CFA Level II Mock Exam 4 - Solutions (PM)

CFA Level II Mock Exam 4 – Solutions (PM)
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CFA Level II Mock Exam 4
June, 2016
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FinQuiz.com – 4th Mock Exam 2016 (PM Session)
Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Economics 18
13-18 Financial Reporting and Analysis 18
19-24 Corporate Finance 18
25-36 Equity Investments 36
37-42 Alternative Investments 18
43-48 Fixed Income 18
49-54 Derivatives 18
55-60 Portfolio Management 18
Total 180

Questions 1through6 relate to Ethical and Professional Standards
Mike Walsh Case Scenario
Mike Walsh is a senior research analyst at Hexagon Investment Advisory Firm (HIAF),
an asset management firm with six branches in the U.S., each with unique service
offerings. Each of HIAF’s branches has a compliance department that supervises the
effective enforcement of the firm’s policies and compliance procedures. The firm has
recently decided to adopt the CFA Institute Research Objectivity Standards, in order to be
more competitive on a global basis. David Palmer has been appointed the head of the
supervisory team with the task of ensuring compliance to the standards. When talking to
Palmer during a meeting, Walsh made the following comment:
Comment 1: “I have a keen interest in following the chemical companies in the U.S.
Over the past few months, I have made several public appearances to
discuss my research and recommendations, two of which received wide
acclaim. One was a media interview broadcasted by ‘Capital Plus’. Since
most of my audience members were not financial professionals, I made
sure that I provide all information that led to my recommendation. The
second was a lecture to a focus group composed of the leading investment
professionals of the industry. Since the group was well-versed with
financial jargon and valuation models, I found it easier to converse with
them since I did not have to explain with that level of detail.”
Walsh continued with the following comment:
Comment 2: “Recently, I prepared a research report on Capital Chemicals (CACH).

After careful analysis of the firm’s financial statements, along with an
assessment of its peer group and the industry, I entered a ‘buy’
recommendation in my report. In addition, apart from the market price of
the security, which was public information and available to all, I stated all
information that could help the reader to perform an independent analysis,
cited all the sources and mentioned the option to get supporting evidence.”
After talking to Walsh, Palmer proceeded with an analysis of HIAF’s policies regarding
research and objectivity. Palmer gathered the following information:

Policy 1: HIAF allows written and oral communications between the research department
and the investment banking department of the firm. However, such
communications are always documented and conducted with the compliance
department acting as an intermediary.
Policy 2: HIAF allows research analysts to participate in marketing activities, including

‘roadshows’ for IPOS and secondary offerings. However, research analysts are
required to disclose this participation in all interviews and public appearances.
While studying HIAF’s trading policies, Palmer met with Paul Taylor, a research analyst
at the firm. Palmer stated that to comply with the Research and Objectivity Standards,
restricted periods of at least 30 calendar days before and five calendar days after report
issuance were recommended. Taylor got confused and stated that he just issued a research
report on a diversified mutual fund offered by Broad Investments (BRIN), a fund offering
a number of investment vehicles to investors. Since the company’s management was
independent of Taylor or his family, HIAF allowed him to trade a day after the issuance
of his report.
Taylor had been following SinTock Enterprises (STE), a computer software and
hardware provider in the U.S. As part of HIAF’s research team, Taylor had written
several reports covering STE over the course of five years, and had also been investing
and trading in the firm’s securities. Due to a change in HIAF’s overall objectives, the
firm decided to discontinue coverage of the firm. Taylor decided to issue a final research
report with a ‘buy’ recommendation.
Palmer continued to assess HIAF’s policies, especially its compliance procedures. When
talking to HIAF’s chief investment officer (CIO), Palmer stated that although HIAF had
explicitly stated a list of activities that were considered violations and had disseminated
that information to all clients and prospects, a publication of the research objectivity
policy was necessary to be in accordance with the Research Objectivity Standards (ROS).
As the day ended, Palmer assisted Taylor with research on a large automobile firm. HIAF
held less than 1.0% of the common equity of the firm. In addition, Taylor had 10% of his
portfolio invested in the firm’s equity. After completing the research report, Palmer
advised Taylor to make a page reference of the disclosure of his conflict of interest on the
front of the report. However, he did not ask Taylor to disclose the fact about HIAF’s
holdings in the firm.

1. With respect to the CFA Institute-ROS, Walsh is most likely in violation of the
standards with respect to:
A. Comment 2 only.
B. Both comments 1 and 2.
C. Neither comment 1 nor comment 2.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b
Comment 1 is in violation. Covered employees have a responsibility to ensure

that the audience of their presentations has sufficient information to make
informed judgments about the objectivity of the research and recommendations.
Walsh cannot discriminate between the general investing public and investment
professionals when disseminating information.
Comment 2 is in violation. When making a recommendation, analysts and firms

are required to disclose the current market price of the security in question.
2. With regards to its policies, HIAF is most likely in compliance with the CFA
Institute-ROS with respect to:
A. Policy 1 only.
B. Policy 2 only.
C. Both policies 1 and 2.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 3, LOS b.
Policy 1 is in compliance. As long as the communications are documented and

conducted with the compliance department as an intermediary, they do not violate
the standards.
Policy 2 is in compliance. Firms may permit research analysts to participate in

marketing activities for IPOs, however, the analysts should disclose this
participation in all interviews and public appearances.

3. With regards to the mutual fund, is HIAF most likely in compliance with the
Research and Objectivity Standards?
A. Yes.
B. No, since he has traded a day after the issuance of the report.
C. No, since he did not provide proper time for clients to act on his advice
before trading for his personal portfolio.
Correct Answer: A
Reference:
HIAF is in compliance. Restrictions on purchases or sales of securities need not

apply to the securities of a diversified investment fund over which the covered
employee or members of his/her immediate families have no investment control.
4. With regards to SinTock Enterprises (STE), is Taylor most likely in compliance

with the ROS?
A. No.
B. Yes, only if Taylor clearly explains the reason for discontinuing coverage.
C. Yes, only if Taylor does not trade or invest in the securities of subject
companies.
Correct Answer: B
Reference:
Firms should not quietly discontinue coverage of a subject company. Taylor is

required to issue a ‘final’ research report that includes a recommendation, and
also an explanation as to why the firm is discontinuing coverage.
5. With regards to its compliance policies, is Palmer correct about the requirement to
be in compliance with the Research Objectivity Standards?
A. Yes.
B. No, since Palmer is stating a recommended practice not a requirement.
C. No, since Palmer has missed out on some other key requirements.

Correct Answer: B
Reference:
Publication of the research objectivity policy is a recommendation not a

requirement.
6. With respect to disclosure requirements, is Palmer’s advice regarding the research

report on the automobile firm most likely in compliance with the ROS?
A. Yes.
B. Only with respect to Taylor’s personal investment.
C. Only with respect to HIAF’s investment in the firm.
Correct Answer: A
Reference:
Palmer’s advice is in compliance. A page reference to the disclosure to all

conflicts of interest should be made on the front of the research report. However,
if a firm holds one percent or more of the common equity of the subject company
as of five business days prior to the issuance of the report, only then it is required
to disclose.

Questions 7 through 12 relate to Economics
Sean Looper Case Scenario
Sean Looper is a finance student doing his PhD in ‘Financial Management’ from a
reputable university in Los Angeles, California. Looper is currently working on his
research paper that explains the impact of a country’s economic developments on its
financial state. In his attempts to write a comprehensive paper and earn a good grade,
Looper approached Ellen Jackson, an old friend and a renowned financial economist.
When talking to Jackson about international parity conditions, Looper expressed his
confusion about the difference between uncovered interest rate parity and the capital
flows model in the determination of the future path of interest rates. Jackson presented
the following differences:
Difference 1: “The uncovered interest rate parity focuses on the nominal interest rate
spread, whereas the capital flows model focuses on the real interest rate
spread.”
Difference 2: “The uncovered interest rate parity states that the high-yield currency
should depreciate relative to the low-yield currency. The capital flows
model, on the other hand, states that it is possible for the currency with
the higher nominal interest rate to appreciate relative to the currency with
the low nominal interest rate.”
Jackson told Looper that since most international parity conditions did not hold in the
short-term, it was possible to earn positive returns by trading in different currencies. He
mentioned the returns earned by ‘carry trades’ and the persistence of such returns. After
listening to Jackson about the implementation of carry trades, Looper posed the following
question:
“From what I understand, it is possible to earn carry trade returns if nominal yield spreads
are high and rising. However, are FX carry trades able to generate positive excess returns
even as nominal yield spreads begin to narrow or converge to zero?”
Looper was still not sure how a country’s central bank could help maintain price stability
in the country and promote growth. Jackson explained the concept of the Taylor Rule and
for clarification presented information about a hypothetical country’s economic vitals.
Exhibit 1 displays this information.

Exhibit 1
Economic Information
Current nominal policy rate 5.00%
Neutral nominal policy rate 4.00%
Neutral real policy rate 2.50%
Target inflation rate 2.50%
Current output gap 1.75%
Current inflation rate 1.50%
Jackson also stated the importance of a country’s fiscal stance on the future of its
currency’s value. When talking about the relationship between fiscal policy and exchange
rate determination, Looper stated that an expansionary fiscal policy under conditions of
high capital mobility is generally positive for a currency. Jackson disagreed, and stated
that a stimulative fiscal policy, although putting upward pressure on domestic interest
rates, will eventually lead to currency depreciation.
As an additional favor, Looper requested Jackson to advice him for a $5,000 investment
that he made in Russian bonds. To provide an accurate recommendation, Jackson
gathered the following information about the Russian market:
• Based on recent data, I believe that the Russian equity market is expected to
return 15.50% per year, which includes a 3.5% perpetual dividend yield.
• According to a macroeconomic forecast of the country, the forecast of long-
term real growth rate of potential GDP for the country equals 3.75% and the
forecast of inflation equals 4.25%.
• The macroeconomic service also estimates next year GDP growth to be 9.5%.
Based on his calculations and analysis, Jackson made the following recommendation to
Looper:
“I suggest you take your money out of bonds and invest in Russian stocks.”
After his meeting with Jackson, Looper continued with writing his research paper. While
reading an article on ‘Economic Growth’, Looper read an example of a developed
economy currently operating at its steady state. The article then considered the effect of
the following factors in increasing the country’s per capita growth:

1. An increase in business investment.

2. An increase in capital accumulation resulting in an increase in new products
offered and the efficiency of production methods.
3. A relaxation of capital controls that results in a significant increase in the inflow
of foreign capital.
Looper was not sure how the above factors might affect growth in the country.
7. Jackson is most accurate with respect to:
A. Difference 1 only.
B. Both differences 1 and 2.
C. Neither difference 1 nor difference 2.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 13, LOS f & j
Difference 1 is correct. The uncovered interest rate parity focuses on the nominal
yield spread and exchange rate movements. The capital flows model, however,
states that the real yield spread would rise if nominal yield spreads rise or if
inflation expectations decline.
Difference 2 is correct. Under the capital flows model, if the nominal yield spread
between the high and low yield market rises, or if the inflation expectations in the
high-yield market decline relative to the low yield market, and/or the risk
premium demanded by investors in the high-yield market declines relative to the
low yield market, the real exchange rate will rise.
8. Assuming everything else remains constant, the best response to Looper’s

question regarding carry trades is:
A. No, because FX carry trades depend on the level and trend of the nominal
yield spreads.
B. Yes, if the fundamental criteria driving exchange rate trends over time
proceed gradually.
C. Yes, if the high yield country tightens its domestic monetary policy, FX
carry trades can lead to positive returns.

Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 13, LOS j
FX carry trades are often able to generate positive excess returns even as nominal
yield spreads stabilize or begin to narrow. If the high yield country tightens its
monetary policy, this would put an upward pressure on the currency’s long-run
value (by lowering inflation expectations) and thereby offset the drag on the
exchange rate coming from a decline in the yield spread.
9. Using the information provided in Exhibit 1, the central bank should most likely:
A. Increase the policy rate by 0.875%.

B. Decrease the policy rate by 0.625%.
C. Decrease the policy rate by 0.250%.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 13, LOS l
Policy rate: 2.50%+1.50% +0.5(1.50%-2.50%)+0.5(1.75%) = 4.375%

This requires a decrease in rate of 5.0%-4.375% = 0.625%.
10. With regards to the effects of fiscal policy on a currency’s exchange rate, Looper
is most likely a proponent of the:
A. Mundell-Fleming model, and Jackson is a proponent of the portfolio

balance model, which states that a country’s budget deficit will be
financed only if risk premiums rise and/or its currency depreciates.
B. Portfolio balance model, and Jackson supports the notion that an
expansive fiscal policy will lead to interest rates rising to unsustainable
levels that eventually lead to currency depreciation.
C. Effects of fiscal policy in the short-run, and Jackson supports the long-run
effects of fiscal policy including government debt buildup and decrease in
money supply.

Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 13, LOS k&l
The Mundell-Fleming model supports the notion that an expansionary fiscal

policy under conditions of high capital mobility is positive for a currency in the
short-run. Jackson seems to be a proponent of the portfolio balance model that
states that in case of a stimulative fiscal policy, the increased supply of domestic
bonds will only be held if interest rates or risk premiums increase or if the
currency depreciates to a level sufficient to generate anticipation of gains from
subsequent currency appreciation.
11. Is Jackson’s recommendation about Looper’s Russian investment most likely

correct, and what is Jackson’s estimate of a combined contribution from
expansion in the P/E multiple and/or profit share of GDP?
A. Yes, and the estimate is closest to 4.0%.

B. No, and the estimate is closest to 8.25%.
C. Yes, and the estimate is closest to 7.5%.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 14, LOS c
Nominal GDP will grow at 3.75%+4.25%= 8.0%. Equity market appreciation

equals 15.50%-3.5% = 12%.
Hence, the combined contribution from expansion in the P/E multiple and/or
profit share of GDP is 12.0%- 8.0% = 4.0%.
With forecasted growth of 9.5% above the long term forecast of 8.0%, output gap
will decrease. To expand this gap, the central bank will increase interest rates. In
such an environment, bond prices will decline. Hence, money should be taken out
of bonds and invested equities.

12. Which of the factors mentioned in the article would most likely result in an
increase in per capita growth?
A. Factor 2 only.
B. Factors 2 and 3 only.
C. Factors 1, 2 and 3.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 14, LOS d
An increase in business investment results in capital deepening. Since the country

is operating at its steady state, additions to capital will have a little impact on per
capita growth. Higher foreign investment will result in a movement along the
production function (similar to that with an increase in business investment). With
high levels of capital to labor, the higher level of foreign investment will not
boost growth as much. If new capital increases the efficiency of production
methods, then more rapid capital accumulation can result in a permanently higher
growth rate of per capita output.

Questions 13 through 18 relate to Financial Reporting and Analysis
C-Tech and Ex-PURT Case Scenario
Kenneth Graham is an economic analyst at CandleWick Investments (CAWIN), a U.S.

based asset management firm offering financial guidance and portfolio management
services to private wealth clients. Graham is particularly interested in the domestic as
well as international developments in the global technology industry. For the purpose of
analysis, Graham is reviewing the financial statements of Comtech Incorporated (C-
Tech), a U.S. based technology firm with business in a number of international markets.
To effectively construe the numbers in C-Tech’s financial statements, Graham requested
Irene Cole, a financial analyst at CAWIN, to assist him in his analysis. Cole presented the
following observations:
Observation 1: “C-Tech engaged in a number of foreign currency transactions and its

net income includes a significant amount of resulting gains. Since such
gains are almost always unrealized, they should be excluded from net
income when calculating performance ratios since they do not reflect
true economic reality. If, on the other hand, C-Tech had prepared its
statements according to IFRS, this problem would not exist.”
Observation 2: “While reviewing the statements, I noticed that C-Tech engages in a

number of transactions involving the Japanese yen, and the gains and
losses on such transactions are reported as part of other operating
expenses. Comparing with a similar company that reports transaction
gains and losses as part of non-operating expenses, C-Tech will report
more volatile profit margins over time.”
Graham proceeded with an analysis of Ex-PURT Inc., a U.S. based multinational firm in
the same industry. Ex-PURT prepares its financial statements according to the U.S.
GAAP. When analyzing the disclosures to its financial statements, Graham determined
that the company neither disclosed the amount nor the location of its foreign currency
transaction gains and losses. Graham believed that the company was probably
opportunistically placing transaction losses off-balance sheet to increase profit margins.
Ex-PURT Inc. owns a subsidiary in Thailand, and translates its financial statements using
the temporal method. Based on his economic analysis, Graham believes that the exchange
rate between the U.S. dollar and the Thai baht would fluctuate considerably in the near
future. However, he is not sure what effect this volatility would have on Ex-PURT’s
consolidated financial statements. When Graham inquired about the effects of the two

translation methods on Ex-PURT’s financial performance, Cole made the following

comment:
“The financial performance of Ex-PURT would vary significantly depending on which

translation method is employed. However, the receivables turnover is the only ratio that
will be the same regardless of which method is employed.”
Graham then presented a fact leading to a question:
“Relative to the current rate method, under the temporal method, the gross profit margin
and operating profit margins are higher, but the net profit margin is lower. What does this
information notify us of?”
While answering Graham, Cole stated that a firm’s multinational operations could also
have an impact on the firm’s effective tax rate. To illustrate the impact on taxes, Cole
studied the financial statements of Ex-PURT and a comparable competitor, along with
their disclosures to financial statements. In doing so, she accumulated the information
displayed in Exhibit 1.
Exhibit 1
Ex-PURT Incorporated, 2010, Notes to financial statements (in millions of $)
2010 2009
Ex-PURT Incorporated
Profit before income tax $3,305 $2,570
Profit before income tax excluding share of 2,120 1,987
profit of associates
Income tax @ the U.S. statutory tax rate 570 534
Tax in foreign jurisdictions 75 45
Competitor
Profit before income tax 1,101 998
Profit before income tax excluding share of 1,505 1,100
profit of associates
Income tax @ the domestic tax rate 376 275
Tax in foreign jurisdictions 49 78
As a final request, Graham asked Cole to help him with an assessment of Bold
Enterprises (BEN), a software firm that his personal portfolio was invested in. Graham
presented the following information to aid the analysis:

Exhibit 2
Bold Enterprises (in thousands of $)
2011 2010
Revenue $1,705 $1,300
Decrease in accounts receivable $88 $34
Change in deferred income (30) 12
Net software costs 350 212
Net income from continued operations 699 615
Tax rate 20% 20%
13. Cole is most accurate with respect to:
A. Observation 1 only.
B. Observation 2 only.
C. Neither observation 1 nor observation 2.
Correct Answer: C
Reference:
Observation 1 is incorrect. Not all unrealized gains should be excluded from net
income. Some gains, although unrealized, reflect economic reality. Also, IFRS
also require that transaction gains and losses go through the income statement.
Observation 2 is incorrect. Since C-Tech reports transaction gains and losses as

part of operating income, only the operating profit margin will be more volatile.
The gross profit margin and the net profit margin will be the same.

14. Are Ex-PURT’s financial statements most likely in accordance with reporting
standards?
A. No.
B. Yes, only if the financial statements are prepared in accordance with the
IFRS.
C. Yes, only if the exchange rates between Ex-PURT’s functional currency
and the foreign currencies in which it has transactions tend to be relatively
stable.
Correct Answer: C
Reference:
Ex-PURT’s financial statements are in accordance with reporting standards only

if the amounts are immaterial. This can be the case if the exchange rates between
Ex-PURT’s functional currency and foreign currencies tend to be relatively
stable.
15. Assuming that Ex-PURT has only one subsidiary, with regards to the Thai
subsidiary, is the comment made by Cole most likely correct, and what is the best
response to Graham’s question?
A. Yes, and the information tells us that the Thai baht strengthened against
the U.S. dollar.
B. No, and the information tells us that the Thai subsidiary has a net
monetary liability exposure.
C. Yes, and the information tells us that the translated fixed asset turnover
would be smaller than the turnover calculated using the current rate
method.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 20, LOS f

The comment is correct. The receivables turnover will be the same under both
methods. Sales are translated at the average rate and receivables are translated at
the current exchange rate under both methods.
The information tells us that the Thai Baht strengthened against the U.S. dollar.
This is because the GP margin and OP margin increased so COGS must be lower
under the temporal method. This implies that historical rates are lower than
current rate and so the baht has most likely strengthened. Also, since net income
is lower, a translation loss is probably included in the income statement due to a
net monetary liability exposure.
16. Using the information provided in Exhibit 1, which of the following is least
accurate?
A. Multinational operation’s increased Ex-PURT’s effective tax rate by

3.54% in 2010, but only 2.26% in 2009.
B. Unlike Ex-PURT, the competitor’s profit mix shifted to countries with
lower marginal tax rates.
C. Ex-PURT is most likely inadequately managing its foreign tax liabilities.
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS a
Multinational operations increased Ex-PURT’s taxes by 75/2,120 = 3.54% in

2010 and by 45/1,987 = 2.26% in 2009. So Option A is correct. Option B is
correct. Taxes in foreign jurisdictions decreased from 7.09% in 2009 to 3.25% in
2010. Hence, the competitor’s profit mix shifted to countries with lower marginal
tax rates. Option C is incorrect. Increase in the effective tax rate due to foreign
operations does not mean that Ex-PURT is not managing its tax liabilities
properly. It can be because the marginal tax rates increased in the countries in
which Ex-PURT earns profits.
17. Using the information in Exhibit 2, the most likely explanation for the relationship
of revenues to accounts receivables is that Bold Enterprises has:
A. reported fictitious revenues.

B. made the credit policy more stringent.
C. engaged in bill-and-hold sales arrangements.

Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 7, Reading 21, LOS h
All figures are in $ thousands.
The increase in revenues (1,705 – 1,300 = 405) is not matched by the increase in
the decline in accounts receivables (88 – 34 = 54).
A possible explanation may be that Bold Enterprises has made its credit policy
more stringent resulting in a faster decline in receivables (more timely payments
on customer accounts) despite an increase in revenues.
If Bold Enterprises had engaged in a bill and hold sales arrangement, its
receivables would have grown faster than revenues as a result of recording sales
transactions earlier than the revenue recognition date.
If Bold Enterprises had recorded fictitious revenues, its revenues and receivables
would have increased by the same absolute amount. However, this is not case as
discussed above.
18. Given that Bold Enterprises capitalizes its software costs, earnings from
continuing operating were effectively overstated by:
A. 18.76% relative to cash costs.

B. 19.74% relative to cash costs.
C. 15.79% relative to cash costs.
Correct Answer: A
Reference:
Operating profit would be overstated by $138. Net income would be reduced by

$138(1-0.20) = $110.40. Hence, NI would be 699-110.40 = 588.6 Hence, earnings
from continuing operations were overstated by 110.40/588.6 = 18.76%

Questions 19 through 24 relate to Corporate Finance
Kenny Oliver Case Scenario
Kenny Oliver is the corporate head at Belle’ Home Interiors (BHI), a U.S. based firm
famous for home furniture, interior decoration and bathroom accessories. BHI was
established twelve years back, and has managed to increase earnings and expand
operations since then. Due to its tremendous success, BHI initiated a dividend-paying
policy three years back to attract investors with high-income preferences. Managing the
company’s dividend policy is one of the many responsibilities of Oliver at the firm.
During the recent executive meeting, Oliver mentioned the ‘clientele effect’ as a factor
that BHI should take into account while setting an appropriate dividend policy. While
clarifying how differential taxes affected investor preferences for dividends versus capital
gains, Oliver stated the following example of Radiant Decorators (RADE), a comparable
firm in the industry:
“The tax rate on capital gains is 15% but the tax rate on dividend income differs
according to investor circumstances. When RADE’s share goes ex-dividend, its share
price, on average, drops by 65% of the amount of the dividend. This ex-dividend price
drop provides information on the tax rates applying to those trading in the stock, and in
turn, about their preference for dividends.”
Oliver continued with the following question:
“Given a 45% dividend tax rate and a 20% capital gains tax rate, if BHI is allowed to
report only 40% of dividends received as taxable income, how will BHI’s share price
behave when it goes ex-dividend?”
As the meeting continued, Oliver was questioned about how diverse taxation systems
affected decisions made by taxable investors. Erin Beck, BHI’s CFO, presented the
following three scenarios for BHI for a 100% payout policy and $100 million in pretax
earnings:
Scenario 1: “Dividends are subject to a double taxation system and BHI’s shareholders
are taxed at a rate of 25% on the dividends they receive. The corporate tax
rate is 20%.”
Scenario 2: “In case of a split-rate tax system, corporate taxes on dividends are 25% and
the shareholder tax rate is 33.33%.

Scenario 3: “Under a dividend imputation tax system, the shareholder tax rate is 50%,
but the corporate tax rate is 35%.”
He then presented his analysis:
Statement 1: “Relative to Scenario 3, Scenario 2 is more attractive for investors since

their dividends are taxed at a much lower rate."
Statement 2: “Relative to Scenario 2, Scenario 1 is more attractive since shareholder

dividends are taxed at a rate that is 9.99% lower.”
After the meeting, Oliver met Beck for lunch at the firm’s cafeteria. Oliver requested
Beck to help him with an assignment given to him by one of BHI’s board members. The
assignment asked for an analysis of the dividend policy of Capital W Enterprises (CWE),
a famous fashion label for women. Oliver then presented information about CWE’s
financials as given in Exhibit 1.
Exhibit 1
Capital W Enterprises
US$ Millions 2009 2010
Net income 786 555
CFO 345 100
FCInv 235 259
FCFE 222 391
Dividends paid 320 265
After analyzing the financials, Beck made the following observations:
Observation 1: “Although the earnings/dividends coverage ratio declined in 2010,

earnings will be considerably more than the amount needed to pay out
dividends. Hence, the company’s dividends seem to be exposed to
minimal risk.”
Observation 2: “Considering the FCFE/dividend coverage ratio trend, the ratio

increased from less than 1 to being sufficiently greater than 1. This
corroborates previous evidence that the company’s dividends are most
likely sustainable, and company liquidity has improved.”

As a further favor, Oliver requested Beck to assess the corporate governance practices of
CWE. He presented the following observations he had made during his analysis of the
firm:
i. The company’s profit margins have decreased due to higher raw material
prices.
ii. The company uses LIFO inventory accounting.
iii. The company expenses interest and overhead.
iv. Startup costs of new operations are mostly capitalized.
19. With regards to the example of RADE, for those who trade around the ex-
dividend day, $1 of dividends is worth:
A. $0.28 in capital gains.

B. $0.47 in capital gains.
C. $0.65 in capital gains.
Correct Answer: C
Reference:
0.65 = (1-TD)/(1-0.15), TD = 0.4475

$1 in dividends is worth $1(1-0.4475)/(1-0.15) = $0.65 in capital gains
20. The most appropriate response to Oliver’s question is that the ex-dividend share
price would be expected to drop by:
A. less than the amount of the dividend.

B. More than the amount of the dividend.
C. An amount very close to the amount of the dividend.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 225, LOSc

The effective tax rate on dividends equals 0.45(0.40) = 0.18
Since the tax rate on dividends is less than the tax rate on capital gains, the share’s
price should drop by more than the amount of dividend when the share goes ex-
dividend.
21. Beck is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. Neither statement 1 nor statement 2.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS e
Effective tax rate on dividends under split rate tax system: 25% + (75 ×0.3333) =
49.99%
Shareholder tax rate under dividend imputation system: 50-35 = 15%
Tax rate under double taxation:$100 × (1- 0.20) = $80; $80 × (1 – 0.25) = $60.
Hence, effective tax rate is 40%.
Hence, statement 1 is incorrect but statement 2 is correct.
22. Considering minimum accruals, Beck is most accurate with respect to:
A. Observation 1 only.
B. Both observations 1 and 2.
C. Neither observation 1 nor observation 2.
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 25, LOS i

Observation 1 is correct. Although the earnings/dividend coverage ratio declined

slightly in 2010 from 2.456 to 2.09, accounting earnings were more than twice the
amount necessary to pay the dividend.
Observation 2 is incorrect. Although the FCFE coverage ratio increased from 0.69
to 1.475, this increase could be the result of an increase in net borrowing. If the
increase in this ratio is the result of net borrowings, it represents a short-term
proposition, and not a sustainable policy.
23. Which of the reporting practices at CWE most likely reflects good corporate
governance?
A. Practices 2 and 3.
B. Practices 2 and 4.
C. Practices 2, 3 and 4.
Correct Answer: A
Reference:
The use of LIFO inventory accounting during periods of rising prices and the
minimal capitalization of interest and overhead represent good quality financial
reporting practices. Expensing, not capitalizing of startup costs of new operations
represents good quality reporting.
24. Which of the following is least likely a representation of good corporate

governance?
A. Annual election of directors.

B. Two-thirds of board members independent of management.
C. Board members with significant personal investments in other companies
for which they serve as directors.
Correct Answer: B
Reference:

Global best practice now recommends that at least three-quarters of the board
members should be independent. Options A and C are correct. Board members
with significant personal investments in the company or other firms for which
they serve as directors represents a commitment to the needs of investors.

Questions 25 through 30 relate to Equity Investments
James Clark Case Scenario
James Clark works for Smart Investing and Equity Management (SIEM), an equity
management firm that is well-known in the global financial world. Clark has worked with
SIEM as its chief investment officer for the past ten years, and has contributed a great
deal to its success. With such experience, Clark is now adept at equity analysis and the
use of appropriate valuation tools. Clark was thus chosen as a guide and trainer for newly
hired financial personnel at SIEM. During his first lecture to the group, Clark presented
the following information about Ester Associates (ESAS).
Exhibit 1
Selected information as of December 21, 2009
Recent quarterly dividend $1.88
Current forecasted dividend
6.5%
growth rate
Beta 1.4
Equity returns 12%
Risk free rate 5.5%
One month later, ESAS’s chief executive officer announced, that based on an increase in
demand for its product and reduction in costs due to efficient inventory management,
earnings growth rate would increase. As part of their dividend policy, ESAS expected
dividend growth rate to equal 8.0% per year. After this news, the share price of ESAS
increased by 21.31%. Clark posed the following question to the group:
“Given that before the announcement market prices reflected intrinsic values, did the
market correctly incorporate the increase in dividend growth rate?”
Clark continued by quoting the example of RedLec Electricals, a firm that provided
equipment to electricity supply companies in Detroit. Due to a slight increase in
population, and a nominal GDP growth rate of 7.0%/year, RedLec believed that demand
would remain stable for coming years. The company had a policy of maintaining a
dividend payout of at least 30%, with historical earnings growth rate of 9.5% and
forecasted earnings growth of 15.5%. The current annual dividend for RedLec was

$1.56/share. A CAPM estimate of RedLec’s ROE equaled 18.0%. After hearing the facts,
Cary Dunn, one of the attendees’ made the following comment:
“Using the Gordon growth model, the intrinsic value of this stock should be $75.65. If the
market price of RedLec’s stock is greater than this value, the stock is overvalued, and
investors could benefit from a short sale.”
To illustrate the proper use of present value models in the valuation of equity
investments, Clark presented data on YUTA Enterprises, a U.S. based firm that started
business two years ago. The company currently pays no dividend and is not expected to
pay one for ten years to come. Ten years from now, YUTA is expected to pay a dividend
of $2.30, and dividends are expected to grow at a perpetual rate thereafter. The company
represents above-average systematic risk and has a beta of 1.23. The equity risk premium
is 4.5% and the risk-free rate is 4.0%. The current market price of YUTA’s stock is
$25.00.
In addition to YUTA Enterprises, Clark also stated data on ASH Products Inc., a retail
chain in a small town near Chicago. Exhibit 2 displays selected financial information of
the firm.
Exhibit 2
ASH Products Incorporated
Current annual dividend $0.98
Current market price $45

Long-term growth rate in
5.00%
dividends
Required return on equity 8.12%
Due to very few similar retail chains in the area, ASH is expected to experience an initial
short-term period of supernormal growth. This growth rate is expected to decline to the
long-term rate over a period of six years.
As the discussion on present value models continued, one of the participants posed the
following question:
Question 1: “Is discounting net income by a firm’s cost of equity an appropriate estimate
of firm value to equity investors?”

Clark answered with the following comment:
“Only in the case in which new investments exactly equal depreciation and the firm is not
investing in working capital or engaging in any net borrowing.”
The participant then posed the following question:
Question 2: “If a firm prepares its financial statements under IFRS, and chooses to report
the interest expense as part of the firm’s financing cash flow, how will free
cash flow to the firm be estimated?”
Clark answered:
“Starting with CFO, the only adjustment that would be needed relates to the investment
in fixed capital.”
Finally, Clark concluded the lecture with an estimation of FCFF of Suffix International
(SUFX). Exhibit 3 displays data on the company’s financial for the year ended 2010.
Exhibit 3
SUFX Financial Information (in US$ thousands)
Depreciation $65.67
Amortization of intangibles 34.12
Net income 156.99
Loss on sale of asset 25.61

Amortization of long-term bond
33.33
premiums
Increase in PP&E 89.00
Interest expense 27.98
Deferred taxes 50.00
Working capital-beginning 118.50

Working capital-ending 165.00
*Taxes are 25% and deferred taxes are expect to reverse in the near future

25. The best response to Clark’s question regarding ESAS’s stock is:
A. Yes.
B. No, the stock is undervalued.
C. No, the stock is overvalued.
Correct Answer: B
Reference:
r = 5.5+1.4(12-5.5) = 14.6%
Original price: 1.88(4)(1.065)/0.146-0.065 = $98.874
New price: 1.88(4)(1.08)/0.146-0.08= $123.0545
Hence, price increase should be 123.0545-98.874 = $24.18 or 24.45%
Since the price increase was less, the stock is undervalued.
26. The comment made by Dunn and the strategy defined by her is most likely:
A. incorrect.
B. correct, only if the estimate of intrinsic value is revised upward to $70.04.
C. correct, only if the estimate of intrinsic value is revised downward to
$72.072.
Correct Answer: A
Reference:
The comment is incorrect. Although, using the Gordon growth model, the
estimate equals $72.072, using the GGM in this case is inappropriate. This is
because forecasted growth is much higher than GDP growth, which implies that
this is unlikely to be sustainable in perpetuity. A better model would be a two-
stage dividend discount model.

27. Assuming that the market fairly prices YUTA’s stock, the growth rate in
dividends that the market expects is closest to:
A. 5.00%
B. 5.48%
C. 5.50%.
Correct Answer: B
Reference:
Required return: 4.0+1.23(4.5) = 9.535%

FV of $25 in 9 years time @ 9.535% = 56.7435
56.7435 = 2.30/0.09535-g, g = 5.48%
28. For ASH Products Inc., the market estimates supernormal growth to be closest to:
A. 13.25%.
B. 17.75%.
C. 22.55%.
Correct Answer: B
Reference:
Using the H-model:

0.0812 = 0.98/45[(1.05) + 3(g-0.05)] + 0.05, g = 17.755%
29. With respect to his answers to the participant’s questions, is Clark most likely
correct?
A. Yes.
B. Only with respect to answer 1.
C. Only with respect to answer 2.
Correct Answer: A

Reference:
For most firms, FCFE and net income are not the same. However, when new
investments exactly equal depreciation and the company is not investing in
working capital or engaging in any net borrowing, FCFE would equal net income.
In this case, discounting net income by the cost of equity can give an estimate of
firm value.
FCFF can be estimated from CFO. FCFF is CFO plus after tax interest expense
minus investment in fixed capital. If a firm does not report interest expense as an
operating activity, then the only adjustment relates to fixed capital.
30. SUFX International’s FCFF for the year ended 2010 is closest to:
A. $134,545.
B. $251,205.
C. $201,205.
Correct Answer: A
Reference:
FCFF: 156.99+65.67+34.12+25.61-33.33-89+[27.98(1-0.25)]-(165-118.50) =
$134,545
Deferred taxes will not be added since they are expected to reverse in the near
future.

Questions 31 through 36 relate to Equity Investments
Pete Sullivan Case Scenario
Vector Financial Group (VFG) is a large U.S. based asset management firm that has
several subsidiaries operating all over USA. Vector Equities (VEEQ) is one such
subsidiary that specializes in the analysis and implementation of equity management
strategies. Pete Sullivan is the chief investment officer at VEEQ, and is adept at the
application of diverse models to determine valuation estimates of stock investments. He
is currently preparing a valuation of Tentacle Enterprises (TENT) as of January 1 2009,
and has assembled the following information for his analysis:
• EPS for 2008 is $3.50.

• Growth rate for the next three years is expected to be 25%, 20% and 13%
respectively. After that the growth rate will slow down to 8%.
• Per share capital investments equal $4.50, $3.97, and $2.50 respectively, after
which they will grow at 8% annually.
• Working capital will be 60% of net investment in fixed capital.
• 45% of net investment in fixed capital and investment in working capital will
be financed with debt.
• The required return on equity for TENT equals 12.00%.
Sullivan is also required to determine whether the stocks of YLS Incorporated and Swift
Enterprises (SWIEN) are overvalued, fairly valued or undervalued. For this, he has
gathered the data provided in Exhibits 1 and 2.
Exhibit 1
YLS Incorporated (in US$)
31 March 30 June 30 September 31 December
2009 EPS $(0.51) $(0.22) $(0.07) $(0.13)

2010 EPS $(0.07) 0.55 0.67 0.70

Exhibit 2
Swift Enterprises (in US$)
2005 2006 2007 2008 2009
EPS $1.23 $1.31 $1.40 $1.45 $1.52
BVPS $3.45 $3.77 $4.20 $4.90 $5.64
ROE 8.0% 9.7% 11.50% 22.76% 23.0%
As of 1st November, 2009, YLS’s stock price closed at $15.83/share. The company’s
fiscal year follows the calendar year. Swift Enterprises stock price on 31 January 2010
was $35.72.
Sullivan has always been a strong proponent of the use of price multiples in equity
buy/sell decision making. To value a large, multinational steel company, Sullivan had
estimated a regression for a similar group of sample stocks in the same industry around
two years ago. The regression determined the relationship between the P/E multiple and
other financial variables, and is given below.
Predicted P/E = 14.56 +(1.57 × Beta) + (0.89 × RR) + (13.33 × EGR) + (4.56 × MR)
where, RR is the retention rate, EGR is the five-year earnings growth rate and MR is the
market return. Since Sullivan had managed to earn abnormal returns for many clients
using this relationship, he is currently trying to determine the P/E for a similar steel
company using the regression. When talking to a colleague, Sullivan made the following
comments:
Statement 1: “Since the company has a beta of 1.50, a retention ratio of 60%, an
earnings growth rate of 12%, the predicted P/E for the company is 17.88,
given a market return of 9%. If the actual P/E falls below this level, the
stock is undervalued and should be bought.”
Statement 2: “For a company reporting a large number of non-recurring items, core EPS
may differ from reported EPS. However, generally, an analyst should not
rely on company-reported core earnings numbers in the estimation of a
trailing P/E multiple.”
Statement 3: “A stock’s forward P/E is calculated using forecasts of a firm’s EPS for the
following fiscal year, not current year forecasts.”
Lastly, Sullivan is estimating the P/E of the U.S. market as a whole. Exhibit 3 displays
the information essential for the assessment.

Exhibit 3
U.S. Market Information
Current earnings yield on the market index 13.0%
Forecasted earnings yield for the next 12 months on
11.0%
the market index
Five-year earnings growth rate forecast 9.0%
Current earnings growth rate 15.0%
A-rated corporate bond yield 6.20%
10-year Treasury bond yield 4.50%
AAA-rated corporate bond yield 5.30%
b 0.15
31. The per share value of TENT as of January 1 2009 is closest to:
A. $63.73.
B. $76.1585.
C. $77.91.
Correct Answer: B
Reference:
2008 2009 2010 2011

EPS 3.50 4.375 5.25 5.9325
FCInv 4.50 3.97 2.50
WCInc 2.7 2.38 1.5
Debt/share 3.24 2.8575 1.8
FCFE 0.415 1.7575 3.7325
PV(FCFE) 0.3705 1.401 2.657
Terminal value: 3.7325(1.08)/0.12-0.08 = $100.7775

Discounting 3 years back we have, $100.7775/(1.12)3 = $71.73
Total value: 0.3705+1.401+2.657+71.73= $76.1585

32. As of November 1st 2009, YLS Incorporated’s forward P/E based on a fiscal-year
definition and current fiscal year forecasted EPS is:
A. 28.43 less than YLS’s NTM P/E.

B. 2.86 less than YLS’s NTM P/E.
C. 13.41 less than YLS’s NTM P/E.
Correct Answer: A
Reference:
Annual estimate 2009: (0.51) + (0.22) + (0.07) +(0.13) =(0.93)

Annual estimate 2010: (0.07) + 0.55 + 0.67 + 0.70 = 1.85
NTM estimate: 2/12 × (0.93)+ 10/12(1.85) = 1.3867
Forward P/E: $15.83/$1.3867 = 11.42
Forward P/E based on current fiscal year forecast: 15.83/-0.93 = -17.02
11.42-(-17.02) = 28.43
33. Using the preferred method of estimation in valuation research, the normalized
earnings yield for Swift Enterprises is closest to:
A. 0.018.
B. 0.024.
C. 0.039.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS e & f
The preferred method of estimation is the method of average ROE. Hence:

Average ROE (over five years): 14.992%
Normalized EPS based on current BVPS: 5.64 (0.14992) = 0.8455
Earnings yield: E/P = 0.8455/35.72 = 0.0236

34. Is Sullivan’s analysis of the steel company as given in statement 1 most likely
correct?
A. No.
B. Yes, only if the predicted P/E estimate equals 18.90.
C. Yes, only if the predicted P/E estimate equals 19.46.
Correct Answer: A
Reference:
The estimation is incorrect. This is because the regression coefficients and

explanatory power of regressions change substantially over a couple of years.
Since the regression was estimated 2 years ago, the relationships may have
changed. Basing the buy/sell decisions on such a regression will most likely be
incorrect.
35. Sullivan is most accurate with respect to:
C. both statements 2 and 3.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, Section 3.1.2 & LOS d
Statement 2 is correct. Analysts should always carefully examine the calculations

of core EPS reported by companies because of differing bases of calculation.
Hence, analysts should not rely on company-reported numbers and should
perform such calculations themselves.
Statement 3 is incorrect. Forward P/E can also be calculated using current fiscal
year forecasts.

36. According to the Fed model and the Yardeni model, the fair value of the market
P/E is closest to:
A. 22.22 and 20.62 respectively.

B. 15.38 and 32.79 respectively.
C. 11.76 and 31.75 respectively.
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, Section 3.1.5.3
Fed Model: 1/ 0.0450 = 22.222

Yardeni Model: 1/ (0.0620 – 0.15(0.09))= 20.62 [using A-rated corporate bond
yield and 5 year earnings growth rate forecast]

Questions 37 through 42 relate to Alternative Investments
Donna Schmidt Case Scenario
Donna Schmidt is a renowned financial consultant offering a wide range of services to

multinational corporations and investment banks. Schmidt has been working as an
independent advisor to several firms and has assisted them in investment decision
making. Given her experience, Spectacle Associates (SPAS), an investment bank, has
hired Schmidt to manage two of SPAS’s largest real estate investment portfolios. Kevin
Manos, SPAS’s CFO, arranged for a meeting with Schmidt before she handled the
accounts. During the meeting, Manos inquired about Schmidt’s methodologies for
estimating real estate values. Schmidt made the following comments:
Comment 1: “The direct capitalization method is very similar to the discounted cash
flow method. Both methods base their calculations on an estimate of
operating income and a discount rate.”
Comment 2: “In evaluating a property we might want to rely on the prices of

comparable properties. For example, if a property has been let at a net
operating income of $550,000 for the first year, and comparables have an
average price of $12,000,000, the cap rate applicable to the property will be
4.58% and it would take almost 22 years for income at the current level to
return the original price.”
After the meeting, Schmidt proceeded with the evaluation of two properties: a
commercial property and a fully let residential property. Schmidt accumulated data on the
commercial property needed to perform her calculations. Exhibit 1 displays this
information.
Exhibit 1
Commercial Property
NOI/ year for the next seven years $500,000
NOI in year 8 $650,000
Growth rate of NOI after year 8 3.00%
Growth rate of property value after year 8 3.00%
Discount rate 15.00%

Schmidt then assessed the reversionary potential of a fully let U.S. residential property.
The property was let for a five-year term two years ago. The property’s rent is subject to
review every five years. The current rent equals $300,000. Schmidt believes that a 4.5%
is appropriate for the term rent. The all risks yield on comparable fully let properties is
5.5%. The property is currently valued at $10,000,000.
Schmidt decided to discuss his estimations with Manos. Manos stated that the residential
property could be valued using the layer method. He, however, disagreed with the rates
Schmidt had used. Manos believed that a rate of 6.0% for the contract rent and 7.5% for
the incremental rent would be more appropriate given market conditions and financial
convention. When he showed his calculations to Schmidt, she made the following
comments:
Statement 1: “The method that I used is very similar to the method based on a terminal
value estimate. Hence, given similar assumptions, the two methods would
yield very similar results.”
Statement 2: “In the layer method, the additional income expected after a rent review
should be capitalized at a lower rate. This is because income could increase
even more after subsequent reviews, and a higher growth rate results in a
lower cap rate. Since future rents are higher than current rents, a lower cap
rate for the former is more appropriate.”
Manos then asked Schmidt about the effect of the holding period assumption on the value
of a real estate property. Schmidt made the following comments to answer:
Statement 3: “An increase in the holding period assumption would decrease the estimate
of the value of the property using the layer method relative to the estimate
generated by the term and reversion approach.”
Statement 4: “Having a holding period that goes beyond when existing leases expire can
make it easier to estimate the resale price at the end of the holding period.”
Manos thanked Schmidt for her time as she continued with further assignments.

37. Schmidt is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. Both comments 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS e &h
Comment 1 is incorrect. The direct capitalization method differs from the DCF
method, in which future operating income is discounted at a discount (total return)
rate to produce a present value. On the other hand, a capitalization approach
capitalizes current NOI at the cap rate. This approach is similar to an income
multiplier approach.
Comment 2 is correct. The cap rate equals the NOI divided by the sales price of a
comparable. Also, the reciprocal of the cap rate is called the ‘years purchase’. It
tells us the number of years that it would take for income at the current level to be
equal to the original purchase price.
38. Using the information provided in Exhibit 1, the going-in cap rate is closest to:
A. 12.00%.
B. 12.15%.
C. 12.33%.
Correct Answer: B
Reference:
Residual or terminal cap rate: 15-3 = 12.0%

Resale: 650,000/0.12 = $5,416,666.7
Discount the NOI for the first seven years and the resale price:
PV: $4,116,535.5
The implied going-in cap rate is $500,000/$4,116,535.5 = 12.15%

39. With regards to the fully let property, the current value of the property implies an
estimated rental value that is:
A. $292,572 more than the term rent.

B. $204,642 more than the term rent.
C. $100,000 more than the term rent.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS g
PV of the term rent for three years @ 4.5% = $824,689.31

PV of reversion: 10,000,000-824,689.31 = $9,175,310.69
FV of reversion after 3 years @5.5% = $10,774,029.44
ERV: 10,774,029.44(0.55) = $592,572
This is $292,572 more than the current term rent of $300,000.
40. Given his preferred method of estimation and assuming an ERV of $400,000,
Manos’s estimate of the value of the fully let property would be closest to:
A. $6,073,281.
B. $6,399,365.
C. $9,293,123.
Correct Answer: A
Reference:
Term rent: 300,000/0.06 = $5,000,000

400,000-300,000 = 100,000
PV of increase in perpetuity: $100,000/0.075 = $1,333,333.33
PV of the above at 7.5% for 3 years: $1,073,280.759
Adding the term rent and PV we have: 5,000,000+1,073,280.759 = $6,073,281

41. Schmidt is most accurate with respect to:
B. both statements 1 and 2.
C. neither statement 1 nor statement 2.
Correct Answer: A
Reference:
Statement 1 is correct. A term and reversion valuation estimate is very similar to a

terminal value based estimation. The terminal value is based on the resale value of
the property in the future, which is the same as the reversion value.
Statement 2 is incorrect. The additional income expected after a rent review is

often capitalized at a higher rate than the all risks yield because it is regarded as
more risky even though it could increase even more after subsequent rent reviews.
42. Schmidt is least accurate with respect to:
C. neither statement 3 nor statement 4.
Correct Answer: A
Reference:
Statement 3 is incorrect. The holding period would not matter because the resale
price represents the present value of income beyond the holding period. The
choice of holding period is more a matter of convenience and about how far into
the future cash flows can be estimated.
Statement 4 is correct. If the holding period goes beyond when existing leases
expire, all leases will be at market rents and have normal rent growth thereafter.
This will make it easier to estimate the resale price.

Questions 43 through 48 relate to Fixed Income
Rax Associates Case Scenario
Rax Associates is a firm providing fixed income valuation services to credit rating
agencies and portfolio management firms. Senior analyst Ingram Yates is examining the
valuation of bonds using spot rates and forward rates as well as the relationship between
the two rates and expected rates of return.
Yates’ first task involves using the bootstrapping process to extrapolate spot rates. These
rates are then used to derive forward rates. Yates collects the rates derived in an exhibit
(Exhibit). The spot rates are then used to arrive at the price of a five-year annual coupon
bond with a coupon rate of 12%.
Exhibit: Forward and Spot Rates and Bond Price

r(1) 2.00%
r(2) 4.00%
r(3) 5.00%
r(4) 7.00%
r(5) 8.00%
f(1,1) 6.04%
f(2,1) 7.03%
f(3,1) 13.23%
f(4,1) 12.09%
Bond price 118.605
per 100 par
Based on the data in the exhibit, Yates arrives at the following conclusions:
Conclusion 1: If forward rates are assumed to be the future spot rates, expected
annualized rate of return should equal the yield-to-maturity (YTM).
Conclusion 2: The five-year YTM will be:

I. lower than the five-year spot rate and
II. closer to the five-year spot rate relative to the four-year spot rate.
Next, Yates explores how the forward curve can be used by traders to earn arbitrage
profits. He uses the data in Exhibit 1 and the assumption in Conclusion 1 to analyze a
forward contract to purchase a two-year zero-coupon bond two years from today. He
arrives at the following conclusion:

Conclusion 3: A trader should expect the bond to generate an identical one-year holding
period return each year over its term to maturity.
Yates summarizes the results of his analysis into a report. His report also features a
discussion on the evolution of spot rates as captured by modern term structure models.
The following statements are included in the report:
Statement 1: The Ho-Lee model is reliable for valuing bonds with embedded options as
parameters are allowed to vary deterministically with time.
Statement 2: Equilibrium models allow for the construction of the yield curve based on
an assumption of the evolution of short-term rates and constant interest rate
volatility.
Yates concludes his research report by discussing why the swap curve is popular amongst
market participants for valuing fixed-income securities relative to the government bond
yield curve.
43. Conclusion 1 is most likely:
A. accurately stated.
B. inaccurately stated; the yield-to-maturity will be relatively lower.
C. inaccurately stated; the yield-to-maturity will be relatively higher.
Correct Answer: B
Reference:

Conclusion 1 is inaccurately stated as the annualized expected rate of return will

be greater than yield-to-maturity (8.07% vs. 7.41% respectively.)
If forward rates are expected to equal future spot rate the (annualized) expected
rate of return would equal 8.07%
Expected rate of return (unannualized):

12(1 + 0.0604)(1+ 0.0703)(1 + 0.1323)(1 + 0.1209) + 12(1+ 0.0703)(1 +
0.1323)(1 + 0.1209) + 12(1 + 0.1323)(1 + 0.1209) + 12(1 + 0.1209) + 112 =
174.268
(174.268 – 118.605)/118.605 = 0.4740
Annualized rate of return:
Solve for ‘x’ in (1 + x)5 = 1+ 0.4740; x = 8.07%
Yield-to-maturity (I/Y) is calculated with the aid of the financial calculator:

N = 5; PV = - 118.605; PMT = 12; FV = 100
I/Y = 7.41%
44. Conclusion 2 is most accurate with respect to the comparison of the five-year
YTM and component:
A. I only.
B. II only.
C. both I and II.
Correct Answer: C
Reference:
Conclusion 2 is accurate with respect to the comparison of the five-year YTM

with components I and II. The YTM represents a weighted average of spot rates
used in the valuation of a bond. Given that the yield curve is upward sloping (as
represented by increasing spot rates with maturity) the five-year YTM will be
lower than the five-year spot rate but greater than the four-year spot rate. In
addition, the YTM will be closer in value to the five-year spot rate relative to the
four-year spot rate as the largest cash flow occurs in year 5 thereby giving r(5) a
greater weight than r(4) when determining y(5).

45. The ‘one-year holding period return’ referred to in Conclusion 3 is equal to:
A. 2.00%.
B. 4.00%.
C. 7.00%.
Correct Answer: A
Reference:
If the future spot rates equal to current forward rates, the one-year holding period
return on the three-year zero-coupon bond should always equal to the one-year
rate regardless of maturity. This is proved below.
A one-year zero-coupon bond which matures at par can be purchased at a price of

98.04 (100/1.02). The one-year holding period return, r(1), is equal to 2.00% -
see below:
100 100
100 ÷ − 1 = 100 ÷ − 1 = 2%
1 + r (1) 1 + 2%
A two–year zero coupon bond which matures at par can be purchased at a price of
92.46 (100/1.042) today. The one-year holding period return, r(1), is equal to
2.00% - see below:
⎛ 100 100 ⎞ 100 100

⎜ ÷ ⎟ − 1 = ÷ − 1 = 2%
⎜ 1 + f (1,1) [1 + r (2)] ⎟
2
1.0604 1.04 2
⎝ ⎠
46. Statement 1 is most likely:
A. correct.
B. incorrect; the Ho-Lee model includes a finite number of parameters.
C. incorrect; the Vasicek model generates the most accurate value for bonds
with embedded options.
Correct Answer: A

Reference:
Statement 1 is most likely correct. Unlike the other Cox-Ingersoll-Ross model and
Vasicek model which include a finite number of parameters, the Ho-Lee model
allows parameters to vary deterministically with time. As a result, the market
yield curve can be modeled with the accuracy needed to value derivatives and
bonds with embedded options, which are significantly affected by interest rate
volatility.
47. Which of the following is most likely being referred to in Statement 2?
A. Ho-Lee model
B. Vasicek model
C. Cox-Ingersoll-Ross model (CIR)
Correct Answer: B
Reference:
Statement 2 is referring to the Vasicek model. This model incorporates a single

parameter, the short-term rate, to estimate the yield curve. Unlike the CIR model,
which assumes that volatility increases with time, the Vasicek model assumes
volatility remains constant over the period of analysis.
48. Which of the following factors most likely contributes to the popularity of the
swap curve relative to the government bond yield curve as a valuation tool?
A. Higher degree of market regulation

B. Generates a yield curve with greater maturity points
C. Reflects the default risk of private borrowers rated below investment grade
Correct Answer: B
Reference:

Unlike the government bond market, the swap market has more maturities with
which to construct a yield curve.
A is incorrect. Unlike government bond markets, which are highly regulated,

swap markets are unregulated.
C is incorrect. The swap curve reflects the default risk of private entities at a
rating of about A1/A+, which represents investment grade.

Questions 49 through 54 relate to Derivatives
Carla Von Case Scenario
Express Advisors (EXA), a funds management firm in the U.S., just hired Carla Von as
their new chief investment officer (CIO). As her first assignment, Von had to manage
EXA’s Derivatives Fund, a fund that had experienced considerable negative returns for
the past few years. During her initial performance review of the fund, Von identified a
number of inaccurate investment criteria leading to suboptimal funds allocation.
Consequently, Von decided to hold an educational seminar on derivatives and their
structure to equip the portfolio management team with the necessary know-how. During
the seminar, Von made the following comments:
Comment 1: “The parties that engage in swaps are generally of good credit quality but
the risk of default is still a major concern. To manage this risk, the swap
rate is set at a spread above the default-free rate. This swap spread
represents the credit risk inherent in a given swap and hence, rises with a
rise in credit risk.”
Comment 2: “When the swap spread increases, fixed-rate payers on swaps end up
paying more. The additional cost to them is much more apparent up front
than the additional cost to floating-rate payers.”
As the seminar continued, Von explained the pricing of put and call options. While doing
so, she made the following comments:
Statement 1: “Delta is an important risk measure of an option. However, a number of

factors can cause the delta to change. For an in-the-money put option, delta
would decrease toward -1.0 as the underlying price moves down, and even
if the underlying price does not move, delta would still move toward -1.0 as
the option moves toward expiration.”
Statement 2: “The relationship between the option price and the underlying price,
measured by delta, is not perfectly linear. Hence, delta measures the
curvature in this relationship and can be compared to convexity, the
relationship between a bond’s duration and yield.”
Before opening the question and answer session, Von concluded her lecture by clarifying
the effect that an option’s time to expiration had on its price, as explained by the Black-
Scholes-Merton model. She stated the following fact:

“Both European and American options will see their prices change as expiration
approaches. However, European options are much more sensitive to theta than American
options.”
After listening to Von state this fact, Roger Brown, a portfolio manager at EXA, posed
the following question:
“Isn’t it true that for some European puts, option prices are higher the shorter the time to
expiration, resulting in positive thetas?”
Brown was particularly interested in the pricing of options on forward and futures
contracts. After the seminar, Brown approached Von to discuss in detail the put-call
forward parity and the ability to generate risk-free profits using a combination of options.
Von stated that a synthetic forward contract could be created by going long a call, short a
put, and either long or short a risk-free bond. Brown was still confused, and asked how an
option could be created from a forward contract. Von stated that a long call could be
created by combining an option position and a bond position with a long forward,
whereas a long put combined these positions with a short forward. Brown then presented
Von with details of a forward contract, a call and a put, and requested her to determine
whether the forward contract was correctly priced. Exhibit 1 displays this information.
Exhibit 1
Exercise price of options $115.50
Call option price $8.75
Put option price $14.50
Forward price $105.50
Time to expiration of options and

90 days
the forward contract
Risk-free rate 5.00%
After reviewing Von’s analysis, Brown asked if a similar analysis was true for American
options on forward and futures contracts. Von responded with the following comment:
Statement 3: “Just like American call options on underlying assets that make no cash
payments are the same as their equivalent European options, an American call on a
forward is the same as a European call on a forward.”
To end with, Brown posed the following question:

“How are the put-call parity for options and put-call parity for options on forwards
related?”
Brown and EXA’s portfolio management team found Von’s seminar particularly helpful
and looked forward to working under her management.
49. Von is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. Both comments 1 and 2.
Correct Answer: B
Reference:
Comment 1 is incorrect. The swap spread is not a measure of the credit risk on a
given swap but rather a reflection of the general level of credit risk in the global
market.
Comment 2 is correct. If the swap spread increases, for a fixed rate payer, the
increase will be apparent in all future payments. For a floating rate payer, only the
next payment will be affected.
50. Von is most accurate with respect to:
C. Both statements 1 and 2.
Correct Answer: A
Reference:
Statement 1 is correct. An in-the-money put will move towards -1.0 if the

underlying price moves down or the put moves toward expiration.

Statement 2 is incorrect. Delta measures the first-order relationship and is similar

to duration, not convexity. it does not account for the curvature of the line.
51. Is Von most likely correct with respect to the fact about thetas, and what is the
best response to Brown’s question?
A. Yes, and positive put thetas would only occur when a put is deep in-the-
money, the volatility, interest rate and time to expiration are low.
B. Yes, and positive thetas would only occur when a put is deep in-the-
money, the volatility and time to expiration are low, but the interest rate is
high.
C. No, and positive thetas would only occur when a put is deep in-the money,
the time to expiration and interest rate are low, but the volatility is high.
Correct Answer: B
Reference:
Von is correct. American options have both an intrinsic value and a time value.
For European options, all of the price can be viewed as time value, and hence,
they are more sensitive to theta.
Positive put thetas tend to occur when the put is deep in the money, the volatility
and time to expiration are low and the interest rate is high.
52. With respect to her comments about creating synthetic forward and option
positions, Von is least accurate with respect to the:
A. synthetic forward only.

B. Long call and long put only.
C. Neither the synthetic forward nor the options.
Correct Answer: C
Reference:

Von is correct. A synthetic forward contract consists of a long call, a short put and
a long or short risk-free bond depending on whether the exercise price of the
options is lower or higher than the forward price. Also, a long call is a long
forward, long put and a zero-coupon bond, whereas a long put is a long call, short
forward and a zero-coupon bond.
53. Based on the information provided in Exhibit 1 and using put-call forward parity,
is the forward contract correctly priced?
A. Yes.
B. No, the forward contract is underpriced.
C. No, the forward contract is overpriced.
Correct Answer: B
Reference:
Synthetic forward contract: 8.75-14.50 + [115.50-105.50/(1.05)0.246575]= 4.1304

Hence, the synthetic forward contract is overpriced and the actual forward
contract is underpriced.
54. Is Von’s comment contrasting American and European options most likely
correct, and what is the best response to Brown’s question concerning put-call
parities?
A. No, and the parities are the same with the only difference being the
replacement of the underlying with the forward contract.
B. Yes, and the parities are the same with the only difference being the
replacement of the underlying with the forward contract and a zero-
coupon bond.
C. Yes, and the parities are different because put-call parity for options on
forwards is much more complex than the simple put-call parity for options
on the underlying.
Correct Answer: B

Reference:
Von is correct. For a forward contract, no justification exists for exercising early,
so an American call on a forward is the same as a European call on a forward.
Put-call parity for both is similar. The only difference is that in put-call parity for
options on forwards, the forward contract and the bond replace the underlying.

Questions 55 through 60 relate to Portfolio Management
Daniel Walsh Case Scenario
Daniel Walsh, CFA, is an equity performance analyst at Terra Jones, a portfolio

management firm. Walsh is in the process of evaluating the performance of two senior
equity portfolio managers, Carla Jefferson and Emanuel Bauch. Both Jefferson and
Bauch follow active management mandates. Jefferson makes active bets with respect to
macroeconomic markets while Bauch makes active bets with respect to the attributes of
stock issuers.
In his performance evaluation of the two managers’ performances, Walsh aims to:
I. employ the arbitrage pricing theory (APT) to derive models suitable for
measuring expected portfolio returns and
II. evaluate the sources of active portfolio risk.
To achieve his first task, Walsh lists down the assumptions he intends to use for
constructing the models.
Assumption 1: The number of factors is specified in advance.
Assumption 2: Any resulting portfolios formed eliminate asset-specific risk.
Assumption 3: Financial markets are assumed to be in disequilibrium.
Walsh proceeds to evaluate a one-stock portfolio being managed by Jefferson. The

portfolio is owned by Sylvia Peterson, a client of Terra Jones’, while the stock is issued
by Green Corp. For the analysis of the portfolio, Walsh collects actual and predicted
values with respect to the three factors which Jefferson has placed active bets on - GDP
growth, changes in the inflation rate, and changes in interest rates. Also included in the
data collected is his estimate of factor sensitivities. The portion of the portfolio return
unexplained by the model is 2%. At the start of the period, Jefferson expected that the
portfolio would generate a return of 7% if there was no surprise in expected return.

Exhibit 1
Actual and Predicted Factor Values and Factor Sensitivities
Actual Values Predicted Factor
Values Sensitivity
GDP growth 1.5 0.8 0.9
Change in interest rates 1.9 1.4 0.7
Change in inflation rate 0.8 1.5 - 1.5
Bauch has generated an average active return of 4% on the portfolios he has managed.
This return was generated by taking active bets on factors relating to attributes of those
issuers whose stocks are held in the managed portfolios. The factors include dividend
yields, earnings growth and earnings variability. Walsh conducts a return attribution
analysis to analyze the sources of active return. The results of the analysis are presented
in the exhibit below:
Exhibit 2
Return Attribution Analysis Results
Factor Sensitivity
Factor Portfolio Benchmark Factor Return (%)
Earnings growth 0.85 1.00 4.50
Earnings variability 0.70 0.60 -3.15
Dividend yield - 1.08 0.95 -2.85
Walsh holds a meeting with the two managers to discuss the results of the performance
evaluation. During the meeting, Bauch asks Walsh how his initial assumptions differ
from those underlying CAPM.
Walsh concludes the meeting by sharing the results of the risk decomposition he has
performed for both managers (Exhibit 3).
Exhibit 3
Results of the Risk Decomposition
Active factor Active specific
Manager risk (%) risk (%)
Bauch 38.50 12.78
Jefferson 35.80 14.55

55. Which of the assumptions identified by Walsh most likely underlies the (APT)?
A. Assumption 1
B. Assumption 2
C. Assumption 3
Correct Answer: B
Reference:
Assumption 2 is one of the assumptions underlying APT. The theory assumes that
there are many assets available to investors for forming portfolios. Therefore,
investors can form well-diversified portfolios which eliminate asset-specific risk.
Assumption 1 is not one of the assumptions underlying APT as the theory does
not indicate the identity or number of risk factors.
Assumption 3 is invalid; this is because APT assumes that financial markets are in
equilibrium.
56. Using the data in Exhibit 1, the return of the portfolio is closest to:
A. 6.97%.
B. 9.03%.
C. 11.03%.
Correct Answer: C
Reference:
Portfolio return = 7% + 0.9(1.5% - 0.8%) + 0.7(1.9% – 1.4%) + - 1.5(0.8 – 1.5) +

2% = 11.03%

57. The multifactor model Walsh has employed to conduct return attribution analysis
(Exhibit 2) is most likely the:
A. statistical factor model.

B. macroeconomic model.
C. fundamental factor model.
Correct Answer: C
Reference:
The fundamental factor model is most preferred when decomposing the sources of
return. Walsh’s choice of model is also evident from the factors he is using;
fundamental factor models employ attributes of stocks or issuers of stock when
decomposing the sources of return.
A is incorrect. In contrast to statistical factor models, fundamental factor models

allow the sources of portfolio performance to be described using commonly
understood terms.
B is incorrect. In contrast to macroeconomic factor models, fundamental factor

models express investment style choices and security characteristics more directly
and often in greater detail.
58. Using the data in Exhibit 2 and the information provided on the return attribution
analysis, Walsh will conclude that:
A. Bauch is not a stock-picker.

B. the dominant source of active return was a positive exposure to the
earnings growth factor.
C. the dominant source of active return was a positive exposure to the
earnings variability factor.
Correct Answer: A
Reference:

Return from factor tilts = (0.85 – 1.00)(4.50%) + (0.70 – 0.60)(- 3.15%) + (- 1.08
– 0.95)(- 2.85%) = 4.7955%
A is correct. Given an active portfolio return of 4%, the security selection return is
negative (4.0000% - 4.7955% = - 0.7955%) indicating that the Bauch is not a
stock picker.
B is incorrect. The contribution of each factor to total active return is calculated

below.
Based on the proportions calculated, the dominant source of active return was due
to his negative exposure to the dividend yield factor.
C is incorrect. See above.
Proportion of earnings growth to total active return = (0.85 – 1.00)(4.50%)/4.00%

= - 0.16875 or –16.875%
Proportion of earnings variability to total active return = (0.70 – 0.60)(-

3.15%)/4.00% = - 0.07875 or – 7.875%
Proportion of dividend yield to total active return = (- 1.08 – 0.95)(-

2.85%)/4.00% = 1.146375 or 114.638%
59. The most appropriate response to Bauch is that the CAPM:
A. assumes that market risk is the only priced risk.

B. assumes that arbitrage opportunities exist in financial markets.
C. uses the return of a portfolio with a beta of 1 to the market index as the
intercept term.
Correct Answer: A
Reference:

A is correct. According to CAPM, differences in mean return are solely explained

by a single factor, the market portfolio return. Greater risk with respect to the
market factor is represented by a higher beta which is associated with a higher
return. According to the theory, investors will only be expected to be
compensated for bearing risk which cannot be diversified away – systematic risk.
Therefore, this risk is the only priced risk.
B is incorrect. CAPM has developed a model for the expected return on assets in
equilibrium based on a mean-variance foundation. The theory assumes financial
markets are in equilibrium.
C is incorrect. Based on the equation for CAPM, the risk-free rate is used as the
intercept.
60. Based on the data provided, which of the following conclusions regarding the
relative risk exposures of the two portfolio managers is most likely valid?
A. Bauch has assumed more nonsystematic risk.

B. Jefferson has assumed more nonsystematic risk.
C. Bauch has assumed less risk by tilting the portfolio away from the
benchmark.
Correct Answer: B
Reference:

Since both managers have different total active factor risk, the proportion of each
component of active risk, active factor risk and active specific risk, to active risk
squared should be calculated.
Proportion of Proportion of Active

Active Risk Active Factor Risk Specific Risk (%)
Squared (%)
Bauch 51.28 75.08 24.92
Jefferson 50.35 71.10 29.90
Based on the calculations, Jefferson has assumed greater nonsystematic risk

relative to Bauch as indicated by the proportion of active specific risk. On the
other hand, Bauch has assumed more risk by tilting the portfolio away from the
benchmark as measured by the proportion of active factor risk.

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FinQuiz.com – 4th Mock Exam 2016 (PM Session)

Questions Topic Minutes

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Questions 1through6 relate to Ethical and Professional Standards

Mike Walsh Case Scenario

Walsh continued with the following comment:

Comment 2: “Recently, I prepared a research report on Capital Chemicals (CACH).

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Policy 2: HIAF allows research analysts to participate in marketing activities, including

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Comment 1 is in violation. Covered employees have a responsibility to ensure

Comment 2 is in violation. When making a recommendation, analysts and firms

Policy 1 is in compliance. As long as the communications are documented and

Policy 2 is in compliance. Firms may permit research analysts to participate in

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HIAF is in compliance. Restrictions on purchases or sales of securities need not

4. With regards to SinTock Enterprises (STE), is Taylor most likely in compliance

Firms should not quietly discontinue coverage of a subject company. Taylor is

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Publication of the research objectivity policy is a recommendation not a

6. With respect to disclosure requirements, is Palmer’s advice regarding the research

Palmer’s advice is in compliance. A page reference to the disclosure to all

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Questions 7 through 12 relate to Economics

Sean Looper Case Scenario

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1. An increase in business investment.

7. Jackson is most accurate with respect to:

8. Assuming everything else remains constant, the best response to Looper’s

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A. Increase the policy rate by 0.875%.

Policy rate: 2.50%+1.50% +0.5(1.50%-2.50%)+0.5(1.75%) = 4.375%

A. Mundell-Fleming model, and Jackson is a proponent of the portfolio

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The Mundell-Fleming model supports the notion that an expansionary fiscal

11. Is Jackson’s recommendation about Looper’s Russian investment most likely

A. Yes, and the estimate is closest to 4.0%.

Nominal GDP will grow at 3.75%+4.25%= 8.0%. Equity market appreciation

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An increase in business investment results in capital deepening. Since the country

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Questions 13 through 18 relate to Financial Reporting and Analysis

C-Tech and Ex-PURT Case Scenario

Kenneth Graham is an economic analyst at CandleWick Investments (CAWIN), a U.S.

Observation 1: “C-Tech engaged in a number of foreign currency transactions and its

Observation 2: “While reviewing the statements, I noticed that C-Tech engages in a

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translation methods on Ex-PURT’s financial performance, Cole made the following

“The financial performance of Ex-PURT would vary significantly depending on which

Graham then presented a fact leading to a question:

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13. Cole is most accurate with respect to:

Observation 2 is incorrect. Since C-Tech reports transaction gains and losses as

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Ex-PURT’s financial statements are in accordance with reporting standards only

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A. Multinational operation’s increased Ex-PURT’s effective tax rate by

Multinational operations increased Ex-PURT’s taxes by 75/2,120 = 3.54% in

A. reported fictitious revenues.

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