Cfa-l2-answers.pdf

Reading 1

Code of Ethics & Standards of Professional Conduct

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FinQuiz.com CFA Level II Item-set - Solution Study Session 1 June 2019

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Reading 1

Code of Ethics & Standards of Professional Conduct

FinQuiz Level II 2019 – Item-sets Solution Reading 1: Code of Ethics & Standard of Professional Conduct Please download item-sets file Reading 2.

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Reading 2

Guidance for Standard I-VII

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FinQuiz.com CFA Level II Item-set – Solution Study Session 1 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 2

Guidance for Standard I-VII

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FinQuiz Level II 2019 – Item-sets Solution Reading 2: Guidance for Standard I-VII 1. Question ID: 10536 Correct Answer: A Standard II (A) Material Nonpublic Information prohibits members/candidates who possess material nonpublic information, which could affect the value of the security, from act or causing others to act/trade on the information. Information is considered to be nonpublic until it has been publically made available in the marketplace. This standard does not prohibit members/candidates to use items of non-material or material and public information to form an opinion regarding a potential corporate action. This holds true even if the member/candidate’s analysis leads him/her to producing conclusions which comprise of material nonpublic information. This is termed as the mosaic theory. By using his observations of Y.T. Automobiles’ production site to produce his conclusion, Webber has not violated this standard (with the information obtained from the observations constituting items of material, public information as well as non-material non-public information). This holds true despite the fact that Webber used the information to conclude that the manufacturer could be at risk of being acquired in a takeover or could file for bankruptcy (which itself can be considered material nonpublic information that investors would like to know). Furthermore the discussions with industry experts and representatives from different manufactures as well as the industry information used as part of the analysis do not violate this standard. In short, Webber has used mosaic theory to arrive at his conclusion and has thus not violated this standard. Standard V (A) Diligence and Reasonable Basis requires members and candidates to exercise thoroughness, independence, and diligence when conducting investment analysis, making investment recommendations and taking investment action. Additionally the standards require members to have a reasonable and adequate basis supported by an appropriate level of research and thorough investigation. Webber’s conclusion is backed by thorough research and investigation and is thus in compliance with this standard. 2. Question ID: 10537 Correct Answer: C Standard II (B) Market Manipulation prohibits members and candidates from “engaging in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.” Transactions that artificially distort prices or volume to give the impression of activity or price movement in a financial instrument reflect violations. By transferring stocks, possessing a low level of liquidity, from the distressed fund to the developed equity fund, Bridges has violated this standard. This is because he has transferred stocks to the latter fund to artificially increase the demand for these stocks. Although this action has been done to improve the value of stocks which may benefit potential investors, such an activity deceives potential investors into believing the stocks they are buying are highly liquid and attractively priced.

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Reading 2

Guidance for Standard I-VII

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Standard III (C) Suitability requires members and candidates, in advisory roles, to make a reasonable inquiry into the client’s investment experience, risk and return objectives, and financial constraints and must reassess and update this information regularly. The standard also requires recommending investments and taking investment actions which are consistent with the client’s financial constraints, risk and return objectives, constraints, and written mandates. Additionally members/candidates must judge the suitability of the investment in the context of the client’s total portfolio. The process of transferring securities from the former to the latter fund does not violate this standard as these stocks are not owned by any clients nor recommended at the time of the transfer. 3. Question ID: 10538 Correct Answer: A Webber has described distressed securities as possessing a low level of liquidity. In addition such stocks of distressed companies are generally highly risky and require a long-term investment horizon. These securities are suitable for those investors with high risk tolerances; sufficient liquidity reserves/low liquidity requirements; and an intermediate to long-term investment horizon making them capable of tolerating the associated risks. Based on standard III (C) Suitability’s requirements, recommending these stocks to client categories A, B and E violate this standard. This is because: • • •

client category A has a short-term time horizon, significant liquidity requirements, and a low risk tolerance level; client category B has significant liquidity requirements; client category E has a below average risk tolerance; making such an investment highly unsuitable for all three categories.

Additionally by sending out the recommendation to existing clients only as opposed to suitable prospective clients and existing clients, standard III (B) Fair Dealing has been violated. This standard requires members and candidates to deal fairly with clients when disseminating investment recommendations and in their professional activities. 4. Question ID: 10539 Correct Answer: C All the three client categories to receive the recommendation should not have received such an investment recommendation (see the solution to Part 3). 5. Question ID: 10540 Correct Answer: B Standard III (D) Performance Presentation requires members and candidates to make every reasonable effort to ensure that the performance they present is fair, accurate, and complete. Members and candidates should not mislead clients by misrepresenting their past performance or reasonably expected future performance. By presenting the performance attained by Emerson at Denver Associates as being attained at Holler and Brookes Associates, the advertisement has violated this standard.

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Reading 2

Guidance for Standard I-VII

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Standard V (C) Record Retention requires members and candidate to “develop and maintain appropriate records to support their investment analysis, recommendations actions and other investment related communications with clients and prospects.” This standard is not relevant in the context of the advertisement. Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program requires members and candidates to avoid misrepresenting or exaggerating the “meaning or implications of membership in CFA institute, holding the CFA designation or candidacy in the CFA Program.” Additionally, there is no such thing as a partial designation. Forecasting that Emerson will successfully complete and pass the Level III examinations violates this standard. Additionally indicating that Emerson will achieve the completion status following the upcoming June examinations violates this standard as there is no such designation. 6. Question ID: 10541 Correct Answer: B The six components of codes of ethics that CFA institute’s members and candidates are required to follow are: • • • • • •

Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets. Place the integrity of the investment profession and the interests of clients above their own personal interests. Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession. Promote the integrity of and uphold the rules governing capital markets. Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

The requirement that members and candidates/investment professionals must exercise diligence, independence, thoroughness and independence when analyzing investments, making recommendations or taking investment actions is covered by the CFA Institute’s Standards of Professional Conduct [Standard V (A) Diligence and Reasonable Basis]. 7. Question ID: 10550 Correct Answer: B When managing accounts to a specific mandate, strategy or investment style, the CFA Institute Standards of Professional Conduct require members and candidates to, “make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of the portfolio.’ Based on the investment policy of Grace Incorporated’s pension plan, Peltier will need to assure he does not make allocations to growth stocks, and chooses securities which bring

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Reading 2

Guidance for Standard I-VII

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industry diversification (belongs to industries distinct from Grace Incorporated) and are securities of stable companies. Based on the data provided, Peltier should ignore stock B altogether as it belongs to the same industry as the surgical manufacturer. Peltier cannot choose stock A as its high P/E and P/B ratio (11.2 and 13.4, respectively) indicate it is a growth stock. Similarly the high projected EPS growth further confirm that it is a growth stock. Thus Peltier should not consider stock B for inclusion to the plan’s investment account. Peltier may select stock C for inclusion into the plan’s investment account. The low P/E ratio and high P/B ratios (3.8 and 13.6, respectively) indicate the stock is a balanced stock. Additionally, stock C belongs to the automobile manufacturing industry which indicates it will bring industry diversification to the plan’s account. By allocating stock C to the investment account, Peltier does not violate the standards. Thus by selecting stock B for the plan’s investment account, Peltier has violated standard III(C) Suitability as he has not followed the plan’s mandate pertaining to industry diversification. 8. Question ID: 10551 Correct Answer: A Standard III (B) Fair Dealing requires members and candidates “to deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.” By allocating 80% of the purchased shares to suitable client accounts, Lawson has not violated this standard. However by not allocating the 20% portion to interested clients and holding them back for an eight-month period, Lawson has violated this standard as she has denied the interest clients of these oversubscribed corporation shares. Standard III (C) Suitability requires members and candidates to make a reasonable inquiry into the client’s circumstances, risk and return objectives and financial constraints prior to making any investment recommendation or taking investment action, determining whether the investment is suitable to the client’s financial situation and consistent with the client’s written objectives, and judging the suitability of investments in the context of the client’s total portfolio. There is nothing in the case which indicates Lawson has violated the standard. There is nothing to indicate that standard III (A) Loyalty, Prudence and Care has been violated. Additionally standard VI (B) Priority of Transactions requires members and candidates to place investment transactions of clients and employers ahead of transactions in which a member and candidate is the beneficial owner. By depositing 20% of the oversubscribed corporation’s shares in her account for a period of eight months, instead of the investment accounts of interest clients, Lawson is benefitting from any potential increase in the stock’s value. 9. Question ID: 10552 Correct Answer: C

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Reading 2

Guidance for Standard I-VII

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Should Lawson accept the round trip cruise offer, Lawson will be violating standard I (B) Independence and Objectivity which requires members and candidates not to “accept any gift, benefit, compensation or consideration that reasonably could be expected to compromise their independence and objectivity.” The condition (to allocate 40% of the shares to Schmidt’s account in exchange for a reward) attached the cruise trip will itself impair Lawson’s independence and objectivity since, after accepting the offer, she will favor Schmidt and allocate a portion of the corporation’s shares to his account only rather to the accounts of other individuals who have expressed an interest in the shares. The allocation of the 40% shares solely to Schmidt’s account additionally suggests that Lawson has violated the standard, III (B) Fair Dealing. Schmidt should have allocated the shares proportionally to those accounts expressing an interest, for which the investment is suitable, as well as distribute amongst suitable accounts on a pro-rata basis. Standard IV (B) Additional Compensation Arrangements requires members and candidates not to accept any 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. Unless Lawson does not obtain consent for the trip, she will violate this standard. She has informed her employer, MIA, of the offer and thus does not violate this standard. 10. Question ID: 10553 Correct Answer: A Standard II (A) Material Nonpublic information prohibits members and candidates from trading on material non-public information or causing others to trade on such information. A problem with the source code of a software development corporation’s major product line is a piece of material information. However it is not necessary that the problem may lead to the discontinuation of the corporation’s major product line and result in a drop in forecasted product revenues. The two retirees are merely speculating and sharing this information with others (either with his friend or fellow portfolio manager) does not result in Brewer violating this standard. 11. Question ID: 10554 Correct Answer: C Standard III (C) Suitability requires members and candidates to make investment recommendations and take investment actions which are consistent with the client’s investment account and risk and return objectives as well as constraints. However members and candidates can only make suitable investment recommendations or take investment actions provided clients are forthcoming in providing the relevant information to their portfolio managers. The chief investment officer's claims are not valid. This is because the officer has not prohibited the portfolio manager from avoiding emerging market stocks. Additionally, the chosen stocks meet the socially responsible criteria. Thus by including such stocks, Brewer has not violated this standard. Additionally, Brewer has not violated III (B) Fair Dealing.

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Reading 2

Guidance for Standard I-VII

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12. Question ID: 10555 Correct Answer: C Standard IV (C) Responsibility of Supervisors requires members and candidates to prevent and detect any violations of the codes and standards, laws, rules and/or regulations by anyone subject to their supervision or authority. As the portfolio manager of The Senior Citizen Endowment’s portfolio, Brewer has not violated any standards (See the solution to Part 5). Thus there are no violations which Peltier need to prevent and/or detect. Thus as supervisor he has not violated this standard. Standard III (C) Suitability is not relevant in this context. 13. Question ID: 10564 Correct Answer: C Standard II (A) Material Nonpublic Information prohibits members and candidates, “who possess material nonpublic information that could affect the value of the security, from taking action on it or causing others to take action on the information.” Although the information on the G&J’s expansion plans may be material and nonpublic, the discussion between Sutton and Mullins does not violate this standard as no effort was made to act or cause someone to act on the information. Standard III (E) Preservation of Confidentiality requires members and candidates to keep information about current, former, and/or prospective clients confidential unless the client permits disclosure; disclosure is required by law; or the information concerns illegal activities on part of the client. As the investment banker of G&J, Sutton has the obligation to preserve the confidentiality of any information received on his client’s expansion plans, which he has exclusively received. Thus by sharing these plans with Mullins, he has violated this standard. Standard IV (C) Responsibility of Supervisors requires members and candidates to make reasonable efforts to prevent and detect any violations of any applicable laws, codes and standards, rules and regulations by anyone subject to their supervision or authority. This responsibility includes implementing adequate compliance procedures, making reasonable efforts to ensure these procedures are monitored and enforced. By implementing a structure to control the interaction between the two departments (investment banking and investment counseling/management departments) and not monitoring the effectiveness of the structure nor ensuring the flow of information between the departments is limited, Herrera as a senior compliance officer has violated this standard. 14. Question ID: 10565 Correct Answer: A Standard I (B) Independence and Objectivity requires members and candidates to use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Any recommendations should be independently arrived at. If investment recommendations are made following instructions, which conflict with the member/candidate’s recommendations, the member or candidate is in violation of this standard. The best action for Mullins to undertake would be to develop a research report and conclude it with a recommendation solely based on his analysis of G&J’s future prospects. Since

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Reading 2

Guidance for Standard I-VII

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Mullins believes G&J’s expansion plans may not succeed, he will probably produce a different recommendation to the buy recommendation instructed by Herrera. 15. Question ID: 10566 Correct Answer: B Standard III (A) Loyalty, Prudence and Care requires members and candidates to act for the benefit of their clients and place client interests first. The standard also requires members and candidates to maintain their duty of loyalty to their clients, act with reasonable care, and exercise prudent judgment. In the course of their duty to their clients members and candidates should seek best price and execution. Although Mace Brokerage charges fees higher than the existing broker, the access to global and local research as well as higher execution speed (relative to the current broker) justify the fees. Thus by appointing Mace Brokerage, Delgado will not be violating this standard but instead will be providing Mighty-You Inc. with greater benefits (i.e. execution). Although Harold and Haroon Associates charges fees lower than the existing broker the execution speeds are relatively slower. Additionally the firm provides access to local research only. Thus the relatively slow execution speed makes this broker unsuitable for Mighty-You Inc. Thus the appointment of this broker-candidate will violate the standard in question as Delgado will not be providing its client with best execution. 16. Question ID: 10567 Correct Answer: B Standard III (C) Suitability requires members and candidates, in an advisory relationship, to make investment recommendations which are suitable to the individual client’s financial situation, risk and return objectives, and written investment mandates. Additionally, members and candidates must judge the suitability of the investment in the context of the total client portfolio. There is a lack of sufficient evidence which may suggest that the firm may have conducted a suitability analysis prior to implementing the derivative strategy on a portion of the client portfolios. It is possible that such a strategy may not be suitable for or may be expressly prohibited by some clients. Thus by implementing a derivative strategy, the firm has violated this standard. Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation or action.” The volatility of the national market, which in turn has substantially increased the risk of several securities in client portfolios, justifies the use of derivative to offset these risks. Thus this standard has not been violated. Under Standard V (B) Communication with Clients and Prospective Clients, member and candidates must disclose to clients the basic format and general principles used to analyze investments, select securities and construct portfolios and promptly disclose any material changes to the processes. By delaying the notification to clients (regarding the inclusion of derivatives in their portfolios) for a period of one month, this standard has been violated.

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Reading 2

Guidance for Standard I-VII

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17. Question ID: 10568 Correct Answer: A Policy 1: Standard II (A) Material Nonpublic Information requires members and candidates to establish a firewall between the investment banking and investment research divisions to prevent the flow of material nonpublic information. Interdepartmental communication must preferably pass through a clearance area within the firm in either the compliance or legal department. Allowing unsupervised communication between the two departments (investment banking and counseling, in the firm’s case) makes Policy 1 inconsistent with this CFA Institute Standards of Professional Conduct standard. Policy 2: Standard III (A) Loyalty, Prudence and Care requires members and candidates to vote proxies in the best interests of clients and their ultimate beneficiaries as well as to vote proxies in an informed and responsible manner. A fiduciary who votes blindly with management on nonroutine governance issues violates this standard. Due to cost and benefits, it is not necessary to vote all proxies. Policy 2 is not consistent with this standard as it does not call for voting in the best interests of clients and ultimate beneficiaries. This is because the policy calls for taking into account any benefits to the firm, in addition to clients’ benefits, and ignores the benefits to beneficiaries (accruing to them as a result of the votes cast). In addition, the policy requires votes to be cast in line the firm’s management which hampers the member/candidate’s ability to cast his or her vote in the best interests of its clients and ultimate beneficiaries. Policy 3: Under Standard V (C) Record Retention members and candidates are required to develop and maintain appropriate records to support their investment analysis, recommendation, actions and other investment related communications with clients and prospective clients. In the absence of any regulatory requirements, the CFA Institute recommends a holding period of at least seven years. By complying with local record retention regulations, policy 3 is consistent with this standard. 18. Question ID: 10569 Correct Answer: A By allocating highly risky securities to the investment portfolios of his risk-averse clients (which require less risky securities), Strickland has clearly violated the standard, III (C) Suitability. Additionally, Strickland’s statement does not justify the addition of these securities to the portfolios. The expected decrease in market and securities’ volatility is merely a prediction which may not materialize after the quoted six-month period. Thus by basing the purchase decision on a mere prediction of a market factor, Strickland has violated the standard V (A) Diligence and Reasonable Basis. There is nothing which may suggest Strickland has been dishonest or engaged in fraudulent practices adversely affected his professional reputation, integrity or competence. Thus Strickland has not violated standard I (D) Misconduct. Strickland has not violated Standard I (C) Misrepresentation nor has he violated standard III (A) Loyalty, Prudence and Care. The justification statement does not guarantee the volatility

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Reading 2

Guidance for Standard I-VII

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will fall from its current levels, but instead uses the term ‘projected’ which implies Strickland has not guaranteed any expected performance and thus has not violated standard III (D) Performance Presentation. 19. Question ID: 10578 Correct Answer: A Standard VI (A) Disclosure of Conflicts requires members and candidates “to make full and fair disclosures of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their respective duties to their clients, prospective clients, and their employer.” The disclosures need to be prominent, delivered in plain language and communicated effectively. Ideally, to avoid the appearance of any conflicts, Howell should not be asked to cover a company with which he may be affiliated. Howell’s family relationship with H.O. Zone’s executive director must be disclosed in his research report as well as to his employer, Trinity Associates. Without taking any steps to minimize this potential conflict and failing to make the relevant disclosures to clients, prospective client and to his employer, Howell has violated this standard. Standard II (A) Material Nonpublic Information requires members and candidates who possess material nonpublic information, which has the potential to affect the value of a security, from acting or causing others to act on the information. There is lack of evidence to suggest that Howell may have not independently arrived at a buy recommendation or used insider information to arrive at the recommendation. A mere speculation by Thackeray does not necessarily mean Howell has used insider information. Additionally by using the recommendation, Thackeray has not violated this standard (due to the uncertainty of the information being acquired from insider resources or not). Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation or action.” Additionally when using secondary research it is necessary to make reasonable and diligent efforts in evaluating the objectivity and independence of the recommendations; reviewing the assumptions used, the rigor of analysis performed, and the date/timeliness of the research. The question of whether Howell may have arrived at his buy recommendation using insider sources remains. Without thoroughly evaluating the independence and/or objectivity of the recommendations and relying on the recommendation Thackeray has violated this standard. 20. Question ID: 10579 Correct Answer: A Standard I (C) Misrepresentation prohibits members and candidates from knowingly making any misrepresentations relating to investment analysis, recommendations, actions or other professional activities in oral or written communications. The standard requires members and candidates to identify or acknowledge the source of ideas or material that is not their own. Additionally it is necessary to cite all sources which are used to develop research reports and work products (other than those obtained from recognized statistical and financial reporting sources).

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Reading 2

Guidance for Standard I-VII

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Although Byrd’s model has been considerably modified from the model developed by the pharmaceutical chief industry executive, Byrd should acknowledge the fact that his model’s structure was inspired by the latter model and continues to use the same factors as those employed by the latter model. By not doing so and marketing the model as his own, he has violated the standard. According to this standard, Byrd must cite the annual industry forecasts obtained from discussions with industry experts but not the industry reports published by the local government agency in his research report. 21. Question ID: 10580 Correct Answer: B Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program requires members and candidates to avoid misrepresenting or exaggerating the “meaning or implications of membership in CFA institute, holding the CFA designation or candidacy in the CFA Program.” Additionally, there is no such thing as a partial designation. The newsletter has accurately referred to Terry and Sosa as CFA Level III candidates. However by stating that Terry will attain a ‘Passed Finalist’ status, the newsletter has incorrectly referenced Terry’s candidacy in the CFA Program and this reflects a violation of this standard. This is because there is no such status. 22. Question ID: 10581 Correct Answer: C Standard I (D) Misconduct prohibits members and candidates from engaging in any professional conduct involving fraud, deceit, dishonesty or committing any act that reflects adversely on their professional reputation, integrity or competence. By assuring McFadden that the financial consultancy department will provide the required tax consultancy services when the firm outsources such services, Terry has been dishonest with her client and has violated this standard. Standard II (B) Market Manipulation prohibits members and candidates from engaging in practices that distort the prices or artificially inflate trading volume with the intent to mislead market participants. However the standard does not prohibit transactions done for tax purposes. Thus the tax-loss harvesting strategy recommended by Terry (selling securities which have fallen in value to offset the gains on securities which have risen in value) does not violate this standard. Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in the best interests of clients, place client interest before their own, use reasonable care, and exercise prudent judgment when managing the accounts of their clients. As McFadden’s financial consultant, Terry has acted in his client’s best interests. Thus she has not violated this standard. Standard I (C) Misrepresentation requires members and candidates to have knowledge of all the services the firm provides and should recommend where a client can obtain the requisite service should the firm not be able to provide it. By assuring her client that the firm is able to address her taxation concerns and is able to provide the necessary consultancy services, Terry has violated his standard. This is because the firm outsources tax consultancy rather than providing it internally. Additionally, Terry has misrepresented the tax-loss harvesting strategy

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Reading 2

Guidance for Standard I-VII

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by incorrectly stating that it will help to reduce the portfolio’s taxable base in both the current and future years. In reality, tax-loss harvesting reduces the portfolio’s taxable basis in the current year to increase it in the future. 23. Question ID: 10582 Correct Answer: C Practice 1: Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to act in their employer’s best interest and not deprive them of the advantage of their skills and abilities or cause any harm to their employers. Members/candidates must continue to work in their employer’s best interest until resignation is effective. A buyout of the firm’s financial consultancy department by the firm managers does not constitute a violation of this standard. This is because the firm may choose how to respond to such an action. Thus practice 1 does not reflect a violation of this standard. Based on standard VI (A) Disclosure of Conflict’s requirements (see the solution to Part 1), a meeting between some of the firm’s managers after office hours does not constitute a violation of this standard. Thus practice 1 does not reflect any violations of the CFA Institute Standards of Professional Conduct. Practice 2: The portfolio managers have complied with standard III (A) Loyalty, Prudence and Care by using the brokerage arrangement to obtain high quality research to directly assist the managers in managing the client portfolio. Standard IV (B) Additional Compensation Arrangements prohibits member and candidates from accepting any gift, benefits, compensation or consideration “that competes with or might create a conflict of interest with their employer’s interest unless they obtain a written consent from all the parties involved.” The portfolio managers have not received any additional compensation which would require disclosure under this standard. Thus this standard has not been violated. Standard VI (C) Referral Fees requires members and candidates to disclose to their employers, current clients, and prospective clients “any compensation, consideration, or benefit received from, or paid to, others for the recommendation of products or services.” The firm’s portfolio managers have referred their clients to their respective broker and have received research in return. This arrangement must be disclosed to their existing clients and/or any prospects who wish to employ any of these portfolio managers to manage his/her investment portfolio. By not disclosing the arrangements to their clients, the portfolio managers have violated this standard. 24. Question ID: 10583 Correct Answer: A With respect to practice 3, Byrd has violated standard I (C) Misrepresentation. This is because Byrd should have known about the error in his resume as he has been quoting his experience for several years. By quoting his experience incorrectly, Byrd has misrepresented his experience with the two industries and has thus violated this standard.

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Reading 2

Guidance for Standard I-VII

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By incorrectly stated his years of experience, Byrd has not violated standard III (D) Performance Presentation, which requires members and candidates to make reasonable efforts to ensure that the performance they present is fair, complete, and accurate. Since the error pertains to his industry experience as opposed to performance information, Byrd has not violated this standard. Standard V (C) Record Retention is not relevant in this context and there is a lack of sufficient evidence to conclude that Byrd has not retained records used to develop research reports and make recommendations. 25. Question ID: 10592 Correct Answer: B Standard I (A) Knowledge of the Law requires members and candidates to understand and comply with all applicable laws, rules and regulations of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of any conflict, members and candidates must comply with the stricter of the two: applicable laws or code and standards. Standard I (D) Misconduct requires members and candidates to avoid any professional misconduct that may reflect adversely on their professional reputation, integrity, or competence and encourages employers to conduct reference checks on potential employees for any past infractions of laws. The law which is applicable to Riku Associates is the local Shimautanian law as opposed to the Japanese law applicable to its parent organization. Because employees with past infractions of securities and/or trading laws of two or more counts are likely to violate such laws again, it is advisable to avoid hiring such employees. Thus the requirements of the Institutes’ codes and standards govern [I (D) Misconduct]. Riku Associates must preferably hire employees with a clean past record. 26. Question ID: 10593 Correct Answer: A Standard IV (C) Responsibility of Supervisors requires members/candidates to make every reasonable effort to prevent and detect violations of the laws, rules, regulations, and/or codes and standards by anyone subject to their supervision or authority. It is permissible to delegate such responsibility but such delegation does not absolve the member/candidate of his/her responsibilities. By instructing Sayuki to review Smith’s portfolio after every 18 months, Sayuki has not complied with this standard as his instructions violate the requirements of III C Suitability (see below). This is because client portfolios need to be reviewed at least annually and whenever there is a change in client and/or market conditions. Any reason given to support this review schedule does not justify such a policy. Standard III (C) Suitability requires members and candidates, who are in an advisory role, to make a reasonable inquiry into the client’s investment experience, risk and return objectives, investment constraints and must reassess and update this information regularly. Client portfolios must be reviewed at least annually and whenever a change in client circumstances and/or market circumstances occurs. By instructing Lowery to conduct reviews for a period longer than the minimum 12-month required, for whatever reason, Sayuki has violated this standard. Additionally, Lowery has also violated this standard as he has conducted the reviews as instructed.

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Reading 2

Guidance for Standard I-VII

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Standard III (A) Loyalty, Prudence and Care does not address client portfolio reviews has not been violated. 27. Question ID: 10594 Correct Answer: C Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their client’s best interests, to exercise prudent judgment, and use reasonable care. The client’s interests should always have priority over the firm’s and portfolio manager’s interests. By recommending the sale of a stock which is harming the client’s portfolio, Lowery has complied with this standard. Standard III (E) Preservation of Confidentiality requires members and candidates to keep all information concerning former, current, and prospective clients confidential unless the client permits disclosure; the disclosure is required by law; or the information pertains to illegal activities on the part of clients. By sharing information regarding Smith’s portfolio holdings with his family friend, Lowery has violated this confidentiality standard. 28. Question ID: 10595 Correct Answer: A Standard II (A) Material Nonpublic Information prohibits members and candidates who possess material nonpublic information, that could affect they value of a security, from acting or causing other to take action on the information. The fact that such information has not yet been disclosed and pertains to the discontinuation of a product line provides sufficient evidence that this piece of information is material and nonpublic. Although Conway may discuss this piece of information with his supervisor, Sayuki, his first course of action should have been to make reasonable efforts to achieve public dissemination of the information by encouraging Furniture Ltd to make the information public. If Furniture Ltd had refused to release the information, his next course of action should have been to disclose the information to his supervisor or compliance department. However Conway has not made any such efforts and thus has violated this standard. Standard III (E) Preservation of Confidentiality is not relevant here as the standard covers confidential client information received by portfolio managers as opposed to the information received by research analysts on the companies they cover. 29. Question ID: 10596 Correct Answer: C Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to act for the benefit of their employer, and not deprive their employer of the advantage of their skills and abilities, or otherwise cause harm to their employer. Members and candidates must not take any actions such as appropriating property for themselves, client lists, or any information or material from their employer without their permission. Members/candidates must continue to act in their employer’s interest until resignation is effective.

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Reading 2

Guidance for Standard I-VII

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In Fukui’s case, participating in an online interview does not violate this standard as she is not disrupting her duties to the firm as an employee. Additionally, since Fukui has not undertaken the potential job opportunity at Howell S. Erwin Associates, there is no need to disclose the opportunity to her employer. Thus Fukui has not violated this standard. Although Gifu has complied with this standard by informing the employer of the job opportunity before resigning, he has violated this standard with respect to the backups of past firm information stored on his home computer. In order to avoid violating this standard, he should have removed the information from his computer before departing Riku Associates or should have received his employer’s consent to continue to store the information. Even if he believes the information to be obsolete, Gifu has violated this standard. 30. Question ID: 10597 Correct Answer: A Standard I (B) Independence and Objectivity requires members and candidates to strive to achieve and maintain independence and objectivity in all their professional activities. Members/candidates must not accept gifts, benefits, compensation or consideration which could reasonably comprise their independence or someone else’s independence and objectivity. Gifts must be disclosed to the member’s employer whatever the case. Fukui has informed her employer of the offer and has thus not violated this standard. Standard III (D) Performance Presentation requires members and candidates to make every reasonable effort that the performance they present is fair, accurate and complete. By intentionally increasing the portfolio return by 0.2% (10.0% – 9.8%) when the portfolio actually achieved a return of 9.8%, Fukui has clearly violated this standard. Standard IV (B) Additional Compensation Arrangements requires members and candidates not to accept any 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 the parties involved. Furthermore, the standard requires members/candidates to disclose the nature of the compensation, the approximate amount of compensation and the duration of the arrangement. A simple description of the location of the underwater farm is not a disclosure which meets the requirements of this standard. Thus by not disclosing the required details, Fukui has violated this standard. 31. Question ID: 10606 Correct Answer: C Standard I (C) Misrepresentation requires members and candidates to avoid knowingly making any misrepresentations when analyzing, making investment recommendations, and/or taking investment action. Among the standard’s requirements is the prohibition imposed on members and candidates from guaranteeing future investment results. Youssef has not guaranteed investment results nor has he made any misrepresentations. Thus he has not violated this standard. Standard V (B) Communication with Clients and Prospective Clients requires members and candidates, amongst other things, to separate opinion from fact in their research reports and recommendations. By using terms such as ‘will’, Youssef is implying that the political crisis in Kenya will definitely intensify as opposed to stating the probabilities of such an event happening. Thus he has violated this standard.

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Reading 2

Guidance for Standard I-VII

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32. Question ID: 10607 Correct Answer: A Standard V (C) Record Retention requires members and candidates to maintain records indicating the nature of their research recommendations, investment analysis, actions, and other investment related communications with clients and prospects. By maintaining a database which contains these records, Youssef has complied with this standard. In addition to requirements presented in the solution to Part 1 standard I (C) Misrepresentation requires members and candidates to cite all the sources used to generate work products and research reports (recognized governmental and statistical sources need not be cited). By not specifically citing the analysts’ reports, surveys, and quotations used and, instead, making a general statement, Youssef’s statement (included as part of his database) violates this standard. Standard III (B) Fair Dealing requires members and candidates to deal fairly with clients when disseminating investment recommendations, taking investment actions or analyzing investments. Youssef has discriminated between investors by providing free access to the database to particular investor categories while charging other investors a nominal fee. 33. Question ID: 10608 Correct Answer: C Standard V (B) Communication with Clients and Prospective Clients defines communication in the form of a recommendation pertaining to an asset allocation, the market, or classes of investments. However any brief communications must be supported by background reports or data that can be made available to interested parties on request. By issuing the recommendation two days prior to the full-length research report, Youssef has not violated this standard. This is because he intends to make the full-length report available as soon as the communication problem abates. 34. Question ID: 10609 Correct Answer: C Under Standard VII (A) Conduct as Members and Candidates in the CFA Program, members and candidates must not engage in any conduct that compromises the integrity or reputation of the CFA Institute, the CFA designation or the integrity, validity or the security of the CFA examination. Members and candidates are not prohibited from expressing their opinions concerning the CFA Institute or CFA Program. Hanson’s statement regarding the CFA Program does not violate this standard. However, standard VII (B) Reference to the CFA Institute, the CFA designation, and the CFA Program, requires members and candidates not to exaggerate or misrepresent the meaning or implication of candidacy in the CFA Program, amongst other requirements. By implying that individuals with a certain level of intellect (who are ‘apt’ enough) are likely to succeed in the program, Hanson has violated this standard. 35. Question ID: 10610 Correct Answer: A Standard I (B) Independence and Objectivity requires members and candidates to achieve and maintain independence and objectivity and not to accept gifts, benefits, compensation, or consideration which could compromise their own or someone else’s independence and

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Reading 2

Guidance for Standard I-VII

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objectivity. Members and candidates should pay for their own commercial transportation and residence and only use the corporate aircraft offered by a client when commercial transportation is not available. By accepting the residential and transportation arrangements offered by the client and not disclosing these arrangements to his employer, Hanson is in violation of this standard. In the course of allowing JTL to make these arrangements, Hanson may have compromised his independence and objectivity. Despite his client’s headquarters being half an hour away, Hanson did not make any attempts to explore the transportation alternatives available. Additionally despite the residential accommodation being modest, Hanson should have used the residential allowances provided by his employer to seek and pay for his own residence and transportation. Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information or otherwise harm the employer. During his stay in Malaysia, Hanson has not violated this standard. 36. Question ID: 10611 Correct Answer: A Hanson has not violated Standard I (B) Independence and Objectivity as he will be receiving a flat fee for preparing the research report. This makes the research report independent of Hanson’s potential recommendation on the steel manufacturer. By not disclosing the research opportunity offered by the steel manufacturer to Greenwich Limited and seeking permission prior to beginning the assignment, Hanson has violated the standard IV (A) Loyalty which requires members and candidates to disclose all aspects of independent practice and receive employer permission prior to the start of the proposed independence practice. Standard VI (A) Disclosure of Conflicts requires members and candidates to make “full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their respective duties to their clients, prospective clients, and their employer.” By not disclosing the fact that he is an employed research analyst serving Greenwich Limited and misleading the steel manufacturer’s executive to believe that he is an independent research analyst, Hanson has violated this standard. 37. Question ID: 10620 Correct Answer: C Standard III (C) Suitability requires members and candidates, in advisory roles, to make a reasonable inquiry into the client’s investment experience, risk and return objectives, financial constraints and reassess and update this information regularly. Additionally members and candidates are required to judge the suitability of the investment in context of the client’s total portfolio. By instructing portfolio managers to conduct a suitability analysis prior to allocating the emerging market stocks, Russet has complied with this standard. Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their client’s best interest and exercise prudent judgment and use reasonable care. There is no evidence that Russet has violated this standard.

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Reading 2

Guidance for Standard I-VII

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Standard IV (C) Responsibility of Supervisors requires members and candidates to make reasonable efforts to prevent and detect any violations of the laws, rules, codes and standards by anyone subject to their supervision or authority. There is no information in the case which may provide evidence that Russet has violated this standard. 38. Question ID: 10621 Correct Answer: C Standard III (C) Suitability requires members and candidates to undertake a client portfolio review on an annual basis (minimal) and whenever client circumstances and/or economic circumstances change. Rapidly changing economies will require more frequent portfolio reviews as opposed to stable economies. Thus the portfolio review frequency is in compliance with this standard’s guidelines. The factors which Russet instructs her portfolio managers to analyze all are factors which have been prescribed by the suitability standard. Thus her instructions are in compliance with the standards. 39. Question ID: 10622 Correct Answer: A Standard II (B) Market Manipulations prohibits members and candidates from engaging in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants. However, this standard does not prohibit legitimate trading that exploits a difference in market power, information, or other market inefficiencies. Green did not intentionally manipulate the prices of the crude oil commodity futures traded. The heavy futures volume being traded has forced the futures contract prices downward resulting in a (larger than expected) positive roll return when rolling into new futures contracts. Thus Green has not violated this standard. Standard V (B) Communication with Clients and Prospective Clients requires members and candidates to use reasonable judgment in identifying the factors important to investment analysis, recommendations, or actions and include those factors in communications with clients and prospects. Additionally members and candidates must disclose the basic principles and general format of the investment process used to analyze investments, select securities, and construct portfolios and disclose any changes materially affecting this process. There are no changes to the investment process which require communication with clients and/or prospects. Thus Green has not violated this standard. 40. Question ID: 10623 Correct Answer: B Standard III (E) Preservation of Confidentiality requires members and candidates to keep information concerning present, former and prospective clients confidential unless the client permits disclosure; information concerns illegal activities on part of the client; or disclosure is required by law. By sharing information on Sanchez’s current financial circumstances with the banking consultant, Russet has not respected the confidentiality of her client’s information and has thus violated this standard.

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Reading 2

Guidance for Standard I-VII

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Additionally, by not revising Sanchez’s IPS to reflect her changed risk tolerance and liquidity requirements (which has decreased and increased, respectively following her bankruptcy), Russet has violated the standard, III (C) Suitability, which calls for revising client information whenever client circumstances change. Speculative investments in commodity futures are no longer suitable for Sanchez and thus by not liquidating the holdings Russet has violated the suitability standard. 41. Question ID: 10624 Correct Answer: B Standard III (B) Fair Dealing requires members and candidates to deal fairly with clients and prospects when disseminating investment recommendations, taking investment actions, and in their general professional activities. In case of oversubscribed issues, members and candidates must allocate them to suitable and interested client accounts on a pro-rata basis. Cooper is in violation of the fair dealing standard on two counts. Firstly, relative to other accounts, he has allocated a larger proportion of the trade to his aunt's account. Secondly, by delaying the allocation of the trade to a regular-fee paying client, he has treated his aunt's account unfairly. Standard VI (B) Priority of Transactions requires members and candidates to undertake personal transactions after clients and employers have had a reasonable opportunity to act upon the recommendation. Family accounts which are client accounts should not be disadvantaged and must be treated like any other client account. By allocating the pharmaceutical manufacturer’s stocks to his aunt’s account a day later following the allocation of the issue to his clients’ accounts, Cooper has unfairly treated his aunt’s account and has violated this standard. 42. Question ID: 10625 Correct Answer: C The portfolio manager has not made any misrepresentations and has not violated the standard, I (C) Misrepresentation. Standard VI (B) Priority of Transactions additionally requires members and candidates to disclose the firm’s personal holding policies upon request. By not fulfilling the client’s inquiry concerning the firm’s personal trading policies and blackout period established, the portfolio manager has violated this standard. 43. Question ID: 15538 Correct Answer: A Armstrong has violated best practice. Best practice is for analysts to accept only a flat fee for their work prior to writing the report, without regard to their conclusions or the report’s recommendations. Direct compensation; payment based on the conclusions of the report, or indirect compensation, such as warrants that could increase in value based on positive coverage in the report are fraught with potential conflicts. Since Armstrong will receive the warrants after the report is completed, it most likely will depend on the conclusions of the report. In addition, Armstrong needs to fully disclose potential conflicts, including the nature of the compensation (although here disclosing the nature of the compensation is not sufficient to meet the Code and Standards).

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Reading 2

Guidance for Standard I-VII

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44. Question ID: 15539 Correct Answer: C Keeling is not in violation of the Standard. In this case, the trip is strictly for business and Keeling is not accepting irrelevant or lavish hospitality. The itinerary required chartered flights, for which analysts are not expected to pay, and Green Motels is the only accommodation in the area. These arrangements, hence, did not violate the standard, since they most likely do not impinge on Keeling’s independence and objectivity. The policy of Salkey’s firm complies closely with Standard 1(B) by avoiding the appearance of a conflict of interest, but Keeling and other analysts do not necessarily violate the Standard. 45. Question ID: 15540 Correct Answer: B RIM is in accordance with the CFA Institute Standards of Professional Conduct with regards to the guarantee. Standard 1(C), misrepresentation, does not prohibit members and candidates from providing clients with information on investment products that have guarantees built into the structure of the product itself or for which an institution has agreed to cover any losses. In this case, the securities are backed by the U.S. government and in case of any losses, RIM has agreed to cover them. As long as RIM describes the concepts in its own words, it does not need to cite the source. However, for the concepts of price multiples, RIM quotes the words of another author, so it needs to cite the source from which the descriptions are quoted (even though these are general concepts). 46. Question ID: 15541 Correct Answer: A Armstrong is not in violation of the Standard. Since Armstrong has obtained the information directly from the original source, he does not need to report how she found out about the information. In fact, best practice is to obtain the study from the original author (CFA Institute in this case), and cite only that author (this will eliminate the risk of relying on second hand information that may misstate the source). If Armstrong used the study provided by Charles in his report, he would need to cite both sources. 47. Question ID: 15542 Correct Answer: C The information about the sale is both material and non-public. Craven has violated the Standard by communicating the inside information to her broker. Roy has violated the standard by initiating a transaction to buy the shares based on material nonpublic information. Pettit is in violation of the standard relating to material nonpublic information because as the firm's CEO she knew the information was both material and nonpublic and by disclosing the information to her daughter, she is in violation. 48. Question ID: 15543 Correct Answer: A Drewry did not violate any Standards. He used information available to the public, and used his own expertise to interpret the information. Simply because the public in general finds the conclusions material does not require that Drewry make his or her work public. Investors who

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Reading 2

Guidance for Standard I-VII

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are not his clients can either do the work themselves or become his client if they want access to his expertise. 49. Question ID: 15559 Correct Answer: B Mayer has violated Standard 3(A), Loyalty, Prudence and Care, because he is using the assets of his clients to benefit his firm and himself. The trading was carried out solely to reach the minimum commission level and not to benefit the clients. Kew has violated Standard 3(A), Loyalty, Prudence and Care, and 3(C), Suitability. The private equity fund is an illiquid investment since it locks up the fund’s asset for three years. The IPS clearly states investment in liquid assets. Therefore, private equity is not suitable for the pension fund. 50. Question ID: 15560 Correct Answer: A Kew has violated his duty to his clients by giving priority to the Growth Fund over the Equity Fund, even though both the funds have the same investment objectives and have similar portfolios. Also, Kew has violated Standard 3(B) Fair Dealing, by giving priority to the discretionary accounts over nondiscretionary accounts. In this case, even though disclosure is made, this would not change the fact that the policy is unfair. 51. Question ID: 15561 Correct Answer: C If MMI fully discloses its agreement with members to boost liquidity over the initial eight months, it does not violate the Standard. MMI may engage in a liquidity-pumping strategy to give its clients a better service, but it must be disclosed. 52. Question ID: 15562 Correct Answer: C Dawe does not violate any of the Standards. He widely disseminated the recommendation and provided the information to all his clients prior to discussing it with the firm’s largest clients. Dawe can provide premium service to some clients provided that he properly distributes the recommendation to all his clients before discussing it with the select few. Also, annual review of the IPS is reasonable, however, in the case of Morrison, there was a major change in income that warrants a more frequent review. Hence, Dawe does not violate any Standard. 53. Question ID: 15563 Correct Answer: A James has violated the Standard. This is because James must obtain the consent of her employer before she accepts such a supplemental benefit. Members and candidates must obtain permission from their employer before accepting additional compensation or other benefits. James accepted the benefit, and then informed her employer. 54. Question ID: 15564 Correct Answer: C Statement 1 is correct. Although a prohibition on all types of proprietary trading when a firm comes into possession of material nonpublic information is not appropriate, in risk-arbitrage

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Reading 2

Guidance for Standard I-VII

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trading, the case for a trading prohibition is compelling. In such a case, the potential for illegal profits is great so the most prudent course for firms is to suspend arbitrage activity when a security is placed on the watch list. Statement 2 is correct. Adequate compliance procedures are those designed to meet industry standards, regulatory requirements, the requirements of the Code and Standards, and the circumstances of the firm. 55. Question ID: 15573 Correct Answer: A Orswitz is required to undertake local trading exams in Trotia and Horsha in order to better comply with the CFA Institute Standards of Professional Conduct. Standard I (A) Knowledge of the Law requires members and candidates to “understand and comply with all the applicable laws, rules, and regulations of any government”, amongst other institutions, “governing their professional activities”. In the event of a conflict, the most strict law, rule, or regulation applies. Based on this standard, the strictest law, amongst U.S., Trotia, and Horsha, is the Trotian law, which requires undertaking local examinations to trade in local and international markets. However, at the same time, Orswitz can not violate the trading laws of Horsha, which also requires traders to undertake the local trading exam. Since Orswitz will be trading solely in Horsha, he will be need to clear Horsha’s trading exam to be granted the country’s trading license, in addition to Trotia’s, in order to avoid violating the professional conduct standards. 56. Question ID: 15574 Correct Answer: B Holly has not violated any standards of professional conduct whereas Earl has violated the standard, independence and objectivity. Standard I (B) Independence and Objectivity requires members and candidates to “use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities”. Research analysts frequently work closely with investment-banking colleagues to help evaluate prospective investment-banking clients. This is appropriate provided conflicts are adequately and effectively managed and disclosed. Given the close relationship between Earl and Holly, which enables them to discuss shared clients, the independence and/or objectivity of the two employees may have been compromised. Additionally, by discussing his research with Holly, Earl may have compromised his own and his sister’s independence and objectivity with respect to dealing with Woodline Inc. However, Holly has not violated this standard. Standard II (A) Material Nonpublic Information requires that members and candidates who “possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information”. Speculating on a potential takeover offer involving Woodline Inc. by a larger floorboards manufacturer does not amount to material nonpublic information. Thus this standard has not been violated. Standard III (E) Preservation of Confidentiality requires members and candidates to keep all information acquired on current, potential, or former clients confidential unless the client permits disclosure; the information concerns illegal activity on the part of the client; or

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Reading 2

Guidance for Standard I-VII

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disclosure is required by the law. Speculations on a potential takeover offer do not amount to confidential information. Thus this standard has not been violated. 57. Question ID: 15575 Correct Answer: B Holly’s best course of immediate action would be to disclose her relationship with Earl to OA’s senior compliance officer. Standard VI (A) Disclosure of conflicts requires members and candidates to disclose any actual and/or potential conflicts of interest which may hinder their duties to their clients and their employer and impair their independence and objectivity. Her relationship with Earl may impair her impartiality when serving clients and thus disclosure to a senior compliance officer may be the optimal solution. Although asking for a change in assignment is a potential solution, it may not help resolve the problem in the event the new assignment pertains to a client which is also covered by Earl. 58. Question ID: 15576 Correct Answer: A The trading department’s trading practices are in compliance with the CFA Institute’s Standards. Standard II (B) Market Manipulation prohibits members and candidates from ‘engaging in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants’. The standard, however, does not prohibit transactions that exploit a difference in market power, information, or other market inefficiencies. Since OA’s trading division has a significant presence in Horsha’s derivatives markets, any derivative contracts entered into on behalf of clients may significantly influence contract prices and allow them to move to the benefit of the firm. Thus this standard has not been violated. Given the lack of information on clients’ requirements and/or circumstances, the suitability of derivatives trades to client portfolios is not relevant in this context. 59. Question ID: 15577 Correct Answer: C Red’s first statement, included within his CV, complies with the standards. His second statement does not comply with the standards. By referring to himself as an employee of R. Owens, he does not violate any standards. Serving as a full-time paid trainee gives him an employee status at the brokerage house. Red’s second statement fails to comply with the standard, VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program. The standard requires members and candidates, amongst other requirements, not to misrepresent the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy of the CFA Program. There is no violation in stating that he has passed the two levels of the CFA exam program in consecutive attempts as he has done so. Additionally, there is no violation in stating his intention to appear for the upcoming Level III examination as he has not cited an expected completion date and is currently registered for the Level III exam. However by including a statement pertaining to his educational achievements in the experience section of his CV, Red

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Reading 2

Guidance for Standard I-VII

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has violated this standard. Red should have included this statement in the educational section of his CV. 60. Question ID: 15578 Correct Answer: B Earl has not violated any standard with respect to disclosing the call options purchased to OA. The independence and objectivity standard has not been violated as the options have not been granted by Lazline. The disclosure of conflicts standard requires members and candidates to disclose any actual and/or potential conflicts of interest which may hinder their duties to their clients and their employer and impair their independence and objectivity. Earl ought to have disclosed the call options purchased on Lazline’s stock to his clients. This is because he covers the pharmaceutical manufacturer and purchasing call options on the manufacturer may impair his independence and objectivity when preparing a research report. This is a matter which requires disclosure to clients as well as the employer. Since he has disclosed the purchase to OA, he has not violated this standard with respect to his employer only. However, by failing to make appropriate disclosure to clients Earl has violated this standard as opposed to the communications with clients and prospects standards. By not sharing the results of his analysis with his employer, Earl has violated the Loyalty standard. His employer has full rights over the research prepared by any employee and by denying his employer these rights, he has violated this standard. 61. Question ID: 15824 Correct Answer: C Standard IV (B) Additional Compensation Arrangements requires members and candidates not to ‘accept any gifts, benefits, compensation, or consideration that competes with, or might reasonably, be expected to create a conflict with, their employer’s interest unless they obtain written consent from all parties involved’. Ramirez may accept the opera tickets and cash bonus as long as he obtains written consent from DHFM. 62. Question ID: 15825 Correct Answer: C DHFM’s client communications policy is inconsistent with the standards. Standard V (B) Communications with Clients and Prospects requires members and candidates to use reasonable judgment to assess what factors are important to their investment analyses, recommendations or actions and include such factors in their communication with clients and prospective clients. Additionally, members and candidates should outline the limitations of their analyses and conclusions contained in their investment analysis. The assumptions underlying linear and multiple regression models as well as any regression variables used are important and thus should be disclosed. 63. Question ID: 15826 Correct Answer: A

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Reading 2

Guidance for Standard I-VII

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Ramirez has violated standard II (A) Material Nonpublic Information. This standard prohibits members and candidates possessing material nonpublic from acting on the information. Based on his special relation with the two corn producers, access to information on a potential unannounced merger between Milanto and Sprout constitutes material nonpublic information. In the case of risk-arbitrage propriety activity, the most prudent course of action would be to suspend such activity while a firm possesses material nonpublic information. By engaging in risk-arbitrage propriety trading based on his access to material nonpublic information Ramirez has violated this standard. Standard III (B) Fair Dealing requires members and candidates to deal fairly and objectively with all their clients when providing investment analysis, making investment recommendations and taking investment action. Since Ramirez has not taken action on any client accounts, he has not violated this standard. Standard VI (B) Priority of Transactions requires members and candidates to place investment transactions undertaken for clients and their employers ahead of their own investment transactions. There is no evidence which may indicate that this standard has been violated. 64. Question ID: 15827 Correct Answer: A Cowbell has violated standard I (C) Misrepresentation which prohibits members and candidates from guaranteeing clients a specific return on an investment. Given that profits generated on a reverse cash-and-carry arbitrage strategy may contain counterparty risks, Cowbell has most likely violated this standard. Standard III (D) Performance Presentation prohibits members and candidates from misrepresenting past or reasonably expected future performance. This standard has not been violated. 65. Question ID: 15828 Correct Answer: A Standard IV (A) Loyalty requires members and candidates to act for the benefit of their firm and not deprive the employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer. Cowbell will not violate the loyalty standard if she and the other hedge fund manager form their hedge fund management firm as they plan to open the firm after leaving their present employment. However, contacting clients using client records stored on the employer’s system, without the employer’s permission, is a violation of the standard. Even though the clients are former, contacting them using DHFM’s database will constitute a violation of the loyalty standard. This will hold true even if the managers contact former clients after resigning from their current positions. 66. Question ID: 15829 Correct Answer: B

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Reading 2

Guidance for Standard I-VII

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The standards recommend members and candidates consider the following procedures, amongst others, when devising a written trade allocation policy: • • •

requiring orders and modifications or cancellations of orders to be in writing and timestamped; processing and executing orders on a first-in, first-out basis; when allocating trades for new issues, obtaining advance indications of interest, allocating securities by client (rather than portfolio manager) and provide a method for calculating allocations.

67. Question ID: 18637 Correct Answer: A By cheating during his CAIA exam, Watts was in violation of the standard relating to conduct as members and candidates in the CFA Program. The standard’s function is to hold members and candidates on a high ethical standard while they are participating in, or involved with, the CFA Program. The conduct covered includes cheating on the CFA examination or any other examination. 68. Question ID: 18638 Correct Answer: B Watts’ first statement is in compliance with the Code and Standards as he accurately describes his current candidacy in the Level III examination in an appropriate way. The second statement is incorrect as Watts has relayed that he is professionally superior to other candidates due to his current CFA Candidacy status. 69. Question ID: 18639 Correct Answer: C Watts and N.M.N Securities did not violate standards relating to fair dealing and suitability as they communicated the information of a new recommendation to all the relevant clients. They are allowed to follow up separately with individual clients as long as they do not give favored clients advanced information when such pre-notification may disadvantage other clients. 70. Question ID: 18640 Correct Answer: A The CFA designation should not be given more prominence than the charter holder’s name. When using the CFA designation, there should be no use of periods. 71. Question ID: 18641 Correct Answer: A If an individual is registered for the CFA exam but declines to sit for an exam or otherwise does not meet the definition of a candidate as described in the CFA Institute bylaws, then that individual is no longer considered an active candidate. Once that person is enrolled to sit for a future examination, his or her candidacy resumes. Addison is no longer an active candidate because she did not appear for the Level I exam. Therefore, she is correct in stating that she is not a Level I candidate. She may refer to herself as a Level I candidate when she next enrolls for the Level I exam.

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Reading 2

Guidance for Standard I-VII

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Reading 2

Guidance for Standard I-VII

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72. Question ID: 18642 Correct Answer: B The following procedure will help in the compliance of Standard VI B- Priority of Transactions: •

Investment personnel involved in investment decision making process should establish blackout procedures prior to trades with clients so that managers cannot take advantage of their knowledge of the client activity by ‘front-running’ client trades.

73. Question ID: 18644 Correct Answer: C According to the standard relating to Knowledge of Law, if a member has reasonable grounds to believe that imminent or ongoing client or employee activities are illegal or unethical, the member or candidate should take appropriate steps which include attempting to stop behavior by bringing it to the attention of the employer through a supervisor or the compliance department. The member should also seek legal advice. However, the standard does not require members and candidates to report violations to the appropriate governmental or regulatory organizations. 74. Question ID: 18645 Correct Answer: B The revised compensation plan is acceptable under the standard related to Conflicts of Interest, but the company must disclose the plan to its clients. 75. Question ID: 18646 Correct Answer: A The CFA Institute standard relating to fair dealing requires that members should not use their position to disadvantage clients, specifically in the case of IPOs. Since this is a stated policy of the firm, there is no violation of standard relating to disclosure of conflict of interest. 76. Question ID: 18647 Correct Answer: A The following policies improve compliance with the Standards and Codes: • •

Members and candidates should maintain a list of all clients and the securities of other investments each client holds to facilitate notification of clients of a change in investment recommendation. When the full amount of the block order is not executed, partially executed orders will be allocated amongst the participating client accounts pro rate on the basis of order size.

77. Question ID: 18648 Correct Answer: A Members who are involved in personal bankruptcy filing are not automatically assumed to be in violation of the standards because personal bankruptcy may not reflect on the integrity or trustworthiness of the person declaring bankruptcy. However, if the bankruptcy involved fraudulent or deceitful business conduct, it may be a violation of this standard.

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Reading 2

Guidance for Standard I-VII

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78. Question ID: 18649 Correct Answer: C Members and candidates should document any violations when disassociating from an activity that violates the Code and Standards. When attending meetings at client’s headquarters, members and candidates should pay for commercial transportation and hotel charges. Standard I does not cover legal transgressions resulting from acts of civil disobedience in support of personal beliefs because such conduct does not reflect poorly on the member’s or candidate’s professional reputation, integrity or competence. 79. Question ID: 18651 Correct Answer: A The Standard related to fair dealing states that all clients cannot be treated equally because it is impossible to reach everyone simultaneously and each client has unique needs and objectives. 80. Question ID: 18652 Correct Answer: A The following reporting requirements are recommended for monitoring and enforcing procedures established to eliminate conflicts of interest related to personal trading: • • • •

Disclosure of personal holdings. Disclosure of beneficial ownerships. Preclearance procedures. Duplicate confirmation of employee transactions.

81. Question ID: 18653 Correct Answer: A Chang’s decision to invest is directly correlated with Park’s statement about the successful quarter at Jeutte and thus violates Standard II. Park’s information would be considered material as it would influence the share price of Jeutte Tech and probably influence the price of the entire exchange-traded fund. Park shared information that was both material and non-public. Company employees regularly have such information about their firms, which is not a violation. However, sharing this information, even in a conversation with friends, constitutes a violation. 82. Question ID: 18654 Correct Answer: A Chang did not violate any standards in trying to solicit donations from readers. Option B is incorrect because the clause in the column does not violate Standard III.

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Reading 2

Guidance for Standard I-VII

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83. Question ID: 18655 Correct Answer: A According to Standard V, Carmen needed the permission of her employer to maintain the files at home after her employment ended. Without permission, she should have deleted the files upon termination. All files created as a part of professional activity are property of the firm, even those created outside work hours. The Code and Standards do not prohibit using one’s personal computer to complete work for one’s employer. 84. Question ID: 18656 Correct Answer: B Carmen violated Standard III by not disclosing that she was a part of a team of managers that achieved the performance shown. if she had also included the return of the portion she directly managed, she would not have violated the standard. 85. Question ID: 18658 Correct Answer: C Members are not required to disclose their responsibilities as CFA charter holders to clients. They are, however, required to disclose all matters that could be expected to impair their independence or objectivity. Service as directors and their firm’s market-making activities are examples of such matters. 86. Question ID: 18659 Correct Answer: B Wes’ duty to his former employer prohibits him from violating any applicable non-compete agreement. 87. Question ID: 18660 Correct Answer: C It is not evident that Peterson did not disclose any additional compensation arrangements to her employer as a result of being a relative to a minority shareholder of Perene. However, he violated Standard IV by not fully disclosing his position as shareholder of Fossil. Additionally, he also violated Standard I by not avoiding a situation that could cause or be perceived to cause a loss of objectivity in making investment recommendations. 88. Question ID: 18661 Correct Answer: A The Standards of Professional Conduct require members to consider client interests ahead of the member and employer interests. As Peterson’s compensation was dependant on a ‘buy’ recommendation, he was not reasonably objective in his analysis. 89. Question ID: 18662 Correct Answer: C Compensation received for recommendation of any kinds of product or services represents a conflict of interest. According to the CFA Institute Standard VI C, Peterson must disclose the referral fee arrangement.

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Reading 2

Guidance for Standard I-VII

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90. Question ID: 18663 Correct Answer: A Peterson’s use of astrology as a research methodology violates the Standard of Diligence and Reasonable Basis. His research methodology and blog may also reflect poorly on his employer and cause Perene harm. 91. Question ID: 18665 Correct Answer: C All clients should be treated fairly and impartially. The flexible trading terms will allow the hedge fund manager to enrich himself and Is a violation of Standard II, concerning trading on material non-public information. 92. Question ID: 18666 Correct Answer: B According to the CFA Institute Standard on Responsibilities of Supervisors, members are supposed to take preventive measures in case of suspected violations. Ward failed in his supervisory role when he accepted Nelson’s explanation for the unusual trading activity. He should have reviewed the client’s goals and objectives, and correspondence records, to see if they have, in fact, requested month end trading. Regardless of the information provided, he should have investigated further. 93. Question ID: 18667 Correct Answer: A Nelson has breached his duty to his family by treating them differently from other clients. They are entitled to the same treatment as any other client of the firm. 94. Question ID: 18668 Correct Answer: B Option B is correct as there is no evidence of unfairly treating clients. 95. Question ID: 18669 Correct Answer: B According to Standard VII, Andrew cannot claim to have finished the CFA Program or be eligible for the CFA charter until he officially learns that he has passed the Level III exam. Until the results for the most recent exam are released, those who sat for the exam continue to refer to themselves as candidates. 96. Question ID: 18670 Correct Answer: C In revealing that questions related to the analysis of inventories and taxes were on the exam, Andrew has violated Standard VII, by providing information to other candidates and the public that is considered confidential to the CFA Program. 97. Question ID: 18672 Correct Answer: B Option B is correct as companies which disclose information to the public on a limited basis create the potential for insider-trading violations.

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Reading 2

Guidance for Standard I-VII

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98. Question ID: 18673 Correct Answer: A Information relating to a tender offer is material by nature. As this information is non-public, Graham cannot trade on this information. 99. Question ID: 18674 Correct Answer: C Graham is required to disclose all matters and information that impairs or is reasonably perceived to impair his independence and objectivity. 100. Question ID: 18675 Correct Answer: C Graham did not fulfill the duty he owed to his clients by not treating them fairly according to the priorities approved by the company. 101. Question ID: 18676 Correct Answer: A The Standards require Graham to make reasonable efforts to make sure performance information is fair, accurate and complete. 102. Question ID: 18677 Correct Answer: C Graham should not have initiated providing services to his family before receiving written consent by his employer. Mere informing is not sufficient.

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Reading 6

Fintech in Investment Management

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FinQuiz.com CFA Level II Item-set – Solution Study Session 3 June 2019

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Reading 6

Fintech in Investment Management

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FinQuiz Level II 2019 – Item-set: 169439 Solution Reading 6: Fintech in investment management 1. Question: Correct Answer: C C is correct. The analysts are incorrect regarding Development 3. ML still requires human judgment in understanding underlying data and selecting the appropriate techniques for data analysis. A is incorrect. The analysts are correct regarding Development 1. The application of fintech to the investment industry means that a greater number of decisions will be executed through computer applications or automated trading applications. Automated trading will provide a number of benefits to investors including lower transaction costs and anonymity. B is incorrect. The analysts are correct regarding Development 2. In addition to the growing amount of traditional data, massive amounts of alternative data from non-traditional sources such as the social media can now be integrated into the portfolio manager’s investment decision-making process. 2. Question: Correct Answer: C C is correct. Cole’s understanding of ML models is inadequate. ML models require massive amounts of data for training and insufficient data have historically limited broader application of such models. B is incorrect. Before data can be used in an ML model, they must be clean and free from bias and spurious data. 3. Question: Correct Answer: B B is correct. Models which overfit the data may discover false relationships that will lead to prediction errors and incorrect output forecasts. A is incorrect. Models which underfit the data, the ML model treats true parameters as if they are noise and is not able to recognize relationships in the training data. In such cases, the resulting model may be too simplistic. C is incorrect. See above.

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Reading 6

Fintech in Investment Management

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4. Question: Correct Answer: C C is correct. Davis is correct regarding Reason 3. Most robo-advisers follow a passive investment approach implementing their investment recommendations with low cost, diversified index mutual funds or exchange-traded funds. Because of their low-cost structure, robo-advisors are able to reach the undeserved members of the population which otherwise may be unable to afford a traditional financial advisor. A is incorrect. Davis is incorrect regarding Reason 1. Although regulations may vary, robo-advisors are likely to be held to a similar level of scrutiny and code of conduct as other investment professionals in a given region. B is incorrect. Davis is incorrect regarding Reason 2. Although they can cover both passive and active investment approaches, most robo-advisors follow a passive investment approach. This investment approach has a zero alpha. 5. Question: Correct Answer: B B is correct. Algorithmic trading breaks a large order into smaller pieces and executes these orders across different exchanges and trading venues. By doing so, algorithmic trading lowers the market impact (and trading costs) of an extremely large order making it highly desirable for institutional investors who place large orders. A is incorrect. Algorithmic trading does not yield greater transparency for the trader. C is incorrect. Algorithmic trading does not seek to eliminate market mispricing for investors. 6. Question: Correct Answer: A A is correct. An application of DLT to investment management is tokenization. DLT streamlines the process of representing ownership to physical assets by creating a single, digital record of ownership with which to verify ownership title and authenticity, including all historical activity.

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Reading 7

Correlation and Regression

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FinQuiz.com CFA Level II Item-set – Solution Study Session 3 June 2019

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Reading 7

Correlation and Regression

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FinQuiz Level II 2019 – Item-sets Solution Reading 7: Correlation and Regression 1. Question ID: 11438 Correct Answer: B Statement 1 is incorrect. A correlation coefficient of zero indicates that there is absolutely no linear relation between the two variables. Variables with a correlation of 0 can have a strong non-linear relationship. If there is no linear relationship, the value of one variable tells us nothing about the value of the other variable. Statement 2 is correct. Correlation coefficients can be computed validly if the means and variances of the two variables, and the covariance between them, are finite and constant. When these assumptions are not true, correlations between two different variables can depend greatly on the sample that is used. 2. Question ID: 11439 Correct Answer: B Correlation that is induced by a calculation that mixes each of the two variables under consideration with a third is termed as a spurious correlation, since it does not measure the direct relationship between the variables. Spurious correlations can suggest results that may not be true. 3. Question ID: 11440 Correct Answer: A Exhibit 1 shows that the correlation between large-cap and small-cap stocks is positive but very low (0.13) which means the two indices represent distinct styles of investing. However, the correlation of the micro-cap index with the large-cap index (and the small-cap index) is very high (almost 1.0), which shows that there is very little difference between the two return series, and therefore, we may not be able to justify distinguishing between large-cap value and micro-cap value, or small-cap value and micro-cap value, as distinct investment styles. Therefore, Option A is most appropriate as it also provides the most opportunity of diversification. 4. Question ID: 11441 Correct Answer: B The t-statistic equals: −0.642√10 − 2 = −2.368 1 − (−0.642)ଶ Since the t-value is not less than –2.7854, the correlation coefficient is not statistically significant (we cannot reject the null hypothesis).

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Reading 7

Correlation and Regression

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5. Question ID: 11442 Correct Answer: C The slope coefficient equals: 0.000865 ଵ = = 1.248 0.000693 Since in a linear regression, the regression line fits through the point corresponding to the means of the dependent and independent variables, solving for the intercept using this point, we have: ଴ = 0.1156 − 1.248(0.0785) = 0.0176 6. Question ID: 11443 Correct Answer: A           0.2187 = = 0.6547 0.2187 + 0.1153

ଶ =

The F-statistic equals: 0.2187 1 = 157.434 0.1153 (85 − 2) 7. Question ID: 15545 Correct Answer: C Kitsis is incorrect with respect to Statement 1. If the correlation is positive one (perfect positive correlation), all the points on the scatter plot lie on a straight line with a positive slope. However, the slope depends on the relationship between the two variables; it could be that when one variable increases by one unit the other increases by half a unit (with an increase in one unit in one variable associated with exactly the same half-unit increase in the other variable). The slope of the line can be different (but positive), but as long as the points lie on a straight line the correlation between them will be 1. Statement 2 is incorrect. Sample correlation can be an unreliable measure when outliers are present. However, removing the outliers is not always the right thing to do, if the outliers provide important information about the variables during the period under analysis. One must use judgment to determine whether the outliers contain information about the variables’ relationship (should be included in the analysis) or contain no information (and should be excluded). 8. Question ID: 15546 Correct Answer: A Even though the correlation between NI and FCFF for the restaurant chain is much higher than the correlation for the sports-wear manufacturer, however, only the correlation coefficient for the sports-wear manufacturer is significant. This is most likely because the sample size used for the analysis of the sports-wear manufacturer is much larger than the sample size used for the restaurant chain. The larger the sample, the smaller the evidence in terms of the magnitude of the sample correlation needed to reject the null hypothesis of zero correlation. Recall that the t-statistic equals r√(n-2)/√1-r2. This shows that as n increases, the

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Reading 7

Correlation and Regression

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t-statistic increases, so that even for a small value of r, the null hypothesis can be rejected. A null hypothesis is more likely to be rejected as we increase the sample size, all else equal. 9. Question ID: 15547 Correct Answer: C Assumptions 1 and 4 are incorrect. The relationship between the dependent variable and the independent variable should be linear in the parameters b0 and b1. This requirement does not exclude the independent or dependent variable from being raised to a power other than one. Assumption 4 is not an assumption of linear regression. 10. Question ID: 15548 Correct Answer: A If Tannis uses a lower level of significance, which is the same as using a higher level of confidence, the critical t-value will increase. This choice leads to wider confidence intervals and to a decreased likelihood of rejecting the null hypothesis. Decreasing the level of significance from 0.05 to 0.01 decreases the probability of the Type 1 error, but it increases the probability of the Type 2 error (failing to reject the null hypothesis when, in fact, it is false). 11. Question ID: 15549 Correct Answer: A Bergren is correct. If the standard error is reduced to half of its current value, the confidence interval will be half as large and the t-statistic twice as large (with a small standard error, the t-value increases). When this happens, the probability of rejecting the null hypothesis increases. 12. Question ID: 15550 Correct Answer: A If forecasts are unbiased, the value of b0 should be 0 and the value of b1 should be 1. At a 0.05 significance level, with 72-2 = 70 degrees of freedom, the critical t-value is 1.994. Given the information in Exhibit 2, the 95% confidence interval for b0 is: 0.0239 ± 1.994(0.4531) –0.8796 to 0.9274 The value of 0 falls within this interval so we cannot reject the null hypothesis that b0 = 0. The 95% confidence interval for b1 is as follows: 0.9248 ± 1.994(0.0948) 0.7358 to 1.1138 The value of 1 falls within this confidence interval, so we cannot reject the null hypothesis that b1=1 at the 0.05 significance level. Because we cannot reject either of the null hypotheses, we cannot reject the hypothesis that the forecasts are unbiased (which means they are unbiased).

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Reading 7

Correlation and Regression

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13. Question ID: 15580 Correct Answer: A The type of data used by the research team at West Newman for conducting their regression analysis is cross-sectional data. This is because the analysts are comparing the effects of earnings announcements on price changes across corporations. If they had used earnings announcements for a single corporation and compared the effects of announcements on that corporation’s share price change across time, the research team would have been using time series data. Factor models are not relevant here. 14. Question ID: 15581 Correct Answer: A The first assumption is consistent with the underlying assumptions. Linear regression assumes that the relationship between the dependent variable and independent variable is linear in the parameters, b0 and b1. This requires the latter two parameters to be raised to the first power only. This requirement does not exclude, the independent variable (in this case E), from being raised to a power other than 1. The second assumption, outlined by the two senior analysts, is inconsistent with the assumptions normally underlying linear regression. Linear regression assumes that the expected value of the error term is 0 and not 1. The third assumption is inconsistent with the underlying assumptions. Linear regression assumes that the error term is normally distributed. Although linear regression may be modified and still be used in the event error term is not normally distributed, the analysts’ assumptions are inconsistent with the assumptions underlying linear regression. 15. Question ID: 15582 Correct Answer: B In order to determine the confidence interval, the following steps need to be followed: 1. Make the prediction: Using the regression model, an EPS of $2.50 indicates change in per share value of $39.056. P1 – P0 = 1.2458 + 15.1242($2.50) = $39.0563 2. Compute the variance of the prediction error: The variance is calculated using the following formula:

s

2

f

(

)

2  1 X −X  = s 1 + +  2  n (n − 1)s x  2  1 (2.50 − 1.6344 )  2 = 0.7542 1 + +   62 (62 − 1)0.4248  2

= 0.59444

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Reading 7

Correlation and Regression

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The standard deviation of the forecast error is sf = (0.59444)0.5 = 0.7710 3. Determine the critical value of the t-statistic. Given a 95% confidence interval and 62 – 2 = 60 degrees of freedom, the critical value of the t-statistic, tc, 2.00. 4. Compute the value of the t-statistic. The 95% confidence interval for P1 – P0 extends from 39.0563 – 2.00(0.7710) to 39.0563 + 2.00(0.7710), or 37.51430 to 40.59830. 16. Question ID: 15583 Correct Answer: B The hypothesized value of the slope coefficient does not fall within the confidence interval. Therefore the null hypothesis that the slope coefficient is 3.50 is rejected. Since the null hypothesis is rejected, this indicates the slope coefficient will not contribute in producing an unbiased estimate of price change. In order to test whether the regression model is able to produce unbiased forecasts, in terms of the slope coefficient only, a confidence interval needs to be constructed for the slope coefficient. Based on the hypothesized value of b1, 3.50, the confidence interval is constructed as follows:

bˆ1 ± t c sbˆ

1

15.1242 ± 2.00*(2.6556) 9.81300 to 20.43540 *The degrees of freedom are 62 – 2 = 60. Using a 95% confidence interval, the t-statistic is 2.00. 17. Question ID: 15584 Correct Answer: A The most appropriate response question 1 is a no and to question 2 is a Type I error. The magnitude of r, the correlation coefficient, needed to reject the null hypothesis decreases as sample size n decreases, for two reasons: 1) due to the degrees of freedom and the absolute value of the critical tc value decreasing and 2) due to the absolute value of the numerator increasing with larger n, resulting in larger magnitude t-values. Selecting a 90% confidence interval, as opposed to 95%, will decrease the width of the confidence interval and increase the likelihood of rejecting the null hypothesis when it is true, i.e. increases the probability of a Type I error. The tc value increases with higher levels of confidence. This will lead to a wider confidence interval and a decreased likelihood of rejecting the null hypothesis. The converse can be said to be true for lower levels of confidence, which will lead to narrower confidence intervals and an increased chance of rejecting the null hypothesis.

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Reading 7

Correlation and Regression

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18. Question ID: 15585 Correct Answer: A Limitation 1 fails to correspond with the limitations generally underlying linear regression. A limitation of regression analysis is that public knowledge of the regression relationships may negate their future usefulness. Public knowledge of stocks categorized as ‘High’, i.e. with strong price reactions, may lead to analysts acting upon the relationship and bidding the price of the stock up, rather than down. Thus stocks in this category may exhibit substantial price increases. This may decrease the usefulness of the model to predict future price changes. The standard estimate of the model may increase as the regression model produces inaccurate forecasts of price changes. Limitation 2 accurately captures a limitation of linear regression. Parameter instability can be a particular problem when comparing the price changes of stocks across the three different categories, in a cross-sectional context, as the characteristics of each category will certainly differ. Limitation 3 accurately captures a limitation of linear regression. If any of the regression assumptions are violated, hypothesis tests and predictions based on linear regression will not be valid. 19. Question ID: 18459 Correct Answer: B The regression model tries to explain the dependent variable through the use of the independent variable. 20. Question ID: 18460 Correct Answer: A The coefficient of determination measures the fraction of the total variation in the dependent variable that is caused by the independent variable. 21. Question ID: 18461 Correct Answer: B The critical value at 80% significance level with 10 degrees of freedom is 1.372. 22. Question ID: 18462 Correct Answer: B R2 = (Multiple R)2 = 0.40692 = 0.1656 23. Question ID: 18463 Correct Answer: B s2f = 0.002391×[1+(1/12) + {(0.0518 – 0.0412)2 / (11 × 0.0846)}] = 0.002391×[1 + 0.0833 + (0.00011236/0.9306)] = 0.002391×[1 + 0.0833 + 0.00012074] = 0.002391×(1.08342) = 0.0026

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Reading 7

Correlation and Regression

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24. Question ID: 18464 Correct Answer: C Sf = 0.00261/2 = 0.0510 Predicted value of interest rate +/- tcsf = 0.02546 +/– (1.372 × 0.0510) = 0.02546 +/– (0.0700) = –0.0445 to 0.0954 25. Question ID: 18466 Correct Answer: A Regression residual is the difference between the actual and the predicted values of the dependent variable. Standard error of estimate measures the degree of variability between the actual and the predicted values of the dependent variable. 26. Question ID: 18467 Correct Answer: A The covariance factor cannot tell the magnitude of the relation between two variables. It can only point out the direction of the relationship. 27. Question ID: 18468 Correct Answer: B It is not possible to measure slope of a scatter graph with zero correlation as there is no linear relation between the observations. 28. Question ID: 18469 Correct Answer: A The standard error of a correlation coefficient is used to determine the confidence intervals around a true correlation of zero. If your correlation coefficient falls outside of this range, then it is significantly different than zero. 29. Question ID: 18470 Correct Answer: C SSE = 0.00872 = 0.000076 SEE = [SSE/ (n-k-1)]1/2 = [0.000076/ 43]½ = 0.001329 30. Question ID: 18471 Correct Answer: A SST = 0.00922 = 0.000085 RSS = SST – SSE = 0.000085 – 0.000076 = 0.000009

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Reading 7

Correlation and Regression

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31. Question ID: 18474 Correct Answer: C Uncertainty in error term and uncertainty in the estimated parameters are the two sources of uncertainty while carrying out regression analysis. 32. Question ID: 18475 Correct Answer: A Parameter instability states that the regression relations like correlations can change over time. Regardless of whether the analyst is carrying out cross- section regression or time-series regression, collecting samples from more than one population would increase parameter instability. 33. Question ID: 18476 Correct Answer: A ANOVA is the procedure through which total variability is divided into components that are matched to their respective sources. This analysis of variance is carried out through the F-test, which is used to test whether all the slope coefficients are equal to zero. 34. Question ID: 18477 Correct Answer: A Confidence Range = B1+/– tc (sb1) = 0.8 +/– 1.734 (0.48) = –0.03 to 1.63 35. Question ID: 18478 Correct Answer: B Since the null hypothesis lies within the critical range, Brick would fail to reject the null hypothesis. 36. Question ID: 18479 Correct Answer: A t = (B1 – b1)/sb1 = (0.8 – 1.2)/ 0.48 = –0.833 37. Question ID: 18481 Correct Answer: B Acceptance of the null hypothesis is a binary decision. It will lead to an imminent rejection of the alternative hypothesis. 38. Question ID: 18482 Correct Answer: A We cannot assume the independent variable is caused by the dependent variable, simply because of the existence of correlation. A third variable could be the reason for the change in both of the previous variables.

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Reading 7

Correlation and Regression

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39. Question ID: 18483 Correct Answer: A Outliers are small numbers of observations at either extreme of a sample. Analysts need to use judgment to determine whether the outliers contain information pertaining to the relationship between the two variables or not. 40. Question ID: 18484 Correct Answer: B A Type II error = failure to reject the null hypothesis although it is wrong. A decrease in the sample size will lead to an increase in the magnitude of the correlation coefficient needed to reject the null hypothesis. This will also lead to an increase in the critical value of the t-statistic, because of which the t-statistic will most likely fall within the critical range. 41. Question ID: 18485 Correct Answer: C R2 = (Total Variation – Unexplained Variation)/Total Variation R2 = (0.004348 – 0.000532)/ 0.004348 = 0.877645 42. Question ID: 18486 Correct Answer: C SEE = [SSE/ (n – k – 1)]1/2 SEE = [0.000532/ (40 – 1 – 1)]½ SEE = 0.003742 = 0.37% or use SEE = MSE1/2 SEE = 0.0000141/2 SEE = 0.003742 43. Question ID: 18488 Correct Answer: A Since the data uses many observations from across time periods for the same company, it can be classified as time-series data. The expected value of the error term is assumed to be zero in the linear regression model. 44. Question ID: 18489 Correct Answer: B t = r √(n-2)/ (1-r2) t = 0.154 √123/ √(1-0.1542) = 1.708/0.988 = 1.729 The calculated t-statistic is 1.729. Since this value falls outside the critical range, Cooper can reject the null hypothesis and conclude that the relation between Revco and the automotive index is statistically significant.

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Reading 7

Correlation and Regression

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45. Question ID: 18490 Correct Answer: C SEE = √MSE = √0.0064 = 0.08 46. Question ID: 18491 Correct Answer: B The calculated t-statistics for the intercept and the slope coefficients are –9.269 and 3.576 respectively. Since both these value fall outside the critical range, Cooper can reject the null hypothesis and conclude that the relation between Revco and the automotive index is statistically significant. Intercept t-statistic = –0.0482/0.0052 = –9.269 Slope Coefficient t-statistic = 0.5893/ 0.1648 = 3.576 47. Question ID: 18492 Correct Answer: B Individual independent variables and their respective residuals are assumed to be uncorrelated. 48. Question ID: 18493 Correct Answer: A Linear regression is also known as linear least squares since the selected values of the intercept and the slope coefficient minimize the sum of squared vertical distances between the observations and the regression line. 49. Question ID: 18495 Correct Answer: A The error of regression coefficient is the standard error of the slope. 50. Question ID: 18496 Correct Answer: A A higher level of significance will lead to a narrower confidence interval. In this case, probability of rejecting the null hypothesis increases. Thus, the probability of Type I error increases. 51. Question ID: 18497 Correct Answer: A A lower level of significance results in a higher critical value of the t-statistic. This would decrease the probability of rejecting the null hypothesis. Thus, the probability of Type I error would decrease. 52. Question ID: 18498 Correct Answer: C The p-value is the smallest level of significance at which the null hypothesis can be rejected. When p<significance level, H0 can be rejected. If p>significance level, H0 cannot be rejected.

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Reading 7

Correlation and Regression

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53. Question ID: 18499 Correct Answer: B The sum of squared regression residuals is the accumulated square of the difference between the actual values of the dependent variable and the predicted value of the dependent variable. The estimated parameters help in reducing this difference. 54. Question ID: 18500 Correct Answer: B Mean Square Error = Sum of Squared Errors/(n-2) MSE = 125000/ (76) = 1645 55. Question ID: 18502 Correct Answer: A The correlation coefficient measures both the direction and the magnitude of a linear relationship. 56. Question ID: 18503 Correct Answer: A The significance level of the correlation coefficient needs to be tested regardless of its value. The t-test used to check the significance of the coefficient requires the number of observations recorded. 57. Question ID: 18504 Correct Answer: C Correlation = Covariance/ (Std Devx × Std Devy) = 79.37/ {(50)1/2 (350)1/2} = 0.600 58. Question ID: 18505 Correct Answer: A t = r (n – 2)1/2/ (1 – r2)1/2 = 0.6 √(43)/ √(1 – 0.36) = 3.934/0.8 = 4.918 59. Question ID: 18506 Correct Answer: A The critical value of the t-statistic is 1.302 with 43 degrees of freedom and a p-value of 0.10. Since the t-statistic falls out of the critical rang, Crater can reject the null hypothesis. 60. Question ID: 18507 Correct Answer: C Option C indicates a reliable correlation between two variables. However, Option A is spurious as the two variables indicated can only have a viable correlation through dividing them by another variable i.e. the number of shares. Option B is also spurious, as many other factors affect a manager’s performance other than their gender.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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FinQuiz.com CFA Level II Item-set – Solution Study Session 3 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 8

Multiple Regression and Issues in Regression Analysis

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FinQuiz Level II 2019 – Item-sets Solution Reading 8: Multiple Regression and Issues in Regression Analysis 1. Question ID: 11515 Correct Answer: C Statement 1 is incorrect. If the natural log of the change in inflation rate increases from 5% to 6% in a specific period, we can expect the stock returns to increase by 0.0986% in that period compared to the previous period, only if all other independent variables are held constant. It is quite likely that if the inflation rate changes, the interest rate and GDP growth rate will also change relative to the previous period, which will affect the dependent variable. Statement 2 is incorrect. If the changes in the inflation rate, GDP growth rate and interest rate are 2%, 1.5% and 3% respectively, the change in the stock market returns will be of: Change in stock market returns = 1.567 + 0.0986[ln(change in inflation rate] + 0.7790[ln(change in GDP growth rate)] –0.2364(change in interest rate) = 1.567 + .0986(0.6931) + 0.7790(0.405465) –0.2364(3) = 1.242% 2. Question ID: 11516 Correct Answer: B t-statistic = 1.567–0/0.1798 = 8.715 F-statistic = [1109.67/3]/[1011.09/(590–4)] = 214.378 3. Question ID: 11517 Correct Answer: A Hofmann is correct. The F-test is more useful in case of multiple regressions. In case of regressions with a single independent variable, the F-test provides the same information as the t-test (since there is only one variable). However, in a multiple regression, the F-test provides useful information on the regression’s overall significance. R2 is more appropriate when there is only one independent variable because it provides an accurate measure of goodness of fit. In case of multiple regressions, the adjusted R2 provides a much more reliable measure of the explanatory power of the regression (it does not automatically increase with an increase in the number of independent variables). Parks is incorrect. Testing individual coefficients using t-tests and testing them together using an Ftest can yield different results. We can reject the hypothesis that all the slope coefficients equal 0 even though none of the t-statistics for the individual coefficients is significant. Conversely, the estimated coefficients can be significantly different from 0 when jointly they are not.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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4. Question ID: 11518 Correct Answer: A Statement 3 is correct. The larger the value of the F-statistic, the more likely it is that there will be a miniscule probability of incorrectly rejecting the null hypothesis, a mistake known as the Type 1 error. This is because the larger the F-statistic, the more likely it is that it will be statistically significant. Hofmann is correct with regards to heteroskedasticity. Heteroskedasticity does not affect the consistency of the regression parameter estimates. A parameter is consistent if the probability that estimates of a regression parameter differ from the true value of the parameter decreases as the number of observations used in the regression increases. The regression parameter estimates from ordinary least squares are consistent regardless of whether the errors are heteroskedastic or homoskedastic. 5. Question ID: 11519 Correct Answer: B Since the predicted value of portfolio returns from the regression model has the average value of portfolio returns (the dependent variable), this means that the regression variables do not explain the dependent variable at all. This means that the regression sum of squares (explained variation) is 0 and therefore, the coefficient of determination is also 0. The F-statistic will also be 0, but the t-statistics can still show statistical significance (especially if there is multicollinearity). 6. Question ID: 11520 Correct Answer: C Positive serial correlation is serial correlation in which a positive error for one observation increases the chance of a positive error for another observation. It also means that a negative error for one observation increases the chance of a negative error for another observation. Positive serial correlation affects the ability to conduct valid statistical tests. First, the F-statistic may be inflated because the MSE will tend to underestimate the population error variance. Second, positive serial correlation causes the standard errors to underestimate the true standard errors. As a result, if positive serial correlation is present, standard linear regression analysis will typically lead us to compute artificially small standard errors for the regression coefficient, which will cause the estimated tstatistics to be inflated, which may, in turn, lead us to incorrectly reject the null hypotheses (type 1 errors). Conditional heteroskedasticity can lead to both type 1 and type 2 errors, whereas multicollinearity most likely leads to type 2 errors. 7. Question ID: 15831 Correct Answer: B The critical t-value value using the information in Exhibit 3, at the 5% significance level is 2.021. Given the computed t-statistics in Exhibit 1, Stowe can conclude that a pharmaceutical firm’s: • • •

reputation affects its cost of capital as 15.76 (t-statistic in absolute terms) > 2.021; earnings quality affects its cost of capital as 15.71 (in absolute terms) > 2.021; and market capitalization affects its cost of capital as 87.9 (in absolute terms) > 2.021.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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8. Question ID: 15832 Correct Answer: C The addition of an independent variable will increase R2, possibly even to a value of 0.45, if the new independent variable contributes to explaining any of the unexplained variation in the regression model. 9. Question ID: 15833 Correct Answer: B Using the information in Exhibit 1, the F-statistic is 1.459. The degrees of freedom in the numerator are 3 (k). The degrees of freedom in the denominator are 36 [40 – (3 + 1)]. The formula for the F-statistic is:

RSS MSR 1, 465 3 k F= = = =1.45892 SSE MSE 12, 050 36 n − ( k +1) 10. Question ID: 15834 Correct Answer: C Stowe is incorrect with respect to comment 1. Since the DW test for Stowe’s OLS regression is 1.32 and r (the sample correlation between regression residuals from one period to the next) is +0.34 [1 – (1.32/2)], this raises questions of positive serial correlation. Because the DW test of 1.32 is lower than the dl value of 1.34, Stowe should reject the null hypothesis of no serial correlation and conclude that the OLS regression has positive serial correlation. Stowe is incorrect with respect to her second comment. It is possible to correct conditional heteroskedasticity by computing robust standard errors or using the generalized least squares method. Unconditional heteroskedasticity causes no major problems for statistical interference. 11. Question ID: 15835 Correct Answer: A In order to compare ܴത ଶ under both models, it is necessary that the dependent variable be defined in an identical manner in both models and that the sample sizes used to estimate the models are the same. Even though the regression equation used for Canadian pharmaceutical industry stocks has the same and type of number of independent variables and sample size and period, the fact that the dependent variable used in the modified version of the regression model is not identical, COCap(x + 1) , to the dependent variable used in the original model, COCap, ܴത ଶwill be different. Thus the two models are not comparable.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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12. Question ID: 15836 Correct Answer: C Stowe is correct with respect to effect 1. When errors are heteroskedastic, the F-test for the overall significance of the regression is unreliable. This unreliability occurs because the mean squared error is a biased estimator of the true population variance. Stowe is correct with respect to effect 2. Multicollinearity will inflate OLS standard errors for the regression coefficients. With inflated standard errors, t-tests on the coefficients have little power (ability to reject the null hypothesis). This increases the occurrence of Type II errors, a failure to reject the null hypothesis when it is false. 13. Question ID: 16535 Correct Answer: C Statements 1 and 2 are incorrect. This is because the p-value of 0.1511 for the F-test means that the smallest level of significance at which we can reject the null hypothesis is roughly 0.15. Even though two of the coefficients are significant, the other coefficients may be insignificant implying that we cannot reject the null hypothesis that returns are equal across quarters at a 5% level of significance. The significance of the two coefficients may be the result of random variation. Hence, portfolio strategies based on differing weights of technology stocks in different quarters will most likely not be profitable. 14. Question ID: 16536 Correct Answer: B Since there is only one independent variable, the critical value of the test statistic for a variable from a x2 distribution with one degree of freedom at the 0.05 level of significance is 3.841. The test statistic equals nR2= 120(0.174) = 20.88. Hence, we can reject the hypothesis of no conditional heteroskedasticity at the 0.05 level. This means that the standard errors are not correct and therefore, the t-tests are not valid. 15. Question ID: 16537 Correct Answer: A To determine whether the errors are serially correlated, we have to calculate the Durbin Watson statistic. For a large sample, it is approximately equal to 2(1-r). In this case it is 2(1-0.650) = 0.70. To test for significance we see that the critical dl value for 120 observations and one independent variable is greater than 1.65 (this is the value for n=100 and k=1, so the value for n=120 will be even higher). Since the DW statistic is far below the dl value, we can reject the null hypothesis of no correlation in favor of the alternative hypothesis of positive serial correlation. 16. Question ID: 16538 Correct Answer: C Statement 3 is incorrect. After correcting for serial correlation using the Hansen method, the regression coefficients and the Durbin-Watson statistic remain unchanged. Only the standard errors are changed (these are called robust standard errors). Statement 4 is incorrect. Multicollinearity occurs when two or more independent variables are highly, but not perfectly, correlated with each other. The case where one independent variable is an exact linear combination of other independent variables is known as perfect collinearity.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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17. Question ID: 16539 Correct Answer: B The classic symptom of multicollinearity is a high R2, a significant F-statistic, even though the tstatistics on the estimated slop coefficients are not significant. The insignificant t-statistics reflect inflated standard errors. 18. Question ID: 16540 Correct Answer: B The predicted value equals: 15.986 – 1.893(5) = 6.521%. The standard deviation of the forecast error is: √0.4301 = 0.65582 Given 12–2 = 10 degrees of freedom and a 95% confidence interval, the critical value of the t-statistic is 2.228. The 95% confidence interval is 6.521 ± 2.228(0.65582) = 5.0598% – 7.982% 19. Question ID: 18509 Correct Answer: A When relevant variables are omitted from the regression, both the parameter coefficients and the standard errors are biased and inconsistent. 20. Question ID: 18510 Correct Answer: A Conditional heteroskedasticity exists when the error variance increases as the value of the independent variables increases. When conditional heteroskedasticity exists in the original regression, the independent variables explain a significant portion of the squared residuals’ variance. 21. Question ID: 18511 Correct Answer: A Computing robust standard errors corrects the standard errors of the estimated coefficients of the model, effectively decreasing or eliminating conditional heteroskedasticity. 22. Question ID: 18512 Correct Answer: A In the presence of conditional heteroskedasticity, the F-test to judge the overall significance is unreliable. T-tests for the significance of the individual regression coefficients are also unreliable as the heteroskedasticity introduces bias into the estimators of the standard errors of the regression coefficients. 23. Question ID: 18513 Correct Answer: B t-statistic = n × R2 residuals = 275 × 0.828% = 2.277 24. Question ID: 18514 Correct Answer: A The calculated t-statistic is 2.277. Since this value falls inside the critical range of 3.841, Miller would fail to reject the null hypothesis and conclude that no conditional heteroskedasticity exists in the regression.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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25. Question ID: 18516 Correct Answer: A When the independent variables do not explain any variation in the dependant variable, the predicted value of the dependant variable is its mean. 26. Question ID: 18517 Correct Answer: A Adj R2 = 1 – [(n – 1)/ (n – k – 1)] (1 – R2) Adj R2 = 1 – [(25 – 1)/ (25 – 3 – 1)] (1 – 0.64) Adj R2 = 1 – (1.142857) (0.36) Adj R2 = 1 – 0.41 = 0.59 27. Question ID: 18518 Correct Answer: C The number of slope coefficients used in a regression equation is equal to the number of independent variables included in the regression. The number of regression coefficients is equal to the number of independent variables plus one. 28. Question ID: 18519 Correct Answer: B One of the assumptions of regression analysis is that the error scatter plot is normally distributed. 29. Question ID: 18520 Correct Answer: B A random independent term with no correlation with the error term will result in a reliable forecast. 30. Question ID: 18521 Correct Answer: A The exclusion of an independent variable decreases R-squared, as the omission will generally lead to a reduced amount of explained variation. 31. Question ID: 18523 Correct Answer: B Positive Serial Correlation

Negative Serial Correlation

Standard Errors

Underestimated

Overestimated

T-Statistics

Inflated

Understated

F- Statistics

Inflated

Understated

Type I error

Increases

Decreases

Type II error

Decreases

Increases

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Reading 8

Multiple Regression and Issues in Regression Analysis

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32. Question ID: 18524 Correct Answer: B When heteroskedasticity results in underestimated standard errors, t-statistic values are inflated and the probability of Type I error increases. 33. Question ID: 18525 Correct Answer: A Unconditional heteroskedasticity occurs when the error variance does not systematically increase or decrease with changes in the value of the independent variable. 34. Question ID: 18526 Correct Answer: A d = 2(1 – r) = 2(0.2) = 0.4 35. Question ID: 18527 Correct Answer: A The Hansen’s method applies the technique of using robust standard errors to account for serial correlation. 36. Question ID: 18528 Correct Answer: C A typical symptom of multicollinearity is a high R-squared value and a significant F-statistic figure, even though the t-statistics of the slope coefficients are insignificant. 37. Question ID: 18530 Correct Answer: A The collection of 300 observations would not be economical in terms of time and cost, as it is yielding only a slightly higher R-squared. Thus, the extended model would be non-parsimonious. 38. Question ID: 18531 Correct Answer: B When an irrelevant independent variable is included, standard errors are overestimated. 39. Question ID: 18532 Correct Answer: B The hyperinflationary time period represents a separate pool of data that should not be merged with the normal time series data used for the regression. 40. Question ID: 18533 Correct Answer: A Discrimant analysis creates an overall score on the basis of a linear function, and this score is used to classify observations into binary or dual categories.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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41. Question ID: 18534 Correct Answer: B Qualitative dependant variables are dummy variables used as dependant variables instead of independent variables. 42. Question ID: 18535 Correct Answer: B The probit model is based on the normal distribution. The logit model is based on the logistic distribution. Discrimant analysis is computed through a method similar to the regression equation. 43. Question ID: 18537 Correct Answer: A Heteroskedasticity results in an incorrect estimate of the error term of the slope coefficient. 44. Question ID: 18538 Correct Answer: A When the independent variable does not explain any variation in the dependant variable, the Fstatistic has a value of zero. This is because the F-statistic divides total variance into explainable components. When the variation itself is unexplainable, its F-statistic can only give a value of zero to the components. 45. Question ID: 18539 Correct Answer: A The only instance, in which serial correlation affects the consistent of the parameter coefficients, is when a lagged value of the dependant variable is used as an independent variable. This carries forward the serial correlation to the next parameter coefficient. 46. Question ID: 18540 Correct Answer: A Adj R2 = 1 – [(n – 1)/ (n – k – 1)] × (1 – R2) = 1 – [(19/17)] × (1 – 0.4747) = 1 – (1.118) × (0.5253) = 1 – 0.5873 = 0.4127 47. Question ID: 18541 Correct Answer: B Adjusted R-squared decreases when the new variable added does not have a significant increase in explanatory power. This is because the factor [(n – 1)/ (n – k – 1)] would decrease with an increase in n.

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Reading 8

Multiple Regression and Issues in Regression Analysis

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48. Question ID: 18542 Correct Answer: B F-statistic attempts to explain the variation in the dependent variable. With an increase in explanatory power, the F-statistic figure would most likely increase. An increase in explanatory power, would also lead to an increase n the adjusted R-squared.

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Reading 9

Times-Series Analysis

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FinQuiz.com CFA Level II Item-set – Solution Study Session 3 June 2019

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Reading 9

Times-Series Analysis

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FinQuiz Level II 2019 – Item-sets Solution Reading 9: Times-Series Analysis 1. Question ID: 18595 Correct Answer: A The first lag of a time series exhibits the autocorrelation of the time series with the previous period. It is the value of the time series in the previous period. 2. Question ID: 18596 Correct Answer: B Whenever we refer to autocorrelation without qualification, we mean autocorrelation between the time-series itself rather than the autocorrelation of the error term or residuals. 3. Question ID: 18597 Correct Answer: A t-statistic = autocorrelation/standard error 4. Question ID: 18598 Correct Answer: C Standard Error = 1/ (52)1/2 = 0.1387 5. Question ID: 18599 Correct Answer: B Since the t-statistics of the individual lags are economically insignificant, Brien will conclude that the error term is not serially correlated. 6. Question ID: 18600 Correct Answer: A Growth Rate = 0.0641 + 0.6954 (0.052) + 0 = 10.0261% 7. Question ID: 18602 Correct Answer: C The two conditions for accurately carrying out the OLS method are: • •

the time-series has to be covariance stationary. the errors need to be uncorrelated.

8. Question ID: 18603 Correct Answer: B Past stationarity does not guarantee future stationarity because the state of the world is dynamic and ever-changing.

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Reading 9

Times-Series Analysis

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9. Question ID: 18604 Correct Answer: A A time-series with seasonality has a non-constant mean and is covariance non-stationary. 10. Question ID: 18605 Correct Answer: A Time-series observations have a logical ordering. Thus, they need to be processed in chronological order of the time periods involved. 11. Question ID: 18606 Correct Answer: B The consequences of a time-series being covariance non-stationary are: • •

the t-statistics will not follow a t-distribution. the estimate of the trend coefficient will be biased and any hypothesis will be invalid

12. Question ID: 18607 Correct Answer: A Serial correlation in a regression with distinct dependent and independent parameters, only affects the estimates of the error term and not the parameter coefficients. 13. Question ID: 18609 Correct Answer: B Mean Reverting Level = b0/ (1 – b1) = 5,210/ (1 – 0.5380) = 11,277 14. Question ID: 18610 Correct Answer: B The regressive model with the smallest RMSE based on out-of-sample data is the most accurate. Insample data forecasts will not be relevant as the best forecast model chosen will be able to accommodate unexpected events in its regression. 15. Question ID: 18611 Correct Answer: A The covariance of a variable with itself is its own variance. That is why the third assumption of covariance stationary time-series is inherently inbuilt into the second assumption. 16. Question ID: 18612 Correct Answer: A A time series accurately explained by the linear or log linear models is generally covariance nonstationary as such data observations do not have a mean reverting scale. 17. Question ID: 18613 Correct Answer: C To accurately evaluate the uncertainty of a forecast, uncertainty related to both the error term and the estimated parameters needs to be considered.

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Reading 9

Times-Series Analysis

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18. Question ID: 18614 Correct Answer: A The serial correlations between residuals in an autoregressive model can be reduced through adding lags of the dependent variable as explanatory variables. 19. Question ID: 11586 Correct Answer: A Statement 1 is correct. The current model is a log linear trend model. Such a model predicts a constant growth rate in the dependent variable (in this case, annual sales) equal to eb1 – 1. In this case b1 = 0.0965. Therefore, the predicted annual growth rate of sales in each period is e0.0965 – 1 = 10.13%. In contrast, a linear trend model predicts that the dependent variable grows by a constant amount from one period to the next. Since the trend coefficient is 1154.78, the model predicts that sales would grow by $1154.78 from one year to the next. Statement 2 is incorrect. Since the model uses the recent 20-year data, the value of sales next year will be the 21st observation. The predicted value equals: Ln y21 = 6.789 + 0.0965(21) Y21 = 6737.87586 million. 20. Question ID: 11587 Correct Answer: A Statement 3 is correct. Serial correlation in the error term is much more critical in terms of its consequences in the case of autoregressive models (like the one Blessing has estimated) than for other models, such as cross-sectional. In AR time-series regressions, serial correlation in the error term causes estimates of the intercept and slope coefficient to be inconsistent. Also, if the profit margin is more volatile in some periods, this means that the variance of the time-series will not be constant, and so the time-series will not be covariance stationary. The standard error equals: 1/√T = 1/√59 = 0.1302 At a 0.05 level of significance and 59-2= 57 degrees of freedom, the critical t-value is about 2. Following is a calculation of the t-statistic for each of the autocorrelations. Lag

Autocorrelation

Standard error

t-statistic

1

0.0986

0.1302

0.7574

2

0.0438

0.1302

0.3364

3

–0.1743

0.1302

–1.3388

4

–0.2319

0.1302

–1.7813

None of the t-statistics has a value greater than 2.0, hence none of the above autocorrelations differs significantly from 0. Hence, the residuals are not serially correlated and the model is correctly specified.

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Reading 9

Times-Series Analysis

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21. Question ID: 11588 Correct Answer: C The mean-reverting level for the regression equals: B0/1-b1 = 0.0934/1-0.7986 = 0.4637 = 46.37% Hence, if the current profit margin is above 46.37%, the model predicts that the profit margin will fall in the next period. If it is below 46.37%, the model predicts that the profit margin will rise in the next period. If it is at the mean-reverting level, then the profit margin will be the same in the next period. 22. Question ID: 11589 Correct Answer: B The current profit margin is 35%. CareLink’s profit margin in the next quarter will be: 0.0934 + 0.7986(0.35) = 0.3729 The profit margin in two quarters will be: 0.0934 + 0.7986(0.3729) = 0.3912 = 39.12% 23. Question ID: 11590 Correct Answer: B Contrasting their standard errors the AR (1) model has a lower standard error than the AR (2) model (3.129 vs. 3.325). Hence, the AR (1) model has a lower in-sample forecast error variance than the AR (2) model. However, comparing their root mean squared error (RMSE), we find that the AR (2) model has a lower RMSE (√15.158 = 3.8933 than the AR (1) model (√15.963 = 3.9953). Hence, the AR (2) model is slightly more accurate out of sample. Since out of sample performance is critical in evaluating a model’s real world contribution, the AR (2) model has more accurate forecasting performance. 24. Question ID: 11591 Correct Answer: A A random walk (and a random walk with a drift) has an undefined mean-reverting level and has no upper bound on its variance. Hence, it is not covariance stationary. However, the error term has a constant variance and is uncorrelated with the error term in previous periods (these are assumptions that we have to make).

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Reading 10

Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & Simulations

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FinQuiz.com CFA Level II Item-set – Solution Study Session 3 June 2019

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Reading 10

Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & Simulations

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FinQuiz Level II 2019 – Item-sets Solution Reading 10: Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Tree & Simulation 1. Question ID: 48612 Correct Answer: B B is correct. Because of the shifts in the market, Campbell has judged historical data to be unreliable. Instead, he has decided to employ cross-sectional data. One of the potential issues which may be encountered is that the real estate funds offered in the market may not be comparable to the three shortlisted funds. A is incorrect. An issue which is encountered when using historical data is that market shifts may render the data unreliable. Campbell is not employing historical data. C is incorrect. An issue with using statistical distributions is that the data may not precisely fit the stringent requirements of a statistical distribution. Therefore, the distribution selected may only approximate and not be close enough to the real distribution. 2. Question ID: 48613 Correct Answer: C C is correct. The first stage of the simulation process involves determining probabilistic variables. Although there is no limit on how the variables can be allowed to vary in a simulation, analysts should focus their attention on a few variables that have a significant impact on value. A is incorrect. While it is true that specifying probability distributions represents the most difficult and crucial stage, this is the second stage of the simulation process. B is incorrect. Checking for correlation across variables is done right after specifying probability distributions (Step 2) and before the actual simulation is run (Step 3). 3. Question ID: 48614 Correct Answer: B B is correct. Campbell will need to run the greatest number of simulations for the Alpha Fund as it has the second highest number of probabilistic inputs and, in addition, has diversity in its distributions. The required number of simulations will be lower where all the inputs have normal distribution (Zone) than one is which some are based on statistical and some on normal, for example (Vector and Alpha). A is incorrect. Although the distributions for Vector’s input variables are diverse, Campbell has specified the lowest number of probabilistic inputs for this fund. C is incorrect. Although Zone has the highest number of probabilistic inputs, the distributions of its input variables are not as diversified as that of Alpha’s.

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Reading 10

Excerpt from Probabilistic Approaches: Scenario Analysis, Decision Trees & Simulations

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4. Question ID: 48615 Correct Answer: A A is correct. Simulation is least appropriate for Vector. Simulations are better suited for continuous risks. On the other hand, decision trees and scenario analysis are better suited for discrete outcomes. B is incorrect. Simulation is appropriate for Alpha as the approach is better suited for continuous risks and allows for the explicit modeling of correlations. C is incorrect. Simulation is appropriate for Zone as the approach is better suited for continuous risks and can be used when the correlations across variables (risks) are independent. 5. Question ID: 48616 Correct Answer: B B is correct. Since Campbell is basing his decision on the variability in simulated values, he will be assuming that all of the risks built into simulations are solely relevant for the investment decision. In effect, he will be ignoring the line between the risks which could have been diversified away (nonsystematic risk) and asset-specific risk. In other words, he may be rejecting a fund which has a high standard deviation in simulated values, even though much of the risk can be diversified when the fund holdings are allocated to client portfolios. A is incorrect. The values derived from simulation represent expected cash flows and are not riskadjusted. C is incorrect. Since Campbell is making his selection of the real estate fund solely based on standard deviation in simulated values, he is not penalizing the unsuitable funds for risk on two counts. Had Campbell rejected Alpha and Zone based on their risk-adjusted discount rates in addition to volatility in simulated values, he would have been penalizing the funds twice for their risk. 6. Question ID: 48617 Correct Answer: C The factor outlined by Campbell in his research report represents an earnings and cash flow constraint. The constraint is internally imposed and managers will want to avoid the possibility of failing to meet performance expectations and missing out on being awarded an incentives compensation.

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Reading 11

Currency Exchange Rates: Determination and Forecasting

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FinQuiz.com CFA Level II Item-set – Solution Study Session 4 June 2019

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Reading 11

Currency Exchange Rates: Determination and Forecasting

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FinQuiz Level II 2019 – Item-sets Solution Reading 11: Currency Exchange Rates: Determination and Forecasting 1. Question ID: 18445 Correct Answer: C C is correct. The larger the transaction, the further away from the current spot exchange rate the dealing price will be. The order placed by the client is large and will widen the bid-offer spread quoted by the dealer. A is incorrect. The type of client, individual or institutional, should not have an effect on the size of the spread quoted. B is incorrect. The trade will take place when the London FX trading center is open, that is, the interbank FX market will be relatively liquid. Thus should narrow the spread quoted by the dealer. 2. Question ID: 18446 Correct Answer: B B is correct. Smart originally purchased CAD 5 million under the original forward contract. To close out its long position in CAD, it will need to sell CAD 5 million forward to the same settlement date. Thus Smart will sell CAD, or alternatively buy USD, at the all-in offer rate of 1.0065 + (–14.1/10,000) = 1.00509. At settlement, Smart will need to purchase CAD 5 million under the original forward contract and sell CAD 5 million under the offsetting forward contract; the CAD will net to zero. However the USD will not net to zero because the forward rate has changed since contract initiation. At settlement Smart will receive CAD 5 million and pay out USD 5,022,097.23 (5,000,000/0.9956) under the original forward contract and sell CAD 5 million and receive USD 4,974,678.88 (5,000,000/1.00509) under the new contract. The difference between the USD received and paid is - USD 47,418.35 (USD 4,974,678.88 – USD 5,022,097.23). This represents an outflow because the original contract was long the CAD (or short the USD) and the CAD subsequently depreciated (or the USD appreciated, because the all-in forward rate increased from 0.9956 to 1.00509). The present value of this outflow is calculated as follows: − USD 47,418.35 = −  47,397.81 60 1 + 0.0026 360

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Reading 11

Currency Exchange Rates: Determination and Forecasting

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3. Question ID: 18447 Correct Answer: A A is correct. To determine whether arbitrage profits are possible, it is first necessary to calculate the bidoffer cross rate on the EUR/USD implied by the interbank market. ௎ௌ஽  ா௎ோ



=  ௃௉௒  ா௎ோ

௕௜ௗ

× ௎ௌ஽ ௃௉௒

௕௜ௗ

௕௜ௗ

= 105.438 × 0.01222180* = 1.2886

  

=

×

 ௔௦௞  ௔௦௞  ௔௦௞ = 105.440 × 0.01222210* = 1.2887

*The JPY/USD rate is calculated as the inverse of the USD/JPY rate. Since the bid is the lower of the two inverse amounts, 0.01222180 and 0.01222210, the bid-offer spread is 0.01222180/0.01222210. Based on the interbank-implied cross rate of 1.2886/1.2887, the dealer is posting an offer rate to sell the USD cheaply, at a rate below the interbank market bid (1.2816 vs. 1.2886, respectively). Therefore, a triangular arbitrage would involve buying USD from the dealer selling it in the interbank market. 4. Question ID: 18448 Correct Answer: B B is correct. Arbitrage profits cannot be earned if the bid (offer) shown by the dealer is lower (higher) than the current interbank market offer (bid). Given that dealer’s bid, 1.4864, is lower than the interbank’s offer, 1.4865, and the dealer’s offer, 1.4866, is higher than the interbank’s bid, 1.4863, arbitrage profits cannot be earned. A is incorrect. The dealer’s offer of 1.4862 is lower than the interbank bid of 1.4863. It is possible to buy USD from the dealer and sell it in the interbank market and earn a profit. C is incorrect. The dealer’ bid of 1.4867 is higher than the interbank offer of 1.4865. It is possible to buy USD from the interbank and sell it to the dealer. 5. Question ID: 18449 Correct Answer: B B is least likely correct. Because Eoria is running a current account deficit, it is expected that the domestic currency will depreciate. However, a depreciation of the domestic currency should contribute to an improvement in Eoria’s trade competitiveness, in the long run, as the level of exports should increase relative to the imports. Masood’s comment with respect to trade competitiveness is incorrect. A is most likely correct. As stated in the preceding paragraph, Eoria’s domestic currency should depreciate because of its current account deficit.

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Reading 11

Currency Exchange Rates: Determination and Forecasting

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C is most likely correct. Relatively long lags can occur between changes in exchange rates, the ultimate adjustment in traded good prices and the eventual impact on import demand, export demand, and the underlying current account imbalance. 6. Question ID: 18450 Correct Answer: C C is least likely correct. The long-run equilibrium real value of Belare’s currency should increase as market participant revise upward their assessment of the domestic currency. This is because a tight fiscal policy should improve Belare’s long-run competitiveness, generate price stability, and gradually boost the real equilibrium value of its exchange rate. A is most likely correct. An improvement in long-run competitiveness and the gradual achievement of price stability policy will encourage investors to reduce the premium demanded for holding the high yield currency’s assets. Therefore the relative risk premium, ϕH ϕL, should decline. B is most likely correct. A tight fiscal policy will put downward pressure on domestic interest rates. With a decrease in Belare’s yield, the interest rate differential, iH – iL, should decline.

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Reading 12

Economic Growth and the Investment Decision

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FinQuiz.com CFA Level II Item-set – Solution Study Session 4 June 2019

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Reading 12

Economic Growth and the Investment Decision

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FinQuiz Level II 2019 – Item-sets Solution Reading 12: Economic Growth and the Investment Decision 1. Question ID: 18340 Correct Answer: A A is correct. A monetary tightening policy will be pursued when actual forecasted GDP is above potential GDP. A’s actual forecasted GDP growth rate, 4.4% (2.6% + 1.8%), is higher than its potential GDP growth rate of 1.5%. This indicates that A’s economy is growing at a rate faster than its long-run potential, which will put an upward pressure on inflation. To bring inflationary pressures under control, the government will need to tighten the monetary policy. B’s actual forecasted GDP growth rate is, 2.3% (1.4% + 0.9%), is below its potential GDP growth rate, 4.0%, suggesting that the monetary authority will pursue a monetary easing policy to close the output gap. C’s actual forecasted GDP growth, 3.6% (2.5% + 1.1%), is equal to its potential GDP growth, suggesting that the monetary will not take any policy action. 2. Question ID: 18341 Correct Answer: B B is correct. B’s actual GDP growth is below the potential growth rate (3.0% vs. 4.0%, respectively); therefore, this will put downward pressure on inflation and nominal interest rates and an upward pressure on bond prices. A is incorrect. As discussed, bond prices should rise when actual GDP growth is below potential GDP growth. C is incorrect. Because potential GDP is growing at a faster rate than actual GDP, consumers will expect their real incomes to rise more rapidly and real interest rates will need to be higher to encourage savings required to fund capital accumulation. Thus, higher rates of potential GDP growth will translate into higher real interest rates and expected real asset returns. 3. Question ID: 18342 Correct Answer: A A is correct. Country A has experienced the greatest growth due to capital deepening relative to country B and C (7.2% vs. 4.0% and 5.5%, respectively) and the greatest growth in labor productivity (7.9% vs. 5.0% and 3.5%, respectively). This suggests that the impact of diminishing marginal returns on per capita output growth was significantly low enough to allow for 91% of labor productivity growth (7.2%/7.9%) to be attributable to capital deepening investments. Although labor productivity growth in country C is purely driven by capital deepening investments, the growth due to capital deepening did not translate into a high labor productivity growth. This suggests that the impact of capital deepening investments was not as successful and that the impact of diminishing marginal returns on GDP growth was higher.

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Reading 12

Economic Growth and the Investment Decision

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Similarly in country C, growth due to capital deepening did not translate into a high growth in labor productivity. This suggests that the impact of diminishing marginal returns is higher. 4. Question ID: 18343 Correct Answer: B B is correct. A permanent increase in the rate of labor productivity growth will increase sustainable economic growth, earnings growth and potential return on equities. Based on the forecast for country C, equity returns in the country should be higher and equity investment activity will increase. 5. Question ID: 18344 Correct Answer: B B is correct. Country B has experienced the highest growth in TFP, 0.8% (see below) over 2000-2010. Growth in TFP(%) = Growth in labor productivity(%) + Growth due to capital deepening(%) Growth in TFP (A) = 7.9% – 7.2% = 0.7% Growth in TFP (B) = 5.0% – 4.0% = 1.0% Growth in TFP (C) = 3.5% – 5.5% = – 2.0% 6. Question ID: 18345 Correct Answer: A A is correct. Country C suffers from the Dutch disease because it is rich in natural resources but has experienced an appreciation in its currency, driven by the strong export demand for its resources. B is incorrect. Country D does not possess ownership of a natural resource supply and its currency has not appreciated (see above). C is incorrect. Without any other indication, sluggish economic growth does not indicate that that country D suffers from the Dutch disease.

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Reading 13

Economics of Regulation

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FinQuiz.com CFA Level II Item-set – Solution Study Session 4 June 2019

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Reading 13

Economics of Regulation

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FinQuiz Level II 2019 – Item-sets Solution Reading 13: Economics of Regulation 1. Question ID: 18588 Correct Answer: B B is correct. Statement 1 is most likely representative of regulatory arbitrage whereby Blackstone exploited differences in economic substance and regulatory interpretation to avoid higher corporate tax rates. By going public as a master limited partnership it was able to take advantage of the differences in tax treatment with respect to organizational structure. 2. Question ID: 18589 Correct Answer: C C is correct. Based on the facts presented in Statement 2, companies will most likely benefit from regulatory competition. Any U.S. based exporter can relieve itself of domestic antitrust laws by trading with U.S. customers, residing in a foreign country, at its discretion with less risk of violating such laws. 3. Question ID: 18590 Correct Answer: C C is correct. The IIROC is described as a SRO, which sets standards, regulates members, and is private in nature. It is a formal SRO with formal regulatory powers. 4. Question ID: 18591 Correct Answer: A A is correct. Financial market regulations focusing on market integrity differ from those targeted towards market stability. The latter are more focused in their approach. To promote market integrity, regulators may require increased disclosure to allow investors to make more informed trading decisions, enhance transparency, and allow markets to operate. B is incorrect. Regulation of commerce focuses on the public provision of public goods. C is incorrect. Regulation of financial institutions focuses on reducing system-wide risks. This will allow for the safety and soundness of financial institutions. 5. Question ID: 18592 Correct Answer: A A is not a valid regulatory tool. The IIROC is not a financial regulator and will not impose capital requirements. B is a valid regulatory tool. According to Statement 3, the IIROC set standards. Therefore, it provides public goods by providing regulatory and investment standards for the debt and equity investment markets. C is a valid regulatory tool. According to Statement 3, the IIROC has the ‘power to suspend, fire, and expel representatives.’ To discipline members it can impose conflict of interest policies to ensure their independence.

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Reading 13

Economics of Regulation

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6. Question ID: 18593 Correct Answer: C C is correct. A captive regulator can benefit the regulated by creating demand for products and by acting as a barrier to entry for rivals. A is incorrect. Encouraging competitive pricing will not allow industry participants, the regulated, to maintain their controlling positions in the industry. B is incorrect. Encouraging foreign competition by reducing barriers to industry entry will not benefit existing companies (the regulated).

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Reading 14

Intercorporate Investment

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FinQuiz.com CFA Level II Item-set - Solution Study Session 5 June 2019

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Reading 14

Intercorporate Investment

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FinQuiz Level II 2019 – Item-sets Solution Reading 14: Intercorporate Investments 1. Question ID: 15552 Correct Answer: B Investment in associate: Purchase price

$1,000,000,000

EI’s share of HD’s net income $200,000,000(0.35)

$70,000,000

Dividends received $98,000,000 (0.35)

($34,300,000)

Amortization of excess purchase price attributable to plant and equipment ($300 million (0.35) –$500,000)/10

($10,450,000)

Investment balance

$1,025,250,000

2. Question ID: 15553 Correct Answer: C Equity Income: Walter’s share of Wood’s reported income 30%(975,500) Amortization of excess purchase price (65,000/8) Unrealized profit Equity Income

$292,650 ($8,125) ($7,140)* $277,385

*Walter’s profit on sale 250,000 – 165,000 = $85,000 Wood’s sells 180,000/250,000 = 72% of the goods purchased; total unrealized profit = 85,000 (0.28) = $23,800, Walter’s share of unrealized profit = 0.30(23,800) = $7,140 3. Question ID: 15554 Correct Answer: B Sweeney is incorrect. There is a small difference between IFRS and U.S. GAAP in their inclusion of contingent liabilities. IFRS include contingent liabilities if their fair values can be reliably measured. U.S. GAAP includes only those contingent liabilities that are probable and can be reasonably estimated. Anderson is correct. The difference between the acquisition price and the fair value of the acquired net assets is recognized immediately as a gain in the profit and loss under both IFRS and the U.S. GAAP. Also, both IFRS and U.S. GAAP now require minority interests to be reported on the consolidated balance sheet as a separate component of stockholder’s equity.

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Reading 14

Intercorporate Investment

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4. Question ID: 15555 Correct Answer: A Under the full goodwill method, goodwill on the consolidated balance sheet would be the difference between the total fair value of the subsidiary and the fair value of the subsidiary’s identifiable net assets: 105,500,000 – (5,350,000+47,000,000+75,500,000-45,200,000) = $105,500,000- $82,650,000 = $22,850,000. The value of the noncontrolling interest will equal the noncontrolling interest’s proportionate share of the subsidiary’s fair value: 105,500,000(0.15) = $15,825,000 5. Question ID: 15556 Correct Answer: B Under the partial goodwill method, goodwill on the parent’s consolidated balance sheet would be the difference between the purchase price and the parent’s proportionate share of the subsidiary’s identifiable net assets: $85,500,000 – (0.85)(82,650,000) = $15,247,500. The value of the non-controlling interest equals the noncontrolling interest’s proportionate share of the fair value of the subsidiary’s identifiable net assets: 0.15(82,650,000) = $12,397,500. 6. Question ID: 15557 Correct Answer: C Statement 3 is incorrect. The amount reported in other comprehensive income is net of taxes. Statement 4 is incorrect. IFRS require that held to maturity securities be recognized initially at fair value plus transaction costs, whereas U.S. GAAP require held to maturity securities be initially recognized at cost including transaction costs. 7. Question ID: 15744 Correct Answer: C The investment in Jador Inc. will be reported as £4,500,000 at the time of purchase. IFRS requires that investments reported as held to maturity are initially recognized at fair value plus transaction costs. Subsequent to initial recognition, IFRS requires that held-tomaturity investments are reported at amortized cost using the effective interest rate method. 8. Question ID: 15745 Correct Answer: C Subsequent to initial measurement, the investment in Jador Inc. will be reported in the balance sheet at amortized cost. The amortized cost is calculated as follows (£’000):

1/1/2010 31/12/2010

(1) Interest Payment

(2) Interest Income

(3) Amortization= (1) – (2)

240

157.5

82.5

(1) 8% ×par value £3,000,000 = £240,000 (2) 3.5% × carrying value £4,500,000 = £157,500

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(4) Carrying Value 4,500 4,418

Reading 14

Intercorporate Investment

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(4) £4,500,000 – (£82,500) = £4,417500 9. Question ID: 15746 Correct Answer: B Amounts recorded in the income statement (£’000) = changes in fair value + dividend payments = (£3,240 – £2,875) + (0.025 × £2,875) = £436.875 ≈ £437 For investments recorded at held for trading, any dividends/and or interests paid on the investment in addition to fair value changes are recorded in the income statement. 10. Question ID: 15747 Correct Answer: C The amount of goodwill recorded on Rigor’s balance sheet under the partial goodwill method is + £1,292,000. This amount is calculated as follows:

Acquisition price* Less: 70% of fair value of net assets** Goodwill

£ 2,825,000 1,533,000 1,292,000

*The fair value of Rigor’s shares exchanged for Vito’s shares is equal to the acquisition cost in Exhibit 1, £2,825,000, which represents the acquisition price. ** Fair value of net assets = Total Assets – Total Liabilities = £4,001,000 – £1,811,000 = £2,190,000 11. Question ID: 15748 Correct Answer: A A significant influence in a corporation is classified as an investment in an associate. Investment in associates should be accounted for by the equity method. 12. Question ID: 15749 Correct Answer: B The closing value of Vito’s revalued machinery, which is recorded on the consolidated balance sheet as at December 31, 2010 is £334,800. Since Rigor has acquired a controlling interest in Vito, Vito’s assets will be recorded in Rigor’s balance sheet at the fair value at the date of acquisition less any subsequent depreciation and revaluations. • •

Given the machine has an original cost of £500,000 and had a total useful life (at the time of purchase) of 8 years, annual depreciation charge is £62,500 (£500,000 ÷ 8 years). Thus the net book value prior to the valuation is £312,500 [£500,000 – (62,500 × 3*)].

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Reading 14

• • • • •

Intercorporate Investment

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*On the date of revaluation, January 1, 2010, the remaining useful life is 5 years. Thus 3 years (8 – 5 years) of the useful life have elapsed. Increase in PPE (net) using Exhibit 2 on revaluation date is £106,000 (£1,546,000 – £1,440,000) Machinery’s revalued amount = £418,500 (£312,500 + £106,000) Revaluation date onwards annual depreciation charge = £83,700 (£418,500 ÷ 5 years) Machinery’s net book value at December 31, 2010 is £334,800 [£418,500 – (£83,700 × 1 year)

13. Question ID: 16068 Correct Answer: C Criterion 3 least likely justifies the classification of Ester Corp as a significant influence investment as it is inconsistent with the indicators generally used to classify a significant influence investment (see below). Under both IFRS and US GAAP when a parent holds 20 to 50 percent of the voting rights of the investee, it is presumed that the entity has significant influence over the investee. Since Green Corp holds 25% of Ester Corp’s stock, this criteria has been met. In addition to percentage ownership, the standards note that significant influence may be evidenced by: • representation on the board of directors (this has been met by criterion 2); • participation in the policy-making process; • material transactions between the investor and the investee (criterion 3 is inconsistent with this indicator as it restricts inter-corporate transactions to a maximum immaterial amount); • interchange of managerial personnel (criterion 1 is consistent with this indicator); or • technological dependency. 14. Question ID: 16069 Correct Answer: A Given that the acquisition price (£500 million) is less than the fair value of Poly Corp’s net assets acquired [0.75(£770 million – £65 million) = £528.75 million], Green Corp will immediately recognize the excess amount, £28.75 million (£528.75 million – £500 million) as a gain in its income statement. Green Corp is required to account for the bargain acquisition using the treatment prescribed by IFRS. In a situation where the acquisition price is less than the fair value of the target’s net assets, the acquisition is considered a bargain acquisition.

15. Question ID: 16070 Correct Answer: A The amount of net income which Green Corp will report in its 2008 income statement in relation to Ester Corp is £2.27 million. This is calculated as follows:

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Reading 14

Intercorporate Investment

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Green Corp’s share of Ester Corp’s net income €3.00000 million (25% × €12 million) Unrealized profit (€0.73125 million) Equity income related to Ester Corp (2008) €2.26875 million * Green Corp’s profit on the sale of detergents to Jason = €5 million − €0.5 million = €4.5 million Ester Corp sells 35% of these detergents while 65% remains unsold. Total unrealized profit = €4.5 million × 65% = €2.925 million Green Corp’s share of unrealized profit = €2.925 million×25% = €0.73125 million 16. Question ID: 16071 Correct Answer: A Assuming an acquisition price of £750 million, the amount of goodwill arising on the date of acquisition, using the full goodwill method (mandatory under U.S. GAAP) is − £55.00 million. The amount of goodwill arising as a result of the full goodwill method is illustrated below: Fair value of the subsidiary*

£650.00 million

Fair value of subsidiary’s identifiable net assets**

£705.00 million

Goodwill

(£55.00 million)

* Fair value of the subsidiary is equal to the market value of the subsidiary’s shares on the date of acquisition, i.e. £650 million **Fair value of subsidiary’s identifiable net assets = £770 million – £65 million = £705 million 17. Question ID: 16072 Correct Answer: B The consolidated assets reported under the acquisition method and pooling of interest method on Green Corp’s balance sheet, in relation to Poly Corp, on the date of its acquisition is US$2,970 million and US$2,765 million, respectively. Thus the amount of consolidated assets reported under the acquisition method is higher. Under the acquisition method, the acquirer will measure the identifiable assets and liabilities of the acquired entity at fair value at the date of acquisition. This means that the total consolidated assets on the date of acquisition, including Green Corp’s total assets, will be US$2,970 million (2,200 + 770). Under the pooling of interests method, the combined companies were portrayed as if they had always operated as a single entity. Consequently, assets and liabilities under this method were recorded at book values. The amount of consolidated assets to be reported on Green Corp’s

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Reading 14

Intercorporate Investment

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balance sheet in relation to Poly Corp and on the date of acquisition is the sum of the book values of the two corporations’ total assets, i.e. US$ 2,765 million (2,200 + 565). 18. Question ID: 16073 Correct Answer: B Traditionally, a special purpose entity (SPE) was consolidated if the sponsor or other entity had control over the trust/SPE. This control was evidenced by ownership of a majority of voting interest in the SPE. If a sponsor/other entity did not control the SPE, it did not need to consolidate the SPE. However, with an increase in regulation, any organization with a beneficial interest in a SPE is required to consolidate the SPE irrespective of whether it owns a majority of voting rights in the SPE or not. Thus Green Corp will be required to consolidate the trust even if it does not own a majority level of voting rights in the SPE as it has a beneficial interest in the trust (see below). Given that Green Corp bears the risk of defaults and is responsible for compensating any defaulted interest and principal payments on the trust’s borrowings, Green Corp has a beneficial interest in the trust. Thus the trust must be consolidated on Green Corp’s financial statements. By leasing the asset, Green Corp receives the benefit of leasing the asset through a residual value guarantee (the defunct factories are marketable after refurbishment) which gives further evidence of its beneficial interest in the trust. 19. Question ID: 11614 Correct Answer: A Since the investment in Tire-Go will provide Fisher Corp. with board representation in addition to the ability to participate in policy decision making matters, it will give it significant influence over the target and thus the investment in Tire-Go should be accounted for under the equity method of accounting accordingly. Under the equity method of accounting, the goodwill is not reported separately in the acquirer’s balance sheet but is incorporated as part of the cost of investment. Thus the amount of goodwill to be reported in the balance sheet is $0. 20. Question ID: 11615 Correct Answer: A If the cost of the investment is less than the investor’s share of the fair value of the associate’s net assets, the difference between them is excluded from the cost of investment and included as income in the determination of the investor’s share of the associate’s profit or loss in the period in which the investment is acquired.

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Reading 14

Intercorporate Investment

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The excess of the purchase price over the fair of Tire-Go’s net assets is calculated as follows:

Purchase Price Book Value of Net Assets ($88,000* × 30%) Excess Purchase Price Attributable to the plant [($15,000 – 8,000) × 30%] Goodwill (residual)

$000 22,000 (26,400) (4,400) (2,100) (6,500)

*net assets = 150,000 – 60,000 – 2,000 = $88,000 Explanation: Firstly, Net Assets = Total Assets – Total Liabilities (1) or Total Shareholder’s Equity (2). • Using (1) and Tire-Go’s balance sheet, Net Assets = 150,000 – (60,000 + 2,000) or Total Assets – (Accounts Payable + Long-Term Debt). • Using (2), Net Assets = 60,000 + 28,000 or (Shareholder’s Equity + Retained Earnings). Thus Fisher Corp. should include $6,500,000 as income as part of Tire-Go’s net profit to determine its share of profits in the associate. 21. Question ID: 11616 Correct Answer: C The fair value option gives the investor the option to account for an equity method investment at fair value. Since the investment in Tire-Go is an equity method investment (see the solution to part 1), the use of the fair value will produce the following financial statement implications for Fisher Corp.:
Subsequent to initial recognition the investment is reported at fair value with any unrealized gains and losses arising from changes in fair value as well as any interest and dividends received included in Fisher Corp.’s income statement.
The investment account does not reflect Fisher Corp.’s proportionate share of TireGo’s profit or loss, dividends or other distributions.
The excess of cost over the fair value of Tire-Go’s identifiable net assets is not amortized, nor is goodwill created. 22. Question ID: 11617 Correct Answer: C The equity income for 2011 is as follows: $ Millions Fisher Corp.’s share of Tire-Go’s reported net profit (30% × $150 million) Unrealized Profit (30% × 0.9334*) Equity Income 2011

$45.00 (0.28) $44.72

Fisher’s profit on the sale to Tire-Go = $7.5 – $5.5 = $2 million Tire-Go sells approximately 53.33% of the goods purchased from Fisher; 46.67% remains unsold. Total unrealized profit = $2 million × 46.67% = $0.9334 million Fisher’s share of the unrealized profit = $0.9334 million × 30% = $0.28 million

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Reading 14

Intercorporate Investment

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23. Question ID: 11618 Correct Answer: B Under the pooling of interests method (permissible for periods prior to June 2001 under U.S. GAAP), the combined companies were portrayed as if they had always operated as a single entity. Assets and liabilities were recorded at book values and pre-combination retained earnings were included in the balance sheet of the combined companies. In contrast, under the purchase/acquisition method, the purchase is viewed as a purchase of the investee’s net assets with the net assets recorded at fair values. The total value of the shareholders’ equity of the consolidated company under the pooling of interests method is calculated as follows: $ ’000 Common Stock ($1 Par Value)* $52,000 Additional Paid in Capital 30,000 Retained Earnings ($55,000 + $1,500) 56,500 Total Shareholders’ Equity $138,500 * Common stock is recorded at par value = [$80,000 (see exhibit 1) – $30,000] + 2,000 (stock issued) = $52,000 The value of shareholder’s equity under the acquisition method is as follows: $ ’000 Common Stock ($1 Par Value)* $52,000 Additional Paid in Capital** 38,000 Retained Earnings 55,000 Total Shareholders’ Equity $145,000 * see above ** Fisher Corp. has issued 2,000,000 shares worth $1 each or with a par value of $2 million to acquire C.S. Corp. Under U.S. GAAP or IFRS the investment must be recorded at fair value. Thus the consideration exchanged is 2,000,000 shares with a market value of $5 each or $10 million. Fisher Corp.’s common stock is increased by the par value of the common shares issued, $2 million. The acquirer’s additional paid in capital is increased by $8 million, which represents the difference between the total market value and par value of the shares issued ($10 million – $2 million), to a total of $38 million. Thus the total shareholders’ equity reported under the acquisition method is higher, relative to the total equity reported under the former method, by $6.5 million ($145 million – 138.5 million). 24. Question ID: 11619 Correct Answer: B Since Fisher Corp. and C.S. Corp. are situated in the U.S. the recognition of the impairment loss will be in accordance with the U.S. GAAP rules.

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Reading 14

Intercorporate Investment

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Under U.S. GAAP, goodwill impairment testing is carried out as a two-step process: 1) Determination of Impairment Loss: The carrying amount of the reporting unit including goodwill is compared to its fair value. If the carrying amount exceeds the fair value, impairment has occurred and impairment is measured as follows: 2) Measurement of Impairment Loss: The impairment loss is measured as the difference between the implied fair value of the reporting unit’s goodwill and its carrying amount. Using the data on C.S. Corp.’s steel conversion unit, the occurrence and amount of impairment loss is determined as follows: 1) Determination of Impairment Loss The unit’s carrying value ($1,500,000) is greater than the fair value ($1,250,000). This suggests that the unit has incurred an impairment loss. 2) Measurement of Impairment Loss Fair market value of the unit Less: net assets Implied Goodwill Current carrying value of goodwill Less: Implied goodwill Impairment loss

$1,250,000 1,180,000 $

70,000

$

200,000 70,000 130,000

$

25. Question ID: 17326 Correct Answer: B Cost of investment = 25% × $20,000,000 × ($15 + $2) = $5,000,000 × $17 = $85,000,000. 26. Question ID: 17327 Correct Answer: C All figures in millions Goodwill = COI – FV of Net Assets = $75 - ($66 × 0.25) = $75 - $16.5 = $58.5 27. Question ID: 17328 Correct Answer: A Profit recognized has to offset previous unrecognized losses. Profit= ($50*0.25) - $12 = $0.5 million. 28. Question ID: 17329 Correct Answer: B Under IFRS, currently exercisable or convertible warrants, call options or convertible securities are jointly considered along with voting shares to determine the voting power of the investor.

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Reading 14

Intercorporate Investment

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29. Question ID: 17330 Correct Answer: B Impairment losses from associates cannot be reversed under any circumstances. 30. Question ID: 17331 Correct Answer: A IFRS allows equity associates, which are venture capital organizations, mutual funds, unit trusts and investment-related insurance funds to be reported under the fair value method. 31. Question ID: 17333 Correct Answer: B Any excess of fair value over purchase price indicated the existence of a bargain acquisition and the gain is to be immediately reported as a gain in the investor’s income statement. 32. Question ID: 17334 Correct Answer: A U.S. GAAP allows goodwill to be calculated only through the full goodwill method. 33. Question ID: 17335 Correct Answer: A Since the acquiree’s shareholders have contractually indemnified the acquirer for the outcome of the case, the acquirer must recognize an indemnification asset. 34. Question ID: 17336 Correct Answer: A CoverTech owns 35% of the voting interests in The Embilon Enterprise. However, since it is unable to exert any significant influence over the latter entity, the investment made would be classified as an investment in financial instruments. 35. Question ID: 17337 Correct Answer: C Special purpose vehicle are created solely for a single purpose to meet the needs of the sponsoring entity. A subsidiary can be classified as a variable interest entity because subsidiary’s business performance varies the interest of the parent. 36. Question ID: 17338 Correct Answer: A Under U.S. GAAP, consolidation is based on: i. the voting interest component. ii. the variable interest component. 37. Question ID: 17340 Correct Answer: C Under IFRS and U.S. GAAP, classification of financial instruments as held-to-maturity is not allowed if in the most recent two preceding years, the entity has sold or reclassified more than an insignificant amount of held-to-maturity securities before maturity. 22% is not an insignificant figure.

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Reading 14

Intercorporate Investment

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38. Question ID: 17341 Correct Answer: C Under IFRS HTM securities are reported initially at fair value plus transaction costs. Cost=$ 52,000 + $3,500= $55,500. 39. Question ID: 17342 Correct Answer: B Held-for trading instruments are initially recognized at their fair values. 40. Question ID: 17343 Correct Answer: A Any unrealized gains or losses arising from changes in fair value of an available-for-sale security are reported in other comprehensive income with a net of tax figure. 41. Question ID: 17344 Correct Answer: B Any unrealized gains or losses on held-for-trading securities are reported in the income statement. 42. Question ID: 17345 Correct Answer: A Unrealized Gain/Loss= Fair Value – Issuance Price – Discount + Premium = $72,000- $80,000 + $4,800= $3,200 loss 43. Question ID: 17347 Correct Answer: B (All figures in $ millions) Purchase Price (23* 50 million* 20%) Entity’s Share of Net Assets (900* 20%) = Excess Purchase Price Attributable to Net Assets: P&E (35-18)*20% Land (15-12)*20% = Goodwill

230 (180) 50 (3.4) (0.6) 46

44. Question ID: 17348 Correct Answer: A When the book value of investor’s share of net assets is greater than the cost of investment, the differential amount is excluded from the cost of investment and included as income in the income statement. 45. Question ID: 17349 Correct Answer: B P&E Amortization= [($35 million-$18 million)*20%]/ 6 = $3.4 million/6= $0.57 million 46. Question ID: 17350 Correct Answer: A Under U.S. GAAP, the fair value option is available for all entities.

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Reading 14

Intercorporate Investment

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47. Question ID: 17351 Correct Answer: C The profit will be recorded in the associate’s income statement. The investor’s share of the unrealized profit will be included in the equity income on the investor’s income statement. 48. Question ID: 17352 Correct Answer: B The equity method does not increase the turnover figures in the income statements. Thus, all margin ratios are overstated as compared to the proportionate consolidation method. 49. Question ID: 17354 Correct Answer: A Carrying value calculation PV= -960, PMT= 80, N=10, FV= 1000, CPT I/Y= 8.613 Interest income = 8.613% × $960 = $82.6848 ≈ $83 50. Question ID: 17355 Correct Answer: A There is no capital gain to be recognized in the income statement as the investment is classified held-to-maturity 51. Question ID: 17356 Correct Answer: C Carrying value calculation PV= -960, PMT= 80, N=10, FV= 1000, CPT I/Y= 8.613 Change N to 7 to account for the three-year change. CPT PV= -968.75. PV of estimated future cash flows calculation I/Y= 8.613, PMT= 0, FV= 500, N= 7, CPT PV= - 280.4 Impairment loss= CV- Recoverable Value= 968.75 – 280.4= 688.35. 52. Question ID: 17357 Correct Answer: A Impairment losses are recognized in the income statement. 53. Question ID: 17358 Correct Answer: B Cumulative loss= Acquisition Cost- Principal Repayments- Current Fair Value- Previously charged impairment loss= 80- 68- 4= 8 54. Question ID: 17359 Correct Answer: B Reversals of impairment losses on AFS equity instruments are not allowed under the IFRS. Reversals of impairment losses on AFS debt instruments are allowed under the IFRS. Reversals of impairment losses on AFS equity instruments and debt instruments are not allowed under U.S. GAAP. 55. Question ID: 17361 Correct Answer: A Subsequent to initial recognition, associate investment at fair value recognizes unrealized gains and losses in the investor’s income statement.

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Reading 14

Intercorporate Investment

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56. Question ID: 17362 Correct Answer: B Under the fair value option, if the price paid for the target exceeds the fair value of identifiable net assets, the excess amount is neither amortized nor recognized as goodwill. 57. Question ID: 17363 Correct Answer: A Impairment loss can be charged in the event of a decrease in expected future cash flows as this qualifies as a loss event under the IFRS. 58. Question ID: 17364 Correct Answer: C Impairment losses cannot be reversed under the equity accounting method. IFRS prohibits the reversal of impairment losses. 59. Question ID: 17365 Correct Answer: B Value in Use= Cash Flows/ Market Rate=$ 80 million/0.09= $889 million 60. Question ID: 17366 Correct Answer: B All figures in $ millions Recoverable amount = higher of (fair value- costs to sell) or (value in use) Recoverable amount = higher of (1,500-8) or (889) Recoverable amount = higher of (1,492) or (889) Recoverable amount = 1,492 Impairment Loss= Carrying Value- Fair Value= 1,800- 1,492= 308 61. Question ID: 17368 Correct Answer: A Reclassification of securities into or out of the designated at fair value category is generally allowed under U.S. GAAP. Reclassification of securities into or out of the designated at fair value category is generally prohibited under the IFRS with a few exceptions. 62. Question ID: 17369 Correct Answer: B IFRS restricts reclassification of securities into or out of the held-for-trading category. U.S. GAAP allows for the reclassification of securities into or out of the held-for-trading category.

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Reading 14

Intercorporate Investment

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63. Question ID: 17370 Correct Answer: B When a security is transferred from available-to-sale to held-to-maturity category, the cumulative amount of the unrealized gains/losses previously recognized in other comprehensive income is recognized in the income statement over the remaining life of the maturity. 64. Question ID: 17371 Correct Answer: A Since the available-for-sale category requires the security to have a measurable fair value, the instrument could only have been classified to that category once the entity was listed. 65. Question ID: 17372 Correct Answer: C The disappearance of an active market for an entity’s securities is not an indicator of impairment. 66. Question ID: 17373 Correct Answer: C The downgrade of an entity’s credit rating is not an indicator of impairment. 67. Question ID: 17375 Correct Answer: A Under U.S GAAP, calculation of the effective interest rate is based on the contractual cash flows occurring over the asset’s contractual life. Under the IFRS, calculation of the effective interest rate is based on the estimated cash flows occurring over the asset’s expected life. 68. Question ID: 17376 Correct Answer: B Interest Revenue= Carrying Valuet-1× Market Interest Rate at date of Security purchase = $275,000 × 10.8%= $29,700. 69. Question ID: 17377 Correct Answer: B Realized Gain= Sale Proceeds- Fair Value at Transaction Date = $297,500- $282,000= $15,500. 70. Question ID: 17378 Correct Answer: A Any realized gains/losses on available for sale securities should be recognized in the income statement. US GAAP states that any unrealized gains/losses arising on the sale should be recognized in comprehensive income. 71. Question ID: 17379 Correct Answer: B Impairment losses on available-for-sale debt securities cannot be reversed under U.S. GAAP guidelines.

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Reading 14

Intercorporate Investment

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72. Question ID: 17380 Correct Answer: C Realized Gain= Sale price- Fair Value + Unrealized Gain = $310,000 - $302,000 + $15,000 = $23,000 73. Question ID: 17382 Correct Answer: C IFRS identify the following common characteristics of joint ventures: 1) A contractual arrangement exists between two or more parties. 2) The contractual arrangement establishes joint control. 74. Question ID: 17383 Correct Answer: B The IFRS requires use of the equity method to account for joint venture investments. 75. Question ID: 17384 Correct Answer: A A venture accounted for under the proportionate consolidation method has a higher debt figure but the same equity amount as compared to the equity method. Thus, proportionate consolidation would lead to a higher debt to equity ratio. 76. Question ID: 17385 Correct Answer: B All direct costs of the business combinations are expensed as incurred under both the IFRS and the U.S. GAAP. 77. Question ID: 17386 Correct Answer: C No goodwill was calculated under the pooling of interests method, as the two entities were treated as if they had always been a single economic entity. 78. Question ID: 17387 Correct Answer: A The pooling of interests method would report a lower cost of goods sold as all the assets in this method are reported at book values.

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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FinQuiz.com CFA Level II Item-set - Solution Study Session 5 June 2019

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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FinQuiz Level II 2019 – Item-sets Solution Reading 15: Employee Compensation: Post-Employment and Share-Based 1. Question ID: 15566 Correct Answer: A Statement 1 is correct. Firms following IFRS would expense the entire cost immediately. Past service costs are generated as a result of plan amendments. Under IFRS past service costs are recognized as an expense in the P&L. In contrast, under U.S. GAAP, past service costs are reported in other comprehensive income in the period in which the change giving rise to the cost occurs. Statement 2 is incorrect. Under U.S. GAAP, unamortized past service costs are reported in accumulated other comprehensive income and subsequently amortized over the average service lives of the affected employees; the amortized amounts are included in the income statement. 2. Question ID: 15567 Correct Answer: C Under U.S. GAAP, actuarial gains and losses that are recognized immediately are included as a component of pension expense. However, under IFRS, actuarial gains and losses are recognized as part of other comprehensive income and are not subsequently amortized to P&L. If they are treated as other comprehensive income, this can reduce the volatility of pension expense (but increase the volatility of equity). U.S. GAAP only allows the deferred recognition of actuarial gains and losses using either the corridor method or the faster recognition method to determine the minimum amount to be reported on the income statement. Park has defined only the corridor method; under the faster recognition method the actuarial gains and losses can be amortized more quickly. 3. Question ID: 15568 Correct Answer: A Estimated final year’s salary: $92,736 Estimated annual payment for each of the 20 years: (92,736×0.025)(10+5) = $34,776 Value at the end of Year 5, of the estimated future payments: $383,179.6 Annual unit credit: 383,179.6/15 = $25,545.30 Benefits attributed to prior years: Annual unit credit (10) = $255,453. Opening obligation: 255,453/(1.065)5 = $186,450.25 Interest cost = 186.450.25(0.065) = $12,119.269 4. Question ID: 15569 Correct Answer: A Statement 3 is correct. An increase in the assumed discount rate can increase the interest cost. However, the interest component of the pension obligation and pension expense may decrease if the decrease in the opening obligation more than offsets the effect of the increase in the discount rate (this is the typical effect). Statement 4 is incorrect. An increase in life expectancy will have no effect on the promised pension payments because the payments are to be paid over a fixed time period.

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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5. Question ID: 15570 Correct Answer: A Total periodic pension costs = Ending funded status – contributions – beginning funded status Total periodic pension costs = ($25,670 – $24,586) – ($19,615 – $18,956) – $65 = $360 6. Question ID: 15571 Correct Answer: B If Care Medicines complied with IFRS, it would report remeasurement amounts as part of net income: Remeasurements = net return on plan assets* - actuarial gains and losses *Net return on plan assets = Actual return – (Plan assets × Interest rate) Remeasurements = [$980 – (12% × $19,615)] + $1,500 = $126.20 ≈ $126 7. Question ID: 15594 Correct Answer: A The amount of pension liability recognized under U.S. GAAP for the year 2009 is 466 million. Under U.S. GAAP the amount recognized under a defined benefit plan is the pension plan’s funded status. The funded status represents the difference between the fair value of the plan assets and the projected benefit obligation (present value of the pension liabilities). If the projected benefit obligation exceeds the fair value of the plan assets, this suggests that the plan is underfunded. In the case of Hewer Corporation, the projected obligation as at December 31, 2009 exceeds the fair value of the corporation’s plan assets on the same date ($589 million vs. $123 million). 8. Question ID: 15595 Correct Answer: B For both the 2008 and 2009 periods, total periodic pension costs exceeded employer/employee contributions (in 2008 periodic pension costs exceeded contributions by $54 million and in 2009 pension costs exceeded contributions by $75 million). In the event that periodic pension costs exceed contributions, the excess can be viewed from an economic perspective as a source of financing. In the case of both 2008 and 2009, the appropriate adjustment would be to reclassify the excess as an inflow related to financing activities rather than to operating activities, i.e. decrease operating cash flows and increase financing cash flows. Since the corporation has not made these cash flow adjustments, its operating cash flows are overstated financing flows are understated for both the periods presented. 9. Question ID: 15596 Correct Answer: B The actuarial loss recognized by Hewer Corporation in its 2009 income statement is $7.0 million. Under the corridor method, the net cumulative unrecognized actuarial gains and losses at the beginning of the reporting period are compared with defined benefit obligation and the fair value of the plan assets at the beginning of the period.

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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If this cumulative unrecognized amount exceeds 10% of the greater of the PBO or the fair value of plan assets, the excess is amortized over the expected average remaining working lives of the employees participating in the plan and is included as a component of pension expense. • • • • • •

PBO at the beginning of 2009 = $448 million Fair value of plan assets at the beginning of 2009 = $149 million Net cumulative unrecognized actuarial gains/losses at the beginning of 2009 = $150 million PBO balance ($448 million) > Fair value of plan assets ($149 million). Thus the PBO value is used. 10% of the PBO amount = $44.8 million ($448 million × 10%) Unamortized portion of net actuarial loss = $105.2 million ($150 million – $44.8 million) Amortized portion of actuarial loss (recognized in 2009’s income statement) = $7.01 million ($105.2 million ÷ 15 years)

10. Question ID: 15597 Correct Answer: C Amongst the actions listed, a(n):
increase in the discount rate to 12.2% in 2010 from 12.1% in 2009, will decrease the value of the PBO being reported in 2010.
decrease in the actual return on plan assets to 8.5% will not affect the PBO amount as actual return on plan assets are not used in the PBO computation.
increase in the rate of compensation increases to 3.8% in 2010 from 3.5% in 2009 will increase the value of PBO being reported in 2010. 11. Question ID: 15598 Correct Answer: C Amongst the rate assumptions listed in Exhibit 2, the discount rate assumptions, expected return on plan assets, and annual compensation rate increases are internally consistent. This is because these rates are all increasing over the periods, 2008 and 2009 and thus correspond to the increase in the expected inflation rate over the two periods. However, the actual return on plan assets is internally inconsistent with these rates (including the expected inflation rate) as this rate of return remains constant at 8% over the two years. 12. Question ID: 15599 Correct Answer: B On January 1, 2008, 2 years of the vesting period have elapsed and 1.5 years remain. For the year 2008, the compensation expense recognized is $360 million ($540 million ÷ 1.5 years). For the year 2009, the compensation expense recognized is $180 million ($540 million – $360 million). 13. Question ID: 11621 Correct Answer: C The funded status is equal to $17,236 ($87,200 – $69,964) which the difference between the ending defined benefit obligation and fair value of plan assets,

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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14. Question ID: 11622 Correct Answer: B Net interest expense = Change in beginning of period funded status × discount rate Net interest expense = $(54,500 – 60,000) × 12% = –$660 15. Question ID: 11623 Correct Answer: C Using the sponsor’s 2010 contributions of $15,425 and a $6,000 total pension costs, the sponsor’s contributions exceed the pension expense by a pre-tax amount of $9,425 ($15,425 – $6,000). The after-tax amount by which the sponsor company’s contributions exceed the pension costs is $7,068.75 or approximately $7,069 [$9,425 × (1 – 0.25)]. Since the sponsor’s contributions exceed the total pension costs, the excess is equivalent to a repayment on a loan in excess of the scheduled payment (financing use of funds). This excess is treated as an increase in cash inflow from operating activities and an increase in cash outflow from financing activities by $7,069. Put another way, the $7,069 excess is treated as a decrease in cash outflow from operating activities and a decrease in cash inflow from financing activities. 16. Question ID: 11624 Correct Answer: A Periodic pension costs are calculated as follows: Total periodic pension costs (income) = Ending funded status – Employer contributions – beginning funded status. Total costs (income) = ($87,200 – $69,964) – $15,425 – ($60,000 – $54,500) = ($3,689) 17. Question ID: 11625 Correct Answer: B Benefit 1: s Stock options have payoffs, which can be characterized as asymmetric or one-sided. In other words, the potential for profits (when the underlying stock price exceeds the option exercise price) is unlimited on the upside and losses (when the stock price falls below the exercise price) are limited to the option premium. Thus the potential for risk aversion is limited and the potential for returns is unlimited on the upside. This benefit accurately reflects a benefit of issuing stock to firm employees. Benefit 2: Although the issuance of stock option will dilute shareholder ownership in the future, as the options are exercised and underlying shares are issued, the firm does not simultaneously issues shares with its stock options issue. Regardless of whether the stock options dilute shareholdings immediately or in the future, the firm’s existing shareholders will be affected by the issue once the options are exercised (and associated shares issued). Thus benefit 2 does not accurately reflect a benefit of issuing stock options to existing firm shareholders. Benefit 3: When stock options are issued an annual compensation expense in recorded on the firm’s income statement thereby reducing the firm’s profitability. Additionally, stock options can dilute the firm’s

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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earnings per share. Thus the issuance of stock options can reduce the firm’s overall profitability as well an individual shareholder’s share in firm profitability. Benefit 3 misrepresents the benefit as well as effect of issuing stock options on firm profitability. 18. Question ID: 11626 Correct Answer: B The fair value of an option tends to decrease with a(n):
increase in underlying exercise price;
increase in assumed dividend yields; and
decrease in stock price volatilities. Relative to current estimates for:
underlying exercise price ($52.10), selecting alternative 2 will result in a lower fair value estimate for the option as it assumes a higher exercise price estimate ($57.45).
dividend yields (3.00%), selecting alternative 2 will result in a lower fair value estimate for the option as it assumes a higher dividend yield estimate (3.85%) whereas alternative 1 will lead to a higher price estimate due to the lower dividend yield estimate.
stock price volatility (23%), selecting alternative 1 will result in a lower fair value estimate as it assumes a lower stock price volatility estimate (22%) whereas alternative 2 will lead to a higher price estimate to the higher volatility estimate. 19. Question ID: 17563 Correct Answer: B Final salary= ($75,000) (1.0525)14 = $153,522 20. Question ID: 17564 Correct Answer: C Lump Sum Payment at Retirement = (0.025 × 161,581)15 = $60,593. 21. Question ID: 17565 Correct Answer: A Annual Unit Benefit = Value at Retirement/ Years of Service = $56,553/15 = $3,770 22. Question ID: 17566 Correct Answer: A Benefits attributed to prior years in year 5 = Annual unit credit ($3,770) × 4 = $15,080 23. Question ID: 17567 Correct Answer: C Lump Sum Payment at Retirement = (0.025 × $161,581)20 = $80,791. 24. Question ID: 17568 Correct Answer: B Annual Unit Benefit = Value at Retirement/ Years of Service = $20,197/20 = $1,010

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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25. Question ID: 17570 Correct Answer: B The number of employees relevant for an accumulated benefit obligation calculation for 10 years = Currently Vested + Expected to meet Vesting Conditions in the next ten years = 25,000+ 125,000 = 150,000. 26. Question ID: 17571 Correct Answer: C The projected benefit obligation is based on the going concern assumption as it assumes the business to maintain its operations for the foreseeable futures. Calculations are made using the assumed turnover rates and salary increases in future periods. 27. Question ID: 17572 Correct Answer: A Interest Cost = Discount rate × Beginning pension obligation = 9% * 48 million = £4.32 million. 28. Question ID: 17573 Correct Answer: B Past service costs is the amount by which a company’s pension obligation relating to employees’ service in prior periods changes as a result of plan amendments or plan curtailments. These costs represent an obligation of the company and are thus included within a company’s pension obligation. 29. Question ID: 17574 Correct Answer: C The return on plan assets does not have any effect on the benefit obligation. The return increases the fair value of the plan assets. 30. Question ID: 17575 Correct Answer: A Curtailment occurs when the number of employees covered by the existing plan is reduced. This reduction may be due to any number of reasons i.e. redundancy, restructuring etc. 31. Question ID: 17577 Correct Answer: A Share based payments are recorded as an expense in the income statement. Regardless of the absence of a cash outflow, the income statement will recognize an expense according to the accrual principle. 32. Question ID: 17578 Correct Answer: A The compensation expense relevant to restricted stock grants is measured based on the fair value of the stock on the grant date. 33. Question ID: 17579 Correct Answer: B When the option price is dependent upon future contingent events to be known after the grant date, the compensation expense is measured at the exercise date.

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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34. Question ID: 17580 Correct Answer: A A lower assumed dividend yield would lead to an increase in the estimated fair value of a stock option according to the option pricing model. 35. Question ID: 17581 Correct Answer: A In 2010, the company will recognize $187.5 million ($750 million/4) as compensation expense. After recognizing this amount, the unrecognized non-vested compensation expense will reduce to $562.5 million ($750 million – $187.5 million) on December 31, 2010. With 3 years remaining, the compensation expense recognized in 2011 is $187.5 million ($562.5 million/3). 36. Question ID: 17582 Correct Answer: B Stock appreciation rights provide the flexibility to employees to benefit from increases in stock price without requiring them to hold shares. They require a current period cash outflow. 37. Question ID: 17584 Correct Answer: A It is compulsory under U.S. GAAP to make individual accounts for each participating employee. 38. Question ID: 17585 Correct Answer: A Under the defined contribution plan, employers are obligated only to make the designated contribution at the required times. The return on the contributions and the overall pension benefit received by the employees is not a responsibility of the employer. 39. Question ID: 17586 Correct Answer: B The defined benefit is funded in advance by the employer over the service life of the employee. Thus, the investment risk is borne only by the employer under defined benefit plans. 40. Question ID: 17587 Correct Answer: A Each additional year of service gives rise to additional benefit which the employee is entitled to at retirement. 41. Question ID: 17588 Correct Answer: B Theoretically, the differences between expected and actual returns arise from short term market fluctuations’ over the long term, these returns should converge. Therefore, in the long term, actuarial gains and losses arising from differences between actual and expected returns on the plan assets should converge. 42. Question ID: 17589 Correct Answer: C The IFRS provides the flexibility of choosing between either converged disclosure of the overall pension expense, or disclosure as separate line items.

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Reading 15

Employee Compensation: Post-Employment and Share-Based

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43. Question ID: 17591 Correct Answer: A (All figures in $’000) The company’s pension plan is overfunded by $19,370 ($108,800 – $89,430) When a company reports a surplus, the amount that can be reported as an asset is the lower of the surplus and asset ceiling (present value of future economic benefits, such as refunds or reductions in future contributions). Since the value of the ceiling ($54,500,000) is greater than the surplus, the asset will be reported at the surplus amount. 44. Question ID: 17592 Correct Answer: A All figures in $’000 The company’s pension plan is overfunded by $19,370 ($108,800 – $89,430) When a company reports a surplus, the amount that can be reported as an asset is the lower of the surplus and asset ceiling (present value of future economic benefits, such as refunds or reductions in future contributions). Since the value of the ceiling ($54,500,000) is greater than the surplus, the asset will be reported at the surplus amount. 45. Question ID: 17593 Correct Answer: C Given that the company complies with U.S. GAAP, it will include the following items in other comprehensive income, equity: • •

Past service costs Remeasurements: o Difference between actual and expected return on plan assets o Actuarial gains and losses – changes arising in a company’s pension obligation due to changes in actuarial assumptions.

Service costs include current and past service costs. The former is immediately recognized in profit and loss while the latter is included in other comprehensive income and subsequently amortized to profit and loss. 46. Question ID: 17594 Correct Answer: A A higher discount rate reduces the PV of the defined obligation by a greater amount. This would lead o a lower pension charge because of lower pension obligation. 47. Question ID: 17595 Correct Answer: C When the actual return is lower than the expected return by a significant amount, with the significance being large enough to require amortization, the amortization would lead to a decrease in pension expense. 48. Question ID: 17596 Correct Answer: B When the cumulative unrecognized actuarial gains or losses exceed 10% of either the PV of defined obligation or the FV of the plan asset, the difference is mortised over the service life of the employees.

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Reading 16

Multinational Operations

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FinQuiz.com CFA Level II Item-set - Solution Study Session 5 June 2019

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Reading 16

Multinational Operations

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FinQuiz Level II 2019 – Item-sets Solution Reading 16: Multinational Operations 1. Question ID: 11628 Correct Answer: A In order to determine where foreign currency translation gains/losses are recorded, it is necessary to determine the method to be used to translate El-Co Fiesta’s financial statements into U.S. $. This method, in turn, is determined by the relationship of the functional currency of the subsidiary and the presentation currency of the parent (Bernstake Ltd.). The relevant functional currency is determined primarily by the currency in which the subsidiary generates and expends cash; the currency which influences the sales price of goods and services; and the currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services. In the case of the El-Co Fiesta, the relevant functional currency is the ARP. Since this currency differs from the parent company’s presentation currency, the relevant translation method to use is the current rate method. The current rate method records translation gains/losses as part of comprehensive income, a component of stockholder’s equity. 2. Question ID: 11629 Correct Answer: A The appropriate translation method is the current rate method (see the solution to part 1). Under this method all monetary and non-monetary assets are translated at the current rate (at December 31, 2009). Thus total assets, in U.S. $ terms, amount to $603,478.26 (ARP 3,470,000 ÷ ARP 5.75/U.S. $) or approximately $603,000. 3. Question ID: 11630 Correct Answer: B Under the temporal method, Bernstake Ltd. would incur a foreign currency translation loss if the subsidiary’s monetary assets were less than its monetary liabilities (or vice-versa) and foreign currency weakened (or strengthened). The parent company would incur a translation gain if the subsidiary’s monetary assets were greater than its monetary liabilities (or vice-versa) and foreign currency strengthened (or weakened). Based on the exchange rate trend, the ARP has weakened (over the year 2009) from being worth 4.45 to 5.75 for every US$. Additionally, translating El-Co Fiesta’s financial statements would result in a translation gain as it as has a net monetary liability exposure (the monetary assets, ARP 1,420,000, are less than the monetary liabilities, ARP 1,730,000) and the ARP has depreciated.

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Reading 16

Multinational Operations

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4. Question ID: 11631 Correct Answer: A The temporal method will produce an inventory turnover ratio that is identical to the pre-translation ratio. Pre-translation ratio is 0.85 (ARP 850,000/ARP 1,000,000) and ratio under the temporal method is 0.85 [(ARP 850,000 ÷ 4.85)/ (ARP 1,000,000 ÷ 4.85)]. The ratio produced under current rate method will be 0.96 [(ARP 850,000 ÷ 5.10)/(ARP 1,000,000 ÷ 5.75)]. This ratio is higher to the one calculated from the temporal method. This is because the ARP has depreciated relative to the dollar, resulting in a lower US$ value for the inventory figure (which is converted at the current rate) under the current method, hence a lower denominator for the ratio. On the other hand, inventory under the temporal method is translated by using the rate at which inventory was acquired. As the rate at which inventory was acquired is historical, the inventory translated under this method has a higher US$ value producing a higher denominator and decreasing the inventory turnover ratio. If El-Co Fiesta used the LIFO method for inventory valuation (instead of FIFO), all inventory units on the balance sheet would have comprised of older items and thus valued at relatively older exchange rates, resulting in higher translated inventory values. Thus LIFO method produces a higher denominator and hence a lower inventory turnover ratio also decreasing the ratio is the lower translated value of the cost of goods sold (translated at a newer, lower exchange rate). Current FIFO inventory valuation method would have resulted in lower translated inventory values (relative to the LIFO method), as the inventory would have relatively recent items with more recent rates being used. This produces a smaller denominator and hence a higher inventory turnover ratio. Also increasing the ratio is the higher translated value of the cost of goods sold (translated at a newer, lower exchange rate). 5. Question ID: 11632 Correct Answer: A Since long-term bonds are monetary liabilities, these are translated using current exchange rates under the temporal method. Thus the U.S. $ value of notes payable amounts to $222,608.70 (ARP 1,280,000 ÷ ARP5.75/U.S. $) or approximately $223,000. 6. Question ID: 11633 Correct Answer: A Under hyperinflationary periods, IFRS requires nonmonetary assets to be restated for the general purchasing power unit of the monetary unit. These restated assets will then be translated under the current rate method at the current exchange rate. Inflation-adjusted inventory = ARP 1,000,000 × 130/100 = ARP 1,300,000 Translated Inventory = ARP 1,300,000 ÷ ARP 8.00/U.S. $ = $162,500

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Reading 16

Multinational Operations

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7. Question ID: 15956 Correct Answer: C Since France Co has a net monetary liability exposure and the Euro has appreciated relative to the dollar (Exhibit 4), the best course of action for the subsidiary would be to finance the purchase of the plant using equity rather than debt (long-term notes payable) since capital stock is not exposed to foreign exchange risk under the temporal method. The subsidiary has a net monetary liability exposure of €6,740 million as its monetary assets (cash and accounts receivable), €3,825, are less than its monetary liabilities (total liabilities), €10,565 million. Eliminating capital stock is not a recommended course of action since the notes payable are exposed to foreign exchange risk under the temporal method (which is used as the translation method since the presentation and functional currencies are identical), whereas capital stock is not. France Co’s existing cash balance of €175 million can only partially reduce its liabilities of €10,565 million. If the parent were required to pay off France Co’s remaining liabilities of €10,390 million (€10,565 million – €175 million), it would need to send US$ 6,754 million (€10,390 million × US$ 0.65/€) on January 1, 2010. On December 31, 2010 Arioco-P would be required to send US$ 7,793 million (€10,390 million × US$ 0.75/€) to pay €10,390 million. This will result in a foreign exchange loss of US$ 1,038 million (US$ 7793 million – US$ 6,754 million), thereby failing to eliminate exposure. 8. Question ID: 15957 Correct Answer: B Given that the Euro has appreciated from 0.65 to 0.75 relative to the US dollar, France Co will report a translation loss under the temporal method as its monetary liabilities are greater than its monetary assets (see the previous solution) resulting in a reduction in net income and hence its total equity balance. On the other hand, since the current exchange rate used to translate total assets under the current method is greater relative to the historical exchange rates used to translate assets under the temporal method and since it has a net asset exposure of €4,566 million (€15,131 million − €10,565 million), there will be a positive translation adjustment. Since the positive translation adjustment will increase the total equity balance, this will result in a higher total balance being reported for the subsidiary under the current rate method. 9. Question ID: 15958 Correct Answer: A A higher gross profit margin will be reported under the temporal method. Under both methods, sales will be translated at the average rate. The rate at which cost of goods sold is to be translated will determine the method to produce the highest gross profit margin for the subsidiary. Under the current rate method, cost of goods sold is translated at the average rate, i.e. US$ 0.70 per €. The rate at which cost of goods sold is translated under the historical method will be an older and lower rate, given the increase in the value of Euro over the 2010 period. Thus, the cost of goods sold will be higher and gross profit lower under the current rate method, which produces a lower gross profit margin using this method.

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Reading 16

Multinational Operations

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10. Question ID: 15959 Correct Answer: A Given that France Co.’s functional currency is identical to Arioco-P’s presentation currency, US$, the temporal method is used to determine its translated retained earnings as follows: € (millions) Cash Accounts Receivable Inventory Total current assets Property, plant, and equipment Less: accumulated depreciation Total assets Total liabilities Capital stock Retained earnings Total

Exchange rate (US$ per €) 0.75 0.75 0.67

$ (millions)

15,136

0.65

9,838.40

(8,360) 15,131 10,565 2,000 2,566 15,131

0.65

(5,434.00) 10,308.25 7,923.75 1,300.00 1,084.50 10,308.25

175 3,650 4,530 8,355

0.75 0.65 to balance

131.25 2,737.50 3,035.10 5,903.85

Since France Co was established on January 1, 2010 it has no opening retained earnings. 11. Question ID: 15960 Correct Answer: C Implication 1 has been inaccurately identified. Implication 2 has been inaccurately identified. In scenarios of hyperinflation, U.S. GAAP simply requires the foreign currency financial statements of the concerned subsidiary to be translated using the temporal method. On the other hand, IAS 21 (IFRS) requires foreign currency financial statements to be restated for inflation and then translated using the current rate. Under the temporal method and U.S. GAAP, liabilities will be translated at an exchange rate of AD 125.53 per US$. Under IFRS, liabilities will not be restated for inflation as they are expressed in terms of the monetary unit current at the balance sheet date. Thus under the current rate method and IFRS, these liabilities will be translated at the same exchange rate as used under the temporal method, i.e. AD 125.53 per US$. Thus the translated liabilities under the two standards are identical. Inflation in Algeria increased by 300% or by 3 times over the 2010 period. At the same time, the AD lost about 26% [(125.53 – 100)/100] of its value. Since the decrease in currency value is not matched by the change in local inflation, IFRS and U.S. GAAP will produce different results. 12. Question ID: 15961 Correct Answer: A Using the temporal method (see the solution to part 4), France Co’s closing inventory account balance is approximately US$ 3,035 million (€4,530 million × US$ 0.67 per €).

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Reading 17

Analysis of Financial Institutions

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FinQuiz.com CFA Level II Item-set - Solution Study Session 5 June 2019

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Reading 17

Analysis of Financial Institutions

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FinQuiz Level II 2019 – Item-sets Solution Reading 17: Analysis of Financial Institutions Item-set Id: 169397 1. Question: Correct Answer: C C is correct. Compared to other financial institutions, banks are systematically more important compared to non-financial institutions because banks serve as intermediaries accepting deposits from capital providers and providing capital via loans to borrowers. Their role as intermediaries between and among providers and recipients of capital creates financial inter-linkages across all types of entities. The network of inter-linkages means that the failure of one bank will negatively affect other financial and non-financial entities. The risk of failure will disrupt financial services and, depending on the size of the institution, has the potential to affect the economy as a whole. A is incorrect. The degree to which a banking institution is regulated does not explain why banking institutions are systemically important. On the other hand, banks are heavily regulated because they are systemically important. B is incorrect. This factor does not explain the systemic importance of banks. 2. Question: Correct Answer: B B is correct. Unlike banks, the overall insurance market has a smaller proportion of cross-border business. A is incorrect. The re-insurance business is largely international similar to the banking sector. C is incorrect. Compared to L&H and P&C insurers, the re-insurance market is engaged in substantial cross-border business. 3. Question: Correct Answer: B B is correct. The bank’s market risk exposure has increased as evidenced from the change in net interest income in response to a yield curve shift; i.e. interest rate sensitivity. The sensitivity has increased as the magnitude of the change in net interest interest income following a yield curve shift in either direction has increased over the three years. A is incorrect. The bank’s capital adequacy has improved as indicated by an increase in the total capital ratio from 2015 to 2017. C is incorrect. Short-term liquidity is measured by the coverage ratio and this trend for this ratio is downward between 2015 and 2017. Short-term liquidity has declined between 2015 and 2017 only to rise briefly in 2016. The long-term liquidity (as measured by the net stable funding ratio) exhibits a downward trend indicating a decline in this measure.

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Reading 17

Analysis of Financial Institutions

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4. Question: Correct Answer: A A is correct. The CAMELS approach analyzes capital adequacy, asset quality, management capabilities, earnings stability, liquidity position and sensitivity to market risk. One of the factors which is overlooked and requires attention is an entity’s corporate culture. B is incorrect. Analyzing governance structure is not relevant to the analysis of a banking institute. C is incorrect. See above. 5. Question: Correct Answer: C C is correct. Response to Question 3: Banks are subject to minimum capital requirements which they are legally obliged to comply with. With respect to P&C insurers, no risk-based global insurance minimum capital standards exist. However, capital standards exist in various jurisdictions. Nevertheless, the degree of regulation is not as extensive as that imposed on banks. Similar to P&C companies, L&H companies are not subject to risk-based global insurance minimum capital standards. In addition, L&H insurers can afford a lower equity cushion and lower capital requirements than P&C insurers because L&H claims are more predictable. Response to Question 4: As discussed above, P&C insurers’ claims are more variable because they arise from accidents and other unpredictable events. 6. Question: Correct Answer: C The efficiency of the underwriting operations is determined using the combined ratio. This ratio is calculated as follows: Combined ratio = Underwriting expense ratio + Underwriting loss ratio Underwriting loss ratio Underwriting expense ratio Combined ratio

Insurer 1 82.3 22.5 104.8

Insurer 2 77.5 20.7 98.2

Insurer 3 69.3 18.8 88.1

Based on the calculations, insurer 3 has the lowest ratio which corresponds to the greatest efficiency in its underwriting operations.

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Reading 18

Evaluating Quality of Financial Reports

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Reading 18

Evaluating Quality of Financial Reports

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FinQuiz Level II 2019 – Item-sets Solution Reading 18: Evaluating Quality of Financial Reports 1. Question ID: 22256 Correct Answer: B

B is correct. The impact of increasing the discount rate to maintain funded status in a period when plan assets were underperforming and subsequently decreasing the discount rate when performance improved will result in financial statements which do not reflect economic reality and are thus not decision useful. Lowering or increasing the discount rate merely to maintain funded status reflects a biased accounting choice. A is incorrect. The process of estimating the discount rate is not prescribed by GAAP and is left to the discretion of company management. Therefore, an in appropriate estimation of this rate is a poor representation of economic reality resulting from a biased accounting choice. C is incorrect. The company was attempting to improve the funded status reported on its balance sheet as opposed to earnings. Therefore, the question of whether earnings are sustainable is not relevant in this context. 2. Question ID: 22257 Correct Answer: C

C is correct. An understatement of financial liabilities held at fair value will result in an overstatement of equity resulting from the overstatement of unrealized gains. Understating the equity balance will result in an overstatement of the return-on-equity measure.

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Reading 18

Evaluating Quality of Financial Reports

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3. Question ID: 22258 Correct Answer: C

C is correct. A possible explanation for receivables growth being faster than that of revenue in each of the three years is that Smart-Tech may be pushing future sales into the current period by offering favorable discounts or generous return policies. This has the effect of encouraging customers to buy more than demanded and thus increasing the company’s accounts receivables balance at a rate faster than the growth in sales revenues. A is incorrect. A stringent credit policy will force customers to make timely payment of accounts receivables and is likely to lead to a decline in outstanding account receivable balances. This will reduce the growth of account receivables relative to sales. B is incorrect. Again, an improvement in credit quality will lead to a decline in accounts receivables with customers making timely payments on their outstanding accounts. This will serve to decrease the growth in receivables relative to sales. 4. Question ID: 22259s Correct Answer: A

A is correct. Given that the litigation claim was filed in 2012, the accrual for losses should be recognized in the year incurred. This would mean that losses should be spread out (if SmartTech incurs losses in 2013) rather than recognized fully recognized solely in the year 2013. By not accruing losses in the previous years, Smart-Tech’s prior year’s earnings are overstated. 5. Question ID: 22260 Correct Answer: B

B is correct. DEPI = Depreciation ratet-1/Depreciation ratet A value for the DEPI variable which is greater than 1.0 indicates a decline in the depreciation rate. A lower depreciation charge will translate into reduced depreciation charges and higher net income. Net profit margin will be higher relative to the previous year due to a lower depreciation charge increasing net income. A is incorrect. Debt-to-equity ratio will be lower relative to the previous year as higher net income will translate into an increase in retained earnings thereby increasing the denominator of this measure. C is incorrect. Total debt-to-total assets will be lower relative to the previous year as a lower depreciation charge will serve to increase the net book value of assets and thus total assets. The denominator of the ratio will consequently increase.

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Reading 18

Evaluating Quality of Financial Reports

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6. Question ID: 22261 Correct Answer: A

A is correct. Being less than 1.00, the value of the AQI index suggests a decline in capital expenditures relative to the previous year. B is incorrect. See above. C is incorrect. The SGAI is an indicator of administrative and marketing efficiency. Based on the value of the index in the exhibit, this indicator signals an improvement in marketing and administrative efficiency.

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Reading 19

Integration of Financial Statement Analysis Techniques

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Reading 19

Integration of Financial Statement Analysis Techniques

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FinQuiz Level II 2019 – Item-sets Solution Reading 19: Integration of Financial Statement Analysis Techniques 1. Question ID: 11718 Correct Answer: B Lester Corporation’s net profit margin (exclusive of associates’ performances) for the year 2010 and the group’s total profit margin are calculated using the following formulas: Tax burden (ex-associates) = net income – income from associates/EBT Interest Burden = EBT/EBIT EBIT Margin = EBIT/Revenue Workings $(12,232 – 3,343)/$14,856 $14,856/$15,353 $15,353/$102,424

Tax burden (ex-associates) × Interest Burden × EBIT Margin = Net Profit Margin (ex-associates) Net Profit Margin (inclusive of associates)

$12,232/$102,242

59.83% 96.76% 14.99% 8.68% 11.96%

By including the performance of associates as part of Lester Corporation’s net profit margin, the exclusive profit margin increases by 3.28% (11.96% – 8.68%) for the year 2010. This represents the effect of associates’ performance on the parent corporation’s performance. In other words, Lester Corporation’s net profit margin exclusive of associates’ investments was lower than the total net profit margin by 3.28%. 2. Question ID: 11719 Correct Answer: C The total asset turnover (ex-associates) for the year 2009 is determining by subtracting the associates’ assets from the group’s assets for the years 2008 and 2009. The average of the adjusted assets for the two years is calculated to determine the total asset turnover. Total assets ex– associates turnover =

100,242 = 0.7380 136,657 + 134,989   2

Total assets turnover (inclusive of associates) =

100,242 = 0.69613 145,646 + 142,353   2

The investments in associates has decreased Lester Corporation’s total asset turnover (exclusive of the associates) by approximately 0.042 (0.69613 – 0.73803).

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Reading 19

Integration of Financial Statement Analysis Techniques

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3. Question ID: 11720 Correct Answer: A Detergents Inc.: This segment will be a cause of concern as it has the highest EBIT relative to the other segments (35.75%). However the capital allocated to the segment has deteriorated from 2009 to 2010 (from 0.78 to 0.52). Additionally, the amount of capital expenditures relative to the total assets has been low over these two years as a ratio of lower than 1 indicates the segment is being allocated a smaller amount of capital expenditures relative to its total assets. All these factors may be a cause of concern for Ali. Lester Corp. Australia & New Zealand: This segment has the second highest EBIT margin with capital expenditures in excess of the total assets over the three years. Additionally, the capital expenditures are in growth mode (increasing from 2008 to 2010). All these factors indicate the segment will not be a cause of concern for Ali. Lester Corp. Europe: This segment has the third highest EBIT margin but the level of capital expenditures relative to assets is considerably low (as evidenced by the lower than 1 ratios over the three years). Additionally the decrease in capital allocation over the three years (from 0.66 to 0.69 to 0.60) may be a cause of concern for the analyst. Mineral Extractions: This segment has the third highest ratio of capital expenditure to total assets but has the second lowest EBIT margin. This segment is detracting capital expenditures from other segments with higher EBIT margins such as Detergents Inc. and Lester Corp. Europe. Additionally, capital expenditures are growing over the three year period. This segment will be a cause of concern for Ali. Lester Skin Care: This segment has the second highest ratio of capital expenditure to total assets but has the lowest EBIT margin. This segment is detracting capital expenditures from other segments with higher EBIT margins such as Detergents Inc. and Lester Corp. Europe. Additionally, capital expenditures are growing over the three year period. This segment will be a cause of concern for Ali. 4. Question ID: 11721 Correct Answer: B In order to determine the earnings quality for Lester Group over the 2007 to 2010 period, the operating cash flow before interest and taxes is compared to the profit/earnings before income and taxes. Using the data in exhibit 3, the two figures are calculated below:

Operating cash flow Cash taxes paid Cash interest paid Operating cash flow before interest and taxes

2010 17,125 789 645 18,559

2009 15,895 598 558 17,051

2008 12,452 465 486 13,403

2007 10,685 325 315 11,325

EBIT

14,856

11,453

10,473

9,856

Operating cash flow before interest and taxes/EBIT (2007) = 1.14 Operating cash flow before interest and taxes/EBIT (2008) = 1.28 Operating cash flow before interest and taxes/EBIT (2009) = 1.49 Operating cash flow before interest and taxes/EBIT (2010) = 1.25

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Reading 19

Integration of Financial Statement Analysis Techniques

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Since the group’s operating cash flow before interest and taxes has consistently exceeded EBIT over the 2007-2010 period and the operating cash flow before interest and taxes/EBIT ratio has increased, Nosov may conclude the group’s earnings quality has increased. 5. Question ID: 11722 Correct Answer: A The cash return on assets over the 2008 to 2010 period is calculated using the group’s operating cash flows illustrated in exhibit 3 and the group’s total assets illustrated in exhibit 1. $ $ $ Operating cash flows 17,125 15,895 12,452 Total assets 150,278 145,646 142,353 Cash return on assets 11.40% 10.91% 8.75% The cash return on assets measure has increased and thus displayed a positive trend over the 2008 to 2010 period. 6. Question ID: 11723 Correct Answer: A The incremental assets relative to total reported assets is calculated using Nosov’s lease multiplier and compared to total reported assets to determine whether additional assets and liabilities (related to off-balance sheet leases) may need to be reported on the segment’s balance sheet. 2010 lease expense Lease multiplier Estimated incremental assets and debt 2010 total assets Estimated incremental assets to total reported assets

€9.54 million 8.52 €81.28 million €500.00 million 16.26%

The estimated incremental assets to total reported assets exceeds the 6% threshold (16.26% vs. 6%). This implies that the reported assets and liabilities do not truly reflect the financial position of the segment and there may be off-balance sheet lease transactions which may have not been reported and may possibly require capitalization. This implies that there are significant assets and liabilities that could be justifiably capitalized on the segment’s balance sheet. The issue needs to be further investigated by Nosov.

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Reading 20

Capital Budgeting

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FinQuiz.com CFA Level II Item-set - Solution Study Session 7 June 2019

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Reading 20

Capital Budgeting

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FinQuiz Level II 2019 – Item-sets Solution Reading 20: Capital Budgeting 1. Question ID: 10678 Correct Answer: C After-tax salvage value is calculated as follows: Annual Depreciation = $175,000 – $80,000/10 = $9,500 Before-tax salvage vale = $80,000 (given) Accumulated depreciation = $9,500 × 6 = $57,000 Net Book Value (Year 6) = $175,000 – 57,000 = $118,000 Therefore, loss on sale = $80,000 – 118,000 = –$38,000 Tax on loss = 0% After-tax salvage value = $80,000 – 0 = $80,000 2. Question ID: 10679 Correct Answer: A In order to determine the EAA for both projects, it is necessary to first determine the NPV of the project. Using your financial calculator and the 2nd CF function, the following values are input: Event Managers Ltd.: CF0 = –$700,000 (–$500,000 + –200,000) CF1 = +$1,882,500 [$3,500,000 – 990,000 – ($3,500,000 – 990,000) (0.25)] CF2 = +$1,882,500 CF3 = +$1,882,500 CF4 = +$1,882,500 The relevant discount rate is 12.50%. Using the discount rate and cash flows, the NPV of the Event Managers Ltd. contract is $4,958,116.14. For a four-year life and a 12.5% discount rate, the payment with an equivalent annuity is $1,649,604.46 (PV = -$4,958,116.14; I/Y = 12.50%; N = 4; FV = 0; CPT PMT) H.S. Creations: CF0 = –$700,000 CF1 = +$1,882,500 CF2 = +$1,882,500 The relevant discount rate is 12.50%. Using the discount rate and cash flows, the NPV of the H.S. Creations contract is $2,460,740.74. For a four-year life and a 12.5% discount rate, the payment with an equivalent annuity is $1,465,588.24 (PV = -$2,460,740.74; I/Y = 12.50%; N = 2; FV = 0; CPT PMT) Thus the project with the highest EAA is the Event Management project.

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Reading 20

Capital Budgeting

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3. Question ID: 10680 Correct Answer: C The optimal abandonment strategy would be to abandon the project in the second year if the subsequent cash flows are less than the abandonment value. If after the first year a low cash flow occurs, Music Inc. can abandon the project for $3,500,000 and give up cash flows of $950,000 for the next four years. The present value of the $950,000 annual cash flows discounted at 12.50% [2% + (7% × 1.5)] for 4 years is $2,855,357.42. Since the present value is less than the abandonment value, Music Inc. should abandon the project if low cash flows occur after the second year. The present value of the $2,500,000 annual cash flows discounted at 12.50% for four years is $7,514,098.46. Since the present value of the cash flows in this case is greater than the abandonment value, Music Inc. should not abandon if the high cash flow occurs after the second year. If a high cash flow occurs and you do not abandon, the NPV is: ଺

ܸܰܲ = −200,000 + ෍

$2,500,000 = $9,934,596.32 1.125௧

௧ୀଵ

If low cash flow occurs and you abandon, you will receive the second year cash flow and the abandonment value. The NPV is: NPV = – $200,000 +

950,000 950,000 + 3,500,000 = $4,160,493.83 + (1.125)1 (1.125)2

The expected NPV is 0.50 ($9,934,596.32) + 0.50 ($4,160,493.83) = $7,047,545.07 4. Question ID: 10681 Correct Answer: B Shortfall 1: One of the shortfalls associated with capital budgeting is that it fails to taking into account economic responses. Conditions in the market may change (such as a new competitor entering the market and reducing profitability) which drastically change the profitability of the project. Thus shortfall 1 has been accurately identified. Shortfall 2: Managers may have a short-term focus and seek to increase short-term measures such as ROE and NP margin. By doing so, they may reject projects which produce negative NPVs and currently reduce such income and profitability measures but may generate greater shareholder value in the long run. Thus shortfall 2 has been incorrectly identified. Shortfall 3: Overhead costs are difficult to estimate and may be inaccurately accounted for in the capital budgeting process. Opportunity costs and sunk costs are difficult to estimate and/or may be excluded in capital budgets. Thus shortfall 3 has been correctly identified.

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Reading 20

Capital Budgeting

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5. Question ID: 10682 Correct Answer: C Inflation reduces the value of depreciation tax savings and the value of the depreciation tax shelter. Higher than expected inflation reduces the value of the depreciation tax shelter and reduces the value of fixed payments to bondholders. Thus the real interest expenses of the corporations will decrease decreasing the fixed payments in real terms. 6. Question ID: 10683 Correct Answer: B The formula for calculating economic income is cash flow + change in market value, where: Change in market value = Ending market value- beginning market value Alternatively, economic income = cash flow – (beginning market value – ending market value) or cash flow – economic depreciation. Beginning market value is the present value of the future after tax cash flows discounted at the applicable required rate of rate The economic income for the first two years has been calculated (in $): Year Beginning Market Value Ending Market Value Change in Market Value After-tax cash flow Economic Income

1 6,395,454.55 4,690,000.00 –1,705,454.55 2,345,000.00 639,545.45

2 4,690,000.00 2,579,500.00 –2,110,500.00 2,579,500.00 469,000.00

3 2,579,500.00 0.00 –2,579,500.00 2,837,450.00 257,950.00

After-tax cash flow (Year 2) = $2,345,000 × 1.1 = $2,579,500 After-tax cash flow (Year 3) = $2,579,500 × 1.1 = $2,837,450 Beginning market value (Year 1) is calculated as the present value of the after tax-cash flows in years 1-3 (CF1 = $2,345,000; CF2 = $2,579,500; CF3 = $2,837,450) Beginning market value (Year 2) is calculated as the present value of the after tax-cash flows in years 2-3 (CF1 = $2,579,500; CF2 = $2,837,450) Beginning market value (Year 2) is calculated as the present value of the after tax-cash flows in year 3 (CF1 = $2,837,450) In addition to the Nevada expansion project, Music Inc. is considering developing a small musical theatre in Ohio. The estimated construction costs will be $1,500,000 which includes a fixed capital investment of $900,000 and the remainder of the investment allocated to net working capital. These costs will be incurred at the beginning of the project. Annual after-tax operating cash flows are forecasted at $2,345,000 in the first year and will rise by 10% thereafter. The final year’s after tax operating cash flow includes the equipment’s after-tax salvage value. The company will apply a 10% discount rate to the project and the capital budget horizon is of 3 years. The applicable tax rate is 25%.

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Reading 20

Capital Budgeting

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7. Question ID: 16124 Correct Answer: A Current NPV of the project can be found using the following relationship: 0.85 = 1 + NPV/$35 million NPV = -$5,250,000 Increasing the NPV by $7.5 we have: New NPV = -$5,250,000 + $7,500,000 = $2,250,000 New benefit-cost ratio (PI index): PI = 1 + 2,250,000/35,000,000 = 1.064 Note: This can also be calculated using the other relationship: PI = PV of future cash flows/initial investment. 8. Question ID: 16125 Correct Answer: B If at the end of first year the low cash flow occurs, REKE can either abandon the project and get $315,000 or receive $70,000 for the next 4 years. $70,000 annual cash flow, discounted for four years at 12% equals $212,614, hence REKE should abandon. Four years of the $120,000 annual cash flow has a present value of $364,482 so REKE should not abandon. If high cash flow occurs and REKE does not abandon: NPV = –350,000 +∑t=1-5 120,000/1.125 = $82,573 If you abandon: NPV = –350,000 + 70,000+315,000/1.12 = –$6,250 The expected NPV equals: 0.40(82,573) + 0.60(–$6250) = $29,279 9. Question ID: 16126 Correct Answer: A Boris is correct with respect to the difference between accounting income and economic income. Accounting income is subject to accounting depreciation, which is based on the original cost of an investment. Consequently, in contrast to economic depreciation, the accounting depreciation schedule does not follow changes in the market value of an asset. Boris is incorrect with respect to the flaw. Economic income ignores interest expenses. However, the effects of financing costs are captured in the discount rate used in a capital budgeting model, and if interest expenses are included in the cash flows (either economic income or after tax operating cash flows), we would be double counting them. 10. Question ID: 16127 Correct Answer: B EBT = EAT / (1-t) EBT = 22,748 / (1-.35) EBT = 34,997 EBIT = EBT + Interest EBIT = 34,997+12,904 EBIT = 47,901

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Reading 20

Capital Budgeting

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NOPAT = EBIT (1- t) NOPAT = 47,901 (1-0.35) NOPAT = 31,136 $WACC = 0.12(67,394+153,948) $WACC = 26,561 EP = 31,136 - 26,561 = 4,575 11. Question ID: 16128 Correct Answer: C PV of residual income Debt investment Equity investment Total value

$87,302 $132,096 $66,048 $285,446

12. Question ID: 16129 Correct Answer: C Boris’s methods are incorrect. The residual income approach takes the perspective of equity investors, so residual income should be discounted at the cost of equity. Since Company XYZ repurchases shares sometimes, the cash flows to shareholders should include both dividends and share repurchases (this approach is known as the claims valuation approach). 13. Question ID: 17625 Correct Answer: C The NPV profile does not intercept the x-axis at any point. Therefore, the IRR is indeterminable. 14. Question ID: 17626 Correct Answer: B All figures in ‘000 Incremental Operating Cash Flow= (∆S-∆C-∆D) (1-T) +∆D Incremental Operating Cash Flow= ($50,000-$11,000-$9,000) (0.72) +$9,000= $21,600+$9,000= $30,600 15. Question ID: 17627 Correct Answer: C All figures in $000 Total NonOperating Cash Flows: Book Value= 160,000 – (35,000*4) = 20,000 NonOperating Cash Flows= Salvage Value+ WC Inv.- T (Salvage Value- Book value) NonOperating Cash Flows=25,000+25,000- 0.28(25,000-20,000) NonOperating Cash Flows=50,000-1,400= 48,600 Total Operating Cash Flows: Operating Cash Flows= (S-C-D) (1-T) +D Operating Cash Flows= (150,000-35,000-55,000) (0.72) +35,000 Operating Cash Flows=78,200 Total Cash Flows: 78,200+48,600= 126,800

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Reading 20

Capital Budgeting

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16. Question ID: 17628 Correct Answer: A All figures in $000 Initial Outlay= In. Inv.= WC Inv. – Salvage Value + T (Salvage Value- Book Value) Initial Outlay=$1,000,000+$65,000-$130,000+ (0.28) ($130,000-$115,000) Initial Outlay=$935,000+$4,200=$939,200 17. Question ID: 17629 Correct Answer: C Correct Answer: C All figures in $000 Operating Cash Flow= (S-C-D) (1-T) +D Operating Cash Flow=$177,000(0.72) +$28,000= $155,440 18. Question ID: 17630 Correct Answer: A All figures in ‘000 TNOCF= ∆Salvage Value + WC Inv. – T (∆Salvage Value- ∆Book Value) TNOCF= $70,000+$65,000-(0.28) [$70,000-$0] TNOCF= $135,000- (0.28) ($70,000) TNOCF= $135,000-$19,600 TNOCF= $115,400

19. Question ID: 17632 Correct Answer: C As both the mentioned projects are not mutually exclusive and carry a positive NPV, the company can afford to invest in both of them. 20. Question ID: 17633 Correct Answer: C (1+m)= (1+r) (1+i) (1+m)= (1.12) (1.04) m=16.48% PV= $8,000,000, FV= 0, I/Y= 16.48, n=2, CPT PMT PMT= $5,013,900 21. Question ID: 17634 Correct Answer: B Profitability Index=1+(NPV/Initial Investment) Profitability Index= 1+($25,000,000/$53,400,000)=1.468 22. Question ID: 17635 Correct Answer: A Soft capital rationing addressed the situation in which the managers of the entity are reluctant to allocate corporate funds to profitable projects despite the availability of liquid resources.

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Reading 20

Capital Budgeting

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23. Question ID: 17636 Correct Answer: C The Tenz project needs to start commercially viable operations within two years of initial investment. Therefore, a timing option has not been provided for this project. The expandable facility signifies an expansion option and the flexibility in price charging indicates the presence of a price setting option. 24. Question ID: 17637 Correct Answer: A The beta of a stock or portfolio is a number describing the relation of its returns with those of the financial market as a whole. It is therefore a measure of the systematic risk of an asset or a project. A low beta indicates a low systematic risk. 25. Question ID: 17639 Correct Answer: B Economic Income= Net After Tax Cash Flows + Change in Market Value Economic Income= $220,000 * (0.65) + $8,000 = $151,000 26. Question ID: 17640 Correct Answer: B The differential overtime is being charged by the research team currently in place, as it is being inconvenienced by its workplace occupation by the project under scrutiny. Had this project not been entered into, the company would not have to bear this extra cost. 27. Question ID: 17641 Correct Answer: B Economic Profit= NOPAT - $WACC Economic Profit= $380,000(1-35%) – {18% x [$500,000- ($184,000/5) x 4]} Economic Profit= $247,000 – [18% x ($500,000-$147,200)] Economic Profit= $247,000- $63,504= $183,496 28. Question ID: 17642 Correct Answer: C MVA= ∑[EPt/ (1 + WACC) t] CF Worksheet: C01= $180,000; F01= 5 NPV: I= 18%; CPT NPV= $562,890 29. Question ID: 17643 Correct Answer: B Total Value of Company= Fair Value of Liabilities + Fair Value of Equity = Far Value of Assets = $18 million 30. Question ID: 17644 Correct Answer: A Residual Income = Net Income – (re × BV of equityt–1) Residual Income = $190,000 – (12% × 360,000) Residual Income = $190,000 – $43,200 = $146,800

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Reading 21

Capital Structure

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FinQuiz.com CFA Level II Item-set - Solution Study Session 7 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 21

Capital Structure

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FinQuiz Level II 2019 – Item-sets Solution Reading 21: Capital Structure 1. Question ID: 10685 Correct Answer: C Theory 1: MM Proposition I (without taxes) states the value of a company is unaffected by its capital structure. In addition the theory assumes that investors have homogenous expectations regarding the cash flows from investments, investors can borrow and lend at the risk free rate and no agency costs or financial distress costs exist. Thus a change in capital structure does not affect company value. If the management-determined capital structure is not in agreement with the capital structure desired by investors, the latter group can borrow or lend at the risk-free rate (as opposed to a general lower rate) to create the capital structure desired. Since the value of the company is the present value of company operating earnings, a change in either the percentage of debt or equity will not affect company value. The value of a leveraged company should equal to the value of an unleveraged company. Theory 1 is inaccurate with respect to the risk-free borrowing and lending assumptions stated. Theory 2: MM Proposition 2 (with taxes) endorses the fact that paying interest will generate tax savings for the corporation. Thus the value of a company should increase with the value of the tax shield (tD). With the presence of corporate taxes, the value of a company with debt is greater than the value of an all equity company. As debt increases, cost of equity also rises with the rise in the cost of equity being smaller than the rise in the no-tax case (due to the absence of tax shield benefits in the latter case). Thus as debt increases, the overall marginal cost of capital falls and company value increases. Wright has inaccurately described the effects of rising equity costs (from additional debt) on the company’s cost of raising additional financing or WACC. 2. Question ID: 10686 Correct Answer: C Under MM II proposition (with taxes), re = r0 + ( r0 − rd ) (1− t )

D E

r0 = 11% rd = 5% t = 30% D/E (2011): Market Value of Debt (2010) = 0.80 × $25 million = $20 million D/E (2011) =

($20 + $3*) million = $23 million ($25 − $3*) million $22 million

* ± $3 million reflect the additional borrowing received/repurchase of common equity.

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Reading 21

Capital Structure

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Thus, re = 11% + (11% - 5%)(1 – 30%)[23/22] = 15.3909091% ≈ 15.39% 3. Question ID: 10687 Correct Answer: C Factor 1: The marketability of the firm’s financial assets does affect the costs of financial distress incurred. Firms whose assets are relatively marketable incur lower costs of financial distress as they have more assets to liquidate in the event of financial distress compared to firms whose assets lack marketability. Thus factor 1 has been correctly identified. Factor 2:

The stronger the firm’s corporate governance system, the lower the probability of bankruptcy and thus the lower the financial distress costs incurred. Thus factor 2 has been correctly identified.

Factor 3:

Bonding costs are incurred by management to ensure they are working in the best interests of shareholders and directly affect net agency costs of equity as opposed to costs of financial distress. Thus factor 3 is incorrectly identified and not relevant in this context.

4. Question ID: 10688 Correct Answer: A When making decisions concerning the level of financial leverage they should undertake, companies should balance the value enhancing effects of financial leverage (tax deductibility of interest) against the value reducing costs of financial distress, asymmetric information, and debt agency costs. The static trade-off theory of capital structure, which incorporates the costs and benefits associated with debt, states that the optimal capital structure is one in which debt is less than 100% of its capital structure. Optimal debt is found at the point where additional/incremental unit of debt would cause the costs of financial distress to increase by a greater amount than the benefit of the additional tax shield. 5. Question ID: 10689 Correct Answer: C Generally, agency costs are costs that arise from the conflict of interests between managers, shareholders, and bondholders. The smaller the stake that managers have in the company, the less is their share in bearing the cost of executive perquisite compensation. This results in an increase in the agency costs of equity. Generally a reduction in net agency costs of equity results from an increase in the use of debt versus equity. The more financially leveraged a company is the less freedom managers have to take on more debt or spend the cash unwisely (for example, through perquisite consumption). Thus debt can act as a disciplining mechanism. This is referred to as the ‘free cash flow hypothesis’ and reflects an effort to reduce the net agency costs of equity.

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Reading 21

Capital Structure

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6. Question ID: 10690 Correct Answer: C Note: Since both countries have similar maturities, the maturities are held constant for the question. Countries that possess efficient legal systems have a lower D/E ratio and longer debt maturity. Relative to B, A has a lower D/E ratio (0.70 vs. 0.55) and has a more efficient legal system. Both countries have long-term maturities (> 20 years). Countries with a bank-based financial system have higher D/E ratios. Relative to A, B has a higher ratio and more likely possesses a bank-based financial system. On the other hand, A possesses a market-based financial system based on its ratio. Countries that follow common law have lower D/E ratios and longer maturities. The converse is true for civil law countries. Relative to B, A has a lower D/E ratio. Thus A most likely is a common law country whereas B is a civil law country based on their respective D/E ratios. Countries with a greater presence of information intermediaries (auditors and analysts) have lower D/E ratios and longer debt maturities. Thus A, based on its D/E ratio, has a greater presence of information intermediaries than B. Countries with a greater presence of institutional investors generally have companies with lower D/E ratios and debt with longer maturities. Based on the respective D/E ratios, country A has a greater presence of institutions relative to B. 7. Question ID: 17646 Correct Answer: B Loss of customers due to deterioration of company reputation is an example of indirect cost of financial distress. 8. Question ID: 17647 Correct Answer: A The specialized nature of the research assets suggests that an active market does not exist for such products. Therefore, these assets might have to be sold at a substantial discount to their value in use in order to attract a customer. This specialization of assets would therefore lead to an increase in costs of financial distress. 9. Question ID: 17648 Correct Answer: A An increase in equity would decrease the financial leverage of the firm. This decrease in leverage will subsequently lead to a decrease in the cost of financial distress. 10. Question ID: 17649 Correct Answer: A The tax paid on $10 of dividends and $10 of interest income is as follows: Dividend: Tax Rate=25% Tax Amount= $10*50%*12.5%= $0.625 Interest Income Tax Rate= 20%

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Reading 21

Capital Structure

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Tax Amount= $10*20%= $2 Since half of the dividends received are nontaxable, and the effective tax amount paid is lower for dividends as compared to the same amount of inflow through interest, dividend income would be more preferable. 11. Question ID: 17650 Correct Answer: C WACC= [KD*(1-T)*D/V] + [Ke*E/V] WACC= [6 %( 0.72)3/4] + [10%*1/4] WACC= 3.2%+ 2.5% WACC= 5.7% Vu= EBIT (1-T)/WACC Vu= $15million*(1-0.28)/0.057 Vu= $10.8 million/0.057=$189 million VL= VU+ tD= $189 million + (28% x $45 million)= $202 million 12. Question ID: 17651 Correct Answer: B Ke= r0+ (r0-rd) (1-T) D/E Ke= 0.08+ (0.08-0.06) (1-0.28)60/40 Ke= 0.08+ 0.0216 Ke= 10.16% 13. Question ID: 17653 Correct Answer: A Information asymmetry suggests that in the event of a mismatch of information between stakeholders and the management, the costs of capital to the company increase due to a higher uncertainty of management reliability. 14. Question ID: 17654 Correct Answer: B Static trade off theory dictates that the optimal capital structure lies at the point where the costs of financial distress are exactly offset by the incremental tax benefit. 15. Question ID: 17655 Correct Answer: B

Assets Debt Equity Before Tax Cost of Debt After Tax Cost of Debt Cost of Equity WACC

0% Debt $45 million $0 million $45 million -

50% Debt $45 million $22.5 million $22.5 million 8%

75% Debt $45 million $33.75 million $11.25 million 11%

12% 12%

5.76% 15% 10.38%

7.92% 18% 10.44%

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Reading 21

Capital Structure

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16. Question ID: 17656 Correct Answer: B When the company’s WACC increases upon raising additional debt, it indicates that the capitalization ratios have exceeded their optimal range. As a result, the costs of financial distress exceed the additional tax benefit incurred. 17. Question ID: 17657 Correct Answer: A An increase in transparency would lead to a decrease in agency costs as there would be less need of monitoring. the clear unabridged view of the company given to the stakeholders would increase their confidence in the company. 18. Question ID: 17658 Correct Answer: C Raising additional debt would limit the financial flexibility of the firm because of more strict covenants and greater payment obligations. This would not give managers room for moving corporate funds to private holdings. Additional equity would decrease leverage and increase agency costs. Dividends once announced are also n obligatory cash outflow. 19. Question ID: 17660 Correct Answer: B Common law is passed through generations due to the presence of relatable precedents. The legal system is deemed to be more efficient for a country following common law policies. Since the equity holders would be ensured of justice in case of management fraud, they would be prone to invest in equity. This would lead to a lower debt to equity ratio. 20. Question ID: 17661 Correct Answer: A Since institutional investors would be trading large chunks of equity in the market, the cost of equity would be relatively low as compared to a company in a market with a major composition of private individual investors. 21. Question ID: 17662 Correct Answer: A In a legally efficient system, investors would be comfortable with investing for long term periods without fear of repayment by company or manipulation by management. 22. Question ID: 17663 Correct Answer: A In a country with high inflation rate, investors prefer equity investments rather than debt investments. This is because the constant stream of cash available from debt investments may not be reinvested in a suitable project. To avoid this reinvestment risk and currency depreciation risk, investors in such a country prefer equity investments. 23. Question ID: 17664 Correct Answer: B Bank based financial markets prefer debt investments as compared to equity investment. The high concentration of tradable debt in a market would lead to a decreased cost of debt.

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Reading 21

Capital Structure

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24. Question ID: 17665 Correct Answer: A The existence of a natural monopoly in a country mitigates private sector investments in that industry. Upon the establishment of a private firm that aims to become a competition for the monopoly, investors may be hard to come by. Hence, debt would be most likely generated. 25. Question ID: 17667 Correct Answer: A An increase in debt level would increase the covenant restrictions on the management. Additionally, the company will need to payout constant interest payments as highlighted by the term of the indenture. This cash unavailability would lead to an immediate decrease in agency costs as there would be a lesser need to monitor the management. 26. Question ID: 17668 Correct Answer: A Investors are more likely to invest in a company with a well-maintained corporate governance system in place. This is because they would qualify the management as trustworthy due to the fact that they follow governance regulations. 27. Question ID: 17669 Correct Answer: B A AAA rating does not necessarily indicate absence of financial distress. The probability of financial distress is always present, granted it may be lower for firms with high credit ratings. 28. Question ID: 17670 Correct Answer: A Retained earnings are the cheapest source of funds in the opinion of a company’s management. Consequently, debt follows due to its tax saving benefits and equity is preferred only to be issued as a last resort. 29. Question ID: 17671 Correct Answer: B If a stock is believed to be overvalued, the management should float additional shares in the market. This would lead to an increased number of floating shares and a likely decrease in price. 30. Question ID: 17672 Correct Answer: A Since the company has recently acquired multiple companies using different mixes of debt and equity capital, its capitalization ratio may be quite volatile at the moment. Until it gets stable, the target capital structure should be used to calculate the WACC of the entity. 31. Question ID: 17674 Correct Answer: A WACC= [Kd*(1-T)*D/V] + [Ke*E/V] WACC= [11 %*( 0.78)*75/150] + [21%*75/150] WACC= 4.29% + 10.5% WACC= 14.79%

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Reading 21

Capital Structure

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32. Question ID: 17675 Correct Answer: C WACCL= WACCUL=11% Value of geared company=Value of un-geared company Value of un-geared company= EBIT/WACC Value of un-geared company=$6million/0.11= $54 million. 33. Question ID: 17676 Correct Answer: B A company’s operating margin and operating income are not affected by changes in the capital structure. Net margin and net income would change as a result of changes in capital structure due to the accommodation of interest in the net income figure. 34. Question ID: 17677 Correct Answer: A Value of leveraged co= Value of unlevered company + (Tax rate*Debt) Value of leveraged co=$450 million + (22%* $45 million) Value of leveraged co=$450 million + $ 9.9 million= $459.9 million. 35. Question ID: 17678 Correct Answer: C Debt/ Equity= 70% Value of Debt= $140 million Value of Equity= $140 million/ 0.7= $200 million. WACC= [KD*D/V] + [Ke*E/V] WACC= [8%*140/340] + [15%*200/340] WACC= 3.29%+ 8.82% WACC= 12.11% Ke= r0+ (r0-rd) D/E Ke= 12.11%+ (12.11%-8%) 140/200 Ke= 14.99% 36. Question ID: 17679 Correct Answer: A Value= Debt + Equity= Interest/ Kd + (EBIT- Interest)/ Ke Value= $16 million/0.08 + ($54 million-$16 million)/0.15 Value= $200 million+$253 million= $453 million.

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Reading 22

Dividends and Share Repurchases: Analysis

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FinQuiz.com CFA Level II Item-set - Solution Study Session 7 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 22

Dividends and Share Repurchases: Analysis

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FinQuiz Level II 2019 – Item-sets Solution Reading 22: Dividends and Share Repurchases: Analysis 1. Question ID: 10692 Correct Answer: B Theory 1: According to the tax argument, an investor residing in a country with higher marginal tax rates for dividend income relative to capital gains, should prefer companies that pay lower dividends and reinvest earnings in profitable growth opportunities. This theory has been inaccurately described by Walters. Theory 2: According to the bird in hand argument, investors prefer a dollar of dividends over a dollar of capital gains as they perceive the former to have greater economic value and lower risk relative to the latter. Thus companies that pay more dividends relative to capital gains, have lower costs of equity capital. This theory has been accurately described by Walters. Theory 3: According to the MM Dividend Irrelevance Proposition, investors assume capital markets are perfect, no taxes and transaction costs exist, and investors have access to equal information. Thus if a company’s dividend policy pays a lower level of dividend relative to the investor’s need for income, the investor can construct their own dividend policy by selling sufficient shares to create their own income stream. This theory has been accurately described by Walters. 2. Question ID: 10693 Correct Answer: A R.W. Automobiles: Based on the current and future earnings volatility, the relative riskiness of the company’s stock will increase, thereby increasing the cost of the corporation’s equity capital and decreasing its share price. HealthCare Pharmaceuticals: Although a policy to resume current dividends is generally viewed as a positive signal from a corporation to its investors that a company’s future prospects will improve which ought to increase share price. However, based on the corporation’s future prospects, a continuous decline in the sales trend and product demand signals future prospects are not too bright. Thus future dividend cuts will signal a fall in corporate share price. W.T. Manufacturing Inc.: A cut in dividends is often perceived as a strong negative signal regarding the firm’s future prospects. Furthermore, a dividend cut following poor profitability forecasts will lead to lower investor confidence regarding the corporation’s future and a lower share price. 3. Question ID: 10694 Correct Answer: C Based on Knox’s marginal tax rates, after taxes, $1 in dividends is worth $1(1 – 0.35) / (1 – 0.40) = $1.08 in capital gains. Since $1.50 exceeds $1.08, Knox would prefer $1 in capital gains to $1 in dividends. Alternatively, $1.50 in capital gains will give Knox ($1.50) (1 – 0.40) = $0.90 capital gains after tax compared with $0.65 = $1 × (1 – 0.35) after tax for $1 of dividends. 4. Question ID: 10695 Correct Answer: B Generally agency conflicts occur because the owners of a corporation are distinct from the managers. This agency conflict may tempt managers to engage in activities which are contrary to the owners’

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Reading 22

Dividends and Share Repurchases: Analysis

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best interest. One such action is investment in negative net present value (NPV) projects where management may waste shareholder funds on projects which give them more operational control but fail to generate shareholder value. This is known as the potential overinvestment agency problem and may also occur when the firm has significant cash flows in excess of the potential profitable projects available. In order to resolve such conflicts, managers may be required to pay out all the company’s free cash flow as dividends such that they have insufficient cash to squander. In the case of Manufacturer A, a lack of operating cash flows relative to the potential oil supplier contracts makes the occurrence of the overinvestment agency problem less likely. Additionally, the presence of non-executives, although equal in number to executives, makes the occurrence of the overinvestment agency problem less likely relative to Manufacturer B, which lacks board independence. The presence of non-executives will bring a heightened level of monitoring and help to reduce agency conflicts. In the case of manufacturer B, the availability of operating cash flows relative to the profitable projects makes the occurrence of the overinvestment agency problem more likely as management will have access to excess funds, which they may utilize for personal benefit. Additionally, the lack of non-executives on the firm’s board heightens the potential for the occurrence of agency conflicts due to the lack of board independence. Thus investors are more likely to pressurize B to increase its dividends per share due to the potential occurrence of the overinvestment agency problem. Gates has been inaccurate with respect to A experiencing such a problem. 5. Question ID: 10696 Correct Answer: B The formula used to calculate dividend is: = Earnings – (Capital budget × Equity Percent in capital structure) Earnings Capital Spending Financed from new debt Financed from retained earnings Financed from new equity or debt Residual cash flow/Residual dividend

$645 million $850 million 0.55 × $850 million = $467.5 million 0.45 × $850 million = $382.5 million $0 $645 million - $382.5 million = $262.5 million

6. Question ID: 10697 Correct Answer: C The benefits of a share repurchase program are: I. a company can use share repurchases as a supplement to regular cash dividends. Thus it may compensate for a lower level of dividends; II. it will help to increase the firm’s EPS at the cost of increasing financial leverage (lower denominator for both measures due to a reduction in shares outstanding) and return on equity (due to the increase in leverage); III. may be interpreted as a signal to investors by management that the company considers its shares a good investment and that the firm’s future prospects are strong; and IV. it provides managerial flexibility by not forcing management to commit to an announced share repurchase. In contrast, when announcing the annual dividend management has a commitment to pay the dividend promised. An announced share repurchase in the open

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Reading 22

Dividends and Share Repurchases: Analysis

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market is not followed by an obligation to follow through with repurchases. Management may repurchase shares in the market at their discretion. Additionally shareholder participation in such programs is optional, unlike the receipt of dividends, which provides shareholders flexibility. Gates has inaccurately identified benefits II and IV. 7. Question ID: 15737 Correct Answer: B Williamson’s statement does not correctly highlight the impact of the dividend payout ratio on the firm’s per share value with respect to the clientele effect. The clientele effect suggests that when the dividend market is in equilibrium, meaning that the demands of all clienteles for various dividend policies are satisfied by sufficient number of companies, a company cannot affect its share value by changing its dividend policy. With at least three competitors providing a dividend payout ratio in the 29% – 32% range (T.N. Farms, Bateson Wells Inc., and Daily Dairy) opting for the highest dividend payout ratio (32%) will not affect Walker-Oats Corporation’s per share value. Knight’s statement correctly highlights the impact of the dividend payout ratio on the firm’s per share value with respect to the dividend irrelevance argument. The argument states that the firm’s dividend policy should have no impact on its cost of capital or shareholder wealth. Furthermore the argument states that dividend policy is irrelevant to share value. According to this proposition, if the firm adopts a payout ratio, which shareholders do not agree with, shareholders can construct their own policy as policy alternatives merely involve tradeoffs of different dividend streams of equal present values. 8. Question ID: 15738 Correct Answer: A If the firm uses its excess free cash flow generated to pay dividends, in the event that it has a lack of profitable investment projects available, paying dividends may help to alleviate the overinvestment agency problem where management invest in negative NPV projects merely to enhance their span of control. This issue may be alleviated because the payment of excess free cash flow as dividends constrains the ability of managers to overinvest in negative NPV projects. It is unlikely that a policy to use excess cash to pay dividends will alleviate the agency conflicts between bondholders and shareholders. Paying dividends reduces the cash cushion available to the company for the disbursement of fixed payments to bondholders. The payment of large dividends could be seen as effectively transferring wealth from bondholders to shareholders. The use of excess free cash flow to pay dividends is unlikely to alleviate or create share overhang. 9. Question ID: 15739 Correct Answer: B Amongst the factors that influence setting a dividend policy, the factor which has influenced Robinson’s second suggestion is the importance to retain financially flexibility. This is because he proposes using the excess cash to provide for a liquidity reserve, as opposed to making dividend payments, in order to obtain financial flexibility to fund unexpected needs. He has not proposed using the excess cash to fund profitable investment opportunities at the expense of omitting or cutting dividend payments. Thus the factor, investment opportunities, has not influenced his policy proposal.

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Reading 22

Dividends and Share Repurchases: Analysis

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Robinson has not shown any concern regarding earnings volatility. Thus the factor, expected future earnings volatility, has not influenced his policy proposal. 10. Question ID: 15740 Correct Answer: C •


  

The debt ratio (debt/asset) =
  
   = *The debt/equity ratio is 0.25, which implies

0.25 = 0.20 0.25 +1.00 *

0.25 . Thus, total equity is 1.00. 1.00

•

Thus, Equity/total assets ratio = 1 – 0.20 = 0.80

•

Total Assets = $3,125,000 =

• •

Thus total debt = $3,125,000 – $2,500,000 = $625,000 The repurchase amount is $200,000 ($2,500,000 × 8%).

$2, 500, 000 0.8

The debt and equity amounts as well as ratios under the ‘before buyback’, after ‘buyback using excess cash’, and ‘after buyback using additional borrowed funds’ scenarios are compared as follows: After Buyback Before Buyback

Debt* Equity (at market)**

All Cash

All Debt

$

%

$

%

$

%

625,000

20.00

625,000

21.37

825,000

26.40

2,500,000

80.00

2,300,000

78.63

2,300,000

73.60

Total Capitalization 3,125,000 100.00 2,925,000 100.00 3,125,000 100.00 * Under the ‘After Buyback All Debt’ strategy the value of the debt is increased by the additional funds borrowed to finance the share repurchase, i.e. $200,000. **Under both ‘After Buyback’ strategies, ‘All Cash’ and ‘All Debt’, the value of the equity is decreased by the share repurchase amount, i.e. $200,000. The share repurchase strategy should be conducted using excess cash as the debt ratio using excess cash (21.37%) is lower relative to the debt ratio generated under a repurchase strategy using borrowed funds (26.40%) by 5.03% (26.40% − 21.37%). 11. Question ID: 15741 Correct Answer: A The earnings/dividend coverage ratios (net income/dividends paid) are calculated in order to analyze the safety of the firm’s dividend policy and/or repurchase program.

Earnings/dividend coverage ratio

2010

2009

2008

£1,234 = 2.77 × £445

£993 = 2.72 × £365

£1,563 = 2.70 × £578

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Reading 22

Dividends and Share Repurchases: Analysis

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The earnings/dividend coverage ratio is increasing over the three-year period, which implies: • •

The firm has sufficient earnings to pay its dividends A small decline in earnings will not jeopardize the payment of dividends as net income in each of the three years exceeds the dividends paid.

Additionally, net borrowings are being increasingly used to fund share repurchases and dividend payments over the three year period. Such a policy cannot be sustained over the long-term due to the risks associated with increasing leverage levels. This indicates: • •

Dynasty Tours does not have a sustainable policy for funding share repurchases and dividends and it may need to eventually cut the dividends and/or curtail the share repurchase program.

12. Question ID: 15742 Correct Answer: C Amongst the three dividend policies, stable dividend policy; constant dividend payout policy; and residual dividend policy, the ‘Most Volatile’ dividend policy is the residual dividend policy whereby dividends may fluctuate from zero or low when capital expenditure needs are high (relative to internally generated funds) to high when the reverse situation occurs. The total dividends paid by Bon Appetite Cuisine for the year 2011, under this policy, are € 1.8 million.

Net income Capital spending/budget Financed from new debt Financed from retained earnings Financed from new equity or debt Residual cash flow = residual dividend

€’000 €4,000 €5,500 0.6 × €5,500 = €3,300 0.4 × €5,500 = €2,200 €0 €4,000 – €2,200 = € 1,800

13. Question ID: 17821 Correct Answer: A When the marginal tax rate of the investor is less than the marginal tax rate of the corporation, the investor receives the difference between the two rates in the form of tax credit.

14. Question ID: 17822 Correct Answer: C Dividend= Earnings – (Capital Expenditure x Equity percentage) Dividend= $8 million – ($13 million x 40%) Dividend= $8 million – ($5.2 million) Dividend= $2.8 million

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Reading 22

Dividends and Share Repurchases: Analysis

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15. Question ID: 17823 Correct Answer: A Investors will demand a higher return from a company following a residual dividend policy as compared to a company following a stable dividend policy. This is because they will face higher volatility of cash flows. 16. Question ID: 17824 Correct Answer: A When capital gains are taxed at a lower rate than dividends, it is beneficial for the company to return cash in the form as repurchases. 17. Question ID: 17825 Correct Answer: A Companies in developed countries offer higher share repurchase schemes than similar companies in developing countries. 18. Question ID: 17826 Correct Answer: B FCFE Coverage Ratio= FCFE/ (Dividend + Share Repurchase) FCFE Coverage Ratio= ($19,000,000 +$7,000,000 - $6,000,000)/ ($3,000,000 + $6.5 million) FCFE Coverage Ratio= $20 million / $9.5 million= 2.11 19. Question ID: 17828 Correct Answer: A Pension funds are tax-exempt institutions, which would make them indifferent between dividend returns and capital gain returns. 20. Question ID: 17829 Correct Answer: A The CFO is right in stating that investor requirements can be satisfied through sufficient capital gains. As the second component of equity return, capital gains can also be used to return money to the investor. 21. Question ID: 17830 Correct Answer: A The adverse effect in price due to the increase of supply of shares in the market after an issue is classified as flotation costs. 22. Question ID: 17831 Correct Answer: B The impairment of capital rule is a legal restriction that states that the net value of a balance sheet’s assets should not fall below a specified amount. 23. Question ID: 17832 Correct Answer: A As the company adheres to a stable dividend policy dictating an annual growth rate of 25%, an earnings decline would still increase the dividend amount paid at the end of next year.

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Reading 22

Dividends and Share Repurchases: Analysis

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24. Question ID: 17833 Correct Answer: C Expected Dividend = Last Year’s Dividend + (Increase in Earnings × Adjustment Factor × Target Payout Ratio) Expected Dividend = $5.45 + ($100,000,000/1,000,000 x 18% x 1/6) Expected Dividend = $5.45 + ($3) Expected Dividend = $8.45 25. Question ID: 17835 Correct Answer: B Statement A is correct. Stock splits does not affect any shareholder’s equity account. Statement B is incorrect. Generally, stock splits happen after significant rise in stock price to bring the price down to a level not perceived too high for investors. Statement C is correct. A two for one stock splits add one new share for every share currently held, as a result, a shareholder’s EPS will reduce to half. 26. Question ID: 17836 Correct Answer: C C is correct. If a company’s shares are trading at very low price, the company will opt for reverse stock splits. In case of reverse stock splits, decrease in number of shares outstanding, results in increase in share price, keeping the company’s underlying fundamentals unchanged. 27. Question ID: 17837 Correct Answer: A The first theory explained by Hector is the Dividend Irrelevancy Theory. It states that the investor is indifferent between return through capital gains or dividends. however, if an investor sells a portion of his shares in one period to recognize a capital gain, he will receive a lower amount of dividend in the next due to the reduced number of shares he is holding. 28. Question ID: 17838 Correct Answer: A The Clientele Effect states that the dividend market is in equilibrium. The return preferences of different types of investors are satisfied through the diverse policies adopted by different institutions. Therefore, the dividend policy will not affect the share price, as dictated by the Dividend Irrelevancy Theory. A change in dividend policy may lose some shareholders of a particular niche but will, in turn, attract shareholders from another. 29. Question ID: 17839 Correct Answer: B Cash Flow from Sale = Sale price – CGT on the capital gain upon sale Cash Flow from Sale = $65- ($65-$30)18% = $65 - $6.3 = $58.7 Total Cash Flow = $58.7 × 200,000 = $11,740,000 30. Question ID: 17840 Correct Answer: B Cash Flow from Sale = Sale price – CGT on the capital gain upon sale+ after-tax amount of dividend Cash Flow from Sale = $55- ($55-$30)18%+ $8(1-12%)

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Reading 22

Dividends and Share Repurchases: Analysis

Cash Flow from Sale = $55- $4.5 +$7.04= $57.54 Total Cash Flow = $57.54 x 200,000= $11,508,000

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Reading 23

Corporate Performance, Governance and Business Ethics

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FinQuiz.com CFA Level II Item-set - Solution Study Session 8 June 2019

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Reading 23

Corporate Performance, Governance and Business Ethics

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FinQuiz Level II 2019 – Item-sets Solution Reading 23: Corporate Performance, Governance and Business Ethics 1. Question ID: 26631 Correct Answer: A

A is correct. The compensation package of the senior portfolio managers highlighted in Scenario 1 is not performance-based and so introduces a principal-agent problem. When compensation is not based on company performance, the interests of managers may not be aligned with those of the stockholders. In this case, senior managers may not have significant incentive to attract new clients in order to regain business and restore firm profitability as they are compensated despite losing their key clients. B is incorrect. Scenario 2 does not highlight a potential principal-agent problem but rather highlights the failure of the employer to respect the right of their employees to compensation commensurate to their working hours. C is incorrect. Scenario 3 may be seen as strategy to alleviate any potential principal-agent problems. Under a ESOP program, employees are given the opportunity to become stockowners and the value of their holdings will increase each time stock price rises. Therefore, the interests of employees will be more aligned with those of stockholders; maximizing stock price to increase returns on their and the owners’ holdings. 2. Question ID: 26632 Correct Answer: A

A is correct. Scenario 2 reflects a potential ethical violation. By underpaying employees relative to the work expected of them, Bridge & Walters has provided substandard working conditions and so this is a clear example of unethical behavior in a corporate setting. 3. Question ID: 26633 Correct Answer: B

B is correct. Out of the steps listed, steps 3 and 4 are not integral to stakeholder impact analysis. The steps which are typically followed are: Step 1: Identify stakeholders Step 2: List down the interests and concerns of identified stakeholders. Step 3: Identify the claims stakeholders will make on an organization based on Step 2. Step 4: Identify the key stakeholders (most important from the organization’s perspective). Step 6: Identify the strategic challenges in meeting claims.

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Reading 23

Corporate Performance, Governance and Business Ethics

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4. Question ID: 26634 Correct Answer: B

B is correct. The stakeholder impact analysis will provide managers with a useful approach to frame any discussion of rights. Rights theories stress on the fundamental human rights and privileges which the manager must consider when addressing stakeholder needs while stakeholder impact analysis will allow for the framing of these rights and privileges. 5. Question ID: 26635 Correct Answer: A

A is correct. The Friedman doctrine asserts that the only social responsibility of businesses is to increase profits as long as the company stays within the rules of the law. Therefore, the theory rejects any social investments which are either not required by the law or for the efficient running of businesses. Because the company’s products have received clearance from the concerned regulatory authority, they will not be expected to undertake further social expenditures to satisfy the concerns of health care officials according to this doctrine. B and C are incorrect (see above). 6. Question ID: 26636 Correct Answer: C

C is correct. Scenario 5 most closely reflects justice theories. By implementing a whistleblowing channel, employees have been provided with the liberty of being able to report an unethical or otherwise illegal violation with full autonomy. This system will act to protect their freedom to execute ethical responsibilities. A is incorrect. Kantian ethics is concerned with treating individuals with dignity and respect. The liberties provided to employees by the whistleblowing channel go beyond this philosophical approach. B is incorrect. Utilitarianism focuses on the maximizing good for the greatest number of people. The implementation of a whistleblowing channel is not consistent with this approach which does not consider justice and therefore will not recognize the need to implement a channel which grants employees with the liberty to report violations in a confidential manner.

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Reading 24

Corporate Governance

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FinQuiz.com CFA Level II Item-set - Solution Study Session 8 June 2019

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Reading 24

Corporate Governance

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FinQuiz Level II 2019 – Item-sets Solution Reading 24: Corporate Governance 1. Question ID: 10857 Correct Answer: A Corporate governance best practices recommend that at least three quarters of the board members should be independent (or, put another way, the number of dependent members should not exceed 25%). The current composition of the board comprises of 6 executives and 7 non-executives (the nonexecutives are independent and executives are generally not independent). Thus 46% of the board comprises of executives, which is clearly more than the 25% advised. An executive holding the dual position of a supplier and executive does not satisfy the independence criteria (directors holding a supplier relationship with the company imply a lack of independence) set by the provisions. Thus the board composition is not in agreement with best practice recommendations for reasons attributable to the proportions of executives and non-executives (dependent vs. independent members) as well the relationship the executive holds with the company. 2. Question ID: 10858 Correct Answer: C The corporate governance guidelines for each policy sub-component is discussed below together with an evaluation of whether each sub-component complies with the guidelines. I:

With respect to the qualifications of directors, best practice recommends executives to have relevant expertise in the industry and in financial operations; legal matters; and accounting and auditing. By requiring all executives to have a minimum 8 years experience with the telecommunications industry together with knowledge of the company’s product base, sub-component I is consistent with best practice guidelines.

II:

By placing a relatively lower level of importance on accounting and auditing knowledge relative to industry experience and product knowledge, sub-component II is inconsistent with best practice guidelines (see above).

III: Best practice guidelines recommend indications of ethical soundness by elected board members including any public statements or writings by the executive pertaining to problems in companies with which (s)he has been associated with in the past such as legal or other regulatory violations involving ethical lapses. By requiring a written statement from executives of involvements in past legal violations and/or fraudulent practices, subcomponent III is consistent with this recommendation. IV: Best practice guidelines recommend the chairman of the board be separate from the senior executive. If the positions are not separate, an investor may doubt the efficiency and effectiveness of the board’s monitoring and oversight activities. If the senior executive is appointed as chairman, the independence of the board may be compromised as the chairman may be influenced by the firm’s management. Thus subcomponent IV does not comply with best

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Reading 24

Corporate Governance

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practice recommendations. If the firm experiences difficulty in appointing an outsider as chairman, the firm may appoint an individual within the firm as chairman provided they have no affiliations (business or personal) with company management. 3. Question ID: 10859 Correct Answer: B I: Best practice codes recommend the compensation committee to be composed entirely of independent members. This subcomponent satisfies this recommendation. II:

Best practice recommends that executive compensation should include incentives to meet longterm goals. However the practice of setting compensation rewards based on comparison to the levels of compensation paid by other companies may not encourage executives to work in the best interests of shareholders as it is not related to the long-term performance of the company. Thus the practice of determining executive compensation packages, adopted by the firm, is not consistent with this provision.

III: Best practice guidelines recommend executive compensation package have a minimum level of compensation unrelated to company performance such as salary and perquisites and be dominated by stock options and restricted stocks whose payoff is related to the performance of the firm. The firm’s existing compensation package satisfies this recommendation as it is dominated by performance-based compensation (90% stocks options and bonuses vs. 10% salary). 4. Question ID: 10860 Correct Answer: B I: The purpose of the audit committee is to provide independent oversight of the company’s financial reporting, non-financial corporate disclosure, and internal control systems. Subcomponent I is consistent with this purpose. II:

Best practice recommends that members have sufficient expertise in financial, accounting, auditing, and legal matters to be able to adequately oversee and evaluate the control, risk management, and compliance systems. Additionally it is advisable for at least two members of the committee to have relevant accounting and auditing expertise. Thus subcomponent II satisfies this recommendation.

III: Best practice recommends the audit committee have full access to and cooperation of management and have authority to investigate fully any matters within its purview. Thus subcomponent III is consistent with this recommendation. IV: Best practice recommends that the internal audit staff should report direct to the audit committee. A policy which requires internal auditors to report to the audit committee through an intermediary (the senior officer) makes subcomponent IV inconsistent with best practice codes. 5. Question ID: 10861 Correct Answer: C Observation 1: Although granting stock options to executives and management is intended to motivate the recipients (of such options) to work in the shareholders’ best interests, large grants of stock options can dilute shareholders’ positions in the company and diminish the value of their holdings. The stock option’s potential dilutive effect is measured by the share overhang (measuring the total number of shares represented by the options relative to the total amount of stock outstanding). A rising trend in the share overhang measure implies an erosion of the value of equity

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Reading 24

Corporate Governance

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holdings. Thus a large grant of stock options (reflecting a rising trend in the share overhang measure) reflects a practice inconsistent with best practice provisions. Observation 2: The board of directors should have the ability and sufficient resources to hire legal and other experts, as required, in order to fulfill their fiduciary duties. Although board members have the liberty to employ such experts at T.S. Telecommunications Inc., subjecting the funds to an authorization process does not grant the board with total freedom. This is because prior to hiring the experts, the funds must be approved by senior management. This observation reflects a practice inconsistent with best practice recommendations. Observation 3: It is important that directors and executives take their fiduciary responsibilities to shareholders seriously particularly in the case of their response of shareholder votes on proxy matters. T.S.’s merger proposal was rejected by a majority shareholder vote. However, T.S. executives demonstrate that they are not concerned with the shareholders’ best interests as they have arranged meetings with the competitor to discuss the proposal. This observation clearly reflects a practice which is inconsistent with best practice recommendations. 6. Question ID: 10862 Correct Answer: C Accounting risk is the risk that a company’s financial statements and related disclosures, upon which investors base their financial decisions, are incomplete, misleading, or materially misstated. Asset risk is the risk that the firm’s assets will be misappropriated by managers or directors in the form of excessive compensation or perquisites. Liability risk is the risk that management will enter into excessive obligations on the shareholder’s behalf that effectively destroy the value of shareholder’s equity. Strategic policy risk is the risk that managers may enter into transactions that may not be in the best long-term interests of shareholders, but may result in large payoffs for managers or directors. Issue 1: Investing in short-term risky securities whose profits will be allocated to director personal accounts reflects asset risk (as directors have been using shareholder funds for their benefit) and strategic policy risk (the characteristics of the investment are unsuitable for shareholders as it exposes the shareholders to excessive risk over a short time horizon, but results in large payoffs for directors). Issue 2: Issue 2 reflects liability risk. Directors have entered into excessive obligations (loan contracts) on behalf of the shareholders. 7. Question ID: 15730 Correct Answer: B Although it is general practice among boards to delegate responsibilities to firm management, the board remains responsible for monitoring management activities. By failing to ensure that Applegate’s management fulfills its loan repayment responsibilities properly, the board has not conducted its oversight responsibilities adequately. In doing so, it has failed to ensure that the obligations to stakeholders, in this case the bank, are met in a timely and complete manner, i.e. on scheduled repayment dates.

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Reading 24

Corporate Governance

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8. Question ID: 15731 Correct Answer: C By jointly owning and managing a personal investment portfolio with Applegate’s senior portfolio manager, Thompson, the independence of Beridze as a board member may be compromised. This is because he may be unduly pressurized to fulfill Thompson’s favors in order to maintain the relationship he holds with the manager outside the firm at the expense of his duties to the firm’s shareholders. Thus, Beridze’s potential lack of independence as a board member may be a concern for Applegate. It is important that individual board members have relevant experience in the industry of the firm they represent. Although Beridze has served investment advisory firms, his experience is limited to institutional investor clients as opposed to individual investors. His lack of experience with the latter investor category suggests a lack of relevant experience. Thus, the lack of Beridze’s experience with such a category may be a concern for Applegate. There has been no reference regarding past ethical lapses with which Beridze may have been involved. Thus this factor will least likely concern Applegate relative to the other two factors. 9. Question ID: 15732 Correct Answer: B Suggestion 1 will not help to improve the quality of Applegate’s corporate governance system. In general, the election of the board on a staggered basis, whereby only a portion of the board stand for re-election each year, does not grant shareholders the power to control who will serve the board and thus ensure the responsiveness of board members to investor concerns. Annual re-election of the entire board ensures shareholders are able to express their views on individual member’s performance during each period and to exercise their right to control who will represent them in the governance and oversight of the firm. Davis’s first suggestion calls for staggered board elections. Suggestion 2 will help to improve the quality of Applegate’s corporate governance system. Corporate governance codes of best practice recommend boards have an audit committee comprised solely of independent directors who have sufficient expertise in financial, auditing, accounting, and legal matters to ensure they are able to oversee and evaluate a firm’s control, risk management and compliance systems. Furthermore, it is advisable for at least two members of the committee to have relevant accounting and auditing expertise. 10. Question ID: 15733 Correct Answer: A Codes of best practice recommend that compensation should be used as a tool to attract, retain, and motivate talented individuals. The compensation should include incentives to meet and exceed longterm corporate goals, rather than short-term performance targets. Shareholders prefer that salary and perquisites constitute a relative small proportion of the compensation package. That is, salary should be adequate but not excessive. Additionally, bonuses should be awarded based solely on exceeding expected performance. Stock options and restricted stock grants help to align the interest of managers with those of shareholders. The salary component comprises 25% of the total compensation and is adequate. This component is smaller relative to the other components, which make up a total of 75% of the total compensation. The proposed components of compensation which focus on the long-term and/or expected performance, i.e. stock options; restricted stock grants; and bonuses, dominate the compensation

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Reading 24

Corporate Governance

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package (consuming a proportion of 75% of the total compensation) and are thus consistent with best practice recommendations. 11. Question ID: 15734 Correct Answer: C As outlined by Task 3, by determining how ‘corporate affairs are conducted’… at ‘board and annual firm meetings’, the regulator has already planned to explore the responsiveness of the board of directors to shareholder proxy votes, conducted at annual company meetings. This task need not be undertaken since it has been currently planned. As outlined by Task 2, a ‘detailed analysis of firm’s financial statements’ and accompanying disclosures entails evaluating the quality, clarity, and completeness of financial information. This task need not be undertaken since it has been currently planned. Since the board has approved the executive compensation package, the regulator may need to assess the potential for stock options to dilute potential shareholding (share overhang). This is because following the implementation of the compensation package stock options and restricted stock grants will be issued which have the potential to dilute shares in the future. This is a task which may need to be undertaken in addition to the three tasks currently planned. 12. Question ID: 15735 Correct Answer: A Problem area 1 reflects a weakness in a core attribute of Applegate’s corporate governance system. A core attribute of a sound corporate governance system includes fairness and equitable treatment in all dealing between managers, directors, and shareholders. Failing to inform shareholders about company meetings where important decisions were made and which required shareholder votes, does not reflect fair dealing. Problem area 2 reflects a weakness in a core attribute of Applegate’s corporate governance system. A core attribute of a sound corporate governance system includes complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position. Failing to disclose offbalance sheet liabilities on its financial statements reflects a weakness in the core attributes of a sound corporate governance system. 13. Question ID: 17842 Correct Answer: C The trade union discrepancy may give rise to a number of lawsuits filed against the company by current and former employees. Thus, the company is exposed to legal risk. It is also vulnerable to reputational risk, as widespread public knowledge of this would lead to a decrease in the entity’s reputation and the possible loss of market value. 14. Question ID: 17843 Correct Answer: C As the corporate assets of the entity are being directed into the director’s personal trading account, they are not being allocated to opportunities that would earn the maximum benefit for its shareholders. Thus, this activity qualifies as an asset risk. This misallocation is also a strategic policy risk as a director has entered into an activity using corporate funds that is not in the best long-term interests of the shareholders of TBE.

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Reading 24

Corporate Governance

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15. Question ID: 17844 Correct Answer: B Best practice dictates minimal capitalization of interest and overhead costs and rapid write-off of all overhead costs. 16. Question ID: 17845 Correct Answer: B A Statement of Government Policies and a Board Self-Assessment Report should be disclosed along with the annual report according to the best practice under corporate governance regulations. 17. Question ID: 17846 Correct Answer: B According to best practice, the stock options should comprise of a major portion of the compensation package while only a small proportion should be allocated to the actual salary payment. 18. Question ID: 17847 Correct Answer: A The LIFO method should be used under corporate governance guidelines as it imparts the inflated inventory costs to the most recent time period. The inflated cost will be captured in the relevant time period and is, therefore, the prudent way of dealing with inventory costs. 19. Question ID: 17849 Correct Answer: C Corporate governance disclosures are presented in the 10-K report, the annual report and the proxy statement by companies following the US GAAP regulations. 20. Question ID: 17850 Correct Answer: B Dave Crosby is the most eligible candidate for the position as he is the current operating manager and, therefore, possesses detailed knowledge of all operational information. His performance has been exceptional during his employment tenure and there is no reason not to promote him to an executive position. He is, however, currently a senior manager and may have an existing and personal relationship with existing management. Regardless of this factor, the other candidates are less eligible for the position. Arnold Calway is a close high school friend of Crosby and this relation falls under the criteria for related party identification. He is also the director of an automobile dealership and, thus, has a vested interest in acquiring a directorship position in an automobile manufacturing entity. Elizabeth Tesan also has a vested interest in the directorship position as she is the partner at a firm currently providing outsourcing services o Allied Autos. 21. Question ID: 17851 Correct Answer: A The independent board members of an organization are required to have at least one annual meeting in isolation from the executive members.

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Reading 24

Corporate Governance

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22. Question ID: 17852 Correct Answer: A The audit committee is to be comprised entirely of independent directors under corporate governance guidelines. 23. Question ID: 17853 Correct Answer: A The nomination committee is to be comprised entirely of independent board members under corporate governance guidelines. 24. Question ID: 17854 Correct Answer: C Dilutive shares = 400,000*25= 10,000,000 Total Number of Shares = 16 million Share Overhang = Number of Dilutive Shares/ Total Number of Shares = 10million/ 16 million = 0.625

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Reading 25

Mergers and Acquisitions

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FinQuiz.com CFA Level II Item-set - Solution Study Session 8 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 25

Mergers and Acquisitions

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FinQuiz Level II 2019 – Item-sets Solution Reading 25: Mergers and Acquisitions 1. Question ID: 10864 Correct Answer: B Conclusion 1: One of the motives given for mergers is that they may help to increase market power. This motive is valid in the case of horizontal and vertical mergers. Given the proposed merger between Skyline Associates and Griston Builders Inc. is a proposed vertical merger (backwardation), a vertical merger will help to lock in the services of the construction team, which are a critical service to Skyline Associates. By locking in the supply of services, the real estate developer could be in a position to influence industry outputs and/or have a measure of control over commercial real estate developed property prices. Furthermore by merging with a foreign construction firm, Skyline Associates will be better placed to serve clients situated in other countries. Thus this conclusion is justified. Conclusion 2: Diversification is sometimes quoted as a motive behind mergers. However such a motive is relevant to a conglomerate investing in companies in industries which have a low correlation to the industry to which the conglomerate belongs. One motive behind cross-border mergers is that they enable companies to exploit potential market inefficiencies by gaining access to cheaper sources of labor. Given the current economic and unemployment situation of the developing country, local labor will be more than willing to work for lower levels of compensation. Thus such a motive is justified. However since the merger in question is a vertical merger in the same industry, the diversification motive stated as part of conclusion 2 is not justified. Conclusion 3: Foreign M&A activity has gained more popularity over the years. One of the motives behind cross-border acquisitions is that it may help circumvent disadvantageous government policy as the firm will be given a local identity in the local/foreign market, once and if merged with Griston Builders Inc. Thus a merger may the only way to overcome the barriers to foreign competition imposed by the local government. Thus conclusion 3 is justified. 2. Question ID: 10865 Correct Answer: B Post-merger value of the combined company (VA*) = VA + VT + S – C VA* = $1,500 + $200 + $950 – ($8 × 50) VA* = $2,250 million Number of new shares issued by Skyline Associates = 0.85 × 50 = 42.5 million. The total number of Skyline Associates’ combined shares after the merger is 100 + 42.5 = 142.5 million The post-merger per share value given to Griston Builders Inc. is $2,250 million/142.5 million = $15.79.

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Reading 25

Mergers and Acquisitions

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Acquirer’s Gains = Synergies – Premium = S – (PT – VT) The total value paid to Griston Builders Inc.’s shareholders is, including the cash component of $400 million ($8 × 50 million) and a stock component of $671.08 ($15.79 × 42.5 million), is $1,071.08 million. The premium is $871.08 million ($1,071.08 million - $200 million). Acquirer’s Gain = $950 million – $871.08 million = $78.93 million 3. Question ID: 10866 Correct Answer: A When stock is used as payment or offered to the target’s shareholders, the target shareholders become part owners of the acquiring company. As part owners, these shareholders share in the post-merger gains and losses. However when cash is paid, target shareholders no longer remain owners in the post-merger company and thus do not share in the post-merger gains and losses. The more confident the acquirer is that estimated synergies will be realized, the more the managers (of the acquirer) will prefer to pay with cash and more the target managers will prefer stock. When it is highly probable that actual synergies will be lower than the synergies predicted prior to the merger, the acquirer’s managers will prefer to issue stock (as they would like the target shareholders to share the losses from a lower-than-expected synergy benefits estimate) whereas target management would prefer cash (as they would not like to share in the losses). Thus the consultant’s comments with respect to expected synergies are incorrect. The other factor which decides the method of payment is the counterparties’ confidence in the companies’ relative values. The more confident the acquirer’s managers are in estimates about the target company’s value, the more the acquirer would prefer cash and the more the target would prefer stock. Thus the consultant’s comment with respect to confidence in target valuation is correct. 4. Question ID: 10867 Correct Answer: B Since K. Shaw Development Corp. has made a takeover offer any pre-takeover defenses suggested will not be effective. Each of the proposed defenses is analyzed for effectiveness below. Defense 1: This illustrates the post-takeover defense, ‘greenmail’. However in order for the defense to be effective the target must agree to purchase its own shares back from the acquirer usually at a premium to market price. A repurchase price involving a discount to market value will not be effective as the acquirer company shareholders will not be willing to sell their holdings back to the target at a loss, but would prefer to sell it in the market at the current market price. Additionally, the use of greenmail as a takeover defense is extremely restricted. For these reasons, the use of this defense will not be effective. Defense 2: This illustrates the post-takeover defense, ‘white-knight defense’. This defense can prove to be highly successful especially if the third party, rescuing the target, has a good strategic fit with it. Based on such a fit, the party can justify a high bid price which may cause the bidder to withdraw its takeover offer. Thus this defense is highly effective in the case of Skyline Associates if implemented as described. Defense 3: This illustrates the pre-takeover defense, ‘supermajority voting provision’. Although an amendment to the corporate charter to provide for a supermajority approval by shareholders for mergers may present the acquirer with significant difficulties in accumulating enough votes to

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Reading 25

Mergers and Acquisitions

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approve a merger, this defense in no longer effective once the offer has been made. Such is the case with Skyline Associates. 5. Question ID: 10868 Correct Answer: B Generally there are two forms of acquisition, stock and asset purchases. Stock purchases involve the acquirer giving the target’s shareholders some combination of cash and securities in exchange for shares of the target company’s stock. An asset purchase involves the acquirer purchasing the target’s assets. In stock purchases, payments are made directly to shareholders in exchange for their shares and thus company shareholders are taxed on their capital gains. There are no corporate-level taxes. The consultant’s comment with respect to stock purchases is partially incorrect. In asset purchases, the acquirer company generally avoids the assumption of liabilities. Thus this form of acquisition is appropriate for the acquirer when it seeks to avoid the responsibility of target liabilities. The consultant’s comments with respect to asset purchases are correct. 6. Question ID: 10869 Correct Answer: A n

Herfindahl-Hirschman Index (HHI) =

∑
        × 100
     



i

The pre-merger HHI is = (35%)2 + (20%)2 + (10%)2 + (5%)2 + (4%)2 + (26%)2 = 2,442 The post-merger HHI (if the two firms are merged) = (35% + 20%)2 + (10%)2 + (5%)2 + (4%)2 + (26%)2 = 3,842 The difference between post-merger HHI and pre-merger HHI is 1,400 (3,842 – 2,442). Since the post-merger HHI is more than 1,800, this indicates that the real estate development industry following the merger will become heavily concentrated. With the difference between pre- and post-merger HHI being more than 50, the merger will evoke an antitrust challenge. 7. Question ID: 17856 Correct Answer: A Since the expected synergies from the merger are significantly favorable, the acquirer’s shareholders would prefer the takeover to be settled in cash. In this way, Comodo’s shareholders will not have an equity stake in Alcoa and Alcoa’s current shareholders would enjoy the entire future equity return without any dilution of control. 8. Question ID: 17857 Correct Answer: A Since Alcoa is considering bypassing Comodo’s management and approaching its shareholders directly, the act in itself qualifies as a hostile takeover. Through this method, the shareholders will be asked to vote for the proposed list by Alcoa for Comodo’s directors. This process is known as a proxy fight, through which Alcoa will be able to replace Comodo’s management.

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Reading 25

Mergers and Acquisitions

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9. Question ID: 17858 Correct Answer: C Due diligence is carried out by both the acquirer and the target. Alcoa will perform due diligence to ensure that Comodo’s assets are worth approximately what they are claimed by the target. Comodo will perform due diligence to examine whether Alcoa has the financial capacity to acquire it. 10. Question ID: 17859 Correct Answer: B Exchange ratio = 2 shares of Alcoa for 3 shares of Comodo Acquirer’s Cost = Exchange Ratio × number of shares outstanding of Comodo × value of Alcoa’s shares Acquirer’s Cost = 2/3 × 12,000,000 × $111= $888,000,000 11. Question ID: 17860 Correct Answer: A Changes made to the corporate constitution to deter any takeover bids are known as shark repellants. Since restricted voting rights require an amendment to the charter at the time of establishment, this pre-offer takeover defense qualifies as a shark repellant. 12. Question ID: 17861 Correct Answer: C Fair price amendments set a floor value bid for the target company. A typical fair price amendment would require Alcoa to pay at least as much as the highest stock price the target traded in the public market for a certain period of time. In this vignette, that span of time is three years. Therefore, the floor value for the minimum bid would be $63.00. 13. Question ID: 17863 Correct Answer: C As the two distinct entities have been merged to create a new, separate corporate entity, this merger will be classified as consolidation. 14. Question ID: 17864 Correct Answer: B As Enigma is developing technology that will be used as a research input by Sensol, Sensol is entering a backward integration. 15. Question ID: 17865 Correct Answer: A Conglomerates are formed as a result of unrelated diversification. Unrelated diversification assists in the smoothing of cash flows over the long term. 16. Question ID: 17866 Correct Answer: A As the integration will lead to a significant increase in the economies of scale of the acquirer, the synergies generated are cost synergies. 17. Question ID: 17867 Correct Answer: B The opportunity cost of time generally makes organic growth more risky than external growth. Management’s proprietary need of building up a company themselves may result in lost opportunities in terms of immediate sales.

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Reading 25

Mergers and Acquisitions

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18. Question ID: 17868 Correct Answer: A A company in its growth stage needs additional capital funds to expand existing capacity. It will most likely reinvest the cash generated through initial sales back into the entity. 19. Question ID: 17870 Correct Answer: B The reconciliation activity is a right available to the target’s board. This dad-hand provision gives the board the power to redeem or cancel the poison pills through a majority vote of the continuing directors. 20. Question ID: 17871 Correct Answer: B Greenmail is the agreement entered with the acquirer in which the target agrees to buy all of its own shares back from the acquiring company at a premium. 21. Question ID: 17872 Correct Answer: C The white squire defense may lead to minimal proceeds being forwarded to the target shareholders. Without receiving their control premiums, the shareholders may get restless and Antahl would face litigation risks. 22. Question ID: 17873 Correct Answer: B The Clayton Anti-Trust Act is not relevant for vertical and conglomerate mergers. As Omega is a chief supplier of Antahl, the merger is a forward integration. 23. Question ID: 17874 Correct Answer: C Anti-Trust laws are subject to review by The Federal Trade Commission and The Department of Justice. 24. Question ID: 17875 Correct Answer: A A HHI level of 780 indicates a market with low concentration. With minimal threat of monopolization, anti-trust regulators will not take any action against the merger. 25. Question ID: 17877 Correct Answer: A Target company’s shareholders are taxed on the capital gain realized through stock acquisition. On the other hand, there are no direct tax consequences of an asset purchase on the target’s shareholders. 26. Question ID: 17878 Correct Answer: C The conglomerate’s directors have adopted an aggressive strategy to increase their span of control and in turn, raise their compensation levels. Therefore, it is apparent that the management has adopted this strategy to favor their own personal incentives.

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Reading 25

Mergers and Acquisitions

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27. Question ID: 17879 Correct Answer: A A cross-border transaction can enable an entity to take advantage of market imperfections. The compensation difference between employees in the States and employees in the Philippines is a market imperfection. 28. Question ID: 17880 Correct Answer: B Since the environmental consultancy service has been accepted by the market, its sales are experiencing exponential growth, its profit margins are high and the number of established companies has had no effect on the demand, the industry can be classified as a rapidly accelerating growth industry. 29. Question ID: 17881 Correct Answer: C One of the characteristics of an industry in its market maturity stage is that it’s growth rate is the same as the overall economy’s growth rate. 30. Question ID: 17882 Correct Answer: A Assets which constitute 50% or more of a company’s balance sheets need shareholder approval before they can be sold by the company. The Competition Council may intercede in this transaction as the purchase of the state of the art assembly line may place Melkus’ competitor in a monopolized assembly position. 31. Question ID: 17884 Correct Answer: A Low premium amounts paid would increase the realized value to the acquirer as the net benefit from the expected synergies would be greater. 32. Question ID: 17885 Correct Answer: B Managerial hubris is the acquiring management’s tendency to overestimate the anticipated synergies from the acquisition. 33. Question ID: 17886 Correct Answer: A Managerial hubris is the overestimation of anticipated synergies by the acquiring management. This would lead to higher bids causing wealth to shift from the acquiring company’s shareholders to the target shareholders. 34. Question ID: 17887 Correct Answer: B The value calculated through the comparable transaction method faces less scrutiny for mispricing by stakeholders. This would lead to a decrease in litigation risk. 35. Question ID: 17888 Correct Answer: C Takeover Premium = (Deal Price- Current Stock Price)/Current Stock Price Takeover Premium = ($60- $53)/$53 = $7/$53 = 13.2%

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Reading 25

Mergers and Acquisitions

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36. Question ID: 17889 Correct Answer: C Takeover Premium = (Deal Price- Current Stock Price)/Current Stock Price Takeover Premium = ($60 – $53)/$53=$7/$53 = 13.2% Estimated Takeover Price = (Estimated Stock Price based on Comparables) × (1+ Takeover Premium) Estimated Takeover Price = $58 × (1.132) = $65.66 37. Question ID: 17891 Correct Answer: B All figures in $’000 Unlevered Net Income = Net Income + Interest After Tax = 10,700 + (1,600 × 0.75) = 11,900 38. Question ID: 17892 Correct Answer: B All figures in $’000 NOPLAT = Unlevered Net Income + Change in Deferred Taxes NOPLAT = 10,300 + (1,800 × 0.75) + 200 = 11,850 39. Question ID: 17893 Correct Answer: C All figures in $’000 Free Cash Flow = Net Income + Interest (After Tax) + Change in Deferred Taxes + Net Non Cash Charges – Changes in Net Working Capital – Capex Free Cash Flow = 9,000 + (1,200 × 0.75) – 200 +1,690 – 800 – 1500 = 9,090 40. Question ID: 17894 Correct Answer: C All figures in $’000 WACC= (0.09 × 60) + (0.20 × 40)] = 13.4% Free Cash Flow = Net Income + Interest (After Tax) + Change in Deferred Taxes + Net Non Cash Charges – Changes in Net Working Capital – Capex Free Cash Flow= 8,300 + (1200 × 0.75) + 500 + 1,250 – 800 – 4,500= 5,650 PV of Free Cash Flow= 5,650 / (1.134)2= 4,394 41. Question ID: 17895 Correct Answer: C The data required by the discounted cash flow method includes a lot of forecasts, estimates and assumptions. This data collected and processed by different analysts would lead to different conclusions. Thus, reliable data is difficult to acquire. 42. Question ID: 17896 Correct Answer: C A split off results in the issue of shares of a newly incorporated entity to the company’s existing shareholders in exchange for their shares of the parent company.

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Reading 25

Mergers and Acquisitions

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43. Question ID: 17898 Correct Answer: B The conditions of the bootstrapping effect are as follows: i. The acquirer’s P/E ratio should not decline after the merger. ii. The shares of the acquirer should trade at a higher P/E ratio as compared to the target’s P/E ratio. 44. Question ID: 17899 Correct Answer: A Number of shares to be issued = Capitalization of the Target/ Share Price of the Acquirer = $18,000,000/ $45= 400,000 shares 45. Question ID: 17900 Correct Answer: C Number of Shares Outstanding of Acquiree= $18,000,000/ $15= 1,200,000 Pre-merger EPS of Acquiree= $15/7= $2.1428 Pre-merger EPS of Acquirer= $45/16= $2.8125 Post Merger EPS = (Acquirer’s pre-merger Earnings+ Target’s pre-merger Earnings)/Post-merger number of shares outstanding Post Merger EPS = [($2.8125 × 15,000,000) × ($2.1428 × 1,200,000)]/ 15,400,000 Post Merger EPS = [$42,187,500 + $2,571,360]/ 15,400,000 Post Merger EPS = $2.906 46. Question ID: 17901 Correct Answer: B Post Merger P/E= Pre-merger stock price of Acquirer/ Post-merger EPS Post Merger P/E= $45/$2.5= 18 47. Question ID: 17902 Correct Answer: A As the fair value of the net assets is greater than the capitalization of the company, an immediate gain can be realized though acquiring the company at the capitalized amount and selling the assets at their break-up value. 48. Question ID: 17903 Correct Answer: B Asset purchases in the United States do not entitle the acquirer to the target’s accumulated tax losses. Therefore, Reffling will not be able to offset its income with the losses of the target.

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Reading 26

Equity Valuation: Applications and Processes

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FinQuiz.com CFA Level II Item-set - Solution Study Session 9 June 2019

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Reading 26

Equity Valuation: Applications and Processes

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FinQuiz Level II 2019 – Item-sets Solution Reading 26: Equity Valuation: Applications and Processes 1. Question ID: 10982 Correct Answer: B Equity valuation tools can be used to address a range of practical problems. Some of them include selecting stocks, rendering fairness opinions, evaluating business strategies and models, communicating with analysts and shareholders and appraising private businesses. In addition, equity valuation tools are also used to infer or extract market expectations by reverse engineering the value from the model used. They can also be used to evaluate corporate events such as mergers, acquisitions and leveraged recapitalizations. However, models cannot be used to ascertain a positive alpha since there is no guarantee of price convergence to intrinsic value (they can only be used to determine a stock’s intrinsic value). 2. Question ID: 10983 Correct Answer: C Statement 1 is incorrect. An asset based approach to valuation is an example of an absolute valuation approach that values a company on the basis of the market value of assets it controls. An asset based valuation can provide an independent estimate of value. Statement 2 is incorrect. Although it is true that the inputs to a valuation model need to be accurate and detailed, ‘quality of earnings analysis’ involves the investigation of issues related to the accuracy of reported accounting results. 3. Question ID: 10984 Correct Answer: A Long depreciable lives, high pension discount rates, and low assumed rate of compensation growth for pensions are non-conservative estimates that will lower expenses and boost reported income, probably to mask problems with performance. Low sales per employee are not an indication of low quality of earnings, however, they may indicate an inefficient use of human resource. Hence, longer depreciable lives and a higher discount rate assumed by Zee Enterprises are warning signs for the quality of its reported earnings. 4. Question ID: 10985 Correct Answer: C Company A has a dominant management team that sets revenue targets for employees. This indicates excessive pressure on employees to meet targets, which may result in aggressive reporting. Company B has management whose compensation is tied to the stock price or profitability. Such arrangements, although desirable, can indicate a risk of aggressive reporting as well.

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Reading 26

Equity Valuation: Applications and Processes

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5. Question ID: 10986 Correct Answer: B Since information about the stocks actual return over the year and required return is given, only the stocks ex post returns can be determined. For stock A: (38.99–33.78) + 1.78 + 2.31/33.78 = 27.53% Alpha = 27.53–22.31 = 5.22% For stock B: (55.48-67.45) + 0.98 + 4.67/67.45 = –9.37% Alpha= –9.37–2.10 = –11.47% 6. Question ID: 10987 Correct Answer: C Statement 3 is incorrect. Liquidation value is indeed the value of a company if it were dissolved and its assets sold individually. However, it should be distinguished from the ‘breakup value’ or ‘private market value’ of a company, which is the sum of the expected value of the company’s parts if the parts were independent entities. In contrast to liquidation value, breakup value is a going-concern concept of value because in estimating a company’s breakup value, the company’s parts are usually valued individually as going concerns. Statement 4 is incorrect. If the marketplace has confidence that the company’s management is acting in the owner’s best interests, market prices should on average reflect fair value. In some situations, however, an asset is worth more to a particular buying maybe because of potential operating synergies. The value to a buyer taking into account these synergies and based on investor’s expectations is termed investment value.

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Reading 26

Equity Valuation: Applications and Processes

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FinQuiz Level II 2019 – Item-sets Solution Reading 26: Equity Valuation: Applications and Processes 7. Question ID: 49102 Correct Answer: A A is correct. Being on the verge of bankruptcy, Alpha Inc. will be subject to considerable financial distress. In this scenario, liquidation value will be most relevant to the company. Liquidation value measures the value of a company which is dissolved and its assets are sold individually. B is incorrect. Investment value is relevant when valuing the worth of a business to a specific buyer. This measure of value is not relevant in the context of Alpha Inc.

8. Question ID: 49103 Correct Answer: A A is correct. Given that SS targets a niche market, it will have an exclusive and limited customer base. The fewer the number of customers, the greater their negotiating power. Therefore, the buyers would represent an inherent downward pressure on industry profitability. B is incorrect. Based on Porter’s five forces, when there are many suppliers of input, suppliers have limited power to raise prices and thus would not represent an inherent downward pressure on industry profitability. SS has access to a large supplier pool and they cannot negatively influence industry profitability based on their pricing power. C is incorrect. A low level of competition will enhance industry profitability. The watch-making industry in which SS operates has a low degree of intra-industry rivalry.

9. Question ID: 49104 Correct Answer: B B is correct. Given that SS operates in an industry with little competition, few potential substitutes will exist thereby decreasing the threat of substitutes. A low threat of substitutes enhances industry profitability. A is incorrect. The threat of substitutes is low. See above. C is incorrect. Given that few potential substitutes exist, switching costs are not relevant in this regard.

10. Question ID: 49105 Correct Answer: C C is correct. SS is neither in financial distress nor in the process of liquidation. Therefore, the company is assumed to be operating as a going concern and the going-concern value will be a relevant value definition. A is incorrect. Intrinsic value is a relevant concept of value when valuing public equities. B is incorrect. Liquidation value is appropriate for a company which is in financial distress and is used to value a company if it were dissolved and its assets were sold individually.

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Reading 26

Equity Valuation: Applications and Processes

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11. Question ID: 49106 Correct Answer: A A is correct. Carlton is acquiring a minority stake in SS. Therefore, a control premium is not required to be incorporated when adjusting Time Associate’s stock for the purposes of valuing SS’s stock. B is incorrect. Given that the SS stock is privately traded, an illiquidity discount will required to be applied as the shares lack the market depth associated with the publically traded stock of Time Associates. C is incorrect. Lack of marketability discounts apply to the value of non-publically traded stocks.

12. Question ID: 49107 Correct Answer: C C is correct. Gains from the sale of the manufacturing plant and the income received from a positive litigation settlement represent non-recurring sources income which is not sustainable. Therefore, Line Corporation’s current year earning comprises unsustainable income sources. A is incorrect. See above. B is incorrect. The capitalization of product development costs will boost the current year’s income at the expense of reducing income in the future years. However, this accounting treatment does not represent an attempt to accelerate revenue.

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Reading 27

Return Concepts

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FinQuiz.com CFA Level II Item-set - Solution Study Session 9 June 2019

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Reading 27

Return Concepts

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FinQuiz Level II 2019 – Item-sets Solution Reading 27: Return Concepts 1. Question ID: 15601 Correct Answer: B Argument 1 fails to support the use of historical risk premium estimates for the purpose of estimating risk premiums on Homalian equity securities. Historical estimates may be readily used when reliable long-term records of equity returns are available. Given that local markets are not well established, the obtaining historical data may be problematic. Argument 2 supports the use of historical estimates. Historical estimates are based on data, rather than forecasts, which gives then an objective quality. Argument 3 fails to support the use of historical risk premium estimates for estimating equity risk premiums. In using a historical estimate to represent the equity risk premium going forward, the analyst assumes that returns are stationary and that the parameters describing the return-generating process are constant in the past and future. This does not allow for scenario analysis to be conducted, whereby an analyst needs to use different estimates for the parameters to arrive at a range of possible outcomes. 2. Question ID: 15602 Correct Answer: C In order to develop a historical risk premium estimate, it is necessary for the analyst to select: I. II. III. IV.

an equity index that accurately represents the returns earned by average equity investors in the markets examined; the time period of the estimate the type of mean calculated the proxy for risk-free return

Vazquez has failed to select a representative market index. He should have selected Homali’s national equity index or an emerging market African index. Although choosing a nineteen year time period will help to increase the precision of sample data, issues related to nonstationarity in data will need to be dealt with. Given the significant political risks to be encountered by foreign investors investing in Homali, it is highly likely that risk premiums will fluctuate considerably over the long term, in addition to the short-term. Thus Vazquez may have to deal with nonstationarity in the returns data used. Generally, a risk-free return can be represented using long-term government bond returns or shortterm government debt instrument returns. A risk premium relative to long-term government bonds is generally preferred over the latter in a multi-period context of valuation. Using the yield on 20 year U.S. government bonds as proxy for the risk-free rate is appropriate and does not pose any issue.

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Reading 27

Return Concepts

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3. Question ID: 15603 Correct Answer: C The weighted average equity risk premium is 3.89%. Using supply-side model, the estimated equity risk premium is calculated as follows: [{(1 + EINFL) (1 + EGREPS) (1 + EGPE) – 1.0} + EINC] – Expected risk-free return Equity risk premium French Manufacturer: [{(1 + 1.45%) (1+ 0.53% + 0.10%) (1 + 3.00%) – 1.0} + (1.21% + 0.35%)] – 2.45% = 4.2618% The GGM equity risk premium estimate is calculated as follows: Dividend yield on the index based on year-ahead aggregate forecasted dividends and aggregate market value + Consensus long-term earnings growth rate − Current long-term government bond yield GGM Japanese Manufacturer

= (175.59 ÷ 9,556.00) + 2.54% − 1.34% = 3.0375%

Weighted average equity risk premium = (0.7) (4.2618%) + (0.3) (3.0375%) = 3.8945% 4. Question ID: 15604 Correct Answer: C Espinoza’s statement accurately captures the process used to derive estimates of future beta. In order to accurately predict future beta, the beta value in a future period needs to be adjusted closer to a mean value of 1.0, i.e. the beta of an average-systematic-risk security. Flynn’s statement does not accurately capture the process used to estimate raw beta. Beta equals to the covariance of returns with the returns on the market portfolio divided by the market portfolio’s variance of returns. 5. Question ID: 15605 Correct Answer: A Agatha’s estimated equity beta is 1.15. In order to estimate the equity beta for a privately traded firm, such as Agatha, the following steps need to be followed: 1) Unlever the benchmark’s beta

  1 BU ≈   BE 1 + (D E ) Given a total debt ratio of 0.3, Horizon’s debt-to-equity ratio is 0.42857 (0.3/0.7).

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Reading 27

Return Concepts

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  1 BU ≈  1.4 = 0.98 1 + (0.3 0.7 )  2) Lever the beta to reflect the subject company’s leverage

BE ' ≈ 1+ ( D' E ') BU Given a total debt ratio of 0.15, Agatha’s debt-to-equity ratio is 0.17647 (0.15/0.85)

BE ' ≈ 1+ ( 0.15 0.85) 0.98 =1.15294 6. Question ID: 15606 Correct Answer: C Hodge has inaccurately described both the country rating and country spread model. The country spread model estimates the equity risk premium as the sum of the equity risk premium of a developed market and a country premium. The country premium is equal to the yield differential between emerging market government bonds (denominated in the currency of the developed market) and developed market government bonds. The country risk rating model provides a regression-based estimate of the equity risk premium based on the empirical relationship between developed market equity returns and institutional investor’s semi-annual risk ratings for the country. The estimated regression equation is then used with risk ratings for less developed markets to predict the required returns for those markets. 7. Question ID: 11054 Correct Answer: A Using a five-year horizon for calculating beta is the most common practice. The most common method to adjust the beta is by using the following equation: 2/3(beta) + (1/3) For T&M, adjusted beta equals: 2/3(1.3) + (1/3) = 1.20 The required return using CAPM equals: 5.1% + 1.20(5.5%) =11.7% To determine whether the Armstrong’s estimate implies above or below average risk, we find the return if beta equals 1: 5.1% +1(5.5%) = 10.6% Since Armstrong estimated a required return of 10.2%, her estimate implies below-average systematic risk.

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Reading 27

Return Concepts

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8. Question ID: 11055 Correct Answer: B Unlevering the benchmark beta: [(1/1+(45/55)] 1.05 = 0.5775 Levering this beta: [1+(32/68)] 0.5775 = 0.849 9. Question ID: 11056 Correct Answer: C Statement 1 is incorrect. Greater complexity, or a model of required return based on multiple factors, does not ensure greater explanatory power than the CAPM for estimating required return. Any selected model should be examined for the value it is adding (which could be greater or less). Statement 2 is incorrect. The statement is true for the APT model. But, in the case of the Fama-French model (a type of a multifactor model), the premiums of two factors are not stated as quantities in excess of the risk free rate (one represents a small cap return premium and the other a value return premium). 10. Question ID: 11057 Correct Answer: B Statement 3 is incorrect. The mean return to shorting large-cap shares and investing the proceeds in small-cap shares is the small-cap premium. The exhibit shows the beta, or sensitivity to this premium, not the premium itself. Since the size beta is negative, the company is a large-cap firm. Statement 4 is correct. The company is a large cap, value stock high liquidity. 11. Question ID: 11058 Correct Answer: B EE stock is the stock of a micro-cap public company. The required return for such a company using the build up method equals: Risk free rate + equity risk premium + incremental premium for small size = 4 + 5.5 + 4.21 = 13.71% The company specific premium is added to determine the required return for a privately held company. 12. Question ID: 11059 Correct Answer: A In some cases, the size premium for the smallest decile may reflect not only the premium for healthy small-cap companies, but former large-cap companies that are in financial distress. If this is the case, the historical estimate may not be applicable without a downward adjustment for estimating the required return for a small but financially healthy company.

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Reading 27

Return Concepts

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13. Question ID: 14069 Correct Answer: A Backfilling index returns has the effect of artificially increasing and biasing an index’s return. By using the returns of the 15 corporations, which were in existence at 1990 and backfilling these returns over the 1975-1989 period, the historical equity risk premium will be biased upwards. 14. Question ID: 14070 Correct Answer: C Both events, the opening of the Lisonian stock exchange followed by an increase in cash flow volatility and the subsequent imposition of capital controls will produce non-stationary historical return series. Additionally, the events have the potential to produce different equity return premiums prior to and following the occurrence of the events. 15. Question ID: 14071 Correct Answer: A Under the Ibboston and Chen model, the supply side estimate of the equity return is broken down into four components:
Expected inflation: EINFL
Expected growth rate in real earnings per share: EGREPS (sum of the labor productivity growth and labor supply growth rate)
Expected growth in the P/E ratio: EGPE
Expected income component: EINC Equity risk premium = [{(1 + EINFL) (1 + EGREPS) (1 + EGPE) – 1.0} + EINC] – Expected risk-free return = [{(1 + 0.034) (1 + 0.025 + 0.014) (1 + 0.0145) – 1.0} + (0.0176 + 0.0015)] – 0.045 = 0.064 or 6.40% 16. Question ID: 14072 Correct Answer: C Factor 1: The raw beta is obtained from an ordinary least squares regression of the return on the stock on the return on the market. However the future beta is often found to be a value closer to a mean value of 1.0, i.e. the beta of an average systematic risk security, than to the value of raw beta. Since valuation is forward-looking it is rational to adjust the raw beta so that it may more accurately predict future beta. Relative to developed markets, transparency in emerging markets is often weaker and thus it may be more difficult to obtain market data to formulate forecasts such as beta. However the beta adjustment is rational in the case of both developed and emerging markets to obtain accurate valuation estimates. Thus factor 1 inaccurately describes the issues involved in estimating returns for emerging markets. Factor 2: Models such as the Fama-French model and the Pastor Stambaugh model are generally limited to developed countries. Historical data on the factors are publically available to 24 countries, which are all developed countries. Although the latter model represents an extension of the former model by including an illiquidity risk premium, either of the two models may be difficult to use in emerging

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Reading 27

Return Concepts

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markets such as Morocco where historical data on the factors may not be readily available. Thus factor 2 inaccurately describes the issues involved in estimating returns for emerging markets. 17. Question ID: 14073 Correct Answer: A The required return using the Fama-French model is calculated using the formula: ri = RF + BimktRMRF + BisizeSMB + BivalueHML = 3.4%* + (1.24)(6.40%) + (− 0.46)(3.50%) + (0.24)(1.80%) = 10.158% ≈ 10.2% * A short-term risk-free rate is used as the expected risk-free rate in the Fama-French model. 18. Question ID: 14074 Correct Answer: B Based on the data provided in exhibit 1, the size beta is – 0.46. The negative beta provides evidence that the House Creations stock has a market capitalization which is higher than the average stock in the market. The negative factor beta will reduce the cost of equity capital. A lower cost of equity capital increases the present value of an equity security (when the cost of equity capital is used to discount a security’s cash flow stream) and thus benefits the cost of equity capital. A positive value premium of 0.24 provides evidence that the stock’s market price is less than the book value of its equity, i.e. it has a high book-to-market ratio. Additionally, the positive value premium provides evidence that the stock is a value stock.

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Reading 27

Return Concepts

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FinQuiz Level II 2019 – Item-sets Solution Reading 27: Return Concepts 19. Question ID: 49109 Correct Answer: C In one year’s time, the stock is expected to pay dividends totaling $3.20 ($0.80 × 4). Expected return = DH/P0 + (V0 – P0/P0) = $3.20/$38.00 + [($40.00 – $38.00)/$38.00] = 13.684% 20. Question ID: 49110 Correct Answer: A If the firm’s stock is correctly valued, it will return its cost of equity. Under this assumption, target price = current price × (1 + Required return) – Dividend Target price = $38.00 × (1.1255) – ($0.80 × 4) ≈ $39.57 21. Question ID: 49111 Correct Answer: C C is correct. With the exception of a flat yield curve scenario, the arithmetic mean is always higher than the geometric mean. Therefore, the historical risk premium estimate will be higher if arithmetic mean returns are used. A is incorrect. Considering that the yield curve is upward sloping, the long-term government bond return will be higher relative to the (short-term) Treasury bill return. Therefore, the historical risk premium estimate will be higher relative to the estimate generated using T-bill returns.

22. Question ID: 49112 Correct Answer: A A is correct. The baseline value for the expected growth in the P/E ratio is 0 which is consistent with an efficient market view. A negative value for this factor suggests that the analyst views the current P/E ratio as reflecting overvaluation.

23. Question ID: 49113 Correct Answer: A Required return = {[(1 + EINFL)(1 + EGREPS)(1 + EGPE) – 1.0] + EINC} EINFL =


     
     


 . 

− 1 =
 .  − 1 = 2.0076%

EGREPS = Labor productivity growth + labor supply growth = 3.0% + 2.2% = 5.2%

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Reading 27

Return Concepts

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Equity Risk Premium = [{(1.020076)(1.052)(0.97) – 1.0} + (0.018 + 0.0025)]-0.02 = 0.041426 or 4.14% 24. Question ID: 49114 Correct Answer: A A is correct. A shortcoming of applying the CAPM to estimate a stock’s required return is that the approach solely considers one source of systematic risk – the sensitivity of the stock’s return to the returns of the broad market index. On the other hand, the Fama-French model considers other sources of systematic risk including value and size and is more suitable for deriving return estimates for Zitter Inc.’s stock. The CAPM is regarded as an incomplete model for measuring risk.

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Reading 28

Industry and Company Analysis

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FinQuiz.com CFA Level II Item-set - Solution Study Session 10 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 28

Industry and Company Analysis

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FinQuiz Level II 2019 – Item-set Solution Reading 28: Industry and Company Analysis

1. Question ID: 19388 Correct Answer: B B is correct. Pithers is using the market growth and market share approach, a top-down approach, as he is forecasting industry growth first and considering how Hollistic Inc.’s market share will change over time. A is incorrect. Davis is using a hybrid approach. Projections 1, 3 and 4 represent the use of the topdown approach; Davis starts at the overall level of the economy and uses the rate of inflation to develop projections at the overall company level. On the other hand, Projection 2 represents the use of the bottom-up approach to forecasting as Davis is using the company’s past cost of sales-to-sales ratio to develop forecasts. The combination of the bottom-up and top-down approach represent a hybrid approach. C is incorrect. Barrett is using a hybrid approach to forecasting. She generates the short-term forecast using a bottom-up approach by focusing on the company’s individual growth rate. However, her long-term forecast is generated using a top-down approach as she projects sales revenue to grow at the nominal GDP growth rate.

2. Question ID: 19389 Correct Answer: C C is correct. All BRL figures are in millions. The company will pass 50% of the 2% increase in coffee beans prices to consumers; selling price per unit should increase by 1% (2% × 0.5) per unit in 2013. Given that sales volume is projected to decline by 8% in 2013, sales revenue is projected to total BRL 799.112 (BRL 860 × 1.01 × 0.92). Projected cost of sales attributable to coffee beans (2013)

= BRL 645 × 0.4 × 1.02 × 0.92 = BRL 242.1072

Remainder projected cost of sales (2013)

= BRL 645 × 0.6 × 0.92 = BRL 356.04

Gross profit margin (2013) = [BRL 799.112 – (BRL 242.1072 + BRL 356.04)] ÷ BRL 799.112 = 25.149%

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Reading 28

Industry and Company Analysis

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3. Question ID: 19390 Correct Answer: A A is correct. An inflection point will occur when the future will look considerably different from the past. This contrasts with a perpetuity calculation which assumes a constant rate of growth into the future. Pithers’ SG&A projection represents an inflection point as the sudden policy announcement will alter SG&A estimates significantly. B is incorrect. Pithers’ sales revenue forecast does not reflect an inflection point as he expects industry revenues to grow slowly and this growth is based on its past pattern. C is incorrect. Barrett’s revenue forecast does not represent an inflection point. Although heightened competition will reduce Hollistic Inc.’s revenue forecast, the decline is gradual and thus does not represent a sudden shift in future revenues.

4. Question ID: 19391 Correct Answer: C C is correct. Hollistic’s market share has remained constant from 2012 and is expected to remain so: All BRL figures are in millions. Market share (2012) = BRL 860/BRL 1,760 = 48.86% Market share (2013) = BRL 877.2/BRL 1,795.2 = 48.86% Industry revenue (2014) = BRL 1,795.2 × 1.02 = BRL 1,831.104 Hollistic Inc.’s revenue (2014) = BRL 1,831.104 × 0.4886 = BRL 894.68

5. Question ID: 19392 Correct Answer: C Part 5) C is correct. With linear growth, it will take approximately 3 years for the revenue growth rate to equal nominal GDP growth rate. Yoy revenue growth (2012 – 2013) = (877.2/860.0) – 1 = 2.0% N = number of years required for the two aforementioned growth rates to equal. We solve for ‘N’ as follows: 2% × 1.001 × N = 6% N = 2.997 years or ≈ 3 years

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Industry and Company Analysis

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6. Question ID: 19393 Correct Answer: B All BRL figures are in millions. Pithers’ SG&A Forecast (2014): SG&A/Gross profit (2012)

= BRL 43/BRL 215 = 20%

SG&A/Gross profit (2014)

= 20% × 1.032 = 21.218%

Assuming that gross profit remains constant (as stated in the question), projected SG&A for 2014 is equal to BRL 45.62 (BRL 215 × 21.218%).

Davis’ SG&A Forecast (2014): BRL 43 × (1.02)2 = BRL 44.74

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Reading 28

Industry and Company Analysis

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FinQuiz Level II 2019 – Item-set Solution Reading 28: Industry and Company Analysis 7. Question ID: 49131 Correct Answer: B Hailey is using the growth relative to GDP growth approach, a top-down approach, to forecast revenues generated from the sale of generator units. This approach involves considering how the growth rate of a specific company will compare relative to nominal GDP growth. 8. Question ID: 49132 Correct Answer: C The forecasted growth in Baseline Corp’s revenue is 4.8% [4% × (1 + 0.20)]. In 2018, the company’s reported revenues are forecasted to equal $1,174.04 million ($1,020 million × 1.0483).

9. Question ID: 49133 Correct Answer: B All $ figures are in millions. Current utility expenses = ($35,900 + $52,100 + $38,000) million = $126,000 million Utility expenses per square foot = $126,000 million/35.5 million = $3,549.29578 Production area space in Year 2019 = 35.5 million × (1.01)4 = 36.9414 million square feet Utility expenses per square foot in Year 2019 = $3,549.29578 × (1.02)4 = $3,841.87189 Total utility expenses in Year 2019 = $3,841.87189 × 36.9414 million = $141,924.13 million or ≈ $141,924 million. 10. Question ID: 49134 Correct Answer: B Interest rate on average cash position = Interest income/average cash position = $4,800/ ($57,600 + $21,500) = 6.068% or 6.07% 11. Question ID: 49135 Correct Answer: C C is correct. The revision in tax laws will result in a decrease in the company’s income subject to taxation because the company will recognize a higher depreciation expense in the current year as a result of the accelerated depreciation method employed. However, the company’s effective tax rate will not be affected if the company adopts the accelerated depreciation method for tax purposes.

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Reading 28

Industry and Company Analysis

12. Question ID: 49136 Correct Answer: C All $ figures are in millions. Profit before taxes Tax payment (0.6 × 0.35 × $50)

$50.0 $10.5

Cash tax rate ($10.5/$50.0)

21.0%

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Reading 28

Industry and Company Analysis

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FinQuiz Level II 2018 – Item-set Solution Reading 28: Industry and Company Analysis 13. Question ID: 49138 Correct Answer: A A is correct. Register Inc. has acquired significant economies of scale in production relative to its competitors thereby reducing the intensity of rivalry between the manufacturer and its competitors. In addition, the dominant market share of the manufacturer further reduces the intensity of rivalry. Therefore, the intensity of rivalry is described as being low. 14. Question ID: 49139 Correct Answer: A The bargaining power of paper suppliers is low because paper is widely available as an input resource. With a wide availability of paper suppliers, their ability to raise the price of paper is limited. 15. Question ID: 49140 Correct Answer: B The more fragmented the consumer base, the lower the bargaining power of an industry’s consumers as their ability to demand lower prices and/or control the quality and quantity of end products is limited. On the other hand, the chain of retail outlets has higher bargaining power as it is the only retain chain to stock the company’s products. Therefore, one would expect this buyer category to have a more commanding position with respect to the pricing, quality and/or quantity of the company’s products. 16. Question ID: 49141 Correct Answer: A

Sales revenue (NAD 15 × 350,000 × 1.20* × 0.84**) Cost of goods sold*** SG&A (NAD 4 × 350,000) Operating profit

NAD 5,292,000 2,665,600 1,400,000 1,226,400

*The 20% increase in the price of the input will be completely passed on to customers in the form of higher selling prices. **The number of units sold will decline to a percentage of 84% (1 – 16%). ***Cost of goods sold reported in 2015 is equal to NAD 2,800,000 (NAD 8 × 350,000). Out of the total figure reported, NAD 840,000 (NAD 2,800,000 × 0.30) is variable while NAD 1,960,000 (NAD 2,800,000 – NAD 840,000) is fixed. In 2018, the fixed component will remain at NAD 1,960,000 while the variable component will decline to NAD 705,600 (NAD 840,000 × 0.84). Total cost of goods sold will amount to NAD 2,665,600 (NAD 1,960,000 + NAD 705,600). FinQuiz.com © 2019 - All rights reserved.

Reading 28

Industry and Company Analysis

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17. Question ID: 49142 Correct Answer: A A is correct. Since the demand is price elastic, a company’s efforts to pass on inflation through higher prices can have a negative impact on volume. Therefore, in an inflationary environment, raising prices too soon will result in volume losses. B is incorrect. On the other hand, raising prices too late will result in a profit margin squeeze in an inflationary environment. 18. Question ID: 49143 Correct Answer: A

Net sales (NAD 15 × 350,000) Cost of goods sold (NAD 8 × 350,000 × 1.15) SG&A expenses (NAD 4 × 350,000 × 1.15) Operating profit

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NAD 5,250,000 3,220,000 1,610,000 420,000

Reading 29

Discounted Dividend Valuation

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FinQuiz.com CFA Level II Item-set - Solution Study Session 10 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 29

Discounted Dividend Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 29: Discounted Dividend Valuation 1. Question ID: 11260 Correct Answer: B Referring to the information in Exhibit 1, dividends do not appear to be adjusted to reflect changes in profitability. Dividends have been relatively constant (around $1.5), whereas the EPS has significantly fluctuated over the five-year period. Hence, the dividend discount model does not appear to be the appropriate choice. Also, to use the residual income model for valuation, the quality of accounting disclosures needs to be good, with the financial statements reflecting an accurate and detailed picture of the true economic performance. As this is not the case with CT, residual income model is also not appropriate. 2. Question ID: 11261 Correct Answer: A The dividends equal: Year 0: 3.67 (0.40) = $1.468 Year 1: 1.468 (1.11) = $1.629 Year 2: $1.629(1.09) = $1.776 Year 3: $1.776(1.10) = $1.9537 Year 4: $1.9537(1.065) = $2.08 The required return on the stock equals: 3.75 + 1.2(5.5) = 10.35% Value at Year 3= $2.08/0.1035-0.065 = $54.044 The value of the stock equals: 1.629/1.1035 + 1.776/(1.1035)2 +(1.9537+54.044)/(1.1035)3 = $44.607 3. Question ID: 11262 Correct Answer: B The expected rate of return is that rate which is implied by the market price of the stock. The expected rate of return is the sum of the dividend yield (D1/P0) and the capital gains yield (g): r = D1/P0 + g = 2.34(1.055)/65.78 + 0.055 = 0.03753+0.055 = 0.092539= 9.25% (the dividend yield equals 3.75%) 4. Question ID: 11263 Correct Answer: C The dividend payout ratio is: 2.34/5.12 = 0.457 Required rate of return = 12% Leading P/E = 0.45703/0.12–0.055 = 7.03125 Trailing P/E = 0.45703(1.055)/0.12–0.055 = 7.4179

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Discounted Dividend Valuation

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5. Question ID: 11264 Correct Answer: B Required rate of return = 4+1.13(5.5) = 10.215% The no-growth P/E = 1/r = 1/0.10215 = 9.7895 Growth P/E = PVGO/E1 78.05 = (1.56/0.10215) + PVGO where (1.56/0.10215) = 15.27 PVGO = $62.778 Growth P/E = 62.778/1.56 = 40.24 6. Question ID: 11265 Correct Answer: C Statement 1 is correct. Gordon growth model can also be used in case of declining dividends, that is, a negative growth rate. As long as the growth rate is less than the required return, the GGM can be used. Statement 2 is correct. Even though cash dividends are more predictable than share repurchases, if applied applied, the DDM is a valid approach to common stock valuation even when the company being analyzed engages in share repurchases. 7. Question ID: 18154 Correct Answer: B Since the FCFE value is negative and is expected to remain negative for the next five years of Captura’s life, the FCFE method cannot be used for company valuation. The FCFF method can be used in instances where the FCFE method yields negative results. Although the company has had a long standing history of dividend payments, the recent scarcity of cash for equity holder needs, would result in zero dividends. Thus, the DDM cannot be used. 8. Question ID: 18155 Correct Answer: A Dividends are less volatile than earnings. Therefore, the dividend discount model values are less sensitive to short term input fluctuations. 9. Question ID: 18156 Correct Answer: A The terminal value of a project is inclusive of the operating and the non-operating cash flows in the last period of a project’s life. 10. Question ID: 18157 Correct Answer: B All figures in $ Residual Income= Net Income- (BV0 of equity x cost of equity) Residual Income= 800,000- [(4,500,000x 25%) x 12%] Residual Income=800,000- (1,125,000 x 12%) Residual Income= 800,000- 135,000 Residual Income= 665,000

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Discounted Dividend Valuation

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11. Question ID: 18158 Correct Answer: A The residual income approach matches profits recognized to the time period in which they are earned. Thus, the RI method characterized the matching or the accrual concept. 12. Question ID: 18159 Correct Answer: C Developed markets, e.g. the U.S. equity market, prefers to distribute cash to the equity holders in the form of share repurchases rather than cash dividends. 13. Question ID: 18161 Correct Answer: C r= [D0(1+g)/P0] + g or [D1/P0] + g r= [$4 x (1.06)/$65] + 6% r= 12.5% 14. Question ID: 18162 Correct Answer: B Value= {[D0 x (1 +gl)]} + {[D0 x H (gs-gl)]} / (r-gl) Value= {[$4 x (1.06)]} + {[$4 x 4 (0.29)]}/ 0.09 Value= {$4.24 + $4.64}/0.09 Value= $98.67/share 15. Question ID: 18163 Correct Answer: B Value= [D0 x (1 + gl)]/ (r-gl) Value= [$4 x 1.06] / 0.09 Value= $47.91/share Total value= $47.91 x 500,000 = 23.6 million 16. Question ID: 18164 Correct Answer: B Value= [D0 x H (gs-gl)]/ (r-gl) Value= [$4 x 4 x 0.29] / [0.09] Value= $55.56/share Total Value= $55.56 x 500,000= $25.8 million 17. Question ID: 18165 Correct Answer: B Input variability is not controllable by a computer system which simply generates the results through the information provided to it. It cannot detect false input through human error or manipulation. 18. Question ID: 18166 Correct Answer: C b=(Net Income- Dividends)/ Net Income b= ($12-$4)/$12= 67%

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Discounted Dividend Valuation

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19. Question ID: 18168 Correct Answer: A P0= E1/r +PVGO $60= [$5(1.12)/0.135] +PVGO $60= $41.48 + PVGO PVGO= $18.52 20. Question ID: 18169 Correct Answer: A When the rate of return from the investment is less than the required rate of return, then despite the increasing EPS, cash flows generated should not be reinvested in the project. The earnings should rather be distributed in the form of cash dividends. 21. Question ID: 18170 Correct Answer: B PVGO is denoted by the formula= P0- (1/r) 22. Question ID: 18171 Correct Answer: C E1= [$6,000,000(1.08)/250,000] No-growth value= E1/r= $25.92/0.17= $152.47 23. Question ID: 18172 Correct Answer: C P/E= (1/r) + (PVGO/E1) P/E= (1/0.17) + (PVGO/E1) $42/$25.92= 5.88 + (PVGO/E1) 1.62= 5.88 + (PVGO/E1) (PVGO/E1) =- 4.26 Percentage= (-4.26/ 1.62) x 100= 263% 24. Question ID: 18173 Correct Answer: C Trailing P/E Ratio= {[D0(1+g)]/E0}/(r-g) Trailing P/E Ratio= {[3(1.08)]/24}/(0.17-0.08) Trailing P/E Ratio=0.135/0.09=1.50 25. Question ID: 18175 Correct Answer: C Factors that support the use of the GGM to value North Shore include: • • •

The corporation’s earnings are in line with the U.S. nominal GDP growth. The corporation’s profitability is stable as evidenced by its steady required return on equity. Additionally, the steady stream of revenue from ongoing projects has secured the business and has helped contribute to its stable profits. Its dividends bear an understandable and consistent relationship to its earnings as evidenced by its policy of steadily increasing dividends.

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Discounted Dividend Valuation

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26. Question ID: 18176 Correct Answer: B The Gordon growth intrinsic value of North Shore, using a required return of 10% and original growth rate of 6.5%, is $16.74 per share. D (1 + g ) $0.55(1 + 0.065 ) V0 = 0 = = $16 .7357 per share. r−g 0.10 − 0.065 27. Question ID: 18177 Correct Answer: B The R2 measure suggests that the prediction ability of beta and the required return values using adjusted or unadjusted beta is low. Instead, the valuation should focus on the bond-yield-plus-risk premium approach. The estimate of the required return on equity using the bond-yield-plus-risk premium approach is 12% (9% + 3%). Based on a 12% required return on equity and 6.5% growth rate, the intrinsic value of North Shore’s shares is $10.65.

V0 =

D0 (1 + g ) 0.55 (1 + 0 .065 ) = = $10 .65 r−g 0.12 − 0 .065

North Shore’s shares are currently overvalued as $15.64 > $10.65. 28. Question ID: 18178 Correct Answer: A The contribution of North Shore’s PVGO to its P/E ratio is 8.43. In order to calculate the contribution of PVGO to P/E, the following formula is used: P/E =

1 PVGO + r E1

12.46 1 PVGO = + 0.8 0.14 E1 PVGO = 8.43 E1

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Discounted Dividend Valuation

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29. Question ID: 18179 Correct Answer: A Based on Costa’s revised estimates, the intrinsic value of North Shore’s shares is $5.86. Based on the forecasted steady decline of North Shore’s dividends, the H-model should be used to determine the firm’s intrinsic value. Under the H-model, intrinsic value is calculated using the following formula:

V0 =

D0 (1+ gL ) D0 H ( gs − gL ) + r − gL r − gL

=

$0.55 (1.025) $0.55 ( 5) ( 0.065 − 0.025) + 0.14 − 0.025 0.14 − 0.025

= $5.85870 ≈ $5.86 30. Question ID: 18180 Correct Answer: B If North Shore adopts the policy discussed by the assistant in his query, North Shore’s intrinsic value will be $6.92. A three stage dividend discount model will be used to calculate the intrinsic value as follows:

Year

Value

Calculation

Dt or Vt

Present values Dt/(1.11)t or Vt/(1.11)t

2010

D1

$0.55(1.055)

$0.58025

$0.52275

2011

D2

$0.55(1.055)(1.04)

$0.60346

$0.48978

2011

V2

$0.55(1.055)(1.04)(1.025)/(0. 11 – 0.025)

$7.27702

$5.90619

Total

$6.91872

31. Question ID: 18182 Correct Answer: C Value = BVPS + PV of RI Value = ($16,000,000 + $11,764,708)/500,000 Value = $55.5/share 32. Question ID: 18183 Correct Answer: C Clean surplus accounting is denoted by the formula: BT= BVt-1+NIt-DIvidendst

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Discounted Dividend Valuation

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33. Question ID: 18184 Correct Answer: C V0 = (D1+P1)/ (1+r) V0 = ($12+ $220)/ (1.15) V0 = $201.73/share 34. Question ID: 18185 Correct Answer: B V0 = (D1)/ (1+r)1 +(D2)/(1+r)2+(D3+P3)/(1+r)3 V0 = ($7/1.15) + ($10/1.32) + ($12+220/1.52) V0 = $166.29/share 35. Question ID: 18186 Correct Answer: A Growth Rate = (12/7)1/2 – 1 Growth Rate = 31% 36. Question ID: 18187 Correct Answer: A ROE = Net Profit Margin x Asset Turnover x Financial Leverage ROE = $850,000/$6,000,000 x $6,000,000/$13,000,000 x 2.5 ROE = 16.4% 37. Question ID: 18189 Correct Answer: A The output of the Gordon’s growth model is very sensitive to small changes in the inputs i.e. assumed growth rate and the required rate. 38. Question ID: 18190 Correct Answer: A Since Hiclor’s current earnings growth rate is greater than the economy’s nominal growth rate, it is recommended to use the multistage dividend discount model instead of the Gordon’s growth model. 39. Question ID: 18191 Correct Answer: B Equity Risk Premium = Short Term Yield on the Market Index + Consensus Long term Earning Growth Rate – Long Term Government Bond Yield Equity Risk Premium = 8% + 18%- 12% = 14% 40. Question ID: 18192 Correct Answer: C Share repurchase at par has a neutral effect on the wealth of the existing shareholders. However, repurchase at par does not guarantee a positive effect. This is because the cash used to repurchase the shares could have been applied to a profitable business or investment opportunity. The opportunity cost for share repurchase at par is not discernible with the information provided.

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Discounted Dividend Valuation

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41. Question ID: 18193 Correct Answer: B The implied growth rate calculation needs the following inputs: • • •

actual market price expected dividend required rate of return

42. Question ID: 18194 Correct Answer: A As a company enters the transition phase of its lifecycle, its return on equity percentage starts falling towards the required return.

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Reading 30

Free Cash Flow Valuation

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FinQuiz.com CFA Level II Item-set - Solution Study Session 11 June 2019

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Reading 30

Free Cash Flow Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 30: Free Cash Flow Valuation 1. Question ID: 11271 Correct Answer: C The company WACC is: WACC = 0.30[0.064(1 – .37)] + 0.70(.122) = 9.75% Firm Value: FCFF1/WACC – g = 350(1.045)/.0975 – 0.045 = $6,966.666,667 million The value of equity is: 6,966.66 – 1,300 = $5,666.666 million The value/share is: 5,666.666/150 = $37.7778 per share 2. Question ID: 11272 Correct Answer: B FCFF equals: Net Income+ noncash charges + after tax interest expense – investment in fixed capital – investment in working capital Noncash charges/Depreciation = $68.75 After tax interest expense = 29.85 (1 – 0.35) = $19.4025 Investment in fixed capital = 830 – 750 = $80 Investment in working capital = [(175 – 150) + (97.55 – 86.31)] – (66 – 60) = $30.24 FCFF: 166.66 +68.75+19.4025 – 80 – 30.24 = $144.5725 3. Question ID: 11273 Correct Answer: A FCFE equals: FCFE = NI + NCC – FCInv – WCInv + Net borrowing FCInv: 900 – 830 = $70 WCInv: [(189 – 175) + (103.4 – 97.55)] – (79 – 66) = $6.85 Net borrowing: (81 – 78) + (396 – 359) = $40 FCFE = 200.06 + 76.09 – 70 – 6.85 + 40 = $239.30

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Free Cash Flow Valuation

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4. Question ID: 11274 Correct Answer: B Statement 1 is incorrect. Although it is correct that U.S. GAAP treats interest paid or received as an operating activity, IFRS treats interest received as either an operating or an investing activity, and interest paid as either an operating or a financing activity. Statement 2 is correct. If WACC is calculated on a pretax basis the FCFF to be discounted should be estimated by adding back interest paid with no tax adjustment. This ensures consistency in the measures of WACC and FCFF. 5. Question ID: 11275 Correct Answer: A FCFF = Net Income+ noncash charges + after tax interest expense –investment in fixed capital – investment in working capital FCFF = 310,000 +(60,000 – 50,000 – 30,000+55,000) +80,000(1–.30) – (350,000 – 10,000) –45,000 = $16,000 6. Question ID: 11276 Correct Answer: B When using EBIT the entire depreciation amount is added back whereas when using EBITDA only the depreciation tax savings (depreciation times the tax rate) is added back. 7. Question ID: 16096 Correct Answer: B North Rock’s FCFF for the year 2009 is approximately $94 million. The incremental fixed capital investment in 2008 was 46.15%, which is calculated as follows:
     −      500 − 200 = = 46.15% 650      The incremental investment in working capital in 2008 was 7.69%, which is calculated as follows:         50 = = 7.69%      650 The forecasted FCFF is calculated using the following formula: EBIT (1 – tax rate) – Incremental Fixed Capital Investment – Incremental Working Capital Investment Thus the forecasted FCFF is calculated as follows (in $ millions):

Sales EBIT EBIT (1 – Tax rate) Incremental fixed capital

$ millions 1,836.000 257.040 167.076 (62.764)

($1,700 × 1.08) 14% of sales 257.040 (1 – 0.35) 0.4615 × (1,700 × 0.08)*

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Reading 30

Free Cash Flow Valuation

Incremental working capital FCFF

(10.458) 93.854

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0.0769 × (1,700 × 0.08)*

*Both incremental fixed capital and working capital investment are calculated based on the respective calculated percentages in 2007 (see above) by the incremental increase in sales which is $136 million ($1,700 million × 0.08) 8. Question ID: 16097 Correct Answer: A North Rock will finance incremental fixed capital and working capital investment with 40% debt (the target debt ratio). The incremental working capital and fixed capital investment forecasted for the year 2009 are (in millions) $62.764 and $10.458, respectively. Net borrowings (NB) are $29 million calculated as follows: NB = DR (Fixed Capital Investment – Depreciation) + DR (Working Capital Investment) or = DR (Incremental Fixed Capital Investment + Incremental Working Capital Investment) = 0.4 ($62.764 + $10.458) = $29.2888 million 9. Question ID: 16098 Correct Answer: C North Rock’s forecasted FCFF for the year 2011 is approximately $82 million. Using the formula laid out in the previous solution, forecasted FCFF is calculated as follows:

Sales EBIT EBIT (1 – Tax rate) Incremental fixed capital Incremental working capital FCFF

$ millions 2,141.510 256.981 167.038 (73.208) (12.199) 81.6310

($1,700 × 1.083) 12%* of sales 256.981(1 – 0.35) 46.15% of sales increase** 7.69% of sales increase**

*Since the EBIT margin will decline by a total of 5% over a five-year period, starting from 2010, the decline in the EBIT margin will be 1% per annum. In 2011, EBIT margin will be 12% (14% − 2%). **The sales increase between 2010 and 2011 is $158.630 million [(1,700 × 1.083) – (1,700 × 1.082)] 10. Question ID: 16099 Correct Answer: B Out of the characteristics highlighted by Fraser, characteristic 2 decreases the usefulness of the modified buildup model for valuing local corporations such as HL Corp. The modified build up method involving various adjustments to the real country return is worth using when real discount rates and growth rates can be estimated more reliably than nominal discount rates and nominal growth rates. When the latter two rates are predictable, the model loses its usefulness. Characteristic 1 does not decrease the usefulness of the modified buildup model for valuing corporations such as HL Corp. The approach is particularly useful for countries with either high or

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Reading 30

Free Cash Flow Valuation

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variable inflation rates. A high but steadily increasing inflation rate makes this model useful for valuation purposes. 11. Question ID: 16100 Correct Answer: B The value of each HL Corp share is approximately EMA 26.9. Using the modified buildup method, the real required rate of return is 8.32%, which is calculated as follows:

Country return (real) +/- Size adjustment +/- Industry adjustment +/- Leverage adjustment Required rate of return (real)

(%) 8.50 − 0.23 + 0.14 − 0.09 8.32

The real growth rate of FCFE is expected to be 2.05% (Exhibit 1), so the value each HL Corp Share is: V଴ =

FCFE଴ 1 + g ୰ୣୟ୪  1.651.0205 = = EMA 26.855 0.0832 − 0.0205 r୰ୣୟ୪ − g ୰ୣୟ୪

12. Question ID: 16101 Correct Answer: A North Rock’s FCFE for the year 2009 is approximately $176 million. Using EBIT, the FCFF for the year 2009 is calculated using the following formula: FCFF = EBIT (1 – Tax rate) + Dep – FCInv – WCInv = $350 (1 – 0.35) + 35.74 – 25.50 – (58.53)* = $179.21 million *WCInv = Increase (decrease) in accounts receivable + increase (decrease) in inventory + decrease (increase) in accounts payable + decrease (increase) in accrued expenses WCInv (in millions) = $15.80 + $10.25 + $17.98 + 14.50 = $58.53 Using the FCFF value, FCFE is calculated using the following formula: FCFE = FCFF – Interest (1 – tax rate) + Net Borrowing = $179.21 – $8.45(1 – 0.35) + ($4.67 – $2.25) = $176.1375 million

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Reading 30

Free Cash Flow Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 30: Free Cash Flow Valuation 13. Question ID: 49198 Correct Answer: B

B is correct. The FCFF model is more suitable for valuing a levered company with a changing capital structure because FCFF estimation may be computed more easily compared to FCFE estimation in these circumstances. A is incorrect. The advantage of FCFE and FCFF approaches over earnings-based measures is that the latter do not account for the reinvestment in working capital and capital assets which a company makes to maintain or maximize the value of the firm. Therefore, the latter approach is not consistent with the shareholder perspective which focuses on long-term value maximization. C is incorrect. See above. 14. Question ID: 49199 Correct Answer: B

FCFF = Net income + non-cash charges + Interest(1 – tax rate) – Fixed capital investment – working capital investment All $ figures are in thousands. Fixed capital investment = $1,410 – $1,390 = $20 Working capital investment:

Accounts receivable Inventory Total current assets excluding cash Accounts payable Accrued taxes and expenses Current liabilities excluding current portion of long-term debt Working capital Increase/(Decrease) in working capital FCFF = $206 + $105(1 – 0.3) + $320 – $20 – $70 = $509.50

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2014 $150 $85 $235

2013 $110 $100 $210

$70 $85

$70 $130

$155 $80 $70

$200 $10 -

Reading 30

Free Cash Flow Valuation

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15. Question ID: 49200 Correct Answer: A

All $ figures are in thousands. FCFE = CFO – FCInv. + Net borrowing = $466 – ($1,410 – $1,390) + [($25+$480) – (90+ $500)] = $361.00 16. Question ID: 49201 Correct Answer: C

C is correct. EBITDA is a poor proxy for FCFF because it fails to consider depreciation tax shield and the investment in fixed capital and working capital. The measure is also a poor proxy for FCFE as it fails to consider cash flow from new borrowings or debt repayments which otherwise feature in a company’s FCFE computation. A is incorrect. Even though EBITDA is a pre-tax measure, this fact does not justify why EBITDA is a poor proxy for FCFF and FCFE. B is incorrect. EBITDA is a before-tax measure and so the discount rate applied to it would be a before-tax rate. 17. Question ID: 49202 Correct Answer: C

All $ figures are in thousands. The two-stage FCFE model will be used to value the Ceta Inc. stock: Year 1 2 3 4

FCFE $1,004(1.25) = $1,255.0000 $1,004(1.25)2 = $1,568.7500 $1,004(1.25)3 = $1,960.9375 $1,004(1.25)3(1.08)/(0.125 – 0.08) = $47,062.50 Total

PV of FCFE $1,255.0000/1.125 = $1,115.5556 $1,568.75000/1.1252 = $1,239.5062 $1,960.9375/1.1253 = $1,377.2291 $47,062.50/1.1253 = $33,053.4979 $36,785.7880

Forecasted intrinsic value = $36,785,788.0/1,800,000 = $20.4365 or $20.44 18. Question ID: 49203 Correct Answer: B

All $ figures are in thousands. FCFE = FCFF – Int.(1 – Tax rate) + Net borrowing FCFF = $1,004 + $105 (1 – 0.30) – ($527 – $480) = $1,030.50

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Reading 30

Free Cash Flow Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 30: Free Cash Flow Valuation 19. Question ID: 49205 Correct Answer: C

Wayne’s opening statement is relevant for calculating FCFF from both EBIT and EBITDA. This is because many noncash charges are made after computing EBIT or EBITDA and do not need to be added back when calculating FCFF and/or FCFE from either of the two. An example of a noncash charge which is not made before computing EBITDA is depreciation. Therefore, it is not added back to EBITDA when computing FCFF/FCFE. However, because depreciation is tax-deductible, the effect of taxes must be accounted for when calculating FCFF. This is done by adding the product of the depreciation expense and tax charge to EBITDA. 20. Question ID: 49206 Correct Answer: C

C is correct. The equation for calculating FCFF from EBITDA is as follows: FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv. Based on this equation, the: • •

product of the depreciation charge and tax rate is added (Option C is correct while option A is incorrect) and after-tax interest expense does not feature in the equation as EBITDA is calculating prior to the inclusion of interest expense (Option B is incorrect).

21. Question ID: 49207 Correct Answer: A

The amount of Wayne Corporation’s FCFF is computed below: Increase in cash balance ($40 – $25) million Plus: Interest expense × (1 – tax rate) = $12 million (1 – 0.30) Plus: Repayment of principal – borrowings = ($10 – $8) million Plus: Cash dividends Less: New share issuances in excess of repurchases ($20 – $15) million Uses of FCFF

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In Millions $15.0 $8.4 $2.0 $15.0 $5.0 $35.4

Reading 30

Free Cash Flow Valuation

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22. Question ID: 49208 Correct Answer: B

Wayne Corporation’s FCFF is computed below (All $ figures are in millions): Sales $450 × 1.10 $495.0 EBIT $495 × 0.20 $99.0 EBIT (1 – tax rate) $99 (1 – 0.30) $69.3 Incremental FC 88.89%* × $450 × 0.10 ($40.0) Incremental WC 8.89%** × $450 × 0.10 ($4.0) FCFF $25.3 *Incremental fixed capital investment =


     

    

$$

= $×. =

88.89%         $$ **Incremental working capital investment = = $×. = 8.89%      23. Question ID: 49209 Correct Answer: A

All $ figures are in millions. Net borrowing = (Fixed capital investment + working capital investment) × debt ratio Net borrowing = ($27.00 + $6.75) × 0.30 = $10.13 Fixed capital investment = 60% × $450 × 0.10 = $27.00 Working capital investment = 15% × $450 × 0.10 = $6.75

24. Question ID: 49210 Correct Answer: B

Based on the data in Exhibit 2, the required return on equity should be calculated using CAPM. r = E(Ri) = RF + Bi[E(RM) – RF] = 3.80% + 1.30[7.35%] = 13.355% ≈ 13.4%

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Reading 30

Free Cash Flow Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 30: Free Cash Flow Valuation 25. Question ID: 49212 Correct Answer: B

V0 =

FCFE0 (1 + g ) 23.5(1 + 0.015*) = = VER256.478 r−g 0.108 * * − 0.015

*Brach Tech’s real required return is 1.2% lower that Venezuela’s real GDP growth, therefore, the company’s real required return is 1.5% (2.7% - 1.2%). **The real required return for Brach Tech is equal to 10.8%. See below: Country return (real) Industry adjustment Size adjustment Leverage adjustment Required rate of return

10.5% + 1.8% - 1.0% - 0.5% 10.8%

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Reading 30

Free Cash Flow Valuation

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26. Question ID: 49213 Correct Answer: B

The reconciliation has been accurately presented with respect to: • • • •

decrease in trade receivable – represents a source of cash and the amount of decrease should be added to net income; increase in other current assets – represents a use of cash and the amount of decrease should be deducted from net income; increase in interest receivable represents a use of cash and should be deducted; and decrease in notes payable – should not feature in the reconciliation and should be omitted.

Based on these three adjustments, the correct figure for operating cash flows is VER 3,587 million. Note: Relevant corrections are highlighted in bold and all figures are in millions. Net income

VER 3,550

Adjustments to reconcile net income to operating cash flows Depreciation Loss on disposal property plant and equipment Increase in inventories Decrease in trade receivables Increase in other current assets Increase in accrued expenses Decrease in interest payable Increase in interest receivable Income tax paid Net cash provided/(used in) operating activities

+ 80 +2 - 14 + 10 - 20 + 15 -8 -6 - 22 VER 3,587

27. Question ID: 49214 Correct Answer: A

A is correct. An increase in depreciation expense is positive for future cash flow from operations (CFO). Net income is reduced by depreciation × (1 – tax rate) while the full amount of depreciation expense is added back when calculating CFO. Therefore, the difference between the depreciation expense – the amount added back to net income to calculate CFO - and the amount by which net income is reduced by depreciation expense is: (tax rate) × (depreciation expense) which represents a positive increment to CFO. Therefore, the CFO reported in reading will increase by VER 24.48 million (VER 80 million × 1.02 × 0.30).

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Reading 30

Free Cash Flow Valuation

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28. Question ID: 49215 Correct Answer: A

FCFE is not affected by divided payments to common shareholders. The reason is that FCFE represent the cash flows available to a company’s shareholders while dividends represent uses of these cash flows. Therefore, the company’s decision to cut its dividend per share should not affect its FCFE. On the other hand, an increase in leverage will increase FCFE in the year the debt is issued by the amount of issuance proceeds. 29. Question ID: 49216 Correct Answer: B

B is correct. Dividend payments are made at the discretion of the corporation’s board of directors and therefore, they may imperfectly signal the company’s long-run profitability. A is incorrect. Dividends represent uses of available cash whereas FCFE represent the cash flow that will be distributed to a company’s shareholders without impairing the company value. C is incorrect. As long as a company’s growth rate is lower than its required rate of return, a declining rate can be used in the dividend discount model. 30. Question ID: 49217 Correct Answer: C

FCFE forecasted for the year 2018 is equal to VER 24.8 million/2.5 million = VER 9.92 2018 Expected (In VER millions) Earnings VER 52.0 Net fixed capital investment - VER 22.0 Net working capital investment - VER 12.0 Debt financing [(VER 22 + VER 12) × + VER 6.80 0.20] Forecasted FCFE VER 24.8

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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FinQuiz.com CFA Level II Item-set - Solution Study Session 11 June 2019

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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FinQuiz Level II 2015 – Item-sets Solution Reading 31: Market-Based Valuation: Price and Enterprise Value Multiples 1. Question ID: 11303 Correct Answer: B Statement 1 is incorrect. A justified price multiple is an estimated fair value of the multiple, which can be justified either on the basis of the method of forecasted fundamentals or on the basis of the method of comparables. In either case, the multiple will be called a justified multiple (it is not necessarily based on forecasted fundamentals). Statement 2 is correct. Of all the accounting adjustments, the potential dilution of EPS generally makes the least demands on analysts’ accounting expertise because companies are themselves required to present both basic EPS and diluted EPS. Because companies present both EPS numbers, the analyst does not need to make the computation. 2. Question ID: 11304 Correct Answer: C Since the firm’s P/E has been negatively related to the recent earnings growth rate and positively related to the future growth rate (the Molodovsky effect), this is most likely due to rebounds in earnings. Hence earnings are cyclical. For cyclical firms, normalized P/Es most closely reflect longterm earning power of the business. Also, since the company has been expanding, and as seen from Exhibit 1, its book value per share has risen significantly. Therefore, the normalized EPS from the average ROE method will better reflect the effect of the current size of the company. The estimation is as follows: (6.7+5.5+14.5+23.5+21.1)/5 = 14.26% Based on current BVPS of $6.95, the normalized EPS equals: (.1426×6.95) = $0.99 The P/E based on this estimate equals: 14.32/0.99 = 14.449 3. Question ID: 11305 Correct Answer: A As of 1st October, three months remained in year 2009. The EPS equals: [(3/12)(0.18*) + (9/12)(0.47)] = $0.3975 *0.02+0.07+(0.03)+0.12 = 0.18 The NTM P/E would be: 9.84/0.3975 = 24.75 The EPS based on a fiscal year definition and next year’s forecasted EPS equals: 0.09 + (0.05) + 0.21 + 0.22 = 0.47 P/E equals: 9.84/0.47 = 20.94

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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4. Question ID: 11306 Correct Answer: B Stock A appears to be undervalued when compared to the index. Stock A and B are both trading at the same P/E of 14.67, versus a P/E of 16.15 for the index. But the last column indicates that Stock A has historically traded at a premium to the index whereas stock B has traded at a discount. Based on the current level, this would imply a P/E for stock B of 0.89×16.15 = 14.37. Stock A should have a P/E of 1.1 × 16.15 = 17.765, hence it is undervalued. 5. Question ID: 11307 Correct Answer: C P/BV = (ROE–g)/(r–g) = .15–.085/.12–.085 = 1.857 The statement is correct with respect to residual income. If the present value of expected future residual earnings is zero, that is, the business earns its required return on investment in every period, the justified P/BV will equal 1. 6. Question ID: 11308 Correct Answer: C PEG does not factor in differences in risk, an important determinant of P/E. Also, PEG does not account for differences in the duration of growth (short-term growth forecasts vs. long-term growth prospects). PEG assumes a linear relationship between P/E and growth, which is another limitation of the ratio, hence, option C is incorrect. 7. Question ID: 16131 Correct Answer: C According to the Fed Model, the justified P/E ratios for the indices are: Euro Index: 1/0.0564 = 17.73 German Index: 1/0.0785 = 12.7388 8. Question ID: 16132 Correct Answer: A According to the Yardeni Model, the justified P/E ratio equals: P/E = 1/CBY – b(LTEG) In this case: P/E = 1/6.7% – 0.10(11.5%) = 14.91 9. Question ID: 16133 Correct Answer: A Mahard is correct with respect to the drawback. A drawback of the Fed Model is that the relationship between interest rates and earnings yields is not a linear one. This drawback is most noticeable at low interest rates. Mahard is incorrect with respect to the benefit. A drawback of the Fed Model is that it inadequately reflects the effects of inflation and incorrectly incorporates the differential effects of inflation on earnings and interest payments.

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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10. Question ID: 16134 Correct Answer: C Cloff is incorrect. In using T-Wires own historical P/E as a benchmark, Cloff has overlooked the fact that the company has undergone shifts in the use of financial leverage. This will impair comparability based on past P/Es, and the method is prone to error. Also, T-Wires is able to fully pass through cost increases to customers, and in case of complete cost pass-through, the justified P/E should not be affected by inflation. 11. Question ID: 16135 Correct Answer: B Because of share repurchases and growth in treasury stock, shareholders equity would grow at a low rate even if retained earnings are growing fast. Also, when a company repurchases shares at a price higher than the current book value per share, it lowers the overall book value per share for the company. This will have the effect of increasing the P/BV. In addition, if the firm has shifted to a JIT inventory system, the amount of inventory it holds will decrease, and the P/BV will increase. 12. Question ID: 16136 Correct Answer: C For two stocks with the same P/B, the one with the higher ROE is relatively undervalued, all else equal. If the present value of expected future residual earnings is positive, the justified P/B will be greater than 1. Option C is correct. 13. Question ID: 18196 Correct Answer: B Normalized Earnings = Total Recent Cyclical Earnings/ Number of Years in Cycle Normalized Earnings = $93.83/7 = $13.40 14. Question ID: 18197 Correct Answer: B Normalized Earnings = Avg. ROE × Current Book Value per share Normalized Earnings = 16% × $103.00 = $16.48 15. Question ID: 18198 Correct Answer: C If Armadillo had reported a loss in the current year, the most appropriate formulae to be used for the normalized earnings calculation would be: Average ROA × Total Assets or Average ROE × Total Shareholders’ Equity

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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16. Question ID: 18199 Correct Answer: C Earnings yield may be used when: • •

earnings are negative. earnings are extremely low.

17. Question ID: 18200 Correct Answer: C The earnings yield of the index = 1/34 = 2.9% As the earning yield is lower than the 10 year Treasury bonds yield, the decision rule of the Fed Model dictates that the index is overvalued. 18. Question ID: 18201 Correct Answer: A The Fed Model does not incorporate the differential effects of inflation on earnings and interest payments. The other two options are correct. 19. Question ID: 18203 Correct Answer: B As the objective is to calculate share price, price multiples must be used. Earnings Yield is appropriate as well, as it is the inverse of the price to earnings ratio. Enterprise value multiples are to be used to calculate the total market value of all sources of capital. 20. Question ID: 18204 Correct Answer: A Value in year n = (Benchmark trailing P/E ratio) × (Forecasted earnings in year n) Forecasted Earnings per Share of Aberdour = $42 *million/8 million= $5.25/share Value = 34 × $5.25 = $178.5/share *Valuation is a forward looking process, so analysts usually focus on forward EPS when earnings forecasts are available; when earnings are not readily predictable, a trailing EPS may be more appropriate than Forward EPS. 21. Question ID: 18205 Correct Answer: B Tighter credit controls would increase the cost of money. This increase in interest rates would be reflected through an increase in the equity returns demanded by the residual stakeholders. The increase in earning yields would be translated as an effective decrease in the P/E ratio. 22. Question ID: 18206 Correct Answer: C As the character of Carnell’s management is questionable, the earnings reported by the company cannot be expected as reliable and transparent. It is, therefore, more prudent to use the price to sales or the price to book value ratios to arrive at a relevant value.

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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23. Question ID: 18207 Correct Answer: B Current EPS = $60 million/ $12 million = $5/share Leading P/E = Current Market Price/ Next Year’s Expected Earnings Current Market Price = $5 × 34 = $170.00 Next Year’s Expected Earnings = $57 million/12 million = $4.75 Leading P/E = $170/$4.75 = 36 24. Question ID: 18208 Correct Answer: C Non-recurring items are excluded from the earnings to arrive at a figure which is sustainable in the future. The cash flow component of earnings is assigned a greater weight than the accrual component of earnings in the valuation. 25. Question ID: 18210 Correct Answer: B Sales per share = ($16,000,000 – $1,200,000 – $500,000)/ 600,000 = $14,300,000/600,000 = $23.83/share b = (NI – Div)/NI = ($16.00 – $1.80)/$16.00 = 88.7% g = b × r= 88.7% × 18% = 16% Justified Price to Sales = [(E0/ S0) (1 – b) (1+g)]/ (r – g) Justified Price to Sales = [($16.00/ $23.83) (1 – 0.887) (1+16)]/ (0.18 – 0.16) Justified Price to Sales = [0.67 × 0.113 × 1.16] / 0.02= 4.39 26. Question ID: 18211 Correct Answer: B Sales per share = ($18,000,000 – $1,500,000 – $800,000)/ 650,000 = $15,700,000/650,000 = $24.15/share b = (NI-Div)/NI = ($14.00 – $1.40)/$14.00 = 90% g = b × r = 90% × 20% = 18% Justified Price to Sales = [(E0/ S0) (1 – b) (1+g)]/ (r-g) Justified Price to Sales = [($14.00/ $24.15) (1– 0.90) (1+18)]/ (0.20 – 0.18) Justified Price to Sales = [0.58 x 0.10 x 1.18] / 0.02 = 3.42 27. Question ID: 18212 Correct Answer: B In cases where stocks have similar P/E ratios, actual or forecasted net profit margin can be calculated through: (P/S)/ (P/E) Zeg’s NP Margin: (P/S)/ (P/E) = 4.39/ 12.5 = 35%

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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Skive’s Net Profit Margin: (P/S)/ (P/E) = 3.42/ 12.5 = 27% 28. Question ID: 18213 Correct Answer: A A low payout ratio as compared to competitors is sustainable income. However, high dividend payouts as compared to industry average figures may be unsustainable in the long term. 29. Question ID: 18214 Correct Answer: B ROIC = Operating Earnings after Tax/ Invested Capital = ($22,000,000 × 0.82)/ $102,000,000 = $18,040,000/ $102,000,000 = 17.70% 30. Question ID: 18215 Correct Answer: A EV = MV of Equity + MV of Preferred Stock + MV of Debt – Cash and Cash Equivalents EV = ($225x 600,000) + $13,000,000 + $25,000,000 – $14,000,000 = $159 million 31. Question ID: 18217 Correct Answer: B CEY = CBY – (b × LTEG) CEY = 8.0% – (0.1 × 4.5%) CEY = 7.55% P/E = 1/CEY = 13.20 32. Question ID: 18218 Correct Answer: A All figures in ‘000 Book Value per Share for Equity Holders = (Total Assets-Total Liabilities- Preferred Stock- Arrears on Preferred Stock)/ Number of Shares Outstanding Book Value per Share for Equity Holders = ($256,000 – $103,000 – $23,000 – $6,000)/8,000 = $15.50 per share 33. Question ID: 18219 Correct Answer: A The approach uses collectable market data in valuation rather than the Gordon Growth Model which uses forecasted values for its calculation. The other two options are correct. 34. Question ID: 18220 Correct Answer: A A share repurchase at a premium to the current book value per share would decrease the overall book value per share for the company. This is because the value of the equity would be reduced by a greater amount than the number of shares purchased through the through the transaction.

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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35. Question ID: 18221 Correct Answer: B All financial assets are reported at fair value for the purpose of calculating the price to book ratio. However, investments classified as held-to-maturity are reported on a historical cost basis. 36. Question ID: 18222 Correct Answer: C b = (NI – Div)/NI = ($4.60 – $1.20)/$4.60 = 74% g = b × r = 74% × 18% = 13.3% Justified P/B = (ROE – g)/ (RR – g) = (0.18 – 0.133)/ (0.15 – 0.133)= 0.047/0.017 = 2.76 37. Question ID: 18224 Correct Answer: C As Postet is an automobile manufacture, it is a cyclical business affected by the ups and downs of the economic lifecycle. The trailing EPS is an inappropriate measure of determining company performance as it is often negative at the bottom of a cycle and positive at the top of the cycle. This is known as the Molodovsky effect. 38. Question ID: 18225 Correct Answer: A b = (Net Income- Dividends)/Net Income g = b x ROE Micro

Milli

Macro

b

72%

80%

65%

g

14.4%

14.4%

14.3%

As the growth rates of all three companies are similar, and Micro is in the growth stage of the industry life cycle, we may safely assume the other two companies to also lie in the growth stage of the lifecycle. 39. Question ID: 18226 Correct Answer: B b = (Net Income – Dividends)/Net Income g = b × ROE Justified Trailing P/E = [(1 – b) × (1+g)]/(r-g) Micro

Milli

Macro

b

72%

80%

65%

g

14.4%

14.4%

14.3%

Justified Trailing P/E

53.38

8.80

57.15

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Reading 31

Market-Based Valuation: Price and Enterprise Value Multiples

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40. Question ID: 18227 Correct Answer: C Regression does take into account differences in the duration of growth. The other two options are correct limitations. 41. Question ID: 18228 Correct Answer: C b = (Net Income- Dividends)/Net Income g = b × ROE Justified Forward P/E = (1 – b)/(r – g) Micro

Milli

Macro

B

72%

80%

65%

G

14.4%

14.4%

14.3%

Justified Forward P/E

46.67

7.69

50.00

Forward P/E (Market)

50.00

30.00

48.00

Overvalued

Overvalued

Undervalued

42. Question ID: 18229 Correct Answer: B PEG Ratio = (Stock’s P/E)/ Expected Earnings Growth Rate Micro: PEG Ratio = 50.0/7 = 7.1 Milli: PEG Ratio = 30/9 = 3.3 Macro: PEG Ratio = 48/12 = 4.0 Decision Rule: The lower the PEG ratio, the more attractive is the investment.

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Reading 32

Residual Income Valuation

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FinQuiz.com CFA Level II Item-set - Solution Study Session 11 June 2019

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Reading 32

Residual Income Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 32: Residual Income Valuation 1. Question ID: 11354 Correct Answer: A Following is the company’s analysis: EBIT Less Interest expense Pretax Income Less Income tax Net Income NOPAT Equity Charge Debt Charge Total Capital Charge Residual income Effective capital Charge After tax net operating return

$1,500,000 $480,000 (20 million × 0.30 × 0.08) $1,020,000 $306,000 (at 30%) $714,000 $1,050,000 (1,500,000 – 30% taxes) $1,820,000 (20 million × 0.70 × 0.13) $336,000 [20 million × 0.30 × (1-0.30)0.08)] $2,156,000 (equity charge + debt charge) $(1,106,000) (NI less equity charge or NOPAT less total charge) 10.78% (Total capital charge/20 million) 5.25% (NOPAT/20 million)

So the after tax net operating return on total assets is 5.53% less than the effective capital charge. 2. Question ID: 11355 Correct Answer: B Year Beg. BVPS

1 $7.50

2 $9.45

3 $11.44

NI/share

$3.45

$4.00

$4.79

Less DPS

$1.5

$2.01

$16.23

Change in RE

$1.95

$1.99

–$11.44

End. BVPS

$9.45

$11.44

$0

NI/share

$3.45

$4.00

$4.79

Less equity charge

$0.90

$1.134

$1.3728

Residual Income

$2.55

$2.866

$3.4172

V0 = 7.50 + 2.55/(1.12) + 2.866/(1.12)2 + 3.4172/(1.12)3 = $14.4938

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Reading 32

Residual Income Valuation

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3. Question ID: 11356 Correct Answer: C Statement 1 is incorrect. It is true that the higher the persistence factor the higher the stream of expected residual income. However, the persistence factor is only related to the continuing residual income, and determines the residual income in the final stage of the company’s operations. Hence, a higher persistence factor does not mean high residual income over the entire life of a security; RI before the final stage is unaffected. Statement 2 is also incorrect. Lower residual income persistence is associated with extreme accounting rates of return. 4. Question ID: 11357 Correct Answer: B Since Scott is not sure about the future demand and profitability of energy stocks, the terminal value will be subject to huge uncertainty. In residual income valuation, the current book value captures a large portion of total value and the terminal value is not a large component. However, this contrasts with other multistage approaches, like DDM and FCFF (DCF), in which the present value of the terminal value is frequently a significant portion of the total value. Also, a lower persistence factor will result in a lower terminal value, a conservative estimate, and is better to use in this case (which will again reduce the TV’s weight in total value). 5. Question ID: 11358 Correct Answer: C Using CAPM, the return on equity is: 4 + 1.3(11) = 18.3% According to the single-stage residual income model, the value of the stock is: V0 = 25.5 + (.205–0.183)/(0.183–0.093)25.5 = $31.74 Since the stock’s intrinsic value is $7.967 less than the current market price of $39.7, the stock is overvalued and should not be bought. 6. Question ID: 11359 Correct Answer: A Year BVPS EPS Less DPS End. BVPS Abnormal rate of return(ROE-r) × beg. BVPS Residual Income

1 $8.15 $4.56 $2.1 $10.61 21.3%

2 $10.61 $5.43 $2.43 $13.61 27.9%

×8.15

×10.61

$1.736

$2.960

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Reading 32

Residual Income Valuation

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7. Question ID: 14104 Correct Answer: A A residual income model is appropriate in the following situations: • • •

the company does not pay dividends or the dividends are unpredictable; the company’s expected free cash flows are negative within the analyst’s forecast horizon; the terminal value is uncertain and is thus unpredictable using an alternative present value approach.

HM’s uncertain dividend payment stream and its negative free cash flow generation pattern, expected over the foreseeable horizon, make the residual income model the most appropriate model to use for valuing HM. 8. Question ID: 14105 Correct Answer: A Benefit 1: The residual income model uses accounting data to produce valuations. The benefit of using accounting data is that is readily available. However, the drawback associated with accounting data is that it may be subject to manipulation by management and may require the use of adjustments. This complicates the use of the model and implies that accounting data may not always be directly/readily usable. Thus benefit 1 fails to accurately capture the benefit of using accounting data as part of the model. Benefit 2: Residual income models focus on economic profitability, which reflects the profits available to shareholders after deducting the cost of providing equity capital by equity shareholders. Thus the model takes the perspective of shareholders by focusing on the profits available to them. On the other hand, measures based on net income may not be as useful to shareholders as they reflect the profits available to all the providers of capital, debt holders and equity holders, as opposed to exclusively to the equity holders. Benefit 2 accurately captures this benefit. Benefit 3: As outlined in the solution to Part 1, the model is most appropriate when forecasted terminal values are highly uncertain making this model beneficial to use in the event of uncertain terminal values. Benefit 3 accurately addresses this benefit.

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Reading 32

Residual Income Valuation

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9. Question ID: 14106 Correct Answer: A Residual income = (ROE – r) × BVt-1 or EPSt – (r × BVt-1) (1) Year

(2) Book Value $*

(3) Projected Income $*

2005 28.85 2006 33.89 7.54 2007 38.64 7.63 2008 46.37 9.66 2009 55.64 11.59 2010 66.77 13.91 Total * Stated as $ per share

(4) Dividend $*

(5) Forecasted ROE (Beginning Equity %)

(6) Cost of Equity (%)

(7) Cost of Equity $

(8) Residual Income (RI) $*

2.50 2.88 1.93 2.32 2.78

26.14 22.51 25.00 25.00 25.00

13.00 13.00 13.00 13.00 13.00

3.7505 4.4057 5.0232 6.0281 7.2332

3.7895 3.2243 4.6368 5.5644 6.6768

(9) Present Value of RI $ 28.85 3.35 2.53 3.21 3.41 3.62 44.97

Workings: (2) = (3) – (4) – BVt-1 (3) = (5) ÷ BVt-1 (4) = (3) × 0.20 (5) = (3) ÷ BVt-1 (7) = (6) × BVt-1 (8) = [(5) – (6)] × BVt-1 Using the persistence factor, 0.75, the present value of the terminal value is calculated using the following formula:

− 
 1 +  − 1 + 
 T=6 2011 residual income = $8.01216 ($6.6768 × 1.20). The growth factor of 1.20 reflects a 20% growth rate where the growth rate is the retention rate multiplied by the ROE: (0.80) (25%) = 0.20 $8.01216 = $11.443893  $11.44 1 + 0.13 − 0.751.13 The current value is thus equal to $56.41 ($44.97 + $11.44) or approximately $56.00.

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Reading 32

Residual Income Valuation

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10. Question ID: 14107 Correct Answer: C The residual income model can be re-written as follows:

P0 ROE − r = 1+ B0 r−g

Should the return on equity (ROE) equal to the cost of equity, the extreme right hand side of the equation, following the ‘+’ sign, equals to zero and the justified price-to-book ratio will equal to 1. Additionally, if the return on equity equals the cost of equity, residual income will equal to zero as demonstrated by the formula below: Residual income = (ROE – r) × BVt-1 11. Question ID: 14108 Correct Answer: B Violations of the clean surplus relationship may occur when accounting standards permit changes directly to the shareholder’s equity account, bypassing the income statement. Items that commonly bypass the income statement include: • • •

foreign currency translation adjustments; certain pension adjustments; and fair value changes of some financial instruments.

Under both U.S. GAAP, which is applicable to HM, and IFRS, foreign currency translation adjustments bypass the income statement and are recorded as a component of shareholder’s equity. In the case of H.M., these adjustments will be recorded as part of comprehensive income (i.e. component of equity). As a result, these adjustments will distort net income, ROE, and hence residual income. However since the adjustments are recorded as a component of equity, the book value of equity is accurately stated. Wade’s statement is inaccurate with respect to the effects of a violation on the book value of equity but is accurate with respect to the fact that foreign currency translation adjustments may be a source of violation. 12. Question ID: 14109 Correct Answer: C The rate of residual income decay will be slower the greater the level of residual income persistence, following the initial income forecast horizon, and: • • • •

the lower dividend payout/the higher the retention rate; should the firm hold a high historical presence or secure a strong competitive position in the industry; the lower the level of special items (nonrecurring items) and accounting accruals being recorded; and the less extreme the accounting rates of return.

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Reading 32

Residual Income Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 32: Residual Income Valuation 13. Question ID: 49226 Correct Answer: A EVA = NOPAT – (Cost of capital × Total capital) EVA = [($32,580,450 × (1 – 0.35)] – (0.15 × $5,425,800*) = $20,363,422.50 ≈ $20,363,000. *Total capital = Total liabilities + total equity = $2,345,100 + $3,080,700 = $5,425,800 14. Question ID: 49227 Correct Answer: B B is correct. An increase in the LIFO reserve is added in when calculating NOPAT.

15. Question ID: 49228 Correct Answer: B B is correct. When calculating NOPAT, an analyst should eliminate deferred taxes such that only cash taxes remain. 16. Question ID: 49229 Correct Answer: A To determine whether Monoline Constructors’ shares are fairly valued or not, a single-stage residual income model will be applied to the data in Exhibit 1 to determine intrinsic value. V0 = B0 +

ROE − r 0.12 − 0.10 ($65.80) = $109.67 B0 = $65.80 + r−g 0.10 − 0.07

Based on a current share price of $115.20, Monoline’s shares are overvalued.

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Reading 32

Residual Income Valuation

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17. Question ID: 49230 Correct Answer: B The formula for calculating intrinsic value per share using the multi-stage residual income model is as follows: T −1

V0 = B0 + ∑ t =1

Et − rBt −1 (PT − BT ) + (1 + r )t (1 + r )T

Beginning book value per share

ROE Equity charge per share

Residual income per share

2015 $10.80

$8.80/$10.80 = 0.81 (0.08 × $10.80) = $0.86 $7.94

2018 $10.80 + $8.80 – $3.25 = $16.35 $6.50/$16.35 = 0.40 (0.08 × $16.35) = $1.31 $5.19

2018 $16.35 + $6.50 $2.40 = $20.45 $5.30/$20.45 = 0.26 (0.08 × $20.45) = $1.64 $3.66

2018 $20.45 + $5.30 $1.85 = $23.90 0.10 (given) (0.08 × $23.90) = $1.91 (0.10 – 0.08) × $23.90 = $0.48

Given that price will equal book value per share at the end of 2018, the second term of the equation (to the right hand side of the plus sign) reduces to zero. Intrinsic value = $10.80 +

$7.94 $5.19 $3.66 $0.48 + + + = $25.86 1.08 1.082 1.083 1.084

18. Question ID: 49227 Correct Answer: C The single stage residual income model is provided by the following expression:

V0 = B0 +

ROE − r B0 r−g

If the ROE is lower than the cost of equity, the company would have negative residual income and would be valued at less than its book value.

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Reading 32

Residual Income Valuation

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FinQuiz Level II 2018 – Item-sets Solution Reading 32: Residual Income Valuation 19. Question ID: 49233 Correct Answer: A A is correct. Terminal value will equal zero on the maturity date of the Ace Limited investment as return on equity declines to cost of equity. In this scenario, the residual income valuation will not be sensitive to terminal value estimates. On the other hand, a large fraction of the stock’s present value in either the discounted dividend or free cash flow models is represented by the present value of the expected terminal value. B is incorrect. A high persistence factor will mean that residual income will be higher in the final stage and the valuation will be higher. However, this fact does not help answer Question 1. C is incorrect. Although residual income is a highly suitable technique when free cash flows are negative, there is no information to indicate Ace Limited is generating negative free cash flows. 20. Question ID: 49234 Correct Answer: B The multi-stage residual income model will be used to calculate residual income.

(EPSt − rBt −1 ) + EPST − rBT −1 (1 + r )t (1 + r − ω )(1 + r )T −1 t =1 T

V0 = B0 + ∑

Given that ROE will decline to the cost of equity after 2018, the third term on the right-hand side will be zero. Beginning book value per share2015 = EPS2015/ROE2015 = $7.45/0.2129 = $34.993 Sum of present value of residual income=

($7.450 − $4.200 ) + ($8.965 − $4.800 ) + ($10.320 − $5.522 ) = $9.6372 (1.12 ) (1.12 )2 (1.12 )3

V0 = $34.993 + $9.6372 = $44.630 or $44.63

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Reading 32

Residual Income Valuation

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21. Question ID: 49235 Correct Answer: A Lowering the dividend payout will increase residual income persistence as the annual amount of deduction (for dividends) from a company’s earnings will be lower leading to a higher stream of residual income in the final stage.

22. Question ID: 49236 Correct Answer: A A is correct. Residual income models are not appropriate for valuation purposes when a company’s ROE is not predictable. Given that Nixing Inc.’s earnings are unpredictable; its ROE cannot be forecasted with a reasonable degree of accuracy. B is incorrect. Residual income models are appropriate when a company does not pay dividends or if its dividends are not predictable. The fact that Nixing Inc. does not currently pay dividends makes the use of the residual income model appropriate for valuation. C is incorrect. The appropriateness of the residual income model is not determined based on how established a company’s revenue base is. 23. Question ID: 49237 Correct Answer: C C is correct. The residual income approach is not appropriate when the clean surplus relationship does not hold. The equation which determines whether this relationship holds is as follows: Bt = Bt-1 + Et – Dt. Based on the calculations below, the residual income model can only be used to value Howard’s stock as the clean surplus relationship holds only for the company. Based of clean surplus relationship: Bt of Lars Plc. = £74.50 + £8.55 – £2.30 = £80.75 Bt of Oron = £87.95 + £10.30 –£3.80 = £94.45 Bt of Howard Corp. = £95.00 +£12.90 – £4.35 =£103.55

24. Question ID: 49238 Correct Answer: B B is correct. In applying a residual income model it is necessary to develop a forecast of future residual income based on recurring items. Litigation expenses related to product quality reflects an unusual charge and the event is unlikely to occur from one period to the next. Therefore, the most suitable course of action is to re-classify the expenses and any associated losses as non-recurring.

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Reading 32

Residual Income Valuation

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FinQuiz Level II 2018 – Item-sets Solution Reading 32: Residual Income Valuation 25. Question ID: 49240 Correct Answer: C Based on the relationship between the justified price-to-book (P/B) ratio and the residual income model (see below), if the cost of equity (represented by ‘r’) is below the company’s required return on equity (represented by ‘ROE’), the company’s expression to right of the plus sign is positive resulting in a ratio which is greater than 1.0.

P0 ROE − r = 1+ B0 r−g 26. Question ID: 49241 Correct Answer: B Based on the single-stage residual income model (see below): • •

Observation 2 will increase residual income as a decline in ‘g’ will increase the expression on the right hand side of the plus sign. Observation 3 will increase the intrinsic value estimate as a lower ‘r’ will increase the expression on the right hand side of the plus sign.

Single-stage residual income model = V0 = B0 +

ROE − r B0 r−g

27. Question ID: 49242 Correct Answer: A Market value added = Market value of the company – Accounting book value of total capital = (1,200,000 × $8.50) – $8,240,300 = $1,959,700 28. Question ID: 49243 Correct Answer: B Tobin’s q is a measure of the productivity of a company’s assets.         

Tobin’s q =            =

$,, !,,×$".#$ $%,#",

= 3.7817 ≈ 3.78

Based on the expression for Tobin’s q, the replacement cost takes into account the effects of inflation. Therefore, a projected increase in inflation will increase the replacement cost of assets, decrease the Tobin’s q measure, and lower the productivity of a company’s assets.

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Reading 32

Residual Income Valuation

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29. Question ID: 49244 Correct Answer: C

Year 2015 2018 2018 2018

Forecasted NI ($) 5.00 6.00 7.20

Ending BV ($)

ROE (%)

Equity Charge ($)

Residual Income –RI ($)

PV of RI ($)

25.00 30.00 36.00 43.20

20 20 20

1.50 1.80 2.16

3.50 4.20 5.04

3.30 3.74 4.23 11.27

The intrinsic value of the company’s shares of stock is calculated using the following expression: V0 = B0 + Sum of discounted RIs + Discounted Premium V0 = $25.00 + $11.27 + (0.15)($43.20)/1.063 = $41.71

30. Question ID: 49245 Correct Answer: A A is correct. Under US GAAP, R&D expenditures, with the exception of expenses related to software development, are expensed directly to the income statement. Unproductive R&D expenditures will lower residual income through the expenditures made. ROE should reflect the productivity of expenditures without any adjustments. Therefore, Mathews should adjust the company’s earnings to reflect these unproductive R&D expenditures.

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Reading 33

Private Company Valuation

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FinQuiz.com CFA Level II Item-set - Solution Study Session 11 June 2019

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Reading 33

Private Company Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 33: Private Company Valuation 1. Question ID: 11390 Correct Answer: C Since Vibrant Manufacturers Inc. has just begun producing its product, it is most likely in the developmental stages of the lifecycle. This also means that the company is still small, and since the future of the firm is uncertain, the going concern premise of value may also be doubtful. This means that future cash flows are difficult to estimate and hence, the income approach is not appropriate. Also, the firm’s product is unique so similar public firms may not be present. Hence, in the earliest stages of development, when the going concern premise may be uncertain, future cash flows are difficult to establish and competitors are not present, the asset based approach is most appropriate. 2. Question ID: 11391 Correct Answer: C First, the SG&A expenses should be reduced by (2,500,000–1,050,000) + 100,000. Second, the land and commercial property are nonoperating assets, so expenses and income related to them should be removed from the income statement. The SG&A expenses should be reduced by $500,000, depreciation should be reduced by $300,000, and operating income should be reduced by $450,000. Overall, the operating income after taxes (at 40%) will increase by: ሺ1,450,000 + 100,000 + 500,000 + 300,000ሻ൫1– 0.40൯– 450,000൫1– 0.40൯ = $1,140,000. 3. Question ID: 11392 Correct Answer: A Dynamic Manufacturers, Next year’s FCFF Revenues ($80,000,000 × 1.04) COGS Gross Profit (0.5625 × 83,200,000) SG&A (10,500,000 × 1.05)

$83,200,000 $36,400,000 $46,800,000 $11,025,000

Pro Forma EBITDA Depreciation (0.03125 × 83,200,000) Pro forma EBIT Pro forma taxes (37%)

$35,775,000 $2,600,000 $33,175,000 $12,274,750

Operating income after taxes Plus Depreciation Less capital expenditures* Less increase in working capital**

$20,900,250 $2,600,000 $2,824,000 $416,000

FCFF

$20,260,250 *= $2,600,000 + 0.07(3,200,000) = $2,824,000 **= 0.13(3,200,000) = $416,000

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Reading 33

Private Company Valuation

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4. Question ID: 11393 Correct Answer: A According to the CAPM, the required rate of return is: 3.25 + 1.21(5.5) = 9.905% According to the expanded CAPM: 3.25+1.21(5.5)+3.5+0.67 = 14.075% 5. Question ID: 11394 Correct Answer: B Since Wilshire is using FCFF as cash flows, the appropriate discount rate is the cost of capital, or the firm’s WACC. The cost of equity using the build-up method equals: 3.25+5.5+3.5+0.67+1.5% = 14.42% The after tax cost of debt = 9.45(1-0.37) = 5.9535% WACC equals: 0.15(0.059535) + 0.85(0.1442) = 13.15% 6. Question ID: 11395 Correct Answer: C Statement 1 is incorrect. Even though nonoperating assets are assets not necessary to the ongoing operations of a business enterprise, in principle, the value of a company is the sum of the value of operating assets and the value of nonoperating assets. Thus, nonoperating assets should be included in the valuation of an enterprise regardless of the valuation approach or method being used. Statement 2 is incorrect. For companies with highly leveraged financial conditions and/or significant volatility expected in future financial performance, the valuation of equity as the residual obtained by subtracting the face value of debt form the value of the enterprise is not appropriate. Estimates of market value based on debt characteristics, known as matrix prices, are an alternative in such cases. 7. Question ID: 15788 Correct Answer: C Given Time Corporation is privately owned it will least likely face the same pressure from external investors as public companies. For that reason, private company management may be able to take a longer term perspective in their decisions and not face the pressure to achieve above-average returns. Due to the concentration of ownership in firm management, Time Corporation will suffer less from issues such as monitoring costs arising from a separation of management and ownership commonly faced amongst public corporations. Being privately traded, the stock of Time Corporation will, as a privately traded stock, has a reduced level of marketability.

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Reading 33

Private Company Valuation

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8. Question ID: 15789 Correct Answer: B Based on Time Corporation’s stage of development and maturity, a market approach is most suitable for valuing the established watchmaker. At the earliest stages of development, the company may be best valued using an asset-based approach. With progress to a development stage company in a high growth mode, the company might be valued using an income approach. 9. Question ID: 15790 Correct Answer: C Given the fact that investors are divided over the likelihood of an IPO, the investment value is the most appropriate definition of value for Time Corporation. The value of the corporation may differ as a result of the different perspectives of investors, making this definition of value appropriate. A lack of comparable firms in the market makes the use of fair market values to define value for Time inappropriate. Given the diversity in expectations, with respect to the IPO, the intrinsic value is an inappropriate value definition. 10. Question ID: 15791 Correct Answer: B Time Corporation’s forecasted FCFF (in ‘000) for the year 2011 is $9,561. This is calculated as follows: Revenues ($35,000,000 × 1.03) Cost of goods sold Gross profit margin (50% × $36,050,000) SG&A Expense (maintained at 2010 level) Pro forma EBITDA Depreciation and amortization ($36,050,000 × 1.5%) Pro forma earnings before interest and taxes Pro forma taxes on EBIT (at 35%) Operating income after tax Plus depreciation and amortization Less: Capital expenditures* Less: Increase in working capital** Free cash flow to the firm

$36,050,000 18,025,000 18,025,000 2,420,000 15,605,000 540,750 15,064,250 5,272,488 9,791,763 540,750 (614,250) (157,500) $9,560,763

*Incremental revenues (revenue generated) = $35,000,000 × 0.03 = $1,050,000 Capital expenditures = $540,750 (projected depreciation) + 0.07($1,050,000) = $614,250 **Increase in working capital = $0.15 additional working capital for every $1 of revenue generated. = $0.15 ×

$1,050,000 = $157,500 $1

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Reading 33

Private Company Valuation

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11. Question ID: 15792 Correct Answer: A Factor 1 fails to address the factors to consider when using the FCFF approach to value a firm. A FCFF model is more robust relative to a FCFE model when substantial capital structure changes are in view as WACC, the discount rate used in a FCFF valuation approach, is less sensitive than the cost of equity, used in a FCFE approach, to changes in financial leverage. Factor 2 correctly addresses the factors to consider when using the FCFF approach to value a firm. In calculating a WACC for a valuation based on FCFF, analysts need to consider that a private company has less access to debt financing than a similar publically traded corporation. The lesser access means that the company will need to rely more on equity financing, which would increase its WACC and consequentially result in a lower firm valuation. 12. Question ID: 15793 Correct Answer: B The value of Emerson’s 15% equity interest is $306,788. This is calculated as follows: Indicated value of equity assuming IPO materializes Interest appraised Pro rata value of 15% equity interest Less: Lack of control discount of 14% Value assuming ready marketability Less: Lack of marketability discount of 6% Indicated value of Emerson’s 15% equity interest

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$2,530,000 15% $379,500 $53,130 $326,370 $19,582 $306,788

Reading 33

Private Company Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 33: Private Company Valuation 13. Question ID: 49247 Correct Answer: C C is correct. The analysts’ main reason for valuing BRIC Limited is transaction-related. A is incorrect. Litigation-related valuations require effective presentations in a legal setting. There is no evidence of the company being positioned in a legal proceeding setting. B is incorrect. Compliance encompasses actions required by law or regulations. Financial reporting and tax reporting are the primary focuses of this type of valuation. 14. Question ID: 49248 Correct Answer: C C is correct. Given that Zeta is in its early stages of development with significant uncertainty regarding the future success of the company’s products, the asset-based approach is most suitable for valuation. The free-cash flow approach may not be suitable as future cash flows may be extremely difficult to predict at this stage of development. 15. Question ID: 49249 Correct Answer: B B is correct. The high growth phase in which Quanto operates makes the application of the FCF approach appropriate. The analysts will make discrete cash flow forecasts until cash flows are expected to stabilize at a constant growth rate. A is incorrect. Once the initial high growth phase is over, the analysts should opt for either the capitalized cash flow method or market approach. C is incorrect. Using market multiples to estimate terminal value in high growth industries would not be appropriate as rapid growth will be incorporated twice: once in the cash flow projections over the projection period and also in the market multiple used in calculating the residual enterprise multiple.

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Reading 33

Private Company Valuation

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16. Question ID: 49250 Correct Answer: A Normalized earnings are defined as “economic benefits adjusted for nonrecurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparisons.” Quanto’s normalized earnings should reflect compensation expense which is in line with that offered in the market. In addition, earnings should not reflect the life insurance premium paid by the company on behalf of its shareholders.

Revenue Cost of goods sold Gross profit Selling, general and administrative expenses (SG&A) Earnings before interest, tax, depreciation and amortization (EBITDA) Depreciation and amortization Earnings before interest and taxes (EBIT) Taxes (@ 30%) Operating income after taxes

As Reported $58,000 $37,700 $20,300 $3,900

Adjusted $58,000 $37,700 $20,300 $3,150

$16,400

$17,150

$9,900 $6,500

$9,900 $7,250

$1,950 $4,550

$2,175 $5,075

17. Question ID: 49251 Correct Answer: B All $ figures are in thousands. Revenue ($58,000 × 1.05) Gross profit ($60,900 × 0.35) SG&A ($3,900 × 1.02) EBITDA Depreciation and amortization ($60,900 × 0.02) EBIT Taxes (@ 30%) Operating income after taxes Add: Depreciation and amortization Less: Working capital investment (0.10 × 0.05 × $58,000) Less: Fixed capital investment – current operations Less: Fixed capital investment – future operations (0.08 × 0.05 × $58,000)

$60,900 $21,315 $3,978 $17,337 $1,218 $16,119 $4,836 $11,283 $1,218 $290 $650 $232 11,329

FCF

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Reading 33

Private Company Valuation

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18. Question ID: 49252 Correct Answer: C C is correct. Analysts believe that The FCFF approach is more robust when there are substantial capital structure changes because the weighted average cost of capital, which represents the discount rate used in a FCFF valuation, is less sensitive than the cost of equity, which is used in a FCFE valuation, to changes in financial leverage. A is incorrect. The cost of equity used in a FCFE valuation is more sensitive to changes in financial leverage.

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Reading 33

Private Company Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 33: Private Company Valuation 19. Question ID: 49275 Correct Answer: A A is incorrect. In evaluating an acquisition, the finance theory indicates that the cost of capital used should be based on the target company’s capital structure and the riskiness of the target company’s cash flows. 20. Question ID: 49276 Correct Answer: C C is correct. In general, the CAPM approach is least appropriate when guideline public companies are not available or are of questionable comparability. Based on ‘O Conner’s analysis of the industry, publically traded comparables do not exist resulting in the CAPM approach being an inappropriate tool for deriving required returns. A and B are incorrect. The CAPM can be applied to derive required return estimates for privately traded companies as long as public company comparables for the company being valued are available and comparable. The CAPM approach adds a premium for small size and company-specific risk when deriving required returns for private companies. 21. Question ID: 49277 Correct Answer: A Initial MVIC to EBITDA from transactions Relative risk and growth adjustment for Prac (9.5 × 0.16) Indicated multiple EBITDA Indicated value of invested capital Less: Debt capital Indicated value of equity

9.5 (1.52) 7.98 $1,280,000 $10,214,400 $625,000 $9,589,400

22. Question ID: 49278 Correct Answer: B Indicated MVIC to EBITDA from transaction Relative risk and growth adjustment for Prac (9.5 × 0.16) Regulatory changes adjustment factor (7.98 × 0.08) Indicated multiple The indicated multiple is approximately 8.62.

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9.5000 (1.5200) 0.6384 8.6184

Reading 33

Private Company Valuation

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23. Question ID: 49279 Correct Answer: B The individual discounts are multiplicative rather than additive and are applied in sequence. Total discount is equal to 54.5% [(1 – (1 – 30%)(1 – 35%)]. 24. Question ID: 49280 Correct Answer: B B is correct. The GTM considers transactions involving the acquisition of the total equity of companies and thus the pricing multiple reflects the value of total companies. On the other hand, pricing multiples from guideline public companies reflect trading in small blocks of stock and may not reflect the total value of the public companies. The fact that SnT is taking over Prac is indicative that the acquirer is purchasing a controlling interest in the latter. A is incorrect. There is no evidence that SnT’s acquisition of Prac will generate synergistic benefits for the former. SnT is not in the software development industry and, therefore, the purchase of a private company in an unrelated industry is an example of a financial transaction. C is incorrect. The composition of a company’s asset base does not drive the decision of which valuation method to use.

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Reading 33

Private Company Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 33: Private Company Valuation 25. Question ID: 49254 Correct Answer: B B is correct. The value assigned to Gatco’s stock of £35 by Peterson reflects intrinsic value. Intrinsic value is defined as the value the investor considers after an evaluation of facts. Peterson arrives at the value of the stock after evaluating earnings projections and the forecasted dividend payout ratio which provides further evidence of the use of this approach. A is incorrect. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between marketplace participants at the transaction date. Data concerning an arm’s length transaction between a buyer and seller is not provided and so stock value does not represent fair value. C is incorrect. Investment value is defined as value to a particular investor based on investor’s investment requirements and expectations. Given that the information collected by Peterson does not reflect his expectations, but that of market analysts’, the value derived cannot be classified as investment value. 26. Question ID: 49255 Correct Answer: A A is correct. For companies that are not expected to grow at a constant rate, FCF using a series of discrete cash flow projections is theoretically preferred to the CCM. B is incorrect. A CCM approach is suitable for valuing a private company in which no projections are available and an expectation of stable future operations exists. C is incorrect. If market pricing evidence from public companies or transactions is limited, a CCM approach may be a suitable approach. 27. Question ID: 49256 Correct Answer: A Required return on equity based on buildup method: Risk-free rate Company-specific risk premium Industry risk premium Small stock premium Equity risk premium Indicated return on equity

2.5% 3.5% 1.0% 4.3% 6.2% 17.5%

Value of Gatco = FCFE1/(r –g) = £1,800,000/(17.5% - 3.5%) = £12,857,142.9 or £12.9 million

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Reading 33

Private Company Valuation

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28. Question ID: 49257 Correct Answer: B The EEM is used to value Spidex. Application of this approach is discussed below: In the current year, residual income = £145,000 – 0.04(£250,000) – 0.12(£770,000) = £42,600 Intangible assets are valued using the formula for a growing perpetuity. The total value of intangible assets is (1.03) (£42,600) / (0.10 – 0.03) = £626,828.57 The total value of working capital, fixed capital, and intangible assets equals to the value of the business according to the EEM. This value is equal to £250,000 + £770,000 + £626,828.57 = £1,646,828.57 or £1.65 million. 29. Question ID: 49258 Correct Answer: A Net assets = Total assets – total liabilities = £13,582,500 – £7,750,000 = £5,832,500 Fair value of inventory = £350,000 × 0.95 = £332,500 Fair value of property, plant, and equipment = £8,200,000 + (£3,500,000 – £2,750,000) – £800,000 = £8,150,000 Fair value of assets = £13,650,000 – £350,000 – £8,200,000 + £332,500 + £8,150,000 = £13,582,500 30. Question ID: 49259 Correct Answer: B Indicated value of equity in operations Interest appraised Pro-rata value of 15% Less: Lack of control discount Value assuming ready marketability Less: Lack of marketability discount of 20% Indicated value of Reed’s 15% equity interest

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£23.500 million 15% £3.525 million 0 £3.525 million £0.705 million £2.820 million

Reading 34

The Term Structure and Interest Rate Dynamics

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FinQuiz.com CFA Level II Item-set - Solution Study Session 12 June 2019

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Reading 34

The Term Structure and Interest Rate Dynamics

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FinQuiz Level II 2019 – Item-sets Solution Reading 34: The Term Structure and Interest Rate Dynamics 1. Question ID: 22072 Correct Answer: B

B is correct. The forward contract value will increase during Year 2 as the expected future spot rate is lower than that implied from the forward rate curve (2.139% and 2.684% respectively). A is incorrect. The forward contract value will decline in Year 1 as the expected future spot rates are higher than that implied by the forward curve (1.994% and 1.954% respectively). C is incorrect. Since the expected and implied spot rates are equal in year 3, the forward contract value will remain unchanged. 2. Question ID: 22073 Correct Answer: C

C is correct. Lev can ride down the yield curve when the yield curve is upward sloping which is the case if the future spot rates expected by investors are realized. If the yield curve does not change its shape and level, an investor with a two-year investment horizon can buy bonds with maturity greater than two years. With the passage of time and assuming an upward sloping yield curve, the bond will be valued at successively lower yields and higher prices as long as yields do not change. In summary, the bond’s total return will exceed that of a bond whose maturity is equal to that of the investment horizon. A is incorrect. Buying a bond with a maturity equal to the investment horizon will earn a lower return in contrast to buying bonds whose maturity exceeds the investor’s investment horizon. B is incorrect. An upward sloping yield curve will allow the trader to generate profit from the strategy as long as the yields do not change.

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Reading 34

The Term Structure and Interest Rate Dynamics

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3. Question ID: 22074 Correct Answer: B

B is correct. The yield curve is downward sloping as the four-year spot rate is lower than the three-year spot rate, which in turn is lower than the two- and one-year spot rates. A downward sloping yield curve implies that forward rates will decline with the passage of time. Therefore the one-year rate for a bond to be delivered three years from today will be lower than the one-year rate for a bond to be delivered two years from today. A is incorrect. Given that the spot curve is not flat, one-period forward rates will not equal to the current spot rate but will be lower. C is incorrect. A downward sloping yield curve will result in expectations for the long-term rate, r(T*+T), being lower than that of the short-term rate r(T*). 4. Question ID: 22075 Correct Answer: B

B is correct. The forward model is used to derive the forward rate f(1,2): f(1,2) = [(1 + 0.025)3/(1 + 0.035)]1/2 – 1 = 0.020036 or 2.00%. 5. Question ID: 22076 Correct Answer: C

C is correct. White is incorrect with respect to his opinions regarding both of the statements. The liquidity preference theory can produce an upward sloping yield curve even when interest rates are declining or flat if the rising liquidity premium is sufficient to offset declining or flat interest rates. Rising spot rates will be consistent with an upward sloping yield curve in any case. Statement 2 reflects the preferred habitat theory which asserts that investors may be willing to move out of their preferred habitat as long as they have incentive. This incentive may be in the form of higher returns or reduced risk. 6. Question ID: 22077 Correct Answer: B

B is correct. Equilibrium models such as the Cox-Ingersoll-Ross (CIR) and Vasicek models assume that short-term rates are mean reverting. That is, they tend to move in a bounded range and show a tendency to revert to a long-run value, b.

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Reading 34

The Term Structure and Interest Rate Dynamics

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FinQuiz Level II 2019 – Item-sets Solution Reading 34: The Term Structure and Interest Rate Dynamics 7. Question ID: 48716 Correct Answer: A A is correct. The spot curve represents the term structure for zero-coupon securities. Given the absence of a coupon on the underlying securities, construction of this curve avoids the complications associated with the reinvestment rate assumption. C is incorrect. The par curve represents the yields to maturity on coupon-paying government bonds. Construction of this curve requires a consideration of the reinvestment rate assumption. 8. Question ID: 48717 Correct Answer: A Hawke is incorrect regarding Statement 2. The shape and level of the spot yield curve is dynamic because the spot curve depends on the market pricing of option-free zero-coupon bonds. Hawke is incorrect regarding Statement 3. The yield on zero-coupon bond maturing in T years is regarded as the most accurate representation of the T-year spot rate. In the absence of default risk, the T-year spot rate is equal to the yield-to-maturity of a zero-coupon bond. 9. Question ID: 48718 Correct Answer: B The forward rate model will be used to determine the presence of the arbitrage opportunities. If the return earned on trading the 3-year bond issue exceeds the geometric mean of one-period forward rates, the trader was able to exploit an arbitrage opportunity.

r (5) = {[1 + r (1)][1 + f (1,1)][1 + f (2,1)][1 + f (3,1)][1 + f (4,1)]}

1/ 5

−1

r (5) = {[1 + 2.0%][1 + 3.8%][1 + 4.6%][1 + 5.1%][1 + 5.9%]} − 1 = 4.27% 1/ 5

According to the forward rate model, the spot rate for a security with a 5-year maturity should be 4.27%. However, the trader’s return (6.0%) is greater than this geometric mean of one-period forward rates. Therefore, he has successfully exploited an arbitrage opportunity. 10. Question ID: 48719 Correct Answer: C As evident from Exhibit 1, the forward curve is upward sloping. Therefore, Hawke should expect the five-year spot rate to be higher than the forward rate on a contract to purchase a 4-year zero-coupon bond one year from today. In other words, f(1, 4) < r (5)

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Reading 34

The Term Structure and Interest Rate Dynamics

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11. Question ID: 48720 Correct Answer: B Given that the yields have declined at all maturity points; the yield curve has experienced a parallel downward shift. Furthermore, given that the short-term rates have declined more than the long-term rates, the slope of the yield curve has steepened. 12. Question ID: 48721 Correct Answer: B A decline in yields will increase the value of the bond portfolio. Change in the value of the portfolio = (- 0.10)(- 0.016) + (- 0.30)(- 0.012) + (- 0.60)(- 0.005) + (0.90)(- 0.003) = + 1.09% The value of the portfolio has increased to $202,180 ($200,000)(1.109).

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Reading 34

The Term Structure and Interest Rate Dynamics

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FinQuiz Level II 2019 – Item-sets Solution Reading 34: The Term Structure and Interest Rate Dynamics 13. Question ID: 48744 Correct Answer: C C is correct. The swap rate represents the interest rate quoted on the fixed rate leg of the swap. 14. Question ID: 48745 Correct Answer: C C is correct. Abdul is valuing the bond on behalf of County House, which is a wholesale bank. These organizations employ the swap curve to value assets and liabilities because they hedge many items on their balance sheet with swaps. A is incorrect. While it is true that swap contracts are non-standardized and customized, this does not explain why the swap rate will be preferred over Treasury spot rates for valuation. B is incorrect. The swap and Treasury markets are both active in the US. This factor will not serve to influence the choice of benchmark. 15. Question ID: 48746 Correct Answer: C I-spread = Bond rate – swap rate of same maturity as bond = 7.99% - 4.55% = 3.44% TED spread = LIBOR – T-bill yield of matching maturity = 3.00% - 1.25% = 1.75% 16. Question ID: 48747 Correct Answer: A A is correct. While the swap spreads provide a convenient way to measure credit and liquidity risk, a more accurate measure is the Z-spread. 17. Question ID: 48748 Correct Answer: B Discount factor = P(t,T) = P(2,4) 1/P(2,4) = [1 + 0.03][1 + 0.04][1 + 0.05][1 + 0.07] = 1.203493 P(2,4) = 1/1.203493 = 0.8309

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Reading 34

The Term Structure and Interest Rate Dynamics

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18. Question ID: 48749 Correct Answer: A Abdul is correct with respect to Conclusion 1 but incorrect with respect to Conclusion 2. The local and pure expectations theories both assert that the one-period return is equal to the risk-free rate. Therefore, the one-year holding period return should equal to the 1-year risk-free rate of 3%. The local expectations theory asserts that the expected return for bonds over longer-time periods is higher than the risk-free rate due to the existence of a premium.

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Reading 34

The Term Structure and Interest Rate Dynamics

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FinQuiz Level II 2019 – Item-sets Solution Reading 34: The Term Structure and Interest Rate Dynamics 19. Question ID: 48772 Correct Answer: A A is correct. Given that callable bonds include embedded options, the yield curve is sloping steeply upwards and the fact that interest rates are volatile, the callable bond’s YTM is a poor estimate of its expected return. Even though default-free zero-coupon bonds do not include embedded options, the assumptions concerning yield curve slope and volatility will result in the zero-coupon bond issue’s YTM being a poor estimate of its expected return. 20. Question ID: 48773 Correct Answer: B Since the forward rates are the assumed reinvestment rates, Mathews’ first step will involve determining the forward rates. f (1,1) = 1.082/1.12 – 1 = 4.1429% f (2,1) = 1.063/1.082 – 1 = 2.1104% f (3,1) = 1.044/1.063 – 1 = - 1.7764% Expected cash flow at the end of Year 4 = 5(1 + 0.041429) (1 + 0.021104) (1 – 0.017764) + 5(1 + 0.021104) (1 – 0.017764) + 5(1 – 0.017764) + 105 = 120.14859 Expected bond return = (120.14859 – 102.70) /102.70 = 16.9899% Expected annualized return = (1 + 0.169899)1/4 = 4.00% 21. Question ID: 48774 Correct Answer: A Mathew expects the spot rate curve to be sloping steeply downwards. In this scenario, the forward rate curve will be below the spot rate curve. 22. Question ID: 48775 Correct Answer: A A is correct. Lester’s comments are accurate with respect to modern term structure models but inaccurate with respect to equilibrium term structure models. Modern term structure models provide quantitative descriptions of how interest rates evolve and attempt to capture the statistical properties of interest rate movements. The CIR model cannot be calibrated to market data because it has a finite number of parameters and therefore it is not possible to specify the parameter values in such a way that model prices coincide with observed market prices.

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Reading 34

The Term Structure and Interest Rate Dynamics

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23. Question ID: 48776 Correct Answer: C C is correct. Mathews is inaccurate regarding Feature 3. The standard deviation makes volatility proportional to the square root of the short-term rate which allows for volatility to increase with the level of interest rates. It also avoids the possibility of non-positive interest rates. Mathews is accurate regarding Feature 1. The CIR model is a single factor model. The short-term interest rate can determine the entire term structure. Mathews is accurate regarding Feature 2. The deterministic or drift term of the model ensures the mean reversion of interest rates towards a long-run value. 24. Question ID: 48777 Correct Answer: A A is correct. Lester’s conclusion concerning the CIR model is appropriate. Because the model requires the short-term rate to follow a certain process, which features mean reversion to a long-term value (deterministic part) and a random normal distribution with a mean of 1 and standard deviation of 0 (stochastic term), the estimated yield curve may not match the observed yield curve.

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Reading 35

The Arbitrage-Free Valuation Framework

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FinQuiz.com CFA Level II Item-set - Solution Study Session 12 June 2019

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Reading 35

The Arbitrage-Free Valuation Framework

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FinQuiz Level II 2015 – Item-sets Solution Reading 35: The Arbitrage-Free Valuation Framework 1. Question ID: 22000 Correct Answer: A

A is correct. Discounting cash flows at their relevant spot rates is inappropriate for bonds with embedded options such as the Joyce Borde Inc. issue. This is because the framework assumes constant interest rates and is inappropriate for valuing bonds with embedded options. Changes in interest rates will impact the size and timing of cash flows of this bond category. B and C are incorrect. The binomial model is appropriate for valuing zero-coupon issues such as Vox Limited while the Monte Carlo method is suitable for valuing bonds with embedded options whose cash flows are path dependent. The Monte Carlo method is suitable because it allows for changing interest rates by making a volatility assumption. In this way, the model incorporates impact of changing interest rates on the size and timing of cash flows. 2. Question ID: 22001 Correct Answer: C

C is correct. Keeping in mind that the bond is valued at par at maturity, the value of the bond is $100 at Time 3. The value of the bond issue at Node 1-2 is derived using the value of the bond at nodes 2-2 and 2-3 (see the table below for the aforementioned nodes). Value of bond issue at Node 2-2 = 0.5 × (100/1.05215 + 100/1.05215) = 95.04348 Value of bond issue at Node 2-3 = 0.5 × (100/1.04102 + 100/1.04102) = 96.05963 Value of bond issue at Node 1-2 = 0.5 × (95.04348/1.03752 + 96.05963/1.03752) = 92.0961 Time 0 Node 1

Time 1 Node 1-1 Node 1-2

Time 2 Node 2-1 Node 2-2 Node 2-3

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Time 3 Node 3-1 Node 3-2 Node 3-3 Node 3-4

Reading 35

The Arbitrage-Free Valuation Framework

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3. Question ID: 22002 Correct Answer: A

A is correct. The Monte Carlo simulation model is well calibrated if it is arbitrage-free. A model is rendered arbitrage-free if it generates a value for the benchmark bond, which is equal to its market price. In order to ensure the Monte Carlo model generates arbitrage-free values for benchmark bonds and fits the current spot rate curve, a constant will need to be added to all short-term rates on all paths. B is incorrect. Increasing the number of paths will only serve to enhance the statistical accuracy of the value estimate. However, this does not mean that the model value of the security is closer to its fundamental value or in other words, the model is well-calibrated. C is incorrect. Stripping and reconstitution allows dealers to separate or recombine the bond’s individual cash flows such that trading activities will eliminate any arbitrage profits. However, the process does not ensure that the Monte Carlo simulation model is well calibrated. 4. Question ID: 22003 Correct Answer: A

A is correct. In order to determine which trade offers the maximum potential for arbitrage profits, the issue’s market price is compared to its arbitrage-free value. Arbitrage-free value of the issue (PV) = 103.6299 FV = 100 I/Y = 4% PMT = 5 N=4 The arbitrage profit realized if the issue is purchased in NYSE, at a price of 103.6214, and sold at its arbitrage-free price of 103.6299 is equal to 0.0085 per 100 par (103.6299 – 103.6214). The trader can maximize arbitrage profits by executing this trade. B is incorrect. The arbitrage profit realized if the issue is purchased in ASE, at a price of 103.6245, and sold at its arbitrage-free price is equal to 0.0054 per 100 par (103.6299 – 103.6245). The realized profit is lower than if the trade is undertaken in NYSE. C is incorrect. The arbitrage profit realized if the issue is purchased at its arbitrage-free price and sold in LSE a price of 103.6311 is equal to 0.0012 per 100 par (103.6311 – 103.6299). The trader realizes the lowest arbitrage profit in this trade.

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Reading 35

The Arbitrage-Free Valuation Framework

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5. Question ID: 22004 Correct Answer: B

B is correct. To determine the arbitrage-free valuation of a bond with embedded options, individual cash flows are discounted at forward rates implied from the benchmark spot rate curve. Implied forward rates are most suitable for this purpose because they account for volatility, which is necessary given that the size and timing of the cash flows generated by bonds with embedded options are sensitive to interest rate volatility. A is incorrect. Benchmark spot rates cannot be directly used to discount cash flows of a bond with embedded options. The reason for this is that the rates do not incorporate a volatility assumption. C is incorrect. Discounting the early coupons on a bond at the security’s yield-to-maturity will give too much discounting and an upward sloping yield curve and too little discounting for a downward sloping yield curve making the yield to maturity inappropriate as a discount rate. Furthermore, using this rate involves making the unrealistic assumption that all cash flows are reinvested at the yield-to-maturity, which is unrealistic given interest rate volatility and its impact on the size and timing of cash flows. 6. Question ID: 22005 Correct Answer: A

A is correct. The law of one price applies to the price of a product trading in more than one market and specifies that the prices of otherwise two identical products trading in different markets should be the same. However, this law is not relevant to the generation of implied forward rates from the benchmark spot rate curve. Both options B and C are incorrect. Implied forward rates generated from the benchmark spot rate curve need to be consistent with 1) an assumed level of interest rate volatility, 2) an interest rate model that governs the random process of interest rates, and 3) the current benchmark yield curve.

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Reading 35

The Arbitrage-Free Valuation Framework

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FinQuiz Level II 2015 – Item-sets Solution Reading 35: The Arbitrage-Free Valuation Framework 7. Question ID: 48723 Correct Answer: B Greene is incorrect with respect to his statement. Regardless of the complexity of the bond, each component must have an arbitrage-free value. Parker is correct with respect to her statement. 8. Question ID: 48724 Correct Answer: A A is correct. A higher volatility assumption results in the forward rates spreading out on the tree. On the other hand, a lower volatility assumption will result in the rates collapsing to the implied forward rates from the current yield curve. 9. Question ID: 48725 Correct Answer: A The process of bootstrapping will be used to derive the spot rates necessary for discounting the cash flows. Year 1 spot rate = 2%

3 103 + ; x = 3.0152 % 1.02 (1 + x )2 5 5 105 Year 3 spot rate = 100 = + + ; x = 5.1224% 2 1.02 (1.030152 ) (1 + x )3 5 5 105 Value of bond issue = + + = 100 .00 2 1.02 (1.030152 ) (1.051224 )3 Year 2 spot rate = 100 =

10. Question ID: 48726 Correct Answer: A A is correct. The rate at Node 6, 6.356%, can be derived using by multiplying the rate at Node 5, 9.467%, by e-2 × 0.20.

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Reading 35

The Arbitrage-Free Valuation Framework

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11. Question ID: 48727 Correct Answer: C C is correct. Mean reversion is implemented by implementing upper and lower bounds on the random process generating future interest rates. Mean reversion has the effect of moving interest rates toward the implied forward rates from the yield curve. A is incorrect. See above. B is incorrect. Mean reversion does not allow interest rates to get too high or too low and achieves this by implementing upper and lower bounds. Therefore, the process helps in reducing interest rate volatility. 12. Question ID: 48728 Correct Answer: C The present value of the bond at Path 4 is calculated as follows:

105 = 95 .9193 1.09467 (95.9193 + 5) = 96.1732 Year 2 Present Value = 1.04935 (96.1732 + 5) = 99.1894 Year 1 Present Value = 1.02 Year 3 Present Value =

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Reading 35

The Arbitrage-Free Valuation Framework

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FinQuiz Level II 2015 – Item-sets Solution Reading 35: The Arbitrage-Free Valuation Framework 13. Question ID: 48751 Correct Answer: A

The process of bootstrapping is used to generate spot rates from the benchmark par yield curve. This process employs linear interpolation to generate the relevant rates. 14. Question ID: 48752 Correct Answer: B

B is correct. Lone believes that the law of one price is being violated; this is because the three issues are believed to be mispriced. When assets are mispriced, there exists an opportunity for arbitrage profits. Therefore, assets are no longer valued under the principal of no arbitrage which otherwise validates arbitragefree valuation. This principal is based on the law of one price and therefore arbitrage opportunities arise as a result of a violation of the law of one price. A is incorrect. The non-negativity of interest rates is a property of the lognormal model of interest rates, which provides structure to the randomness of interest rates in a binomial interest rate tree. C is incorrect. The existence of arbitrage opportunities will increase the demand of mispriced securities. Prices will adjust until opportunities disappear. Therefore, the existence of such opportunities is never permanent. 15. Question ID: 48753 Correct Answer: C

To determine the amount of mispricing, it is first necessary to determine the arbitrage-free value. This value is derived using spot rates which are calculated using the par yields provided in Exhibit 2. 5 105 + ; z 2 = 5.051% 100 = 1.03 (1 + z 2 )2 7 7 107 100 = + + ; z3 = 7.198% 2 1.03 (1.05051) (1 + z3 )3 7 7 107 + + = 99.9999 or 100.00 Arbitrage-free value = 2 1.03 1.05051 1.071983 Therefore, the Sliver Inc. issue is mispriced by $5 per 100 of par value.

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Reading 35

The Arbitrage-Free Valuation Framework

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16. Question ID: 48754 Correct Answer: C

C is correct. Using spot rates to discount the cash flows for callable bonds ignores one key aspect of these securities – that is, cash flows are dependent on the path of interest rates. Changes in future interest rates will affect the likelihood that the option will be exercised which, in turn, will impact the cash flows. A is incorrect. The process of discounting cash flows using spot rates considers the time value of money and so this is not a valid argument. B is incorrect. Mean reversion in interest rates is a concept which is specifically considered for Monte Carlo simulation. It is unlikely to constitute a limitation of Lone’s preliminary analysis. 17. Question ID: 48755 Correct Answer: B

B is correct. The process of calibration allows for the resulting bond values to be arbitragefree or, in other words, equal to the current observable market price. A is incorrect. Incorporating mean reversion in Monte Carlo simulation ensures that interest rates never get too high or too low. 18. Question ID: 48756 Correct Answer: A

The value of the Gary-Tills issue at each of the three nodes is presented below:  100.000   100 .000  Node 1-1: 0.5  + 0.5  = 92.684  1.07984   1.07984   100.000   100 .000  Node 1-2: 0.5  + 0.5  = 93.929  1.06463   1.06463   92.684   93.929  Node 1-0: 0.5  + 0.5  = 90.589  1.03   1.03 

The value of the issue is calculated incorrect at Node 1-0.

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Reading 35

The Arbitrage-Free Valuation Framework

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FinQuiz Level II 2015 – Item-sets Solution Reading 35: The Arbitrage-Free Valuation Framework 19. Question ID: 48779 Correct Answer: C C is correct. The attendee’s explanation of the arbitrage-free valuation is inaccurate because the process is based on the no-arbitrage principal which implies that identical assets should sell at the same price. This results in an absence of arbitrage opportunities or, in other words, an inability to earn riskless profits with a zero net investment of money. Although arbitrage-free valuation values a bond as a portfolio of zero-coupon securities, the approach does not allow a market participant to realize an arbitrage profit through stripping and reconstitution. B is incorrect. See above. 20. Question ID: 48780 Correct Answer: B The value additivity principal states that the value of the whole is equal to the sum of its parts. A violation of this principal results in riskless profits. The individual strategies in the options are analyzed to determine profits today.

Today’s profit

Option A (102 × 0.9804) – $100 = $0.00

Option B (102 × 0.9804) – $95 = $5

Option C $95 – $100 = - $5.00

The strategy listed on option B is the only strategy to generate arbitrage-free profits based on the value additivity principal. 21. Question ID: 48781 Correct Answer: A Statement 1 is correct. Arbitrage-free valuation is based on the no-arbitrage principal, which implies that two otherwise identical assets should sell at the same price. Similarly, two cash flows with the same maturity and identical risks but attached to different bonds should be discounted at the same rate. Statement 2 is incorrect. To derive an arbitrage-free value of an option-free bond, the YTMs on onthe-run Treasury securities represent the benchmark rates. Spot rates need to be derived from the benchmark rates using bootstrapping which in turn is used to discount the bond’s cash flows to derive the arbitrage-free value.

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Reading 35

The Arbitrage-Free Valuation Framework

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22. Question ID: 48782 Correct Answer: C C is correct. Gloethe is inaccurate regarding Step 4. Determining the present value or arbitrage-free value using the binomial interest rate tree involves discounting the cash flows at the one year forward rate at the higher and lower nodes and averaging the two present values. This procedure is repeated while working from the right to left (backwards) of the binomial interest rate tree. The value at the root of the tree (leftmost node) represents the arbitrage-free value. In short, backward induction is used to derive the arbitrage-free value. A is incorrect. The first step in constructing a binomial tree involves the specification of a benchmark par curve by using bonds of a particular country or currency. B is incorrect. The second step in constructing the tree is to determine the rates at each node using an interest rate model, a volatility assumption and the benchmark par curve. 23. Question ID: 48783 Correct Answer: B B is correct. The volatility assumption is estimated using implied volatility as it is based on the observed market prices of an interest rate derivative – the swaption. 24. Question ID: 48784 Correct Answer: B Gloethe is inaccurate regarding both his statements. The Monte Carlo method simulates a large number of interest rate paths based on a probability distribution and assumed volatility. Spot rates are generated from the simulated one-month interest rates which are in turn used to calculate the present value of cash flows across interest rate paths. In short, simulated interest rates are not directly used to discount the security’s cash flows. Statement 4 is also inaccurate. To ensure that the model fits the current spot rate curve and is well calibrated, modelers will want to ensure that the model produces benchmark bond values equal to market prices. The model will be drift adjusted by adding a constant to all interest rate paths such that the average present value for each benchmark bond equal to its current market price. Adjusting the model for drift will ensure that the model fits the current spot rate curve and is well calibrated.

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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FinQuiz.com CFA Level II Item-set - Solution Study Session 13 June 2019

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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FinQuiz Level II 2019 – Item-sets Solution Reading 36: Valuation and Analysis: Bonds with Embedded Options 1. Question ID: 48730 Correct Answer: A Putable bonds are the most effective hedges against rising interest rates. A rise in interest rates will decrease the value of the straight bond. However, an increase in the value of the embedded put option will partially offset this decline. Therefore, putable bonds are more valuable when interest rates decline. A rise in interest rates will give the option holder to put the bond back to the issuer and reinvest the proceeds of the retired bond in a higher-yielding bond. On the other hand, the value of the callable bond declines similarly to the underlying straight bond. The embedded call option is out of the money and does not help to offset the decline. Therefore, a callable bond is not considered a hedge against rising interest rates. 2. Question ID: 48731 Correct Answer: C C is correct. The current yield-to-maturity is higher relative to bond A’s and C’s coupon rates (5.7% vs. 3% and 4%, respectively.) The call option is out of the money as it is unlikely to be called. Therefore, the effect of a shift in interest rates will have a similar effect on the prices of a callable and option-free issue. Both Bond C and the option-free bond have similar effective durations, 2.7. A is incorrect. The effective duration of a callable bond declines relative to that of the straight bond when current yields decline below coupon rates. This is when the call option is in the money. B is incorrect. The effective duration of a putable bond cannot exceed that of the straight bond regardless of the relationship between current yields and coupon rates. 3. Question ID: 48732 Correct Answer: C C is correct. The option-free bond changes very little in response to interest rate movements. On the other hand, the value of a callable bond decreases and putable bond increases with an increase in interest rate volatility.

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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4. Question ID: 48733 Correct Answer: A The calculated bond values at each node using the binomial tree are illustrated in the exhibit below: Year 0

R = 1.500% V = 104.433 Callable at 101.00

Year 1

Year 2

Year 3

R = 4.098% V = 100.867 Coupon = 5

C = 105.000

R = 2.777% V = 103.072 Coupon = 5 Callable at 101.000

R = 3.355% V = 101.592 Coupon = 5 Callable at 101.000

R = 2.273% V = 103.644 Coupon = 5 Callable at 101.000

R = 2.747% V = 102.193 Coupon = 5 Callable at 101.000

C = 105.000

C = 105.000 C = 105.000

Given that Bond B is currently callable the value of the bond is equal to 101 per 100 of par value. 5. Question ID: 48734 Correct Answer: B A higher volatility assumption will decrease the OAS of a callable bond. 6. Question ID: 48735 Correct Answer: C The effective convexity of the bonds is calculated using the formula: Effective convexity =

(PV− ) + (PV+ ) − [2 × (PV0 )] (∆Curve)2 × (PV0 )

Effective convexity (Bond A) =

101.632 + 100.765 − [2 × 101.156] = 52.52 (0.004 )2 × (101.156)

Effective convexity (Bond C) =

101.149 + 99.893 − [2 × 100.207] = 391.69 (0.004)2 × (100.207 )

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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FinQuiz Level II 2019 – Item-sets Solution Reading 36: Valuation and Analysis: Bonds with Embedded Options 7. Question ID: 48758 Correct Answer: A Using the spot rates, the forward rates are determined using linear interpolation: F(0,1) = 1.50% F(1,1) = 1.02252/1.015 – 1 = 3.0055% F(2,1) = 1.0313/1.02252 – 1 = 4.8213% Today Cash flow Discount rate Value of callable bond

103.448

Year 1

Year 2

Year 3

5.000 1.500%

5.000 3.006%

105.000 4.821%

101.936 Called at 100

100.171 Called at 100

8. Question ID: 48759 Correct Answer: A A is correct. The advantage which the key rate duration measure has over the effective duration measure is that the former considers shaping risk – the bond’s sensitivity to changes in the shape of the yield curve. B is incorrect. Both duration measures consider parallel shifts in the yield curve. C is incorrect. Both the effective and key rate duration measures are appropriate for measuring the price sensitivity of bonds whose cash flows are sensitive to the path of interest rates. The exercise of the embedded call option depends on where the interest rate stands relative to the coupon rate. Consequently, the cash flows and the value of callable bonds depend on the path which interest rates follow.

9. Question ID: 48760 Correct Answer: A The price of the bond will respond primarily to the movements in the ten-year par rate when the coupon rate is 2%. When the coupon rate is 2%, the 10-year key rate is the highest while the other key rates are close to zero. This indicates that the callable bond behaves similarly to a ten-year option-free bond at this coupon rate.

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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10. Question ID: 48761 Correct Answer: C The issue is first callable five years from today. Because of the virtual certainty of being called at a coupon rate of 8%, the callable bond behaves similarly to 5-year option-free bond; the 10-year key rate duration is negligible (0.15) relative to the 5-year key rate duration (1.64). 11. Question ID: 48762 Correct Answer: A A is correct. When interest rates decline, putable bonds exhibit greater upside price potential relative to callable bonds. While both bonds increase in value, negative convexity will compress the price appreciation potential of callable bonds. B is incorrect. Although the embedded call option increases with a decline in interest rates, Davis should not opt for a callable bond issue because of the price compression resulting from negative convexity (see above). C is incorrect. The value of the embedded put option decreases with a decline in interest rates.

12. Question ID: 48763 Correct Answer: B To determine whether the issue is influenced by stock- or bond-related factors, Davis will need to determine whether the issue exhibits stock risk-return characteristics or is a busted convertible and exhibits bond-like characteristics. A comparison between the underlying share price and conversion price will reveal this. Conversion price = Par value/Conversion ratio = $100,000/90,000 = $1.11 Given that the current market price exceeds the conversion price ($2.50 > $1.11), the convertible bond exhibits stock risk-return characteristics. Therefore, share price volatility will have the greatest influence on the value of the convertible issue.

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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FinQuiz Level II 2019 – Item-sets Solution Reading 36: Valuation and Analysis: Bonds with Embedded Options 13. Question ID: 48816 Correct Answer: A

A is correct. Given that interest rates are forecasted to rise to a level which significantly exceeds the coupon rate, the embedded call option will have a very low value and the callable bond will exhibit positive convexity. In this scenario, the increase in rate will have a similar effect on the prices of callable and option-free bonds which both exhibit positive convexity. 14. Question ID: 48817 Correct Answer: C

The minimum value of the convertible is known as the floor value and is calculated as the greater of the conversion value and the value of the underlying option-free bond. Conversion value = Underlying share price × Conversion ratio = $5.80 × 200 = $1,160 Straight bond value = $1,500 Minimum value = Greater of $1,160 and $1,500 Therefore, the floor value is equal to $1,500

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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15. Question ID: 48818 Correct Answer: C

C is correct. The market conversion premium per share limits downside risk to the straight value. However, the exact amount of downside risk cannot be known by buyers of convertible bonds. Investors know only that the most they can lose is the difference between the convertible bond price and straight bond value. However, the latter is not fixed and so the amount of loss cannot be known with certainty beforehand. A is incorrect. Scholes has correctly calculated the market conversion premium per share. Market conversion price = Convertible bond price/conversion ratio = $1,200/200 = $6.00 Market conversion premium per share = Market conversion price – underlying share price = $6.00 – $5.80 = $0.20 B is incorrect. See above. 16. Question ID: 48819 Correct Answer: C

Conclusion 2 is most accurate regarding share price movements. The upside potential of a convertible bond issue primarily depends on the prospects of the underlying common stock. 17. Question ID: 48820 Correct Answer: A

A is correct. The value of the convertible bond ($1,200) is lower than the greater of the conversion value ($5.80 × 200 = $1,160) and straight value ($1,500) which indicates that an arbitrage opportunity exists. Investors can purchase the convertible bond at a price of $1,200 and secure a profit of $ ($1,500 – $1,200 = $300).

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Reading 36

Valuation and Analysis: Bonds with Embedded Options

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18. Question ID: 48821 Correct Answer: B

The convertible bond is trading similar to a hybrid instrument as the current share price ($5.80) exceeds the convertible bond price ($5.00) and is expected to decline towards the latter. In this scenario, the change in the convertible bond price will be lower than the change in the underlying share price as the issue has a floor. Therefore, the decline in the convertible bond price will be less than 13.79% [($5.80 – $5.00)/$5.80], which is equal to the decline in the share price.

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Reading 37

Credit Analysis Models

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FinQuiz.com CFA Level II Item-set - Solution Study Session 13 June 2019

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Reading 37

Credit Analysis Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 37: Credit Analysis Models 1. Question ID: 19517 Correct Answer: C C is correct. Yamada is inaccurate with respect to his justification because traditional credit models such as credit ratings rank the credit risk of an entity but do not provide an estimate of a loan’s default probability. On the other hand, reduced form models use hazard estimation procedures to estimate default intensity (probability) and loss given default. B is incorrect. Reduced form models use hazard estimation procedures. Estimating default probabilities using these procedures is very flexible as they incorporate changes in the business cycle and are independent of balance sheet structure. 2. Question ID: 19518 Correct Answer: C C is correct. Reduced form models use hazard estimation procedures to estimate default probabilities. These procedures incorporate changes in the business cycle and are independent of the balance sheet structure allowing for model flexibility. On the other hand, structural models assume that asset return volatility will remain constant over time, independent of changing business conditions and economic cycles. A is incorrect. Both structural and reduced form models assume markets are frictionless. B is incorrect. The structural model allows for an understanding of default probability based on option analogy. Reduced form models allow for an understanding of default probability based on business cycle conditions and company circumstances. Therefore, this does reflect not an advantage of reduced form models over structural models. 3. Question ID: 19519 Correct Answer: B B is correct. The 3-year issue has a lower loss given default (see below). Expected loss = loss given default × default probability Loss given default (3-year) = $1.245*/0.035 = $35.571 Loss given default (4-year) = $0.939*/0.025 = $37.560 *The calculations below represent $1,000 of par value. A is incorrect. The sum of the recovery rate and loss given default equals to 100%. Based on the calculated loss given default for the two issues, the 4-year issue has a lower recovery rate. Recovery rate = 1 – loss given default Recovery rate (3-year issue) = 1 – [($35.571 × $1,000)/$100,000] = 64.43% FinQuiz.com © 2019 - All rights reserved.

Reading 37

Credit Analysis Models

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Recovery rate (4-year issue) = 1 – [($37.560 × $1,000)/$100,000] = 62.44% C is incorrect. Expected loss represents the loss expected in the event a bond defaults prior to maturity; that is, the loss figure is undiscounted and therefore does not reflect the time value of money. Furthermore, the default probability is simply multiplied by the loss given default. With no adjustment for the risk of cash flows, expected loss does not reflect a risk premium. 4. Question ID: 19520 Correct Answer: C C is correct. The expected loss amounts to $1,245 ($1.245 × $1,000). The maximum amount an investor is willing to pay to at third party to convert the issue to a defaultfree bond (remove the credit risk) is equal to 154.775 ($912.393 – $757.618), the present value of expected loss. Given that the expected loss is $1,090.225 ($1,245 – $154.775) higher than the present value of expected loss, the premium for credit risk is dominated by the discount for the time value of money. A is incorrect. The present value of expected loss reflects the time value of money and credit risk premium. Therefore, it is incorrect to state either of the two components is not reflected by the measure. B is incorrect (see above). 5. Question ID: 19521 Correct Answer: A A is correct. The present value of expected loss due to credit risk is $1.039; equal to the difference between the credit-adjusted and risk-free values on June 30, 2014 ($45.722 – $44.683). 6. Question ID: 19522 Correct Answer: A A is correct. Thomas and Yamada are inaccurate with respect to Fact 1. The cash flow structure of ABS is complex and includes prepayments, principal repayments and coupon interest. Furthermore different special purpose vehicles (SPVs) have different waterfall structures. In this situation, Monte Carlo simulation procedures are often used. However, the two individuals have incorrectly pointed out that these procedures are also applied to corporate bonds. B is incorrect. Thomas and Yamada are accurate with respect to Fact 2. Credit risk measures used for corporate or sovereign bonds can be applied to ABS bonds: probability of loss, expected loss, and the present value of expected loss. The probability of default does not apply to ABS and is replaced by a probability of loss given that a default in the collateral pool does not cause a default to either the SPV or a bond tranche. C is incorrect. Thomas and Yamada are accurate with respect to Fact 3. Given the fact that ABS is structured debt and its complexity, the use of the same credit-rating scales (as that used for corporate or sovereign bonds) may at times be inappropriate.

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Reading 37

Credit Analysis Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 37: Credit Analysis Models 7. Question ID: 48737 Correct Answer: C

C is correct. The present value of expected loss includes the probability of default, the loss given default, the time value of money and the risk premium in its computation. This measure is the present value of the product of default probability and loss given default, both of which depend on the health of the economy. A is incorrect. Credit scores are not a suitable measure of credit risk as they do not explicitly depend on current economic conditions. Furthermore, the measure merely ranks a borrower’s credit riskiness and does not provide an estimate of a borrower’s default probability. In this way, credit scores are an incomplete measure of risk. Furthermore, the time value of money is not considered. B is incorrect. Even though the loss given default measure depends on the current health of the economy and incorporates the riskiness of a corporation’s cash flows, it is not suitable given Engle’s objectives. This is because the loss given default does not consider the time value of money. 8. Question ID: 48738 Correct Answer: B

B is correct. The cost of removing credit risk is greatest for the Smithson Manufacturing issue as evidenced by the present value of expected loss. This measure represents the largest price one would be willing to pay to remove the credit risk of purchasing and holding the bond. A is incorrect. Credit scores provide ordinal ranking, ordering borrowers’ riskiness from highest to lowest. Therefore, they do not provide cardinal ranking – which determines the riskiness of one borrower relative to another in multiples. C is incorrect. The recovery rate is measured as: ‘1 – loss given default (in %)’. The loss given default is often expressed as a percentage of the position or exposure. Smithson Manufacturing’s recovery rate = 1 – 0.20 = 0.80 Carl Jones plc = 1 – 0.25 = 0.75 Alpha Ltd = 1 – 0.50 = 0.50 Given that the recovery rate is the highest, a corporate lender should expect to receive the most from the Smithson Manufacturing issue. FinQuiz.com © 2019 - All rights reserved.

Reading 37

Credit Analysis Models

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9. Question ID: 48739 Correct Answer: A

Concern 1 does not accurately represent a concern of using credit scores while Concern 2 does. Credit scores change as the borrower’s behavioral or financial circumstances change. Given that credit scores are updated to reflect this change in circumstances, Jefferson should not have a problem with this feature of credit scores. On the other hand, there is some pressure on credit rating agencies to maintain stability in the scores generated by lenders. This may serve to distort the objectivity of the credit risk measure. 10. Question ID: 48740 Correct Answer: C

The debt option analogy is based on the notion that holding the company’s equity is economically equivalent to owning a European call option on the company’s assets with strike price K and maturity T. C is correct. What the debt option analogy implies for debt holders is: the time T value of the company’s debt is equal to K (the face value of debt) if the value of a company’s assets is greater than K. On the other hand, the value of debt is equal to the time T value of the company’s assets if the value of the company’s asset base falls below K. A is incorrect. The debt option analogy states that debt holders lend equity holders K dollars and simultaneously sell them an insurance policy for K dollars on the value of their assets. B is incorrect. A company’s shareholders have limited liability; that is, in the event that the asset value declines below K, debt holders can only claim the value of a company’s assets. In other words, the value of debt holder’s claims does not extend to the assets of a company. 11. Question ID: 48741 Correct Answer: A

D(t, T) = AtN(-d1) + Ke-r(T-t) N(d2) D(0,3) = $1,200(0.097) + $850e-0.025(3 – 0)(0.1451*) = $230.823 ≈ $231 *Probability asset value 3 years from today is ≥ face value of debt = 0.1451

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Reading 37

Credit Analysis Models

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12. Question ID: 48742 Correct Answer: A

A is correct. Gavin is recommending the use of the structural model to generate credit ratings. This model relies on a number of assumptions including that the risk-free rate is constant over time. B is incorrect. The structural model only assumes that a company’s assets trade in frictionless markets. The model does not make any assumption with respect to a company’s debt. C is incorrect. The probability of default depends exclusively on a company’s assumed liability structure.

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Reading 37

Credit Analysis Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 37: Credit Analysis Models 13. Question ID: 48765 Correct Answer: A Reason 1 does not accurately reflect one of the strengths of using credit ratings. The accuracy of externally generated credit ratings may be distorted if agencies are compensated on the basis of an issuer-pays model. To obtain more business, credit rating agencies may have an incentive to give a higher rating than may be deserved. Reason 2 does not accurately reflect one of the strengths of credit ratings. Ratings create an ordinal ranking of borrowers. This type of ranking cannot be used as a basis to compare the relative riskiness of two borrowers. Reason 3 does not accurately reflect one of the strengths of credit ratings. Although the motivation to maintain stable ratings reduces unnecessary volatility in debt market prices, this comes at a cost of reduced accuracy. Stable ratings can only be accurate on average because they change infrequently while information on the business cycle arrives continuously. Furthermore, stability in ratings will reduce the correspondence to a debt offering’s default probability. 14. Question ID: 48766 Correct Answer: B B is correct. Reduced form which models rely on historical estimation to estimate parameters introduce flexibility into the estimation process. Historical estimation is an application of hazard rate procedures. These procedures incorporate business cycle changes and are independent of the requirement to specify a particular balance sheet structure. A is incorrect. See above. C is incorrect. Reduced form models using historical estimation employ past observations of bond prices to predict the future. 15. Question ID: 48767 Correct Answer: A A is correct. Jarrow’s application of the model is inappropriate because there are more maturity points and therefore more variables to estimate (unknowns) than the number of bonds in the data set. B is incorrect. Even though default probabilities and loss given defaults are not constants in reality, the expected percentage loss per year implied by the credit spread can be roughly estimated by assuming otherwise. C is incorrect. The reduced form model can be used to estimate risky zero-coupon bond yields from coupon bond prices.

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Reading 37

Credit Analysis Models

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16. Question ID: 48768 Correct Answer: A Expected percentage loss per year implied by the yields = Average yield spread Zero-coupon government bond Yield (%)= Zero-coupon AM bond yield =

(2.50 + 2.55 + 2.60 + 2.60 + 2.63)% = 2.576% 5

(3.84 + 3.90 + 4.00 + 4.01 + 4.11)% = 3.972% 5

Expected percentage loss per year = 0.03972 – 0.02576 = 0.01396

17. Question ID: 48769 Correct Answer: B The credit risk-adjusted valuation is derived using the continuously compounded total yield which is used to compute the discount factor. Credit risk-adjusted value = $120 × 0.9725 = $116.70

18. Question ID: 48770 Correct Answer: B A limitation of using both reduced and structural models in decomposing the credit spread is that the assumption of frictionless markets implies that there is no quantity impact of a purchase or sale on the price of the security. The presence of a quantity impact introduces liquidity risk. In reality, markets are not frictionless and liquidity risk is very much present. The true credit spread consists of both the expected percentage loss (derived from either the reduced form or structural model) and a liquidity risk premium.

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Reading 37

Credit Analysis Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 37: Credit Analysis Models 19. Question ID: 48823 Correct Answer: A

Although Monte Carlo simulation procedures are often used in practice, both the structural and reduced form model can be used to value ABS. 20. Question ID: 48824 Correct Answer: B

B is correct. Historical estimation cannot be used to estimate a structural model’s parameters because the assets of an SPV, represented by the collateral loan pool, do not trade in frictionless markets and hence its value is not observable. Therefore, one cannot use standard statistics to compute a mean return or the asset’s return standard deviation. Historical estimation relies on past time-series observations of the underlying asset’s price and standard statistical procedures to estimate the parameters and therefore relies on past observations of security prices. C is incorrect. Calibration or implicit estimation procedures should be used when estimating the structural model’s parameters. Based on the data presented in the framework, Lewis is relying on historical estimation procedures. 21. Question ID: 48825 Correct Answer: B

When measuring the credit risk of ABS, the probability of loss is used as opposed to the probability of default. Unlike corporate debt, an ABS does not default when an interest payment is missed but the ABS continues to trade until either its maturity date or its face value is eliminated because of accumulated losses in the collateral pool or through early loan prepayments. In addition, a default in the collateral pool does not cause a default to the SPV or a bond tranche. Therefore, the probability of default is not a relevant measure of credit risk. 22. Question ID: 48826 Correct Answer: B

Although credit-rating agencies use the same rating scale as that used for corporate and sovereign debt, the complexity of ABS may make use of the same scales inappropriate. The alleged mis-ratings of structured products in the recent past have resulted in credit rating agencies revising their rating methodologies.

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Reading 37

Credit Analysis Models

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23. Question ID: 48827 Correct Answer: B

Gabrielle has the highest credit score and thus lower credit riskiness. Therefore, she is the most eligible candidate for the loan based on credit standing. 24. Question ID: 48828 Correct Answer: B

B is correct. If a borrower borrows from many institutions and in many forms, his/her credit score may have different implications for default probability on different types of loans. This is because there are no cross-default clauses for retail borrowers and so it is possible for the borrower to be more likely to default on one type of loan than on another. Given that Walters is the only borrower to borrow one form of loan, there will be less disparity between his credit score and individual loan default probability compared to Selena and Gabrielle who have more than one form of borrowing.

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Reading 38

Credit Default Swaps

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FinQuiz.com CFA Level II Item-set - Solution Study Session 13 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 38

Credit Default Swaps

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FinQuiz Level II 2019 – Item-sets Solution Reading 38: Credit Default Swaps 1. Question ID: 20436 Correct Answer: B B is correct. CDS B’s credit spread is higher than its standard rate (6.0% vs. 1.0%, respectively) which will result in the payment of an upfront premium from the protection buyer to the protection seller. This is because the coupon is insufficient to cover the credit risk associated with the swap and an upfront premium payment will make up for this discrepancy. The standard rate may not always equal the CDS credit spread. This discrepancy is accounted for by an upfront premium. A credit spread less (greater) than the standard rate will result in a payment from the protection seller (buyer) to the protection buyer (seller). A is incorrect. CDS A’s credit spread is lower than its standard rate (3.5% vs. 5.0%, respectively) resulting in the payment of an upfront premium from the protection seller to the protection buyer. C is incorrect. CDS C’s credit spread is equal to its standard rate; therefore, there is no upfront premium payment. 2. Question ID: 20437 Correct Answer: C C is correct. TM will receive the highest proceeds, $13.5 million, from settling CDS C (see below). In the case of cash settlement, the payout ratio is based on the cheapest-to-deliver defaulted debt. Since CDS A and C require cash settlements, the contract’s recovery rate is 80% and 25% respectively. The CDS’s payout ratio is determined using the formula, [(1 – recovery rate %) × Notional]. TM can cash settle CDS A for $2 million [(1 – 0.80) × $10 million] and sell its bonds for $8 million (0.8 × $10 million) receiving total proceeds of $10 million. TM will receive the face amount of the bond, $12 million, in the case of CDS B. TM can cash settle CDS C for $7.5 million [(1 – 0.25) × $10 million] and sell its bonds for $6 (0.6 × $10 million) receiving total proceeds of $13.5 million.

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Reading 38

Credit Default Swaps

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3. Question ID: 20438 Correct Answer: A A is correct. Gross index CDS notional principle = $350 million Hedge protection sold = 20% Notional amount of entity B in CDS index (purchased) = $7 million/0.20 = $35 million Net notional principal on the CDS index trade (excluding entity B) = ($350 – $35) million = $315 million 4. Question ID: 20439 Correct Answer: A A is correct. Based on the CDS trade undertaken by TM’s management, it believes that long-term credit risk will increase relative to short-term credit risk. By going short a long-term CDS and long a short-term CDS, this curve steepening trade reflects short-term bullish views on credit risk. 5. Question ID: 20440 Correct Answer: A A is correct. Coupon payment = $10 million × 0.05/4 = $0.125 million Recovery rate is based on the cheapest-to-deliver bond, which is the issue selling at 25% par. Thus, the recovery rate is 25%. The sum of the first three loan payments total $0.375 million ($0.125 million × 3). If default occurs, loss given default on the first three loan payments only is equal to $0.28125 million [$0.375 million × (1 – 0.25)] or approximately $0.3 million.

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Reading 38

Credit Default Swaps

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6. Question ID: 20441 Correct Answer: C C is correct. As a protection buyer, TM is economically short the reference obligation and benefits from an increase in the company’s credit spread. A widening of the credit spread will imply that the TM will pay the same fixed coupon to cover a larger credit risk. TM can offset its position by entering into a new CDS with the same terms as the original CDS, but with higher premium, as protection seller. Therefore, the entity can sell protection for a higher premium. A is incorrect. Based on Greene’s forecast, the bond’s credit spread will widen to 6.7% (5.0% + 1.7%). Given that the spread in the CDS market will still be higher relative to the bond market (6.9% vs. 6.7%, respectively), the basis is positive. B is incorrect. Credit risk will continue be more expensive in the CDS market (6.9%). relative to the bond market (5.0% + 1.7% = 6.7%) despite the widening of credit spread. TM can take advantage of this opportunity by selling protection in the CDS market and going short the bond, paying 6.7% for transferring credit risk.

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Reading 38

Credit Default Swaps

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FinQuiz Level II 2019 – Item-sets Solution Reading 38: Credit Default Swaps 7. Question ID: 48885 Correct Answer: C The recovery rate is based on the cheapest-to-deliver issue. A debt obligation issued by the borrower which is ranked equivalently or higher in priority of claims to the reference obligation is covered. Given that the subordinated issue is not ranked pari passu to the reference obligation, the senior unsecured issue is classified as the cheapest-to-deliver issue. 8. Question ID: 48886 Correct Answer: C Given that the CDS spread is lower than the issue’s credit spread (5% and 7%, respectively), the protection buyer is paying a standard rate (CDS spread) which is insufficient to cover the risk of the bond. Therefore, the protection buyer will make a cash upfront payment to the seller. 9. Question ID: 48887 Correct Answer: B A long position in a CDS is equivalent to a package of long put options. Put options enable the option holder to sell (put) the underlying to the seller if the underlying performs poorly relative to the exercise price. Thus, the option holder is compensated for the poor performance of the underlying. A CDS performs in a similar manner. Poor performance of the bond or loan results in the protection seller compensating the protection buyer. 10. Question ID: 48888 Correct Answer: B A CDS does not eliminate credit risk but simply substitutes the credit risk of the reference entity with the CDS seller.

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Reading 38

Credit Default Swaps

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11. Question ID: 48889 Correct Answer: C Expected loss = Loss given default × Probability of default If the borrower defaults on the first loan payment, the amount lost is ($5 × 70%) = $3.50 If the borrower defaults on the second loan payment, the amount lost is ($105 × 70%) = $73.50 Probability of default on first and second loan payments = 4% Probability of default on second loan payment = 96% × 4% = 3.84% There is a 4% chance of losing $77.00 ($3.50 + $73.50) and a 3.84% chance of losing $73.50. Expected loss = ($77.00 × 4%) + ($73.50 × 3.84%) = $5.9024 ≈ $5.90 12. Question ID: 48890 Correct Answer: B Sigma Corp can cash settle for $21.0 million (1 – 0.30)($30 million) and sell the issue for $10.5 million (35%)($30 million) for total proceeds of $31.5 million. Alternatively, the company can physically deliver the entire $30 million of the issue. Physical settlement will be the preferred option due to its lower cost.

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Reading 38

Credit Default Swaps

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FinQuiz Level II 2019 – Item-sets Solution Reading 38: Credit Default Swaps

13. Question ID: 48892 Correct Answer: C Observation 2 qualifies as a potential credit event. Failure to pay on a scheduled interest payment after a grace period may trigger a payment from the credit protection seller to protection buyer. Observation 1 is defined as a potential succession event as there is a plan to change the corporate structure of the reference entity. Observation 3 is does not qualify as a potential credit event. Restructuring includes a number of possible events including reduction or deferral of principal or interest which is forced on the borrower by creditors and is thus involuntary. Given that the borrower has requested a reduction, the event does not classify as a restructuring event. 14. Question ID: 48893 Correct Answer: C The present value of the protection leg is greater than the present value of the premium leg ($150 vs. $146, respectively) indicating that the protection buyer has a greater claim on the CDS payoff and will make an upfront payment to the protection seller. The present value of the protection leg is the present value of the contingent obligation that the credit protection seller will have to make to the credit protection buyer.

15. Question ID: 48894 Correct Answer: C An increasing hazard rate implies a greater probability of default in the later years which in turn will result in an upward sloping credit curve. 16. Question ID: 48895 Correct Answer: C Credit spread = Upfront premium*/Duration + Fixed coupon = (83.3333 + 98) basis points = 181.33 basis points *Value of upfront premium = 5%/6 = 0.0083333 × 100 × 100 = 83.3333 basis points

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Reading 38

Credit Default Swaps

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17. Question ID: 48896 Correct Answer: A A is correct. Given that the credit spread has narrowed, the protection buyer continues to pay a fixed coupon of 98 basis points to receive coverage on a company whose risk justifies a reduced level of coupons. Therefore, the protection buyer (seller) will incur a loss (profit) and the amount of that loss is calculated below: Loss for the protection buyer = (- 0.25%)(5)($2,500,000) = - $31,250 C is incorrect. The profit to the protection seller is $31,250. 18. Question ID: 48897 Correct Answer: A Credit spread of the bond issue is the excess of the yield over LIBOR. Given that the credit spread of the issue (7.0% - 2.5% = 4.5%) is lower than the credit spread of the CDS (7.0%), its premium is lower relative to the CDS market which means its price is too high. The CDS is pricing too much credit risk and bond market is pricing too little credit risk. To capture arbitrage profits, the basis trade would involve selling the CDS (protection) and the underlying bond issue.

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Reading 39

Pricing & Valuation of Forward Commitments

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FinQuiz.com CFA Level II Item-set - Solution Study Session 14 June 2019

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Reading 39

Pricing & Valuation of Forward Commitments

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FinQuiz Level II 2019 – Item-sets Solution Reading 39: Pricing & Valuation of Forward Commitments 1. Question ID: 71637 Correct Answer: A

Three months after initiation, the current value of the original 6 x 9 FRA is determined using the 90- and 180-day LIBOR rates. The following steps will be followed to determine the current value of the FRA: Step 1: Calculate the new FRA rate of a contract which initiates today and expires at the same time as the original FRA. The relevant rates to use are the 90- and 180-day LIBOR. FRA (90, 180 – 90, 90) = {[1 + (0.0438 × 180/360)]/[1 + (0.0425 × 90/360)] – 1} ÷ (90/360 = 0.044626 or 4.46% Step 2: Calculate the current value of the FRA as the difference between the initial FRA price and the FRA price determined in step 2 discounted at the provided rate of 5.60% over a period of 180 days. Value of the FRA = {[(4.46% - 4.50%) × 90/360] × SEK 50,000,000}/[1 + (0.056 × 180/360)] = - SEK 6,534.5333 ≈ - SEK 4,549 Because the FRA rate has declined, the value of the FRA will be negative to Macro Limited. 2. Question ID: 71638 Correct Answer: C

Because the original FRA contract is a 6 x 9 FRA, the relevant rates to use are the 180- and 270-day LIBOR for determining the potential for arbitrage profits. The FRA rate using the hypothetical market LIBOR rates is calculated as follows: FRA (0, 180, 90) = {1 + (0.0568 × 270/360)]/[1 + (0.056 × 180/360)] – 1}/(90/360) = 0.05681 or 5.68% Comparing the initial FRA rate of 4.50% to the market rate of 5.68%, the original contract would have been underpriced if the hypothetical rates actually existed at time 0.

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Reading 39

Pricing & Valuation of Forward Commitments

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3. Question ID: 71639 Correct Answer: C

C is correct. Unlike a fixed-rate swap, a floating rate swap in general is not priced because a single coupon rate is not designated to the swap. At each reset date, the coupon rate will be re-established according to the LIBOR prevailing at the time. The same holds true for a floating rate bond which is used to price the swap; the coupon rate is reset at each reset date. A is incorrect. The statement holds true for fixed-for-fixed currency swaps in which the coupon rates on fixed-rate bonds are selected to match the fixed swap rates resulting in future net cash flows equaling zero. B is incorrect. The value of the swap is equal to par on each reset date. 4. Question ID: 71640 Correct Answer: B

The notional principal paid by Macro Limited at contract initiation is equal to SEK 54,347,826.09 (£5,000,000/0.092). Using the rates provided in the exhibit, the SEK present value factors are determined as follows:

Days to Maturity 180 360 540

SEK Spot Interest Rates (%) 3.0 3.5 4.1

Present Value Factors 0.98522 0.96618 0.94206

The annualized SEK swap fixed rate is determined as follows: rFIX,SEK =

1 − 0.9426 360 × = 3.968% 0.98522 + 0.96618 + 0.94206 180

Annual swap fixed payment = SEK 54,347,826.09 × 0.03968 × 180/360 = SEK 1,078,260.87 or ≈ SEK 1.09 million

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Reading 39

Pricing & Valuation of Forward Commitments

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5. Question ID: 71641 Correct Answer: A

At the initiation of the swap, Macro Limited will receive £5 million from and pay SEK 54,347,826.09 (£5,000,000/0.092) to the swap counterparty. 6. Question ID: 71642 Correct Answer: A

A is correct. Based on the formula for calculating forward iron ore prices (see below), an increase in the risk-free rate, ‘r’, will increase forward prices relative to spot prices. B is incorrect. Carry benefits, represented by the symbol γ0 in the formula, decrease the burden of carrying the underlying instrument through time and so an increase in carry benefits will decrease the forward price relative to the spot price. C is incorrect. Expectations of the future underlying price have no bearing on the forward price. Therefore, an expectation that the underlying will increase in value has no impact on the forward price. Forward price formula: F0(T) = (S0 + θ0 – γ0)(1 + r)T 7. Question ID: 10932 Correct Answer: C The formula used to calculate the no-arbitrage forward price at contract initiation is as follows:

F (0,T ) = S 0 (1 + r )

T

F (0, T ) = AUD1,000(1 + 5%)

7 12

= AUD1,028.8698 ≈ AUD1,029

8. Question ID: 10933 Correct Answer: C Since the actual forward price is AUD 1,500 while the forward price determined as part of the noarbitrage formula (solution to Part 1) is AUD 1,029, the forward contract is overpriced. Thus Cohen should undertake a short position in the wheat forward contract. Using the spot price of wheat and the forward price (AUD 1,500), the rate of return will be:

AUD1,500 − 1 = 0.50 AUD1,000 The risk –free return for seven months is 50%. The annualized return is 100.4% which is calculated as follows:

(1.5)12 7 − 1 = 1.003875

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Reading 39

Pricing & Valuation of Forward Commitments

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9. Question ID: 10934 Correct Answer: A Since Cohen already holds a corporate bond investment in Test Manufacturing, he will undertake a short position in a forward contract in which the underlying is the manufacturer’s corporate bond. The formula to calculate the value of a corporate bond forward contract at time T is:

Vt (0,T ) = Bt (T + Y ) − PV (CI , t ,T ) − F (0,T ) (1 + r )

T +t

C

200 days into the forward contract, the first coupon date (181 days) has already passed. The second and third coupon payments are 165 days (365 – 200) and 347 days (547 – 200), respectively, away.



   (1.05 )(365− 200 )365      85  The present value of the third coupon payment is AUD 81.14739 =   (1.05 )(547−200 )365    The present value of the second coupon payment is AUD 83.14578 = 

85

Since the forward contract will expire a day after the third coupon payment, the time to maturity is 348 days [(547 + 1) – 200]. Thus, Vt (0, T ) = AUD1,250.50 − 83.14578 − 81.14739 − 1,075.45

(1.05)548−200 365

= AUD

59.63858831 or AUD 59.64 Since Cohen already holds the corporate bonds, he is short the forward contract, thus the value of the forward contract to Cohen is - AUD 59.64 and the value to the manufacturer is + AUD 59.64 10. Question ID: 10935 Correct Answer: B The duration of an FRA agreement beginning in 2 months time covering a loan to be taken out in eight months time is 6 months (8 – 2 months) or 180 days (30 days × 6). Since Test Manufacturing would like to protect against increase in borrowing costs, it should undertake a long position in an FRA agreement. The formula to calculate the initial FRA rate is:

 h+m  1 + L0 (h + m ) 360   360    − 1 FRA(0, h, m) =    h    m   1 + L (h )   0    360 

( (

) )

 1 + 14% × 240  360 − 1 360  = 0.159671 or 15.97% FRA (0,30,180) =  1 + 7.50% × 60  180  360  

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Reading 39

Pricing & Valuation of Forward Commitments

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11. Question ID: 10936 Correct Answer: B The formula to calculate the value of the FRA on day g is:

 m  1 + FRA(0, h, m)  1 360   ( ) Vg 0, h, m = − h−g  h+m− g  1 + Lg (h − g )  1 + Lg (h + m − g )   360   360 

  180  11 + 15.971×  360  1   − = = AUD0.99366538 − AUD0.99297011 = AUD0.00069527 210   30   1 + (7.65%)  1 + 15.00% ×  360   360  

Based on the AUD 2.5 million notional principal (AUD 5 million × 50%), the value of the forward contract after 30 days is approximately AUD 1,738 (AUD 2,500,000 × 0.00069527). 12. Question ID: 10937 Correct Answer: A Since Howell’s clients already own Australian investments Howell will need to undertake a short position in a forward contract that will allow her to sell AUD for USD. However prior to determining the value of the forward contract after one month, it is necessary to determine the forward price at the initiation of the contract. Using continuous compounding, the formula used to calculate the initial forward price of a forward currency contract is:

(

F (0, T ) = S 0 e − r

fc

T

)e

r CT

F (0, T) = F (0, T ) =  0.98e



−5%× 3 12

e 3.50%× 312 = USD0.97633188 per AUD 

Using the initial forward price and current spot price (ST = USD 1.10 per AUD), the formula used to calculate the value of a forward currency contract at time T (using continuous compounding) is:

[

(T −t )

VT (0,T ) = ST e − r

fc

VT (0, T ) = 1.10e 

−5%× 2

]− F (0,T )e

12

− r C (T −t )

 − 0.97633188e −3.50%×212 = 0.12021823 ≈ USD 0.12 per AUD. 

Since Howell is short the currency forward, the value of the forward contract is USD – 0.12 per AUD.

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Reading 39

Pricing & Valuation of Forward Commitments

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13. Question ID: 49261 Correct Answer: B

No-arbitrage forward price of the equity forward is determined by the following formula:


F(0,T) = (ܵ଴,் ݁ ିఋ ் )݁ ௥


்



= (3,250݁ ି଴.଴ଵ଻ ×ଵ.ହ )݁ ଴.଴ସଽଷଵ×ଵ.ହ = 3,411.39

14. Question ID: 49262 Correct Answer: B

The forward contract is overpriced. Therefore, the most suitable strategy would involve selling a forward contract on the index and, since the investor does not own index stocks, borrowing funds to buy the underlying index stocks at the spot price today (S0). 15. Question ID: 49263 Correct Answer: C

Value of the forward contract = Vt (0,T) = c c S t e −δ (T −t ) − F (0, T )e − r (T −t ) = 3,700 e −0.017 [1.5−(2 12 )] − 3,600 e −0.04931[1.5−(2 12 )] = 246 .15 16. Question ID: 49264 Correct Answer: A

Marshall is correct with respect to Analysis 1. The forward price is calculated by compounding the spot price at the risk-free rate. Therefore, the pricing of the forward contract assumes that S0 units of currency are invested in the asset which is designed to earn the risk-free rate. Marshall is also correct with respect to Analysis 2. The sale of a forward contract on an asset position is priced assuming that the spot price is invested in a risk-free bond that pays F(0,T) at time T. 17. Question ID: 49265 Correct Answer: A

The forward contract on the ABC Inc. stock is an off-market FRA as the initial value if intentionally set at a nonzero value. The forward contract price on off-market forwards is determined in the process of negotiation between two parties and not by discounting the price of the asset at the risk-free rate. 18. Question ID: 49266 Correct Answer: A Miller’s statement 1 is correct and statement 2 is incorrect.

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Reading 39

Pricing & Valuation of Forward Commitments

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Eurodollar time deposits are dollar loans made by one bank to another. Although the term Eurodollars refers to dollar denominated loans, similar loans exist in other currencies. The primary Eurodollar rate is called Libor. 19. Question ID: 10939 Correct Answer: C The formula used to calculate the futures price of a futures bond contract is:

f 0 (T ) =

B C 0 (T + Y )[1 + r0 (T )] − FV (CI ,0, T ) CF (T ) T

Where T = 2.25

FV (CI ,0, T ) = $45(1.0525)

1.75

+ $45(1.0525)

1.25

+ $45(1.0525)

0.75

+ $45(1.0525)

0.25

= $189.5275 ≈ $189.53

BC0 (T + Y) = $1,127.95 [N = 10 (5×2); I/Y = 3% (6%/2); PMT = $45 (9%/2 × $1,000); FV = $1,000; PV = X)

$1,127.95(1 + 5.25% ) f 0 (2.25) = 1.75

2.25

− $189.53

= $614.8857 ≈ $614.89

20. Question ID: 10940 Correct Answer: B Observation 1: If the futures price for a bond futures contract is higher than the no-arbitrage futures price, opportunities for arbitrage profits exist. The investor can buy the bond and sell futures to earn more than the risk free rate. On the other hand when the futures price is lower than the no-arbitrage price, investors can sell short the bond and undertake a long position in futures. However, the latter transaction may become difficult unless the bond underlying the long futures contract (from which the arbitrage was computed) remains the cheapest to deliver. If that is not the case, the short (counterparty to the long) will not deliver the bond and the arbitrage will not be successful. Thus there is no guarantee that the short will deliver the same cheapest to deliver bond (cheapest at the time of contract initiation) and this situation constrains the arbitrage transaction. Melton is inaccurate with respect to observation 1. Observation 2: If a futures contract has many deliverable bonds and the bond underlying such a contract is delivered, the long pays an amount equal to the futures price multiplied by the conversion factor. The conversion factor adjustment does not add risk to the risk-free transaction. Melton is accurate with respect to observation 2.

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Reading 39

Pricing & Valuation of Forward Commitments

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21. Question ID: 10941 Correct Answer: C The unusual construction of the Euro-dollar futures contract relative to the Euro-dollar spot market means that no-risk free combination of a Euro-dollar time deposit and a Euro-dollar futures contract can be constructed. The Euro-dollar is a time deposit and an add-on instrument whereas the Eurodollar futures contract is structured like a T-bill. Thus Melton is correct with respect to this comment. Although the mismatch of the design of the spot and futures instruments in the Euro-dollar market make the contract difficult to use for hedging purposes, but the Eurodollar futures can still be used a hedging instrument. This is because an increase (decrease) in interest rates will decrease (increase) the value of the time deposit but increase (decrease) the payoff from the Euro-dollar futures contract. Thus the hedge can be quite effective even if it is not perfect. Melton has incorrectly stated that hedging using Euro-dollar futures will be ineffective. 22. Question ID: 10942 Correct Answer: C The formula used to calculate the continuously compounded dividend yield is δ = ln(1 + δ ) . Since the information given on the S&P 500 concerns discrete dividends, the formula used to calculate δ is: C

1 FV (D,0, T ) = 1− T T (1 + δ ) S 0 (1 + r )

To obtain δ , the following formula is used: δ C = (1 T )ln(1 + δ )

T

C

Using the information on Sweeney’s futures investment, the contnuousy compounded dividend yield is calculated below. T = 0.3479 (127/365)

1 $2.54 = 1− = 0.998374 ≈ 0.9984 T 0.3479 (1 + δ ) 1,534.65(1 + 5.25% ) The inverse of this will produce (1 + δ ) . Thus 1/0.9984 = 1.0016 T

δC =

ln(1.0016) = 0.004595 ≈ 0.460% 0.3479

23. Question ID: 10943 Correct Answer: A Prior to determining the optimal strategy to follow, it is necessary to determine the no-arbitrage futures price for the pound sterling futures contract. The general formula used is:

 S0 f 0 (T ) =   1+ r C 

(

)

T

 (1 + r )T  

T = 56/365 = 0.1534

f 0 (0.1534) =

$1.60 (1.05)0.1534 = $1.5977 (the no-arbitrage futures price) 0.1534 (1.06) FinQuiz.com © 2019 - All rights reserved.

Reading 39

Pricing & Valuation of Forward Commitments

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The current futures price is $1.78. Thus the futures contract is overpriced and if Swanson wishes to engage in a risk-free arbitrage, the contract should be sold. However prior to selling the futures contract the number of currency units, which need to be purchased, should be determined. The number of currency units to purchase is:

1 = 0.9911 which will cost 0.9911($1.60) = $1.5858. Thus $1.5856 units are purchased (1.06)0.1534 and the futures contract is sold at $1.78. During the life of the contract, 0.9911 currency units will grow to 1 currency unit as the futures price converges to the spot price and equals it during expiration. At expiration, the pounds are converted to dollars at the futures rate, $1.78. Thus the return per dollar invested is

1.78 = 1.1225 1.5856

Thus a return of 1.1225 is earned on each dollar invested over the 56-day period. In contrast, the riskfree return earned on a risk-free investment (the no-arbitrage return on a futures contract) over the 56day period 1.0075 = (1.05)0.1534. Thus the return earned over the 56-day period is 0.1150 (1.1225 – 1.0075) or 11.50% higher and Swanson should undertake the arbitrage strategy. 24. Question ID: 10944 Correct Answer: A In general, if interest rates are positively correlated with futures prices, traders with long positions will prefer futures over forwards because they will generate gains when interest rate are going up, and traders can invest those gains for higher returns. Thus the marking to market of futures become more attractive. Conversely, when interest rates go down investors can borrow to cover the losses at lower rates. In contrast when futures prices are negatively correlated with interest rates, traders will not prefer to mark to market so forward contracts will carry higher prices. Since Swanson has only held a long position in Dutch equity futures over quarters 5 and 6, the data over the quarters 1-4 is not necessary for analysis in this context. The correlations between interest rates and equity futures prices have been positive over Q5 and Q6 (0.04 and 0.35, respectively). Being long in the Dutch equity futures, Swanson would continue to prefer futures over forwards as the rising futures prices imply a gain upon the marking to market of her futures position and the rising rates imply that these gains are reinvested at higher rates. 25. Question ID: 49268 Correct Answer: C Osborne’s opening statement is only correct with respect to the equivalence of futures to a spot transaction. Because the futures price converges to the spot price on expiration date, the purchase of a futures contract which expires immediately is equivalent to purchasing the underlying in the spot market. Osborne is incorrect in stating that the futures price converges to the spot price each time the account is marked to market. Convergence only takes place on the expiration date.

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Pricing & Valuation of Forward Commitments

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26. Question ID: 49269 Correct Answer: C The value of a futures contract before it has been market to market is the gain or loss accumulated since the account was last market to market. At 12:00 hours on Day 2, the futures contract is in between two marked to market days. Therefore, the value of the futures contract at this time is equal to the difference in prices on Day 1 on market close (at 17:00 hours) and on Day 2 at 12:00, $50 – $46 = $4. 27. Question ID: 49270 Correct Answer: C Based on a current spot price of $48, the no-arbitrage price of a 3-month futures contract should equal to $48.3560 ($48 × 1.030.25). At $49, the futures contract is overpriced. To exploit the arbitrage opportunity, the futures contract should be sold and the underlying asset purchased. At the expiration of the contract, $0.36 ($48 × 0.03 × 3/12) represents interest lost from the $48 tied in the asset. On expiration date: Profit on futures = ST – $49 Total profit = $49 – $48 – $0.36 = $0.64 28. Question ID: 49271 Correct Answer: A A is correct. The future value difference between storage costs and the convenience yield is indicative of either backwardation or contango. If this difference is positive, storage costs exceed the convenience yield thereby increasing the futures price relative to the current spot price and indicating that the futures market is in contango. C is incorrect. The relationship between the futures price and expected spot price is indicative of the existence of normal backwardation or normal contango. 29. Question ID: 49272 Correct Answer: A Given that the transaction is assumed to be risk-free, the risk premium is zero and the current spot price is calculated using the following formula:

S0 =

S T − FV (CB ,0, T ) $ 39 .24 − 12 .60 = = $ 26 .249 or $26.25 (1 + r )T (1.03 )0.5

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Pricing & Valuation of Forward Commitments

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30. Question ID: 49273 Correct Answer: B Osborne is correct with respect to her statement while Lester is incorrect with respect to his statement. Eurodollar futures serve as imperfect hedges because they are structured like a T-bill contract - as though the underlying were a discount instrument. On the other hand, the Eurodollar time deposit is an add-on instrument. A mismatch between the spot market and futures contract results in an imperfect hedge between the two. However, this does not mean that Eurodollars futures are an ineffective hedging tool. 31. Question ID: 49282 Correct Answer: C

The currency futures contract is overpriced based on a comparison between the current and no-arbitrage futures prices (€0.9398 vs. €0.9262). Therefore, an arbitrage strategy would involve selling the USD currency futures and buying the underlying USD. 32. Question ID: 49283 Correct Answer: B

Given that the current futures price exceeds the no-arbitrage price, the following steps need to be followed as part of a strategy to earn a risk-free profit: Step 1: Buy 1/(1.042)165/360 = 0.98132 units today which should cost 0.98132(€0.92) = €0.902814 Step 2: Invest the 0.98132 units at the US risk-free rate of 4.2% for 165 days. The amount will grow to 1.00000 units. Step 3: Enter into currency futures to convert the USD to EUR at a rate of €0.9398. Return per € invested over 165 days is 0.9398/0.902814 – 1 = 0.040967 or 4.0967%. The domestic risk-free rate over 165 days is (1.0575)165/360 – 1 = 2.596%. The arbitrage transaction is much better as the return exceeds the domestic risk-free rate by 1.500%. 33. Question ID: 49284 Correct Answer: B

The bond pays coupons semi-annually (6 months apart) at a rate of 4.75%. Four coupon payments will be received over the maturity of the 1.75-years futures contract. The accumulated interest on these coupon payments is: €4.75(1.04)1.25 + €4.75(1.04)0.75 + €4.75(1.04)0.25 = €14.67728 f(2) = €102.72(1.0575)1.75 – €14.67728 = €98.60

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Pricing & Valuation of Forward Commitments

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34. Question ID: 49285 Correct Answer: B

The amount which the long must pay the short when the underlying bond is delivered is equal to the product of the futures price and conversion factor, f(0) × CF. 35. Question ID: 49286 Correct Answer: B

B is correct. The delivery option permits the party holding the short position with the flexibility in deciding which bond to deliver. 36. Question ID: 49287 Correct Answer: B

If the arbitrageur buys the futures contract and sells short the underlying, (s) he must be reasonably assured that the short will deliver the bond from which the potential arbitrage profit is computed. The CTD bond has a tendency to change over the course of time and if the bond on which the profit was computed is no longer the CTD bond, the short will not deliver this bond and the arbitrage will not be successful.

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Reading 40

Valuation of Contingent Claims

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FinQuiz.com CFA Level II Item-set - Solution Study Session 14 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 40

Valuation of Contingent Claims

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FinQuiz Level II 2019 – Item-sets Solution Reading 40: Valuation of Contingent Claims 1. Question ID: 71729 Correct Answer: A

Rogers is accurate regarding Statement 1 and inaccurate regarding Statement 2. The probability used in the expectations approach is determined objectively and is not based on an investor’s personal views regarding risk preferences. The expectations approach discounts all cash flows using an estimated risk-free interest rate. 2. Question ID: 71730 Correct Answer: B

B is correct. Knight is incorrect regarding his analysis of how option values are derived when the expectations approach is used within the binomial model framework to determine call option values at each node. The formula for deriving call option value at each node using the expectations approach is: c = PV[πc+ + (1 – π)c-] This formula demonstrates that the call option value at Time 0 is equal to the present value of the cash flows or call option payoffs at Time 1 using a risk-neutral probability (π). C is incorrect. The statement summarizes how option values are estimated when the noarbitrage approach is used within a binomial model framework. 3. Question ID: 71731 Correct Answer: B

B is correct. The formula for deriving the call option value at Time 0 using the expectations approach is: c = PV[π2c++ + 2π(1 – π)c+– + (1 – π)2c– –] π = (1 + r – d)/(u – d) = (1 + 0.10 – 0.65)/(1.50 – 0.65) = 0.5294 c++ = Max(0, Su2 – X) = Max[0, $180 – $80] = $100.00 c+- = Max(0, Sud – X) = Max[0, ($80 × 1.50 × 0.65) – $80] = $0 c-- = Max(0, Sd2 – X) = Max [0, ($80 × 0.652) – $80] = $0 c = 1/(1.10)2[(0.52942 × $100) + 2(0.5294)(1 – 0.5294)($0) + (1 – 0.5294)2($0) = $23.1623 ≈ $23.16 FinQuiz.com © 2019 - All rights reserved.

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Valuation of Contingent Claims

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4. Question ID: 71732 Correct Answer: C

C is correct. An American call option will give the option holder the right to exercise early, purchase the underlying before it goes ex-dividend, and capture the dividend payment. Note that the call option is only in the money at Node 2 and therefore the value of the call option at Node 3 is ignored. The present value of the dividend payment at Time 0 is $4.5455 ($5/1.10). The value of the stock without dividends at Node 2 is $113.1818 [($80 – $4.5455) × 1.50]. The exercise value of the call option including dividends at Node 2 is $38.1818 [Max 0, ($113.1818 + $5) – $80] ≈ $38.18. 5. Question ID: 71733 Correct Answer: C

The carry benefit is equal to the foreign currency risk-free rate, which in this case is the US$ risk-free rate of 0.50%. 6. Question ID: 71734 Correct Answer: C

C is correct. The term N(d2) is interpreted as the probability that the call option expires in the money and is calculated as N(d2) = 1 – N(-d2). Therefore, the probability that the ¥ call option will expire in the money is 51.70% [(1 – 0.4830) × 100].

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Valuation of Contingent Claims

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7. Question ID: 10968 Correct Answer: A In order to determine the intrinsic value of the call option, the following steps need to be followed: Step 1: Determine u & d. u = 1.45 (1+ 45%) d = 0.75 (1 – 25%) Step 2: Determine S+ and S-. S+ = €65 (1.45) = €94.25 S- = €65 (0.75) = €48.75 Step 3: Determine c+ and c- (values of the option at expiration) c+ = Max(0,94.25 – 70) = €24.25 c- = Max(0,48.75 – 70) = €0 Step 4: Determine the risk-neutral probability. π=

1.05 − 0.75 = 0.428571 ≈ 0.4286 1.45 − 0.75

1 – π = 0.5714 Step 5: Determine the price of the call today (c). c=

0.4286(24.25) + 0.5714(0) = 9.89619 ≈ 9.90 1.05

8. Question ID: 10969 Correct Answer: C At €13, the call is overpriced (relative to €9.90). Thus, the calls will need to be sold. The number of calls which need to be sold for 1 unit of the underlying stock (n) is determined by the following formula: c+ − c− 24 .25 − 0 n= + = = 0.532967 ≈ 0.5330 − S −S 94 .25 − 48 .75 Reginald should purchase 533 (0.5330 × 1,000) units of Jasper Inc.’s stocks and sell 1,000 calls. The outlay/net cash flow is: Sell 1,000 calls at €13 Buy 533 units of Jasper Inc.’s stocks at €65 Net cash flow

+13,000 –34,650 –21,645

The initial outlay is €21,645. The value of the investment at expiration will be If ST = 94.25 533(94.25) – 1,000(24.25) = €25,985.25 If ST = 48.75 533(48.75) – 1,000(0) = €25,983.75 The rate of return is thus 20.05% = (25,985.25/21,645 – 1)

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9. Question ID: 10970 Correct Answer: B Based on Ramirez’s expectations regarding the acceptance of E&E Agriculture and the projected drop in stock price, Ramirez should purchase a put option on Jasper Inc.’s stock holdings. This will protect the stock investment from a fall in stock price and give Ramirez the flexibility to benefit from an increase in stock price (by letting the option expire). Buying a call option is not the best course of action as it will provide a limited payoff if stock prices rise above the exercise price (ST – X), whereas the put option will provide unlimited payoff. Additionally, the call will not provide adequate protection if the stock price falls below the exercise price. Selling a call option is not the best course of action because if the stock price falls below the exercise, the counterparty will not exercise the option leaving Ramirez (as the option writer) with the option premium as profit (which will be insufficient to cover the loss on the stock investment). If price rises above the exercise price, the counterparty will exercise the call and Ramirez will be responsible for paying the difference between the stock price and exercise price. 10. Question ID: 10971 Correct Answer: A Assumption 1: The Black-Scholes-Merton model assumes that the risk-free rate is not random and is constant. Thus assumption 1 is partially incorrect. Assumption 2: The basic model does not take into account the cash flows generate by the underlying asset but the model can be modified by adjusting the spot price of the underlying asset. Assumption 2 is accurate. 11. Question ID: 10972 Correct Answer: B Volatility is the only variable in the option pricing model which cannot be directly observed and easily obtained. Thus Ramirez is correct with respect to this statement. The benefit of using the historical method to estimate volatility is that is based on factual data (what happened in the past). However in order to get the estimate, a large amount of data is required. This means some of the data needs to be obtained by going far back into the past. The drawback of doing so is that the data loses its relevance and the volatility estimate becomes less reliable. Thus Ramirez has inaccurately pointed out the ability of this method to produce reliable estimates. The drawback of using the implied volatility method to estimate volatility is that it assumes that the market correctly prices the options, which makes it difficult to identify mispriced options. Thus the drawback of the implied volatility method has been accurately illustrated.

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12. Question ID: 10973 Correct Answer: B The formula to calculate the put option value using the put-call-forward parity is:

p0 = c0 + [X − F (0,T )]/(1 + r )

T

P0 = 70.50 + [70 – 100.89]/(1.05)1.5 = 41.789949 ≈ €41.79 The current put price is €65.45. Relative to the price of the put obtained from the put-call-forward parity, the put is overpriced. The appropriate (arbitrage) strategy is to sell the put and purchase the synthetic put. To buy the synthetic put it is necessary go long the call, short the forward contract and hold a bond with a face value of X – F (0,T). The payoff from the transaction at the start of the contract is: Sell put Buy call Buy Bond

+ 65.45 (70.50) – (70 – 100.89)/(1.05)1.5 €23.66

13. Question ID: 16110 Correct Answer: B The speaker is inaccurate with respect to technique 1. A synthetic bond position is created by combining a long put (buying a put option), a long position in the underlying asset (purchasing the underlying stock), and a short call position (selling a call option). Although this technique is easily applicable to European options, put-call parity with respect to American options is considerably more complex. The resulting parity equation is a complex combination of inequalities. Thus, it cannot be concluded that a given combination exactly equals another combination. X/(1+r)T = p0+S0–c0 The speaker is accurate with respect to technique 2. A pay-fixed, receive-equity swap can be replicated by issuing a fixed-rate bond and using the issuance proceeds to purchase either stock or an index portfolio. 14. Question ID: 16111 Correct Answer: A The most appropriate strategy would be buying the synthetic call or selling the synthetic put. Using the put-call parity, the synthetic call and put prices are calculated as follows: c0 = p0 + S0 – X/(1+r)T = $5.15 + $68.60 – $65/(1.025)150/365 = $9.4063 p0 = c0 + X/(1+r)T – S0 = $9.66 + $65/(1.025)150/365 – $68.60 = $5.4037

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The actual call is worth $9.66 while the synthetic call is worth $9.41. The appropriate strategy would be to buy the synthetic call. The actual put is worth $5.15 while the synthetic put is worth $5.40. The appropriate strategy would be to sell the synthetic put. 15. Question ID: 16112 Correct Answer: A The put option with the lowest put price is option J. The put option price, using the Black-ScholesMerton model is calculated using the following formula: ‫  
݁ܺ = ݌‬ሾ1 − ܰሺ݀ ሻሿ − ܵ ሾ1 − ܰሺ݀ ሻሿ ೎

The continuously compounded risk-free rate, rC, is 2.469% [In (1 .025)]. ܲ   = $54.00݁
.×/ ሾ1 − 0.5714ሿ − 55.25ሾ1 − 0.6293ሿ = $2.29 ܲ   = $55.25݁ = $2.84


.×  ఴ భమ

ሾ1 − 0.5120ሿ − 55.25ሾ1 − 0.5714ሿ

16. Question ID: 16113 Correct Answer: C If BC’s share price declines by $15, the approximate new put option price of an option identical to M is $65.45. Delta can be obtained approximately from the Black-Scholes-Merton formula as N(d1) for calls and N(d1) – 1 for puts. Given that option M’s call option delta N(d1), is 0.6368, the put option delta is approximately – 0.3632 (0.6368 – 1). The relation between the change in underlying asset price, delta, and change in option price is captured by the following equation: Change in option price = Delta × change in underlying asset price For a $15 decline in BC’s share price, the approximate new put option price is $65.45; Change in put option price = − 0.3632 × − $15 = $5.448 Approximate new put option price = $60.00 + $5.448 = $65.448

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17. Question ID: 16114 Correct Answer: B Greene has correctly identified implication 1. As the options on BC’s shares are European options, the price of European options on assets such as corporate shares are not very sensitive to the risk-free rate. Therefore, a change in the risk-free rate (either increase or decrease) should not have much impact on the price of the option identified by Greene. Greene has incorrectly identified implication 2. With respect to call option, longer the time to expiration, higher will be the option price. Extending the expiration date of call option L from eight to ten months should increase the price. 18. Question ID: 16115 Correct Answer: C In order to estimate historical volatility, recent past stock price data is obtained. This price data is converted into returns then compounded continuously. Next, continuous returns’ variation is calculated. Since price data is on monthly basis, the variance is multiplied by 12 to convert into annual standard deviation. This is a technique that may be used as a starting point to estimate future volatility. It is a valid volatility estimation technique. 19. Question ID: 18382 Correct Answer: B P++ = [Min (0, Strike Rate – Reference rate)]/ (1+r) = Min (0, 0.1412-0.1200)/1.1412=0 P+-/P-+ = [Min (0, Strike Rate – Reference rate)]/ (1+r) = Min (0, 0.1150-0.1200)/1.1150 = 0.004484 P-- = [Min (0, Strike Rate – Reference rate)]/ (1+r) = Min (0, 0.0810-0.1200)/1.081= 0.0361 P+ = [ProbA(P++ Value) + ProbB(P+-Value)]/(1+r) = [0.5(0.0) + 0.5 (0.004484)/1.1305 = 0.002242/1.1305 = 0.001983 P– = [ProbA(P++ Value) + ProbB(P-+Value)]/(1+r)= [0.5(0.004484) + 0.5(0.0361)]/1.0905 = 0.020292/1.0905 = 0.018608 Option price at T0 = {0.5(0.001983) + 0.5(0.018608)}/1.1225 = 0.010296/1.1225= 0.009172

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20. Question ID: 18382 Correct Answer: A P+ = [Min (0, Strike Rate – Reference rate)]/ (1+r) = Min (0, 0.1305 – 0.1200)/ 1.1305 = 0 P– = [Min (0, Strike Rate – Reference rate)]/ (1+r) = Min (0, 0.0905 – 0.1200)/ 1.0905 = 0.0295/1.0905 = 0.027052 T0 price of 1 year floorlet = {ProbA(P+Value) + ProbB(P-Value)}/(1+r) = {0.5(0) + 0.5(0.027052)}/ 1.1225 = 0.01205 T0 price of floor = T0 price of one-year floorlet+ T0 price of two-year floorlet = 0.01205 + 0.0092 = 0.02125 21. Question ID: 18382 Correct Answer: A Fundamental Price

Market Price

Conclusion

One Year Floorlet

1.21%

1.00%

Underpriced

Two Year Floorlet

0.92%

0.60%

Underpriced

Two Year Floor

2.13%

2.36%

Overpriced

22. Question ID: 18382 Correct Answer: B American options are worth more as they would be able to lock in prices in case of future default. European Options do not carry that added feature of early exercise and are therefore lower in price. 23. Question ID: 18382 Correct Answer: A Effective hedging nets off trading costs against benefits derived through risk reduction. This trade-off is necessary to generate an overall positive return. 24. Question ID: 18382 Correct Answer: A The exercise price of the call option, the put option and the face value of the risk-free bond are the same. 25. Question ID: 18389 Correct Answer: A A higher payout ratio will decrease the value of the underlying asset which will subsequently increase the value of a put option. 26. Question ID: 18390 Correct Answer: B Options are not solely standardized contracts. They may be standardized or customized.

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27. Question ID: 18391 Correct Answer: B S0 × e–(D × T) = 235 × e (–0.55) = $222.42 28. Question ID: 18392 Correct Answer: A The option price derived through the BSM model is relatively overvalued as compared to the market. Through backward calculations on the current market price, calculate the implied volatility rate. To calculate a lower option price, use a lower volatility rate; as volatility rates and option prices are positively correlated. 29. Question ID: 18393 Correct Answer: B P/E = D/Y × [(1+g)/Ke-g] A lower p/e ratio is the only deduction which results from a reduced growth rate. Reduced growth rates would lead to an increase in payout ratios. 30. Question ID: 18394 Correct Answer: A The Black Model on forward and future contracts is applicable only to European Options. 31. Question ID: 18396 Correct Answer: A p0 = c + [(X – F)/ (1 + R)T] p0 = 20 + [(92.50 – 105.25)/(1.07)3] p0 = 20 + [–10.41] = $9.60 Currently trading at $6.00 Underpriced by $3.40 32. Question ID: 18397 Correct Answer: A F = (P0 – C0)(1+ R)T + X Ft = (6 – 20) (1.07)3 + (92.5) Ft = $75.35 33. Question ID: 18398 Correct Answer: A As the forward is underpriced, Hall would advise the firm to buy the forward and sell the synthetic forward.

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34. Question ID: 18399 Correct Answer: A If

St<$92.50

St>$92.50

Short Call

0

-(St-$92.50)

Long Put

$92.50-St

0

$105.25-$92.50

$105.25-$92.50

St-$105.25

St-$105.25

0

0

Short Bond Long Forward Payoff at Expiration 35. Question ID: 18400 Correct Answer: A

The constant rebalancing necessary for dynamic hedging helps hedge the fluctuations in value. When the dynamic hedging is not applied, greater fluctuations in value are allowed without any action being taken. 36. Question ID: 18401 Correct Answer: A When the trading option and the value derived through the BSM rate are equal, it is assumed that the hedging portfolio is earning the risk-free rate. 37. Question ID: 18403 Correct Answer: C Time decay is unfavorable for the buyer of the option as he generates decreased opportunity savings from his position. The seller of the option, in turn, is positively affected through decreased time remaining as he has to pay less opportunity cost. 38. Question ID: 18404 Correct Answer: C A gamma value that is relatively smaller than other options helps in hedging a larger amount of the underlying asset, as a small gamma value indicates a stable delta. A large gamma value effectively points towards a volatile option delta. This highly fluctuating delta would not be able to hedge a large price change in the underlying stock and would require frequent portfolio rebalancing 39. Question ID: 18405 Correct Answer: C Vega is highest for at the money options, but the first excerpt does not touch upon the moneyness concept at all. Vega is not linked to either increase or decrease in an option’s price, but its moneyness at the particular price.

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40. Question ID: 18406 Correct Answer: B Call Option Delta = 0.75/5 = 0.15 41. Question ID: 18407 Correct Answer: B Number of Put Options Needed = 500000/0.85 = 588235 42. Question ID: 18408 Correct Answer: A An arbitrage opportunity exists if the underlying asset performs better than the risk-free rate. This opportunity can be availed through buying the underlying and financing this investment through borrowing at the risk-free rate. This makes it possible to generate an unlimited amount of money. 43. Question ID: 18410 Correct Answer: C An increase in volatility results in the increase in both call and put option values. 44. Question ID: 18411 Correct Answer: B The underlying asset’s price will decrease by the PV of cash flows. A decrease in the underlying asset’s price leads to an increase in put option value. 45. Question ID: 18412 Correct Answer: B European put options may either be higher or lower with greater time remaining to expiration. 46. Question ID: 18413 Correct Answer: C The volatility is assumed to be constant to facilitate its inclusion in the model. The concept that this reason is why only European Options can be valued through the BSM is baseless. 47. Question ID: 18414 Correct Answer: B The BSM calls for unrestricted selling of stock, with freedom of full use of short sale proceeds. Derivative prices would not be affected by short selling of underlying stock. 48. Question ID: 18415 Correct Answer: A The existence of cash flows from the underlying asset give the holder sufficient reason to exercise the option early. The holder of an option on a stock would prefer the right to exercise just before the stock goes ex-dividend. Through this process, the holder foregoes the time value but captures the dividend.

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49. Question ID: 18417 Correct Answer: A Gamma values of both call and put options are at their maximum when the options are at-the-money and close to expiration. 50. Question ID: 18418 Correct Answer: C Only at-the-money options have a high gamma value. Deep-in-the-money options have low gamma ratios. 51. Question ID: 18419 Correct Answer: B Deep-in-the-money put options have a positive theta given that they are characterized by: • • •

low time remaining to maturity, so that there are less chances of the option decreasing in value. high interest rates, so that the money generated through options can be reinvested at a high rate to generate greater income. low volatility rates, so that there are less chances of fluctuations that will take the option to an atthe- money or out-of-the-money scenario.

52. Question ID: 18420 Correct Answer: C The time decay of an option leads to a decrease in the option value. However, an increase in the time to maturity results in an increase in option value. 53. Question ID: 18421 Correct Answer: C The risk free rate for a put option is negative as it signifies the lost interest because of the delayed availability of cash. 54. Question ID: 18422 Correct Answer: B A fiduciary call is the greater of the exercise price of the option or the price of the underlying asset. If St < X, the call value is zero and the bond would be worth X. If St > X, the call is worth St-X and the bond is

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55. Question ID: 11141 Correct Answer: C Fact 1: Swap contracts can be thought of as equivalent to forwards and futures. In the case of forwards, swaps are different from forward contracts in that swaps call for a series of equal payments whereas forward contracts are almost always priced at different fixed rates. It is common to think of swaps as a series of forward rate agreements all priced at the swap fixed rate and not the rate they would normally be priced in the market. Thus forwards can be used to construct swaps. Swaps can be thought of as equivalent to futures contracts if the future interest rates are certain (which makes them equivalent to forward contracts). However, this is not typically the case as future interest rate are almost always uncertain. Futures can be used to construct swaps provided interest rates are certain. Thus fact 1 has been accurately outlined. Fact 2: A swap can be constructed from a combination of options with expiration dates corresponding to the settlement dates of the swap. A pay fixed swap can be thought of as equivalent to buying a call option and selling a put option. This is because if interest rates rise, the call option holder receives the difference between the strike rate and current market rate. Similarly the pay-fixed party in the swap receives a payment equal to the difference between the floating payment and fixed rate in the swap. If interest rates go down, the seller of a put option pays the difference. Similarly the pay-fixed side pays the floating side of the swap the difference between the floating and fixed rate. Thus fact 2 has been accurately outlined. 56. Question ID: 11142 Correct Answer: C Based on the CEO’s statement, “We need a strategy which will protect us from the effects of rising interest rates on borrowing costs”, the best course of action will be to enter into a transaction that will allow the party to pay a fixed rate of interest regardless of the movements in interest rates. The best swap contract for Furnace Works Ltd. to undertake is a pay fixed/receive floating swap which ensures the company pays a fixed rate of interest and compensates it if interest rates rise above the fixed rate (by making a net payment). The value of the swap at contract initiation is always zero. Since the swap transaction recommended by the executive has not yet begun, it will have a market value of zero.

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57. Question ID: 11143 Correct Answer: B In order to value the swap, the following steps will be followed: Step 1: Determine the Euro discount factors B180€ = B360€ = B540€ =

1 1 + 3% ×180

( (

1

(

1

= 0.98522167 ) 360

1 + 3.12% × 360 1 + 3.25% × 540

= 0.96974399 ) 360 = 0.95351609 ) 360

Step 2: Determine the present value (PV) of the fixed payments in Euros. The fixed rate (given) paid by Beta Build on the swap is 3.45%. The non-annualized rate is 1.725% (3.45%/2). Thus, PV Fixed Payments = €0.01725(0.98522167 + 0.96974399 + 0.95351609) + €1.0(0.95351609) = €1.00368740. Step 3: Determine the total PV of fixed payment in $. The euro notional principal established at the start of the swap is calculated as $25 million/0.85 The total euro fixed payments are converted to $ at the new exchange rate. Thus the total PV of fixed payments paid by Beta Build is $26,568,195.89 (€1.00368740)($25,000,000/0.85)($0.90) Step 4: Determine the total PV of floating payments paid by Alpha Corp. in U.S. $. The PV of floating rate payments is simply $1.0 multiplied by the notional principal as floating rate bonds re-set at each swap payment date (which corresponds to the 180th day in this case). Thus the total PV of floating payments is $25,000,000. Step 5: Determine the value of the swap. Since Beta Build pays the fixed rate and receives the floating rate, the value of the swap to Beta Build will be $25,000,000 – $26,568,195.89 = –$1,568,195.89 ≈ –$1,600,000

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58. Question ID: 11144 Correct Answer: A The motives behind using a swaption include: • •

•

they are used to terminate an existing swap – a party holding a pay floating/receive fixed swap will enter into a payer swaption, and not a receiver swaption, to terminate the existing swap. they are used by parties who anticipate the need for a swap at a future date but wish to secure a fixed rate today, while retaining the flexibility to not engage in the swap at a later date or engage in a swap at a more favorable rate in the market. Thus a corporation may want to secure its borrowing costs today by securing a fixed rate on a swap, which may be needed in the future. they are used by parties to speculate on interest rates.

59. Question ID: 11145 Correct Answer: B In order to determine the best course of action to take the expiration of the receiver swaption, the swap’s market rate will need to be calculated and compared to the exercise rate. If the exercise rate is greater than the market rate, the swap should be exercised. This is because the swap will allow for the receipt of a greater amount fixed payments relative to the rate achievable in the market.

(

1

(

1

(

1

(

1

1 + 4.55% + 90

= 0.98875294 ) 360

1 + 4.88% + 180

= 0.97618118 ) 360

1 + 4.90% + 270 1 + 5.00% + 360

= 0.96455269 ) 360 = 0.95238095 ) 360

1 − 0 .95238095 = 0.01226705 Market/Fixed rate = 0.98875294 + 097618118 + 0.96455269 + 0.95238095 or 1.23%. Annualized market rate = 1.23% (360/90) = 4.92% Compared to the exercise rate of 3%, the annualized market fixed rate is much higher. Thus the best course of action would be to let the swaption expire at enter into a new swap at the current market rate of 4.92% to receive a higher fixed rate. Entering into the present swaption at a swap rate of 3% is not optimal as it will result in the receipt of fixed payments at a rate lower than current annualized market swap rates (3% vs. 4.92%). Rolling the present swaption into a new receiver swaption at the market rate is not optimal for the same reasons and such a transaction may not exist (depending on local market factors).

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60. Question ID: 11146 Correct Answer: A

(

1

1+ 10.05% + 90

(

360

1

1+ 10.45% + 270

(

)

360

1

1+ 10.53% + 450

= 0.97549079

)

= 0.92732120

)

= 0.88368497

360 1− 0.88368497 = 0.0417424 or 4.17424% 0.97549079 + 092732120 + 0.88368497

The annual fixed rate is 8.35% (4.17424% × 360/180). 61. Question ID: 18431 Correct Answer: A Only the counterparty to which the greater amount is owed is exposed to credit risk in a swap. 62. Question ID: 18432 Correct Answer: A The payoffs from an interest bearing swaptions are similar to coupon bearing bonds. 63. Question ID: 18433 Correct Answer: B Change in Price of Call = Delta × Change in Price of Underlying 64. Question ID: 18434 Correct Answer: A Division of the expiration date into smaller units would lead to an increase in pricing accuracy as the spreads will tighten. 65. Question ID: 18435 Correct Answer: C Similar to its use for European options on forwards and futures. The Black model can also be used for the valuation of European options on interest rates. This is done through replacing the forward price in the model by the forward interest rate. 66. Question ID: 18436 Correct Answer: A The statement is a detailed explanation of second generation derivatives based on the put-call-parity.

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67. Question ID: 18438 Correct Answer: C Invoice price paid by the buyer to the seller = (Contract Size × Future Settlement Price × Conversion Factor) + Accrued Interest = ($100,000 × 92 18/32 × 2.8) + $5200 = $264,375 68. Question ID: 18439 Correct Answer: B Future Price = Converted Price/ Conversion Factor = $90.80/ 0.9421 = $96.38. 69. Question ID: 18440 Correct Answer: C Commercial banks occupy the largest segment in the CDS market. Hedge funds are the largest growing participants of the CDS market. Fund managers use the positions created by the CDS market to exploit mispricings. 70. Question ID: 18441 Correct Answer: C Fixed rate payer Swap is suitable as a hedging instrument for a floating rate borrower to hedge interest rate risk. 71. Question ID: 18442 Correct Answer: B A fixed rate receiver swap is equivalent to a long interest rate put and a short interest rate call. A fixed rate payer swap is equivalent to a long interest rate call and a short interest rate put. 72. Question ID: 18443 Correct Answer: A One of the reasons behind the referral of a swap as a series of off-market forward contracts is because the swap fixed rate applied to the fixed leg of the calculation is equal to the average rate of on-market FRAs. 73. Question ID: 48830 Correct Answer: B Currency swaps exchange notional principals at the end of the swap’s life and therefore, credit risk is concentrated towards the middle and end of the swap’s life. Credit risk at contract initiation, which is the current risk at the time of entry, is low otherwise parties would not be willing to enter into the contract. Therefore, potential credit risk is higher relative to the current credit risk. 74. Question ID: 48831 Correct Answer: A While it is fairly common to view swaps as being equivalent to options and swaps, the equality of swaps to futures contracts holds true only in very limited cases. FinQuiz.com © 2019 - All rights reserved.

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75. Question ID: 48832 Correct Answer: B Quarterly dollar swap fixed payment = 0.03/4 × $1 = $0.0075 Present value of dollar swap payments = $0.0075(0.99494 + 0.98945 + 0.97816 + 0.96823) + $1(0.96823) = $0.997711 The dollar notional principal established at the start of the swap is $1.3333 (1/€0.75). The current value of the fixed rate leg of the swap in Euros is $1.3333 × €0.80 × $0.997711 = €1.064198 Present value of Euro swap payments = [€1 + (0.025 × 90/360)] × 0.99215 = €0.998351 Value of the pay $ fixed, receive € floating = €0.998351 – €1.064198 = - €0.065848 ≈ €0.0658 76. Question ID: 48833 Correct Answer: A The swap spread is not a measure of the credit risk of a given swap but a reflection of the credit risk in the global economy. Therefore, one would expect swap spreads to widen as a result of economic recession and remain unaffected by the credit risk of individual swap counterparties. 77. Question ID: 48834 Correct Answer: B Sports IMEX wants to protect its future investment from a loss in income which will result from a decline in interest rates. To hedge against a decline in interest rates, the company should enter into a receiver swaption which will allow the company to receive a fixed rate of interest and require it to pay the floating rate.

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78. Question ID: 48835 Correct Answer: A To calculate the swap fixed rate at day 360 (swaption expiration date), the discount factors are calculated for the three years of the underlying swap’s tenor:

1 = 0.966184 1 + (0.035)(360 / 360) 1 = 0.926784 L (720) = 1 + (0.0395)(720 / 360) 1 = 0.888099 L (1,080) = 1 + (0.042)(1,080 / 360) L (360) =

Swap fixed rate =

1 − 0.888099 = 0.040237 or 4.02% (0.966184 + 0.926784 + 0.888099) Maturity (Days) 360 720 1,080 1,440

Rate (%) 3.50 3.95 4.20 4.75

79. Question ID: 18375 Correct Answer: C Fixed Rate = [1–{1/ (1+360-day LIBOR)}]/ [{1/ (1+ 180-day LIBOR (n/360))} + {1/(1+ 360-day LIBOR (n/360))}] Fixed Rate = [1-{1/ (1.055}]/ [{1/ (1+0.052(180/360))} + {1/ (1+ 0.055(360/360))}] = 0.027117 Annual Fixed Rate = 0.027117 × 2 = 5.4234% 80. Question ID: 18376 Correct Answer: A A plain vanilla currency swap pays floating on dollars and fixed on foreign. The floating rate cash flows on the settlement date are based on the previous period’s ending floating interest rate. Floating Rate Cash Flows = 0.06 × $2,000,000 = $120,000

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Valuation of Contingent Claims

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81. Question ID: 18377 Correct Answer: B Fixed Rate Payments = 0.05 × (180/360) × $20,000,000 = $500,000 PV of remaining payments = $500,000/ (1+ 0.05 × (90/360)) + $20,500,000/ (1+ 0.054 × (270/360)) = $20,195,893 Floating payment in 90 days = 0.048 × (180/360) × $20,000,000 = $480,000 PV of floating payment = $480,000/ (1.0125) = $474,074 The second floating-rate payment combined with 1 at the end of the swap has a present value of 1 on the first payment date. The present value of 1 is 1/ (1 + 0.05 × (90/360)) = 0.987654321 so the present value of the second floating rate payment combined with the principal amount is = 0.987654321 × $20,000,000 = $19,753,086 Total value = 19,753,086 + 474,074 = $20,227,159 The value of the swap to the fixed-rate payer is $20,227,159 – $20,195,893 = $31,266. 82. Question ID: 18378 Correct Answer: B A payer swaption will give Andrex the right to pay a lower fixed price if market rates increase. 83. Question ID: 18379 Correct Answer: B PV of fixed payments (CHF) = [(0.048(180/360))/ (1+0.048(90/360)] + [(1+0.048(180/360))/ (1+0.054(270/360)] = 0.02372 + 0.98414 = 1.00786 Current exchange rate value = 1.00786 × 0.35 = $ 0.35275 Notional amount = 1,000,000/0.34 = CHF 2,941,176 $ value of CHF payments = $0.35275 × CHF 2,941,176 = $ 1,037,500 PV of fixed payments (USD) = [(0.052(180/360))/ (1+0.052(90/360)] + [(1+0.052(180/360))/ (1+0.054(270/360)] = 0.02567 + 0.98606= 1.01173 Value = 1.01173 x 1,000,000 = 1,011,730 The value of the swap to the dollar payer is 1,037,500 – 1,011,730 = $25,770 FinQuiz.com © 2019 - All rights reserved.

Reading 40

Valuation of Contingent Claims

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84. Question ID: 18380 Correct Answer: A A swaption is like an option on a bond with payments equal to the fixed payments on the swap. It can be used to hedge the rate on an anticipated swap transaction and can be used to offset a current position in the swap.

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Reading 41

Derivative Strategies

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FinQuiz.com CFA Level II Item-set - Solution Study Session 14 June 2019

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Reading 41

Derivative Strategies

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FinQuiz Level II 2019 – Item-sets Solution Reading 41: Derivative Strategies 1. Question ID: 71824 Correct Answer: B

An equity swap does not involve any initial outlay but involves an agreement by one party to trade the return on a stock portfolio for the return of another asset. Therefore, this type of agreement is the cheapest in terms of required initial investment amount. Strategy 1 is relatively expensive compared to Strategy 2 as WLC will need to pay option premium to purchase call options. Initial investment outlay = $0.85/call × 1,000 calls/contract × 125 contracts = $106,250 Strategy 3 is the most expensive out of the three as the initial investment cost is $2.5 million. 2. Question ID: 71825 Correct Answer: A

A synthetic long call position is replicated from a long stock and long put position. 3. Question ID: 71826 Correct Answer: A

Under the equity swap, WLC will receive the total return on the equity stock and pay the sixmonth LIBOR. Total stock return = [($21.00 – $20.00) + $0.30]/$20.00 = 0.065 or 6.50% LIBOR return for the six-month period = 0.80%/2 = 0.40% WLC will receive a net payment from the swap counterparty which amounts to (6.50% 0.40%) × $2,500,000 = $152,500. Put another way, WLC will make a net payment of – $152,500 to the swap counterparty. 4. Question ID: 71827 Correct Answer: C

The put strategy executed by Rubin is described as a bear spread strategy as this position is constructed by buying a put option with the higher exercise price of $40 and writing another put option at the lower exercise price of $38.

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Reading 41

Derivative Strategies

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5. Question ID: 71828 Correct Answer: B

The maximum profit will occur when the underlying price is equal to or lower than the put option with the lowest exercise price. If the underlying price is $38, the profit on each option is as follows: 38-Put = - Max (0, X – ST) + premium = - Max [0, (38 – 38)] + $2.05 = $2.05 40-Put = Max (0, X – ST) + premium = Max [0, (40 – 38)] – $2.33 = - $0.33 Maximum gain = $2.05 – $0.33 = $1.72 6. Question ID: 71829 Correct Answer: C

C is correct. A longer time to expiration would mean that there is a greater chance that the option will move in the money, resulting in the option being exercised by the buyer and the stock being called away from the writer. A is incorrect. Based on the option prices in Exhibit 3 it is clearly evident that the option writer can earn greater income from writing the longer-term option. B is incorrect. Exercise value is the difference between the underlying price and exercise price. Given that the underlying is expected to remain relatively constant, the exercise value will also remain constant for the at-the-money call option under consideration.

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Reading 42

Private Real Estate Investments

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FinQuiz.com CFA Level II Item-set - Solution Study Session 15 June 2019

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Reading 42

Private Real Estate Investments

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FinQuiz Level II 2019 – Item-sets Solution Reading 42: Private Real Estate Investments 1. Question ID: 17814 Correct Answer: B Because they facilitate owner divisibility, publically traded real estate securities are relatively liquid in contrast to their private counterparts. However real estate performance has not been highly correlated with the performance of asset classes such as stocks and bonds, so adding real estate helps to lower the risk of the portfolio (provide diversification). This is true with regard to both publically and privately traded real estate and justifies the addition of the asset class to existing client portfolios. Private real estate is traded less often and is not publically traded. Therefore, there are an insufficient amount of transactions from which prices can be determined. Thus privately traded real estate often exhibits ‘stale’ prices, which do not reflect their actual values. On the other hand, because publically traded real estate trade on formal exchanges, their prices are readily determinable. 2. Question ID: 17815 Correct Answer: A Hotels require the most day-to-day management. While shopping centers are relatively management intensive, the level of active management required is relatively lower in comparison to hotels. 3. Question ID: 17816 Correct Answer: C For a property to make the highest and best possible use of its location, the value of the existing building (excluding land value) should exceed the land value.

Selling price Vacant land value Value under existing use (building only)

Property 1 $1,800,000 1,000,000 $800,000

Property 2 $25,000,000 14,850,000 $10,150,000

Property 3 $3,200,000 $3,300,000 $(100,000)

Property 3 is not making the highest and best possible use as the value under existing use is $(100,000). Thus Property 3 should be considered for demolition. 4. Question ID: 17817 Correct Answer: A The property is being valued using a rate of 13% discount rate. The implied 5% (13% – 8%) growth rate being used is 3% higher than the rate at which NOI and property values are increasing. Holding the discount rate constant, the denominator ‘r – g’ used to capitalize each year‘s NOI before resale is lower when a 5% growth rate is used. This implies the appraiser is overvaluing the property.

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Reading 42

Private Real Estate Investments

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5. Question ID: 17818 Correct Answer: C The implied going-in cap rate is 2% lower than the terminal cap rate. A lower going-in cap rate implies: •

• •

The markets are expected to be weaker in the future with lower expectations for rental growth than in the current market. Investors are willing to pay a higher price for a property with greater growth potential and therefore the current implied growth rate will be higher and going-in cap rate lower in this scenario; or interest rates are expected to be higher in the future resulting in a higher terminal cap rate therefore pushing up discount rates; and there is uncertainty of what NOI will be in the future which may result in the selection of a higher terminal cap rate.

6. Question ID: 17819 Correct Answer: A The following steps need to be followed to determine the implied going-in cap rate: Step 1: Estimate resale price after four years. Resale or terminal cap rate = 15% – 4% = 11% Resale value = $330,000/0.11 = $3,000,000 Step 2: Discount the level NOI for the first three years and the resale price: PMT = $200,000 FV = $3,000,000 n=3 i = 15% Solving for PV, the current value of the property is $2,429,194 and using the formula, going-in cap rate = NOI/Market value, the implied going-cap rate is $200,000/$2,429,194 = 8.23%

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Reading 42

Private Real Estate Investments

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FinQuiz Level II 2019 – Item-sets Solution Reading 42: Private Real Estate Investments 7. Question ID: 48905 Correct Answer: A A is correct. The most appropriate form of real estate investment is REIT shares as management of the underlying property is professionally managed and requires no real estate expertise on the part of the investor in shares of REITs (Concern 1 is addressed). In addition, the shares of publically traded REITs are traded in public markets and thus have greater liquidity making the asset class suitable for Richards who has liquidity concerns (Concern 2 is addressed). REITs are a type of publically traded equity investment. REIT shares are typically liquid and active trading results in prices that are more likely to reflect market value (Concern 3 is addressed). 8. Question ID: 48906 Correct Answer: B Sheffield is accurate with respect to Drawback 1. Equity investors have a residual claim on real estate and this value is equal to the value of the real estate less the amount owed to the mortgage lender. C is incorrect. Equity investors are entitled to two income streams: an income stream resulting from such activities as renting the property and a capital appreciation component resulting from changes in the value of the underlying asset. 9. Question ID: 48907 Correct Answer: C C is correct. Sheffield is inaccurate with respect to drawback 2 because he has incorrectly stated that equity real estate investments bring little to no diversification opportunities to a portfolio. Real estate equity offers diversification benefits as it is less than perfectly correlated with stocks and bonds. B is incorrect. Real estate investment returns are influenced by factors affecting the profitability of companies leasing the space and the strength of the overall economy. 10. Question ID: 48908 Correct Answer: B Rental income at full occupancy (€45,860/0.50) - Vacancy and collection losses - Operating expenses - Property management expenses = NOI

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€91,720 €7,800 €6,540 €2,220 €75,160

Reading 42

Private Real Estate Investments

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11. Question ID: 48909 Correct Answer: B Value of property if renovated = [Stabilized NOI/(Discount rate – long-term growth rate)] - PV of loss in income = [€19,880/(0.10 – 0.06)] – €5,750 = €491,250 12. Question ID: 48910 Correct Answer: B If the value of a site under existing use (with the constructed property) is more than the land value, the office complex should remain on site. Otherwise, the complex should be demolished.

Value under existing use Implied land value Value of office complex

Property 1 €400,000 €380,000 €20,000

Property 2 €740,050 €750,000 - €9,950

Property 3 €185,100 €181,050 €4,050

The value of Property 2 has a negative implied building value indicating that the building should be demolished.

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Reading 42

Private Real Estate Investments

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FinQuiz Level II 2019 – Item-sets Solution Reading 42: Private Real Estate Investments 13. Question ID: 48912 Correct Answer: A GIM = Sales price/gross income GIM (Comparable 1) = $1,200,000/$750,000 = 1.60 GIM (Comparable 2) = $890,000/$428,080 = 2.08 GIM (Comparable 3) = $970,500/$576,050 = 1.68 GIM (Comparable 4) = $420,000/$380,900 = 1.10 Average GIM = (1.60 + 2.08 + 1.68 + 1.10)/4 = 1.615 Sales prices = 1.615 × $1,580,000 = $2,551,700 ≈ $2,552,000 14. Question ID: 48913 Correct Answer: C The GIM method does not consider explicitly vacancy rates and operating expenses and thus implicitly assumes that the ratio of vacancy and expenses to gross income is similar for the comparable and subject properties. 15. Question ID: 48914 Correct Answer: C C is correct. Unlike public equity real estate investments, privately traded equity investments do not trade in public markets and are less likely to behave like the stock market. Therefore, one would expect the individual correlations between private equity real estate and stocks and bonds to be lower relative to the former type of equity real estate. A is incorrect. A private equity investment in a hotel chain will require the investor to incur higher property management expenses. In general, private equity real estate is more management intensive compared to a public real estate equity investment. In the case of the latter, the underlying real estate is professionally managed. B is incorrect. Private real estate investments may receive a favorable tax treatment. Similarly, publically traded REITs may also have some tax benefits in some countries. Therefore, there is no distinct tax advantage of investing in private equity real estate.

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Reading 42

Private Real Estate Investments

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16. Question ID: 48915 Correct Answer: A Stone has observed the terminal cap rate to be higher relative to the going-in cap rate. When this is the case, the following holds true: • • •

interest rates are expected to be higher pushing up discount rates; therefore, the future discount rates are expected to be higher or growth is expected to be lower as the property is older at the time of sale and the market may not be competitive or there is greater uncertainty of what the NOI will be in the future compared to today.

17. Question ID: 48916 Correct Answer: B The following steps will be followed to estimate the current value of the real estate: Step 1: Estimate resale price after four years: Resale price = $250,000/(0.07) = $3,571,429 Step 2: Discount the level NOI for the first four years and the resale price: PMT = $190,000 FV = $3,571,429 n=4 i = 10% The current (present) value of the property is estimated to be $3,041,608. 18. Question ID: 48917 Correct Answer: A When the growth rate is equal to zero, the value of the property is calculated as: NOI/Discount rate. Value = $190,000/0.10 = $1,900,000

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Reading 42

Private Real Estate Investments

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FinQuiz Level II 2019 – Item-sets Solution Reading 42: Private Real Estate Investments 19. Question ID: 48919 Correct Answer: B B is correct. The sales comparison approach cannot be used when there is a lack of comparable properties being sold in the market. This makes the use of the cost approach more appropriate as it does not rely on the sale of comparables. C is incorrect. The cost approach relies on the replacement cost of property, which assumes it is built today using current construction costs and standards. Therefore, when construction is no longer feasible, the replacement cost will be difficult to determine, which in turn will make it difficult to employ the cost approach for valuation. A is incorrect. The discount rate is not used when valuing a property using the cost approach. Failing to fully consider a property’s risk in the discount rate will result in the income approach producing an incorrect value. 20. Question ID: 48920 Correct Answer: C $1,400,000 Replacement cost Curable physical deterioration Incurable deterioration [(8 – 6)/8] × $1,350,000 Economic obsolescence Incurable functional obsolescence ($4,950/0.10) Locational obsolescence ($320,000 – $30,000) Land value Final appraised value (land and building)

- $50,000 $1,350,000 - $337,500 - $35,000 - $49,500 - $290,000 + $80,000 $718,000

In addition to the data collected in Exhibit 1, Emmanuel makes the following observations: 21. Question ID: 48921 Correct Answer: C Observation 1 mandates that an environmental inspection should be conducted to determine the impact of the contamination on property and land values. Observation 2 mandates a property survey be done to determine whether the conversion activity is conducted within the premises of the property.

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Reading 42

Private Real Estate Investments

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22. Question ID: 48922 Correct Answer: B Subject Property Annual rental income per unit (p.u.) Adjusted rental income p.u. Average rental income p.u. × Number of units Appraised value

Property 1

Property 2

Property 3

$1,200 $1,209.60

$2,800 $2,954.00

$3,000 $3,123

$2,428.87 500 $1,214,433

23. Question ID: 48923 Correct Answer: C C is correct. When a property is older, estimating depreciation and obsolescence becomes more difficult. The cost approach will generate an unreliable estimate of value. Therefore, the approach will be more reliable for newer properties that have a relatively modern design in a stable market. A is incorrect. See above. B is incorrect. The sales comparison assumes that investors make rational purchase decisions. Therefore, the sales comparison approach will be appropriate when this assumption holds. 24. Question ID: 48924 Correct Answer: B Since the loan will be advanced in accordance with a maximum loan to value ratio, the mortgage loan amount is first calculated and then used to determine the loan to value ratio. Return on equity = Cash flow/equity Equity = $30,000/0.12 = $250,000 Equity = Price – Mortgage Mortgage = $3,375,000 – $250,000 = $3,125,000 Loan-to-value ratio = $3,125,000/$3,375,000 = 0.9259 or 92.6%

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Reading 43

Publicly Traded Real Estate Securities

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FinQuiz.com CFA Level II Item-set - Solution Study Session 15 June 2019

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Reading 43

Publicly Traded Real Estate Securities

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FinQuiz Level II 2019 – Item-sets Solution Reading 43: Publicly Traded Real Estate Securities 1. Question ID: 17980 Correct Answer: B The contractual nature of REITs' rental income combined with high income payout rates makes REITs the most stable and highest yielding of publically traded equities. A is incorrect. In general, publically traded real estate securities (equity REITs and REOCs) provide the ability to trade on stock exchanges. Thus REITs and REOCs both provide liquidity. C is incorrect. Because REITs are constrained in their operations, investment choices and distributions, REITs are prevented from maximizing their returns. 2. Question ID: 17981 Correct Answer: C The most appropriate response to Concern 1 is Yes. The stock market value of publically traded REITs is more volatile than the appraised net asset value of privately traded REITs. Net asset values based on appraised values rather than actual transaction prices tend to underestimate volatility. The most appropriate response to Concern 2 is No. Investments in publically traded REITs are not suitable for investors seeking control over property-level investment decisions. Investors desiring control should opt for a direct investment in the underlying property. 3. Question ID: 17982 Correct Answer: C NOI is a figure calculated before the deduction of general and administrative expenses. A is incorrect. Insurance costs are incorporated in the NOI calculation and are thus an element of AFFO. B is incorrect. Straight-line rent is an element of NOI and AFFO. It is the average contractual rent over a lease term. Subtracting cash rent paid from straight-line rent produces non-cash rent; thus straight-line rent is the sum of cash rent paid and non-cash rent, in other words it is equivalent to the gross rental revenue.

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Reading 43

Publicly Traded Real Estate Securities

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4. Question ID: 17983 Correct Answer: C Total NAV = $25.40 × 5,000,000 = $127,000,000 Total NAV = $25.40 × 5,000,000

$127,000,000

Plus: debt and other liabilities

$2,345,000

Less: Prepaid and other assets

$760,000

Less: Land held for future development

$9,000,000

Less: Accounts receivable

$2,125,000

Less: Cash and equivalents

$120,000

Estimated value of operating real estate (1) Assumed cap rate (2)

$117,340,000 7%

Estimated next 12 months cash NOI (1 × 2)

$8,213,800

Less: General and administration expenses

$200,000

Less: interest expense

$45,000

FFO

$7,968,800

FFO per share ($7,968,800/5,000,000) P/FFO ($33.50/1.59376)

$1.59376 21.02x

5. Question ID: 17984 Correct Answer: B Residential REITs are most undervalued relative to their average subsector P/AFFO multiple. To determine which type of REITs is most undervalued, it is necessary to determine the level of discount to the average subsector P/AFFO: Office

Residential

Healthcare

REITs' P/AFFO*

16.8x

15.3x

21.6x

Average subsector P/AFFO (given)

18.9x

17.7x

22.4x

(11.1%)

(13.6%)

(3.57%)

REITs (Discount)/Premium to average subsector REITs P/AFFO = Current share price/AFFO per share

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Reading 43

Publicly Traded Real Estate Securities

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6. Question ID: 17985 Correct Answer: C Healthcare REITs are the least desirable from an investment perspective. Given that the economy is in an expansionary phase, short remaining lease terms provide mark-tomarket opportunities on term rent. All three properties have lease terms exceeding a year and are thus almost equivalent in this respect; the three REITs do not provide attractive mark-to-market opportunities. Low-in place rents provide upside potential to cash flows upon lease re-negotiation while high inplace rents represent additional risk to maintaining current cash flows. Office REITs and residential REITs have low-in place rents and are desirable from this perspective while healthcare REITs are least desirable. The properties underlying office REITs have the highest percentage of tenant occupancy while healthcare REITs' properties have the lowest percentage occupancy. Thus healthcare REITs are undesirable from this perspective. Based on in-place vs. market rent and percentage of occupied space, healthcare REITs are the least desirable form of investment.

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Reading 43

Publicly Traded Real Estate Securities

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FinQuiz Level II 2019 – Item-sets Solution Reading 43: Publicly Traded Real Estate Securities 7. Question ID: 48926 Correct Answer: A A is correct. REIT shares can be traded on the stock exchange and therefore they provide greater liquidity than buying and selling real estate in property markets. Due to their large lot sizes, a direct investment in real estate represents a relatively illiquid form of investment. B is incorrect. The maintenance of a REIT structure is costly and may not be offset by the benefits. C is incorrect. The stock market of a REIT is more volatile than the appraised value of a REIT. Therefore, one would expect the REIT shares to have higher price and return volatility. 8. Question ID: 48927 Correct Answer: B B is correct. Investment in REITs allows investors to diversify their real estate portfolios by geography and property type. This type of diversification is hard to achieve in direct property investing because of the large size and value of each property. A is incorrect. Because REITs are associated with high dividend yields, there is less income available for reinvestment. This low rate of reinvestment will reduce income growth potential. C is incorrect. Because investors in REITs have their interests managed by professional managers, control over property-level investment decisions no longer remains in their hands. This contrasts with investors acquiring a direct investment in real estate; the latter are actively involved in the management of the underlying property. 9. Question ID: 48928 Correct Answer: B B is correct. Trends in government funding influences the value of an investment in a health care REIT and is not relevant for the purposes of analysis. A is incorrect. Job creation will lead to an increase in the use of storage space as personal and small businesses need space to rise.

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Reading 43

Publicly Traded Real Estate Securities

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10. Question ID: 48929 Correct Answer: C To determine whether the warehouse property is mispriced, the P/AFFO multiple of the property relative to the average industry needs to be calculated and compared. P/AFFO = Market price per share/[(NOI – General and administrative expenses – interest expense – non-cash rent – maintenance-type capital expenditures)/Shares outstanding] *Non-cash rent = Straight-line rent – cash rent P/AFFO (Warehouse) = $47.56/[{$175,000 – $4,250 – $2,250 – ($40,000 – $35,000) – $1,080}/52,000] = $15.23 P/AFFO (Average Industry) = $52.09/[{$180,000 – $4,780 – $1,890 – ($45,000 – $25,000) – $2,010}/50,000] = $17.21 The warehouse appears to be relatively undervalued as it has a lower P/AFFO multiple compared to the average industry. 11. Question ID: 48930 Correct Answer: B NAV = NOI/Market cap rate = $175,000/0.08 = $2,187,500 NAVPS = $2,187,500/52,000 = $42.07 12. Question ID: 48931 Correct Answer: B Lewis is inaccurate regarding to Reason 1. FFO estimates are readily available through market data providers. Lewis is accurate regarding Reason 2. Applying a multiple to the FFO and AFFO may not capture the intrinsic value of real estate assets held by the REIT or REOC. An example of this includes a parcel of land and empty building which do not produce current income and thus do not contribute to FFO but have value. Lewis is accurate regarding Reason 3. The recent increase in one-time items such as gains as well as new revenue recognition rules have affected the income statement making the P/FFO and P/AFFO multiples more difficult to compute and complicating comparisons between companies.

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Reading 43

Publicly Traded Real Estate Securities

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FinQuiz Level II 2019 – Item-sets Solution Reading 43: Publicly Traded Real Estate Securities 13. Question ID: 48933 Correct Answer: A The repositioning strategy will be dilutive to earnings because the cap rate at which the properties will be sold is higher than yields at which they are reinvested reflecting lower risk premiums. Therefore, the REIT will most likely face cash flow growth pressures in the near term as a material portion of the portfolio is reinvested into higher-quality properties. 14. Question ID: 48934 Correct Answer: B

Prior to discounting the dividends, the required rate of return will need to be determined using CAPM: Required rate of return = 2.20% + 0.65(6.85%) = 6.6525% = 6.6525% Present value (PV) of Divided (2015) = $0.85/(1.066525) = $0.7970 PV of Dividend (2018) = $1.10/(1.066525)2 = $0.9671 PV of Dividend (2018) = $2.50/(1.066525)3 = $2.0608 PV of perpetual dividend in 2018 = $2.5(1.05)/(0.066525 – 0.05) = $158.85 PV of perpetual dividend today = $158.85/(1.066525)3 = $130.94 Current value of office REIT share = $0.7970 + $0.9671 + $2.0608 + $130.94 = $134.76 15. Question ID: 48935 Correct Answer: A A is correct. A higher long-term growth rate will decrease the cap rate and a lower cap rate will increase the current value of each REIT share.





Intrinsic Value =   =  C is incorrect. Parking income (other income) increases the net operating income, which eventually increases the intrinsic value of the property.

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Reading 43

Publicly Traded Real Estate Securities

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16. Question ID: 48936 Correct Answer: B B is correct. Observation 1 will have an indeterminate impact on NAVPS while Observation 2 will increase NAVPS. A higher future rental income stream will increase NOI and thus NAVPS; the latter includes the next 12 months’ expected NOI as a component. On the other hand, a higher cap rate resulting from a higher rental income stream will reduce the NAVPS. The dividend growth rate does not affect the NAVPS calculation. Therefore, the observation does not have a clear cut impact on the NAVPS measure. Observation 2 will serve to increase NAVPS. Land held for future development is added to the estimated value of operating real estate to arrive at net asset value. Therefore, an increase in the land value will serve to increase NAVPS. A is incorrect. The NAVPS includes the next 12 months’ growth in NOI as a component in its calculation. C is incorrect. NAVPS includes the value of land as a component. Where the market value of land cannot be reliably estimated, book value is used instead. 17. Question ID: 48937 Correct Answer: C C is correct. National GDP growth is one of the main drivers influencing the value of an office REIT as businesses are prepared to pay more rent as well as demand office space to accommodate more business in a stronger economy. A and B are incorrect. The value of an office REIT is least affected by retail sales growth and population growth. 18. Question ID: 48938 Correct Answer: A REITs are characterized by high dividend yields often paying a significant portion of their income as dividends. Therefore, this makes the dividend discount model an appropriate valuation tool.

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Reading 43

Publicly Traded Real Estate Securities

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FinQuiz Level II 2019 – Item-sets Solution Reading 43: Publicly Traded Real Estate Securities 19. Question ID: 48940 Correct Answer: B Penn should invest in either the REIT or REOC to achieve diversification. On the other hand, diversification is hard to achieve in direct property investing because of the large size and value of the property. Unlike REITs, REOCs as well as direct property investors are free to invest in any kind of real estate subject only to the limitations that may be imposed by their articles of incorporation and/or the market. In contrast to REOCs, REITs are constrained in their investments, operations, and distributions. REOCs are free to use a wider range of capital structures and degrees of financial leverage. 20. Question ID: 48941 Correct Answer: C For his personal investment portfolio, Penn should select either a REOC or REIT investment. Both types of structures permit investors to purchase shares that represent fractional interests with a much lower investment than a single commercial property. On the other hand, large lot sizes of real estate considerably increase the cost of investment making it difficult for investors such as Penn to purchase. 21. Question ID: 48942 Correct Answer: B B is correct. Equity markets of most countries have shown a preference for the tax advantages, highincome distributions and stringent operating and financial mandates that come with the REIT status. Therefore, REOCs have less access to equity capital and lower market valuations relative to REITs. A is incorrect. See above. C is incorrect. REOCs are ordinary taxable corporations thus subjecting investors to the taxation of their dividend income.

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Reading 43

Publicly Traded Real Estate Securities

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22. Question ID: 48943 Correct Answer: C C is correct. Given that the management of the underlying properties is delegated to subsidiary REITs, due diligence of senior management serving the parent REIT is not relevant. A is incorrect. Because the income of a hotel REIT is variable and demand is cyclical, analysts need to be wary of structures that use a high degree of financial leverage. Therefore, a review of the REIT’s balance sheet and leverage levels need to be examined. B is incorrect. Compared to other real estate, hotels have the shortest lease terms. Short-term leases are a positive consideration in an expansionary economy and/or rental market and a negative consideration in a declining economy and/rental market.

23. Question ID: 48944 Correct Answer: A Estimated next 12 months cash NOI Assumed cap rate Estimated value of operating real estate Cash and cash equivalents Land held for future development Prepaid assets Total debt Other liabilities Net asset value Shares outstanding Net asset value per share

$325,280 10% $3,252,800 + $50,088 + $30,100 + $19,200 - $1,560,500 - $150,780 $1,640,908 ÷ 60,000 $27.35

24. Question ID: 48945 Correct Answer: B Penn is accurate with respect to Reason 1 but inaccurate with respect to Reason 2. One of the main reasons of why REIT shares trade at a premium or discount relative to their NAV is that public equity market investors ascribe a different value to the REIT relative to the private buyers. When the value ascribed by the public equity market is lower relative to private buyers, REIT shares trade at a discount to their NAV. When the underlying property market is illiquid, estimating a NAV becomes difficult as the estimates can become quite subjective.

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Reading 44

Private Equity Valuation

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FinQuiz.com CFA Level II Item-set - Solution Study Session 15 June 2019

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Reading 44

Private Equity Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 44: Private Equity Valuation 1. Question ID: 11383 Correct Answer: A With a $20 million investment in D.S. Associates and an investment value of $25 million in three years time, the IRR on the investment is 7.72%. Since the investment’s IRR does not exceed the specified hurdle rate (8%) the theoretical carried interest of $1 million ($5 million × 20%) will not be paid to the managers until and unless the fund generates a value which results in its IRR exceeding the hurdle rate. 2. Question ID: 11384 Correct Answer: C Fact 1: The general partner of a buyout investment is paid variable revenue comprising of carried interest, transaction fees, and monitoring fees. While carried interest is the main source of variable revenue to the general partner of a venture capital firm, transaction and monitoring fees are rare in practice. Thus the GP of a buyout fund earns revenue which may not be earned by the GP of venture capital firms. Fact 1 has been correctly identified. Fact 2: In context of the variability of returns on investment portfolios comprising of buyout funds, the underlying investments are characterized by lower variances across investment returns. Additionally, bankruptcies are of rare occurrence. In contrast, the variability of venture capital fund portfolios are characterized by very high returns from a limited number of investments and a significant number of write-offs from low performing investments or failures. Thus fact 2 does not accurately address the level of write-offs and success rates of the latter investment type. Fact 3: A venture capital firm requires a significant cash burn rate to ensure company development and commercial viability. This contrasts with buyout funds which offer the investor restructuring and cost reduction potentiality. Fact 3 does not accurately address the purpose of the high cash burn rate. 3. Question ID: 11385 Correct Answer: B Management fees represent the percentage of committed capital paid annually to the GP over the fund’s lifetime. Neither provision 1 nor 2 make reference to management fees. Transaction fees are paid to GPs in their advisory capacity when providing investment banking services for transactions such as merger and acquisitions or IPOs. These fees may be subject to a sharing agreement between the GP and limited partners. Provision 2 makes reference to this economic term. Rachet is a mechanism which helps to determine the allocation of equity between shareholders and the management team of the private equity controlled company. Provision 1 makes reference to this economic term.

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Reading 44

Private Equity Valuation

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A placement fee is an upfront or a trailer fee fundraising fee charged by the fund raiser. Neither provision 1 nor 2 make reference to this type of fee. 4. Question ID: 11386 Correct Answer: C The exit value, twelve years following the investment is $94 million (18.8 × $5 million). Initially the proportion of initial investment attributable to the private equity (PE) fund, preference shares, and the management are as follows: Preference Shares = $10 million(0.4)(0.05) = $0.2 million PE fund = $10 million (0.4)(0.85) = $3.40 million • 65% of the senior bonds have been paid, reducing the debt from $6 million to $2.1 million [$6 million − (0.65) ($6 million)]. The senior bond holders will be paid $2.10 million. • Preference shareholders are paid a 15% return for 12 years, so they receive $0.20(1.15)12 = $1.07 million. • The PE equity fund receives 90% of the terminal equity value, or 0.90[94 – (2.10 + 1.07) = $81.747 million. Using the initial total value (share of the initial investment) of the PE equity fund and the preference shares of $3.60 million ($0.20 million + $3.40 million) and the final total value upon termination of $82.82 million ($81.75 million + $1.07 million), the annual IRR earned by the private equity fund is approximately 29.86%. 5. Question ID: 11387 Correct Answer: B Factor 1: Market risk reflects the change in the general market conditions (interest rates or currency exchange rates) which adversely affects private equity investments. The impact of market risk is long-term in nature and temporary short-term market fluctuations are generally irrelevant. Fact 1 does not correctly address market risk as it refers to this risk affecting investments over the short-term (temporary) and long-term as opposed to the long-term only. Factor 2: Lack of diversification arises from investment portfolios being highly concentrated in investments of the same vintage year and/or at the same stages of development. This exposes the portfolio to significant losses (possibly during a market downturn producing simultaneous losses for these highly correlated investments). Factor 2 correctly addresses this risk exposure/factor. Factor 3: Government regulations can pose significant risks to private equity funds if the underlying investee companies’ product and services are subject to changes in governmental regulations that adversely impair their business model. The exposure of company practices to evolving and consequentially more stringent measures correctly addresses this risk exposure/factor.

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Reading 44

Private Equity Valuation

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6. Question ID: 11388 Correct Answer: B In order to determine the per-share value after the first round of financing, the following steps are followed: Step 1: Determine the post-money valuation at the time of the second round of financing (POST2) POST2 = V/(1 + R2) = $50/(1.10)2 ≈ $41.32 Step 2: Determine the pre-money valuation at the time of the second round of financing (PRE2) PRE2 = POST2 – I2 = $41.32 – 3 = $38.32 Step 3: Determine the post-money valuation at the time of the first round of financing (POST1) POST1 = PRE2/(1 + R1) = 38.32/(1.12)3 ≈ $27.28 Step 4: Determine the pre-money valuation at the time of the first round of financing (PRE1) PRE1 = POST1 – I1 = $27.28 – 4 = $23.28 Step 5: Determine the required ownership fraction for the investors in the first round (F1) F1 = I1/POST1 = $4/27.28 ≈ 0.146628 Step 6: Determine the number of shares required by the investors in the first round to achieve their desired ownership fraction (y1) y1 = x1[F1/(1 – F1)] = 2[0.1466276/1 – 0.1466276)] ≈ 0.3436427 Step 7: Determine the price per share in the first round (p1) p1 = I1/y1 = $4/0.3436427 ≈ $11.64 per share 7. Question ID: 16243 Correct Answer: A The percentage of fees paid to SPVIII’s managers is inconsistent with the percentage of management fees typically paid to the general partner of private equity funds. Fees are typically in the range of 1.5% to 2.5% of committed capital. Private equity funds tend to have durations of 10 to 12 years, which may be extendable to an additional 2 to 3 years. SPVII’s duration (13 years) is consistent with typical fund structures. Vintage year is the year when the private equity fund was launched. There is nothing indicating that either of the three funds’ vintage years is inconsistent with the typical fund structure. 8. Question ID: 16244 Correct Answer: B The amount of carried interest paid in 2010 is C$3.16 million. The first year that NAV is higher than committed capital, carried interest is 20% of the excess. Thereafter, provided that NAV before distribution exceeds the committed capital, carried interest equals (20%)(increase in NAV before distributions).

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Reading 44

Private Equity Valuation

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Since NAV before distributions exceeded the fund’s committed capital (C$200 million) for the first time in 2010, carried interest is C$3.16 million [20% × (C$215.8 millions – C$200 millions)]. 9. Question ID: 16245 Correct Answer: C The TVPI of the SPV I fund at December 31, 2010 is 2.13. TVPI is the portfolio company’s distributed and undistributed value as a proportion of the cumulative invested capital. It is presented net of management fees and carried interest. It is calculated as the sum of ‘the residual value to paid-in capital (RVPI) and distributions to paid-in capital (DPI)’. Paid in capital (in C$ millions) = 35 + 15+ 40 + 10 = 100 DPI = (C$0 + C$0 + C$20) / C$100 = 0.20 RVPI = C$192.64* / C$100 = 1.9264 *NAV after distributions in 2010 (in C$ millions)= 215.8 – 3.16 –20 = 192.64 TVPI = 0.20 + 1.9264 = 2.1264 10. Question ID: 16246 Correct Answer: A Net IRR of the SPV III fund during the 2008 to 2010 period is – 9.26% Net IRR is estimated by calculating the internal rate of return between the following cash flows: called-down capital + operating results – management fees – carried interest or cash flows for calculating gross IRR – management fees – carried interest Cash flows 2007 (In C$ million) = − 65 Cash flows 2008 = − 35 – 0.3 = − 35.3 Cash flows 2009 = 0 – 0.4 = − 0.4 Cash flows 2010 = 80 – 0.6 – 1.4 = 78.0 Net IRR = − 9.26% 11. Question ID: 16247 Correct Answer: A The executives are correct with respect to the benefit, to LPs, of adopting the co-investment clause. The co-investment clause grants LPs the first right of investing along with the general partner. The advantage of co-investment clause for LPs is that fees are likely to be lower (or zero) on co-invested capital. The executives are incorrect with respect to the benefit to LPs, of adopting the key man clause. The key man clause will ensure that in the event a certain number of key named executives leave the fund, or devote insufficient time to the fund management, the GP may be prohibited from making any new investments until a new key name executive is employed.

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Reading 44

Private Equity Valuation

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12. Question ID: 16248 Correct Answer: A SPVIII’s gross IRR is − 8.10% (see below). SPV III has demonstrated very modest returns based on the gross IRR measure. A negative gross IRR indicates that SPV III is still experiencing the J-curve effect. The J-curve effect refers to the typical time profile of reported returns by private equity funds, whereby low or negative returns are reported in the early years of a private equity fund. This period of low returns is followed by increased returns thereafter, as the private equity firm manages portfolio companies toward exit. Gross IRR is estimated by calculating the IRR between the called down capital at the beginning of the period and operating results. Using the following cash flows IRR is calculated as – 8.10%: CF0 = − C$65; C01 = − C$35; C02 = C$0; C03 = C$80

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Reading 44

Private Equity Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 44: Private Equity Valuation 13. Question ID: 48947 Correct Answer: A The alignment of interests between private equity managers and the management of the companies they control is possible because the former do not suffer from the short-termism prevailing in public companies. Short-termism prevails in public companies as a result of the pressure on managers to meet quarterly earnings targets. On the other hand, private equity firms have a longer time horizon to manage their equity investments. Therefore, firms manage their investment in a way which maximizes the value of investor holdings as well their (fee) income resulting in an alignment of economic interests. B is incorrect. The payment of cash generated to shareholders does not assist in the alignment of interests. C is incorrect. Private equity firms are not the sole catalysts of change in a large organization. 14. Question ID: 48948 Correct Answer: A A is correct. Evidence suggests that many public companies have established a long track record of creating value. Therefore, only a part of the value added comes from superior reorganization and reengineering capabilities while financial leverage and alignment of interests between private equity firm owners and the managers of the firms they control also play a role in value creation. 15. Question ID: 48949 Correct Answer: B B is correct. Given that the private equity fund managed by Lex Associates invests in mature companies, the earnings multiple approach is suitable for valuation. This approach applies to companies with a significant operating history which have a predictable stream of cash flows making it suitable for the Lex Fund. A is incorrect. The replacement cost approach rarely applies to mature companies as it is difficult to estimate the cost of recreating a company with a long operating history. C is incorrect. The real option approach generally applies to companies operating at the seed or startup stage where management or shareholders have significant flexibility in making radically different strategic decisions.

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Reading 44

Private Equity Valuation

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16. Question ID: 48950 Correct Answer: B Policy 1 is an example of a non compete clause which restricts company founders from starting the same activity during a predefined time period. Policy 2 is an example of the earn-outs clause which links the acquisition price paid by the private equity firm to the firm’s future financial performance over a predetermined time horizon. Policy 3 is an example of the reserved matters clause which requires certain areas of strategic importance to be subject to approval or veto of the private equity firm. 17. Question ID: 48951 Correct Answer: C At the terminal year, preference shares receive €3,221,020 [€2,200,000(1.10)4] on their investment while debt holders receive €1,000,000. The private equity fund receives 0.80[€12,500,000 – (€1,000,000 + €3,221,020)] = €6,623,184 on their €800,000 investment which gives an IRR of 60.42%. 18. Question ID: 48952 Correct Answer: C When using the income approach for valuing LBO transactions, the initial high and declining financial leverage is the main technical issue that needs to be factored into the approach.

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Reading 44

Private Equity Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 44: Private Equity Valuation 19. Question ID: 48987 Correct Answer: B B is correct. The discounted cash flow approach is not a good starting point for valuing a VC investment because there is uncertainty surrounding the projected future cash flows. The approach depends on a predictable cash flow stream to generate value. 20. Question ID: 48988 Correct Answer: B B is correct. A clawback provision will require Romero Associates (the general partner, GP) to return capital to limited partners (LPs), including Oregon Associates, in excess of the agreed profit split between the GPs and LPs. This provision ensures that, when a private equity firm exits from a highly profitable investment early in the fund’s life but subsequent performances are less profitable, the GP will pay back capital contributions, fees and expenses back to LPs in line with the fund’s prospectus. A is incorrect. A co-investment clause grants LPs the first right to co-invest with the GP. This allows for fees and profit share to be lower on co-invested capital. C is incorrect. A distribution waterfall is a payment mechanism which ensures that distributions are made to LPs before the GP receives carried interest. 21. Question ID: 48989 Correct Answer: B B is correct. In contrast to buyout funds, which require full blown due diligence (financial, strategic, commercial, legal, tax and environmental), venture capital firms tend to conduct primarily commercial and technological due diligence before investing. Since the portfolio companies have a very short operating history, VC firms do not conduct extensive financial due diligence. A is correct. See above. C is incorrect. VC firms are primarily equity funded with use of leverage being very rare and limited.

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Reading 44

Private Equity Valuation

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22. Question ID: 48990 Correct Answer: A All $ figures are in millions. NAV after distributions = NAV before distributions – Carried interest – Distributions NAV before distributions = NAV after distributions t – 1 + call-down capital – management fees + operating results NAV before distributions = $0 + $75 – (0.02 × $75) – $10 = $63.5 NAV after distributions = $63.5 – $0* – $0 = $63.5 *In the first year, NAV is lower than committed capital ($63.5 million versus $405 million). Therefore, carried interest is $0. 23. Question ID: 48991 Correct Answer: A All $ figures are in millions. Realized return on investment (Distributions to Paid in Capital) = $5/($75 + $30) = 0.0476x or 0.05x 24. Question ID: 48992 Correct Answer: B B is correct. A closed end fund structure restricts existing investors from redeeming their shares during the lifetime of the fund. A is incorrect. A closed end fund structure limits the entry of new investors to predefined time periods, at the discretion of the GP. C is incorrect. See above.

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Reading 44

Private Equity Valuation

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FinQuiz Level II 2019 – Item-sets Solution Reading 44: Private Equity Valuation 25. Question ID: 48994 Correct Answer: C C is correct. One of the challenges associated with exit via an IPO is that the private company must have an established operating history with excellent growth prospects. Being a startup, there is uncertainty surrounding Rita Robotics’ ability to build a reasonable amount of operating history in five years’ time. A is incorrect. Going public offers significant advantages including high valuation multiples as result of enhanced liquidity. An enhancement of liquidity is the result of private company shares being traded on an established trading platform. B is incorrect. Although exit via an IPO has numerous benefits, it comes at an expense of less flexibility for managers who are now subject to the scrutiny of analysts, investors and the public market at large. However, it is incorrect to attribute the reduced flexibility to excessive leverage. 26. Question ID: 48995 Correct Answer: A To determine the price per share, two variables are required – Stone Tech’s 1) initial investment amount (given as $5 million) and 2) the number of shares needed to acquire a 58.7% stake in Rita Robotics (denoted y). Given that the founders own 1,800,000 shares, the number of shares required by Stone Tech is calculated as follows: y = 1,800,000[0.587/(1 – 0.587)] = 2,558,354 Price per share = $5,000,000/2,558,354 = $1.95

27. Question ID: 48996 Correct Answer: B B is correct. Prior to determining the pre-money valuation, it is necessary to determine the postmoney valuation. Based on the data in the exhibit, an investment of $5 million buys 58.7% of the company. Therefore 58.7% × post-money valuation = $5 million. Post-money valuation = $5 million/0.587 = $8.5179 million Pre-money valuation = $8.5179 million – $5 million = $3.5179 million or $3.5 million

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Reading 44

Private Equity Valuation

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28. Question ID: 48997 Correct Answer: A A is correct. Investors in the Stone Tech fund will not experience a dilution of ownership interests if the fund is used to finance both stages. This is because the same fund is merely expanding its investment in Rita Robotics while ownership is retained by fund investors. B is incorrect. Given the challenges surrounding exit via an IPO, it is unlikely that Stone Tech agreeing to finance both rounds will help avoid this uncertainty. 29. Question ID: 48998 Correct Answer: C The required investment for the second round is $2 million while the post-money valuation at the beginning of the second round is $5,340,576 ($35,000,000/1.64). The additional ownership fraction required by Stone Tech is equal to 37.4% ($2,000,000/$5,340,576). 30. Question ID: 48999 Correct Answer: A The post-money valuation in the second financing round is equal to $35,000,000/1.454 = $7,917,645. The ownership stake demanded by the second round of investors would equal $2,000,000/$7,917,645 = 25.26% or 25.3%

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Reading 45

Commodities & Commodity Derivatives: An Introduction

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FinQuiz.com CFA Level II Item-set - Solution Study Session 15 June 2019

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Reading 45

Commodities & Commodity Derivatives: An Introduction

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FinQuiz Level II 2019 – Item-sets Solution Reading 46: Commodities & Commodity Derivatives: An Introduction 1. Question ID: 71898 Correct Answer: C

C is correct. By capitalizing on Orme’s expectations, Sun Capital will participate in the commodities futures markets as an informed investor. This is because the firm will believe it has an information advantage with respect to volatility and it will seek to profit from this by trading futures. A is incorrect. Arbitrageurs who have the ability to inventory physical commodities can capitalize on mispricing between the commodity futures price and spot price. However, Sun Capital does not possess this capacity. B is incorrect. A liquidity provider will provide insurance to hedgers in exchange for an expected profit. By acting on Orme’s expectations, Sun Capital will not be playing the role of a liquidity provider as its objectives will differ from the motives of this commodity participant. 2. Question ID: 71899 Correct Answer: B

B is incorrect. Since live cattle is consumed by individuals and used to make food products year round, the demand for this commodity is not seasonal. A is incorrect. Grain is used by ranchers as an input to feed livestock. Therefore, fluctuations in grain prices will directly affect the cost of raising an animal and the final selling price. B is incorrect. With a growing middle class in emerging and frontier markets, consumers capable of purchasing meat protein as part of their regular diet increases. This will result in a higher demand for livestock and increased investment in the livestock and meatpacking industries.

Reading 45

Commodities & Commodity Derivatives: An Introduction

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3. Question ID: 71900 Correct Answer: C

C is correct. The storage costs of livestock such as live cattle are tied to grain prices. If grain prices increase, then animals are slaughtered more quickly to avoid the higher cost of feeding them. This will pull supply forward in the near term leading to an excess supply and lower prices. However, an increase in storage costs will not produce the same effect on natural gas supply. A is incorrect. Natural gas can easily be transported via ships. Slaughtered meat is usually frozen and advances in freezing technologies means that products are moving from one part of the world to another in response to differences in production costs and demand. Therefore, the advancement of technology has allowed slaughtered meat to become more transportable. B is incorrect. Weather has a surprising impact on animal health and weights. In the winter cattle suffer more than hogs and chickens because of their height. Winter is a key driver of the demand for natural gas with colder months driving up the demand for natural gas. 4. Question ID: 71901 Correct Answer: A

A is correct. A commodity futures market is said to be in contango when long-term futures prices are higher than the near-term futures prices or futures prices are higher than the spot price. The opposite occurs in backwardation. Based on the trend in live cattle futures prices and the relation between the spot and futures prices, this sector is in a state of contango. On the contrary, the natural gas sector is in a state of backwardation. B is incorrect. Positive calendar spreads can only be earned when futures markets are in backwardation. Negative calendar spreads are associated with futures markets in contango. As established above, the live cattle market is in a state of contango and therefore an investor can only earn a negative calendar spread. C is incorrect. As commodity futures markets shift from being in a state of contango to backwardation, the roll returns will fluctuate accordingly. Therefore, it is impossible for an investor to earn roll returns in perpetuity.

Reading 45

Commodities & Commodity Derivatives: An Introduction

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5. Question ID: 71902 Correct Answer: A

A is correct. Orme is relying on the insurance theory to explain the trend in futures prices. This is because he assumes that the hedging pressure of commodity sellers has lead to the present state of backwardation in the natural gas sector. This coincides with the insurance theory which assumes that the futures market is in backwardation as a result of the demand for commodity sellers to seek price insurance. B is incorrect. The theory of storage attempts to explain how the level of commodity storage influences commodity futures price curves. Orme is not considering the level of natural gas storage and is therefore not relying on this theory. C is incorrect. Hedging pressure hypothesis compares the demand of commodity producers and consumers for price insurance. Orme does not address commodity consumers when analyzing the futures price trend and is therefore not relying on this theory of commodity futures returns. 6. Question ID: 71903 Correct Answer: C

C is correct. If Sun Capital is seeking to capitalize on the difference between expected versus observed volatility for a reference price commodity, it should employ a volatility swap. Under this arrangement, both parties speculate on how volatile prices will be versus expectations. A is incorrect. A basis swap exchanges periodic payments based on the values of two related references prices which are not perfectly correlated. This type of swap will not be relevant for exploiting the volatility expectation. B is incorrect. A variance swap involves two buyers periodically exchanging payments based on the proportional difference between an actual variance in price levels and a fixed amount of variance established at the outset of the contract. However, this type of swap will not be relevant for Sun Capital which seeks to exploit the difference between actual and expected volatility in price levels.

Reading 46

The Portfolio Management Process & the investment policy statement

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FinQuiz.com CFA Level II Item-set - Solution Study Session 16 June 2019

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Reading 46

The Portfolio Management Process & the investment policy statement

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FinQuiz Level II 2019 – Item-sets Solution Reading 46: The Portfolio Management Process 1. Question ID: 11278 Correct Answer: C The planning stage of the portfolio management process includes the following steps: 1. Determine the client’s objectives and constraints. 2. Create the IPS which generally details the reporting requirements, rebalancing guidelines, frequency and format of investment communication, manager fees, investment strategy, and the desired investment styles of the managers. Investment strategies include passive, active and riskcontrolled active strategies. 3. The third stage involves formulating capital market expectations which are long-run forecasts of the risk and return characteristics for various asset classes. 4. The final stage involves determining the strategic asset allocation. This stage combines the IPS and capital market expectations to determine target asset class weights, maximum and minimum permissible asset class weights. The newsletter has incorrectly addressed the fourth stage of the planning process. 2. Question ID: 11279 Correct Answer: B The execution stage incorporate the following steps: 1. The ‘portfolio selection/composition decision’: this decision involves the integration of investment strategies with capital market expectations to select specific assets for the portfolio. 2. The ‘portfolio implementation decision, which involves initiating portfolio decisions using analysts’ input and trading desks to implement these decisions. 3. The portfolio is revised as investor circumstances or capital market expectations change. Fixing the portfolio revisions to one year is not appropriate as client circumstances or market expectations may change more frequently than the stipulated frequency. Thus the newsletter has incorrectly addressed the third step of the execution process. 3. Question ID: 11280 Correct Answer: B Generally portfolios may require rebalancing when: • • •

investor circumstances (objectives and/or constraints) change; capital market expectations change; and deviations from strategic asset allocation as specified by the IPS.

Frequent investment officer changes are not a factor which would dictate portfolio revisions. Such changes generally do not affect investor circumstances or capital market expectations.

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Reading 46

The Portfolio Management Process & the investment policy statement

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4. Question ID: 11281 Correct Answer: C Assertion 1: In context of pension plans, the return requirements and risk tolerances are contingent upon whether the plan in question is a defined benefit or defined contribution plan. Defined benefit plans state their return requirements in terms of the return that will adequately fund liabilities on an inflation-adjusted basis. The risk tolerance of such plans depend upon the plan and sponsor characteristics, plan features, funding status, and workforce characteristics. Defined contribution plans’ return requirements depend on the stage of life of the individual participants. The risk tolerance of such plans varies with the risk tolerance of individual participants. Thus assertion 1 has inaccurately addressed the return requirements and risk tolerances of pension plans by failing to make a distinction between the two categories. Assertion 2: The risk tolerances of individual investors; defined contribution plans; and banks, as institutional investors, vary according to the type of investor. Thus assertion 2 has incorrectly pointed out that individuals are the only investor category whose risk tolerance varies. 5. Question ID: 11282 Correct Answer: A With sufficient pre-retirement (salary) and post-retirement income (pension) to cover her current and post-retirement living expenses, Lance has a low level of liquidity needs. Since her current and future needs (living expenses) are secured, Lance is capable of taking risks. There is nothing to indicate that her spending needs are extravagant. Additionally at 47 years of age, her risk taking ability is high. Together these factors demonstrate an above average ability to take risk. 6. Question ID: 11283 Correct Answer: A Harper is currently 35 years of age and has 15 (50 – 35) years left to retirement. Thus her time horizon can be defined as being long-term. Harper has a multi-stage horizon, which includes: 1. the current period till the time of his mother’s death (she is terminally ill); 2. from her death to the date of his retirement; 3. retirement onwards.

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Reading 46

The Portfolio Management Process & the investment policy statement

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FinQuiz Level II 2019 – Item-sets Solution Reading 46: The Portfolio Management Process 7. Question ID: 48646 Correct Answer: C C is correct. The portfolio perspective is based on the concept that an asset class should not be evaluated from a stand-alone perspective, but from a portfolio perspective. This means that portfolio managers should consider the interrelationship between the asset classes and how much risk each asset class brings to the portfolio. B is incorrect. The portfolio perspective does not address how portfolio management should be viewed and dealt with – as a process or random set of individual procedures. 8. Question ID: 48647 Correct Answer: C The ‘Ethical Responsibilities’ excerpt accurately presents the concept with respect to all three points discussed. Ethical conduct is the foundation requirement for managing investment portfolios. In addition, the conduct of a manager affects the well-being of clients and thus looking after their welfare is crucial. Furthermore, portfolio managers must keep in mind that they are in a position of trust as reflected by the Code of Ethics and Standards of Professional Conduct. 9. Question ID: 48648 Correct Answer: C Lee retired 25 years ago when his investable asset base was $95,000. Given that he withdrew $25,000 each year for 25 years and built a $1 million investment portfolio at the end of this time period, his post-tax required rate of return was 26.97% (see below). Given a 30% tax rate, his pre-tax required rate of return was 38.53% [26.97%/(1 – 0.3)]. N = 25; PV = - 95,000; PMT = 25,000; FV = 1,000,000 I/Y = 26.9737% 10. Question ID: 48649 Correct Answer: B Lee has significant liquidity concerns as is evident from his desire to hold cash in reserves and his dependence on the investment portfolio as a source of liquidity. Hector can modify the payoff structure of a risky portfolio to address liquidity requirements using derivative strategies. 11. Question ID: 48650 Correct Answer: A Concern 2 addresses a tax constraint only. The increase in estate tax rates may influence Lee’s decision to transfer his investment portfolio upon his death. Therefore, tax concerns will influence any investment decisions made on behalf of his portfolio.

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Reading 46

The Portfolio Management Process & the investment policy statement

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12. Question ID: 48651 Correct Answer: C C is correct. Performance appraisal is an evaluation of a manager’s performance relative to his or her stated benchmark. The portfolio performance can be examined in terms of absolute returns via three distinct sources – decisions from strategic asset allocation, market timing (returns attributable to short-term deviations from the strategic asset allocation, and security selection. A is incorrect. The policy has incorrect described returns from market timing as security selection returns. B is incorrect. Residual returns are not stated as a source of absolute returns.

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Reading 46

The Portfolio Management Process & the investment policy statement

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FinQuiz Level II 2019 – Item-sets Solution Reading 46: The Portfolio Management Process 13. Question ID: 48702 Correct Answer: A If the impact of the occurrence of an event on the financial circumstances of the investor is significant enough, an additional time horizon stage is warranted. The receipt of the $0.5 million will increase Redel’s ability to take risk and will therefore require an additional time horizon stage. 14. Question ID: 48703 Correct Answer: A A is correct. The receipt of the $0.5 million will increase the size of Redel’s financial asset base. Therefore, she will be able to tolerate greater volatility in her asset base as a result of employing riskier investment strategies. In conclusion, Redel’s ability to take risk will increase. B is incorrect. An increase in the inflation rate will not have an impact on her ability to take risk. C is incorrect. The impact of an increase in tax rates should be reflected in the tax constraints section of Redel’s IPS. Therefore, Note 3 will not have an influence on her risk taking ability. 15. Question ID: 48704 Correct Answer: A Both notes 1 and 4 combined indicate that a revision in Redel’s liquidity requirements is warranted. Redel is required to spend $500,000 in three months which reflects a demand on portfolio liquidity (given that her earnings are only sufficient to offset her living expenses). The receipt of the inheritance sum will reduce the demand on portfolio liquidity as Redel can employ the amount received towards the boat purchase. 16. Question ID: 48705 Correct Answer: B Out of the three statements made by Redel, only Statement 2 reflects a unique circumstances constraint. These circumstances are internal factors (other than a liquidity requirement, time horizon, or tax concern) that may constrain portfolio choices. The requirement to avoid tobacco stocks constrains Knight’s investment choices with respect to his client’s portfolio and does not constitute a constraint which may classify in any of the aforementioned categories.

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Reading 46

The Portfolio Management Process & the investment policy statement

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17. Question ID: 48706 Correct Answer: C C is correct. Note 7 reflects a legal and regulatory constraint which will not have an impact on the investment account’s risk tolerance. A is incorrect. The plan sponsor will need to arrange for the payment of benefit payments for the employees who have elected to retire early. This will put a strain on portfolio liquidity and decrease the plan’s risk tolerance (Note 5). B is incorrect. The risk tolerance of the plan will decrease as a result of the deficit reported in the current year (Note 6). 18. Question ID: 48707 Correct Answer: C The return requirement for a foundation’s investment account should reflect compensation for investment expenses and expected inflation. Required return = 3.5% + 0.9% + 1.3% = 5.7%

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Reading 46

The Portfolio Management Process & the investment policy statement

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FinQuiz Level II 2019 – Item-sets Solution Reading 46: The Portfolio Management Process 19. Question ID: 48709 Correct Answer: A Boyle’s ability to take risk is classified as average. She has a long-time horizon and has no plans for retirement; both these factors serve to increase her risk-taking ability. However, she has significant liquidity needs including funding for her children’s university education, paying installments on the residential mortgage loan and car lease agreement. Since her salary does not cover her living expenses, she will heavily depend on her portfolio to meet these requirements. Therefore, the liquidity constraint serves to decrease her risk-taking ability. Her overall risk-taking ability is average. 20. Question ID: 48710 Correct Answer: A Boyle’s liquidity constraints are significant. She depends on her portfolio to pay for installments on both the mortgage and automobile loan as well as fund her children’s university education. In addition, she will need to rely on her portfolio to fund her living expenses which significantly exceeds her current income. Boyle’s current income and capital gains are subject to taxes. Therefore, the tax constraints on her portfolio are significant. 21. Question ID: 48711 Correct Answer: B Boyle’s willingness to take risk should be dictated by the investment portfolio details as opposed to her opinion on risk taking. Her opinion on risk taking is in clear conflict with her portfolio holdings given that the former indicates a below average willingness whereas the latter indicates an above average willingness. Boyle’s allocation to high-yield bonds, venture capital equity funds, and small-cap equities indicates an above average willingness to bear risk. 22. Question ID: 48712 Correct Answer: A Emerson is correct with respect to Statement 1 and incorrect with respect to Statement 2. The planning process involves an elaboration of the investment strategy – the manager’s approach to investment analysis and security selection. Emerson is incorrect with respect to Statement 2. The formulation of the investment strategy is a key component of the planning process.

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Reading 46

The Portfolio Management Process & the investment policy statement

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23. Question ID: 48713 Correct Answer: A A is correct. An advantage of the adopting the single-period perspective in the risk and return characteristics of asset allocations is its simplicity. Options B and C are incorrect. A multiperiod perspective can address the liquidity and tax considerations that arise from rebalancing portfolios over time, as well as serial correlations in returns. 24. Question ID: 48714 Correct Answer: A A is correct. The ‘Asset Allocation’ Policy correctly addresses what triggers a permanent revision in the strategic asset allocation. The asset allocation may temporarily drift from the strategic asset allocation to reflect a change in investor’s circumstances. However, if the change in circumstances becomes permanent, the manager is required to update the IPS and the temporary asset allocation will become the new revised strategic asset allocation. On the other hand, tactical asset allocation strategies respond to changes in short-term capital market expectations rather than to investor circumstances.

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Reading 47

An Introduction to Multifactor Models

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FinQuiz.com CFA Level II Item-set - Solution Study Session 16 June 2019

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Reading 47

An Introduction to Multifactor Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 47: An Introduction to Multifactor Models 1. Question ID: 48581 Correct Answer: B Based on the equation for the one-factor model, expected portfolio returns should be equal to the following: Portfolio A (Expected Return) = 0.0764 + (0.0560 × 0.18) = 0.08648 Portfolio B (Expected Return) = 0.0764 + (0.0560 × 1.05) = 0.13520 Portfolio C (Expected Return) = 0.0764 + (0.0560 × 1.96) = 0.18616 Compared to the expected return calculated by the one-factor model, Portfolio B is offering a relatively lower return. Portfolio B is overvalued. An arbitrage opportunity exists which can be exploited by selling portfolio B and investing the proceeds in portfolios A and C. The arbitrage profit earned per dollar shorted is equal to $0.1352 – $0.0924 = $0.0428 2. Question ID: 48582 Correct Answer: A Emerson is using arbitrage pricing theory (APT) to derive the one-factor model as evidenced by the assumption undertaken with respect to arbitrage opportunities. However, she is inaccurate with respect to Assumption 1 which implies that financial markets are highly liquid. However, APT does not make any assumptions with respect to market liquidity. Emerson is accurate with respect to Assumption 2. A key assumption of APT is that there are many assets so investors can form well-diversified portfolios that eliminate asset-specific risk. 3. Question ID: 48583 Correct Answer: B The contribution of each factor to active returns needs to be calculated. K

Total active return =

∑

[(Portfolio sensitivity)k – (Benchmark sensitivity)k] × (Factor return)k +

i =1

Security selection Or Total active return = Factor return + Security selection Factor return = [(0.90 – 1.70) × 0.105] + [- 1.85 – (- 2.50) × 0.258] + [(0.08 – 1.00) × - 0.095] + [(0.60 – 0.60) × 0.008] = 0.1711 Active return = 0.1711 – 0.0640 = 0.1071 Contribution of SMB to active return = [(0.90 – 1.70) × 0.105]/0.1071 = - 0.7843 Contribution of HML to active return = [- 1.85 – (- 2.50) × 0.258]/0.1071 = 1.5658

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Reading 47

An Introduction to Multifactor Models

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Contribution of WML to active return = [(0.60 – 0.60) × 0.008]/0.1071 = 0 HML has the greatest contribution to active return in absolute and non-absolute terms. 4. Question ID: 48584 Correct Answer: C Boyle has a negative active exposure to the HML (value) factor of – 0.92 (0.08 – 1.00). Value stocks should have a positive active exposure while growth stocks should have a negative active exposure. This implies that he has adopted a growth mandate. His portfolio exposure is inconsistent with the investment mandate and benchmark. The negative sensitivity to the SMB (size) factor of – 2.50 in the benchmark indicates a large-cap orientation and that Boyle’s performance benchmark is appropriate given his investment mandate. However, Boyle has adopted a positive active exposure of 0.70 [- 1.80 – (- 2.50)] to this factor. Therefore, his portfolio exposure is inconsistent with the investment mandate in this regard. 5. Question ID: 48585 Correct Answer: B Total residual risk is measured by active specific risk. This risk can be calculated using the following equation:

∑ (w ) σ n

Active specific risk =

a

2

i

2

εi

i =1

where w a i represents the active weight

(All $ figures are in millions)

Active specific risk = ($1.0/$2.0)2(0.2010)2 + ($0.4/$2.0)2(0.1540)2 + ($0.5/$2.0)2(0.0130)2 + ($0.1/$2.0)2(0.610)2 = 0.01199 or 11.99% 6. Question ID: 48586 Correct Answer: A Emerson is inaccurate with respect to Statement 1; accurate with respect to Statement 2. Non-systematic risk may feature in the macroeconomic model and for a stock it might represent the return from an unanticipated company-specific event or nonsystematic risk. However, this risk is represented by the residual term. The intercept of the model represents an asset’s expected return. A distinction between macroeconomic multifactor models and fundamental factor models is the specification of variables. In case of the former, the factor (surprise) series is developed first and then the factor sensitivities are estimated through regression. In case of the latter, the factor sensitivities (attributes) are specified first and then the factor returns are estimated through regression. Both models differ with respect to how statistical techniques are used to specify model variables.

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Reading 47

An Introduction to Multifactor Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 47: An Introduction to Multifactor Models 7. Question ID: 48625 Correct Answer: A A is correct. Jing’s conclusion concerning statistical factor models is correct. In this model, the factors are portfolios of securities in the group under study where the factors are defined by portfolio weights. A portfolio of Polish stocks would be represented by a weight of 57% ($5.7 million/$10.0 million) and a portfolio of Turkish stocks would be represented by a weight of 25% ($2.5 million/$10.0 million). 8. Question ID: 48626 Correct Answer: B B is correct. Weidman has incorrectly asserted that statistical factor models require substantial assumptions. In reality, these models make minimal assumptions. C is incorrect. Weidman has correctly asserted that the model does not lend itself to the economic analysis of the factors. Associating a statistical factor with economic meaning is generally not possible with this model. 9. Question ID: 48627 Correct Answer: C C is correct. To determine whether the manager has passive risk exposure to any of the factors, information concerning the benchmark and portfolio factor exposures should be provided. 10. Question ID: 48628 Correct Answer: C Using a macroeconomic factor model, the expected fund return is equal to - 1.50% (calculated below). A benchmark expected return of 1.05% will yield a zero active return, which in turn implies a passive risk exposure. Expected Fund Return = 2.20% + (0%)(1.5) + (- 2%)(0.8) + (1.5%)(- 1.1) + (1.0%)(0.0) = -1.05% 11. Question ID: 48629 Correct Answer: B To speculate on an expansion in money supply, Portfolio B is the most optimal choice because it has a sensitivity of 1.00 to the money supply factor and 0.00 to all other factors. This portfolio is therefore the most efficient in placing a pure bet on an expansion in money supply. A long position should be taken in portfolio B to bet on the positive growth in money supply.

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Reading 47

An Introduction to Multifactor Models

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12. Question ID: 48630 Correct Answer: A The analysis in Exhibit 3 demonstrates the employment of multi-factor models in portfolio construction. These models permit portfolio managers to make focused bets or control portfolio risk relative to the benchmark’s risk. Therefore, Weidman is using multi-factor models to establish a specific desired risk profile for a portfolio.

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Reading 47

An Introduction to Multifactor Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 47: An Introduction to Multifactor Models 13. Question ID: 48653 Correct Answer: C Emerging market stocks are often characterized by high share price volatility. Davis’ portfolio has the most significantly positive active exposure (1.60 – 0.00 = 1.60) to this factor. Both Thornton’s and Segal’s portfolios do not have active exposure to the share price volatility factor. 14. Question ID: 48654 Correct Answer: B Value stocks are characterized by high book-to-market ratios and low earnings yield. B is correct. Segal’s portfolio has an active exposure of - 0.70 (1.10 – 1.80) and 1.55 (1.55 – 0.00) to the earnings yield and book-to-market ratio factors, respectively. The negative active exposure to the earnings yield factor suggests that he his portfolio has an exposure to (low earnings yield) value stocks. Both exposures clearly indicate that Segal’s portfolio has a value bias. Thornton has a positive active exposure of 0.05 (1.85 – 1.80) and 1.50 (1.50 – 0.00) to the earnings yield and book-to-market ratio factors, respectively. Thornton’s exposure to the earnings yield factor suggests that his portfolio does not have a value/growth bias while his exposure to the book-tomarket ratio factor suggests his portfolio has a value bias. Therefore, the value bias conclusion is indeterminate. C is incorrect. Davis has an active exposure of 0.00 (1.80 – 1.80) and – 0.80 (- 0.80 – 0.00) to the earnings yield and book-to-market ratio factors, respectively. Based on his exposure to earnings yield, he has no value/growth bias while his exposure to the book-to-market factor indicates he has a growth bias. 15. Question ID: 48655 Correct Answer: C The decision of which manager to select will solely be based on the return from factor tilts. Davis’ portfolio has generated the highest return from factor tilts (see below) and will be the preferred candidate. Thornton = (1.85 – 1.80)(6.74%) + (1.00 – 1.00)(3.33%) + (1.50 – 0.00)( 3.28%) + (0.04 – 0.00)(12.50%) = 5.7570% Segal = (1.10 – 1.80)(6.74%) + (0.00 – 1.00)(3.33%) + (1.55 – 0.00)(3.28%) + (0.08 – 0.00)(12.50%) = - 1.964% Davis = (1.80 – 1.80)(6.74%) + (1.35 – 1.00)(3.33%) + (- 0.80 – 0.00)(3.28%) + (1.60 – 0.00)(12.50%) = 18.5415%

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Reading 47

An Introduction to Multifactor Models

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16. Question ID: 48656 Correct Answer: B The decision of which manager to select will be based on the information ratio(IR) calculated for each manager: Thornton’s IR = 1.93%/5.42% = 0.3561 Segal’s IR = 5.45%/11.30% = 0.4823 Davis’ IR = 2.47%/8.56% = 0.2886 Segal is projected to generate the highest information ratio for his portfolio and should be selected. 17. Question ID: 48657 Correct Answer: A Allen is correct with respect to both advantages. Multifactor models have the ability to decompose and attribute sources of total and active risk. Allen is correct with respect to the second advantage. Allen is employing a fundamental factor model as is evident by his choice of factors. When decomposing the sources of tracking error, an analyst’s first choice is the fundamental factor model because the model can decompose the sources of active risk and directly relate them to the manager’s portfolio decisions. 18. Question ID: 48658 Correct Answer: B Use 1 is classified as rules-based active management. These strategies tilt specific systematic risk factors when constructing portfolios. The objective of this approach is to capture systematic risk exposures traditionally attributed to a manager’s skill or alpha in a rules-based manner at low cost. Use 2 is classified as passive management. Analysts seeking to construct a fund which tracks an index with many component securities will rely on a multifactor model to replicate the index’s fund exposures, mirroring those of the index tracked.

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Reading 47

An Introduction to Multifactor Models

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FinQuiz Level II 2019 – Item-sets Solution Reading 47: An Introduction to Multifactor Models 19. Question ID: 48660 Correct Answer: A

The sensitivity of each stock to dividend yield is calculated as follows: bik =


               

bearnings growth bDividend yield


      

ARC Corp = 0.1355 .%

.%.%

1.8% − 1.0% = 0.6154 1.3%

Skim Ltd 8.8% − 10.4% = −0.1032 15.5% 1.5% − 1.0% = 0.3846 1.3%

Based on the calculations, the ARC Corp stock has the greatest sensitivity to the two factors. 20. Question ID: 48661 Correct Answer: C

Fundamental factor models employ scaling, which permits model users to interpret all factor sensitivities similarly despite different units of measure and scale in the variables. 21. Question ID: 48662 Correct Answer: B

Unlike macroeconomic models, the factors in a fundamental factor model are stated as returns rather than return surprises, in relation to their predicted values. Therefore, the factors do not generally have expected values of zero. A is incorrect. Although factor sensitivities are attributes of a security in a fundamental factor model, this does not explain why factors do not have expected values of zero. C is incorrect. The factors in macroeconomic models are defined as surprises, which refer to the difference between the actual and predicted values of variables. Therefore, it is incorrect to state that factor surprises are calculated as the difference between actual and unpredicted values.

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Reading 47

An Introduction to Multifactor Models

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22. Question ID: 48663 Correct Answer: A

Lone is accurate with respect to Conclusion 2; inaccurate with respect to Conclusion 3. The intercept of the macroeconomic factor model reflects the effect of the predicted values of the macroeconomic variables on expected stock returns. Therefore, the intercept reflects expected stock returns. Although analysts prefer the fundamental factor model in return attribution as they allow the sources of a portfolio’s performance to be described using commonly understood terms, macroeconomic models (although a less preferred option) may also be used. 23. Question ID: 48664 Correct Answer: C

The ability to generate active returns based on portfolio holdings is measured using the security selection return. This return is calculated as the difference between the active return of 5% and the factor return. Lone was unable to generate a security selection return with respect to the ARC Corp stock. Active return attributable to ARC Corp stock = (5%)(0.20) = 1% Total factor return = [0.85 – (- 1.03 )](1.50%) + (0.40 – 1.00)(2.85) = 1.11% Security selection return = 1.00% - 1.11% = - 0.11%. Lone was able to generate a 2.3275% security selection return due to his above average ability to select shares of the Skim Ltd stock. Active return attributable to Skim Ltd stock = (5%)(0.80) = 4% Total factor return = [0.75 – (- 1.03 )](1.50%) + (0.65 – 1.00)(2.85) = 1.6725% Security selection return = 4% - 1.6725% = 2.3275%. 24. Question ID: 48665 Correct Answer: B

A pure earnings growth factor portfolio has an exposure of 1.00 to the earnings growth factor and zero to the dividend yield factor. ARC Corp Factor return (Earnings growth) = [0.85 – (- 1.03)](1.50%) = 2.82% Skim Ltd Factor return (Earnings growth) = [0.75 – (- 1.03)](1.50%) = 2.67% Total active return* = (2.82%)(0.50) + (2.67%)(0.50) = 2.745% *Return from individual security selection decisions is 0%.

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Reading 48

Measuring & Managing Market Risk

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FinQuiz.com CFA Level II Item-set - Solution Study Session 16 June 2019

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Reading 48

Measuring & Managing Market Risk

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FinQuiz Level II 2019 – Item-sets Solution Reading 48: Measuring & Managing Market Risk 1. Question ID: 71547 Correct Answer: C

C is correct. The reliability of the VAR estimate is verified using a process known as backtesting. This involves comparing the frequency of losses implied by VAR with the actual frequency of loss occurrence. Based on an average of 22 trading days in a typical month, a 16% one-month VAR would imply that the minimum losses (as stated by VAR) are expected to occur on 16% of the trading days or on 3.52 (16% × 22 days) days in a month. Based on the data in the exhibit, the actual loss frequency of Portfolio C (4 days) exceeds that implied by the 16% VAR. 2. Question ID: 71548 Correct Answer: B

B is correct. VAR can be interpreted as the level of confidence that portfolio losses will not exceed the VAR amount of $2.5 million, 84%* of the time over a period of one month. A is incorrect. VAR is not a worst-case scenario. Portfolio losses can and will exceed VAR. C is incorrect. The interpretation of VAR is incorrect because VAR is stated in terms of a minimum loss and loss frequency; these essential elements are missing in option C’s statement. 3. Question ID: 71549 Correct Answer: C

C is correct. The Monte Carlo simulation method is capable of handling any complex distribution. This will allow the method to be readily used to analyze the riskiness of embedded options which are characterized by a non-normal return distribution. A is incorrect. The parametric method is difficult to use when the investment portfolio contains options. Although adjustments can be made to render options more responsive to the parametric method, these adjustments are not perfect which limits the usefulness of the parametric method when there are options in the portfolio. B is incorrect. The maximum drawdown is not a method used to estimate VAR.

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Reading 48

Measuring & Managing Market Risk

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4. Question ID: 71550 Correct Answer: A

A is correct. Mendes is accurate regarding Reason 1 and inaccurate regarding Reason 2. Historical simulation uses the distribution implied by the historical prices of the risk factors which eliminates the need to assume a return distribution. The method constructs a return distribution using actual prices for the risk factors. However, the biggest assumption which underlies the historical simulation method and the return distribution of the parameters is that history will repeat itself. Another assumption is that each day in the time series carries an equal weight which can be a potential problem if there is a trend in volatility – lower in earlier periods and higher in later periods or vice versa. 5. Question ID: 71551 Correct Answer: A

A is correct. Based on the facts presented, Mendes is applying historical simulation to determine how risk sensitivities will react if current market events were to reoccur. Historical scenarios have the advantage that they are uncontroversial because there is historical evidence to prove that the events did occur. B is incorrect. A limitation of applying historical simulation to the risk factor sensitivities gamma and delta is that the measures are not suitable for handling the type of extreme movements typically associated with stress tests. C is incorrect. A drawback of historical simulation is that it assumes that history will repeat itself. Therefore, any correlation behavior observed in the past is expected to continue into the foreseeable future. However, correlations do not necessarily remain constant as assumed and can break down in periods of market stress. 6. Question ID: 71552 Correct Answer: C

C is correct. Ex-ante tracking error measures the volatility of the performance of a portfolio with respect to its benchmark. Hedge funds are typically absolute-return strategies for which a benchmark does not always exist. In this scenario, a benchmark-relative measure such as relative VAR will not be used in the risk analysis. Both banks are long-only asset managers can use ex-ante tracking error with the latter frequently employing ex-ante tracking error as a key risk metric to estimate the degree to which the current portfolio could outperform its benchmark.

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Reading 49

Economics and Investment Markets

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FinQuiz.com CFA Level II Item-set - Solution Study Session 17 June 2019

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Reading 49

Economics and Investment Markets

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FinQuiz Level II 2019 – Item-sets Solution Reading 49: Economics and Investment Markets 1. Question ID: 48596 Correct Answer: B B is correct. BEI rates reflect investors’ expectations concerning inflation as well as a premium to compensate investors for the uncertainty concerning inflation. BEI rates are calculated by subtracting real yields from nominal yields. Bond Issue 3-month 1-year 4-year 8-year 15-year

BEI Rate 0.5% 0.4% 0.4% 1.7% 2.9%

An increase in the BEI rates from the 4-year issue and onwards indicates an expectation that inflationary pressures will be rising which in turn will lead to an increase in the cost of goods and services. High inflationary pressures arise from higher demand for resources so that cost and prices rise as fast. A is incorrect. See above. C is incorrect. BEI rates do not help conclude whether bonds have been effective as hedges against bad consumption outcomes. 2. Question ID: 48597 Correct Answer: B B is correct. An upward sloping yield curve suggests that shorter-maturity bonds carry lower expected returns (and thus lower premiums) relative to higher-maturity bonds. Shorter-maturity bonds are seen as being more effective as an inflation hedge which implies that during bad economic times these instruments will generate payoffs. Therefore, investors are willing to pay a high price for them leading to a decline in the expected return and bond risk premiums relative to long-maturity bonds. A is incorrect. An inverted yield curve is viewed as a predictor of an economic recession. C is incorrect. The nominal yields are increasing with maturity. This indicates that bond risk premiums are increasing with maturity.

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Reading 49

Economics and Investment Markets

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3. Question ID: 48598 Correct Answer: B B is correct. The interpretation of an upward sloping yield curve is often ambiguous. The positive relationship between bond risk premiums and maturity does not necessarily embody expectations of future rate increases. Conversely it could imply a combination of expected rate increases and risk premiums or even rate cuts that are more than offset by the existence of positive risk premiums. C is incorrect. The limited supply of short-term default-free government bonds will drive down shortterm yields. However, they will not explain the shape of the entire yield curve. 4. Question ID: 48599 Correct Answer: B Both credit risky and default-free bonds are exposed to interest rate risk. A parallel upward shift in the yield curve will have an identical proportionate impact on the prices of the four-year default-free issue and the comparable Aa2 corporate issue. If investors are risk-neural, they will demand a return on their corporate bond investments which is sufficient to compensate them for the possible loss they would incur from holding a corporate bond. This expected loss will depend on the probability of default and expected recovery rate in the event of default. The expected loss on the 8-year government bond will equal to the loss adjusted expected return of the Aa1 corporate issue. Expected loss = 5% Loss-adjusted return = (11.8%)(1 – 0.05) = 11.21% or 11.2% 5. Question ID: 48600 Correct Answer: A When an economy enters into the recessionary phase of the business cycle, credit spreads will widen as there is a general increase in issuer defaults and thus credit risk. In this scenario, the spreads on bonds with a low rating and/or that are part of a cyclical sector will widen the most and in turn will experience the greatest percentage price decline. Out of the two lowest rated issues (A1 and Baa1), the A1 issue is part of the cyclical sector. The credit spreads on bond issues belonging to this sector are highly sensitive to fluctuations in the business cycle. Although, the Baa1 issue carries the lowest rating, it is part of the non-cyclical sector and is less sensitive to fluctuations in business cycle activity.

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Reading 49

Economics and Investment Markets

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6. Question ID: 48601 Correct Answer: A Campbell is correct with respect to his statement while Burns is incorrect with respect to his statement. The expected returns on equity investments will decline when the economy takes a downturn. In such a scenario, companies suffer a decline in profitability. Therefore, expected equity returns and profitability are pro-cyclical. Burns is correct in pointing out that risk-averse investors will seek to avoid equities when the economy takes a downturn; this is because equities are a poor hedge against bad consumption outcomes. However, he has incorrectly pointed out the positive covariance relationship. During bad economic times, expected future consumption is low (inter-temporal rate of substitution is high) and equities decline in price. This results in a decline in equity returns and produces a negative covariance relationship between the intertemporal rate and equity returns which, in turn, causes investors to demand a positive risk premium.

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Reading 49

Economics and Investment Markets

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FinQuiz Level II 2019 – Item-sets Solution Reading 49: Economics and Investment Markets 7. Question ID: 48639 Correct Answer: A Given the volatility in economic growth and inflation, 1-year nominal zero-coupon bonds will serve as the best hedge against bad consumption outcomes. The relative payoff from a short-term issue and thus the relative certainty about the amount of consumption that the investor will be able to undertake with the payoff suggests that this issue will be a good hedge against bad consumption outcomes. Furthermore, the negative correlation between asset payout and economic growth suggests that the asset will generate a payoff when there is weak economic growth. B is incorrect. On the other hand, the payoff from the 12-year government bond is only certain in nominal terms. Investors will have less confidence in their ability to form views about future inflation resulting in less certainty about the real value of the bond’s payoff. C is incorrect. Credit risky corporate bonds will be more sensitive to shifts in the economic cycle relative to the two government issues. Spreads will tend to widen as the business cycle takes a downturn at the same time as the risk of default increases. The relationship between the economic cycle and defaults mean that credit risky bonds will tend to perform poorly in bad economic times. 8. Question ID: 48640 Correct Answer: C C is correct. In addition to the premium demanded for inflation and inflation uncertainty, investors of credit risky bonds demand a credit premium. The total premium quoted for this bond issue will be the highest. A is incorrect. The risk premium demanded for 1-year zero-coupon government bonds will be the lowest because of the negative correlation between bond payoffs and economic growth. The issue provides a good hedge against bad consumption outcomes (when marginal utility of consumption is high) and so will bear a negative risk premium. B is incorrect. While the premium demanded on 12-year zero-coupon government bonds is higher than the 1-year government bonds, it is lower than that quoted on corporate bonds. This is because the returns on default-free coupon bonds do not incorporate a credit spread.

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Reading 49

Economics and Investment Markets

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9. Question ID: 48641 Correct Answer: A A is correct. The difference in yield between the 12-year corporate and default-free issue reflects credit spread. B is incorrect. The BEI rate is equal to the difference between a zero-coupon nominal default-free bond and a zero-coupon default-free real bond of the same maturity. C is incorrect. A premium for inflation uncertainty will be included in the yields of the two 12-year issues. 10. Question ID: 48642 Correct Answer: C Edmond has short-listed value stocks for his portfolio. Value stocks tend to outperform growth stocks when the economy is in a state of recession. In addition, large-cap stocks tend to outperform smallcap stocks during bad economic times. Therefore, Edmond stock selection suggests that he most likely anticipates a recession. 11. Question ID: 48643 Correct Answer: B According to the Taylor rule (see below), the policy rate is equal to 1.55%.

prt = lt + it + 0.5(it − i *t ) + 0.5(Yt − Y *t ) = 2.0% + 1.5% + 0.5(1.5% − 2.2% ) + 0.5(− 3.2% ) = 1.55% Given that inflation is below the target level and the output gap is negative, the policy rate should be below the neutral interest rate. 12. Question ID: 48644 Correct Answer: A A is correct. A downward-sloping yield curve implies that short-term interest rates are expected to decline. In addition, bond risk premiums are expected to decline. A decline in bond risk premiums implies that investors are willing to pay a high price of the consumption hedging properties on government bonds. B is incorrect. The expected change in short-term interest rates is ambiguous when the yield curve is upward-sloping. C is incorrect. A decline in risk premiums suggests that investors place more value of the consumption-hedging properties of government bonds.

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Reading 49

Economics and Investment Markets

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FinQuiz Level II 2019 – Item-sets Solution Reading 49: Economics and Investment Markets 13. Question ID: 48681 Correct Answer: A Real yields are positive correlated to real GDP growth and volatility. Therefore, real GDP growth will be the lowest in Yugoslavia corresponding to the low real yield on 1-year default-free government bonds. When real GDP growth is low, investors worry more about their future and their consumption abilities in the future indicating that their inter-temporal rate of substitution is high. Therefore, Peterson should expect that the investor’s willingness to trade current consumption for future wealth (inter-temporal rate of substitution) to be the highest for Yugoslavia. 14. Question ID: 48682 Correct Answer: A A is correct. Real yields or inflation-adjusted yields are not affected by inflation expectations. B is incorrect. High (low) GDP growth volatility will translate into high (real) yields. C is incorrect. The policy rate of central banks has an influence on the real yields of default-free government bonds. The former rate should fluctuate around the neutral policy rate as central banks respond to changes in the output gap.

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Reading 49

Economics and Investment Markets

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15. Question ID: 48683 Correct Answer: C The yield curve in Peru is expected to be sloping steeply upwards and so 1-year default-free government bonds should bear the lowest risk premium. This contrasts with Yugoslavia, where the yield curve is expected to invert and the premium demanded on short-term bonds should be higher. An upward sloping yield curve can be interpreted as the yields on short-dated bonds beings less positively correlated with bad times than are long-dated bonds. The less positive or more negative correlation will make short-dated bonds more reliable as hedges against bad consumption outcomes than long-dated bonds. This, in turn, implies that the premium should be higher for the latter. The yield curve should be upward sloping to reflect the differences in premium. When the yield curve is inverted, short-dated bonds will quote a higher premium relative to longdated bonds. In addition, a steeply sloping yield curve will correspond to high inflation expectations. An inverted yield curve will signal a decline in inflation once a peak has been reached during the late stages of a business expansion. 16. Question ID: 48684 Correct Answer: B Based on the calculations below, bond risk premiums are projected to increase. An increase in premiums implies that investors place less value on the consumption-hedging properties of government bonds. Therefore, the demand for such bonds is projected to decline. The bond risk premiums (BRP) for each of the five issues are calculated as follows: Bond risk premium = Projected yield on conventional government bond – Projected yield on inflation-indexed government bond – Expected inflation rate BRP (3-month) = 3.8% – 2.4% - 0.9% = 0.5% BRP (12-month) = 4.5% – 2.1% - 1.1% = 1.3% BRP (15-month) = 5.9% – 1.9% - 1.4% = 2.6% BRP (18-month) = 6.8% – 1.5% - 1.5% = 6.8% 17. Question ID: 48685 Correct Answer: B Based on the maturity schedule, inflation risk premiums increase with maturity. Therefore, Peterson should expect domestic interest rates to increase with inflation.

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Reading 49

Economics and Investment Markets

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18. Question ID: 48686 Correct Answer: C C is correct. When credit spreads are narrowing, lower-rated corporate bonds will outperform higher-rated bonds. This is because the latter are associated with a higher credit spread and thus the increase in price as a result of narrowing in spread will be greater for this issue. Therefore, relative to the higher-rated Issue 2, Issue 3 is the most attractive from an investment perspective. A is incorrect. When credit spreads are narrowing, corporate bonds will outperform government bonds making Issue 1 the least attractive from an investment perspective. B is incorrect. See above.

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Reading 49

Economics and Investment Markets

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FinQuiz Level II 2019 – Item-sets Solution Reading 49: Economics and Investment Markets 19. Question ID: 48695 Correct Answer: B

Since the local government has proposed to pay rental income that is indexed to inflation, the discount rate that would apply to the investment in commercial property would include liquidity and equity risk premium in addition to the real risk-free rate. On the other hand, the discount rate on the investment in which ATC Services is the borrower would equal to the sum of the real risk-free rate, liquidity risk premium, equity risk premium, credit risk premium, premium for expected inflation, and premium for inflation uncertainty. Therefore, the difference between the two rates is equal to the sum of the credit risk premium, premium for expected inflation, and premium for inflation uncertainty. The discount rate on an investment in which ATC Services is the borrower is higher by 3.00% + 0.75% + 1.80% = 5.55% 20. Question ID: 48696 Correct Answer: A

The equity risk premium compensates investors for the uncertainty related to the value of the property at the end of the lease.

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Reading 49

Economics and Investment Markets

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21. Question ID: 48697 Correct Answer: A

The discount rate used for the investment is equal to 1.40% + 3.00% + 0.75% + 1.80% + 1.20% + 0.90% = 9.05% Using a financial calculator, the implied property value is equal to: $6,131,406.58. CF1-7: $250,000 CF8: $9,750,000 I/Y = 9.05% NPV = 6,131,406.58 Given that the asking price of $9.5 million is greater than the implied property value, the return would be less than the implied hurdle rate of 9.05%. Therefore, the investment would not be worthwhile for Train Inc. 22. Question ID: 48698 Correct Answer: B

Young is incorrect with respect to Reason 1. Rental income has been found to be relatively stable in nominal terms and almost immune to the business cycle. Young has incorrectly pointed out this fact. On the other hand, Young has correctly stated that commercial property capital values are sensitive to business cycle fluctuations. 23. Question ID: 48699 Correct Answer: B

In general, commercial real estate has been found to be an ineffective hedge against bad consumption outcomes. The reason for this is that commercial real estate prices are procyclical, declining during recessionary periods and rising during periods of economic growth. During recessionary periods, current income and consumption will be low and so the marginal utility derived from an additional unit of consumption increases which decreases the inter-temporal rate of substitution. Therefore, the correlation between the two variables is positive.

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Reading 49

Economics and Investment Markets

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24. Question ID: 48700 Correct Answer: B

Young is incorrect regarding Conclusion 1; correct regarding Conclusion 2. Property risk premiums are positively correlated with equity risk premiums. Both premiums tend to rise during bad economic times. Young is correct regarding Conclusion 2. Because commercial real estates are privately traded, they are relatively illiquid. Therefore, investors will experience difficulty in easily converting this asset class to cash during bad economic times. On the other hand, equity is a relatively liquid asset class and conversion to cash during bad economic times is easier.

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Reading 50

Analysis of Active Portfolio Management

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FinQuiz.com CFA Level II Item-set - Solution Study Session 17 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 50

Analysis of Active Portfolio Management

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FinQuiz Level II 2019 – Item-sets Solution Reading 50: Analysis of Active Portfolio Management 1. Question ID: 48587 Correct Answer: C Based on the calculations below, Wright is expected to generate the most positive returns by underweighting Japanese stocks as this decision is expected to generate the highest value added return. Value added return = (Portfolio weight – Benchmark weight)(Portfolio return – benchmark return) Value added return (Swedish stocks) = (0.3050 – 0.2580)(12.50% - 13.70%) = - 0.0564% Value added return (UK stocks) = (0.2760 – 0.2385)(15.91% - 11.89%) = 0.15075% Value added return (Japanese stocks) = (0.2185 – 0.3260)(29.77% - 39.00%) = 0.9923% 2. Question ID: 48588 Correct Answer: B Security selection return = wp ,i RA,i + ∆wp , j RA, j + ....∆wp , x RA, x Security selection return = (0.305)(12.50% - 13.70%) + (0.276)(15.91% - 11.89%) + (0.2185)(29.77% - 39.00%) + (0.2005)(25.03% - 27.54%) = - 1.77649 or - 1.776% 3. Question ID: 48589 Correct Answer: A To calculate the information coefficient using the basic fundamental law of active management, optimal portfolio active risk and return needs to be determined. Portfolio active risk = [(3.66%)2 (0.305 – 0.258)2 + (4.50%)2 (0.2760 – 0.2385)2 + (6.80%)2(0.2185 – 0.3260)2 + (2.77%)2(0.2005 – 0.1775)2]0.5 = 0.77233% Portfolio active return = (0.305 – 0.258)(12.50% – 13.70%) + (0.2760 – 0.2385)(15.91% – 11.89%) + (0.2185 – 0.3260)(29.77% – 39.00%) + (0.2005 – 0.1775)(25.03% – 27.54%) = 1.0288% Basic fundamental law: E(RA) = IC BRσ A 1.0288% = IC 4 × 0.77233% IC = 0.666045

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Analysis of Active Portfolio Management

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4. Question ID: 48590 Correct Answer: B B is correct. A consequence of the two country stocks being positively correlated is that the breadth of the investment strategy will be lower than the number of securities in the portfolio; this is because part of the manager’s forecast will be higher or lower based on the perspective the investor has about the industry. This will considerably reduce the number of independent decisions a manager has about an industry. Since the breadth of the investment strategy will remain overstated, Ali’s proposed strategy will not contribute positively towards increasing the information ratio of the investment account; IR = IC BR . B is incorrect. The transfer coefficient is not affected by the correlation between stock returns or an improvement in forecasting accuracy. C is incorrect. Ali’s suggestion will not help in increasing the expected information ratio of the portfolio because the information ratio can only increase if the active return decisions are independent over time and the information coefficient can be maintained. In the case of the client’s investment account, active return decisions are not independent. A policy aiming to increase managerial skill will increase the information coefficient but will not serve to increase the information ratio when rebalancing decisions are accounted for. 5. Question ID: 48591 Correct Answer: C Active return based on the Grinold rule: E(RA) = Expected IC × σA × Score = 0.25 × 3.80% × 2.20 = 2.09% The transfer coefficient is less than 1.0 which provides evidence that the portfolio manager’s ability to translate active return forecasts into actual active returns is restricted due to portfolio constraints. With limits on active risk, the percentage of successful and unsuccessful market calls cannot be used to calculate the expected active return. 6. Question ID: 48592 Correct Answer: A Gregory is incorrect with respect to Statement 1. While the variance in performance due to constraintinduced is equal to TC2 = 0.372 = 0.1369 or 13.7%, this value is a component of realized (and not expected) variation. Gregory is also incorrect with respect to Statement 2. The maximum possible Sharpe ratio of a constrained portfolio is equal to the sum of the squared Sharpe ratio of the benchmark and the product of the squared information ratio of an unconstrained portfolio and squared transfer coefficient.

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Reading 50

Analysis of Active Portfolio Management

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FinQuiz Level II 2019 – Item-sets Solution Reading 50: Analysis of Active Portfolio Management 7. Question ID: 48632 Correct Answer: C Statement 1 is inaccurate. While active security return can be defined as the residual return in a single-factor statistical model, RAi = Ri – βiRB, the benchmark return does not necessarily need to be the market return as the fundamental law does not require the empirical validity of any equilibrium theory of required returns. Evans has correctly pointed out that active security return can be defined as benchmark excess return or the actively managed portfolio’s excess return, RAi – RB. 8. Question ID: 48633 Correct Answer: C When the TC = 0, there would be no correspondence between the active return forecasts and active weights and thus expectation of value added from active management. In this case, one would expect the manager to follow a passive risk management mandate. Manager C is therefore following a mandate which is inconsistent with the stated active mandate. 9. Question ID: 48634 Correct Answer: A Evans is correct with respect to Observation 1. Manager A’s constrained portfolio’s active risk is higher than the optimal active risk. According to the full fundamental law of active management, optimal active risk is calculated as:

σ A = TC

IR * 0.78 σ B = 0.90 × × 0.13 = 0.1404 or 14.04% SR B 0.65

The portfolio’s actual active risk is higher than the optimal active risk (15.50% and 14.04%, respectively). Manager A can reduce his portfolio risk by mixing 9.42% (1 – 14.04/15.50) in the benchmark and 90.58% in the actively managed fund. Evans is incorrect with respect to Observation 2. Manager B’s actual active risk of 12.85% is lower than the optimal active risk of 13.71% (see below).

σ A = TC

IR * 0.65 σ B = 1.00 × × 0.1856 = 0.1371 0.88 SR B

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Reading 50

Analysis of Active Portfolio Management

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10. Question ID: 48635 Correct Answer: B The Sharpe ratio of each managed portfolio is calculated using the formula: SR2P = SR2B + (TC)2(IR*)2 SR2P (Portfolio A) = 0.652 + (0.90)2(0.78)2 = 0.9153 SR2P (Portfolio B) = 0.882 + (1.00)2(0.65)2 = 1.1969 SR2P (Portfolio D) = 0.732 + (0.75)2(0.20)2 = 0.5554 The portfolio with the highest squared Sharpe ratio will have the highest Sharpe ratio and that portfolio is B. 11. Question ID: 48636 Correct Answer: C Marshall’s statement is inaccurate as the risk being mentioned is strategy risk. Strategy risk reduces expected and average realized information ratios. The higher the uncertainty about forecasting ability (IC), the smaller the expected value added is likely to be. An overestimated IC will lead to a smaller expected value added. 12. Question ID: 48637 Correct Answer: A In an absence of portfolio constraints, the transfer coefficient is equal to 1.00. In this scenario, the expected active return for managers A, B and C after incorporating the uncertainty of the information coefficient is: E(RA) – Manager A:

IC

σA =

0.05 × 15 .50% = 5.032 % 0.1540

σ IC 0.04 × 12.85% = 4.283% E(RA) – Manager B = 0.1200 0.07 × 5.11% = 1.5827% E(RA) – Manager D = 0.2260

After incorporating the lower information coefficients, Manager A generates the highest expected active return on his portfolio.

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Reading 50

Analysis of Active Portfolio Management

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FinQuiz Level II 2019 – Item-sets Solution Reading 50: Analysis of Active Portfolio Management 13. Question ID: 48667 Correct Answer: C The basic fundamental law states that the expected active return is E(RA) = IC BRσ A There is no information to indicate that the returns of the bond issues in Forecast 1 are correlated. Therefore, the breadth of the strategy is equal to 40. Given that the forecasts are made semi-annually, expected active return is equal to 15.74% = ( 0.20 ×

(40 × 2) × 8.8% ).

In contrast, the breadth for Forecast 2 will not equal to the number of securities in question (10) because active return forecasts relate to GDP growth expectations, which is fairly stable. Therefore,

(

)

expected active return returns will not equal 5.56% 0.20 × 10 × 8.8% . The breadth for forecast will be lower than the number of securities in question (20) as the returns of stocks constituting the fund are positively correlated. Therefore, Adams should expect the expected

(

)

active returns to be lower than 7.87% 0.20 × 20 × 8.8% . 14. Question ID: 48668 Correct Answer: A Adams is correct with respect to the limitation he has outlined. Unlike equity securities, for which the risk factors can be decomposed and systematic risk factors removed, almost all bonds represent a combination of duration risk, credit risk and optionality. Therefore, returns are highly correlated in subtle ways which complicates the process of determining breadth.

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Reading 50

Analysis of Active Portfolio Management

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15. Question ID: 48669 Correct Answer: A Based on the calculations below, Gilbert appears to enjoy the higher information ratio.

STD (R A ) =

IR STD (RB ) SRB

Rearranging this equation, we can determine the information ratio for each fund manager: IR (Gilbert) = (12.90%/20.88%) × 0.75 = 0.4634 IR (Cohen) = (9.15%/14.60%) × 0.40 = 0.2507 16. Question ID: 48670 Correct Answer: B Considering the leverage levels and the expected active risk provided in the exhibit, the optimal risk is calculated for the two managers: (Optimal active risk/actual active risk) – 1 = leverage Gilbert’s optimal level of aggressiveness = (0.2 + 1) × 12.90% = 15.480% Cohen’s optimal level of aggressiveness = (0.5 + 1) × 9.15% = 13.725% Based on the above calculations, the following conclusions can be made: •

B is correct. Gilbert has a higher optimal level of aggressiveness as indicated by a higher risk figure (15.480% vs. 13.725%).

•

A is incorrect. Leverage serves to increase the level of aggressiveness for the two managers. Gilbert’s active risk level will increase from its current level of 12.90% to 15.480% while Cohen’s active risk level will increase from its current level of 9.15% to 13.725%.

•

C is incorrect. See the above calculations.

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Reading 50

Analysis of Active Portfolio Management

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17. Question ID: 48671 Correct Answer: B Given that both the Domestic Equity fund’s Sharpe ratio and active risk is higher than its benchmark, the objective will be to maintain the fund Sharpe ratio while minimize risk. B is correct. The initial expected excess return of the fund is 23.75% (0.95 × 25.00%). The strategy will decrease the expected excess return to 19.84% (0.95 × 20.88%). A is incorrect. The fund’s Sharpe ratio will not be affected by the active risk reduction strategy. 18. Question ID: 48672 Correct Answer: A Increasing or decreasing the level of aggressiveness has no impact of the information ratio of an unconstrained portfolio because active risk and active return will increase proportionally. There is no evidence to indicate that the Fund is subject to investment constraints. Therefore, the information ratio will remain unchanged.

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Reading 50

Analysis of Active Portfolio Management

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FinQuiz Level II 2019 – Item-sets Solution Reading 50: Analysis of Active Portfolio Management 19. Question ID: 48679 Correct Answer: B

Since ex post value added returns are being calculated, the realized or the ex post information coefficient will be used. E (R A IC R ) = (TC )(IC R ) BRσ A

Gayle’s realized active returns = (0.50)(0.25) 2 × 8.85% = 1.564% Paul’s realized active returns = (1.00)(0.15) 2 × 8.60% = 1.824% Lee’s realized active returns = (0.97)(0.18) 2 × 5.78% = 1.427% Based on the value added returns calculated, Paul has generated the highest value added returns during the period.

20. Question ID: 48680 Correct Answer: B

The variation in the performance over time, which is attributable to the success of the forecasting process, is calculated as TC2. Based on this measure, Paul has reported the highest transfer coefficient and thus the highest TC2 measure.

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Reading 50

Analysis of Active Portfolio Management

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21. Question ID: 48681 Correct Answer: A

A is correct. Conclusion 1 is based on the mean variance theory which assumes that portfolio with the highest Sharpe ratio is the one with the highest information ratio: SR2P = SR2B + IR2 However, given that the value of Gayle’s TC is less than 1.0, this conclusion is not correct. SR2P = SR2B + (TC)2(IR*)2 Gayle’s unconstrained portfolio’s information ratio = IR =

SR 2 P − SR 2 B = 0.952 − 0.622 = 0.71979 Gayle’s portfolio’s Sharpe ratio based on constraints = SRP = 0.62 2 + (0.50 ) (0.71979) = 0.71689 2

2

Immediately after considering portfolio constraints, her portfolio’s Sharpe ratio declines below that of Paul’s portfolio. The latter’s portfolio is not subject to portfolio constraints and will thus maintain a Sharpe ratio of 0.86. 22. Question ID: 48682 Correct Answer: A

A is correct. Weaver is correct with respect to Conclusion 2 because the ex post IC for all four managers is lower relative to their ex ante IC. The difference between the two values can be attributable to an overestimated forecasting ability resulting from overconfidence. C is incorrect. The transfer coefficient measures the correlation between forecasted active returns and optimal active weights.

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Reading 50

Analysis of Active Portfolio Management

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23. Question ID: 48683 Correct Answer: A

A is correct. Conclusion 3 can be directly implemented for Paul without influencing her existing information ratio. Based on a TC of 1.00, Paul’s portfolio is not subject to any constraints and, therefore, she can increase her aggressiveness without changing the overall information ratio. Increasing the aggressiveness of an unconstrained portfolio will increase active return and risk by the same magnitude leaving the overall information ratio unchanged. B is incorrect. As evident from the TC and his portfolio’s active risk, Jacobs has adopted a passive management approach. Increasing his aggressiveness will change his investment mandate as well as the zero or near-zero information ratio reported for his investment portfolio. C is incorrect. Based on a TC of less than 1.00, Lee’s portfolio is subject to constraints and therefore increasing the aggressiveness of the active weights will influence his reported information ratio. 24. Question ID: 48684 Correct Answer: A

Asset allocation return = (0.35 – 0.50)(10.5%) + (0.65 – 0.50)(7.0%) = - 0.525%

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Reading 51

Algorithmic Trading & High-Frequency Trading

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FinQuiz.com CFA Level II Item-set - Solution Study Session 17 June 2019

Copyright © 2010-2019. FinQuiz.com. All rights reserved. Copying, reproduction or redistribution of this material is strictly prohibited. [email protected].

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Reading 51

Algorithmic Trading & High-Frequency Trading

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FinQuiz Level II 2019 – Item-sets Solution Reading 51: Algorithmic Trading & High-Frequency Trading 1. Question ID: 71587 Correct Answer: C

C is correct. The trading strategy most appropriate for the pension fund is volume-weighted average price. The volume-weighted average price uses the historical trading volume distribution for a security over the course of the day dividing the order into slices in a way which is proportioned to the distribution. This technique is an example of the execution algorithm which has a goal of achieving a benchmarked (fair) price. The HFT strategy most appropriate for the bank is mean reversion. The difference between the current price of $50 and the mean price of $40 presents an arbitrage opportunity to sell the underlying bonds of the issue. 2. Question ID: 71588 Correct Answer: A

The order submitted by Twain is classified as a child order which represents a subset of the overall parent order. The instructions sent by the pension fund manager to Twain represents a parent order. The parent order specifies whether the order is a buy or a sell order, the quantity, and the algorithm to use. 3. Question ID: 71589 Correct Answer: B

B is correct. While the use of algorithms has helped to bring down the cost of execution, this positive impact of algorithmic trading does not underlie Twain’s beliefs with respect to the need for trading strategies to evolve. A and C are incorrect. The scenario presented by Twain is an example of a market fragmentation strategy in which an instrument trades in multiple trading venues at different prices and liquidities and traders aggregate the liquidity and send the order to the venue with the greatest price and liquidity. The increased fragmentation of markets has made it necessary for trading strategies to evolve such that they can operate more effectively in an environment with fragmented liquidity and avoid the intensifying market impact of a large trade. Furthermore, low latency and rapid update is important to avoid trading on stale liquidity information.

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Reading 51

Algorithmic Trading & High-Frequency Trading

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4. Question ID: 71590 Correct Answer: B

Fat finger trades are trades in which order entry mistakes are made. By entering an order to sell 100 bonds instead of 1,000 bonds, BMC has engaged in fat finger trading. 5. Question ID: 71591 Correct Answer: A

Twain is correct with respect to Comment 1 and Comment 2. Although trading venues have had real-time surveillance technologies for a long time, there is a lack of consistency across the market. The monitoring and surveillance role of regulators is also challenged by the multitude of high-frequency algorithms, market fragmentation, cross-asset trading, and dark pools (where trading venues do not publish their liquidity and are only open to selected clients). 6. Question ID: 71592 Correct Answer: B

B is correct. Although HFT techniques as well as the market and news event data purchased by HFTs are available to any firm, these techniques are quite costly to develop and run, and many investors cannot afford them, creating unequal access to information. C is incorrect. HFT research literature strongly supports the assertion that HFT has led to narrowing of bid-ask spreads, lower transaction costs, and an increase in liquidity and price efficiency. All these developments have taken place without an increase in volatility.

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