Mock Questions - Mock Exam 2025 #2- First Session

Level II of the CFA® Exam Mock Questions - Mock Exam 2025 #2- First Session Offered by AnalystPrep Last Updated: Dec 27, 2024 1 ©2024 AnalystPrep “This document is protected by International copyright laws. Reproduction and/or distribution of this document is prohibited. Infringers will be prosecuted in their local jurisdictions.” Case 22: Eric Noble Eric Noble, Richard Wong, and Christine Jenney are all investment analysts and citizens of the U.S. Mr. Noble's employer is a multinational investment company based in the United States, but he is stationed in Sahara – a country with a fast-growing capital market. Local laws are minimal – in form and content, and there are no punitive measures put in place to discourage the release of material non-public information in a non-procedural manner. Noble, believing that, as a U.S. citizen working for a US-based company, he should comply only with U.S. law and ignore local law. Wong, on the other hand, works in the landlocked nation of Switzerland. To prevent front-running of clients trades, local laws impose a restriction period spanning at least 60 calendar days before and ten calendar days after issuance of any research report. One of Noble's clients is the board of trustees of a private university endowment fund. The trustees provide Noble with the fund's financial information, including planned expenditures. Noble receives a phone call on Sunday afternoon from Simpson, a prominent alumnus, requesting that Noble email him comprehensive financial information about the fund. According to Simpson, he has a potential contributor but needs the information that day to close the deal and cannot contact any of the trustees. Jenney resides in Florida, USA. She, however, works in the island nation of Panamba where she does business with a client who is a citizen of Sahara. Panambian securities laws and regulations are less strict than the dictates of the CFA Institute Code and Standards. Although the more strict law applies, a clause within the local laws states that the law of the client's home country governs. Eric Noble is a strong advocate of the CFA program. His business cards and office letterheads all have the CFA logo printed on them, and he only hires CFA candidates or charterholders. Noble recently hired Mark Johnson, a CFA candidate and recent finance graduate from a tier 1 university with excellent quantitative and qualitative skills. Johnson has passed Levels I and II of the CFA program and is currently awaiting the results of the final exam. In his welcome note to Johnson, Noble notes that: 2 © 2014-2024 AnalystPrep. "As a CFA finalist, I have a lot of faith in your work. I expect you to perform considerably better than most of the analysts we already have, and I'm confident of your promotion in a few years. In my personal opinion, I believe the CFA program has nourished you with immensely important portfolio management skills that will go a long way toward helping this company attain its goals." On the same day, Noble instructs the digital team to put up Johnson's professional biography on the company's official website, telling them, "Use mine as a template. Just change the name, title, CFA logo, and other information as necessary. When Johnson reports to work the following day, he finds his bio already uploaded on the website. On it is his name, firm name, his professional history, and academic achievements, including the fact that he has passed level I and II of the CFA exam in consecutive years. Within a few weeks, Johnson passes level III of the CFA exam and after satisfying all the additional requirements, he is awarded the CFA charter. Since then, he has earned both his CFA designation and a Ph.D. in Finance, he would like to have his professional bio and related documents updated to reflect these achievements. He is however unsure of the proper method of doing so. A year into his role as an investment analyst, Johnson is tasked with the development, maintenance, and enhancement of the proprietary models the firm uses to manage its portfolio of derivatives. Eager to impress in his new role, Johnson develops a habit of reading widely on all topics related to derivatives trading. While browsing online, he comes across a website run by Smart CFA. The blog outlines some intriguing research and suggests several upgrades that could improve his employer's current models. In the next few days, Johnson spends time incorporating the factors discussed in the online blog. The updated results form part of his preliminary research report which carries several buy recommendations. Before the report has been published, Johnson sends it to the corporate finance department for verification of the information. After receiving the verified report, he sends it to the legal department for documentation in line with company policies. Five years after receiving his CFA charter, Johnson resigns his and spends the next three years growing his large-scale farming business. Because he is not actively engaged in the investment 3 © 2014-2024 AnalystPrep. profession, he does not file a completed Professional Conduct Statement with CFA Institute and does not pay his CFA Institute membership dues. Two years later, Johnson becomes a selfemployed analyst accepting assignments as an independent consultant. Without reinstating his CFA Institute membership by filing his Professional Conduct Statement and paying his dues, he requests his manager to reprint the business cards and professional bio as used in his previous role, albeit without the name of his former employer. He also coins a tagline for his new business which reads, "The Best Portfolio Adviser in Town." In a conversation with a prospective client, he states that she has learned a great deal from the CFA Program and that many firms require their employees to be CFA charterholders. He would recommend the CFA Program to anyone pursuing a career in investment consultancy. Q.1 Which of the following statements is most likely true? A. Noble violated Standard I(A) - Knowledge of the Law B. Wong must abide by the CFA Institute Code and Standards in all his research work C. Jenny must adhere to the CFA Institute Code and Standards Q.2 Should Noble share the fund's information with Simpson? A. Yes, because disclosure would benefit the client B. No, because he is bound by client confidentiality C. Yes, provided he promptly notifies the trustees 4 © 2014-2024 AnalystPrep. Q.3 In which of the following scenarios has a CFA Institute Standard of Professional Conduct been violated? A. Nobles insistence on only hiring CFA charterholders of candidates B. Noble's welcome note to Johnson C. Johnson's professional biography Q.4 After gaining the right to use the CFA designation, which of the following designation formats should Johnson use on his resume, business cards, and professional bio? He should: A. Cite the CFA designation first, followed by his Ph.D. B. Cite the Ph.D. designation first, followed by the CFA designation C. Cite all his designations in any order 5 © 2014-2024 AnalystPrep. Case 23: Analiese Geiger Analiese Geiger, CFA is a foreign exchange expert at Centilane. She is looking for investment opportunities in the market. Geiger had her assistant, Michael Roger, gather the following information: The Australian dollar (AUD) interest rate is 4%. The British pound (GBP) interest rate is 6%. The spot exchange rate is 1.95 AUD/GBP. The 1-year AUD/GBP forward rate is 1.94. The expected inflation rate in Australia is 1.5% The expected inflation rate in the U.K. is 2.5%. Geiger believes covered interest parity will hold for at least the next 12 months. Geiger notices a difference between the market forward rate and the forward rate required by covered interest rate parity. She could borrow AUD at the Australian interest rate to take advantage of this arbitrage opportunity before it disappears. Mark Weber, CFA, is a former colleague and acquaintance of Geiger. He works as a junior analyst at Pearl River Investment Research & Advisors (PRIRA) based in Dallas, Texas. Pearl River Investment, which serves mostly institutional investors, is well-known for providing emerging and frontier market focused investment research. Texas Public Workers' Retirement Fund (TPWRF), a large institutional investor, has approached PRIRA before investing in two emerging economies – Petronia and Coaldovia. TPWRF believes that long-term stock market returns are directly correlated with a country's GDP growth rate. TPWRF seeks advice from PRIRA about potential GDP growth rates, interest rate changes, exchange rate fluctuations, and fiscal policies for both countries. Weber searches government websites, industry associations, central banks, and reputable political and economic newspapers to prepare a snapshot of the political and economic conditions in both economies. Based on these readings, Weber has prepared a brief profile, a part of which is given below: 6 © 2014-2024 AnalystPrep. Exhibit 1 – Economic Conditions in Petronia and Coaldovia Growth rate of technological progress Share of capital in GDP Growth rate of capital Growth rate of labor Long-term growth rate in labor productivity Petronia 2.75% 0.3 2.50% 3.50% 3.00% Coaldovia 3.00% 0.55 1.50% 1.00% 2.25% In addition to this quantitative data, some nuggets of qualitative information about the politicoeconomic development in Petronia and Coaldovia also draw Weber's attention. Petronia: Petronia's government has failed to get the national parliament's approval for legislation to reform the labor market. The government plans to continue economic policies of import substitution for the foreseeable future. The government plans to subsidize technical education. Coaldovia: Coaldovia's government plans to create a national monopoly to explore, extract, and export natural gas. Economic decision-makers believe trade and exports will be the key drivers of economic growth. The average age for the working population is 42 years. Capital Ride Hedge Fund (CHF) is another client of PRIRA. CHF has significant investment exposure in Petronia. Three months back, it sold 16.5 million Petronian Dollars (PED) through a 9-month forward contract at an exchange rate of 8.2550 per U.S. Dollar. CHF has approached PRIRA to mark its forward position to market. Weber gathers the following information to determine this. 7 © 2014-2024 AnalystPrep. Exhibit 2 – Forward Rates and Interest Rates Spot rate – (PED/USD) 8.3050– 8.3250 Six months forward points −250/ − 300 Six months interest rate on PED (annualized) 6.50% Six months interest rate on USD (annualized) 3.00% CHF is also planning to enter into a carry trade, borrowing 1,000 in Japanese Yen (JPY) and investing in Coaldovian Dollars (COD). However, CHF's fund manager wants to know the likely returns from this carry trade. Interest rates and exchange rates for both currencies are as follows: Exhibit 3 – Interest Rates and Exchange Rates Today's One-Year Interest Rates COD 12% JPY 1.5% Currency Pair Spot Rate Expected Spot Rate in Today One year 20.75 21.25 101.50 100.75 COD/USD JPY/USD Q.1 The 1-year AUD/GBP forward rate as required by covered interest rate parity is closest to: A. 1.91 B. 1.95 C. 1.99 Q.2 According to the growth accounting equation, the two countries' potential GDP growth rate will be closest to: A. Petronia: 6.50%; Coaldovia: 4.30% B. Petronia: 6.00%; Coaldovia: 4.30% C. Petronia: 6.00%; Coaldovia: 3.25% 8 © 2014-2024 AnalystPrep. Q.4 The one-year all-in expected profit from the carry trade for COD in JPY will be closest to: A. 0.0605 B. 0.0705 C. 0.105 Q.3 The mark-to-market profit or loss to CHF for the short forward position on Petronian Dollars will be closest to: A. a USD 5,946 loss. B. a USD 5,946 profit. C. a USD 6,035 profit. 9 © 2014-2024 AnalystPrep. Case 25: ModFarm, Inc. ModFarm, Inc., is a large-scale manufacturer of high-quality farm machinery, including land mowers and combine harvesters used in the harvesting of wheat. While many companies have struggled through the last few years particularly in the face of the continued global economic weakness and oft-unpredictable political climate, ModFarm has enjoyed a surging demand for its products as a result of the continued mechanization of agriculture in Asia and Africa. The strong demand has taken its toll through higher inventory costs but the company has so far been successful at passing these costs on to customers through higher prices. ModFarm’s products have expected useful lives of 25 years on average. The company has traditionally depreciated its assets on a straight-line basis. Liza McCarthy, CFA, works as an equity analyst at Crystal Investments. She is reviewing MofFarm’s recent financial statements. ModFarm prepares its financial results according to US GAAP. Exhibits 1 and 2 contain selected portions of the company’s statement of operations and statement of financial position, while Exhibit 3 contains selected notes from the company’s 2017 financial statements. Exhibit 1 – ModFarm Inc. Consolidated Results of Operations ($ millions) For the Year Ended 31 December 2017 Sales 82 , 302 Cost of goods sold 58 , 506 Gross profit 23 , 796 Net profit 7 , 003 Exhibit 2 – ModFarm Inc. Consolidated Financial Position ($ millions) $ \begin{array}{l|r|r} \textbf{December 31} & \bf{2017} & \bf{2016} \\ \hline \text{Cash} & 1,049 & 2,195 \\ \hline \text{Receivables} & 29,645 & 27,657 \\ \hline \text{Inventories} & 12,576 & 10,342 \\ \hline \text{Other current assets} & \underline{2,455} & \underline{4,755} \\ \hline \text{Current assets} & 45,725 & 44,949 \\ \hline {\text{Net PP&E}} & 17,526 & 15,820 \\ \hline \text{Other assets} & \underline{37,488} & \underline{32,426} \\ \hline \text{Total assets} & \underline{100,739} & \underline{93,195} \\ \\ \text{Accounts payable} & 8,088 & 6,755 \ \hline 10 © 2014-2024 AnalystPrep. \text{Other current liabilities} & \underline{30,030} & \underline{30,564} \ \hline \text{Total current liabilities} & 38,118 & 37,319 \ \hline \text{Long-term liabilities} & \underline{49,041} & \underline{39,181} \ \hline \text{Total liabilities} & 87,159 & 76,500 \ \hline \text{Total shareholders’ equity} & 13,580 & \underline{16,695} \ \hline \text{Total liabilities and shareholders’ equity} & \underline{100,739} & \underline{93,195} \ \end{array} $ Exhibit 3 – Selected Notes to the Financial Statements of ModFarm Inc. Note 1: Inventories Inventories are stated at the lower of cost or market, with cost determined using the lastin, first-out (LIFO) method. $ millions 2017 2016 LIFO reserve 4 , 757 4, 643 No LIFO liquidation occurred during the years 2015 to 2017 Note 2: Depreciation and amortization Depreciation of plant and equipment follows the straight-line method $ millions Consolidated depreciation expense 2017 2016 1, 096 776 Note 3: Income Taxes The company’s effective tax rate has been 30% for each of the last 5 years. ModFarm offers its employees a defined benefit pension plan. Information on the company’s retirement plans is presented in Exhibit 4. Exhibit 4 – ModFarm Retirement Plan Information 2017 (in $ millions) 11 © 2014-2024 AnalystPrep. Employer contributions Current service costs Past service costs Discount rate used to estimate plan liabilities Benefit obligation at the beginning of the year Benefit obligation at the end of the year Actuarial loss due to increase in pan obligation Plan assets at the beginning of the year Plan assets at end of year Actual return on plan assets Expected rate of return on plan assets 6, 600 1, 320 792 7.0% 277, 200 275, 352 3, 036 257, 400 255, 420 17, 820 8.0% As part of its motivation packs, ModFarm has put in place a stock options plan for top executives. Exhibit 5 presents information on the volatility assumptions used to value the stock options. Exhibit 5 – ModFarm Volatility Assumptions Used to Value Stock Options Grant Year 2017 Valuation Assumptions (2013– 2017) 2016 Valuation Assumptions (2012– 2016) Weighted Average Expected Volatility 21% 18.5% Q.1 Assuming ModFarm used the FIFO method to account for its inventory, its cost of goods sold (in millions) in 2017 would be closest to: A. 57000 B. 58608 C. 58392 Q.2 If ModFarm had been using the FIFO accounting since incorporation, its retained earnings at the end of 2017 would most likely be higher by: A. 4757 B. 3330 C. 1427 12 © 2014-2024 AnalystPrep. Q.3 The amount of periodic pension cost (in millions) that would be reported in P&L under IFRS is closest to: A. 3696 B. 2850 C. 3498 Q.4 The retirement benefits (in millions) paid during the year were closest to: A. 26400 B. 29172 C. 25500 13 © 2014-2024 AnalystPrep. Case 26: Chang Lee Professor Chang Lee, an expert in corporate finance, has been hired by Corporate Consultants Inc. to advise on a suitable capital structure for Yogu Inc., one of its clients. Yogu Inc., based in Anagonia, manufactures semiconductors. The company has developed a new technology to develop semiconductors that can be extensively and exclusively used in smartphones. The company plans to set up a separate subsidiary for manufacturing semiconductors exclusively for smartphones using the new technology. The company is confident that the proposed subsidiary will capture more than 80 percent of the market in the next few years. The cost of setting up the company works out to be USD 20 billion. The company is planning to raise the entire capital using a combination of debt and equity. It has decided to seek the services of Corporate Consultants Inc. for this purpose. Corporate Consultants Inc. has tie-ups with academic and industry experts in corporate finance. Professor Chang Lee estimates the WACC by first assessing the cost of capital and the cost of debt. The marginal tax rate for the company is 35 percent. The following table captures the capital structure and related information: Capital Structure and related information Type of Capital Common Equity Preferred Equity Debt Current Capital Selected Capital Structure Type Information 70% Traded actively. 10% Redeemable at a par value of 1000 per share. The dividend yield is 8.5%. The current share price is 940. They are frequently traded. 20% Straight unsecured debt with a BBB credit rating. Single debt issue with an 8% coupon rate. Professor Chang Lee uses the Fama-French five-factor model (FF5) and CAPM to estimate Yogu's cost of equity by regressing Yogu’s excess returns on the relevant risk factors. A 20-year 14 © 2014-2024 AnalystPrep. government benchmark rate of 3.5% is used as a risk-free proxy. The table below contains details on factor betas from FF5 and CAPM. FF5 and CAPM risk premiums and Factor Beta Factor Factor Beta Risk Premium Market (ERP) Value (HML) Size (SMB) Profitability (RMW) Investment (CMA) 0.75 0.17 0.65 0.12 0.4 5% 4.2% 2.2% 3.5% 4% Market (ERP) 0.75 5% FF5 Risk Premium and Factor Betas CAPM Risk Premium and Factor Betas Professor Lee estimates Yogu’s cost of equity using the BYPRP approach, where she assumes a historical risk premium of 6% earned by equity investors relative to long-term yields from corporate bonds. The senior partner at the company is curious about how Professor Lee arrived at an ERP of 5% in his cost of equity estimation. Lee explains that he used the historical approach, using an arithmetic mean and the long-term government bill rate Q.1 Yogu’s cost of preferred equity is closest to? A. 0.06 B. 0.085 C. 0.09 Q.3 Suppose Yogu’s cost of debt is 5.5%. The cost of common equity using the BYPRP model will be closest to? A. 0.115 B. 0.09 C. 0.06 15 © 2014-2024 AnalystPrep. Q.2 Yogu’s cost of common equity using the Fama-French 5-factor model is closest to? A. 0.114 B. 0.12 C. 0.09 Q.4 Yogu’s cost of common equity using the CAPM is closest to? A. 0.114 B. 0.115 C. 0.0725 16 © 2014-2024 AnalystPrep. Case 28: Darlene Gregg Darlene Gregg, a junior analyst, was recently hired at N.A. Financial, a mid-sized Canadian investment firm. She is assisting her manager, Robert Mugo, in the management of a portfolio for high-net-worth clients. Over the years, Mugo has carved out a reputation for unparalleled work ethic and outstanding financial performance. He has been working at N.A. Financial for the last ten years and earned his CFA charter within the last three years. He's been and an active member ever since. Mugo has been analyzing several equity stocks for possible future purchases in line with the investment needs of a group of her clients. He asks Gregg to help compute the required return for each stock. Before Gregg gets down to work, Mugo wants to make sure that Gregg has sound knowledge of basic equity valuation concepts. He invites Gregg to his office to discuss the various approaches used to calculate the required return. While discussing the various approaches used to estimate the risk premium, Gregg states that: "Under the survey estimate method, a survey is conducted for all equity investors. The data gathered is then used to come up with a reasonable risk premium." Mugo adds that: "A recent survey, published in a well-known financial journal, came up with a risk premium of 3.5% for one of the stocks I was considering for the portfolio of one of my clients." To test Gregg's knowledge on equity valuation, Mugo asked her to calculate the required return for KOP based on the CAPM, using the risk premium put forth in the financial journal. According to Mugo, KOP stock has had a historical sensitivity of 0.9 relative to the market, and Treasury bills are currently earning 3.8%. KOP also pays a dividend of $2.03 and the stock trades at $11.04. The company's dividend is expected to increase by 6%. Gregg believed that he could also use multi-factor models such as the Fama-French model and CAPM to calculate the required return. In response, Mugo stated that both of these models are based on one similar concept and that only the factors considered by each method differ. Gregg nodded in agreement, adding that the Fama-French model takes into consideration a liquidity 17 © 2014-2024 AnalystPrep. premium. To come up with the required return based on these two models, Gregg gathered the following data: Exhibit 1: 1. R mkt – R f = 4.5%; and βmkt = 1.2 2. R small– Rbig = 2.5; and βSMB = 0.5 3. R HMB– R LBM = 1.5; and βHML = −0.1 4. Liquidity Premium = 3%; and βliquidity = −0.1 5. R f = 3.8% Q.1 KOP's required return based on the CAPM is closest to: A. 3.83%. B. 6.95%. C. 7.95%. Q.2 Gregg made statements about the survey estimate method and the difference between two multi-factor models. Are these statements correct ? A. Only one of those statements is correct. B. Both statements are correct. C. Both statements are incorrect. 18 © 2014-2024 AnalystPrep. Q.3 Based on Exhibit 1, the required return according to the Fama-French model is closest to: A. 10.6%. B. 10.3%. C. 10.0%. Q.4 The forward looking ERP estimate using the dividend discount model method closest to: A. 10.03%. B. 20.6%. C. 8.76%. 19 © 2014-2024 AnalystPrep. Case 29: Steven Garcia Steven Garcia works for a leading research house in the U.S. He has been involved in derivatives strategies but his current project is on credit default swaps (CDS). Since he is unfamiliar with these financial instruments, Garcia asks Mark White - a colleague with experience advising clients on the use of CDSs - to help him with the project. White explains the basics to Garcia and mentions that purchasing a CDS is like purchasing insurance against a credit event - once the premium is paid, the protection seller assumes all credit risk. White begins with the example of QWR Corporation, which currently has the following three bond issues trading in the market: Bond A, a 3-year senior unsecured debenture, trading at 45% of par Bond B, a 3-year senior unsecured debenture, trading at 50% of par Bond C, a 3-year subordinated unsecured debenture, trading at 25% of par White mentions that one of his clients owns $5 million of Bond B (at par value) and purchased a $5 million senior CDS protection. Garcia then analyzes the credit quality of two companies – Alpha Corporation and Beta Corporation. After his analysis, he makes the following comments about their credit quality: Alpha Corporation: There is serious short-term stress in the market and that is reflected in the credit curve of Alpha. Beta Corporation: After recent financial turmoil, the company's 5-year CDS spread is unchanged, but the 10-year CDS spread has widened by 200bps. Garcia then mentions that one of his clients is considering buying a 10-year CDS on Beta Corporation debt to hedge its current portfolio position. The client asks him to determine if an upfront payment would be required and, if so, the premium amount. The following exhibit gives information on the CDS: Exhibit 1 - Data for CDS on Beta Corporation Credit Spread 600 bps Duration 7 years Coupon Rate 4% 20 © 2014-2024 AnalystPrep. Garcia also advises his client to execute a basis trade to take advantage of the pricing difference of the Alpha Corporation bonds and CDS. He mentions that the Alpha's bond is currently yielding 6% and a comparable CDS contract has a credit spread of 4.25% and the Libor is 1.25%. The basis trade would consist of a long position both in the bond and in the CDS contract. Garcia also mentions an opportunity arising in the market on Gamma Corp, which is planning a recapitalization plan involving a large stock buyback program financed by new debt. Garcia then asks White to explain the underlying principles and the factors that influence the price of a CDS. White makes the following comments: Comment 1: Probability of default is constant and doesn't vary with time Comment 2: Loss given default (LGD) is the amount of loss if a default occurs. LGD is directly proportional to the recovery rate. Comment 3: The hazard rate is the probability that an event will occur given that it has not already occurred. Q.1 The profit that the basis trade for Alpha Corporation can capture if convergence occurs in the bond and CDS markets is closest to: A. 0.25%. B. 0.50%. C. 1.75%. 21 © 2014-2024 AnalystPrep. Q.2 Which of the comments regarding underlying principles and factors that influence the prices of CDS is most likely correct? A. Comment 1 B. Comment 2 C. Comment 3 Q.3 Which of the following is most likely to be the best strategy on Gamma Corp? A. Buy both the stock and CDS protection B. Sell the stock and buy CDS protection C. Buy the stock and sell CDS protection Q.4 Based on Exhibit 1, what is the upfront premium as a percentage of the notional for the CDS protection on Beta Corporation? A. 0.02 B. 0.105 C. 0.14 22 © 2014-2024 AnalystPrep. Case 30: Trevor Holden Trevor Holden advises corporate finance and treasury departments on borrowing decisions and working capital management. In particular, Holden specializes in analyzing and recommending derivatives strategies that help his clients maintain an acceptable level of exposure to marketbased risks. Holden is meeting with Martha Coleman, CFO of Brownstone Design (Brownstone), a US-based office furniture manufacturer. Nine months ago, Brownstone Designs reached a strategic partnership with Elemental Interiors that would see the two firms collaborate on certain projects. As part of the partnership, Brownstone signed a forward agreement to purchase 100,000 shares of Elemental Interiors' stock, which trades under the ticker symbol ETI and does not pay a dividend, at USD 35.50 per share one year later. The current market price of ETI shares is USD 38.21. Coleman asks for Holden's advice on how to value this forward contract, which expires in three months. She is concerned because the prices are being generated by Brownstone's internal valuation models appear to be inconsistent with the market price of new 6-month futures contracts on ETI stock, which are currently trading at USD 39.00 per-share. Holden looks up the latest quotes and finds that the relevant 3-month and 6-month interest rates have discount factors of 0.990005 and 0.979639, respectively. The next item of business to be discussed concerns Brownstone's working capital management. Coleman tells Holden that the company will be depositing USD 13,500,000 next month and is considering taking a long position in a 1 x 6 forward rate agreement (FRA). The terms of this FRA stipulate that, when it expires in one month, the interest rate for the floating leg will be set and payment will be made based on the difference between the exercise rate and the prevailing reference rate. Holden responds with the following two statements: Statement A: “The FRA position that Brownstone is considering is the equivalent of going long a onemonth Libor deposit and short a six-month Libor deposit.” Statement B: 23 © 2014-2024 AnalystPrep. “If Brownstone takes this FRA position, the company will receive payments based on a fixed rate.” Finally, the two colleagues discuss Brownstone's longer-term borrowing needs. Coleman informs Holden that, next month, Brownstone will be taking out a 5-year bank loan with annual floatingrate interest payments based on LIBOR. Coleman adds that she would like to convert this loan into a fixed-rate obligation. Holden advises that Brownstone enter a 5-year, pay-fixed, receive Libor interest rate swap. Specifically, he recommends Libor swap rates equal to 45 basis points plus the zero-coupon Treasury spot rates shown below. Exhibit 1: Zero-coupon spot curve Term (years) Zero-coupon rate (annual) 1 4.30% 2 4.70% 3 5.00% 4 5.15% 5 5.25% After listening to his recommendation, Coleman asks Holden “Is an interest rate swap essentially a series of forward rate agreements?” Q.4 What is Holden's most likely response to Coleman's question about interest rate swaps' A. Yes B. No, because interest rate swaps are contingent claims C. No, because interest rate swaps are exchange-traded derivatives 24 © 2014-2024 AnalystPrep. Q.1 On a per-share basis, the value of the Brownstone's forward contract to purchase ETI stock is closest to: A. 2.97. B. 3.06. C. 3.10. Q.3 Assuming that it reflects the law of one price, the rate on the fixed leg of the five-year, Liborbased interest rate swap recommended by Holden is closest to: A. 4.76%. B. 5.66%. C. 5.22%. Q.2 Which of the following is the most accurate assessment of Holden's statements about the forward rate agreement position being considered by Brownstone? A. Both Statement A and Statement B are incorrect B. Statement A is correct and Statement B is incorrect C. Statement B is correct and Statement A is incorrect 25 © 2014-2024 AnalystPrep. Case 31: Jayden Smith Jayden Smith is an investment manager at Yash mutual fund. Smith reviews the limit order book for XYZ Inc. taken from the NYSE Arca exchange. Three dealers, (1,2,3) make the market for XYZ Inc. as shown in Exhibit 1. Smith executes a market buy order for 700 shares of XYZ Inc., based on the prices in the limit order book. Exhibit 1: Limit Order Book for XYZ Inc Dealer 1 2 3 Limit Price 90.04 90.03 90.02 buy Shares 100 300 200 orders Time 14 : 05 : 22 14 : 05 : 25 14 : 05 : 25 Dealer 4 3 2 Limit Price 90.05 90.06 90.07 Sell Shares 400 100 200 Orders Time 14 : 05 : 21 14 : 05 : 21 14 : 05 : 21 Smith sees a potential market sell order for 10,000 shares of ABC Co. The order is traded over the day and is split into four trades that are executed as per Exhibit 2. Exhibit 2: Market Buy Order for ABC Co. Trade Time 1 10.00am 2 11.00am 3 12.00noon 4 13.00pm Trade Price $50.40 $52.32 $52.30 $52.25 Trade Size 2 , 200 2 , 800 3 , 500 1 , 500 Bid Price $50.43 $52.35 $52.35 $52.30 Ask price $50.46 $52.38 $52.33 $52.31 Smith also runs a mentorship program on trading. During one of the introduction sessions, Smith mentions that electronic trading has benefited investors through greater trade process efficiencies and reduced transaction costs. However, it has increased systemic risks such as fat finger errors and malevolent order streams. Additionally, Smith highlights that electronic trading systems are prone to market manipulation, where some trading strategies are employed to produce misleading or false market prices, quotes, or fundamental information to profit from distorting the normal operation of markets. Over the next session, Smith asks the students to describe some of the market manipulation strategies. He receives the following responses: 26 © 2014-2024 AnalystPrep. Response I: Bluffing Involves submitting orders and arranging trades to influence other traders’ perceptions of value. Response II: Gunning the market A manipulator uses this strategy to obtain control over resources necessary to settle trading contracts. He/ she then withdraws these resources from the market, making traders default on their contracts, some of which the manipulator may hold—the manipulator profits by providing high price resources or by closing the contracts at very high prices. Response III: Squeezing and cornering The manipulator sells quickly to push prices down with the hope of triggering stop-loss sell orders. A stop-loss (or stop) sell order becomes valid for execution once the specified stop price condition is met by a trade occurring at or below the stop price. 27 © 2014-2024 AnalystPrep. Case 91: Alex Johnson Portfolio Manager Alex Johnson helms the Equity Growth Fund, a well-established fund with a strategy poised on capturing high-growth opportunities across various sectors. Despite the fund's strong focus on individual stock picking, Alex is contemplating integrating exchangetraded funds (ETFs) into her investment strategy to gain broad market exposure and sectorspecific plays. Before making any concrete decisions, she decides to deep dive into the mechanics, trading, and application nuances relative to ETFs. Alex's team have pinpointed MarketFlex ETFs Inc. as their go-to ETF provider considering their diverse offerings and robust tracking accuracy. MarketFlex has recently launched an ETF, the MarketFlex Total Market (MFTM), designed to mimic the performance of the Total Market Index, representing 98% of all publicly traded securities in the U.S. It features a competitive fee structure and has a creation unit size of 100,000 shares. Alex notes the importance of understanding the creation/redemption mechanisms offered by MarketFlex, the expected liquidity of MFTM in secondary markets, and how its bid-ask spreads compare to the underlying securities within the Total Market Index. Despite robust performance tracking, Alex is aware of potential tracking errors that may arise from rebalancing discrepancies, dividend reinvestments, and the underlying cash holdings. With the MFTM ETF trading near its NAV, she remains vigilant about the prospects of premiums or discounts that may emerge in different market conditions. As with any investment, Alex knows the importance of considering ETF-related risks, such as liquidity under stress scenarios, and the costs associated with owning and trading ETF shares. Alex's fund typically holds a large position, say $10,000,000, in selected investments, and she is assessing how this would translate to trading in MFTM ETFs, both in terms of shares to be bought, associated costs like the expense ratio, and potential market impact. Additionally, Alex is curious about the tax efficiency of ETFs, in comparison to mutual funds, due to their unique creation and redemption process. 28 © 2014-2024 AnalystPrep. Q.1 On a particular trading day, the MFTM ETF's average bid price is $50.05 and the average ask price is $50.15, The bid-ask spread and the spread percentage based on the ask price ar closest to. A. $0.10, 0.20% B. $0.10, 0.299% C. $0.15, 0.299% Q.2 If the secondary market trading price of the MFTM is \$50.50 while the NAV is \$50.00, what is the ETF trading at? Additionally, would this scenario typically lead to creation or redemption activities? A. 1% premium, leading to creation B. 1% premium, leading to redemption C. 1% discount, leading to creation Q.3 Alex learns the MFTM ETF incurs an expense ratio of 0.10% annually. If the fund invests $10,000,000 in MFTM, the annual management cost would be closest to? A. 1000 B. 10000 C. 100 Q.4 MarketFlex reveals that there was a significant redemption of MFTM shares leading to a temporary discount to NAV. What risk does this highlight and how might Alex mitigate it? A. Market risk, mitigated by diversifying across different ETFs. B. Liquidity risk, mitigated by setting stop-loss orders. C. Liquidity risk, mitigated through due diligence on the ETF's underlying securities. 29 © 2014-2024 AnalystPrep. 30 © 2014-2024 AnalystPrep. Case 919: Annabel Temitope Annabel Temitope is evaluating the expected residual income as of the end of September 2014 for Asia Pulp and Paper Company (PAP), a vertically-integrated pulp and paper producer. Using an adjusted beta of 1.20 relative to the S&P 500 Index, a 10-year government bond yield of 1.70%, and an estimated equity risk premium of 3.80%, Temitope uses the capital asset pricing model (CAPM) to estimate PAP’s required rate of return. Temitope obtains the following as of the close of September 2014. Exhibit 1. Asia Pulp and Paper Company Current market price $11.90 Book value per share as of 31 December 2013 $9.96 Consensus annual earnings estimates FY 2014 $3.52 FY 2015 $3.64 Annualized dividend per share forecast FY 2014 $1.46 FY 2015 $1.55 David Emmanuel, Temitope’s supervisor, has reviewed her computations on PAP's expected residual value income. He has calculated the stock value of PAP and would like Temitope to do the same. They use different approaches but perform the calculations using consistent assumptions. Emmanuel’s approach: calculate the stock value using the residual income model. Temitope’s approach: calculate the stock value using the dividend discount model instead. Cynthia Promise, a co-worker of Temitope, specializes in the airline industry. Recently she has been monitoring Southwest Airlines (NYSE: LUV). She considers a stock fairly valued if her intrinsic value calculation using the single-stage residual income model is within 10% of the current market price. She has gathered the following information for LUV: Current book value per share = $26 Current market price per share = $44 Assumed long-term ROE is 11% and long-term growth is 5.5% 31 © 2014-2024 AnalystPrep. The cost of equity based on the Capital Asset Pricing Model is 8.5% Emmanuel asks Temitope and Promise to create a list of strengths and weaknesses of residual income models. They worked together and submitted the following list to Emmanuel. Strength 1: The models focus on economic profitability. Strength 2: The debt capital cost is appropriately reflected by interest expense. Weakness 1: The models do not work well when cash flows are unpredictable. Weakness 2: Accounting data used as inputs may require significant adjustments. Emmanuel reviews the list created by Temitope and Promise and makes the following two statements: Statement 1: The residual income model is most appropriate when a company’s dividends are not predictable. Statement 2: The residual income model is least appropriate if the book value is not predictable. 32 © 2014-2024 AnalystPrep. Q.1 Based on the information provided in Exhibit 1, the forecast ending book value per share for FY 2014 is closest to: A. $9.96. B. $12.02. C. $13.48. Q.2 Based on the information in exhibit 1, the forecast residual income for fiscal year 2015 that Temitope would calculate would be closest to: A. $2.90. B. $3.10. C. $3.20. Q.3 Which of the following two statements by Temitope and Promise is most likely correct? A. Strength 2 and Weakness 1 B. Strength 1 and Weakness 2 C. Strength 1 and Weakness 1 33 © 2014-2024 AnalystPrep. Q.4 Which of Emmanuel's statements about the appropriateness of the residual income model is most accurate? A. Statement 1 B. Statement 2 C. Both Statement 1 and Statement 2 34 © 2014-2024 AnalystPrep. Case 920: Phoenix Wealth Management Hector Rodriguez, CFA, is the Chief Investment Officer at Phoenix Wealth Management (PWM), a firm that caters to high-net-worth individuals and institutional investors. PWM has recently introduced a new global equity fund, which has been marketed extensively to prospective clients as an opportunity to diversify their portfolios with international exposure. As part of the marketing materials, Hector includes performance projections based on backtested data using a proprietary investment strategy developed by the firm’s research team. The backtested performance shows significant outperformance compared to a global equity index over the last ten years. However, the fine print discloses that these figures do not account for transaction costs or management fees. One of PWM's clients, Carla Gomez, whom Hector personally advises, expresses interest in the new global equity fund. Carla has a moderately conservative risk profile and is looking for stable, long-term growth. Hector recommends a sizable allocation to the new fund, emphasizing its potential for outperformance and alignment with her objectives, without discussing the impact of fees or transaction costs on the projected returns. Meanwhile, Hector is aware that some senior analysts at PWM have concerns about the replicability of the back tested performance in actual market conditions. These concerns have not been communicated to the marketing department or included in the client-facing materials. Hector believes the strategy is sound and decides not to address this issue further. Moreover, Hector’s annual bonus is significantly influenced by the amount of capital attracted to the new fund. This compensation arrangement is not disclosed to PWM’s clients or explicitly accounted for in the firm's official conflict of interest policy. Soon after, PWM’s compliance department is reviewing the fund’s marketing materials and raises questions about the presentation of back tested performance data. They suggest revising the materials to include a clear explanation of the limitations of backtesting and its differences from actual trading results. 35 © 2014-2024 AnalystPrep. After the global equity fund is launched, its initial performance is considerably below the back tested results. As a result, Carla suffers losses that are not in line with her risk tolerance. She complains to PWM, stating that she was not fully informed about the risks and costs associated with the investment. Q.1 According to Standard II: Integrity of Capital Markets, which aspect of the presentation of the global equity fund in the marketing materials is Hector Rodriguez, CFA, most likely to have violated? A. Misrepresentation by failing to disclose the impact of fees on returns. B. Plagiarism by using a proprietary investment strategy without proper citation. C. Market manipulation by influencing the fund's reported performance figures. Q.2 With respect to Standard III: Duties to Clients, what should Hector Rodriguez, CFA, have done differently when recommending the new fund to Carla Gomez? A. Discussed the limitations of the backtested performance data. B. Enforced the compliance department's suggestions regarding marketing materials. C. Recommended a smaller allocation to diversify risks. Q.3 Concerning Standard IV: Duties to Employers, which action is Hector Rodriguez, CFA, most likely to have failed to perform adequately? A. Not disclosing his compensation arrangement related to the global equity fund. B. Making an investment recommendation not suitable for the client's profile. C. Overseeing the marketing department's distribution of potentially misleading materials. 36 © 2014-2024 AnalystPrep. Q.4 Based on Standard (V) - Investment Analysis, Recommendations, and Actions, which of the following best describes a likely violation by Hector Rodriguez, CFA? A. Not performing diligent and thorough analysis on the new fund's strategy. B. Incorporating nonpublic information in his investment recommendations. C. Providing investment analysis that was not based on a reasonable and adequate basis. 37 © 2014-2024 AnalystPrep. Case 921: Orion Hedge Fund Orion Hedge Fund, a boutique investment firm with $2 billion in AUM, is known for its agile and alternative investment strategies. In a rapidly shifting financial landscape, Orion's management team is assessing the performance and risk profiles of several strategies from the last six months to ensure continued investor satisfaction and superior financial returns. Four of the key strategies currently under scrutiny are: 1. Convertible Arbitrage Strategy: Orion's initiative to profit from pricing inefficiencies between a company's convertible bonds and its stock. Currently, $300 million is allocated to this strategy, and the typical debt-to-equity conversion rate is 40:1. 2. Distressed Securities Strategy: This strategy involves investing in the debt and equity of companies under financial distress or going through bankruptcy. Orion has committed $250 million to distressed assets with an anticipated return of 18% due to potential restructuring or recovery. 3. Managed Futures Strategy: An approach leveraging futures contracts on indices, commodities, and rates with $350 million of AUM assigned to it. The expectation is to capture trends and momentum in these markets. 4. Short Selling Strategy: A speculative technique capitalizing on the anticipated decline in stock prices. The strategy's capital allocation is $100 million, and the short interest rate charged by the brokerage is 3% per annum. Orion's portfolio managers and analytics team are tasked with quantifying the performance metrics as well as any potential risk mitigation strategies that could be applied moving forward. Q.1 What is the notional exposure of the Convertible Arbitrage Strategy with respect to the underlying stock, assuming no market movement has taken place? A. $7.5 million B. $120 million C. $12 million 38 © 2014-2024 AnalystPrep. Q.2 If the Distressed Securities Strategy yields a higher than anticipated return at 22%, what is the additional return in dollar value over the initially expected return? A. $8 million B. $10 million C. $12 million Q.3 What is the total fee earned by Orion Hedge Fund from the Managed Futures Strategy if the fund charges a 2% management fee and a 20% performance fee on the profits, assuming the strategy profits were $42 million for the period? A. $15.4 million B. $8.4 million C. $12.4 million Q.4 Assuming the Short Selling Strategy experienced a market rally and led to a loss of 10% on the capital allocated, what would be the total loss including the borrowing cost at the end of the year? A. $13 million B. $10 million C. $11 million 39 © 2014-2024 AnalystPrep. Level II of the CFA® Exam Mock Questions - Mock Exam 2025 #2- Second Session Offered by AnalystPrep Last Updated: Dec 27, 2024 1 ©2024 AnalystPrep “This document is protected by International copyright laws. Reproduction and/or distribution of this document is prohibited. Infringers will be prosecuted in their local jurisdictions.” Case 32: Robert Murdock Robert Murdock, CFA, is a portfolio manager at Figtree Investments. As the senior-most member of management at the firm, he has discretionary authority over all of his accounts. He sits in the human resource panel and helps with the recruitment of analysts. After a rigorous interview process, Figtree investments recently hired five analysts. On their first day of work, Murdock informs them that by signing the employment contract, the analysts agree to unequivocally comply with the firm's code of ethics and compliance manual. He proceeds to hand each of the analysts a copy of the code and compliance manual without divulging any further details. The analysts spend the next hour perusing the document. Here's an excerpt from the compliance manual: Exhibit 1: Figtree Company Compliance Manual I. Employees 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, prospective clients, and employer. Employees must ensure that such disclosures are prominent, are delivered in a clear, precise, and plain language. II. Officers must ensure that all employees directly under their supervision adhere to applicable rules and regulations III. Employees must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer's interest unless they obtain written consent from all parties involved. IV. Research analysts must not communicate to members of the investment division unless such communication occurs to verify information and reporting. In case this happens, the compliance department must be notified immediately after such communication occurs One of the newly recruited analysts is Jessica Pearson, CFA. As part of her first research assignment, she is asked to participate in a client-organized tour of the client's production plants located in New York, U.S.A. On arrival in New York, there happens to be a major but unrelated demonstration on the streets such that Pearson and a few other analysts get somewhat stranded. Pearson is unable to access the hotel paid for by Figtree, her employer. One of the employees of the client approaches Pearson and a few other participants with an alternative offer of accommodation at a nearby hotel with modest rates. Pearson is not able to establish communication with the office to seek approval. She and the other participants accept the offer. The following day, Pearson makes a phone call to her supervisor and explains the turn of events the previous day. 2 © 2014-2024 AnalystPrep. One week later, one of Figtree's clients, Sarah Wayne, Chief Executive Officer of Super Technologies, invites Murdock to lunch. At the restaurant, the CEO goes ahead to reveal the reason for the lunch. "As you already know, one of our competitors, Blue Ray Partners, has proposed a cash offer for all outstanding shares of Super Technologies. The firm's top brass have made it clear that they don't want me to be CEO if their bid proves successful." Wayne then proceeds to show Murdock her projections for an ambitious growth strategy that's predicted to increase performance two-fold. “I’m aware that Figtree is the trustee of our firm’s internal stock ownership plan. In light of these projections, I hope the trustee will prioritize the interests of our shareholders and vote against the takeover.” After taking a look at Wayne’s business projections, Murdock says, “This plan looks good and attainable, and I shall recommend that the trustee vote against the offer.” Wayne adds, “My friend Evans Murray told me you recently took over the management of the Murray Family Trust. Perhaps the trustee could vote against the acquisition too. Evans Murray is my longtime friend, and I’m confident he’d be receptive to my long-term growth projections.” In response, Murdock says, “I’m bound by client confidentiality, and therefore don’t have much to say about the Murray Trust. What I do understand is that there indeed was a change of guard at the Trust, and it has traditionally preferred less risky investments. I doubt it would have significant holdings in Super Technologies.” Murdock is sure not to reveal that Evans Murray is a major client at Figtree with a significant personal stake in Super Technologies. Back at the office, Murdock meets with Karen Simriti, CFA, a trustee of the Super technologies internal stock ownership scheme. He proceeds to show her Wayne’s projections, adding that, “I think this plan looks good and I’d like you to analyze it further. Wayne is one of our most loyal accounts and down the years we’ve had good business with her. I’d like us to keep her.” While browsing online, Simriti comes across a blog that features current trends and insights into emerging technologies. She immediately identifies striking similarities between the business 3 © 2014-2024 AnalystPrep. model being discussed and Wayne’s proposed plan. At the end of the online discussion, Simriti concludes that the takeover would not be in the best interests of shareholders and votes the plan’s shares in favor of the status quo. A few weeks after the acquisition has been rebuffed, Murdock and Wayne meet again for lunch. Wayne is particularly delighted with the turn of events and informs Murdock that she is ending the relationship with her longtime personal investment manager in favor of Figtree Investments. Wayne adds, “Now that you manage most on my investment portfolio, I’d like to be less aggressive with my portfolio. I would like to be a bit more risk-averse. The two then discuss Wayne’s financial situation in more detail, including his current financial situation, risk tolerance, and financial objectives. The meeting concludes with Murdock promising to update Wayne’s investment policy statement to reflect Wayne’s new position. After the meeting, Murdock realizes that Wayne is now a top 10 client in terms of wealth at the firm, and her reduced appetite for risk puts her in the same investment bracket as four other clients. He pulls a copy of one of the client’s IPS and uses it as a template to come up with Wayne’s updated IPS. However, the other client has rather different tax circumstances by being a retired army general. With time, the portfolio return consistently outperforms the benchmark that Wayne and Murdock had agreed on. To appreciate Murdock’s great work, Wayne gifts Murdock a Tesla and a cash lump sum of $40,000. Murdock fails to disclose receiving this rewar Q.1 By accepting the offer for alternative accommodation from the client, did Pearson violate Standard I(B) on independence and objectivity? A. No. B. Yes, because client-funded accommodation could be used to influence her assessment of the client. C. Yes, because she informed her employer about the offer after accepting it. 4 © 2014-2024 AnalystPrep. Q.2 When discussing the Murray Family Trust, does Murdock violate any CFA Institute Standards of Professional Conduct? A. No B. Yes, relating to misrepresentation C. Yes, relating to duties to clients Q.3 When deciding how to vote the internal stock ownership plan shares, does Simriti violate any CFA Institute Standards? A. Yes, relating to fair dealing B. No C. Yes, relating to diligence and reasonable basis Q.4 Would Murdock's acceptance of the reward without relevant disclosure to his boss violate any CFA Institute Standards? A. Yes. B. No, he is solely responsible for the outperformance of Wayne's portfolio and does not need to disclose the gift. C. No, no Standard informs the disclosure of acceptance of gifts from clients. 5 © 2014-2024 AnalystPrep. Case 33: Brittany Ruiz Brittany Ruiz is the chief investment officer (CIO) at Black-Mount Capital Advisory Firm (BMCA), a leading U.S. based money management firm. Last year, BMCA launched the BMCA Equity Fund that invested in domestic and international markets stocks, including those of Russia, Brazil, Canada, and the U.K. During its annual performance review, Ruiz discovered that the fund earned a considerably less return than that of its benchmark. Concerned with the outcome, Ruiz called a meeting with the fund’s portfolio management team to discuss key issues related to the quantitative analysis of the fund’s investments. A leading quantitative expert, Anthony Webb, was invited to chair the meeting. While analyzing the regression models used by the PM team to predict stock returns, Webb requested the information provided in Exhibit 1. The information relates to a time-series model for annualized monthly returns to a Brazilian stock index. Exhibit 1: Annualized Monthly Returns to a Brazilian Stock Index Lag Autocorrelation 1 0.1320 2 0.1856 3 -0.0098 4 0.0056 5 -0.0062 Critical t-value 1.96 Number of observations 398 After his analysis, Webb presented the following conclusions to the portfolio management team: Conclusion 1: “This time series can be best modeled using a moving average (2) model rather than an autoregressive model.” Conclusion 2: “A moving average (2) model would be different from a simple moving average because the former would place different weights on the terms in the moving average. And unlike the MA(2), a simple moving average is based on observed time series values.” Since 10% of the BMCA Equity Fund was invested in large-cap Russian stocks, Webb considered it crucial to study the characteristics of the Russian capital markets. While reviewing BMCA’s autoregressive (1) model used to predict the Russian inflation rate, Webb suspected that the model might have a unit root. To accurately test for the presence of a unit root in the time series, 6 © 2014-2024 AnalystPrep. Webb decided to regress the first difference of the time series on the first lag of the time series. After obtaining the regression results, Webb calculated the t-statistic conventionally for the coefficient. He then used the critical t-values computed by Dickey and Fuller to determine significance. Since he could not reject the null hypothesis at the 5% significance level, Webb concluded that the series did not have a unit root and was stationary. When talking to Ruiz about ‘random walks’ Webb stated that a time-series that was a random walk could not be analyzed using standard regression analysis. He made the following statements: Statement 1: “There is no finite mean-reverting level for a random walk. In addition, the variance of the time-series increases or decreases as we go further into the future without any lower or upper bound. This violates the assumption of a finite variance for the time-series.” Statement 2: “To model a random walk, we should first-difference it. This results in a meanreverting level of 0. In addition, the variance of a first-differenced time-series is not only finite, but is also constant. The time-series then becomes covariance stationary.” Webb continued by stating that if a time-series is a random walk, it is best to model the firstdifferenced series with an autoregressive model to predict future movements in the time-series. He also stated that the key to choosing the correct model was to analyze each model’s R2: the first-differenced AR model would generally have an R2 greater than the R2 of the original AR model for a random walk, since the first-differenced model better fits the data. Q.1 Webb is most accurate concerning: A. Conclusion 1 and conclusion B. Conclusion 2 only. C. Neither conclusion 1 nor conclusion 2. Q.2 Is Webb’s conclusion regarding the presence of a unit root in the inflation rate time-series most accurate? A. Yes. B. No, because the regression variables that he used and his computed t-statistic were incorrect. C. No, because his application of the regression-based unit root test was incorrect. 7 © 2014-2024 AnalystPrep. Q.3 Webb is most accurate concerning: A. Statement 1 only. B. Statement 2 only. C. Neither statement 1 nor statement 2. Q.4 With regards to his comments about random walks, Webb is most likely: A. Correct. B. Incorrect about the criterion of choosing the correct model. C. Incorrect about using first-differenced AR models and the criterion of choosing the correct model. 8 © 2014-2024 AnalystPrep. Case 34: Mandarin, Inc. Mandarin, Inc. operates a chain of five-star hotels throughout the U.K and the U.S. Over the last couple of years, the company has embraced an aggressive expansion strategy that has culminated in the acquisition of several high-profile hotels. Its largest acquisition - that of World Cuisines was made in 2000, under the uniting of interests method. Mandarin complies with US GAAP while preparing its financial statements. After lengthy negotiations, Mandarin has decided to form a 50/50 joint venture with Best Foods Inc, under which the companies will share control of several hotels in the Las Vegas strip. Mandarin intends to employ the equity method to account for the joint venture. Best Foods complies with IFRS and will use the proportionate consolidation method to account for the venture. John Fletcher is an equity analyst who has covered both companies for more than five years. He has estimated the joint venture’s financial information for 2015 to prepare his estimates of each company’s earnings and financial performance. This information is presented in Exhibit 1 below: Exhibit 1 – Selected financial statement forecasts for Joint Venture ($ millions) Year Ending 31 December 2015 Revenue Operating income Net income 31 December Total assets Shareholders’ equity 2015 3, 146 282 136 2015 3, 300 1, 630 On 1 January 2017, Mandarin acquired 80% of the outstanding shares of SeaFoods in exchange for shares of Mandarin’s no common stock with a fair value of $828,000. The fair value of the subsidiary’s shares on the date of the exchange was $920,000. Below is selected financial information from the two companies immediately before the exchange of shares and recording of the acquisition: Exhibit 2 –Selected financial Information for Mandarin and SeaFoods before acquisition (in $ millions) 9 © 2014-2024 AnalystPrep. Cash and receivables Inventory PP&E Payables Long-term debt Net assets Shareholders’ equity Capital stock (no par Retained earnings Mandarin Book Value 184, 000 575, 000 1, 081, 000 1, 840, 000 253, 000 552, 000 805, 000 1, 035, 000 SeaFoods Book Value 69 , 000 368, 000 437, 000 874, 000 92 , 000 322, 000 414, 000 460, 000 400, 200 634, 800 156, 400 303, 600 SeaFoods Fair Value 69 , 000 368, 000 630, 000 1, 067, 000 92 , 000 322, 000 414, 000 653, 000 On January 1, 2013, Best Foods acquired 40% of the shares of Meat&Grill for $1,000,000. During the year, Meat&Grill earned $100,000 and paid dividends of $30,000. Q.1 Based on Fletcher's estimates, the amount of joint venture operating income (in $ millions) included on Mandarin's consolidated 2015 financial statements should be: A. 282 B. 0 C. 141 10 © 2014-2024 AnalystPrep. Q.2 Based on Exhibit 2, calculate the value of PP$E (net) on the consolidated balance sheet under both IFRS and US GAAP (in $ millions). A. IFRS GAAP $1, 711, 000 $1, 518, 000 B. IFRS GAAP $1, 585, 000 $1, 585, 000 C. IFRS GAAP $1, 711, 000 $1, 711, 000 Q.3 Based on Exhibit 2, the value of goodwill and the value of the non-controlling interest at the acquisition date (in $ millions) under the full goodwill method are closest to: A. Goodwill Non-controlling interest $92 , 000 $130, 600 B. Goodwill Non-controlling interest $267, 000 $184, 000 C. Goodwill Non-controlling interest $175, 000 $165, 600 11 © 2014-2024 AnalystPrep. Q.4 At the end of 2013, Best Foods reported investment in Meat&Grill as: A. $1 million. B. $1.028 million. C. $0.93 million. 12 © 2014-2024 AnalystPrep. Case 35: BigLights Limited Mark Wobble is the chief financial analyst at Merilyn Woods. He was asked by Ruchi Kapoor, the firm’s chief investment analyst, to analyze the common stock of BigLights Limited, a company that observes IFRS while preparing its financial statements. BigLights Limited is a major producer of renewable energy utilities like solar panels, windmills, and hand-held solar lanterns. It has three major operating segments – Home lighting products, Industrial products, and Street lighting units. Selected financial data for the company is presented in Exhibits 1 and 2: Exhibit 1 –BigLights Limited Selected Financial Information as of December 31 (in $ millions) 2017 2 , 694 7 , 685 Operating cash flow Operating income Sales Interest expense Operating lease payments Cash interest paid Cash taxes paid 21 , 725 21 , 308 167 157 139 124 89 585 Total assets Capital expenditures Expenditures on intangible assets Current debt Long-term debt 93 547 22 , 107 21 , 960 906 919 80 79 2 , 498 1 , 482 Total shareholders’ equity 2016 3 , 552 2 , 963 2 , 859 1 , 775 12 , 395 10 , 619 Exhibit 2 – Selected Notes to the Financial Statements - BigLights Limited Note 6: Revenue Recognition Revenue from the sale of goods is recognized in the income statement at the moment when the significant risks and rewards of ownership of the goods have been transferred to the buyer, which is mainly upon shipment. In special circumstances, at the customer’s request, the 13 © 2014-2024 AnalystPrep. company may sell products on a bill-and-hold basis provided that the product is ready for shipment. Such goods are segregated, and the risks of ownership and legal title have passed to the customer. This practice is limited only to customers who are government agencies who request it for budgetary and physical planning reasons. The amount of such bill-and-hold sales averages about 3% of consolidated sales annually. Note 9: Property, Plant, and Equipment Up until 31 December 2017, the company amortized its machinery and equipment on a straightline basis over an 8-year expected useful life. As of 2018, the company’s estimate of the useful life of certain machinery and equipment will be reduced to eight years. Note 13: Restructuring Charges In 2017, the company introduced an early retirement program. Under the new program, employees who were 55 years of age or older would be allowed to retire voluntarily. As it turned out, a larger number of employees than anticipated accepted the offer, and the company recorded an expense of $11.55 million, of which $ 5.0 million was classified as nonrecurring. Note 17: Financial and Operating Leases The implicit interest rate on finance leases for 2016 and 2017 was 7.0% Operating Lease commitments are as follows ($ millions): Due 1 January: 2018, 2019, 2020, and 2021 195 Due 1 January 2022 120 Total of future Lease payments thereafter* 480 Total commitments 1,380 After 2022, all lease payments are assumed to be the same as in 2015. 14 © 2014-2024 AnalystPrep. Wobble has reasons to believe that the recent increase in profitability is the result of earnings management. In defense of this belief, he presents the following information to Kapoor: Exhibit 3 – Selected Accrual, Cash Flow, and Profit Ratios as of 31 DecemberBigLights Limited Cash flows accruals ratio Balance sheet accruals ratio (Operating cash flow) ( ) (Operating income) Revenue : Cash collected ratio) Net profit margin 2017 2016 10.5% −12% 8.8% −2.8% 0.35 1.20 98.6% 29.8% 97.9% 13.3% In response, Kapoor says, “The comparison you have made between operating cash flow and operating earnings is biased upward when comparing to accrual-based operating income.” Wobble says, “Although the company could repay all of its debt and maintain its reinvestment if it chose to do so, there are off-balance-sheet issues to consider. I’m in the process of capitalizing the operating leases but so far have only calculated the adjusted long-term debt/equity ratio for 2016.” It is shown in Exhibit 4. Exhibit 4 – BigLights Long-term Debt/Equity ratios 2016 Unadjusted After capitalization of capital leases 17% 25% Wobble also has doubts over the company’s recent capital allocation decisions and earnings sustainability. He suspects that the top-performing segments are being allocated a smaller proportion of capital expenditures relative to their total assets. He presents his findings in Exhibit 5 below: Exhibit 5 – Segments Data 15 © 2014-2024 AnalystPrep. EBIT 2017 Home L. Products 15.18 Industrial 22.5 Street Lighting 15.95 Margin Segment as a total 2016 2017 14.96 7.92 22.44 28.27 15.62 73.81 assets Segment % of as a assets total 2016 2017 7.92 31.90 31.90 7.04 70.18 71.06 Capex % of Capex 2016 39.49 4.84 65.67 Q.4 Based on Exhibit 3, which of the following statements is most appropriate ? A. The company experienced less cash earnings than accounting earnings in 2017 B. Kapoor's comment about the bias in the cash flow to operating income ratio is correct C. The company's earnings quality has improved in 2016 according to the cash-flowbased Q.2 Using 2017 data, suppose the company wished to pay off all of its debt while maintaining its current reinvestment policy. How many years would it take to do this? A. 2.1 years B. 2.3 years C. 2.8 years Q.1 Based on the lease information in Exhibits 1 and 2, the company's adjusted long-term debt/assets ratio as of the end of December 2017, is closest to: A. 0.1116 B. 0.1 C. 0.125 16 © 2014-2024 AnalystPrep. Q.3 The interest coverage ratio for 2016 after capitalizing the operating leases is closest to: A. 15.5 B. 14.3 C. 13.7 17 © 2014-2024 AnalystPrep. Case 36: Blake Levine On the morning of 15 September 2014, Blake Levine, a fixed-income investment analyst, is asked by his supervisor, Natalie Jonas, to analyze a convertible bond issued by Veridian Pharmaceuticals (VDP). Levine immediately gathers the relevant data from the convertible bond's offerings circular, shown below in Exhibit 1. Exhibit 1: Information on VDP's convertible bond Issue date 15 September 2013 Maturity date 15 September 2018 Coupon 4% of par value paid annually in arrears First interest payment 15 September 2014 (unless redeemed or converted) Issue price 100% of par value denominated in bonds of $100, 000 Conversion period 15 October 2013 to 15 August 2018 Initial conversion price $5.00 per share Conversion ratio $100, 00 par value convertible to 20,000 shares Threshold dividend $0.20 per share Change of control conversion price $3.25 per share While gathering the market data shown below in Exhibit 2, Levine learns that VDP also issued an option-free bond on 15 September 2013 that was otherwise equivalent to the convertible bond and that the company's common stock was trading at $4.25 per share on the day these bonds were issued. Exhibit 2: Market data (as of 15 September 2014) VDP share price $5.25 VDP share price volatility per annum 22% VDP dividend per share $0.12 Price of VDP's convertible bonds $121, 000 Interest rate (all maturities) 2.5% On 16 September 2014, Jonas asks Levine how to synthetically construct a convertible VDP bond that is both callable and putable. Levine responds that this can be accomplished by combining a long position in an option-free bond issued by VDP with multiple options positions, which he lists. On 18 September 2014, VDP releases news on positive results of clinical trials for one of the drugs in its development pipeline, and the price of the company's shares increases to $30. Later 18 © 2014-2024 AnalystPrep. that day, Jonas asks Levine, “How, if at all, has the risk-return profit of VDP's convertible bond changed as a result of the significant increase in the price of the company's common stock?” Q.1 The options positions listed by Levine in response to Jonas' question on 16 September 2014 most likely include a: A. Long position in a call option on VDP's stock and a long position in a call option on the underlying option-free bond. B. Long position in a call option on VDP's stock and a short position in a call option on the underlying option-free bond. C. Long position in a put option on the underlying option-free bond and a short position in a call option on VDP's stock. Q.2 The market conversion price on 15 September 2014 is closest to: A. $5.25. B. $6.05. C. $6.30. Q.3 On 15 September 2014, the premium at which VDP's convertible bond is trading over the otherwise equivalent option-free bond is closest to: A. 14.5%. B. 15.2%. C. 16.9%. 19 © 2014-2024 AnalystPrep. Q.4 The minimum value of the convertible bond on 15 September 2014 is closest to: A. 103500 B. 105643 C. 121000 20 © 2014-2024 AnalystPrep. Case 38: Neil Berry Neil Berry, CFA, is a senior analyst at Kuntman Investments, an international equities investment firm. Berry has been asked to value Velocity Inc. – a Mexico-based original equipment manufacturer (OEM). Velocity has significant inroads in both local and international markets, particularly in the United States. Velocity’s closest competitor, Rivard Inc., is listed on the local stock exchange and is very actively traded. Following a successful IPO, Velocity recently joined Rivard on the stock exchange. However, trading on its stock has been somewhat thin. Berry refers to the financials of both entities: Exhibit 1: Financial Information for Velocity Inc. and Rivard Inc. Velocity Inc. Current Assets Long-term Assets Total Rivard Inc. 55 Current Assets 135 Long-term Assets 190 Total 80 130 210 Current Liabilities Long-term Debt Owner's equity Total 10 120 60 190 15 140 55 210 Current Liabilities Long-term Debt Owner's equity Total Income Statement Velocity Inc. Revenue EBIDTA Operating income Interest expenses Income tax rate 425 146 117 6 30% The cost of equity is 6.16%. To understand Velocity Inc.’s plans for future CapEx and growth strategy, Berry sets up a call with Nathan McCardle, the CEO of Velocity. During the call, McCardle highlights that Velocity is not planning for growth in CapEx. They are focusing on reducing debt level, and their target debt-to-equity ratio for the next two years is 1.5:1. Due to the lower liquidity in Velocity’s stock, Berry is wary of using regression analysis to estimate its beta. He uses Rivard’s beta to estimate the beta for Velocity, as both companies are quite similar in terms of operations and size. However, he adjusts the beta of Rivard – which is 21 © 2014-2024 AnalystPrep. stable at 0.9 – to reflect the beta drift with Velocity. Having computed all the inputs for the analysis, Berry went to brief his senior colleague, Mattie Robinson, about his approach and methodology. Robinson pointed out that: Both entities gained part of their revenue through exports to the U.S. Berry should take into consideration foreign exchange rate risk and also consider the appropriateness of using the Country Spread model or the Country Risk model for building a risk premium into the required return. Berry decided to use the Country Spread model and stated that he would use the U.S. market as a benchmark and add a premium for the emerging Mexican market. Robinson further opined that: “While doing the valuation of an entity, an analyst should take into consideration its strategies and macroeconomic environment. In particular, several stock-specific factors make the valuation of public companies different from the valuation of private ones.” Robison asked Berry to consider analyzing Velocity based on Porter’s Five Forces model. Q.1 The adjusted Beta (adjusted for Beta drift) for Rivard Inc. is closest to: A. 0.967. B. 0.934. C. 1.000. 22 © 2014-2024 AnalystPrep. Q.2 If the risk-free rate is 3%, and the required market return over the risk-free rate is 4%, the required return for Velocity Inc. using the CAPM model is closest to: A. 0.79. B. 8.66%. C. 6.16%. Q.3 Use exhibit 1 to estimate the required return on debt. Based on your answer, the weighted average cost of capital (WACC) for Velocity, Inc. is closest to: A. 7.38%. B. 4.56%. C. 4.39%. Q.4 Robinson suggested the use of two different methods to incorporate a risk premium in the required return and related to the Country Risk method. Would these methods be appropriate for the purpose at hand? A. Yes, both would be appropriate B. No, none of them would be appropriate C. Only one of them would be appropriate 23 © 2014-2024 AnalystPrep. Case 42: James Ward James Ward is an experienced financial planner at a renowned wealth management firm based in New York, U.S.A. One of his clients, Sarah Wayne, just made a sizable capital gain after taking up a share buyback offer floated by a technology company she invested in 15 years ago. Wayne has decided to invest 30% of the proceeds in an insurance product that combines a life cover with an immediate annuity. Thanks to the product, her income will substantially increase. She has enlisted Ward’s help to invest the remaining amount of the buyback proceeds. After taking into account Wayne’s risk appetite, Ward proposes an investment in government bonds. He recommends purchasing a one-year U.S. government zero-coupon bond. At present, the bond is priced at $95.8 for every $100 par value. Ward estimates the one-year real risk-free rate at 1.3% and the unexpected inflation over the next year to be 1.05%. Wayne would like to have some exposure to international markets, and Ward puts forth three countries all of which present attractive investment destinations. Exhibit 1 presents selected data on the three countries. Exhibit 1 – Selected Macroeconomic Data Nominal GDP Growth Inflation Rate Volatility of Real GDP Growth Yield Curve shape Country A Country B 7.5% 4% 5% 2% Low High Country C 3% 2.5% Low Flat Upward Slope Flat Trailing 12-month Equity index P/E 12.5 15.5 16.5 In his analysis, Ward observes that, “Other things equal, equilibrium price-to-earnings (P/E) ratios will most likely decrease if inflation is expected to increase.” 24 © 2014-2024 AnalystPrep. Q.1 The implied premium for expected inflation for the one-year government zero-coupon bond proposed by Ward is closest to: A. 0.025 B. 0.02 C. 0.017 Q.2 Based on the data in Exhibit 1, which country would be the least attractive investment destination in terms of current real short-term interest rates? A. Country B B. Country C C. Country A Q.3 Holding all else constant, the change in Wayne's income will most likely result in: A. An increase in her required risk premium for investing in risky assets. B. An increase in her intertemporal rate of substitution. C. A decrease in her required risk premium for investing in risky assets. Q.4 In Ward's comment on the behavior of the equilibrium price-to-earnings (P/E) ratios if expected inflation increased correct? A. No, P/E ratios would remain constant B. No, P/E ratios would increase C. Yes, P/E ratios would decrease 25 © 2014-2024 AnalystPrep. Case 911: AlphaGen Capital AlphaGen Capital is a hedge fund specializing in a variety of strategies with a significant focus on long/short equity. The fund prides itself on astute stock selection and a deep fundamental analysis approach. Founded by a group of experienced portfolio managers, who bring their sector-specific expertise, particularly in technology, finance, and healthcare, AlphaGen seeks to generate consistent alpha for its investors by maintaining a flexible portfolio of both long and short positions, while using leverage and beta tilts wisely to enhance returns and manage risk.

Investment Scenario

You are given the task of analyzing AlphaGen's recent portfolio moves and strategy adjustments. The cur

• AlphaGen increased its long positions in undervalued healthcare stocks by 5%, anticipating regulatory
• It increased short positions in overvalued tech stocks by 10% because of anticipated resistance to new
• The fund applied a beta tilt, reducing net long exposure to 40% in anticipation of a market downturn b

Q.1 What is AlphaGen's new gross exposure after the recent adjustments? A. 1.3 B. 1.25 C. 0.95 Q.2 What would AlphaGen's total portfolio value be if it started with $100 million and applied 2x leverage to its new gross exposure? A. $ 250 million B. $ 145 million C. $ 200 million 26 © 2014-2024 AnalystPrep. Q.3 The expected return of the fund if the anticipated return for long positions is 12% and for short positions is 6%, considering the changed exposures and no leverage is closest to. A. 0.069 B. 0.132 C. 0.126 Q.4 Suppose the market went down by 10%, AlphaGen's new portfolio value considering its net exposure before and after beta tilt will be closest to. Assume initial value is $100 million and no leverage. A. $95 million and $96 million B. $95 million and $94 million C. $92 million and $98 million 27 © 2014-2024 AnalystPrep. Case 922: Vlad Stratov Vlad Stratov, CFA is a trainee at Levi Bank. He has recently been transferred to the foreign exchange department as part of his training. Stratov has been assigned to Syndey Gomez, CFA. Gomez informs Stratov that a Brazilian corporate client who exports Coffee to the United Kingdom is looking to estimate the potential hedging cost for a sale that will close in one year. Gomez requests Stratov to determine the discount/ premium for a 360-day forward contract using the exchange rate data in the Exhibit below. Exhibit 1: Select BRL and GBP Currency Data Spot (BRL/GBP) 7.26 Annual (360-day) MRR (GBP) 4.54% Annual (360-day) MRR(BRL) 7.56 To determine their profit potential Gomez considers two possible trades. One involves a carry trade which involves the EUR and USD. She anticipates a higher return compared to buying a one-year domestic note given the current market conditions, influenced by low US interest rates and his predictions for exchange rates in one year. Stratov provides Gomez with one-year forecasts and selected current market data to asses the carry trade in Exhibit 2. Exhibit 2: Interest Rates and Spot Rates for The Proposed Carry Trade EUR CAD USD Today’s One-Year MRR 1.1% 1.6% 0.9% Currency Pair CAD/EUR USD/CAD Projected Spot Rate a Year 1.48 0.732 Today’s Spot Rate 1.50 0.72 The second trade involves a possible triangular arbitrage trade between the JPY, SEK and USD that will be executed based on the interbank spot rate presented in Exhibit 3 and a dealer’s quote of 14.3/14.4 JPY/SEK. Exhibit 3: Interbank Quotes Currency Pair Bid/Offer JPY/USD 106.39/106.41 SEK/USD 9.730/9.732 28 © 2014-2024 AnalystPrep. Levi Bank has another corporate client, Maxmillan Ltd who would like to execute currency trades with its subsidiaries in China and Europe at the best bid-offer spread. Its Chinese subsidiary is about to close a deal to acquire 2 Brazilian companies and wants to lock in the trade involving the Chinese Yen and Brazilian Real as early as 9:00 am New York time. Q.1 Using Exhibit 1, the forward premium for a 360-day BRL/GBP forward contract is closest to? A. 1.651 B. 0.561 C. 0.209 Q.2 Using Exhibit 2, the potential all-in EUR return on the carry trade is closest to: A. -0.51 B. 0.01213 C. 0.011 Q.3 Based on Exhibit 3, the most appropriate action regarding the triangular arbitrage trade is: A. To execute the trade, buy SEK in the interbank market and sell SEK to the dealer. B. To decline the trade because there is not arbitrage profits. C. Execute the trade, buy SEK from the dealer and sell SEK in the interbank market. 29 © 2014-2024 AnalystPrep. Q.4 Which factor will most likely lead to a wider bid-offer spread for Maxmillian Ltd needed trade: A. Lower liquidity. B. Lower volatility. C. Lower transaction costs. 30 © 2014-2024 AnalystPrep. Case 923: Andy Lew Andy Lew, CFA is a portfolio manager with April Bank Securities. The firm is located in Seoul, South Korea, and has a high net worth client base. The firm focuses on emerging markets such as India, Brazil, South Africa, and Russia. Recently, Lee Park Yu, a retired senior executive, approached Andy Lew. Yu has a large portfolio, but it is entirely invested in South Korean securities. He wants to diversify his investments in India, but Indian securities regulations do not allow him to own stocks or bonds directly in his account. Lew suggests that Yu consider derivative positions on Indian stocks and bonds. Lew recommends three options: 1. Enter into a currency swap to pay a floating interest rate on a notional principal of South Korean Won (SKW) 900 million and receive a floating interest rate on a notional principal of Indian Rupee (INR) 30 million 2. Enter into an equity swap to pay, semi-annually, a fixed interest rate on SKW and receive returns of Sensex, a widely followed Indian stock index 3. Purchase a long call on Sensex Lew collects interest rate data from India and South Korea and information on Sensex. Interest rate term structure: SKW Days INR Interest Rates 180 7.2% 5.4% 360 8.0% 6.0% Interest Rates Sensex: Exchange Rate INR 1 = SKW 30 Current stock price 26850 Risk free interest rate 6.00% Current volatility 20% u 1.25 d 0.8 Exercise price 28000 Yu enters into the currency and equity swaps following Lew's advice to diversify his fixed income 31 © 2014-2024 AnalystPrep. and equity investment portfolio. Yu also buys call options on Sensex. However, Yu believes that South Korean interest rates are likely to decline and asks Lew if he can transfer his interest rate risk. Lew says Yu can manage the interest rate risk with swaptions. Q.1 Later that day, Sensex announces it will start paying dividends effective immediately. As a result, the value of the call option of Sensex should: A. Remain the same B. Increase C. Decrease Q.2 To transfer the risk of a decline in interest rates, the most appropriate swaption for Yu would be: A. A payer swaption B. A receiver swaption C. An arrear swaption Q.3 According to the one period binomial model, the price of the Sensex call option is closest to: A. 3000 B. 3200 C. 5600 32 © 2014-2024 AnalystPrep. Q.4 Suppose the Sensex stock increases in value over one period. The call option delta would be equal to: A. B. C. Stock pr ice−Strike Stock Stock pri ce−Cal l pri ce1 −Sto ck pr ice1 −Stri ke Call pr ice−Ca ll p rice1 −Call pr ice0 pr ice0 p rice0 pri ce0 Stock pr ice1 −Call p rice1 Stock pr ice0 −Call p rice0 33 © 2014-2024 AnalystPrep. Case 924: Giuseppe Mancini Giuseppe Mancini is a junior analyst working for the Orion Investment Group. Giuseppe has had several meetings with his manager to discuss a possible investment in Kyoto Pharmaceuticals. Following the discussions, Giuseppe has been asked to estimate Kyoto’s cost of equity and debt in a bid to determine Kyoto’s valuation and WACC. He managed to gather the following crucial information about Kyoto. Company: Kyoto Pharmaceuticals Business Model Large-cap, publicly traded company Manufacture of cancer and diabetes medication. Has high research and development costs. Pharmaceuticals Industry Revenues, Earnings, Cash flows Revenues have been upward, but most of the earnings and cash flows have been reduced due to high research and development costs. Nature of Assets Property, plant, and equipment make up a significant part of their assets. The company also has intangible assets. Kyoto has had a robust financial performance in terms of profitability and sales. Three years back, the company made plans to set up an insulin manufacturing plant. Kyoto issued redeemable preferred stock to finance this project, which came at a high cost. Recent financial filings show that Kyoto will issue new unsecured debt to retire the preferred shares at par value. Kyoto’s capital structure is shown in Exhibit 1 below. 34 © 2014-2024 AnalystPrep. Exhibit 1: Kyoto’s Current Capital Structure and Related Information. Capital Type Capital Selected Capital Structure Type Information Debt 20% A single debt issue @ 7% coupon rate with seven years left to maturity, paid semiannually —unsecured debt with a BBB credit rating but no available YTM. Common Equity 70% Traded actively Preferred Equity 10% Frequently traded with a share price of 720. 8% dividend rate redeemable at a par value of 1000 per share. Giuseppe also gathered information on four liquid, semiannual-pay corporate bonds with the same credit rating as Kyoto. The data is presented in Exhibit 2. Exhibit 2: Information on BBB-Rated Bonds Coupon Rate Remaining Current Price (per 100 of par Maturity value) Bond A 100 7% 4 years Bond B 102.6 6% 4 years Bond C 98.5 5% 8 years Bond D 108.9 8% 8 years Using the Fama-French five-factor (FF5) model and the CAPM, Giuseppe estimates Kyoto’s equity cost by regressing Kyoto’s excess returns on risk factors with data from the most recent 60 months of returns. He uses the 20-year government benchmark rate of 3.5% as the risk-free proxy. Exhibit 3 contains information on factor betas along with estimated factor risk premiums. 35 © 2014-2024 AnalystPrep. Exhibit 3: FF5 and CAPM Factor Beta and Risk Premiums Factor Factor Beta Risk Premium CAPM Factor Betas and Risk Premiums Market (ERP) 0.85 4.8% FF5 Factor Betas and Risk Premiums Market (ERP) Size (SMB) Value (HML) Profitability (RMW) Investment (CMA) 0.81 0.5 0.2 −0.16 0.32 4.8% 2% 4% 2.9% 3.9% Using the BYPRP, Giuseppe estimates Kyoto’s cost of equity. He assumes a historical risk premium of 5.8% earned by equity investors relative to long-term bond yields. Giuseppe prepares and submits the report to his manager. The manager is curious about which criteria were used to estimate the ERP of 4.8% in his cost of equity estimate. Giuseppe informs the manager that the estimation was derived using the historical approach, electing to use the arithmetic mean and the short-term government bill rate. Q.1 Given the current capital structure, Kyoto’s cost of debt is closest to: A. 0.0595 B. 0.0622 C. 0.0589 Q.2 Kyoto’s Cost of common equity using the BYPRP model is closest to? A. 0.0628 B. 0.1175 C. 0.058 36 © 2014-2024 AnalystPrep. Q.3 Which of the following is the least likely action that Kyoto’s management can take to lower the cost of issuing debt: A. Issuing secured debt, secured by some property, plant, and equipment. B. Issuing debt with a put option. C. Issuing unsecured debt. Q.4 Kyoto’s cost of common equity using CAPM is closest to? A. 12. 08% B. 0.0628 C. 0.0758 37 © 2014-2024 AnalystPrep. Level II of the CFA® Exam Mock Questions with Answers - Mock Exam 2025 #2- First Session Offered by AnalystPrep Last Updated: Dec 27, 2024 1 ©2024 AnalystPrep “This document is protected by International copyright laws. Reproduction and/or distribution of this document is prohibited. Infringers will be prosecuted in their local jurisdictions.” Case 22: Eric Noble Eric Noble, Richard Wong, and Christine Jenney are all investment analysts and citizens of the U.S. Mr. Noble's employer is a multinational investment company based in the United States, but he is stationed in Sahara – a country with a fast-growing capital market. Local laws are minimal – in form and content, and there are no punitive measures put in place to discourage the release of material non-public information in a non-procedural manner. Noble, believing that, as a U.S. citizen working for a US-based company, he should comply only with U.S. law and ignore local law. Wong, on the other hand, works in the landlocked nation of Switzerland. To prevent front-running of clients trades, local laws impose a restriction period spanning at least 60 calendar days before and ten calendar days after issuance of any research report. One of Noble's clients is the board of trustees of a private university endowment fund. The trustees provide Noble with the fund's financial information, including planned expenditures. Noble receives a phone call on Sunday afternoon from Simpson, a prominent alumnus, requesting that Noble email him comprehensive financial information about the fund. According to Simpson, he has a potential contributor but needs the information that day to close the deal and cannot contact any of the trustees. Jenney resides in Florida, USA. She, however, works in the island nation of Panamba where she does business with a client who is a citizen of Sahara. Panambian securities laws and regulations are less strict than the dictates of the CFA Institute Code and Standards. Although the more strict law applies, a clause within the local laws states that the law of the client's home country governs. Eric Noble is a strong advocate of the CFA program. His business cards and office letterheads all have the CFA logo printed on them, and he only hires CFA candidates or charterholders. Noble recently hired Mark Johnson, a CFA candidate and recent finance graduate from a tier 1 university with excellent quantitative and qualitative skills. Johnson has passed Levels I and II of the CFA program and is currently awaiting the results of the final exam. In his welcome note to Johnson, Noble notes that: 2 © 2014-2024 AnalystPrep. "As a CFA finalist, I have a lot of faith in your work. I expect you to perform considerably better than most of the analysts we already have, and I'm confident of your promotion in a few years. In my personal opinion, I believe the CFA program has nourished you with immensely important portfolio management skills that will go a long way toward helping this company attain its goals." On the same day, Noble instructs the digital team to put up Johnson's professional biography on the company's official website, telling them, "Use mine as a template. Just change the name, title, CFA logo, and other information as necessary. When Johnson reports to work the following day, he finds his bio already uploaded on the website. On it is his name, firm name, his professional history, and academic achievements, including the fact that he has passed level I and II of the CFA exam in consecutive years. Within a few weeks, Johnson passes level III of the CFA exam and after satisfying all the additional requirements, he is awarded the CFA charter. Since then, he has earned both his CFA designation and a Ph.D. in Finance, he would like to have his professional bio and related documents updated to reflect these achievements. He is however unsure of the proper method of doing so. A year into his role as an investment analyst, Johnson is tasked with the development, maintenance, and enhancement of the proprietary models the firm uses to manage its portfolio of derivatives. Eager to impress in his new role, Johnson develops a habit of reading widely on all topics related to derivatives trading. While browsing online, he comes across a website run by Smart CFA. The blog outlines some intriguing research and suggests several upgrades that could improve his employer's current models. In the next few days, Johnson spends time incorporating the factors discussed in the online blog. The updated results form part of his preliminary research report which carries several buy recommendations. Before the report has been published, Johnson sends it to the corporate finance department for verification of the information. After receiving the verified report, he sends it to the legal department for documentation in line with company policies. Five years after receiving his CFA charter, Johnson resigns his and spends the next three years growing his large-scale farming business. Because he is not actively engaged in the investment 3 © 2014-2024 AnalystPrep. profession, he does not file a completed Professional Conduct Statement with CFA Institute and does not pay his CFA Institute membership dues. Two years later, Johnson becomes a selfemployed analyst accepting assignments as an independent consultant. Without reinstating his CFA Institute membership by filing his Professional Conduct Statement and paying his dues, he requests his manager to reprint the business cards and professional bio as used in his previous role, albeit without the name of his former employer. He also coins a tagline for his new business which reads, "The Best Portfolio Adviser in Town." In a conversation with a prospective client, he states that she has learned a great deal from the CFA Program and that many firms require their employees to be CFA charterholders. He would recommend the CFA Program to anyone pursuing a career in investment consultancy. 4 © 2014-2024 AnalystPrep. Q.1 Which of the following statements is most likely true? A. Noble violated Standard I(A) - Knowledge of the Law B. Wong must abide by the CFA Institute Code and Standards in all his research work C. Jenny must adhere to the CFA Institute Code and Standards The correct answer is C. Whenever applicable law is stricter than the requirements of the Code and Standards, members are required to adhere to applicable law; otherwise, they must adhere to the Code and Standards. In Jenny’s scenario, applicable law states that the law of the client’s home country (Sahara) governs and the law in Sahara is less strict than the Code and Standards. As such, she must adhere to the stricter applicable law – the Code and Standards. A is incorrect. Noble is right to ignore local law and abide by the requirements of the Code and Standards which are clearly stricter than the rules of the developing country. In handling material nonpublic information that comes into his possession, he must follow Standard II(A) – Material Nonpublic Information. B is incorrect. According to recommendations of the CFA Code and Standards, restrictions of at least 30 calendar days before and 5 calendar days after report issuance should be applied. In this scenario, local laws impose a restriction period spanning at least 60 calendar days before and 10 calendar days after the issuance of any research report. As such, the member must abide by the stricter local laws in his research. CFA Level II, Study Session 17, Learning Module 48: Guidance for Standards I-VII, LOS 48(a): Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 5 © 2014-2024 AnalystPrep. Q.2 Should Noble share the fund's information with Simpson? A. Yes, because disclosure would benefit the client B. No, because he is bound by client confidentiality C. Yes, provided he promptly notifies the trustees The correct answer is B. This question relates to Standard III(A) – Loyalty, Prudence, and Care and Standard III(E) – Preservation of Confidentiality. In this case, the member manages funds of a private endowment. Clients, who are, in this case, the trustees of the fund, must place some trust in members and candidates. Noble cannot disclose confidential financial information to anyone without the permission of the fund, regardless of whether the disclosure may benefit the fund. Therefore, answer A is incorrect. C is incorrect Noble must notify the fund and obtain the fund’s permission before publicizing the information. CFA Level II, Study Session 17, Learning Module 48: Guidance for Standards I-VII, LOS 48(a): Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 6 © 2014-2024 AnalystPrep. Q.3 In which of the following scenarios has a CFA Institute Standard of Professional Conduct been violated? A. Nobles insistence on only hiring CFA charterholders of candidates B. Noble's welcome note to Johnson C. Johnson's professional biography The correct answer is B. Noble's welcome note to Johnson has violated Standard VII(B) - Reference to CFA Institute, the CFA designation, and the CFA program. Noble's first sentence strongly suggests that owing to Johnson's candidacy in the CFA program, the latter has better skills than other employees at the company. It also attempts to make promotional promises tied to the CFA designation. That's precisely what Standard VII (B) is meant to prevent. Individuals may refer to their CFA designation, CFA Institute membership, or candidacy in the CFA Program but must not exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA Program. The second part of Noble's note is however fully in compliance with the CFA Code and Standards because it expresses Noble's personal opinion. A is incorrect. There's nothing wrong with hiring only the individuals with ties to the CFA program, either as charterholders or candidates. C is incorrect. Based on the information given, no evidence suggests a violation has occurred while putting up Johnson's professional bio. Even though Johnson's bio looks much like Noble's, efforts have been made to remove sections that potentially could result in a violation of the standards. Most notably, the CFA logo is excluded from Johnson's bio. Asserting that Johnson passed his exams in consecutive years is also in compliance since that is factual information. CFA Level II, Study Session 17, Learning Module 48: Guidance for Standards I-VII, LOS 48(a): Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 7 © 2014-2024 AnalystPrep. Q.4 After gaining the right to use the CFA designation, which of the following designation formats should Johnson use on his resume, business cards, and professional bio? He should: A. Cite the CFA designation first, followed by his Ph.D. B. Cite the Ph.D. designation first, followed by the CFA designation C. Cite all his designations in any order The correct answer is C. The order of designations cited on such items as resumes and business cards is a matter of personal preference. Johnson is free to cite the CFA designation either before or after citing his Ph.D. CFA Level II, Study Session 17, Learning Module 48: Guidance for Standards I-VII, LOS 48(a): Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 8 © 2014-2024 AnalystPrep. Case 23: Analiese Geiger Analiese Geiger, CFA is a foreign exchange expert at Centilane. She is looking for investment opportunities in the market. Geiger had her assistant, Michael Roger, gather the following information: The Australian dollar (AUD) interest rate is 4%. The British pound (GBP) interest rate is 6%. The spot exchange rate is 1.95 AUD/GBP. The 1-year AUD/GBP forward rate is 1.94. The expected inflation rate in Australia is 1.5% The expected inflation rate in the U.K. is 2.5%. Geiger believes covered interest parity will hold for at least the next 12 months. Geiger notices a difference between the market forward rate and the forward rate required by covered interest rate parity. She could borrow AUD at the Australian interest rate to take advantage of this arbitrage opportunity before it disappears. Mark Weber, CFA, is a former colleague and acquaintance of Geiger. He works as a junior analyst at Pearl River Investment Research & Advisors (PRIRA) based in Dallas, Texas. Pearl River Investment, which serves mostly institutional investors, is well-known for providing emerging and frontier market focused investment research. Texas Public Workers' Retirement Fund (TPWRF), a large institutional investor, has approached PRIRA before investing in two emerging economies – Petronia and Coaldovia. TPWRF believes that long-term stock market returns are directly correlated with a country's GDP growth rate. TPWRF seeks advice from PRIRA about potential GDP growth rates, interest rate changes, exchange rate fluctuations, and fiscal policies for both countries. Weber searches government websites, industry associations, central banks, and reputable political and economic newspapers to prepare a snapshot of the political and economic conditions in both economies. Based on these readings, Weber has prepared a brief profile, a part of which is given below: 9 © 2014-2024 AnalystPrep. Exhibit 1 – Economic Conditions in Petronia and Coaldovia Growth rate of technological progress Share of capital in GDP Growth rate of capital Growth rate of labor Long-term growth rate in labor productivity Petronia 2.75% 0.3 2.50% 3.50% 3.00% Coaldovia 3.00% 0.55 1.50% 1.00% 2.25% In addition to this quantitative data, some nuggets of qualitative information about the politicoeconomic development in Petronia and Coaldovia also draw Weber's attention. Petronia: Petronia's government has failed to get the national parliament's approval for legislation to reform the labor market. The government plans to continue economic policies of import substitution for the foreseeable future. The government plans to subsidize technical education. Coaldovia: Coaldovia's government plans to create a national monopoly to explore, extract, and export natural gas. Economic decision-makers believe trade and exports will be the key drivers of economic growth. The average age for the working population is 42 years. Capital Ride Hedge Fund (CHF) is another client of PRIRA. CHF has significant investment exposure in Petronia. Three months back, it sold 16.5 million Petronian Dollars (PED) through a 9-month forward contract at an exchange rate of 8.2550 per U.S. Dollar. CHF has approached PRIRA to mark its forward position to market. Weber gathers the following information to determine this. 10 © 2014-2024 AnalystPrep. Exhibit 2 – Forward Rates and Interest Rates Spot rate – (PED/USD) 8.3050– 8.3250 Six months forward points −250/ − 300 Six months interest rate on PED (annualized) 6.50% Six months interest rate on USD (annualized) 3.00% CHF is also planning to enter into a carry trade, borrowing 1,000 in Japanese Yen (JPY) and investing in Coaldovian Dollars (COD). However, CHF's fund manager wants to know the likely returns from this carry trade. Interest rates and exchange rates for both currencies are as follows: Exhibit 3 – Interest Rates and Exchange Rates Today's One-Year Interest Rates COD 12% JPY 1.5% Currency Pair COD/USD JPY/USD Spot Rate Expected Spot Rate in Today One year 20.75 21.25 101.50 100.75 Q.1 The 1-year AUD/GBP forward rate as required by covered interest rate parity is closest to: A. 1.91 B. 1.95 C. 1.99 The correct answer is A. Covered interest rate parity requires that the forward rate satisfy the following formula: days FAUD/G BP = 1 + RAU D ( 360 ) days 1 + R GBP ( 360 ) SAU D/ GBP = 1 + 0.04 (1) (1.95) = 1.91 1 + 0.06 (1) CFA Level II, Learning Module 28: The Term Structure and Interest Rate Dynamics, LOS 28(h): explain traditional theories of the term structure of interest rates and describe the implications of each theory for forward rates and the shape of the yield curve. 11 © 2014-2024 AnalystPrep. Q.2 According to the growth accounting equation, the two countries' potential GDP growth rate will be closest to: A. Petronia: 6.50%; Coaldovia: 4.30% B. Petronia: 6.00%; Coaldovia: 4.30% C. Petronia: 6.00%; Coaldovia: 3.25% The correct answer is B. According to the growth accounting equation, Potential GDP growth rate = Rate of technological progress + (Share of capital in GDP)(Growth rate of capital) + (Share of labor in GDP)(Growth rate of labor) Using the equation given above, Potential GDP growth rate for Petronia = 2.75% + (0.3)(2.50%) + (1 − 0.3)(3.50%) = 5.95% Potential GDP growth rate for Coaldovia = 3.00% + (0.55)(1.50%) + (1 − 0.55)(1.00%) = 4.275% CFA Level II, Learning Module 9: Economic, LOS 9(e): demonstrate forecasting potential GDP based on growth accounting relations 12 © 2014-2024 AnalystPrep. Q.4 The one-year all-in expected profit from the carry trade for COD in JPY will be closest to: A. 0.0605 B. 0.0705 C. 0.105 The correct answer is B. Spot rate for COD/JPY today = 20.75 = 101.50 0.2044 Expected spot rate for COD/JPY one year later = 21.25 = 100.75 0.2109 JPY 1,000 will be converted to COD 1, 000 × 0.2044 = 204.4 Invested for one year at 12% interest rate, COD 204.4 × 1.12 = 228.93 1 Converted to JPY 228.93 × ( 0.2109 ) = 1 , 085.49 After one year, borrowed JPY that needs to be repaid = 1 , 000 × 1.015 = 1, 015 All-in profit from carry trade = 1 , 085.49 − 1 , 015 = 70.49 On the borrowed amount of JPY 1,000, the profit will be 7.05% CFA Level II, Learning Module 28: The Term Structure and Interest Rate Dynamics, LOS 28(h): explain traditional theories of the term structure of interest rates and describe the implications of each theory for forward rates and the shape of the yield curve. 13 © 2014-2024 AnalystPrep. Q.3 The mark-to-market profit or loss to CHF for the short forward position on Petronian Dollars will be closest to: A. a USD 5,946 loss. B. a USD 5,946 profit. C. a USD 6,035 profit. The correct answer is B. To mark-to-market, the short forward position in PED, the Capital Ride Hedge Fund (the dealer) will need to buy PED via a 6-month forward contract. The 6-month forward buying price for PED will be 8.3050 - 0.0250 = 8.280 PED/USD, or equivalently, 1/8.280 USD per PED. In 6 months, The dealer will receive USD 1,998,789 = 16,500, 000 8.2550 at the maturity of the original 9-month forward contract. The dealer will have to deliver USD 1,992,754 = 16,500 ,000 8.280 at the maturity of the 6-month forward contract. Therefore, the dealer will receive USD 1,998,789 – USD 1,992,754 = USD 6,035 more after six months. PV of USD 6,035 at 3.00% interest rate is 5, 946 = 6, 035 (1.03)0.5 The dealer has a profit on mark-to-market amounting to USD 5,946. CFA Level II, Learning Module 8: Currency Exchange Rates: Understanding Equilibrium Value, LOS 8(d): calculate the mark-to-market value of a forward contract 14 © 2014-2024 AnalystPrep. Case 25: ModFarm, Inc. ModFarm, Inc., is a large-scale manufacturer of high-quality farm machinery, including land mowers and combine harvesters used in the harvesting of wheat. While many companies have struggled through the last few years particularly in the face of the continued global economic weakness and oft-unpredictable political climate, ModFarm has enjoyed a surging demand for its products as a result of the continued mechanization of agriculture in Asia and Africa. The strong demand has taken its toll through higher inventory costs but the company has so far been successful at passing these costs on to customers through higher prices. ModFarm’s products have expected useful lives of 25 years on average. The company has traditionally depreciated its assets on a straight-line basis. Liza McCarthy, CFA, works as an equity analyst at Crystal Investments. She is reviewing MofFarm’s recent financial statements. ModFarm prepares its financial results according to US GAAP. Exhibits 1 and 2 contain selected portions of the company’s statement of operations and statement of financial position, while Exhibit 3 contains selected notes from the company’s 2017 financial statements. Exhibit 1 – ModFarm Inc. Consolidated Results of Operations ($ millions) For the Year Ended 31 December 2017 Sales 82 , 302 Cost of goods sold 58 , 506 Gross profit 23 , 796 Net profit 7 , 003 Exhibit 2 – ModFarm Inc. Consolidated Financial Position ($ millions) $ \begin{array}{l|r|r} \textbf{December 31} & \bf{2017} & \bf{2016} \\ \hline \text{Cash} & 1,049 & 2,195 \\ \hline \text{Receivables} & 29,645 & 27,657 \\ \hline \text{Inventories} & 12,576 & 10,342 \\ \hline \text{Other current assets} & \underline{2,455} & \underline{4,755} \\ \hline \text{Current assets} & 45,725 & 44,949 \\ \hline {\text{Net PP&E}} & 17,526 & 15,820 \\ \hline \text{Other assets} & \underline{37,488} & \underline{32,426} \\ \hline \text{Total assets} & \underline{100,739} & \underline{93,195} \\ \\ \text{Accounts payable} & 8,088 & 6,755 \ \hline 15 © 2014-2024 AnalystPrep. \text{Other current liabilities} & \underline{30,030} & \underline{30,564} \ \hline \text{Total current liabilities} & 38,118 & 37,319 \ \hline \text{Long-term liabilities} & \underline{49,041} & \underline{39,181} \ \hline \text{Total liabilities} & 87,159 & 76,500 \ \hline \text{Total shareholders’ equity} & 13,580 & \underline{16,695} \ \hline \text{Total liabilities and shareholders’ equity} & \underline{100,739} & \underline{93,195} \ \end{array} $ Exhibit 3 – Selected Notes to the Financial Statements of ModFarm Inc. Note 1: Inventories Inventories are stated at the lower of cost or market, with cost determined using the lastin, first-out (LIFO) method. $ millions 2017 2016 LIFO reserve 4 , 757 4, 643 No LIFO liquidation occurred during the years 2015 to 2017 Note 2: Depreciation and amortization Depreciation of plant and equipment follows the straight-line method $ millions Consolidated depreciation expense 2017 2016 1, 096 776 Note 3: Income Taxes The company’s effective tax rate has been 30% for each of the last 5 years. ModFarm offers its employees a defined benefit pension plan. Information on the company’s retirement plans is presented in Exhibit 4. Exhibit 4 – ModFarm Retirement Plan Information 2017 (in $ millions) 16 © 2014-2024 AnalystPrep. Employer contributions Current service costs Past service costs Discount rate used to estimate plan liabilities Benefit obligation at the beginning of the year Benefit obligation at the end of the year Actuarial loss due to increase in pan obligation Plan assets at the beginning of the year Plan assets at end of year Actual return on plan assets Expected rate of return on plan assets 6, 600 1, 320 792 7.0% 277, 200 275, 352 3, 036 257, 400 255, 420 17, 820 8.0% As part of its motivation packs, ModFarm has put in place a stock options plan for top executives. Exhibit 5 presents information on the volatility assumptions used to value the stock options. Exhibit 5 – ModFarm Volatility Assumptions Used to Value Stock Options Grant Year 2017 Valuation Assumptions (2013– 2017) 2016 Valuation Assumptions (2012– 2016) Weighted Average Expected Volatility 21% 18.5% Q.1 Assuming ModFarm used the FIFO method to account for its inventory, its cost of goods sold (in millions) in 2017 would be closest to: A. 57000 B. 58608 C. 58392 The correct answer is C. COGS (FIFO) = COGS (LIFO) − Increase in LIFO reserve = 58, 506 − (4, 757 − 4, 643) = 58,392 CFA Level II, Learning Module 13: Multinational Operations, LOS 13(d): compare the current rate method and the temporal method, evaluate how each affects the parent company's balance sheet and income statement, and determine which method is appropriate in various scenarios 17 © 2014-2024 AnalystPrep. Q.2 If ModFarm had been using the FIFO accounting since incorporation, its retained earnings at the end of 2017 would most likely be higher by: A. 4757 B. 3330 C. 1427 The correct answer is B. The LIFO reserve at the end of 2017 was $4,757, indicating that cumulative gross profits would have been $4,757 higher under FIFO. With a tax rate of 30%. The cumulative additional income tax expense would be $4, 757 × 0.30 = $1 , 427 Resulting in an increase in retained earnings of $4, 757– $1 , 427 = $3, 330. CFA Level II, Learning Module 13: Multinational Operations, LOS 13(d): compare the current rate method and the temporal method, evaluate how each affects the parent company's balance sheet and income statement, and determine which method is appropriate in various scenarios 18 © 2014-2024 AnalystPrep. Q.3 The amount of periodic pension cost (in millions) that would be reported in P&L under IFRS is closest to: A. 3696 B. 2850 C. 3498 The correct answer is C. Under IFRS, the components of periodic pension cost that would be reported in P&L are: Service cost (both current and past) + net interest expense or income Service cost = 1, 320 + 792 = 2, 112 Net interest expense = net pension liability × discount rate income = (277, 200– 257 , 400) × 0.07 = 1, 386 Periodic pension cost = 2, 112 + 1, 386 = $3, 498 CFA Level II, Learning Module 12: Multinational Operations, LOS 12(e): explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the notes to the financial statements affects financial statements and ratios 19 © 2014-2024 AnalystPrep. Q.4 The retirement benefits (in millions) paid during the year were closest to: A. 26400 B. 29172 C. 25500 The correct answer is A. Benefit paid = beginning obligation + current service costs + past service costs + interest expense + increase in obligation due to actuarial loss − ending obligation = 277, 200 + 1 , 320 + 792 + 277, 200 × 0.07 + 3, 036 − 275, 352 = $26, 400 CFA Level II, Learning Module 12: Multinational Operations, LOS 12(b): explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset) 20 © 2014-2024 AnalystPrep. Case 26: Chang Lee Professor Chang Lee, an expert in corporate finance, has been hired by Corporate Consultants Inc. to advise on a suitable capital structure for Yogu Inc., one of its clients. Yogu Inc., based in Anagonia, manufactures semiconductors. The company has developed a new technology to develop semiconductors that can be extensively and exclusively used in smartphones. The company plans to set up a separate subsidiary for manufacturing semiconductors exclusively for smartphones using the new technology. The company is confident that the proposed subsidiary will capture more than 80 percent of the market in the next few years. The cost of setting up the company works out to be USD 20 billion. The company is planning to raise the entire capital using a combination of debt and equity. It has decided to seek the services of Corporate Consultants Inc. for this purpose. Corporate Consultants Inc. has tie-ups with academic and industry experts in corporate finance. Professor Chang Lee estimates the WACC by first assessing the cost of capital and the cost of debt. The marginal tax rate for the company is 35 percent. The following table captures the capital structure and related information: Capital Structure and related information Type of Capital Common Equity Preferred Equity Debt Current Capital Selected Capital Structure Type Information 70% Traded actively. 10% Redeemable at a par value of 1000 per share. The dividend yield is 8.5%. The current share price is 940. They are frequently traded. 20% Straight unsecured debt with a BBB credit rating. Single debt issue with an 8% coupon rate. Professor Chang Lee uses the Fama-French five-factor model (FF5) and CAPM to estimate Yogu's cost of equity by regressing Yogu’s excess returns on the relevant risk factors. A 20-year 21 © 2014-2024 AnalystPrep. government benchmark rate of 3.5% is used as a risk-free proxy. The table below contains details on factor betas from FF5 and CAPM. FF5 and CAPM risk premiums and Factor Beta Factor Factor Beta Risk Premium Market (ERP) Value (HML) Size (SMB) Profitability (RMW) Investment (CMA) 0.75 0.17 0.65 0.12 0.4 5% 4.2% 2.2% 3.5% 4% Market (ERP) 0.75 5% FF5 Risk Premium and Factor Betas CAPM Risk Premium and Factor Betas Professor Lee estimates Yogu’s cost of equity using the BYPRP approach, where she assumes a historical risk premium of 6% earned by equity investors relative to long-term yields from corporate bonds. The senior partner at the company is curious about how Professor Lee arrived at an ERP of 5% in his cost of equity estimation. Lee explains that he used the historical approach, using an arithmetic mean and the long-term government bill rate 22 © 2014-2024 AnalystPrep. Q.1 Yogu’s cost of preferred equity is closest to? A. 0.06 B. 0.085 C. 0.09 The correct answer is C. Yogu’s preferred equity currently trades at 940 and is actively traded. Given a par value of 1000 and an 8.5% annual dividend rate, the annual dividend is 85 (8.5%×1000). We then use the DDM formula with a growth rate of 0 to estimate the cost of preferred equity. re = re = D1 V0 85 = 0.090 = 9.00% 940 CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. 23 © 2014-2024 AnalystPrep. Q.3 Suppose Yogu’s cost of debt is 5.5%. The cost of common equity using the BYPRP model will be closest to? A. 0.115 B. 0.09 C. 0.06 The correct answer is A. re = rd + RP re = 0.055 + 0.06 = 0.115 = 11.5% CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. Q.2 Yogu’s cost of common equity using the Fama-French 5-factor model is closest to? A. 0.114 B. 0.12 C. 0.09 The correct answer is A. re = rf + β1 (ERP ) + β2 (SMB) + β3 (HML) + β4(RMW) + β5 (CMA) re = 0.035 + 0.75(0.05) + 0.65(0.022) + 0.17(0.042) + 0.12(0.035) + 0.4(0.04) re = 0.114 = 11.4% CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. 24 © 2014-2024 AnalystPrep. Q.4 Yogu’s cost of common equity using the CAPM is closest to? A. 0.114 B. 0.115 C. 0.0725 The correct answer is C. re = rf + β1 (ERP ) re = 0.035 + 0.75(0.05) re = 0.0725 = 7.25% CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. 25 © 2014-2024 AnalystPrep. Case 28: Darlene Gregg Darlene Gregg, a junior analyst, was recently hired at N.A. Financial, a mid-sized Canadian investment firm. She is assisting her manager, Robert Mugo, in the management of a portfolio for high-net-worth clients. Over the years, Mugo has carved out a reputation for unparalleled work ethic and outstanding financial performance. He has been working at N.A. Financial for the last ten years and earned his CFA charter within the last three years. He's been and an active member ever since. Mugo has been analyzing several equity stocks for possible future purchases in line with the investment needs of a group of her clients. He asks Gregg to help compute the required return for each stock. Before Gregg gets down to work, Mugo wants to make sure that Gregg has sound knowledge of basic equity valuation concepts. He invites Gregg to his office to discuss the various approaches used to calculate the required return. While discussing the various approaches used to estimate the risk premium, Gregg states that: "Under the survey estimate method, a survey is conducted for all equity investors. The data gathered is then used to come up with a reasonable risk premium." Mugo adds that: "A recent survey, published in a well-known financial journal, came up with a risk premium of 3.5% for one of the stocks I was considering for the portfolio of one of my clients." To test Gregg's knowledge on equity valuation, Mugo asked her to calculate the required return for KOP based on the CAPM, using the risk premium put forth in the financial journal. According to Mugo, KOP stock has had a historical sensitivity of 0.9 relative to the market, and Treasury bills are currently earning 3.8%. KOP also pays a dividend of $2.03 and the stock trades at $11.04. The company's dividend is expected to increase by 6%. Gregg believed that he could also use multi-factor models such as the Fama-French model and CAPM to calculate the required return. In response, Mugo stated that both of these models are based on one similar concept and that only the factors considered by each method differ. Gregg nodded in agreement, adding that the Fama-French model takes into consideration a liquidity 26 © 2014-2024 AnalystPrep. premium. To come up with the required return based on these two models, Gregg gathered the following data: Exhibit 1: 1. R mkt – R f = 4.5%; and βmkt = 1.2 2. R small– Rbig = 2.5; and βSMB = 0.5 3. R HMB– R LBM = 1.5; and βHML = −0.1 4. Liquidity Premium = 3%; and βliquidity = −0.1 5. R f = 3.8% Q.1 KOP's required return based on the CAPM is closest to: A. 3.83%. B. 6.95%. C. 7.95%. The correct answer is B. Required return = Risk-Free Rate + Beta × Risk Premium Required return = 3.8% + 0.9 × 3.5% Required return = 6.95% CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. 27 © 2014-2024 AnalystPrep. Q.2 Gregg made statements about the survey estimate method and the difference between two multi-factor models. Are these statements correct ? A. Only one of those statements is correct. B. Both statements are correct. C. Both statements are incorrect. The correct answer is C. Under the survey estimate method, the equity risk premium is inferred from the expectations of a sample. This sample generally consists of experts in the field of equity valuation. It does not include all equity investors. Thus, the first statement is incorrect. Gregg's statement about the Fama-French (FF) and the Pastor-Stambaugh (PS) models is also incorrect. The FF model does not include a liquidity premium, but the PS model does. CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. 28 © 2014-2024 AnalystPrep. Q.3 Based on Exhibit 1, the required return according to the Fama-French model is closest to: A. 10.6%. B. 10.3%. C. 10.0%. The correct answer is B. The Fama-french model is based on three factors: market premium, small-cap return premium, and value return premium. R mkt – R f = return on a value-weighted market index minus the risk-free rate R small– Rbig = average return on small-cap portfolios minus average return on large-cap portfolios R HBM– R LBM = average return on high book-to-market portfolios minus average return on low book-to-market portfolios Required return = R f + R mkt – Rf × βmkt + R small– Rbig × βSMB + R HBM – R LBM × βHML Required return = 3.8% + 4.5% × 1.2 + 2.5% × 0.5 + 1.5% × −0.1 Required return = 10.3% Note: incorrectly incorporating the liquidity risk premium will give a required return of 10%. CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (e) Estimate the cost of debt or required return on equity for a public company and a private company. 29 © 2014-2024 AnalystPrep. Q.4 The forward looking ERP estimate using the dividend discount model method closest to: A. 10.03%. B. 20.6%. C. 8.76%. The correct answer is B. ERP = E( ERP = D1 ) + E(g) − rf V0 2.03 + 0.06 − 0.038 = 0.2058 = 20.6% 11.04 CFA Level II, Learning Module 20: Cost of Capital: Advanced Topics, LOS 20 (c) Explain historical and forward-looking approaches to estimating an equity risk premium. 30 © 2014-2024 AnalystPrep. Case 29: Steven Garcia Steven Garcia works for a leading research house in the U.S. He has been involved in derivatives strategies but his current project is on credit default swaps (CDS). Since he is unfamiliar with these financial instruments, Garcia asks Mark White - a colleague with experience advising clients on the use of CDSs - to help him with the project. White explains the basics to Garcia and mentions that purchasing a CDS is like purchasing insurance against a credit event - once the premium is paid, the protection seller assumes all credit risk. White begins with the example of QWR Corporation, which currently has the following three bond issues trading in the market: Bond A, a 3-year senior unsecured debenture, trading at 45% of par Bond B, a 3-year senior unsecured debenture, trading at 50% of par Bond C, a 3-year subordinated unsecured debenture, trading at 25% of par White mentions that one of his clients owns $5 million of Bond B (at par value) and purchased a $5 million senior CDS protection. Garcia then analyzes the credit quality of two companies – Alpha Corporation and Beta Corporation. After his analysis, he makes the following comments about their credit quality: Alpha Corporation: There is serious short-term stress in the market and that is reflected in the credit curve of Alpha. Beta Corporation: After recent financial turmoil, the company's 5-year CDS spread is unchanged, but the 10-year CDS spread has widened by 200bps. Garcia then mentions that one of his clients is considering buying a 10-year CDS on Beta Corporation debt to hedge its current portfolio position. The client asks him to determine if an upfront payment would be required and, if so, the premium amount. The following exhibit gives information on the CDS: Exhibit 1 - Data for CDS on Beta Corporation Credit Spread 600 bps Duration 7 years Coupon Rate 4% 31 © 2014-2024 AnalystPrep. Garcia also advises his client to execute a basis trade to take advantage of the pricing difference of the Alpha Corporation bonds and CDS. He mentions that the Alpha's bond is currently yielding 6% and a comparable CDS contract has a credit spread of 4.25% and the Libor is 1.25%. The basis trade would consist of a long position both in the bond and in the CDS contract. Garcia also mentions an opportunity arising in the market on Gamma Corp, which is planning a recapitalization plan involving a large stock buyback program financed by new debt. Garcia then asks White to explain the underlying principles and the factors that influence the price of a CDS. White makes the following comments: Comment 1: Probability of default is constant and doesn't vary with time Comment 2: Loss given default (LGD) is the amount of loss if a default occurs. LGD is directly proportional to the recovery rate. Comment 3: The hazard rate is the probability that an event will occur given that it has not already occurred. 32 © 2014-2024 AnalystPrep. Q.1 The profit that the basis trade for Alpha Corporation can capture if convergence occurs in the bond and CDS markets is closest to: A. 0.25%. B. 0.50%. C. 1.75%. The correct answer is B. Alpha's bond is currently yielding 6% and a comparable CDS contract has a credit spread of 4.25%, while Libor is 1.25%. The bond's credit spread = 6% - 1.25% = 4.75% The bond and CDS markets imply different credit spreads. Credit risk is cheap in the CDS market at 4.25% relative to the bond market that is 4.75%. Since the protection and bond were both purchased, the trade will capture the 0.50% difference between 4.75% and 4.25% if convergence occurs. CFA Level II, Learning Module 32: Credit Default Swaps, LOS 32(c): explain the principles underlying and factors that influence the market's pricing of CDS. 33 © 2014-2024 AnalystPrep. Q.2 Which of the comments regarding underlying principles and factors that influence the prices of CDS is most likely correct? A. Comment 1 B. Comment 2 C. Comment 3 The correct answer is C. The hazard rate is the probability that an event will occur given that it has not already occurred. Hence, Comment 3 is correct. The probability of default is the likelihood of the default of an entity in a given year. This is not constant and usually increases over time. Hence, Comment 1 is incorrect. Loss given default (LGD) is the amount of loss if a default occurs. LGD is inversely proportional to the recovery rate. The expected loss for any given period = Hazard rate x loss given default. Hence, Comment 2 is incorrect. CFA Level II, Learning Module 31: Credit Analysis Models, LOS 31(a): explain expected exposure, the loss given default, the probability of default, and the credit valuation adjustment. Q.3 Which of the following is most likely to be the best strategy on Gamma Corp? A. Buy both the stock and CDS protection B. Sell the stock and buy CDS protection C. Buy the stock and sell CDS protection The correct answer is A. Gamma bond's credit spread will likely increase because of the leveraged capitalization. An increase in the credit spread would increase the price of CDS protection. Also, an increase in the stock buyback would be expected to increase the value of the stock. So, the best strategy is to buy both the stock and the CDS protection as both will likely increase in value. CFA Level II, Learning Module 32: Credit Default Swaps, LOS 32(b): describe credit events and settlement protocols with respect to CDS. 34 © 2014-2024 AnalystPrep. Q.4 Based on Exhibit 1, what is the upfront premium as a percentage of the notional for the CDS protection on Beta Corporation? A. 0.02 B. 0.105 C. 0.14 The correct answer is C. Upfront premium % = (Credit spread − Fixed coupon) × Duration Upfront premium = (0.06 − 0.04) × 7 Upfront premium = 14% of notional. CFA Level II, Learning Module 32: Credit Default Swaps, LOS 32(b): describe credit events and settlement protocols with respect to CDS. 35 © 2014-2024 AnalystPrep. Case 30: Trevor Holden Trevor Holden advises corporate finance and treasury departments on borrowing decisions and working capital management. In particular, Holden specializes in analyzing and recommending derivatives strategies that help his clients maintain an acceptable level of exposure to marketbased risks. Holden is meeting with Martha Coleman, CFO of Brownstone Design (Brownstone), a US-based office furniture manufacturer. Nine months ago, Brownstone Designs reached a strategic partnership with Elemental Interiors that would see the two firms collaborate on certain projects. As part of the partnership, Brownstone signed a forward agreement to purchase 100,000 shares of Elemental Interiors' stock, which trades under the ticker symbol ETI and does not pay a dividend, at USD 35.50 per share one year later. The current market price of ETI shares is USD 38.21. Coleman asks for Holden's advice on how to value this forward contract, which expires in three months. She is concerned because the prices are being generated by Brownstone's internal valuation models appear to be inconsistent with the market price of new 6-month futures contracts on ETI stock, which are currently trading at USD 39.00 per-share. Holden looks up the latest quotes and finds that the relevant 3-month and 6-month interest rates have discount factors of 0.990005 and 0.979639, respectively. The next item of business to be discussed concerns Brownstone's working capital management. Coleman tells Holden that the company will be depositing USD 13,500,000 next month and is considering taking a long position in a 1 x 6 forward rate agreement (FRA). The terms of this FRA stipulate that, when it expires in one month, the interest rate for the floating leg will be set and payment will be made based on the difference between the exercise rate and the prevailing reference rate. Holden responds with the following two statements: Statement A: “The FRA position that Brownstone is considering is the equivalent of going long a onemonth Libor deposit and short a six-month Libor deposit.” Statement B: 36 © 2014-2024 AnalystPrep. “If Brownstone takes this FRA position, the company will receive payments based on a fixed rate.” Finally, the two colleagues discuss Brownstone's longer-term borrowing needs. Coleman informs Holden that, next month, Brownstone will be taking out a 5-year bank loan with annual floatingrate interest payments based on LIBOR. Coleman adds that she would like to convert this loan into a fixed-rate obligation. Holden advises that Brownstone enter a 5-year, pay-fixed, receive Libor interest rate swap. Specifically, he recommends Libor swap rates equal to 45 basis points plus the zero-coupon Treasury spot rates shown below. Exhibit 1: Zero-coupon spot curve Term (years) Zero-coupon rate (annual) 1 4.30% 2 4.70% 3 5.00% 4 5.15% 5 5.25% After listening to his recommendation, Coleman asks Holden “Is an interest rate swap essentially a series of forward rate agreements?” 37 © 2014-2024 AnalystPrep. Q.4 What is Holden's most likely response to Coleman's question about interest rate swaps' A. Yes B. No, because interest rate swaps are contingent claims C. No, because interest rate swaps are exchange-traded derivatives The correct answer is A. It is accurate to characterize an interest rate swap as a series of forward rate agreements. The periodic payoffs during the term of an interest rate swap are based on the difference between an agreed fixed rate and the prevailing level of a reference rate. However, unlike FRAs, which cover only a single period, interest rate swaps cover multiple periods. Interest rate swaps are not contingent claims as both counterparties are committed in advanced to making payments and neither has the option of walking away if the market rate moves in a direction that is adverse to their interests. Further, interest rate swaps are not traded on organized exchanges, but rather they are negotiated in the over-the-counter (OTC) market. CFA Level II, Learning Module 33: Pricing and Valuation of Forward Commitments, LOS 33(e): describe how interest rate swaps are priced and calculate and interpret their noarbitrage value. 38 © 2014-2024 AnalystPrep. Q.1 On a per-share basis, the value of the Brownstone's forward contract to purchase ETI stock is closest to: A. 2.97. B. 3.06. C. 3.10. The correct answer is B. The value of a long forward contract position based on a non-dividend-paying stock is the present value of the difference between the market price and the strike price. In this example, it is first necessary to determine the appropriate interest rate to use when discounting to the present. The forward contract was initiated nine months ago and expires in three months and the relevant 3-month interest rate has a present value factor of 0.990005. The applicable annual rate (r) can be obtained as follows: 0.990005 = 1 (1 + r)0.25 Note that 0.25 represents the fraction of the year (3/12 months) remaining until to expiry. Solving the above equation yields an annual rate of 4.1%, which means that the price of a 3month forward contract to purchase ETI stock would have a price of: 38.21 × (1 + 4.1%)0.25 = 1.0101 × 3.21 = 38.5959 The difference between this price and the strike price is: 38.5959 − 35.50 = 3.0959 The present value of this difference is: 3.0959 = 3.0648 or 3.06 (1 + 4.1%)0.25 CFA Level II, Learning Module 33: Pricing and Valuation of Forward Commitments, LOS 33(a): describe how equity forwards and futures are priced, and calculate and interpret their no-arbitrage value. 39 © 2014-2024 AnalystPrep. Q.3 Assuming that it reflects the law of one price, the rate on the fixed leg of the five-year, Liborbased interest rate swap recommended by Holden is closest to: A. 4.76%. B. 5.66%. C. 5.22%. The correct answer is B. To determine the rate for the fixed leg of the interest rate swap that Holden has recommended, it is first necessary to calculate the present value factors for the five relevant Libor rates, which is done as follows: Term (years) Zero-coupon spot rate LIBOR spot rate PV Factor 1 4.30% 4.30% + 0.45% = 4.75% 1 = (1+4.75%) 1 0.95465 2 4.70% 4.70% + 0.45% = 5.15% 1 = (1+5.15%) 2 0.90444 3 5.00% 5.00% + 0.45% = 5.45% 1 = (1+5.45%) 3 0.85282 4 5.15% 5.15% + 0.45% = 5.60% 1 = (1+5.60%) 4 0.80416 5 5.25% 5.25% + 0.45% = 5.70% 1 = (1+5.70%) 5 0.75792 Sum 4.274 Note that LIBOR spot rates have been arrived at by adding 45 basis points to the corresponding zero-coupon Treasury spot rate. The fixed rate of a swap is calculated as one minus the present value factor in the final period of the term divided by the sum of the present value factors for all periods in the term. In this example, (1 − 0.75792) = 0.05664 or 5.66% 4.274 CFA Level II, Learning Module 33: Pricing and Valuation of Forward Commitments, LOS 33(a): describe how equity forwards and futures are priced, and calculate and interpret their no-arbitrage value. 40 © 2014-2024 AnalystPrep. Q.2 Which of the following is the most accurate assessment of Holden's statements about the forward rate agreement position being considered by Brownstone? A. Both Statement A and Statement B are incorrect B. Statement A is correct and Statement B is incorrect C. Statement B is correct and Statement A is incorrect The correct answer is A. Both statements are incorrect. Holden is inaccurate in claiming that the FRA under consideration is equivalent to going long a one-month Libor deposit and short a six-month Libor deposit. The positions he has described in Statement A would replicate a short FRA position. The long FRA position being considered by Brownstone can be replicated by taking a short position in a one-month Libor deposit and a long position in a six-month Libor deposit. Holden is also incorrect to say that, by taking a long position in this FRA, Brownstone would receive fixed-rate payments. Being long a forward rate agreement means paying a fixed rate and receiving a floating rate. CFA Level II, Learning Module 33: Pricing and Valuation of Forward Commitments, LOS 33(a): describe how equity forwards and futures are priced, and calculate and interpret their no-arbitrage value. 41 © 2014-2024 AnalystPrep. Case 31: Jayden Smith Jayden Smith is an investment manager at Yash mutual fund. Smith reviews the limit order book for XYZ Inc. taken from the NYSE Arca exchange. Three dealers, (1,2,3) make the market for XYZ Inc. as shown in Exhibit 1. Smith executes a market buy order for 700 shares of XYZ Inc., based on the prices in the limit order book. Exhibit 1: Limit Order Book for XYZ Inc Dealer 1 2 3 Limit Price 90.04 90.03 90.02 buy Shares 100 300 200 orders Time 14 : 05 : 22 14 : 05 : 25 14 : 05 : 25 Dealer 4 3 2 Limit Price 90.05 90.06 90.07 Sell Shares 400 100 200 Orders Time 14 : 05 : 21 14 : 05 : 21 14 : 05 : 21 Smith sees a potential market sell order for 10,000 shares of ABC Co. The order is traded over the day and is split into four trades that are executed as per Exhibit 2. Exhibit 2: Market Buy Order for ABC Co. Trade Time 1 10.00am 2 11.00am 3 12.00noon 4 13.00pm Trade Price $50.40 $52.32 $52.30 $52.25 Trade Size 2 , 200 2 , 800 3 , 500 1 , 500 Bid Price $50.43 $52.35 $52.35 $52.30 Ask price $50.46 $52.38 $52.33 $52.31 Smith also runs a mentorship program on trading. During one of the introduction sessions, Smith mentions that electronic trading has benefited investors through greater trade process efficiencies and reduced transaction costs. However, it has increased systemic risks such as fat finger errors and malevolent order streams. Additionally, Smith highlights that electronic trading systems are prone to market manipulation, where some trading strategies are employed to produce misleading or false market prices, quotes, or fundamental information to profit from distorting the normal operation of markets. Over the next session, Smith asks the students to describe some of the market manipulation strategies. He receives the following responses: 42 © 2014-2024 AnalystPrep. Response I: Bluffing Involves submitting orders and arranging trades to influence other traders’ perceptions of value. Response II: Gunning the market A manipulator uses this strategy to obtain control over resources necessary to settle trading contracts. He/ she then withdraws these resources from the market, making traders default on their contracts, some of which the manipulator may hold—the manipulator profits by providing high price resources or by closing the contracts at very high prices. Response III: Squeezing and cornering The manipulator sells quickly to push prices down with the hope of triggering stop-loss sell orders. A stop-loss (or stop) sell order becomes valid for execution once the specified stop price condition is met by a trade occurring at or below the stop price. 43 © 2014-2024 AnalystPrep. Case 91: Alex Johnson Portfolio Manager Alex Johnson helms the Equity Growth Fund, a well-established fund with a strategy poised on capturing high-growth opportunities across various sectors. Despite the fund's strong focus on individual stock picking, Alex is contemplating integrating exchangetraded funds (ETFs) into her investment strategy to gain broad market exposure and sectorspecific plays. Before making any concrete decisions, she decides to deep dive into the mechanics, trading, and application nuances relative to ETFs. Alex's team have pinpointed MarketFlex ETFs Inc. as their go-to ETF provider considering their diverse offerings and robust tracking accuracy. MarketFlex has recently launched an ETF, the MarketFlex Total Market (MFTM), designed to mimic the performance of the Total Market Index, representing 98% of all publicly traded securities in the U.S. It features a competitive fee structure and has a creation unit size of 100,000 shares. Alex notes the importance of understanding the creation/redemption mechanisms offered by MarketFlex, the expected liquidity of MFTM in secondary markets, and how its bid-ask spreads compare to the underlying securities within the Total Market Index. Despite robust performance tracking, Alex is aware of potential tracking errors that may arise from rebalancing discrepancies, dividend reinvestments, and the underlying cash holdings. With the MFTM ETF trading near its NAV, she remains vigilant about the prospects of premiums or discounts that may emerge in different market conditions. As with any investment, Alex knows the importance of considering ETF-related risks, such as liquidity under stress scenarios, and the costs associated with owning and trading ETF shares. Alex's fund typically holds a large position, say $10,000,000, in selected investments, and she is assessing how this would translate to trading in MFTM ETFs, both in terms of shares to be bought, associated costs like the expense ratio, and potential market impact. Additionally, Alex is curious about the tax efficiency of ETFs, in comparison to mutual funds, due to their unique creation and redemption process. 44 © 2014-2024 AnalystPrep. Q.1 On a particular trading day, the MFTM ETF's average bid price is $50.05 and the average ask price is $50.15, The bid-ask spread and the spread percentage based on the ask price ar closest to. A. $0.10, 0.20% B. $0.10, 0.299% C. $0.15, 0.299% The correct answer is A. The bid-ask spread is the difference between the ask and bid price: $50.15 − $50.05 = $0.10. The spread percentage based on the ask price is 0.10 × 100% = 0.199 ≈ 0.20 50.15 Q.2 If the secondary market trading price of the MFTM is \$50.50 while the NAV is \$50.00, what is the ETF trading at? Additionally, would this scenario typically lead to creation or redemption activities? A. 1% premium, leading to creation B. 1% premium, leading to redemption C. 1% discount, leading to creation The correct answer is A. The ETF is trading at a premium of 50.50 − 50.00 × 100% = 1% 50.00 This scenario would typically incentivize APs to engage in creation activities as they could arbitrage the difference between the NAV and the market price. 45 © 2014-2024 AnalystPrep. Q.3 Alex learns the MFTM ETF incurs an expense ratio of 0.10% annually. If the fund invests $10,000,000 in MFTM, the annual management cost would be closest to? A. 1000 B. 10000 C. 100 The correct answer is B. The cost is calculated by multiplying the total investment amount by the expense ratio: (0.0010 × 10 , 000, 000) = $10 , 000 Q.4 MarketFlex reveals that there was a significant redemption of MFTM shares leading to a temporary discount to NAV. What risk does this highlight and how might Alex mitigate it? A. Market risk, mitigated by diversifying across different ETFs. B. Liquidity risk, mitigated by setting stop-loss orders. C. Liquidity risk, mitigated through due diligence on the ETF's underlying securities. The correct answer is C. Large redemptions resulting in discounts to NAV indicate liquidity risk. Alex can mitigate this risk by performing due diligence on the ETF’s underlying securities and their liquidity profiles, ensuring that the ETF can comfortably meet redemption requests without significantly impacting NAV. 46 © 2014-2024 AnalystPrep. Case 919: Annabel Temitope Annabel Temitope is evaluating the expected residual income as of the end of September 2014 for Asia Pulp and Paper Company (PAP), a vertically-integrated pulp and paper producer. Using an adjusted beta of 1.20 relative to the S&P 500 Index, a 10-year government bond yield of 1.70%, and an estimated equity risk premium of 3.80%, Temitope uses the capital asset pricing model (CAPM) to estimate PAP’s required rate of return. Temitope obtains the following as of the close of September 2014. Exhibit 1. Asia Pulp and Paper Company Current market price $11.90 Book value per share as of 31 December 2013 $9.96 Consensus annual earnings estimates FY 2014 $3.52 FY 2015 $3.64 Annualized dividend per share forecast FY 2014 $1.46 FY 2015 $1.55 David Emmanuel, Temitope’s supervisor, has reviewed her computations on PAP's expected residual value income. He has calculated the stock value of PAP and would like Temitope to do the same. They use different approaches but perform the calculations using consistent assumptions. Emmanuel’s approach: calculate the stock value using the residual income model. Temitope’s approach: calculate the stock value using the dividend discount model instead. Cynthia Promise, a co-worker of Temitope, specializes in the airline industry. Recently she has been monitoring Southwest Airlines (NYSE: LUV). She considers a stock fairly valued if her intrinsic value calculation using the single-stage residual income model is within 10% of the current market price. She has gathered the following information for LUV: Current book value per share = $26 Current market price per share = $44 Assumed long-term ROE is 11% and long-term growth is 5.5% 47 © 2014-2024 AnalystPrep. The cost of equity based on the Capital Asset Pricing Model is 8.5% Emmanuel asks Temitope and Promise to create a list of strengths and weaknesses of residual income models. They worked together and submitted the following list to Emmanuel. Strength 1: The models focus on economic profitability. Strength 2: The debt capital cost is appropriately reflected by interest expense. Weakness 1: The models do not work well when cash flows are unpredictable. Weakness 2: Accounting data used as inputs may require significant adjustments. Emmanuel reviews the list created by Temitope and Promise and makes the following two statements: Statement 1: The residual income model is most appropriate when a company’s dividends are not predictable. Statement 2: The residual income model is least appropriate if the book value is not predictable. Q.1 Based on the information provided in Exhibit 1, the forecast ending book value per share for FY 2014 is closest to: 48 © 2014-2024 AnalystPrep. A. $9.96. B. $12.02. C. $13.48. The correct answer is B. Which calculates the forecast ending book value per share for FY 2014 for Asia Pulp and Paper Company. To determine this value, we use the formula for ending book value per share, which is the beginning book value plus earnings per share minus dividends per share. Mathematically, it is represented as: Ending Book Value per Share = Bt−1 + Et − Dt Where: Bt−1 is the book value at the end of the previous year, which is \$9.96. Et is the earnings per share for the year, which is \$3.52. Dt is the dividend per share for the year, which is \$1.46. Plugging in these values, we get: Ending Book Value per Share = 9.96 + 3.52 − 1.46 = 12.02 This calculation shows that the forecast ending book value per share for FY 2014 is \$12.02, which corresponds to option B. A is incorrect. Suggests that the forecast ending book value per share for FY 2014 is \$9.96, which is simply the book value at the end of the previous year (2013). This option does not account for the earnings accrued or dividends paid during 2014. Ignoring these factors results in an inaccurate calculation of the book value at the end of 2014. The book value per share is a dynamic measure that changes with the company's financial activities such as earning profits and distributing dividends. Therefore, maintaining the previous year's book value without adjustments does not reflect the true financial position at the end of 2014. C is incorrect. Suggests that the forecast ending book value per share for FY 2014 is \$13.48. This value appears to be a miscalculation as it does not correctly apply the formula for ending book value per share. If we examine the components used in the formula, there is no combination of reasonable adjustments to earnings or dividends that would result in a book value of \$13.48 under the given data. This option likely represents a computational error or a misunderstanding of how to apply the formula, leading to an overestimation of the book value. 49 © 2014-2024 AnalystPrep. Study Session 10, Learning Module 26: Residual Income Valuation, LOS 26(c): Calculate the intrinsic value of a common stock using the residual income model and compare value recognition in residual income and other present value models Q.2 Based on the information in exhibit 1, the forecast residual income for fiscal year 2015 that Temitope would calculate would be closest to: A. $2.90. B. $3.10. C. $3.20. The correct answer is A. To determine the forecasted residual income for fiscal year 2015 for Asia Pulp and Paper Company, we start by calculating the required rate of return using the Capital Asset Pricing Model (CAPM). The formula for CAPM is given by: Required Return = Risk-Free Rate + (Beta × Equity Risk Premium) Substituting the given values, we have: Required Return = 1.70% + (1.20 × 3.80%) = 1.70% + 4.56% = 6.26% Next, we calculate the beginning book value for 2014 by adding the earnings per share for 2014 and subtracting the dividends paid in 2014 from the book value at the end of 2013: Beginning Book Value = 9.96 + 3.52 − 1.46 = 12.02 The residual income for 2015 is then calculated using the formula: Residual Income2015 = Earnings2015 − (Required Return × Beginning Book Value) Residual Income2015 = 3.64 − (6.26% × 12.02) = 3.64 − 0.7525 ≈ 2.89 50 © 2014-2024 AnalystPrep. Thus, the forecasted residual income for 2015 is approximately $2.89, which rounds to $2.90, making option A the correct answer. B is incorrect. Option B suggests a residual income of $3.10. This calculation error likely arises from an incorrect application of the required return or an inaccurate adjustment of the beginning book value. As shown in the detailed calculation above, the correct residual income, after accounting for the required return on the beginning book value, is approximately $2.89, not $3.10. Any deviation from this calculation would result from incorrect application of the CAPM or arithmetic errors in computing the earnings minus the equity charge. C is incorrect. Option C suggests a residual income of $3.20. This value is too high and indicates a misunderstanding or miscalculation of either the earnings, the required return, or the beginning book value. The precise calculation using the CAPM to determine the required return and applying it to the beginning book value to find the equity charge provides a residual income of approximately $2.89. The figure of $3.20 could only be reached by significantly underestimating the equity charge or overestimating the earnings, both of which are incorrect based on the given data. Study Session 10, Learning Module 26: Residual Income Valuation, LOS 26(a): Calculate and interpret residual income, economic value added, and market value added; Q.3 Which of the following two statements by Temitope and Promise is most likely correct? A. Strength 2 and Weakness 1 B. Strength 1 and Weakness 2 C. Strength 1 and Weakness 1 The correct answer is B. The combination of Strength 1 and Weakness 2 accurately reflects the characteristics and limitations of the residual income model. Strength 1 highlights that the residual income model focuses on economic profitability, which is a crucial aspect as it measures the excess return earned over the required rate of return, providing a clear picture of the company's ability to generate wealth over its cost of capital. This strength is particularly important in financial analysis as it helps in understanding the true economic benefit to shareholders. Weakness 2 points out that the accounting data used in the residual income model may require significant 51 © 2014-2024 AnalystPrep. adjustments. This is because accounting figures often need modifications to reflect economic reality better, such as adjustments for different accounting policies or non-operating items that can distort the true economic earnings of a company. This weakness is critical as it affects the accuracy and reliability of the model, making it essential for analysts to carefully adjust and scrutinize the inputs. A is incorrect. While Strength 2 suggests that the debt capital cost is appropriately reflected by interest expense, this is generally not accurate. The cost of debt should ideally be considered at the market rate applicable to the company's current borrowing, adjusted for its specific risk profile, rather than just the accounting interest expense which might not accurately reflect the true cost of debt under different financial structures or market conditions. Additionally, Weakness 1 is incorrectly identified; the residual income model can indeed be useful when cash flows are unpredictable. This model does not rely directly on cash flows but rather on accounting profits adjusted for charges on equity capital, making it suitable for situations where cash flow predictions are challenging or unreliable. C is incorrect. Strength 1 is correctly identified as a strength of the residual income model. However, Weakness 1 is not a valid weakness for this model. Contrary to the statement, the residual income model can be particularly useful in scenarios where cash flows are unpredictable. This model focuses on accounting earnings rather than cash flows, which can provide a more stable basis for evaluation when cash flows are volatile or not easily forecastable. This characteristic allows the model to be applied effectively in industries or scenarios where cash flow predictability is low. Study Session 10, Learning Module 26: Residual Income Valuation, LOS 26(j): Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock Q.4 Which of Emmanuel's statements about the appropriateness of the residual income model is most accurate? A. Statement 1 B. Statement 2 C. Both Statement 1 and Statement 2 The correct answer is C. 52 © 2014-2024 AnalystPrep. Both statements made by Emmanuel regarding the appropriateness of the residual income model are accurate, making option C the correct answer. The residual income model is particularly useful in situations where dividends are not predictable. This model allows for the evaluation of a company's profitability after accounting for the true cost of capital. It is beneficial because it focuses on the economic profits that are generated over and above the minimum required return. This is crucial in scenarios where dividends, which are typically a reflection of a company's profitability and financial health, do not provide a clear picture due to their unpredictability. Therefore, the residual income model serves as an alternative method to assess a company's value and potential for return to shareholders when dividend patterns are inconsistent or nonrepresentative of the company's underlying performance. Statement 1 is incorrect. While Statement 1 correctly identifies that the residual income model is suitable when dividends are unpredictable, it is important to clarify that this model does not solely rely on dividend predictability. The model primarily focuses on the income generated after meeting the equity charge (the required rate of return on equity), which is a broader measure of profitability and not just dependent on dividend distributions. The model's appropriateness in such scenarios is due to its ability to provide a measure of residual income, which can offer insights into the company's performance independent of dividend declarations. This makes it a valuable tool in financial analysis, especially for companies where dividends are not a reliable indicator of financial health or are absent. Statement 2 is incorrect. Statement 2 highlights a critical limitation of the residual income model, which is its dependency on the predictability of book value. Since the calculation of residual income involves subtracting the equity charge from net income, and the equity charge is derived from the book value of equity, any unpredictability in book value can significantly impair the model's reliability and accuracy. If the book value is subject to high volatility or is not reflective of the company's true economic value due to accounting practices or other factors, the residual income calculated may not provide a true representation of the company's ability to generate wealth over its cost of capital. This limitation is crucial in financial analysis and valuation, making the model less suitable in situations where the book value is not stable or predictable. Study Session 10, Learning Module 26: Residual Income Valuation, LOS 26(j): Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock; 53 © 2014-2024 AnalystPrep. Case 920: Phoenix Wealth Management Hector Rodriguez, CFA, is the Chief Investment Officer at Phoenix Wealth Management (PWM), a firm that caters to high-net-worth individuals and institutional investors. PWM has recently introduced a new global equity fund, which has been marketed extensively to prospective clients as an opportunity to diversify their portfolios with international exposure. As part of the marketing materials, Hector includes performance projections based on backtested data using a proprietary investment strategy developed by the firm’s research team. The backtested performance shows significant outperformance compared to a global equity index over the last ten years. However, the fine print discloses that these figures do not account for transaction costs or management fees. One of PWM's clients, Carla Gomez, whom Hector personally advises, expresses interest in the new global equity fund. Carla has a moderately conservative risk profile and is looking for stable, long-term growth. Hector recommends a sizable allocation to the new fund, emphasizing its potential for outperformance and alignment with her objectives, without discussing the impact of fees or transaction costs on the projected returns. Meanwhile, Hector is aware that some senior analysts at PWM have concerns about the replicability of the back tested performance in actual market conditions. These concerns have not been communicated to the marketing department or included in the client-facing materials. Hector believes the strategy is sound and decides not to address this issue further. Moreover, Hector’s annual bonus is significantly influenced by the amount of capital attracted to the new fund. This compensation arrangement is not disclosed to PWM’s clients or explicitly accounted for in the firm's official conflict of interest policy. Soon after, PWM’s compliance department is reviewing the fund’s marketing materials and raises questions about the presentation of back tested performance data. They suggest revising the materials to include a clear explanation of the limitations of backtesting and its differences from actual trading results. 54 © 2014-2024 AnalystPrep. After the global equity fund is launched, its initial performance is considerably below the back tested results. As a result, Carla suffers losses that are not in line with her risk tolerance. She complains to PWM, stating that she was not fully informed about the risks and costs associated with the investment. Q.1 According to Standard II: Integrity of Capital Markets, which aspect of the presentation of the global equity fund in the marketing materials is Hector Rodriguez, CFA, most likely to have violated? A. Misrepresentation by failing to disclose the impact of fees on returns. B. Plagiarism by using a proprietary investment strategy without proper citation. C. Market manipulation by influencing the fund's reported performance figures. The correct answer is A. Misrepresentation occurs when material information that could affect investment decisions, such as the impact of fees and transaction costs on returns, is omitted or inadequately disclosed. Hector and PWM's marketing materials are likely to have misled clients by not presenting the impact of fees on the back tested performance data. B is incorrect. Plagiarism is not indicated in this scenario as the proprietary investment strategy was developed by PWM's own research team. C is incorrect. There is no indication provided that Hector engaged in market manipulation, which typically involves actions taken to distort the price or volume of a security. CFA Level II, Ethics, Learning Module 2: Guidance for Standards I–VII, LOS (a) demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 55 © 2014-2024 AnalystPrep. Q.2 With respect to Standard III: Duties to Clients, what should Hector Rodriguez, CFA, have done differently when recommending the new fund to Carla Gomez? A. Discussed the limitations of the backtested performance data. B. Enforced the compliance department's suggestions regarding marketing materials. C. Recommended a smaller allocation to diversify risks. The correct answer is A. Standard III requires that members and candidates must ensure that investment analyses, recommendations, and actions are appropriate to the client's situation. Hector should have discussed with Carla the risks associated with the new fund, including the limitations of backtested performance data, its lack of accounting for fees, and the analysts' concerns about its replicability. B is incorrect. While it is important to enforce compliance recommendations, the question specifically addresses Hector's actions when dealing directly with a client. C is incorrect. Although diversification of risks is important, the core issue here is the lack of full and fair disclosure to the client, which is a primary duty under Standard III. CFA Level II, Ethics, Learning Module 2: Guidance for Standards I–VII, LOS (a) demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 56 © 2014-2024 AnalystPrep. Q.3 Concerning Standard IV: Duties to Employers, which action is Hector Rodriguez, CFA, most likely to have failed to perform adequately? A. Not disclosing his compensation arrangement related to the global equity fund. B. Making an investment recommendation not suitable for the client's profile. C. Overseeing the marketing department's distribution of potentially misleading materials. The correct answer is A. Standard IV requires members and candidates to maintain loyalty to their employer and also disclose conflicts that could compromise their independence and objectivity. Hector's failure to disclose his compensation arrangement could lead to a bias in recommending the fund to clients, and this conflict of interest should have been disclosed to his employer and managed in accordance with PWM's policies. B is incorrect. Suitability of investment recommendations to a client's profile is covered under Standard III rather than Standard IV. C is incorrect. While Hector should oversee marketing materials, Standard IV specifically relates to duties to one's employer, which in this case pertains to disclosure of conflicts such as compensation arrangements that could impact investment recommendations. CFA Level II, Ethics, Learning Module 2: Guidance for Standards I–VII, LOS (a) demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 57 © 2014-2024 AnalystPrep. Q.4 Based on Standard (V) - Investment Analysis, Recommendations, and Actions, which of the following best describes a likely violation by Hector Rodriguez, CFA? A. Not performing diligent and thorough analysis on the new fund's strategy. B. Incorporating nonpublic information in his investment recommendations. C. Providing investment analysis that was not based on a reasonable and adequate basis. The correct answer is C. Standard V requires that members and candidates have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action. Hector's endorsement of the global equity fund, based on backtested performance without disclosing its limitations or considering the concerns raised by senior analysts, suggests a lack of a reasonable and adequate basis for his recommendation. A is incorrect. While Hector may not have delved into the replicability concerns, there is no explicit indication that he did not perform his due diligence. The issue is more with the basis for and presentation of his analysis. B is incorrect. There is no information provided that indicates Hector used nonpublic information to make his recommendations. CFA Level II, Ethics, Learning Module 2: Guidance for Standards I–VII, LOS (a) demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations 58 © 2014-2024 AnalystPrep. Case 921: Orion Hedge Fund Orion Hedge Fund, a boutique investment firm with $2 billion in AUM, is known for its agile and alternative investment strategies. In a rapidly shifting financial landscape, Orion's management team is assessing the performance and risk profiles of several strategies from the last six months to ensure continued investor satisfaction and superior financial returns. Four of the key strategies currently under scrutiny are: 1. Convertible Arbitrage Strategy: Orion's initiative to profit from pricing inefficiencies between a company's convertible bonds and its stock. Currently, $300 million is allocated to this strategy, and the typical debt-to-equity conversion rate is 40:1. 2. Distressed Securities Strategy: This strategy involves investing in the debt and equity of companies under financial distress or going through bankruptcy. Orion has committed $250 million to distressed assets with an anticipated return of 18% due to potential restructuring or recovery. 3. Managed Futures Strategy: An approach leveraging futures contracts on indices, commodities, and rates with $350 million of AUM assigned to it. The expectation is to capture trends and momentum in these markets. 4. Short Selling Strategy: A speculative technique capitalizing on the anticipated decline in stock prices. The strategy's capital allocation is $100 million, and the short interest rate charged by the brokerage is 3% per annum. Orion's portfolio managers and analytics team are tasked with quantifying the performance metrics as well as any potential risk mitigation strategies that could be applied moving forward. 59 © 2014-2024 AnalystPrep. Q.1 What is the notional exposure of the Convertible Arbitrage Strategy with respect to the underlying stock, assuming no market movement has taken place? A. $7.5 million B. $120 million C. $12 million The correct answer is A. The notional exposure of the Convertible Arbitrage Strategy with respect to the underlying stock can be calculated by considering the total amount allocated to this strategy and the conversion rate from debt to equity. The allocation to the Convertible Arbitrage Strategy is $300 million, and the conversion rate is 40:1. This means that for every $40 of convertible bonds, they can be converted into $1 worth of stock. To find the notional exposure to the stock, we divide the total allocation by the conversion rate: Conversion rate = 40 : 1 Allocation = $300 million Allocation Notional stock exposure = Conversion rate $300 million Notional stock exposure = 40 Notional stock exposure = $7.5 million B and C are incorrect. Option C suggests a notional exposure of $12 million, which is also incorrect but closer to the actual value than option B. This option might result from a calculation error or a slight misunderstanding of how the conversion rate affects the notional exposure. It's essential to apply the conversion rate precisely as defined (40:1) to avoid such discrepancies. The correct calculation method, dividing the total allocation of $300 million by the conversion rate of 40, confirms that the notional exposure is indeed $7.5 million, not $12 million. CFA Level II, Learning Module 4: Hedge Fund Strategies, LOS (b) Discuss investment characteristics, strategy implementation, and role in a portfolio of equity-related hedge fund strategies. Q.2 If the Distressed Securities Strategy yields a higher than anticipated return at 22%, what is 60 © 2014-2024 AnalystPrep. the additional return in dollar value over the initially expected return? A. $8 million B. $10 million C. $12 million The correct answer is B. Which calculates the additional return in dollar value when the Distressed Securities Strategy yields a higher than anticipated return. Initially, the expected return rate was 18%, but the actual return achieved was 22%. The allocation to this strategy was $250 million. To find the additional return, we subtract the anticipated return rate from the actual return rate, which gives us an additional return rate of 4% (22% - 18%). Applying this additional return rate to the allocated amount, the calculation is as follows: Additional return = 4% × $250 million = 0.04 × $250 million = $10 million This calculation shows that the additional return, due to the higher performance, amounts to $10 million over the initially expected return. A is incorrect. Option A suggests an additional return of $8 million, which does not align with the calculations based on the given data. Using the formula for additional return, which is the difference in percentage points between the actual and anticipated return rates multiplied by the capital allocation, the correct additional return should be calculated as follows: Incorrect additional return = 2% × $250 million = 0.02 × $250 million = $5 million This calculation erroneously assumes a 2% increase rather than the correct 4%, leading to a result of $5 million, which is incorrect and does not match the $8 million suggested by option A. C is incorrect. Option C suggests an additional return of $12 million. This figure is also incorrect based on the actual calculations. If we were to assume a 6% increase in return rate instead of the correct 4%, the calculation would be: Incorrect additional return = 6% × $250 million = 0.06 × $250 million = $15 million 61 © 2014-2024 AnalystPrep. This hypothetical scenario would result in a $15 million additional return, which is still not aligned with the $12 million proposed by option C. The correct calculation based on a 4% increase yields a $10 million additional return, confirming that option C's suggestion of $12 million is incorrect. CFA Level II, Learning Module 4: Hedge Fund Strategies, LOS (f) Discuss investment characteristics, strategy implementation, and role in a portfolio of specialist hedge fund strategies. Q.3 What is the total fee earned by Orion Hedge Fund from the Managed Futures Strategy if the fund charges a 2% management fee and a 20% performance fee on the profits, assuming the strategy profits were $42 million for the period? A. $15.4 million B. $8.4 million C. $12.4 million The correct answer is A. To determine the total fee earned by Orion Hedge Fund from the Managed Futures Strategy, we need to calculate both the management fee and the performance fee separately and then sum them up. The management fee is straightforward to calculate. It is 2% of the total assets under management (AUM) allocated to this strategy, which is $350 million. Therefore, the management fee is: Management fee = 2% × $350 million = $7 million The performance fee is calculated based on the profits generated by the strategy. Given that the profits were $42 million and the performance fee rate is 20%, the performance fee calculation is as follows: Performance fee = 20% × $42 million = $8.4 million Adding both fees together gives the total fee earned from the Managed Futures Strategy: 62 © 2014-2024 AnalystPrep. Total fee = Management fee + Performance fee = $7 million + $8.4 million = $15.4 million B is incorrect. The option B suggests a total fee of $8.4 million, which only accounts for the performance fee and completely disregards the management fee. As calculated above, the management fee alone contributes an additional $7 million to the total fee, making the total significantly higher than what is suggested in option B. C is incorrect. Option C proposes a total fee of $12.4 million. This figure appears to be a miscalculation as it neither matches the sum of the correctly calculated management and performance fees nor aligns with any logical combination of the fees involved. The correct total fee, as derived from the sum of the $7 million management fee and the $8.4 million performance fee, is $15.4 million, which is clearly outlined in option A. CFA Level II, Learning Module 4: Hedge Fund Strategies, LOS (f) Discuss investment characteristics, strategy implementation, and role in a portfolio of specialist hedge fund strategies. Q.4 Assuming the Short Selling Strategy experienced a market rally and led to a loss of 10% on the capital allocated, what would be the total loss including the borrowing cost at the end of the year? A. $13 million B. $10 million C. $11 million The correct answer is A. To calculate the total loss including the borrowing cost for Orion Hedge Fund's Short Selling Strategy, we start by understanding the initial conditions. The strategy had an allocated capital of $100 million. During a market rally, the strategy experienced a 10% loss on this capital. Additionally, there is a borrowing cost of 3% per annum charged on the total allocated capital. First, we calculate the direct loss from the market rally: Loss from market rally = Loss rate × Allocation = 0.10 × $100 million = $10 million This represents the immediate loss due to the decline in the value of the stocks that were short sold. 63 © 2014-2024 AnalystPrep. Next, we calculate the annual borrowing cost: Borrowing cost = Borrowing cost rate × Allocation = 0.03 × $100 million = $3 million This cost is the interest paid on the borrowed funds used to finance the short sales. Adding these two amounts gives the total loss for the year: Total loss = Loss from market rally + Borrowing cost = $10 million + $3 million = $13 million Thus, the total financial impact on the hedge fund from this strategy, considering both the loss from the market rally and the borrowing costs, is $13 million. B is incorrect. The option suggesting a total loss of $10 million only accounts for the loss from the market rally and completely disregards the additional borrowing cost. As calculated, the borrowing cost adds another $3 million to the loss, making the total $13 million. Ignoring the borrowing cost underestimates the financial impact on the hedge fund and does not provide a complete picture of the losses incurred from the strategy. C is incorrect. The option suggesting a total loss of $11 million is incorrect because it neither correctly calculates the loss from the market rally nor accounts for the full borrowing cost. The actual loss from the market rally is $10 million, and the borrowing cost is $3 million, totaling $13 million. Any figure that deviates from this calculation either omits some costs or miscalculates the existing figures, leading to an inaccurate assessment of the financial outcome of the strategy. CFA Level II, Learning Module 4: Hedge Fund Strategies, LOS (b) Discuss investment characteristics, strategy implementation, and role in a portfolio of equity-related hedge fund strategies. 64 © 2014-2024 AnalystPrep.