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2010 Level II Mock Exam: Afternoon Session ANSWERS AND REFERENCES

Trendwise Case Scenario

Trendwise is an investment firm advising individual clients, as well as, offering a variety

of mutual funds, including the Omega Fund (OF). OF has a large ownership stake in

Cyclical Industries (CI). OF and CI have one director in common, Glenn Libra.

At the April OF board meeting, portfolio manager Ileana Natali, CFA, stated that after

conducting thorough research and analysis, she was firmly convinced the fund should sell

its shares of CI. One director advised Natali, “Don’t sell CI. It’s a great stock, isn’t it Mr.

Libra?” Libra listened but did not respond. Hearing the director’s comment, Natali

decided not to sell the shares as planned. In the following weeks the stock price rose

dramatically.

One month later, Libra phoned Natali, requesting she vote OF’s shares to reelect him to

the CI board of directors. Natali then sent Libra an email saying, “I voted OF’s shares for

you, a step I feel is in the best interest of our fundholders.” Natali continued, “Please be

aware we recently conducted a cost-benefit analysis and determined it is not worthwhile

to vote all proxies. We are sending all clients a copy of our new proxy-voting policies

which will explain, we may not vote all proxies in the future.”

Libra warned, “Voting proxies is an integral part of the management of investments. A

fiduciary who fails to vote proxies may violate CFA Standards.” In response, Natali

agreed to consult counsel and the CFA handbook regarding the new policies.

The following week, Natali’s supervisor asked her to evaluate a proposal from Brock

Securities Brokerage (Brock). Brock recently proposed a soft dollar arrangement with

Trendwise. Trendwise claims compliance with the CFA Institute Soft Dollar Standards.

In her evaluation, Natali noted Brock proposes a higher commission rate than Trendwise

pays its current brokerage firm. She also indicated Brock’s fees are within a reasonable

range. In addition, Natali indicated Brock could possibly provide better trade execution

than Trendwise’s present broker. Natali proposes to use Brock on a trial basis.

In a memorandum to Trendwise’s compliance officer, Natali states:

“I believe the proposed brokerage arrangement from Brock satisfies the two fundamental

principles in the CFA Institute Soft Dollar Standards Trendwise must use in evaluating

soft dollar arrangements:

Principle 1: All client commissions paid to a broker are the property of the client.






Principle 2: Mutual funds, such as Omega, establish their own policies with respect to the

use of certain brokers.

I recommend we use Brock only for OF transactions. This will allow us to verify the

quality of Brock’s trade execution, and the soft dollar credits will decrease the research

costs to OF’s fundholders. After a one-year trial period, we will inform our directors of

this new arrangement and report the results of the arrangement. If the directors decide to

renew the contract, we will inform the fundholders.

The following week Natali’s supervisor sent her a memo asking if the following firm

policies need any revisions to comply with the CFA Institute Research Objectivity

Standards:

Policy 1. Base compensation for analysts is determined from the quality of research

performed. Year-end bonuses may be adjusted based on an analyst’s work with

investment banking and corporate finance teams.

Policy 2. In their relationships with corporate issuers, analysts are prohibited from either

directly or indirectly promising favorable reports, or threatening negative reports. Price

targets may be agreed upon as long as the corporate issuer meets all disclosure

requirements prior to the report being issued.

Policy 3. In their relationships with corporate issuers, analysts are prohibited from

sharing with or communicating to a subject company, prior to publication, any section of

a research report.

Policy 4. Ensure that covered employees do not share information about the subject

company or security with any person who could have the ability to trade in advance of or

otherwise disadvantage the firm’s mutual funds.

1. With respect to her actions concerning Libra and Cyclical Industries (CI), Natali

least likely violated the CFA Institute Standards of Professional Conduct

concerning:

A. Loyalty.

B. Conflicts of interest.

C. Independence and Objectivity.

Answer: A

“Guidance for Standards I-VII”

2010 Modular Level II, Vol. 1, pp. 48-51, 80-82

Study Session 1-2-a

Demonstrate a thorough knowledge of the Code of Ethics and Standards of

Professional Conduct by applying the Code and Standards to specific situations.






A is correct because Natali’s actions least likely impacted her employer. By

changing her recommendation to keep CI and appease an important client she has

violated both the Conflicts of Interest and Independence Standards, Standard VI

(A) and Standard I (B).

2. In their discussion of the new proxy voting policy, whose statements are

consistent with the CFA Institute Standards?

A. Libra’s only.

B. Natali’s only.

C. Both Libra’s and Natali’s.

Answer: C

“Guidance for Standards I-VII”

2010 Modular Level II, Vol. 1, p. 50

Study Session 1-2-a



C is correct because statements made by both Natali and Libra are consistent with

the Standards. According to Standard III (A) (Loyalty, Prudence, and Care)

voting proxies is an integral part of the management of investments and a

fiduciary who fails to vote proxies may violate the Standard. The Standards of

Practice Handbook also states that a cost-benefit analysis may show that voting all

proxies may not benefit the client, so voting proxies may not be necessary in all

instances. Members and candidates should disclose to clients their proxy-voting

policies, which Natali has done.

3. Which aspect of Trendwise’s duty to its clients is most likely to be violated by its

proposed soft dollar arrangement with Brock?

A. All soft dollar practices must be fully disclosed.

B. Investment managers must at all times seek best trade execution.

C. Commissions paid must be reasonable in relation to the research and

execution services provided.

Answer: A

CFA Institute Soft Dollar Standards

2010 Modular Level II, Vol. 1, pp. 50, 144-145

Study Sessions 1-2-a, 1-3-b








Critique company soft dollar practices and policies.

A is correct because according the Soft Dollar Standards, once a manager decides

to use soft dollar services, the manager should fully disclose to its clients its

brokerage commission policies. Trendwise proposes to inform clients only at

year’s end which would not meet the Standards requirement.

4. In her statement about evaluating soft dollar arrangements, Natali is most likely

correct with respect to:

A. Principle 1.

B. Principle 2.

C. Both Principles 1 and 2.

Answer: A

CFA Institute Soft Dollar Standards

2010 Modular Level II, Vol. 1, pp. 143-145

Study Session 1-3-a

Define “soft dollar” arrangements and state the general principles of the Soft

Dollar Standards.

A is correct as Natali stated Principle 1 correctly. According to the Soft Dollar

Standards, I. General Principles, brokerage is the property of the client.

5. In response to her supervisors question regarding the firm’s policies on research

objectivity, Natali’s best response would be:

A. both policies 1 and 2 are consistent with the current Standards.

B. both policies 1 and 2 are inconsistent with the current Standards and require

changes.

C. the policy on analyst compensation requires changes, but the policy regarding

relationships with corporate issuers is consistent with current Standards.

Answer: B

CFA Institute Research Objectivity Standards


Study Session 1-4-b

Critique company policies and practices related to research objectivity and

distinguish between changes required and changes recommended for compliance

with the Research Objectivity Standards.

B is correct. Both policies 1 and 2 are inconsistent with the current Standards.

According to the Research Objectivity Standards, firms must establish and






implement salary, bonus, and other compensation for analysts that do not directly

link compensation to investment banking or other corporate finance activities on

which the analyst collaborated (either individually or in the aggregate.) The

Standards also state that research analysts are prohibited from directly or

indirectly promising a subject company or other issuer a favorable report or

specific price target, or from threatening to change reports, recommendations, or

price targets.

6. To make the firm’s policies consistent with CFA Institute Research Objectivity

Standards, Natali should suggest the following regarding Policy 3 and 4:

A. both policies 3 and 4 are consistent with the current Standards.

B. both policies 3 and 4 are inconsistent with the current Standards.

C. policy 3 requires changes, but policy 4 is consistent with current Standards.

Answer: B

CFA Institute Research Objectivity Standards


Study Session 1-4-b

Critique company policies and practices related to research objectivity and

distinguish between changes required and changes recommended for compliance

with the Research Objectivity Standards.

B is correct. According to the Research Objectivity Standards, analysts are

prohibited from sharing with, or communicating with or communicating to a

subject company, prior to publication, any section of a research report that might

communicate the research analyst’s proposed recommendation, rating, or price

target. It is recommended that the compliance or legal department receive a draft

research report before sections are shared with the subject company. She also

needs to change Policy 4 so that it is applicable to all clients, not just mutual

funds.






Walter Speckley Case Scenario

Walter Speckley is a high net worth individual who recently relocated from Europe to the

United States. Speckley sold his European properties and will receive the €10 million

proceeds 180 days from now. The terms of the sale require the funds to remain in escrow

for an additional 180 days after receipt. He intends to invest the escrowed funds in a 180-

day euro-denominated money market instrument.

When the escrow period ends 360 days from now, Speckley intends to convert these

funds to U.S. dollars and buy stock in the First Bank of Kanata (FBK), a small regional

U.S. bank that he has identified as an attractive investment opportunity. FBK stock is

priced in U.S. dollars and the company will pay a dividend of $5.00 per share 180 days

from now.

Speckley’s investment objectives are to lock in:

1. the yield he will receive on his euro-denominated money market investment 180

days from now;

2. the exchange rate he will receive when he converts his funds from euros to U.S.

dollars 360 days from now; and

3. the current purchase price of FBK stock.

To accomplish these objectives, Speckley plans to use forward contracts. Exhibit 1

describes the transactions proposed by Speckley.

Exhibit 1

Time-line of Events

Now

180 Days from

Now 360 Days from Now

Cash transactions

Property sale proceeds received --- €10,000,000 ---

Euro-denominated money market

investment --- €10,000,000 Investment matures

Euros converted into U.S. dollars --- --- Dollars received

FBK stock purchase (in U.S. dollars) --- --- Stock purchased

Dividend paid on FBK stock --- $5.00 per share ---

Derivatives transactions

Euribor forward rate agreement Contract entered --- Contract matures

Forward currency contract Contract entered --- Contract matures

Forward contract on FBK stock Contract entered --- Contract matures






Speckley approaches Illing & Partners, a private investment bank, to obtain price quotes

on the various forward contracts. Illing & Partners base their price quotes on the

information in Exhibit 2.

Exhibit 2

Spot Market Information

180-day Euribor 2.50%

360-day Euribor 3.50%

180-day U.S. yield 3.00%

360-day U.S. yield 3.00%

Dollars per euro (spot) $1.25

Price per share of FBK stock $100.00

Howard Dunn, an analyst at Illing & Partners, explains to Speckley that currency forward

prices are determined in part by the current levels of domestic and foreign interest rates

and the levels of domestic and foreign interest rates expected at the expiration of the

forward contract.

Dunn tells Speckley that he will receive fewer dollars when he converts his proceeds

using the 360-day forward currency contract than he would receive at the current spot

exchange rate. When Speckley asks why, Dunn replies:

“The forward exchange rate reflects that 360-day U.S. interest rates are lower than 360-

day European interest rates.”

Speckley enters into a Euribor forward rate agreement, a short position in a currency

forward contract to exchange dollars for euros, and a long position in a FBK forward

contract. As the currency forward contract nears maturity, the market value of the long

position is $149,000 and Speckley estimates that the probability that his counterparty will

default at maturity is 25 percent.

7. Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the

price of a 360-day euro forward contract is closest to:

A. $1.244.

B. $1.250.

C. $1.256.

Answer: A

“Forward Markets and Contracts,” Don M. Chance


Study Session 16-58-c






Calculate and interpret the price and the value of 1) a forward contract on a fixed

income security, 2) a forward rate agreement (FRA), and 3) a forward contract on

a currency.

The formula for the forward currency price is:

F(0,T) = [ S0 / ( 1 + rf )

T ] ( 1 + r )

T

where F(0,T) = the forward price at time “0” for a delivery date at time “T”

(which is one year, or “1”, in this case)

S0 = the spot exchange rate

rf = the foreign interest rate

r = the domestic interest rate.

In this item set, the domestic interest rate is the U.S.

Substituting in the information from Exhibit 2:

F(0,T) = ( 1.25 / 1.035 ) ( 1.030) = 1.244


price of a 360-day forward contract on FBK stock is closest to:

A. $97.93.

B. $98.07.

C. $103.00.

Answer: A



Study Session 16-58-b

Calculate and interpret the price and the value of an equity forward contract,

assuming dividends are paid either discretely or continuously.

The price formula for a forward contract on an equity security is:

F(0,T)= [ S0 – PV(D,0,T) ] ( 1 + r )T

= [ S0 ( 1 + r )T ] – FV(D,0,T)

where S0 = the current price of the equity

PV(D,0,T) = the present value of the dividend stream across the life of the

forward contract (“T”) FV(D,0,T) = the future value of the dividend stream

across the life of the contract

Given the information in the problem and in Exhibits 1 and 2, the contract is for

one-year (T = 1) and the dividend occurs in 180 days (½ year). Substituting this

into the formula:

F(0,T) = [ 100 – { 5 / ( 1 + .03 )0.5

} ] ( 1 + .03 )

= [ 100 ( 1 + .03 ) ] – [ 5 ( 1 + .03 )0.5

]

= $97.93






9. Dunn’s explanation of the currency forward price is most likely:

A. correct.

B. incorrect because forward exchange rates are not affected by current domestic

and foreign interest rates.

C. incorrect because forward exchange rates are not affected by domestic and

foreign interest rate expectations.

Answer: C



Study Session 16-58-a

Explain how the value of a forward contract is determined at initiation, during the

life of the contract, and at expiration

C is correct because currency forward prices are determined by the current

exchange rate, the current domestic and foreign interest rates and the maturity of

the contract.

10. Dunn’s explanation of the difference between the 360-day forward exchange rate

and the current spot exchange rate is most likely:

A. correct.

B. incorrect because the forward exchange rate will also depend upon inflation

expectations.

C. incorrect because the forward exchange rate will be higher than the spot rate

when U.S. interest rates are lower than European interest rates.

Answer: A






a currency.

The exchange rate on forward currency contracts is determined by:

F0(T) = [ S0 / ( 1 + rf )

T ] ( 1 + r )

T

where F0(T) = the current price of the forward contract expiring at time “T”

S0 = the current spot exchange rate

rf = the foreign interest rate

r = the domestic interest rate.






When domestic interest rates (U.S. in this item set) are lower than foreign interest

rates, the forward exchange rate will be lower than the spot exchange rate; this is

based on the assumption that the exchange rate is quoted as the amount of

domestic currency required to purchase 1 unit of foreign currency.

11. The credit risk of the currency forward contract from Speckley’s perspective is

closest to:

A. $0.

B. $37,250.

C. $149,000.

Answer: A



Study Session 16-58-d

Evaluate credit risk in a forward contract, and explain how market value is a

measure of the credit risk to a party in a forward contract.

Speckley is short the Euro forward which has a positive market value. The long

counterparty stands to lose $149,000 if Speckley defaults.


rate on a Euribor forward rate agreement (FRA) that meets Speckley’s needs is

closest to:

A. 2.22%.

B. 3.00%.

C. 4.44%.

Answer: C






a currency

The formula for an FRA rate is:

FRA(0,h,m) =

1 +

L0(h+m)(h+m

/360) - 1

(360/m) 1 + L0(h) (

h/360)






where FRA(0,h,m) is the rate on an FRA contracted at time “0” expiring at time

“h” for an investment period lasting from “h” to “h+m” and L0(h) is the h-period

Euribor rate at time “0”. In Speckley’s case, h = m = 180. Using this and the

information in Exhibit 2:

FRA(0,180,180) = [ { ( 1 + .035 ) / ( 1 + .025[1/2]) } - 1 ] 2 = 0.0444






Sofiya Prutko Case Scenario

Sofiya Prutko, CFA, is a partner at Fedir Investments, a firm that acts as a private conduit

for issuing securities backed by non-conforming residential mortgages. Fedir has

assembled an $80 million pool of 30-year, fixed-rate mortgages with unusually high loan-

to-value ratios and intends to privately place the securities created from this pool.

Prutko’s task is to determine the best structure for the securities. As part of that process,

she has scheduled a series of meetings with current and potential investors.

Her first meeting is with an endowment fund manager who may purchase a portion of the

securities if they meet his needs. During the meeting, Prutko is asked about the pool’s

characteristics and its estimated cash flows. She explains that the pool has a WAC of

7.10 percent and a WAM of 356 months and that, under current market conditions,

prepayments are expected at 310 PSA. Later in the discussion, she presents a table

showing pool cash flow estimates for a different prepayment assumption. An incomplete

part of that table appears in Exhibit 1.

Exhibit 1

Mortgage Pool Monthly Cash Flow Estimate

Months

From Now

Outstanding

Balance

Mortgage

Payment

Net

Interest

Scheduled

Principal

Prepayment

24 $47,563,831 $327,321 $281,419 $45,901

The endowment fund manager explains that one of his primary concerns is that market

interest rates will rise, leading to prepayment rates that are much lower than currently

expected. He also explains that he wants a relatively long-term investment (average life

greater than 5 years) and does not want to receive any cash flow from it for a number of

years.

Prutko’s second meeting is with the manager of a public pension fund that invests in a

wide variety of fixed income securities. The manager is currently concerned about credit

risk but states that, “Although I’m concerned because some non-agency issuers have

more credit risk than Fannie Mae and Freddie Mac, credit enhancement can be used to

achieve a credit rating equal to that of Fannie and Freddie securities.” Prutko describes

the credit risk characteristics of Fedir’s securitizations relative to agency securities and

adds, “in addition, for each $100 in mortgage principal, we issue only $95 in par-value

securities, retaining $5 as an equity position.”

After meeting with these two individuals and others, Prutko decides to separate the pool

into two $40 million pools. The first pool is used to back a pair of interest-only and

principal-only stripped securities with a $38 million par value. The second pool is used

to back a CMO structure with two $12 million sequential planned amortization class

(PAC) tranches, PAC-A and PAC-B, and one $14 million support tranche. Interest rates

at new issue suggest that prepayments will occur at 310 PSA and the initial PAC collar is






200-450 PSA for PAC-A and 230-420 PSA for PAC-B. Each strip security and CMO

tranche is privately placed, as was originally desired.

13. Given the 310 PSA prepayment assumption, the current prepayment rate of the

pool is closest to a CPR of:

A. 2.5%.

B. 18.6%.

C. 41.3%.

Answer: A

“Mortgage-backed sector of the bond market,” Frank J. Fabozzi, CFA



Compare and contrast the conditional prepayment rate (CPR) with the Public

Securities Association (PSA) prepayment benchmark.

During the first 30 months of a pool’s life,

%5.2%48.210.3*1333.*%610.3*30

4*%6

100

levelPSA *

30

t * 6%CPR

where t is the number of months since the mortgages were originated. Since the

WAM is 356, 4 months have elapsed.

14. Given a single monthly mortality prepayment assumption of 2.1482 percent and

the other information about the 24th

month of the pool’s life that is provided in

Exhibit 1, the expected prepayment amount is closest to:

A. $1,014,735.

B. $1,020,780.

C. $1,021,766.

Answer: B




Calculate the prepayment amount for a month, given the single monthly mortality

rate.

The (expected) prepayment amount = (Pool balance – scheduled principal

payment) × single monthly mortality (SMM). $1,020,780 = ($47,563,831 -

$45,901) ×0.021482.






15. The endowment fund manager’s concern about the impact of movements in

market interest rates is best described as a concern about:

A. extension risk.

B. contraction risk.

C. prepayment risk.

Answer: A



Study Session 15-55-f

Explain the factors that affect prepayments and the types of prepayment risks.

Prepayment risk includes contraction risk (the risk that the prepayment rate will

rise resulting in a shortening of the security’s life) and extension risk (the risk that

the prepayment rate will fall, resulting in a lengthening of the security’s life.) The

investor has expressed a clear concern about falling prepayment rates – indicating

a concern about extension risk. This is also, generically, a concern about

prepayment risk – but is better described as extension risk.

16. The pension fund manager’s statement about the credit risk of non-agency

mortgage-backed securities is most likely:

A. correct.

B. incorrect, with respect to the use of credit enhancement.

C. incorrect, with respect to the credit risk of non-agency issuers.

Answer: A



Study Session 15-55-k

Compare and contrast agency and nonagency mortgage-backed securities.

The pension fund manager’s statement is true because most private label issuers

do have more credit risk than FNMA or FHLMC and credit enhancement (in a

variety of forms, such as third party default protection or overcollateralization)

can be used to increase the credit rating of an issue to the level of Fannie and

Freddie securities.






17. According to the information that Prutko provided to the pension fund manager,

the kind of credit enhancement that Fedir provides is best described as:

A. wrapping.

B. overcollateralization.

C. excess spread accounts.

Answer: B

“Asset-backed sector of the bond market,” Frank J. Fabozzi, CFA



Distinguish among the various types of external and internal credit enhancements.

“Overcollateralization in a structure refers to a situation in which the value of the

collateral exceeds the amount of the par value of the outstanding securities

issued…” (p. 451) Wrapping refers to a third party guarantee from a monoline

insurer. Excess spread accounts require security structures that do not pay out all

incoming interest to the security holders, allowing the establishment of a “spread

account” where excess interest payments are stored and can be used to cover

future defaults, if needed.

18. Which type of CMO tranche would most likely meet the endowment fund

manager’s desired investment maturity and cash flow characteristics?

A. An accrual tranche.

B. A sequential-pay tranche.

C. A planned amortization class tranche.

Answer: A



Study Session 15-55-h

Distinguish among the sequential pay tranche, the accrual tranche, the planned

amortization class tranche, and the support tranche in a CMO.

Of the three, the accrual tranche typically receives principal only after all

sequential-pay and/or planned amortization class tranches have been paid off,

meeting the investor’s need for a long-term security. Further, until its principal

repayment begins, the accrual tranche does not pay interest but accrues it to

principal, meeting the investor’s need to not receive any cash flow for a number

of years.






Lisa Jaworski Case Scenario

Lisa Jaworski is an equity portfolio manager for Thornhurst Investments, a large

investment management company based in Charlotte, North Carolina. Thornhurst

currently uses the Capital Asset Pricing Model (CAPM) to evaluate securities and mean-

variance portfolio optimization to construct equity portfolios. Jaworski is meeting with

two assistant portfolio managers, Yaodong Bi and Niyati Ahuja. Bi and Ahuja have been

asked to do some research on ways to improve on the methods currently being used by

Thornhurst to evaluate securities and develop portfolios.

Jaworski begins the meeting by outlining some issues relating to the CAPM. She makes

the following statements:

Statement 1

“One of the reasons I am uncomfortable using the CAPM is that it makes some very

restrictive assumptions such as:

investors pay no taxes on returns and no transaction costs on trades,

investors have unique views on expected returns, variances and correlations of

securities, and

investors can borrow and lend at the same risk-free rate of interest.”

Statement 2

“We are also faced with a problem that our mean-variance optimization models can

generate unstable minimum-variance efficient frontiers. Consequently, we face

considerable uncertainty regarding recommendations we make to our clients on asset

allocation. I attribute the instability to our use of:

a short sales constraint, and

historical betas.”

Bi suggests that multifactor models provide a better way to model stock returns. He

develops two models on a whiteboard while stating: “There are two ways to model stock

returns using the following multifactor model:

Model 1

In this model, stock returns ( ) are determined by surprises in economic factors such as

GDP growth and the level of interest rates.

Model 2

Here, stock returns ( ) are determined by factors that are company attributes such as

price-earnings ratio and market capitalization.






While the interpretation of the intercept is similar for both models, the factor

sensitivities are interpreted differently in the two models.”

Ahuja notes that a multifactor Arbitrage Pricing Model (APT) provides a much better

basis than the CAPM for calculating expected portfolio returns and evaluating portfolio

risk exposures. In order to illustrate the advantages of the multifactor APT model, Ahuja

provides information for two portfolios Thornhurst currently manages. The information

is provided below in Exhibit 1. The current risk-free rate is 2 percent.

Exhibit 1

Factor Sensitivities and Risk Premia

Factor

Factor Sensitivities Risk

Risk Factor Portfolio A Portfolio B Benchmark Premium (%)

Confidence Risk 0.81 0.04 0.5 4.5

Inflation Risk -0.15 -0.45 -0.25 -1.2

Business Cycle Risk 1.23 0.09 0.9 5.2

Ahuja makes the following statement:

Statement 3

“We can tell from Exhibit 1 that Portfolio A is structured in such a manner that it will

benefit from an expanding economy and improving confidence because the factor

sensitivities for confidence risk and business cycle risk exceed the factor sensitivities for

the benchmark. Portfolio B has very low factor sensitivities for confidence risk and

business cycle risk but moderately high exposure to inflation risk, therefore Portfolio B

can be referred to as a factor portfolio for inflation risk.”

Jaworski wants to examine how active management is contributing to portfolio

performance.

Ahuja responds with the following statement:

Statement 4

“Our models show that Portfolio A has annual tracking error of 1.25 percent and an

information ratio of 1.2 while Portfolio B has annual tracking error of 0.75 percent and an

information ratio of 0.87.”

19. Which assumption of the CAPM is most likely incorrect in Jaworski’s Statement

1? The assumption regarding:

A. borrowing and lending.

B. taxes and transaction costs.

C. expected returns, variances and correlations.






Answer: C

“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.

Pinto, and David E. Runkle


Study Session 18-64-e

Explain the capital asset pricing model (CAPM), including its underlying

assumptions and the resulting conclusions

C is correct. This statement is incorrect. The CAPM assumes that investors have

identical views on expected returns, variances and correlations of securities.

20. Is Jaworski’s Statement 2 most likely correct?

A. Yes.

B. No, she is incorrect about the short sales constraint.

C. No, she is incorrect about the use of historical betas.

Answer: B




Study Session 18-64-i

Discuss reasons for and problems related to instability in the minimum-variance

frontier.

B is correct. Jaworski is wrong. One of the reasons for an unstable minimum-

variance efficient frontier is the absence of a short sales constraint. That is

unconstrained mean variance optimization models produce inherently unstable

efficient frontiers. The solution is to impose a no short sales constraint.

21. With regard to the statement on multifactor models, Bi is most likely incorrect

with respect to the:

A. intercept value .

B. factor sensitivities .

C. description of the factors.

Answer: A









Study Session 18-64-j

Discuss and compare macroeconomic factor models, fundamental factor models,

and statistical factor models.

A is correct. Model 1 is a macroeconomic factor model. In this model the

intercept value is the expected return on the stock. Model 2 is a fundamental

factor model. In fundamental factor models the factor sensitivities are

standardized, thus the intercept is not interpreted as anything more than a

regression intercept that ensures that expected asset specific risk equals zero (see

page 431). It is not interpreted as the expected return for the stock as in the

macroeconomic factor model.

22. Based on the information in Exhibit 1, the expected return for portfolio A is

closest to:

A. 8.4%

B. 10.2%

C. 12.2%

Answer: C




Study Session 18-64-l

Discuss the arbitrage pricing theory (APT), including its underlying assumptions

and its relation to the multifactor models, calculate the expected return on an asset

given an asset’s factor sensitivities and the factor risk premiums, and determine

whether an arbitrage opportunity exists, including how to exploit the opportunity.

C is correct. The expected return for portfolio A is calculated as:

E(RA) = 2% + 0.81 × 4.5% + -0.15 × -1.2% + 1.23 × 5.2% = 12.21%

23. Is Ahuja’s Statement 3 most likely correct?

A. Yes

B. No, she is incorrect about Portfolio A

C. No, she is incorrect about Portfolio B.

Answer: C



2010 Modular Level II, Vol. 6, pp. 432-435, 452-454.






Study Session 18-64-l, m

Discuss the arbitrage pricing theory (APT), including its underlying assumptions

and its relation to the multifactor models, calculate the expected return on an asset

given an asset’s factor sensitivities and the factor risk premiums, and determine

whether an arbitrage opportunity exists, including how to exploit the opportunity.

Explain the sources of active risk, define and interpret tracking error, tracking

risk, and the information ratio, and explain factor portfolio and tracking portfolio.

C is correct. Ahuja is incorrect about Portfolio B. Factor portfolios by definition

will have a factor sensitivity of 1 to a particular factor and zero sensitivity for all

other factors. For Portfolio B to be a factor portfolio for the inflation risk factor it

must have factor beta of 1 to inflation risk and zero for the other factors.

24. Based on Statement 4 by Ahuja, an appropriate conclusion is that the portfolio

that has benefited the most from active management is:

A. portfolio B because of tracking error.

B. portfolio A because of the information ratio.

C. portfolio B because of the information ratio.

Answer: B



2010 Modular Level II, Vol. 6, pp.444-452

Study Session 18-64-m

Explain the sources of active risk, define and interpret tracking error, tracking

risk, and the information ratio, and explain factor portfolio and tracking portfolio.

B is correct. Portfolio A has the highest information ratio. The information ratio

provides the mean active returns per unit of active risk.






Brigitte Langlois Case Scenario

Brigitte Langlois, a fixed income securities analyst for Cunard Securities, is responsible

for evaluating and monitoring the creditworthiness of companies whose bonds are held in

Cunard's High Yield International Corporate Bond Fund. Langlois bases her buy and sell

decisions on a multivariate bankruptcy prediction model that estimates the probability

that a company will face insolvency within the next 18 months. As inputs into the model,

Langlois uses adjusted, rather than reported, accounting data to calculate a company's

liquidity, solvency, and profitability ratios.

Langlois and her research assistant, Barclay Kingston, are preparing a research report on

Duban Inc., a U.S. based company, and Kerwin Corporation, Duban’s recently acquired

Swedish affiliate, to determine whether either company's intermediate-term bonds would

be suitable investments for Cunard's bond fund.

Langlois assigns Kingston several tasks:

“I want you to analyze Duban’s long-term solvency because I am concerned about its

obligation to provide pension benefits. Because Duban uses U.S. GAAP while Kerwin

uses International Financial Reporting Standards (IFRS), I want you to prepare an

analysis of their financial statements.”

Langlois provides Kingston with information about Duban’s pension plan, which is

shown below in Exhibit 1.






Exhibit 1

Duban Inc.

Selected Footnote Disclosure

Pension Plan Information

(in U.S. $ millions)

2009 2008

Reconciliation of Pension Benefit Obligation (PBO)

Opening Balance $1,606 $1,296

Service Cost 86 81

Interest Cost 147 131

Plan Amendments 237

Benefits Paid (148) (145)

Participant Contributions 8 6

Closing Balance $1,699 $1,606

2009 2008

Reconciliation of Plan Assets

Opening Balance $507 $592

Return on Plan Assets (41) (21)

Employer Contributions 117 75

Participant Contributions 8 6

Benefits Paid (148) (145)

Closing Balance $443 $507

Other Information

Unrecognized Prior Service Cost 227 250

Unrecognized Actuarial Loss 348 205

Expected Return on Plan Assets 46 45

Amortization of Unrecognized Prior Service Cost 23 12

Amortization of Unrecognized Loss 15 10

Langlois continues to outline Kingston’s tasks:

“I would like you to compute the effect of the consolidation of Kerwin on Duban’s

profitability. As outlined in Exhibit 2, since the acquisition by Duban, Kerwin’s

performance has improved dramatically, but I think they should still be considered a

Swedish based company for our investment purposes for the following reasons:

They sell all of their output in Sweden, in kronas.

Although they purchase some components from Duban, all of the labor and other

costs are incurred in Sweden.

They are able to finance all of their working capital needs from local sources.”

Selected information from Duban’s financial statements and Management’s Discussion

and Analysis relating to its investment in Kerwin, is shown below in Exhibit 2.






Exhibit 2

Selected Information from Duban’s 2009 Financial Statements

and Management’s Discussion and Analysis

Concerning Duban’s Investment in Kerwin

Sweden is an important foreign market for Duban Inc. On 1 January 2009, we made an

investment in Kerwin Corporation in expectation of strong consumer demand. As

indicated in the following table, as a result of Duban’s involvement in the Swedish

operations Kerwin's 2009 net sales increased by 25 percent compared with 2008 sales. In

addition, Kerwin's 2009 net income increased by 40percent compared to the prior year.

Kerwin: Selected Financial Data (in SEK millions)

2009 2008

Net sales 56,000 44,800

Net income 5,000 3,600

Monetary assets 13,000 12,000

Non-monetary assets 32,500 28,000

Monetary liabilities 18,000 17,500

Equity 27,500 22,500

USD/SEK Exchange Rate

2009 2008

Year-end rate, 31 December $0.140 = 1SEK $0.127 = 1SEK

*Average rate during year $0.132= 1SEK $0.141= 1SEK

25. Based on Exhibit 1, funded status of Duban’s pension plan under U.S. GAAP for

2009 ($ millions) would be closest to a liability of:

A. 681.

B. 1,256.

C. 1,831.

Answer: B

“Employee Compensation: Post-Retirement and Share-Based,” Elaine Henry,

CFA and Elizabeth Gordon


Study Session 6-22-g






Evaluate the underlying economic liability (or asset) of a company’s pension and

other post-employment benefits.

The pension liability is calculated as follows:

Plan Assets 443

Less: PBO (1,699)

Funded Status - (deficit) (1,256)

26. Based on Exhibit 1, the pension expense ($ millions) that would be reported on

Duban's 2009 income statement under U.S. GAAP would be closest to:

A. 187.

B. 225.

C. 230.

Answer: B




Study Session 6-22-c, d

Describe the components of a company’s defined-benefit pension expense.

Explain the impact of a defined benefit plan’s assumptions on the defined benefit

obligation and periodic expense.

The pension expense is calculated as follows:

Service Cost 86

Interest Cost 147

Expected Return on Plan Assets (46)

Amortization of Unrecognized Prior Service Cost 23

Amortization of Unrecognized loss 15

Pension Expense 225

27. Based on Exhibit 1, the underlying economic pension expense ($ millions) for

Duban for 2009 would be closest to:

A. 192.

B. 233.

C. 274.

Answer: C










Calculate the underlying economic pension expense (income) and other post-

employment expense (income) based upon disclosures.

The economic pension expense is calculated as follows:

Service Cost 86

Interest Cost 147

Actual Return on Plan Assets 41

Economic Pension Expense 274

Alternative calculation: the change in the net funded position plus the employer’s contributions.

(1699- 443) – (1606-507) + 117 = $274

28. Langlois’ description of Kerwin’s operations most likely classifies the U.S. dollar

as the:

A. local currency.

B. functional currency.

C. presentation currency.

Answer: C

“Multinational Operations,” Timothy Doupnik

2010 Modular Level II, Vol. 2, pp 172-173


Distinguish among presentation currency, functional currency, and local currency.

Langlois’ describes the krona as the functional currency for Kerwin – the sales

prices and costs are primarily determined in Sweden and Kerwin is able to finance

its operations locally. Therefore the U.S. dollar is not the functional currency, but

the presentation currency.

29. If the Swedish krona is chosen as Kerwin’s functional currency, Kerwin’s 2009

return on equity ratio (%) after translation, using the year-end balance for equity,

will be closest to:

A. 17.1.

B. 18.2.

C. 18.8.

Answer: A


2010 Modular Level II, Vol. 2, pp 173-174, 183, 185






Study Session 6-23-d, e

Calculate the translation effects, evaluate the translation of a subsidiary’s balance

sheet and income statement into the parent company’s currency, and analyze the

differential effect of the current rate method and the temporal method on the

subsidiary’s financial ratios.

Analyze how using the temporal method versus the current rate method will affect

the parent company’s financial ratios.

If the functional currency is the SEK, then Duban should use the current rate method to

translate Kerwin. The equity will include the initial investment, current retained earnings

and the required translation adjustment to bring the balance sheet back into balance

following translation.

ROE = Net Income/Total Equity (year-end balance)

Net Income 5,000 x 0.132 = 660 Translate at average rate

Total Equity

o Initial Equity 22,500 x 0.127 = 2,858 Translate at historical rate (Jan 2009)

o Increase in Retained

Earnings

5,000 x 0.132 = 660

Translate at average rate

o Translation Adjustment 332 To balance the balance sheet (see

following calculation)

Total Equity 3,850

ROE 660/3,850 = 17.1%

Translation Adjustment: Translation Translated Value

Translated Net Assets (1) (27,500) x 0.140 3,850

Less Translated Initial Equity 22,500 x 0.127 2,858

Less Translated Increase in Retained Earnings 5,000 x 0.132 660

Translation adjustment: amount needed to balance the balance

sheet

332

(1) Net Assets = Net Non-monetary assets + Monetary assets – Monetary liabilities

= 13,000 + 32,500 – 18,000 = 27,500 OR Net assets = Equity = 27,500

30. With the changes in the krona indicated in Exhibit 2, compared to using the

current rate method, net income under the temporal method, will most likely be:

A. lower.

B. higher.

C. the same.

Answer: A


2010 Modular Level II, Vol. 2, pp 170-171, 173-176






Study Session 6-23-d, e

Calculate the translation effects, evaluate the translation of a subsidiary’s balance

sheet and income statement into the parent company’s currency, and analyze the

differential effect of the current rate method and the temporal method on the

subsidiary’s financial ratios.

Analyze how using the temporal method versus the current rate method will affect

the parent company’s financial ratios.

Under the temporal method the balance sheet exposure is limited to monetary

assets and liabilities. Kerwin has a net liability exposure on its balance sheet

(monetary liabilities exceed monetary assets) therefore the strengthening of the

Swedish krona against the U.S dollar will result in a negative translation

adjustment. This negative translation adjustment will be included in Duban’s net

income under the temporal method decreasing net income.






Brad Turner Case Scenario

Brad Turner is the Chief Financial Officer of Foster Inc., a Canadian based

manufacturing corporation that operates internationally. Foster has Cdn$20 billion in

total assets, with excess cash to invest for a planned acquisition in two years.

Information about Foster’s equity portfolio and fixed income portfolio is provided in

Exhibits 1 and 2, respectively. All securities were purchased on the first day of the

current year. Foster adheres to International Financial Reporting Standards (IFRS) when

accounting for its investments in the securities of other companies.

Exhibit 1

Foster Inc. Equity Portfolio

(at year end, Cdn$ thousands)

Characteristic Security

Alton Inc. Barker Inc. Cosmic Inc. Darnell Inc.

Classification

Held-for-

trading

Available-

for-sale

Available-

for-sale

Associated

Company

Cost $100,000 $150,000 $250,000 $500,000

Market Value,

end-of-year $97,000 $151,000 $257,000 $506,000

Dividends received

during the year

$1,000

$2,000

$3,000

$4,000

Foster’s share of

investee’s net income

for the year

$5,000

$7,000

$10,000

$15,000

Note: Darnell Inc. has $2 billion in total assets. Foster owns 40 percent of Darnell’s

equity and has representation on Darnell’s Board of Directors but does not have

effective control.

Exhibit 2

Foster Inc. Fixed Income Portfolio

(at year end, Cdn$ thousands)

Characteristic Security

Eldon Inc. Fizz Inc. Gilt Inc. Harp Inc.

Classification

Held-for-

trading

Available-

for-sale

Held-to-

maturity

Held-to-

maturity

Cost $20,000 $35,000 $50,000 $60,000

Market Value,

end-of-year $23,000 $45,000 $45,000 $64,000

Interest earned for the

year $1,000 $2,000 $4,000 $5,000

Note: All fixed income securities were purchased at par value.






Turner is interested in understanding the effect of the investment portfolios on Foster’s

year-end financial statements. Foster is re-evaluating its investment strategy, including

what would have been the effect if Foster had designated more of the securities as

investments at fair value. Turner does not think the decline in market value of any of the

securities is permanent, but when discussing it with his investment officer, Charlene

Chen, she makes the following statement:

“I think the impairment in Gilt Inc. is permanent and we should recognize the impairment

loss in net income. However, if it recovers next year we will be able to reverse the loss.”

For Turner’s analysis, all tax effects are ignored.

31. The contribution of the equity portfolio to Foster’s net income ($) for the year is

closest to:

A. 7,000.

B. 18,000.

C. 26,000.

Answer: B

“Intercorporate Investments,” Susan Perry Williams

2010 Modular Level II, Vol. 2, pp. 12, 20

Study Session 5-21-a, c

Describe the classification, measurement, and disclosure under the International

Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)

investments in associates, 3) joint ventures, 4) business combinations, and 5)

special purpose and variable interest entities (SPEs and VIEs).

Analyze the effects on financial ratios of the different methods used to account for

intercorporate investments.

The sum of dividends for the first three investments (Alton, Barker & Cosmic) is

reduced by the unrealized loss on the held-for-trading security (Alton); to this

amount must be added Foster’s share of Darnell’s net income, as determined

under the equity method. The result is: 1,000 + 2,000 + 3,000 – 3,000 + 15,000 =

$18,000.

32. If at acquisition, all of the equity securities that were eligible to be designated as

investments at fair value were so designated, the amount that the entire equity

portfolio would contribute to Foster’s net income ($) for the year is closest to:

A. 11,000.

B. 21,000.

C. 26,000.






Answer: C


2010 Modular Level II, Vol. 2, pp. 12-13, 27








Only the equity securities that were designated as available-for-sale (Barker and

Cosmic) could have been designated at fair value and the unrecognized gains

from those securities would then be included in income. Because Foster is a

manufacturing company and not a venture capital or mutual fund company, it may

not account for its significant influence in Darnell using fair value.

Income would be equal to the dividends from Alton, Barker, and Cosmic plus the

changes in market value for those same three securities plus the income from

Darnell using the equity method. The result is 1,000 + 2,000 + 3,000 – 3,000 +

1,000 + 7,000 + 15,000 = $26,000.

33. Compared to its current classification, if Foster had classified its investment in

Darnell as a joint venture and accounted for it in the preferred manner, the most

likely effect on Foster’s return on assets (ROA) is that ROA would be:

A. no change.

B. a decrease.

C. an increase.

Answer: B










The preferred method of accounting for a joint venture under IFRS is proportional

consolidation.






Proportionate consolidation will not change the net income, but will reduce the

return on assets because total assets will increase: under the equity method, the

cost, $500 million will be included in total assets; under the proportionate

consolidation method $800 million (40% of $2 billion) will be included in total

assets.

34. At year-end, the carrying value ($) of the fixed income portfolio will be closest to:

A. 168,000.

B. 177,000.

C. 178,000.

Answer: C








Unrecognized gains on both the held-for-trading (Eldon) and available-for-sale

(Fizz) securities will be added to the investments’ carrying cost. The result is that

$13,000 (3,000 + 10,000) will be added to the $165,000 cost (20,000 + 35,000 +

50,000 + 60,000), for a total of $178,000.

35. If Turner is correct in his opinion about Gilt’s loss, a positive effect on reported

net income will most likely occur if Foster classifies:

A. both Gilt and Harp as held-for-trading securities.

B. Gilt as a held-for-trading security, and Harp as an available-for-sale security.

C. Gilt as an available-for-sale security, and Harp as a held-for-trading security.

Answer: C















Harp’s unrecognized gain of $4,000 will be included in income if it were

classified as a trading security, while Gilt’s unrecognized loss of ($5,000) will be

included in comprehensive income as part of equity if it were classified as

available-for-sale. Thus, net income increases by the $4,000 of Harp’s

unrecognized gain.

Balance

Sheet

Income

Statement

Other

Comprehensive

Income

Harp Trading security 64 +4

Available for sale 64 +4

Gilt Trading security 45 -5

Available for sale 45 -5

36. Chen’s statement is most accurate under:

A. IFRS only.

B. U.S. GAAP only.

C. both IFRS and U.S. GAAP.

Answer: A




Distinguish between IFRS and U.S. GAAP in the classification, measurement,

and disclosure of investments in financial assets, investments in associates, joint

ventures, business combinations, and special purpose and variable interest

entities.

Impairment of a held-to-maturity investment is recognized in net income under

both U.S. GAAP and IFRS, but only IFRS allows the subsequent reversal of an

impairment loss.






Rhonda Hamilton Case Scenario

Rhonda Hamilton, CFA, manages the Select Electric Fund. Hamilton is reviewing a

research report written by her colleague Brian Ender about the U.S. electric utility

industry. Ender’s report includes the results of a regression of the monthly return for an

electric utility equity index for the previous 203 months (the dependent variable) against

the monthly returns for the Standard &Poor’s 500 (S&P500) and the difference between

the monthly returns on long-term U.S. government bonds and one-month U.S. Treasury

bills (SPREAD) (the two independent variables).

Hamilton has reviewed Ender’s regression results. She agrees that S&P500 and

SPREAD are reasonable independent variables, but she is not convinced of the validity of

Ender’s model. Using Enders’ data, Hamilton tested for and confirmed the presence of

conditional heteroskedasticity. She then ran a regression similar to that run by Ender and

corrected for conditional heteroskedasticity using robust standard errors (i.e., Hansen’s

method). Hamilton’s regression model and relevant statistics are presented in Exhibit 1.

Exhibit 1

Hamilton’s Regression Model

Electric Utility Industry

Variable Coefficient t-statistic p-value

Constant 0.0069 0.013 0.99

S&P500 0.3625 6.190 <0.01

SPREAD 1.0264 4.280 <0.01

R2 = 0.40

Durbin-Watson Statistic = 0.84

Correlation between SPREAD and S&P500 = 0.30

Hamilton hypothesizes that the returns for the electric utility equity index have a

sensitivity coefficient to bond yields (i.e., SPREAD) equal to one. She is also interested

in the precision of the sensitivity of electric utility equity returns to S&P500. Hamilton

wants to use the regression results to address both of these issues. Selected values of the

t-distribution are shown in Exhibit 2.






Exhibit 2

Selected Values of the t-Distribution

(degrees of freedom = df, one-tailed probabilities = p)

Df p = 0.05 p = 0.025

100 1.660 1.984

110 1.659 1.982

120 1.658 1.980

200 1.653 1.972

1.645 1.960

37. Given Hamilton’s finding regarding heteroskedasticity, the most appropriate

conclusion is that the variance of the error term is correlated with:

A. the dependent variable only.

B. the independent variables only.

C. both the dependent and independent variables.

Answer: B

“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,

CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,

CFA


Study Session 3-12-g

Discuss the types of heteroskedasticity and the effects of heteroskedasticity and

serial correlation on statistical inference.

Hamilton’s test confirmed the presence of conditional heteroskedasticity, which

means that the variance of the error term is correlated with the values of the

independent variables.

38. If Hamilton assumes that the monthly values for both SPREAD and S&P500 are

1.0 percent, the predicted monthly return (%) for the electric utility equity index is

closest to:

A. 0.36.

B. 1.03.

C. 1.38.

Answer: C








CFA



Calculate and interpret 1) a confidence interval for the population value of a

regression coefficient and 2) a predicted value for the dependent variable, given

an estimated regression model and assumed values for the independent variables.

Substituting the assumed values into the estimated model results in the following:

Monthly return = –0.0069% + 1.0264(1.0%) + 0.3625(1.0%) = 1.38%.

39. The portion (%) of the variation in utility index returns explained by the

regression model is closest to:

A. 16.

B. 40.

C. 60.

Answer: B



CFA


Study Session 3-12-e

Calculate and interpret the F-statistic, and discuss how it is used in regression

analysis, define, distinguish between, and interpret the R2

and adjusted R2

in

multiple regression, and infer how well a regression model explains the dependent

variable by analyzing the output of the regression equation and an ANOVA table.

The explained variation is equal to the R2 = 40%.

40. Based on the results in Exhibit 1, the value of the test statistic relating to

Hamilton’s null hypothesis about the value of the sensitivity coefficient to

SPREAD is closest to:

A. 0.11.

B. 0.24.

C. 4.28.

Answer: A

“Correlation and Regression,” Richard A. DeFusco, CFA, Dennis W. McLeavey,

CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA









CFA


Study Session 3-11-g, 3-12-b

Formulate a null and alternative hypothesis about a population value of a

regression coefficient, select the appropriate test statistic, and determine whether

the null hypothesis is rejected at a given level of significance

Formulate a null and an alternative hypothesis about the population value of a

regression coefficient, calculate the value of the test statistic, determine whether

to reject the null hypothesis at a given level of significance, using a one-tailed or

two-tailed test, and interpret the result of the test.

The null hypothesis is H0: bspread = 1. The calculated value of the t-statistic is t =

(1.0264 – 1.0)/standard error. The standard error is 1.0264/4.28 = 0.24. The

calculated value for t = (1.0264 – 1.0)/0.24 = 0.11.

41. Based on the results in Exhibit 1, if degrees of freedom = 200, the 95 percent

confidence interval for the sensitivity of electric utility equity index returns to

S&P500 is closest to:

A. 0.22 to 0.50.

B. 0.25 to 0.48.

C. 0.27 to 0.46.

Answer: B

“Correlation and Regression,” Richard A. DeFusco, CFA, Dennis W. McLeavey,

CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA




CFA


Study Session 3-11-f, 3-12-c

Calculate and interpret the standard error of estimate, the coefficient of

determination, and a confidence interval for a regression coefficient.

Calculate and interpret 1) a confidence interval for the population value of a

regression coefficient and 2) a predicted value for the dependent variable, given

an estimated regression model and assumed values for the independent variables.

The standard error is found in Exhibit 1 as follows: t-statistic = 6.19 =

0.3625/standard error. The standard error = 0.0586. The two-tailed critical t-






value (1.972) is taken from the table with p = 0.025. The confidence interval is

0.3625 (1.972 0.0586), or 0.25 to 0.48.

42. Because there are only two independent variables in her regression, Hamilton’s

most appropriate conclusion is that multicollinearity is least likely a problem,

based on the observation that the:

A. model R2 is relatively low.

B. correlation between S&P500 and SPREAD is low.

C. model F-value is high and the p-values for S&P500 and SPREAD are low.

Answer: B



CFA



Describe multicollinearity and discuss its causes and effects in regression

analysis.

Multicollinearity arises from a high correlation among the independent variables.

In Hamilton’s regression model, the correlation between the SPREAD and the

S&P500 variables is only 0.30.






Katz Case Scenario

Oscar Katz is a representative with a German manufacturing firm, Stadt AG. Katz is

meeting with an investor, Jerry Stevens, to discuss projected financial information

through 2011. A portion of the projections are provided in Exhibit 1.

Exhibit 1:

Stadt AG

Forecasted Income Statements

(all monetary figures €1,000, except for price per unit)

2010 2011

Units sold 1,300 1,500

Price per unit 12.00 13.20

Sales 15,600 19,800

Variable costs 9,360 11,880

Fixed costs 4,000 4,400

Operating income 2,240 3,520

Interest 336 370

Pretax earnings 1,904 3,150

Tax 491 904

Net income 1,413 2,246

Dividends 645 326

Stevens asks why the tax is not a constant proportion of the pretax earnings. Katz

clarifies that his firm operates under a split rate system for taxation. Earnings to be

distributed as dividends are taxed at a 20% rate and earnings to be retained are taxed at a

30% rate.

Stevens’ next question is about the dividend policy. Katz states that equity financing is

determined in advance based on projected spending needs and a debt-to-equity ratio of

1.50. Consequently, earnings are retained to the level of the projected equity financing.

The remaining earnings are distributed as dividends.

Stevens asks Katz about the margin of error in the projection of sales price and the

number of units expected to be sold. Katz informs Stevens that the projected sales price

and expected units to be sold are based on historical trends from a stable industry making

the margin of error approximately 10% for both figures.






Stevens is also concerned about Stadt AG being able to maintain the debt-to-equity ratio

of 1.50. Stevens believes, assuming no change in the cost of debt or changes in other

parameters, that increasing debt will not affect the operating breakeven point, but will

lower net income which will increase the net income breakeven point. Katz assures

Stevens that Stadt AG is committed to maintaining and possibly even lowering the

current debt level.

43. If the personal tax rate is 42%, the effective tax rate (%) on the corporate earnings

distributed as dividends by Stadt AG is closest to:

A. 46.4.

B. 53.6.

C. 62.0.

Answer: A

“Dividends and Dividend Policy,” George H. Troughton, CFA and Catherine E.

Clark, CFA

2010 Modular Level II, Vol.3, p. 164


Calculate the effective tax rate on a dollar of corporate earnings distributed as a

dividend using the double-taxation, split rate, and tax imputation systems.

Effective Tax rate on dividends = 1 – (1– corporate rate on dividends) x (1 –

personal rate) = 53.6% = 1 – (1 – 0.20)*(1 – 0.42)

44. The dividend policy of Stadt AG is best described as a:

A. stable dividend policy.

B. residual dividend policy.

C. target payout ratio policy.

Answer: B

“Dividends and Dividend Policy,” George H. Troughton, CFA and Catherine E.

Clark, CFA

2010 Modular Level II, Vol.3, pp. 171-175

Study Session 8-29-j

Compare and contrast the following dividend policies: residual dividend, longer-

term residual dividend, dividend stability, and target payout ratio.

Because the firm pays out all of its earnings after considering its investment plans

and equity financing needs, the firm is following a residual dividend policy. See

example in Table 7 on page 172.






45. The degree of operating leverage for 2010 is closest to:

A. 1.56.

B. 2.79.

C. 3.90.

Answer: B

“Capital Structure and Leverage” Raj Aggarwal, CFA, Cynthia Harrington, CFA,

Adam Kobor, CFA, and Pamela Peterson, CFA



Calculate and interpret the degree of operating leverage, the degree of financial

leverage, and the degree of total leverage.

Degree of operating leverage = (Sales – Var Costs)/(Sales – Var Costs – Fixed

Costs)

=2.79 = (15,600 – 9,360) ÷ (15,600 – 9,360 – 4,000)

46. The degree of financial leverage for 2011 is closest to:

A. 1.12.

B. 1.50.

C. 1.57.

Answer: A





Calculate and interpret the degree of operating leverage, the degree of financial

leverage, and the degree of total leverage.

Degree of financial leverage = EBIT/(EBIT – INT)

DFL = 1.12 = (19,800 – 11,880 – 4,400) ÷ (19,800 – 11,880 – 4,400 –

369.60)

47. The risk associated with the discussion about the margin of error in projections is

best described as:

A. sales risk.

B. business risk.

C. operating risk.






Answer: A



2010 Modular Level II, Vol.3, pp. 103-104


Define and explain leverage, business risk, sales risk, operating risk, and financial

risk and classify a risk given a description.

Sales risk is the uncertainty with respect to the price and quantity of goods and

services.

48. Stevens’ discussion of the effects of increasing debt is most likely:

A. correct.

B. incorrect, because the operating breakeven point will change.

C. incorrect, because the net income breakeven point will not increase.

Answer: A




Study Session 8-28-a, 8-28-c, 8-28-d

Define and explain leverage, business risk, sales risk, operating risk, and financial

risk and classify a risk given a description.

Calculate the breakeven quantity of sales and determine the company’s net

income at various sales levels.

Describe the effect of financial leverage on a company’s net income and return on

equity.

The net income breakeven point (F + C) ÷ (P – V) will increase as the nominal

cost of debt, C in the formula, increases. The operating breakeven point is

unaffected F ÷ (P – V) and net income will decrease as debt increases.






Lisa McDonald Case Scenario

Lisa McDonald and Basil Moore, her research assistant, are valuing the common stock of Coppa

Enterprises using a residual income valuation approach. To support the valuation, Moore

assembles the basic information shown in Exhibit 1.

Exhibit 1

Basic Information for Valuation of Coppa Enterprises

• Current book value per share is $14.00.

• Required rate of return for common stock is 10%.

• Forecasted data for the next four years is: Yr 1 Yr 2 Yr3 Yr 4

Net income per share: $4.00 $4.00 $3.50 $3.60

Residual income per share: $2.60 $2.20 $1.50 $1.50

• Although the firm will be profitable after year 4, residual income is expected to be

zero.

After completing and discussing the valuation, McDonald decides to modify the approach. To

facilitate this second valuation, Moore provides the alternative information shown in Exhibit 2.

Exhibit 2

Alternative Information for Valuation of Coppa Enterprises

• Current book value per share is $14.00.

• Required rate of return for common stock is 10%.

• Forecasted return on equity (ROE) for the next four years is:

Yr 1 Yr 2 Yr3 Yr 4

Forecasted ROE: 40% 30% 25% 20%

• Annual dividends per share will be $1.00 each year for the next four years.

• Although the firm will be profitable after year 4, residual income is expected to be

zero.

After completing the second valuation, McDonald and Moore discuss other factors that

may affect the valuation of Coppa Enterprises. Moore expresses concern about valuing

the firm if residual income is positive beyond the four-year time horizon specified in

Exhibits 1 and 2.

Specifically, Moore makes the following two observations about residual income models:

1) One advantage to the single-stage residual income model is that it assumes the

excess ROE above the cost of equity will persist indefinitely.

2) In residual income models the terminal value may not be a large component of

total value because ROE may fade over time toward the cost of equity.






McDonald has other concerns as reflected in the following two statements.

1) The residual income approach can provide different valuations because of two

different methods for computing capital charge. Particularly, the equity charge

method gives a higher residual income than the total capital charge method,

thereby resulting in a higher firm valuation.

2) The economic value added (EVA) is a superior approach to equity valuation than

the residual income approach because it uses just one method for computing

capital charge as the cost of capital times the total capital.

Their discussion concludes with a statement by Moore:

“The residual income valuation approach requires adjustments for off-balance sheet items

and violations to the clean surplus relationship. Operating leases require adjustments to

both the amount of equity and the future earnings of Coppa Enterprises. Furthermore, the

company's "available for sale" investments call for making adjustments to the book value

of equity but not the income statement."

49. Using Exhibit 1 and the residual income valuation model, the value per share ($)

of Coppa Enterprises is closest to:

A. 20.33.

B. 21.59.

C. 26.03.

Answer: A

"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas

Robinson, CFA, and John Stowe, CFA


Study Session 12-43-c, f, j

Calculate future values of residual income given current book value, earnings

growth estimates, and an assumed dividend payout ratio.

Calculate and interpret the intrinsic value of a common stock using a single-stage

(constant growth) residual income model.

Calculate and interpret the intrinsic value of a common stock using a multistage

residual income model, given the required rate of return, forecasted earnings per

share over a finite horizon, and forecasted continuing residual earnings.

Because there is no residual income after year 4, the residual income valuation

model is: 4

1

00)1(t

t

t

r

RIBV






4320)10.1(

50.1

)10.1(

50.1

)10.1(

20.2

)10.1(

60.200.14V

0V = 14.00 + 2.3636 + 1.8182 + 1.1270 + 1.0245 = 14.00 + 6.333 = $20.33

50. Using Exhibit 2, the residual income ($) for Coppa Enterprises in year 1 is closest

to:

A. 4.20.

B. 4.60.

C. 5.20.

Answer: A



2010 Modular Level II, Vol. 4, pp. 580-583; 596




The formula for residual income is RIt = Et – rBt-1 = (ROEt – r) × Bt-1,

so RI1 = (0.40 – 0.10) × 14.00 = $4.20.

51. Using Exhibit 2 and the residual income valuation model, the value per share ($)

of Coppa Enterprises common stock is closest to:

A. 22.25.

B. 25.42.

C. 28.71.

Answer: B




Study Session 12-43-c, f, j




(constant growth) residual income model.

Calculate and interpret the intrinsic value of a common stock using a multistage

residual income model, given the required rate of return, forecasted earnings per

share over a finite horizon, and forecasted continuing residual earnings.






In general, RIt = Et – rBt-1 = (ROEt – r) × Bt-1. This calculation is shown in the

table below. Besides calculating the current rate of abnormal earnings, (ROEt –

r), one must calculate the beginning of year book values, Bt-1. As the table shows,

Bt = Bt-1 + Et – Dt

Year t 1 2 3 4

(See Exhibit 1, p. 581)

Bt-1 14.00 18.60 23.18 27.98

Et = ROEt × Bt-1 5.60 5.58 5.80 5.60

Dt 1.00 1.00 1.00 1.00

Bt = Bt-1 + Et – Dt 18.60 23.18 27.98 32.57

(See Exhibit 3, p. 585)

ROEt 40% 30% 25% 20%

r 10% 10% 10% 10%

(ROEt – r) 30% 20% 15% 10%

RIt = (ROEt – r) × Bt-1 4.200 3.720 3.477 2.798

4

1

00)1(t

t

t

r

RIBV

4320)10.1(

798.2

)10.1(

477.3

)10.1(

72.3

)10.1(

20.400.14V

0V = 14.00 + 3.818 + 3.074 + 2.612 + 1.911 = 14.00 + 11.416 = $25.416 = $25.42

52. In regard to Moore’s two observations about residual income models, it is most

accurate to state that he is:

A. correct with respect to both observations.

B. incorrect with respect to both observations.

C. correct with respect to observation (2) but incorrect with respect to

observation (1).

Answer: C




Study Session 12-43-c, f




(constant-growth) residual income model.






Moore is correct in stating that in residual income models the terminal value may

not be a large component of total value because ROE may fade over time toward

the cost of equity. In regard to his first observation, it is a drawback of residual

income models, not an advantage.

53. With respect to McDonald's two statements regarding residual income and

economic value added (EVA) approaches, she is most accurate with respect to:

A. statement 1 only.

B. statement 2 only.

C. neither statement.

Answer: C





Calculate and interpret residual income and related measures (e.g., economic

value added and market value added).

It is correct that the residual income approach provides for two methods for

computing capital charge – equity charge and total capital charge. However, as

demonstrated in Example 1 (pp. 575-576) and the related discussion, both

approaches give the same residual income. Therefore statement is not correct.

It is also correct that the economic value added uses only one method for capital

charge – cost of capital times total capital. But, it is incorrect to state that it is

superior to the residual income approach for equity valuation because EVA’s

focus is not equity valuation. It is one of a variety of commercial models which

are marketed primarily for measuring internal corporate performance and

determining executive compensation. Therefore, statement 2 is also incorrect.

54. With respect to Moore’s concluding statements, which of the following is most

accurate? Moore’s statement is:

A. correct with respect to operating leases but not clean surplus relationship.

B. correct with respect to the clean surplus relationship but not operating leases.

C. incorrect with respect to both operating leases and the clean surplus

relationship.

Answer: C









Study Session 12-43-d, o

Discuss the fundamental determinants of residual income.

Discuss accounting issues in applying residual income models (e.g., clean surplus

violations, variations from fair value, intangible asset effects on book value, and

nonrecurring items) and the appropriate analyst response to each issue.

Operating leases do not affect the amount of equity (because operating leases

involve off-balance sheet assets that offset the off-balance sheet liabilities) but

can affect an assessment of future earnings for the residual income component of

the value. Therefore, Moore's statement that both the amount of equity and the

future earnings of Coppa Enterprises need adjustments is incorrect. Changes in

market values of investments considered to be "available for sale" would be

reflected directly in stockholders' equity requiring no further adjustments. Those

changes are not reflected on the income statement and therefore require

adjustments. Thus, both the statements by Moore are incorrect.






Castle Enterprises Case Scenario

The Castle Enterprises is a U.S. based pension plan (fund) and Vinesh Koh is the

chairman of its board of trustees. The trustees are having a meeting with Ashar Gupta, the

plan's financial advisor.

Gupta begins with a discussion of the plan’s current and potential investments and he

states the following:

* The plan currently holds a number of foreign stocks denominated in euros. From

these investments, the projected dividend and capital gains income over the next

year is €1.2 million and €2 million, respectively. In addition, for these

investments, the foreign countries’ tax authorities apply a withholding tax of

15% and follow the standard approach with respect to withholdings.

* To achieve best execution in its international investing, the fund emphasizes two

aspects related to execution costs:

(i) maintaining anonymity and

(ii) minimizing commissions & fees.

* The plan may want to consider exchange traded funds (ETFs) as an investment

alternative. He lists the following three characteristics as advantages of ETFs:

Tax efficiency

Excellent liquidity at a low cost

Redemption in cash at a known Net Asset Value (NAV)

Koh intervenes and asks Gupta why an ETF based on the J100 Index, which includes the

100 largest Japanese stocks, is trading below its official Net Asset Value (NAV)?

Gupta states that the Japanese ETF's discount is caused by the following three factors:

The recent U.S. Dollar strengthening relative to the Japanese Yen

The underperformance of the stocks in the J100 index, relative to the broader

stock index of the largest 500 companies (J500 Index)

The non-overlapping market hours between New York and Tokyo

Finally, Gupta suggests two international stocks, Kong Holdings and Akunuri Enterprises

for direct investment. Gupta recommends investment in Akunuri Enterprises on the basis

of its ex-ante alpha computed from the data in Exhibit 1.






Exhibit 1

Estimated Information for Kong Holdings and Akunuri Enterprises

Kong Akunuri

Estimated rate of return 15.0% 12.0%

Beta 1.2 0.8

Total market return 13.0%

Risk free return 3.0%

Koh, however, argues that a portfolio approach should be taken in adding international

stocks to the fund instead of selecting individual stocks. He asks Gupta to use the

Treynor-Black (T-B) model and construct an optimal portfolio of international stocks.

Further, he makes the following two statements in support of the T-B model.

1) The model constructs the optimal risky portfolio as a combination of the passive

and active portfolios.

2) Each stock's weight in the active portfolio is determined on the basis of its alpha,

beta, and σ2 (e).

Gupta agrees to consider Koh's suggestion and the meeting ends.

55. Based on the projected income from its euro denominated investments, the total

amount of withholding taxes (€ millions) the fund will reclaim is closest to:

A. 0.18.

B. 0.30.

C. 0.48.

Answer: A

"Equity: Markets and Instruments," by Bruno Solnik and Dennis McLeavey, CFA



Calculate the impact of different national taxes on the return of an international

investment.

Withholding equals 0.15 x 1.2 million euros = 0.18 million euros; the standard

approach is that withholding is applied to the dividend income only.






56. Which of the following trading techniques is most consistent with Gupta’s claim

regarding best execution in the firm's international investing?

A. Agency trade

B. Principal trade

C. External crossing

Answer: C




Discuss the various components of execution costs (i.e., commissions and fees,

market impact, and opportunity cost) and approaches to reducing these costs.

External crossing keeps execution costs very low and anonymity is assured.

57. Gupta’s list of the advantages of ETFs is least accurate with respect to:

A. taxes.

B. liquidity.

C. redemption.

Answer: C




Discuss the advantages of exchange traded funds (ETFs) and explain the pricing of

international ETFs in relation to their net asset value (NAV).

An ETF is based on the NAV computed one or a couple of days after the shareholder

commits to redemption. So, the redemption value is unknown when the investor decides

to redeem. For this reason, as well as an assessment of a large cash redemption charge,

redemption by individual ETF holders is discouraged.

58. Which of Gupta’s proposed factors best explains the discount on the J100-based

ETF?

A. Exchange rate movements

B. Market hours in different regions

C. Performance of the stocks in J100 Index






Answer: B




Discuss the advantages of exchange traded funds (ETFs) and explain the pricing

of international ETFs in relation to their net asset value (NAV).

Non-overlapping market hours in different regions (here New York and Tokyo)

can lead to a timing difference between the pricing of the ETF and the pricing of

the underlying instruments. The ETF price in New York will indeed be affected

by expectations about future stock prices in Tokyo which could differ

significantly from the official NAV.

59. Is Gupta’s recommendation in favor of Akunuri stock most likely correct?

A. No, because Kong's ex-ante alpha > Akunuri's by 1%

B. No, because Kong's ex-ante alpha > Akunuri's by 3%

C. Yes, because Akunuri's ex-ante alpha > Kong's by 1%

Answer: C

"Return Concepts," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,

CFA, and John Stowe, CFA


"Portfolio Concepts," by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA,

Jerald E. Pinto, CFA, and David E. Runkle, CFA


Study Session 10-35-a; 18-64-e

Distinguish among the following return concepts: holding period return, realized return

and expected return, required return, discount rate, the return from convergence of price

to intrinsic value (given that price does not equal value), and internal rate of return.

Explain the capital asset pricing model (CAPM), including its underlying assumptions

and the resulting conclusions.

Using the data in Exhibit 1:

Kong Ex ante alpha: CAPM suggests E(Ri) = RF + β[E(RM) - RF] = 3+1.2(13-3) =

15,

thus ex-ante alpha i.e. the expected return minus the CAPM expected return is 15-

15 = 0%.

Akunuri Ex ante alpha: CAPM suggests = E(Ri) = RF + β[E(RM) - RF] = 3+0.8(13-

3) = 11,






thus ex-ante alpha i.e. the expected return minus the CAPM expected return is 12-

11 = 1%.

Therefore, Akunuri is preferred to Kong.

60. Which of the two statements by Koh in support of T-B is most accurate?

A. Statement 1 only

B. Statement 2 only

C. Both statements 1 and 2 are accurate.

Answer: C

"The Theory of Active Portfolio Management Investments," by Zvi Bodie, Alex

Kane, and Alan J. Marcus



Discuss the steps and the approach of the Treynor–Black model for security

selection.

The Treynor-Black (T-B) model uses two portfolios – the passive index portfolio

and the active portfolio to determine the optimal risky portfolio. Each stock's

weight in the active portfolio is determined on the basis of its alpha, beta, and σ2

(e). Thus, both statements by Koh are correct.

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