Victoria Novak Case Scenario

Victoria Novak Case Scenario
Victoria Novak, CFA, was waiting in line at a coffee shop when she
overheard a conversation between two people talking about an individual
financial adviser. According to the two, this adviser had received numerous
complaints over the past month, including some suspected illegal activity
regarding a complex financial transaction. One particular comment caught her
attention, “We would not have this case on our hands right now if we had
included an industry standard in our new regulations requiring all licensees,
who we regard as our clients, to abide by the CFA Code of Ethics and
Standards of Professional Conduct.”
Novak approaches the two and says, “I’m sorry, but I couldn’t help but
overhear your conversation. I’m Victoria Novak, a CFA® charterholder. Are you
charterholders, too?”
In response, Abraham Kovi introduces himself and his colleague, Stanley

Marin, and says, “We’re both CFA® Level 2 Program candidates and work at
the Capital Market Regulatory Authority (Regulators).”
Novak responds, “I’m really passionate about ethics and would love to
talk more.”
After the three find a table, Novak asks about their desire to implement
the CFA Code and Standards as an industry standard.
Marin responds, “We regularly check the CFA Institute website to see if
anyone in our jurisdiction has been sanctioned for improper behaviors. Those
individuals are subject to greater scrutiny because of their past misbehaviors.”
Kovi adds, “For instance, we recently discovered from the CFA Institute
website that Mario Jovic, CFA, the owner of a small licensed financial advisory
firm in our jurisdiction was subject to a public sanction. Consequently, we
have started our own investigation and found several clients had registered
complaints with the firm.”
Kovi continues, “We have also received several complaints against

another adviser who is running his own firm and is a charterholder. The
complaints are related to how the investment management fees were calculated
on active management accounts as per their client agreements. The adviser
had placed client funds at a commercial bank in fixed-term deposits at above-
market rates. Subsequently, the deposits were frozen by the Central Bank as
part of a bank restructuring program and reset at lower-than-market rates.
Part of the restructuring restricted the withdrawal of any deposits for three
years to give the bank time to recover without a threat of a run on the bank.
The adviser continues to charge management fees on these deposits based on
their anticipated maturity values, despite not being able to manage them as per
client mandates. He includes the assets in performance presentations, noting
in a footnote they are not available for withdrawal.”
Novak asks the two, “If you had the Code and Standards in place
industry-wide right now, what sanctions would you consider against this
adviser?”
Marin responds, “Three sanctions come to my mind.”
Sanction 1: Require the adviser to pay into an Investor Protection Fund

whereby clients can make claims to help recover their losses and to deter
future abuses and violations.
Sanction 2: Require the adviser to hire an independent compliance consultant

to undertake an assessment and recommend and implement processes
and procedures to prevent and detect violations.
Sanction 3: Require the adviser to design a formal training program for existing
staff and any new hires to help them understand their responsibilities as
required by the Code and Standards.
Is the comment regarding the requirement for all licensees that Novak
overheard while waiting in line at the coffee shop most likely correct?
A. No.
B. Yes, with regards to Standard I(A), Knowledge of Law.
C. Yes, with regards to Standard IV(C), Responsibilities of Supervisors.
KEY = A
A is correct. The comment “We would not have this case on our hands
now if we had included an industry standard in our new regulations requiring
all licensees to abide by the CFA Code of Ethics and Standards of Professional
Conduct,” is not correct with regards to Standard I(A), Knowledge of Law, or
Standard IV(C), Responsibilities of Supervisors. Although Standard I(A),
Knowledge of Law, requires CFA Institute members and CFA candidates to
uphold all laws, rules, regulations, and the CFA Code and Standards, members
and candidates are not required to have detailed knowledge of or be experts on
all the laws that could potentially govern their activities. As a result, it is
unlikely to prevent 100% of all illegal activity or unethical behavior by staff,
although the implementation of the Code and Standards should increase
compliance. Likewise, abiding by Standard IV(C), Responsibilities of
Supervisors, which requires members and candidates to make reasonable
efforts to ensure that anyone subject to their supervision or authority complies
with applicable laws, rule, regulations, and the Code and Standards, will not
ensure 100% compliance, particularly when regulations and operating
environments are changing.
B is incorrect. Standard I(A), Knowledge of Law, requires CFA Institute

members and CFA candidates to uphold all laws, rules, regulations, and the
CFA Code and Standards, members and candidates are not required to have
detailed knowledge of or be experts on all the laws that could potentially govern
their activities. As a result, it is unlikely to prevent 100% of all illegal activity or
unethical behavior by staff, although the implementation of the Code and
Standards should increase compliance.
C is incorrect. Standard IV(C), Responsibilities of Supervisors, which

requires members and candidates to make reasonable efforts to ensure that
anyone subject to their supervision or authority complies with applicable laws,
rule, regulations, and the Code and Standards, will not ensure 100%
compliance, particularly when regulations and operating environments are
changing.
Guidance to Standards I – VII
Standard I(A) Professionalism, Standard IV(C) Responsibilities of

Supervisors
LOS a
After Novak and the two regulators found a table, who most likely violated CFA
Standards of Professional Conduct?
A. Kovi
B. Merin
C. Novak
KEY = A
A is correct. Kovi violated Standard III(E), Preservation of Confidentiality,

by citing the name of the individual currently under the regulator’s
investigation. Mentioning Jovic’s previous CFA sanction, however, does not
violate the standard in that this is public information. Standard III(E) requires
CFA Institute members and CFA candidates to keep information about current,
former, and prospective clients confidential. This standard is applicable
because the regulators regard its licensees as clients. The ethical behavior of
Jovic is still under investigation, so his name should not have been revealed by
Kovi. Neither Merin or Novak violated the CFA Standards of Professional
Conduct. Novak speaking about ethics and the implementation of the
Standards is not a violation. Merin mentioned only that the regulator checks
the CFA Institute website to see if anyone in their jurisdiction had been
sanctioned for improper behaviors. None of these activities of Novak and Merin
violate any standards.
B is incorrect. Merin does not violate any CFA Standards when stating,
“We regularly check the CFA Institute website to see if anyone in our
jurisdiction has been sanctioned for improper behaviors. Those individuals are
subject to greater scrutiny because of their past misbehaviors.” He has not
divulged any confidential information.
C is incorrect. Novak does not violate any CFA Standards by discussing

her love of ethics and enquiring about the implementation of CFA Standards of
Professional Conduct as an industry standard.
Standard III(E) Preservation of Confidentiality
LOS a
To avoid violating CFA Standards of Professional Conduct, which of the

following actions is most appropriate for the adviser to address client
complaints regarding bank deposits?
A. Review the client agreement with his largest clients.
B. Remove the deposits from future performance presentations.
C. Reimburse past fees charged on deposits and stop future management

fees.
KEY = C
C is correct. To avoid violating CFA Standards of Professional Conduct,

reimbursing past fees charged on deposits and stopping future fees would be
the adviser’s most appropriate action. As a CFA® charterholder, the adviser
has the responsibility to put the interests of his clients before his own or his
firm’s as per Standard III(A), Loyalty, Prudence, and Care. By charging fees on
assets that are not manageable (i.e., are not available to redeem or restructure
into assets earning higher returns) and that may no longer meet the clients’
mandates, he is currently not acting for the benefits of his clients. Although the
frozen deposits are not in his control, he could lessen the damage by
reimbursing past fees charged and removing these assets from being charged
any future fees. Even if the client agreements are legally correct, the adviser
would still be in violation of Standard III(A), Loyalty, Prudence, and Care, by
not protecting his clients’ interests above his or his firms. By removing the
frozen fixed assets from the performance presentation, the adviser would be
violating Standard III(D), Performance Presentation, which requires CFA
Institute members and CFA candidates to make reasonable efforts to ensure
that it is fair, accurate, and complete. These assets still are part of the clients’
portfolio and thus should be included in the performance presentations despite
their lower-than-market returns dragging down performance.
A is incorrect. Although the client agreement may be legally correct,

charging asset management fees on assets that cannot be effectively managed
nor meet client mandates and are earning below market interest rates does not
put the interests of the client ahead of the adviser or his firm. Standard III(A),
Loyalty, Prudence, and Care, states that CFA Institute members and CFA
candidates have a duty of loyalty to their clients and must place their clients’
interests before their employer’s or their own interests.
B is incorrect. By removing the frozen fixed assets from the performance

presentation, the adviser would be violating Standard III(D), Performance
Presentation, which requires CFA Institute members and CFA candidates to
make reasonable efforts to ensure that it is fair, accurate, and complete.
Removing the value of the assets would distort the accuracy of the portfolio
valuation and the allocation of asset types.
Standard III(A) Loyalty, Prudence and Care, Standard III(D)

Performance Presentation
LOS b
Which proposed sanction against the adviser most likely complies with CFA
Standards of Professional Conduct?
A. Sanction 1
B. Sanction 2
C. Sanction 3
KEY = B
B is correct. Sanction 2, Require the adviser to hire an Independent

Compliance Consultant to undertake an assessment, and recommend
processes and procedures to prevent and detect violations, most likely complies
with CFA Standards of Professional Conduct. Standard IV(C), Responsibilities
of Supervisors, requires CFA Institute members and CFA candidates to make
reasonable efforts to ensure that anyone subject to their supervision or
authority complies with applicable laws, rules, regulations, and the Code and
Standards. If the regulator finds the systems and processes of supervision are
insufficient at the adviser’s firm, they have the responsibility to appoint an
independent compliance officer until such time the firm has implemented
corrective action to prevent and detect ethical and legal violations in the future.
Paying into an Investor Protection Fund is not sufficient to prevent and detect
future violations of applicable laws, rules, regulations, and the Code and
Standards as required by Standard IV(C), Responsibilities of Supervisors. The
adviser, as the owner of the firm, would be responsible for implementing
supervisory processes and procedures to comply with the CFA Code and
Standards. The training program would need to be implemented and carried
out at least annually or when any new regulations are introduced.
A is incorrect. Although the adviser’s clients possibly could benefit from
him paying into an Investor Protection Fund so claims could be made to
recover their losses, it is not sufficient to prevent and detect future violations of
applicable laws, rules, regulations, and the Code and Standards as required by
Standard IV(C), Responsibilities of Supervisors. The adviser, as the owner of
the firm, would be responsible for implementing supervisory processes and
procedures to comply with the CFA Code and Standards.
C is incorrect. Although designing a formal Code and Standard training

program for existing staff and any new hires is necessary, it is not enough in
itself. To comply with Standard IV(C), Responsibilities of Supervisors, the
training program would need to be implemented and be carried out at least
annually or when any new regulations are introduced. Training also should be
considered if and when the firm introduces any new procedures and products
or services to encourage compliance.
Standard IV(C) Responsibilities of Supervisors
LOS b
Daltonia Case Scenario

Daltonia is a medium sized developing country. Government policies
have gradually opened the borders for international trade and the flow of
capital. Trade is now substantial with members of the EU and is often
denominated in Euros (€). During the early 2000s, privatization of some
publicly owned industries, creation of a new free-floating currency, the Dornan
(DRN), and sound policies implemented at the central bank put the economy
on a track for steady growth and stability. Foreign currency reserves are sizable
in comparison to the average daily turnover of the DRN.
Naim Birol, Minister of Finance for Daltonia, is preparing his annual

report on the state of the economy and currency markets for the legislative
branch of government. He will examine the long- and short-term trends in GDP
growth, per capita income, inflation, and exchange rates. He is also responsible
for recommending policy initiatives for the legislature to consider in order to
promote overall economic prosperity for Daltonian citizens.
In order to estimate long-term GDP growth, Birol examines the data in

Exhibit 1 intending to use Solow’s growth accounting equation.
Exhibit 1 Long-Term Trends of Daltonian Economy

Growth due to capital deepening 2.3%
Population growth 3.4%
Growth rate of total factor productivity –0.6%
Growth in labor productivity 1.7%
Growth in capital 6.1%
Share of GDP paid to labor 65%
Birol consults his colleague Ziya Pamuk to review the policy choices
facing the Daltonian government and the possible effects on economic growth
and per capita income.
Pamuk states:
“Daltonia’s politicians are debating the effects of growth rate

policies focused on three outcomes:
• higher rates of saving and investment
• importing more technological innovations
• greater investment in research and development (R&D)
I conclude that the impact from these policies will cause a long-
term increase in the economy’s growth rate and our standard of
living. Furthermore, if we emphasize R&D spending, then higher
rates of saving and investment are unlikely to encounter
diminishing marginal returns.”
Birol believes Daltonia needs to address a recent increase in inflation and
appreciation in the exchange rate. Should these trends accelerate, the
country’s present prosperity could be threatened. Birol and Pamuk discuss
policy alternatives.
Birol states: “Since Daltonia allows capital to flow freely, the clearest choice is
to implement expansionary monetary and fiscal policies to stop the
appreciation of the currency according to the Mundell–Fleming model.”
Pamuk replies: “The long run solution to the problem, at least according to the
portfolio balance approach, would be a policy choice by the Daltonian
government to run large budget deficits on a sustained basis.”
Birol adds: “There is also a timing dimension to consider. According to

Dornbusch, with inflexible domestic prices in the short run, any decrease
in nominal money supply will induce an increase in the domestic interest
rate. This will encourage capital inflows and cause the exchange rate to
overshoot to the upside in the short run, until domestic prices have a
chance to react.”
Birol wants to be on the lookout for situations which might trigger a

currency crisis. He and Pamuk discuss recent economic developments that
might provide potential warning signs.
Birol: “Moving our currency to a floating exchange rate has reduced our
susceptibility to a currency crisis.”
Pamuk: “Banking crises often precede currency crises, but our banking sector
has grown and strengthened substantially by offering foreign
denominated savings accounts to foreign investors and lending those
funds for domestic infrastructure investments.”
Pamuk: “I’m concerned that the ratio of exports to imports has been increasing
recently and the ratio of M2 to bank reserves has been falling.”
In examining the currency markets, Birol is concerned that local
currency dealers are being taken advantage of by arbitrageurs from Europe. He
analyzes the rate quotes in Exhibit 2 for evidence of triangular arbitrage and
carry trade opportunities by European hedge funds attempting to exploit the
DNR currency.
Exhibit 2 Interbank and Dealer Currency Quotes and Rates

Projected
Currency Bid Offer Spot in one One-Year
Pair (spot) (spot) year Libor Rates
Interbank Market:
EUR/USD 0.8045 0.8065 0.8200 EUR 0.8%
DNR/USD 1.2050 1.2100 1.2280 USD 0.9%
Daltonian Dealer:
DNR/EUR 1.5140 1.5190 DNR 3.0%
Using the specified growth accounting equation, which is the most appropriate
conclusion Birol can make from his data on trends in the economy?
A. Daltonia’s economy is performing at a steady state rate of growth.
B. Output per worker is falling.
C. GDP growth is primarily driven by labor.
C is correct. The components of growth can be determined using Solow’s

growth accounting equation:
∆Y/Y = ∆A/A + α∆K/K + (1 − α)∆L/L
where:
∆Y/Y = GDP percentage growth

∆A/A = percentage growth from total factor productivity (TFP)
∆K/K = percentage growth in capital
∆L/L = percentage growth in labor
α = share of income paid to capital factor
1 – α = share of income paid to labor factor, also the elasticity of output

with respect to labor
TFP = Labor productivity growth – Growth in capital deepening = 1.7 –

2.3 = –0.6, which is given in Exhibit 1. Also given, 1 – α = 0.65 and α = 0.35
GDP growth = ∆Y/Y = 3.75 Arising from the total of

components below:
∆A/A = growth due to TFP −0.6
α∆K/K = growth due to capital + 2.13 = (0.35) × 6.1
(1 − α)∆L/L = growth due to labor + 2.21 = (0.65) × 3.4
3.75 GDP growth
Growth due to labor of 2.21% is greater than the growth due to capital or
TFP.
A is incorrect. Once the economy reaches steady state growth, capital

deepening cannot be a source of sustained growth in the economy.
B is incorrect. Output per worker is rising since GDP growth of 3.75% is

greater than population growth of 3.4%.
Economic Growth and the Investment Decision
LOS d,h
Sections 4.2-4.3
Pamuk’s conclusion regarding the growth policy debate is most consistent with
which model of economic growth?
A. Classical
B. Endogenous
C. Neoclassical
B is correct. Pamuk’s conclusion is consistent with the endogenous

growth model. In the endogenous growth model, the economy does not reach a
steady growth rate equal to the growth of labor plus an exogenous rate of labor
productivity growth. Instead, saving and investment decisions can generate
self-sustaining growth at a permanently higher rate. This situation is in sharp
contrast to the neoclassical model, in which only a transitory increase in
growth above the steady state is possible. The reason for this difference is
because of the externalities on R&D, diminishing marginal returns to capital do
not set in.
A is incorrect. The scenario outlined is not consistent with the classical

growth model.
C is incorrect. The scenario outlined is not consistent with the

neoclassical model.
Economic Growth and the Investment Decision
LOS i
Section 5.3
Which of the statements regarding policy alternatives discussed between Birol

and Pamuk in response to Daltonia’s recent increase in inflation and
deterioration in exchange rate is least accurate?
A. Birol’s statement regarding Dornbusch
B. Pamuk’s statement regarding the portfolio balance approach

C. Birol’s statement regarding Mundell–Fleming
C is correct. Birol’s statement regarding the Mundell–Fleming model is

inaccurate because restrictive (not expansionary) fiscal policy, along with
expansionary monetary policy, would lead to capital outflows and cause the
currency to depreciate assuming high capital mobility.
A is incorrect because Birol’s statement regarding Dornbusch is

accurate.
B is incorrect because Pamuk’s reply regarding the portfolio balance

approach is accurate.
Currency Exchange Rates: Understanding Equilibrium Value
LOS k
Section 6
Which of the recent economic developments discussed by Birol and Pamuk is

most likely to lead to a currency crisis?
A. The banking sector
B. The exchange rate system
C. The trend in terms of trade and monetary ratios
A is correct. Pamuk’s description of growth in the banking sector coupled

with short-term funding denominated in foreign currency can lead to a
currency crisis. Countries with fixed or partially fixed exchange rates are more
susceptible. Broad measures of money such as M2 are likely to be rising (not
falling) just prior to a crisis. The terms of trade are favorable for Daltonia.
B is incorrect. Countries with fixed or partially fixed exchange rates are

more susceptible.
C is incorrect. Broad measures of money such as M2 are likely to be
rising (not falling) just prior to a crisis.
LOS m
Section 8
Based on the exchange rate quotes in Exhibit 2, an opportunistic European

hedge fund interested in triangular arbitrage between the dealer and
interbank markets is most likely to:
A. discover that no triangular arbitrage opportunity exists.
B. buy EUR in the interbank market and sell EUR to the Daltonian
dealer.
C. buy EUR from the Daltonian dealer and sell EUR in the interbank
market.
B is correct. Calculate the interbank implied cross rate for (DRN/EUR).

Invert the (EUR/USD) quotes. The 0.8045 bid becomes 1/0.8045 = 1.243 offer
for (USD/EUR). The 0.8065 offer becomes 1/0.8065 = 1.240 bid for
(USD/EUR).
Determine the interbank implied cross currency quotes for (DRN/EUR)

as follows:
Bid: 1.205(DRN/USD) × 1.24 (USD/EUR) = 1.4942 (DRN/EUR)
Offer: 1.210 (DRN/USD) × 1.243 (USD/EUR) = 1.504 (DNR/EUR).
The offer on the interbank is less than the bid by the dealer. A hedge
fund can by EUR (sell DRN) in the interbank market for DRN 1.504 and sell
EUR (buy DRN) to the Daltonian dealer for a higher price of DRN 1.514.
A is incorrect. There is an arbitrage profit opportunity as shown in the
calculations.
C is incorrect. This is the opposite of the profitable transaction.
LOS b
Section 2.1
Using the data provided in Exhibit 2 for the interbank market only, a European
investor who attempts to exploit the DNR currency market with a normal
one-year carry trade based on a 100,000 EUR position will most likely
achieve a net profit in EUR of:
A. 1,963.
B. 3,018.
C. 2,218.
A is correct. Using the data provided in Exhibit 2 for the interbank

market only, a European investor who attempts to exploit the DNR currency
market with a normal one-year carry trade based on a 100,000 EUR position
will most likely achieve a net profit in EUR of:
Sell 100,000 EUR × (1/0.8065)(USD/EUR) = 123,992.56 USD
Sell 123,992.56 USD × 1.2050(ENR/USD) = 149,411 DNR

Invest at 3.0% DRN Libor: 149,411 DNR × (1 + 0.03) = 153,893.37 DNR
Convert to EUR at projected spot:
153,893.37 DNR × (1/1.228)(USD/DNR) × 0.82(EUR/USD) = 102,763

EUR
Less borrowing cost: 100,000 × 0.8% = EUR 800
Ending balance = EUR101,963 EUR
Less 100,000 beginning value = EUR 1,963 profit
B is incorrect. The mistake is omitting the deduction of the borrowing

cost.
C is incorrect. The mistake is using the bid of 0.8045 and inverting it in

the first step. When you invert, the quote has a new base currency. The
inverted bid is now an ask.
LOS i
Section 4.1
NBRC Vignette
Giulia Gallo works as a senior manager at the National Banking
Regulatory Commission (NBRC). She is meeting with her team today to review
Banco San Bruno (BSB), a large commercial bank with operations across the
country. The central bank announced a rate hike last month, and Gallo wants
to re-examine BSB’s ability to withstand the changing environment. Antonio
Rossi, her junior colleague, displays the summary information (Exhibit 1) he
has gathered on BSB’s earnings composition and comments that he thinks the
earnings composition has become less volatile and more sustainable.
Exhibit 1: Key Components of BSB’s Earnings
(€ millions) Current Prior Year

Year
Net interest income 55,288 50,285
Net fee income 22,648 21,107
Net trading income 18,651 18,624
Total 96,587 90,016
Gallo further explains that BSB has been flagged by the data analytics
system. The flag warns that BSB may be acting to boost its net interest income
by shifting its portfolio toward more long-term assets without a corresponding
shift on the liability side of the balance sheet. “I don’t like it,” said Gallo. Seeing
Rossi’s puzzled look, she adds, “It’s a value creation strategy in a stable
interest rate market, but it heightens their risk, especially in this environment
of increasing rates.”
The team next turns to BSB’s balance sheet. Rossi displays the
information he has gathered (Exhibit 2), and they use it to calculate the Total
Tier 1 Capital.
Exhibit 2: Excerpts from BSB’s Year-End Balance Sheet
(€ billions) Current Prior Year

Year
Customer deposits 502 572
Subordinated debt 23 21
Preferred shares 17 17
Common shares 12 12
Retained earnings 187 201
As the discussion draws to a close, Gallo mentions that at the next

meeting, they will complete a
detailed CAMELS (capital adequacy, asset quality, management,
earnings, liquidity, and sensitivity) analysis of BSB.
Rossi’s comment about BSB’s earnings composition is best described as:
A. correct.
B. incorrect with respect to volatility.
C. incorrect with respect to sustainability.
Key = A
A is correct. Net trading income is typically considered more volatile than

net interest income or net fee income. As a component of the total, BSB’s net
trading income has decreased from 20.7% to 19.3% per the following table,
while the sustainable components (net interest income and net fee income)
have increased. Overall, BSB’s earnings composition has become less volatile
and more sustainable.
(€ millions) Current (%) Prior Year (%)

Year
Net interest income 55,288 57.2% 50,285 55.9%
Net fee income 22,648 23.5% 21,107 23.4%
Net trading income 18,651 19.3% 18,624 20.7%
Total 96,587 100.0% 90,016 100.0%
B is incorrect. Net trading income, which is typically considered volatile

income, has decreased as a proportion of the total. As such, Rossi’s comment
that the earnings composition has become less volatile is correct.
C is incorrect. Both net interest income and net fee income, which are
considered more sustainable sources of income, have increased as a proportion
of the total. As such, Rossi’s comment that the earnings composition has
become more sustainable is correct.
Analysis of Financial Institutions
LOS e, c
Section 3.1.4, 3.3.4
The value creation strategy Gallo refers to is best described as:
A. maturity transformation.
B. contractual maturity mismatch.
C. risk-weighted asset stratification.
Key = A
A is correct. When banks borrow money (liabilities) on shorter terms than

the terms for lending to customers (assets), they create value by lending at
higher rates than their short-term funding costs. This is called maturity
transformation.
B is incorrect. A contractual maturity mismatch is the result of the

strategy described but is not the name of the strategy itself.
C is incorrect. Risk-weighted asset stratification is part of the process of

assessing a bank’s capital adequacy.
LOS c
Section 3.3.4, 3.1.5
BSB’s Total Tier 1 Capital (in billions) for the current year is closest to:
A. €199.
B. €216.
C. €239.
Key = B
B is correct. Total Tier 1 Capital includes Common Equity Tier 1 Capital

plus other instruments (such as preferred shares) that bear no fixed maturity
and carry no requirement to pay dividends or interest without the full
discretion of the bank. Common Equity Tier 1 Capital includes common stock,
capital surplus, retained earnings, and other comprehensive income. BSB’s
Total Tier 1 Capital is as follows:
(€ billions)
Common stock 12
Retained earnings 187
Common Equity Tier 1 199

Capital
Preferred shares 17
Total Tier 1 Capital €216
A is incorrect. This calculation correctly includes the Common Equity

Tier 1 components (common shares (€12) and retained earnings (€187)) for a
total of €199. However, it incorrectly excludes preferred shares, which should
be included as part of Total Tier 1 Capital. 12 + 187 = €199.
C is incorrect. This calculation correctly includes preferred shares (€17),

common shares (€12), and retained earnings (€187). However, it incorrectly
also includes subordinated debt (€23), bringing the total to €239. Subordinated
debt is part of Tier 2 Capital. 17 + 12 + 187 +23 = €239.
LOS e, c
Section 3.3.1
In the next meeting when completing the detailed analysis suggested by Gallo,
which of the following topics is least likely to be covered?
A. Currency exposure
B. Governance structure
C. Concentration of funding
Key = A
A is correct. In the next meeting, they are to complete a detailed CAMELS

analysis of BSB, which would not include an analysis of currency exposure.
Currency exposure is relevant to the analysis of a bank, but it is not covered by
the CAMELS approach.
B is incorrect. A strong governance structure is a critically important

aspect of the management capabilities element of CAMELS.
C is incorrect. Concentration of funding is one of the liquidity-monitoring

metrics described in Basel III. It is covered under the liquidity position element
of CAMELS.
LOS d, c
Section 3.2.2
Pacific Case Scenario

Pacific Wind Capital Management (PWCM) is a global equity manager
based in Singapore. During a weekly investment call, managers of its Alpha
fund express an interest in exploring basic materials stocks in Canada and in
the emerging market country of South Africa. Ri Lin, PWCM’s senior materials
analyst, assigns performing initial research on South Africa materials stocks to
Ji-min Kim, a junior research analyst at the firm.
Before reviewing specific stocks, Lin provides Kim with the data in
Exhibit 1 and asks her to estimate the forward-looking risk premium for South
African equities.
Exhibit 1 Market Data
South Africa
Current equity market dividend yield 2.70%
Dividend yield based on year-ahead aggregate forecasts 3.00%
Consensus long-term earnings growth rate 5.90%
Risk-free rate (90-day government bill) 5.00%
20-year government bond yield 8.50%
United States
20-year government bond yield 3.50%
Initial screening of selected South African stocks identifies Jacobs

Brands LTD and Krantz Group LTD as the most attractive candidates for
further analysis. Lin directs Kim to estimate the market betas of these stocks.
Krantz Group is thinly traded, making it difficult to run a return regression to
estimate beta. As an alternative, Kim decides to use the South Africa Basic
Materials Index as a proxy to estimate the beta of Krantz relative to the MSCI
World Index.
Exhibit 2 Market Beta and Debt Ratios
South Africa Basic Materials Equity Market Index (SABMI)
Estimated SABMI beta to MSCI World Index 0.9
Estimated SABMI beta to MSCI South Africa Index 0.8
Average SABMI debt-to-total capital-ratio 0.4
Krantz Group
Debt-to-equity ratio 0.75
Lin then asks Kim to calculate the justified price-to-sales (P/S) and
EV/EBITDA multiples for these South African stocks, starting with Jacobs
Brands, using the data in Exhibits 3 and 4.
Exhibit 3 Jacobs Brands LTD Selected Financial Statement Items (ZAR
millions)
Cash and cash equivalents 1,260
Short-term investments 486
Accounts receivable, net 480
Inventories 1,657
Total sales 4,821
Interest 161
Taxes 964
Depreciation and amortization 171
Net income 446
Capital investment 121
Exhibit 4 Additional Financial Metrics (ZAR millions)
Jacobs Brands Krantz Group
Market value of common equity 5,284 868
Market value of debt 2,687 651
Market value of preferred stock 1,210 0
Estimated dividend payout ratio 25.00% 5.00%
Estimated earnings growth rate 5.00% 6.00%
Estimated required rate of return 9.50% 10.00%
Before making recommendations, Kim and Lin discuss the comparability

of a number of metrics they have compiled for South African stocks with stocks
Lin has identified in Canada through separate analysis.
“In regard to estimating the required rate of return for the South African
and Canadian equity markets,” Kim says, “I believe the most important
adjustments will be:
• accounting for differences in GDP growth rates,
• incorporating exchange rate forecasts into the calculations, and
• including a country premium for stocks in South Africa.”
When concluding their discussion, they make the following observations

regarding comparison of valuation multiples for companies across two different
countries:
1. EV/EBITDA is less likely to be impacted by differences in international

accounting standards than P/E or price to free cash flow to equity
(P/FCFE).
2. When the inflation rates in two countries are the same, the justified P/E
multiple should be lower for companies with a higher inflation pass-
through rate, all else being equal.
3. Assuming all else is equal, a company in a country with high inflation will
have lower justified P/E multiples than a company in a country with
lower rates of inflation.
Based on the data provided in Exhibit 1, Kim’s forward-looking estimate for the
South Africa equity risk premium is closest to:
A. 3.9%.
B. 5.4%.
C. 0.4%.
C is correct. Using the constant growth dividend discount model (Gordon

growth model), the equity risk premium can be presented as:
Dividend yield on the index based on year-ahead aggregate forecasts 3.0%
plus consensus long-term earnings growth rate + 5.9%
minus current long-term government bond yield. – 8.5%
Equity risk premium = = 0.4%
A is incorrect. It incorrectly uses the South African risk-free rate: 3.0% +

5.9% – 5.0% = 3.9%.
B is incorrect. It incorrectly uses the US long-term government bond

yield: 3.0% + 5.9% – 3.5% = 5.4%.
Return Concepts
LOS b
Section 3.2
Using Exhibit 2, Kim’s estimated beta of Krantz Group is closest to:
A. 0.84.
B. 0.95.
C. 1.13.
B is correct. The four steps that occur when doing beta estimation are
shown in the table below:
Step 1: Select proxy for Krantz Kim decided to use the SABMI
Group
Step 2: Estimate the beta of the Given as 0.90
proxy
Step 3: Unlever the benchmark’s  1 

=βu  βi
beta 1 + D E 
D/E for the index is not given, but if debt is

40% of total capital, then debt to equity
would be 40/60 = 0.6667.
βu = (1/1.6667) × 0.9 = 0.6 × 0.9 = 0.54
Step 4: Relever beta to reflect the βc = [1 + (D′/E′)]βu = (1 + 0.75) × 0.54 = 0.95

company’s D/E
βu = beta unlevered; βi = beta index; βc = estimated company beta.
A is incorrect. This answer incorrectly uses the beta to the MSCI South
Africa Index, not the MSCI World Index (beta of 0.8 instead of 0.9 in Step 2): βu
= (1/1.6667) × 0.8 = 0.6 × 0.8 = 0.48; βc = [1 + (D′/E′)]βu = (1 + 0.75) × 0.54 =
0.84.
C is incorrect. This answer incorrectly uses the debt to capital ratio of

the index instead of debt to equity (0.40 instead of 0.6667 in Step 3): βu =
(1/1.4) × 0.9 = 0.71 × 0.9 = 0.643; βc = [1 + (D′/E′)]βu = (1+ 0.75) × 0.64 = 1.125.
Return Concepts
LOS d
Section 4.1
Using the data in Exhibits 3 and 4, the justified P/S ratio that Kim calculates
for Jacob Brands is closest to:
A. 1.62.
B. 1.10.
C. 0.54.
C is correct.
(E0 S0 )(1 − b)(1 + g )

Justified P/S ratio =
r−g
Step 1: Calculate E0/S0 (446/4,821) = 0.0925
Step 2: (1 – b) Given in Exhibit 4 0.25
Step 3: (1 + g) g = 5% (given in Exhibit 4) 1.05

Step 4: Calculate (r – g) 0.095 – 0.050 = 0.045
Step 5: Apply formula (0.0925 × 0.25) × (1.05/0.045) = 0.540
b = earnings retention rate; g = earnings growth rate; r = required rate of return
B is incorrect. It represents current P/S ratio not justified P/S ratio.
P/S = Equity market capitalization/Total sales = 5,284/4,821= 1.10
Alternatively, 0.0925 × (0.25)/(0.45), i.e., P/S = (E/S)(1 – b)/(r – g)
A is incorrect. It represents a payout ratio that is too high. The middle

term in the numerator reflects 1 minus the payout ratio instead of 1 minus the
retention rate.
P/S = (E/S)(1 – b)(1 + g)/(r – g) = (.0925)(0.75)(1.05)/(.045) = 1.62
Market-Based Valuation: Price and Enterprise Value Multiples
LOS h
Section 3.3
Using the data in Exhibits 3 and 4, the EV/EBITDA ratio Kim calculates for
Jacobs Brands is closest to:
A. 4.3.
B. 4.6.
Step 1: Calculate Enterprise Value Step 2: Calculate EBITDA
Enterprise value = EV = EBITDA =
MV of common equity 5,284 Net income 446
+ MV of preferred stock + 1,210 + Interest expense + 161
+ MV of debt + 2,687 + Taxes + 964
– Cash and cash equivalents – 1,260 + Depreciation and amortization + 171

– Short term investments – 486 EBITDA = = 1,742
Enterprise value = = 7,435
Step 3: Calculate EV/EBITDA = 7,435/1,742 = 4.27
C. 3.6.
A is correct.
B is incorrect. The short-term investments are not subtracted from the

EV calculation: 7,435 + 486 = 7,921/1,742 = 4.55.
C is incorrect. The market value of the preferred stock is ignored in the

EV calculation: 7,435 – 1,210 = 6,225/1,742 = 3.57.
LOS n
Section 4
Which of Kim’s suggested adjustments when comparing the required rates of

return for South African and Canadian stocks is least relevant? The
adjustment related to:
A. the country premium.
B. exchange rate forecasts.
C. GDP growth rates.
C is correct. Differences in GDP growth rates between countries may

exist, but this is not an important consideration specific to estimating required
rate of return between the two countries. Both exchange rates and model
issues in emerging markets are important considerations that concern analysts
estimating required returns in a global context.
A is incorrect. Investing in emerging markets such as South Africa is
typically associated with greater expected risk, and analysts may want to
consider incorporating a country spread model or a country risk rating model.
B is incorrect. Equity risk premium estimates in home currency terms

can be higher or lower than estimates in local currency terms.
Return Concepts
LOS f
Section 4.4
Which of the observations regarding comparison of cross-border valuation

multiples is the most accurate?
A. Observation 3
B. Observation 1
C. Observation 2
A is correct. All else being equal, companies operating in a country with

higher inflation will have a lower justified P/E than those operating in a
country with lower inflation.
B is incorrect. International accounting differences affect the

comparability of all price multiples. However, cash based multiples such as
P/FCFE will generally be the least impacted by accounting differences.
C is incorrect. If the inflation rates are equal but pass-through rates

differ, the justified P/E should be lower for the company with the lower pass-
through rate.
LOS o
Sections 3.1.6, 5
Neptune Case Scenario ITEM SET 1
Brad Belmar is the director of risk management at Neptune Asset
Advisors, a fixed-income firm located in New Jersey. Louise Lake, an analyst in
his group, models credit risk in the firm’s funds for risk
management oversight. Belmar and Lake discuss the process of modeling
credit risk, and Belmar makes the following comments:
Comment 1: “When modeling credit risk, the expected exposure reflects the
amount of money an investor is expected to lose given default,
discounted by the risk-free rate.
Comment 2: The credit valuation adjustment for each bond is the present value
of expected loss over its term to maturity and reflects the
probability of default and recovery rate.
Comment 3: Another modeling factor is the probability of

default, which reflects actual historical probabilities of default.”
Belmar asks Lake to develop a credit rating system for

Neptune, independent of the ratings provided by such credit rating agencies as
Moody’s, S&P, and Fitch. The key objective is for Neptune’s
ratings to transition more rapidly than that of the agencies based on new
information flow. Belmar would like the internal methodology to have the
same characteristics as the outside agencies. He tells Lake, “These
characteristics should include:
• First, developing ordinal ratings—focusing on the probability of default and

representing a lettering system applied to issuers as well as specific bond
issues—and an outlook indicating improvement or deterioration in credit
quality.
• Second, the ratings should be notched to incorporate differences in the

expected loss given default for specific issues arising from subordination.
In this manner, we can adjust the rating downward one or two notches to
distinguish between subordinated debt and senior unsecured debt.”
Belmar also wants the risk monitoring of portfolios to include not only
corporate bonds but also securitized debt. He explains to Lake that there are
various types of securitized debt and that there are differences in the credit
analysis of these securities compared to corporate bonds. He suggests that they
segment the analysis depending on the characteristics of the securities. He
tells Lake, “We should apply a portfolio-based analytical approach to the
existing book of loans in short-term structured finance vehicles with granular,
homogeneous assets. For example, in a credit card ABS securitization, we can
use the distribution of FICO scores to derive a mean default and recovery rates.
On the other hand, we should apply a statistical-based approach to medium-
term, granular, and heterogeneous obligations, such as auto ABS. Finally,
a loan-by-loan approach is appropriate for discrete or non-granular
heterogeneous portfolios, such as CMBS.”
Belmar wants to develop a quantitative model that would augment the

fundamental analysis conducted by the firm’s analysts. He and Lake debate the
merits of different models of corporate credit risk.
Belmar points out to Lake several issues related to these models:
Issue 1: “A structural model is best suited for risk

management. At Neptune, we have access to the all the data inputs
needed in the model for companies held in the firm’s funds. I like the
option approach the model takes, which explains why default
occurs. Although we do not know the value of each firm’s assets, we can
imply it from market data.
Issue 2: A reduced form model uses company-specific and macroeconomic

variables, with all the inputs readily available, and the
model explains when default occurs. These models treat default as an
endogenous event.
Issue 3: Both types of models have disadvantages. With structural models, for
example, it is difficult to measure the default barrier. For reduced form
models, a disadvantage is that they don’t explain the reasons for
default, which can be a surprise that does not typically happen in
practice.”
Belmar is most likely correct with regard to

which comment regarding modeling credit risk?
A. Comment 1
B. Comment 2
C. Comment 3
Key=B
B is correct. Comment 2 is correct. Belmar’s Comment 1 is

incorrect since expected exposure reflects the amount of money an investor is
expected to lose before any possible recovery, and it is not discounted by the
risk-free rate. Comment 3 is also incorrect as the probability of default reflects
risk-neutral probabilities of default, not actual historical probabilities.
A is incorrect because Comment 1 is incorrect.
C is incorrect because Comment 3 is incorrect.
Credit Analysis Models
LOS a
Sections 2
Is Belmar’s explanation of credit rating methodology characteristics most

likely correct?
A. Yes.
B. No, with regard to his first characteristic.
C. No, with regard to his second characteristic.
Key=A
A is correct. Belmar asks Lake to develop a credit rating system that has
the same characteristics as those used by the public rating agencies but
that maintains the ability to more actively reflect new information flow. The
characteristics he describes in both statements are correct with regard
to outside rating agencies.
B is incorrect, as the statement is correct.
C is incorrect, as the statement is correct.
LOS b
Section 3
Belmar is most likely correct with regard to which credit analysis approach for
securitized debt?
A. Portfolio
B. Statistical
C. Loan-by-loan
Key=C
C is correct. Belmar is correct regarding only the loan-by-loan approach

for CMBS, which are discrete obligations. The combination of asset type and
tenor as well as the relative granularity and homogeneity of the underlying
obligations drive the approach to credit analysis for a given instrument type.
For example, short-term structured finance vehicles with granular,
homogeneous assets tend to be evaluated using a statistical-based approach to
the existing book of loans (the reading exhibit refers under “Credit Analysis
Approach” to the book of loans against which the statistical analysis is
applied). This changes to a portfolio-based approach for medium-term granular
and homogeneous obligations because the portfolio is not static but changes
over time (refer to the exhibit in the reading showing “Summary of Asset
Types” and “Characteristics of Core Structured Finance Asset Classes” for
additional detail).
A is incorrect because short-term structured finance vehicles with

granular, homogeneous assets tend to be evaluated using a statistical-
based (not portfolio-based) approach to the existing book of loans.
B is incorrect. A portfolio-based approach is used for medium-term

granular and homogeneous obligations because the portfolio is not static but
changes over time.
LOS h
Section 8
Which of the issues that Belmar points out regarding quantitative credit
models is least likely correct?
A. Issue 1
B. Issue 2
C. Issue 3
Key=B
B is correct. Belmar is incorrect with regard to Issue 2. Reduced-

form models get around the problem of not knowing the firm’s asset values by
not treating default as an endogenous (internal) variable. Instead, the default is
an exogenous (external) variable that occurs randomly. Unlike structural
models that aim to explain why a default occurs, reduced-form models aim to
explain statistically when it occurs.
A is incorrect because Belmar’s comments regarding structural

models (Issue 1) are correct. Asset values are not known, but they can be
inferred from Assets = Liabilities + Equity.
C is incorrect because Belmar’s comments regarding disadvantages of

each model (Issue 3) are correct.
LOS d
Section 4
Dieter Klopp Case Scenario

SCAI is a registered investment adviser based in Nashville,
Tennessee, providing investment and private wealth
management advice to endowments, retirement plans, and corporations. Dieter
Klopp, a portfolio manager, is meeting with analysts Nabil Salah and Lisa
Suarez to discuss fixed-income investment opportunities and portfolio
management strategies. Klopp presents the group with the information on spot
rates shown in Exhibit 1:
Exhibit 1. Spot Rates for Zero-Coupon Bonds
Maturity Spot
(Years) Rate
1 2.041%
2 2.598%
3 2.818%
4 2.956%
5 3.304%
Salah is currently evaluating a corporate bond and makes the following

statements:
Statement 1: “The value of a bond calculated by discounting its future cash

flows by their corresponding spot rates will be the same as the value
obtained by discounting future cash flows by the yield-to-maturity of a
bond, as long as the yield-to-maturity is some weighted average of the
spot rates.”
Statement 2: “Yield-to-maturity is a good estimate of the expected return on a

bond assuming coupons are reinvested at the prevailing spot rates.”
Statement 3: “If the yield curve remains flat during the holding period, the
realized rate of return on a bond will be the same as the expected rate of
return.”
Salah asks Klopp to explain the spot curve in Exhibit

1. Klopp responds that the spot rate curve in Exhibit 1 is derived
from the par curve using a process called bootstrapping. The par rates are
yields-to-maturity, at various maturities, for on-the-run, coupon-paying
government bonds priced at par. Bootstrapping is a process of forward
substitution, where successive spot rates are derived from par rates one at a
time. The process begins with recognizing that the one-year spot rate is the
same as the one-year par rate. The two-year spot rate, r(2), is then calculated
by solving the following equation:
2 − year Par coupon 2 − year Par coupon + Par value

Par Value= + .
(1 + (2)) (1 + r (2))2
This process continues until all spot rates are derived.
Klopp then asks Suarez how the spot curve can be used in fixed-income
analysis. Suarez responds, “Our expectations regarding the evolution of future
spot rates compared to the forward curve allow for an evaluation of the relative
value of a bond and the identification of appropriate bond trading
strategies. Interest rate scenarios and corresponding appropriate strategies are
outlined here”:
Scenario 1: If we expect future spot rates to be lower than current forward

rates, then we should short the bond since it is likely to be overvalued.
Scenario 2: If the spot curve is expected to be above the forward curve

and our expectations turn out to be correct, the bond should be
purchased since the one-year return will be more than the one-year risk-
free rate.
Scenario 3: If the yield curve is upward sloping and we expect spot

rates to evolve as implied by the forward curve, then a strategy of buying
bonds with maturities longer than the investment holding period will
allow us to earn a return greater than a maturity matching strategy.
Based on the information in Exhibit 1, the forward rate for a two-year zero-
coupon bond issued three years from today is closest to:
A. 3.13%.
B. 4.04%.
C. 4.71%.
KEY=B
B is correct. The forward rate model can be used to calculate this.
((1+r(T))T=(1+r(1))(1+f(2,1))(1+f(3,1))…(1+f(T-1,1))
Specifically:
The forward rate for a two-year zero-coupon bond issued three years
from today is f (3,2):
(1 + f(3.2))2 = [(1+f (3,1))(1 + f(4,1))]
= (1 + r (5))5 / (1 + r (3))3
= (1.03304)5 / (1.02818)3 = 1.08235
f (3,2) = 1.082350.5 – 1 = 0.040362.
A is incorrect. 3.13% is incorrect; it is a simple average of the four-year

spot rate and the five-year spot rate.
C is incorrect. 4.71% is incorrect and is calculated as
((1.03304^5) / (1.02956^4) = 1.17648/1.12359 = 1.0471 → minus 1 =

4.71%.
This calculation incorrectly uses five-year and four-year spot rates.
The Term Structure and Interest Rate Dynamics
LOS b
Section 2.1
Which of Salah’s three statements is least likely correct?
A. Statement 1
B. Statement 2
C. Statement 3
KEY=B
B is correct. Statement 2 is incorrect. The yield-to-maturity provides a

poor estimate of expected return if interest rates are volatile, the yield curve is
steeply sloped upward or downward, there is significant risk of default, or the
bond has embedded options. Yield-to-maturity is a poor estimate of expected
return because it does not capture the effect of reinvesting coupons at new
rates due to changes in the shape of the yield curve. Recall that to realize the
initial yield-to-maturity requires that coupons be reinvested as implied by the
initial yield-to-maturity.
A is incorrect. Statement 1 is correct. The value of a bond calculated by

discounting its future cash flows by their corresponding spot rates will be the
same as the value obtained by discounting future cash flows by the yield-to-
maturity of a bond, only if the yield-to-maturity is some weighted average of the
spot rates used to value the bond.
C is incorrect. Statement 3 is correct. If the yield curve remains flat

during the holding period, the realized rate of return on a bond will be the
same as the expected rate of return.
LOS a
Section 2.2
Is Klopp’s statement on par rates and bootstrapping most likely correct?
A. Yes.
B. No, he is incorrect about par rates.
C. No, he is incorrect about bootstrapping.
KEY=C
C is correct. Klopp correctly describes par rates but is incorrect

about the process of bootstrapping. The spot rate curve is derived from the par
rate curve using a process called bootstrapping. The par rates are yields-to-
maturity, at various maturities, for on-the-run, coupon-paying government
bonds priced at par. Bootstrapping is a process of forward substitution, where
successive spot rates are derived from par rates one at a time. For example, the
one-year spot rate is the same as the one-year par rate. The two-year spot
rate r(2) is calculated as follows:
2 − year Par coupon 2 − Par coupon + Par value

Par Value = +
(1 + r (1)) (1 + r (2))2
In our example, r(1) is the one-year spot rate 2.041%. This process
continues until all spot rates are derived. Note that in his explanation in the
vignette, Klopp incorrectly states the first term in the equation as
2 − year Par coupon

(1 + r (2))
A is incorrect. Klopp correctly describes par rates and incorrectly

describes the process of bootstrapping.
B is incorrect. Klopp correctly describes par rates and incorrectly

describes the process of bootstrapping.
LOS c
Section 2.1
In Suarez’s response to Klopp, under which scenario is the recommended

strategy most likely appropriate?
A. Scenario 1
B. Scenario 2
C. Scenario 3
KEY=C
C is correct. If expected spot rates evolve as indicated by the forward

curve (Scenario 3), then a strategy of buying bonds with maturities longer than
the investment holding period will earn a return greater than a maturity
matching strategy. This is known as riding the yield curve or rolling down the
yield curve. As the bond approaches maturity, it rolls down the yield curve and
is valued at successively higher prices and can be sold before maturity to
realize a higher return.
A is incorrect. If we expect future spot rates to be lower than current

forward rates (Scenario 1), the appropriate strategy is to purchase (not
short) the bond since it is likely undervalued.
B is incorrect. If we expect future spot rates to be higher than current

forward rates (Scenario 2), then the appropriate strategy is to short the
bond (not purchase) since it is likely overvalued. The return will be less than
the one-year risk-free rate.
LOS d, e
Section 2.3, 2.4
Cummins Case Scenario

High Street Investment Management is an investment subadvisory firm
partnering with Registered Investment Advisors to provide counsel for options
trading strategies. Scott Cummins is High Street’s CEO and chief investment
officer. Phyllis Schwartz leads the client relationship team. David Spelding is a
recent college graduate, who just joined the firm as an analyst. Cummings and
Schwartz are conducting an introductory training session on options pricing,
focusing on the binomial option valuation model (i.e., the binomial model).
Cummins begins the session by listing, in Exhibit 1, variables and values

for a binomial model to illustrate an outcome.
Exhibit 1: Binomial Model Variables and Values

Variable Value
Stock price (S) US$100
Exercise price US$100

(X)
Up factor (U) 1.35

Down factor .75
(D)
Risk-free rate 2.00%
(r)
Schwartz states, “The one-period binomial model is based on the no-

arbitrage approach in which an investor does not take any risk or use his own
money. Based on the information in Exhibit 1, the probability of an up move is
45%. For an investor, the no-arbitrage approach is similar to both the
expectations approach and the discounted cash flow approach. Each approach
is based on the investor’s expectation regarding the future course of the
underlying stock price.”
Schwartz then introduces the two-period binomial model. He states that

the two-period binomial lattice can be viewed as three one-period binomial
lattices and that each lattice may be used to value a call option. Schwartz
instructs Spelding to use the two-period binomial model and the information in
Exhibit 1 to calculate the value of a two-year European-style call option.
Cummins states that long-/short-hedge fund managers seek to identify

and exploit any mispricing that may exist between the price of an option and
the price of its underlying stock, utilizing a replicating strategy. Cummins asks
Spelding to assess the three scenarios outlined in Exhibit 2, based on the
information in Exhibit 1 and assuming that the price of a one-year European-
style call option is $19.25.
Exhibit 2: Scenarios and Replicating Strategies

Replicating Strategy
Options Trade Stock Trade Financing
Scenario Sell Buy Lend

1
Scenario Sell Buy Borrow

2
Scenario Buy Sell Lend

3
Schwartz then asks Spelding to use the information in Exhibit 1 to

calculate the no-arbitrage value of a two-year US-style put option, assuming
that the option may be exercised in one year.
Is Schwartz’s statement about the one-period binomial model most likely

correct?
A. Yes.
B. No, she is incorrect about the probability of an up move.
C. No, she is incorrect about expectations of future stock prices.
KEY = C
C is correct. Schwartz’s statement is incorrect. The expectations

approach is a variation of the no-arbitrage approach to the binomial model. The
results of each are identical. Under the no-arbitrage approach and the
expectations approach, expected options payoffs are a function of a risk-
neutral probability. The investor’s outlook with respect to the future course of
the stock price is not a relevant consideration for the no-arbitrage approach or
the expectations approach. The investor’s outlook with respect to the future
course of the stock price is a relevant consideration for the discounted cash
flow approach to securities valuation.
A is incorrect. Schwartz’s statement is incorrect. The expectations
approach is a variation of the no-arbitrage approach to the binomial model. The
results of each are identical. Under the no-arbitrage approach and the
expectations approach, expected options payoffs are a function of a risk-
neutral probability. The investor’s outlook with respect to the future course of
the stock price is not a relevant consideration for the no-arbitrage approach or
the expectations approach. The investor’s outlook with respect to the future
course of the stock price is a relevant consideration for the discounted cash
flow approach to securities valuation.
B is incorrect. Schwartz’s statement with respect to the probability of an

up move is correct. The calculation follows:
π =  FV (1) − d  / ( u − d ) = [1.02 − .75] / (1.35 − .75 ) = .27 / .60 = .45 = 45%
Valuation of Contingent Claims
Section 1, 2, 3.1
LOS a
According to Schwartz’s instructions to Spelding, the value of a two-year

European-style call option is closest to:
A. $16.60.
B. $29.04.
C. $32.66.
KEY = A
A is correct. The correct calculations follow:
RN Probability equation:
π=  FV (1) − d  / ( u − d )= [1.02 − .75] / (1.35 − .75 )= .45

Call Option equation:
c ++ Max ( 0, u 2 S
= = − X ) Max 0,1.352 (100 )=
− 100  82.25
c +− = c +− = Max ( 0, udS − X ) = Max 0, (1.35 × .75 ×100 ) − 100  = 1.25
=c −− Max ( 0, d 2=
S − X ) Max 0, (.752 ×100 )=
− 100  0
c PV (π 2 c ++ ) + ( 2π (1 − π ) c −+ ) + (1 − π ) c −− 
2
=
 
2
 1  
 (.45 × 82.25 ) + ( 2 (.45 ) × (1 − .45 )1.25 ) + (1 − π × 0 ) 
2 2
=c 
 1 + .02 
=c .961169 × [16.6556 + .61875 =

+ 0] $16.604
Note: Not tested but provided for learning purposes:
Put Option equation (Put-Call Parity):
p = c + PV(X) – S
2
 1 
p= 16.604 + 100 /  − 100= $12.720
1 + .02 
B is incorrect. The .60 probability of an up move is incorrectly calculated.

The incorrect call option calculation follows:
Incorrect probability of an upmove calculation:
[u − d ] /1.0 =
π= [1.357 − .75] /1.00 =
.60
c PV (π 2 c ++ ) + ( 2π (1 − π ) c −+ ) + (1 − π ) c −− 
2
=
 
2
 1  
 (.60 × 82.25 ) + ( 2 (.60 ) × (1 − .60 )1.25 ) + (1 − π × 0 ) 
2 2
=c 
 1 + .02 
=c .9611688 × [ 29.61 + 0.60 +=

0] 29.037
= $29.04
= 0] 29.037
c .9611688 × [ 29.61 + 0.60 += = $29.04 C is incorrect. The 𝑐𝑐 +− figure of
35 is incorrectly calculated and used. The incorrect call option calculation

follows:
RN Probability of .45 is correct.
c PV (π 2 c ++ ) + ( 2π (1 − π ) c −+ ) + (1 − π ) c −− 
2
=
 
2
 1  
 (.45 × 82.25 ) + ( 2 (.45 ) × (1 − .45 ) 35 ) + (1 − π × 0 ) 
2 2
=c 
 1 + .02 
=c .961169 × [16.6556 + 17.325 =

+ 0] $32.66
Section 3.1, 3.2
LOS b
With respect to the replicating strategies, which scenario is most likely correct?
A. Scenario 1
B. Scenario 2
C. Scenario 3
KEY = B
B is correct. The $19.25 price of the call option exceeds its value of
$15.44, as calculated based on both the no-arbitrage approach and the
expectations approach. Accordingly, the replicating strategy per 100 shares is
to (1) sell 1 option, (2) buy h shares, and (3) borrow h * (up/down factor price +
up/down call payoff).
The call option calculations follow:
No-arbitrage approach:
c+ + c− 35 − 0 35
Hedge ratio=
h = = = .5833
+
S −S −
135 − 75 60
( )
Call Option value c= hS + PV ( −hS − + c − ) = .5833 ×100 + ( −.5833 × 75 + 0 ) /1.02= 52.33 + ( −42.89 )= $15.44
Expectations approach:
Probability of an up move π =  FV (1) − d  / ( u − d )= [1.02 − .75] / (1.35 − .75)= .45
Call Option value c= PV π c + + (1 − π ) c − = (.45 × 35 + .55 × 0 ) /1.02= 15.75 /1.02= $15.44
A is incorrect. The $19.25 price of the call option exceeds its value of
C is incorrect. The $19.25 price of the call option exceeds its value of
Section 3.1
LOS c
The no-arbitrage value of a two-year American-style put option is most likely
closest to:
A. $12.72.
B. $13.48.
C. $13.75.
KEY = B
B is correct. The no-arbitrage approach to calculating the early exercise

premium follows. Note that the two-period binomial model is used to calculate
(for purposes of comparison) the value of the European-style put option and
the American-style put option. The value of the European-style put option is
$12.72. The value of the American-style put option is $13.48. Accordingly, the
early exercise premium is $.76. The calculations follow.
Component Denote Value Put Value: Two-Period Binomial

Terms d Model
Stock Price S 100 Early Exercise 0.760

Premium
Exercise Price X 100 European Style p 12.720
Up Factor u 1.35 American Style p 13.480
Down Factor d 0.75 Put Up p+ 0.000
Interest Rate r 2.00% Put Down p– 23.591

(European Style)
Probability of π 0.4500 Put Down p– 25.000

Up Move (American Style)
Stock Up S+ 135.000
Stock Down S– 75.000
Put Up Up p++ 0.000
Put Up Down p+- 0.000

Put Down Down p-- 13.750
Stock Up Up S++ 182.250
Stock Up Down S+- 101.250
Stock Down Down S-- 56.250
European Style
Item Value
Item Value Stock 182.250
Stock 135.0000 Put 0.000
Put 0.000
Item Value HR 0 Item Value
Stock 100 Stock 101.250
Put 12.720 Item Value Put 0.000
HR - Stock 75.0000
0.39318
Put 23.591 Item Value
HR -0.97 Stock 56.250
Put 43.750
American Style
Item Value
Item Value Stock 182.250
Stock 135.0000 Put 0.000
Put 0.000
Item Value HR 0 Item Value
Stock 100.000 Stock 101.250
Put 13.480 Item Value Put 0.000
HR - Stock 75.000
0.41667
Put 25.000 Item Value
HR -0.97 Stock 56.250
Put 43.750
A is incorrect. $12.72 represents the value of a two-year European-style

put option. The no-arbitrage approach to calculating the early exercise
premium follows. Note that the two-period binomial model is used to calculate
(for purposes of comparison) the value of the European-style put option and
the American-style put option. The value of the European-style put option is
$12.72. The value of the American-style put option is $13.48. Accordingly, the
early exercise premium is $.76.
C is incorrect. $13.75 represents the intrinsic value of the put option at

year 1 ($25.00) times the probability of a down move (1 – .45 = .55). $25.00 ×
.55 = $13.75. This is not correct. The no-arbitrage approach to calculating the
early exercise premium follows. Note that the two-period binomial model is
used to calculate (for purposes of comparison) the value of the European-style
put option and the American-style put option. The value of the European-style
put option is $12.72. The value of the American-style put option is $13.48.
Accordingly, the early exercise premium is $.76.
Section 3.2
LOS b
Ahn Case Scenario

Quentin Ahn is head of QA Global Macro Strategies (QA), a firm offering
institutional investment management in alternative investments. QA manages
passive and active commodity funds. Simmons College is exploring whether to
incorporate commodities into its endowment portfolio. Ahn is meeting with the
head of Simmons’ investment committee, Ashton Zhang, to explain how QA
achieves investment returns in commodities.
Ahn states: “Unique factors drive changes in prices in different
commodity sectors. For example, commodity prices can be affected by factors
such as weather, GDP growth, or the level of emerging market wealth.”
Ahn continues: “We invest in commodities using futures contracts,

whose traded prices can vary from their underlying spot prices and I believe the
following three statements describe how the valuation of commodities
compares with that of equities and bonds.”
Statement 1: Contrary to a bond that receives periodic income, owning a

commodity can incur costs.
Statement 2: Just as the value of a default-free bond equals its face value at
maturity, the value of the commodity future converges to the physical
spot price at delivery.
Statement 3: The valuation of commodities and equities are based on a

discounted forecast of possible future prices based on such factors as the
expected volatility of future prices.
Ahn states: “We seek to achieve positive investment returns by taking

advantage of the relationship between commodity spot and futures prices. Our
futures positioning will depend on whether the futures price curve is in
contango or backwardation. Another tactic is to establish long and short
positions of different months of the same commodity futures contract to earn
the price difference, which is what we call a calendar spread.”
Exhibit 1 shows portions of three futures price curves.
Exhibit 1: Selected Commodity Spot and Futures Prices
Heating
Crude Oil Oil Lumber
Spot 40.67 1.1600 552.10
January future 39.93 1.1590 573.30

March future 39.93 1.1560 601.30
Ahn concludes: “Price movement is not the only source of returns.

Participants in commodity futures markets are also able to account for an
additional roll return in their investment activities, which vary depending on
their natural positioning in the market. For example, our long-only QA Energy
Commodities Fund, an airline hedging fuel costs and a crude oil producer
would all use the same crude oil futures, but this would not necessarily result
in the same roll return.”
When discussing unique factors driving price changes, the three commodity
pricing factors Ahn notes would most likely have the smallest impact on
the price of:
A. gold.
B. cotton.
C. copper.
KEY = A
A is correct. The three commodity pricing factors noted by Ahn would

have the smallest impact on the price of gold, which historically has acted as a
store of value, similar to currencies, and its price is less likely to be influenced
by weather, GDP growth, or the level of emerging market wealth. Global supply
and demand effects, such as inflation expectations and fund flows, are more
important to the pricing of gold.
B is incorrect. The price of cash crops such as cotton can be affected

significantly by weather as a freeze can severely damage crops.
C is incorrect. Copper is positively correlated to industrial production

and GDP growth directly affects industrial product demand.
Introduction to Commodities and Commodity Derivatives

Section 2.1
LOS a
When commenting on the pricing of physical commodities, Ahn is most likely

correct with regard to:
A. Statement 1.
B. Statement 2.
C. Statement 3.
KEY = A
A is correct. As opposed to a stock or bond that receives periodic income,

owning a commodity incurs transportation and storage costs, which affects the
shape of the forward price curve of commodity derivative contracts.
B is incorrect. The force of arbitrage, normally forcing the convergence of

the futures price and spot price at the end of the contract, may not be entirely
enforced if delivery is required at a specific location and if some participants do
not have the ability to make or take delivery of the commodity.
C is incorrect. The valuation of equities is based on the estimation of

future profitability and cash flows, while valuation of commodities is based on
a discounted forecast of future possible prices based on such factors as supply
and demand of a physical item or the expected volatility of future prices.
Section 2.3
LOS c
Based on the data in Exhibit 1, Ahn would most likely conclude that:
A. the basis for heating oil futures is 0.0030.
B. lumber futures offer the greatest calendar spread.

C. the crude oil futures markets are in a state of backwardation.
KEY = C
C is correct. Ahn would conclude that the crude oil futures markets are
in a state of backwardation, which exists when the spot price exceeds the
futures price, as it does in the January crude oil futures contract.
A is incorrect. The difference between spot and futures prices is called

the basis. The basis for heating oil futures would be 0.0010 for January and
0.0040 for March; 0.0030 is the calendar spread between the January and
March futures.
B is incorrect. A positive calendar spread is associated with futures

markets that are in backwardation, whereas a negative calendar spread is
associated with futures markets that are in contango. Lumber futures have
successively higher prices and are in contango.
Section 3.2
LOS e
Using the crude oil futures prices in Exhibit 1, who would most likely account
for the lowest roll return until March?
A. An airline hedging fuel costs
B. The QA Energy Commodities Fund
C. A crude oil producer hedging production
KEY = C
C is correct. A crude oil producer would be short futures to hedge the

risk of future falling prices. For example, falling prices would decrease future
sales and income. Crude oil futures are in backwardation, causing successive
futures contracts to be sold at lower prices and causing roll yield to be
negative.
A is incorrect. The airline would be long crude oil futures by hedging

potential rising fuel costs. A futures curve in backwardation would allow it to
purchase successive futures contracts at lower prices, increasing roll yield.
B is incorrect. The Energy Commodities Fund would be long crude oil

futures by being a long-only fund. A futures curve in backwardation would
allow it to purchase successive futures contracts at lower prices, increasing roll
yield.
Section 3.3.2
LOS h
Hallasan Capital Partners Case Scenario

Dea Cho is a senior portfolio manager for Hallasan Capital, an
investment management firm located in Gyeongju, South Korea. Hallasan
specializes in using multifactor models to build and manage global investment
portfolios for institutional clients.
Chung-Hee Kwon works for Cho as a research analyst and often is

tasked with working on factor models. During a conversation with Cho, Kwon
mentions that he has not worked on building models using the arbitrage
pricing theory (APT) framework. Cho asks Kwon what he knows about APT.
Kwon explains that while both the APT and capital asset pricing model (CAPM)
provide an expression of the expected return of an asset, the APT provides an
alternative framework to CAPM and cites three key attributes of APT:
Attribute 1: The APT model makes stronger assumptions than the CAPM.
Attribute 2: APT makes the assumption that investors can form portfolios that
eliminate asset-specific risk.
Attribute 3: APT makes the assumption that arbitrage opportunities exist
among well-diversified portfolios.
Hallasan manages a global equity strategy for Gyeongiu Electric, an

institutional client. This portfolio is managed to overweight or underweight
certain factors. These factors include small minus big (SMB), high minus low
book value (HML), and winners minus losers (WML). Exhibit 1 provides
information regarding the portfolio sensitivities to these factors, the premiums
of these factors, and the return of the value-weighted equity index in excess of
the one-month T-bill rate (RMRF). The risk-free rate is currently 1.5%.
Exhibit 1: Portfolio Sensitivities and Factor Premiums
Risk Factor RMRF SMB HML WML
Gyeongiu 1.01 0.45 0.95 −0.09

Electric Portfolio
Factor
Sensitivity
Factor Premium 3.11% 2.11% 3.75% 1.56%
Following the conclusion of a performance reporting period, Cho asks

Kwon to evaluate the risk attributes and results of two of Hallasan’s
institutional portfolios relative to a global equity benchmark over the previous
year. Kwon compiles the data in Exhibit 2 and provides the results to Cho for
discussion and analysis.
Exhibit 2: One-Year Portfolio Performance Data
Portfolio Active Active Active Information

Specific Factor Risk Ratio
Risk (%) Risk (%) Squared
City of Daegu 10 90 0.38% 0.70
Gangwon Pension Plan 75 25 0.09% 0.62
Cho asks Kwon to share observations on how the portfolios have

performed. Kwon responds that Daegu’s portfolio appears to have had the
largest active return and Gangwon’s portfolio appears to have the highest
contribution of active risk from stock selection.
Which of Kwon’s attributes about APT is most likely correct?
A. Attribute 1
B. Attribute 2
C. Attribute 3
Key = B
B is correct. Attribute 2 given by Kwon is correct. APT makes the

assumption that investors can form well-diversified portfolios that eliminate
asset-specific risk.
A is incorrect. Attribute 1 given by Kwon is incorrect. APT makes less

strong assumptions than the CAPM.
C is incorrect. Attribute 3 given by Kwon is incorrect. It should state that

APT requires that arbitrage opportunities do not exist among well-diversified
portfolios.
Using Multifactor Models
Section 3
LOS a
The strategy incorporated in the management of the equity portfolio for

Gyeongiu Electric is most likely an example of which type of factor
model?
A. Statistical
B. Fundamental
C. Macroeconomic
Key = B
B is correct. The model described is based on company fundamental

factors, such as market capitalization and valuation, as well as a company
share-related factor to explain cross-sectional differences in stock prices. This
is an example of a fundamental factor model. Statistical factor models do not
rely on defining the factors up front. Macroeconomic models would represent
broader economic factors, such as interest rates, inflation, and credit spread.
A is incorrect. Statistical factor models make minimal assumptions and

factors are observed from the returns of securities in a group. There are two
primary types of statistical models: (1) factor analysis models in which the
factors are the portfolios of securities that best explain historical return
covariances, and (2) principal component models in which the factors are
portfolios of securities that best explain historical return variances.
C is incorrect. Macroeconomic factor models have factors that represent

surprises in macroeconomic variables, such as interest rates, inflation,
business cycle, and credit spreads.
Section 4
LOS d
Assuming an equilibrium with no alpha or no residual, the expected return of

the Gyeongiu Electric Portfolio is closest to:
A. 7.5%.
B. 9.0%.
C. 10.5%.
Key = B
B is correct. The formula for determining the expected portfolio return
from the information provided is:
E ( Rp ) =
RF + β p,1RMRF + β p, 2 SMB + β p,3HML + β p, 4WML ( + error )
E ( Rp
= ) 1.5% + (1.01)( 3.11% ) + ( 0.45)( 2.11% ) + ( 0.95)( 3.75% ) + ( −0.09 )(1.56% ) +=
0 9.013%
A is incorrect. This return calculation does not include the risk-free rate
of 1.5%.
C is incorrect. This return calculation does not include the risk-free rate
or adjust the returns for the factor sensitivities.
Section 3
LOS c
Is Kwon most likely accurate in his comments regarding how the portfolios
have performed?
A. Yes.
B. No, with regard to his comment on Daegu’s portfolio.
C. No, with regard to his comment on Gangwon’s portfolio.
Key = A
A is correct. Kwon correctly interprets the performance of the various

portfolios from the information compiled in Exhibit 2. Kwon is correct that
Daegu’s portfolio has the highest active return. The information ratio is defined
as active return divided by active risk or tracking error. Daegu has by far the
largest active risk, and although it has a lower information ratio than Ulsan, its
information ratio is 83% as high with an active risk that is 3.1 times larger
(square root of Daegu active risk squared divided by square root of Ulsan active
risk squared). As a result, Daegu must have the largest active return. Kwon is
also correct that Gangwon’s portfolio appears to have the highest contribution
of active risk from stock selection; 75% of Gangwon’s active risk comes from
active specific risk, which means security specific risk. Even when considering
Daegu’s higher active total risk, only 10% of Daegu’s active risk comes from
active specific versus active factor sources, indicating the most security specific
(stock selection) risk from Gangwon.
B is incorrect. Kwon is correct that Daegu’s portfolio has the highest

active return. The information ratio is defined as active return divided by active
risk or tracking error. Daegu has by far the largest active risk, and although it
has a lower information ratio than Ulsan, its information ratio is 82% as high
with an active risk that is more than three times larger. As a result, Daegu
must have the largest active return.
C is incorrect. Kwon is correct that Gangwon’s portfolio appears to have

the highest contribution of active risk from stock selection; 75% of Gangwon’s
active risk comes from active specific risk, which means security specific risk.
Even when considering Daegu’s higher active total risk, only 10% of Daegu’s
active risk comes from active specific versus active factor sources, indicating
the most security specific (stock selection) risk from Gangwon.
Section 5
LOS e
Muckroth Investment Management Case Scenario

Dierdre O’Callahan is a senior risk manager at Muckroth Investment
Management, a global investment firm headquartered in Dublin, Ireland.
O’Callahan’s team is responsible for tracking and estimating portfolio risk for
the firm’s various investment strategies and for communicating risk exposures
to Muckroth’s portfolio managers, investment committee, and chief risk officer.
O’Callahan’s team also offers risk consulting services to the firm’s institutional
investor clients.
When assessing portfolio risk, O’Callahan makes frequent use of value at

risk (VaR) in addition to other measures, such as volatility, sensitivity risk, and
scenario risk. O’Callahan believes that VaR is an appropriate risk measure in
this application for the following reasons:
Reason 1: The reliability of VaR can be easily verified through a process known
as backtesting.
Reason 2: VaR takes portfolio liquidity into account when some of the assets
are relatively illiquid.
Reason 3: VaR effectively accounts for an increase in asset correlations during

times of market stress.
Michelle Ryan is a senior portfolio manager on the Muckroth Alpha

Fund. Ryan and O’Callahan are reviewing the VaR report O’Callahan prepared
for this fund to ensure that the fund is within the risk parameters established
by the firm and communicated to investors. The Alpha Fund has assets under
management of €315 million and has an expected annualized return of 10.4%
with a volatility of 17.52%. The report describes VaR in both percentage and
euro terms. It uses the parametric method of VaR at the 5% level (1.65
standard deviations), assuming 250 trading days per year.
After reviewing the current VaR report, Ryan asks O’Callahan to

calculate how much the VaR estimate would change if she were to reduce the
portfolio weight of Bordeaux Industries stock in the Alpha Fund from 6% to 2%
of the portfolio and then use the proceeds to establish a new 4% position in
Riga Bank & Trust. O’Callahan tells Ryan that there are several extensions of
VaR analysis that she can run.
Axiomada, a prospective institutional client, is impressed by Muckroth’s
investment track record and would like to learn more about the consulting
services Muckroth offers to monitor risk. Representatives from Axiomada set
up a meeting with O’Callahan to discuss how Muckroth considers important
risk categories facing institutional investors. O’Callahan provides Axiomada
with a risk management document Muckroth has prepared for institutional
clients that includes Exhibit 1. Exhibit 1 illustrates how Muckroth considers a
variety of different risk categories depending on the type of institutional
investor.
Exhibit 1: Important Risk Categories by Type of Institutional Investor
Risk Category Bank Hedge Fund Pension Plan
Liquidity Gap √ √
VaR √ √
Tracking Error √ √
Leverage √ √
Scenario Analysis √ √
Key Rate Duration √ √
Active Share √
Operational Risk √ √
Capital
Which of the reasons O’Callahan lists in support of VaR is most likely correct?
A. Reason 1
B. Reason 2
C. Reason 3
Key = A
A is correct. Reason 1 that O’Callahan made in support of VaR, “The
reliability of VaR can be easily verified through a process known as
backtesting,” is correct. The reliability of VaR can be verified easily and VaR is
capable of easily being verified through backtesting. To determine whether a
5% VaR estimate is reliable, one can determine over a historical period of time
whether estimated losses were incurred, subject to reasonable statistical
variation.
B is incorrect. Reason 2, “VaR takes portfolio liquidity into account when

some of the assets are relatively illiquid,” is incorrect. VaR fails to take into
account liquidity. As a result, if some assets in a portfolio are illiquid, VaR
could be understated, even under normal market conditions.
C is incorrect. Reason 3, “VaR effectively accounts for an increase in

asset correlations during times of market stress,” is incorrect. VaR
underestimates risk during periods of extreme market stress as it is sensitive
to rising correlations eroding the diversification benefits that exist during
normal conditions.
Measuring and Managing Market Risk
Section 2
LOS d
In its current form, the 5% daily parametric VaR estimate for the Muckroth
Alpha Fund is most likely closest to:
A. €3.36 million.
B. €4.68 million.
C. €5.63 million.
Key = C
C is correct. In its current form, the daily parametric VaR estimate for
the Muckroth Alpha Fund is closest to €5.63 million.
To calculate the daily 5% parametric VaR from the data provided, use the
following steps:
Step 1: Convert annual return to daily = 0.104 / 250 = 0.000416
Step 2: Convert annual standard deviation to daily = 0.1752 / SQRT(250) =

0.01108
Step 3: Multiply the portfolio standard deviation by 1.65 = 0.01108 × 1.65 =

0.018283
Step 4: Absolute value of [expected return - adjusted standard deviation]

= 0.000416 – 0.018283 = –0.017867, absolute value = 0.017867
Step 5: Multiply step 4 by the value of the portfolio = €315 million × 0.017867
= €5.628 million
A is incorrect. This answer incorrectly neglects to multiply the portfolio

standard deviation by 1.65 (5% confidence level).
B is incorrect. This answer incorrectly uses 365 days when calculating

daily return and standard deviation instead of the 250 trading days provided.
Section 2
LOS c
Which extension of VaR would O’Callahan most likely utilize to satisfy Ryan’s
request?
A. Relative VaR
B. Conditional VaR
C. Incremental VaR
Key = C
C is correct. O’Callahan would utilize incremental VaR to satisfy Ryan’s

request. Incremental VaR is used to see how VaR will change if a position size
is changed relative to the remaining positions. VaR is recalculated under the
proposed allocation and the incremental VaR is the difference between the
“before” and “after” VaR.
A is incorrect. Relative VaR is a measure of the degree to which the

performance of a given investment portfolio might deviate from its benchmark.
This is used to estimate tracking risk relative to a benchmark. In this case,
Ryan is seeking to estimate how the portfolio change would affect VaR, not to
understand risk relative to a benchmark, so incremental VaR would be a more
appropriate extension.
B is incorrect. Conditional VaR, also referred to as expected tail loss or

expected shortfall, is used to determine the average loss that would be incurred
if the VaR cutoff is exceeded. Conditional VaR would be used to estimate
average losses in an extreme “tail risk” move, not to model a change in portfolio
position sizes.
Section 2
LOS e
In Exhibit 1 provided to Axiomada, for which institutional investor type does

Muckroth most likely accurately list important risk categories?
A. Bank
B. Hedge fund
C. Pension plan
Key = A
A is correct. The Muckroth team is accurately describing risk

considerations facing a bank, which include liquidity gap, VaR, leverage, key
rate duration, operational risk capital, and scenario analysis.
B is incorrect. Hedge funds would not be focused on categories such as

tracking error or active shares, which are more traditional asset manager
metrics, and instead would be focused on categories such as sensitivities,
scenario analysis, gross exposure, and drawdown.
C is incorrect. Pension plans are less likely to focus on items such as

operational risk capital and would include VaR (surplus at risk), interest rate
and curve risk, glide path, and liability hedging exposures instead of return-
generating exposures.
Section 4
LOS j

Victoria Novak Case Scenario

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Victoria Novak Case Scenario

In response, Abraham Kovi introduces himself and his colleague, Stanley

Kovi continues, “We have also received several complaints against

Marin responds, “Three sanctions come to my mind.”

Sanction 1: Require the adviser to pay into an Investor Protection Fund

Sanction 2: Require the adviser to hire an independent compliance consultant

B. Yes, with regards to Standard I(A), Knowledge of Law.

C. Yes, with regards to Standard IV(C), Responsibilities of Supervisors.

B is incorrect. Standard I(A), Knowledge of Law, requires CFA Institute

C is incorrect. Standard IV(C), Responsibilities of Supervisors, which

Guidance to Standards I – VII

Standard I(A) Professionalism, Standard IV(C) Responsibilities of

A is correct. Kovi violated Standard III(E), Preservation of Confidentiality,

C is incorrect. Novak does not violate any CFA Standards by discussing

Guidance to Standards I – VII

Standard III(E) Preservation of Confidentiality

To avoid violating CFA Standards of Professional Conduct, which of the

A. Review the client agreement with his largest clients.

B. Remove the deposits from future performance presentations.

C. Reimburse past fees charged on deposits and stop future management

C is correct. To avoid violating CFA Standards of Professional Conduct,

A is incorrect. Although the client agreement may be legally correct,

B is incorrect. By removing the frozen fixed assets from the performance

Standard III(A) Loyalty, Prudence and Care, Standard III(D)

B is correct. Sanction 2, Require the adviser to hire an Independent

C is incorrect. Although designing a formal Code and Standard training

Guidance to Standards I – VII

Standard IV(C) Responsibilities of Supervisors

Daltonia Case Scenario

Naim Birol, Minister of Finance for Daltonia, is preparing his annual

In order to estimate long-term GDP growth, Birol examines the data in

Exhibit 1 Long-Term Trends of Daltonian Economy

Population growth 3.4%

Growth rate of total factor productivity –0.6%

Growth in labor productivity 1.7%

Growth in capital 6.1%

Share of GDP paid to labor 65%

“Daltonia’s politicians are debating the effects of growth rate

• higher rates of saving and investment

• importing more technological innovations

• greater investment in research and development (R&D)

Birol adds: “There is also a timing dimension to consider. According to

Birol wants to be on the lookout for situations which might trigger a

Exhibit 2 Interbank and Dealer Currency Quotes and Rates

EUR/USD 0.8045 0.8065 0.8200 EUR 0.8%

DNR/USD 1.2050 1.2100 1.2280 USD 0.9%

DNR/EUR 1.5140 1.5190 DNR 3.0%

A. Daltonia’s economy is performing at a steady state rate of growth.

B. Output per worker is falling.

C. GDP growth is primarily driven by labor.

C is correct. The components of growth can be determined using Solow’s

∆Y/Y = ∆A/A + α∆K/K + (1 − α)∆L/L

∆Y/Y = GDP percentage growth

∆K/K = percentage growth in capital

∆L/L = percentage growth in labor

α = share of income paid to capital factor

1 – α = share of income paid to labor factor, also the elasticity of output

TFP = Labor productivity growth – Growth in capital deepening = 1.7 –

GDP growth = ∆Y/Y = 3.75 Arising from the total of

∆A/A = growth due to TFP −0.6

α∆K/K = growth due to capital + 2.13 = (0.35) × 6.1

(1 − α)∆L/L = growth due to labor + 2.21 = (0.65) × 3.4

3.75 GDP growth