(4 minutes)
QUESTION 14 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.
Pamela Itsuji, a currency trader for a Japanese bank, is evaluating the price of a six-
month
Japanese yen/U.S. dollar currency futures contract. She gathers the currency and interest
rate
data shown in Exhibit 14-1.
Exhibit 14-1
Currency Exchange Rate and Six-Month Interest Rate Data
Japan and U.S.
Japanese Yen/U.S. Dollar Spot Currency Exchange Rate ¥124.30000/$1.00000
Six-month Japanese Interest Rate 0.10%
Six-month U.S. Interest Rate 3.80%
A. Calculate the theoretical price for a six-month Japanese yen/U.S. dollar currency
futures
contract, using the data in Exhibit 14-1 and Japanese yen as the local currency. Show
your calculations.
(4 minutes)
Itsuji is also reviewing the price of a three-month Japanese yen/U.S. dollar currency
futures
contract, using the currency and interest rate data shown in Exhibit 14-2. Because the
threemonth
Japanese interest rate has just increased to 0.50 percent, Itsuji recognizes that an arbitrage
opportunity exists and decides to borrow $1 million U.S. dollars to purchase Japanese
yen.
Exhibit 14-2
Currency Exchange Rate and Three-Month Interest Rate Data
Japan and U.S.
Japanese Yen/U.S. Dollar Spot Currency Exchange Rate ¥124.30000/$1.00000
New Three-month Japanese Interest Rate 0.50%
Three-month U.S. Interest Rate 3.50%
Three-month Currency Futures Contract Value ¥123.26050/$1.00000
B. Calculate the yen arbitrage profit from Itsuji’s strategy, using the data in Exhibit 14-2.
Show your calculations.
(8 minutes)
QUESTION 15 HAS THREE PARTS FOR A TOTAL OF 12 MINUTES.
Alex Siegel is a mortgage-backed securities portfolio manager. Recently he has been
given the
authority to purchase other asset-backed securities (ABS). He is aware that the credit
quality of
ABS is a primary consideration in their evaluation but is uncertain about credit
enhancement
structures.
A. Identify and describe one example of each of the following types of credit
enhancement
structures:
i. External
ii. Internal
(4 minutes)
Siegel is considering two asset-backed securities to purchase for his portfolio, but he is
concerned about the performance of each security if interest rates decline. Characteristics
of the
two securities are given in Exhibit 15-1.
Exhibit 15-1
Characteristics of Two Asset-backed Securities
Type Structure Lockout Seasoning Weighted Average
Maturity
Home Equity Loans Closed-end None 10 months 350 months
Automobile Receivables --- 18 months 10 months 50 months
B. Identify which of the two securities in Exhibit 15-1 is likely to experience the greater
effect on its cash flows as the result of a 100 basis point parallel decline in interest rates.
Justify your response by referring to one characteristic of each security.
(4 minutes)
Siegel is also considering the purchase of collateralized mortgage obligations (CMOs).
C. Contrast the effects of a 100 basis point parallel decline in interest rates on the cash
flows of the following types of CMOs:
i. Planned amortization class
ii. Support class
(4 minutes)
QUESTION 16 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.
Rich McDonald, CFA, is evaluating his investment alternatives in Ytel Incorporated by
analyzing a Ytel convertible bond and Ytel common equity. Characteristics of the two
securities
are given in Exhibit 16-1.
Exhibit 16-1
Ytel Incorporated
Convertible Bond and Common Equity Characteristics
Characteristic Convertible Bond Common Equity
Par Value $1,000 ---
Coupon (Annual Payment) 4% ---
Current Market Price $980 $35 per share
Straight Bond Value $925 ---
Conversion Ratio 25 ---
Conversion Option At any time ---
Dividend --- $0
Expected Market Price in One Year $1,125 $45 per share
A. Calculate, based on Exhibit 16-1, the:
i. Current market conversion price for the Ytel convertible bond
ii. Expected one-year rate of return for the Ytel convertible bond
iii. Expected one-year rate of return for the Ytel common equity
Note: Your responses should ignore taxes and transaction costs.
(6 minutes)
One year has passed and Ytel’s common equity price has increased to $51 per share.
Also, over
the year, the interest rate on Ytel’s non-convertible bonds of the same maturity increased,
while
credit spreads remained unchanged.
B. Name the two components of the convertible bond’s value. Indicate whether the value
of each component should decrease, stay the same, or increase in response to the:
i. Increase in Ytel’s common equity price
ii. Increase in interest rates
Answer Question 16-B in the Template provided on page 84.
(6 minutes)

Answer Question 16 on This Page


Template for Question 16-B
Indicate whether the value of each component should
decrease, stay the same, or increase in response to the:
Name the two components
of the convertible bond’s
value
i. Increase in Ytel’s
common equity price
(circle one)
ii. Increase in interest rates
(circle one)
1.
Decrease
Stay the same
Increase
Decrease
Stay the same
Increase
2.
Decrease
Stay the same
Increase
Decrease
Stay the same
Increase
2002 CFA Level II Examination
Morning Session – Essay
IMPORTANT INSTRUCTIONS TO CANDIDATES
1. Write your candidate number in the spaces provided on the front cover of this
examination book.
2. Complete and sign the pledge attached to the front cover of this examination
book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.
3. Write your answers in blue or black ink on the designated answer pages in the
examination book.
4. Label each part of your answer (A, B, C, D or i, ii, iii, etc.).
5. Only answers written on the correct answer pages will be graded. You may
make
marks and notes on the question pages, but these marks will not be graded.
6. If you use all of the designated pages, check the box at the bottom of the last
page
of your answer and continue your answer on the unnumbered extra pages at the
back of the examination book. Label extra pages with the correct question
number.
7. Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C
calculator.
Use of any other calculator will result in the submission of a Violation Report to
AIMR.
8. You must stop writing immediately when instructed to do so at the conclusion of
the examination.
9. Violation of any of AIMR's examination rules will result in AIMR voiding your
examination results and may lead to a suspension or termination of candidacy in
the CFA Program.
DO NOT OPEN THIS EXAMINATION BOOK
UNTIL INSTRUCTED TO DO SO BY THE PROCTOR.
DO NOT REMOVE ANY EXAMINATION MATERIALS
FROM THE TESTING ROOM.
2002 Level II Guideline Answers
Morning Session - Page 1
LEVEL II, QUESTION 1
Topic: Asset Valuation
Minutes: 14
Reading Reference:
“Valuing a Firm–The Free Cashflows to the Firm Approach,” Ch. 12, Investment
Valuation:
Tools and Techniques for Determining the Value of Any Asset, Aswath Damodaran (Wiley,
1996)
Purpose:
To test the candidate’s ability to calculate the value of a firm using FCFF and to evaluate
the
appropriateness of using FCFF versus FCFE.
LOS: The candidate should be able to
“Valuing a Firm–The Free Cashflows to the Firm Approach” (Study Session 10)
a) explain how free cashflows to the firm (FCFF) is measured;
b) explain the stable-growth FCFF model and the two-stage FCFF model and use each
model to
calculate the value of a company;
c) describe the type of company that each model is best suited to analyze.
Guideline Answer:
A. DCom’s total firm value at end of year 2000, based on the free cash flows to the firm
(FCFF)
model, is calculated as follows:
n
nnn
t
n
t
g
) WACC 1 (
) (WACC / FCFF
) WACC 1 (
FCFF 1 t
1+

-
+
+
+
=

.
where FCFF = EBIT × (1 – t) + Depr – (Cap Ex) – .wc
2002 Level II Guideline Answers
Morning Session - Page 2
FCFF for DCom 2001 2002 2003 2004
EBIT ($69.68) ($47.51) ($10.52)
After-tax rate = (1 – t) 0.7 0.7 0.7
Depreciation & Amortization = Depr $129.00 $136.50 $144.00
Less Capital Expenditures = (Cap Ex) $400.00 $50.00 $50.00
Less Change in Working
Capital = .wc $5.19 ($4.32) ($6.47)
Free cash flows to the firm = FCFF ($324.97) $57.56 $93.11 $107.08*
Growth Rate = g 50% 50% 50% 15%
Terminal Value2003 = FCFF2004 / (WACC – g2004) $5,354.00
PV of FCFF @ 17%**
PV of terminal value at 17%
($277.75) $42.05 $58.14
$3,342.88
DCom’s total firm value at
end of year 2000 $ 3,165.32 million
*FCFF2004 = FCFF2003 × (1 + g2004) = $93.11 × 1.15
**WACC = 17%
B. The total firm value as determined by the FCFF model is not the appropriate measure
of
value to estimate the contribution DCom should make to the market price of Jones Group
equity. To address the effect of DCom on Jones Group’s value, the value of DCom must
first
be apportioned between bondholders and equity holders, which the FCFF approach does
not
do. Because DCom has a positive amount of debt outstanding, using the total firm value
as
determined by FCFF without adjustment for DCom’s debt will overstate DCom’s
expected
contribution to the value of Jones Group’s equity.
The FCFF model could be used in this situation, but only if the market value of DCom
debt
is deducted from the value computed using the model. Deducting the market value of the
debt effectively apportions the value of DCom between the bondholders and equity
holders.
2002 Level II Guideline Answers
Morning Session - Page 3
LEVEL II, QUESTION 2
Topic: Asset Valuation
Minutes: 16
Reading References:
“Competitive Strategy: The Core Concepts,” Michael E. Porter, Competitive Advantage:
Creating and Sustaining Superior Performance (The Free Press, 1985), 2002 CFA Level
II
Candidate Readings
Purpose:
To test the candidate’s ability to identify the competitive factors in an industry that
influence the
performance of companies in that industry.
LOS: The candidate should be able to
“Competitive Strategy: The Core Concepts” (Study Session 9)
a) analyze the competitive advantage and competitive strategy of a company and the
competitive forces that affect the profitability of a company;
b) analyze basic types of competitive advantage that a company can possess and the
generic
strategies for achieving a competitive advantage.
Guideline Answer:
A.
Identify the competitive
strategy being used by
DCom
Differentiation Focus
1. The company seeks to focus on a segment or group of
segments within an industry by tailoring its strategy to serve
that segment/group to the exclusion of others.
2. The company seeks to achieve a competitive advantage in a
target segment even though it does not possess a competitive
advantage overall.
Describe two characteristics
of that strategy
3. The company does not seek to compete on price but on
tailored product offerings. As a result the company’s product
usually commands a price premium.
Identify two of Anderson’s
responses that support
that strategy
(circle two numbers)
Response 1 identifies the focused target market.
Response 4 identifies the specific method of differentiation
(network reliability).
2002 Level II Guideline Answers
Morning Session - Page 4
B.
Identify the competitive
strategy most likely to be
used by traditional
telephone companies in the
long-haul data
communications industry
Cost Leadership
1. A company decides to become the low-cost provider in the
industry.
2. A company seeks to serve a broad scope of customers with
a generic product offering.
Describe two characteristics
of that strategy
3. A company adopting this strategy believes that there is little
room to differentiate its products or services from those of its
competitors on any basis other than cost.
Identify two of Blume’s
observations that support
that strategy
(circle two numbers)
Observation 3 identifies extremely low cost base as a source
of potential competitive advantage for established service
providers.
Observation 5 identifies removal of regulation as a means to
allow entry by established service providers with technology
and infrastructure in place to serve the broad market.
2002 Level II Guideline Answers
Morning Session - Page 5
LEVEL II, QUESTION 3
Topic: Asset Valuation
Minutes: 11
Reading Reference:
Analysis for Financial Management, 6th edition, Robert C. Higgins (Irwin, 2000)
B. “Managing Growth,” Ch. 4
Purpose:
To test the candidate’s ability to calculate the sustainable growth rate and to determine
what
corrective actions should be taken in the event that the sustainable growth rate diverges
from the
actual growth rate.
LOS: The candidate should be able to
“Managing Growth” (Study Session 8)
a) explain the concept of sustainable growth and identify its determinants;
b) calculate the sustainable growth of a company, given balance sheet and income
statement
data;
c) describe the courses of action that a company could take when actual growth exceeds
sustainable growth and the possible effects of those actions on the company;
d) describe the courses of action that a company could take when sustainable growth
exceeds
actual growth and the possible effects of those actions on the company.
Guideline Answer:
A.
Profit Margin = Net income / Sales = P
= $122.69 / $1,833.45 = 0.066918
Retention Rate = 1 – (Dividends / Net income) = R
= 1 – $88.18 / $122.69 = 0.281278
Asset Turnover = Sales / Assets = A
= $1,833.45 / $3,100.85 = 0.591273
Financial Leverage = Assets / Equity = T
T = $3,100.85 / $1,475.16 = 2.102043
T* = $3,100.85 / $1,440.64 = 2.152411
g = P × R × A × T = 2.35%
g* = P × R × A × T* = 2.40%
* Calculated with beginning of period Equity
2002 Level II Guideline Answers
Morning Session - Page 6
Alternate calculation 1:
Return on Equity = Net income / Average Equity = ROE
= $122.69 / $1,457.90* = 0.084155
Retention Rate = 1 – (Dividends / Net income) = R
= 1– ($88.18 / $122.69) = 0.281278
g = ROE × R = 2.37%
*Average equity = ($1,440.64 + $1,475.16) / 2
Alternate calculation 2:
g = (Shareholders’ Equity2003 / Shareholders’ Equity2002) – 1
= ($1,475.16 / $1,440.64) – 1 = 1.02396 – 1 = 2.40%
B. To remain on its desired growth curve, Jones Group management will need to make
one or
more of the following policy changes:
• issue new equity
• increase debt ratio (leverage)
• reduce payout ratio (increase retention rate)
• generate cash through profitable pruning of business units
• increase prices
• reduce costs through outsourcing or other means (increase operating efficiency)
• merge with another company that can provide excess cash flow or increased debt
capacity
C.
i. Profit margin: In the short-term, excess capacity will result in low profit margins. Until
the excess capacity is utilized, the marginal revenues that DCom will generate as revenue
growth continues will have a marginal cost close to zero. This will cause the profit
margin of Jones Group to increase, which will result in a higher sustainable growth rate.
ii. Asset turnover: Because of the excess capacity, DCom’s asset turnover is very low. As
revenue growth continues and capital expenditures decrease, asset turnover will increase,
which will result in a higher sustainable growth rate for Jones Group.
2002 Level II Guideline Answers
Morning Session - Page 7
LEVEL II, QUESTION 4
Topic: Asset Valuation
Minutes: 11
Reading References:
“Valuing Zero-Income Stocks: A Practical Approach,” Barney Wilson, Practical Issues in
Equity Analysis (AIMR, 2000), 2002 CFA Level II Candidate Readings
Purpose:
To test the candidate’s ability to: 1) understand when a bimodal distribution may be a
better
representation of the distribution of expected revenues for a high growth/high risk growth
company, such as an Internet company, and 2) recognize the importance of, and
difficulties in,
establishing discount, growth, and fade rates when valuing high growth/high risk
companies.
LOS: The candidate should be able to
“Valuing Zero-Income Stocks: A Practical Approach” (Study Session 12)
a) explain why a bimodal distribution better characterizes the prospects of a high
growth/high
risk company, such as an Internet related company;
b) discuss why it is difficult to apply a traditional present value model to the valuation of
high
growth/high risk companies because of discount rate and fade rate problems;
c) describe how a multiple-scenario DCF method combined with reality checks such as
priceto-
earnings ratios and market capitalization can improve an analyst’s ability to value
highgrowth/
high risk companies.
Guideline Answer:
A. The shape of the probability distribution in Exhibit 4-1 is bimodal. Given the bimodal
distribution of revenue growth rates, using the expected value of the revenue growth rate
to
value DCom may not be appropriate because the expected value:
• will not be the most likely outcome, and
• is not a plausible outcome for a single iteration of a bimodal scenario.
B. Beyond Tooley’s statement that scenario analysis is only useful for studying various
alternative outcomes, Richardson’s scenario analysis is also useful in analyzing DCom,
because:
• it can help Richardson identify the key drivers of DCom’s success or failure, such as
revenue growth and market share, and
• as events occur that affect DCom, Richardson can evaluate how these events affect the
probabilities assigned to the different scenarios and hence the probability of the
company’s success or failure.
2002 Level II Guideline Answers
Morning Session - Page 8
C. If the fade rate (the rate at which high or supernormal growth slows) is lower than
forecasted,
then higher earnings growth will be sustained longer into the future, leading to higher
valuations. Specifically, revenues will be higher than forecasted, resulting in higher
profitability (all else equal) and higher valuations.
2002 Level II Guideline Answers
Morning Session - Page 9
LEVEL II, QUESTION 5
Topic: Asset Valuation
Minutes: 12
Reading References:
1. Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith
C.
Brown (Dryden, 2000)
A. “Analysis of Financial Statements,” Ch. 12
2. “General Principles of Credit Analysis,” Level II, Ch. 9, Fixed Income Analysis for the
Chartered Financial Analyst Program, Frank J. Fabozzi, (Frank J. Fabozzi Associates,
2000)
3. “Credit Analysis for Corporate Bonds,” Jane Tripp Howe, Ch. 20, pp. 371–392, The
Handbook of Fixed Income Securities, 5th edition, Frank J. Fabozzi, ed. (Irwin, 1997),
2002
CFA Level II Candidate Readings
Purpose:
To test the candidate’s understanding of corporate credit analysis for a bond issuer by
discussing
characteristics and issues with respect to financing rather than by calculating analytical
data.
LOS: The candidate should be able to
“Analysis of Financial Statements” (Study Session 9)
g) compute return on equity (ROE) using the duPont system and the extended duPont
system;
h) use financial ratios for comparative analysis of a company over time and relative to its
industry or to the market.
“General Principles of Credit Analysis” (Study Session 14)
d) discuss sources of liquidity for a company and the importance of these sources in the
credit
analysis process;
h) discuss why and how cash flow from operations is used to assess the ability of an
issuer to
service its debt obligations and to identify the financial flexibility of a company;
j) explain the typical elements of the debt structure of a high-yield issuer, the
interrelationships
among these elements, and the impact of these elements on the risk position of the lender.
“Credit Analysis for Corporate Bonds” (Study Session 14)
c) analyze the components of a company’s return on equity (ROE) and explain the
importance
of expected earnings growth and ROE in determining credit quality.
Guideline Answer:
A. There are several effects on Jones Group’s creditworthiness if the one-year bank loan
is
used:
1. The bank loan may have a priority lien on Jones Group’s assets, making most existing
or
new-issue “senior” notes less secure. Less security implies a higher cost of funds in the
future.
2. The short one-year maturity of the bank loan subjects Jones Group to a refunding time
horizon that may be shorter than management considers optimal.
2002 Level II Guideline Answers
Morning Session - Page 10
3. The variable interest rate on the bank loan subjects Jones Group to interest rate risk and
volatility at a time when management may prefer locking in the cost of funds.
4. Profits can be positively or negatively affected depending on whether rates are lower or
higher on the bank debt versus maturing debt. This will affect the earning capacity of the
firm, as well as financial flexibility and therefore creditworthiness.
5. Financial flexibility and hence creditworthiness can be positively or negatively
affected
depending on whether and how covenants on bank debt differ from covenants on
maturing debt.
B. There are several issues relating to the sale of Jones Group assets:
1. There is a time constraint, in that Jones Group needs to execute the sale of assets prior
to
the debt maturity to ensure that the funds will be available.
2. There may be a loss of control over operating assets required for the securitization for
the
asset-backed securities.
3. The asset sale may involve a lower cost of capital than other sources of financing.
4. Total cost of issuance may differ substantially, higher or lower, than other sources of
financing.
5. Covenants on existing debt may limit/prohibit asset sales.
6. Effects of covenants on existing debt with respect to an asset sale, even absent
violation,
and on the securitized debt may adversely affect financial flexibility.
7. Any over collateralization required by the rating agency to support securitization may
potentially result in an insufficient amount of funds to refinance the maturing debt.
C. Considering the components of after-tax ROE, there are several possible explanations
for
after-tax ROE remaining constant while operating income was declining:
1. Decreasing operating income could have been offset by an increase in non-operating
income (i.e., from discontinued operations, extraordinary gains or income, gains from
changes in accounting policies) because both are components of profit margin (net
income/sales).
2. Another offset to decreasing operating income could have been declining interest rates
on
any interest rate obligations, which would have decreased interest expense and allowed
pre-tax margins to remain stable.
3. Leverage could have increased as a result of a decline in equity from: a) writing down
an
equity investment, b) stock repurchases, c) losses, or d) selling new debt. The effect of
the increased leverage could have offset a decline in operating income.
4. An increase in asset turnover would also offset the decline in operating income. Asset
turnover could increase as a result of the sales growth rate exceeding the asset growth
rate, or from the sale or write-off of assets.
5. If the effective tax rate declined, the resulting increase in earnings after tax could offset
a
decline in operating income. The decline in effective tax rates could result from increased
tax credits, the use of tax loss carry forwards, or a decline in the statutory tax rate.
2002 Level II Guideline Answers
Morning Session - Page 11
LEVEL II, QUESTION 6
Topic: Asset Valuation
Minutes: 18
Reading References:
Investment Valuation: Tools and Techniques for Determining the Value of Any Asset,
Aswath
Damodaran (Wiley, 1996)
A. “Dividend Discount Models,” Ch. 10
Purpose:
To test the candidate’s ability to calculate a two-stage DDM value for an established
company’s
equity.
LOS: The candidate should be able to
“Dividend Discount Models” (Study Session 10)
a) explain and calculate the value of a company’s equity using the dividend discount
model
(DDM), the Gordon growth model, the two-stage DDM, the H model, and the three-stage
DDM.
Guideline Answer:
Because expected dividends exhibit two stages, a two-stage dividend discount model is
appropriate. In the first stage, which includes 2002 and 2003, dividends are expected to
be level
at $0.74 which represents a 60 percent reduction from the 2001 dividend of $1.85. In the
second
stage, beginning in 2004, the dividend will be restored to its former $1.85 level and will
grow at
a constant 8 percent rate thereafter.
2002 2003 2004 Terminal
Value
Projected Dividend = Dn $0.74 $0.74 $1.85 $2.00
Dividend Growth Rate = g 8%
Required Rate of Return = r 11% 11% 11% 11%
Terminal Value = (D2004 ×
(1 + g)) / (r2004 – g)
$66.67
Present Value of Dividends @ 11% $0.67 $0.60 $1.35
Present Value of Terminal Value @ 11% $48.75
Share price based on DDM $51.37
2002 Level II Guideline Answers
Morning Session - Page 12
LEVEL II, QUESTION 7
Topic: Asset Valuation
Minutes: 12
Reading Reference:
Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd edition,
Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (Irwin 1995)
A. “Minority Interest Discounts, Control Premiums, and Other Discounts and Premiums,”
Ch.
14, pp. 300-303 and 316-326
B. “Discounts for Lack of Marketability,” Ch. 15, pp. 331-334, 342-359
Purpose:
To test the candidate’s understanding of minority and/or marketability discounts.
LOS: The candidate should be able to
“Minority Interest Discounts, Control Premiums, and Other Discounts and Premiums”
(Study
Session 11)
a) describe the concept and importance of control;
d) discuss the impact of state statute provisions on minority versus control value;
e) discuss the top down, horizontal, and bottom up approaches for valuing minority
interests;
f) discuss the market evidence with respect to control premiums and minority discounts.
“Discounts for Lack of Marketability” (Study Session 11)
d) describe the major factors affecting the discount for lack of marketability.
2002 Level II Guideline Answers
Morning Session - Page 13
Guideline Answer:
Statement
Indicate
whether each
of
Rutherford’s
statements is
correct or
incorrect
(circle one)
Justify your response with one reason
(if incorrect)
1. A common approach to
valuing minority interests uses
a “bottom up” valuation
method, which is similar to
valuing publicly traded
common stocks using the
dividend discount model.
Correct
2. Statutes enacted by some
sovereign entities that increase
the rights of minority
shareholders usually serve to
increase the magnitude of the
minority discount.
Incorrect
Sovereign entity statute provisions that
increase the power of the minority holder will
serve to reduce the magnitude of the discount
that must be taken for a minority interest,
because such provisions effectively reduce the
differences in status between controlling and
minority interests.
3. Of the “top down,”
“horizontal,” or “bottom up”
methods of valuing minority
interests, both the “top down”
and “horizontal” methods
require an estimate of value
for the total enterprise.
Incorrect
Only the “top down” method requires that the
entire enterprise be valued. The other methods
only require that the minority interest be
valued.
4. In general, market control
premiums are lower for
strategic acquisitions than for
financial acquisitions.
Incorrect
Entities that acquire control for strategic
reasons should be, and typically are, able to
justify a higher premium than entities that
acquire control for purely financial reasons.
This is because the synergies that attach to a
strategic acquisition are expected to result in
higher returns to the acquiring entity than the
returns that are to be obtained from a purely
financial transaction.
2002 Level II Guideline Answers
Morning Session - Page 14
LEVEL II, QUESTION 8
Topic: Portfolio Management
Minutes: 7
Reading Reference:
Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown
(Dryden, 2000)
B. “An Introduction to Portfolio Management,” Ch. 8
PURPOSE
To test the candidate’s ability to: 1) identify and briefly describe several measures of risk,
and 2)
identify which measures are appropriate to measure the risk of a stand-alone asset versus
a
portfolio.
LOS: The candidate should be able to
“An Introduction to Portfolio Management” (Study Session 20)
b) identify several measures of risk and explain the circumstances in which their use
might be
appropriate in both stand-alone and portfolio contexts.
Guideline Answer:
A. The measure of risk that is most consistent with the client’s statement is “range of
returns.” A
major weakness of this measure is that it focuses on the extremes of the distribution,
attaching excessive importance to these values. The range of returns measure ignores the
shape of the distribution with respect to both expected value and volatility. In addition,
this
measure does not utilize a benchmark or market portfolio for comparison purposes to
assess
overall portfolio risk.
B. Portfolio A is more likely to achieve the client’s objective.
The client is risk averse and has strongly stated a minimum required rate of return or
“floor”
relative to achieving his retirement goals. Thus, the risk measure for assessing which
portfolio is most appropriate for the client is one that focuses on downside risk. Exhibit 8-
1
shows that portfolio A has a lower probability (27.54 percent) of failing to meet the
client’s
minimum required rate of return (8 percent average annual return) over a ten-year
holding
period, compared to portfolio B’s 45.92 percent probability of failing to earn 8 percent.
The
one-year holding period probabilities are not appropriate measures given the longer-term
nature of the client’s objective.
2002 Level II Guideline Answers
Morning Session - Page 15
LEVEL II, QUESTION 9
Topic: Portfolio Management
Minutes: 15
Reading References:
Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown
(Dryden, 2000)
A. “Efficient Capital Markets,” Ch. 7
C. “An Introduction to Asset Pricing Models,” Ch. 9
Purpose:
To test the candidate’s ability to: 1) to distinguish between systematic and unsystematic
risk, 2)
describe the role of the market portfolio, and 3) use the SML to determine whether a
security is
undervalued, overvalued, or properly valued.
LOS: The candidate should be able to
“Efficient Capital Markets” (Study Session 20)
a) describe the set of assumptions that imply an efficient capital market.
“An Introduction to Asset Pricing Models” (Study Session 20)
a) distinguish between the original capital market theory assumptions and the revised
assumptions that underlie the capital asset pricing model (CAPM);
b) explain how the presence of a risk-free asset changes the characteristics of the
Markowitz
efficient frontier;
c) describe the market portfolio and the role it plays in the formation of the capital market
line
(CML);
d) define and distinguish between systematic and unsystematic risk;
g) calculate, based on the SML, the expected return for an asset;
i) determine, based on the SML, whether a security is undervalued, overvalued, or
properly
valued.
Guideline Answer:
A. Agree; Regan’s conclusion is correct. By definition the market portfolio lies on the
capital
market line (CML). Under the assumptions of capital market theory, all portfolios on the
CML dominate, in a risk-return sense, portfolios that lie on the Markowitz efficient
frontier
because, given that leverage is allowed, the CML creates a portfolio possibility line that
is
higher than all points on the efficient frontier except for the market portfolio, which is
Rainbow’s portfolio. Because Eagle’s portfolio lies on the Markowitz efficient frontier at
a
point other than the market portfolio, Rainbow’s portfolio dominates Eagle’s portfolio.
2002 Level II Guideline Answers
Morning Session - Page 16
B. Unsystematic risk is the unique risk of individual stocks in a portfolio that is
diversified away
by holding a well-diversified portfolio. Total risk is composed of systematic (market) risk
and unsystematic (firm-specific) risk.
Disagree; Wilson’s remark is incorrect. Because both portfolios lie on the Markowitz
efficient frontier, neither Eagle nor Rainbow has any unsystematic risk. Therefore,
unsystematic risk does not explain the different expected returns. The determining factor
is
that Rainbow lies on the (straight) line (the CML) connecting the risk-free asset and the
market portfolio (Rainbow), at the point of tangency to the Markowitz efficient frontier
having the highest available amount of return per unit of risk. Wilson’s remark is also
countered by the fact that because unsystematic risk can be eliminated by diversification,
the
expected return to bearing it is zero. This happens as a result of well-diversified investors
bidding the price of every asset up to the point at which only systematic risk earns a
positive
return (unsystematic risk earns no return).
C.
Common Stock Calculate the required rate of return
Indicate whether each
stock is undervalued,
fairly valued, or
overvalued
(circle one)
Furhman Labs
E(R) = Rf + Beta × (Rm – Rf)
= 5.0% + 1.5 × (11.5% – 5.0%)
= 14.75%
Overvalued*
Garten Testing
E(R) = Rf + Beta × (Rm – Rf)
= 5.0% + 0.8 × (11.5% – 5.0%)
= 10.20%
Undervalued*
*Supporting calculations:
Furhman: Forecast – Required = 13.25% – 14.75% = –1.50% (Overvalued)
Garten: Forecast – Required = 11.25% – 10.20% = 1.05% (Undervalued)
If the forecast return is less (greater) than the required rate of return, the security is
overvalued
(undervalued).
2002 Level II Guideline Answers
Morning Session - Page 17
LEVEL II, QUESTION 10
Topic: Portfolio Management
Minutes: 6
Reading Reference:
Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown
(Dryden, 2000)
C. “An Introduction to Asset Pricing Models,” Ch. 9
Purpose:
To test the candidate’s ability to discuss the security market line (SML) and explain how
the
SML differs from the CML.
LOS: The candidate should be able to
“An Introduction to Asset Pricing Models” (Study Session 20)
b) explain how the presence of a risk-free asset changes the characteristics of the
Markowitz
efficient frontier;
c) describe the market portfolio and the role it plays in the formation of the capital market
line
(CML);
d) define and distinguish between systematic and unsystematic risk;
f) discuss the security market line (SML) and how it differs from the CML.
Guideline Answer:
A. McKay should borrow funds and invest those funds proportionally in Murray’s
existing
portfolio (i.e., buy more risky assets on margin).
In addition to increased expected return, the alternative portfolio on the capital market
line
(CML) will also have increased variability (risk), which is caused by the higher
proportion of
risky assets in the total portfolio.
B. McKay should substitute low beta stocks for high beta stocks to reduce the overall
beta of
York’s portfolio.
By reducing the overall portfolio beta, McKay will reduce the systematic risk of the
portfolio
and therefore its volatility relative to the market. The security market line (SML) suggests
such action (moving down the SML), even though reducing beta may result in a slight
loss of
portfolio efficiency unless full diversification is maintained. York’s primary objective,
however, is not to maintain efficiency but to reduce risk exposure; reducing portfolio beta
meets that objective. Because York does not permit borrowing or lending, McKay cannot
reduce risk by selling equities and using the proceeds to buy risk free assets (i.e., lending
part
of the portfolio).
2002 Level II Guideline Answers
Morning Session - Page 18
LEVEL II, QUESTION 11
Topic: Portfolio Management
Minutes: 6
Reading Reference:
Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown
(Dryden, 2000)
D. “Extensions and Testing of Asset Pricing Theories,” Ch. 10
Purpose:
To test the candidate’s understanding of Roll’s concept of benchmark error.
LOS: The candidate should be able to
“Extensions and Testing of Asset Pricing Theories” (Study Session 20)
d) discuss why Roll’s critique of the CAPM and Shanken’s challenge to the APT cause
many
observers to consider the models to be untestable;
e) describe the concept of benchmark error.
Guideline Answer:
The effects of an incorrectly specified market proxy are that:
i. The beta of Black’s portfolio is likely be underestimated (too low) relative to the beta
calculated based on the “true” market portfolio. This is because the Dow Jones Industrial
Average (DJIA) and other market proxies are likely to have less diversification and a
higher
variance of returns than the “true” market portfolio as specified by the capital asset
pricing
model. Consequently, beta computed using an overstated variance (Betaportfolio =
Covarianceportfolio, market proxy / Variancemarket proxy) will be underestimated.
ii. The slope of the security market line (SML), i.e., the market risk premium, is likely to
be
underestimated relative to the “true” market portfolio because the “true” market portfolio
is
likely to be more efficient—plotting on a higher return point for the same risk—than the
DJIA and similarly misspecified market proxies. Consequently, the proxy-based SML
would
offer less expected return per unit of risk.
2002 Level II Guideline Answers
Morning Session - Page 19
LEVEL II, QUESTION 12
Topic: Asset Valuation
Minutes: 9
Reading Reference:
Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. “The Swaps Market: Introduction,” Ch. 20, pp. 608-625 and pp. 632-643
B. “ The Swaps Market: Refinements,” Ch. 21, pp. 648-671
Purpose:
To test the candidate’s: 1) understanding of a plain interest rate swap and how it can be
used to
efficiently manage the balance sheet of a corporation, and 2) ability to replicate a plain
vanilla
swap with two bonds.
LOS: The candidate should be able to
“The Swaps Market: Introduction” (Study Session 17)
a) discuss the characteristics of and motivations for swap contracts and differentiate swap
contracts from futures contracts, especially with respect to payment date versus
expiration
date;
b) diagram (with a box and arrow diagram) and explain the cash flows between the
parties to a
plain vanilla swap contract, including situations in which an intermediary participates;
e) illustrate the appropriate cash flow diagram for a swap and calculate the net
borrowing/lending costs for the two swap counterparties.
“The Swaps Market: Refinements” (Study Session 17)
a) demonstrate how swap agreements can be viewed as a combination of capital market
instruments.
Guideline Answer:
A. The instruments needed by Scott are a fixed-coupon bond and a floating rate note
(FRN).
The transactions required are to:
• issue a fixed-coupon bond with a maturity of three years and a notional amount of $25
million, and
• buy a $25 million FRN of the same maturity that pays one-year LIBOR + 75 bps.
B. At the outset, Rone will issue the bond and buy the FRN, resulting in a zero net cash
flow at
initiation. At the end of the third year, Rone will repay the fixed-coupon bond and will be
repaid the FRN, resulting in a zero net cash flow at maturity. The net cash flow associated
with each of the three annual coupon payments will be the difference between the inflow
(to
Rone) on the FRN and the outflow (to Rone) on the bond. Movements in interest rates
during
the three-year period will determine whether the net cash flow associated with the
coupons is
2002 Level II Guideline Answers
Morning Session - Page 20
positive or negative to Rone. Thus, the bond transactions are financially equivalent to a
plain
vanilla pay-fixed interest rate swap.
2002 Level II Guideline Answers
Morning Session - Page 21
LEVEL II, QUESTION 13
Topic: Asset Valuation
Minutes: 17
Reading Reference:
Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. “Option Payoffs and Option Strategies,” Ch. 11, pp. 316-346
C. “Option Sensitivities and Option Hedging,” Ch. 14, pp. 422-437
Purpose:
To test the candidate’s: 1) understanding of different option combinations, specifically
strangle
strategies, and 2) ability to relate delta and gamma to the price of a call option.
LOS: The candidate should be able to
“Option Payoffs and Option Strategies” (Study Session 18)
b) calculate the cost of the following option-trading strategies: straddle, strangle, bull and
bear
spreads, and butterfly spread;
c) determine, using a profit/loss diagram, the profit or loss of an option-trading strategy
for any
asset value.
“Option Sensitivities and Option Hedging,” (Study Session 18)
c) calculate the change in option price, given delta and the change in asset price;
d) calculate delta, given the change in option price and the change in asset price;
k) relate gamma to changes in an option’s delta and stock price.
Guideline Answer:
A. Donie should choose the long strangle strategy.
A long strangle option strategy consists of buying a put and a call with the same
expiration
date and the same underlying asset. In a strangle strategy, the call has an exercise price
above
the stock price and the put has an exercise price below the stock price. An investor who
buys
(goes long) a strangle expects that the price of the underlying asset (TRT in this case) will
either move substantially below the exercise price on the put or above the exercise price
on
the call. With respect to TRT, the long strangle investor buys both the put and call options
for
a total cost of $9.00, and will experience large profits if the stock price moves more than
$9.00 above the call exercise price or $9.00 below the put exercise price. This strategy
would
enable Donie’s client to profit from a large move in the stock price, either up or down, in
reaction to the expected court decision.
2002 Level II Guideline Answers
Morning Session - Page 22
B. i. The maximum possible loss per share is $9.00, which is the total cost of the two
options
= $5.00 + $4.00.
ii. The maximum possible gain is unlimited, if the stock price moves outside the
breakeven
range of prices.
iii. The breakeven prices are $46.00 and $69.00. The put will just cover costs if the stock
price finishes $9.00 below the put exercise price ($55.00 – $9.00 = $46.00), and the call
will just cover costs if the stock price finishes $9.00 above the call exercise price ($60.00
+ $9.00 = $69.00).
The following diagram provides support for the answers above.
Long strangle
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
35 40 45 50 55 60 65 70 75 80
Stock Price($)
Profit/Loss($)
C. The delta for a call option is always positive, so the value of the call option in Exhibit
13-1
will increase if the stock price increases. Specifically, if the stock price increases by
$1.00,
the price of the call will increase by approximately $0.63:
.Price call = 0.6250 × $1.00) = $0.625 increase
D. Gamma is the second derivative of the option price with respect to the stock price and
measures how delta changes with changes in the underlying stock price.
The gamma for the put option in Exhibit 13-1 would increase if the stock price decreases
to
$57.00. Gamma is relatively small when an option is out-of-the-money but becomes
larger as
the option approaches near-the-money, which is the case as the underlying asset value
moves
down toward the put option’s $55 exercise price.
$46.0 $69.0
2002 Level II Guideline Answers
Morning Session - Page 23
LEVEL II, QUESTION 14
Topic: Asset Valuation
Minutes: 12
Reading Reference:
Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
D. “Foreign Exchange Futures,” Ch. 9, pp. 261–266
Purpose:
To test the candidate’s ability to calculate the value of, and determine if there is an
arbitrage
opportunity available in, a currency futures contract.
LOS: The candidate should be able to:
“Foreign Exchange Futures” (Study Session 17)
b) compute, using the cost-of-carry model, the theoretical futures price and determine
whether
an arbitrage profit exists;
d) compute the profits from an arbitrage strategy.
Guideline Answer:
A. The theoretical futures contract price is ¥122.0645, calculated as follows:
period g compoundin
period g compoundin
market) foreign in the rate interest (1
market) local in the rate interest (1 price spot price Futures
+
+
×=
= ¥124.30000 × (1 + 0.0010)0.5 / (1 + 0.0380)0.5
= ¥124.30000 × (1.00049988 / 1.01882285)
= ¥122.06453
B. The yen arbitrage profit is ¥129,928.61, calculated as follows:
Borrow $1,000,000 for 3 months @ 3.50%
Repay principal + interest = $1,000,000 × 1.0350.25 = $1,008,637.45
Exchange the $1,000,000 borrowed @ ¥124.30 / $1.00 = ¥124,300,000
Invest the ¥124,300,000 for 3 months at 0.50%
Receive principal + interest = 124,300,000 × 1.0050.25 = ¥124,455,084.52
Sell 3-month futures to pay off US$ denominated loan
Payoff (in ¥) = $1,008,637.45 × ¥123.2605 / $1.00 = ¥124,325,155.91
Yen arbitrage profit = Proceeds from yen investment – repayment (in ¥) of the US$ loan
= ¥124,455,084.52 – ¥124,325,155.91 = ¥129,928.61
2002 Level II Guideline Answers
Morning Session - Page 24
LEVEL II, QUESTION 15
Topic: Asset Valuation
Minutes: 12
Reading References:
Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi
(Frank J.
Fabozzi Associates, 2000)
A. “Mortgage-Backed Securities,” Level II, Ch. 3
B. “Asset-Backed Securities,” Level II, Ch. 4
Purpose
To test the candidate’s understanding of the basic structures, cash flow characteristics,
and
methods of analysis of mortgage-based securities (MBS) and asset-backed securities
(ABS).
LOS: The candidate should be able to
“Mortgage-Backed Securities” (Study Session 16)
m) explain why and how a collateralized mortgage obligation (CMO) is created and
distinguish
among the different types of CMO structures (including sequential-pay tranches, accrual
tranches, floater tranches, inverse floater tranches, planned amortization class tranches,
support tranches, and support tranches with schedules);
o) explain, for planned amortization class (PAC) tranches, the initial PAC collar and the
effective collar;
p) explain why the support tranches have the greatest prepayment risk in a CMO
structure.
“Asset-Backed Securities” (Study Session 16)
b) explain the difference between an external and internal credit enhancement;
c) explain the different types of external credit enhancements (corporate guarantees, letter
of
credit, and bond insurance) and the problems associated with enhancing by means of
thirdparty
guarantors;
d) explain the different types of internal credit enhancements (reserve accounts and
seniorsubordinated
structures);
g) describe the cash flow for securities backed by closed-end home equity loans, open-
end
home equity loans, manufactured housing loans, student loans, and Small Business
Administration loans;
h) explain a prospectus prepayment curve for home equity loan-backed securities;
k) explain why prepayments that result from refinancing may not be significant for
manufactured housing-backed securities and automobile loan-backed securities.
2002 Level II Guideline Answers
Morning Session - Page 25
Guideline Answer:
A. i. External credit enhancements take the form of third-party guarantees that provide
protection against losses up to a specified amount. The most common examples of
external credit enhancement are:
• corporate guarantees, in which another corporation guarantees the performance of the
underlying collateral,
• letters of credit from a bank, in which a bank issues a letter of credit supporting the
performance of the collateral, and
• bond insurance, in which an insurance company writes a policy to cover losses to
investors.
The underlying credit of the issue is only as good as the credit enhancement regardless of
the quality of the loans.
ii. Internal credit enhancements take the form of internal structures that provide a cushion
or
support for credit losses. There are three common examples of internal credit
enhancements.
• Reserve funds take the form of either cash reserves or excess servicing reserves. Cash
reserves are created from issuance proceeds, and excess servicing reserves are
accumulated over the life of the issue from the difference between the net coupon and
the gross coupon. In either case a reserve is set aside for any possible future losses.
• Overcollateralization occurs when the issue is structured with collateral in excess of
the total par value of the tranches. The amount of overcollateralization can be used to
absorb losses, thereby shielding the tranches from losses up to the amount of the
overcollateralization.
• Senior/subordinated structure occurs when an issue is offered with more than one
tranche, where a senior tranche exists with a junior or subordinated tranche. The
junior or subordinated tranche acts as the first tranche to incur losses, which protects
the senior tranche.
B. The cash flows of the home equity loans will be much more affected (and the cash
flows of
the automobile receivables much less afffected) by a decline in interest rates.
The cash flows of the home equity-backed ABS will be more affected because the home
equity ABS:
• exhibits high prepayment risk (those loans will be vulnerable to refinancing by
homeowners when rates decline), and
• is fairly new (short seasoning) and has not been exposed to a low rate environment.
2002 Level II Guideline Answers
Morning Session - Page 26
The cash flows of the automobile receivable-backed ABS will be less affected because
the
auto ABS:
• does not typically exhibit prepayment risk (individuals do not tend to refinance car
loans), and
• also has an 18-month lockout that will protect it from receiving principal early.
C. With a decline in interest rates, prepayments would likely increase, and the two types
of
collateralized mortgage obligations (CMOs) would experience dramatically different
effects.
i. Planned amortization class (PAC) CMOs are created to offer protection within a
designated band of Public Securities Association (PSA) prepayment rates. The PAC
tranche is protected from the initial stream of excess prepayments and thus should see
minimal prepayments.
ii. Support bonds are the class of CMO that takes the excess prepayment from the PAC
tranches to provide protection to the PACs. The support bonds will become very short in
average life and experience a rapid increase in the return of principal as the result of
accepting the excess cash flows from the PAC tranche.
2002 Level II Guideline Answers
Morning Session - Page 27
LEVEL II, QUESTION 16
Topic: Asset Valuation
Minutes: 12
Reading Reference:
Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi
(Frank J.
Fabozzi Associates, 2000)
B. “Valuing Bonds with Embedded Options,” Level II, Ch. 2
Purpose:
To test the candidate’s understanding of the characteristics and return profile of
convertible
bonds compared to those of the associated common equity.
LOS: The candidate should be able to
“Valuing Bonds with Embedded Options” (Study Session 15)
p) compute the value and explain the meaning of the following for a convertible bond:
conversion value, straight value, market conversion price, market conversion premium
per
share, market conversion premium ratio, premium payback period, and premium over
straight value;
q) discuss the components of a convertible bond’s value that must be included in an
optionbased
valuation approach;
r) compare the risk–return characteristics of a convertible bond with the risk–return
characteristics of ownership of the underlying common stock.
Guideline Answer:
A. i. The current market conversion price is $39.20.
Market conversion price = convertible bond’s market price / conversion ratio
= $980.00 / 25
= $39.20
ii. The expected one-year return for the Ytel convertible bond is 18.88%.
Expected return = ((end of year price + coupon) / current price) – 1
= (($1,125.00 + $40.00) / $980.00) – 1
= 0.18878
= 18.88%
2002 Level II Guideline Answers
Morning Session - Page 28
iii. The expected one-year return for the Ytel common equity is 28.57%.
Expected return = (end of year price / current price) – 1
= ($45.00 / $35.00) – 1
= 0.28571
= 28.57%
B.
Indicate whether the value of each component should
decrease, stay the same, or increase in response to the:
Name the two components
of the convertible bond’s
value
i. Increase in Ytel’s common
equity price
(circle one)
ii. Increase in interest rates
(circle one)
1. Straight value
Stay the same
Decrease
2. Option value
Increase
Increase
Although not required to answer the question, the following explains the template entries:
The two components of the bond’s value are straight value (its value as a bond) and
option value
(the value associated with the potential conversion into equity).
i. The increase in the equity price does not affect the straight value component of the Ytel
convertible but does increase the call option component value significantly, because the
call
option becomes deep “in the money” when the $51.00 per share equity price is compared
to
the convertible’s conversion price of $40.00 ($1,000.00 / 25) per share.
ii. The increase in interest rates decreases the straight value component (bond values
decline as
interest rates increase) of the convertible bond and increases the value of the equity call
option component (call option values increase as interest rates increase), though this
increase
may be small or unnoticeable when compared to the change in the option value resulting
from the increase in the equity price.

2001 CFA® Level II Examination

Morning Section - Essay


Candidate Number:

_____ _____ _____ _____ _____ _____


THIS BOOK IS THE PROPERTY OF:

Association for
Investment Management
and Research
Post Office Box 3668
Charlottesville VA 22903-0668
USA
Tel: 804-951-5499

© 2001 Association for Investment Management and Research. All rights


reserved.
FOR AIMR USE ONLY
FOR AIMR USE ONLY
The following list contains the command words used on the Morning
Section of
the 2001 Level II examination. Candidates may want to refer to this list as
they
formulate their answers.

Calculate: To ascertain or determine by mathematical processes.

Compute: To determine, especially by mathematical means.

Construct: To create by organizing ideas or concepts logically and coherently.

Describe: To transmit a mental image, an impression, or an understanding of the


nature
and characteristics of.

Determine: To come to a decision as the result of investigation or reasoning; to


settle or
decide by choice among alternatives or possibilities.

Discuss: To discourse about through reasoning or argument; to present in detail.

Explain: To give the meaning or significance of; to provide an understanding of; to


give
the reason for or cause of.

Identify: To establish the identity of; to show or prove the sameness of.
Indicate: To point out or point to with more or less exactness; to show or make
known
with a fair degree of certainty.

Justify: To prove or show to be valid, sound, or conforming to fact or reason; to


furnish grounds or evidence for.

Name: To mention or identify by name.

Relate: To show or establish logical or causal connection between.

Select: To choose from a number or group . usually, by fitness, excellence, or other


distinguishing feature.

Show: To set forth in a statement, account, or description; to make evident or clear.

State: To express in words.

Support: To provide with verification, corroboration, or substantiation.

The Morning Section of the 2001 CFA Level II Examination has 14


questions.
For grading purposes, the maximum point value for each question is equal to
the
number of minutes allocated to that question.

Question Topic Minutes


1 Asset Valuation 10
2 Asset Valuation 14
3 Asset Valuation 16
4 Asset Valuation 9
5 Asset Valuation 11
6 Asset Valuation 16
7 Portfolio Management 6
8 Portfolio Management 26
9 Asset Valuation 10
10 Asset Valuation 8
11 Asset Valuation 12
12 Asset Valuation 10
13 Asset Valuation 22
14 Asset Valuation 10

Total: 180

Questions 1 through 5 relate to Peninsular Research. A total


of 60 minutes is allocated to
these questions. Candidates should answer these questions in
the order presented.

QUESTION 1 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Peninsular Research is initiating coverage of a mature manufacturing industry. John


Jones, CFA,
head of the research department, gathers the data given in Exhibit 1-1 to help in his
analysis.

Exhibit 1-1
Fundamental Industry and Market Data
Forecasted Industry Earnings Retention Rate 40%
Forecasted Industry Return on Equity 25%
Industry Beta 1.2
Government Bond Yield 6%
Equity Risk Premium 5%

A. Compute the price-to-earnings (P0/E1) ratio for the industry based on the
fundamental
data in Exhibit 1-1. Show your work.

(4 minutes)

Jones wants to analyze how fundamental P/E ratios might differ among countries. He
gathers the
data given in Exhibit 1-2.

Exhibit 1-2
Economic and Market Data
Fundamental Factors Country A Country B
Forecasted Growth in
Real Gross Domestic Product (GDP)
5% 2%
Government Bond Yield 10% 6%
Equity Risk Premium 5% 4%
B. Determine whether each of the fundamental factors in Exhibit 1-2 would cause
P/E
ratios to be generally higher for Country A or higher for Country B. Justify each of
your
conclusions with one reason.

Note: Consider each fundamental factor in isolation, with all else remaining equal.

Answer Question 1-B in the Template provided on page 4.

(6 minutes)

Template for Question 1-B

Fundamental Factor
Determine whether
P/E ratios
Higher for Country A or
Higher for Country B
(Circle One)

Justify with one reason


Forecasted Growth in
Real Gross Domestic
Product (GDP)
Higher for Country A

Higher for Country B

Government Bond Yield


Higher for Country A

Higher for Country B

Equity Risk Premium


Higher for Country A

Higher for Country B


Candidates should use Exhibits 2-1, 2-2, and 2-3 to answer
Questions 2 and 3.

QUESTION 2 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES.

One of the companies that Jones is researching is Mackinac Inc., a U.S.-based


manufacturing
company. Mackinac has released its June 2001 financial statements, which are shown in
Exhibits 2-1, 2-2, and 2-3.

Exhibit 2-1
Mackinac Inc.
Annual Income Statement
for the Year ended June 30, 2001
(in thousands, except per-share data)

Sales $250,000
Cost of Goods Sold 125,000
Gross Operating Profit $125,000
Selling, General, and Administrative Expenses 50,000
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) $75,000
Depreciation and Amortization 10,500
Earnings Before Interest and Taxes (EBIT) $64,500
Interest Expense 11,000
Pretax Income $53,500
Income Taxes 16,050
Net Income $37,450
Shares Outstanding 13,000
Earnings Per Share (EPS) $2.88

Exhibit 2-2
Mackinac Inc.
Balance Sheet
as of June 30, 2001
(in thousands)

Current Assets:
Cash and Equivalents $20,000
Receivables 40,000
Inventories 29,000
Other Current Assets 23,000
Total Current Assets $112,000

Non-Current Assets:
Property, Plant, and Equipment $145,000
Less: Accumulated Depreciation (43,000)
Net Property, Plant, and Equipment $102,000
Investments 70,000
Other Non-Current Assets 36,000
Total Non-Current Assets $208,000
Total Assets $320,000

Current Liabilities:
Accounts Payable $41,000
Short Term Debt 12,000
Other Current Liabilities 17,000
Total Current Liabilities $70,000

Non-Current Liabilities:
Long Term Debt $100,000
Total Non-Current Liabilities $100,000
Total Liabilities $170,000

Shareholders. Equity:
Common Equity $40,000
Retained Earnings 110,000
Total Equity $150,000
Total Liabilities and Equity $320,000

Exhibit 2-3
Mackinac Inc.
Cash Flow Statement
for the Year ended June 30, 2001
(in thousands)

Cash Flow from Operating Activities:


Net Income $37,450
Depreciation and Amortization 10,500

Change in Working Capital:


(Increase) Decrease in Receivables ($5,000)
(Increase) Decrease in Inventories (8,000)
Increase (Decrease) in Payables 6,000
Increase (Decrease) in Other Current Liabilities 1,500
Net Change in Working Capital ($5,500)
Net Cash from Operating Activities $42,450

Cash Flow from Investing Activities:


Purchase of Property, Plant, and Equipment ($15,000)
Net Cash from Investing Activities ($15,000)

Cash Flow from Financing Activities:


Change in Debt Outstanding $4,000
Payment of Cash Dividends (22,470)
Net Cash from Financing Activities ($18,470)

Net Change in Cash and Cash Equivalents $8,980


Cash at Beginning of Period 11,020
Cash at End of Period $20,000

Jones is particularly interested in Mackinac.s sustainable growth and sources of return.

A. Calculate Mackinac.s sustainable growth rate. Show your calculations.

Note: Use June 30, 2001 year-end balance sheet data rather than averages in ratio
calculations.

(4 minutes)
B. Name each of the five components in the extended DuPont System and
calculate a value
for each component for Mackinac.

Note: Use June 30, 2001 year-end balance sheet data rather than averages in ratio
calculations.

(10 minutes)

QUESTION 3 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES.

Mackinac has announced that it has finalized an agreement to handle North American
production
of a successful product currently marketed by a foreign company. Jones decides to value
Mackinac using the dividend discount model (DDM) and the free cash flow-to-equity
(FCFE)
model. After reviewing Mackinac.s financial statements in Exhibits 2-1, 2-2, and 2-3 and
forecasts related to the new production agreement, Jones concludes the following:

Mackinac.s earnings and FCFE are expected to grow 17 percent per year over the
next three years before stabilizing at an annual growth rate of 9 percent.
Mackinac will maintain the current payout ratio.
Mackinac.s beta is 1.25.
The government bond yield is 6 percent and the market equity risk premium is
5 percent.

A. Calculate the value of a share of Mackinac.s common stock using the two-stage
DDM.
Show your calculations.

(8 minutes)

B. Calculate the value of a share of Mackinac.s common stock using the two-stage
FCFE
model. Show your calculations.

(8 minutes)

QUESTION 4 HAS TWO PARTS FOR A TOTAL OF 9 MINUTES.

Jones is discussing with a corporate client the possibility of that client acquiring a 70
percent
interest in Mackinac.

A. Discuss whether the dividend discount model (DDM) or free cash flow-to-equity
(FCFE)
model is more appropriate for this client.s valuation purposes.

(3 minutes)

The proposed takeover could be hostile in nature, and both Jones and the client are
concerned
about possible defensive measures that Mackinac management might adopt to discourage
the
takeover. The client has asked Jones about the following:

Employee Stock Ownership Plans (ESOP)


Stock purchase rights
Golden parachutes

B. Explain how each of these three measures could be used as a defense against a
hostile
takeover.

(6 minutes)
QUESTION 5 HAS TWO PARTS FOR A TOTAL OF 11 MINUTES.

Peninsular has another client who has inquired about the valuation method best suited for
comparison of companies in an industry that has the following characteristics:

Principal competitors within the industry are located in the United States, France,
Japan, and Brazil.
The industry is currently operating at a cyclical low, with many firms reporting losses.
The industry is subject to rapid technological change.

Jones recommends that the client consider the following valuation ratios:

1. Price-to-earnings
2. Price-to-book value
3. Price-to-sales

A. Determine which one of the three valuation ratios is most appropriate for
comparing
companies in this industry. Support your answer with two reasons that make that
ratio
superior to either of the other two ratios.

(5 minutes)

The client also has expressed interest in Economic Value Added (EVA®) as a measure of
company performance. Jones asks his assistant to prepare a presentation about EVA for
the
client. The assistant.s presentation includes the following statements:

1. EVA is a measure of a firm.s excess shareholder value generated over a long period
of time.

2. In calculating EVA, the cost of capital is the weighted average of the after-tax yield
on long-term bonds with similar risk and the cost of equity as calculated by the
capital asset pricing model.

3. EVA provides a consistent measure of performance across firms.

B. Determine whether each of the statements is correct or incorrect and, if


incorrect,
explain why.

Note: Explanations cannot repeat the statement in negative form, but must indicate what
is needed to make the statement correct.
Answer Question 5-B in the Template provided on page 29.

(6 minutes)

Template for Question 5-B

Statement
Determine
whether
Correct or
Incorrect
(Circle One)

If incorrect, explain why


1. EVA is a measure of a
firm.s excess shareholder
value generated over a
long period of time.

Correct

Incorrect

2. In calculating EVA, the


cost of capital is the
weighted average of the
after-tax yield on long-
term bonds with similar
risk and the cost of equity
as calculated by the
capital asset pricing
model.

Correct

Incorrect

3. EVA provides a
consistent measure of
performance across firms.

Correct

Incorrect

QUESTION 6 HAS ONE PART FOR A TOTAL OF 16 MINUTES.

Katherine Cooper is preparing a report on the optical network component business. She
begins
her research by analyzing the competitive conditions of the industry.

One of the dominant firms in the industry is Rubylight Inc. Exhibit 6-1 contains an
excerpt from
the President.s Letter in the annual report.

Exhibit 6-1
Rubylight Inc.
2000 Annual Report
Excerpt from President.s Letter

The reference number preceding each sentence is for your use


in answering the question.

[1]Rubylight Inc. had an exceptional year in 2000. [2]The results in almost every corner
of the business exceeded our expectations. [3]Sales at Rubylight climbed 73 percent
over fiscal 1999 to $135 million, representing the strongest year-on-year sales growth in
the company.s history. [4]Our gross margin remained constant, compared to the prior
year, at a respectable 67 percent. [5]We managed to maintain our margins, despite an
increase in direct materials cost, through an improvement in product mix and price
increases. [6]The capital markets have rewarded us for this superior financial
performance; the company.s stock price closed the year at an all time high. [7]We have
an outstanding team here at Rubylight, deserving high praise for performance.

[8]The backlog (unfulfilled orders) expanded by 39 percent. [9]This was principally


due to an inability of our supplier to ship two application-specific integrated circuits
(.ASIC.) that are critical to the superior performance of the Rubylight product.
[10]Although the ASIC designs are owned by Rubylight, the integrated circuits must be
fabricated in highly specialized facilities, of which there are only two worldwide.
[11]The extremely capital intensive nature of these facilities prevents us from
manufacturing the integrated circuits ourselves. [12]Shortages of electronic component
supplies and fabrication time are worldwide phenomena that have also plagued our major
competitor.
[13]One of the strategic imperatives in the optical components industry is to get your
components incorporated into the designs of your customers. products, known as
.design wins,. which makes it very expensive for the customer to make a component
substitution. [14]Early in the year we announced the appointment of Dr. Brian Richards
as the Chief Technology Officer. [15]Dr. Richards is one of the pioneers of the optical
switching industry and has numerous patents to his credit. [16]He and his very fine
team in our Research and Development department continue to work closely with our
customers to ensure design wins for the next generation of products.

[17]On the competitive landscape, we have seen some interesting developments over the
last year. [18]Our major competitor has focused on building distribution in the
European market. [19]That competitor appears to be exiting North America and the Far
East, which are our strongholds. [20]However, we have seen several start-ups enter the
North American market. [21]They have been able to attract significant venture capital
financing, which gives them greater ability to build brand recognition than start-ups have
enjoyed in the past.

[22]On the technology front, recent developments in micro-electronic mechanical


technology have created the promise of a dramatic improvement in product performance.
[23]Typically the start-ups have been focused on this technology.

Name each of the competitive forces faced by Rubylight, using Porter.s five-force
model.
Determine whether each competitive force is favorable or unfavorable for
Rubylight. Select,
for each competitive force, only two sentences from the President.s Letter that support
whether
the competitive force is favorable or unfavorable for Rubylight.

Note: No sentence may be selected more than once; only the sentence reference numbers
are
needed for your selection.

(16 minutes)

Answer Question 6 in the Template provided on page 33.

Template for Question 6


No sentence may be selected more than once; only the sentence reference numbers are
needed in
the third column. The first row of the template is completed for illustrative purposes.
Name the Competitive Force
Determine whether
Favorable or
Unfavorable
(Circle One)
Select two sentences
that support whether
favorable or
unfavorable
SAMPLE

Bargaining power of customers


SAMPLE

Unfavorable
SAMPLE
5 and 8

Favorable

Unfavorable

Favorable

Unfavorable

Favorable

Unfavorable

Favorable

Unfavorable

Favorable
QUESTION 7 HAS ONE PART FOR A TOTAL OF 6 MINUTES.

Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify
mispriced
securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In
comparing CAPM and APT, the consultant made the following arguments:

1. Both the CAPM and APT require a mean.variance efficient market portfolio.

2. Neither the CAPM nor APT assumes normally distributed security returns.

3. The CAPM assumes that one specific factor explains security returns but APT does
not.

State whether each of the consultant.s arguments is correct or incorrect. Indicate,


for each
incorrect argument, why the argument is incorrect.

Note: Indications cannot repeat the argument in negative form, but must indicate what is
needed
to make the argument correct.

Answer Question 7 in the Template on page 37.

(6 minutes)

Template for Question 7

Argument
State whether
Argument is
Correct or
Incorrect
(Circle One)

Indicate, for each incorrect


argument, why the argument is
incorrect

1. Both the CAPM and APT


require a mean.variance
efficient market portfolio.
Correct

Incorrect

2. Neither the CAPM nor APT


assumes normally distributed
security returns.
Correct

Incorrect

3. The CAPM assumes that one


specific factor explains
security returns but APT does
not.
Correct

Incorrect

QUESTION 8 HAS FIVE PARTS FOR A TOTAL OF 26 MINUTES.

Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC
Company common stock worth $100,000. Her financial advisor provided her with the
forecasted
information given in Exhibit 8-1.

Exhibit 8-1
Risk and Return Characteristics
Expected
Monthly Returns
Expected
Standard Deviation
of Monthly Returns
Original Portfolio 0.67% 2.37%
ABC Company 1.25% 2.95%

The expected correlation coefficient of ABC stock returns with the original portfolio
returns is
0.40.

The inheritance changes her overall portfolio and she is deciding whether or not to keep
the ABC
stock.

Assuming Grace keeps the ABC stock,

A. Calculate the:

i. expected return of her new portfolio that includes the ABC stock
ii. expected covariance of ABC stock returns with the original portfolio returns
iii. expected standard deviation of her new portfolio that includes the ABC stock

(6 minutes)

If Grace sells the ABC stock, she will invest the proceeds in risk-free government
securities
yielding 0.42 percent monthly.

Assuming Grace sells the ABC stock and replaces it with the government securities,

B. Calculate the:

i. expected return of her new portfolio that includes the government securities
ii. expected covariance of the government security returns with the original portfolio
returns
iii. expected standard deviation of her new portfolio that includes the government
securities

(6 minutes)
C. Determine whether the beta of her new portfolio that includes the government
securities
will be higher or lower than the beta of her original portfolio. Justify your response
with
one reason. No calculations are required.

(4 minutes)

Based on conversations with her husband, Grace is considering selling the $100,000 of
ABC
stock and acquiring $100,000 of XYZ Company common stock instead. XYZ stock has
the same
expected return and standard deviation as ABC stock. Her husband comments, .It doesn.t
matter
whether you keep all of the ABC stock or replace it with $100,000 of XYZ stock..

D. State whether her husband.s comment is correct or incorrect. Justify your


response with
one reason. No calculations are required.

(4 minutes)

In a recent discussion with her financial advisor, Grace commented, .If I just don.t lose
money
in my portfolio, I will be satisfied.. She went on to say, .I am more afraid of losing
money than
I am concerned about achieving high returns..
E. i. Describe one weakness of using expected standard deviation of returns as a
risk
measure for Grace.

ii. Identify one alternate risk measure that is more appropriate under the
circumstances and justify your response with one reason.

(6 minutes)

QUESTION 9 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Buckner Industries has prepared the condensed forecast income statement for the year
ending
December 31, 2002, shown in Exhibit 9-1.

Exhibit 9-1
Buckner Industries
Condensed Forecast Income Statement
Year Ending December 31, 2002
(in thousands except for per share data)

Earnings Before Interest and Taxes (EBIT) $94,500


Interest Expense 11,000
Pretax Income $83,500
Income Taxes (30% tax rate) 25,050
Net Income $58,450
Shares Outstanding 12,000
Earnings Per Share (EPS) $4.87

After creating the forecast, Buckner develops a new product, which will require $100
million in
additional capital expenditures at the beginning of 2002. With the new product, EBIT in
2002 is
expected to be 15 percent higher than the amount forecast in Exhibit 9-1. To finance the
increase
in the capital budget, Buckner is considering a plan using 50 percent equity and 50
percent long-
term debt. New equity would be issued at $25.00 net proceeds per share and the interest
rate on
the new long-term debt would be 8.50 percent. Buckner is reviewing how this financing,
if
completed on December 31, 2001, would affect the company.s EPS.
A. Construct a pro forma income statement for 2002, assuming the financing plan
is
adopted.

Answer Question 9-A in the Template provided on page 51.

(6 minutes)

Instead of using 50 percent equity and 50 percent long-term debt, Buckner decides to
finance the
entire capital budget increase by issuing $100 million in new long-term debt.

Jack Deven, a fixed income portfolio manager with LightStreet Investments, is concerned
about
the effect of such a large debt issuance on Buckner.s credit quality and calculates selected
pro
forma financial credit quality ratios, shown in Exhibit 9-2 on page 50. LightStreet owns
previously issued option-free Buckner bonds in its U.S. Corporate Bond portfolio. These
bonds
have a 10-year maturity and a modified duration of 6.5 years.

Deven wants to compare his recalculated credit ratios to LightStreet.s credit quality
standards,
also shown in Exhibit 9-2. Buckner satisfied each of these credit quality standards prior
to the
new debt issue. For each standard no longer satisfied after the new debt issue, Deven
believes
the yield on the previously issued Buckner bonds will increase by 10 basis points.

Exhibit 9-2
Buckner Industries
LightStreet Credit Quality Standards and
Selected Pro Forma Financial Credit Quality Ratios
Financial Credit Quality Ratios
LightStreet
Credit Quality
Standards
Pro Forma Credit Quality
Ratios with Financing by
$100 Million Long-Term
Debt
Interest Coverage Ratio 4.00x 5.57x
Cash Flow from Operations (CFO)-to-Total Debt 0.50x 0.44x
Pretax Return on Total Capital 18% 22%
Pretax Income-to-Sales 28% 33%
Total Debt-to-Total Capital 50% 54%
B. i. Identify the ratios that would contribute to an increase in the total yield on the
previously issued Buckner bonds if Deven.s analysis is correct.

ii. Calculate the direction and magnitude of the percentage price change due to the
change in yield.

(4 minutes)

Template for Question 9-A

Condensed Income Statement


Forecast from
Exhibit 9-1
(in thousands
except for per
share data)

Construct a pro forma income


statement for 2002, if the
financing plan is adopted
Earnings Before Interest and Taxes (EBIT) $94,500
Interest Expense 11,000
Pretax Income $83,500
Income Taxes 25,050
Net Income $58,450
Shares Outstanding 12,000
Earnings Per Share $4.87

Questions 10 and 11 relate to Rajiv Singh. A total of 20


minutes is allocated to these
questions. Candidates should answer these questions in the
order presented.

QUESTION 10 HAS TWO PARTS FOR A TOTAL OF 8 MINUTES.

Rajiv Singh, a bond analyst, is examining the risk and return characteristics of mortgage
pass-
through securities.

A. Describe each of the two prepayment risks for a mortgage pass-through security
and
relate each risk to changes in interest rates.
(4 minutes)

Information about two tranches of collateralized mortgage obligations (CMOs) is given


in
Exhibit 10-1.

Exhibit 10-1
Option-Adjusted Spread (OAS) Output
from a Monte Carlo Simulation of Two CMO Tranches
(15% annual volatility)

Tranche
OAS
(Basis points)
Option Cost
(Basis points)
Z Spread
(Basis points)
Effective Duration
(Years)
I 108 28 136 2.5
II 76 99 175 2.5

Using only the information in Exhibit 10-1,

B. Identify which CMO tranche is less expensive on a relative value basis and
justify your
response.

(4 minutes)

QUESTION 11 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES.

Singh is also analyzing a convertible bond. The characteristics of the bond and the
underlying
common stock are given in Exhibit 11-1:

Exhibit 11-1
Convertible Bond and Underlying Stock Characteristics
Convertible Bond Characteristics
Par Value $1,000
Annual Coupon Rate (annual pay) 6.5%
Conversion Ratio 22
Market Price 105% of par value
Straight Value 99% of par value
Underlying Stock Characteristics
Current Market Price $40 per share
Annual Cash Dividend $1.20 per share

A. Compute the bond.s:

i. Conversion value
ii. Market conversion price
iii. Premium payback period

(6 minutes)

B. Determine whether the value of a callable convertible bond will increase,


decrease, or
remain unchanged in response to each of the following changes, and justify each of
your
responses with one reason:

i. An increase in stock price volatility


ii. An increase in interest rate volatility

(6 minutes)

Answer Question 11-B in the Template provided on page 65.

Template for Question 11-B


Change
Determine whether the
value will Increase,
Decrease, or
Remain Unchanged
(Circle One)
Justify your response with one reason

An increase in
stock price
volatility
Increase

Decrease

Remain Unchanged
An increase in
interest rate
volatility
Increase

Decrease

Remain Unchanged

QUESTION 12 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Noah Kramer, a fixed income portfolio manager based in the country of Sevista, is
considering
the purchase of a Sevista government bond. The Sevista government is issuing new 25-
year
maturity debt in an amount equal to one-fourth of the total Sevista government debt
outstanding.
The proceeds from the new debt issue will be used to retire an equal amount of existing
5-year
maturity government debt. Prior to the new issue, total outstanding debt of the Sevista
government is evenly distributed among 5-, 15-, and 25-year maturities.

A. Indicate how the Sevista government bond yield curve is likely to change as a
result of
the new 25-year maturity debt issue. Support your answer using the Preferred Habitat
Theory of the term structure of interest rates.

Note: Limit your response to the effects of the refinancing.

(4 minutes)

Kramer decides to evaluate two strategies for implementing his investment in Sevista
bonds.
Exhibit 12-1 gives the details of the two strategies, and Exhibit 12-2 contains the
assumptions
that apply to both strategies.

Exhibit 12-1
Investment Strategies
(Amounts are Market Value Invested)
Strategy 5 Year Maturity
(Modified Duration
= 4.83)
15 Year Maturity
(Modified Duration
= 14.35)
25 Year Maturity
(Modified Duration
= 23.81)
I $5 million 0 $5 million
II 0 $10 million 0

Exhibit 12-2
Investment Strategy Assumptions
Market Value of Bonds $10 million
Bond Maturities 5 and 25 years
or
15 years
Bond Coupon Rates 0.00%
Target Modified Duration 15 years

Before choosing one of the two bond investment strategies, Kramer wants to analyze how
the
market value of the bonds will change if an instantaneous interest rate shift occurs
immediately
after his investment. The details of the interest rate shift are shown in Exhibit 12-3.

Exhibit 12-3
Instantaneous Interest Rate Shift
Immediately After Investment
Interest Key Rate Maturity Interest Key Rate Change
5 Year Down 75 basis points (bps)
15 Year Up 25 bps
25 Year Up 50 bps

B. Calculate, for the instantaneous interest rate shift shown in Exhibit 12-3, the
percent
change in the market value of the bonds that will occur under:

i. Strategy I
ii. Strategy II

(6 minutes)

QUESTION 13 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES.


Ashton Bishop is the debt manager for World Telephone, which needs .3.33 billion Euro
financing for its operations. Bishop is considering the choice between issuance of
debt
denominated in:

Euros (.), or
U.S. dollars, accompanied by a combined interest rate and currency swap.

A. Explain one risk World would assume by entering into the combined interest rate
and
currency swap.

(4 minutes)

Bishop believes that issuing the U.S. dollar debt and entering into the swap can lower
World.s
cost of debt by 45 basis points. Immediately after selling the debt issue, World
would swap the
U.S. dollar payments for Euro payments throughout the maturity of the debt. She
assumes a
constant currency exchange rate throughout the tenor of the swap.

Exhibit 13-1 gives details for the two alternative debt issues. Exhibit 13-2 provides
current
information about spot currency exchange rates and the 3-year tenor Euro/U.S. Dollar
currency
and interest rate swap.

Exhibit 13-1
World Telephone Debt Details
Characteristic Euro Currency Debt U.S. Dollar Currency Debt
Par Value .3.33 billion $3 billion
Term to Maturity 3 Years 3 Years
Fixed Interest Rate 6.25% 7.75%
Interest Payment Annual Annual

Exhibit 13-2
Currency Exchange Rate and Swap Information
Spot currency exchange rate $0.90 per Euro ($0.90/.1.00)
3-year tenor Euro/U.S. Dollar
fixed interest rates

5.80% Euro/7.30% U.S. Dollar


B. Show the notional principal and interest payment cash flows of the combined
interest rate
and currency swap.

Note: Your response should show both the correct currency ($ or .) and amount for
each
cash flow.

Answer Question 13-B in the Template provided on page 77.

(12 minutes)

C. State whether or not World would reduce its borrowing cost by issuing the debt
denominated in U.S. dollars, accompanied by the combined interest rate and currency
swap. Justify your response with one reason.

(6 minutes)

Template for Question 13-B


Cash Flows
of the Swap
Year 0 Year 1 Year 2 Year 3
World Pays
Notional Principal
Interest Payment
World Receives
Notional Principal
Interest Payment

QUESTION 14 HAS TWO PARTS FOR A TOTAL OF 10 MINUTES.

Donna Doni, CFA, wants to explore potential inefficiencies in the futures market. The
TOBEC
stock index has a spot value of 185.00 now. TOBEC futures contracts are settled in cash
and
underlying contract values are determined by multiplying $100 times the index value.
The
current annual risk-free interest rate is 6.0 percent.

A. Calculate the theoretical price of the futures contract expiring six months from
now,
using the cost-of-carry model. Show your calculations.

(4 minutes)
The total (round-trip) transaction cost for trading a futures contract is $15.00.

B. Calculate the lower bound for the price of the futures contract expiring six months
from
now. Show your calculations.

(6 minutes)

2001 CFA Level II Examination


Morning Section . Essay

IMPORTANT INSTRUCTIONS TO CANDIDATES

1. Write your candidate number in the spaces provided on the front cover of this
Essay examination book.

2. Complete and sign the pledge attached to the front cover of this examination
book.
Your examination will not be graded unless the pledge is signed. The pledge will
be detached prior to grading.

3. Write your answers in blue or black ink on the designated answer pages in the
examination book.

4. Label each part of your answer (A, B, C, D or i, ii, iii, etc.).

5. Use only the Texas Instruments BAII Plus or the Hewlett Packard 12C
calculator.
All other calculators will be confiscated and a report will be submitted to AIMR.

6. Only answers written on the correct answer pages will be graded. You may
make
marks and notes on the question pages, but these marks will not be graded.

7. If you use all of the designated pages, check the box at the bottom of the last
page
of your answer and continue your answer on the unnumbered extra pages at the
back of the examination book. Label extra pages with the correct question
number.
8. You must stop writing immediately when instructed to do so at the conclusion
of
the examination.

9. Violations of any of AIMR's examination rules will result in AIMR voiding


your
examination results and may lead to a suspension or termination of candidacy in
the CFA Program.

DO NOT OPEN THIS EXAMINATION BOOK


UNTIL INSTRUCTED TO DO SO BY THE PROCTOR.
DO NOT REMOVE ANY EXAMINATION MATERIALS
FROM THE EXAMINATION ROOM.
2001 Level II Guideline Answers
Morning Section . Page 1
LEVEL II, QUESTION 1

Topic: Asset Valuation


Minutes: 10

Reading Reference:
.Price/Earnings Multiples,. Ch. 14 Investment Valuation: Tools and Techniques
for Determining
the Value of Any Asset, Aswath Damodaran (Wiley, 1996)

Purpose:
To test the candidate.s: 1) understanding of industry and country price/earnings multiples,
and 2)
ability to calculate values for those multiples.

LOS: The candidate should be able to


.Price/Earnings Multiples. (Study Session 10)
a) calculate a price-to-earnings ratio (P/E) for a stable company based on the
fundamental data
used in the DDM;
c) analyze the effects of growth rates, risk, payout ratios, and interest rates on P/E
multiples;
d) calculate a P/E for the market as a whole and analyze the effects of changes in each of
the
components on the P/E;
e) explain why differences or changes in such economic factors as interest rates, real
GNP
growth, and country risk can cause P/Es to differ between countries at any one time or
within
one country over different time periods;
g) illustrate the relationship between dividend yield, the Treasury bond rate, the expected
growth rate in dividends, and the equity risk premium.

Guideline Answer:
A. The industry.s estimated P/E can be computed using the following model:

P0 / E1 = payout ratio / (r . g)

However, because r and g are not explicitly given, they must be computed using the
following formulas:

gind = ROE × retention rate = 0.25 × 0.40 = 0.10

rind = government bond yield + (beta of industry  equity risk premium)


= 0.06 + (1.2 × 0.05)
= 0.06 + 0.06
= 0.12

Therefore:

P0 / E1 = 0.60 / (0.12 . 0.10) = 30.0x

2001 Level II Guideline Answers


Morning Section . Page 2

B.

Fundamental Factor
Determine whether
P/E ratios
Higher for Country A or
Higher for Country B
(Circle One)

Justify with one reason


Forecasted Growth in
Real Gross Domestic
Product (GDP)

Higher for Country A


Higher expected growth in GDP
implies higher earnings growth and a
higher P/E.
Government Bond Yield

Higher for Country B

A lower government bond yield


implies a lower risk-free rate and a
higher P/E.
Equity Risk Premium

Higher for Country B

A lower equity risk premium implies


a lower required return and a higher
P/E.

2001 Level II Guideline Answers


Morning Section . Page 3
LEVEL II, QUESTION 2

Topic: Asset Valuation


Minutes: 14

Reading References:
1. .Managing Growth,. Ch. 4 Analysis for Financial Management, 5th or 6th
edition, Robert C.
Higgins (Irwin, 1998 or 2000)
2. .Analysis of Financial Statements,. Ch. 12 Investment Analysis and Portfolio
Management,
5th edition, Frank K. Reilly and Keith C. Brown (Dryden, 1997)

Purpose:
To test the candidate.s ability to calculate: 1) a company.s sustainable growth rate, and 2)
the
financial ratios that comprise the extended DuPont System.

LOS: The candidate should be able to


.Managing Growth. (Study Session 8)
a) explain the concept of sustainable growth and its underlying factors;
b) calculate the sustainable growth of a company, given balance sheet and income
statement
data.
.Analysis of Financial Statements. (Study Session 9)
e) explain why analysts use financial ratios;
f) calculate financial ratios in the following categories: common size, internal liquidity,
operating efficiency, operating profitability, business risk, financial risk, growth, and
external
liquidity;
g) use financial ratios for comparative analysis of a company over time and relative to its
industry or to the market;
j) contrast the ratios that would be useful for stock valuation, predicting bond ratings,
and
forecasting bankruptcy.

Guideline Answer:
A. Sustainable growth rate = return on equity × earnings retention rate
= ($37,450 / $150,000) × (1 . ($22,470 / $37,450))
= 24.97% × 0.40
= 9.99%
2001 Level II Guideline Answers
Morning Section . Page 4

B.
Component Value
Operating Profit Margin (EBIT / Sales)
Total Asset Turnover (Sales / Total Assets)
Interest Expense Rate (Interest Expense / Total Assets)
Financial Leverage Multiplier (Total Assets / Equity)
Tax Retention Rate [100% - (Income Tax / EBT)]
0.258
0.781
0.034
2.133
0.700

Note: Although not part of the guideline answer, the components shown above may be
used in
the following formula to compute return on equity (ROE):

ROE = [(Operating Profit Margin × Total Asset Turnover) . Interest Expense Rate]
× Financial Leverage Multiplier × Tax Retention Rate

= [(0.258 × 0.781) . 0.034] × 2.133 × 0.700 = 0.2501 ˜ 25%


2001 Level II Guideline Answers
Morning Section . Page 5
LEVEL II, QUESTION 3

Topic: Asset Valuation


Minutes: 16

Reading Reference:
Investment Valuation: Tools and Techniques for Determining the Value
of Any Asset, Aswath
Damodaran (Wiley, 1996).
A. .Dividend Discount Models,. Ch. 10
B. .Free Cashflows to Equity Discount Models,. Ch. 11

Purpose:
To test the candidate.s ability to calculate the value of a company.s equity using: 1) the
two-
stage dividend discount model, and 2) the two-stage free cash flow model.

LOS: The candidate should be able to


.Dividend Discount Models. (Study Session 10)
a) explain and calculate the value of a company.s equity using the dividend discount
model
(DDM), the Gordon growth model, the two-stage DDM, the H model, and the three-stage
DDM.
.Free Cashflows to Equity Discount Models. (Study Session 10)
b) calculate the value of a company using the FCFE model, the two-stage FCFE model,
and the
E Model (three-stage FCFE model).

Guideline Answer:
A. Using a two-stage dividend discount model, the value of a share of Mackinac is
calculated as
follows:

DPS0 = Cash Dividends / Shares Outstanding = $22,470 / 13,000 = $1.7285


DPS1 = DPS0 × 1.17 = $2.0223
DPS2 = DPS0 × 1.172 = $2.3661
DPS3 = DPS0 × 1.173 = $2.7683
DPS4 = DPS0 × 1.173 × 1.09 = $3.0175

Cost of Equity (r) = Long Bond Rate + (Beta × Equity Risk Premium)
= 0.06 + (1.25 × 0.05) = 0.1225 or 12.25%

Value per share = DPS1 / (1 + r) + DPS2 / (1 + r) 2 + DPS3 / (1 + r) 3 + [DPS4 / (r .


gstable)] / (1 + r) 3
Value of Mackinac = $2.0223 / 1.1225 + $2.3661 / 1.12252 + $2.7683 / 1.12253
+ [$3.0175 / (0.1225 . 0.09)] / 1.12253 = $1.8016 + $1.8778 + $1.9573 + 65.6450 =
$71.28

2001 Level II Guideline Answers


Morning Section . Page 6
B. Using the two-stage FCFE model, the value of a share of Mackinac is calculated as
follows:

Net Income = $37,450


Depreciation = $10,500
Capital Expenditures = $15,000
Change in Working Capital = $5,500
New Debt Issuance . Principal Repayments = Change in Debt Outstanding = $4,000

FCFE0 = Net Income + Depreciation . Capital Expenditures . Change in Working Capital


. Principal Repayments + New Debt Issues

= Net Income + Depreciation . Capital Expenditures . Change in Working Capital


+ (New Debt Issues . Principal Repayments)

= $37,450 + $10,500 - $15,000 - $5,500 + $4,000

= $31,450 or $2.4192 per share

FCFE1 = FCFE0 × 1.17 = $2.8305


FCFE2 = FCFE0 × 1.172 = $3.3117
FCFE3 = FCFE0 × 1.173 = $3.8747
FCFE4 = FCFE0 × 1.173 × 1.09 = $4.2234
Cost of Equity (r) = Long Bond Rate + (Beta × Equity Risk Premium)
= 0.06 + (1.25 × 0.05) = 0.1225 or 12.25%

Value per share = FCFE1 / (1+ r) + FCFE2 / (1 + r) 2 + FCFE3 / (1 + r)3


+ [FCFE4 / (r . gstable)] / (1+ r)3

Value of Mackinac = $2.8305 / 1.225 + $3.3117 / 1.12252 + $3.8747 / 1.12253


+ [$4.2234 / (0.1225 . 0.09)] / 1.12253
= $2.5216 + $2.6283 + $2.7395 + $91.8798 = $99.77
2001 Level II Guideline Answers
Morning Section . Page 7
LEVEL II, QUESTION 4

Topic: Asset Valuation


Minutes: 9

Reading References:
1. Investment Valuation: Tools and Techniques for Determining the
Value of Any Asset, Aswath
Damodaran (Wiley, 1996)
A. .Dividend Discount Models,. Ch. 10
B. .Free Cashflows to Equity Discount Models,. Ch. 11
2. .Mergers, LBOs, Divestitures, and Holding Companies,. Ch. 21, Fundamentals of
Financial
Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998)

Purpose:
To test the candidate.s: 1) ability to determine the valuation model that is most
appropriate given
a specific company.s circumstances, and 2) understanding of different measures that can
be used
against a hostile takeover.

LOS: The candidate should be able to


.Dividend Discount Models. (Study Session 10)
e) discuss what type of company each model is best suited to analyzing.
.Free Cashflows to Equity Discount Models. (Study Session 10)
c) describe the type of company that each FCFE model is best suited to analyze;
f) compare and contrast dividend discount models and FCFE models.
.Mergers, LBOs, Divestitures, and Holding Companies. (Study Session 11)
h) discuss the defensive tactics that a target company can use against the threat of a
hostile
takeover.

Guideline Answer:
A. The FCFE model is best for valuing firms for takeovers or where there is a reasonable
chance
of changing corporate control. Because controlling stockholders can change the dividend
policy, they are interested in estimating the maximum residual cash flow after meeting all
financial obligations and investment needs. The dividend discount model is based upon
the
premise that the only cash flows received by stockholders are dividends. FSFE uses a
more
expansive definition to measure what a firm can afford to pay out as dividends.
2001 Level II Guideline Answers
Morning Section . Page 8

B. Employee Stock Ownership Plans (ESOP): A large block of stock in an ESOP (either
existing
or recently created) is likely to vote in support of management positions and therefore
make
an unwanted takeover more difficult.

Stock purchase rights: Such rights are a type of .poison pill. that give current stockholders
the right to purchase, at bargain prices, either new stock in their company or stock in the
acquiring company when a hostile potential acquirer purchases a certain percentage of the
stock of their company. This makes the purchase price higher, reducing the likelihood of
an
unwanted takeover.

Golden parachute: Golden parachutes are large payments to specified current managers;
such
payments are triggered only by the purchase of the firm, thereby materially increasing the
acquisition expense to the buyer and reducing the likelihood of an unwanted takeover.

2001 Level II Guideline Answers


Morning Section . Page 9
LEVEL II, QUESTION 5

Topic: Asset Valuation


Minutes: 11

Reading References:
1. Investment Valuation: Tools and Techniques for Determining the
Value of Any Asset, Aswath
Damodaran (Wiley, 1996)
A .Price/Book Value Multiples,. Ch. 15
B. .Price/Sales Multiples,. Ch. 16
2. Company Performance and Measures of Value Added, pp. 1-47, Pamela
P. Peterson and
David R. Peterson (Research Foundation of the ICFA, 1997)
3. .An Analysis of EVA®,” Richard Bernstein and Carmen Pigler,
Quantitative Viewpoint
(Merrill Lynch, 19 December 1997)

Purpose:
To test the candidate.s: 1) understanding of differences among valuation approaches, 2)
ability to
determine the appropriateness of using a specified valuation approach, and 3)
understanding of
alternative performance measurement and valuation methods.

LOS: The candidate should be able to


.Price/Book Value Multiples. (Study Session 10)
a) list the advantages and disadvantages of using price-to-book value (PBV) multiples in
stock
valuation;
e) explain the advantages and disadvantages of using the PBV model compared with
other
valuation models.
.Price/Sales Multiples. (Study Session 10)
a) list the advantages and disadvantages of using price-to-sales (PS) multiples in stock
valuation;
e) explain the advantages and disadvantages of using the PS model compared with other
valuation models.
Company Performance and Measures of Value Added (Study Session 12)
f) demonstrate the link between EVA® and MVA;
g) demonstrate the differences among EVA®, MVA, and CFROI;
.An Analysis of EVA®. (Study Session 12)
a) briefly explain EVA® and MVA and the connection between the two concepts;
b) demonstrate how EVA® can be used as a criterion for selecting stocks.

2001 Level II Guideline Answers


Morning Section . Page 10
Guideline Answer:
A. For companies in the industry described, the price-to-sales ratio would be superior to
either of
the other two ratios because the price-to-sales ratio is:

More useful in valuing companies with negative earnings or negative book values (a
frequent consequence of rapid technological change)
Better able to compare companies in different countries that are likely to be using
different accounting methods, i.e., standards (a consequence of the multinational nature
of the industry)
Less subject to manipulation, i.e., managing earnings by management (a frequent
consequence when firms are in a cyclical low and likely to report losses)
Not as volatile as PE multiples and hence may be more reliable for use in valuation
Less subject to distortion from currency translation effects
Less influenced by accounting values in the presence of rapid technological change
2001 Level II Guideline Answers
Morning Section . Page 11
B.

Statement
Determine
whether
Correct or
Incorrect
(Circle One)

If incorrect, explain why


1. EVA is a measure of a
firm.s excess
shareholder value
generated over a long
period of time.

Incorrect
EVA is a measure of economic profit. Such a
measure may or may not have also generated
.excess shareholder value..
EVA is a measure of value added by the firm.s
management during a period.
2. In calculating EVA, the
cost of capital is the
weighted average of the
after-tax yield on long-
term bonds with similar
risk and the cost of
equity as calculated by
the capital asset pricing
model.

Correct
3. EVA provides a
consistent measure of
performance across
firms.

Incorrect
Size of the firm, for example, affects
EVA/MVA. The measure also requires
estimates of cost of capital and other
components of the calculation. It is, therefore,
anything but straightforward and not
necessarily consistent across firms.
Accounting standards, methods, practices, and
decisions result in differences.

2001 Level II Guideline Answers


Morning Section . Page 12
LEVEL II, QUESTION 6

Topic: Asset Valuation


Minutes: 16

Reading References:
1. .Competitive Strategy: The Core Concepts,. Michael E. Porter, Competitive
Advantage:
Creating and Sustaining Superior Performance (The Free Press, 1985)
2. .Industry Analysis,.Ch.6, Security Analysis on Wall Street: A
Comprehensive Guide to
Today.s Valuation Methods, Jeffrey C. Hooke (Wiley, 1998)

Purpose:
To test the candidate.s understanding of the competitive forces that affect the profitability
of a
company.

LOS: The candidate should be able to


.Competitive Strategy: The Core Concepts. (Study Session 9)
a) analyze the competitive advantage and competitive strategy of a company and
the
competitive forces that affect the profitability of a company;
b) analyze basic types of competitive advantage that a company can possess and
the generic
strategies for achieving a competitive advantage;
c) analyze the risks associated with each of the generic strategies;
d) discuss the difficulties and risks of simultaneously using more than one of the
generic
strategies.
.Industry Analysis. (Study Session 9)
a) discuss the factors that should be included in an industry analysis model;
c) analyze the effects of business cycles on industries (growth, defensive, cyclical);
d) analyze the impact of external factors (such as technology, government, foreign
influences,
demography, and social changes) on industries.

2001 Level II Guideline Answers


Morning Section . Page 13
Guideline Answer:

Name the Competitive Force


Determine
whether
Favorable or
Unfavorable
(Circle One)
Select two sentences that support
whether favorable or unfavorable
SAMPLE
Bargaining power of customers
SAMPLE
Favorable
SAMPLE
5 and 8
20, 21, 22, 23
Threat of new entrants
Unfavorable
---OR---
Favorable 10, 11, 12, 15, 16
13, 15, 16
Threat of substitute products
Favorable
---OR---
Unfavorable 22, 23
Bargaining power of suppliers Unfavorable 9, 10, 11, 12
12, 18, 19
Rivalry among existing firms
Favorable
---OR---
Unfavorable 20, 21, 22, 23

2001 Level II Guideline Answers


Morning Section . Page 14
LEVEL II, QUESTION 7
Topic: Portfolio Management
Minutes: 6

Reading Reference:
Investment Analysis and Portfolio Management, 5th edition, Frank K. Reilly
and Keith C. Brown
(Dryden, 1997)
A. .An Introduction to Asset Pricing Models,. Ch. 9
B. .Extensions and Testing of Asset Pricing Theories,. Ch. 10

Purpose:
To test the candidate.s understanding of similarities and differences between APT and the
CAPM.

LOS: The candidate should be able to


.An Introduction to Asset Pricing Models. (Study Session 20)
j) explain the similarities and differences between arbitrage pricing theory (APT) and the
CAPM.
.Extensions and Testing of Asset Pricing Theories. (Study Session 20)
d) explain why the assumptions that underlie the CAPM and APT cause many observers
to
consider the models to be untestable.

2001 Level II Guideline Answers


Morning Section . Page 15
Guideline Answer:

Argument
State whether
Argument is
Correct or
Incorrect
(Circle One)

Indicate, for each incorrect


argument, why the argument is
incorrect

1. Both the CAPM and APT


require a mean.variance
efficient market portfolio.
Incorrect

CAPM requires the mean-variance


efficient portfolio, but APT does not.

2. Neither the CAPM nor APT


assumes normally distributed
security returns.

Incorrect

CAPM assumes normally distributed


security returns, but APT does not.

3. The CAPM assumes that one


specific factor explains
security returns but APT does
not.

Correct

2001 Level II Guideline Answers


Morning Section . Page 16
LEVEL II, QUESTION 8

Topic: Portfolio Management


Minutes: 26

Reading Reference:
.An Introduction to Portfolio Management,. Ch. 8, Investment Analysis and
Portfolio
Management, 5th edition, Frank K. Reilly and Keith C. Brown (Dryden, 1997)

Purpose:
To test the candidate.s: 1) ability to calculate portfolio risk and return measures,
and 2)
understanding of alternative risk measures.

LOS: The candidate should be able to


.An Introduction to Portfolio Management. (Study Session 20)
b) identify several alternative measures of risk and explain the circumstances in which
their use
might be appropriate;
c) compute the standard deviation of rates of return for a risky asset;
d) describe and illustrate the change in the risk-return tradeoff of a two-asset portfolio as
the
correlation between the two assets changes in specified ways;
e) explain and illustrate how a given investor will choose an optimal risky portfolio from
a
given set of alternative portfolios;
f) describe and calculate the expected return and variance of a two-asset portfolio;
g) describe and calculate the covariance and correlation coefficient between two asset
returns.

Guideline Answer:
A. Subscript OP refers to the original portfolio, ABC to the new stock, and NP to the
new
portfolio.

i. The expected return is 0.728 percent.

E(rNP ) = wOPE(rOP) + wABCE(rABC)

E(rNP ) = 0.9(0.67) + 0.1(1.25)

E(rNP ) = 0.603 + 0.125 = 0.728%

ii. The expected covariance is 2.80.

COV = r (OP )(ABC )

COV = 0.40 (2.37)(2.95) = 2.7966 ˜ 2.80


2001 Level II Guideline Answers
Morning Section . Page 17
iii. The expected standard deviation is 2.27 percent.

NP = [wOP
2 OP 2 + wABC
2 ABC 2 + 2wOP wABC COV]1/2

NP = [2 (2.372) + 2(2.952) + 2(0.9)(0.1)(2.80)]1/2

NP = [4.5497 + 0.0870 + 0.5040]1/2 = 2.2673 ˜ 2.27%

B. Subscript OP refers to the original portfolio, GS to government securities, and NP to


the new
portfolio.

i. The expected return is 0.645 percent.

E(rNP) = wOPE(rOP) + wGSE(rGS)


E(rNP) = 0.9(0.67) + 0.1(0.42)

E(rNP) = 0.603 + 0.042 = 0.645%

ii. The expected covariance is 0.

COV = r (OP )(GS )

COV = 0 (2.37)(0) = 0

iii. The expected standard deviation is 2.13 percent.

NP = [wOP
2 OP 2 + wGS
2 GS 2 + 2wOP wGS COV] 1/2

NP = [2 (2.372) + 2(0) + 2(0.9)(0.1)(0)] 1/2

NP = [4.5497 + 0 + 0]1/2 = 2.133 ˜ 2.13%


2001 Level II Guideline Answers
Morning Section . Page 18

C. Adding the risk-free government securities would cause the beta of the new portfolio
to be
lower. The new portfolio beta will be a weighted average of the individual security betas
in
the portfolio; the presence of the risk-free securities would lower that weighted average.

D. The comment is not correct. Although the standard deviations and expected returns of
the
two securities under consideration are the same, the covariances between each security
and
the original portfolio are unknown, making it impossible to draw the conclusion stated.
For
instance, if the covariances are different, selecting one security over the other may result
in a
lower standard deviation for the portfolio as a whole. In such a case, that security would
be
the preferred investment if all other factors are equal.

E. i. Grace clearly expressed the sentiment that the risk of loss was more important to
her than
the opportunity for return. Using variance (or standard deviation) as a measure of risk in
her case has a serious limitation because it does not distinguish between positive and
negative price movements.
ii. Two alternative risk measures that could be used instead of variance are:

Range of Returns, which considers the highest and lowest expected returns in the
future
period, with a larger range being a sign of greater variability and therefore of greater risk;

Semivariance, which can be used to measure expected deviations of returns below the
mean or some other benchmark, e.g., zero.

Either measure would potentially be superior to variance for Grace. Range of returns
would help to highlight the full spectrum of risk she is assuming, especially the downside
portion of the range about which she is so concerned. Semivariance would also be
effective, because it implicitly assumes that the investor wants to minimize the likelihood
of returns falling below some target rate; in Grace.s case, the target rate would be set at
zero (to protect against negative returns).
2001 Level II Guideline Answers
Morning Section . Page 19
LEVEL II, QUESTION 9

Topic: Asset Valuation


Minutes: 10

Reading References:
1. .The Financing Decision,. Ch. 6, including Appendix, Analysis for Financial
Management,
5th or 6th edition, Robert C. Higgins (Irwin, 1998 or 2000)
2. .General Principles of Credit Analysis,. Level II, Ch. 9, Fixed Income Analysis
for the
Chartered Financial Analyst Program, Frank J. Fabozzi, (Frank J. Fabozzi
Associates, 2000)
3. An Example of How to Use and Compute Effective Duration and
Effective Convexity, Gerald
W. Buetow, Jr., Robert R. Johnson, and Donald L. Tuttle (AIMR, 1999)
4. .The Analysis and Valuation of Bonds,. Ch. 16, pp. 525-579, Investment
Analysis and
Portfolio Management, 5th edition, Frank K. Reilly and Keith C. Brown (Dryden,
1997)

Purpose:
To test the candidate.s: 1) ability to evaluate the use and effects of leverage, and 2)
understanding of the relationship between leverage and credit quality.

LOS: The candidate should be able to


.The Financing Decision. (Study Session 14)
b) calculate the pro forma earnings per share (EPS), using alternative mixes of bond and
stock
financing;
c) calculate key coverage ratios resulting from alternative mixes of bond and stock
financing
and interpreting consequences for S&P debt ratings;
e) infer the impact of higher financial leverage on the market value of the firm.
.General Principles of Credit Analysis. (Study Session 14)
a) explain how credit analysis encompasses examination of the borrower.s character, the
borrower.s capacity to repay, the underlying collateral, and the issue.s covenants;
d) explain the key ratios (short-term solvency ratios, capitalization ratios, and coverage
ratios)
used by credit analysts to assess the ability of a firm to satisfy its debt obligations and
discuss
the importance of these ratios;
e) compute the ratios explained in (d) above and use their level and trend to evaluate an
issuer.s
potential credit rating;
h) describe the various covenants and discuss their importance in assessing credit risk for
both
investment grade and non-investment grade companies.
An Example of How to Use and Compute Effective Duration and
Effective Convexity (Study
Session 16)
c) interpret the range of effective duration and effective convexity values over a
spectrum of
yields, identify the bond with an embedded option, and explain the type of embedded
option;
d) compute the effective duration and effective convexity of a bond, given information
about
how the bond.s price will increase or decrease with a given change in interest rates;
e) compute the estimated percentage price change of a bond with an embedded option(s),
using
both effective duration and effective convexity.
2001 Level II Guideline Answers
Morning Section . Page 20
.The Analysis and Valuation of Bonds. (Study Session 14, 2000 Level I)
o) calculate the duration and convexity components of price change for a bond for a
given
change in market yield.

Guideline Answer:
A. Interest expense increases $4.25 million because only $50 million of the $100 million
capital
investment is funded with debt at an interest rate of 8.50 percent ($50 million × 0.085 =
$4.25
million). The other $50 million comes from the sale of new equity. The new equity
causes
outstanding shares to increase by 2 million ($50 million / $25 per share). The completed
pro
forma is as follows:

Condensed Income Statement


Forecast from
Exhibit 9-1
Construct a pro forma income
statement for 2002, if the financing
plan is adopted
Earnings Before Interest and
Taxes (EBIT) $94,500

$108,675

Interest Expense 11,000

15,250

Pre-tax Income $83,500

93,425

Income Taxes 25,050

28,027.50

Net Income $58,450

$65,397.50

Shares Outstanding 12,000

14,000

Earnings Per Share $4.87

$4.67

2001 Level II Guideline Answers


Morning Section . Page 21

B. i. Buckner.s Cash Flow from Operations-to-Total Debt is less than desired (0.44 vs.
0.50)
and Total Debt-to-Total Capital is greater than desired (0.54 vs. 0.50), both of which
would no longer satisfy LightStreet.s credit quality standards.

ii. If Deven is correct, the yield on Buckner.s outstanding bonds would increase 20 basis
points (bps); each of the two factors in (i) above would contribute 10 bps to the increase
in yield. Because the outstanding bonds have a modified duration of 6.50 years, their
price is expected to decline by 1.3 percent as a result of the deteriorating credit quality:

.6.50 years × .002 = 0.013 = .1.3%

2001 Level II Guideline Answers


Morning Section . Page 22
LEVEL II, QUESTION 10

Topic: Asset Valuation


Minutes: 8

Reading Reference:
Fixed Income Analysis for the Chartered Financial Analyst Program,
Frank J. Fabozzi (Frank J.
Fabozzi Associates, 2000)
A. .Mortgage-Backed Securities,. Level II, Ch. 3
B. .Valuing Mortgage-Backed and Asset-Backed Securities,. Level II, Ch. 5

Purpose:
To test the candidate.s: 1) understanding of prepayment risk, and 2) ability to use the
OAS
concept to evaluate asset-backed securities.

LOS: The candidate should be able to


.Mortgage-Backed Securities. (Study Session 16)
k) explain contraction and extension prepayment risks and why they occur;
m) explain why and how a collateralized mortgage obligation (CMO) is created and
distinguish
among the different types of CMO structures (including sequential-pay tranches, accrual
tranches, floater tranches, inverse floater tranches, planned amortization class tranches,
support tranches, and support tranches with schedules).
.Valuing Mortgage-Backed and Asset-Backed Securities. (Study Session 16)
j) apply the option-adjusted spread (OAS) analysis to value mortgage-backed securities
and
identify rich and cheap securities;
o) determine when an asset-backed security should be valued using the zero-volatility
spread
approach or the option-adjusted spread approach (using Monte Carlo simulation).

Guideline Answer:
A. The prepayment risk associated with declining interest rates is contraction risk: The
upside
price potential is compressed because of accelerating prepayments, and the cash flows
must
be reinvested at lower rates. The average life of the pass-through shortens.

The prepayment risk associated with rising interest rates is extension risk: The price
decline
is exacerbated because of slowing prepayments. The average life of the pass-through
lengthens.
2001 Level II Guideline Answers
Morning Section . Page 23

B. The purpose of option-adjusted spread (OAS) analysis is to identify mortgage-backed


securities where value is greater than price. In the Monte Carlo simulation, the OAS is
the
spread that when added to all the spot rates on all interest rate paths will make the
average
present value of the paths equal to the observed market price (plus accrued interest) of the
security. In addition, the difference between the security.s zero-volatility spread and OAS
is
the security.s option cost. Thus, the higher the OAS, the lower the option cost and the
greater
the excess of value over price.

In this case, Tranche I appears to be the least expensive on a relative value basis because,
for
the same duration, it carries a higher option adjusted spread (108 basis points) and lower
option cost (28 basis points). That is,

Tranche I = higher OAS and lower option cost = .cheap.


Tranche II = lower OAS and higher option cost = .rich.

2001 Level II Guideline Answers


Morning Section . Page 24
LEVEL II, QUESTION 11

Topic: Asset Valuation


Minutes: 12
Reading Reference:
.Valuing Bonds with Embedded Options,. Level II, Ch. 2 Fixed Income Analysis
for the
Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi
Associates, 2000)

Purpose:
To test the candidate.s: 1) understanding of the risk-return characteristics of bonds with
embedded options, and 2) ability to calculate various valuation measures for a convertible
bond.

LOS: The candidate should be able to


.Valuing Bonds with Embedded Options. (Study Session 15)
p) describe the basic features of a convertible bond;
q) compute the value and explain the meaning of the following for a convertible bond:
conversion value, straight value, market conversion price, market conversion premium
per
share, market conversion premium ratio, premium payback period, and premium over
straight
value;
r) discuss the components of a convertible bond.s value that must be included in an
option-
based valuation approach;
s) compare the risk.return characteristics of a convertible bond with the risk.return
characteristics of ownership of the underlying common stock.

Guideline Answer:
A. i. Conversion value of a convertible bond is the value of the security if it is
converted
immediately. That is,
= market price of the common stock × conversion ratio
= $40 × 22
= $880

ii. Market conversion price is the price that an investor effectively pays for the common
stock if the convertible bond is purchased.
= market price of the convertible bond / conversion ratio
= $1,050 / 22
= $47.7273 ˜ $47.73
2001 Level II Guideline Answers
Morning Section . Page 25
iii. Premium payback period is the period of time that it takes the investor to recover the
premium paid for the convertible bond. Because the investor generally receives higher
coupon interest from the convertible bond than would be received from the common
stock dividends (based on the number of shares equal to the conversion ratio), the period
of time to recover the premium can be determined.
Premium payback period = conversion premium per share / income differential per share
Conversion premium/share = $47.7273 . $40 = $7.7273
Income differential/share = ($1,000 × 6.5%) / 22 . $1.20 = $2.9545 . 1.20 = $1.7545
Premium payback period = $7.7273 / $1.7545 = 4.4043 ˜ 4.40 years

B. The value of the convertible bond = value of the straight bond


+ value of the conversion option
. value of the call option on the bond

Change
Determine whether the
value will Increase,
Decrease, or
Remain Unchanged
(Circle One)
Justify your response with one reason

An increase in
stock price
volatility

Increase

The conversion option on the stock


becomes more valuable.
An increase in
interest rate
volatility

Decrease

The chance of the bond being called


increases, causing the value of the call
option on the bond to become more
valuable.
2001 Level II Guideline Answers
Morning Section . Page 26
LEVEL II, QUESTION 12

Topic: Asset Valuation


Minutes: 10

Reading Reference:
1. .The Term Structure and the Volatility of Interest Rates,. Level II, Ch. 1 Fixed
Income
Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi
(Frank J. Fabozzi
Associates, 2000)
2. .The Analysis and Valuation of Bonds,. Ch. 16, pp. 525-579, Investment
Analysis and
Portfolio Management, 5th edition, Frank K. Reilly and Keith C. Brown (Dryden,
1997)

Purpose:
To test the candidate.s: 1) understanding of different theories of the term structure of
interest
rates, and 2) ability to evaluate the effects of term structure changes on fixed income
securities.

LOS: The candidate should be able to


.The Term Structure and the Volatility of Interest Rates. (Study Session 15)
g) explain the various forms of the expectation theory (pure expectations theory,
liquidity
theory, and preferred habitat theory) and the implications of each theory for the shape of
the
yield curve;
k) describe how to measure the yield curve risk of a security or a portfolio, using key
rate
duration;
l) compute and interpret yield volatility, given historical yields.
.The Analysis and Valuation of Bonds. (Study Session 14, 2000 Level I)
o) calculate the duration and convexity components of price change for a bond for a
given
change in market yield.

Guideline Answer:
A. The government yield curve will steepen with the yields for longer maturities
increasing and
the yields for shorter maturities decreasing. According to Preferred Habitat Theory,
yields at
the long end of the curve will increase because of the increased supply of longer maturity
debt and the reluctance of investors to move into this sector without adequate
compensation.
Similarly, short rates will decline because of the decreased supply of short-term debt and
the
reluctance of investors to leave this sector.
2001 Level II Guideline Answers
Morning Section . Page 27
B. This question may be answered based on either the Fabozzi reading or the Reilly and
Brown
reading. Fabbozzi solves the problem using Key Rate Duration and Reilly and Brown use
Modified Duration. Both solutions are presented below:

Key Rate Duration


i. Strategy I
% . MV5yr = .5.00 × (.0.75%) = 3.75%
% . MV25yr = .25.00 × (0.50%) = .12.50%
% . MVStrategy I = 0.5 × (3.75%) + 0.5 × (.12.50%) = .4.375%

ii. Strategy II
% . MV15yr = –15.00 × (0.25%) = –3.75%
% . MVStrategy II = 1.0 × (–3.75%) = –3.75%

Modified Duration

i. Strategy I
% . MV5yr = .4.83 × (.0.75%) = 3.6225%
% . MV25yr = .23.81 × (0.50%) = .11.9050%
% . MVStrategy I = 0.5 × (3.6225%) + 0.5 × (.11.9050%) = .4.1413%

ii. Strategy II
% . MV15yr = –14.35 × (0.25%) = –3.5875%
% . MVStrategy II = 1.0 × (–3.5875%) = –3.5875%

2001 Level II Guideline Answers


Morning Section . Page 28
LEVEL II, QUESTION 13

Topic: Asset Valuation


Minutes: 22

Reading Reference:
.The Swaps Market: Introduction,. Ch. 20, pp. 608.625 and 632.643, Futures, Options
&
Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)

Purpose:
To test the candidate.s: 1) understanding of a fixed-for-fixed currency swap, and 2)
ability to
evaluate the effect of a swap on a company.s borrowing costs.

LOS: The candidate should be able to


.The Swaps Market: Introduction. (Study Session 17)
a) discuss the characteristics of and motivations for swap contracts and differentiate
swap
contracts from futures contracts, especially with respect to payment date versus
expiration
date;
b) diagram (with a box and arrow diagram) and explain the cash flows between the
parties to a
plain vanilla swap contract, including situations in which an intermediary participates;
c) calculate a swap.s cash flows;
d) distinguish betweens swap situations in which all flows are netted and swap situations
that
involve an exchange of principal;
e) illustrate the appropriate cash flow diagram for a swap and calculate the net
borrowing/lending rates for the two swap counterparties;
f) determine whether entering a swap arrangement reduces a party.s borrowing costs;
h) illustrate and explain how a plain vanilla interest rate swap and a plain vanilla
currency swap
can be combined to form a combined interest and currency swap (CIRCUS).

Guideline Answer:
A. World would assume both counterparty risk and currency risk.

Counterparty risk is the risk that Bishop.s counterparty will default on payment of
principal
or interest cash flows in the swap.

Currency risk is the currency exposure risk associated with all cash flows. If the US$
appreciates (Euro depreciates), there would be a loss on funding of the coupon payments;
however, if the US$ depreciates, then the dollars will be worth less at the swap.s
maturity.

2001 Level II Guideline Answers


Morning Section . Page 29
B.

Year 0 Year 1 Year 2 Year 3


World Pays
Notional
Principal
$ 3 billion . 3.33 billion
Interest Payment . 193.14 million1 . 193.14 million . 193.14 million
World Receives
Notional
Principal
. 3.33 billion $ 3 billion
Interest Payment $ 219 million2 $ 219 million $ 219 million

1 . 193.14 million = . 3.33 billion × 5.8%


2 $ 219 million = $ 3 billion × 7.3%
C. World would not reduce its borrowing cost, because what Bishop saves in the Euro
market,
she loses in the dollar market. The interest rate on the Euro pay side of her swap is 5.80
percent, lower than the 6.25 percent she would pay on her Euro debt issue, an interest
savings
of 45 bps. But Bishop is only receiving 7.30 percent in U.S. dollars to pay on her 7.75
percent U.S. debt interest payment, an interest shortfall of 45 bps. Given a constant
currency
exchange rate, this 45 bps shortfall exactly offsets the savings from paying 5.80 percent
versus the 6.25 percent. Thus there is no interest cost savings by selling the U.S. dollar
debt
issue and entering into the swap arrangement.
2001 Level II Guideline Answers
Morning Section . Page 30
LEVEL II, QUESTION 14

Topic: Asset Valuation


Minutes: 10

Reading Reference:
Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. .Futures Prices,. Ch. 3, pp.43-76
B. .Stock Index Futures: Introduction,. Ch. 7, pp. 202-212

Purpose:
To test the candidate.s understanding of and ability to use the cost-of-carry model in
evaluating
futures positions.

LOS: The candidate should be able to


.Futures Prices. (Study Session 17)
d) determine, using the cost-of-carry model, whether an arbitrage profit exists for various
underlying assets;
e) identify the existence of an arbitrage opportunity, identify and arrange the appropriate
strategy (a cash-and-carry arbitrage or a reverse cash-and carry arbitrage), list the
appropriate
trades to arbitrage, and compute the corresponding arbitrage profits;
h) illustrate how market imperfections (transactions costs, unequal borrowing and
lending rates,
and restrictions on short selling) create upper and lower no-arbitrage futures pricing
bounds.
.Stock Index Futures: Introduction. (Study Session 17)
c) calculate the fair value of a stock index futures contract.

Guideline Answer:
A. According to the cost-of-carry rule, the futures price must equal the spot price plus
the cost of
carrying the spot commodity forward to the delivery date of the futures contract.

Value of December contract:


F0,t = S0  (1 + C)
Where:
S0 = Spot price at t = 0
C = Risk-free rate

F0,6 = 185.00  (1 +
2
06 . 0 )
F0,6 = 190.55

2001 Level II Guideline Answers


Morning Section . Page 31
B. Assuming that the only carrying charge is the financing cost at an interest rate of 6.00
percent, the lower bound imposed by the reverse cash-and-carry strategy including
transaction costs is:

Cash Inflows:
Buy 1 contract of TOBEC stock index futures (December contract)
Sell the index spot at 185.00 × $100 = $18,500
Invest the proceeds at the risk-free rate for six months (until the expiration of the six-
month contract)
$18,500 × (1 +
2
06 . 0 ) = $19,055

Six months from now:


At expiration the futures price is assumed to converge to the spot price, and
Sell 1 contract of TOBEC stock index futures (December contract)
Buy the index spot
Collect on investment = $19,055
Pay transaction costs = $15.00
Total = ($19,055 . $15.00) = $19,040
Lower bound =
100 $
040 , 19 $ = 190.40