CFA Level II Mock Exam 4 - Solutions (AM)

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

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

Questions 1 through 6 relate to Ethical and Professional Standards
Walnut Brothers Case Scenario
Walnut Brothers (WAB) is an equity management firm in Alabama, USA. WAB has
been famous for the quality of the services it offers, and has hence received a very high
ranking amongst competitors. Tom Hamilton, an independent financial consultant, was
intrigued by WAB’s success and desired to learn the key to its success. Accordingly,
Hamilton contacted Laura Snow, WAB’s chief investment officer, for a tour of the firm
and an insight into its practices. During his initial conversation with Snow, Hamilton
determined that some of the research reports produced by WAB were compensated
indirectly as stock warrants of the subject companies offered to the analysts who wrote
the report. In addition, WAB’s employees often accepted paid travel arrangements,
including chartered flights, from the companies they covered. However, these
arrangements were accepted only when commercial transportation to the specific areas
was unavailable.
While touring, Hamilton met Jackie Lee, a portfolio manager at WAB. Lee followed the
five largest firms in the telecommunications sector of the U.S. market. Consequently, he
was evaluating the investment prospects of AXO Tech Ltd, a telecom firm, to prepare a
research report for distribution to WAB’s clients. Upon request, Lee allowed Hamilton to
review the report, since it only contained factual information and no recommendation as
yet. When Hamilton reviewed the report, he determined that Lee had cited specific
quotations of some analysts and had referenced them as ‘by a leading analyst’ and ‘by an
investment expert’. In addition, for comparison purposes, Lee had included the statistical
estimates of other analysts in an exhibit form, mentioning just the numbers. He properly
cited those analysts in his report.
Apart from the above report, Lee was also reviewing the financial statements of Total
Enterprises (TEN). In his efforts to determine a valuation estimate for the firm, Lee used
a statistical model that related a stock’s price to a number of fundamental factors. The
model was developed by Jonathan Gray, a research analyst that worked with WAB
around three years ago. Gray had expended considerable hours in designing the model,
and had used his expertise to make it statistically correct. Lee used the model in his
report, but did not cite Gray’s name since he no longer worked for the firm. In addition,
he also used considerable portions of unedited information from a research report
prepared by another analyst at the firm. He released the report under his name.

After meeting Lee, Hamilton came across Anthony Ford, one of WAB’s leading financial
analyst. With his skill and expertise, Ford had contributed a great deal to WAB’s success
and had also managed to gain considerable respect in the global financial circle. Many
investors and institutional clients followed his research, and the investing public kept on a
watchful eye on his new releases. Consequently, the information provided by him had a
significant effect on the market, and on the prices of the concerned securities. While
talking to Ford, Hamilton discovered that he had recently altered his recommendation on
the stock of HT Enterprises. He, however, only distributed his changed recommendation
to his personal clients and no one else.
Hamilton visited the in-house trading department of WAB to evaluate their trading
policies and procedures. When he asked Snow about them, she answered with the
following comment:
“When WAB is in possession of material nonpublic information, it ensures the following

policies are strictly followed:
1. A prohibition on all types of risk-arbitrage trading.
2. Market-making activities are allowed, however, market makers are allowed only
to take the contra side of unsolicited customer trades.”
Continuing with his tour of the department, Hamilton met Pebble Toss, an investment
advisor at WAB. Toss had entered into an agreement with one of her brokers, Vault
Company, whereby Vault would send new client accounts to her in exchange for trading
those accounts exclusively through Vault. In her own time, Toss had carefully studied the
execution polices and prices of a number of Vault’s competitors, and had arrived to the
conclusion that Vault offered the best price and execution. So, in addition to the clients
that explicitly stated that their trades be handled through Vault, Toss also directed
transactions of other clients to Vault. In doing so, she disclosed this arrangement to the
clients. Hamilton was not sure of this policy. He carefully studied one of Vault’s
competitors, the Pinnacle Exchange (PINE). PINE was planning to launch a new futures
contract, and in order to convince hedgers and arbitrageurs to use the contract, PINE
entered into an agreement with the members to commit to a certain level of trading
volume in exchange for reduced commissions. PINE believed that this practice would
help large institutions, as well as the individual investors.

1. With regards to WAB’s compensation policy and travel funding, is the firm most
likely in compliance with the CFA Institute Standards of Professional Conduct?
A. Yes.
B. Only with respect to compensation.
C. Only with respect to travel funding.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a.
Compensation that can influence the research report can be direct, such as
payment based on the conclusions of the report, or indirect, such as stock
warrants. Best practice is for analysts to negotiate a flat fee prior to writing the
report.
WAB is not in violation of the standards with regards to travel funding. Whenever
commercial transportation is unavailable, members and candidates can accept
modestly arranged travel to participate in information gathering events.
2. With regards to the report on AXO Tech Ltd, has Lee most likely violated the
CFA Institute Standards of Professional Conduct?
A. Yes.
B. Only with respect to the specific quotations.
C. Only with respect to the statistical estimates.
Correct Answer: A
Reference:
Lee has violated the Standards. Misrepresentation through plagiarism can take
various forms. Citing specific quotations as attributable to ‘leading analysts’ and
‘investment experts’ without naming the specific references is one of them.
Another one is presenting statistical estimates of forecasts prepared by others
without including the qualifying statements or caveats that may have been used.

3. With regards to his report on Total Enterprises, has Lee most likely violated the
CFA Institute Standards of Professional Conduct?
A. Yes.
B. Only with respect to the statistical models used.
C. Only with respect to the portions of research report used.
Correct Answer: C
Reference:
The models developed by an analyst while being employed by a firm are the
property of the firm. The firm may issue future reports using those models
without providing attribution to the prior analysts. However, a member or
candidate cannot reissue exact part of a research report under his or her name.
4. With regards to his changed recommendation, has Ford most likely violated
Standard II-A, Material Nonpublic Information, of the CFA Institute Standards of
Professional Conduct?
A. No.
B. No, only if Ford makes the information public before it is distributed to his
clients.
C. No, only if Ford disseminates the information to his clients and the public
at the same time.
Correct Answer: A
Reference:
Ford has not violated the standards. Even though the general public may find
Ford’s conclusions material, he is not required to make his work public. Ford is
creating the report based on information made available to the public and by using
his expertise. Anyone who wants to gain access to that expertise can become his
client.

5. Are WAB’s trading policies most likely in compliance with Standard II-A,
Material Nonpublic Information, of the CFA Institute Standards of Professional
Conduct?
A. Yes.
B. Only with respect to risk-arbitrage.
C. Only with respect to market making.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS b.
When in possession of material nonpublic information, firms should allow market

makers to remain passive to the market, and not to prohibit all proprietary trading.
However, when it comes to risk-arbitrage trading, the case of trading prohibition
is more compelling because the potential for illegal profit making is greater.
6. Which of the following acts is most likely in violation of Standard II-B, Market
Manipulation, of the CFA Institute Standards of Professional Conduct?
A. The brokerage arrangement by Pebble Toss.

B. The strategy by PINE.
C. Both the brokerage arrangement by Pebble Toss and the strategy by PINE.
Correct Answer: B
Reference:
Since Toss ensures that best price and execution is received, such an arrangement
is allowed. Also, she discloses the arrangement to her clients. Hence, she is not in
violation of the Standards.
PINE is in violation of the Standards. This is because PINE is intentionally

misleading investors to believe they chose the most liquid instrument who may
see the liquidity of the contract reduced after the term of the agreement expires.

Questions 7 through 12 relate to Quantitative Methods
Brittany Ruiz Case Scenario
Brittany Ruiz is the chief investment officer (CIO) at Black-Mount Capital Advisory
Firm (BMCA), a leading U.S. based money management firm. Last year, BMCA
launched the BMCA Equity Fund that invested in stocks of domestic and international
markets including those of Russia, Brazil, Canada and U.K. During the fund’s annual
performance review, Ruiz discovered that the fund earned a return considerably less than
that of its benchmark. Concerned with the outcome, Ruiz called a meeting with the fund’s
portfolio management team to discuss key issues related to quantitative analysis of the
fund’s investments. Anthony Webb, a leading quantitative expert was invited to chair the
meeting. While analyzing the regression models used by the PM team to predict stock
returns, Webb requested for the information provided in Exhibit 1. The information
relates to a time-series model for annualized monthly returns to a Brazilian stock index.
Exhibit 1: Annualized Monthly Returns to a Brazilian Stock Index

Lag Autocorrelation
1 0.1320
2 0.1856
3 -0.0098
4 0.0056
5 -0.0062
Critical t-value 1.96
Number of observations 398
After his analysis, Webb presented the following conclusions to the portfolio
management team:
Conclusion 1: “This time series can be best modeled using a moving average (2) model
rather than an autoregressive model.”
Conclusion 2: “A moving average (2) model would be different from a simple moving
average because the model will place different weights on the terms in the
moving average. In addition, unlike the model, a simple moving average is
based on observed values of the time series.”

Since 10% of the BMCA Equity Fund was invested in large-cap Russian stocks, Webb
considered it crucial to study the characteristics of the Russian capital markets. While
reviewing BMCA’s autoregressive (1) model used to predict the Russian inflation rate,
Webb suspected that the model might have a unit root. To accurately test for the presence
of a unit root in the time series, Webb decided to regress the first difference of the time
series on the first lag of the time series. After obtaining the results of the regression,
Webb calculated the t-statistic in the conventional manner for the coefficient. He then
used the critical t-values computed by Dickey and Fuller to determine significance. Since
he could not reject the null hypothesis at the 5% significance level, Webb concluded that
the series did not have a unit root and was stationary.
When talking to Ruiz about ‘random walks’ Webb stated that a time-series that was a
random walk could not be analyzed using standard regression analysis. He made the
following comments:
Statement 1: “For a random walk, there is no finite mean-reverting level. In addition, the
variance of the time-series increases or decreases as we go further into the
future without any lower or upper bound. This violates the assumption of a
finite variance for the time-series.”
Statement 2: “To model a random walk, we should first-difference it. This results in a
mean-reverting level of 0. In addition, the variance of a first-differenced
time-series is not only finite, but is also constant. The time-series then
becomes covariance stationary.”
Webb continued by stating that if a time-series is a random walk, it is best to model the
first-differenced series with an autoregressive model to predict future movements in the
time-series. He also stated that the key to choosing the correct model was to analyze each
model’s R2: the first-differenced AR model would generally have an R2 greater than the
R2 of the original AR model for a random walk, since the first-differenced model better
fits the data.
Ruiz then asked Webb to help the team decide which model to use to forecast the
Canadian interest rate: An AR(1) forecasting model of Canadian interest rates and an
AR(2) model of Canadian rates. Ruiz presented Webb with the following information:
• The standard errors from the AR(1) model and the AR(2) model were 4.359 and
4.109 respectively.

• Using a sample period from 1985 to 2010, the AR(1) model’s residuals exhibit
serial correlation, but the AR(2) model is correctly specified.
• For a shorter sample period from 1995 to 2010 both models were correctly
specified.
• The root mean squared error from the AR(1) model was 4.213 and from the
AR(2) model was 4.250.
• The Canadian interest rate showed considerable volatility from 1985-2010, with
values becoming much larger after 1995.
As an ending note, Webb explained the presence of conditional heteroskedasticity to

BMCA’s portfolio management team. He stated that if a time-series model was
conditionally heteroskedastic, then the standard errors of the regression coefficients
would be incorrect, and the hypothesis tests would be invalid. He added that this was true
only for autoregressive models but not for moving-average models or autoregressive
moving-average models.
7. Webb is most accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. Neither conclusion 1 nor conclusion 2.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, Sections 6.1 & 6.2
Conclusion 1 is correct. The standard error is 1/(398)1/2 = 0.05012. Using this

standard error and autocorrelations given in Exhibit 1, we can see that only the
first two autocorrelations are significantly different from 0 and all
autocorrelations beyond that are 0. Hence, an MA(2) model is most appropriate.
Conclusion 2 is correct. A simple moving average gives equal weight to all the
periods in the moving average whereas a moving-average time-series model can
put different weights. A simple moving average is based on observed values of a
time series.

8. Is Webb’s conclusion regarding the presence of a unit root in the inflation rate
time-series most likely correct?
A. Yes.
B. No, because the regression variables that he used and his computed t-
statistic is incorrect.
C. No, because his application of the regression-based unit root test was
incorrect.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS n.
If we cannot reject the null hypothesis, then the time series has a unit root and is
non-stationary.

9. Webb 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 1, Study Session 3, Reading 11, LOS i.
Statement 1 is incorrect. The variance of a random walk increases without an

upper bound: As ‘t’ increases, variance can approach infinity. There is a lack of
an upper bound, not a lower bound.
Statement 2 is correct.

10. With regards to his comments about random walks, Webb is most likely:
A. Correct.
B. Incorrect about the criterion of choosing the correct model.
C. Incorrect about the use of first-differenced AR models and about the
criterion of choosing the correct model.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS i.
Modeling the first-differenced series with an AR model does not help predict the
future and is not necessarily the best model. Also, we cannot necessarily choose
which model is correct solely by comparing the R2 of the two models.
11. For predicting the Canadian interest rates, which model should most likely be
used:
A. The AR(1) model.

B. The AR(2) model.
C. Neither the AR(1) model nor the AR(2) model.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS g
The RMSE for the AR(1) model is smaller than the RMSE for the AR(2) model
and hence, the AR(1) model is more accurate out of sample. Although for a longer
time period, the AR(1) model is not correctly specified, the vignette clearly states
that volatility increased significantly after 1995. Hence, the best approach would
be to model each period separately. Since the AR(1) model is correctly specified
for the smaller sample period, it can be used for predicting interest rates.


12. With respect to his comment about conditional heteroskedasticity, Webb is most
likely:
A. Correct.
B. Incorrect with respect to autoregressive moving-average models.
C. Incorrect with respect to autoregressive moving-average models and
moving-average models.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 3, Reading 11, LOS m
The standard errors of the regression coefficients in AR, MA, or ARMA models
will be incorrect, and hypothesis tests would be invalid.


Questions 13 through 18 relate to Economics
Sapphire Financial Strategists Case Scenario
Sapphire Financial Strategists (SFS), a U.S. based capital management firm, has received
considerable critical acclaim from several financial journals and capital analysts. Rebecca
Stephan, a portfolio manager, and the CEO at the firm, has played a pivotal role in the
success of the firm. To further the company’s achievements, Stephan launched the SFS
Global Fund, an investment vehicle for investors with the desire to invest in international
stocks and bonds. Stephan appointed Jeffery Harnish, a financial analyst and exchange
rate specialist, the head of the fund’s portfolio management team. During the team’s
initial meeting, Harnish presented the following investment opportunities:
Opportunity 1: “Investing money in Australian fixed-income will prove profitable. This is

because Australia’s one-year deposit rate is 6% whereas that of the U.S.
is 3.5% so a higher yield can be captured. The fact that the AUD is
expected to depreciate by 1.0% over the investment horizon, supports the
profitability of this investment.”
Opportunity 2: “I have been deciding whether to invest in Canadian or Japanese fixed-

income. Based on my analysis, the nominal interest rates in Canada and
Japan are 6.0% and 8.0% respectively. Also, the annual inflation rate in
Japan is 5.0%. Assuming the Fisher effect holds, I believe that inflation
in Canada will be almost 3.0%. This means that the Japanese Yen will
depreciate by 2.0% relative to the CAD over our investment horizon.”
Opportunity 3: I strongly recommend entering into a carry-trade position based on

borrowing the British pound and investing in the Australian dollar. I have
gathered the following information to support my decision.
Exhibit 1
One-year Spot Rate Spot Rate

Currency Currency pair
rate at T0 at T0 at T1
GBP 2.75% GBP/USD 0.817 0.804
AUD 6.00% USD/AUD 0.975 0.978

This will ensure that we earn a positive return on our trade.”
After the meeting was over, Harnish was approached by Tammy Lee, a currency overlay
manager at SFS, to discuss foreign exchange carry trades in detail. Lee stated that he had
entered into a carry trade with the euro as the funding currency. He added that the
inflation rate in the U.S. was 2.5% greater than the inflation rate in the euro area. After
explaining the details to Harnish, Lee expressed his concern for the profitability of his
trade given the high risks embedded in such strategies. To advise him, Harnish made the
following comment:
“I believe you should exit your strategy if the U.S. dollar starts to depreciate in value by
less than 2.0% relative to the euro, or when the euro starts to appreciate in value relative
to the dollar by more than 2.0%.”
Lee then asked Harnish to elucidate the influence of current account trends on the path of
exchange rates over time. Harnish made the following comments:
Statement 1: “If a country imported more goods than it exported, its currency would
adjust to this current account deficit, causing it to depreciate.”
Statement 2: “Due to the debt sustainability channel, if a country runs a large and
persistent current account deficit, not only will its currency depreciate, but
the currency’s real long-run equilibrium value would also be revised
downward.”
Statement 3: “If Country A has a large current account deficit relative to Country B,
Country A will most likely experience a build-up of Country B’s assets
held by it, and this would result in a depreciation in Country A’s currency
relative to Country B’s currency.”
13. With respect to Opportunity 1, which of the following would least likely erode the
profitability of the investment?
A. The ex ante PPP and Fisher effects hold.

B. The covered interest rate parity holds.
C. The uncovered interest rate parity holds.

Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS f & g
The yield differential in this case is 2.5%. Since the AUD is expected to
depreciate by only 1.0%, a yield of 1.5% can be captured. However, if uncovered
interest rate parity holds, the expected percentage depreciation of the spot
exchange rate will be reflected in the nominal yield spread. This will erode the
profitability of the investment.

If the en ante PPP and Fisher effects hold, the uncovered interest rate parity will
hold, and profitability will be eroded.
14. With respect to Opportunity 2, is Harnish’s analysis most likely accurate?
A. Yes, because the Fisher effect captures the relationship between interest
rates and inflation, and ultimately explains their effect on exchange rate
movements.
B. No, because the relationship explained by Harnish is the ex ante
purchasing power parity, not the Fisher effect.
C. No, because Harnish has overlooked a major assumption underlying the
Fisher effect which will affect his calculations.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS e.
A major assumption underlying the Fisher effect is that the level of real interest
rates in the domestic country is identical to the level of real interest rates in the
foreign country. This proposition that real interest rates will converge to the same
level across different markets is known as the real interest rate parity condition.

15. With regards to Opportunity 3, the all-in return to the trade, measured in GBP
terms, would be closest to:
A. 1.89%.
B. 3.99%.
C. 4.64%.

Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS i
To find the cross rate we multiply: GBP/AUD = 0.817×0.975 = 0.796575

Similarly, one year later the cross rate will be: 0.804 × 0.978 = 0.786312
The unhedged return on the Australian deposit is closest to:
(1/0.7965)(1+6.00%)0.786312 = 1.04644
Against 4.644% return, the borrowing costs must be charged:

4.644%-2.75% = 1.89%

16. With regards to his comment to Lee, Harnish is most likely advising to manage
crash risk by using:
A. purchasing power parity benchmarks, but he is incorrect as to when to exit

the strategy.
B. Uncovered interest rate parity as a benchmark, and he is correct as to when
to exit the strategy.
C. PPP benchmarks, and he is correct as to when to exit the strategy.
Correct Answer: C
Reference:
Harnish is using the purchasing power parity benchmark to determine when to

close the position. With regards to his exit strategy, Harnish recommends existing
when the likelihood of depreciation of the high-yield currency (in this case the
dollar) is building up. Similarly, he recommends exiting when the likelihood of
the euro appreciating increases. His given percentages are most likely the
prescribed PPP threshold bands.


17. Is Harnish’s statement 2 most likely correct, and with regards to statement 1, what
will mostlikely cause the country’s currency to depreciate less in order to correct
the trade balance?
A. Yes; and export demand being more price elastic than import demand will
cause the currency to depreciate less.
B. No; and import prices rising by more than the decrease in export prices
will cause the currency to depreciate less.
C. No; and a smaller initial gap between exports and imports will cause the
currency to depreciate less.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 4, Reading 13, LOS j
Statement 2 is correct. If a country runs a large and persistent current account

deficit over time, eventually a depreciation of the country’s currency will be
required to ensure that the deficit narrows. If the deficit is persistent, ever-rising
net external debt levels should give rise to steady downward revision of the
currency’s real long-run equilibrium value.
If export demand is more price elastic than import demand, the currency will
depreciate less.
18. With respect to statement 3, what mechanism of exchange rate correction is

Harnish most likely referring to, and is his statement correct?
A. The debt sustainability channel, and the statement is correct.

B. The portfolio balance channel, and the statement is incorrect.
C. The portfolio balance channel, and the statement is correct.
Correct Answer: B
Reference:

Harnish is referring to the portfolio balance channel. However, countries with

current account surpluses will see a buildup of their holdings of deficit nations’
assets. Attempting to reduce these holdings will cause the deficit nations’
currencies to depreciate.

Questions 19 through 24 relate to Corporate Finance
Courtney Hagen Case Scenario
Courtney Hagen worked as a financial consultant for a number of U.S. based sell-side
firms before joining Discoverers Company Limited (DCL), an electronics firm
specializing in components used by automobile firms. DCL is contemplating investment
in a high-tech machine that is expected to significantly increase its production efficiency.
Hagen has been advised to choose from the following available options:
Option 1: A machine with a useful life of 3 years that requires an initial investment of
$32,500. The investment is expected to return $13,700, $15,900 and $17,000
during its three years of useful life respectively.
Option 2: A machine with a useful life of 4 years that requires an initial investment of
$40,000. The cash flows from the investment equal $12,000, $14,500, $25,000
and $7,000 respectively.
Both projects have a 12% required rate of return. Given that the machines will be
replaced regularly, Hagen plans to be particularly careful in selecting the right option.
Hagen decided to discuss her analytical technique with Nancy Harland, one of DCL’s
corporate finance experts. Harland mentioned approaches to assessing the profitability of
each option:
1. The Least Common Multiple Approach.

2. The Equivalent Annual Annuity Approach.
When talking about these approaches with Hagen, Harland made the following comment:
“The above two approaches to comparing investment projects are each based on solid
financial rationale. However, they can sometimes yield conflicting results. In such cases,
analysts must use their judgment to determine which approach more accurately reflects
reality.”

After completing her analysis, Hagen was asked to assess a capital project with the
following characteristics:
• The initial outlay is $155,000.

• The project life is three years.
• Annual after-tax operating cash flows have a 50% probability of being $25,000
per year and a 50% probability of being $75,000 per year.
• Salvage value at termination is zero and the required rate of return is 11%.
DCL has the option of abandoning the project after one year and receive a salvage value
of $120,000. Hagen has been asked to advice the board whether to invest in the project or
not.
After completing her assignments for the day, Hagen proceeded with learning more about
capital budgeting and investment decisions. When reading a book on ‘Capital
Budgeting’, Hagen discovered the existence of a number of alternative procedures to the
widely employed capital budgeting model. The book presented the following models:
• Economic Profit Model

• Residual Income Model
• Claims Valuation Model
Hagen was intrigued with the analytical basis of the models as explained by the
application of these models to a hypothetical company. To test his understanding of the
procedures, Hagen decided to recalculate company value after making the following
changes:
• Increasing the depreciation estimate by 20%.

• Increasing the after-tax gain from salvage value by 15%.
• Increasing the cost of debt by 10% but keeping the cost of equity unchanged.
After performing the necessary calculations, Hagen formulated the following conclusions
considering each of the changes in isolation:
Conclusion 1: “Change 1 will increase the value of the company under the economic
profit model relative to the residual income model, since it will decrease
the dollar cost of capital, or the capital charge. Change 2 however, will
increase the value of the company by the same amount under both
methods.”

Conclusion 2: “Change 3 will decrease the market value added under the economic profit
model. Also, the new company value under the residual income model
and the claims valuation model will decrease.”
Hagen decided to mention these alternative approaches to the DCL’s executives at their
next meeting. Although Hagen acknowledged the rationale of their use, she was not sure
under what circumstances was each of them appropriate. She planned to discuss this
during the meeting too.
19. Using the EAA approach, Hagen should most likely choose:
A. Option 1.
B. Option 2.
C. Neither Option 1 nor Option 2.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS c
NPV of Option 1: -32,500 + PV(13,700)+PV(15,900)+PV(17,000) = $4,507.79

NPV of Option 2: -40,000+ PV(12,000) +PV(14,500) + PV(25,000) + (7,000) =
$4,516.73
Checking EAA of Option 1: $1,876.81

EAA of Option 2: $1,487.05
Hence, Hagen should choose option 2.
20. With respect to her comment about the two approaches, Harland is most likely:
A. correct.
B. Incorrect, because both methods will always result in the same decision.
C. Incorrect, because the least common multiple approach is closer to the
NPV criterion and hence, is superior to the EAA approach.
Correct Answer: B
Reference:

Harland is incorrect. The two approaches are logically equivalent and will result
in the same decision. Consequently, analysts generally choose one approach over
the other based on personal preference.
21. With regards to the abandonment option, the capital project that Hagen is
analyzing has an NPV if DCL does not abandon that is:
A. $28.279 greater than the NPV if DCL plans to abandon the project.
B. $24,369 less than the NPV if DCL plans to abandon the project.
C. $63,361.38 greater than the NPV if DCL plans to abandon the project.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOSf
DCL will only not abandon the project if the high cash flow occurs. The NPV in
this case is:
NPV = -155,000 + PV (75,000 for 3 years) = $28,278.60
DCL will abandon if the low cash flow occurs. In this case the NPV equals:
NPV = -155,000 + PV (25,000) + PV (120,000) = -$35,082.78
The difference is:

28,278.60-(-35,082.78) = $63,361.38
22. With regards to the capital project that Hagen is analyzing, optimal abandonment
raises the NPV by:
A. $26,324.
B. $36,216.35.
C. $61,093.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOS f

NPV without the abandonment option:

Expected cash flow: 0.50(25,000) + 0.5(75,000) = $50,000
NPV = -155,000 + PV(50,000 for 3 years) = -$32,814.26
NPV with optimal abandonment:

If high cash flows occur, NPV is $28,278.60. If low cash flows occur NPV is -$-
$35,082.78. The expected NPV is 0.50(28,278.60)+0.5(-$35,082.78) = $3,402.09
NPV is raised by $3,402.09-(-32,814.26) = $36,216.35
23. Hagen is most accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. Both conclusions 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 8, Reading 23, LOSi
Conclusion 1 is incorrect. Increasing the depreciation estimate will affect the

value of the company in the same way under both methods. With similar
assumptions and used correctly, the capital budgeting models are consistent with
each other. The latter part of the conclusion is correct.
Conclusion 2 is correct. Increasing the cost of debt will reduce MVA by

increasing WACC. Also, new company value will decrease under the residual
income and claims valuation approaches since the book value of debt will
decrease.
24. Which of the following investors are least likely to use the ‘claims valuation
approach’?
A. Real estate investors.

B. Corporate managers.
C. Security analysts.

Correct Answer: B
Reference:
Corporate managers usually value an asset by valuing its total after-tax cash
flows. Security analysts and real estate investors often evaluate investments by
valuing the cash flows to the equity investor after payments to creditors, which is
like the claims valuation approach.

Questions 25 through 30 relate to Financial Reporting and Analysis
Hawk Investments Case Scenario
Hawk Investments (HAWIN) is a U.S. based financial advisory firm that just recently
started business in the institutional sector of the domestic capital market. Ron Johnson
heads the research department of the firm and is currently working with three research
analysts to assess the existing investment potential of the global automobile sector. Jennie
Cooks has been assigned the task of evaluating the financial statements of Full-Circle
Automobiles (FCA), a U.S. based automobile firm with operations worldwide. FCA
established a subsidiary last year in an emerging economy due to an anticipated increase
in the local demand for FCA’s products. Although the economy experienced a GDP
growth rate of more than 5.00% over the past three years, the inflation rate was over
27%/year over the same period. As a result of the high inflation, the currency of the
country lost almost half of its purchasing power by the end of 2010. Exhibits 1, 2 and 3
display some key financial and market information that Cooks gathered to further her
analysis.
Exhibit 1
Key Information from Foreign Subsidiary’s Financial Statements
(in foreign currency units FC)
(in FC millions) 31 Dec 2009 31 Dec 2010
Cash 3,500 5,600
Inventory 15,000 15,000
Property, plant
33,000 33,000
and equipment
Notes payable 17,500 19,500
Long-term debt 9,000 9,000
Retained earnings 0 2,700
Revenues 4,000
Expenses 850
*Capital stock equaled $25,000 in the beginning of 2010

Exhibit 2
Foreign Currency Price Index 2010
Beginning value 100
Average value 175
Ending value 200
Exhibit 3
Exchange Rate
US $ per FC
1 January 2010 0.875
Average 2010 0.702
When discussing the financial numbers with Johnson, Cooks made the following
comment:
“Relative to the translated net income under U.S. GAAP, the dollar net income under
IFRS related to the foreign subsidiary for the year 2010 is higher.”
Johnson agreed and replied with the following comment:
“I prefer using the translation approach required by IFRS since this method, equivalent to
doing an appraisal, best represents economic reality.”
During their discussion Cooks mentioned that FCA also operated a subsidiary in the
European market. She stated that during the past year, FCA’s board of directors
instructed to sell a considerable portion of the subsidiary’s inventory to pay off a large
portion of its long-term debt. In addition, as part of the subsidiary’s capital budgeting
decisions, an upcoming purchase of land was to be financed by the issuance of common
stock rather than a bank loan. During the same year, the euro appreciated relative to the
dollar.
To increase her knowledge about the effects of translation methods on the financial
statements of a multinational company, Cooks stated the example of a hypothetical U.S.
based multinational firm with just one subsidiary operating in Canada. Cooks posed the
following questions to Johnson with regards to the current rate method and temporal
method:

Question 1: “Assuming the Canadian dollar weakens against the euro, and the subsidiary
has a larger amount of monetary assets than monetary liabilities, how will
the net income under the two translation methods compare?”
Question 2: “What will be the effect on the firm’s financial ratios of translating the
Canadian subsidiaries’ financial statements under the two methods?”
Johnson answered with the following statements:
Answer 1: “The net income under the temporal method would be greater than the net
income under the current rate method.”
Answer 2: “Under the current rate method, many of the underlying relationships of the
Canadian subsidiary in CAD will be preserved after translation. However, under the
temporal method, most of these relationships will be distorted.
Johnson concluded their conversation with a discussion about disclosure requirements

related to translation methods under IFRS and U.S. GAAP. He made the following
comment:
“Both IFRS and U.S. GAAP require two types of disclosures:
• the amount of exchange differences recognized in net income, and

• the amount of cumulative translation adjustment along with a reconciliation of
the amount.
In addition, under the U.S. GAAP, companies are required to disclose the two separate
amounts that constitute the total exchange difference recognized in net income.”

25. Assuming PPP holds, Cooks comment with regards to translated net income is
most likely:
A. correct.
B. incorrect, because the dollar net income under IFRS will be lower.
C. incorrect, because the dollar net income under IFRS would be the same.
Correct Answer: C
Reference:
The emerging economy is clearly a high inflation country. If the percentage

change in the general price index in the high inflationary country is the same as
the change in the exchange rate, the results of translation will be the same under
both U.S. GAAP and IFRS. In this case, The GPI doubled and the FC lost half of
its purchasing power (PPP holds so the FC will lose half its value in dollar terms),
the results will be the same.
26. Is Johnson correct about his comment regarding preference of the IFRS approach,
and what is the net purchasing power gain/loss under IFRS, as of Dec 31 2010?
A. No, and the net purchasing power gain is $6,119.

B. No, and the net purchasing power gain is $13,986.
C. Yes, and the net purchasing power gain is $10,056.
Correct Answer: A
Reference:

Johnson is incorrect. Although the method required by IFRS is closer to reality

than that under U.S. GAAP, doing an appraisal best represents reality.
Net purchasing power gain:

Gain on increase in notes payable: $2,000(200-175)/175 = FC286
Loss on increase in cash: $2,100 (200-175)/175 = -FC300
Total gain or loss from holding
beginning balance and increase: [17,500 + 286] –[3,500+300] = FC13,986
Current exchange rate would be half of beginning: $0.4375/FC
Hence, translation gain in $ terms: 13,986 ($0.4375) = $6,119
27. Using the information provided in Exhibits 1, 2 and 3, the translated retained
earnings under IFRS will be closest to:
A. $87.5.
B. $3,302.
C. $6,169.
Correct Answer: C
Reference:
Inflation adjusted:
Cash: 5,600
Inventory: 15,000 (200/100) = 30,000
PP&E: 33,000 (200/100) = 66,000
Total: 101,600
Notes payable: 19,500

Long-term debt: 9,000 (200/100) = 18,000
Capital stock: 25,000 (200/100) = 50,000
Retained earnings = 14,100 (to balance)
Total = 101,600
Hence, translated RE: 14,100 (0.4375) = $6,168.75

28. Regarding the subsidiary in the European market, FCA most likely translates its
financial statements using:
A. the current rate method.

B. the temporal method.
C. either the current rate method or the temporal method.
Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 20, LOS d
FCA is clearly managing its balance sheet exposure. It is trying to reduce its
monetary liability exposure in the face of an appreciating euro. This implies that
the firm is most likely using the temporal method of translation because under this
method, managing monetary liabilities and monetary assets can reduce or
eliminate translation losses.
29. Johnson is most accurate with respect to:
A. Answer 1 only.
B. Answer 2 only.
C. Both answers 1 and 2.
Correct Answer: B
Reference:
Answer 1 is incorrect. The CAD has depreciated and the subsidiary has a net
monetary asset exposure, so a translation loss would arise. Hence, net income
under the temporal method would be smaller.
Answer 2 is correct. The current rate method preserves most of the underlying
relationships (for all those ratios that use information from either the balance
sheet or the income statement, but not both). In contrast, the temporal method
distorts most of the underlying relationships.

30. With respect to his comment regarding disclosure requirements, Johnson is most
likely:
A. incorrect.
B. correct only with respect to IFRS.
C. correct only with respect to U.S. GAAP.
Correct Answer: B
Reference:
CFA Level II, Volume 2, Study Session 6, Reading 20, Section 3.7
U.S. GAAP does not require that companies disclose the two separate amounts.

Questions 31 through 36 relate to Financial Reporting and Analysis
Craig McKay Case Scenario
Craig McKay just graduated from a renowned university of Michigan with a Masters
degree in financial management. As part of the degree program, McKay had worked at
Monarch Advisors (MONA), a medium-sized asset management firm, as an internee in
its portfolio management department. After graduation, McKay planned to join the firm
again, this time as part of MONA’s portfolio management team. Naomi Garcia, the head
of MONA’s strategy and investment planning department, called for a meeting with
McKay. To ensure that McKay fulfilled the eligibility criteria for the job, Garcia
instructed McKay to undergo a comprehensive analysis of three firms: AtCo Ltd, UpTel
Inc., and WiLess Tech Ltd. An initial review of AtCo’s financial statements showed that
the company leased certain equipment under operating and capital leases. McKay
accumulated some information about the firm’s lease obligations as displayed in
Exhibit 1.
Exhibit 1
AtCo Ltd Lease Obligations as of December 2007 (US$ thousands)
Capital Operating
Minimum future
25,550 966,530
lease payments
Amount of interest 7,593 -
Current portion of
950 -
the obligation
AtCo Ltd.’s financial information
Total Liabilities 888,000
Total Equity 230,870
Excerpt from Note 21: Debt Commitments and Lease obligations.

The company has taken several bank loans to fund the purchase of certain property and
machines. The average interest rate on these bank loans is 8.00%. The current interest rate
on finance leases similar to the ones AtCo has entered is 7.70%.

To completely understand the effects of financial reporting of leases, McKay reviewed

the financial statements of one of AtCo’s lessors, Finlea Incorporated. Finlea recently
leased a piece of machinery to AtCo that has a useful life of 5 years and zero salvage
value. The present value of the lease payments is $200,000, which also equals its fair
value. The annual lease payments equal $43,860 each and the lease contract calls for five
such payments. Finlea’s discount rate is 11%. McKay was unsure how the classification
of this lease as an operating or a direct finance lease would impact Finlea’s financial
statements. In addition, McKay discovered that, just recently, Finlea dramatically
increased its estimate of the discount rate applicable to determine the present value of its
current year lease receivables. During an informal discussion with Garcia, McKay
presented the following observations:
Observation 1: “The interest rate that equates AtCo’s future minimum lease payments
with the present value of these payments is 10.5%. Since this rate is
much higher than the current rate on capital leases, AtCo is most likely
opportunistically reducing the present value of its finance leases and
thus its reported debt.”
Observation 2: “The dramatic revision of the discount rate used to determine lease
receivables suggests that Finlea might be trying to increase profits
shown in the current year’s financial statements. An analyst should
carefully determine whether such revision is justified given current
market conditions.”
McKay proceeded with an analysis of UpTel Inc. and WiLess Tech Ltd, both companies
operating as suppliers in the technology sector. UpTel uses the FIFO method for
accounting for its inventory and WiLess uses the LIFO method. For a comparison of their
inventory management techniques, McKay selected the following information about the
two companies.
Exhibit 2
Selected Financial Information for UpTel Inc. and WiLess Tech Ltd. as of
December 2008 (in US$ millions)
UpTel Inc. WiLess Tech Ltd.
Inventories 18,304 9,905

Total assets 95,203 65,029
Cost of goods sold 32,000 42,098
Tax rate 25% 25%

McKay accumulated the following additional information:
• If WiLess used the FIFO inventory valuation method, reported inventories

would have been $6,700 million higher in 2008 and $5,500 higher in 2007.
• WiLess’s COGS includes an amount related to inventory write-downs. The

valuation allowance in year 2008 increased slightly relative to the previous
year.
McKay formulated the following conclusions:
Conclusion 1: “Assuming everything else remains constant, WiLess’s effectiveness of

inventory management are overstated due to its inventory valuation
method and inventory write-downs.”
Conclusion 2: “Assuming everything else is comparable and remains constant,

WiLess’s gross profit margin and net profit margin are understated
relative to UpTel’s due to its choice of inventory valuation method.
However, the absolute percentage difference will be less for the net profit
margin than for gross profit margin.”
31. AtCo Ltd.’s debt to equity ratio if all operating leases were treated as finance
leases will increase by:
A. 72.12%.
B. 76.55%.
C. 108.86%.
Correct Answer: B
Reference:
The amount reported as

finance leases would be: [(25,550-7593)/25,550] 966,530 = $679,295
Unadjusted debt/equity: 880,000/230,870 = 3.846
Adjusted debt/equity: 1,567,295/230,870 = 6.79
6.79-3.846/3.846 = 76.55%

32. Ignoring all other financial statement effects, with respect to the leased machine,
what would be the effect on Finlea’s income before taxes of reporting the lease as
a finance lease rather than an operating lease at year 1 end?
A. Income before taxes would be $13,315 higher.

B. Income before taxes would be $18,140 higher.
C. Income before taxes would be $$8,491 higher.
Correct Answer: A
Reference:
Under finance lease: Lease revenue: (200,000-43,860) × 0.11= $17,175

Under operating lease: (40,000) + 43,860 = $3,860 [40,000 is the depreciation]
Income before taxes would increase by: 17,175-3,860 = $13,315
33. McKay is most accurate with respect to:
A. Observation 1 only.
B. Observation 2 only.
C. both observations 1 and 2.
Correct Answer: B
Reference:
Observation 1 is incorrect. The interest rate implicit in the capitalization of

finance lease obligations reflects the interest rate at the time the lease occurred.
This may differ from current rates.
Observation 2 is correct. Increasing the discount rate would reduce the present
value of the lease, and would in turn, affect the value of the interest expense and
lease payments. Hence, an analyst should carefully consider recent market
conditions to determine whether such an increase is warranted.

34. Based on the information McKay has gathered, which of the following is most
accurate?
A. UpTel appears to have a lower percentage of assets tied up in inventory

than WiLess.
B. WiLess appears to have a lower percentage of assets tied up in inventory
than UpTel.
C. Both Wiless and UpTel have comparable inventory management
efficiency.
Correct Answer: A
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS c &e
Converting WiLess’s figures to FIFO:

Inventory: 9,905 + 6,700 = $16,605
Total assets: 65,029+6,700-(6,700×0.25) = $70,054
Inventory/total assets:
UpTel: 18,304/95,203 = 19.23%
WiLess: 16,605/70,054 = 23.70%
35. Which of the above information about UpTel and WiLess appears to be least
consistent with economic reality?
A. The cost of goods sold amounts.

B. The LIFO reserve amount.
C. The inventory write-down information.
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e
WiLess uses the LIFO method of inventory accounting. Given increasing

inventory costs, the inventory carrying amounts under the LIFO are already
conservatively presented. Thus, it is far less likely that inventory write-downs will
occur under LIFO.

36. McKay is most accurate with respect to:
A. Conclusion 1.
B. Conclusion 2.
C. Both conclusions 1 and 2.
Correct Answer: C
Reference:
CFA Level II, Volume 2, Study Session 5, Reading 16, LOS e
Conclusion 1 is correct. Under LIFO, a company appears to be managing its

inventory more effectively. Also, when a company has inventory write-downs, the
same is true.
Conclusion 2 is correct. The net profit margin and gross profit margin would be
understated. The absolute percentage difference is less for net profit margin than
for gross profit margin because of income taxes.

Questions 37 through 42 relate to Equity Investments
Paul Marcus Case Scenario
Paul Marcus, a financial strategist and portfolio manager, is particularly interested in

valuation based on comparables. Marcus is currently working with Bob Mervak, a
research analyst, to value two steel companies using market-based valuation measures.
Marcus plans to use the enterprise value to EBITDA ratio to determine relative over or
undervaluation of the firms. Selected financial information of the two firms: Silver Steel
Inc. and Caveworks Steel Ltd, is presented in Exhibit 1.
Exhibit 1
Selected Financial Information as of December 2010 (in US$ millions)
Silver Steel Inc. Caveworks Steel Ltd.
Accounts payable $65,000 $47,500
Long-term debt 1,120 750
Total current assets 2,985 2,076
Common stock shares
250 300
outstanding
Current assets net of cash
1,540 822
and short-term investments
Return on invested capital 5.10% 7.50%
Annual revenue growth 18.99% 10.23%
Debt to equity 23.01% 15.67%
Net Income 952 799
Interest 66 37
Taxes 231 111
Depreciation and
379 355
Amortization
*Depreciation expenses match capital expenditures for each firm. Silver Steel’s stock
price is $35, whereas Caveworks’s stock price is $41.
When talking to Mervak about the usefulness of his chosen metric, Marcus made the
following comments:

Statement 1: “The enterprise value to EBITDA measure is particularly useful in this

case. Unlike the price to FCFF and price to sales measures, this measure
provides a more appropriate comparison of the companies since they have
a considerable difference in their debt to equity ratios.”
Statement 2: “The EV/EBITDA multiple will also reflect differences in Silver Steel’s
and Caveworks Steel’s capital programs. Since both companies are
capital-intensive, the use of this multiple is particularly useful in this
case.”
Before their discussion concluded, Mervak mentioned the growing use of momentum
valuation indicators among analysts. He stated that such valuation indicators were
increasingly being used in selecting investments during portfolio construction, but was
not sure how they were used. He presented the following information to Marcus about
two companies’ SUE scores.
Exhibit 2
Earnings surprise and SUE scores as of the last quarter of 2009 (in US dollars)
Mean Consensus
Percentage Surprise SUE score
EPS forecast
Company A 15.00 75 5.89
Company B 75.00 50 4.55
After reviewing the data provided, Marcus formulated the following conclusions:
Conclusion 1: “Given the information provided in Exhibit 2 is accurate, in the past, the
consensus forecasts for Company B were less accurate than the consensus
forecasts for Company A.”
Conclusion 2: “Using the variability in analysts’ EPS estimates for Company B, the
scaled earnings surprise for Company A equals 1.365.”
Mervak continued by inquiring about residual income valuation models. He asked how
such models compared to other present value approaches. Marcus made the following
comments about the strengths of residual income approaches:

Strength 1: “The uncertainty associated with the valuation estimate derived from the
residual income model is significantly less than the uncertainty of the
valuation estimate calculated using other present value models.”
Strength 2: “If the clean surplus relationship holds, the two components of the model:
book value and future earnings, will have a balancing effect on each other.
Hence, aggressive accounting practices that report a higher book value
will not result in a higher valuation estimate relative to conservative
accounting practices reporting a lower book value.”
As part of his last assignment, Marcus is using the historical returns on a broad-based
market price index from 1999-2010 to determine an estimate of the equity risk premium
inherent in the European capital market. He gathered the following facts to assist his
analysis:
1. During 2005-2010 businesses in the European market flourished and real

productivity increased. However, the inflation rate rose by 3% during the same
time period.
2. Analysts’ consensus estimate for Europe’s equity risk premium relative to bills
was 11.50% and relative to bonds was 13.04%.
Marcus used the mean historical return to estimate the risk premium. Relative to the U.S.
equity risk premium, Marcus’s estimate for Europe’s risk premium was notably higher.
37. Based solely on the information provided in Exhibit 1, how does the valuation of
Silver Steel Inc. compare with that of Caveworks?
A. Silver Steel Inc. appears to be undervalued.

B. Caveworks Steel Inc. appears to be undervalued.
C. The comparison appears to be inconclusive.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS n & r

Silver Steels EV/EBITDA :

EV: 1,120+(250×35)-(2,985-1,540) = $8,425 million
EBITDA: 952+66+231+379 = $1,628 million
EV/EBITDA: 8,425/1,628 = 5.17
Caveworks:
750+(300×41)-(2,076-822) = $11,796 million
EBITDA: 799+37+111+355 = $1,302 million
EV/EBITDA: 11,796/1,302 = 9.06
Compared to Silver Steel, Caveworks EV/EBITDA multiple is higher even

though annual revenue growth is lower. However, Caveworks has a lower
debt/equity ratio and is more profitable with a ROIC that is higher than Silver
Steel. This may suggest that Caveworks’s higher enterprise value multiple is
justified. Hence, the comparison is inconclusive.
38. Marcus is least accurate with respect to:
A. Statement 2 only.
B. Both statements 1 and 2.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS n
Statement 1 is correct. Enterprise value measures provide a more appropriate

comparison than price to cash multiples when companies have significantly
different capital structures.
Statement 2 is correct. Since depreciation expenses match capital expenditures in

this case, EBITDA will reflect differences in businesses’ capital programs. Hence,
in this case, EBITDA comparisons can be useful for these capital-intensive firms.
39. Marcus is most accurate with respect to:
A. conclusion 1 only.
B. both conclusions 1 and 2.
C. neither conclusion 1 nor conclusion 2.

Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS p
Earnings surprise:
Company A: 15-x/15 = 75% , x = $26.25, Hence, surprise is 26.25-15 = $11.25
Company B: x=$112.50, surprise: $37.5
The standard deviation of the historical forecast errors:
Company A: 11.25/5.89=1.91
Company B: 37.5/4.55 = 8.24
Hence, conclusion 1 is correct.
Conclusion 2 is incorrect. No information is provided about the dispersion in
analysts’ forecasts, a variable essential in the calculation of scaled earnings
surprise.
40. Marcus is most accurate with respect to:
A. Strength 1 only.
B. both strengths 1 and 2.
C. neither strength 1 nor strength 2.
Correct Answer: B
Reference:
Strength 1 is correct. The earlier recognition of value in a residual income

approach relative to other present value approaches that depend on terminal value
estimates, reduces uncertainty to a considerable extent.
Strength 2 is correct. If the clean surplus relationship holds, the present value of
differences in future income will be exactly offset by the initial differences in
book value.

41. Based solely on the information provided in the vignette, Marcus’s estimate for
the equity risk premium will most likely be:
A. biased upward.
B. biased downward.
C. either biased upward or biased downward.
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 10, Reading 30, LOS b
Positive inflation and productivity surprises can result in the mean estimate to be
biased upward. However, the use of a price-weighted index biases the estimate
downward due to a failure to incorporate the return from dividends.
42. Given the information in the vignette, which of the following is most likely true
about the U.S. and European capital markets?
A. The European yield curve is downward sloping.

B. The historical time series used by Marcus is nonstationary.
C. For the European market, the geometric mean return will equal the
arithmetic mean return.
Correct Answer: A
Reference:
Since the premium relative to bills is lower than the premium relative to bonds,
the return on bills is higher than the return on bonds, implying an inverted yield
curve.

Questions 43 through 48 relate to Equity Investments
Jackie Lee Case Scenario
Jackie Lee is an equity analyst at Core Money Management (CMM), a U.S. based firm
that invests in domestic and international equity markets. The Core Equity Fund (CEF),
launched by CMM almost three years ago, has managed to attract a number of wealthy
private wealth clients. In the recent year, CEF’s performance corresponded to the top half
of the first decile of comparable equity funds ranked according to their recent annual
rates of return. Lee was part of the investment selection team for CEF, and is now
considering several potential options for inclusion in the fund. As a first step towards
determining the attractiveness of the investments, Lee is establishing the over or
undervaluation of the U.S. equity market as a whole. Exhibit 1 displays the information
Lee has collected.
Exhibit 1
Forecasted values for selected financial and economic variables of the U.S. market
Inflation rate 4.5%
Nominal GDP growth rate 7.8%
Forward dividend yield 5.5%
Market’s reinvestment return 2.0%
Equity risk premium 16%
Risk-free rate 3.2%
While noting down the key outcomes of his analysis, Lee wrote the following statement
as a side-note:
“Using the price-earnings multiple as a benchmark, the return from capital appreciation
for the U.S. market will be greater than the earnings growth rate.”
Lee is contemplating the addition of utility stocks to the CEF to enhance diversification
benefits. One such stock is that of Sintock Utilities, a publicly traded firm in the utilities
sector. For the purpose of valuing this stock Lee determined the following values.

Exhibit 2
Sintock Utilities
5-year beta estimate 0.76
10-year beta estimate 0.65
U.S. equity risk premium
6.5%
relative to bonds
U.S. equity risk premium
7.7%
relative to bills
30-day T-bills YTM 2.5%
20-year U.S. government
3.8%
bonds YTM
Lee is planning to use the most common industry practices for estimating Sintock stock’s
required return. In addition, he believes that an adjusted beta best reflects economic
reality. To confirm his calculations, Lee contacts an equity analyst that put Sinstock’s
required return on equity at 10.3%.
Lee is also evaluating an equity stake in a private company and is using a public
comparable’s beta as a benchmark for his calculations. The private company is 30%
funded with debt. The benchmark, however, has 70% debt in its capital structure which is
very close to the industry average. Lee’s estimated beta equaled 1.2. When comparing his
beta estimation with that of other analysts, Lee found out that an analyst that
benchmarked the required return on a median industry beta recorded a beta of 0.70.
Lee is writing an article on ‘Equity Valuation” that contrasts various models used to
determine the required return on equity. In the article, Lee made the following comments
about the Fama-French model:
Statement 1: “Similar to other multifactor models, this model has factor betas
representing an asset’s sensitivity to a factor holding other factors constant,
and risk premiums representing the expected return accruing to the asset
with unit sensitivity to a factor and zero sensitivity to all other factors, in
excess of the risk-free rate.”
Statement 2: “The size and value factor betas, only if greater than 1, represent a small-
cap, value stock respectively. Similarly the market beta, only if greater than
1 represents above-average systematic risk.”

Lee received $50,000 as a bonus as part of CMM’s performance-based compensation

plan. Lee plans to invest the money in European equities for the coming year. Lee wants
to find the present value of the cash flow to be received on his investment. The current
European market is characterized by an inverted yield curve and high inflation. The
current bill rate is 10.5% and the current bond rate is 7.0%. The bill-relative and bond-
relative risk premia estimates are 6.5% and 6.0% respectively. Lee is not sure what
discount rate to use to find the present value of his investment return.
43. Assuming the information provided in Exhibit 1 is accurate, is the statement

written as a side-note by Lee most likely accurate?
A. Yes.
B. No, because the capital appreciation for the U.S. market will be less than
the earnings growth rate.
C. No, because the capital appreciation for the U.S. market will equal the
earnings growth rate.
Correct Answer: A
Reference:
According to the Ibboston and Chen model:
{ [(1.045)(1.033)(x)-1] + 0.075 } – 0.032 = 0.16

x = 1.034753
Hence, the return due to P/E expansion is 3.47%. Since the P/E multiple
expanded, the return from capital appreciation will be greater than the earnings
growth rate.
44. Using the CAPM, Lee’s estimate of Sinstock’s required return is most likely:
A. 2.05% less than the analyst’s estimate, who most likely assumes the stock
has below-average systematic risk.
B. 1.04% less than the analyst’s estimate, who most likely assumes the stock
has average systematic risk.
C. 1.52% less than the analyst’s estimate, who most likely assumes the stock
has above-average systematic risk.

Correct Answer: B
Reference:
Using a five-year beta is the most common practice. Adjusted beta:

2/3(0.76)+1/3 = 0.84
Required return: 3.8 + 0.84(6.5) = 9.26%
Assuming average systematic risk (beta=1) required return equals 10.3(3.8+6.5).
45. Based on the information provided in the vignette, with regards to the private
company that Lee is valuing, which of the following is most accurate?
A. Lee’s benchmark has systematic risk that is 1.17 points greater than the
median industry risk.
B. Lee’s benchmark has systematic risk that is 0.45 points less than the
C. Lee’s benchmark has systematic risk that is 0.50 points greater than the
Correct Answer: A
Reference:
CFA Level II, Volume 4, Study Session 10, Reading 30, LOSd
(1+30/70)x = 1.2, x = 0.84

0.84 = 1/[1+70/30] × x
x = 0.84/0.30 = 2.8
For the analyst:
(1+30/70)x = 0.70 , x = 0.49
0.49 = 1/[1+70/30] × x, x = 1.63
2.8-1.63 = 1.17
46. Lee is most accurate with respect to:
A. Statement 2 only.
B. both statements 1 and 2.
Correct Answer: C

Reference:
CFA Level II, Volume 4, Study Session 10, Reading 30, Los c.
Statement 1 is incorrect. In case of the Fama-French model, the premiums of two

factors are not stated as quantities in excess of the risk-free rate.
Statement 2 is incorrect. The neutral value for the size and value betas is zero.
47. The discount rate that Lee should use to value his European investment is closest
to:
A. 17%, since short-term rates are more plausible in this case.

B. 13%, since an inverted yield curve predicts a downward path for short-
rates and inflation.
C. 16.5%, since risk premium should always be relative to bonds, but the
risk-free rate is most appropriately represented using the bill-rate.
Correct Answer: A
Reference:
Since the cash flow is a year-ahead cash flow, short-term forecasts will be
appropriate. The required return estimate will equal: 10.5+6.5= 17.0%
48. Which of the following about the Fama-French model is most accurate?
A. The return on the market in the Fama-French model is determined by

subtracting the one-month T-bill rate from the return on a market value-
weighted equity index.
B. If, in the coming year, growth stocks are expected to outperform value
stocks, the value premium in the Fama-French model would be negative.
C. The liquidity premium in an extended Fama-French model refers to the
marketability of the investment; the lower the marketability, the greater
the premium.
Correct Answer: A
Reference:

The risk premium is the return on a market value-weighted index in excess of the
one-month T-bill rate. Options B and C are incorrect. The liquidity premium
refers to the liquidity of the investment, which differs from marketability.

Questions 49 through 54 relate to Fixed Income
Thornton Holmes (TH) Case Scenario
Thornton Holmes (TH) is an advisory firm, which offers security valuation and analysis
services to asset management firms. Rupert Singh, TH’s senior fixed income analyst is
valuing three fixed-rate corporate bonds issued by Bridgedale Manufacturers (BM) on the
date of evaluation and each with a stated maturity of three years. Details concerning the
three issues are summarized in an exhibit (Exhibit 1).
Exhibit 1:
Fixed-rate Corporate Bonds Issued by BM
Price per Coupon rate Effective Embedded
Issue 100 par ($) (%) Duration Option? Call Date*
A ? 6 5.4 Yes Two years from now
B 101.655 6 ? Yes One year from now
C 102.592 6 4.8 No N/A
*Callable at par
At the time of evaluation, the spot rate curve is flat at 5%. Singh uses a 15% volatility
assumption to calibrate the binomial interest rate tree (Exhibit 2).
Exhibit 2: Binomial Interest Rate Tree

Using a 15% Volatility Assumption
Year 0 Year 1 Year 2
5% 5.809% 6.749%
4.304% 5.000%
3.704%
The yield curve is forecasted to experience a downward parallel shift by 2% in the

coming few months. Singh attempts to project the impact of the yield curve shift on the
effective durations of the three issues by considering two alternative scenarios.
Scenario 1: Effective durations of Bond A and Bond B will decline by 0.7% and 1.5%
respectively.
Scenario 2: The price of Bond B rises by 1.3%.

After presenting the scenarios, Singh calculates the impact on the price of the bond
underlying Bond B if Scenario 2 materializes.
June Walsh, Singh’s colleague. Contrary to Singh, Walsh projects the yield curve to
steepen and recommends her colleague employ key rate durations to analyze the impact
of yield changes on bond prices.
Based on Walsh’s forecast, Singh concludes that if the yield curve steepens, a shift in any
of the par rates other than the three year rate will have no effect on the value of Bond C.
Singh’s final task is to value a convertible bond issued by Scale Tech. He is particularly
interested in assessing the impact of Walsh’s forecast on the value of the embedded
option. The Scale Tech convertible does not have embedded call and put options.
49. Using Exhibits 1 and 2, the value of Bond A’s embedded call option (per 100 of
par) is closest to:
A. $0.157.
B. $0.937.
C. $1.712.
Correct Answer: B
Reference:

The value of the call option is calculated the difference in price of Bond A and
Bond C (option-free bond) $0.937 (102.592 – 101.655).
PV = 99.849 PV = 99.298
PV = 101.655 R = 5.809% R = 6.749%
R = 5% C=6 C=6
PV = 100.952
PV = 101.626 R = 5.000%
R = 4.304% C=6
C=6 Called at 100
PV = 102.214
R = 3.704%
C=6
Called at 100
50. Considering Scenario 1 in isolation and holding all else constant, relative to bonds
A and B, the effective duration of Bond C will change by an amount (no
calculations are necessary):
A. less than 0.7%.

B. greater than 1.5%.
C. between 0.7% and 1.5%.
Correct Answer: A
Reference:
Relative to bonds with embedded options the prices of otherwise identical option-
free bonds change very little in response to interest rate movements. Therefore,
one would expect the change in duration to be less than 0.7%.
51. Considering Scenario 2 in isolation, the full price of the bond if yield were to rise
by 2% would have been closest to:
A. 82.074.
B. 83.407.
C. 93.666.

Correct Answer: B
Reference:
PV− − PV+
Effective duration =
2 × Δyield × PV0
($102.592 × 1.013) − PV+

5.0 =
2 × 0.02 × $102.592
PV+ = $83.407
52. Considering Scenario 2 in isolation, relative to Bond B, the absolute percentage

price change of Bond C will most likely be:
A. equal to 1.3%.
B. lower than 1.3%.
C. higher than 1.3%.
Correct Answer: C
Reference:
Given that the yields at all maturities are forecasted to fall below the 6% coupon
rate, the embedded call option will increase in value, as there is a possibility that
the option will be exercised. The presence of the embedded call will limit the
upside potential of a Bond B and thus the price appreciation will be lower relative
to Bond C, an otherwise identical option-free bond. Therefore, the price of Bond
C will appreciate by an amount, which is greater than 1.3%.
53. Singh’s conclusion is most likely:
A. correct.
B. incorrect; shifting any of the par rates will impact bond value.
C. incorrect; shifting the three year par rate will have effect on bond value.
Correct Answer: B

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS k
Since Bond C is not trading at par shifting any of the par rates will have an effect
on bond value. Although shifting the maturity matched par rate (6-year rate) will
have the greatest effect on value, it is incorrect to state that a shift in any other par
rates will have no impact on bond value.
Only when a bond is trading at par does a shift in non-maturity-matched par rates
have no effect on bond value.
54. Walsh’s forecast will most likely result in the value of the conversion option:
A. increasing.
B. decreasing.
C. remaining unchanged.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS n
Given that the convertible bond does not have an embedded call or put option, the
value of the conversion option will only be influenced by movements in the
issuer’s stock price.

Questions 55 through 60 relate to Derivatives
Samantha Thomas Case Scenario
Samantha Thomas works for Original Investments (ORIN), an asset management firm
that specializes in the more traditional debt and equity investments. After three years of
working with ORIN, Thomas believes that the firm should expand its investment
universe to include derivative instruments as well as direct and indirect investments in
real estate and commodities. In preparing for the next meeting, Thomas planned to
present the following points contrasting swaps with other derivative contracts:
Point 1: “Swaps are very similar to a series of forward contracts combined in a single
transaction. However, there are some differences: For a given term structure,
unlike a series of FRAs, swaps are a series of equal fixed payments. Also, in
contrast to a single forward contract, in interest rate swaps, the next payment
that each party makes is known.”
Point 2: “Swaps can also be equated to combinations of options. For example, the
payoffs of a fixed rate payer in a plain vanilla interest rate swap can be
mimicked by buying a series of call options and selling a series of put options
with expirations at the swap payment dates.”
As additional clarification, Thomas decided to demonstrate the pricing of an interest rate

swap to the meeting attendees. She considered the following swap:
“A one-year interest rate swap with semiannual payments at a time when the annualized
LIBOR spot rates are as follows:
Exhibit 1
Spot Rates
Days Rate %
180 7.75
360 8.30

100 days into the contract, the term structure is as follows:
Exhibit 2
Term Structure
Days Rate%
80 7.35
180 7.80
260 8.00
360 8.10
After compiling her presentation, Thomas called Edison Burk, a derivatives dealer and a
friend, to discuss her meeting points. During the course of their discussion, Thomas told
Burk the example of the semiannual swap that she planned to include in her presentation.
After hearing from Thomas, Burk posed the following question:
“Suppose that instead of an interest rate swap, the swap is a currency swap and the two
currencies are the dollar and the CAD. Considering the above term structure for LIBOR
and a current exchange rate of $0.8562, what will the value of the swap be to the pay $
fixed and receive CAD fixed party 100 days into the contract if the following term
structure of interest rates hold:
Exhibit 3
Canadian Rates after
Days Spot Canadian rate
100 days
80 7.6% 7.5%
180 8.0% 7.7%
260 8.2% 8.0%
360 8.5% 8.2%
Since Burk had been a party to a number of swap contracts, Thomas inquired about the
existence of variants of the standard swap. In response, Burk made the following
comments:
Statement 1: “Some swaps are employed by end users for speculative purposes who take
a position in anticipation of a change in the relative level of credit risk in
the market.”

Statement 2: “Some institutions wish to exploit the interest rate differential between two
countries, but also wish to hedge the currency risk. Swaps can be designed
to fulfill this objective.”
Before concluding their phone conversation, Thomas talked about swaptions and their
uses. When talking about payer swaptions, Thomas stated that a payer swaption could be
valued as though it was a combination of a put option and a call option on a bond. Burk
agreed, and stated that although not as widely used, forward swaps required no payment
of cash up front and were priced using the spot term structure in a manner similar to the
pricing of standard swaps.
55. Thomas is most accurate with respect to:
A. Point 1 only.
B. Point 2 only.
C. both points 1 and 2.
Correct Answer: B
Reference:
Point 1 is incorrect. A swap is equivalent to a series of off-market forward

contracts, reflecting the fact that the implicit forward contracts that make up the
swap are all priced at the swap fixed rate and not at the rate at which they would
normally be priced in the market.
Point 2 is correct.
56. The fixed rate on the semiannual swap is closest to:
A. 1.978%.
B. 4.063%.
C. 7.961%.
Correct Answer: B
Reference:

The present value factors are:
B0(180) = 1/1+0.0775[(180/360)] = 0.962696

B0(360) = 1/1+0.0830[(360/360)] = 0.923361
The fixed rate is: 1-0.923361/(0.962696+0.923361) = 0.04063 = 4.063%
57. Assuming a notional principal of $20 million, the market value of the semiannual
swap to the fixed rate payer 100 days into the contract, is closest to:
A. -$34,180.
B. -$27,893.
C. $13,039.
Correct Answer: A
Reference:
Days Rate%
80 7.35
180 7.80
260 8.00
360 8.10
100 days into the contract, the payments will be made in 80 days and 260 days.
The new set of discount factors is:

1/1+0.0735[80/360] = 0.98393
1/1+0.0800[260/360] = 0.945378
Present value of fixed payments: 0.04063(0.98393+0.945378) + 1(0.945378) =

1.023766
Present value of floating payments: The first floating payment will be

0.0775(180/360) = 0.03875, So, [1+0.03875] (0.98393) = 1.022057
Hence, the value to the pay fixed, receive floating side is: 1.022057-1.023766 = -
0.001709. Hence, value is $20 million (-0.001709) = -$34,180

58. If the new exchange rate is $0.8100, the best response to Burk’s question
assuming a $1 notional principal, is that the value of the currency swap will be
closest to:
A. -$0.05348.
B. $0.17411.
C. $0.00186.
Correct Answer: A
Reference:
The fixed rate in dollars will be the same as above: 4.063%. The fixed rate in
CAD will be:
1/1+0.08(180/360) = 0.961538
1/1+0.085(360/360) = 0.921659
1-921659/(0.961538+0.921659) = 0.0416 = 4.16%
After 100 days, discount factors:
1/1+0.075(80/360) = 0.983607
1/1+0.08(260/360) = 0.945378
Present value of the fixed payments in CAD: 0.0416(0.983607+0.945378)

+1(0.945378) = 1.025624
Present value of the fixed payments in dollars: 1.023766

CAD notional principal at the start of the swap: 1/0.8562 = CAD1.167951
Hence, Pay $ fixed, receive CAD fixed: -$1.023766 +

CAD1.167951($0.8100)1.025624 = -$0.053484
59. Which of the following swaps will be most suitable to meet the objectives
presented in statements 1 and 2?
A. Basis swaps and diff swaps respectively.

B. Overnight index swaps and arrears swaps respectively.
C. Constant maturity swaps and basis swaps respectively.

Correct Answer: A
Reference:
CFA Level II, Volume 6, Study Session 17, Reading 50, Section 5
A basis swap is usually a position taken in anticipation of a change in the relative

level of credit risk in the market (spread between the two rates involved in the
swap is a reflection of investors’ perception of the general level of credit risk in
the market).
A diff swap is a pure play on the interest rate differential between two countries
and is basically a currency swap with the currency risk hedged.
60. With respect to their comments about swaptions and forward swaps, are Thomas
and Burk most likely correct?
A. Only Burk is correct

B. Only Thomas is correct.
C. Neither Burk nor Thomas is correct.
Correct Answer: C
Reference:
CFA Level II, Volume 6, Study Session 17, Reading 50, LOS f and Section 6.5
Thomas is incorrect. A payer swaption is like a put only.
Burk is incorrect. Although forward swaps require no payment up front, they are
priced by pricing the swap off of the forward term structure instead of the spot
term structure.

CFA Level II Mock Exam 4 - Solutions (AM)

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

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Walnut Brothers Case Scenario

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“When WAB is in possession of material nonpublic information, it ensures the following

1. A prohibition on all types of risk-arbitrage trading.

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When in possession of material nonpublic information, firms should allow market

A. The brokerage arrangement by Pebble Toss.

PINE is in violation of the Standards. This is because PINE is intentionally

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Questions 7 through 12 relate to Quantitative Methods

Brittany Ruiz Case Scenario

Exhibit 1: Annualized Monthly Returns to a Brazilian Stock Index

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As an ending note, Webb explained the presence of conditional heteroskedasticity to

7. Webb is most accurate with respect to:

Conclusion 1 is correct. The standard error is 1/(398)1/2 = 0.05012. Using this

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Statement 1 is incorrect. The variance of a random walk increases without an

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A. The AR(1) model.

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Questions 13 through 18 relate to Economics

Sapphire Financial Strategists Case Scenario

Opportunity 1: “Investing money in Australian fixed-income will prove profitable. This is

Opportunity 2: “I have been deciding whether to invest in Canadian or Japanese fixed-

Opportunity 3: I strongly recommend entering into a carry-trade position based on

One-year Spot Rate Spot Rate

GBP 2.75% GBP/USD 0.817 0.804

AUD 6.00% USD/AUD 0.975 0.978

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This will ensure that we earn a positive return on our trade.”

A. The ex ante PPP and Fisher effects hold.

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14. With respect to Opportunity 2, is Harnish’s analysis most likely accurate?

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To find the cross rate we multiply: GBP/AUD = 0.817×0.975 = 0.796575

Against 4.644% return, the borrowing costs must be charged:

A. purchasing power parity benchmarks, but he is incorrect as to when to exit

Harnish is using the purchasing power parity benchmark to determine when to

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Statement 2 is correct. If a country runs a large and persistent current account

18. With respect to statement 3, what mechanism of exchange rate correction is

A. The debt sustainability channel, and the statement is correct.

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Harnish is referring to the portfolio balance channel. However, countries with

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Questions 19 through 24 relate to Corporate Finance

Courtney Hagen Case Scenario

1. The Least Common Multiple Approach.

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• The initial outlay is $155,000.

• Economic Profit Model

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