2021 CFA LII Mock Exam 2 – AM Session

Maria Cadler Case Study

Over the last 15 years, Maria Cadler, CFA, was the Director of
Research at Voeltz Asset Management, supervising more than 10 research
analysts. Her team was responsible for making investment recommendations to
the portfolio managers who determined which investment recommendations
to implement. Voeltz’s annual investment performance was always in the
top quartile when compared to other investment firms managing similar
portfolios. However, over the last 6 months, their rolling 12-month
performance had dropped to the fourth quartile. Voeltz’s clients were losing
money despite the market rising. As a result, she and several
others were terminated. To prepare for her employment search, she updates
her LinkedIn profile by adding the following statement, “I was part of a team of
investment professionals with a successful investment performance track
record, with investment returns consistently ranking in the top quartile when
compared to similar investment managers. As a result of our success, I was
offered and subsequently accepted a board seat for a local charitable
organization. Working with them has been so rewarding, despite
taking a considerable amount of my time during evenings and weekends.”

In preparation for job interviews, Cadler reaches out

to Voeltz’s clients, former colleagues, and vendors to ask if they would write her
a letter of recommendation. She makes the following requests to:

Abby: “Each year, you have given my team lots of kudos

for our investment research and investment recommendations.
I’m wondering if you wouldn’t mind writing a letter
of recommendation for me. I can give you the details of my role as team
leader so you can include them.”
Robert: “Since we both find ourselves looking for a job, how about we provide
letters of recommendation for each other? I can provide some key points I
would like for you to highlight, and you’re welcome to provide points for
me to include in my recommendation of you.”

Fredrica: “When I get a new position, I’d love to recommend your services, as I
appreciate the independent economic research reports you provided to
my team. In the meantime, could you please write me a
recommendation that mentions what great equity research reports my
team provided to our clients?”

During an interview with a potential employer, Cadler describes a time

when quick thinking was rewarded with big returns for her clients: “We did our
own extensive research and also received broker-sponsored company
research. One time, we had just completed a research report on a large-cap
company offering a competing product to one of the small-cap companies in
which we had heavily invested. We determined it was time to sell the small-cap
company, as it would likely lose considerable market share on its most popular
product. In order to execute as quickly as we could before the market made the
same determination, we sold 100% of the holdings in the small-cap company
and bought the large-cap company for all of our discretionary
clients. To expedite the small-cap trades, we utilized a few stockbrokers not yet
on our approved broker list because our existing brokers told us they were
unable to complete all of the trades requested in a timely manner. We
found that it is critical to act fast when trading in small-cap shares. As a
result, we were able to obtain incredible returns for most of our clients.”

The potential employer stated, “From your description of the large-cap

trade, it sounds as if you may not have treated your non-discretionary
clients equitably. If you were to work for us, how would you ensure all clients
are treated fairly?” Cadler responded, “While I could make multiple
recommendations, here are three:
Recommendation 1: Make sure any changes to investment recommendations
are communicated equitably to all clients, making sure those clients who
acted on any prior recommendations are notified.

Recommendation 2: Ask all clients to sign a waiver stating they

acknowledge that when trading illiquid shares, fair dealing will not be
possible as allocation will be on a first-come, first-served basis. We want
to ensure clients have full disclosure of our trade allocation process.

Recommendation 3: Prorate trades, both when buying and selling, in those

times when 100% of the orders can’t be executed so all clients are able to
benefit. To facilitate this, block trading should be utilized when
available and company policies should reflect best execution
procedures.”

1.

In the initial update of her LinkedIn profile, Cadler most likely complied
with which of the CFA Institute Standards of Professional Conduct? 

A. Standard I(C): Misrepresentation

B. Standard VI(A): Disclosure of Conflicts

C. Standard III(D): Performance Presentation

2.

Which of Cadler’s recommendation requests most likely complies with Standard

I(B): Independence and Objectivity now and/or in the future? Her request
to:

A. Abby

B. Robert

C. Fredrica
 3.

Cadler’s quick-thinking action most likely violated Standard V(A): Diligence and
Reasonable Basis because:

A. outside parties influenced their investment action.  

B. of the timing and execution of the small-cap share trades.

C. of an inappropriate swap of small-cap to large-cap shares. 

4.

Which of Cadler’s responses to the question regarding non-discretionary

clients would most likely violate the Standards of Professional Conduct?

A. Recommendation 1

B. Recommendation 2

C. Recommendation 3 

Cheng Case Study

Marisa Cheng, CFA, is a portfolio manager with a large full-service
investment advisory firm. She has been invited to speak on a podcast with a
target audience of recent university graduates entering the investment
industry. Cheng decided to focus her talk on her favorite topic: “How to
Advance Your Career.” During the podcast, she mentions that most portfolio
managers start in the Research Department. She then shares her philosophy
that when entering the industry as an entry-level research analyst, you should
create a research report at least once a week to prove yourself. This is
particularly easy if you are an equity analyst, as the research analysis process
should be the same regardless of the security being analyzed.

Cheng then offers advice to the audience about the benefits of changing
employers, which she believes allows a person to move into higher positions
with greater responsibilities. She explains “Based on my experience, younger
employees get overlooked when employers are filling middle to senior
management positions. By moving to a different firm every three to five years,
you can typically join at a more senior level with higher pay. However, when
you move to a new firm, you need to be cautious so your employer and client
relationships are not harmed.”

Cheng recommends the following actions:

Action 1: Notify clients of your new role before changing employers.

Action 2: Utilize your own viewpoints based on your skills and experiences.

Action 3: Share policies and processes utilized in past positions.

The podcast interviewer asks, “I know this is a bit off today’s topic, but I
was wondering, as a CFA® charterholder, how do you ensure you are serving
your clients’ interests as required by the CFA Code of Ethics and Standards of
Professional Conduct? For instance, what would you do if you learned in a
meeting with your client that due to a change in their circumstances, the
investment product they have invested in no longer meets their investment
goals and constraints outlined in their investment policy statement?”

Cheng responds, “Let’s consider three options.”

Option 1: I could immediately reassure them their existing product is still

suitable even under their changing circumstances.

Option 2: I could advise them to shop around to determine whether other

investment management firms had a more appropriate product to meet
their investment goals and give them a list of questions to ask so they
could compare services.
Option 3: I could advise them to add some of our other investment products to
their existing investment portfolio, so their new overall investment return
objectives and risk profile could be met given their new circumstances.

After thanking the interviewer for the opportunity to speak, Cheng makes
the following final statement:

“I would like to encourage all the listeners who are interested in

advancing their careers in the investment industry to become CFA
charterholders. The three sequential exams are very tough, as you can be
tested on a wide array of curriculum topics, including financial analysis,
economics, and derivatives. Becoming a charterholder also demonstrates you
are more professional than those without the CFA® charter. By upholding the
CFA Code of Ethics and Standards of Professional Conduct, you send a
message to the industry that you really care about the interests of your clients
and the integrity of the capital markets.”

1.

Is Cheng’s philosophy regarding an entry-level research analyst role most likely

consistent with guidance for Standard V(A) Diligence and Reasonable
Basis?

A. No.

B. Yes, with regard to weekly research reports.

C. Yes, with regard to the equity analysis process.

2.

Given Cheng’s advice regarding changing jobs, which recommended action

should an employee most likely take to avoid violating the CFA Standards
of Professional Conduct?

A. Action 1
 B. Action 2

C. Action 3

3.

To avoid violating CFA Standards of Professional Conduct, which of Cheng’s

options in response to the interviewer’s question is least appropriate?

A. Option 1

B. Option 2

C. Option 3

4.

Which component of Cheng’s final statement most likely causes her to violate
CFA Standards of Professional Conduct?

A. The message to the industry

B. A CFA charterholder’s level of professionalism

C. Comment on testing and curriculum

Jordan Garfield Case Scenario

Jordan Garfield, an analyst for a firm that specializes in international
equities, is investigating the behavior of HighTech Inc., a technology stock. He
believes its returns should be influenced by the return on the NASDAQ index,
as many analysts suggest. Garfield collects five years of monthly returns from
2005 to 2009 for the NASDAQ index.

Garfield estimates a simple linear regression using the NASDAQ return

to explain the variation in HighTech’s return. The summary output from this
analysis is shown in Exhibit 1.
Exhibit 1 Garfield’s First Regression Model, Summary Output, Regression
of HighTech Returns on NASDAQ Index Returns, 2005–2009

Regression
Statistics

Multiple R 0.737399823

R2 0.543758499
Standard error of
estimate

Observations 60
Standard
Coefficient Error p-value

Intercept 0.001795002 0.007209589 0.804260285

NASDAQ return 1.086005661 0.130620835 0.000000000

Degrees of Sum of Mean Square

ANOVA Freedom (DF) Squares (SS) (MS)

Regression 1 0.214743645 0.214743645

Residual 58 0.180181024 0.003106569

Total 59 0.394924669

Garfield presents the regression results to the investment committee with

the following three conclusions:

1. The regression intercept is statistically significant.

2. The model explains more than half of the variation in HighTech’s returns.

3. The NASDAQ index return and the HighTech return are positively correlated.

The committee asks Garfield whether he can use the model to predict the
return on HighTech’s stock. Ram Gupta, a committee member, asks: “What
would HighTech’s return be in a month when the return on the NASDAQ index
is 0.05633?”
 Another committee member, Riko Samora, thinks that the simple
regression model omits important factors that might affect HighTech’s
performance. Samora believes that because more than 40% of HighTech’s
customers are in Tokyo, the value of the Japanese currency should influence
HighTech’s sales and that the model’s significance would considerably improve
if Garfield considers this fact.

Following Samora’s suggestion, Garfield runs a multiple linear regression

adding the change in the JPY/USD exchange rate as a second independent
variable. The results from this regression are shown in Exhibit 2.

Exhibit 2 Garfield’s Second Regression Model, Summary Output,

Regression of HighTech Returns on NASDAQ Index Returns and JPY/USD
Changes, 2005–2009
Regression Statistics

Multiple R 0.753840729

R2 0.568275844

Adjusted R2 0.553127628

Standard error of estimate 0.054691883

Durbin–Watson (DW) 2.02

Observations 60
Standard
Coefficients Error t-Statistic p-Value

Intercept 0.000214 0.007127649 0.030025 0.976152

NASDAQ return 1.122096 0.130216256 8.617173 0.000000

JPY/USD change 0.2864262 0.291700144 0.981919 0.330289

Degrees of Sum of Squares Mean Square
ANOVA Freedom (DF) (SS) (MS)

Regression 2 0.224426149 0.112213075

Residual 57 0.170498519 0.002991202

Total 59 0.394924669

Garfield presents the new results to Samora, who asks him two
questions:

1. Are the results of this second regression significant?

2. Do you suspect that the model has problems with multicollinearity or serial
correlation?

Garfield responds to the Samora’s questions by examining the F-, t-, and
DW statistics in the regression output to see whether they are significant.

1.

The standard error of estimate of the regression model shown in Exhibit 1 is

closest to:

A. 0.0031.

B. 0.1802.

C. 0.0557.

2.

Which of Garfield’s conclusions to the investment committee about the findings

from his first model (Exhibit 1) is least likely correct? Conclusion:

A. 1

B. 2

C. 3

3.

In response to Gupta’s question about predicting HighTech’s return, Garfield’s

prediction (in decimal form) will be closest to:
 A. 0.06118.

B. 0.04154.

C. 0.06297.

4.

Using the results shown in Exhibit 2, the value of the F-statistic is closest to:

A. 9.63.

B. 37.51.

C. 16.76.

5.

Based on the results of the regression model shown in Exhibit 2, the best
conclusion Garfield can make about a hypothesis that the coefficient
JPY/USD change is zero is to:

A. reject the alternative hypothesis.

B. reject the null hypothesis.

C. fail to reject the null hypothesis.

6.

In preparing his response to Samora’s second question, Garfield’s most

appropriate conclusion is that the model:

A. has multicollinearity but not serial correlation.

B. has serial correlation but not multicollinearity.

C. does not have either multicollinearity or serial correlation.

Mark Crawley Case Scenario

 Mark Crawley is an analyst at a London-based private equity firm and is
reviewing the firm’s file on Thames Air Plc (Thames), a company it provides
financing for. Thames uses International Financial Reporting Standards (IFRS)
in the preparation of its financial statements. Thames is a relatively new airline
based in the United Kingdom specializing in flights and vacation packages to
Mediterranean locations, primarily Spain. Thames sells most of its flights and
vacation packages to British residents in British pounds (GBP) and considers
the costs of local competitors’ packages when determining its prices. Costs are
incurred in multiple currencies:

• Wage costs are primarily in GBP.

• Typical of the industry, airline fuel and lease costs are normally priced in US
dollars (USD).

• The landing fees paid at the vacation-area airports are in the local currency,
primarily euros (EUR).

First, Crawley turns his attention to the effect of the transactions

undertaken in various currencies by Thames.

• He reviews the change in the exchange rate for the USD to GBP during 2015,
shown in Exhibit 1, and wonders what the effect of this change was on
Thames’s operating income.

• At year-end (31 December), Thames had a large outstanding payable in Spain

related to landing fees that were incurred there evenly over the final
quarter. The company paid the amount in full on its due date of 28
February. Crawley observed that the EUR to GBP exchange rate had
changed between when the costs were incurred and the year-end and
again by the payment date, as also shown in Exhibit 1.

Exhibit 1 Selected Exchange Rate Data

 GBP/USD Close GBP/EUR Close

1-Jan-15 0.64

30-Jun-15 0.72

31-Dec-15 0.68 0.75

28-Feb-16 0.73

Average, 1 July–31 December 2015 0.7325

Average, 1 October–31 December 2015 0.74

Because of the growing demand for vacation rentals in Spain during the
past year, Thames acquired 100% of Tagus SA (Tagus), a Spanish company
that owns a small vacation hotel and a few villas. Tagus has long-term debt
outstanding from a Spanish bank that financed the 2012 purchase of the
vacation properties, which will now be rented as part of the vacation packages
offered by Thames. Tagus incurs all costs related to operating and maintaining
the rental properties in EUR.

Since the acquisition, all of Tagus’s revenue comes from Thames’s sales
in Britain of the vacation packages. Tagus receives the amounts in GBP. But
Tagus hopes to expand and start renting out any excess capacity of the
properties, or newly acquired properties, to local tourists in the next few years.
Crawley notices that Thames is using the temporal method to translate Tagus’s
financial statements prior to consolidation and asks another analyst, Dee
Chopra, if this is appropriate.

Crawley next reviews the information in Exhibit 2 related to the Tagus

acquisition to consider the effect on Thames’s year-end financial statements
(31 December 2015).
Exhibit 2 Selected Financial Information of Tagus SA at Acquisition and
Year-End (EUR thousands)

Balance
Balance Sheet Sheet Income Statement

Year-End
Date of (31 Six-Month Period Ending
Acquisition (30 December
June 2015) 2015) 31 December 2015

Cash and 4,000 4,200 Revenues 8,200

accounts
receivable

Inventory 2,000 2,250 Operating 6,485

costs

Capital assets 15,000 14,625 Operating 1,715

income

Total assets 21,000 21,075 Interest 395

expense

Earnings 1,320
before taxes

Current 3,500 3,400 Income 395

liabilities taxes

Long-term debt 10,000 9,750 Earnings 925

after tax

Share capital 5,000 5,000

Dividends 500

Retained 2,500 2,925

earnings
 Total liabilities 21,000 21,075
and
shareholders’
equity

As the final step in his review, Crawley starts a ratio analysis of Thames
and Tagus, and he asks Chopra which ratios, if any, would be unaffected by
Thames’s choice of translation method for Tagus.

1.

The functional currency of Thames is most likely:

A. EUR.

B. GBP.

C. USD.

2.

Which of the following statements about the effect of the change in the USD to
GBP exchange rate during the year is most accurate? Operating income
for Thames would:

A. increase because of the positive effect on revenues.

B. increase because of the positive effect on operating costs.

C. decrease because of the negative effect on operating costs.

3.

Which of the following best describes the effect on Thames’s financial

statements of the payment terms related to the landing fees in Spain?
Thames would:

A. report an unrealized exchange loss at year-end.

 B. defer recognizing any currency effects until the payable is paid.

C. adjust the landing fees expense to reflect the change in exchange rate
when they are paid.

4.

Chopra’s best answer to Crawley’s question about Thames’s use of the

temporal method to translate Tagus’s financial statements is that it is:

A. correct, if the presentation currency of Tagus’s financial statements is

GBP.

B. correct, because the functional currency of Tagus is GBP.

C. incorrect, because the functional currency of Tagus is EUR.

5.

The most likely effect of the change in the exchange rate between the EUR and
GBP arising from Thames’s investment in Tagus in 2015 will be a
translation:

A. loss reported in net income.

B. adjustment reported in other comprehensive income.

C. gain reported in net income.

6.

The best answer Chopra can give to Crawley’s question about which ratio
would be unaffected is the:

A. receivables turnover ratio.

B. current ratio.

C. operating profit margin.

Capital Architecture Partners Case Scenario
Capital Architecture Partners (CAP) is a corporate finance advisory firm
based in New York City. Deiondre Brown, a principal at CAP, is reviewing her
notes on a project for one of her clients, Red Hill Corp. (Red Hill). The company
is considering an aggressive expansion plan that will require new issues of both
debt and equity.

Brown recalls that Red Hill’s major shareholder, Jordan Jamieson, is a

strong proponent of the company’s all-equity capital structure. He is concerned
that adding debt to the capital structure will increase the cost of equity;
increase the risk of default; and, on balance, increase the weighted average
cost of capital.

Brown pulls up the current draft of the report for Red Hill. The
introduction covers some of the key concepts in corporate finance. It then
explains the pecking order theory and its rationale for managers’ preferences
for various financing methods.

Brown estimates that Red Hill’s current cost of capital is 15%, and the
company could access debt at a rate of 8% as long as its debt-to-equity (D/E)
ratio does not exceed 40%. The corporate tax rate is 22%. As a reference point
for the report, she calculates the cost of equity assuming the maximum D/E
ratio.

In reviewing the contract details for Red Hill’s CEO, who was hired in the
prior year, Brown confirms the existence of a five-year noncompete clause. She
makes a note that this information should be highlighted in the equity offering
documents.

1.

Which of Jamieson’s concerns about the effect of changing Red Hill’s capital
structure is least accurate? The concern related to:
 A. the cost of equity.

B. the risk of default.

C. the weighted average cost of capital.

2.

The theory explained in the draft report introduction suggests that managers
favor financing methods that minimize:

A. risk.

B. cost.

C. information content.

3.

The cost of equity that Brown calculates for the report is closest to:

A. 12.5%.

B. 17.2%

C. 17.8%

4.

The information Brown wants to highlight in the equity offering documents is

most likely an example of:

A. bonding costs.

B. residual losses.

C. monitoring costs.

Penny White Vignette

 Penny White owns a valuation consultancy firm, P-White Valuation
(PWV). PWV clients are portfolio managers, law firms, and wealthy individuals
who need services concerning private and publicly traded companies.

White is having a meeting with an intern, Betty Marshall, regarding her

current and future projects. White tells Marshall that she will start analyzing
private firms next week. White states that the valuation process can have two
stages depending on the results of the first stage of analysis.

Stage 1: The valuation is based on current and forecasted macroeconomic

conditions and future trends in the given industry. Many times, the
client does not even know the name of the firm of interest at this stage.

Stage 2: Assuming the client is interested in the investment, more information

about the firm of interest is revealed after non-disclosure agreements are
in place. PWV will analyze the firm’s customer and supplier information
and incorporate information from Stage 1.

White states, “Given the small size of most private firms, the client’s
general strategy is to purchase the private firm and have its sales increase
quickly, which reduces the average cost of the product or service. The best
situation is if the firm eventually becomes large enough to start increasing its
return on invested capital, which is a pre-tax measure that increases as
earnings increase with no additional capital investment.”

Marshall then discusses her current projects that entail analyzing

publicly traded firms with White. Marshall is concerned about the effects of
inflation on her revenue and cost assessments.

White says to Marshall, “If the firm uses futures contracts to offset
possible increases in future costs, the firm may not necessarily need to
increase the price of its products.”
 Marshall then states that she is using the most recent five years of sales
growth for determining a terminal value in her analysis. White tells her that
she needs to consider that the economic expansion of the last 10 years has
greatly benefited the company she is analyzing over that period. Marshall
agrees and the meeting concludes.

1.

The Stage 2 analysis for private equity firms is best described as a:

A. hybrid approach.

B. top-down approach.

C. bottom-up approach.

2.

White’s statement in regard to the return on invested capital (ROIC) is most

likely:

A. correct.

B. incorrect as to it being a pre-tax measure.

C. incorrect as to the relationship between earnings and capital

investment.

3.

When discussing the effects of inflation, White’s statement least likely

incorporates which of Porter’s five forces?

A. Supplier bargaining power

B. Customer bargaining power

C. Threat of cheaper substitute products

 4.

Compared with a terminal value based on a “normalized” growth rate,

Marshall’s terminal value calculation is most likely:

A. lower.

B. higher.

C. similar.

Arbitrage Partners Case Study

Davis Zhang is a fixed-income analyst at Arbitrage Partners, a hedge
fund focusing on global macro arbitrage opportunities. The fixed-income team
focuses on securities issued in developing markets that trade in multiple world
financial centers. Zhang is conducting a training session for a new analyst,
John Holly.

Zhang explains: “Our fixed-income team focuses on constructing a

portfolio of fixed-income securities issued in local markets that trade in
multiple markets around the world. We seek out securities we believe to
be mispriced and identify these using an arbitrage-free approach to valuation,
which can be described as follows. The cash flows of any fixed-income security
can be thought of as a package of separate zero-coupon bonds. Each zero-
coupon bond in such a package is valued separately at a discount rate
corresponding to the interest rate on the yield curve at the time of the cash
flow.

When the present values of the coupon payments are summed and
added to the present value of the principal payment at maturity, the
result should equal the current price of the bond. In order to calculate the
arbitrage-free value of a bond, we determine the future coupon and principal
payments for the bond. If the yield curve is positively sloped, the appropriate
interest rate used to discount each cash flow will be different. However, in the
event the yield curve is flat, all cash flows will be discounted in the same
manner as in the traditional approach to valuing bonds.”

Holly comments: “Last year, South Africa issued multiple two-year and
four-year Green Bonds denominated in US dollars with annual coupons. The
four-year bonds were callable, while the two-year bonds had no embedded
options.

I recall an example of an arbitrage opportunity of the two-year bonds

trading in different global financial centers. The benchmark yield curve, bond
coupon rates, and bond prices are shown in Exhibits 1 and 2.”

Exhibit 1. Benchmark Interest Rates

Maturity Coupon Rate Spot Rate 1-Year Implied

(Years) Forward Rate

1 5.00% 5% 5.00% (current)

2 5.97% 6% 7.01%

3 6.91% 7% 9.03%

4 7.81% 8% 11.06%

Exhibit 2. Bond Price Quotes

Market Coupon Rate Quoted Price

Dubai 1% 90.842

Shanghai 2% 92.684

New York 4% 94.630

Zhang adds: “While your example represents good practice, we

also need to be able to value bonds with embedded options where expected
cash flows of bonds with options change depending on the path of future
interest rates. We typically construct an interest rate tree as a visual
representation of the paths of future interest rates, with the average of possible
future values being centered on the current yield curve. The following three
steps can be employed to construct an interest rate tree for valuing a particular
bond:

Step 1: Using prices of the benchmark bonds, determine the current par curve.

Step 2: Estimate interest rate volatility, and calculate the potential paths of
future rates.

Step 3: Starting with the current market price, calculate each successive
node’s value.”

The interest rate tree must then be calibrated to fit the actual yield curve
while being consistent with an underlying interest rate model.”

Holly states: “I believe the iterative process must involve a trial-and-error

search to determine the higher and lower rates subsequent to each node in the
tree, which branches out from an average yield centered on the forward rate
curve. The rates must also be consistent with an assumption of log-normality,
the volatility assumption, and the observed market value of the bond being
evaluated.”

1.

Is Zhang most likely correct in his description of calculating the arbitrage-free

approach to fixed-income security valuation?

A. Yes.

B. No, with respect to the discount rate used with a flat yield curve.

C. No, with respect to the discount rate used with a positively sloped
yield curve.

2.

According to the data in Exhibits 1 and 2, in which trading location is the

bond most likely mispriced?
 A. Dubai

B. Shanghai

C. New York

3.

Which of Zhang’s three steps to value bonds with embedded options is least
likely correct?

A. Step 1

B. Step 2

C. Step 3

4.

When describing calibrating the interest rate tree, Holly is least likely correct
with respect to the:

A. volatility assumption.

B. assumption of log-normality.

C. value of the bond being evaluated.

Monmouth Case Scenario 2

Tom River is a global credit portfolio manager at Monmouth Asset
Advisors, a fixed-income firm located in New Jersey. Each
Monday, River reviews the firm’s weekly strategy update, prepared by Reed
Bank, which is used as an input in positioning credit portfolios that reflect the
firm’s evolving market views. In this week’s strategy report, Bank states the
following: “Markets are experiencing a heightened level of volatility across
both the Treasury curve and credit spreads. Employment
trends, however, have been strong thus far, with low unemployment and
higher-than-expected wage growth. In addition, the recent rise in oil demand
and other commodities is beginning to impact input prices for manufacturers.
The credit rating agencies are reassessing economic conditions and as a result
are changing credit outlooks and credit watches to negative. We are seeing
bond dealers shrink their balance sheets.”

River asks his analyst, Sandy Manasquan, to collect

data and estimate the expected price return over one year for the BBB-rated
bonds in his portfolio. The bonds would have a modified duration at the end
of the year of 6.5, and they have an average weighted coupon of
2.50%. Manasquan compiles the data shown in Exhibit 1 for his analysis,
which comprises the migration probabilities from BBB and the spread level for
each rating category.

Exhibit 1. One-Year Transition Matrix (%) and Credit Spreads

AAA AA A BBB BB

Migration (%) 0.03 0.27 4.6 86 9.1

Credit 50 75 120 160 280
Spread (bps)

River considers buying a 1.75% annual payment corporate bond in

which dealers are quoting a market price (bid/ask) of $101.15/$101.65.
He asks Manasquan to complete the data in Exhibit 3 and use the data from
Exhibits 2 and 3 to provide him with a fair value price for the bond. The bond
is assumed to have a 1% probability of default and a 40% recovery rate.

Exhibit 2. Value of a 1.75% Annual Payment Corporate Bond Assuming No

Default (VND)
Exhibit 3. Credit Valuation Adjustment (CVA) for the 1.75% Annual
Payment Corporate Bond

Date Expected LGD POD Discount CVA per

Exposure Factor Year

1 ? ? ? 1.004016 ?

2 100.8859 60.5316 0.9900% 0.990030 0.5933

3 101.7500 61.1468 0.9703% 0.931942 0.5571

4 101.7500 61.0500 0.9703% 0.931942 0.5521

River asks Bank to collect data for the term structure of credit spreads.
Bank plots the data and is surprised to find that some curves are higher than
others and that across the term structure, some are upward sloping while
others are flat or downward sloping. River provides his interpretation of the
graph to Bank and makes the following comments:
Comment 1: “Credit quality tends to be a key driver of credit spreads. For
high-quality securities, investors do not demand much higher
compensation for longer maturities because those companies have less
sensitivity to the credit cycle, therefore resulting in only slightly upward
sloping curves.

Comment 2: The liquidity of an issuer can influence the curve as even wider
bid/ask spreads for certain issuers can impact the curve’s shape. If an
issuer currently plans to refinance front end issues with longer
maturities, the issuer’s credit curve will flatten.

Comment 3: Another factor in the shape of the curve is that government

bonds used in the benchmark curve may not be available for certain
maturities, requiring an interpolation between the two closest maturities.
An alternative to address this issue is to use a benchmark swap curve
based on interbank rates.”

1.

Based on Bank’s strategy report, what should River conclude regarding the
direction of benchmark yields and spreads over the benchmark
yield, respectively? Yields and spreads, respectively, most likely will be:

A. higher and wider.

B. lower and narrower.

C. higher and narrower.

2.

Based on the data in Exhibit 1, the expected price return on the BBB-rated
bonds in River’s portfolio over his horizon attributable to ratings
migration is closest to:

A. 1.01%.
 B. –4.10%.

C. –6.57%.

3.

Based on the data in Exhibits 2 and 3, is the corporate bond River considers
buying most likely offered at fair value?

A. Yes.

B. No, it is offered below fair value.

C. No, it is offered above fair value.

4.

Which comment made by River regarding the term structure of credit spreads
is least likely correct?

A. Comment 1

B. Comment 2

C. Comment 3

Clark Case Scenario

The Snyder Family Office manages financial and investment matters for
the Snyder family. Rob Clark is CIO of the Snyder Family Office. Jason Snyder
represents the family’s interests with the Family Office. Snyder and Clark are
meeting to discuss the family’s possible interest in private equity investing.

Snyder begins the meeting by asking about the risks and costs of private
equity investing. Clark acknowledges that private equity contains risk factors
and cost considerations that are less prevalent than those in public equities.
One risk factor is illiquidity, since private equity investments are not traded on
an active secondary market. Thus, an important consideration is the timing of
exits relative to a private equity investor’s time horizon. Another risk factor is
diversification. Because of the highly concentrated nature of a typical private
equity fund, investors have little opportunity to benefit from diversification. A
cost consideration is management fees; private equity is generally regarded as
being more costly than public mutual funds and ETFs. Both types of funds
charge administrative costs as a percentage of an investment’s net asset value.

Snyder asks Clark to explain the general structure of a private equity

fund. Clark replies by stating that the general partner of a private equity fund
performs two primary functions: (1) raising capital and (2) managing the
investment and exit of portfolio companies. The fee structure of a private equity
fund is intended to align the interests of the general partner with the limited
partners. Clark produces a table (Exhibit 1) that illustrates the fee structure
and investment returns for three private equity funds. Each fund has a
European distribution waterfall.

Exhibit 1. Fees and Returns for Three Private Equity Funds ($ millions)

Fund A Fund B Fund C

Management Fee 2% 2% 2%

Carried Interest 17% 18% 20%

Hurdle Rate 7% 8% 10%

Paid in Capital 100.0 100.0 100.0

Gross Return Year 1 6% 8% 10%

Gross Return Year 2 12% 10% 8%

Clark continues the discussion by stating that private equity returns are
typically analyzed and measured on the basis of return multiples. The return
multiples most frequently used by limited partner investors are paid in capital
(PIC); distributed to paid-in (DPI); residual value to paid-in (RVPI); and total
value to paid-in (TVPI). Clark then produces another table (Exhibit 2), which
illustrates cash flow and distribution data for Funds D and E and that is used
to calculate the return multiples.

Exhibit 2. Cash Flow and Distribution Data ($ millions)

Fund D Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Capital Called 50.0 10.0 10.0 10.0 10.0 10.0

Down

Operating Results 0.0 10.0 35.0 35.0 35.0 35.0

Fees & Carried 1.0 1.2 3.7 7.8 7.2 6.5
Interest
Distributions 0.0 0.0 10.0 10.0 15.0 15.0

Fund E Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Capital Called 75.0 5.0 5.0 5.0 5.0 5.0

Down

Operating Results 0.0 0.0 0.0 0.0 40.0 110.0

Fees & Carried 1.5 1.6 1.7 1.8 7.2 23.5

Interest

Distributions 0.0 0.0 0.0 0.0 0.0 25.0

Clark illustrates how return data may be interpreted by producing a

third table (Exhibit 3), which compares the financial performance for Funds F,
G, and H. Each fund has $100.0 million in committed capital and a remaining
life of four years.

Exhibit 3. Comparison of Financial Performance

PIC DPI RVPI

Fund F 0.50 0.60 1.90

Fund G 0.75 0.30 2.60

Fund H 1.00 0.75 1.55

 Snyder studies the third table (Exhibit 3) and states, “because of
differences in committed capital and returns, I am unsure as to which fund has
recorded the best performance to date. Over its remaining life, Fund H will
likely produce the highest total return because of its realized and unrealized
returns since inception.”

1.

Clark’s explanation of private equity risks and costs is least likely correct with
respect to:

A. illiquidity.

B. diversification.

C. management fees.

2.

Based on Clark’s explanation of private equity fund structures and Exhibit 1,

the fund which produced the highest net return over two years to its
limited partners is most likely:

A. Fund A.

B. Fund B.

C. Fund C.

3.

Based on Exhibit 2, the RVPI for Fund D and Fund E, respectively, is closest to:

A. 1.73 and 1.88.

B. 1.88 and 2.13.

C. 2.13 and 1.73.

 4.

Is Snyder’s interpretation of Fund H most likely correct?

A. Yes.

B. No, because of its realized return.

C. No, because of its unrealized return.

Antrim Capital Partners Case Scenario

Liam Ferguson works as an equity portfolio manager for Antrim Capital
Partners, a wealth management firm located in Belfast, Northern Ireland.
Antrim specializes in managing equity and commercial real estate portfolios for
institutional investors throughout Europe.

Joanne Donaghy, a representative of a large investment consulting

firm, is considering recommending Antrim to institutional clients. As part of
her due diligence, Donaghy is engaged in discussions with members of
Antrim’s investment team, including Ferguson. She asks Ferguson to explain
how Antrim’s process considers the relationship between the business cycle
and earnings growth expectations. Ferguson makes the following observations:

Observation 1: “Toward the end of a recession, corporate profit

growth increases, resulting in a negative risk premium.”

Observation 2: “The earnings of cyclical companies are considered a leading

indicator for broader economic growth.”

Observation 3: “During recessions, equities offer a good hedge against bad

consumption outcomes.”

Ferguson describes how Antrim assesses overall market

valuations using several measures, including the market P/E multiple.
Ferguson describes changes in factors that could impact valuations
and contribute to higher P/E multiples, including an increase in the equity risk
premium, decreasing volatility of real GDP growth, and an increase in
uncertainty regarding future inflation.

Donaghy is interested in understanding Antrim’s approach to commercial

real estate investing. As part of her diligence, she speaks with Colleen
McKenna, head of Antrim’s real estate team. Donaghy asks McKenna for her
view on the role of commercial real estate in diversified portfolios. McKenna
responds that commercial real estate investments have both equity- and bond-
like characteristics. She further explains, “From a bond-like perspective, rental
income can be viewed as analogous to the coupon income derived from a
bond, especially in countries with “upward only” restrictions that help protect
property owners. Changes in property values resulting from the state of the
underlying economy and any redevelopment opportunities provide an equity-
like dimension to the investment.”

McKenna decides to walk Donaghy through a pricing example of the

commercial properties in the portfolio to understand the pricing dynamics of
this market. She explains that the fundamental present value formula can be
applied to commercial real estate: “The numerator of the present
value formula is comprised of the sum of future expected rent payments. The
denominator reflects a discount rate that can vary depending on type of tenant
and lease structure. For example, the discount rate for a property leased to a
developed market government tenant paying rent indexed to inflation
would reflect the real default-free rate, a risk premium for the uncertainty of
the property value at the end of the lease, and a risk premium for the illiquidity
of the property. If this property were instead leased to a commercial tenant
paying fixed-rate nominal rent, the discount rate would also reflect expected
future inflation, a risk-premium for future inflation uncertainty, and a risk
premium for credit risk.”

1.
Which of Ferguson’s observations about equities and business cycles
is most likely correct?

A. Observation 1

B. Observation 2

C. Observation 3

2.

When discussing factors that impact P/E multiples, Ferguson is most

likely correct regarding:

A. risk premium.

B. GDP volatility.

C. future Inflation.

3.

Is McKenna most likely accurate in her description of the bond-like and equity-
like characteristics of commercial real estate investment?

A. Yes.

B. No, with regard to her description of equity-like characteristics.

C. No, with regard to her description of bond-like characteristics.

4.

In her discussion about the present value formula for commercial real
estate, McKenna is least likely correct regarding her description of the:

A. numerator.

B. the discount rate for a commercial lease.

C. the discount rate for a government lease.