CFA LV 2 2019 Mock Exam Willy - Morning Session With Solutions

2019
WILEY’S CFA®
PROGRAM
EXAM REVIEW
LEVEL II
CFA PROGRAM
®
MOCK EXAM
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ISBN 978-1-119-60357-3
Morning Session – Answers
Questions 1 to 6 relate to Ethical and Professional Standards
Sophie Gold, CFA, and Lloyd Henderson, CFA, currently work together as portfolio managers for
Hadlow Investments Company (HIC) and comanage the Hadlow Global Biotechnology Fund (HGBF).
Gold has more than 30 years of equity market experience and has been with HIC for 20 years. Henderson
has been an equity analyst in the health and biotechnology sectors for more than 15 years and has
recently joined HIC as a portfolio manager for the fund.
HGBF currently employs seven other analysts and research assistants in managing the fund, and the
HGBF team is broken up into several subsectors and geographical segments. Due to the small size of the
team, both Gold and Henderson are responsible for a number of these subsectors and segments.
Henderson left his previous employer, Adderson Pension and Insurance Company (APIC), on good terms,
having helped provide the Adderson Pension Fund (APF) with strong returns over the previous decade.
He also contributed to APIC’s weekly investor update, and was often promoted to clients as a major
contributor to the success of APF. He is seen as one of the leading experts in the biotechnology space and
was brought into the HGBF team after waiting for his 6 months noncompete period to end.
Upon arriving at HIC, Henderson was happy to receive a call from one of his former colleagues at
APIC, Sneha Patel, who worked on the trading desk at Adderson. She is a good friend of Henderson and
contacted him because several clients had asked about his current position.
Without permission from APIC, Patel decides to e-mail over to Henderson a list of the clients who are
known to hold biotechnology stocks and who have given permission for their details to be passed on to
him and other third parties. Henderson happily accepts the list and begins to contact the clients and advise
them of his work for HGBF without promoting or recommending the fund to these clients. This helps
to reduce the number of queries coming through to APIC regarding Henderson and does not lead to any
clients leaving APIC.
Using publicly available information produced by APIC, Henderson is also able to compile his
performance attribution record for his time working on the APF fund. This shows an outperformance of
over 5% p.a. by the APF fund in the biotechnology sector. Using this data, HIC produces a synthetic track
record for HGBF and inserts this into promotional material for the fund, disclosing its hypothetical nature
and construction methodology.
Among her responsibilities, Gold oversees the research and analysis of health care property and other
support infrastructures. MyCare Robotics (MCR), a company that develops nursing and companion aides,
has been on her radar over the past few quarters and has invited her to attend an analysts’ weekend at its
headquarters in Dresden, Germany. MCR has offered to pay for flights and five-star accommodation for
the 2-day visit.
Upon entering the main MCR facility in Dresden with the other analysts, Gold overhears one of the
security guards complain about how busy he has become as orders seemed to have picked up dramatically
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64
over the past few months. As she is the only analyst in the group who can speak German, only she
understands the potential importance of this information.
Unbeknownst to the group of analysts, the chief financial operator, Herbert Wolff, is retiring in the next
few months and is hoping to make a good impression of the company to boost the value of the shares and
options he owns in MCR. He therefore provides the analysts with medium-term guidance that has highly
inflated sales and earnings figures.
Based on the reports provided by Wolff, the information garnered from the facility security guard, and
her previous analysis of the company, Gold decides to place a large buy order for MCR stock in HGBF
and a small order for her own account. As there is a lack of sellers in the market, Gold buys her own stock
before placing the buy order for HGBF to avoid having to buy at a higher price.
1. With regard to his acceptance of APIC client details, Henderson most likely violated which of the
following?
A. Standard III(D) Duties to clients: Suitability

B. Standard IV(A) Duties to employers: Loyalty
C. Standard III(E) Duties to clients: Preservation of confidentiality
Answer: B
Although the client details were given freely by an employee of APIC, this information is still
the property of APIC and Henderson would need to receive permission from his former employer
before using the information. The fact that the information had seemingly no negative effect on
APIC is irrelevant. He has therefore violated Standard IV(A) Duties to employers: Loyalty.
2. Regarding the HGBF promotional material, has HIC violated the CFA Institute Standards of
Professional Conduct?
A. No, because HIC has included appropriate disclosures.

B. Yes, because they have misrepresented the track record of the fund.
C. Yes, because they have included proprietary information of APIC.
65
Answer: A
As HIC has disclosed how the track record was constructed and its hypothetical nature, the
company is not likely in violation of the standards.
3. To avoid violating CFA Institute Standards of Professional Conduct, what would have been the
most appropriate response by Gold regarding the company visit invitation?
A. Gold should have declined the invitation to attend the analysts’ weekend.
B. Gold should have declined the offer for the flights and accommodation.
C. Gold should have declined the offer for the five-star accommodation, but could accept the
travel offer.
Answer: B
To avoid violation of Standard I(B) Professionalism: Independence and objectivity, HIC

should pay for Gold’s travel and accommodation expenses. As Dresden is easily accessible by
commercial airlines, it is not appropriate for MCR to pay for flights. It is also not appropriate for
MCR to pay for luxury accommodation for the analysts.
4. Without violating Standard II(A) Integrity of capital markets: Material nonpublic information,
can Gold use the information she has received from overhearing the MCR security guard’s
complaint?
A. Yes, because this is public information.

B. Yes, because this is immaterial information.
C. No, because this is nonpublic information.
Answer: B
The information is likely to be immaterial because the information by itself might not be
significant or reliable. Such information can be used with other immaterial information and
public information in forming investment recommendations under the mosaic theory. Therefore,
it would not be a violation to use this information in making an investment recommendation.
5. In placing the large buy order for MCR stock, has Gold violated the CFA Institute Standards of
Professional Conduct concerning either diligence or manipulation of share prices?
A. Yes, because she has not conducted sufficient research to make such an investment.
B. No, because the investment is based on a reasonable level of research and analysis.
C. Yes, because she used information from Wolff that was intended to inflate the share price of
MCR.
66
Answer: B
Gold has used the information from her company visit and her previous analysis in making
the MCR investment decision, and there is no evidence that she has violated Standard V(A)
Investment analysis, recommendations, and actions: Diligence and reasonable basis.
6. Regarding the placement of the small order of MCR stock for her personal account, Gold has
most likely violated which of the following?
A. Standard VI(A) Conflicts of interest: Priority of transactions

B. Standard II(A) Integrity of capital markets: Market manipulation
C. Standard V(A) Investment analysis, recommendations, and actions: Diligence and reasonable
basis
Answer: A
In placing her personal order ahead of the HGBF order, Gold has violated Standard VI(A)
Conflicts of interest: Priority of transactions. In so doing, she is likely to be able to purchase her
stock for a lower price than the HGBF clients.
67
Questions 7 to 12 relate to Quantitative Methods
Philippe Sanchez, CFA, and Kimie Yamamoto, CFA, are asset consultants for iMacro Analytics and are
conducting research into the currencies of various countries.
Sanchez is investigating the relationship between Country X’s currency ($X) and the return of equities
in Country A. To do so, he has produced the following covariance matrix, which is based on the past
30 quarters of data.
Covariance (n = 30) $X (quarterly change) Country X quarterly stock return

$X (quarterly change) 0.01885% 0.00407%
Country X quarterly stock return 0.00407% 0.07748%
Sanchez presents his research to his manager, Emma Ferguson, CFA. The research implies a level of
correlation between Country X’s currency and its stock market.
Ferguson: Great work! If we can show that Country X’s currency is correlated with its stock market, we
will then be able to use the changes in the currency to predict which direction the stock market is
headed.
Sanchez: To have more confidence in the sample correlation, I will need to run the analysis over a longer
time frame.
Following Sanchez’s research, Yamamoto decides to run a similar analysis on Country Z’s currency
and stock market return. In doing so, she finds that the correlation between the quarterly change in the
currency ($Z) and the quarterly change in the stock market is –0.16929. This is also based on the most
recent 30 quarters of data. She tests this correlation at the 10% significance level using the following
T-distribution table:
Two-Tailed T-Test Values

df 0.1 0.05 0.01
28 1.701 2.048 2.763
29 1.699 2.045 2.756
30 1.697 2.042 2.750
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Yamamoto also decides to run a regression for the change in $Z over the change in Country Z’s gross
domestic product (GDP) and has produced the following scatter plot diagram:
As a final analysis for $Z, Yamamoto runs a regression for the quarterly change in $Z over two
independent variables. The first variable she has chosen is the quarterly change in Country Z’s trade
balance. The second variable she has chosen is Country Z’s purchasing managers’ index (PMI). She
decides to set this variable up as a dummy variable with an observation of 1 referring to an expanding
PMI and an observation of 0 referring to a contracting PMI. The results of her regression are as follows:
Regression Statistics
Multiple R 0.432055538
R-squared 0.186671988
Adjusted R-squared 0.126425469
Standard error 0.011765983
Observations 30
ANOVA
df SS MS F
Regression 2 0.000857894 0.000428947 ?
Residual 27 0.003737836 0.000138438
Total 29 0.00459573
Coefficients Standard Error t-Stat P-value

Intercept –0.004987931 0.00379844 –1.313152549 0.20018281
Z trade change 0.593490358 0.356387782 1.665293785 0.10741722
Z PMI dummy 0.011233667 0.00480471 2.338052877 0.02704192
69
Using a critical value of 2.5106 (F0.10,2,27), Yamamoto tests the results of her regression model at the 10%
significance level and presents these to Ferguson.
Yamamoto: As the adjusted R2 is above the 10% significance level, this model is a good fit for explaining
the variance in $Z movements.
Ferguson: However, as the p-value for the quarterly change in Country Z’s trade balance is above 10%, I
would suggest you remove this variable from your analysis or replace it.
7. Referring to Sanchez’s analysis of Country X’s currency and stock market returns, the correlation
coefficient between the quarterly change in $X and the quarterly return of Country X’s stock
market is closest to:
A. 0.01135
B. 0.10650
C. 0.27870
Answer: B
Cov(X.Y)
r=
s X .sY
0.00407%
r$X,Stock(X) = = 0.10650
0.01885% × 0.07748%
8. Are the statements made by Sanchez and Ferguson regarding the analysis of Country X’s
currency and stock market returns correct?
A. Both statements are correct.

B. Only Sanchez’s statement is correct.
C. Only Ferguson’s statement is correct.
Answer: B
Sanchez’s statement is correct, as increasing the sample size will increase the reliability of the
statistics. Ferguson’s statement implies that movements in the currency of Country X cause
predictable movements in Country X’s stock market. This statement is incorrect, as she has
confused correlation between two variables with causation.
70
9. Using the T-table extract provided, is the correlation coefficient between $Z and Country Z’s
stock market significant at the 10% level (α = 0.010)?
A. No, as the absolute value of the test statistic of 0.655 is less than the critical value of 2.045.
B. No, as the absolute value of the test statistic of 0.909 is less than the critical value of 1.071.
C. Yes, as the absolute value of the test statistic of 4.34 is greater than the critical value of
1.699.
Answer: B
r n−2 −0.16929 30 − 2
t= = = −0.9089
1− r2 1 − (−0.16929)2
t0.10/2,28 = 1.701 (from table)
As the absolute value of the test statistic is less than the critical value, we cannot reject the null
hypothesis that there is no correlation between the variables at the 10% significance level.
10. Regarding the scatter plot diagram of the quarterly change in $Z versus the quarterly change in
Country Z’s GDP, which of the following statements is most accurate?
A. There is no relationship between the variables.

B. There is a linear relationship between the two variables.
C. There is nonlinear relationship between the two variables.
Answer: C
The scatter plot diagram does indicate a nonlinear relationship between the change in $Z and
Country Z’s GDP. This is evident by the visible serial correlation of the residuals.
71
11. In analyzing her multiple regression model, which of the following is most likely to be
Yamamoto’s conclusion (based on the F-test)?
A. Reject the null hypothesis that neither of the independent variables has a linear relationship
with the quarterly change in $Z.
B. Reject the null hypothesis that at least one of the independent variables has no linear
relationship with the quarterly change in $Z.
C. Fail to reject the null hypothesis of the F-test, as there is not enough evidence to show that
linear relationships exist between the independent variables and the quarterly change in $Z.
Answer: A
MSR
The test statistic (F-stat) =
MSE
0.000428947
= = 3.09847
0.000138438
As the F-stat is greater than the critical value of 2.5106, we reject the null hypothesis for the
F-test (that none of the slope coefficients are significantly different from zero) and can conclude
that the model significantly explains the variance in the quarterly change in $Z.
12. Regarding the results of the multiple regression, which of the statements by Ferguson and
Yamamoto is/are correct?

B. Only Ferguson’s statement is correct.
C. Only Yamamoto’s statement is correct.
Answer: B
Ferguson’s statement is correct, as a p-value greater than the required significance level indicates
that the independent variable does not significantly explain the variance in the dependent
variable. The p-value of the slope coefficient for the change in Country Z’s trade balance
is 0.107417, which is slightly above the significance level of 10%. Thus, it might be worth
removing this variable from the model or replacing it. Yamamoto’s statement is incorrect since an
R2 of at least 30% is generally considered a reasonable fit. An R2 of 18.6672% or an adjusted R2
of 12.6425% indicates a poor model fit (i.e., the model is not a good estimator for the variance in
the change in $Z).
72
Questions 13 to 18 relate to Economics
Joan Dacre, CFA, is a senior analyst at Red Stem Strategies (RSS), working in its foreign exchange
research department. She is responsible for providing recommendations for the various RSS hedge
funds regarding currencies and money markets within the Americas region, which includes all of North
America, Central America, South America, and the Caribbean.
A junior analyst in her team, Fernando Munoz, CFA, has prepared the morning rate sheet for two regional
banks, Bank A and Bank B.
Bank A rate sheet
Bank A Bid Offer

USD/MXN 18.3462 18.3495
USD/CLP 607.863 607.915
EUR/USD 1.1648 1.1651
Bank B rate sheet
Bank B Bid Offer

EUR/CLP 708.253 708.498
BRL/JPY 37.0565 37.0649
JPY 3-month rate (p.a.) 0.0083 0.0088
BRL 3-month rate (p.a.) 0.0763 0.0791
Munoz suggests, “Based on the rates for the Chilean peso quoted by Bank A and Bank B, I think there
is an arbitrage trade we should enter. One leg of this arbitrage trade would be to buy CLP from Bank B
against the euro.”
Dacre has also noticed the large interest rate differential between the Brazilian real (BRL) and the
Japanese yen. She is particularly interested because the RSS in-house research indicates that the exchange
rate between the two currencies is expected to remain unchanged over the coming 3 months. She is
considering taking advantage of the carry trade with a position of JPY 100,000,000.
Dacre has been asked by one of the RSS portfolio managers, Johann Benson, CFA, to help determine
whether recent news regarding one of the countries in her region is of concern. The central bank of
Mulvencia has recently responded to an increase in unemployment and worsening of business confidence
by loosening its monetary policy. The country has high capital mobility, and this policy change comes at a
time when the Mulvencian government has started to cut spending heavily to rein in debt levels. Benson’s
portfolios are overweight Mulvencia’s currency (floating), and he is deciding whether he should amend
this position.
73
Benson is also currently putting together medium- to long-term growth prospects for various countries
around the globe and has prepared the following data:
Total factor production Labor force Labor factor

Country growth (%) growth (%) share (%)
Country J 1.1 0.7 59
Country K 2.3 1.5 41
Country L 1.2 1.4 54
In discussing the economic growth rates of these countries with another RSS portfolio manager, Benson
makes the following observations:
Statement 1: Country K’s growth in potential GDP of 7.2% is greater than Country L’s growth in
potential GDP of 5.1%. Therefore, Country K is more likely to benefit from capital deepening.
Statement 2: Country L will not benefit from capital deepening, as the estimated steady-state growth rate
seems to be in line with its growth in potential GDP of 5.1%.
13. Bank A’s cross rates for the Mexican peso against the Chilean peso (MXN/CLP) is closest to
which of the following?
A. 0.030181/84
B. 33.1270/357
C. 33.1298/329
Answer: B
MXN/CLPbid = USD/CLPbid ÷ USD/MXNoffer

= 607.863/18.3495 = 33.1270
MXN/CLPoffer = USD/CLPoffer ÷ USD/MXNbid

= 607.915/18.3462 = 33.1357
14. Regarding Munoz’s statement about the potential arbitrage opportunity, which of the following is
most accurate?
A. Munoz’s statement is correct.

B. Munoz’s statement is incorrect, as no arbitrage opportunity exists.
C. Munoz’s statement is incorrect, as the correct trade would involve selling CLP to Bank B.
74
Answer: B
To test whether a triangular arbitrage opportunity exists, the EUR/CLP cross rates (bid and offer)
for Bank A need to be calculated.
EUR/CLPbid = USD/CLPbid × EUR/CLPbid

= 607.863 × 1.1648 = 708.039
EUR/CLPoffer = USD/CLPoffer × EUR/CLPoffer

= 607.915 × 1.1651 = 708.282
EUR/CLPBankA: 708.039/282
The bid and offer cross rate for Bank A overlaps with the quotes from Bank B, and, therefore, no
arbitrage opportunity exists.
15. The profit that Dacre is expecting to earn by taking a long position in BRL and a short position in
JPY is closest to which of the following?
A. 0
B. JPY 1,664,405
C. JPY 1,746,889
Answer: B
To execute the carry trade, Dacre would borrow JPY 100,000,000 for 3 months and effectively
convert this to BRL and invest for 3 months. At the end of the 3 months, Dacre would then
convert the BRL back to JPY and repay the JPY loan.
Day 0:
Borrow JPY 100,000,000 @ 0.88% p.a. for 3 months
Convert JPY 100,000,000 @ 37.0649 = BRL 2,697,970.32
Invest BRL 2,697,970.32 @ 7.63% p.a. for 3 months
After 3 months:
JPY borrowing = JPY 100,000,000 × [1 + 0.88% × (3/12)]
= JPY 100,220,000
BRL investment = BRL 2,697,970.32 × [1 + 7.63% × (3/12)]

= BRL 2,749,434.10 × 37.0565 (converting back to JPY)
= JPY 101,884.404.75
Profit = JPY 101,884,404.75 – JPY 100,220,000

= JPY 1,664,404.75
75
16. Based on the current policy settings, in which direction would Dacre expect the Mulvencian
currency to most likely move in the short term?
A. The Mulvencian currency is likely to appreciate.

B. The Mulvencian currency is likely to depreciate.
C. The Mulvencian currency is likely remain unchanged.
Answer: B
The current settings in Mulvencia are an expansionary monetary policy and a tight or restrictive
fiscal policy. Both these settings are likely to lead to lower interest rates; thus, the currency
is likely to depreciate in the short term, due to a relative flight of capital into higher-yielding
currencies.
17. Based on the estimates Benson has prepared, Country J’s steady-state growth rate is closest to
which of the following?
A. 2.6%
B. 3.1%
C. 3.4%
Answer: A
Steady-state growth rate (Y) = Growth rate of TFP/Labor factor share + Labor force growth rate
YJ = 1.1%/59% + 0.7%
= 2.56%
76
18. Regarding Benson’s statements about the growth in potential GDP of Country K and Country L,
which of the following is most accurate?
A. Only Statement 1 is correct.

B. Only Statement 2 is correct.
C. Both statements are incorrect.
Answer: C
Benson has incorrectly inferred that a country with a higher growth in potential GDP would
benefit more from capital deepening. Though this may be true in some circumstances, it is not a
general rule. Capital deepening is likely to be more effective where a country’s estimated steady-
state growth rate is less than the growth rate in potential GDP.
Furthermore, to determine whether capital deepening might be appropriate for Country L, its
estimated steady-state growth rate should be compared with its growth rate in potential GDP
of 5.1%.
YL = 1.2%/54% + 1.4%
= 3.62%
As the estimated steady-state growth rate (3.6%) is significantly less than the growth rate in
potential GDP (5.1%), Country L’s economy seems to be in disequilibrium (as defined by the
neoclassical model), and Country L would likely benefit from capital deepening.
77
Questions 19 to 24 relate to Financial Reporting and Analysis
Jopping Gaming Entertainment (JGE), a Norwegian software developer that specializes in virtual role-
playing games, currently employs 42 staff out of its office in Oslo. As part of its remuneration package,
JGE enrolls each full-time employee in the Jopping Gaming Pension Plan (JGPP). This retirement
scheme is a defined benefit plan, with pension benefits calculated based on years in JGE employment and
final salary.
Henrik Anderssen, CFA, is currently reviewing the JGPP as part of valuation work being undertaken as
part of a potential merger. He has prepared the following information relating to the JGPP based on the
prior year’s annual report (20X2) and unaudited data provided by JGE’s finance manager.
JGPP 20X1 (NOK) 20X2 (NOK)

Fair value of assets 1,685,437 1,967,008
Pension benefit obligation 1,640,338 1,781,455
Contribution by JGE 200,000 180,000
Benefits paid to employees 23,000 23,000
20X3 unaudited financials:
Service costs NOK 126,450

JGE contribution NOK 50,000
Benefits paid NOK 23,000
Return on assets –NOK 138,568
Actuarial gain NOK 281,300
Plan expenses NOK 60,000
JGE prepares its financials using the International Financial Reporting Standards (IFRS) and calculates
all interest costs for the year 20X3 based on a discount rate of 3.60% (a decrease from 4.25% in 20X2).
There are no prior services costs or management expenses for the plan, and no contributions from
employees into the fund.
Anderssen is troubled with some of the 20X3 figures provided by JGE and consults with a member of
his firm’s corporate finance team. He is particularly concerned about the discount rate used and the large
actuarial item reported, and he provides his colleague with the following inquiries.
Statement 1: It seems to me that JGE has significantly overestimated the expected returns on the assets
in its pension plan as shown by the negative return on assets. I think it would be appropriate for JGE
to reduce the assumptions for the expected return on plan assets going forward to ensure that pension
obligations and expenses are reported appropriately.
Statement 2: I believe JGE has been too aggressive in its actuarial assumptions, perhaps to keep the
pension’s funding status in positive territory. Having reviewed further notes from JGE’s CFO, I will make
an adjustment to the figures provided by reducing the actuarial gain to NOK 120,000.
78
19. Which of the following statements regarding JGE’s pension plan is most accurate?
A. JGE is not obligated to make payments to the plan beyond the amount specified in employee
agreements.
B. JGE would be required to account for the overall pension obligation, as well as the
accumulated benefit obligation (ABO) and vested benefit obligation (VBO).
C. The JGPP currently represents a low-risk retirement solution for JGE employees since (1)
JGE carries the investment risk of the plan, and (2) the fund has been overfunded in the most
recent reporting years (20X1 and 20X2).
Answer: C
As the JGPP is a defined benefit plan, the employer, JGE, carries the investment risk of the
plan. This is in comparison with a defined contribution plan, in which the employees bear the
investment risk of the plan assets. The employees still bear default risk (i.e., if the employer goes
bankrupt and cannot meet pension obligations), but as the fund is overfunded (as assets for both
20X1 and 20X2 exceed the respective present value of obligations), the risk of the plan becoming
significantly underfunded is low; hence, default risk is also reduced.
20. The periodic pension cost (PCC) for JGE for 20X2 is closest to which of the following?
A. NOK 5,553
B. NOK 39,546
C. NOK 44,436
Answer: B
Periodic pension cost (PPC) can be calculated by subtracting the change in funding status from
the contributions made to the pension plan:
PPC = Contributions – ΔFunding status
ΔFunding status20X2 = Funding status20X2 – Funding status20X1

= (1,967,008 – 1,781,455) – (1,685,437 – 1,640,338)
= 140,454
PPC20X2 = 180,000 – 140,454

= NOK 39,546
79
21. Based on the information prepared, the net pension assets of JGPP for 20X3 is closest to which
of the following?
A. NOK 173,570
B. NOK 214,703
C. NOK 237,703
Answer: C
Net pension asset (liability) = Fair value of plan assets – Present value of pension obligations
Ending fair value of pension plan assets can be calculated by adding and subtracting items to the
beginning fair value of pension assets as follows:
FV plan assets (ending) =

FV plan assets (beginning)
+ Return on assets
+ Contributions to plan
– Benefits paid from plan
– Plan expenses
FV Assets20X3 = 1,967,008 – 138,568 + 100,000 – 23,000 – 0

= NOK 1,905,440
Ending present value of pension plan obligations can be calculated by adding and subtracting
items to the beginning pension obligations as follows:
Pension obligations (ending) =

Pension obligations (beginning)
+ Service costs
+ Interest costs
+/– Actuarial losses/gains
– Benefits paid from plan
Interest costs = Prior year’s pension obligation × Interest (discount) rate

Interest costs20X3 = 1,781,455 × 3.6% = NOK 64,132
PBO20X3 = 1,781,455 + 126,450 + 64,132 – 281,300 – 23,000

= NOK 1,667,737
Net pension asset20X3 = 1,905,440 – 1,667,737

= NOK 237,703
80
22. Based on the information prepared, the pension expense that JGE would include on the income
statement is closest to which of the following?
A. NOK 47,850
B. NOK 119,770
C. NOK 290,582
Answer: B
Under IFRS, the pension costs that are included on the income statement are services costs and
net interest costs. Other pension costs are accounted for in Other Comprehensive Income.
Net interest cost, which is a measure of the cost of the pension liability less the return gained
from the pension assets, is calculated based on the amount of plan assets and obligations at the
beginning of the period and the discount rate (under IFRS both liability cost and asset return are
estimated using the same discount rate; actual asset return is not used in the calculation of net
interest cost):
Net interest cost = Beginning net plan liability (asset) × Discount rate
Pension expense20X3 = 126,450 + (1,781,455 – 1,967,008) × 3.6%

= NOK 119,770
23. In regard to Statement 1 made by Anderssen in his query to the corporate finance team, which of
the following statements is least accurate?
A. Under U.S. GAAP, higher expected returns have no effect on pension expenses.
B. A higher expected return on assets assumption would have no effect on the level of pension
obligations.
C. Anderssen’s statement is irrelevant since expected return assumptions are not utilized for
pension accounting under IFRS.
Answer: A
This is an incorrect statement because a higher expected return on assets assumption would
reduce the pension expense reported under U.S. GAAP.
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24. In regard to Statement 2, if Anderssen were to adjust the financials by reducing the actuarial gain,
which of the following outcomes is most likely?
A. Both income statement pension expenses and total periodic pension costs would increase.
B. Income statement pension expenses would increase, and total periodic pension costs would
remain unchanged.
C. Income statement pension expenses would remain unchanged, and total periodic pension
costs would increase.
Answer: C
Actuarial losses are pension costs, so a reduction in the actuarial gain would increase total
periodic pension costs. Actuarial movements do not flow through the income statement
(accounted for through Other Comprehensive Income), so the change in the actuarial gain would
not affect the income statement pension expense.
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Questions 25 to 30 relate to Corporate Finance
Melissa Cortez, CFA, and Sandeep Kapoor, CFA, work in the finance department of a large car
manufacturer that specializes in high-end sports cars. Due to slowing sales, the company has decided to
diversify into different market segments.
One segment that the company is considering is automated heavy vehicles. To move into this product
line, the automaker can utilize its existing manufacturing plant, but will need bring on additional skills
and expertise. The life of this project is expected to be 6 years. The company will give the new product
line 3 years to reach sales targets, and if it does not do so, the automaker will look to abandon the line
and shift into related technologies. If the segment is successful, the business will look to expand the
manufacturing plant to increase production.
Cortez and Kapoor have prepared the following forecasts for the new product line of automated heavy
vehicles:
($ millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales 70 100 120 130 140 150
Cash operating expenses –40 –30 –35 –40 –45 –50
Fixed capital investment* –240
Working capital investment* –10 –40
Project assets (end of year) 250 260 230 200 170 140 110
*Fixed capital investment costs to be depreciated down to the salvage value of $60 million over 6 years using
straight-line depreciation method. The working capital increase is not expected to be recovered.
Other details of the business and project include:
Corporate tax rate 40%

Debt-to-equity 2:3
Cost of equity 16.8%
Pre-tax cost of debt 7.9%
Project beta 1.40
Market premium 7.6% p.a.
Risk-free rate 3.8%
During discussions on the viability of the project, Cortez and Kapoor discussed the value of any real
options that might flow through to the business:
Cortez: If a project has a net present value (NPV) that initially indicates that it will not provide an
adequate return, after considering the value of certain project options, these options may actually
make the project viable.
Kapoor: This might be the case for expansion options, as the exercise of these is expected to provide
added income. However, abandonment options will generally lead to a lower NPV.
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The finance department has also been asked to analyze a competing project that is focused on transport
vehicles. This project will also require start-up capital of $250 million in year 0, but has an expected life
of only 4 years.
Cortez: If the projects were expected to be repeated indefinitely, we could compare the projects using
the equivalent annual annuity approach. To do this, we would find the internal rate of return of each
project and choose the project with the higher return.
Kapoor: We could also use the least common multiple of lives approach. Under this approach we would
repeat the both the projects out to 24 years.
The company has $50 million in cash on its balance sheet, which is entirely being used as part of its
working capital requirements. The company has also approached financiers, who determine that they
could arrange up to $200 million in debt finance. As they have done for past projects, the company will
follow the “pecking order” approach to finance this project.
25. The operating cash flow for year 2 is closest to which of the following?
A. $24 million
B. $40 million
C. $54 million
Answer: C
Operating cash flow (OCF) is equal to operating profit after tax with depreciation added back:
OCF = (Sales – Cash operating expenses – Depreciation) (1 – Tax rate) + Depreciation
OCFYear2 = (100 – 30 – 30) (1 – 40%) + 30

= $54 million
26. When discounting cash flows for the project utilizing either the company’s weighted average cost
of capital (WACC) or a project-specific rate, which of the following statements is most accurate?
A. Using the company’s WACC will always result in a higher net present value (NPV).
B. As the project’s required rate of return is greater than the company’s WACC, using the
project-specific discount rate will result in a lower net present value (NPV).
C. As the project’s required rate of return is less than the company’s WACC, using the project-
specific discount rate will result in a higher net present value (NPV).
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Answer: B
WACC = wd × kd(1 – t) + we × ke
wd = 2/5 = 40%
we = 3/5 = 60%
WACCcompany = 40% × 7.9% × (1 – 40%) + 60% × 16.8%

= 11.98%
Ri = Rf + βi(Rm – Rf)
Rproject = 3.8% + 1.4 × 7.6%

= 14.4%
The company WACC is less than the project’s risk-adjusted discount rate; therefore the latter will
result in a lower net present value (as cash flows are discounted at the higher rate).
27. In regard to the statements made by Cortez and Kapoor about the real options of the project,

B. Both statements are incorrect.
C. Only Cortez’s statement is correct.
Answer: C
Cortez’s statement is correct, as options provide value and can turn an initial assessment with a
negative NPV into an assessment with a positive NPV.
Kapoor’s statement is incorrect, as real options cannot have a negative value.
28. Using a WACC of 10%, the present value of the year 4 economic profit is closest to which of the
following?
A. $8.6 million
B. $10.9 million
C. $16.0 million
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Answer: B
Economic profit (EP) in any period is the net operating profit after-tax (NOPAT) of a project less
the expected return on the firm’s assets used to generate the return ($WACC).
NOPAT = (Sales – Cash operating expenses – Depreciation) (1 – Tax rate)
NOPATYear4 = (130 – 40 – 30) (1 – 40%)

= $36 million
$WACC = Capital (start of period) × WACC
$WACCYear4 = 200 × 10%

= $20 million
EPYear4 = 36 – 20
= $16 million
PV of EPYear4 = 16/(1 + 10%)4

= $10.93 million
29. In regard to the statements made by Cortez and Kapoor regarding the competing projects, which
of the following is most accurate?

C. Only Kapoor’s statement is correct.
Answer: B
Cortez’s statement is incorrect as she does not define the equivalent annual annuity approach
accurately. Under this approach, the project’s cash flows are translated into an annuity cash flow,
and the annuity amounts for each project are then compared.
Even though his approach would yield the right result, Kapoor’s statement is also incorrect, as the
least common multiple of 6 and 4 is 12, not 24.
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30. In following the pecking order approach to project financing, the amount of equity the company
would raise to finance the initial capital costs of $250 million for either of the projects is closest
to which of the following?
A. $0
B. $50 million
C. $150 million
Answer: B
The total amount of finance required is $250 million. The pecking order approach would first
utilize surplus cash ($0 as existing cash being used to fund operations), then debt ($200), leaving
$50 million needed to be funded by equity.
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Questions 31 to 36 relate to Corporate Finance
Mediterranean Spa and Resorts (MSR) is a large European hotel chain with headquarters in Barcelona.
It has more than 300 properties in Europe, the Middle East, and Northern Africa and employs between
4,000 and 6,000 people every year. Its target market is primarily Northern European and North American
tourists, and the company has recorded strong annual growth in profits over the past decade.
Two independent directors of MSR, Antonio Casals, CFA, and Marie Picard, CFA, have been discussing
some of the current issues facing the hotelier. In particular, a recent surge in the main operating currency
(euro) has some of the directors worried that revenues may be hit particularly hard. They have already
started to see a drop in tourist numbers from the United Kingdom, United States, and Canada, and, if this
continues, some of the company’s long-term plans and strategies may be significantly affected.
Casals: A drop in guest numbers is a sign that we are not adequately meeting the interests of one of our
key stakeholders, our customers. Even though protecting our shareholders’ capital is critical to the
business’s success, we need to reduce prices so as to better address the interests of our customer
base.
Picard: To maintain profit levels and protect the interests of our stakeholders, we should shift to non-
euro suppliers where possible. If the currency depreciates, we could then move back to using local
suppliers.
Many of MSR’s hotels and resorts are in remote locations along the Mediterranean coastline. As a
result, many local communities and villages rely heavily on the seasonal influx of tourists to the MSR
properties. The hotelier, in turn, relies on these local communities to provide infrastructure and places of
interest for hotel guests. MSR also manages relationships with a number of airlines, local airports, and
bus companies in order to ensure there is appropriate access to its hotels and resorts.
MSR has a policy of not hiring staff under the age of 14, regardless of whether local laws permit
employment of minors. Recently, a manager of one of its hotels on the island of Berkinos was removed
for not complying with this policy.
In her appeal for reinstatement to the MSR board of directors, the ex-employee conceded that she had
failed to adequately abide by the corporate labor policy in hiring a 12-year-old boy, even though the local
government encouraged work for boys of such an age. She claimed she had done so due to the situation
of the child’s family, with the boy needing to take care of his sick mother and younger sister. Casals and
Picard discussed the situation with the head of business development, Angelo Bayan.
Picard: It would seem to me that the hotel manager had a moral obligation to employ the boy. I
understand that the child’s education and well-being might have been negatively affected, but surely
the greater good was served by allowing the boy to earn some money.
Casals: Hiring the child, though innocent as it may seem to some, has taken away from the boy’s
fundamental rights, such as adequate schooling. Regardless of the good intentions of the manager,
decisions that take away basic rights are not ethical.
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Bayan: I’ve worked since I was 7 years old, and besides, it is very common on that island for minors to
be employed in some way or another. MSR should really just focus on what it does best and not try
to solve world peace.
MSR utilizes a number of suppliers across the region, and it wants to ensure that they deal only with
entities that have sound corporate governance systems and processes. The company has recently built its
first resort in Croatia and is currently searching for a local shuttle bus service to transport guests to and
from the airport. As such, MSR is reviewing two potential suppliers.
Supplier 1: A sole proprietor who owns and runs a bus service and has some business debt.
Supplier 2: A partnership that employs a driver to run the bus service, with no debt.
To highlight the rigor of its own corporate governance practices, the MSR board of directors has prepared
the following “Statement of Corporate Governance,” which will appear on its website and reports to
shareholders:
At Mediterranean Spa and Resorts, we pride ourselves on the ethical approach we take to managing
our business and are strong advocates for good corporate governance. Led by our CEO and chair,
Michel Mons, the board of directors is confident that MSR can best address the varied interests of
our stakeholders, and the board highlights the following:
• MSR employs a fully independent audit committee who have industry, financial, legal, and
accounting expertise.
• Other committees, which are majority independent, include the nominating committee and
compensation committee.
• The board consists of 12 highly skilled and experienced directors, 9 of whom are
independent.
• Independent directors meet annually separately from internal directors.
• Directors also have access to MSR’s legal counsel to help assess the company’s compliance
to regulatory requirements.
• All related-party transactions must have prior board approval.
MSR has also been active in managing the risks associated with its environmental and social
responsibilities. In particular, the directors are cognizant of the growing importance that guests are
placing on the company’s use of natural resources and fossil fuels. As such, the directors are considering
a joint venture in solar farms on one of MSR’s Moroccan properties, which will allow the company to
increase its use of renewable energy from the current level of 10% to 60%. This may also help provide a
marginal benefit to the company’s bottom line after considering subsidies and tariffs.
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31. Regarding the statements made by Casals and Picard in regard to the drop in guest numbers,

C. Only Casals’s statement is correct.
Answer: B
Casals’s statement is incorrect, as a drop in customer numbers is not necessarily due to poor
customer satisfaction or a lack of prioritizing customer interests. In this case, the drop in
numbers is due to an external factor (the appreciating currency), which has reduced MSR’s
competitiveness.
Picard’s statement is incorrect, as shifting between suppliers is not likely to be in the best
interests of suppliers, who are a major stakeholder group. MSR will need to take into account the
interests of this stakeholder group, as well as others, when considering different strategies.
32. Regarding MSR’s relationship with the local community and businesses, which of the following
statements is least correct?
A. A stakeholder impact analysis (SIA) would likely identify the impact of the business on local
villages.
B. stakeholder impact analysis (SIA) would likely identify airport operators as stakeholders to
the business.
C. A stakeholder impact analysis (SIA) carried out by MSR is likely to include local
communities as stakeholders, but would not identify them as important stakeholders.
Answer: C
A stakeholder is any entity that has a claim, interest, or stake in the organization, which includes
local communities. For most businesses, the most important stakeholders tend to be shareholders,
employees, and customers. However, in the case of MSR, it is apparent that local communities
play an integral role in the success of its operations, and MSR would likely identify them as
important stakeholders.
33. In regard to the appeal from the ex-employee, which of the following statements is most correct?
A. Picard follows a utilitarian approach to ethics.

B. Bayan follows a justice theory approach to ethics.
C. Casals follows a Friedman doctrine approach to ethics.
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Answer: A
Utilitarian ethics is concerned with decisions that produce the greatest good for the greatest number
of people. Picard believes the hotel manager acted ethically since the hiring of the boy, though
coming with some negative effects for the boy, produced a greater positive impact for his family.
34. Regarding the shuttle bus suppliers, which of the following statements is most correct?
A. Supplier 1 has no conflicts of interest between stakeholders.

B. Supplier 2 has conflicts of interest between owners, creditors, and employees.
C. Supplier 1 and Supplier 2 would not have conflicts of interest between owners and managers.
Answer: C
For both Supplier 1 and Supplier 2, the owners are the same as the managers. This removes the
conflict of interest between owners and managers. For Supplier 2, conflicts between partners are
addressed through partnership contracts.
35. With reference to the “Statement of Corporate Governance,” which of the following components
of MSR’s corporate governance are least likely to be line with an effective board of directors?
A. Chairperson, nomination committee composition, and use of internal counsel

B. Chairperson, frequency of independent director meetings, and compensation committee
composition
C. Number of independent directors on the board, audit committee composition, and
compensation committee composition
Answer: A
MSR’s appointment of its CEO and chairperson is not a desirable characteristic, as they should
be separate people. Further, it is best practice for the audit, nomination, and compensation
committees to be fully independent. It is also best practice for the board to have access to external
legal counsel to assist with regulatory compliance issues.
36. In considering the solar farm venture, the main risk that the board of directors is looking to
mitigate is most likely to be which of the following?
A. Financial risk
B. Legislative risk
C. Reputational risk
Answer: C
It seems likely that the directors are concerned with being seen as not prioritizing environmental,
social, and governance (ESG) factors, which can have adverse effects on customer satisfaction,
revenues, and the cost of capital. This is reputational risk.
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Questions 37 to 42 relate to Equity
Ed Hunter, CFA, is a junior analyst at TMM Micro Opportunities (TMM), a boutique research house that
specializes in micro-cap stocks listed on stock exchanges in the United States. He has recently graduated
from college with a degree in finance and moved to TMM after completing a graduate program at a large
stockbroker.
Hunter has been tasked with assisting Marshall Cronje, CFA, the capital goods sector specialist at TMM.
Together, they are currently researching a handful of new companies that have come to Cronje’s attention
following the request of a key client. It is now the beginning of the 20X2 financial year.
The first company that they are reviewing is Quick 3D Inc. (Q3D), a manufacturing company based in
Dayton, Ohio, which specializes in the 3D printing of parts for the construction industry. Q3D has been
operating for 8 years and listed on the Nasdaq stock exchange 5 years ago. It paid its first dividend to
shareholders this year at $0.60 per share, and dividends are expected to grow strongly as the company
grows into different markets and regions. Hunter has produced forecasts that show that the rate of growth
for the dividends is expected to be 30% p.a. for the current year, slowing at a constant rate down to
6% p.a. over the next 10 years. Dividend growth is expected to remain at this level from then onward.
Hunter has decided to use a required rate of return on equity of 12% to value Q3D’s shares.
The next company to be reviewed is Ice Roads and Rails Inc. (IRR), a provider of logistics infrastructure
to transport companies in the northern states of the United States and Canada. The company is over
75 years old, with more than 50 full-time employees and annual turnover of close to $30 million. Hunter
has prepared the following financial data and forecasts:
20X0 (A) 20X1 (A) 20X2 (F) 20X3 (F) 20X4 (F)
Earnings per share ($) 4.51 4.90 5.63 5.86 6.80
Dividends per share ($) 4.00 4.15 4.35 4.50 4.70
Other current information for IRR:
Current share price $79.43

20X4 share price forecast $92.90
Book value per share $44.23
Profit margin 18.3%
Return on equity (ROE) 17.0%
Required rate of return 11.0%
Growth rate 5.0%
Hunter: IRR is quite overvalued as evidenced by the large difference between the share price and book
value.
Cronje: The company’s justified price-to-book (P/B) ratio is lower than the actual P/B ratio—a clear
indication of the share price is trading too high.
The last company requiring a review is Greenstone Chemicals Inc. (GCI), a supplier of specialist cleaning
materials to large-scale solar plants. To assist with the analysis of GCI, Cronje has also asked for the help
of his colleague, Jenny Hsu, CFA, who is an analyst on TMM’s energy sector team.
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Hunter and Hsu work together to put together the following information:
Current share price $39.20

20X1 dividends per share (DPS) $1.86
20X1 earnings per share (EPS) $2.65
20X2 EPS (forecast) $2.83
Peer trailing price/earnings (P/E) 14.6
Peer leading P/E 14.2
20X1 sales $34.652 million
20X1 asset turnover 0.31 times
20X1 financial leverage 1.22
20X1 net income $16.774 million
Hsu: As there are no similar companies in North America, we have chosen the median P/E ratios of
similar companies in Europe and Asia as our peer group. These businesses have quite similar
operations, so using these P/E ratios as comparisons is appropriate.
Cronje: GCI’s leading P/E ratio would indicate that its stock might be relatively undervalued.
Hunter: One of the peer group P/E ratios seemed abnormally high. In such circumstances, it may be
better to use the mean P/E ratio rather than the median P/E ratio.
37. Using the dividend information provided by Hunter, the value of Q3D shares are closest to which
of the following?
A. $5.65 per share

B. $22.60 per share
C. $34.60 per share
Answer: B
Using the information provided, a value for Q3D’s shares can be calculated utilizing the H-model
equation:
D0 (1 + gL ) + D0 × H(gS − gL )
V0 =
r − gL
0.60(1 + 0.06) + 0.60 × 10 2 (0.30 − 0.06)

VQ3D =
0.12 − 0.06
= $22.60
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38. Given the forecasts provided, the valuation of IRR shares is closest to which of the following?
A. $71.36 per share

B. $78.94 per share
C. $83.09 per share
Answer: B
The value of IRR shares can be estimated by discounting the forecast dividends and year 3 share
price:
dn Vn
V0 = ∑ i =1
n
n +
(1 + r) (1 + r)n
VIRR = 4.35/(1.11) + 4.5/(1.11)2 + (4.7 + 92.9)/(1.11)3
= $78.94
39. The present value of growth opportunities (PVGO) for IRR is closest to which of the following?
A. $28.25 per share

B. $31.67 per share
C. $34.92 per share
Answer: A
E1
PVGO = Share price –
r
PVGOIRR = $79.43 – (5.63/0.11)
= $28.25
40. Regarding the statements made by Hunter and Cronje about the relative value of IRR, which of
the following is most correct?

C. Only Cronje’s statement is correct.
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Answer: B
Hunter’s statement is incorrect, as book values can differ from fair values greatly for reasons
other than misvaluations (e.g., historical cost accounting, valuing of growth).
Cronje’s statement is also incorrect, as IRR’s justified P/B ratio is higher than its actual P/B ratio.
Actual P/B = Share price/Book value per share
Actual P/BIRR = $79.43/$44.23

= 1.796
ROE − g
Justified P/B =
r−g
PVGOIRR = (0.17 – 0.05)/(0.11 – 0.05)
= 2.00
41. The sustainable growth rate of GCI is closest to which of the following?
A. 3.67%
B. 5.47%
C. 8.62%
Answer: B
The sustainable growth rate of a company (g) is the rate of which dividends are able to grow
based on the level of earnings and the company’s retention rate (b):
g = b × ROE
Using DuPont ratios:
ROE = Profit margin × Asset turnover × Financial leverage
bGCI = 1 – 1.86/2.65
= 29.87%
gGCI = 29.87% × (16,774/34,652) × 0.31 × 1.22

= 5.47%
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42. In relation to the statements made by the analysts regarding the P/E ratios of GCI and the peer
group, which of the following is most correct?
A. Only Hsu’s statement is correct.

B. Only Cronje’s statement is correct.
C. Only Hunter’s statement is correct.
Answer: B
Cronje’s statement is correct. The leading P/E of GCI is 13.83 ($39.20/$2.83), which is less
than the peer group’s leading P/E of 14.2. This would be an indication of GCI’s relative
undervaluation.
Hsu’s statement is incorrect. While using the P/E ratios of similar companies in different
countries may be appropriate, such ratios might need to be adjusted to take into account
differences between different countries’ markets.
Hunter’s statement is also incorrect. Small samples that contain outlier observations may have
means that are not representative of the bulk of the group. In such circumstances, the median
would provide a better measure.
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Questions 43 to 48 relate to Fixed Income
Felicity Daniher, CFA, works in the treasury department of Mega Rich Minerals Ltd (MRM), a large
Australian mining company. Due to a surge in demand for raw materials, the business has recently
expanded facilities at sites throughout Australia and Southeast Asia. To fund this expansion, MRM has
raised more than $2 billion in equity and debt over the past year.
With MRM requiring another $300 million in capital due to cost blowouts at two of its mine expansions,
Daniher is tasked with raising further debt and is comparing three different bond types:
• Bond 1: A 5-year bond that requires MRM to retire a proportion of the issue each year
• Bond 2: A 6-year bond that can be called by MRM on a limited number of specified dates
• Bond 3: A 5-year bond that allows the bondholder to keep the bond for a number of years
following maturity, along with giving the bondholder the right to sell back the bond prior to
maturity
Daniher is also looking at the pricing of a 4-year, default-free bond, which can be sold back to MGM at
the end of year 2 and year 3 at par. The bond has an annual coupon of $6, and Daniher has prepared the
following implied forward rates.
Forward rates
1f0 6.20%
1f1 6.30%
1f2 6.86%
1f3 5.89%
On a recent conference call with potential investors, Daniher was asked various questions relating to the
interest rate risk inherent in several MGM bond issues. Daniher makes the following statements:
Statement 1: Most of our bonds have embedded options. This reduces the duration relative to an
option-free bond.
Statement 2: As we are potentially in a rising rate environment, the interest rate sensitivity in our putable
bonds is lower, as compared to the sensitivity when rates are declining.
One of the investors on the conference call, Bill Fernley, CFA, is a portfolio manager for 8th Avenue
Fixed Income Specialists. One of his funds has a large investment in a MGM callable bond, and he
comments on recent price movements.
Fernley: Recent underperformance in my fund is largely attributable to a large drop in the MGM bond
price. We have other funds that have MGM putable bonds, and I have noticed that these bond prices
did not fall nearly as much.
Daniher: Callable bonds can have more downside potential than similar putable bonds when interest
rates rise. Due to the effects of negative convexity, this is particularly true when the embedded call
option is well out-of-the-money.
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Against market expectations, Daniher believes that interest rates are not set to rise, but to remain steady
or even fall. As such, she is considering offering floating-rate bonds with a 4-year maturity. She expects
rates to remain at or slightly below current levels during this entire period, and she wishes to price these
bonds as high as possible.
MGM currently has two different issues of convertible bonds outstanding, MGMA25 and MGMB40.
Both bonds are convertible into MGM stock, which is currently trading at $38.23. Daniher is reviewing
these bonds and has compiled the following information:
MGMA25 MGMB40
Market price $154,688 $102,653
Straight bond value $97,658 $101,390
Initial conversion price 25 40
Conversion rate 4,000 2,500
43. Regarding the bond types being considered by Daniher in raising capital to cover the cost
blowouts, which of the following is most correct?
A. None of the bonds provide embedded options to bondholders.

B. Bond 1 is a sinking fund bond, Bond 2 is an Bermudan-style callable bond, and Bond 3 is an
extendable bond.
C. Bond 1 is a putable bond with accelerated provisions, Bond 2 is an American-style callable
bond, and Bond 3 is a convertible bond.
Answer: B
Bond 1 requires MGM to retire a proportion of the issue each year. This is a sinking fund bond.
Bond 2 provides MGM with the option to call the bond at certain dates prior to maturity, which is
a Bermudan-style callable bond. Bond 3 is a putable bond that effectively gives bondholders the
option to extend the bond’s maturity. This is an extendable bond.
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44. In relation to the 4-year, default-free bond, the current value (year 0) of its embedded option per
bond is closest to which of the following?
A. $0
B. $0.63
C. $0.89
Answer: B
The first step will be to calculate the value of the bond with the option at each year (ex-coupon),
working backward using the forward rates provided.
Year 4 value = $100 + $6 = $106

Year 3 value = $106/1.0589 = $100.104
Year 2 value = ($100.104 + $6)/1.0686 = $99.292
Therefore, the bond will be sold back to the issuer at $100 at the end of year 2).
Year 1 value = ($100 + $6)/1.063 = $99.718 (bond cannot be sold back because option is only
for year 2 and year 3)
V0,PB = ($99.718 + $6)/1.062 = $99.546
The next step is to calculate the value of the respective option-free bond.
V0,OFB = $6/1.062 + $6/1.0632 + $6/1.06863 + $106/1.05894

= $98.919
Therefore, the value of the put option is $0.627 per bond ($99.546 – $98.919).
45. Regarding Daniher’s statements to investors, which of the following is most accurate?

B. Only Statement 1 is correct.
C. Only Statement 2 is correct.
Answer: A
Statement 1 is correct, as bonds with embedded options will always have a lower duration than
similar option-free bonds.
Statement 2 is also correct, as putable bonds are more sensitive to interest rate declines than to
interest rate increases.
99
46. Is Daniher’s response to Fernley correct?
A. No, as callable bonds have less downside potential in a rising rate environment.
B. No, as callable bonds have less downside potential when the embedded call option is out-of-
the-money.
C. No, as negative convexity does not have any real effect when the embedded call option is
out-of-the-money.
Answer: C
The effective convexity of callable bonds will turn negative only when yields fall and the
embedded call option is at-the-money or near-the-money.
47. In regard to the 4-year floating-rate bond, which type of bond would be most appropriate for
Daniher to issue?
A. Ratchet bond
B. Capped floater
C. Floored floater
Answer: C
Daniher would be looking for a bond that might benefit from a decline in interest rates. As she
also wants to receive a high price for the issue, she would want to construct a bond that had
investor options or benefits embedded. A floored floater provides investors with protection that
prevents the coupon from falling below a certain level. This bond would benefit in a rising rate
environment. The bond also has embedded investor options that would increase the price that
MGM might receive for the bond. As Daniher does not expect interest rates to fall significantly,
this embedded benefit might not cost MGM anything at all, and hence a floored floater would be
most appropriate to issue.
100
48. Regarding MGM’s convertible bonds, which of the following statements is most accurate?
A. MGMA25 has a higher market conversion premium ratio and higher premium over
straight value.
B. MGMA25 has a higher market conversion premium ratio, and MGMB40 has a higher
premium over straight value.
C. MGMB40 has a higher market conversion premium ratio, and MGMA25 has a higher
premium over straight value.
Answer: C
Market conversion price − Market price of common stock
Market conversion premium ratio (MCPR) =
Market price of common stock
(Market conversion price = Market price of bond/Conversion ratio)
154,688
4,000 − 38.23
MCPRA =
38.23
= 1.16%
102,653
2,500 − 38.23
MCPRB =
38.23
= 7.41%
Therefore, MGMB40’s market conversion premium ratio is higher.

Market price of bond
Premium over straight value (POSV) = −1
Straight price of bond
154,688
POSVA = −1
97,658
= 58.40%
102,653
POSVB = −1
101,390
= 1.25%%
Therefore, MGMA25’s premium over straight value is higher.
101
Questions 49 to 54 relate to Derivatives
Jerry Montagna, CFA, Wayne Cluff, CFA, and Ken Tsang, CFA, are dealers on the derivatives desk
of Bering House Market Makers (BHMM). The company’s main clients include banks, insurers, and
institutions, and they trade in most financial and derivative markets across the globe, including dealing in
both exchange-traded and over-the-counter (OTC) securities.
Montagna is currently in discussion with a client, a portfolio manager who has a large exposure to
Spanish government bonds. This part of the portfolio has a duration of 7.2 years, with a mix of medium-
term and long-term maturities. The manager is expecting Spanish government bond rates to drop over the
coming months and would like to increase the overall duration of the portfolio. Due to a short-term lack
of liquidity, Montagna has been asked to advise on strategies to change the portfolio’s exposures quickly
and without a large capital outlay, and he provides the client with the following suggestions:
Statement 1: To increase the duration of the portfolio, we could avoid counterparty risk by accessing the
over-the-counter market and buying Spanish bond interest rate futures.
Statement 2: We can organize an interest rate swap that has a duration greater than 7.2 years, in which
you pay Euribor.
The same client is also interested in participating in a new bond issue by a company in Malaysia, and
speaks to Cluff, who has broader experience with the Asia region. The company, an A-rated white goods
manufacturer, is raising USD 800 million in bonds. In various disclosures to potential bondholders, the
company specifies that 50% of the issue will be modified so as to change the currency risk exposure from
USD into the Malaysian ringgit (MYR). The portfolio manager is concerned about his currency exposures
and asks Cluff how the company might go about modifying the currency risk.
Cluff: The company could use a currency swap in which future USD coupon payments could effectively
be changed into MYR payments. The rate of MYR payments, which would be paid to the swap
counterparty, would be set up front and hence the risk of USD risk for the company would be
reduced. There would be no exchange of currencies up front or at the end of the swap contract; it
would simply be a swap of interest rate payments throughout the term of the contract.
Tsang works on the options desk and primarily deals with U.S. equity options. Reinhart Motors LLC
(RMO) is a large automotive company situated in New Jersey. Several senior executives are clients of
BHMM, using their capabilities to manage their RMO stock holdings and stock options. It is now mid-
February and RMO is trading at $20.00 with an annualized volatility of 20%. Prices for options expiring
in 1, 2, 3, and 4 months from today are as follows:
Call option premiums ($) Exercise price ($) Put option premiums ($)
MAR APR MAY JUN MAR APR MAY JUN
2.072 2.178 2.292 2.405 18 0.012 0.059 0.116 0.172
1.165 1.345 1.504 1.647 19 0.102 0.223 0.322 0.408
0.491 0.713 0.891 1.046 20 0.429 0.591 0.71 0.806
0.143 0.318 0.473 0.614 21 1.091 1.206 1.303 1.386
Note: Assumed risk-free rate is 4.0% p.a.
102
Situation 1: Wilhelme Mann, the RMO chief operating officer, is looking at buying a new house and will
need to sell a large portion of his shares for a home deposit due in 3 months’ time. Mann is concerned
about short-term price volatility and wants to protect his portfolio from any significant price drops while
not sacrificing potential gains from a price rise. Tsang recommends that he purchase May put options
with a strike price of $19. In order to cover the cost of the premium, he also recommends that Mann write
April call options with a strike price of $21.
Situation 2: Another RMO executive, Xavier Kruger, is aware of other executives that have taken
advantage of various options strategies to earning extra income from their RMO shares. Kruger intends to
write March call options with a strike price of $21 as an initial transaction.
Situation 3: Fabian Mandelo, the Europe, Middle East, and Africa (EMEA) regional sales manager, has
RMO options expiring in 3 months’ time with a strike price of $15. Tsang proposes a straddle option
strategy to Mandelo utilizing his current option exposure and writing an additional 3-month call option
with a higher expiry.
Situation 4: One of the RMO executives, Debby Major, is nearing retirement and is thinking about
reducing her exposure over the coming months should the share price rise. Tsang recommends that she
write options in order to pick up some additional income while she waits for the share price to rise to the
higher level.
49. In regard to Montagna’s statements about the Spanish bond exposures, which of the following is
most correct?
A. Both statements are incorrect.

B. Only statement 1 is correct.
C. Only statement 2 is correct.
Answer: C
Statement 2 is correct. Entering into an interest rate swap contract, in which the client pays
the floating rate (Euribor) and receives a fixed rate, and where swap duration is greater than
7.2 years, would increase the portfolio’s duration.
Statement 1 is incorrect. Purchasing interest rate futures would be an effective way by which
to increase duration; however, Montagna incorrectly states that the futures contract would be
accessed via the over-the-counter market. Interest rate futures that carry no counterparty risk
would be accessed via an exchange.
103
50. As to Cluff’s response regarding the Malaysian company’s bond issue, which of the following is
most correct?
A. Cluff is incorrect, as MYR would be received from the counterparty.

B. Cluff is incorrect, as the company would use currency futures to hedge the position.
C. Cluff is incorrect, as there would be exchange of currencies up front and at the end of the
contract.
Answer: C
When entering into a currency swap, the parties exchange the notional currency amounts up
front, and reverse the exchange at the end of the contract. Cluff is incorrect in stating that only the
interest payments are exchanged.
51. Regarding Tsang’s recommendation to Mann in Situation 1, which of the following is most
correct?
A. Tsang should not have recommended that Mann buy put options.
B. Tsang should not have recommended that Mann write call options.
C. If Mann writes the same amount of call options as put options bought, the position would
generate a cash inflow.
Answer: B
Buying put options is an appropriate way in which to protect the value of a portfolio of shares
(protective put strategy). This strategy has an initial cost, similar to an insurance premium, and
it also allows the portfolio to gain from upside movements in the price of the underlying shares.
Writing options to cover the initial cost of the put will reduce the initial cash outflow; however,
the writing of call options will limit the potential upside should the share price move substantially
higher. This is a collar strategy and would not be appropriate for Mann.
52. In regard to Kruger’s option strategy in Situation 2, if the share price rises to $20.50 over the next
month, which of the following is least correct?
A. The maximum loss for the position is $19.857.

B. The maximum gain for the position is $1.143 per option.
C. The profit at expiration for the position is $0.143 per option.
Answer: C
Profit/loss = ST – max[(ST – X),0] + c0 – S0

= $20.50 – $0 + $0.143 – $20
= $0.643
104
53. In regard to Tsang’s recommendation of a straddle option strategy for Mandelo in Situation 3,
which of the following is most correct?
A. The proposed position is bear spread strategy.

B. The proposed position is not a straddle position, as Mandelo should have recommended
buying a put option instead.
C. The proposed position is not a straddle position, as Mandelo should have recommended
writing a put option instead.
Answer: B
A straddle strategy usually involves the purchase of a call option along with the purchase of a put
option with the same exercise price. Tsang has recommended a bull spread strategy.
54. In regard to Tsang’s proposal for Major in Situation 4, which of the following is most correct?
A. Tsang should recommend that Major write JUN18 call options.

B. Tsang should recommend that Major write MAR21 call options.
C. Tsang should not recommend an options strategy, as Major is close to retirement.
Answer: B
Writing calls for Major would be an appropriate way of realizing a higher expected price for her
shares. She could write calls with a strike price higher than the current level. If the share price
rises to that level, then the options will be exercised and she will sell her shares at her target price.
If the share price doesn’t get to that level, then she will have at least earned some income. The
MAR21 call options are the only options given with a higher strike price than the current share
price and would be appropriate (as would the longer-dated $21 strike price options).
105
Questions 55 to 60 relate to Portfolio Management
Vanessa Hewson, CFA, serves as an independent asset consultant on many investment and asset allocation
committees. She has more than 20 years of experience in investment advice and management, and her
primary area of expertise is in the setting of capital market expectations and strategic asset allocations.
The Mirabella Art and History Foundation (MAHF) has engaged her to work on its investment
committee. The foundation has assets worth more than GBP 120 million, and it uses these funds to meet
the foundation’s objectives of providing scholarships to early-career artists and historians throughout the
United Kingdom.
The foundation had previously outsourced its investment management to a domestic financial services
firm, but has recently brought these functions in-house. Hewson has been tasked with helping to establish
the foundation’s investment policy statement (IPS). Excerpts from Hewson’s draft IPS follow:
Risk tolerance: The MAHF investment trust has an above-average tolerance for investment risk. This is
due to the relative flexibility the foundation has in determining grant levels over any 3-year rolling period.
Return requirement: The rate of return required to be earned by the MAHF investment trust is 6.50%
(expected annual outlay) above inflation over any 7-year rolling period.
Liquidity constraints: The MAHF investment trust is required to maintain a level of liquidity (cash
and government bonds only) equivalent to 5 years’ worth of expected foundation outlays (grants and
expenses).
Tax constraints: The MAHF investment trust enjoys tax-free status on all investment income and gains.
The trust has a preference for tax-effective investments including tax-free bonds and deferred-tax trusts.
Investment time horizon: The MAHF investment trust is expected to remain in perpetuity.
As part of her investment committee consultancy work, Hewson is currently reviewing three portfolios. In
line with the arbitrage pricing theory (APT) model, each of these portfolios has a known sensitivity to a
single factor, as shown:
Portfolio Sensitivity to factor

A 0.7
B 1.6
C 1
Portfolio A has an expected return of 9.6%, and Portfolio B has an expected return 16.8%.
During a recent investment committee meeting, the committee members engaged in discussion about the
merits of using factor models as part of their efforts on setting capital market expectations. Diana Goh,
CFA, another independent asset consultant, favors the use of the Carhart four-factor model in determining
the expected return of a stock or stock portfolio.
106
Goh: With an additional four factors beyond CAPM, the Carhart model takes into account more variables
to explain return premiums.
Hewson: I am comfortable with a factor relating to size of companies, but I would have to see further
evidence that a momentum factor is consistent in explaining the variance in returns.
In subsequent discussions, Hewson and Goh discuss other multifactor models. A model that Goh has been
working on is a fundamental factor model to help determine the expected return on stocks. The factors in
the model are dividend yield and P/E. The average dividend yield of the market is 2.2% (with a variance
of 0.0081%) and the average P/E of the market is 15.6 (with a variance of 38.44%).
The fundamental factor model uses standardized values for the factor sensitivities and has produced an
intercept value of –1.2%. Goh has prepared the following data for QRS, a stock that is under review:
Stock Dividend yield (%) P/E

QRS 0.8 29.4
In reviewing Goh’s work, Hewson makes the following observations:
Statement 1: I think the model is flawed, as it gives an intercept figure of –1.2%. It is not possible to
have a negative risk-free rate.
Statement 2: I think it would also be a good idea to differentiate between tech stocks and nontech stocks
by using a dummy variable.
Statement 3: It would also be a good idea to include a GDP surprise factor into the model to take into
account the overall direction of the broader economy.
The Millennium Pension Fund (MPF), a public welfare fund for those suffering from post-traumatic
stress disorder, has contracted Hewson to review its risk measurement practices. Following a recent bear
market in which the fund experienced an unexpectedly high loss of capital, the trustees of MPF decided
to implement a risk model estimating the portfolio’s value at risk (VaR).
The MPF VaR model uses assumptions of various normal distributions for a number of risk
factors, historical correlations, and risk factor weightings in the portfolio. Hewson has been tasked
with improving the way in which MPF measures portfolio risk, and she makes the following
recommendations:
Recommendation 1: Assumptions of normal distributions might continue to underestimate loss of capital

in extreme negative events. I would suggest the use of nonsymmetrical distributions with negative skews
for a number of the risk factors.
Recommendation 2: I would also look to measure conditional VaR. This will help you to track the risk
of your portfolio in line with an appropriate benchmark.
107
55. Regarding Hewson’s draft of the MAHF IPS, which of the following is least correct?
A. The preference for tax-effective investments is mostly redundant given the trust’s tax status.
B. The liquidity requirement might be difficult to achieve, considering the required return.
C. The rate of return required by the trust is likely to be too high, considering the stated risk
tolerance.
Answer: C
The stated foundation has an above-average tolerance for investment risk. The return requirement
of 6.5% p.a. above inflation over a 7-year rolling period is consistent with such a level of risk
tolerance.
56. Utilizing the one-factor APT model, the expected return of Portfolio C is closest to which of the
following?
A. 12.0%
B. 13.2%
C. 14.4%
Answer: A
Under APT:
E(Rp) = RF + βpλ
E(RA) = 9.6% = RF + 0.7λ
E(RB) = 16.8% = RF + 1.6λ
Rearranging and solving simultaneously for λ:
0.168 − 0.096
λ= = 0.08
1.6 − 0.7
Substituting λ back into the equation: E(RA)
9.6% = RF + 0.7 × 0.08
RF = 4.0%
Therefore:
E(RC) = 4.0% + 1.0 × 0.08

= 12.0%
108
57. Regarding the discussions regarding the Carhart model, which of the following is most correct?

B. Only Goh’s statement is correct.
C. Only Hewson’s statement is correct.
Answer: C
Hewson’s statement is correct. Two of the factors in the Carhart four-factor model are size
and momentum. However, Goh’s statement is incorrect, as the Carhart model has only three
additional factors beyond CAPM (the market return premium is shared between both models).
58. The factor sensitivities for QRS are closest to which of the following?
A. Dividend yield factor sensitivity of –1.73; P/E factor sensitivity of 0.36

B. Dividend yield factor sensitivity of –1.56; P/E factor sensitivity of 2.23
C. Dividend yield factor sensitivity of –1.40; P/E factor sensitivity of 13.80
Answer: B
Stock value of attribute − Average value of attribute
Factor sensitivity (b) =
Standard deviation of attribute
0.8% − 2.2%
bQRS,div =
0.0081%
= –1.556
29.4 − 15.6
bQRS,PE =
38.44
= 2.226
59. Regarding Hewson’s statements about the fundamental factor model, which of the following is
most correct?
A. Statement 1 is correct.
B. Statement 2 is correct.
C. Statement 3 is correct.
Answer: B
Hewson has correctly identified both a valid fundamental factor and the use of a dummy variable.
Industry or sector membership, represented by a binary dummy variable, can be a useful
inclusion into the fundamental factor model.
109
60. Regarding Hewson’s recommendations to MPF, which of the following is most correct?
A. Only recommendation 1 is valid.

B. Only recommendation 2 is valid.
C. Both recommendations are valid.
Answer: A
Recommendation 1 is a valid criticism of the current MPF approach to risk measurement. The
use of normal distributions in measuring potential outcomes is likely the reason for the previously
unexpected high loss experienced by the fund. To avoid underestimating the magnitude of left tail
events, the use of nonsymmetrical distributions with fatter tails might be appropriate.
Recommendation 2 is not valid, as conditional VaR does not track risk in relation to a benchmark;
that type of measurement is relative VaR.
110

CFA LV 2 2019 Mock Exam Willy - Morning Session With Solutions

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2019

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Questions 1 to 6 relate to Ethical and Professional Standards

A. Standard III(D) Duties to clients: Suitability

A. No, because HIC has included appropriate disclosures.

To avoid violation of Standard I(B) Professionalism: Independence and objectivity, HIC

A. Yes, because this is public information.

A. Standard VI(A) Conflicts of interest: Priority of transactions

Covariance (n = 30) $X (quarterly change) Country X quarterly stock return

Two-Tailed T-Test Values

Coefficients Standard Error t-Stat P-value

A. Both statements are correct.

A. There is no relationship between the variables.

A. Both statements are correct.

Bank A rate sheet

Bank A Bid Offer

Bank B rate sheet

Bank B Bid Offer

Total factor production Labor force Labor factor

MXN/CLPbid = USD/CLPbid ÷ USD/MXNoffer

MXN/CLPoffer = USD/CLPoffer ÷ USD/MXNbid

A. Munoz’s statement is correct.

EUR/CLPbid = USD/CLPbid × EUR/CLPbid

EUR/CLPoffer = USD/CLPoffer × EUR/CLPoffer

Borrow JPY 100,000,000 @ 0.88% p.a. for 3 months

Convert JPY 100,000,000 @ 37.0649 = BRL 2,697,970.32

Invest BRL 2,697,970.32 @ 7.63% p.a. for 3 months

BRL investment = BRL 2,697,970.32 × [1 + 7.63% × (3/12)]

Profit = JPY 101,884,404.75 – JPY 100,220,000

A. The Mulvencian currency is likely to appreciate.

A. Only Statement 1 is correct.

JGPP 20X1 (NOK) 20X2 (NOK)

20X3 unaudited financials:

Service costs NOK 126,450

PPC = Contributions – ΔFunding status

ΔFunding status20X2 = Funding status20X2 – Funding status20X1

PPC20X2 = 180,000 – 140,454

FV plan assets (ending) =

FV Assets20X3 = 1,967,008 – 138,568 + 100,000 – 23,000 – 0

Pension obligations (ending) =

Interest costs = Prior year’s pension obligation × Interest (discount) rate

PBO20X3 = 1,781,455 + 126,450 + 64,132 – 281,300 – 23,000

Net pension asset20X3 = 1,905,440 – 1,667,737

Pension expense20X3 = 126,450 + (1,781,455 – 1,967,008) × 3.6%

($ millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Other details of the business and project include:

Corporate tax rate 40%

OCF = (Sales – Cash operating expenses – Depreciation) (1 – Tax rate) + Depreciation

OCFYear2 = (100 – 30 – 30) (1 – 40%) + 30

WACCcompany = 40% × 7.9% × (1 – 40%) + 60% × 16.8%

Rproject = 3.8% + 1.4 × 7.6%

A. Both statements are correct.

Kapoor’s statement is incorrect, as real options cannot have a negative value.

NOPAT = (Sales – Cash operating expenses – Depreciation) (1 – Tax rate)

NOPATYear4 = (130 – 40 – 30) (1 – 40%)

$WACC = Capital (start of period) × WACC

$WACCYear4 = 200 × 10%

PV of EPYear4 = 16/(1 + 10%)4

A. Both statements are correct.

A. Both statements are correct.

A. Picard follows a utilitarian approach to ethics.

A. Supplier 1 has no conflicts of interest between stakeholders.

A. Chairperson, nomination committee composition, and use of internal counsel

Other current information for IRR: