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CFA LV 2 2019 Mock Exam - Morning Session With Solutions
CFA LV 2 2019 Mock Exam - Morning Session With Solutions
The morning session of the 2019 Level II Chartered Financial Analyst Mock ®
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
Questions Topic Minutes
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2 2019 Level II Mock Exam AM
are in possession of material non-public information. Thorpe shares with the Hearing
Panel the following draft policies being considered for adoption to ensure compliance
with Standard II(A): Material Nonpublic Information:
Policy 1 Portfolio managers are required to submit to the compliance officer
all research reports distributed to clients.
Policy 2 Heightened review of all trading when the firm is in possession of
material non-public information is required.
Policy 3 Receipt of potential material non-public information should be
reported at the next earliest compliance meeting.
Shortly after Thorpe’s presentation to the Hearing Panel, he states on his social
media page, “I’m desperate! I’m so afraid I’ll be permanently kicked out of the CFA
Program. But I’ve taken the following actions to protect myself no matter what the
outcome:
■ I’ve written to all my clients to reconfirm my commitment to continuing educa-
tion, but I left out the part about the potential sanction;
■ I complained to my compliance officer about how unfair I thought the Hearing
Panel process is in case my boss wants to fire me; and
■ I advertised in the CFA Society newsletter to promote my new consulting prac-
tice to help people going through a disciplinary review.”
B is correct. Okada is least likely to investigate CFA Institute Standard III: Duties to Clients.
When trading in Savanna shares, Thorpe likely displayed loyalty, prudence, and care by
putting the interests of his clients before his own, as required under Standard III: Duties
to Clients. Thorpe, however, likely violated Standard II: Integrity of Capital Markets when
he traded on information that could be considered material and non-public. Despite
insider trading being legal in Thorpe’s jurisdiction, as a CFA candidate, he is required
under Standard I: Professionalism to uphold the stricter standard, which in this case is the
CFA Institute Code and Standards. By violating Standard II: Integrity of Capital Markets,
he has likely violated Standard I: Professionalism.
A is incorrect because despite insider trading not being against the law in Thorpe’s
jurisdiction, as a CFA candidate, he is required to uphold the CFA Institute Code of Ethics
and Standards of Professional Conduct. Because insider trading is a violation of the
Standards, he likely violated Standard I: Professionalism by not upholding the stricter
CFA Institute Standards. In this case, Standard II: Integrity of Capital Markets is stricter
than the laws of Thorpe’s jurisdiction.
C is incorrect because Thorpe likely violated Standard II: Integrity of Capital Markets
in that he traded on information that could be considered material, because a lower
earnings forecast would likely negatively affect the share price if it were known to the
public. The earnings warning was not yet available to the public, so by trading in advance
4 2019 Level II Mock Exam AM
of the notice, Thorpe likely traded on material non-public insider information. Even
though insider trading is not illegal in Thorpe’s market, he has an obligation to follow
the stricter standard—the CFA Institute Code and Standards.
2 Should Thorpe most likely revise how he submitted his Fair Dealing defense to
avoid violating Standard III(E): Preservation of Confidentiality?
A No.
B Yes, he must delete the contact details.
C Yes, he must remove the AUM percentage details.
A is correct. Thorpe did not violate CFA Institute Standard I: Professionalism. Thorpe
was unlikely to be influenced by the gift baskets when making the investment decision,
because his primary interest was to protect his clients and himself and the share price
was anticipated to fall after the earnings warning was publicly released. Standard I(B):
Independence and Objectivity prohibits the acceptance of gifts that would jeopardize
a member’s or candidate’s independence and objectivity. In addition, because the gift
baskets’ total value was USD600 and they were being shared among six people, Thorpe
was in compliance with the firm’s gift policy of not accepting a gift valued at more than
USD100. Standard I(D): Misconduct requires Thorpe to comply with his firm’s policies so
as to not reflect adversely on his professional reputation and integrity. Thorpe most likely
did not violate any CFA Institute Standard I: Professionalism provisions when accepting
the gift baskets on behalf of his colleagues.
2019 Level II Mock Exam AM 5
B is incorrect because even though the gift baskets’ total value was USD600, they
were shared among six people; therefore, Thorpe was in compliance with the firm’s policy
of not accepting a gift valued at more than USD100 per gift. Standard I(D): Misconduct
requires Thorpe to comply with his firm’s policies so as to not reflect adversely on his
professional reputation and integrity.
C is incorrect because Thorpe was unlikely to be influenced by the gift baskets when
making the investment decision because his primary interest was to protect his clients
and himself and the share price was anticipated to fall after the earnings warning was
publicly released. Standard I(B): Independence and Objectivity prohibits the acceptance
of gifts that would jeopardize a member’s or candidate’s independence and objectivity.
B is correct. Thorpe’s use of industry experts who are former consultants of competitors
of Savanna puts him at risk of violating Standard II: Integrity of Capital Markets. Even
though the experts are former consultants, they still may be in possession of pertinent
confidential information that is material and non-public. Standard II: Integrity of Capital
Markets dictates that members and candidates are ultimately responsible for ensuring they
are not requesting or acting on confidential information received from external experts.
A is incorrect because the use of data from a specialty social media site open to the
public would not cause Thorpe to gather material non-public information, so he would
not be in violation of Standard II: Integrity of Capital Markets.
C is incorrect because Thorpe’s personal observations of grocery stock turnover of
products would be considered non-material and public information. Therefore, infor-
mation collected via this technique would be used as part of a mosaic of gathering data
to determine an investment recommendation. No violation of Standard II: Integrity of
Capital Markets has taken place.
B is correct. Thorpe’s firm should adopt Policy 2: Heightened review of all trading when the
firm is in possession of material non-public information is required. This is a recommended
procedure to prevent a violation of Standard II(A): Material Nonpublic Information in that
it helps to restrict the flow of confidential information to those who need to know the
information to perform their jobs effectively. Any trading in a restricted security could
help detect information leaks.
A is incorrect. To prevent potential violations of Standard II(A): Material Nonpublic
Information, the policy should state that the research reports should be reviewed by
the compliance officer prior to, not after, client distribution. The compliance officer will
review the reports to determine whether any of the recommendations are based on
material non-public information.
C is incorrect because a recommended procedure for Standard II(A): Material Nonpublic
Information is that such information should be reported to the compliance officer imme-
diately upon receipt. Waiting until the next compliance meeting, which could be days or
even weeks later, would be inconsistent with the recommended procedures.
6 Which of Thorpe’s actions after the Hearing Panel presentation most likely vio-
lated CFA Institute Standards?
A His letter to his clients
B His complaint to the compliance officer
C His new disciplinary review consulting practice
Epstein remarks that the model is fine, but it doesn’t seem particularly unique.
Additionally, she is concerned as to whether it matters that some of the variables, such
as dividend yield and reinvestment rate, appear to be related to each other.
Epstein asks Litvenko whether it is possible to identify companies that are likely to
outperform the market in the next period rather than just trying to predict the return
for a company. He replies that his model as stated would not be a suitable approach
for identifying outperformers, but there are ways to conduct such an analysis.
Litvenko tells Epstein that he can use a dataset harvested from social media to
develop better predictive models based on behavioral factors. While he has limited
computing power and has not yet worked with the data, he believes that it offers a
unique opportunity to implement innovative strategies if the right tools are used.
Epstein agrees to a trial with the new data, and Litvenko considers how best to approach
the problem using machine learning. He begins by creating the data description table
8 2019 Level II Mock Exam AM
shown in Exhibit 2 for those variables he would like to include, with the goal of creating
a model to predict which mid-cap stocks will outperform the index. All variables will
be measured continuously over a four-year period.
Exhibit 2
Before he can view meaningful results, Litvenko realizes he will have to train the
machine learning model so that it follows the correct path. Because he is new to the
machine learning approach, he begins by identifying the principles of model speci-
fication and model training. He makes the following list of the steps he believes are
involved in the machine learning model training process:
1 Find the appropriate underlying economic theory.
2 Establish training and validation samples.
3 Improve the classification accuracy of the model.
Litvenko later studies the model created by the computer. While he is generally
satisfied with its fit, he is concerned that the large number of variables used may mean
that he is “overfitting” his model, with some variables adding little to its explanatory
power. He is also convinced that the relationships he is observing between the binary
outcome and the explanatory variables are non-linear. He considers alternatives to
his modeling approach to address these concerns.
7 Based on the information provided in Exhibit 1, Epstein’s estimate of the next
period return on Storcon, Inc., is closest to:
A 18.5%.
B 22.5%.
C 27.3%.
where
8 Epstein’s concern regarding the relationship between the dividend yield and the
reinvestment rate variables is most appropriately addressed by evaluating the:
A R2 and t-statistics.
B Durbin–Watson statistic.
C Breusch–Pagan test results.
A is correct. The concern that Epstein has in regard to the relationship between the
dividend yield and the reinvestment rate is that the two independent variables are
likely highly correlated with one another—which is referred to as multicollinearity.
There is no specific test for multicollinearity. However, it can be identified by large R2
values and significant F-statistics, combined with low or insignificant t-statistics due to
inflated standard errors.
B is incorrect. The Durbin–Watson statistic is used to test for serial correlation.
C is incorrect. The Breusch–Pagan test is used to diagnose heteroskedasticity.
A is correct. A probit model is appropriate for a binary decision, such as whether a security
is likely to outperform the market or not.
B is incorrect. A dummy variable is a qualitative independent variable. A model to
classify outcomes as binary requires a qualitative dependent variable.
C is incorrect. A logarithmic transformation of an independent variable is appropriate
when its relationship with the dependent variable is non-linear, but it will not change
the form of the dependent variable to binary (outperforms or does not).
10 Given Litvenko’s resources and experience and using the variables shown in
Exhibit 2, the type of machine learning he should use is best described as:
A deep learning.
B supervised learning.
C unsupervised learning.
11 The item from Litvenko’s list that best describes a step in the machine learning
model training process is:
A Item 1.
B Item 2.
C Item 3.
2019 Level II Mock Exam AM 11
B is correct. Establishing training and validation samples is one of the steps in the pro-
cess of training machine learning (ML) models. The emphasis in ML contexts is typically
on improving the accuracy in classification or prediction, but that is not a step in the
process. Finding the appropriate underlying economic theory is the first principle of
financial economic modeling but is not a step in training ML models.
A and C are incorrect.
12 The concerns Litvenko has with his machine learning model can best be
addressed using which of the following alternative modeling approaches?
A CART approach
B Clustering algorithm
C Penalized regression technique
A is correct. The CART (classification and regression trees) approach is most commonly
used when the outcome is binary (outperforms or does not) and there may be significant
non-linear relationships among variables. Variables are added in order of the greatest
contribution to misclassification error reduction and cease being added when there is
no further meaningful reduction possible.
B is incorrect. Clustering algorithms are a form of unsupervised learning that groups
unlabeled data objects according to machine-identified patterns within the data, with
no theory or predetermined relationships.
C is incorrect. Penalized learning reduces the number of independent variables, but
it assumes linear relationships.
Eriksson and Lars start the meeting by reviewing some of the relevant currency
exchange rates, shown in Exhibit 2. The functional currency for the eurozone and
US subsidiaries is the local currency (EUR and USD, respectively), thus the financial
statements of both are translated using the current rate method. Both subsidiaries
are consistently profitable.
Next, they review the performance and related disclosures by region. The number
of stores operated in each region is shown in Exhibit 3.
In preparation for the meeting, Lars looked at the US region and calculated the
effect of the change in the SEK/USD exchange rate on the increase in sales from 2014
to 2015. Her notes include the following:
■■ In 2014, the sales per store, in SEK, were the same for both US and Swedish
stores.
■■ The sales per US store in USD remained constant in 2015.
Eriksson reminds Lars that Trana defines organic growth in retail as coming from
two factors:
1 increasing the number of stores, and
2 increasing the sales per store in the local currency.
He says that he wants to provide disclosures related to the organic growth rate in
domestic sales per store, by region, and asks Lars to calculate it for the eurozone region
where the sales figures (in millions) were SEK18,394 in 2014 and SEK21,640 in 2015.
In 2012, at the start of Trana’s expansion into North American markets, the com-
pany established a subsidiary, Anart Inc., in a South American country to benefit from
lower labor and shipping costs. The details of the Anart investment are as follows:
■■ Anart is 80% owned by Trana with 20% local investment.
■■ It sells all of its production to Trana and Trana’s other subsidiaries and deter-
mines the transfer price as full cost plus 5%.
■■ In 2015, sales (in millions) from Anart to Trana companies were SEK4,485 with
net profit of SEK204.
■■ The corporate tax rate in the country is 10%.
Throughout 2013, the South American country experienced high rates of infla-
tion, approaching 30% per year. Trana had originally assumed that the high inflation
rate was temporary, but it has shown no signs of decreasing and is now a concern.
Eriksson and Lars discuss the impact of Anart on Trana’s financial statements and
Eriksson asks Lars:
“Is the same accounting method being used this year to account for Anart
in the consolidated financial statements as in prior years?”
Eriksson reminds Lars that there is a proposal in Sweden to reduce the corporate
tax rate from the current 22% to 16.5%. He would like to provide pro-forma disclosures
related to the potential change in net income this change could provide for Trana.
He reminds Lars that the average tax rate for the eurozone countries where Trana
operates is 30% and 25% in the United States. Sweden operates under a tax treaty with
all countries in which it has subsidiaries, such that it will owe taxes on foreign earned
income to the extent that the Swedish rate exceeds the foreign rate.
In closing the meeting, Eriksson mentions that Trana is undertaking a compre-
hensive review of its operations in 2016, and its objectives include reducing overall
tax costs by lowering its effective tax rate and reducing foreign exchange gains and
losses reported on the income statement.
13 Using Exhibits 1, 2, and 3 and Lars’s notes about the US operations, the change
in sales reported for the US region (in SEK millions) explained by the change in
the SEK/USD exchange rate in 2015 is closest to:
A SEK737.
B SEK813.
C SEK1,432.
14 2019 Level II Mock Exam AM
A is correct. The number of stores in the United States is the same in 2014 and 2015
(80). The average sales per US store in 2014 is the same as the Swedish stores, and the
USD sales are the same in both years. But when sales are converted into SEK, the values
reflect the change in the exchange rate over the period.
B is incorrect. It uses the average sales overall, not the Swedish ones to determine
sales level.
Multinational Operations
LOS c
Sections 3.2, 3.4
Integration of Financial Statement Analysis Techniques
2019 Level II Mock Exam AM 15
LOS c
Section 2
14 Using Eriksson’s definition, the organic growth rate in sales per store in the
eurozone region between 2014 and 2015 that Lars calculates is closest to:
A 0%.
B –6.2%.
C 10.3%
B is correct. To reflect the growth in domestic sales per store, it is necessary to elim-
inate the foreign exchange effect.
2014 2015
2014 2015
C is incorrect. It is the growth rate in Euros in total, not adjusting for the increase in
the number of stores.
(2,372 – 2,150)/2,150 = 10.3% (numbers from A’s justification table)
Multinational Operations
LOS i
Section 5.1
15 The best estimate of the proportion of Anart’s sales that is reflected in Trana’s
consolidated income statement is:
A 0%.
B 100%.
C 80%.
16 2019 Level II Mock Exam AM
A is correct. Trana owns 80% of Anart. Because this is a controlling interest, Trana would
consolidate Anart into the group financial statements. Even though Trana owns only
80%, consolidation requires the inclusion of 100% of the subsidiary’s assets, liabilities,
revenues, and expenses (excepting intercompany sales, which are eliminated on consol-
idation to prevent double counting). Therefore, because Anart sells all of its production
to Trana and Trana’s other subsidiaries, none of Anart’s sales would be included in the
consolidated income statement.
B is incorrect. Even though Trana only owns 80%, consolidation requires 100% inclusion
of the subsidiary’s assets, liabilities, revenues, and expenses. Intercompany sales (here
100%), however, must be eliminated
C is incorrect. Even though Trana only owns 80%, consolidation requires 100% inclusion
of the subsidiary’s assets, liabilities, revenues, and expenses. Intercompany sales (here
100%), however, must be eliminated.
Intercorporate Investments
LOS c
Sections 2, 6.5
A is correct. Because Anart is an extension of Trana (Anart sells 100% of its production to
the group) its functional currency would be the Swedish krona, not the local currency,
and it would be considered an integrated foreign operation. As an integrated foreign
operation, Trana would normally, and historically, have accounted for Anart using the
temporal method. But the country in which Anart operates is experiencing high inflation;
three years (2013–2015) of rates near 30% would exceed the 100% indicator of hyperin-
flation. Therefore, under IFRS, the nonmonetary items must be adjusted for the loss in
purchasing power to better reflect economic reality. Note that only the nonmonetary
items are adjusted because monetary ones would already be expressed in the monetary
unit current at the balance sheet date.
B is incorrect. Only nonmonetary items are affected by the loss of purchasing power
and must be restated.
C is incorrect. Now that the high inflation has lasted at least three years it can be
considered hyperinflation, and different translation methods must be used to reflect
economic reality.
Multinational Operations
LOS g
Sections 3.2.2, 3.2.4, and 3.5
17 If the proposed reduction in Swedish tax rates had been in effect in 2015, the
increase in Trana’s net profit (in SEK millions) would have been closest to:
A SEK31.2.
B SEK18.6.
2019 Level II Mock Exam AM 17
C SEK29.8.
A is correct. The proposed change in Swedish tax rates would have affected the
income earned in Sweden (SEK338 before tax) and the pre-tax income earned in the
South American subsidiary (SEK227, see calculation in following table) because the tax
rate there is lower than in Sweden and hence subject to tax at Swedish rates. The income
earned in tax jurisdictions with rates higher than Sweden’s (Europe and the United States)
are not subject to tax in Sweden and thus would not have been affected.
* To calculate EBT, divide net profit of SEK204 by (1 – tax rate): 204/(1 – 0.10) = SEK227.
Multinational Operations
LOS h
Section 4
18 Which of the following strategies would be most likely to help Trana achieve at
least one of the objectives mentioned by Eriksson for 2016?
A Raise the price at which Anart sells its goods to other group members
B Increase the number of stores in the US region
C Initiate a hedge on the net asset position of the eurozone subsidiary
A is correct. Anart operates in a South American country with the lowest tax rate of the
group—10% versus 25% in the United States, 30% in the eurozone, and 22% (or 16.5%)
in Sweden. If more of the corporate profits are earned by Anart, the effective tax rate
will decrease.
■■ Anart currently earns a return of 204/4,485 = 4.5%, whereas the overall corporate
profit rate is 10.3% (3,096/30,200).
■■ Any income taxed in South America would be eligible for a tax credit in Sweden,
and Trana would be liable for the tax difference between the local 10% rate and
the rate in Sweden (22% or 16.5%).
18 2019 Level II Mock Exam AM
■■ To the extent that taxable income can be diverted from the US or eurozone oper-
ations (where the rates are higher than Sweden’s), it would result in an overall tax
saving for Trana.
■■ By increasing the price at which Anart sells goods to the US and eurozone subsid-
iaries, it would increase the taxable income earned in South America and reduce
the taxable income (through higher cost of goods sold) in the United States and
the eurozone. Because of the tax treaty with Sweden, there would be no net
tax savings on the goods sold to US and eurozone stores by Anart if the prices
change.
Because both retail subsidiaries are translated using the current rate method, all
foreign exchange gains/losses are reported in other comprehensive income not on
the income statement. Therefore, the effects of hedging the exposure in the eurozone
subsidiary would also be reported in other comprehensive income and not affect the
income statement.
Increasing the number of stores in the US would increase the amount of income in
the highest tax jurisdiction and hence increase taxes, not lower them.
B is incorrect. Increasing the number of stores in the US region will not affect the tax
rate, but would increase taxable income because the tax rate there is greater than in
Sweden and would not affect foreign exchange gains and losses on the income statement
because it is self-sustaining, and the gains and losses go to other comprehensive income.
C is incorrect. The eurozone subsidiary is also self-sustaining, and any effect of hedging
its net asset position would go to other comprehensive income, not net income. The
eurozone’s taxes are higher than in Sweden, so there would be no lowering of taxes either.
Multinational Operations
LOS h
Section 4
Carlyle reviews analysts’ reports. She notes the significant change in cash due to
the high sales volume and wonders whether that will prompt a dividend increase.
However, most analysts have stated that because the industry is cyclical, the increase
in sales is believed to be temporary.
2019 Level II Mock Exam AM 19
Carlyle asks her assistant, Richard Lee, to investigate whether Avignon might use
its surplus cash for a share repurchase rather than for dividends. Lee, a junior analyst,
comments that share repurchases can be beneficial for several reasons:
1 The distribution of cash among shareholders is equivalent to what would have
otherwise been distributed to them as dividends.
2 Share repurchases provide greater flexibility to management than the payment
of cash dividends.
3 When directly negotiated, share repurchases can be used to purchase stock for
less than the current market price.
Lee believes that looking at other companies that have completed share repurchases
could be helpful to his analysis. He looks at the history of SpeedyPro Inc. (“SpeedyPro”),
a US-based industrial services company whose business depends heavily on the petro-
leum exploration and production sector. SpeedyPro made its first share repurchase
in early 2017 using surplus cash. SpeedyPro’s selected financial information just prior
to the repurchase is shown in Exhibit 2.
Lee returns to Carlyle to continue the discussion. Carlyle explains to Lee that a
complete analysis of the impact of a share repurchase should also include an evalua-
tion of the effects on leverage. She points out that Avignon’s most recent bond issue
includes a covenant that limits the company’s debt-to-equity ratio to 35%. She asks
Lee to prepare an analysis for Avignon, using the information in Exhibit 3, to see if
the debt covenant will be violated if the company repurchases shares.
20 If the analysts’ beliefs about the increase in sales are correct, the change in divi-
dend policy that Avignon would most likely make would be to:
A declare a special dividend.
B increase the quarterly dividend amount.
C cut the quarterly dividend in anticipation of next year’s sales forecast.
A is correct. If analysts are correct that the change in sales is temporary, the company is
most likely to declare a special dividend. Companies, particularly in cyclical industries, may
choose to use special dividends to distribute more earnings during strong earning years.
B is incorrect. Most companies strive to maintain or increase their dividends and
will not increase the regular dividend unless they believe they can continue to pay at
or above that level. Rather, they will pay an extra dividend at the end of the year when
earnings are unusually good.
C is incorrect. A record of consistent or increasing dividends is widely interpreted as
a signal of profitability, and most companies strive to not reduce dividends.
22 If SpeedyPro had used all of its surplus cash to repurchase its shares, based on
Exhibit 2, the percentage increase in EPS would have been closest to:
A 10%.
B 28%.
C 25%.
B is correct. SpeedyPro offered a 10% premium over the current price. This is most con-
sistent with a fixed-price tender offer, which normally requires a premium. Negotiated
purchase agreements are almost as likely to take place at prices lower than market
because they are at prices above market, particularly when shareholders are trying to
meet liquidity needs. Open market purchases are market based and can be timed to
avoid price impact.
A is incorrect. Negotiated purchase agreements are almost as likely to take place
at prices lower than market as they are at prices above market when shareholders are
trying to meet liquidity needs.
C is incorrect. Open market purchases are market based and can be timed to avoid
price impact.
24 The best answer to Carlyle’s question about the potential violation of the debt
covenants is that the covenant:
A will be violated if Avignon uses debt to finance the repurchase.
B will be violated if Avignon uses the surplus cash to finance the repurchase.
C is not violated if Avignon repurchases shares.
A is correct. The debt-financed repurchase increases the debt-to-equity ratio above the
35% threshold and thus violates the debt covenant.
B is incorrect. The D/E stays below 35% when the company uses the surplus cash to
finance the repurchase. (See table above: 31.7%.)
C is incorrect. The D/E is above the 35% threshold when the repurchase is financed
with debt.
Zhang notes that Cratt is currently trading at $11.31 and reminds the club that
the company had been sued over patent infringement for producing coats and blan-
kets for dogs with the names and logos of local professional sports teams on them
without the teams’ permission. The company had settled quickly out of court to avoid
further negative publicity. Zhang believes the company will not be incurring legal fees
again in the foreseeable future but believes that because the company’s strategy is to
grow by acquisition, costs related to acquisitions will continue to be incurred and are
relevant in any analysis. She does not agree with the company’s exclusion of those
costs from core EPS. She calculates Cratt’s trailing price-to-earnings ratio (P/E) on
the basis of her beliefs.
Using data available from the New York Stock Exchange (NYSE), Zhang finds the
average P/E multiple for the Consumer Goods Index (14.8) and the Processed and
Packaged Goods sector of that index (32.9). She then performs a screen to narrow the
latter group down to other, smaller processed and packaged goods producers to create
her own index for comparison purposes. Partial results for the companies identified
in her screen are shown in Exhibit 2.
24 2019 Level II Mock Exam AM
Zhang observes that Lane Foods must have both a higher-than-average growth
rate and risk to justify its high P/E and that perhaps they should consider looking at
Lane as a potential investment at their next meeting.
The club members further discuss Zhang’s index and the wide range in both
market capitalizations and P/Es for companies in the index. The discussion focuses
on whether the arithmetic mean of the index is the best value to be using in their
analysis. Zhang remembers learning about the weighted harmonic mean. She decides
to calculate the weighted harmonic mean for the index and makes the following
statement to support her decision:
“The harmonic mean can be used to mitigate the effects of both large and
small outliers.”
Moving on from Cratt, Tom Kaminski, another group member, presents some
preliminary research on Rapier Ltd., an integrated producer in the forest products
industry. Kaminski explains that the industry is cyclical and is currently at mid-c ycle.
He notes that over this portion of the current cycle, Rapier has shown steady growth
in total assets. Kaminski realizes he needs to take these factors into consideration
when calculating normalized EPS to determine Rapier’s P/E.
The meeting continues with Kaminski providing some follow-up from the club’s
last meeting:
“I have more information on KPK Inc., which we discussed in our last
meeting. You may recall that we settled on a discounted cash flow model
that we considered appropriate for the stock. I have used it to calculate the
justified fundamental P/E. In addition, along with current and forecasted
EPS for the next four quarters, I have determined other P/Es for the stock
(Exhibit 3). Because the stock is part of the NYSE Consumer Goods Index
that Zhang mentioned earlier, I have also included the index P/E. Based on
this analysis, I recommend that the club buy KPK shares.”
Exhibit 3 Various P/E Multiples Related to KPK Inc. and Its Industry
Justified Consumer Goods
Trailing P/E Forward P/E (Fundamental) P/E Index P/E
25 Based on Exhibit 1 and Zhang’s beliefs about recurring costs, her trailing P/E is
closest to:
2019 Level II Mock Exam AM 25
A 10.98.
B 10.01.
C 8.64.
B is correct. Zhang believes that the acquisition costs will continue to be incurred and,
therefore, should not be excluded from Cratt’s core EPS; however, the legal costs are
non-recurring and should be excluded.
Using that definition, recurring EPS in 2017 = $1.03 + 0.10 = $1.13. Trailing P/E = $11.31 ÷
$1.13 = 10.01.
A is incorrect. It uses the GAAP (reported) EPS: P/E = $11.31 ÷ 1.03 = $10.98. But that
includes the legal fees, which Zhang believes will not recur and should not be included.
C is incorrect because it uses core EPS as reported by Cratt: P/E = $11.31 ÷ 1.31 = $8.64,
which excludes the acquisition costs.
26 Zhang’s observation about Lane Foods’ high P/E is best described as:
A correct.
B incorrect with respect to the growth rate.
C incorrect with respect to the risk.
C is correct. The observation about Lane’s P/E is incorrect with respect to risk. Companies
with higher-than-average risk (operating or financial) have lower P/Es, not higher ones.
She is correct with respect to the growth rate. Companies with higher-than-average
growth rates have higher P/Es.
A is incorrect. The observation is incorrect with respect to the risk. Companies with
higher-than-average risk (operating or financial) have lower P/Es, not higher ones. She
is correct with respect to the growth rate. Companies with higher-than-average growth
rates have higher P/Es.
B is incorrect. She is correct with respect to the growth rate. Companies with higher-
than-average growth rates have higher P/Es.
27 The weighted harmonic mean of the P/Es in Zhang’s index (Exhibit 2) is closest
to:
A 11.1.
B 10.8.
C 15.4
26 2019 Level II Mock Exam AM
B is correct. The weighted harmonic mean is the value obtained by calculating the
weighted average (based on market capitalization weights) of the reciprocals of the
observations (the P/E) and then taking the reciprocal of the average. The weighted
harmonic mean for Zhang’s index in Exhibit 2 is calculated as follows:
28 Zhang’s statement to support using the harmonic mean is best described as:
A incorrect with respect to large outliers.
B incorrect with respect to small outliners.
C correct.
2019 Level II Mock Exam AM 27
B is correct. Zhang’s statement is incorrect with respect to small outliers. The harmonic
mean tends to mitigate the impact of large outliers. It may aggravate the impact of small
outliers, but such outliers are bounded by zero on the downside.
A is incorrect. The harmonic mean may aggravate the impact of small outliers, but
such outliers are bounded by zero on the downside.
C is incorrect. The harmonic mean may aggravate the impact of small outliers, but
such outliers are bounded by zero on the downside.
29 When determining Rapier’s P/E, the most appropriate method for Kaminski to
use to calculate the company’s normalized EPS is the:
A average ROE over the most recent full cycle times the current book value
per share.
B current EPS because Rapier is mid-c ycle.
C average EPS over the most recent full cycle.
A is correct. The average ROE over the most recent full cycle times the current book value
is the most appropriate method to use to calculate normalized EPS in cyclical industries
when there have been changes in the company’s size, as is the case for Rapier and its
asset growth.
B is incorrect. Even though the company is mid-c ycle, the current EPS may not be the
same as the average or normalized EPS over the cycle.
C is incorrect. Averaging the EPS over the cycle is one way to calculate normalized EPS
in a cyclical industry but does not account for changes in the business’s size.
30 Which of the following best supports Kaminski’s recommendation for KPK? The
justified (fundamental) P/E is greater than the:
A trailing P/E.
B forward P/E.
C index P/E.
A is correct. Kaminski recommends that the club invest in KPK. That would be appropri-
ate if the company is currently undervalued. He has forecasted a share price based on
fundamentals (DCF) and has forecasted EPS. Therefore, the club can calculate a justified
(fundamental) P/E based on those inputs and compare it with the other P/E values to
determine the attractiveness of the stock. The justified (fundamental) P/E would be a
better metric to base the decision on than one of the other P/Es because it is supported
28 2019 Level II Mock Exam AM
by company fundamentals. From Exhibit 3, the justified (fundamental) P/E is greater than
the trailing P/E. Therefore, KPK is currently undervalued by (15.0 – 14.6) ÷ 14.6 = 2.7%,
and the club should invest.
B is incorrect. The forward P/E is not the most reliable P/E, because it is not based on
company fundamentals.
C is incorrect. The index is a general comparable and does not represent the value of
the company as well as the justified P/E. Therefore, it not as reliable a buy signal.
Muniz states that effective duration indicates the sensitivity of a bond’s price to
interest rate changes and is a measure of interest rate risk. She notes: “When interest
rates rise and are high relative to the bond’s coupon rate, the effective duration of
a callable bond falls and is lower than the effective duration of an otherwise similar
straight bond. On the other hand, for the same interest rate scenario, the effective
duration of a putable bond will be similar to the effective duration of a comparable
straight bond.”
Muniz wraps up the training session by posing the following question: “If you expect
a steepening of the yield curve, what duration measure provides the best indication
of the interest rate risk for a callable bond?” The group is asked to submit answers to
Muniz the following day.
31 Which of Morgan’s statements is least likely correct:
A Statement 1.
B Statement 2.
C Statement 3.
B is correct. Statement 2 is incorrect. Both bondholder options and issuer options can
be embedded in the same bond. For example, convertible bonds contain a conversion
option that allows the bondholder to convert bonds to the issuer’s common stock. At
the same time, the convertible bond can have an embedded call option that allows the
issuer to call the bond issue to take advantage of low interest rates or to force conversion.
A is incorrect. Statement 1 is correct.
C is incorrect. Statement 3 is correct.
B is correct, Gomaa is correct. The option-adjusted spread (OAS) is the constant spread
that is added to all one-period forward rates on the interest rate tree and results in the
present value of the bond’s cash flows, or arbitrage-free value, equaling the bond’s
market price. Gomaa also correctly describes how to use OAS for relative valuation. For
two bonds that have otherwise similar characteristics, the bond with the higher OAS is
underpriced, or, alternatively, the bond with the lower OAS is overpriced.
30 2019 Level II Mock Exam AM
A is incorrect. Morgan is incorrect. The OAS is the constant spread that is added to all
one period forward rates on the interest rate tree (not the term structure) and results in
the present value of the bond’s cash flows, or arbitrage free value, equaling the bonds
market price.
C is incorrect. Scahill is incorrect. For two bonds that are otherwise similar in all respects,
the bond with the lower OAS is most likely overpriced not underpriced.
C is correct.
(PV− ) − (PV+ )
Effective Duration =
2(∆Curve)(PV0 )
100.64 − 100.32
= = 1.59
2(0.001)(100.5)
A is incorrect. It is incorrectly calculated as:
100.64 − 100.32
= 3.18
(0.001)(100.5)
B is incorrect. It is incorrectly calculated as follows:
100.64 − 100.5
= 0.697 or 0.70
2(0.001)(100.32)
B is correct. Muniz’s comments on the effective duration of callable and putable bonds
are incorrect. For callable bonds, when interest rates rise and are high compared to the
bond’s coupon rate, the call option is out of the money and the price of the callable
bond and an otherwise identical straight bond are almost the same. Thus, the effect of
an interest rate change on the price of a callable bond and the straight bond is similar—
that is, the effective duration of the callable and straight bonds is similar. For putable
bonds, when interest rates rise and are high compared to the bond’s coupon rate, the
put option is in the money and the price of the putable bond will not fall as much as the
straight bond because the investor can put the bond. Thus, the effective duration of the
putable bond is lower than the effective duration of the straight bond.
A is incorrect. Muniz’s comments on the effective duration of callable and putable
bonds are incorrect.
C is incorrect. Muniz’s comments on the effective duration of callable and putable
bonds are incorrect.
36 For the interest rate scenario presented by Muniz, the most appropriate dura-
tion measure is:
A key rate duration.
32 2019 Level II Mock Exam AM
B one-sided up duration.
C effective duration.
A is correct. A bond’s sensitivity to changes in the shape of the yield curve, steepening
or flattening, is captured by key rate duration. One-sided duration (up or down) is better
than effective or two-sided duration at capturing the interest rate sensitivity of a callable
or putable bond but only for a parallel shift in the yield curve, not for changes in the
shape of the yield curve.
B is incorrect. A bond’s sensitivity to changes in the shape of the yield curve, steep-
ening or flattening, is captured by key rate duration. One-sided duration (up or down) is
better than effective or two-sided duration at capturing the interest rate sensitivity of a
callable or putable bond but only for a parallel shift in the yield curve, not for changes
in the shape of the yield curve.
C is incorrect. A bond’s sensitivity to changes in the shape of the yield curve, steep-
ening or flattening, is captured by key rate duration. One-sided duration (up or down) is
better than effective or two-sided duration at capturing the interest rate sensitivity of a
callable or putable bond but only for a parallel shift in the yield curve, not for changes
in the shape of the yield curve.
Exhibit 1
Current six-month Libor 1.00%
Six-month forward rate in six months 1.15%
2019 Level II Mock Exam AM 33
A 1.25%.
B 1.15%.
C 1.00%.
C is correct. When using the two-period binomial model to value interest rate options,
the value of the underlying instrument at Node 0 is the spot rate. The spot rate (and the
at-the-money strike price) is the current Libor rate of 1.00%.
B is incorrect. The value of the underlying instrument is the spot rate, not the forward
rate.
A is incorrect. The value of the underlying instrument is 1.00%; 1.25% is the client’s
upper tolerance bound.
B is correct. Franco is incorrect because he describes a long call option, which according
to the Black model can be viewed as the futures component minus the bond component.
Long put options hedge against rising interest rates. The Black model evaluates put
options as the bond component minus the futures component.
A is incorrect. The statement is incorrect.
C is incorrect. The Black model evaluates put options as the bond component minus
the futures component.
40 Is Weber’s description of the swaption used for the hedge most likely correct?
A No, because it would be correctly evaluated as the bond component minus
the swap component
B No, because he is describing a receiver swaption
C Yes
C is correct. A payer swaption would hedge against rising interest rates. According to the
Black model, the value of a payer swaption can be described as the swap component
minus the bond component.
B is incorrect. A receiver swaption hedges against falling interest rates and Weber is
describing a payer swaption.
2019 Level II Mock Exam AM 35
A is incorrect. The receiver swaption is evaluated as the bond component minus the
swap component.
41 Assuming one option per share, an appropriate delta hedge for the GI stock
would most likely be to:
A sell 168,010 calls.
B sell 148,428 calls.
C buy 40,100 puts.
A is correct. The call delta is 0.5952. The number of calls to hedge 100,000 shares is
calculated as 1/0.5952 = 168,010. An appropriate hedge for 100,000 shares of stock with
a delta of 1 would be to sell 168,010 calls.
B is incorrect. This assumes DeltaH (used when selling calls against 100,000 short
puts) should be used. The portfolio delta is 1 and the put delta is –0.4010 and DeltaH
= –0.6737 (or –0.4010/0.5952), which would be used when hedging a short position of
puts on 100,000 shares of stock. Using calls, the number of hedging units is 1/–0.6737;
1/0.6737 = 148,428.
C is incorrect. The correct number of puts to purchase is calculated as 1/Delta put
or 249,376 puts.
42 If the price of GI stock approaches $75 over the next 30 days, which of the fol-
lowing changes in option parameter measures will most likely be observed?
A Decreases in vega and the absolute value of theta
B Increases in vega and the absolute value of theta
C A decrease in vega and an increase in the absolute value of theta
B is correct. Typically, theta is negative for options. The speed of the option value decline
increases, however, as time to expiration decreases. Vega is high when options are at
or near the money. During the next 30 days, the options will approach expiration and
approach being at the money.
A is incorrect.
C is incorrect. Vega increases as the options become closer to at-the-money.
Following his meeting with Madan, Chen is asked by a portfolio manager at Yushan
to do an initial review of Robologistix LTD, a potential investment opportunity. After
reviewing the company’s operating history, Chen notes the following characteristics
regarding Robologistix:
■■ limited operating history;
■■ significant product breakthrough in development, with outcome uncertain;
■■ difficult-to-forecast cash flows;
■■ weak asset base; and
■■ newly formed management team.
The portfolio manager asks Chen to determine the pre-money valuation for the
potential investment in Robologistix, using the following assumptions:
■■ Time to exit event = 6 years.
2019 Level II Mock Exam AM 37
43 The language in the offering document that Madan asks Chen to explain most
likely describes:
A a clawback provision.
B carried interest.
C a ratchet clause.
44 Is Chen most likely accurate regarding provisions that benefit LPs versus those
that benefit GPs?
A Yes
B No, with regard to items that benefit the LPs
C No, with regard to items that benefit the GPs
C is correct. The co-investment provision is generally favorable for LP investors. With this
provision, LPs generally have a first right of co-investing along with the GP. This can be
advantageous for the LPs because fees and profit share are likely to be lower (or zero)
on co-invested capital. The GP and affiliated parties are also typically restricted in their
co-investments to prevent conflicts of interest with their LPs. Placement fees are paid
to the fundraiser, either up front or as a trailer fee, corresponding to a fraction of the
amount invested by the limited partners.
A is incorrect. The co-investment provision is generally favorable for LP, not GP,
investors.
B is incorrect. The items Chen lists as benefits for LP investors are accurate.
C is correct. DPI (distributed to paid in) is the cumulative distributions paid out to LPs as
a proportion of the cumulative invested capital. In this case, DPI = £345 (Total distribu-
tions)/£280 (Total call downs) = 1.23×.
A is incorrect; 2.35 represents the value for TVPI (DPI + RVPI) = 1.23 + 1.12.
B is incorrect; 1.12 reflects the value for RVPI = £312.6/£280.
B is correct. The solution table was constructed using the information provided
in Exhibit 1. The carried interest is shown in column 7 and is calculated as 20% times
the increase in net asset value (NAV) before distributions: 0.2 × (£545.1 – £408.3) =
£27.4 million. Note that for carried interest to apply, NAV before distribution must exceed
committed capital.
A is incorrect. It reflects the NAV in 2016 minus the total paid in capital times 20%:
0.2 × (£545.1 – £280) = £53.0 million.
C is incorrect. It reflects the carried interest amount in 2015.
47 Which of the following valuation methods is Chen least likely to use for
Robologistix?
A Real option method
2019 Level II Mock Exam AM 39
B is correct. From the information provided (limited market history, weak asset base,
low cash predictability, new management team), Robologistix is most likely a venture-
stage company. Early-stage companies are best evaluated using the replacement cost
or real option methods. Discounted cash flow (DCF) valuation is more appropriate for
companies that have a longer operating history and is least appropriate for Robologistix.
A and C are incorrect. Early-stage companies are best evaluated using the replacement
cost, venture capital, or real option approaches.
48 Based on the assumptions Chen has for Robologistix, the estimated value per
share is closest to:
A £3.54.
B £4.29.
C £2.50.
C is correct. Using the basic VC method, the price per share can be calculated for the
general case in a five-step procedure (from Appendix 1.1, 1.2):
Yusuf welcomes everyone to the meeting and begins by stating, “We use multi-
factor models for portfolio construction as well as return and risk attribution.” She
asks, “Can anyone tell me how arbitrage pricing theory (APT) is related to these
multifactor models?”
Quek responds, “APT helps us determine the appropriate number of factors to
use in a multifactor model; however, it does not specify the identity of those factors.”
Yusuf continues, “Multifactor models fall into one of three categories: macroeco-
nomic factor models, fundamental factor models, and statistical factor models. For
macroeconomic factor models, the factors are the value, or level, of selected macro-
economic variables. For fundamental factor models, the factors are company share
attributes, such as price-to-earnings ratio and market capitalization. Finally, when
using statistical factor models, we apply statistical techniques, such as factor analysis
or principal component analysis, to derive factors that are portfolios of securities that
best explain historical return covariances and variances.”
To explain the use of multifactor models for portfolio return attribution, Yusuf
presents the group with portfolio and benchmark information in Exhibit 1. She also
notes the risk-free rate of return is 1.3%.
Yusuf asks the group to use Exhibit 1 to characterize the portfolio manager’s invest-
ment style. Cerra responds, “This manager has a large-cap orientation and follows a
contrarian strategy with a growth bias.”
Yusuf continues, “Based on your review of the information in Exhibit 1 and given
that the portfolio manager’s active return from security selection is 1.5%, I would like
each of you to identify the factor that contributes the most to the manager’s active
return.” The analysts respond as follows:
Cerra says, “My calculations suggest that it is the Value factor.”
Quek responds, “I disagree. In my view, it is the Momentum factor.”
Singh states, “No, my analysis indicates that it is the Market factor.”
Finally, Yusuf provides the group with the information in Exhibit 2 and states, “As I
previously stated, multifactor models can also be used to identify a portfolio manager’s
risk exposures. Please use the information in Exhibit 2 to identify the portfolio with
the highest active factor risk related to style factors, relative to active risk.”
2019 Level II Mock Exam AM 41
Exhibit 2 Active Risk Squared Analysis for Selected Portfolios (Entries Are
in Percentage Squared)
Active Factor
Industry Style Total Active Active Risk
Portfolio Factor Factor Factor Specific Squared
X 12 28 40 24 64
Y 7.2 14.4 21.6 14.4 36
Z 4 10 14 2 16
B is correct. Quek is incorrect in stating that APT specifies the number of factors in a mul-
tifactor model but is correct in stating that APT does not specify the identity of factors
in a multifactor model. APT does not indicate the number of factors or their identity.
A is incorrect. Quek is incorrect in stating that APT specifies the number of factors in a
multifactor model but correct in stating that APT does not specify the identity of factors
in a multifactor model. APT does not indicate the number of factors or their identity.
C is incorrect. Quek is correct in stating that APT does not specify the identity of factors
in a multifactor model. APT does not indicate the number of factors or their identity.
50 In her statement about the three types of multifactor models, Yusuf is least
likely correct with respect to:
A statistical factor models.
B fundamental factor models.
C macroeconomic factor models.
C is correct. In macroeconomic models, the factors are “surprises” (how much higher or
lower than what was expected) in macroeconomic variables, not the level or value of
macroeconomic variables.
A is incorrect. Statistical models are described accurately. Statistical factor models
use factor analysis to produce factors that are portfolios of securities that best explain
historical return covariances. Alternatively, they use principal component analysis to
derive factors that are portfolios of securities that best explain historical return variances.
42 2019 Level II Mock Exam AM
B is incorrect. Fundamental factor models are described correctly; the factors are
company share attributes, such as price-to-earnings ratio and market capitalization.
C is correct.
A is correct. Cerra is correct regarding the growth bias. The factor sensitivity for the
Value factor is –0.6, which signifies a growth bias. Cerra is incorrect regarding a large-cap
orientation and a contrarian strategy. The portfolio factor sensitivity for the Small-Cap
factor is 0.5, indicating a small-cap orientation. For the Momentum factor, the factor
sensitivity of 0.5 indicates a momentum bias, not a contrarian strategy, which would be
true if the factor sensitivity for the Momentum factor were negative and not close to zero.
B is incorrect. Cerra is incorrect with regard to the contrarian strategy. For the
Momentum factor, the factor sensitivity is 0.5, which indicates a momentum bias.
2019 Level II Mock Exam AM 43
53 Which of the following analysts most likely provides the correct answer to
Yusuf ’s question on the contribution to active return?
A Quek
B Cerra
C Singh
B is correct. Cerra is correct. To determine which factor contributes most to active return,
note the following:
Contribution to Active
Factor Sensitivity (1) – (2) Factor Return
Factor Portfolio Benchmark Difference Return Absolute Proportion
(1) (2) (3) (4) (3) × (4)
A is incorrect. Quek is incorrect. The Value factor has the highest contribution to
active return.
C is incorrect. Singh is incorrect. The Value factor has the highest contribution to
active return.
C is correct. Portfolio Z has the highest active factor risk exposures to the style factor.
Portfolio Z active style risk squared ÷ Active risk squared = 10 ÷ 16 = 62.5%.
Portfolio X active style risk squared ÷ Active risk squared = 28 ÷ 64 =
43.75%.
Portfolio Y active style risk squared ÷ Active risk squared = 14.4 ÷ 36 = 40%.
A is incorrect. Portfolio X active style risk squared ÷ Active risk squared = 28 ÷ 64 =
43.75%.
B is incorrect. Portfolio Y active style risk squared ÷ Active risk squared = 14.4 ÷ 36 =
40%.
Exhibit 1 (Continued)
At their meeting, Arndt discusses with Schenke the intended use of the funds and
explains that the AEP sales proceeds will not be needed to supplement the Arndts’
present and future spending needs. EUR12 million of the funds will be invested in
a commercial real estate partnership in the United States, and TCAM is to manage
EUR20 million. In the next eight months, ownership of these investments will be
transferred to the Arndt Family Dynasty Trust.
In preparation for the meeting with Schenke, Arndt has prepared an investment
policy statement, shown in Exhibit 2.
Schenke points out that TCAM adopts a portfolio perspective when approaching
investment management and views portfolio management as a process consisting
of three steps: a planning step, an execution step, and a feedback step. Shenke also
presents the information provided in Exhibit 3.
46 2019 Level II Mock Exam AM
55 Based on Exhibit 1, Arndt’s risk tolerance and liquidity constraints should most
likely be described as combining a high:
A ability to take risk with high liquidity risk.
B ability to take risk with low liquidity risk.
C willingness to take risk with low liquidity risk.
B is correct. Arndt has above average ability to take risk and low liquidity risk. The multi-
generational time horizon allows for an above average ability to take risk, and liquidity is
not required from the investments for spending needs. Capital gains taxes of EUR8 million
(20% tax rate of EUR40 million total proceeds) are only a portion of the sales proceeds
and are not at risk of being uncovered. The amount of income from the couple’s salaries
plus the AEP dividends will prevent investment portfolio volatility from affecting their
financial abilities. Current income and savings cover all current liquidity needs.
A is incorrect. Arndt has low liquidity risk. Spending needs are covered through earned
income and dividend payments.
C is incorrect. Arndt has a low willingness to take risk. The Ardnts do not wish to have
more than a EUR5 million invested in equities and want to avoid annual drawdowns
greater than 5%.
56 Based on Exhibit 2, which of Arndt’s goals and constraints are least likely con-
sistent with each other?
A Goal 2 and Constraint 1
B Goal 1 and Constraint 3
C Goal 2 and Constraint 3
C is correct. Goal 2, which defines the maximum annual loss of 5% under normal circum-
stances, and Constraint 3, which defines the long time horizon before funds will first
be needed, are least consistent with each other. The long time horizon would normally
indicate a higher-than-average ability to take risk, making Goal 2—which limits the
annual unrealized loss—inconsistent with Constraint 3.
A is incorrect. The low maximum annual loss defined in Goal 2 is consistent with the
low allocation in equities defined in Constraint 1.
2019 Level II Mock Exam AM 47
B is incorrect. The high return objective of Goal 1 is consistent with the long time
horizon of Constraint 3
57 Based on Exhibits 1 and 2, the time horizon for Arndt’s TCAM portfolio can be
best described as:
A a single-stage long-term time horizon.
B a multistage time horizon—the first lasting eight months, followed by an
indefinite long-term time horizon.
C a multistage time horizon—the first lasting approximately 12 years, followed
by an indefinite long-term time horizon.
A is correct. Arndt’s TCAM portfolio has a single-stage long-term time horizon. The
portfolio will be held in a trust for the grandchildren, from which funds will probably
not be required for at least 20 years and will continue to be managed for subsequent
generations. These funds are not needed for the Arndts’ spending needs.
B is incorrect. In the next eight months, the real estate investment will be made and
taxes will be due. These will not change the long-term time horizon of the portfolio for
the benefit of the grandchildren and later family generations.
C is incorrect. The Arndts may retire in 12 years, but they have sufficient financial
resources from other sources. The time horizon of this portfolio is not affected by
retirement needs.
B is correct. Arndt has ignored the importance of diversification (and a portfolio perspec-
tive) in his decision to add to his commercial real estate investments. Commercial real
estate already represented more than 90% of the Arndts’ assets before the sale. Equities
and intermediate-term bonds would offer a diversifying benefit to the entire portfolio.
A is incorrect. Equities could serve as a diversifier to commercial real estate.
C is incorrect. Bonds could serve as a diversifier to commercial real estate.
C is correct. Schenke and Arndt are discussing the Arndts’ objectives and constraints in
order to create an investment policy statement (IPS). These are all parts of the planning
step of the portfolio management process. The feedback step of the portfolio manage-
ment process does not refer to Schenke’s responses to Arndt’s comments and questions.
A is incorrect. Feedback refers to monitoring, rebalancing, and portfolio evaluation.
B is incorrect. Preparing an IPS is part of the planning step.
60 In order to create Arndt’s strategic asset allocation, Shenke will most likely use
information from:
A Exhibits 2 and 3.
B Exhibit 2 only.
C Exhibit 3 only.
A is correct. In order to create a strategic asset allocation for Arndt, Schenke combines
information from the IPS (Exhibit 2) and capital market expectations (Exhibit 3). The
strategic asset allocation will include target asset class weights and maximum and min-
imum permissible asset class weights, which are specified as risk control mechanisms.
B is incorrect. Information from Exhibits 2 and 3 is required.
C is incorrect. Information from Exhibits 2 and 3 is required.