Professional Documents
Culture Documents
Case 1: 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
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
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.
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
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conflicts of interest, (2) selectively differentiate services to clients, and (3) outline all manager
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
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
Requirement 1: be reviewed by peers as soon as practical to ensure adequate basis and due
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
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
Task 1: systems are in place to detect violations of laws, rules, regulations, firm policies, and the
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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
1. Which of Kingfisher's statements in the RFP regarding its qualifications most likely violates
A. Justification 3.
B. Justification 2.
C. Justification 1.
Correct answer: C.
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
CFA Level 2
Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program
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. Compensation arrangements
C. Conflicts of interest
Correct answer: A.
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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
CFA Level 2
Standard III(B): Fair Dealing; Standard VI(A): Conflicts of Interest; Standard IV(B): Additional
Compensation Arrangements
3. Do Kingfisher's proposed policy statements related to Capital Market Integrity most likely
C. No
Correct answer: C.
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
misleading information and transactions that deceive or would be likely to mislead market
CFA Level 2
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Level II– Mock 68
A. diversified portfolio.
B. investment plan.
C. periodic review.
Correct answer: A.
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
CFA Level 2
A. Requirement 1
B. Requirement 3
C. Requirement 2
Correct answer: C.
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.
CFA Level 2
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6. Which of the following tasks suggested by the government committee would least likely
A. Task 1
B. Task 3
C. Task 2
Correct answer: A.
CFA Level 2
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Case 2: Hahn
Rolf Hahn is an analyst with Weissdorn GmbH. He is puzzled by the most recent report of his
firm's statistical analysis of one of its investments, VeriZoom, Inc. The reported correlation of
VeriZoom with the market seems to be too high. He suspects that the new software the firm
installed the previous week is not programmed to correctly calculate correlations. Hahn decides to
Hahn accesses Weissdorn's returns database and downloads the appropriate monthly returns data
needed to estimate the correlation of VeriZoom and the MSCI Europe Large Cap Index, the index
Weissdorn uses as the market proxy. Using a spreadsheet program, Hahn establishes the variance
Exhibit 1
Given the results in Exhibit 1, Hahn's suspicion that the software is incorrect with the correlations
is confirmed. He asks his assistant, Angela Greene, to help him recalculate the statistics for each
firm Weissdorn covers. While working to complete this task, Greene asks Hahn why correlation is
so important in portfolio management. Hahn replies that correlation can establish the strength of
Greene responds by asking if the only means of evaluating whether the correlation is close to 0 is
the judgment of the analyst. Hahn says that there is a statistical test to determine whether a sample
correlation is statistically significantly different from 0. Hahn takes the results for another firm
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that Weissdorn follows, Anchor-Wise, Inc. (AWI), and uses them to demonstrate the test. The data
Exhibit 2
0.267 60 1.67
Greene asks Hahn if there are other techniques that can be used to evaluate the relationship
between two variables. Hahn answers that regression, a technique closely related to correlation
analysis, can be used to establish the relationship between two variables within the assumptions of
the analysis.
For example, he says that they might want to evaluate the following:
where RAWI is the monthly total return on AWI, RMSCI is the monthly total return on the MSCI
Europe Large Cap Index, and ɛ represents the error term. Greene and Hahn use the data they
downloaded for AWI and the MSCI index and run the regression. The results are given in Exhibit
3.
Exhibit 3
Regression Statistics
Multiple R 0.2666
R2 0.0711
Observations 60
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Regression 1 0.0052
Residual 58 0.0685
Total 59 0.0738
b
0.005 0.0045 1.1151
0
b
0.0634 0.0301 2.1069
1
Hahn next considers the topic of multiple regression. To provide an example that he and Greene
can review, he downloads data that allow him to establish the following:
where RAWI is the quarterly return for AWI, ΔGDP USA is the change in US real GDP for the
quarter, and YCUSA is the slope of the yield curve (measured as the difference between the
1-month US Treasury rate and the 10-year Treasury rate) at the end of the quarter. The results of
Exhibit 4
Regression Statistics
Multiple R 0.096
R squire 0.0092
Observations 39
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Regression 2 0.0003
Residual 36 0.0009
Total 38 0.0334
Hahn points out to Greene that interpretation of the results from a multiple regression can be
biased unless various conditions are met. He mentions three such conditions. The error term must
• be normally distributed.
7. Based on the data in Exhibit 1, the correlation between VeriZoom and the MSCI Europe
A. 0.733.
B. 0.550.
C. 0.980.
Correct answer: A.
Cov( X , Y )
r=
S X SY
0.0220
In this case, r = = 0.7333
0.0225 × 0.0400
CFA Level II
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"Correlation and Regression," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and
David E. Runkle
Section 2.3
A. Statement 3
B. Statement 1
C. Statement 2
Correct answer: C.
Correlation measures the linear association between two variables. Variables with a correlation
CFA Level II
"Correlation and Regression," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and
David E. Runkle
Section 2.4
9. Assuming that the returns for Anchor-Wise and the returns for the MSCI Europe Large Cap
Index come from a bivariate normal distribution, the results shown in Exhibit 2 most likely
indicate that:
Correct answer: C.
r n−2 0.267 60 − 2
The test statistic, t, is: t = t= = 2.110
1− r 2
1 − 0.267 2
where r is the correlation and n is the Because 2.110 is greater than the critical value of
number of observations. 1.670, we reject the null hypothesis that the correlation
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is 0.
CFA Level II
"Correlation and Regression," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and
David E. Runkle
Section 2.6
10. Based on the results reported in Exhibit 3, the F-statistic to test whether the slope of the
A. 2.107.
B. 4.157.
C. 4.403.
Correct answer: C.
For a regression with one independent variable, as is the case here, the F-statistic is calculated as
RSS 0.0052
F= = = 4.403
SSE 0.0685
n-2 58
where RSS is the regression sum of squares, SSE is the residual sum of squares, and n is the
number of observations.
CFA Level II
"Correlation and Regression," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and
David E. Runkle
Section 3.6
A. b 0 and b1 are both statistically significantly different from zero, but b2 is not significant.
C. none of the coefficients in the regression are significantly different from zero.
Correct answer: C.
All three coefficients are not statistically significantly different from zero at the 5% level; their
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p-values are too high. To accept the hypotheses that they are statistically different from zero, the
CFA Level II
Section 2
"Correlation and Regression," Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, and
David E. Runkle
Section 3.5
12. Which of Hahn's conditions relating to the error term in a multiple regression is correctly
stated?
Correct answer: C.
Multiple linear regression assumes that the error term is normally distributed, has an expected
CFA Level II
Section 2.1
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Questions 13-18 relate to Economics
Case 3: Drawbridge
international investment firm. He is meeting with equity analyst Andrew Gillibrand and
fixed-income analyst Eliana Navarro to discuss new investment opportunities and the economic
"Before we look at new investment opportunities, I want to review some prior transactions. A few
months ago, Drawbridge entered into a carry trade in a set of currencies. This morning, we were
unfortunately forced to close out the position at a sizable loss as a result of unexpected market
volatility."
Hollingsworth continues:
"Earlier in the year, Drawbridge hedged a long exposure to the Australian dollar (AUD) by selling
AUD5 million forward against the US dollar (USD); the all-in forward price was 0.8940
(USD/AUD). It is now three months prior to the settlement date, and I want to mark the forward
position to market."
Exhibit 1 provides information about current rates in the foreign exchange markets.
Exhibit 1
On completion of the agenda items relating to the foreign exchange markets, Hollingsworth and
his team move on to new investment opportunities. They begin with a discussion about the
relationship between economic growth and the performance of equity and debt markets.
Gillibrand: "When we consider our equity investments over the long term, our primary focus
should be on the rate of GDP growth. For longer time horizons, changes in earnings and the
price/earnings multiple are relatively less important in determining appreciation in the stock
market."
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Navarro: "When we look at our fixed-income investments, we should keep in mind that higher
rates of potential GDP growth will translate into higher real interest rates and higher expected real
asset returns."
Hollingsworth: "Anticipating changes in potential GDP can be quite lucrative for us because credit
rating agencies often use the growth of potential GDP as an input in evaluating sovereign risk. In
general, there is an inverse relationship between estimated potential GDP growth and credit
quality."
The economic growth projections for two of the countries in which Drawbridge is considering
making new investments are presented in Exhibit 2. Hollingsworth prefers the Solow growth
accounting equation to calculate potential GDP growth rather than the more simplistic labor
Exhibit 2
Growth in Total
Output
Factor
Inflation Rate Elasticity of Growth Rate of Growth Rate of
Country Productivity
(%) Capital Capital (%) Labor (%)
(%)
The conversation then turns to the topic of convergence. Navarro says: "Even though Country B's
per capita growth is expected to exceed that of Country A for some time, according to the
neoclassical model, eventually both countries will experience the same growth rate because the
Exhibit 3. Although both countries had below-average levels of per capita GDP 50 years ago, over
time, the per capita GDP growth rate of Country C has risen rapidly and for nearly 20 years has
been well above average. The growth rate for Country D, however, has risen more slowly. Today,
Country C ranks among the advanced economies whereas Country D remains a developing nation.
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Exhibit 3
13. The primary factor that was most likely the cause of Drawbridge's outcome in its carry trade
was:
A. flight to safety.
B. leverage.
C. stop-loss orders.
Correct answer: B.
The primary reason for crash risks is related to the fact that carry trades are leveraged: The
low-yield currency is borrowed, with proceeds invested in the high-yield currency. The leverage
magnifies the effect of losses and gains relative to the investors' equity base. In low-volatility
markets, investors can become complacent and allow positions to grow large in a search for yield.
This crowded positioning tends to unwind rapidly when a market shock occurs because many
traders try to exit their positions almost simultaneously before the leverage effects wipe out their
equity. Stop-loss orders are triggered, and given the market uncertainty, there is a flight to safety
CFA Level II
"Currency Exchange Rates: Determination and Forecasting," Michael R. Rosenberg and William
A. Barker
Section 4
14. The mark-to-market value for Drawbridge's forward position is closest to:
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A. –USD44,774.
B. –USD42,576.
C. –USD44,800.
Correct answer: A.
1.Drawbridge sold AUD5 million forward to the settlement date at all-in forwaed price of
0.8940(USD/AUD)
2.To make the position to market Drawbridge offsets the forward translation by buying AU
D5 million, three months forward to the settlement date.
3.For the offsetting forward contract,because the AUD is the base currency in the
USD/AUD quote, buying
AUD forward means paying the offer for both the spot rate and the forward points.
I.The All-in three month forward rate is calculated as, 0.9066-0.00364=0.90296=-USD44,
800
(This amount is a cash outflow because Drawbridge sold the AUD forward and the
AUD appreciated against the USD)
4.To determine the mark- to-market value of the original forward position, calculate the pre
sent value of the USD cash flow using the three-month USD discount rate.
− USD 44800
= −USD 44774
90
1 + 0.0023
360
CFA Level II
"Currency Exchange Rates: Determination and Forecasting," Michael R. Rosenberg and William
A. Barker
Section 2.2
15. Which of the statements about economic growth and the performance of equity and debt
A. Hollingsworth's
B. Navarro's
C. Gillibrand's
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Correct answer: A.
There is a direct relationship, not an indirect one, between estimated potential GDP growth and
credit quality: Higher growth leads to higher quality—that is, an improvement in the likelihood of
CFA Level II
Section 3
16. Based on the data in Exhibit 2, the GDP growth rate in Country A using Hollingsworth's
A. 2.94%.
B. 2.74%.
C. 2.86%.
Correct answer: B.
Hollingsworth's preferred method of calculating the GDP growth rate is the Solow growth
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DY
Thus, = 1.5 + (0.3 × 3.2 ) + (0.7 × 0.4 ) = 1.4 + 0.96 + 0.28 = 2.74
Y
CFA Level II
Section 4.3
17. Navarro's statement about the convergence of growth between Country A and Country B is
A. conditional convergence.
B. club convergence.
C. absolute convergence.
Correct answer: C.
Absolute convergence means that developing countries, regardless of their characteristics, will
eventually catch up with developed countries and match them in per capita output. The
neoclassical model assumes all countries have access to the same technology and, as a result, per
capita income in all countries should eventually grow at the same rate.
CFA Level II
Section 5.4
18. Country D's current economic status can best be explained by past government policies that
encouraged:
A. domestic substitutes.
B. free trade.
C. foreign investment.
Correct answer: A.
Policies that encourage the production of domestic substitutes are inward oriented, attempting to
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develop domestic industries by restricting imports, despite the fact that it may be more costly to do
so. As a result, the country would not benefit from the positive effects of integrating domestic
industries with the global economy and benefiting from trade and foreign investment.
CFA Level II
Sections 2.6, 6
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Case 4: Thames
Mark Crawley is an analyst at a London-based private equity firm and is reviewing the firm's file
on Thames Air Plc (Thames), a company it provides financing for. Thames uses International
Financial Reporting Standards (IFRS) in the preparation of its financial statements. Thames is a
relatively new airline based in the United Kingdom specializing in flights and vacation packages
to Mediterranean locations, primarily Spain. Thames sells most of its flights and vacation
packages to British residents in British pounds (GBP) and considers the costs of local competitors'
packages when determining its prices. Costs are incurred in multiple currencies:
Typical of the industry, airline fuel and lease costs are normally priced in US dollars (USD).
The landing fees paid at the vacation-area airports are in the local currency, primarily euros
(EUR).
First, Crawley turns his attention to the effect of the transactions undertaken in various currencies
by Thames.
He reviews the change in the exchange rate for the USD to GBP during 2015, shown in Exhibit 1,
and wonders what the effect of this change was on Thames's operating income.
At year-end (31 December), Thames had a large outstanding payable in Spain related to landing
fees that were incurred there evenly over the final quarter. The company paid the amount in full on
its due date of 28 February. Crawley observed that the EUR to GBP exchange rate had changed
between when the costs were incurred and the year-end and again by the payment date, as also
shown in Exhibit 1.
Exhibit 1
Selected Exchange Rate Data
GBP/USD Close GBP/EUR Close
1-Jan-15 0.64
30-Jun-15 0.72
31-Dec-15 0.68 0.75
28-Feb-16 0.73
Average, 1 July-31 December 2015 0.7325
Average, 1 October-31 December 2015 0.74
Because of the growing demand for vacation rentals in Spain during the past year, Thames
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acquired 100% of Tagus SA (Tagus), a Spanish company that owns a small vacation hotel and a
few villas. Tagus has long-term debt outstanding from a Spanish bank that financed the 2012
purchase of the vacation properties, which will now be rented as part of the vacation packages
offered by Thames. Tagus incurs all costs related to operating and maintaining the rental
properties in EUR.
Since the acquisition, all of Tagus's revenue comes from Thames's sales in Britain of the vacation
packages. Tagus receives the amounts in GBP. But Tagus hopes to expand and start renting out any
excess capacity of the properties, or newly acquired properties, to local tourists in the next few
years. Crawley notices that Thames is using the temporal method to translate Tagus's financial
statements prior to consolidation and asks another analyst, Dee Chopra, if this is appropriate.
Crawley next reviews the information in Exhibit 2 related to the Tagus acquisition to consider the
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As the final step in his review, Crawley starts a ratio analysis of Thames and Tagus, and he asks
Chopra which ratios, if any, would be unaffected by Thames's choice of translation method for
Tagus.
A. USD.
B. EUR.
C. GBP.
Correct answer: C.
The functional currency is the currency of the primary economic environment in which an entity
operates. Using the IFRS factors for determining the functional currency, Thames's functional
currency is most likely GBP. The company sets its prices in GBP based on competitive factors in
the British market; it is financed, to date, by a British private equity firm, and it receives its
CFA Level II
Sections 2, 3.2
20. Which of the following statements about the effect of the change in the USD to GBP
exchange rate during the year is most accurate? Operating income for Thames would:
Correct answer: C.
Thames incurs fuel and lease costs in USD. During the year, the USD has strengthened relative to
the GBP (from GBP0.6400/USD to GBP0.6800/USD), thereby making purchases (costs) in USD
CFA Level II
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Section 2.3
21. Which of the following best describes the effect on Thames's financial statements of the
B. adjust the landing fees expense to reflect the change in exchange rate when they are paid.
Correct answer: A.
Between incurring the fees and the year-end, the EUR appreciated against the GBP
holding a liability in an appreciating currency) in net income. The payable would be originally
recorded when the landing fees were incurred during the final quarter (GBP0.7400) but revalued
CFA Level II
Section 2.2
22. Chopra's best answer to Crawley's question about Thames's use of the temporal method to
Correct answer: B.
The functional currency of Tagus currently appears to be GBP. The operations of Tagus are
presently just an extension of Thames as supported by the fact that the only source of revenue is
payments from Thames, received in GBP. Even though Tagus incurs most costs and its financing
(long-term debt) in EUR, under IFRS, Factors 1 and 2 (dealing with revenues and sales prices)
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rank higher than Factors 3 and 4 (dealing with operating and financing costs) when determining
functional currency. Under IFRS, when the functional currency of the subsidiary is the same as the
parent, the temporal method should be used to translate the subsidiary's financial statements.
CFA Level II
Section 3.2
23. The most likely effect of the change in the exchange rate between the EUR and GBP arising
Correct answer: B.
Thames is using the temporal method for its translation of Tagus, and the initial exposure is a net
liability exposure (monetary liabilities of EUR13,500 exceed the monetary assets of EUR4,000).
The EUR strengthened against the GBP during the six-month period (from GBP0.7200/EUR to
GBP0.7500/EUR). The net effect of having a net liability position in a strengthening currency will
be a translation loss for Thames, which, under the temporal method, is reported in net income.
CFA Level II
24. The best answer Chopra can give to Crawley's question about which ratio would be
unaffected is the:
C. current ratio.
Correct answer: A.
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The accounts receivable turnover ratio is calculated as sales/average accounts receivable. Under
both the current method and the temporal method, both sales and accounts receivable are
translated at the same rates: average for sales and year-end for accounts receivable (accounts
receivable are a monetary asset for the temporal method). Therefore, this ratio would not be
CFA Level II
Section 3.4
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Elizabeth Robbin is the new chief investment officer at Teacher Retirement Systems (TRS), which
oversees 21 funds from 11 different firms. She plans to implement new performance measurement
Robbin is meeting with her staff to gauge what they know about manager selection and evaluation.
She starts by asking her staff to share with her their understanding of the term "value added." She
notes the following responses from three analysts, David Gladden, Agnes Wert, and Sandra
Marano.
Gladden: A manager adds value when the portfolio return is greater than that of its benchmark.
Marano: Value added can come from multiple sources, including asset allocation and security
selection.
Robbin reviews data compiled by Gladden for Bosphorus Investment Advisers for the meeting.
After reviewing Gladden's work, Robbin requests that the analysts include the information ratio in
Exhibit 1
Fund average annual return (%) 18.54 Benchmark standard deviation 9.55
Because the analysts are unfamiliar with the use of the information ratio, Robbin explains how it
might be useful in investment manager selection and in choosing the level of active portfolio risk.
She asks each analyst to make an observation about his or her understanding of the information
ratio.
Marano: The information ratio will change as the active weights deviate from the benchmark
weights.
Gladden: Because TRS's investment policy prohibits short positions, TRS would be unable to take
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Wert: The information ratio appears to be the best criterion to evaluate the past performance of our
active managers.
Robbin points out that the Sharpe ratio and the information ratio are both useful tools in evaluating
portfolio managers and asks Gladden to explain some of the important differences between the
two.
Gladden notes, "The information ratio is a measure of relative expected or realized reward to risk
whereas the Sharpe ratio measures the absolute risk-return trade-off of a portfolio. Sharpe ratios
help investors focus on the relative value added by active management. Although the information
ratio is not affected by the addition of cash or leverage, the Sharpe ratio is affected by the addition
of either."
Robbin then introduces the Fundamental Law of Active Management to her analysts, illustrating it
with a graphic called the "correlation triangle." "This graph explains how a manager's forecasted
returns, decisions about the portfolio's active weights, and realized active returns are related to
Wert observes, "That makes sense. It is difficult to add value if the manager's forecasts do not
correspond at least somewhat to the realized active returns. Also, if the portfolio manager does not
overweight securities for which he has forecasted the best relative returns, he will not generate
Lastly, Robbin illustrates to her team how they might apply the Fundamental Law of Active
Robbin observes, "Kariba may be overstating its expected active return. Because Kariba
rebalances weekly, it claims that its number of independent decisions is high. However, some of
these securities (exchange-traded funds) may cluster in economic regions where the same general
analysis applies to several securities. That would mean that Kariba's breadth is in fact much lower
than stated. Furthermore, Kariba asserts that each security is independently evaluated. That may
not be true either. For example, a strategy that favors a particular economic region will likely
persist for several months, and therefore, the investment decisions are not independent. Again, the
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25. Which statement regarding the measurement of value added is least likely to be correct?
Correct answer: C.
Positive return alone does not reflect value added. The value added of an actively managed
portfolio (RA) is the difference between the return on the portfolio (RP) and the return on the
RA = RP - RB
CFA Level II
"Analysis of Active Portfolio Management," Roger G. Clarke, Harindra de Silva, and Steven
Thorley
Section 2.2
26. Based on the information presented in Exhibit 1, the information ratio for Bosphorus is
closest to:
A. 0.95.
B. 0.53.
C. 0.26.
Correct answer: C.
The information ratio is calculated by dividing the active return (RA) by the active risk. The active
risk is the standard deviation of the difference between portfolio return and the benchmark return
STD(RP - RB)]. .
RF - RB RA
IR = =
STD(RF - RB ) STD(RA )
CFA Level II
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"Analysis of Active Portfolio Management," Roger G. Clarke, Harindra de Silva, and Steven
Thorley
Section 3.2
27. With respect to the information ratio, which analyst's observation is least likely correct?
Correct answer: C.
The information ratio is unaffected by the aggressiveness of the active weights (deviations from
benchmark weights) because both the active return and the active risk increase proportionally.
CFA Level II
"Analysis of Active Portfolio Management," Roger G. Clarke, Harindra de Silva, and Steven
Thorley
Section 3.3
28. In his statement regarding the information and Sharpe ratios, Gladden is most likely correct
Correct answer: B.
The information ratio is a measure of relative expected or realized reward to risk, whereas the
CFA Level II
"Analysis of Active Portfolio Management," Roger G. Clarke, Harindra de Silva, and Steven
Thorley
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29. Is Wert correct in her assessment of the Fundamental Law of Active Management?
C. Yes
Correct answer: C.
Both observations are correct. A manager's forecasts must correspond at least somewhat to the
realized returns if the manager is to generate a positive relative return (information coefficient),
and the manager must overweight securities for which he has forecasted the best relative returns in
CFA Level II
"Analysis of Active Portfolio Management," Roger G. Clarke, Harindra de Silva, and Steven
Thorley
Section 4.1
30. Is Robbin correct with respect to her assertion about Kariba overstating its expected active
return?
A. Yes
B. No, she is incorrect regarding the impact of the overlap in individual security evaluations
C. No, she is incorrect regarding the impact of the number of independent decisions
Correct answer: A.
The expected active return is expressed as the expected information ratio multiplied by the active
risk target, or
assumption or forecast that persists through multiple rebalancing periods, then breadth will be
lower, reducing the information ratio and thus the expected active return.
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CFA Level II
"Analysis of Active Portfolio Management," Roger G. Clarke, Harindra de Silva, and Steven
Thorley
Section 6.2
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John Earl is a project analyst for Kames Inc. Earl is currently reviewing the projected annual
income statements, shown in Exhibit 1, for the five-year life of Project #162 to determine the net
present value (NPV) of the project using an annual discount rate of 10%.
Exhibit 1
Cash operating
210,000 224,000 245,000 273,000 308,000
expenses
The project will require an increase in fixed assets of $150,000 that will be fully depreciated.
Current assets are expected to increase by $80,000 and current liabilities are expected to increase
by $45,000. This increase in net working capital will be recovered when the project is finished.
Just prior to completing the analysis, Earl finds out that the fixed assets can be depreciated using
Exhibit 2
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Given the use of the accelerated depreciation method, Earl concludes that the NPV of Project #162
increases to $127,818 .
In an initial discussion with a fellow analyst, David North, about Project #162, Earl tells North:
“I have prepared the analysis using nominal values and a nominal discount rate.”
North responds:
“Even though the analysis is in nominal terms, the discount rate should be increased by an
“I intend to also calculate the economic profit by subtracting the dollar cost of capital from the net
North replies:
“I suggest you determine the key inputs for the analysis, and then examine each input separately
by varying its value between plus or minus 1% or 2%. This variance will give you better insight
31. Given the information in Exhibit 1, the after-tax operating cash flow (in thousands) for Year 1
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Level II– Mock 68
A. $36.0.
B. $71.4.
C. $66.0.
Correct answer: C.
CFA Level II
Section 5
32. The initial investment outlay (in thousands) for Project #162 is closest to:
A. $275.
B. $185.
C. $230.
Correct answer: B.
where
The initial investment is the increase in the fixed assets plus the additional working capital:
CFA Level II
35 / 62
Level II– Mock 68
Section 5.3
33. By switching to an accelerated depreciation method, the increase in NPV for Project #162 is
closest to:
A. $11,112.
B. $4,445.
C. $6,667.
Correct answer: B.
It is not necessary to compute the NPV in Exhibit 1 to find this value, but that approach will also
lead to the correct answer. Instead, sum the discounted differences in the depreciation cash flows
CFA Level II
B. incorrect because the inflation rate adjustment should be based on expected inflation.
C. correct.
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Correct answer: A.
The response is incorrect because nominal cash flows should be discounted using a nominal
CFA Level II
Section 6.4
C. correct.
Correct answer: A.
The statement is incorrect because the appropriate calculation is earnings before interest and taxes
(EBIT) × (1 – Tax rate) – Dollar cost of capital (see equation). Because there is interest on debt on
the income statement, net income does not equal EBIT × (1 – Tax rate).
CFA Level II
Section 8.3.1
B. sensitivity analysis.
C. scenario analysis.
Correct answer: B.
North’s final suggestion describes sensitivity analysis because each variable/input examined is
CFA Level II
37 / 62
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Section 7.3.1
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Level II– Mock 68
Case 7: Darwin
Gabrielle Marchand and Cristiano Palmeiro are junior analysts recently hired by Nordfjord
Investment Management, an international investment firm. They have been assigned by senior
analyst Anniken Kristensen to work as a team to research Darwin Industrial (Darwin), a major
Marchand and Palmeiro start by researching the industry. They discuss how the competitive
The industry is fragmented and there is a strong rivalry for market share, particularly among the
larger participants.
Paints and coatings are the logical or only choice for many applications, but alternatives, such as
There is some brand loyalty, although it is not pervasive. The essentially identical product
offerings from the various manufacturers enable customers to easily switch brands.
Marchand and Palmeiro's research reveals that the industry's growth prospects are predictable
because they are closely tied to economic growth, particularly the housing, construction,
automotive, and industrial products sectors. Responding to regulatory pressure and increasing
consumer demand for environmentally friendly products, Darwin has been at the forefront of
developing products that are more eco-friendly and safer for its employees to manufacture and for
customers to use.
In developing their sales and expense forecasts, Marchand and Palmeiro review selected financial
data on Darwin and selected economic factors, as shown in Exhibit 1. Using 2015 as the base year,
general and administrative and depreciation and amortization expenses to be fixed, and
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Exhibit 1
2014 2015
Income statement
(€ millions) (€ millions)
Interest expense 96 92
After completing their forecast of the income statement, Marchand and Palmeiro discuss
approaches to forecasting balance sheet accounts. Marchand asks Palmeiro which accounts on the
balance sheet can be most reliably forecasted from the income statement.
Kristensen and her team then move on to a discussion of the various ways of comparing Darwin's
profitability with other firms in the industry, and they make the following comments:
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Kristensen: I prefer return on invested capital (ROIC) because it is not affected by the amount of
Palmeiro: Return on equity (ROE) is the most common measure of shareholder return, although
Darwin's share repurchase program will affect the relevance of the ratio.
Marchand: We could use return on capital employed (ROCE), but its significance will be limited if
37. Based on Marchand and Palmeiro's notes, the industry's competitive strength is most likely
related to the:
C. threat of substitutes.
Correct answer: C.
Marchand and Palmeiro's analysis indicates that although there are alternative products available
for some situations, paints and coatings are the logical or only choice for many applications. Thus,
the threat of substitutes would be considered low to medium, which would improve the
CFA Level II
"Industry and Company Analysis," Matthew L. Coffina, Anthony M. Fiore, and Antonius J. van
Ooijen
Section 3
38. Based on the analysts' research about industry growth prospects and Darwin's response,
which of the following would be the most appropriate classification of Darwin's strategic
style?
A. Shaping
B. Visionary
C. Classical
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Correct answer: B.
Darwin's strategic style would be best classified as visionary. The visionary style works best in an
industry that is predictable and in which companies have the ability to bring about change in the
industry. Darwin appears to be taking deliberate steps to succeed and to lead the industry through
CFA Level II
"Your Strategy Needs a Strategy," Martin Reeves, Claire Love, and Philipp Tillmanns
39. Marchand and Palmeiro's modeling approach can be most appropriately described as:
A. bottom up.
B. top down.
C. hybrid.
Correct answer: C.
The analysts base their sales forecasts on economic factors, including GDP growth, which is a
top-down approach. They also base their projections on an analysis of the company's historical
sales and expense data, which is a bottom-up approach. Thus, by using a combination of top-down
and bottom-up approaches, Marchand and Palmeiro are using a hybrid approach.
CFA Level II
"Industry and Company Analysis," Matthew L. Coffina, Anthony M. Fiore, and Antonius J. van
Ooijen
Sections 2.1.1–2.1.3
40. Based on the analysts' sales and expense forecasts and the data in Exhibit 1, their forecasted
A. €861 million.
B. €827 million.
C. €853 million.
Correct answer: A.
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2015 2016
2016 vs. 2015 Calculation
(€ (€millions)
Sales 9,280 GDP + 1% = 5.5% increase 9,280 × 1.055 9,790
Selling
1,940 Stable percentage of sales (1,940/9,280) × 9,790 2,047
expenses
G&A
485 No change 485
expenses
D&A
294 No change 294
expenses
Operating
1,160 1,316
profit
Interest = 92/1,533 = 6%
92 1,433 × 0.06 86
expense Debt to decline by €100
million
Income
320 30% tax rate 1,230 × 0.3 369
taxes
CFA Level II
"Industry and Company Analysis," Matthew L. Coffina, Anthony M. Fiore, and Antonius J. van
Ooijen
41. The best answer to Marchand's question about forecasting balance sheet accounts is:
A. operating loans.
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C. inventory.
Correct answer: C.
The income statement can be the starting point for balance sheet modeling. A common way to
forecast working capital accounts (i.e., inventory) would be by using efficiency ratios, such as
inventory turnover. Projections for long-term assets, such as property, plant, and equipment, are
less directly tied to the income statement. The operating loan balance would depend on the
working capital needs and cash flow forecasts, so it is two steps removed from the income
statement.
CFA Level II
"Industry and Company Analysis," Matthew L. Coffina, Anthony M. Fiore, and Antonius J. van
Ooijen
Section 2.5
42. Which of the three analysts' comments about the methods used to compare Darwin's
A. Palmeiro's
B. Marchand's
C. Kristensen's
Correct answer: B.
Marchand's comment is the least accurate. ROCE is essentially ROIC before tax and is defined as
operating profit divided by capital employed. As a pretax measure, ROCE is useful when
profitability would not favor companies benefiting from low tax rate systems.
CFA Level II
"Industry and Company Analysis," Matthew L. Coffina, Anthony M. Fiore, and Antonius J. van
Ooijen
Section 2.5
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Case 8: Wingersheek
Sandy Annisquam is the head of trading at Wingaersheek Arbitrage Opportunities, LLP, a hedge
fund specializing in fixed income strategies. The firm’s investment approach is to exploit small
price differences across similar or identical securities. Annisquam has asked Choate Hake to
develop a comprehensive automated trading system that will allow traders to identify
opportunities in the market. Annisquam and Hake are discussing several applications that need
Hake begins development on an algorithm that will evaluate government bonds that have been
stripped. He tests his logic by evaluating a dollar-denominated Tangoran government bond with
a 3.20%, annual pay coupon maturing in three years, using data in Exhibit 1. The bond is quoted
Exhibit 1
Hake develops a framework for valuing bonds using a binomial interest rate tree. He
understands that there are several factors used in developing the tree and asks Annisquam for
counsel on the correct data to use. Annisquam makes the following comments to Hake:
Comment 1: In the valuation process, the interest rate tree generates cash flows that are interest
rate dependent; but does not provide the interest rates used to discount those cash flows.
Comment 2: Two assumptions must be made to create a binomial tree. The first is an interest
rate model such as a lognormal model of interest rates. The second is a volatility of interest rates.
Comment 3: Volatility can be measured relative to the current level of rates. By using a
lognormal distribution, interest rate movements are proportional to the level of rates and are
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Level II– Mock 68
Annisquam asks Hake to use a binomial interest rate tree to calculate the value of a bond. He
tests the module using a three-year, $100 par value, 4% annual pay coupon bond and the data in
Exhibit
4.50%
3.6%
2.9%
3.25%
2.6%
2.
2.35%
Annisquam tells Hake that he needs to calibrate the binomial interest rate tree to match a term
structure of interest rates. Hake wants to better understand this process and asks Annisquam to
describe it. Annisquam says, “Calibrating an interest rate tree requires an iterative process that
ensures that the upper and lower rates are consistent with the volatility assumption, the interest
rate model, and the observed market value of the benchmark bond. The cash flows of the bond
are discounted using the interest rate tree, and if this doesn’t produce the correct price, another
Annisquam then develops a model that compares the value of a bond determined using a binomial
interest rate tree to its value determined using spot rates. The bond he selects for the comparison
is non-benchmark, option-free, has five years to maturity and an annual-pay coupon rate of 3%.
The coupon rate is below the coupon rate of the benchmark bond. The yield curve is currently
downward sloping. The output of Annisquam’s model shows that the spot rates generate a value
equal to the market price of the bond, but the interest rate tree methodology produces a higher
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Level II– Mock 68
value.
Annisquam wants Hake to develop a program for pricing securities that are interest rate path
dependent, such as mortgage-backed securities (MBS). He believes that using the Monte Carlo
method and employing 2,000 simulations will provide an average present value across all
scenarios equal to the actual market value of the securities. Hake runs a simulation and uses it to
value a benchmark bond. He finds that the value generated does not equal the market price of the
bond.
43. Based on the market price of the Tangoran government bond and the interest rates in Exhibit
1, what profitable arbitrage opportunity should Hake's algorithm most likely identify?
B. Buying the Year 1 and Year 2 strips and selling the Year 3 strip
Correct answer: A.
The value of the bond's cash flows using spot rates is $103.4816 and is determined as follows:
So, strips could be purchased for $103.4816 and reconstituted into the bond, which could be sold
CFA Level II
Sections 2.3, 3
44. Which of Annisquam's comments regarding binomial interest rate trees is least likely correct?
A. Comment 3
B. Comment 2
C. Comment 1
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Level II– Mock 68
Correct answer: C.
Annisquam is incorrect in Comment 1. The interest rate tree performs two functions in the
valuation process: (1) generating the cash flows that are interest rate dependent and (2) supplying
the interest rates used to determine the present value of the cash flows.
CFA Level II
Section 3
45. Using the backward induction method and the data in Exhibit 2, the value of the bond Hake
A. 101.069
B. 101.584
C. 102.532
Correct answer: C.
Value at Year 2:
Find prices two periods from the end. Time 1 values are the average of Time 2 discounted plus the
coupon payment.
CFA Level II
Section 3.3
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Level II– Mock 68
46. Is Annisquam most likely correct in regard to his comments on calibrating a binomial interest
rate tree?
C. Yes
Correct answer: C.
Annisquam is correct with regards to his comments on calibrating a binomial interest rate tree.
CFA Level II
Section 3.4
47. Assuming Annisquam's spot rate valuation is correct, why does his model most likely
C. The model is incorrect because both methodologies should value the bonds equally.
Correct answer: C.
The binomial tree is based on the spot rate curve and a no arbitrage condition, therefore any
option-free bond should have the same value whether using the spot rate curve or the binomial
tree.
CFA Level II
Section 3.5
48. To correct the problem Hake encounters when using a Monte Carlo simulation, he would
most likely:
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Correct answer: C.
Using a Monte Carlo simulation, the model will produce benchmark bond values equal to the
market prices only by chance. A constant is added to all interest rates on all paths such that the
average present value for each benchmark bond equals its market value.
CFA Level II
Section 4
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Case 9: Scott
Halstead Capital Advisers (Halstead) is an investment advisory firm that specializes in taxable
fixed-income investing. Its clients consist of medium-sized foundations and endowments that
select outside managers, such as Halstead, after having formulated their investment policy and
Charles Scott, Halstead's chief investment strategist, and Catherine Bird, a quantitative analyst,
meet to discuss a research report that Bird is producing. The report will address various
fixed-income investing topics, including investment strategies, credit market spreads, and yield
curve movements.
Bird is analyzing a newly issued US Treasury bond with a five-year maturity and a 7.00% coupon.
For long-term investors that buy this US Treasury bond and hold it to maturity, Bird is assessing
whether the realized return will match its current 7.00% yield to maturity. Her analysis is based on
an expectation that the forward path of interest rates will follow the current spot rate curve.
Current spot rates and extrapolated one-year forward rates are provided in Exhibit 1.
Exhibit 1
1 3.00%
2 4 5.01%
3 5 7.03
4 6 9.06
5 7 11.1
For another investor who may sell prior to maturity, Scott states that the future value of this
Treasury bond is a function of projected spot rates relative to the forward curve. Bird agrees and
says, "Let's assume that an investor purchases this US Treasury bond at par, to yield 7.00% to
maturity. He then holds the bond for two years, at which time the one-year, two-year, and
three-year spot interest rates are each assumed to equal 8.00%." Bird determines that the expected
return for the initial two-year holding period would equal 4.42%.
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Scott recognizes that this US Treasury bond may not be suitable for investors who want zero
is newly issued, with a five-year term, and priced at $71.30 ($100.00 face value) to yield 7.00% to
maturity. Scott says that some investors may purchase this Treasury zero-coupon note today and
hold it for five years to maturity. Scott continues by stating that other investors may purchase this
Treasury zero-coupon note in two years and then hold it for three years to maturity. Scott asks
Bird to determine the forward rate that would cause investors to be indifferent about either
purchasing the Treasury zero-coupon note today or purchasing it two years from today.
Scott reminds Bird to include an update on credit instruments. He provides details on a newly
issued zero-coupon bond by Coores Corporation, rated A1/A+, with five years to maturity priced
to yield 7.30% to maturity. This credit typically trades in line with high-quality financial
institutions and corporate issuers. Current market rates are 7% for the five-year risk-free spot rate,
Bird proposes to review other credit spread indicators that measure credit and liquidity risk for
money market securities, general creditworthiness of individual debt issuers, and counterparty risk.
Statement 1: Z-spread represents the difference between the yield on credit bonds and the
Statement 2: Libor-OIS (overnight index swaps) spread represents the difference between
Statement 3: TED (Treasury-eurodollar) spread represents the difference between Libor and
Scott asks Bird to evaluate the impact of yield curve movements on fixed-income securities. Bird
constructs a yield curve factor model that describes three independent yield curve movements. The
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Level II– Mock 68
Exhibit 2
Time to Three
One Year Two Years Four Years Five Years
Maturity Years
49. Based on the data provided in Exhibit 1 and assuming that Bird's interest rate expectation
materializes, the realized return for the US Treasury bond if held to maturity would most
likely be:
Correct answer: C.
The realized return would be greater than the yield to maturity (YTM) because the coupons would
be reinvested at forward rates that increase and eventually exceed the YTM because the spot curve
is upward sloping. The YTM can be a poor estimate of expected return if interest rates are volatile
and if the yield curve is steeply sloped (up or down). YTM assumes that all reinvestment of
CFA Level II
"The Term Structure and Interest Rate Dynamics," Thomas S.Y Ho, Sang Bin Lee, and Steven E.
Wilcox
Section 2.2
50. Based on the data provided in Exhibit 1 and considering Bird's assumptions regarding an
investor who purchases the US Treasury bond and holds it for two years, the US Treasury
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Level II– Mock 68
A. fairly valued.
B. overvalued.
C. undervalued.
Correct answer: B.
The US Treasury bond is overvalued today for an investor buying at par and then selling after two
years given the forward curve in Exhibit 1 and Bird's assumptions. For any bond in which the
expected future spot rate (8.00%, three-year spot rate assumed by Scott) is higher than the current
forward rate (7.03%, three-year forward rate implied by the current spot curve), the bond is
overvalued versus its intrinsic value because the market is placing a lower discount rate on its cash
flows (7.03% forward rate today versus 8.00% assumed future spot rate). Note that the 4.42%
expected return for the initial two-year holding period is based on the presumed spot curve (flat at
1 1 107
7 + 1.081 + 1.082 + 1.083 + 100 − 1 = 4.42%
Note that the 4.42% expected return is less than the 7.00% coupon.
CFA Level II
"The Term Structure and Interest Rate Dynamics," Thomas S.Y Ho, Sang Bin Lee, and Steven E.
Wilcox
Section 2.4
51. Using the information provided in Exhibit 1, the forward rate at which an investor would be
indifferent to purchasing the US Treasury zero-coupon note today or two years from today is
closest to:
A. 7.00%.
B. 11.10%.
C. 9.05%.
Correct answer: C.
The forward rate at which an investor would be indifferent to purchasing the Treasury
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Level II– Mock 68
zero-coupon note today or two years from today, or the breakeven rate, is equal to the three-year
rate, two years forward = f(2,3) = 9.05%, where r(1)= 3%, r(2)=4%, r(3)=5%, r(4)=6%, r(5)=7%.
"The Term Structure and Interest Rate Dynamics," Thomas S.Y Ho, Sang Bin Lee, and Steven E.
Wilcox
Section 2.1
52. Using the information provided, is the Coores Corporation bond most likely mispriced?
A. Yes, because of the difference between the swap rate and the yield to maturity
B. Yes, because of the difference between the swap rate and the spot rate
C. No
Correct answer: C.
The Coores bond is likely not mispriced because its 7.30% yield to maturity is equivalent to the
swap rate for the equivalent maturity (7.00% spot rate plus 0.30% swap spread). Also, Coores
default risk rating of A1/A+ matches the default risk rating of most commercial banks, which
CFA Level II
"The Term Structure and Interest Rate Dynamics," Thomas S.Y Ho, Sang Bin Lee, and Steven E.
Wilcox
Section 3.4
53. Which of Bird's statements regarding measures of credit risk is most likely correct?
A. Statement 3
B. Statement 2
C. Statement 1
Correct answer: C.
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Level II– Mock 68
Statement 1 relates to Z-spreads, which represent the constant basis point spread that would need
to be added to the implied spot curve to determine the price of a bond that has credit risk.
Accordingly, the Z-spread is directly affected by the general creditworthiness of individual debt
issuers.
CFA Level II
"The Term Structure and Interest Rate Dynamics," Thomas S.Y Ho, Sang Bin Lee, and Steven E.
Wilcox
Section 3.5
54. Using the information provided in Exhibit 2, the movements characterized by Factor 1,
Correct answer: A.
Factor 1, Factor 2, and Factor 3 represent movements in steepness, curvature, and level,
respectively. Factor 1 represents a change in steepness in the yield curve because the changes in
yield increase through each maturity point. Factor 2 represents a change in curvature in the yield
curve because the changes in the front end and back end of the curve are different from the change
in the middle of the curve. Factor 3 represents a change in level in the yield curve because the
changes in yield are essentially the same across all maturity points.
CFA Level II
"The Term Structure and Interest Rate Dynamics," Thomas S.Y Ho, Sang Bin Lee, and Steven E.
Wilcox
Section 6.2
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Zoe Schulman is an alternative investments research analyst with Principal Investments, LLC, a
wealth management firm. In the past, the account managers at Principal were free to select real
estate investments without referring to a formal buy list, leading to inconsistent returns across
client portfolios. To ensure a more consistent approach, the firm would like to create an approved
list, which would provide a source of investment selections for all client portfolios.
From the investments already held in client portfolios, Schulman identifies the three largest REIT
holdings and asks the account managers to justify why these REITs were selected considering the
current economic cycle. She compiles Exhibit 1 and presents it in a report to her manager, Holden
Dwelley.
Schulman determines that all three REITs use the historical cost method in their accounting
statements. In her analysis, she calculates and reports net asset value per share (NAVPS), instead
of book value per share (BVPS), as an absolute valuation metric and provides the following
Reason 1: NAVPS accounts for the value of property not currently generating revenue.
Reason 2: NAVPS includes the added value of the management of the REIT.
Reason 3: NAVPS reflects the market value of the property portfolio rather than often stale
Schulman collects financial data for all three REITs to calculate NAVPS. Exhibit 2 presents select
Exhibit 2
Pro forma cash net operating income (NOI) for last 12 months $320 million
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Schulman submits a first draft of her report to Dwelley. He notes that she has failed to consider
real estate operating companies (REOCs) in current client portfolios for inclusion on the approved
REOCs are far less commonly traded in the United States than REITs.
When editing the report, Dwelley questions Schulman's reliance on NAVPS over a dividend
discount model (DDM) and notes the following characteristics of these valuation measures:
Characteristic 1:DDM reflects all earned income, whereas NAVPS only reflects income that is
Characteristic 2: NAVPS is based solely on historical revenue and does not reflect upcoming
Characteristic 3: DDM uses discount rates consistent with the required rate of return for public
equity investment..
For a more comprehensive analysis, Schulman's report also presents relative valuation measures,
such as the ratio of price to funds from operations (P/FFO). Selected information for REIT 3 is
provided in Exhibit 3
Exhibit 3
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Level II– Mock 68
55. Which of the account managers' justifications in Exhibit 1 regarding the selection of each of
Correct answer: B.
The justification for REIT 2 is correct: GDP growth is the top economic driver in all sectors. Job
CFA Level II
"Publicly Traded Real Estate Securities," Anthony Paolone, Ian Rossa O'Reilly, and David Kruth
Section 3.6
56. Which of Schulman's reasons regarding her preferred approach to valuing REITs is most
likely correct?
A. Reason 1
B. Reason 2
C. Reason 3
Correct answer: C.
Reason 3 is correct. NAVPS is preferable to BVPS in valuing REITs because of the use of the
market value of assets. Although accounting values based on the fair value method also serve as a
useful valuation metric, those based on historical cost are generally not relevant.
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Level II– Mock 68
CFA Level II
"Publicly Traded Real Estate Securities," Anthony Paolone, Ian Rossa O'Reilly, and David Kruth
Section 5
57. Using the data in Exhibit 2, the NAVPS of REIT 1 is closest to:
A. $39.76.
B. $40.69.
C. $37.65.
Correct answer: B.
Capitalized value of operating real estate=NOI/ Discount rate
Other assets=Cash and equivalents+ Undeveloped land+ Accounts receivable+Other liabilities
Liabilities= Total, debate+Other liabilities
NAV=Operating assets+Other assets-Liabilities
NAVPS= NAV/ Number of common shares
(US$ millions)
CFA Level II
"Publicly Traded Real Estate Securities," Anthony Paolone, Ian Rossa O'Reilly, and David Kruth
Section 5.2
58. Which of Schulman's justifications for omitting REOCs from the approved list is most likely
correct?
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Level II– Mock 68
Correct answer: B.
REITs are traded much more than REOCs in the United States; they comprise up to 97% of public
CFA Level II
"Publicly Traded Real Estate Securities," Anthony Paolone, Ian Rossa O'Reilly, and David Kruth
Sections 2–3.3
59. Which of Dwelley's characteristics of the DDM and NAVPS methods is most likely correct?
A. Characteristic 3
B. Characteristic 1
C. Characteristic 2
Correct answer: A.
Characteristic 3 is correct because the discount rate (cap rate) used in NAV calculation is based on
private valuation of comparable properties. The discount rate used in DDM calculation is based on
CFA Level II
"Publicly Traded Real Estate Securities," Anthony Paolone, Ian Rossa O'Reilly, and David Kruth
Sections 7–8
A. 14.9.
B. 13.5.
C. 16.7.
Correct answer: A.
The calculation of FFO is based on net income after adding back amortization and depreciation.
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CFA Level II
"Publicly Traded Real Estate Securities," Anthony Paolone, Ian Rossa O'Reilly, and David Kruth
Section 6.2
62 / 62