CFA Institute 2020 Mock Exam A - Morning Session (With Solutions)

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2020 Level II Mock Exam (A) AM

The morning session of the 2020 Level II Chartered Financial Analyst® Mock
Examination has 60 questions. To best simulate the exam day experience, candidates
are advised to allocate an average of 18 minutes per item set (vignette and multiple
choice questions) for a total of 180 minutes (3 hours) for this session of the exam.
THE FOLLOWING INFORMATION RELATES TO

QUESTIONS 1–6
Kyra Johnson, CFA, was recently hired by Sedgwick Investment Management (Sedgwick)
as its new chief executive officer. Sedgwick’s parent company owns several subsidiaries
in the financial services industry. Although there are currently no outstanding com-
pliance issues, Sedgwick’s employees have a history of unethical behavior and always
seem to be on the brink of additional violations. Sedgwick’s board of directors has
tasked Johnson with bringing the firm’s policies and procedures into compliance with
the CFA Institute Code of Ethics and Standards of Professional Conduct.
Shortly after Johnson was hired, the following announcement appeared in a major
financial newspaper:
The board of directors of Sedgwick Investment Management is pleased
to announce the hiring of Ms. Kyra Johnson, CFA, as the company’s new
chief executive officer. She has demonstrated the ability to successfully
complete a rigorous and comprehensive study program demanded by the
CFA designation. The credibility of her CFA charter and the skills the
CFA Program cultivates are key assets Ms. Johnson brings to Sedgwick.
As a CFA charterholder, Ms. Johnson has superior qualities to manage our
clients’ investments and guide the investment process. We are thrilled to
have Ms. Kyra Johnson, CFA, as a member of the Sedgwick Investment
Management team.
One of the first things Johnson did after arriving at the firm was to meet with
Corey Tao, CFA, the firm’s chief compliance officer. Tao had been with the firm only
a few months. He told Johnson the previous violations had primarily related to equity
research, equity trading, and client confidentiality. After reviewing the summary of
violations and the firm’s existing handbook, Johnson and Tao decided to submit the
following recommendations regarding the firm’s trade allocation procedures for block
trades to the board of directors for approval:
Recommendation 1: All accounts participating in a block trade should receive
the same execution price and pay the same commission rate.
Recommendation 2: Orders will be executed on a first-in, first-out basis, with
consideration given to bundling orders for efficiency.
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2 2020 Level II Mock Exam (A) AM
During the meeting Tao also mentioned to Johnson that the company handbook
fails to address an area where he has some concerns and suggested the following policy
addition, breaking it down into three points:
Point 1: Traders are prohibited from engaging in communication with brokers
or dealers that would artificially cause a stock’s price to rise or fall.
Point 2: Research analysts are not allowed to communicate unrealistic expecta-
tions regarding a company’s results that may affect the market price of a stock.
Point 3: Portfolio managers are not allowed to enter into an agreement to pro-
mote the stock of any publicly listed company.
Several days after their meeting, Tao brings to Johnson’s attention the details
of a phone call he received. He explained that a very upset client called to lodge a
complaint. The client had received a promotional letter in the mail from a company
called SedgeFin offering a variety of financial services. Tao explained to the client the
firm was unaware of the letter and that SedgeFin was a new subsidiary of Sedgwick
Investment Management’s parent company. After some checking, Tao learned the letter
targeted Sedgwick’s clients, both domestic and international. Tao reassured the client
that his only contract was with Sedgwick and absolutely no investment information
had been provided to SedgeFin.
Tao later received a call from a news reporter who requested an interview. Tao is
one of several people at the firm authorized to speak with the press. The reporter was
interested in writing a piece about Johnson and the circumstances behind her joining
the firm. They scheduled a time for the call and Tao forwarded to the reporter a copy
of the board’s press release. Prior to the interview, Johnson told Tao to address the
reporter’s questions truthfully but not to provide any details. When asked during the
interview about the firm’s history of unethical behavior, Tao responded, “One of Ms.
Johnson’s first acts was to strengthen the firm’s Code of Ethics, and although there
had been a few prior incidences of questionable conduct, they were exaggerated in
the press and happen in most investment firms.”
Shortly after the press interview, Johnson stopped by Tao’s office to notify him
she would be unavailable over the next several days. She explained that for the last
several years she has taught the ethics portions of the CFA Program exam, at all
three levels, for an exam prep course offered by the local society. She told him she
had always enjoyed teaching and is nicely compensated for this work but typically
donates her pay to CFA Institute Research Foundation. She planned to donate her
compensation again this year. This is the first time Tao has heard about her teaching,
and he commented, “You realize you might be in violation of the Standard IV(B):
Additional Compensation Arrangements.”
1 Which statement in Sedgwick’s hiring announcement is most likely an incor-
rect reference to the CFA Program or the CFA designation? The statement
referencing:
A the skills the program cultivates.
B the demands of the study program for the CFA designation.
C her ability to manage investments and guide the process.
C is correct. The statement referencing Ms. Johnson’s ability to manage investments

and guide the process is an incorrect reference to the CFA designation. The statement
that Ms. Johnson, as a CFA charterholder, “has superior qualities to manage our clients’
investments and guide the investment process” is an incorrect reference as outlined by
Standard VII(B): References to CFA Institute, the CFA Designation, and the CFA Program.
2020 Level II Mock Exam (A) AM 3
Those with the CFA designation are encouraged to use it only in a manner that does not
misrepresent or exaggerate its meaning or implications. Claims of superiority would be
considered an exaggeration.
A and B are incorrect. Neither the statement “She has demonstrated the ability to
successfully complete a rigorous and comprehensive study program demanded by the
CFA designation” nor the statement “The credibility her charter affords and the skills
the program cultivates are key assets Ms. Johnson brings to Sedgwick” are incorrect
references to the CFA Program or the CFA designation.
Guidance for Standards I-VII
2 Are the recommendations submitted to the board of directors most likely con-
sistent with the CFA Institute Recommended Procedures for Compliance with
Standard III(B): Fair Dealing?
A Yes
B No with regard to Recommendation 1
C No with regard to Recommendation 2
A is correct. Recommendation 1, “All accounts participating in a block trade should receive

the same execution price and pay the same commission rate,” and Recommendation 2,
“Orders will be executed on a first-in, first-out basis, with consideration given to bundling
orders for efficiency,” are consistent with the CFA Institute Recommended Procedures
for Compliance with Standard III(B): Fair Dealing. This standard states, “Members and
Candidates must deal fairly and objectively with all clients when providing investment
analysis, making investment recommendations, taking investment action, or engaging
in other professional activities.”
B and C are incorrect.
3 When considering the three points of Tao’s new policy as a whole, which CFA
Institute Standard of Professional Conduct is he most likely addressing?
A Standard VI: Conflict of Interest
B Standard II: Integrity of Capital Markets
C Standard V: Investment Analysis, Recommendations, and Actions
B is correct. When considering all three of Tao’s policy suggestions as a whole, he is

addressing CFA Institute Standard II: Integrity of Capital Markets. Specifically, Standard II(B):
Market Manipulation requires members and candidates not to engage in practices that
artificially inflate trading volume or distort prices and not to enter into an agreement to
promote a stock with the intent to mislead market participants.
A and C are incorrect. When considering Tao’s policy suggestions as a whole, they
address neither Standard VI: Conflict of Interest nor Standard V: Investment Analysis,
Recommendations, and Actions.

4 Did a violation of the CFA Institute Standards of Professional Conduct most

likely occur as a result of the SedgeFin promotional letter?
A No
B Yes, with regard to Standard VI: Conflicts of Interest
C Yes, with regard to Standard IV: Duties to Employers
C is correct. Standard IV: Duties to Employers was violated; specifically, a violation of

Standard IV(C): Responsibilities of Supervisors occurred as a result of the SedgeFin pro-
motional letter. Standard IV(C) states, “Members and Candidates must make reasonable
efforts to ensure anyone subject to their supervision or authority complies with applicable
laws, rules, regulations, and the Code and Standards.” Confidential client information,
which includes a client’s mailing address, was released to a sister company, which is a
violation of CFA Standard III(E): Preservation of Confidentiality. Someone in a supervisory
position should have reviewed the information before it ever was forwarded to SedgeFin
to prevent the release of confidential client information. As a result, both Standard III(E)
and Standard IV(C) have been violated.
A is incorrect. “No” is incorrect; a violation of CFA Institute Standard IV: Duties to
Employers occurred as a result of the SedgeFin promotional letter. Specifically, a violation
of Standard IV(C): Responsibilities of Supervisors occurred as a result of the SedgeFin
promotional letter.
B is incorrect. The SedgeFin promotional letter has not resulted in a violation of
Standard VI: Conflicts of Interest, which states, “Members and Candidates must make
full and fair disclosure of all matters that could reasonably be expected to impair their
independence and objectivity or interfere with respective duties to their clients, pro-
spective clients, and employer.”
5 Who has most likely violated the CFA Institute Standards of Professional
Conduct regarding the newspaper interview?
A Tao
B Johnson
C Both Tao and Johnson
A is correct. Tao has violated Standard I(D): Misconduct, which states, “Members and
Candidates must not engage in any professional conduct involving dishonesty, fraud, or
deceit or commit any act that reflects adversely on their professional reputation, integ-
rity, or competence.” Tao’s comment downplayed the prior unethical incidents, which
alone may not be a violation, because we do not have enough information about those
incidents. However, his statement that unethical violations “happen in most investment
firms” is untrue and is a clear violation. Employees of most investment firms are not guilty
of committing unethical behavior, nor is he in a position to know such information. His
comment to the reporter reflects adversely on his professional reputation, integrity,
and competence.
B is incorrect. Johnson’s comments regarding the newspaper interview have not vio-
lated any CFA Institute Standards of Professional Conduct. Johnson has simply instructed
Tao to tell the truth but not to provide any details. By instructing him to not provide any
details, she is fulfilling her responsibility as Tao’s supervisor to prevent any violation of
Standard III(E): Preservation of Confidentiality.
C is incorrect. Although Tao has violated Standard I(D): Misconduct, Johnson’s com-
ments regarding the newspaper interview did not violate any of the CFA Institute
Standards of Professional Conduct.
6 In addition to being in violation of Standard IV(B): Additional Compensation

Arrangements, which other CFA Institute Standards of Professional Conduct
has Johnson most likely violated?
A Standard IV(A): Loyalty
B Standard III(A): Loyalty, Prudence, and Care
C Both Standard IV(A): Loyalty and Standard III(A): Loyalty, Prudence, and
Care
C is correct. In addition to being in violation of Standard IV(B): Additional Compensation

Arrangements, Johnson is also most likely in violation of both Standard IV(A): Loyalty
and Standard III(A): Loyalty, Prudence, and Care. Standard IV(A): Loyalty states, “In mat-
ters related to their employment, Members and Candidates must act for the benefit
of their employer and not deprive their employer of the advantage of their skills and
abilities, divulge confidential information, or otherwise cause harm to their employer.”
Since Johnson will be out of the office and unavailable, she will need to make appro-
priate arrangements to ensure the interests of the firm are addressed while she is away.
Standard III(A): Loyalty, Prudence, and Care states, “Members and Candidates have a duty
of loyalty to their clients and must act with reasonable care and exercise prudent judge-
ment. Members and Candidates must act for the benefit of their clients and place their
clients’ interests before their employer’s or their own interest.” Johnson will also need
to make sure arrangements are made to address the needs of the firm’s clients because
she will be unavailable and unable to address their needs directly. A potential violation
of Standard VI(A): Disclosure of Conflicts also occurred: Johnson needs to disclose her
teaching position as well as the compensation she receives to prevent any violation.
A and B are incorrect.

QUESTIONS 7–10
Carlos Martin, a recent graduate of the financial engineering program at a well-known
university, has just been hired by Jubilación S.L., a Madrid-based firm that specializes
in retirement planning. He has been asked to develop a machine learning (ML) tool
to help assign each client to one of the firm’s five strategic investment portfolios.
To build the training set with 50 defined features, 300 randomly selected working-
age clients will be asked a set of open-ended questions by Lucia Fernandez, a market
researcher. The resulting answers will include demographic data, information about
risk preferences, and other retirement details. A Jubilación analyst will assign each
individual in the sample to one of the five portfolios. Martin initially plans to perform
machine learning analysis and use the model to assign new clients to the appropriate
portfolio based on their responses to the questions.
Fernandez brings a sample set of responses back to Martin for further discussion.
She tells him that in the interview sessions, many of the responses she has obtained
are complex and subjective. For example, most individuals she interviews are not
clear about the concept of risk tolerance and provide comparisons or abstract con-
cepts rather than specific numbers or levels. In some cases, their fear of loss seems
to increase at an increasing rate when some scenarios are presented. Martin decides
he will have to review these risk tolerance responses and use a model that groups
them into risk categories.
Fernandez delivers the completed set of interview data to Martin. After some
preliminary analysis, Martin decides that he is ready to develop the algorithm the
chatbot will use to advise clients as to which of its five strategic investment portfolios
is best for meeting their retirement goals. Martin notes that the final dataset has 50
features, and he is concerned that some of them are likely to be correlated, which
may lead to model misstatement. He considers three methods to address this issue:
1 Combine variables using the ensemble model.
2 Use the bootstrap aggregating (bagging) method.
3 Employ principal components analysis.
7 Martin’s initial planned machine learning analysis is best described as a form of:
A categorical learning.
B supervised learning.
C unsupervised learning.
B is correct. Martin initially plans to use ML to develop a model that assigns new clients
to the appropriate portfolio based on their responses to the questions. The analysis is a
form of supervised learning. Like regression, supervised learning involves ML algorithms
that infer patterns between a set of inputs (the X’s, in this case the individual interview
question responses) and the desired output (Y, the target ending portfolio value). The
inferred pattern is then used to map a given input set into a predicted output.
A is incorrect. Categorical learning is a means to classify variables, not a method of
machine learning.
C is incorrect. Unsupervised learning has no target output. Rather, the machine simply
analyzes the structure of the data and seeks patterns within it.
Machine Learning
8 If Martin were to use a k-nearest neighbor model, the value for k would be clos-
est to:
A 5.
B 50.
C 300.
A is correct. Martin wants to classify clients into five different clusters (five strategic invest-
ment portfolios), according to the retirement portfolio that is most suitable for their needs.
B is incorrect. 50 is the number of features in the dataset for each interview conducted.
These features will be used in the classification process to determine which portfolio
is most suitable.
C is incorrect. 300 is the number of interviews conducted, not the number of clusters
into which these 300 observations will be sorted.
Machine Learning
9 The most appropriate model for Martin to use in analyzing the responses to the
risk tolerance questions is a:
A neural network (NN) model.
B support vector machine (SVM) model.
C least absolute shrinkage and selection operator (LASSO) model.
A is correct. The responses to the risk tolerance questions, while labeled data used in a
classification analysis, appear to be non-linear. Thus, an NN model would be the most
appropriate choice.
B is incorrect. SVM models are best used for linear data.
C is incorrect. LASSO models are used for linear data and are typically used for regres-
sion analysis, not for clustering analysis. Assigning a new client to an existing selection
of portfolios is a type of clustering.
Machine Learning
10 Which of the methods Martin considers to address potential feature correlation

is the most suitable?
A Method 1
B Method 2
C Method 3
C is correct. Method 3 is principal components analysis (PCA). In a dataset with many

correlated features, as Martin has, PCA could be used. PCA reduces the number of vari-
ables needed to explain the variation in the data.
A is incorrect. Method 1 is the ensemble method. This method combines the predic-
tions from multiple models; it does not combine features.
B is incorrect. Method 2 is the bagging method. This method increases the number
of datasets by sampling randomly from the original dataset. It does not change the
number of features.
Machine Learning

QUESTIONS 11–16
Charles Hollingsworth is an investment strategist at Drawbridge Asset Partners
(Drawbridge), an international investment firm. He is meeting with equity analyst
Andrew Gillibrand and fixed-income analyst Eliana Navarro to discuss new invest-
ment opportunities and the economic factors they should consider as they make their
investment selections.
Hollingsworth begins the meeting with the following statement:
“Before we look at new investment opportunities, I want to review some
prior transactions. A few months ago, Drawbridge entered into a carry trade
in a set of currencies. This morning, we were unfortunately forced to close
out the position at a sizable loss as a result of unexpected market volatility.”
Hollingsworth continues:
“Earlier in the year, Drawbridge hedged a long exposure to the Australian
dollar (AUD) by selling AUD 5 million forward against the US dollar (USD);
the all-in forward price was 0.8940 (USD/AUD). It is now three months prior
to the settlement date, and I want to mark the forward position to market.”
Exhibit 1 provides information about current rates in the foreign exchange markets.
Exhibit 1 Current Foreign Exchange Data

Spot rate (USD/AUD) 0.9062/0.9066
Three-month points –36.8/–36.4
Three-month Libor (AUD) 2.88%
Three-month Libor (USD) 0.23%
On completion of the agenda items relating to the foreign exchange markets,

Hollingsworth and his team move on to new investment opportunities. They begin
with a discussion about the relationship between economic growth and the perfor-
mance of equity and debt markets.
Gillibrand: “When we consider our equity investments over the long term, our
primary focus should be on the rate of GDP growth. For longer time horizons,
changes in earnings and the price/earnings multiple are relatively less important
in determining appreciation in the stock market.”
Navarro: “When we look at our fixed-income investments, we should keep in
mind that higher rates of potential GDP growth will translate into higher real
interest rates and higher expected real asset returns.”
Hollingsworth: “Anticipating changes in potential GDP can be quite lucrative
for us because credit rating agencies often use the growth of potential GDP as
an input in evaluating sovereign risk. In general, there is an inverse relationship
between estimated potential GDP growth and credit quality.”
The economic growth projections for two of the countries in which Drawbridge is
considering making new investments are presented in Exhibit 2. Hollingsworth prefers
the Solow growth accounting equation to calculate potential GDP growth rather than
the more simplistic labor productivity growth accounting equation.
Exhibit 2 Long-Term Growth Projections

Growth in
Total Factor Output
Inflation Productivity Elasticity Growth Rate Growth Rate
Country Rate (%) (%) of Capital of Capital (%) of Labor (%)
Country A 1.7 1.5 0.3 3.2 0.4

Country B 1.8 1.3 0.4 3.7 0.5
The conversation then turns to the topic of convergence. Navarro says: “Even
though Country B’s per capita growth is expected to exceed that of Country A for
some time, according to the neoclassical model, eventually both countries will expe-
rience the same growth rate because the model assumes all countries have access to
the same technology.”
Hollingsworth presents the long-term relative performance of Countries C and
D, shown in Exhibit 3. Although both countries had below-average levels of per cap-
ita GDP 50 years ago, over time, the per capita GDP growth rate of Country C has
risen rapidly and for nearly 20 years has been well above average. The growth rate
for Country D, however, has risen more slowly. Today, Country C ranks among the
advanced economies whereas Country D remains a developing nation.
Exhibit 3 Real Per Capita GDP Growth

GDP/Capita 50 GDP Growth Rate
Country Years Ago GDP/Capita Today over Past 50 Years
Country C 6,950 35,190 3.30%

Country D 8,240 20,410 1.83%
11 The primary factor that was most likely the cause of Drawbridge's outcome in its
carry trade was:
A stop-loss orders.
B flight to safety.
C leverage.
C is correct. The primary reason for crash risks is related to the fact that carry trades are
leveraged: The low-yield currency is borrowed, with proceeds invested in the high-yield
currency. The leverage magnifies the effect of losses and gains relative to the investors’
equity base. In low-volatility markets, investors can become complacent and allow
positions to grow large in a search for yield. This crowded positioning tends to unwind
rapidly when a market shock occurs because many traders try to exit their positions
almost simultaneously before the leverage effects wipe out their equity. Stop-loss orders
are triggered, and given the market uncertainty, there is a flight to safety that further
increases demand for the low-yield currency.
A is incorrect. Another factor that accelerates selling is that traders often have stop-loss
orders in place that are triggered when price declines reach a certain level. This can lead
to cascades of selling in which position liquidation begets further position liquidation.
B is incorrect. During periods of market turmoil, there is generally a flight to safety

into assets and currencies that seem to offer the most protection during times of uncer-
tainty—typically low interest rate currencies.
Currency Exchange Rates: Understanding Equilibrium Value
12 The mark-to-market value for Drawbridge’s forward position is closest to:

A –USD44,774.
B –USD44,800.
C –USD42,576.
A is correct.
1 Drawbridge sold AUD 5 million forward to the settlement date at an all-in
forward price of 0.8940 (USD/AUD).
2 To mark the position to market, Drawbridge offsets the forward transaction by
buying AUD 5 million three months forward to the settlement date.
3 For the offsetting forward contract, because the AUD is the base currency in
the USD/AUD quote, buying AUD forward means paying the offer for both the
spot rate and forward points.
I. The all-in three-month forward rate is calculated as 0.9066 – 0.00364 =
0.90296
II. This gives a net cash flow on settlement day of 5,000,000 × (0.8940 –
0.90296) = –USD44,800
(This is a cash outflow because Drawbridge sold the AUD forward and the AUD
appreciated against the USD).
4 To determine the mark-to-market value of the original forward position, cal-
culate the present value of the USD cash outflow using the three-month USD
discount rate: –USD44,8000/[1 + 0.0023(90/360)] = –USD44,774.
B is incorrect. The present value of the cash flow was not calculated (step 4 of
calculation).
C is incorrect. The cash flow was calculated using the bid rate instead of the offer rate.
1 The all-in three-month forward rate = 0.9062 – 0.00368 = 0.90252
2 This gives a net cash flow on settlement day of 5,000,000 × (0.8940 – 0.90252)
= –USD42,600, and the present value is calculated as –USD42,600/[1 +
0.0023(90/360)] = –USD42,576.
Currency Exchange Rates: Understanding Equilibrium Value
13 Which of the statements about economic growth and the performance of equity
and debt markets is the least accurate?
A Navarro’s
B Hollingsworth’s
C Gillibrand’s
B is correct. There is a direct relationship, not an indirect one, between estimated poten-
tial GDP growth and credit quality: Higher growth leads to higher quality—that is, an
improvement in the likelihood of promised cash flows occurring.
C is incorrect:. Gillibrand’s statement is accurate. In the long run, the growth rate of
GDP dominates. The ratio of earnings to GDP can neither rise nor decline forever, so over
the long term it must approximate zero. Similarly, the P/E ratio cannot grow or contract
forever, so over the long term it must also approximate zero. Thus, the drivers of potential
GDP are ultimately the drivers of stock market performance.
A is incorrect. Navarro’s statement is accurate. The growth rate of potential GDP is an
important determinant of the level of real interest rates, and thus real asset returns in
general, in the economy. Faster growth in potential GDP means consumers expect their
real income to rise more rapidly. Thus, higher rates of potential GDP growth translate
into higher real interest rates and higher expected real asset returns in general.
Economic Growth and the Investment Decision
14 Based on the data in Exhibit 2, the GDP growth rate in Country A using
Hollingsworth’s preferred method of calculation is closest to:
A 2.74%.
B 2.94%.
C 2.86%.
A is correct. Hollingsworth;s preferred method of calculating the GDP growth rate is

the Solow growth accounting equation, and the rate is calculated as follows:
ΔY/Y = ΔA/A + α(ΔK/K) + (1 – α)(ΔL/L)
where
ΔY/Y = Growth in gross domestic product, GDP

ΔA/A = Growth in total factor productivity = 1/5%
ΔK/K = Growth rate of capital = 3.2%
ΔL/L = Growth rate of labor = 0.4%
α = Output elasticity of capital = 0.3
1 – α = Output elasticity of labor = 0.7
Thus, ΔY/Y = 1.5 + (0.3 × 3.2) + (0.7 × 0.4) = 1.5 + 0.96 + 0.28 = 2.74
C is incorrect. The calculation did not apply (1 – α).
ΔY/Y = 1.5 + (0.3 × 3.2) + 0.4 = 1.5 + 0.96 + 0.4 = 2.86
B is incorrect. The inflation rate was incorrectly used in place of TFP in the calculation.
ΔY/Y = 1.7 + (0.3 × 3.2) + (0.7 × 0.4) = 1.7 + 0.96 + 0.28 = 2.94
15 Navarro’s statement about the convergence of growth between Country A and

Country B is best described as:
A conditional convergence.
B club convergence.
C absolute convergence.
C is correct. Absolute convergence means that developing countries, regardless of their

characteristics, will eventually catch up with developed countries and match them in
per capita output. The neoclassical model assumes all countries have access to the same
technology and, as a result, per capita income in all countries should eventually grow
at the same rate.
A is incorrect. Conditional convergence means convergence is conditional on the
countries having the same saving rate, population growth rate, and production function.
If these conditions hold, the neoclassical model implies convergence to the same level
of per capita output as well as the same steady state growth rate.
B is incorrect. Club convergence is where only rich and middle-income countries that
are members of the club are converging to the income level of the richest countries in
the world. This means the countries with the lowest per capita income in the club grow
at the fastest rate. Countries outside the club continue to fall behind.
16 Country D’s current economic status can best be explained by past government
policies that encouraged:
A domestic substitutes.
B foreign investment.
C free trade.
A is correct. Policies that encourage the production of domestic substitutes are inward
oriented, attempting to develop domestic industries by restricting imports, despite the
fact that it may be more costly to do so. As a result, the country would not benefit from
the positive effects of integrating domestic industries with the global economy and
benefiting from trade and foreign investment.
B is incorrect. Foreign investment will potentially increase the developing economy’s
physical capital stock, leading to higher productivity, employment and wages, and pos-
sibly increased domestic savings.
C is incorrect. Encouraging free trade is an outward-oriented policy. This policy
attempts to integrate domestic industries with the global economy through trade and
make exports a key driver of growth.

QUESTIONS 17–20
Javier Casado, an analyst who manages funds for high-net-worth investors, is eval-
uating Bardem S.A. (Bardem) as a possible addition to a large investment portfolio.
Bardem, based in Madrid, Spain, is a manufacturing firm that specializes in packaging
materials. The company reports using IFRS, and its reporting currency is the Euro.
Casado learns that Bardem acquired a 25% stake in Ariana Shipping S.A. (Ariana)
on 1 January 2020. Ariana, which is based in Greece, has bought packaging supplies
from Bardem in the past based on catalog prices. Casado believes that the purchase
will change the relationship between the two companies and will also affect Bardem’s
financial reporting. He mentions to a coworker, Ana Domingues, that the price paid
by Bardem for the Ariana shares was €80 million.
Domingues tells Casado that Bardem’s purchase of Ariana’s equity will likely
allow Bardem to influence Ariana’s financial and operating performance. As a result,
she states, Bardem will be required to use the equity method of accounting for this
investment. Casado replies that the equity method of accounting is only required
under IFRS for joint ventures or when the investee holds a seat on the associate’s
board of directors.
Bardem prepares the following table to examine the purchase more closely.
Exhibit 1 Book Values and Fair Values of Ariana Shipping Assets and
Liabilities as of 31 December 2019 (€ millions)
Book Value Fair Value
Current assets 15 15
Plant and equipment 230 275
Land 100 115
345 405
Liabilities 110 110
Net assets 235 295
Domingues says that she is concerned that Bardem didn’t sufficiently investigate
Ariana before the purchase, given economic uncertainty surrounding Greek compa-
nies. She asks Casado what will happen to Bardem’s financial statements if the value of
Ariana is permanently impaired due to business losses or other demonstrable events.
Casado replies that if the equity method is not required, then there will be no impact.
However, if the equity method is used, he states:
1 Goodwill must be separately tested for impairment.
2 Impairment losses cannot be reversed even if fair value later increases.
3 Impairment losses exceeding the goodwill value are allocated pro-rata to the
unit’s non-cash assets.
Domingues informs Casado of a final piece of information relevant to his evalua-
tion. To increase liquidity, Bardem is considering borrowing €70M against accounts
receivable. As an alternative to borrowing, they could securitize the receivables by
creating a special purpose entity (SPE) over which they would exercise control. To do
so, they would invest €5M in the SPE. The SPE would then borrow €70M, and would
buy €75M in receivables from Bardem. Domingues comments that securitization using
an SPE would impact Bardem’s reported financial condition in three ways. It would:
1 reduce the cost of borrowing.
2 increase the level of current assets.
3 improve balance sheet ratios.
17 In the discussion about using the equity method to account for Bardem’s pur-
chase of Ariana, which statement is most accurate? The statement by:
A Domingues.
B Casado concerning joint ventures.
C Casado concerning board of directors’ positions.
A is correct. Domingues’ statement that Bardem will be required to use the equity method
is accurate. The equity method of accounting is required when an investor holds 20% to
50% of the voting rights of an associate unless circumstances clearly demonstrate that
the investor cannot exercise significant influence. Holding a seat on the board is a factor
to consider, but is not required to demonstrate influence.
B is incorrect. Although the equity method is required for joint ventures, it is also
required for investments in associates.
C is incorrect. Representation on the board is one way of exerting influence, but there
are other ways that influence can be evidenced.
Intercorporate Investments
18 If Bardem does use the equity method of accounting for its purchase of Ariana,
using Exhibit 1, the value of goodwill, in millions, arising from the purchase is
closest to:
A €6.25.
B €21.25.
C €15.00.
A is correct. Bardem’s purchase price for Ariana will include goodwill of €6.25 per the
calculation below. Under the equity method the goodwill is included in the investment
amount on Bardem’s balance sheet.
Cost of the acquisition (€ millions) 80.00

Less:
Fair value of net identifiable assets 295
Bardem’s share thereof 25%
295 × 25% 73.75
Goodwill 6.25
B is incorrect. This is the value if they use the BV of Ariana’s net assets: 80 – (0.25 ×
235) = 21.25.
C is incorrect. It uses the amount attributable to increase of fair value over book value
of net assets, multiplied by proportionate share: (295,000 – 235,000) × 0.25 = 60,000 ×
0.25 = €15,000.
19 Which of Casado’s three statements regarding the potential impairment of the

investment in Ariana is most accurate? Statement:
A 2
B 1
C 3
A is correct. Both IFRS and US GAAP prohibit the reversal of impairment losses recog-
nized using the equity method, even if the fair value later increases. Under the equity
method goodwill is included in the value of the investment and is not tested separately.
Impairment losses exceeding goodwill are allocated pro-rata to the unit’s non-cash
assets when the investor has control over the investee, not under the equity method.
B is incorrect. IFRS includes goodwill in the carrying value of the investment, so it is
not separately tested for impairment.
C is incorrect. Impairment losses exceeding goodwill are allocated pro-rata to the
unit’s non-cash assets.
20 If Bardem creates a special purpose entity rather than borrowing against its
receivables, which of Domingues’ comments is most accurate? Comment:
A 1
B 2
C 3
A is correct. Bardem’s cost of borrowing through the SPE is likely to decrease, because
the SPE is bankruptcy remote from Bardem, and the lenders will have a direct claim on
the receivables, thus allowing the SPE to borrow at preferred rates.
B is incorrect. Bardem’s accounts receivable will decrease by €75M, while its cash will
increase by €70M (€75M cash from the sale of receivables less €5M to set up the SPE).
After consolidation, those changes are reversed and the consolidated balance sheet will
be identical to the balance sheet under receivables borrowing.
C is incorrect because both IFRS and US GAAP will require the SPE to be consolidated
into Bardem’s balance sheet. The result is that the consolidated balance sheet will be
identical to the balance sheet under receivables borrowing, and there will be no change
in the ratios.

QUESTIONS 21–24
Cindy Scott is reviewing cash flow projections for a $300,000 capital investment for
adaptable equipment to service her company’s manufacturing efforts. After careful
study, analysts have determined that when put to the best use over the next five years,
the incremental contribution of the equipment produces a positive net present value
(NPV) of $183,109, assuming a 15% annual discount rate (see Exhibit 1).
Exhibit 1 Forecasted Cash Flow

(all values in $) Year 1 Year 2 Year 3 Year 4 Year 5
Sales 370,000 425,500 510,600 663,780 531,024

Variable cash expenses 185,000 212,750 255,300 331,890 265,512
Fixed cash expenses 30,000 50,000 50,000 50,000 50,000
Depreciation* 60,000 60,000 60,000 60,000 60,000
Operating income before 95,000 102,750 145,300 221,890 155,512
tax
Tax (40%) 38,000 41,100 58,120 88,756 62,205
Operating income after 57,000 61,650 87,180 133,134 93,307
tax
After-tax operating cash 117,000 121,650 147,180 193,134 153,307
flow
Salvage value 20,000
Salvage value after tax 12,000
Total after-tax cash flow 117,000 121,650 147,180 193,134 165,307
* Straight-line over five years

NPV (15% annual discount rate): $183,109
Scott receives a request from her manager, Pat Stevens, to calculate accounting
income using the cash flow analysis in Exhibit 1. Scott learns that the equipment is
to be financed entirely with a loan at 12%, with interest paid annually for five years
and the full principal paid at the end of the fifth year.
Scott asks Ted Ludlow, another coworker, for additional suggestions about the
analysis. Ludlow makes the following two suggestions:
■■ Consider the analysis in Exhibit 1 as a base case and then produce two addi-
tional analyses, an optimistic and a pessimistic case, assuming different possible
economic environments.
■■ Calculate operating income after tax minus the dollar cost of capital (i.e., the
weighted average cost of capital (WACC) multiplied by the capital investment).
While applying the suggestions from Ludlow, Scott is informed about a competing
project that performs the same task over a three-year period. The new project has an
NPV of $128,146 with the same discount rate and capital investment as the project
in Exhibit 1 (five-year project). Scott starts to consider the merits of the new project
(three-year project) relative to the five-year project.
21 The accounting income for Year 2 is closest to:
A $25,650.
B $61,650.
C $40,050.
C is correct.
Operating income before tax – Interest = Taxable income
$102,750 – ($300,000 × 0.12) = $66,750
Accounting income or net income = Taxable income × (1 – Tax rate)
$66,750 × (1 – 0.40) = $40,050

A is incorrect. It is the operating income after tax (from Exhibit 1) less the interest
expense: 61,650 – (300,000 × 12%) = 25,650
B is incorrect. It is the operating income after tax (from Exhibit 1): 102,750 × (1 – 0.40)
= 61,650.
Capital Budgeting
22 Ludlow’s first suggestion to Scott is best described as an example of:

A sensitivity analysis.
B scenario analysis.
C Monte Carlo simulation.
B is correct. Ludlow’s suggestion of considering alternate economic environments is an

example of scenario analysis.
A is incorrect. Ludlow’s suggestion is an example of scenario analysis.
C is incorrect. Ludlow’s suggestion is an example of scenario analysis.
Capital Budgeting
23 Ludlow’s second suggestion is best described as the calculation of:

A free cash flow to equity.
B residual income.
C economic profit.
C is correct. Ludlow’s suggestion is an example of economic profit: EBIT × (1 – tax rate)

– $WACC. EBIT is earnings before interest and taxes.
A is incorrect because Ludlow’s suggestion is an example of economic profit.
B is incorrect because Ludlow’s suggestion is an example of economic profit.
Capital Budgeting
24 When comparing the two competing projects, Scott should most likely accept:
A only the five-year project.
B both projects.
C only the three-year project.
C is correct. The competing projects are mutually exclusive, which means that only one of
the two positive NPV projects can be accepted. The choice of which project to accept is
based on choosing the project with either (1) the highest equivalent annual annuity (EAA)
or (2) the highest value based on the least common multiple of lives (LCML) approach.
The three-year project should be chosen using either approach, as shown.
EAA for three-year project:

NPV × Present value annuity factor (three years at 15%) =
1  1 
EAA × 1 − 
0.15  (1 + 0.15)3 
 
EAA = 128,146/2.2832 = 56,126
EAA for five-year project:
NPV × Present value annuity factor (five years at 15%) =
1  1 
EAA × 1 − 
5
0.15  (1 + 0.15) 
 
EAA = 183,109/3.3522 = 54,624
The three-year project is preferred because it has a higher EAA.
Least common multiple lives: The least common multiple, given 3 and 5, is 15. Compare
the NPV of each project, assuming each project is repeated for 15 years.
NPV (three-year project, 15 years) =
128,146 128,146 128,146 128,146
128,146 + + + + = 328,183.62
3 6 9
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)12
NPV (five-year project, 15 years):
183,109 183,109
183,109 + + = 319, 408
5
(1 + 0.15) (1 + 0.15)10
The three-year project is preferred because the NPV over 15 years is higher.
A is incorrect. Based on both methods (EAA and LCML), the three-year project should
be accepted.
B is incorrect. Based on both methods (EAA and LCML), the three-year project should
be accepted.
Capital Budgeting

QUESTIONS 25–30
Louisiana High Growth Investors (LHGI), a large hedge fund in New Orleans, Louisiana,
is considering the purchase of Black Tiger Prawns Inc. (BTP), a publicly traded com-
pany headquartered in the same city, for $500 million. BTP’s revenues and earnings
are cyclical, from both seasonal and business cycle effects. It is a small-cap firm, and
its stock trades thinly in the OTC market.
As a part of the analysis, Jose Rivera, equity analyst at LHGI, compiles the data
presented in Exhibit 1, Panel A, and estimates the forward-looking equity risk premium
using the Gordon growth model (GGM). Rivera adds 1.50% to the risk premium he has
computed to account for the additional small firm risk premium associated with BTP.
Rivera shows his computations to Kamini Royappa, chief investment officer.
Royappa suggests that the macroeconomic model with supply-side analysis using the
Ibbotson–Chen format provides a better estimate for BTP’s risk premium. She also
suggests that BTP commands a 0.75% risk premium for its thin trading in addition to
the small firm risk premium that Rivera has already considered. Following the sug-
gestions by Royappa, Rivera collects additional data presented in Exhibit 1, Panel B.
Exhibit 1 Data for Forward-Looking Risk Premium Estimates

Panel A: Data for the GGM
Current price level of the market index 1,480.00

Current year’s dividend on the market index $31.25
Year-ahead forecasted dividend on the market index $33.60
Long-term earnings growth rate for the market index 6.00%
Current long-term government bond yield 4.00%
Current short-term government bond yield 2.75%
Panel B: Data for the macroeconomic model using the Ibbotson–Chen format
Expected growth rate in real earnings per share 3.00%

Expected growth rate in P/E 1.50%
Expected income component 2.50%
Expected TIPS yield 2.15%
Expected inflation 1.81%
TIPS = Treasury Inflation-Protected Securities
Furthermore, Royappa says, “In addition to the forward-looking estimates of the

equity risk premium for BTP, you should also compute historical estimates of the risk
premium for the stock. But note the following three caveats as you undertake com-
putations, especially when using the capital asset pricing model (CAPM) approach:
1 Compared with the geometric mean return, the arithmetic mean return is con-
sistent with the assumptions of single period models, such as the CAPM.
2 In almost all cases, the equity risk premiums based on long-term government
bonds tend to be smaller than those based on short-term government bonds.
3 Make sure to adjust the risk premium upward if the market index has experi-
enced survivorship bias as a result of removing poorly performing companies.”
Next, Rivera presents his assessment of a risk premium for BTP to the investment
committee and asks for the committee’s advice regarding approaches to valuing BTP.
Katrina Smirnoff, portfolio manager, prefers to use two multiples-based approaches:
the justified price-to-book ratio (P/B) and the ratio of enterprise value to earnings
before interest, taxes, depreciation, and amortization (EV/EBITDA). Furthermore, she
makes the following three statements regarding different relative valuation approaches:
1 In assessing BTP’s trailing P/E, be sure to adjust for its counter-c yclical property
called the Molodovsky effect.
2 The P/E-to-growth (PEG) measure is better than P/E because it correctly
accounts for differences in risk and the duration of growth between BTP and its
peers.
3 Note that BTP’s return on equity (ROE) is much higher than its peers.
Therefore, on the basis of justified P/B, BTP will appear overvalued relative to
its peers with the same P/B.
Additionally, Smirnoff suggests that Rivera should adjust BTP’s multiples to reflect
a 25% discount for additional risks because of its small size and thin trading. Rivera
agrees with Smirnoff and collects the data needed, which are shown in Exhibit 2.
Exhibit 2 BTP’s Selected Financial Data ($ millions)

Net income 20
Interest 5
Taxes 10
Depreciation 80
Amortization 15
Earnings growth rate 5.50%
Book value of equity 100
Market value of equity 250
Long-term debt 150
Cash 50
Required return on stock 11.00%
Weighted average cost of capital 9.00%
25 Using Exhibit 1 and Rivera’s adjustment, the risk premium for BTP stock
according to the Gordon growth model is closest to:
A 5.77%.
B 5.61%.
C 7.02%.
A is correct. First compute the GGM equity risk premium and then add Rivera’s adjustment
for small firm risk premium. Computations are as follows:
GGM equity risk premium estimate = Dividend yield on the index based
on year-ahead aggregate forecasted
dividends and aggregate market
value + Consensus long-term earn-
ings growth rate – Current long-
term government bond yield
Dividend yield: 33.60/1,480 = 2.27%

Plus: Consensus long-term earnings growth rate 6.00%
Minus: Current long-term government bond yield –4.00%
Equals: Equity risk premium per GGM 4.27%
Plus: Rivera’s adjustment for small firm risk premium 1.50%
Equals: GGM equity risk premium including Rivera’s adjustment 5.77%
B is incorrect. The mistake is in the computation of dividend yield: using the current
year’s dividend, as opposed to the use of year ahead forecasted dividend.
Dividend yield (based on current dividend): 31.25/1,480 = 2.11%

Plus: Consensus long-term earnings growth rate 6.00%
Minus: Current long-term government bond yield –4.00%
Equals: Equity risk premium (incorrect) 4.11%
Plus: 1.50% small firm risk premium 5.61%
C is incorrect. It uses short-term government bond yield instead of long-term gov-

ernment bond yield:
2.27 + 6.00 – 2.75 + 1.50 = 7.02%
Return Concepts
26 Using the appropriate data in Exhibit 1 for the macroeconomic model and the
adjustments considered by Rivera and Royappa, the risk premium for BTP stock
is closest to:
A 5.62%.
B 7.54%.
C 7.19%.
C is correct. First, compute the equity risk premium according to the macroeconomic
model with four components. Next, add the small firm and thin trading risk premiums.
Equity risk premium according to the macroeconomic model:
[(1 + EINFL)(1 + EGREPS)(1 + EGPE) – 1] + EINC – Expected risk-free rate
where
EINFL= expected inflation

EGREPS = expected growth in real earnings per share
EGPE = expected growth in P/E
EINC = expected income component
Equity risk premium: [(1.0181)(1.03)(1.015) – 1] + 0.025 – 0.04 4.94%

Plus: Risk premiums for small firm and thin trading: 1.50% + 0.75% 2.25%
Equals: Risk premium for BTP including premiums for small firm 7.19%
and thin trading
A is incorrect. It ignores the expected growth rate in P/E ratio.
Equity risk premium: [(1.0181)(1.03) – 1] + 0.025 – 0.04 3.37%

Plus: Risk premia for small firm and thin trading: 1.50% + 0.75% 2.25%
= Risk premium for BTP including premia for small firm and thin 5.62%
trading
B is incorrect; it mistakenly uses TIPs yield for expected inflation

Equity risk premium: {[(1.0215)(1.03)(1.015) – 1] + 0.025} – 0.04 5.29%

Plus: Risk premia for small firm and thin trading: 1.50% + 0.75% 2.25%
= Risk premium for BTP including premia for small firm and thin 7.54%
trading
Return Concepts
27 Which of the three caveats regarding the historical estimates of risk premium
that Royappa has stated is least accurate?
A Caveat 2
B Caveat 1
C Caveat 3
C is correct. Caveat 3, the caveat concerning survivorship bias, is the least accurate.
Survivorship bias in equity market data series arises when poorly performing or defunct
companies are removed from membership in an index, so only relative winners remain.
Survivorship bias tends to inflate historical estimates of the equity risk premium. When
using a series that has such bias, however, the historical risk premium estimate should
be adjusted downward.
A is incorrect because it is an accurate statement. A bond-based equity risk premium
estimate in almost all cases is smaller than a bill-based estimate.
B is incorrect because it is an accurate statement. The arithmetic mean return as the
average one-period return best represents the mean return in a single period. The major
finance models for estimating required return—in particular the CAPM and multifactor
models—are single-period models, so the arithmetic mean, with its focus on single-
period returns, appears to be a model-consistent choice.
Return Concepts
28 Which of the three statements regarding relative valuation approaches that

Smirnoff has stated is most accurate? Her statement concerning the:
A justified P/B.
B P/E.
C PEG measure.
B is correct. BTP is a cyclical company. Empirically, P/Es for cyclical companies are often
highly volatile over a cycle even without any change in business prospects. High P/Es on
depressed earnings per share (EPS) at the bottom of the cycle and low P/Es on unusually
high EPS at the top of the cycle reflect the countercyclical property of P/Es known as
the Molodovsky effect.
A is incorrect. The justified P/B computed suggests that if we are evaluating two stocks
with the same P/B, the one with the higher ROE is relatively undervalued, all else equal.
These relationships have been confirmed through cross-sectional regression analyses.
C is incorrect. PEG does not factor in differences in risk, an important determinant of

P/E. PEG does not account for differences in the duration of growth.
Market-Based Valuation: Price and Enterprise Value Multiples
29 Using the data in Exhibit 2 and the adjustment suggested by Smirnoff, BTP’s
justified P/B is closest to:
A 1.98.
B 3.11.
C 3.30.
A is correct.
ROE = Net income/Book value of equity = 20/100 = 20.0%
Justified P/B = P0/B0 = (ROE – g)/(r – g) = (0.20 – 0.055)/(0.11 – 0.055) =
2.64
Adjustment per Smirnoff ’s suggestion: 2.64 × (1 – 0.25) = 1.98
B is incorrect. it uses WACC for r rather than the required return on stock.
P/B = (ROE – g)/(r – g) = (0.20 – 0.055)/(0.09 – 0.055) = 4.14
Adjustment per Smirnoff 's suggestion: 4.14 × (1 – 0.25) = 3.11
C is incorrect. It makes an incorrect adjustment for Smirnoff’s suggested discount.
Adjustment per Smirnoff 's suggestion: 2.64 × (1 + 0.25) = 3.30
30 Using the data in Exhibit 2 and the adjustment suggested by Smirnoff, BTP’s
EV/EBITDA multiple is closest to:
A 3.36.
B 2.31.
C 2.02.
C is correct.
EV = Market value of equity + Debt – Cash = 250 + 150 – 50 = 350
EBITDA= Net Income + Interest + Taxes + Depreciation + Amortization =
20 + 5 + 10 + 80 + 15 = 130
EV/EBITDA = 2.69
Adjustment per Smirnoff ’s suggestion: 2.69 × (1 – 0.25) = 2.02
A is incorrect. It incorrectly applies the 25% discount per Smirnoff’s suggestion.
Adjustment per Smirnoff ’s suggestion: 2.69 × (1 + 0.25) = 3.36
B is incorrect. It ignores cash.
EV = Market value of equity + Debt (ignores cash): 250 + 150 = 400
EBITDA= Net income + Interest + Taxes + Depreciation + Amortization =

130
EV/EBITDA = 3.08
Adjustment per Smirnoff 's suggestion: 3.08 × (1 – 0.25) = 2.31

QUESTIONS 31–34
Gabrielle Marchand and Cristiano Palmeiro are junior analysts recently hired by
Nordfjord Investment Management, an international investment firm. They have been
assigned by senior analyst Anniken Kristensen to work as a team to research Darwin
Industrial (Darwin), a major company in the paints and coatings industry.
Marchand and Palmeiro start by researching the industry. They discuss how the
competitive environment could impact profitability and make the following notes:
■■ The industry is fragmented, and there is a strong rivalry for market share, par-
ticularly among the larger participants.
■■ Paints and coatings are the logical or only choice for many applications,
but alternatives, such as aluminum, vinyl, and wood, are available for some
situations.
■■ There is some brand loyalty, although it is not pervasive. The essentially identi-
cal product offerings from the various manufacturers enable customers to easily
switch brands.
In developing their sales and expense forecasts for 2016, Marchand and Palmeiro
review selected financial data on Darwin and selected economic factors, as shown in
Exhibit 1. Using 2015 as the base year, the analysts expect Darwin’s
■■ sales to grow 1% faster than projected nominal global GDP growth,
■■ cost of goods sold as a percent of sales to decline 0.5% annually,
■■ selling expenses to remain stable as a percentage of sales,
■■ general and administrative and depreciation and amortization expenses to be
fixed, and
■■ net debt to decline €100 million in 2016.
Exhibit 1 Darwin Industrial Selected Financial Data

2014 2015
(€ millions) (€ millions)
Income statement
Sales 8,838 9,280
Cost of goods sold (COGS) 5,183 5,401
Gross profit 3,655 3,879
Selling expenses 1,836 1,940
General and administrative expenses (G&A) 485 485
Exhibit 1 (Continued)
2014 2015
(€ millions) (€ millions)
Depreciation and amortization expenses (D&A) 294 294
Operating profit 1,040 1,160
Interest expense 96 92
Earnings before taxes (EBT) 944 1,068
Income taxes (30%) 283 320
Net profit 661 748
Average balance sheet items

Total assets 7,730
Net debt 1,533
Total liabilities 4,279
Total equity 3,451
Selected Economic Data

2016 global GDP growth rate 4.50%
Marchand and Palmeiro use a five-year forecast horizon when building their long-
term model for Darwin after considering the following factors:
Factor 1 Nordjford has historically experienced a 25% annual turnover in its
equity portfolio.
Factor 2 The paint and coatings industry’s performance is closely tied to the
business cycle.
Factor 3 Darwin recently announced a corporate restructuring, and the bene-
fits are expected to be fully realized by the end of 2017.
31 Based on Marchand and Palmeiro’s notes, the industry’s competitive strength is

most likely related to the:
A threat of substitutes.
B rivalry among the firms.
C bargaining power of buyers.
A is correct. Marchand and Palmeiro’s analysis indicates that although there are alternative
products available for some situations, paints and coatings are the logical or only choice
for many applications. Thus, the threat of substitutes would be considered low to medium,
which would improve the competitive position and profitability of firms in the industry.
B is incorrect. The industry is fragmented with no dominant market leader, and there
is a strong rivalry for market share, which limits pricing power. This would reduce com-
petitive strength and profit opportunities.
C is incorrect. Brand loyalty is not of great importance to customers. Many products

are basically identical, and switching costs for customers is low. This would reduce com-
petitive strength and profit opportunities.
Industry and Company Analysis
32 Marchand and Palmeiro’s modeling approach can be best described as:

A bottom-up.
B hybrid.
C top-down.
B is correct. The analysts base their sales forecasts on economic factors, including GDP
growth, which is a top-down approach. They also base their projections on an analysis
of the company’s historical sales and expense data, which is a bottom-up approach.
Thus, by using a combination of top-down and bottom-up approaches, Marchand and
Palmeiro are using a hybrid approach.
A is incorrect. The analysts base their sales forecasts on economic factors, including
GDP growth, which is a top-down approach. They also base their projections on an anal-
ysis of the company’s historical sales and expense data, which is a bottom-up approach.
C is incorrect. The analysts base their sales forecasts on economic factors, including
GDP growth, which is a top-down approach. They also base their projections on an anal-
ysis of the company’s historical sales and expense data, which is a bottom-up approach.
33 Based on the analysts’ sales and expense forecasts and the data in Exhibit 1,
their forecasted net profit for Darwin in 2016 will be closest to:
A €861 million.
B €853 million.
C €827 million.
A is correct.
2015 2016
(€ millions) 2016 vs. 2015 Calculation (€ millions)
Sales 9,280 GDP + 1% = 5.5% increase 9,280 × 1.055 9,791

COGS 5,401 Percentage of sales, expected [(5,401/9,280) – 0.005)] × 5,649
to decline 0.5% in 2016 9,790
Selling expenses 1,940 Stable percentage of sales (1,940/9,280) × 9,790 2,047
G&A expenses 485 No change 485
D&A expenses 294 No change 294
2015 2016
Interest expense 92 Rate on 2015 net debt 1,433 × 0.06 86
= 92/1,533 = 6%
Debt to decline by
€100 million
EBT 1,068 1,230
Income taxes 320 30% tax rate 1,230 × 0.3 369
Net profit 748 861
B is incorrect. The candidate incorrectly calculates interest expense as a percentage

of sales instead of debt.
2015 2016

COGS 5,401 % of sales, expected to [(5,401/9,280) – 0.005)] × 5,649
decline 0.5% in 2016 9,790
Selling expenses 1,940 Stable % of sales (1,940/9,280) × 9,790 2,047
Interest expense 92 Rate on 2015 net debt Cost of 2016 net debt 97
= 92/9,280 (sales) = 0.99% = 9,790 × 0.99% = 97
EBT 1,068 1,219
Net profit 748 853
C is incorrect. The candidate did not reduce the COGS by 0.5% in 2016.
2015 2016
(E millions) 2016 vs. 2015 Calculation (E millions)

COGS did not decline by
COGS 5,401 (5,401/9,280) × 9,790 5,698
0.5% as % of sales
Selling expenses 1,940 Stable % of sales (1,940/9,280) × 9,790 2,047
Rate on 2015 net debt
Interest expense 92 = 92/1,533 = 6% 1,433 × 0.06 86
Declines by 100
EBT 1,068 1,181
(continued)
2015 2016
(E millions) 2016 vs. 2015 Calculation (E millions)
Net profit 748 827
34 Which factor considered by Marchand and Palmeiro best justifies the use of the
five-year forecast horizon in the Darwin model?
A Factor 2
B Factor 1
C Factor 3
A is correct. Industry cyclicality can influence the analyst’s choice of timeframe because
the forecast period should be long enough to allow the business to reach an expected
mid-c ycle level of sales and profitability. Factor 2 best justifies the use of a five-year fore-
cast horizon given that the industry’s performance is closely tied to the business cycle.
B is incorrect. Nordjford’s 25% annual turnover would be more consistent with a
four-year forecast horizon.
C is incorrect. Given that the benefits of the corporate restructuring are expected to
be fully realized within two years, a five-year forecast horizon is more than sufficient to
see the impact in Darwin’s financial statements.

QUESTIONS 35–40
Lillian Krishnan is a fixed-income analyst at Pedu Advisors, an investment manage-
ment firm. In the past year, a number of corporations have issued putable bonds. She
is analyzing these bonds to determine if they are buy candidates for any of Pedu’s
client portfolios.
Krishnan knows the market perceives this asset class to be inefficient given that
bonds with embedded options are currently mispriced. To examine this issue, she has
gathered data on a group of comparable bonds that have the same market liquidity.
This information is found in Exhibit 1. Using only this information, Krishnan deter-
mines there must be a mispricing.
Exhibit 1 Bond Characteristics and Prices

Bond A Bond B Bond C
Remaining maturity 12 years, 4 months 12 years, 6 months 12 years, 1 month

Credit rating AA3 AA3 AA3
Coupon rate 7.00% 7.00% 7.00%
Exhibit 1 (Continued)
Bond A Bond B Bond C

Optionality option-free callable putable
Price 98.573 99.107 99.218
Pedu’s chief economist recently distributed an interest rate forecast that states that
interest rate volatility is expected to decrease, and the yield curve, which is currently
flat, is expected to become upward sloping. Krishnan considers the impact of these
expected changes on the values of the bonds in Exhibit 1.
Krishnan then analyzes Bond D, which pays an annual 3.20% coupon rate and
matures 3 years from now. The bond is putable at 98 one year and two years from now.
She assumes 15% interest rate volatility and, using yields on par bonds, constructs the
binomial interest rate tree found in Exhibit 2.
Exhibit 2 Binomial Interest Rate Tree

Year 0 Year 1 Year 2
6.21%
4.31%
2.11% 4.60%
3.19%
3.41%
Krishnan is evaluating a bond valuation model available from Klang Analytics. To

test the model, she inputs data for a 15-year putable bond recently purchased by a
client. She uses the model to calculate the current value of the bond and the expected
values if market interest rates were to rise or fall by 25 basis points (bps). Krishnan
uses the results in Exhibit 3 to estimate the bond’s effective duration.
Exhibit 3 Value of 15-Year Putable Bond

Change in interest rates +25 bps no change –25 bps
Value of bond 95.376 97.584 99.384
Krishnan discusses the use of the valuation model to calculate effective duration
and effective convexity with one of Klang Analytics’ developers. The developer makes
the following statements to Krishnan:
Statement 1 The effective convexity of a putable bond cannot be less than that
of an otherwise identical option-free bond.
Statement 2 The effective convexity of a callable bond can be negative in some
circumstances, but the effective convexity of a putable bond is
always positive.
Statement 3 The effective duration of a callable bond cannot be greater than

that of an otherwise identical option-free bond, and the effective
duration of a putable bond cannot be less than that of the option-
free bond.
35 Assuming Bond A is correctly priced and given the information in Exhibit 1, is

Krishnan most likely correct that there is a mispricing?
A Yes, Bond C must be mispriced.
B Yes, Bond B must be mispriced.
C No, there is no evidence of a mispricing.
B is correct. All bonds have the same coupon rate and credit rating and approximately
the same remaining maturity. The pricing of all three (below par), implies the coupon
rate of a par bond with this credit rating and approximate maturity is higher than 7.0%.
Bond A is not callable, while Bond B is callable and has a slightly longer maturity than
Bond A. Both of these differences imply that Bond B’s price should be lower than Bond
A’s, but it is higher.
A is incorrect because Bond A is option-free while Bond C is putable and has a slightly
shorter maturity than Bond A. Both of the ways Bond C differs from Bond A would imply
a higher price than Bond A, which it has. Therefore there is no evidence that Bond C is
mispriced.
C is incorrect because either Bond A or Bond B must be mispriced, or possibly both.
Valuation and Analysis: Bonds with Embedded Options
36 If interest rate volatility changes in the way predicted in the chief economist’s
interest rate forecast, which bond described in Exhibit 1 will most likely experi-
ence the largest decrease in price?
A Bond B
B Bond C
C Bond A
B is correct. The value of a straight (option-free) bond (Bond A) doesn’t change when
interest rate volatility changes. The value of the callable bond (Bond B) is equal to the
value of the otherwise identical straight bond minus the value of the call option. The
value of the putable bond (Bond C) is equal to the value of the otherwise identical straight
bond plus the value of the put option. The values of the put and call options decrease
when interest rate volatility decreases, so the value of the callable bond will increase
and the value of the putable bond will decrease.
A is incorrect because the value of the callable bond will increase when interest rate
volatility decreases.
C is incorrect because the value of the straight (option-free) bond (Bond A) doesn’t
change when interest rate volatility changes.

37 If the shape of the yield curve changes in the way predicted in the chief econo-
mist’s interest rate forecast and the price of Bond A does not change, the price
of Bond C will most likely:
A decrease.
B increase.
C not change.
B is correct. As the yield curve moves from flat to upward sloping, the value of the put
option embedded in Bond C will increase. Because the value of a putable bond is the
value of the otherwise identical option-free bond plus the value of the put option, the
value of Bond C will increase.
A is incorrect because the value of the embedded put option and therefore the value
of this putable bond will increase when the yield curve moves from flat to upward sloping.
C is incorrect because the value of the embedded put option and therefore the value
of this putable bond will increase when the yield curve moves from flat to upward sloping.
38 Using the interest rate information found in Exhibit 2, the value of the three-
year putable bond analyzed by Krishnan is closest to:
A 101.072.
B 99.727.
C 99.206.
B is correct. We start by calculating the bond values at Year 2 by discounting the cash
flow for Year 3 with the three forward rates:
103.2/1.0621 = 97.166 (bond is put at 98)
103.2/1.0460 = 98.662
103.2/1.0341 = 99.797
Year 1 node values are calculated as follows:
3.2 + (0.5 × 98 + 0.5 × 98.662)
97.336 = (bond is put at 98)
1.0431
3.2 + (0.5 × 98.662 + 0.5 × 99.797)

99.263 =
1.0319
At Year 0, the value of the putable bond is:
3.2 + (0.5 × 98 + 0.5 × 99.263)
99.727 =
1.0211
A is incorrect because it is calculated using a put strike price of par (100).
C is incorrect because it is calculated as if it is a straight bond (ignoring the put option).
39 The effective duration calculated using the information in Exhibit 3 is closest to:
A 8.02.
B 4.11.
C 8.21.
C is correct.
(PV− ) − (PV+ )
The effective duration of a bond =
2 × (∆ curve) × PV0
where the 0, –, and + subscripts refer to the current yield curve, the decrease in the
yield curve, and the increase in the yield curve, respectively, and Δ curve refers to the
size of the yield curve shift. Therefore, for this bond, the effective duration is
99.384 − 95.376
= 8.21
2 × 0.0025 × 97.584
A is incorrect because it uses the par value in the denominator rather than the cur-
rent value:
99.384 − 95.376
= 8.02
2 × 0.0025 × 100
B is incorrect because it ignores the 2 in the denominator and uses a change of 1%
rather than 0.25%:
99.384 − 95.376
= 4.11
0.01 × 97.584
40 Which of the statements made by the Klang Analytics developer is most likely
correct?
A Statement 2
B Statement 1
C Statement 3
A is correct. Statement 2 is correct. The convexity of a callable bond turns negative when
the call option is near the money, because the upside for the bond is much smaller than
the downside (because the value is capped at the call price). The convexity of a putable
bond is always positive because when the option is near the money, the upside for the
bond is much larger than the downside (because the floor value is the put price).
B is incorrect because the statement is false. The value of a putable bond cannot
fall below the put price, whereas the value of the option-free bond can. Therefore the
effective duration of the option-free bond can be larger than that of the putable bond.
C is incorrect because at high interest rates, the value of the putable bond is equal to
the floor price, so the effective duration is very low and the effective convexity is close to
zero. The effective convexity of the option-free bond is higher because its value continues
to decrease, albeit at an ever decreasing rate (convexity gets smaller).


QUESTIONS 41–46
Eleni Petsas is a portfolio manager in the fixed-income division of PDK Wealth
Management (PDKW), based in Los Angeles. Petsas is running a training session for
newly hired analysts Bonita Vasquez, Neil Gorman, and Rohit Kumar to examine the
use of Credit Default Swaps (CDSs) in fixed-income portfolio management.
Petsas begins the session by asking the analysts to identify types of CDSs. Vasquez
responds, “There are three types of CDS; single-name CDSs, index CDSs, and tranche
CDSs. A single-name CDS is on any obligation of a specific reference entity. An index
CDS allows investors to take a position on the credit risk of multiple companies,
although higher credit correlations make the index CDS more expensive to purchase.
Tranche CDSs also cover multiple borrowers, but losses are covered only up to a
specific level.”
Petsas notes that a payment from the credit protection seller to the credit protec-
tion buyer is triggered whenever a credit event occurs. She asks each of the analysts to
identify a credit event in the United States that will trigger a payment. The following
are the responses of each analyst:
Vasquez: “A declaration of bankruptcy by the reference entity is a credit event
that will trigger a payment from the CDS seller.”
Gorman: “If the reference entity fails to make a scheduled interest or principal
payment, it is recognized as a failure-to-pay credit event.”
Kumar: “A change in seniority of outstanding obligations is also recognized as a
credit event that will trigger a payment by the protection seller.”
To facilitate a discussion of CDS pricing and CDS trading strategies, Petsas presents
the group with the information in Exhibit 1.
Exhibit 1 Select CDS Information

Credit
Spread Recovery Tenor Coupon
CDS Type (bps) Rate (yrs.) (bps) Duration
CDX NA IG Index 59 40% 5 100 4.76

CDX NA HY Index 328 30% 5 500 4.34
Company A Single-Name 194 25% 5 100 4.57
Company A Single-Name 266 40% 10 100 7.38
Company B Single-Name 165 40% 5 500 4.55
Company B Single-Name 326 40% 10 500 8.19
Notes: CDX NA IG is an index of CDSs of investment-grade North American corporations. CDX

NA HY is an index of CDSs of high-yield North American corporations.
Petsas states, “I would like you to formulate appropriate CDS trading strategies
using the information provided in the following statements:”
Statement 1 “Our economists expect the US economy to strengthen over the
coming year, with spreads on high-yield CDSs tightening by 100
bps and spreads on investment-grade CDSs tightening by 8 bps.”
Statement 2 “Our analysts expect that the credit curve for Company A will
flatten, whereas the credit curve for Company B is expected to
steepen.”
Statement 3 “Company A has a bond with five years to maturity with a credit
risk premium of 85.40 bps, and Company B has a bond with five
years to maturity with a credit risk premium of 205.60 bps.”
Only Kumar responds, as follows: “A trade that addresses Statement 2 would be to
sell Company A CDSs with a 10-year tenor and buy Company A CDSs with a 5-year
tenor. Alternatively, one could buy Company B CDSs with a 10-year tenor and sell
Company B CDSs with a 5-year tenor.”
41 In her response to Petsas regarding types of CDS, Vasquez is least likely correct
with regard to:
A index CDSs.
B tranche CDSs.
C single-name CDSs.
C is correct. Vasquez is incorrect about single-name CDSs. A single-name CDS is typically

on a senior unsecured obligation (reference obligation) of a specific borrower (reference
entity). However, only debt obligations of the borrower that are ranked equivalently,
in terms of priority of claims, are covered by the CDS. Vasquez incorrectly states that
a single-name CDS is on any reference obligation, regardless of the priority of claims.
Vasquez correctly describes index CDSs and tranche CDSs.
A is incorrect. Vasquez correctly describes an index CDS.
C is incorrect. Vasquez correctly describes a tranche CDS.
Credit Default Swaps
42 With regard to Petsas’ question on credit events, who is least likely correct?
A Kumar
B Gorman
C Vasquez
A is correct. Kumar is incorrect. In the United States, a restructuring, where there is a

change in seniority of outstanding obligations, is not recognized as a credit event that
triggers a payment by the protection seller. A restructuring is recognized as a credit event
outside the United States. In the United States and elsewhere, bankruptcy and failure to
pay are recognized credit events.
B is incorrect. Gorman is correct; failure to pay is a credit event in the United States
and elsewhere.
C is incorrect. Vasquez is correct; a declaration of bankruptcy is recognized as a credit
event in the United States and elsewhere.
43 Based on Exhibit 1, the price per 100 par of Company A CDSs is closest to:
A 95.70.
B 99.06.
C 104.29.
A is correct. Up-front premium = (Credit spread – Fixed coupon) × CDS duration

= (1.94 – 1.0) × 4.57 = 4.2958.
Price of CDS per 100 par = 100 – Up-front premium
= 100 – 4.2958 = 95.7042.
B is incorrect. It is incorrectly calculated as follows: Up-front premium = (Credit
spread – Fixed coupon)
= (1.94 – 1.0) = 0.94.
= 100 – 0.94 = 99.06.
C is incorrect. It is incorrectly calculated as follows: Up-front premium = (Fixed cou-
pon – Credit spread) × CDS duration
= (1.0 – 1.94) × 4.57 = –4.2958.
= 100 – (–4.2958) = 104.2958.
44 Based on the information in Exhibit 1 and Statement 1, an appropriate long/

short trade would be to:
A sell CDX NA IG and buy CDX NA HY.
B sell CDX NA HY and buy CDX NA IG.
C sell Company A CDSs and buy Company B CDSs.
B is correct. The appropriate long/short trade in this case is to take a long position by
selling CDX NA HY and take a short position by buying CDX NA IG. Because high-yield
spreads (100 bps) are expected to tighten by more than investment-grade spreads (8
bps), CDX NA HY will gain by more than CDX NA IG, resulting in a net gain on the trade.
A is incorrect. The trade to sell CDX NA IG (long) and buy CDX NA HY (short) is only
appropriate if the US economy is expected to weaken.
C is incorrect. The trade to sell Company A CDSs (long) and buy Company B CDSs
(short) may be appropriate if the US economy is expected to weaken. The coupon on
Company A is 100 bps, indicating it is investment grade, whereas company B, with a 500
bp coupon, is high yield.
45 Is Kumar’s response to Statement 2 by Petsas most likely correct?

A Yes
B No, she is incorrect about the trade involving Company A CDSs.
C No, she is incorrect about the trade involving Company B CDSs.
A is correct. Kumar is correct. For Company A, the expectation is for a flattening of the
credit curve. Here the appropriate trade is to sell (go long) long-term (10-year tenor)
CDSs and buy (go short) short-term (5-year tenor) CDSs. For Company B, the expectation
is for a steepening credit curve, so the appropriate trade is to buy (go short) long-term
(10-year tenor) CDSs and sell (go long) short-term (5-year tenor) CDSs.
B and C are incorrect. Kumar is correct about the trades involving Companies A and B.
46 Which of the following trades is most likely appropriate on the basis of the
information in Statement 3 and Exhibit 1? Go long:
A Company B five-year CDSs and short Company B five-year bonds.
B Company A five-year CDSs and short Company A five-year bonds.
C Company A five-year bonds and CDSs and go short Company B five-year
bonds and CDSs.
B is correct. The correct trade is to go long (sell) Company A five-year CDSs and short
Company A five-year bonds. The bond credit spread of 85.40 bps is less than the CDS
credit spread of 193.45 bps. This implies that the bond is overpriced and the CDS is
underpriced. Thus, the appropriate strategy is to short the overpriced bond and go long
the underpriced CDS (sell CDSs).
A is incorrect. For Company B, the correct strategy is to go short (buy) Company B
five-year CDSs and go long Company B five-year bonds. The bond credit spread of 205.60
bps is greater than the CDS credit spread of 165.29 bps. This implies that the bond is
underpriced and the CDS is overpriced. Thus, the appropriate strategy is to short the
overpriced CDS (buy CDSs) and go long the underpriced bond.
C is incorrect. Company A bond is overpriced, so you would go short, not long.
Company B bond is underpriced, so you would go long, not short.

QUESTIONS 47–52
Shoshone Capital is a private equity firm that structures funds as limited partnerships
for which it serves as the general partner. The funds focus on buyouts of publicly
traded companies. Shoshone has produced a new marketing brochure that it will use
to solicit capital investments. The first section of the brochure describes the common
characteristics of buyout investments, including the following:
Characteristic 1 The target firms generally have experienced management
teams.
Characteristic 2 The target firms often have the potential for substantial cost
reductions.
Characteristic 3 The deals are generally arranged through relationships with
the existing shareholders.
Section 2 of the brochure discusses how Shoshone aligns its interests with those
of the managers of its portfolio companies.
Shoshone’s brochure provides an example of a typical acquisition, in which it pur-
chased LUW, Inc., for $160 million. After the acquisition, LUW’s new capital structure
consisted of $80 million in debt, $65 million in preference shares, and $15 million in
common equity. After six years, Shoshone sold LUW, Inc., to another private equity
firm for $285 million.
The brochure also provides an example of a private equity fund called Tensleep
Fund, which has committed capital of $150 million, a management fee of 2%, carried
interest of 20%, and a hurdle rate of 9%. Carried interest is paid on a deal-by-deal
basis. In the example, the fund calls $100 million in commitments at the beginning
of the first year and invests $40 million in Firm A and $60 million in Firm B. At the
beginning of the second year, it calls the remaining $50 million and invests it in Firm
C. At the end of the second year, the investment in Firm B is sold for $70 million. At
the end of the third year, the fund’s investment in Firm A is worth $54 million, its
investment in Firm C is worth $40 million, and it has $46 million in cash.
The brochure concludes with the history of a second private equity fund called
Pocatello Fund. The first five years of this fund’s cash flows and distributions are
presented in Exhibit 1.
Exhibit 1 Pocatello Fund Cash Flows and Distributions ($ millions)

Paid-In Mgmt. Operating NAV before Carried NAV after
Year Capital Fees Results Distributions Interest Distributions Distributions
2005 40 0.8 –3 36.2 36.2

2006 55 1.1 4 54.1 54.1
2007 80 1.6 11 88.5 88.5
2008 100 2 27 133.5 4.2 19 110.3
2009 125 2 34 167.3 6.6 38 122.7
Note: NAV is net asset value.
47 Which of the characteristics listed in the brochure regarding buyout invest-

ments is least likely correct?
A Characteristic 3
B Characteristic 1
C Characteristic 2
A is correct. Characteristic 3 describes venture capital investments, which are commonly

the result of relationships between venture capitalists and entrepreneurs (existing
shareholders or owners). Most buyout transactions are auctions, which involve multiple
potential acquirers.
A is incorrect because buyout targets often offer potential for cost reductions.
B is incorrect because buyout targets typically have experienced management teams.
Private Equity Valuation

48 Which of the following clauses is most likely to be included in Section 2 of

Shoshone’s brochure?
A Liquidation preference
B Reserved matters
C Tag-along, drag-along rights
C is correct. Tag-along, drag-along rights protect the interests of managers, not the pri-
vate equity firm. Tag-along, drag-along rights ensure that any potential future acquirer
of the company may not acquire control without extending an acquisition offer to all
shareholders, including the management of the company.
A is incorrect because liquidation preferences place the returns of the private equity
firm ahead of those of other investors, including the portfolio firm’s managers.
B is incorrect because private equity firms may require that certain strategically
important decisions (such as acquisitions or divestitures) be approved by the private
equity firm, protecting its equity interests, not those of managers.
49 When LUW, Inc., was sold by Shoshone, which part of its capital structure most
likely decreased in size?
A Debt
B Preference shares
C Common equity
A is correct. A common source of value creation in leveraged buyouts is debt reduction.

B is incorrect because preference shares typically accrue dividends with payment
deferred until the company is sold.
C is incorrect because the value of the company has increased, increasing the value
of common equity.
50 Compared with the exit route chosen, Shoshone’s least likely alternate exit route
for the LUW, Inc., investment would be a(n):
A initial public offering.
B management buyout.
C liquidation.
C is correct. Liquidation is the route chosen if the company is no longer viable. The exit
route used for LUW, Inc., was a secondary market transaction at a price that indicated
a strong company.
B is incorrect because a management buyout is possible, given that management
already has an equity stake in the firm.
A is incorrect because an initial public offering is possible, though likely more expen-
sive than a secondary market transaction.
51 The carried interest paid to the general partner of the Tensleep Fund at the end
of the second year is closest to:
A $0.7 million.
B $0.
C $2.0 million.
B is correct. Although the investment in Firm B produced a $10 million profit in two years,
that figure represents an annual return (internal rate of return, or IRR) of only 8.01% =
(70 million/60 million)1/2 – 1, which is below the hurdle rate. The general partner will
not receive any carried interest payments until the fund’s IRR exceeds the hurdle rate.
A is incorrect because it assumes the general partner receives the difference between
the hurdle rate (9%) and the deal’s internal rate of return (8%).
C is incorrect because it assumes the 20% carried interest earned from the $10 million
deal profit is paid, even though the hurdle rate is not met.
52 In 2009, the total value to paid in of the Pocatello Fund is closest to:
A 1.44×.
B 0.98×.
C 0.46×.
A is correct. Total value to paid in (TVPI) equals distributed to paid in (DPI) plus residual
value to paid in (RVPI), where DPI is the sum of distributions divided by paid-in capital
[(19 + 38)/125] = 0.46, and RVPI is NAV after distributions divided by paid-in capital
(122.7/125) = 0.98. TVPI = 0.46 + 0.98 = 1.44.
C is incorrect because it is only DPI.
B is incorrect because it is only RVPI.

QUESTIONS 53–56
Provident Advisers is a registered investment advisory firm that uses exchange-
traded funds (ETFs) for its clients’ investment portfolios. Ted Sorrill is CEO and chief
investment officer of Provident. Steve Mives, a prospective client, is a high-net-worth
individual who is considering transforming his actively managed portfolio of individ-
ual stocks and bonds into actively managed and passive ETFs. Mives is considering
this strategy because of the advice of his accountant, Andrew Hart. Sorrill, Mives,
and Hart are meeting to discuss ETFs and their growing use in the construction of
investment portfolios.
Sorrill begins the meeting by describing how ETFs are subject to the same regu-
lations as mutual funds and noting that ETFs trade intra-day, similar to public stocks.
Hart adds that ETF authorized participants conduct trades in the secondary market to
eliminate the arbitrage gap and conduct trades in the primary market to both create
and redeem ETF shares.
Mives asks Sorrill to describe how ETF performance is measured. Sorrill explains
that most ETFs are designed to track the performance of a specific benchmark index,
such as the S&P 500 Index. Sorrill cautions, however, that there are numerous sources
of tracking error that may cause a deviation in an ETF’s return relative to its bench-
mark index. Sorrill provides an example, stating that one of the sources of tracking
error is an ETF portfolio manager’s operations with short sellers.
Mives wants to maintain the current blended stock and bond benchmark alloca-
tions following his portfolio’s transition from individual stocks and bonds to active
and passive ETFs. Sorrill states that whenever active ETF managers implement active
views, gaps with respect to desired market exposures may result. For Mives’s portfolio,
Sorrill plans to use passive ETFs to maintain benchmark exposure should any of the
active ETF managers implement active views that cause changes in the portfolio’s
industry sector weightings. Passive ETFs will enable Sorrill to maintain benchmark
exposure while not necessarily replacing an active ETF manager.
Hart states that active ETF strategies have evolved such that market capitalization
is no longer the only benchmark factor for equity strategies and that fixed-income
strategies may be constructed with minimal sensitivity to movements in interest rates.
He states that smart beta equity risk factors, such as dividend yield, size, value, and
momentum, enable investors to implement an active view while continuing to track a
designated benchmark. He then describes the strategy of smart beta fixed-income ETFs
that focus on generating returns from taking credit risk and hedging out duration risk.
53 Is Hart’s statement about ETF authorized participants likely correct?
A Yes
B No, regarding trades in the primary markets
C No, regarding trades in the secondary markets
C is correct. Hart’s statement about authorized participants is not correct because of

trades in the secondary market. ETF secondary market trades are transactions between
buyers and sellers of existing ETF shares. No new ETF shares are created by trades in
the secondary market. ETF authorized participants create and redeem ETF shares in the
primary market.
A is incorrect. Hart’s statement is incorrect. ETF authorized participants do not trade
in the secondary market. ETF authorized participants create and redeem shares in the
primary market.
B is incorrect. Hart’s statement that ETF authorized participants create and redeem
ETF shares in the primary markets is correct.
Exchange Traded Funds: Mechanics and Applications
54 In describing tracking error, Sorrill’s example most likely relates to:

A trading costs.
B full replication.
C securities lending.
C is correct. Sorrill’s description of ETF tracking error includes a reference to securities

lending by the ETF portfolio manager. Many ETF portfolio managers lend a portion of
their portfolio holdings to short sellers. Securities lending provides income for an ETF
that offsets a portion of an ETF’s administrative expenses.
A is incorrect. Trading costs are a source of tracking error but are not caused by
operations with short sellers. .
B is incorrect. Replication (lack of full replication) is a source of tracking error but is
not caused by operations with short sellers.
55 Sorrill’s explanation of benchmark exposure most likely describes portfolio:

A rebalancing.
B completion strategies.
C liquidity management.
B is correct. Sorrill’s explanation of benchmark exposure describes portfolio completion.

ETFs can be used to fill a temporary gap in exposure to an asset class. Gaps may arise
whenever an active manager transitions a portfolio away from a desired market exposure
(for example, the portfolio’s benchmark). An investor may use a passive ETF to maintain
the exposure while retaining the manager.
A is incorrect. Sorrill’s explanation describes completion strategies, not portfolio
rebalancing. Portfolio rebalancing describes how ETFs are used by investors to remain
fully invested according to target weights whenever changes in market values cause a
portfolio’s segments to deviate from target weights.
C is incorrect. Sorrill’s explanation describes completion strategies, not portfolio
liquidity management. Portfolio liquidity management describes how ETFs are used by
investors to efficiently invest excess cash balances, which reduces a portfolio’s cash drag.
56 Is Hart’s comments about active ETF strategies likely correct?

A Yes
B No, because of the comment about smart beta equity risk factors
C No, because of the comment about smart beta fixed-income ETFs
A is correct. Hart’s comments about smart beta are correct. Factor (smart beta) ETFs are
benchmarked to an index created with predefined rules for screening and weighting
constituent holdings whose index rules are structured around return drivers, or factors,
such as dividend yield, size, value, and momentum. Academic research has supported
these factors as contributors to the equity risk premium. Hart’s comment about smart
beta fixed-income ETFs is correct. Interest rate swaps are used by the managers of smart
beta fixed-income ETFs to minimize interest rate risk, enabling the ETFs’ return to be
generated by taking credit risk.
B is incorrect. Hart’s comment about smart beta equity risk factors is correct.
C is incorrect. Hart’s comment about smart beta fixed-income ETFs is correct.

QUESTIONS 57–60
Galina Fund is an investment fund focusing on small-cap Eastern European equities.
Lev Svoboda is the senior portfolio manager for the Galina Fund, which employs its
own traders. Svoboda gives head trader Mislav Varga an order for an initial purchase
of 2,000 shares of Szabo Technologies (ST), a thinly traded stock, at a limit price of
EUR80.10.
Varga and Svoboda view the electronic order book for ST at 9:47:00, just after the
day’s first 5,000 shares of ST have traded at a price of EUR79.70. Varga buys 1,000
shares at a VWAP of EUR79.86. Two trades immediately follow: one for 500 shares
and another of 400 shares, both at EUR79.95. The next trade occurs at 9:47:15, with
Varga buying the second lot of 1,000 shares at an average price of EUR79.99. The limit
order book for ST at the time of the first purchase is shown in Exhibit 1, with the four
dealers in the stock coded A through D.
EXHIBIT 1 ST Stock Limit Order Book Extract

Bid Ask
Dealer Time Entered Bid Size Dealer Time Entered Ask Size
C 9:46:50 AM 77.65 300 D 9:46:55 AM 79.80 600

B 9:47:00 AM 77.65 400 C 9:46:50 AM 79.95 400
A 9:47:00 AM 77.65 200 A 9:47:00 AM 79.95 700
D 9:46:55 AM 77.65 600 B 9:47:00 AM 79.95 400
C 9:46:55 AM 77.55 1,200 C 9:47:00 AM 80.00 800
Reviewing the trade with Varga, Svoboda observes, “Trading expenses consist of
both explicit and implicit costs. The fact that the first purchase of 1,000 shares was
executed at a price higher than the ask price prevailing at the time the order was
entered illustrates the following trade cost factors:
Factor I Changes in dealers’ bid and ask prices prior to an execution repre-
sent implicit costs.
Factor II The difference between the initial ask price and the purchase price
is essentially the price concession you made to fill the trade.
Factor III The 6 cent difference between the execution price and the initial ask
price is measurable and, therefore, considered to be an explicit cost.”
Varga comments, “The market has been moving up this morning, and I see that
ST’s CEO is scheduled to speak at a government-sponsored investment conference
about the company’s short-term sales outlook at 10:00 a.m. Electronic traders will
likely be on the alert for any new disclosures.”
57 Compared with Varga’s first trade, the second trade had an effective spread cost
that was:
A greater but was executed within the quoted spread.
B less but was executed outside the quoted spread.
C greater and was executed outside the quoted spread.
C is correct. The effective spread cost estimate for buy orders is calculated as
Trade size × {Trade price − (Bid + Ask/2)}
or as follows:
For the first trade: 1,000 × (79.80-77.65)/2) = 1,075.
For the second trade, there are still 200 shares offered by Dealer B at 79.95. Therefore,
the effective spread cost is 1,000 × (79.95-77.65)/2) = 1150.
The effective spread cost was larger for the second trade, and the execution price of
79.925 was within the quoted spread at the time the order was entered.
A is incorrect. The effective spread cost was greater for the second trade but was
outside the quoted spread.
B. is incorrect. The effective spread cost was greater for the second trade.
Trading Costs and Electronic Markets
58 When comparing his two trades to the VWAP benchmark using all trades
through the completion of his purchase, Varga would most likely conclude the
price of the:
A first trade was less costly.
B second trade was less costly.
C average execution price was less costly than either single trade.
A is correct. The VWAP benchmark is the sum total dollar value of the benchmark trades
divided by the total quantity of the trades. The VWAP transaction cost estimate formula
for buy orders is as follows: Trade size × (Trade VWAP-V WAP benchmark).
The total dollar value of the benchmark trades is
(5, 000 × 79.70) + (500 × 79.85) + (400 × 79.85) + (1, 000 × 79.99)
(5,000 + 1,000 + 500 + 400 + 1,000)
= 79.774
For the first trade, the VWAP transaction cost is 79.86-79.774 = 0.086.
For the second trade, the VWAP transaction cost is 79.99-79.774 = 0.216.
The VWAP transaction cost for the average execution price is 79.925-79.774 = 0.151,or
less than that of the second trade but more than that of the first trade.
B is incorrect. The first trade was less costly.
C is incorrect. The combined execution was not less costly than the first trade.
59 Which of Svoboda’s three trading cost factors is least likely correct?

A Factor I
B Factor II
C Factor III
C is correct. The execution price of the first purchase includes 600 shares at 79.80 and
400 shares at 79.95, averaging a price of 79.86, and was 6 cents higher than the initial ask
price of 79.80, because of the order “walking up” the limit order book. After the market
bid was filled, the order continued to buy at higher prices. The higher cost resulting from
the higher purchase price is not a hard dollar cost and, accordingly, should be considered
to be an implicit cost, not an explicit cost.
A is incorrect. Changes in dealers’ bid and ask prices do belong in the category of
implicit costs.
B is incorrect. Orders larger than those available at current bid and ask quotes will
have a greater market impact, which must be accepted in order to execute these orders.
60 Which of the following electronic traders would most likely profit by trading in
ST this morning immediately after the CEO’s remarks at 10:00 a.m.?
A Electronic dealers
B Low-latency traders
C Electronic arbitrageurs
B is correct. Low-latency traders include news traders who subscribe to high-speed

electronic news feeds reporting news releases made by corporations, governments, and
other aggregators of information. They can quickly analyze these releases to determine
whether the information will move markets and can profit when they can execute against
stale orders that do not yet reflect the new information.
A is incorrect. Electronic dealers, like all dealers, make markets with the expectation
that they can profit from round trips at favorable net spreads. Although they often
monitor news feeds, it is more often in order to decide whether to provide liquidity to
or withdraw liquidity from other traders.
C is incorrect. Electronic arbitrageurs look across markets for arbitrage opportunities
in which they can buy an undervalued instrument and sell a similar overvalued one.

CFA Institute 2020 Mock Exam A - Morning Session (With Solutions)

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CFA Institute 2020 Mock Exam A - Morning Session (With Solutions)

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1

2020 Level II Mock Exam (A) AM

THE FOLLOWING INFORMATION RELATES TO

C is correct. The statement referencing Ms. Johnson’s ability to manage investments

Guidance for Standards I-­VII

A is correct. Recommendation 1, “All accounts participating in a block trade should receive

Guidance for Standards I-­VII

B is correct. When considering all three of Tao’s policy suggestions as a whole, he is

Guidance for Standards I-­VII

4 Did a violation of the CFA Institute Standards of Professional Conduct most

C is correct. Standard IV: Duties to Employers was violated; specifically, a violation of

Guidance for Standards I-­VII

Guidance for Standards I-­VII

6 In addition to being in violation of Standard IV(B): Additional Compensation

C is correct. In addition to being in violation of Standard IV(B): Additional Compensation

Guidance for Standards I-­VII

THE FOLLOWING INFORMATION RELATES TO

10 Which of the methods Martin considers to address potential feature correlation

C is correct. Method 3 is principal components analysis (PCA). In a dataset with many

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Current Foreign Exchange Data

On completion of the agenda items relating to the foreign exchange markets,

Exhibit 2 Long-­Term Growth Projections

Country A 1.7 1.5 0.3 3.2 0.4

Exhibit 3 Real Per Capita GDP Growth

Country C 6,950 35,190 3.30%

B is incorrect. During periods of market turmoil, there is generally a flight to safety

Currency Exchange Rates: Understanding Equilibrium Value

12 The mark-­to-­market value for Drawbridge’s forward position is closest to:

Currency Exchange Rates: Understanding Equilibrium Value

Economic Growth and the Investment Decision

A is correct. Hollingsworth;s preferred method of calculating the GDP growth rate is

ΔY/Y = Growth in gross domestic product, GDP

Economic Growth and the Investment Decision

15 Navarro’s statement about the convergence of growth between Country A and

C is correct. Absolute convergence means that developing countries, regardless of their

Economic Growth and the Investment Decision

Economic Growth and the Investment Decision

THE FOLLOWING INFORMATION RELATES TO

Cost of the acquisition (€ millions) 80.00

19 Which of Casado’s three statements regarding the potential impairment of the

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Forecasted Cash Flow

Sales 370,000 425,500 510,600 663,780 531,024

* Straight-­line over five years

$66,750 × (1 – 0.40) = $40,050

22 Ludlow’s first suggestion to Scott is best described as an example of:

B is correct. Ludlow’s suggestion of considering alternate economic environments is an

23 Ludlow’s second suggestion is best described as the calculation of:

C is correct. Ludlow’s suggestion is an example of economic profit: EBIT × (1 – tax rate)

EAA for three-­year project:

THE FOLLOWING INFORMATION RELATES TO

Exhibit 1 Data for Forward-­Looking Risk Premium Estimates

Current price level of the market index 1,480.00

Expected growth rate in real earnings per share 3.00%

TIPS = Treasury Inflation-­Protected Securities

Furthermore, Royappa says, “In addition to the forward-­looking estimates of the

Exhibit 2 BTP’s Selected Financial Data ($ millions)

Dividend yield: 33.60/1,480 = 2.27%

Dividend yield (based on current dividend): 31.25/1,480 = 2.11%

C is incorrect. It uses short-­term government bond yield instead of long-­term gov-

EINFL= expected inflation

Equity risk premium: [(1.0181)(1.03)(1.015) – 1] + 0.025 – 0.04 4.94%

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Guidance for Standards I-VII

Exhibit 1 Current Foreign Exchange Data

Exhibit 2 Long-Term Growth Projections

Exhibit 3 Real Per Capita GDP Growth

12 The mark-to-market value for Drawbridge’s forward position is closest to:

Exhibit 1 Forecasted Cash Flow

* Straight-line over five years

EAA for three-year project:

Exhibit 1 Data for Forward-Looking Risk Premium Estimates

TIPS = Treasury Inflation-Protected Securities

Furthermore, Royappa says, “In addition to the forward-looking estimates of the

Exhibit 2 BTP’s Selected Financial Data ($ millions)

C is incorrect. It uses short-term government bond yield instead of long-term gov-

Market-Based Valuation: Price and Enterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples

Exhibit 1 Darwin Industrial Selected Financial Data

Exhibit 1 Bond Characteristics and Prices

Exhibit 2 Binomial Interest Rate Tree

Exhibit 3 Value of 15-Year Putable Bond

Exhibit 1 Select CDS Information

Notes: CDX NA IG is an index of CDSs of investment-grade North American corporations. CDX

C is correct. Vasquez is incorrect about single-name CDSs. A single-name CDS is typically

A is correct. Up-front premium = (Credit spread – Fixed coupon) × CDS duration

Exhibit 1 Pocatello Fund Cash Flows and Distributions ($ millions)