2014 CFA Level 2 Mock Exam Afternoon - Ans

Kostecka
Jacob Kostecka, CFA, is a portfolio manager at Forkson Investment Management, an asset

management and research focused organization. After obtaining his CFA charter last month,
Kostecka was transferred to the private wealth management division at Forkson.
Dharshi Bope, a private wealth client, was involved in a major motorcycle accident and is in
critical condition, fighting for his life. Bope is a single parent with a daughter, Paveen Nathoo, in
her mid-twenties. Since the accident, Nathoo has managed her father’s affairs, paying all
expenses, including investment advisory fees. In several conversations with Nathoo, Kostecka
highlighted Bope’s low risk tolerance and investment goal of capital preservation. Nathoo has
indicated her interest in managing the account more aggressively and possibly moving to
another management firm. Nathoo recently petitioned the court to appoint her full power of
attorney to legally manage Bope’s affairs. Prior to the court decision, Nathoo asks Kostecka to
invest her father’s account in the initial public offering (IPO) of Chatterbox, a highly sought after
social media company that has yet to generate a profit.
The following week, the court approves Nathoo’s request to act on behalf of her father. Going
through records in her father’s home, Nathoo discovers documents showing Bope embezzled
several million dollars from his employer, a real estate development company. Most of these
funds were placed directly into Bope’s personal account, for which Nathoo is now responsible.
Nathoo informs Kostecka about her discovery; however, Kostecka does not act on this
information, however, because it is a large account for Forkson.
Nathoo establishes a non-discretionary investment account at Forkson tied to her newly

established business. Shortly thereafter, Kostecka joins the board of Jabbertalk.com, a smaller
social media competitor to Chatterbox. Based on his knowledge of Chatterbox, Kostecka
believes the stock of Jabbertalk is a good investment, even though it is not yet profitable.
Buoyed by his faith in social media, Kostecka ultimately purchases shares of Jabbertalk’s IPO for
Nathoo’s account, as well as for all clients he currently manages. When Kostecka informs
Nathoo of the purchase, she expresses concern about her legal responsibilities and lack of
accounting knowledge in overseeing the account. Kostecka provides Nathoo a list of
recommended professionals he has worked with in the past, including attorneys and
accountants. When he was in college 10 years earlier, Kostecka was engaged to one of the
attorneys but broke off the relationship prior to their wedding, and one of the accountants was
Kostecka’s college roommate. Since then, Kostecka has not had any contact with the lawyer and
accountant.
The Jabbertalk investment is profitable on the first day of trading, doubling from its opening
price. Kostecka tells his clients the multifactor valuation model used by Forkson shows
Jabbertalk stock is still undervalued. Forkson’s research report, due out the next day, will
recommend investors hold their Jabbertalk shares. However, Kostecka tells all his clients
simultaneously they should sell their shares because he believes Jabbertalk is overvalued and
the stock price will fall soon. Kostecka notes he has followed through on this belief by selling his
personal holdings of Jabbertalk shares. Nathoo ignores Kostecka’s recommendation to sell
Jabbertalk. Over the next week, the stock declines 75%.
Watching Jabbertalk’s severe share price decline, Nathoo becomes furious with Kostecka
because he did not sell shares of Jabbertalk in her account. She files a complaint with Kostecka’s
supervisor, Sally Fang, CFA, claiming she was misled on the value of the IPO in the days
immediately after the stock started trading. Kostecka responds to the complaint by telling Fang,
“the analyst who wrote the hold recommendation on Jabbertalk has only passed his CFA Level II
examination. As a charterholder, I have earned the right to use the CFA designation, so I am
more qualified to manage clients’ investments.”
In order to build his client base, Kostecka prepares performance information to show
prospective clients. He includes the firm’s composite performance based on similar
discretionary client portfolios that are in compliance with the GIPS Standards. In addition,
Kostecka prepares his own composite performance, including all accounts he manages. This
presentation includes Nathoo’s account assuming she had sold her shares of Jabbertalk. Along
with his performance record, Kostecka provides a footnote disclosing the following language: “If
your account is managed on a discretionary basis, you might expect results similar to those
shown above.”
1.) With regard to the investment request made by Nathoo to invest in Chatterbox,
Kostecka should most likely:
A. seek advice from the court.

B. comply with her request.
C. follow Bope’s investment goals.
Answer = C
“Guidance for Standards I–VII”, by CFA Institute

Standard III(A): Loyalty, Prudence, and Care; Standard III(C): Suitability
The account should be managed according to the client’s investment goal of capital
preservation and a low risk tolerance. Under Standard III (A) Loyalty, Prudence, and
Care, the first step for members and candidates in fulfilling their duty of loyalty to
clients is to determine the identity of the “client” to whom the duty of loyalty is owed.
Only when the daughter is granted legal responsibility over her father’s affairs by the
court does she become the client.
2.) By not acting on the information reported by Nathoo, which CFA Institute Standard of
Professional Conduct has Kostecka least likely violated?
A. Loyalty, Prudence, and Care

B. Duties to Employers
C. Knowledge of the Law
Answer = A

Standard I (A) Knowledge of the Law, Standard III (A) Loyalty, Prudence, and Care.
Standard IV (A) Duties to Employers (Loyalty)
Kostecka has not violated Standard III (A) Loyalty, Prudence, and Care as he has put his
clients interests first. However, by not dissociating himself from the illegally embezzled
funds, Kostecka has violated Standard I (A) Knowledge of the Law. By managing these
funds, Kostecka benefits directly via management fees and could be associating himself
with suspicious financial transactions and potentially violating anti money laundering
regulations. In addition, by not dissociating himself from the embezzled funds, Kostecka
has also placed his firm in a position where it may suffer reputational harm so has
violated Standard IV (A) Duties to Employers (Loyalty).
3.) With regard to investing in Jabbertalk and recommending experts, Kostecka most likely
needs to disclose conflicts related to his:
A. attorney relationship.
B. board membership.
C. accountant relationship.
Answer = B

Standard III (C) Suitability, Standard VI (A) Conflicts of Interest.
Kostecka’s board service creates the opportunity to receive material nonpublic

information involving Jabbertalk and is a basic conflict of interest. As a result , according
to Standard VI (A) Conflicts of Interest, the directorship should be disclosed. Members
and candidates must make full and fair disclosure of all matters that could reasonably be
expected to impair their independence and objectivity or interfere with respective
duties to their clients, prospective clients, and their employer. Because the member has
not made any disclosure concerning his board membership, he is in violation of
Standard VI (A).
Kostecka has also ignored his clients mandate of low risk tolerance and capital
preservation and is in violation of Standard III (C) Suitability. In addition, Nathoo has
violated her fiduciary duty as a “trustee” of the account as she failed to manage her
fathers’ portfolio in accordance with his wishes.
4.) In relation to Kostecka’s handling of the Jabbertalk stock recommendation, which of the
following CFA Institute Standards of Professional Conduct did he least likely violate?
A. Fair Dealing
B. Communication with Clients
C. Priority of Transactions
Answer = A

Standard III (B) Fair Dealing, Standard V (B) Communication with Clients and
Prospective Clients, Standard VI (B) Priority of Transactions
Standard III (B) Fair Dealing requires members and candidates to deal fairly and
objectively with all clients when providing investment analysis, making investment
recommendations, taking investment action, or engaging in other professional activities.
When Kostecka informs clients of the upcoming investment recommendation by
Forkson, he has treated all clients fairly because this disclosure is provided to all of his
current clients.
5.) When Kostecka defends himself against Nathoo’s complaint, he most likely violated the
CFA Institute Code of Ethics and Standards of Professional Conduct concerning the:
A. misrepresentation of the meaning of the designation.

B. right to use the CFA designation.
C. reference to candidacy in the CFA Program.
Answer = A

Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program
Statements overstating the competency of an individual or imply, either directly or

indirectly, that superior performance can be expected from someone with the CFA
designation are not allowed under Standard VII (B) Reference to CFA Institute, the CFA
Designation, and the CFA Program. The Standard specifically states when referring to
the CFA Institute, CFA Institute membership, the CFA designation, or candidacy in the
CFA Program, members and candidates must not misrepresent or exaggerate the
meaning or implications of membership in the CFA Institute, holding the CFA
designation, or candidacy in the CFA Program.
6.) Kostecka’s performance presentation most likely conforms to the CFA Institute Standard
III (D) Performance Presentation with regard to:
A. composites representing similar discretionary investment portfolios.

B. fair and accurate representation of performance.
C. disclosure in the footnote.
Answer = A

Standard III (D) Performance Presentation.
Kostecka’s performance presentation of his firm’s composite performance is in

compliance with Standard III (D) Performance Presentation.
KingFisher
The government of a developing country published a request for proposal (RFP) for the
development of policies to improve the business conduct of its capital markets licensees, with
the hope of improving confidence levels among investors.
Kingfisher Financial Development Partners responded with a detailed proposal including the
following justifications for why the firm should win the tender:
Justification 1: With a team of three CFA charterholders, Kingfisher is more qualified than our
competitors to design policies to uphold and enhance capital market integrity.
Justification 2: Each team member must annually renew his or her commitment to abide by
the CFA Institute Code of Ethics and Standards of Professional Conduct (Code
and Standards).
Justification 3: In addition, every team member passed each level of the CFA exam on the
first attempt.
Kingfisher is later notified that it had won the tender. The Kingfisher team consists of team
leader Khalid Juma, CFA, and his two associates, Vimal Bachu, CFA, and Anila Patel, CFA.
Kingfisher and the government agree that the first step toward improving market integrity is to
create an industry-wide code of conduct based on the Code and Standards. Although the Code
and Standards are not intended to be adopted in full by the government, the decision is made to
concentrate on four main areas: professionalism, capital market integrity, duties to clients, and
investment recommendations.
The Kingfisher team subsequently drafts the following policy statements:
Levels of Professionalism
Financial services professionals must act in a professional manner at all times to help protect the
integrity of the country’s capital markets. As such, financial services professionals must ensure
that they meet at a minimum three major requirements. Professionals must (1) disclose all
conflicts of interest, (2) selectively differentiate services to clients, and (3) outline all manager
compensation arrangements for clients.
Capital Market Integrity

Financial services professionals must protect the integrity of the capital markets by ensuring
that any insider information obtained is managed in such a way as to prevent the investing
public from being disadvantaged. In addition, no financial services professional can knowingly
participate in any activity devised to mislead investors or distort any price-setting mechanism.
Duties to Clients
Clients’ interests must come before those of the financial services firm and/or its staff. To
ensure that clients’ interests are protected, all portfolios must be invested according to each
client’s investment plan and must be well diversified across all asset classes available.
Furthermore, fund managers must annually review client needs and objectives and rebalance
portfolios if required.
Investment Recommendations
All investment recommendations should be made after extensive research undertaken by or on
behalf of the firm. In addition, each research report must
Requirement 1: be reviewed by peers as soon as practical to ensure adequate basis and due
diligence policies were followed,
Requirement 2: be assessed to determine the quality of the recommendation over time, and
Requirement 3: only include names of team members who took part in the research and
agreed with the recommendation.
The Kingfisher team and the government committee meet to agree on the draft code of
conduct. Members of the government committee suggest the following additional policy: “Each
financial services firm must have a compliance supervisor to ensure that
Task 1: systems are in place to detect violations of laws, rules, regulations, firm policies, and the
industry-wide code of conduct and to enforce investment-related compliance policies;
Task 2: the firm has adequate documented compliance policies and procedures and it trains all
personnel on the same and makes sure the policies and procedures are followed; and
Task 3: inadequate procedures are identified and recommendations to correct inadequate
procedures are submitted to senior management for approval and implementation.”
1.) Which of Kingfisher's statements in the RFP regarding its qualifications most likely
violates the CFA Institute Standards of Professional Conduct?
A. Justification 2.
B. Justification 3.
C. Justification 1.
Answer = C
"CFA Institute Guidance for Standards I–VII," CFA Institute

Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program
It is a violation of Standard VII(B): Reference to CFA Institute, the CFA Designation, and
the CFA Program to imply that the competencies of a CFA charterholder are superior to
those of others not holding the designation. It is not a violation, however, to factually
state that charterholders must annually renew their commitment to abide by the Code
and Standards or that each of the team members passed all three CFA exams on their
first attempt.
2.) With regard to the proposed policy statement relating to Levels of Professionalism,
which draft requirement least likely reflects any of the CFA Institute Standards of
Professional Conduct?
A. Differentiation of services
B. Conflicts of interest
C. Compensation arrangements
Answer = A
Standard III(B): Fair Dealing; Standard VI(A): Conflicts of Interest; Standard IV(B):
Additional Compensation Arrangements
Standard III(B): Fair Dealing accommodates the differentiation of services to clients as

long as such services are not offered selectively. The different service levels should be
disclosed to clients and prospective clients and should be available to everyone. A
requirement to disclose all conflicts of interest would not violate Standard VI(A):
Disclosure of Conflicts, nor would the outline of all compensation arrangements violate
Standard IV(B): Additional Compensation Arrangements.
3.) Do Kingfisher's proposed policy statements related to Capital Market Integrity most
likely violate any CFA Institute Standards of Professional Conduct?
A. Yes, with regard to material nonpublic information

B. No
C. Yes, with regard to market manipulation
Answer = B

Standard II(A): Material Nonpublic Information; Standard II(B): Market Manipulation
Kingfisher's proposed general principles related to Capital Market Integrity properly

address in principle Standard II(A): Material Nonpublic Information and Standard II(B):
Market Manipulation. Standard II(A) does not disallow the possession of insider
information but does disallow using the information to take unfair advantage of the
general investing public. Standard II(B) requires the prohibition of market
manipulation—that is, dissemination of false or misleading information and transactions
that deceive or would be likely to mislead market participants by distorting the price-
setting mechanism of financial instruments.
4.) Which of Kingfisher's proposed requirements to ensure Duties to Clients is least

appropriate to prevent violations of CFA Institute Standards of Professional Conduct?
The requirement calling for a(n):
A. investment plan.
B. diversified portfolio.
C. periodic review.
Answer = B

Standard III(A): Loyalty, Prudence and Care
Standard III(A): Loyalty, Prudence, and Care requires a client's portfolio to be managed
by investment guidelines agreed on with the client. Some clients' investment objectives
may not allow for a diversified portfolio across all asset classes available. Therefore, it
may violate Standard III(A) to include all asset classes available
5.) Which of Kingfisher's proposed requirements regarding investment recommendations is

most appropriate to prevent violations of Standard V(A): Diligence and Reasonable
Basis?
A. Requirement 2
B. Requirement 1
C. Requirement 3
Answer = A

Standard V(A): Diligence and Reasonable Basis
It is recommended that firms develop and use measurable criteria for assessing the
quality of research to help comply with Standard V(A): Diligence and Reasonable Basis.
Therefore, the research recommendations need to be assessed to determine their
validity over time. Did the process and the analyst's view lead to the right
recommendation? If over time recommendations consistently prove to be wrong,
perhaps the research processes need to be changed—or the analysts themselves.
6.) Which of the following tasks suggested by the government committee would least likely
conform to Standard IV(C): Responsibilities of Supervisors?
A. Task 1
B. Task 3
C. Task 2
Answer = A

Standard IV(C): Responsibilities of Supervisors
Task 1 is insufficient in that Standard IV(C): Responsibilities of Supervisors requires

supervisors to enforce non-investment-related policies as well as investment-related
policies.
National Plastics
National Plastics Corp. is a leading manufacturer of high-quality injection-molded plastic

packaging materials used by various industries, primarily food and beverage processing and
packaging firms. In late November 2012, the company received approval for two important
patent applications—one providing for improved tamper protection for plastic containers and
another for an improved biodegradable plastic film that allows for better food preservation.
On 4 January 2013, Haines Foods and Snacks, Inc., launched a hostile takeover bid for all of the
shares of National at $30 per share (a $5 premium in excess of the pre-bid price). Haines Foods
is a national distributor of deli and dairy products. If its bid is successful, it plans to continue to
operate National as a wholly owned subsidiary.
Zenith ThermoPlastics Inc. produces plastic containers and bags that are used by the food and
beverage industry. Keith Whelan, who is both chief executive officer and chief financial officer of
Zenith, had been in discussions with National to either purchase or license their newly patented
technologies. As a possible alternative, in view of the Haines bid, Whelan began to consider
having Zenith make its own takeover bid for National.
Whelan provided National’s most recent financial statements, shown in Exhibits 1, 2, and 3, to
one of his assistants, Mike Noth, with directions to calculate National’s free cash flow using the
discounted cash flow approach as a first step in determining the maximum value that Zenith
should be willing to pay for National’s shares.
Exhibit 1: National Plastics Corp. Selected Financial Data, for Year

Ending 31 December
($ millions) 2012
Revenues 1,614
Cost of goods sold 841
Selling, general, and administrative expense 436
Earnings before interest, taxes, depreciation, and
337
amortization (EBITDA)
Depreciation expense 61
Operating income 276
Interest expense 47
Pretax income 229
Income tax (32%) 73
Net income 156
Share Information
Number of outstanding shares (millions) 60
2012 Earnings per share $2.60
2012 Dividends paid (millions) $37
2012 Dividends per share $0.62
Exhibit 2: National Plastics Corp. Consolidated Balance Sheets
as of 31 December
($ millions) 2012 2011
Cash and cash equivalents 8 5
Other current assets 315 295
Total current assets 323 300
Long-term assets, net 1,203 1,130
Total assets 1,526 1,430
Current liabilities 696 670

Long-term debt 562 611
Common stockholders’ equity 268 149
Total liabilities and stockholders’ equity 1,526 1,430
Exhibit 3: Other Financial Information

for National Plastics Corp. as of 31
December 2012
Effective tax rate 32.00%
Cost of equity 12.00%
Weighted average cost of
9.00%
capital
Noth soon returns and points out that the free cash flows from National will differ in future
years as a result of its new patents—he suggests that, just as Zenith wanted to license the
technology, other plastic firms would also be interested. Noth also suggests that because
National has a lower debt-to-equity ratio than the rest of the industry, it could support more
debt, so he has adjusted the weighted average cost of capital (WACC) accordingly. Noth’s
projected cash flows and other estimates are provided in Exhibit 4.
Exhibit 4: Estimates and Assumptions of Mike Noth Used in Valuing National

Plastics as of January 2013
($ millions except WACC)
2013 2014 2015 2016 Thereafter
End-of-year
free cash 170 165 180 195 Growth at 5% a year
flow to firm
WACC 10.50%
Total debt immediately following acquisition 650
After a discussion about the appropriate cash flow estimates and discount rates to use in
determining the value of National to Zenith, Whelan decides that Zenith should make a mixed
offer for all of National’s shares at $35 per share, consisting of $23 in cash and Zenith common
stock with an exchange ratio of 0.24. The details of the offer are in Exhibit 5.
Exhibit 5: Details of Zenith’s Planned Tender Offer for All of National

Plastics’ Common Shares
National Plastics Zenith ThermoPlastics
Pre-merger price $25/share $50/share
Shares outstanding 60 million 100 million
Zenith will pay $35 per share for National,

Tender Offer consisting of $23 in cash and Zenith common
shares with an exchange ratio of 0.24.
Following the merger, Zenith’s shares are

Post-merger
expected to be priced at $53/share.
Zenith believes that most of the synergies arising

Synergies from the
from the merger will result from National’s new
merger
patents.
Because National and Zenith are based in the United States, Whelan also decides to have Noth
calculate the pre- and post-acquisition Herfindahl-Hirschman Index (HHI) for the industry. Noth’s
HHI calculations are 1,910 pre-acquisition and 2,000 post-acquisition. Based on the HHI values,
Whelan concludes that (1) the industry is currently highly concentrated but (2) under applicable
US law, an increase in the HHI of less than 100 should not generate any governmental
challenges to block the acquisition of National.
When Whelan presents Zenith’s proposed takeover to the board of directors the following day,
one of the directors made the following statements:
1. Although I am certainly in favor of this takeover, I think we would achieve the greatest
value from the acquisition if we offered more stock and less cash.
2. If Zenith does not realize the potential synergies of this acquisition in the next five years,
I suggest a “spin-off” as a means to recover some of the money lost in this venture.
3. A positive initial market reaction will confirm that we did not overpay for Zenith.
1.) If Haines Foods is successful in its attempt to acquire National Plastics, the business
combination is best classified as which type of merger?
A. Horizontal, conglomerate
B. Vertical, backward
C. Vertical, forward
Answer = B
"Mergers and Acquisitions," Rosita P. Chang and Keith M. Moore

Section 2
If Haines acquires National, it would be a vertical merger because they are both in the
same production chain. It is an example of backward integration because Haines is
closer to the consumer than the packaging manufacturer.
2.) National's free cash flow to the firm (FCFF) for 2012 is closest to (in millions):
A. $104.
B. $121.
C. $182.
Answer = B
"Mergers and Acquisitions," Rosita P. Chang and Keith M. Moore

Section 7.1.1
“Free Cash Flow Valuation,” Jerald Pinto, Elaine Henry, Thomas Robinson, and John
Stowe
Section 3.1
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
NI Net income 156

+ Int(1 – + Net interest after
47 × (1 – 0.32) 32
Tax rate) tax
+ NCC + Non-cash charges Depreciation expense 61
– Capital
– FCInv (1,203 − 1,130) + 61 – 134
expenditures
– Changes in net (315ª – 696) – (295ª –
– WCInvª – (6)
working capitalª 670) = –6
Free cash flow to

FCFF =121
firm
ªChange in net working capital excludes changes in cash and cash
equivalents.
3.) Based on Noth's assumptions in Exhibit 4, the most that Zenith should be willing to pay
per share of National is closest to:
A. $60.
B. $51.
C. $40.
Answer = C
“Mergers and Acquisitions,” Rosita P. Chang and Keith M. Moore

Section 7.1.1
“Free Cash Flow Valuation,” Jerald Pinto, Elaine Henry, Thomas Robinson, and John
Stowe
Section 4.3
Year Free Cash Flow Present Value (PV) PV

(FCF) of FCF at 10.5% ($ millions)
($ millions)
2013 170 170/(1.105) 154
2
2014 165 165/(1.105) 135
3
2015 180 180/(1.105) 133
4
2016 195 195/(1.105) 131
PV of FCF 553
Terminal growth rate 5%
Terminal value, 2016
= 3,722.73
4
Terminal value at start of 2013 3,723/(1.105) 2,497
Enterprise value 3,050
Less debt after acquisition 650
Maximum value of equity 2,400
Maximum price per share (60 million shares) 2,400/60 = $40
4.) Based on Zenith's proposed tender offer and information in Exhibit 5, the synergy
arising from this merger is closest to (in millions):
A. $943.
B. $1,063.
C. $643.
Answer = A

Section 7.2
Shares of Zenith outstanding after merger (millions)
Original from Zenith 100
Issued in acquisition 14.4 0.24 share acquirer/share target × 60
Total shares 114.4

Value of shares post-merger = $53/share × 114.4 = $6,063 million
Value of shares post-merger in terms of pre-acquisition values, synergies, and

cash paid
($ millions)
Value pre merger of Zenith 5,000 $50/share × 100 million shares
Value pre merger of
1,500 $25/share × 60 million shares
National
+ Synergies +X Currently unknown
– Cash paid – 1,380 $23/share × 60 million shares

Value of all shares post
6,063 Value from above
merger
Synergies 943 Solve for X
Note: Value to National’s shareholders post-merger is the actual amount paid for the
takeover.
5.) The most accurate interpretation of Whelan's conclusions concerning the pre- and post-
acquisition HHI is that they are:
A. both correct.
B. incorrect in regard to the increase in HHI necessary to trigger a governmental
challenge to the acquisition.
C. incorrect in regard to the industry being highly concentrated.
Answer = B

Section 6.2
See Exhibit 2 in "Mergers and Acquisitions" reading; an HHI greater than 1,800 indicates
that an industry is highly concentrated. Should the HHI in a highly concentrated industry
change by 50 or more, a governmental challenge to a particular business combination is
very likely. In this instance, the industry is highly concentrated and the HHI changes by
90, making Whelan's second conclusion incorrect. A government challenge is likely.
6.) Which of the statements made by the member of the Board of Directors is most
accurate?
A. Statement 3
B. Statement 1
C. Statement 2
Answer = A

Section 7.2, 9
Initial market reaction is an important barometer for the value investors place on the
gains from merging as well as an indication of future returns.
Sagara
Sagara, a resource-abundant West African country, has a developing economy with low capital
per worker available. Although the majority of its population is impoverished, Sagara has a long
history of advanced education and is committed to technological progress. President Benjamin
Banantoumou recently appointed Fatima N'Diarra, PhD, as Economic Development Secretary,
and asks her to help him develop economic policies to promote growth.
Last year, Banantoumou attended a summit of international leaders, where he learned that
developing countries typically face several factors that affect their growth prospects, such as
1 enforcement of substantive laws,

2 restrictions on imports, and
3 low rates of saving.
N'Diarra, who has studied the Cobb–Douglas production function, believes that Sagara's primary
goal should be to raise the growth rate of per capita GDP. Her two recommendations, therefore,
are to
1 increase capital, and

2 invest in technology to raise total factor productivity (TFP).
N'Diarra adds this conclusion:

"Because the Cobb–Douglas function exhibits constant returns to scale, as we approach the
steady state rate of growth, we should place greater emphasis on continuing to grow TFP in
order to avoid diminishing marginal returns on capital."
Banantoumou believes that the Sagara economy relies too heavily on the export of natural
rubber. He is convinced that significant industrial capital investment will persuade foreign direct
investors that he is serious about economic development. He announces that the Sagara
government will construct a large tire factory to take advantage of the country's rubber
resources. Banantoumou expects that as a result of this investment, per capita productivity will
rise rapidly driving rapid growth in GDP.
N'Diarra is not as optimistic. She warns Banantoumou that Sagara could fall prey to a resource
curse known as the Dutch disease. As demand from the tire factory drives up the price of
rubber, capital flows out of the country and the local currency could depreciate rapidly. This
situation can be prevented if foreign investors are allowed to own rubber plantations directly
rather than just having access through international markets.
N'Diarra believes that according to the classical growth theory, gains in per capita GDP are
temporary because the resulting population explosion will lower per capita GDP to subsistence
real wage levels. She considers endogenous growth theory to be more realistic, believing that
(1) investments, such as the new tire factory, will increase the rate of per capita output growth
until the steady state rate of growth is achieved; and (2) investment in research and
development will boost growth even further, thus extending the abnormal growth period before
diminishing marginal returns eventually set in.
In the years after the tire factory begins production, Sagara's GDP is expected to grow at a rate
exceeding 10% annually, the per capita GDP will increase commensurately, and the country's
literacy rate will double. Manufacturing is likely to grow by 15% annually. But this rapid growth
will also bring concerns regarding regulation of the manufacturing sector. The government has
at times struggled to advance the regulatory structure to address problems associated with the
impact of rapid growth on such problems as pollution, power outages, and water shortages.
Banantoumou is worried that companies have learned to preemptively cooperate with their
regulators with the expectation that the regulators will favor their point of view over a
competitor's.
As the local financial markets evolve, N'Diarra recommends that she and Banantoumou study
and discuss the legal and regulatory structure of the United States to generate ideas that they
can implement in Sagara. During their discussion, N'Diarra remarks, "In the United States, self-
regulated organizations can become independent regulators empowered by a government
agency to enforce laws. The US government usually provides this type of regulator with
funding."
1.) Of the factors cited by Banantoumou after the international leaders summit, which is
least likely to limit sustainable growth?
A. Factor 1
B. Factor 3
C. Factor 2
Answer = A
"Economic Growth and the Investment Decision," Paul Kutasovic

Section 2.7
"Economics of Regulation," Chester S. Spatt

Section 2.1
Substantive law focuses on the rights and responsibilities of entities and relationships
among entities. A well-developed legal system of substantive and procedural laws and
respect for property rights are likely to encourage growth, not limit it. Factors that limit
growth include restrictions on imports and low rates of saving.
2.) In reference to the Cobb–Douglas function, N'Diarra's conclusion is best described as:
A. incorrect because the Cobb–Douglas function does not exhibit constant returns to
scale.
B. incorrect because increased TFP is not subject to the law of diminishing returns.
C. correct.
Answer = C
CFA Level II
Sections 4.1, 4.2
The stated conclusion is accurate in its entirety. The Cobb–Douglas function exhibits
constant returns to scale, which means that if all inputs are increased at the same
percentage, then output rises at that percentage. Diminishing marginal productivity
exists with respect to each individual input (if the other input is held constant).
Continued growth in per capita output is possible even in the steady state as long as
there is ongoing technological progress (increases in TFP).
3.) N'Diarra's warning regarding the resource curse and its prevention is most likely
incorrect with respect to:
A. her comments about both currency depreciation and direct ownership of rubber
plantations.
B. her comment about currency depreciation.
C. her comment about owning rubber plantations directly.
Answer = A
CFA Level II
Sections 4.5
Both her comments are incorrect. In the Dutch disease scenario, currency appreciation
driven by strong export demand for resources makes other segments of the economy, in
particular manufacturing, globally uncompetitive. She is also incorrect regarding direct
ownership of the rubber plantations by foreigners; access to natural resources is
essential but ownership is not.
4.) N'Diarra's understanding of the two growth theories is most accurate with regard to:
A. endogenous growth theory.

B. both classical growth theory and endogenous growth theory.
C. classical growth theory.
Answer = C
CFA Level II
Sections 5.1, 5.2, 5.3
N'Diarra's understanding of classical growth theory is correct, as is her understanding of

its implications. Classical growth theory holds the view that the growth rate of real GDP
per person is temporary because of population explosion. Her description of
endogenous growth theory is not accurate. She references a steady state rate of growth
and diminishing marginal returns, which are tenets of neoclassical growth theory.
5.) Banantoumou's concern regarding the regulatory structure is most likely an example of
regulatory:
A. arbitrage.
B. capture.
C. competition.
Answer = C

Section 2.2.1
Banantoumou's concern is an example of regulatory capture. Regulated companies'

efforts to fight particular regulations tend to attract more public attention than when
the companies are sympathetic to the contemplated regulations. Even more
fundamentally, academics have argued that regulation often arises to enhance the
interests of the regulated, often called the "regulatory capture" theory. For example,
regulatory actions and determinations can restrict potential competition and coordinate
the choices of rivals.
6.) N'Diarra's remark about self-regulated organizations (SROs) is best described as:
A. correct.
B. incorrect because SROs do not enforce laws.
C. incorrect because the US government does not fund independent regulators.
Answer = C

Section 2.1
Some independent regulators are SROs empowered to enforce the law. They do not
typically rely on government funding.
Treadway
Hannah Treadway is an analyst at Knight Investment Management. Knight holds Cooper Creek
Cable Limited (CCCL) as part of its Australian and Far East investment portfolio. CCCL is a
diversified cable and communications company operating in Western Australia. The company
consists of three divisions:
 Cable: Provides subscription television services and high speed internet to residential
customers.
 Media: Owns and operates a group of radio stations and publishes several magazines.
 Wireless: Offers wireless voice and data communications services.
Treadway is just starting her annual review of the company based on its most recent financial
statements, excerpts of which are shown in Exhibits 1 and 2. The financial statements for CCCL
are prepared in accordance with Australian Accounting Standards (AASB) which comply with
International Financial Reporting Standards (IFRS). All figures are in Australian dollars.
Exhibit 1: Cooper Creek Cable Limited Statement of Earnings, For Years Ending 31 December
(A$ thousands) 2013 2012
Revenue 711,200 674,600
Programming and communication expenses 312,900 317,000
Gross margin 398,300 357,600
Depreciation expense 98,750 78,650
Amortization of intangibles 7,250 8,150
Reversal of impairment loss -12,500 0
Gain (loss) on sale of assets held for sale -14,400 0
Operating costs 185,900 173,000
Interest expense 64,100 65,900
Income from investments in associates 1,200 850
Profit before tax 70,400 32,750
Tax benefit (expense) 17,600 -8,187
Net profit for the year 88,000 24,563
Exhibit 2: Cooper Creek Cable Limited Balance Sheet, As of 31 December

(A$ thousands) 2013 2012
Cash 95,600 74,400
Accounts receivable, net 35,700 33,500
Assets held for sale ______0 23,500
Total current assets 131,300 131,400
Investments in associates 42,700 42,300
Capital assets, net 221,800 241,200
Intangible assets, net 43,250 24,500
Goodwill 11,000 6,500
Deferred tax assets 185,500 169,900
Total assets 635,550 615,800
Trade payables 92,100 104,200

Interest bearing loans 49,700 0
Short-term unearned revenue 12,500 21,250
Other liabilities 23,800 23,000
Total current liabilities 178,100 148,450
Interest bearing debt 703,800 814,300
Long-term unearned revenue 6,500 13,500
Total liabilities 888,400 976,250
Issued capital 556,400 536,800

Accumulated losses -809,250 -897,250
Total equity -252,850 -360,450
Total liabilities and equity 635,550 615,800
CCCL sustained substantial losses in its start-up period (1998–2002), from which it is still
benefiting for tax purposes, but it has been profitable since 2002 and reported a record profit
after tax in 2013. But Treadway is wondering if CCCL’s revenues in general are supported by
cash flows and if the company might be trying to increase the appearance of profitability in
order to increase the share price, which remains low.
The wireless division was acquired by CCCL in a share purchase in late 2012. Treadway wants to
review the accounting policies CCCL has adopted for both revenue and expenses incurred on
long-term wireless contracts. Excerpts of the accounting policies are shown in Exhibit 3.
Exhibit 3: Excerpts of Accounting Policy Notes

(all figures A$ thousands)
Note 1 d) Long-Term Wireless Contracts
Customers who enter into long-term service contracts for wireless services can obtain their
handsets for a nominal amount. Commencing in 2013 the discount offered on the handsets,
relative to the regular price, is capitalized as a customer acquisition cost and straight-line
amortized over the life of the contract, or a minimum of three years.
Note 1 g) Unearned Revenue

Unearned revenue for subscriptions, or for services paid in advance, was historically recognized
on a straight-line basis over the term of the contract or subscription. After reviewing the
historical pattern of usage and cancellations for service contracts in 2013, the pattern of
recognition was changed to recognize the majority of the revenues in the first 12 months after
the service contract is signed and the remainder in the year following.
Note 12) Broadcast Licenses

During 2013, the company successfully disposed of broadcast licenses that were held for sale for
$37,900 (net book value of $23,500). Based on the successful completion of that sale, the
impairment losses taken in 2011 on other licenses have been reversed, restoring those
intangible assets to their amortized historical cost.
After reading the note about the rapid reversal of the impairment loss related to the broadcast
licenses (Exhibit 3, Note 12), Treadway strongly believes that it arose as an attempt by
management to manage earnings. She realizes that both her 2011 and 2012 analyses were
affected by these actions and now need to be reconsidered.
Finally, Treadway noted that during 2013, CCCL acquired 100% of MusicMusic (MM), a specialty
cable music channel. At the time of the acquisition the company disclosed the following
information:
The company has assigned the following values to the two intangibles (the MusicMusic brand name
and its associated broadcast licenses) that arise from this acquisition:
MusicMusic brand name A$2,000 (A$ thousands)
Broadcast licenses A$5,500 (A$ thousands)
1.) The cash collected from customers in 2013 is closest to (A$ thousands):
A. $700,250.
B. $709,000.
C. $693,250.
Answer = C
“Evaluating Financial Reporting Quality,” Scott Richardson and Irem Tuna

Section 4.1.1.2
To calculate cash collections from customers, the revenue figure on the statement of
earnings is adjusted for the large decreases in unearned revenue (both short-term and
long-term) and the increase in accounts receivable.
(A$ thousands)
Revenue as reported 711,200
Decrease in short-term unearned revenue 12,500 – 21,250 -8,750
Decrease in long-term unearned revenue 6,500 – 13,500 -7,000
Increase in accounts receivable 35,700 – 33,500 -2,200
Cash collected from customers 693,250
2.) The cash received from CCCL's investments in associates in 2013 is closest to (A$
thousands):
A. $800.
B. $1,200.
C. $400.
Answer = A
"Intercorporate Investments," Susan Perry Williams

Section 5.1
Investments in associates are accounted for using the equity method. Only the
dividends received from associate companies would be cash, not the amount reported
as income from investments in associates. When using the equity method to account for
an investment, the investment account on the balance sheet increases by the amount of
accrued investment income recognized and decreases by the amount of dividends
received. Therefore, analysis of the balance sheet account changes will solve for
dividends (the cash).
(A$ thousands)
Opening balance investment account 42,300
Plus investment income recognized (from Statement of
+1,200
Earnings)
Deduct dividends received: Solve for X –X
Closing balance investment account 42,700
Solving for X, dividends, and cash received = A$800 thousand
3.) The change in which of the following items is most likely an indication that CCCL might
be recognizing revenue early?
A. Deferred tax assets

B. Days sales in receivables
C. Unearned revenue
Answer = C
"Evaluating Financial Reporting Quality," Scott Richardson and Irem Tuna

Section 4.1.1.2
The decrease in unearned revenue could be an indication of early revenue recognition

as amounts previously deferred are brought into income and not replaced with new
deferred revenues on the balance sheet. An increase in days sales in receivables could
be an indicator of early revenue recognition, but for CCCL the ratio did not change
significantly (18.1 days in 2012 to 18.3 days in 2013 using year-end receivables).
Deferred tax assets can arise from differences in revenue recognition for taxes and
financial statement purposes (they would rise with increases in unearned revenue) but
there is no indication that revenue is the reason for the increase in deferred tax assets
(in fact unearned revenue decreased). The deferred tax assets most likely arise from the
loss carryforwards generated from earlier losses.
4.) The new accounting policy adopted in 2013 for the customer acquisition cost (Note 1d)
most likely increases CCCL's:
A. cash from operations.

B. debt-to-asset ratio.
C. quality of earnings.
Answer = A
"Long-Lived Assets: Implications for Financial Statements and Ratios," Elaine Henry and
Elizabeth A. Gordon
Section 2
"Evaluating Financial Reporting Quality," Scott Richardson and Irem Tuna
Section 4.2.2
In 2013, CCCL started capitalizing the discount offered (from selling the handsets at a
lower price) instead of recording it in the period it is incurred. This change in the policy
would increase net income (by lowering expenses) and cash from operations. The
amounts capitalized would be recorded as cash outflows for investing activities,
compared with cash from operations if they were expensed.
5.) If Treadway's belief about management's motivation behind the 2011 treatment of the
broadcast licenses is correct, compared with the economic reality in 2012, her original
2012 analysis would most likely have:
A. overstated net profit margin.

B. understated return on assets.
C. understated fixed asset turnover.
Answer = A
Financial Ratio List at beginning of Financial Reporting and Analysis Volume

Elizabeth A. Gordon
Section 4.1
The broadcast licenses were written down in 2011 but the write-down was reversed in
2013. Therefore, during 2012 the intangible assets were understated, which would have
understated amortization expense for the year and increased profit. Thus, in 2012 net
profit margin was overstated.
6.) The amount of customer acquisition costs, Exhibit 3, Note 1d, capitalized during 2013 is
closest to (A$ thousands):
A. $18,500.
B. $6,000.
C. $13,500.
Answer = B
Elizabeth A. Gordon
Sections 2, 4
"Intercorporate Investments," Susan Perry Williams

Section 6.2.1
To determine the amount of customer acquisition costs capitalized, analyze the changes
in intangible assets as follows:
(A$ thousands)
Opening intangible assets, net 24,500
Add impairment loss reversal 12,500
Add new broadcast licenses from MM acquisition 5,500
Add brand name from MM acquisition 2,000
Capitalized customer acquisition cost: Solve for X X
Deduct amortization expense – 7,250
Ending intangibles assets, net 43,250
Solving for X, capitalized customer acquisition cost = A$6,000 thousand
Ready Power
Ready Power Inc. is a manufacturer of high-quality industrial electric generators. Although many
companies have been negatively affected by the continued global economic weakness, Ready
Power has experienced strong demand for its products, largely as a result of several recent
natural disasters and many occurrences of rolling brownouts and blackouts arising from
excessive strains on power grids. Although this strong demand has resulted in higher inventory
costs in recent years, the company has been able to pass the cost on to customers through
higher prices. The company’s generators have expected useful lives of about 25 years. The
company also normally depreciates its assets on a straight-line basis.
Margo Lenz, CFA, an equity analyst at Livermore Investment Council, is reviewing Ready Power’s
recent financial statements, which are prepared according to US GAAP.
Exhibits 1 and 2 contain selected portions of the company’s statement of operations and
statement of financial position, and Exhibit 3 contains selected notes from the company’s 2013
financial statements.
Exhibit 1: Ready Power Consolidated Results of Operations

($ millions)
For the Year Ending 31 December 2013 2012
Sales 24,910 21,803
Cost of goods sold 17,729 15,935
Gross profit 7,181 5,868
Net profit 2,122 1,712
Exhibit 2: Ready Power Consolidated Financial Position

($ millions)
As of 31 December 2013 2012
Cash 318 665
Receivables 8,983 8,381
Inventories 3,811 3,134
Other current assets 744 1,441
Current assets 13,856 13,621
Net property, plant, and equipment 5,311 4,794
Other assets 11,360 9,826
Total assets 30,527 28,241
Exhibit 3: Ready Power Selected Notes to Consolidated Financial Statements
Note 1. Operations and Summary of Significant Accounting Policies
D. Inventories
Inventories are stated at the lower of cost or market, with cost determined using the
last in, first out (LIFO) method.
($ millions) 2013 2012

LIFO reserve 1,442 1,407
No LIFO liquidation occurred during 2012 and 2013.
F. Depreciation and amortization

Depreciation of plant and equipment is computed using the straight-line depreciation
method.
($ millions) 2013 2012
Consolidated depreciation
332 235
expense
J. Income taxes: The company’s effective tax rate has always been 29%.
Note 10. Property, plant, and equipment (PP&E)

31-Dec
($ millions) 2013 2012
Land 110 92
Plant and equipment 10,257 9,426
Total plant and equipment 10,367 9,518
Less accumulated
–5,056 –4,724
depreciation
Net PP&E 5,311 4,794

Harold Mays, one of Lenz’s assistants, made the following comments about Ready Power’s
inventory policy:
1. One of the advantages of using LIFO is that it simplifies the accounting process for
inventory because it gives the same results for inventory and cost of goods sold whether
the company uses a periodic or perpetual inventory system.
2. Another advantage of using LIFO is that it appears to improve the company’s cash
conversion cycle.
3. One disadvantage with LIFO, however, is that it is more likely that the company will
incur inventory write-downs than under the first in, first out (FIFO) method
Lenz mentioned to Mays that earlier that day, she had seen Bill Jacobs, the CEO of Ready Power,
in an exclusive interview on a cable news network specializing in financial news and information.
Lenz was particularly interested in the portion of the interview dealing with the company’s new
program to lease electrical generators. An excerpt from a transcript of the interview is shown in
Exhibit 4.
Exhibit 4: Excerpt from an Interview of Bill Jacobs on Cable TV, 4 March 2014
Jacobs: The firm is meeting the growing demand for our electrical generators and will be
introducing a leasing program to further consolidate our lead in this area. We anticipate that
about 80% of the leases we grant will have a term of 20 years or more, with the remainder
having shorter terms of around 5 years.
After reading the excerpt from the interview, Mays wondered what impact the company’s new
position as a lessor and its classification of leases would have on the company’s future financial
statements. Finally, he comments:
1. For a given leased asset, in the initial year of the lease, Ready Power’s profits
should be higher if the company classifies the lease as an operating lease.
2. Regardless of how the company classifies a lease, its total cash flow and operating
cash flow over the lease term will be the same.
3. The leasing program will decrease Ready Power’s liquidity position.
1.) If Ready Power had used the FIFO method to account for its inventory, its cost of goods
sold (COGS) in 2013 would have been closest to (in millions):
A. $17,694.
B. $16,287.
C. $17,764.
Answer = A
“Inventories: Implications for Financial Statements and Ratios,” Michael A. Broihahn

Section 3.1
($ millions)
COGS (FIFO) = COGS (LIFO) – Increase in LIFO reserve*
17,729 – 35 = 17,694
*Increase in LIFO reserve = 1,442 – 1,407 = 35
2.) If Ready Power had been using FIFO accounting since incorporation, its retained
earnings at the end of 2013 would most likely be higher by (in millions):
A. $1,024.
B. $2,927.
C. $1,442.
Answer = A

Section 3.1
The LIFO reserve at the end of 2013 was $1,442 million, indicating that cumulative gross
profits would have been $1,442 million higher under FIFO. With a tax rate of 29%
(Exhibit 3, Note 1.J), the cumulative additional income tax expense would be $1,442 ×
0.29 = $418 million, resulting in an increase in retained earnings of $1,442 – $418 =
$1,024 million.
3.) The statement in Note 1.D of Exhibit 3 concerning LIFO liquidations most likely means
that for the stated period:
A. there were no inventory write-downs in either of the two years.

B. units manufactured (or purchased) equaled or exceeded unit sales for each year.
C. costs and prices must have been rising throughout.
Answer = A
"Inventories: Implications for Financial Statements and Ratios," Michael A. Broihahn

Section 3.2
"Inventories: Implications for Financial Statements and Ratios," Michael A. Broihahn

Sections 2, 3
LIFO liquidation arises when the number of units sold exceeds the number of units
purchased or manufactured and thus a portion of the older inventory is sold off or
liquidated.
4.) With regard to Mays' comments about the LIFO method, which of his statements is
most accurate?
A. Statement 3
B. Statement 1
C. Statement 2
Answer = A

Section 2.3
Only Statement 2 is correct. In periods of rising inventory prices, as recently experienced

by the company, LIFO COGS is higher and average inventory is lower, which results in
faster inventory turnover and thus lower days of inventory on hand (DOH). Receivables
and payables are not affected by the choice of inventory method. The lower DOH will
appear to shorten the operating and cash conversion cycles.
5.) In 2013, the estimated remaining life (in years) of the company's asset base is closest to:
A. 15.7.
B. 16.0.
C. 15.2.
Answer = A
“Long-Lived Assets: Implications for Financial Statements and Ratios,” Elaine Henry and
Elizabeth A. Gordon
Section 5
Net (depreciable) PP&E (excludes land) from Note 10: $5,311 – $110 = $5,201
million Depreciation expense from Note 1.F: $332 million
6.) Which of May's statements about the new leasing program is most accurate?
A. Statement 1
B. Statement 2
C. Statement 3
Answer = C
“Long-Lived Assets: Implications for Financial Statements and Ratios,” Elaine Henry and
Elizabeth A. Gordon
Section 6.2.2
Moyle
Bridget Moyle is a senior associate in the risk management division of ANM Financial Advisers
(ANMFA). Moyle specializes in the use of derivatives to help ANMFA manage its various risk
exposures. Moyle is meeting with two recently hired analysts, Jordan Petsas and Katy Iacocca.
Petsas and Iacocca have been asked to prepare for a discussion on the fundamentals of futures,
options, and swaps.
Moyle asks, “Is it true that the futures price on an asset must equal the spot price of the asset
on the expiration date of the futures contract? Explain why or why not.”
Petsas responds,
At expiration, futures prices and spot prices must converge. If the spot price exceeds the
futures price, then an investor could purchase the futures contract and execute the
contract to purchase the underlying at the lower futures price, sell it at the higher spot
price, and make an arbitrage profit. If the spot price is less than the futures price at
expiration, then an investor could purchase the asset at the spot price and enter into a
short futures contract to sell it at the higher price, thus locking in a profit.
Moyle provides Petsas and Iacocca with the following information for a Treasury bond and asks
them to calculate the price of a futures contract on this bond. The bond has a face value of
$100,000, pays a 7% semiannual coupon, and matures in 15 years. The bond is priced at
$156,000 and yields 2.5%. The futures contract expires in eight months, and the annualized risk-
free rate is 1.5%. There are multiple deliverable bonds, and the conversion factor for this bond is
1.098.
The next item on the agenda is a discussion of option valuation models. Moyle states, “We are
currently considering the purchase of put options on shares of the Rousseff Corporation.
Selected information is provided in Exhibit 1.
Exhibit 1: Selected Stock and Options Data for Rousseff Corporation and the Risk-Free
Interest Rate
Exercise price $590
Days to expiration (two 30-day periods) 60
Current stock price $609.90
Up move on stock (per 30-day period) 12%
Down move on stock (per 30-day period) 4%
30-day risk-free interest rate 0.25%
Iacocca responds, “In general, we could value the option using either the Black–Scholes–Merton
model or the binomial option pricing model. But there is not enough information presented to
use the Black–Scholes–Merton model.”
“That is correct,” states Moyle, and continues, “With respect to the Black–Scholes–Merton
model, can you explain how the risk-free rate, time to expiration, and volatility affect European
option prices?”
In answer to Moyle’s question, Iacocca states, “Higher risk-free rates result in lower call and put
option prices. Longer times to expiration result in higher call prices, but the impact on put prices
is unclear. Higher volatility results in higher call and put option prices.”
The group turns its attention to swaps. Moyle states, “As you all know, a plain vanilla interest
rate swap allows the buyer of the swap to make a fixed payment and receive a variable
payment. Can you explain how these interest rate swaps can be described as being equivalent to
a combination of other assets?”
Petsas responds, “An interest rate swap can be viewed as a series of forward rate agreements
(FRAs) priced at the swap fixed rate or as a combination of a purchase of an interest rate call
option and the purchase of an interest rate put option.”
Finally, Moyle presents the term structure of Libor spot rates in Exhibit 2 and asks Iacocca and
Petsas to use this information to calculate the annualized swap fixed rate on a one-year interest
rate swap with quarterly payments, for which the underlying is 90-day Libor.
Exhibit 2: Current Libor Term Structure of Spot

Rates
Days Rate (%)
90 3.13
180 3.41
270 3.73
360 4.12
1.) Is Petsas' response to Moyle regarding futures and spot prices most likely correct?
A. No, the explanation of when the spot price exceeds the futures price is incorrect
B. Yes
C. No, the explanation of when the spot price is less than the futures price is incorrect
Answer = B
"Futures Markets and Contracts," Don M. Chance

Section 7.1.1
Petsas' response to Moyle is correct. Futures and spot prices must converge at
expiration. If they do not, then it is possible to earn an arbitrage profit. If the spot price
is greater than the futures price, then one could earn an arbitrage profit by buying the
futures contract and executing the contract to purchase the underlying at the lower
futures price and to sell it at the higher spot price. If the futures price exceeds the spot
price at expiration, then an investor could purchase the asset at the spot price and enter
into a short futures contract to sell it at the higher price, thus locking in a profit.
2.) Based on the information provided by Moyle, the futures price on the Treasury bond is
closest to:
A. $140,298.
B. $154,047.
C. $143,494.
Answer = B
"Futures Markets and Contracts," Don M. Chance

Section 7.2.3
The futures price is calculated as follows:
$3,508.6958 = 3,500(1.015)(2/12).
3.) Based on the information in Exhibit 1, the price of the put option using the two-period
binomial option pricing model is closest to:
A. $9.31.
B. $14.98.
C. $1.96.
Answer = B
"Option Markets and Contracts," Don M. Chance

Section 6.2
++ ++
p = Max[0, X – S ] = Max[0, 590 – 765.06] = 0
+– +–
p = Max[0, X – S ] = Max[0, 590 – 655.76] = 0
–– ––
p = Max[0, X – S ] = Max[0, 590 – 562.08] = 27.92
++
S = 609.90 × 1.12 × 1.12 = 765.06
+–
S = 609.90 × 1.12 × 0.96 = 655.76
––
S = 609.90 × 0.96 × 0.96 = 562.08
4.) With respect to Moyle's question about the impact of selected inputs on the price of
options, Iacocca is least likely correct about:
A. volatility.
B. time to expiration.
C. the risk-free rate.
Answer = C
"Option Markets and Contracts," Don M. Chance

Section 7.3
Iacocca is incorrect about the risk-free rate. Higher risk-free rates result in higher call
option prices and lower put option prices. She is correct about the impact of time to
expiration and volatility on put and call option prices.
5.) Is Petsas' response to Moyle regarding an interest rate swap most likely correct?
A. No, he is incorrect about the combination of calls and puts

B. No, he is incorrect about the pricing of FRAs
C. Yes
Answer = A
"Swap Markets and Contracts," Don M. Chance

Section 4.1
Petsas is incorrect in stating that an interest rate swap is a combination of a long

interest rate call option and a long interest rate put option. A combination of the
purchase of an interest rate call option and the sale of an interest rate put option is
equivalent to a plain vanilla interest rate swap payment. Thus, if the underlying variable
rate is below the exercise rate, the call is worthless and the short put will require a net
payment to the holder of the put. This scenario replicates the situation in an interest
rate swap in which the fixed payment (exercise rate) exceeds the variable rate resulting
in a net payment by the buyer of the swap.
6.) Based on the information in Exhibit 2, the annualized fixed rate on the swap is closest
to:
A. 3.60%.
B. 4.04%.
C. 4.12%.
Answer = B
“Swap Markets and Contracts,” Don M. Chance

Section 4.2.1
The appropriate present value factors are provided in the following table:
B0(90) 0.9922
B0(180) 0.9832
B0(270) 0.9728
B0(360) 0.9604
The fixed rate is calculated as follows:
The annualized rate = 0.0101 × 4 = 0.0404.

Metev
Rila Rakia & Beer Ltd. (RRBL), a small privately owned company, produces high quality rakia (a
high-potency hard liquor), vino (wine), and bira (beer) in Bulgaria. After Bulgaria joined the
European Union in 2007, international demand for the country’s liquor, wine, and beer
increased substantially. Most firms in the industry, including RRBL, have been reporting double-
digit sales growth on a year-over-year basis.
Metiu Metev, a portfolio strategist at a major German investment consulting firm, inherited
RRBL from his grandparents. Frankfurter Destillerie & LiqueurFabrik (FDLF), a German distillery
interested in entering the Bulgarian market, has made a cash offer of BGN900 million for the
company’s equity (BGN = Bulgarian Lev; EUR1 = BGN1.95586, pegged rate). FDLF will assume
RRBL’s entire outstanding debt, including both current liabilities and long-term debt. If Metev
does not want to sell a controlling interest, FDLF’s minimum equity stake will be 40%, with an
appropriate discount for lack of control.
Metev starts by evaluating the company himself using the capitalized cash flow method (CCM)
and taking the following steps:
· Using the build-up method to estimate the required rate of return on equity
· Computing the firm’s weighted average cost of capital (WACC) using the book values of
debt and considering the current weight of total debt in capital structure to be optimal
Exhibits 1A, 1B, 2, and 3 contain RRBL’s financial data and other inputs that Metev uses.
Before responding to FDLF’s offer, however, Metev meets with Vasil Nenkov, his colleague and a
senior equity analyst covering the wine and beer industry in the Balkan region. After reviewing
the data and Metev’s valuation analysis, Nenkov suggests that 11% would be a more reasonable
estimate of RRBL’s WACC based on an analysis of industry peers. Metev decides to use this rate
to calculate the value of RRBL’s equity.
Nenkov also makes the following comments:
1. CCM is most often used for the valuation of large public companies, and it is less
valid for valuing private companies, such as RRBL.
2. The excess earnings method is preferable because it provides an estimate of the
value of intangible assets by capitalizing future earnings in excess of the estimated
return requirements associated with working capital and fixed assets.
Nenkov also suggests that the enterprise value (EV) multiple approach should work well for
valuing RRBL. After searching his database, Nenkov finds that Rhodopi Wineries PLC, a publicly
traded company and a close competitor of RRBL, is currently valued at an EV/EBITDA (earnings
before interest, taxes, depreciation, and amortization) multiple of 7.2. Nenkov further suggests
two adjustments:
 RRBL should command an upward adjustment of 25% in the EV/EBITDA multiple

reflecting its lower risk and higher growth relative to Rhodopi Wineries.
 Forward-looking EBITDA should be used to determine RRBL’s value.
On a cautionary note, Nenkov makes two statements regarding the use of EV/EBITDA approach
to valuation.
1. It is more appropriate than the P/E for comparing companies with different
financial leverage.
2. EBITDA underestimates cash flow from operations if working capital is growing.
Finally, Metev recalls FDLF’s willingness to purchase a non-controlling ownership interest at a

discount for lack of control. Nenkov responds by saying that a control premium of 30% is
typically applied for purchase transactions of small privately owned firms similar to RRBL and
proper adjustment for lack of control should be made if the transaction involves a non-
controlling interest. Metev thanks Nenkov for his help and goes back to his desk to revise his
valuations.
Exhibit 1A: RRBL EBITDA and Other Data

FY2012 FY2013
(BGN millions)
(Actual) (Pro Forma)
Revenues 248.5 300.6
Cost of goods sold –132.3 –172.5
Gross profit 116.2 128.1
Selling, general, and
–19.2 –23.0
administrative expenses
EBITDA 97 105.1
Other Data
Capital expenditures 2.5 4
Interest expense 2.7 3.6
Depreciation and amortization 5 6.4
Increase in working capital 0.8 1
Exhibit 1B: Additional Information for RRBL

Pre-tax cost of debt 10.00%
Weight of total debt in capital structure 30%
Tax rate 25%
Exhibit 2: RRBL Balance Sheet for FY2012
(BGN millions)
Assets Liabilities and Equity
Cash and short-term
50 Accounts payable 10
investments
Receivables and inventory 40 Notes payable 8
Net fixed assets 50 Long-term debt 30
Patents and trademarks 20 Common equity 112
Total liabilities and

Total assets 160 160
equity
Exhibit 3: Other Data and Inputs
Bulgarian government’s 10-year bond yield 3.90%
Beta of publicly traded firms in the industry 0.75

Equity risk premium 6.00%
Small stock risk premium 2.50%
Industry risk premium –1.0%
RRBL’s company-specific risk premium 1.50%
Long-term growth rate beyond FY2013 5.00%
1.) According to the method used by Metev for computing the cost of equity and data in
Exhibits 1B and 3, RRBL's WACC is closest to:
A. 10.9%.
B. 11.3%.
C. 9.2%.
Answer = B
"Private Company Valuation," Raymond D. Rath
Section 4.2.1
Using data from Exhibit 3, the cost of equity (build-up method) = Risk-free rate + Equity
risk premium + Small stock risk premium + Industry risk premium + Company-specific
risk adjustment.
Cost of equity = 3.9 + 6.0 + 2.5 – 1.0 + 1.5 = 12.9%
WACC = Pre-tax cost of debt (1 – T) × (Debt weight) + Cost of equity × (Equity weight)
WACC = 10.0 × (1 – 0.25) × (0.3) + 12.9 × (0.7) = 2.25 + 9.03 = 11.28%
2.) According to the revised method used by Metev, the WACC suggested by Nenkov, and
the data provided in Exhibit 3, RRBL's capitalization rate is closest to:
A. 11.0%.
B. 6.0%.
C. 8.5%.
Answer = B

Section 4.2.1
Capitalization rate = (WACC – Long-term growth rate) = 11.0% – 5.0% = 6.0%
3.) Regarding the two comments that Nenkov made after reviewing Metev's valuation
analysis, he is most accurate with respect to:
A. Comment 1 only.
B. both Comments 1 and 2.
C. Comment 2 only.
Answer = C

Section 4.2.3, 4.2.4
Nenkov is incorrect with respect to his first comment because the capitalized cash flow
method is rarely used for the valuation of public companies and it is more appropriate
for valuing a private company such as RRBL. Nenkov's second comment is correct
because the excess earnings method involves estimating the earnings remaining after
deducting the amounts that reflect the required returns to working capital and tangible
assets. The residual amount of earnings (i.e., the excess earnings) is capitalized to obtain
an estimate of the value of intangible assets. Therefore, Nenkov's second comment is
correct.
4.) Using Nenkov's findings from his search of the database, his suggestions regarding
appropriate adjustments, the information in Exhibit 1A and Exhibit 2, and the EV/EBITDA
multiples approach, RRBL's value of equity is closest to:
A. BGN946 million.
B. BGN916 million.
C. BGN966 million.
Answer = C

Section 4.2.3
Adjusted EV/EBITDA multiple = 7.2 × (1.25) = 9.0

EV = EBITDA2013 × Adjusted EV/EBITDA = 105.1 × 9.0 = 945.9
Value of equity = EV + Cash and short-term investments – Long-term debt = 945.9 + 50.0
– 30.0 = 965.9
5.) Regarding Nenkov's two cautionary statements concerning the use of the enterprise
value method of valuation, he is most likely correct with respect to:
A. both Statements 1 and 2.

B. Statement 1 only.
C. Statement 2 only.
Answer = B
"Market-Based Valuation: Price and Enterprise Multiples," Jerald Pinto, Elaine Henry,
Thomas Robinson, and John Stowe
Section 4.1
Statement 1 is correct because EBITDA is a pre-interest earnings figure, in contrast to

earnings per share, which is a post-interest figure. Thus the differences in financial
leverage do not affect EBITDA. Statement 2 is incorrect because EBITDA overestimates
cash flow from operations if working capital is growing. Therefore, only Statement 1 is
correct.
6.) The discount for lack of control, given the typical control premium indicated by Nenkov,
is closest to:
A. 12%.
B. 30%.
C. 23%.
Answer = C

Section 4.5.1
Discount for lack of control = 1 – [1/(1+ Control premium)] = 1 – [1/(1.30)] = 23.1%
Richter
Katharina Richter, CFA, is a fixed-income analyst at Paar Advisers, an investment advisory firm.
She is evaluating a set of mortgage-backed securities (MBS) so that she can make
recommendations about those securities for the firm's clients.
The securities, which are not yet issued, will be backed by a pool that currently contains $117.54
million of US 30-year residential mortgages. The pool has a weighted average coupon (WAC) of
4.80% and a weighted average maturity (WAM) of 243 months, which implies 17 months of
seasoning. Richter reviews current prepayment estimates for this pool from three different
providers. The first estimates a conditional prepayment rate (CPR) of 8.50%; the second, a
prepayment speed of 220 PSA (Public Securities Association prepayment benchmark); and the
third, a single monthly mortality rate (SMM) of 0.70%. As Richter reads about one provider's
prepayment expectations, she finds the following statement: "Although US mortgage interest
rates are very low relative to the historical average, rates have been this low or lower for a
number of years. Furthermore, the general state of the economy is very poor. These factors
cause us to expect low prepayment rates for the coming months." After some analysis, Richter
realizes market conditions are such that these securities will not to be issued for another two
months. At issue, the pool will not be replenished with new mortgage loans. She adjusts her
analysis of the pool, using the SMM estimate of 0.70%, to reflect this delay.
One of Paar's clients, Konrad Hartmann, is concerned that mortgage interest rates might rise by
about 1% in the near future and remain at that higher level for some time. He asks Richter which
of the many types of collateralized mortgage obligation (CMO) tranches and stripped MBS
would perform best if his concerns are realized. Hartmann is also interested in the
characteristics of MBS. He tells Richter that he understands that MBS are considered path-
dependent securities for three reasons:
Reason 1 The influence of earlier prepayments on current cash flows.

Reason 2 The tendency of few mortgage borrowers to prepay early in the life of their
mortgages.
Reason 3 The way the current prepayment rate reflects whether borrowers have
already had an opportunity to refinance at the current mortgage rate.
Hartmann shows Richter some spread information he has received regarding three CMO
tranches. This information is shown in Exhibit 1. He tells Richter that he would be happy to
invest in any of these securities based on their other characteristics and asks which he should
choose, based solely on this information.
Exhibit 1: Spread Comparison
Zero Option-
Nominal Volatility Adjusted
Spread Spread Spread
Security X 2.12% 1.67% 0.00%
Security Y 3.18% 1.30% –0.27%
Security Z 1.84% 1.46% 0.67%
1.) Of the three prepayment estimates Richter reviews, the highest is most likely the one
presented in terms of:
A. PSA.
B. CPR.
C. SMM.
Answer = B
“Mortgage-Backed Sector of the Bond Market,” Frank J. Fabozzi

Section 3D
The prepayment estimate provided for the SMM is 0.70%. For the one presented as a
CPR, SMM=1 ‒ (1 ‒ CPR)1/12, so a CPR of 8.50% implies that SMM=1 ‒ (1 ‒ 0.085)1/12
=0.0074-0.74%. The pool has 17 months of seasoning, so a 220 PSA implies CPR = 17 ×
0.2% × 2.20 = 7.48%, which implies that SMM=1 ‒ (1 ‒ 0.0748)1/12 =0.65%. The highest
prepayment estimate of the three is the estimate of CPR = 8.50%.
2.) The statement Richter reads about prepayment expectations is most likely:
A. correct.
B. incorrect with regard to the impact of current mortgage rates.
C. incorrect with regard to the impact of current economic conditions.
Answer = A
"Mortgage-Backed Sector of the Bond Market," Frank J. Fabozzi

Section 3F
Although mortgage rates are low, which would normally imply high rates of
prepayment, they have been low for some time. Therefore, any higher rate mortgage
borrowers have already had the opportunity to refinance at the current low (or even
lower) rates. Newer borrowers borrowed at these low (or lower) rates, so they will not
have a refinancing incentive. This "burnout" effect means that the current low mortgage
rates are not expected to produce high rates of prepayment, as stated. Furthermore, a
poor economy will result in lower housing turnover, which will reduce the rate of
prepayment that would be caused by people moving to new houses.
3.) The expected balance of the mortgage pool Richter is analyzing on the revised date of
issue is closest to:
A. $115,329,054.
B. $115,894,440.
C. $115,333,047.
Answer = C

Section 3D
Based on the beginning balance of $117.54 million, WAC of 4.80%, WAM of 243 months,
and SMM of 0.70%, the expected cash flows of the pool for the next two months are as
follows:
Principle
Month and Interest Principal Prepayment Balance
Interest
0 117,540,000
1 757,174 470,160 287,014 820,771 116,432,215
2 751,874 465,729 286,145 813,022 115,333,047
For Month 1 (Month 2), the principle and interest payment is the level (annuity)
payment for a principal balance of 117,540,000 (116,432,215) paid over 243 (242)
months at a monthly rate of 0.40% (4.80%/12); the interest payment is 0.40% of the
previous month's principal balance; the scheduled principal payment is the difference
between the principle and interest payment and the interest payment; the expected
prepayment is 0.70% of the previous month's principal balance minus the scheduled
principal payment; and the ending principal balance is the previous month's principal
balance minus the schedule principal payment minus the expected prepayment.
4.) Which of these security types is Richter most likely to suggest for Hartmann?
A. A principal-only strip
B. A planned amortization class (PAC) tranche
C. A support tranche
Answer = B

Section 4E
If interest rates rise moderately, prepayment rates will decline moderately. The PAC
tranche will still be within its effective prepayment collar, so its cash flows will remain as
promised or planned. The tranche's value will be reduced only by the increase in the
discount rate.
5.) Which of Hartmann's reasons as to why MBS are path-dependent securities is least likely
correct?
A. Reason 2
B. Reason 1
C. Reason 3
Answer = A
"Valuing Mortgage-Backed and Asset-Backed Securities," Frank J. Fabozzi

Section 4
The reason described is related to seasoning, which is a characteristic of mortgage pools

but not a cause of path dependency.
6.) Based on the information in Exhibit 1, Hartmann should most likely invest in:
A. Security Z.
B. Security Y.
C. Security X.
Answer = A
"Valuing Mortgage-Backed and Asset-Backed Securities," Frank J. Fabozzi

Section 4E
Security Z has the highest option-adjusted spread (OAS). The OAS is the spread measure
that takes into account the cost of the prepayment option embedded in MBS. A higher
OAS implies a higher expected return after accounting for the negative value of the
prepayment option. The nominal spread and zero volatility spread do not take into
account the cost of the embedded prepayment option.
Shah
Vikram Shah works as a portfolio manager for Heddon Investment Advisers. Shah is meeting
with the investment committee of a corporate pension fund to discuss portfolio performance as
well as strategies and techniques used in the management of the pension fund. For the meeting,
Shah has collected the information shown in Exhibit 1.
Exhibit 1: Selected Financial Information
Investment-Grade US Emerging Market

Large-Cap
Corporate Bonds Stocks
US Stocks
Expected Annual Return (%) 11 8 16
Expected standard deviation

14 6 22
of annual returns (%)
Return Correlations
Large-cap US stocks 1 0.3 0.4
Investment-grade US
--- 1 –0.1
corporate bonds
Emerging market stocks --- --- 1
Shah explains that his firm uses mean–variance portfolio analysis to guide asset allocation. He
states:
We use mathematical techniques to identify a set of efficient portfolios. From this set, we select
a portfolio that best matches our risk preferences. The pension fund’s assets are currently
invested in the following proportions: 60% US large-cap stocks, 35% US investment-grade
corporate bonds, and 5% emerging market stocks. Our analysis suggests that we should modify
our current allocations so that the new allocations are 55% US large-cap stocks, 30% US
investment-grade corporate bonds, and 15% emerging market stocks. This reallocation will
result in a mean–variance efficient portfolio that is better aligned with our risk preferences.
Jerry Cramer, a member of the investment committee, wants to know how correlations
between securities and the number of securities in the portfolio affect the pension portfolio’s
diversification benefits.
Shah responds, “As the average correlation between securities in a portfolio increases, the risk
reduction benefits of diversification decrease. Furthermore, as the average correlation between
securities in a portfolio rises, the number of securities in the portfolio must be increased in
order to achieve the same percentage of portfolio risk reduction when the average correlation
between securities is lower.”
Another board member, Kala Amato, notes that no part of the pension portfolio is invested in a
risk-free asset. She wants to know the impact of combining the current portfolio with an
investment in a risk-free asset.
In response, Shah states: “If we combine our portfolio with an investment in a risk-free asset,
the result will be a new linear efficient frontier that is referred to as the capital allocation line
(CAL), or the capital market line (CML). The risk and return of the resulting new portfolio will be
linear combinations of the risk and return of the risk-free investment and our portfolio.”
Cramer asks Shah, “Can you explain the model that you use to select stocks for inclusion in the
equity portion of the pension portfolio?”
Shah responds, “At Heddon, the primary model we use is a multifactor model in which the
factors are price-to-earnings ratio (P/E), financial leverage, and market capitalization.”
Shah moves on to a discussion about how Heddon assesses portfolio risk. He states, “We use a
risk model to decompose active risk into the following two components:
Component 1
This component is referred to as ‘active factor risk,’ which is systematic risk attributable to
differences in factor exposures between the portfolio and the benchmark. Note that the factors
in our model are P/E, financial leverage, and market capitalization.
Component 2
The second component is a function of the individual asset’s active weight in the portfolio and
the variance of returns unexplained by the three factors. This component is the active specific
risk or asset selection risk.”
Shah continues, “We prefer to structure our portfolio so that in addition to being on the
efficient frontier, it tilts, relative to the benchmark, toward stocks of large-capitalization
companies with lower P/Es and lower levels of leverage. Exhibit 2 shows the factor sensitivities
for the recommended portfolio and the benchmark.”
Exhibit 2: Factor Sensitivity

Factor Portfolio Benchmark
P/E –0.25 –0.35
Financial leverage –0.60 –0.40
Market capitalization 0.5 0.35
1.) Based on the information presented in Exhibit 1, the standard deviation of Shah's new
portfolio is closest to:
A. 10.04%.
B. 6.34%.
C. 12.80%.
Answer = A
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and

David E. Runkle
Section 2.2
2.) Is Shah's response to Cramer's question about the impact of correlation on portfolio risk
diversification benefits and the number of securities required to achieve a certain level
of risk diversification most likely correct?
A. No, he is incorrect about average correlation and the number of securities required
to achieve a certain level of portfolio risk diversification
B. No, he is incorrect about the impact of average correlation on risk diversification
C. Yes
Answer = A

David E. Runkle
Section 2.4
Shah is incorrect about average correlation and the number of securities required to
achieve a particular level of portfolio risk reduction. As the correlation between securities
increases, the number of securities required to achieve a particular level of portfolio risk
decreases. Portfolio risk is
For example, consider a situation in which the average correlation is 0.3. In this situation,
2
the minimum possible portfolio variance, when n is very large, is 0.3σ —that is, 0.3 times
the variance of a single stock. To achieve a portfolio with only 110% of this minimum
possible portfolio variance, 25 stocks would be needed:
If the average correlation is 0.5, it can be shown that only 10 stocks are needed to
2
achieve a portfolio that is 110% of the minimum possible portfolio variance of 0.5σ :
That is, 25 stocks are needed to achieve a risk level of 110% of the minimum possible
portfolio risk when the correlation is 0.3. Ten stocks are needed to achieve a risk level of
110% of the minimum possible portfolio risk when the correlation is 0.5.
3.) In his response to Amato, Shah is most likely correct with respect to the:
A. risk and return of the new portfolio.

B. CAL and the CML.
C. new efficient frontier.
Answer = A

David E. Runkle
Section 2.5
Shah is correct that the risk and return of the new portfolio will be linear combinations of
the risk and return of the risk-free investment and the portfolio, respectively. The reason
is because the return and risk of the new portfolio is calculated as
E(Rp) = w1 × E(R1) + (1–w1) × E(R2),

SD(Rp) = w1 × SD(R1).
4.) Shah's response to Cramer's question regarding the model used by Heddon Investment
Advisers would imply that the multifactor model is most likely a:
A. fundamental factor model.

B. macroeconomic factor model.
C. statistical factor model.
Answer = A

David E. Runkle
Section 4.1
The multifactor model that Shah describes is a fundamental factor model. In fundamental
factor models, the factors are attributes of stocks or companies that are important in
explaining cross-sectional differences in stock prices. Among the fundamental factors
that have been used are the ratio of book value to price, market capitalization, the price-
to-earnings ratio, and financial leverage.
5.) Is Shah correct about the components of active risk?
A. Yes
B. No, he is incorrect about Component 1
C. No, he is incorrect about Component 2
Answer = A

David E. Runkle
Section 4.6.2
Shah correctly describes the two components of active risk. We can separate a portfolio's
active risk squared into two components: (1) active factor risk is the contribution to active
risk squared resulting from the portfolio's different-from-benchmark exposures relative to
factors specified in the risk model (or systematic risk), and (2) active specific risk (or
asset selection risk) is the contribution to active risk squared resulting from the portfolio's
active weights on individual assets as those weights interact with assets' residual risk
(also referred to as idiosyncratic risk).
6.) With respect to the factor tilts of the portfolio in Exhibit 2, Shah is least likely correct
about the:
A. market capitalization.
B. financial leverage.
C. P/E.
Answer = C

David E. Runkle
Section 4.6
Shah is incorrect with respect to the P/E. He states that his firm ensures that the portfolio
is tilted toward low P/E stocks. The factor sensitivity of the portfolio to the P/E factor is
negative (–0.25), indicating that it does invest in low P/E stocks. However, the
benchmark's sensitivity is –0.35, indicating that stocks in the benchmark have lower P/Es
than stocks in the portfolio. Thus, the portfolio is not tilted toward low P/E stocks relative
to the benchmark.

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