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2010 Level II Mock Exam: Afternoon Session ANSWERS AND REFERENCES
Trendwise Case Scenario
Trendwise is an investment firm advising individual clients, as well as, offering a variety
of mutual funds, including the Omega Fund (OF). OF has a large ownership stake in
Cyclical Industries (CI). OF and CI have one director in common, Glenn Libra.
At the April OF board meeting, portfolio manager Ileana Natali, CFA, stated that after
conducting thorough research and analysis, she was firmly convinced the fund should sell
its shares of CI. One director advised Natali, “Don’t sell CI. It’s a great stock, isn’t it Mr.
Libra?” Libra listened but did not respond. Hearing the director’s comment, Natali
decided not to sell the shares as planned. In the following weeks the stock price rose
dramatically.
One month later, Libra phoned Natali, requesting she vote OF’s shares to reelect him to
the CI board of directors. Natali then sent Libra an email saying, “I voted OF’s shares for
you, a step I feel is in the best interest of our fundholders.” Natali continued, “Please be
aware we recently conducted a cost-benefit analysis and determined it is not worthwhile
to vote all proxies. We are sending all clients a copy of our new proxy-voting policies
which will explain, we may not vote all proxies in the future.”
Libra warned, “Voting proxies is an integral part of the management of investments. A
fiduciary who fails to vote proxies may violate CFA Standards.” In response, Natali
agreed to consult counsel and the CFA handbook regarding the new policies.
The following week, Natali’s supervisor asked her to evaluate a proposal from Brock
Securities Brokerage (Brock). Brock recently proposed a soft dollar arrangement with
Trendwise. Trendwise claims compliance with the CFA Institute Soft Dollar Standards.
In her evaluation, Natali noted Brock proposes a higher commission rate than Trendwise
pays its current brokerage firm. She also indicated Brock’s fees are within a reasonable
range. In addition, Natali indicated Brock could possibly provide better trade execution
than Trendwise’s present broker. Natali proposes to use Brock on a trial basis.
In a memorandum to Trendwise’s compliance officer, Natali states:
“I believe the proposed brokerage arrangement from Brock satisfies the two fundamental
principles in the CFA Institute Soft Dollar Standards Trendwise must use in evaluating
soft dollar arrangements:
Principle 1: All client commissions paid to a broker are the property of the client.
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Principle 2: Mutual funds, such as Omega, establish their own policies with respect to the
use of certain brokers.
I recommend we use Brock only for OF transactions. This will allow us to verify the
quality of Brock’s trade execution, and the soft dollar credits will decrease the research
costs to OF’s fundholders. After a one-year trial period, we will inform our directors of
this new arrangement and report the results of the arrangement. If the directors decide to
renew the contract, we will inform the fundholders.
The following week Natali’s supervisor sent her a memo asking if the following firm
policies need any revisions to comply with the CFA Institute Research Objectivity
Standards:
Policy 1. Base compensation for analysts is determined from the quality of research
performed. Year-end bonuses may be adjusted based on an analyst’s work with
investment banking and corporate finance teams.
Policy 2. In their relationships with corporate issuers, analysts are prohibited from either
directly or indirectly promising favorable reports, or threatening negative reports. Price
targets may be agreed upon as long as the corporate issuer meets all disclosure
requirements prior to the report being issued.
Policy 3. In their relationships with corporate issuers, analysts are prohibited from
sharing with or communicating to a subject company, prior to publication, any section of
a research report.
Policy 4. Ensure that covered employees do not share information about the subject
company or security with any person who could have the ability to trade in advance of or
otherwise disadvantage the firm’s mutual funds.
1. With respect to her actions concerning Libra and Cyclical Industries (CI), Natali
least likely violated the CFA Institute Standards of Professional Conduct
concerning:
A. Loyalty.
B. Conflicts of interest.
C. Independence and Objectivity.
Answer: A
“Guidance for Standards I-VII”
2010 Modular Level II, Vol. 1, pp. 48-51, 80-82
Study Session 1-2-a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of
Professional Conduct by applying the Code and Standards to specific situations.
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A is correct because Natali’s actions least likely impacted her employer. By
changing her recommendation to keep CI and appease an important client she has
violated both the Conflicts of Interest and Independence Standards, Standard VI
(A) and Standard I (B).
2. In their discussion of the new proxy voting policy, whose statements are
consistent with the CFA Institute Standards?
A. Libra’s only.
B. Natali’s only.
C. Both Libra’s and Natali’s.
Answer: C
“Guidance for Standards I-VII”
2010 Modular Level II, Vol. 1, p. 50
Study Session 1-2-a
Demonstrate a thorough knowledge of the Code of Ethics and Standards of
Professional Conduct by applying the Code and Standards to specific situations.
C is correct because statements made by both Natali and Libra are consistent with
the Standards. According to Standard III (A) (Loyalty, Prudence, and Care)
voting proxies is an integral part of the management of investments and a
fiduciary who fails to vote proxies may violate the Standard. The Standards of
Practice Handbook also states that a cost-benefit analysis may show that voting all
proxies may not benefit the client, so voting proxies may not be necessary in all
instances. Members and candidates should disclose to clients their proxy-voting
policies, which Natali has done.
3. Which aspect of Trendwise’s duty to its clients is most likely to be violated by its
proposed soft dollar arrangement with Brock?
A. All soft dollar practices must be fully disclosed.
B. Investment managers must at all times seek best trade execution.
C. Commissions paid must be reasonable in relation to the research and
execution services provided.
Answer: A
CFA Institute Soft Dollar Standards
2010 Modular Level II, Vol. 1, pp. 50, 144-145
Study Sessions 1-2-a, 1-3-b
Demonstrate a thorough knowledge of the Code of Ethics and Standards of
Professional Conduct by applying the Code and Standards to specific situations.
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Critique company soft dollar practices and policies.
A is correct because according the Soft Dollar Standards, once a manager decides
to use soft dollar services, the manager should fully disclose to its clients its
brokerage commission policies. Trendwise proposes to inform clients only at
year’s end which would not meet the Standards requirement.
4. In her statement about evaluating soft dollar arrangements, Natali is most likely
correct with respect to:
A. Principle 1.
B. Principle 2.
C. Both Principles 1 and 2.
Answer: A
CFA Institute Soft Dollar Standards
2010 Modular Level II, Vol. 1, pp. 143-145
Study Session 1-3-a
Define “soft dollar” arrangements and state the general principles of the Soft
Dollar Standards.
A is correct as Natali stated Principle 1 correctly. According to the Soft Dollar
Standards, I. General Principles, brokerage is the property of the client.
5. In response to her supervisors question regarding the firm’s policies on research
objectivity, Natali’s best response would be:
A. both policies 1 and 2 are consistent with the current Standards.
B. both policies 1 and 2 are inconsistent with the current Standards and require
changes.
C. the policy on analyst compensation requires changes, but the policy regarding
relationships with corporate issuers is consistent with current Standards.
Answer: B
CFA Institute Research Objectivity Standards
2010 Modular Level II, Vol. 1, p. 168
Study Session 1-4-b
Critique company policies and practices related to research objectivity and
distinguish between changes required and changes recommended for compliance
with the Research Objectivity Standards.
B is correct. Both policies 1 and 2 are inconsistent with the current Standards.
According to the Research Objectivity Standards, firms must establish and
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implement salary, bonus, and other compensation for analysts that do not directly
link compensation to investment banking or other corporate finance activities on
which the analyst collaborated (either individually or in the aggregate.) The
Standards also state that research analysts are prohibited from directly or
indirectly promising a subject company or other issuer a favorable report or
specific price target, or from threatening to change reports, recommendations, or
price targets.
6. To make the firm’s policies consistent with CFA Institute Research Objectivity
Standards, Natali should suggest the following regarding Policy 3 and 4:
A. both policies 3 and 4 are consistent with the current Standards.
B. both policies 3 and 4 are inconsistent with the current Standards.
C. policy 3 requires changes, but policy 4 is consistent with current Standards.
Answer: B
CFA Institute Research Objectivity Standards
2010 Modular Level II, Vol. 1, pp. 168-169
Study Session 1-4-b
Critique company policies and practices related to research objectivity and
distinguish between changes required and changes recommended for compliance
with the Research Objectivity Standards.
B is correct. According to the Research Objectivity Standards, analysts are
prohibited from sharing with, or communicating with or communicating to a
subject company, prior to publication, any section of a research report that might
communicate the research analyst’s proposed recommendation, rating, or price
target. It is recommended that the compliance or legal department receive a draft
research report before sections are shared with the subject company. She also
needs to change Policy 4 so that it is applicable to all clients, not just mutual
funds.
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Walter Speckley Case Scenario
Walter Speckley is a high net worth individual who recently relocated from Europe to the
United States. Speckley sold his European properties and will receive the €10 million
proceeds 180 days from now. The terms of the sale require the funds to remain in escrow
for an additional 180 days after receipt. He intends to invest the escrowed funds in a 180-
day euro-denominated money market instrument.
When the escrow period ends 360 days from now, Speckley intends to convert these
funds to U.S. dollars and buy stock in the First Bank of Kanata (FBK), a small regional
U.S. bank that he has identified as an attractive investment opportunity. FBK stock is
priced in U.S. dollars and the company will pay a dividend of $5.00 per share 180 days
from now.
Speckley’s investment objectives are to lock in:
1. the yield he will receive on his euro-denominated money market investment 180
days from now;
2. the exchange rate he will receive when he converts his funds from euros to U.S.
dollars 360 days from now; and
3. the current purchase price of FBK stock.
To accomplish these objectives, Speckley plans to use forward contracts. Exhibit 1
describes the transactions proposed by Speckley.
Exhibit 1
Time-line of Events
Now
180 Days from
Now 360 Days from Now
Cash transactions
Property sale proceeds received --- €10,000,000 ---
Euro-denominated money market
investment --- €10,000,000 Investment matures
Euros converted into U.S. dollars --- --- Dollars received
FBK stock purchase (in U.S. dollars) --- --- Stock purchased
Dividend paid on FBK stock --- $5.00 per share ---
Derivatives transactions
Euribor forward rate agreement Contract entered --- Contract matures
Forward currency contract Contract entered --- Contract matures
Forward contract on FBK stock Contract entered --- Contract matures
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Speckley approaches Illing & Partners, a private investment bank, to obtain price quotes
on the various forward contracts. Illing & Partners base their price quotes on the
information in Exhibit 2.
Exhibit 2
Spot Market Information
180-day Euribor 2.50%
360-day Euribor 3.50%
180-day U.S. yield 3.00%
360-day U.S. yield 3.00%
Dollars per euro (spot) $1.25
Price per share of FBK stock $100.00
Howard Dunn, an analyst at Illing & Partners, explains to Speckley that currency forward
prices are determined in part by the current levels of domestic and foreign interest rates
and the levels of domestic and foreign interest rates expected at the expiration of the
forward contract.
Dunn tells Speckley that he will receive fewer dollars when he converts his proceeds
using the 360-day forward currency contract than he would receive at the current spot
exchange rate. When Speckley asks why, Dunn replies:
“The forward exchange rate reflects that 360-day U.S. interest rates are lower than 360-
day European interest rates.”
Speckley enters into a Euribor forward rate agreement, a short position in a currency
forward contract to exchange dollars for euros, and a long position in a FBK forward
contract. As the currency forward contract nears maturity, the market value of the long
position is $149,000 and Speckley estimates that the probability that his counterparty will
default at maturity is 25 percent.
7. Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the
price of a 360-day euro forward contract is closest to:
A. $1.244.
B. $1.250.
C. $1.256.
Answer: A
“Forward Markets and Contracts,” Don M. Chance
2010 Modular Level II, Vol. 6, pp. 38-40
Study Session 16-58-c
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Calculate and interpret the price and the value of 1) a forward contract on a fixed
income security, 2) a forward rate agreement (FRA), and 3) a forward contract on
a currency.
The formula for the forward currency price is:
F(0,T) = [ S0 / ( 1 + rf )
T ] ( 1 + r )
T
where F(0,T) = the forward price at time “0” for a delivery date at time “T”
(which is one year, or “1”, in this case)
S0 = the spot exchange rate
rf = the foreign interest rate
r = the domestic interest rate.
In this item set, the domestic interest rate is the U.S.
Substituting in the information from Exhibit 2:
F(0,T) = ( 1.25 / 1.035 ) ( 1.030) = 1.244
8. Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the
price of a 360-day forward contract on FBK stock is closest to:
A. $97.93.
B. $98.07.
C. $103.00.
Answer: A
“Forward Markets and Contracts,” Don M. Chance
2010 Modular Level II, Vol. 6, pp. 26-30
Study Session 16-58-b
Calculate and interpret the price and the value of an equity forward contract,
assuming dividends are paid either discretely or continuously.
The price formula for a forward contract on an equity security is:
F(0,T)= [ S0 – PV(D,0,T) ] ( 1 + r )T
= [ S0 ( 1 + r )T ] – FV(D,0,T)
where S0 = the current price of the equity
PV(D,0,T) = the present value of the dividend stream across the life of the
forward contract (“T”) FV(D,0,T) = the future value of the dividend stream
across the life of the contract
Given the information in the problem and in Exhibits 1 and 2, the contract is for
one-year (T = 1) and the dividend occurs in 180 days (½ year). Substituting this
into the formula:
F(0,T) = [ 100 – { 5 / ( 1 + .03 )0.5
} ] ( 1 + .03 )
= [ 100 ( 1 + .03 ) ] – [ 5 ( 1 + .03 )0.5
]
= $97.93
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9. Dunn’s explanation of the currency forward price is most likely:
A. correct.
B. incorrect because forward exchange rates are not affected by current domestic
and foreign interest rates.
C. incorrect because forward exchange rates are not affected by domestic and
foreign interest rate expectations.
Answer: C
“Forward Markets and Contracts,” Don M. Chance
2010 Modular Level II, Vol. 6, pp. 38-40
Study Session 16-58-a
Explain how the value of a forward contract is determined at initiation, during the
life of the contract, and at expiration
C is correct because currency forward prices are determined by the current
exchange rate, the current domestic and foreign interest rates and the maturity of
the contract.
10. Dunn’s explanation of the difference between the 360-day forward exchange rate
and the current spot exchange rate is most likely:
A. correct.
B. incorrect because the forward exchange rate will also depend upon inflation
expectations.
C. incorrect because the forward exchange rate will be higher than the spot rate
when U.S. interest rates are lower than European interest rates.
Answer: A
“Forward Markets and Contracts,” Don M. Chance
2010 Modular Level II, Vol. 6, pp. 38-43
Study Session 16-58-c
Calculate and interpret the price and the value of 1) a forward contract on a fixed
income security, 2) a forward rate agreement (FRA), and 3) a forward contract on
a currency.
The exchange rate on forward currency contracts is determined by:
F0(T) = [ S0 / ( 1 + rf )
T ] ( 1 + r )
T
where F0(T) = the current price of the forward contract expiring at time “T”
S0 = the current spot exchange rate
rf = the foreign interest rate
r = the domestic interest rate.
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When domestic interest rates (U.S. in this item set) are lower than foreign interest
rates, the forward exchange rate will be lower than the spot exchange rate; this is
based on the assumption that the exchange rate is quoted as the amount of
domestic currency required to purchase 1 unit of foreign currency.
11. The credit risk of the currency forward contract from Speckley’s perspective is
closest to:
A. $0.
B. $37,250.
C. $149,000.
Answer: A
“Forward Markets and Contracts,” Don M. Chance
2010 Modular Level II, Vol. 6, pp. 44-45
Study Session 16-58-d
Evaluate credit risk in a forward contract, and explain how market value is a
measure of the credit risk to a party in a forward contract.
Speckley is short the Euro forward which has a positive market value. The long
counterparty stands to lose $149,000 if Speckley defaults.
12. Based on the information in Exhibits 1 and 2 and assuming a 360-day year, the
rate on a Euribor forward rate agreement (FRA) that meets Speckley’s needs is
closest to:
A. 2.22%.
B. 3.00%.
C. 4.44%.
Answer: C
“Forward Markets and Contracts,” Don M. Chance
2010 Modular Level II, Vol. 6, pp. 31-37
Study Session 16-58-c
Calculate and interpret the price and the value of 1) a forward contract on a fixed
income security, 2) a forward rate agreement (FRA), and 3) a forward contract on
a currency
The formula for an FRA rate is:
FRA(0,h,m) =
1 +
L0(h+m)(h+m
/360) - 1
(360/m) 1 + L0(h) (
h/360)
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
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where FRA(0,h,m) is the rate on an FRA contracted at time “0” expiring at time
“h” for an investment period lasting from “h” to “h+m” and L0(h) is the h-period
Euribor rate at time “0”. In Speckley’s case, h = m = 180. Using this and the
information in Exhibit 2:
FRA(0,180,180) = [ { ( 1 + .035 ) / ( 1 + .025[1/2]) } - 1 ] 2 = 0.0444
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Sofiya Prutko Case Scenario
Sofiya Prutko, CFA, is a partner at Fedir Investments, a firm that acts as a private conduit
for issuing securities backed by non-conforming residential mortgages. Fedir has
assembled an $80 million pool of 30-year, fixed-rate mortgages with unusually high loan-
to-value ratios and intends to privately place the securities created from this pool.
Prutko’s task is to determine the best structure for the securities. As part of that process,
she has scheduled a series of meetings with current and potential investors.
Her first meeting is with an endowment fund manager who may purchase a portion of the
securities if they meet his needs. During the meeting, Prutko is asked about the pool’s
characteristics and its estimated cash flows. She explains that the pool has a WAC of
7.10 percent and a WAM of 356 months and that, under current market conditions,
prepayments are expected at 310 PSA. Later in the discussion, she presents a table
showing pool cash flow estimates for a different prepayment assumption. An incomplete
part of that table appears in Exhibit 1.
Exhibit 1
Mortgage Pool Monthly Cash Flow Estimate
Months
From Now
Outstanding
Balance
Mortgage
Payment
Net
Interest
Scheduled
Principal
Prepayment
24 $47,563,831 $327,321 $281,419 $45,901
The endowment fund manager explains that one of his primary concerns is that market
interest rates will rise, leading to prepayment rates that are much lower than currently
expected. He also explains that he wants a relatively long-term investment (average life
greater than 5 years) and does not want to receive any cash flow from it for a number of
years.
Prutko’s second meeting is with the manager of a public pension fund that invests in a
wide variety of fixed income securities. The manager is currently concerned about credit
risk but states that, “Although I’m concerned because some non-agency issuers have
more credit risk than Fannie Mae and Freddie Mac, credit enhancement can be used to
achieve a credit rating equal to that of Fannie and Freddie securities.” Prutko describes
the credit risk characteristics of Fedir’s securitizations relative to agency securities and
adds, “in addition, for each $100 in mortgage principal, we issue only $95 in par-value
securities, retaining $5 as an equity position.”
After meeting with these two individuals and others, Prutko decides to separate the pool
into two $40 million pools. The first pool is used to back a pair of interest-only and
principal-only stripped securities with a $38 million par value. The second pool is used
to back a CMO structure with two $12 million sequential planned amortization class
(PAC) tranches, PAC-A and PAC-B, and one $14 million support tranche. Interest rates
at new issue suggest that prepayments will occur at 310 PSA and the initial PAC collar is
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200-450 PSA for PAC-A and 230-420 PSA for PAC-B. Each strip security and CMO
tranche is privately placed, as was originally desired.
13. Given the 310 PSA prepayment assumption, the current prepayment rate of the
pool is closest to a CPR of:
A. 2.5%.
B. 18.6%.
C. 41.3%.
Answer: A
“Mortgage-backed sector of the bond market,” Frank J. Fabozzi, CFA
2010 Modular Level II, Vol. 5, pp. 371-372
Study Session 15-55-d
Compare and contrast the conditional prepayment rate (CPR) with the Public
Securities Association (PSA) prepayment benchmark.
During the first 30 months of a pool’s life,
%5.2%48.210.3*1333.*%610.3*30
4*%6
100
levelPSA *
30
t * 6%CPR
where t is the number of months since the mortgages were originated. Since the
WAM is 356, 4 months have elapsed.
14. Given a single monthly mortality prepayment assumption of 2.1482 percent and
the other information about the 24th
month of the pool’s life that is provided in
Exhibit 1, the expected prepayment amount is closest to:
A. $1,014,735.
B. $1,020,780.
C. $1,021,766.
Answer: B
“Mortgage-backed sector of the bond market,” Frank J. Fabozzi, CFA
2010 Modular Level II, Vol. 5, pp. 373-376
Study Session 15-55-c
Calculate the prepayment amount for a month, given the single monthly mortality
rate.
The (expected) prepayment amount = (Pool balance – scheduled principal
payment) × single monthly mortality (SMM). $1,020,780 = ($47,563,831 -
$45,901) ×0.021482.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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15. The endowment fund manager’s concern about the impact of movements in
market interest rates is best described as a concern about:
A. extension risk.
B. contraction risk.
C. prepayment risk.
Answer: A
“Mortgage-backed sector of the bond market,” Frank J. Fabozzi, CFA
2010 Modular Level II, Vol. 5, pp. 381-382
Study Session 15-55-f
Explain the factors that affect prepayments and the types of prepayment risks.
Prepayment risk includes contraction risk (the risk that the prepayment rate will
rise resulting in a shortening of the security’s life) and extension risk (the risk that
the prepayment rate will fall, resulting in a lengthening of the security’s life.) The
investor has expressed a clear concern about falling prepayment rates – indicating
a concern about extension risk. This is also, generically, a concern about
prepayment risk – but is better described as extension risk.
16. The pension fund manager’s statement about the credit risk of non-agency
mortgage-backed securities is most likely:
A. correct.
B. incorrect, with respect to the use of credit enhancement.
C. incorrect, with respect to the credit risk of non-agency issuers.
Answer: A
“Mortgage-backed sector of the bond market,” Frank J. Fabozzi, CFA
2010 Modular Level II, Vol. 5, pp. 408-409
Study Session 15-55-k
Compare and contrast agency and nonagency mortgage-backed securities.
The pension fund manager’s statement is true because most private label issuers
do have more credit risk than FNMA or FHLMC and credit enhancement (in a
variety of forms, such as third party default protection or overcollateralization)
can be used to increase the credit rating of an issue to the level of Fannie and
Freddie securities.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
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17. According to the information that Prutko provided to the pension fund manager,
the kind of credit enhancement that Fedir provides is best described as:
A. wrapping.
B. overcollateralization.
C. excess spread accounts.
Answer: B
“Asset-backed sector of the bond market,” Frank J. Fabozzi, CFA
2010 Modular Level II, Vol. 5, pp. 449-453
Study Session 15-56-d
Distinguish among the various types of external and internal credit enhancements.
“Overcollateralization in a structure refers to a situation in which the value of the
collateral exceeds the amount of the par value of the outstanding securities
issued…” (p. 451) Wrapping refers to a third party guarantee from a monoline
insurer. Excess spread accounts require security structures that do not pay out all
incoming interest to the security holders, allowing the establishment of a “spread
account” where excess interest payments are stored and can be used to cover
future defaults, if needed.
18. Which type of CMO tranche would most likely meet the endowment fund
manager’s desired investment maturity and cash flow characteristics?
A. An accrual tranche.
B. A sequential-pay tranche.
C. A planned amortization class tranche.
Answer: A
“Mortgage-backed sector of the bond market,” Frank J. Fabozzi, CFA
2010 Modular Level II, Vol. 5, pp. 382-395
Study Session 15-55-h
Distinguish among the sequential pay tranche, the accrual tranche, the planned
amortization class tranche, and the support tranche in a CMO.
Of the three, the accrual tranche typically receives principal only after all
sequential-pay and/or planned amortization class tranches have been paid off,
meeting the investor’s need for a long-term security. Further, until its principal
repayment begins, the accrual tranche does not pay interest but accrues it to
principal, meeting the investor’s need to not receive any cash flow for a number
of years.
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Lisa Jaworski Case Scenario
Lisa Jaworski is an equity portfolio manager for Thornhurst Investments, a large
investment management company based in Charlotte, North Carolina. Thornhurst
currently uses the Capital Asset Pricing Model (CAPM) to evaluate securities and mean-
variance portfolio optimization to construct equity portfolios. Jaworski is meeting with
two assistant portfolio managers, Yaodong Bi and Niyati Ahuja. Bi and Ahuja have been
asked to do some research on ways to improve on the methods currently being used by
Thornhurst to evaluate securities and develop portfolios.
Jaworski begins the meeting by outlining some issues relating to the CAPM. She makes
the following statements:
Statement 1
“One of the reasons I am uncomfortable using the CAPM is that it makes some very
restrictive assumptions such as:
investors pay no taxes on returns and no transaction costs on trades,
investors have unique views on expected returns, variances and correlations of
securities, and
investors can borrow and lend at the same risk-free rate of interest.”
Statement 2
“We are also faced with a problem that our mean-variance optimization models can
generate unstable minimum-variance efficient frontiers. Consequently, we face
considerable uncertainty regarding recommendations we make to our clients on asset
allocation. I attribute the instability to our use of:
a short sales constraint, and
historical betas.”
Bi suggests that multifactor models provide a better way to model stock returns. He
develops two models on a whiteboard while stating: “There are two ways to model stock
returns using the following multifactor model:
Model 1
In this model, stock returns ( ) are determined by surprises in economic factors such as
GDP growth and the level of interest rates.
Model 2
Here, stock returns ( ) are determined by factors that are company attributes such as
price-earnings ratio and market capitalization.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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While the interpretation of the intercept is similar for both models, the factor
sensitivities are interpreted differently in the two models.”
Ahuja notes that a multifactor Arbitrage Pricing Model (APT) provides a much better
basis than the CAPM for calculating expected portfolio returns and evaluating portfolio
risk exposures. In order to illustrate the advantages of the multifactor APT model, Ahuja
provides information for two portfolios Thornhurst currently manages. The information
is provided below in Exhibit 1. The current risk-free rate is 2 percent.
Exhibit 1
Factor Sensitivities and Risk Premia
Factor
Factor Sensitivities Risk
Risk Factor Portfolio A Portfolio B Benchmark Premium (%)
Confidence Risk 0.81 0.04 0.5 4.5
Inflation Risk -0.15 -0.45 -0.25 -1.2
Business Cycle Risk 1.23 0.09 0.9 5.2
Ahuja makes the following statement:
Statement 3
“We can tell from Exhibit 1 that Portfolio A is structured in such a manner that it will
benefit from an expanding economy and improving confidence because the factor
sensitivities for confidence risk and business cycle risk exceed the factor sensitivities for
the benchmark. Portfolio B has very low factor sensitivities for confidence risk and
business cycle risk but moderately high exposure to inflation risk, therefore Portfolio B
can be referred to as a factor portfolio for inflation risk.”
Jaworski wants to examine how active management is contributing to portfolio
performance.
Ahuja responds with the following statement:
Statement 4
“Our models show that Portfolio A has annual tracking error of 1.25 percent and an
information ratio of 1.2 while Portfolio B has annual tracking error of 0.75 percent and an
information ratio of 0.87.”
19. Which assumption of the CAPM is most likely incorrect in Jaworski’s Statement
1? The assumption regarding:
A. borrowing and lending.
B. taxes and transaction costs.
C. expected returns, variances and correlations.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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Answer: C
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle
2010 Modular Level II, Vol. 6, p. 404
Study Session 18-64-e
Explain the capital asset pricing model (CAPM), including its underlying
assumptions and the resulting conclusions
C is correct. This statement is incorrect. The CAPM assumes that investors have
identical views on expected returns, variances and correlations of securities.
20. Is Jaworski’s Statement 2 most likely correct?
A. Yes.
B. No, she is incorrect about the short sales constraint.
C. No, she is incorrect about the use of historical betas.
Answer: B
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle
2010 Modular Level II, Vol. 6, pp. 415-419
Study Session 18-64-i
Discuss reasons for and problems related to instability in the minimum-variance
frontier.
B is correct. Jaworski is wrong. One of the reasons for an unstable minimum-
variance efficient frontier is the absence of a short sales constraint. That is
unconstrained mean variance optimization models produce inherently unstable
efficient frontiers. The solution is to impose a no short sales constraint.
21. With regard to the statement on multifactor models, Bi is most likely incorrect
with respect to the:
A. intercept value .
B. factor sensitivities .
C. description of the factors.
Answer: A
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
2010 Modular Level II, Vol. 6, pp. 420-423, 430-431
Study Session 18-64-j
Discuss and compare macroeconomic factor models, fundamental factor models,
and statistical factor models.
A is correct. Model 1 is a macroeconomic factor model. In this model the
intercept value is the expected return on the stock. Model 2 is a fundamental
factor model. In fundamental factor models the factor sensitivities are
standardized, thus the intercept is not interpreted as anything more than a
regression intercept that ensures that expected asset specific risk equals zero (see
page 431). It is not interpreted as the expected return for the stock as in the
macroeconomic factor model.
22. Based on the information in Exhibit 1, the expected return for portfolio A is
closest to:
A. 8.4%
B. 10.2%
C. 12.2%
Answer: C
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle
2010 Modular Level II, Vol. 6, pp. 432-434
Study Session 18-64-l
Discuss the arbitrage pricing theory (APT), including its underlying assumptions
and its relation to the multifactor models, calculate the expected return on an asset
given an asset’s factor sensitivities and the factor risk premiums, and determine
whether an arbitrage opportunity exists, including how to exploit the opportunity.
C is correct. The expected return for portfolio A is calculated as:
E(RA) = 2% + 0.81 × 4.5% + -0.15 × -1.2% + 1.23 × 5.2% = 12.21%
23. Is Ahuja’s Statement 3 most likely correct?
A. Yes
B. No, she is incorrect about Portfolio A
C. No, she is incorrect about Portfolio B.
Answer: C
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle
2010 Modular Level II, Vol. 6, pp. 432-435, 452-454.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Study Session 18-64-l, m
Discuss the arbitrage pricing theory (APT), including its underlying assumptions
and its relation to the multifactor models, calculate the expected return on an asset
given an asset’s factor sensitivities and the factor risk premiums, and determine
whether an arbitrage opportunity exists, including how to exploit the opportunity.
Explain the sources of active risk, define and interpret tracking error, tracking
risk, and the information ratio, and explain factor portfolio and tracking portfolio.
C is correct. Ahuja is incorrect about Portfolio B. Factor portfolios by definition
will have a factor sensitivity of 1 to a particular factor and zero sensitivity for all
other factors. For Portfolio B to be a factor portfolio for the inflation risk factor it
must have factor beta of 1 to inflation risk and zero for the other factors.
24. Based on Statement 4 by Ahuja, an appropriate conclusion is that the portfolio
that has benefited the most from active management is:
A. portfolio B because of tracking error.
B. portfolio A because of the information ratio.
C. portfolio B because of the information ratio.
Answer: B
“Portfolio Concepts,” Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle
2010 Modular Level II, Vol. 6, pp.444-452
Study Session 18-64-m
Explain the sources of active risk, define and interpret tracking error, tracking
risk, and the information ratio, and explain factor portfolio and tracking portfolio.
B is correct. Portfolio A has the highest information ratio. The information ratio
provides the mean active returns per unit of active risk.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Brigitte Langlois Case Scenario
Brigitte Langlois, a fixed income securities analyst for Cunard Securities, is responsible
for evaluating and monitoring the creditworthiness of companies whose bonds are held in
Cunard's High Yield International Corporate Bond Fund. Langlois bases her buy and sell
decisions on a multivariate bankruptcy prediction model that estimates the probability
that a company will face insolvency within the next 18 months. As inputs into the model,
Langlois uses adjusted, rather than reported, accounting data to calculate a company's
liquidity, solvency, and profitability ratios.
Langlois and her research assistant, Barclay Kingston, are preparing a research report on
Duban Inc., a U.S. based company, and Kerwin Corporation, Duban’s recently acquired
Swedish affiliate, to determine whether either company's intermediate-term bonds would
be suitable investments for Cunard's bond fund.
Langlois assigns Kingston several tasks:
“I want you to analyze Duban’s long-term solvency because I am concerned about its
obligation to provide pension benefits. Because Duban uses U.S. GAAP while Kerwin
uses International Financial Reporting Standards (IFRS), I want you to prepare an
analysis of their financial statements.”
Langlois provides Kingston with information about Duban’s pension plan, which is
shown below in Exhibit 1.
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preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
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Exhibit 1
Duban Inc.
Selected Footnote Disclosure
Pension Plan Information
(in U.S. $ millions)
2009 2008
Reconciliation of Pension Benefit Obligation (PBO)
Opening Balance $1,606 $1,296
Service Cost 86 81
Interest Cost 147 131
Plan Amendments 237
Benefits Paid (148) (145)
Participant Contributions 8 6
Closing Balance $1,699 $1,606
2009 2008
Reconciliation of Plan Assets
Opening Balance $507 $592
Return on Plan Assets (41) (21)
Employer Contributions 117 75
Participant Contributions 8 6
Benefits Paid (148) (145)
Closing Balance $443 $507
Other Information
Unrecognized Prior Service Cost 227 250
Unrecognized Actuarial Loss 348 205
Expected Return on Plan Assets 46 45
Amortization of Unrecognized Prior Service Cost 23 12
Amortization of Unrecognized Loss 15 10
Langlois continues to outline Kingston’s tasks:
“I would like you to compute the effect of the consolidation of Kerwin on Duban’s
profitability. As outlined in Exhibit 2, since the acquisition by Duban, Kerwin’s
performance has improved dramatically, but I think they should still be considered a
Swedish based company for our investment purposes for the following reasons:
They sell all of their output in Sweden, in kronas.
Although they purchase some components from Duban, all of the labor and other
costs are incurred in Sweden.
They are able to finance all of their working capital needs from local sources.”
Selected information from Duban’s financial statements and Management’s Discussion
and Analysis relating to its investment in Kerwin, is shown below in Exhibit 2.
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Exhibit 2
Selected Information from Duban’s 2009 Financial Statements
and Management’s Discussion and Analysis
Concerning Duban’s Investment in Kerwin
Sweden is an important foreign market for Duban Inc. On 1 January 2009, we made an
investment in Kerwin Corporation in expectation of strong consumer demand. As
indicated in the following table, as a result of Duban’s involvement in the Swedish
operations Kerwin's 2009 net sales increased by 25 percent compared with 2008 sales. In
addition, Kerwin's 2009 net income increased by 40percent compared to the prior year.
Kerwin: Selected Financial Data (in SEK millions)
2009 2008
Net sales 56,000 44,800
Net income 5,000 3,600
Monetary assets 13,000 12,000
Non-monetary assets 32,500 28,000
Monetary liabilities 18,000 17,500
Equity 27,500 22,500
USD/SEK Exchange Rate
2009 2008
Year-end rate, 31 December $0.140 = 1SEK $0.127 = 1SEK
*Average rate during year $0.132= 1SEK $0.141= 1SEK
25. Based on Exhibit 1, funded status of Duban’s pension plan under U.S. GAAP for
2009 ($ millions) would be closest to a liability of:
A. 681.
B. 1,256.
C. 1,831.
Answer: B
“Employee Compensation: Post-Retirement and Share-Based,” Elaine Henry,
CFA and Elizabeth Gordon
2010 Modular Level II, Vol. 2, pp. 113-117
Study Session 6-22-g
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preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Evaluate the underlying economic liability (or asset) of a company’s pension and
other post-employment benefits.
The pension liability is calculated as follows:
Plan Assets 443
Less: PBO (1,699)
Funded Status - (deficit) (1,256)
26. Based on Exhibit 1, the pension expense ($ millions) that would be reported on
Duban's 2009 income statement under U.S. GAAP would be closest to:
A. 187.
B. 225.
C. 230.
Answer: B
“Employee Compensation: Post-Retirement and Share-Based,” Elaine Henry,
CFA and Elizabeth Gordon
2010 Modular Level II, Vol. 2, pp. 101-102
Study Session 6-22-c, d
Describe the components of a company’s defined-benefit pension expense.
Explain the impact of a defined benefit plan’s assumptions on the defined benefit
obligation and periodic expense.
The pension expense is calculated as follows:
Service Cost 86
Interest Cost 147
Expected Return on Plan Assets (46)
Amortization of Unrecognized Prior Service Cost 23
Amortization of Unrecognized loss 15
Pension Expense 225
27. Based on Exhibit 1, the underlying economic pension expense ($ millions) for
Duban for 2009 would be closest to:
A. 192.
B. 233.
C. 274.
Answer: C
“Employee Compensation: Post-Retirement and Share-Based,” Elaine Henry,
CFA and Elizabeth Gordon
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
2010 Modular Level II, Vol. 2, pp. 114-121
Study Session 6-22-h
Calculate the underlying economic pension expense (income) and other post-
employment expense (income) based upon disclosures.
The economic pension expense is calculated as follows:
Service Cost 86
Interest Cost 147
Actual Return on Plan Assets 41
Economic Pension Expense 274
Alternative calculation: the change in the net funded position plus the employer’s contributions.
(1699- 443) – (1606-507) + 117 = $274
28. Langlois’ description of Kerwin’s operations most likely classifies the U.S. dollar
as the:
A. local currency.
B. functional currency.
C. presentation currency.
Answer: C
“Multinational Operations,” Timothy Doupnik
2010 Modular Level II, Vol. 2, pp 172-173
Study Session 6-23-a
Distinguish among presentation currency, functional currency, and local currency.
Langlois’ describes the krona as the functional currency for Kerwin – the sales
prices and costs are primarily determined in Sweden and Kerwin is able to finance
its operations locally. Therefore the U.S. dollar is not the functional currency, but
the presentation currency.
29. If the Swedish krona is chosen as Kerwin’s functional currency, Kerwin’s 2009
return on equity ratio (%) after translation, using the year-end balance for equity,
will be closest to:
A. 17.1.
B. 18.2.
C. 18.8.
Answer: A
“Multinational Operations,” Timothy Doupnik
2010 Modular Level II, Vol. 2, pp 173-174, 183, 185
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Study Session 6-23-d, e
Calculate the translation effects, evaluate the translation of a subsidiary’s balance
sheet and income statement into the parent company’s currency, and analyze the
differential effect of the current rate method and the temporal method on the
subsidiary’s financial ratios.
Analyze how using the temporal method versus the current rate method will affect
the parent company’s financial ratios.
If the functional currency is the SEK, then Duban should use the current rate method to
translate Kerwin. The equity will include the initial investment, current retained earnings
and the required translation adjustment to bring the balance sheet back into balance
following translation.
ROE = Net Income/Total Equity (year-end balance)
Net Income 5,000 x 0.132 = 660 Translate at average rate
Total Equity
o Initial Equity 22,500 x 0.127 = 2,858 Translate at historical rate (Jan 2009)
o Increase in Retained
Earnings
5,000 x 0.132 = 660
Translate at average rate
o Translation Adjustment 332 To balance the balance sheet (see
following calculation)
Total Equity 3,850
ROE 660/3,850 = 17.1%
Translation Adjustment: Translation Translated Value
Translated Net Assets (1) (27,500) x 0.140 3,850
Less Translated Initial Equity 22,500 x 0.127 2,858
Less Translated Increase in Retained Earnings 5,000 x 0.132 660
Translation adjustment: amount needed to balance the balance
sheet
332
(1) Net Assets = Net Non-monetary assets + Monetary assets – Monetary liabilities
= 13,000 + 32,500 – 18,000 = 27,500 OR Net assets = Equity = 27,500
30. With the changes in the krona indicated in Exhibit 2, compared to using the
current rate method, net income under the temporal method, will most likely be:
A. lower.
B. higher.
C. the same.
Answer: A
“Multinational Operations,” Timothy Doupnik
2010 Modular Level II, Vol. 2, pp 170-171, 173-176
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Study Session 6-23-d, e
Calculate the translation effects, evaluate the translation of a subsidiary’s balance
sheet and income statement into the parent company’s currency, and analyze the
differential effect of the current rate method and the temporal method on the
subsidiary’s financial ratios.
Analyze how using the temporal method versus the current rate method will affect
the parent company’s financial ratios.
Under the temporal method the balance sheet exposure is limited to monetary
assets and liabilities. Kerwin has a net liability exposure on its balance sheet
(monetary liabilities exceed monetary assets) therefore the strengthening of the
Swedish krona against the U.S dollar will result in a negative translation
adjustment. This negative translation adjustment will be included in Duban’s net
income under the temporal method decreasing net income.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Brad Turner Case Scenario
Brad Turner is the Chief Financial Officer of Foster Inc., a Canadian based
manufacturing corporation that operates internationally. Foster has Cdn$20 billion in
total assets, with excess cash to invest for a planned acquisition in two years.
Information about Foster’s equity portfolio and fixed income portfolio is provided in
Exhibits 1 and 2, respectively. All securities were purchased on the first day of the
current year. Foster adheres to International Financial Reporting Standards (IFRS) when
accounting for its investments in the securities of other companies.
Exhibit 1
Foster Inc. Equity Portfolio
(at year end, Cdn$ thousands)
Characteristic Security
Alton Inc. Barker Inc. Cosmic Inc. Darnell Inc.
Classification
Held-for-
trading
Available-
for-sale
Available-
for-sale
Associated
Company
Cost $100,000 $150,000 $250,000 $500,000
Market Value,
end-of-year $97,000 $151,000 $257,000 $506,000
Dividends received
during the year
$1,000
$2,000
$3,000
$4,000
Foster’s share of
investee’s net income
for the year
$5,000
$7,000
$10,000
$15,000
Note: Darnell Inc. has $2 billion in total assets. Foster owns 40 percent of Darnell’s
equity and has representation on Darnell’s Board of Directors but does not have
effective control.
Exhibit 2
Foster Inc. Fixed Income Portfolio
(at year end, Cdn$ thousands)
Characteristic Security
Eldon Inc. Fizz Inc. Gilt Inc. Harp Inc.
Classification
Held-for-
trading
Available-
for-sale
Held-to-
maturity
Held-to-
maturity
Cost $20,000 $35,000 $50,000 $60,000
Market Value,
end-of-year $23,000 $45,000 $45,000 $64,000
Interest earned for the
year $1,000 $2,000 $4,000 $5,000
Note: All fixed income securities were purchased at par value.
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preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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Turner is interested in understanding the effect of the investment portfolios on Foster’s
year-end financial statements. Foster is re-evaluating its investment strategy, including
what would have been the effect if Foster had designated more of the securities as
investments at fair value. Turner does not think the decline in market value of any of the
securities is permanent, but when discussing it with his investment officer, Charlene
Chen, she makes the following statement:
“I think the impairment in Gilt Inc. is permanent and we should recognize the impairment
loss in net income. However, if it recovers next year we will be able to reverse the loss.”
For Turner’s analysis, all tax effects are ignored.
31. The contribution of the equity portfolio to Foster’s net income ($) for the year is
closest to:
A. 7,000.
B. 18,000.
C. 26,000.
Answer: B
“Intercorporate Investments,” Susan Perry Williams
2010 Modular Level II, Vol. 2, pp. 12, 20
Study Session 5-21-a, c
Describe the classification, measurement, and disclosure under the International
Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)
investments in associates, 3) joint ventures, 4) business combinations, and 5)
special purpose and variable interest entities (SPEs and VIEs).
Analyze the effects on financial ratios of the different methods used to account for
intercorporate investments.
The sum of dividends for the first three investments (Alton, Barker & Cosmic) is
reduced by the unrealized loss on the held-for-trading security (Alton); to this
amount must be added Foster’s share of Darnell’s net income, as determined
under the equity method. The result is: 1,000 + 2,000 + 3,000 – 3,000 + 15,000 =
$18,000.
32. If at acquisition, all of the equity securities that were eligible to be designated as
investments at fair value were so designated, the amount that the entire equity
portfolio would contribute to Foster’s net income ($) for the year is closest to:
A. 11,000.
B. 21,000.
C. 26,000.
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Answer: C
“Intercorporate Investments,” Susan Perry Williams
2010 Modular Level II, Vol. 2, pp. 12-13, 27
Study Session 5-21-a, c
Describe the classification, measurement, and disclosure under the International
Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)
investments in associates, 3) joint ventures, 4) business combinations, and 5)
special purpose and variable interest entities (SPEs and VIEs).
Analyze the effects on financial ratios of the different methods used to account for
intercorporate investments.
Only the equity securities that were designated as available-for-sale (Barker and
Cosmic) could have been designated at fair value and the unrecognized gains
from those securities would then be included in income. Because Foster is a
manufacturing company and not a venture capital or mutual fund company, it may
not account for its significant influence in Darnell using fair value.
Income would be equal to the dividends from Alton, Barker, and Cosmic plus the
changes in market value for those same three securities plus the income from
Darnell using the equity method. The result is 1,000 + 2,000 + 3,000 – 3,000 +
1,000 + 7,000 + 15,000 = $26,000.
33. Compared to its current classification, if Foster had classified its investment in
Darnell as a joint venture and accounted for it in the preferred manner, the most
likely effect on Foster’s return on assets (ROA) is that ROA would be:
A. no change.
B. a decrease.
C. an increase.
Answer: B
“Intercorporate Investments,” Susan Perry Williams
2010 Modular Level II, Vol. 2, pp. 20-24, 32-33
Study Session 5-21-a, c
Describe the classification, measurement, and disclosure under the International
Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)
investments in associates, 3) joint ventures, 4) business combinations, and 5)
special purpose and variable interest entities (SPEs and VIEs).
Analyze the effects on financial ratios of the different methods used to account for
intercorporate investments.
The preferred method of accounting for a joint venture under IFRS is proportional
consolidation.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
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Proportionate consolidation will not change the net income, but will reduce the
return on assets because total assets will increase: under the equity method, the
cost, $500 million will be included in total assets; under the proportionate
consolidation method $800 million (40% of $2 billion) will be included in total
assets.
34. At year-end, the carrying value ($) of the fixed income portfolio will be closest to:
A. 168,000.
B. 177,000.
C. 178,000.
Answer: C
“Intercorporate Investments,” Susan Perry Williams
2010 Modular Level II, Vol. 2, pp. 11-12, 17-19
Study Session 5-21-a
Describe the classification, measurement, and disclosure under the International
Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)
investments in associates, 3) joint ventures, 4) business combinations, and 5)
special purpose and variable interest entities (SPEs and VIEs).
Unrecognized gains on both the held-for-trading (Eldon) and available-for-sale
(Fizz) securities will be added to the investments’ carrying cost. The result is that
$13,000 (3,000 + 10,000) will be added to the $165,000 cost (20,000 + 35,000 +
50,000 + 60,000), for a total of $178,000.
35. If Turner is correct in his opinion about Gilt’s loss, a positive effect on reported
net income will most likely occur if Foster classifies:
A. both Gilt and Harp as held-for-trading securities.
B. Gilt as a held-for-trading security, and Harp as an available-for-sale security.
C. Gilt as an available-for-sale security, and Harp as a held-for-trading security.
Answer: C
“Intercorporate Investments,” Susan Perry Williams
2010 Modular Level II, Vol. 2, pp. 11-12, 17-18
Study Session 5-21-a, c
Describe the classification, measurement, and disclosure under the International
Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)
investments in associates, 3) joint ventures, 4) business combinations, and 5)
special purpose and variable interest entities (SPEs and VIEs).
Analyze the effects on financial ratios of the different methods used to account for
intercorporate investments.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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Harp’s unrecognized gain of $4,000 will be included in income if it were
classified as a trading security, while Gilt’s unrecognized loss of ($5,000) will be
included in comprehensive income as part of equity if it were classified as
available-for-sale. Thus, net income increases by the $4,000 of Harp’s
unrecognized gain.
Balance
Sheet
Income
Statement
Other
Comprehensive
Income
Harp Trading security 64 +4
Available for sale 64 +4
Gilt Trading security 45 -5
Available for sale 45 -5
36. Chen’s statement is most accurate under:
A. IFRS only.
B. U.S. GAAP only.
C. both IFRS and U.S. GAAP.
Answer: A
“Intercorporate Investments,” Susan Perry Williams
2010 Modular Level II, Vol. 2, pp. 16-17
Study Session 5-21-b
Distinguish between IFRS and U.S. GAAP in the classification, measurement,
and disclosure of investments in financial assets, investments in associates, joint
ventures, business combinations, and special purpose and variable interest
entities.
Impairment of a held-to-maturity investment is recognized in net income under
both U.S. GAAP and IFRS, but only IFRS allows the subsequent reversal of an
impairment loss.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Rhonda Hamilton Case Scenario
Rhonda Hamilton, CFA, manages the Select Electric Fund. Hamilton is reviewing a
research report written by her colleague Brian Ender about the U.S. electric utility
industry. Ender’s report includes the results of a regression of the monthly return for an
electric utility equity index for the previous 203 months (the dependent variable) against
the monthly returns for the Standard &Poor’s 500 (S&P500) and the difference between
the monthly returns on long-term U.S. government bonds and one-month U.S. Treasury
bills (SPREAD) (the two independent variables).
Hamilton has reviewed Ender’s regression results. She agrees that S&P500 and
SPREAD are reasonable independent variables, but she is not convinced of the validity of
Ender’s model. Using Enders’ data, Hamilton tested for and confirmed the presence of
conditional heteroskedasticity. She then ran a regression similar to that run by Ender and
corrected for conditional heteroskedasticity using robust standard errors (i.e., Hansen’s
method). Hamilton’s regression model and relevant statistics are presented in Exhibit 1.
Exhibit 1
Hamilton’s Regression Model
Electric Utility Industry
Variable Coefficient t-statistic p-value
Constant 0.0069 0.013 0.99
S&P500 0.3625 6.190 <0.01
SPREAD 1.0264 4.280 <0.01
R2 = 0.40
Durbin-Watson Statistic = 0.84
Correlation between SPREAD and S&P500 = 0.30
Hamilton hypothesizes that the returns for the electric utility equity index have a
sensitivity coefficient to bond yields (i.e., SPREAD) equal to one. She is also interested
in the precision of the sensitivity of electric utility equity returns to S&P500. Hamilton
wants to use the regression results to address both of these issues. Selected values of the
t-distribution are shown in Exhibit 2.
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Exhibit 2
Selected Values of the t-Distribution
(degrees of freedom = df, one-tailed probabilities = p)
Df p = 0.05 p = 0.025
100 1.660 1.984
110 1.659 1.982
120 1.658 1.980
200 1.653 1.972
1.645 1.960
37. Given Hamilton’s finding regarding heteroskedasticity, the most appropriate
conclusion is that the variance of the error term is correlated with:
A. the dependent variable only.
B. the independent variables only.
C. both the dependent and independent variables.
Answer: B
“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,
CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,
CFA
2010 Modular Level II, Vol. 1, pp. 325-328
Study Session 3-12-g
Discuss the types of heteroskedasticity and the effects of heteroskedasticity and
serial correlation on statistical inference.
Hamilton’s test confirmed the presence of conditional heteroskedasticity, which
means that the variance of the error term is correlated with the values of the
independent variables.
38. If Hamilton assumes that the monthly values for both SPREAD and S&P500 are
1.0 percent, the predicted monthly return (%) for the electric utility equity index is
closest to:
A. 0.36.
B. 1.03.
C. 1.38.
Answer: C
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,
CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,
CFA
2010 Modular Level II, Vol. 1, pp. 315-317
Study Session 3-12-c
Calculate and interpret 1) a confidence interval for the population value of a
regression coefficient and 2) a predicted value for the dependent variable, given
an estimated regression model and assumed values for the independent variables.
Substituting the assumed values into the estimated model results in the following:
Monthly return = –0.0069% + 1.0264(1.0%) + 0.3625(1.0%) = 1.38%.
39. The portion (%) of the variation in utility index returns explained by the
regression model is closest to:
A. 16.
B. 40.
C. 60.
Answer: B
“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,
CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,
CFA
2010 Modular Level II, Vol. 1, pp. 319-320
Study Session 3-12-e
Calculate and interpret the F-statistic, and discuss how it is used in regression
analysis, define, distinguish between, and interpret the R2
and adjusted R2
in
multiple regression, and infer how well a regression model explains the dependent
variable by analyzing the output of the regression equation and an ANOVA table.
The explained variation is equal to the R2 = 40%.
40. Based on the results in Exhibit 1, the value of the test statistic relating to
Hamilton’s null hypothesis about the value of the sensitivity coefficient to
SPREAD is closest to:
A. 0.11.
B. 0.24.
C. 4.28.
Answer: A
“Correlation and Regression,” Richard A. DeFusco, CFA, Dennis W. McLeavey,
CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
2010 Modular Level II, Vol. 1, pp. 262-264
“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,
CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,
CFA
2010 Modular Level II, Vol. 1, pp. 304-308
Study Session 3-11-g, 3-12-b
Formulate a null and alternative hypothesis about a population value of a
regression coefficient, select the appropriate test statistic, and determine whether
the null hypothesis is rejected at a given level of significance
Formulate a null and an alternative hypothesis about the population value of a
regression coefficient, calculate the value of the test statistic, determine whether
to reject the null hypothesis at a given level of significance, using a one-tailed or
two-tailed test, and interpret the result of the test.
The null hypothesis is H0: bspread = 1. The calculated value of the t-statistic is t =
(1.0264 – 1.0)/standard error. The standard error is 1.0264/4.28 = 0.24. The
calculated value for t = (1.0264 – 1.0)/0.24 = 0.11.
41. Based on the results in Exhibit 1, if degrees of freedom = 200, the 95 percent
confidence interval for the sensitivity of electric utility equity index returns to
S&P500 is closest to:
A. 0.22 to 0.50.
B. 0.25 to 0.48.
C. 0.27 to 0.46.
Answer: B
“Correlation and Regression,” Richard A. DeFusco, CFA, Dennis W. McLeavey,
CFA, Jerald E. Pinto, CFA, and David E. Runkle, CFA
2010 Modular Level II, Vol. 1, pp. 262-264
“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,
CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,
CFA
2010 Modular Level II, Vol. 1, pp. 375-381, 389-390
Study Session 3-11-f, 3-12-c
Calculate and interpret the standard error of estimate, the coefficient of
determination, and a confidence interval for a regression coefficient.
Calculate and interpret 1) a confidence interval for the population value of a
regression coefficient and 2) a predicted value for the dependent variable, given
an estimated regression model and assumed values for the independent variables.
The standard error is found in Exhibit 1 as follows: t-statistic = 6.19 =
0.3625/standard error. The standard error = 0.0586. The two-tailed critical t-
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value (1.972) is taken from the table with p = 0.025. The confidence interval is
0.3625 (1.972 0.0586), or 0.25 to 0.48.
42. Because there are only two independent variables in her regression, Hamilton’s
most appropriate conclusion is that multicollinearity is least likely a problem,
based on the observation that the:
A. model R2 is relatively low.
B. correlation between S&P500 and SPREAD is low.
C. model F-value is high and the p-values for S&P500 and SPREAD are low.
Answer: B
“Multiple Regression and Issues in Regression Analysis,” Richard A. DeFusco,
CFA, Dennis W. McLeavey, CFA, Jerald E. Pinto, CFA, and David E. Runkle,
CFA
2010 Modular Level II, Vol. 1, pp. 336-339
Study Session 3-12-h
Describe multicollinearity and discuss its causes and effects in regression
analysis.
Multicollinearity arises from a high correlation among the independent variables.
In Hamilton’s regression model, the correlation between the SPREAD and the
S&P500 variables is only 0.30.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
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posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Katz Case Scenario
Oscar Katz is a representative with a German manufacturing firm, Stadt AG. Katz is
meeting with an investor, Jerry Stevens, to discuss projected financial information
through 2011. A portion of the projections are provided in Exhibit 1.
Exhibit 1:
Stadt AG
Forecasted Income Statements
(all monetary figures €1,000, except for price per unit)
2010 2011
Units sold 1,300 1,500
Price per unit 12.00 13.20
Sales 15,600 19,800
Variable costs 9,360 11,880
Fixed costs 4,000 4,400
Operating income 2,240 3,520
Interest 336 370
Pretax earnings 1,904 3,150
Tax 491 904
Net income 1,413 2,246
Dividends 645 326
Stevens asks why the tax is not a constant proportion of the pretax earnings. Katz
clarifies that his firm operates under a split rate system for taxation. Earnings to be
distributed as dividends are taxed at a 20% rate and earnings to be retained are taxed at a
30% rate.
Stevens’ next question is about the dividend policy. Katz states that equity financing is
determined in advance based on projected spending needs and a debt-to-equity ratio of
1.50. Consequently, earnings are retained to the level of the projected equity financing.
The remaining earnings are distributed as dividends.
Stevens asks Katz about the margin of error in the projection of sales price and the
number of units expected to be sold. Katz informs Stevens that the projected sales price
and expected units to be sold are based on historical trends from a stable industry making
the margin of error approximately 10% for both figures.
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Stevens is also concerned about Stadt AG being able to maintain the debt-to-equity ratio
of 1.50. Stevens believes, assuming no change in the cost of debt or changes in other
parameters, that increasing debt will not affect the operating breakeven point, but will
lower net income which will increase the net income breakeven point. Katz assures
Stevens that Stadt AG is committed to maintaining and possibly even lowering the
current debt level.
43. If the personal tax rate is 42%, the effective tax rate (%) on the corporate earnings
distributed as dividends by Stadt AG is closest to:
A. 46.4.
B. 53.6.
C. 62.0.
Answer: A
“Dividends and Dividend Policy,” George H. Troughton, CFA and Catherine E.
Clark, CFA
2010 Modular Level II, Vol.3, p. 164
Study Session 8-29-h
Calculate the effective tax rate on a dollar of corporate earnings distributed as a
dividend using the double-taxation, split rate, and tax imputation systems.
Effective Tax rate on dividends = 1 – (1– corporate rate on dividends) x (1 –
personal rate) = 53.6% = 1 – (1 – 0.20)*(1 – 0.42)
44. The dividend policy of Stadt AG is best described as a:
A. stable dividend policy.
B. residual dividend policy.
C. target payout ratio policy.
Answer: B
“Dividends and Dividend Policy,” George H. Troughton, CFA and Catherine E.
Clark, CFA
2010 Modular Level II, Vol.3, pp. 171-175
Study Session 8-29-j
Compare and contrast the following dividend policies: residual dividend, longer-
term residual dividend, dividend stability, and target payout ratio.
Because the firm pays out all of its earnings after considering its investment plans
and equity financing needs, the firm is following a residual dividend policy. See
example in Table 7 on page 172.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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45. The degree of operating leverage for 2010 is closest to:
A. 1.56.
B. 2.79.
C. 3.90.
Answer: B
“Capital Structure and Leverage” Raj Aggarwal, CFA, Cynthia Harrington, CFA,
Adam Kobor, CFA, and Pamela Peterson, CFA
2010 Modular Level II, Vol.3, p. 106
Study Session 8-28-b
Calculate and interpret the degree of operating leverage, the degree of financial
leverage, and the degree of total leverage.
Degree of operating leverage = (Sales – Var Costs)/(Sales – Var Costs – Fixed
Costs)
=2.79 = (15,600 – 9,360) ÷ (15,600 – 9,360 – 4,000)
46. The degree of financial leverage for 2011 is closest to:
A. 1.12.
B. 1.50.
C. 1.57.
Answer: A
“Capital Structure and Leverage” Raj Aggarwal, CFA, Cynthia Harrington, CFA,
Adam Kobor, CFA, and Pamela Peterson, CFA
2010 Modular Level II, Vol.3, p. 111
Study Session 8-28-b
Calculate and interpret the degree of operating leverage, the degree of financial
leverage, and the degree of total leverage.
Degree of financial leverage = EBIT/(EBIT – INT)
DFL = 1.12 = (19,800 – 11,880 – 4,400) ÷ (19,800 – 11,880 – 4,400 –
369.60)
47. The risk associated with the discussion about the margin of error in projections is
best described as:
A. sales risk.
B. business risk.
C. operating risk.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
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Answer: A
“Capital Structure and Leverage” Raj Aggarwal, CFA, Cynthia Harrington, CFA,
Adam Kobor, CFA, and Pamela Peterson, CFA
2010 Modular Level II, Vol.3, pp. 103-104
Study Session 8-28-a
Define and explain leverage, business risk, sales risk, operating risk, and financial
risk and classify a risk given a description.
Sales risk is the uncertainty with respect to the price and quantity of goods and
services.
48. Stevens’ discussion of the effects of increasing debt is most likely:
A. correct.
B. incorrect, because the operating breakeven point will change.
C. incorrect, because the net income breakeven point will not increase.
Answer: A
“Capital Structure and Leverage” Raj Aggarwal, CFA, Cynthia Harrington, CFA,
Adam Kobor, CFA, and Pamela Peterson, CFA
2010 Modular Level II, Vol.3, p. 116
Study Session 8-28-a, 8-28-c, 8-28-d
Define and explain leverage, business risk, sales risk, operating risk, and financial
risk and classify a risk given a description.
Calculate the breakeven quantity of sales and determine the company’s net
income at various sales levels.
Describe the effect of financial leverage on a company’s net income and return on
equity.
The net income breakeven point (F + C) ÷ (P – V) will increase as the nominal
cost of debt, C in the formula, increases. The operating breakeven point is
unaffected F ÷ (P – V) and net income will decrease as debt increases.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Lisa McDonald Case Scenario
Lisa McDonald and Basil Moore, her research assistant, are valuing the common stock of Coppa
Enterprises using a residual income valuation approach. To support the valuation, Moore
assembles the basic information shown in Exhibit 1.
Exhibit 1
Basic Information for Valuation of Coppa Enterprises
• Current book value per share is $14.00.
• Required rate of return for common stock is 10%.
• Forecasted data for the next four years is: Yr 1 Yr 2 Yr3 Yr 4
Net income per share: $4.00 $4.00 $3.50 $3.60
Residual income per share: $2.60 $2.20 $1.50 $1.50
• Although the firm will be profitable after year 4, residual income is expected to be
zero.
After completing and discussing the valuation, McDonald decides to modify the approach. To
facilitate this second valuation, Moore provides the alternative information shown in Exhibit 2.
Exhibit 2
Alternative Information for Valuation of Coppa Enterprises
• Current book value per share is $14.00.
• Required rate of return for common stock is 10%.
• Forecasted return on equity (ROE) for the next four years is:
Yr 1 Yr 2 Yr3 Yr 4
Forecasted ROE: 40% 30% 25% 20%
• Annual dividends per share will be $1.00 each year for the next four years.
• Although the firm will be profitable after year 4, residual income is expected to be
zero.
After completing the second valuation, McDonald and Moore discuss other factors that
may affect the valuation of Coppa Enterprises. Moore expresses concern about valuing
the firm if residual income is positive beyond the four-year time horizon specified in
Exhibits 1 and 2.
Specifically, Moore makes the following two observations about residual income models:
1) One advantage to the single-stage residual income model is that it assumes the
excess ROE above the cost of equity will persist indefinitely.
2) In residual income models the terminal value may not be a large component of
total value because ROE may fade over time toward the cost of equity.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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McDonald has other concerns as reflected in the following two statements.
1) The residual income approach can provide different valuations because of two
different methods for computing capital charge. Particularly, the equity charge
method gives a higher residual income than the total capital charge method,
thereby resulting in a higher firm valuation.
2) The economic value added (EVA) is a superior approach to equity valuation than
the residual income approach because it uses just one method for computing
capital charge as the cost of capital times the total capital.
Their discussion concludes with a statement by Moore:
“The residual income valuation approach requires adjustments for off-balance sheet items
and violations to the clean surplus relationship. Operating leases require adjustments to
both the amount of equity and the future earnings of Coppa Enterprises. Furthermore, the
company's "available for sale" investments call for making adjustments to the book value
of equity but not the income statement."
49. Using Exhibit 1 and the residual income valuation model, the value per share ($)
of Coppa Enterprises is closest to:
A. 20.33.
B. 21.59.
C. 26.03.
Answer: A
"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas
Robinson, CFA, and John Stowe, CFA
2010 Modular Level II, Vol. 4, pp. 580-583
Study Session 12-43-c, f, j
Calculate future values of residual income given current book value, earnings
growth estimates, and an assumed dividend payout ratio.
Calculate and interpret the intrinsic value of a common stock using a single-stage
(constant growth) residual income model.
Calculate and interpret the intrinsic value of a common stock using a multistage
residual income model, given the required rate of return, forecasted earnings per
share over a finite horizon, and forecasted continuing residual earnings.
Because there is no residual income after year 4, the residual income valuation
model is: 4
1
00)1(t
t
t
r
RIBV
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4320)10.1(
50.1
)10.1(
50.1
)10.1(
20.2
)10.1(
60.200.14V
0V = 14.00 + 2.3636 + 1.8182 + 1.1270 + 1.0245 = 14.00 + 6.333 = $20.33
50. Using Exhibit 2, the residual income ($) for Coppa Enterprises in year 1 is closest
to:
A. 4.20.
B. 4.60.
C. 5.20.
Answer: A
"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas
Robinson, CFA, and John Stowe, CFA
2010 Modular Level II, Vol. 4, pp. 580-583; 596
Study Session 12-43-c
Calculate future values of residual income given current book value, earnings
growth estimates, and an assumed dividend payout ratio.
The formula for residual income is RIt = Et – rBt-1 = (ROEt – r) × Bt-1,
so RI1 = (0.40 – 0.10) × 14.00 = $4.20.
51. Using Exhibit 2 and the residual income valuation model, the value per share ($)
of Coppa Enterprises common stock is closest to:
A. 22.25.
B. 25.42.
C. 28.71.
Answer: B
"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas
Robinson, CFA, and John Stowe, CFA
2010 Modular Level II, Vol. 4, pp. 580-587
Study Session 12-43-c, f, j
Calculate future values of residual income given current book value, earnings
growth estimates, and an assumed dividend payout ratio.
Calculate and interpret the intrinsic value of a common stock using a single-stage
(constant growth) residual income model.
Calculate and interpret the intrinsic value of a common stock using a multistage
residual income model, given the required rate of return, forecasted earnings per
share over a finite horizon, and forecasted continuing residual earnings.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
In general, RIt = Et – rBt-1 = (ROEt – r) × Bt-1. This calculation is shown in the
table below. Besides calculating the current rate of abnormal earnings, (ROEt –
r), one must calculate the beginning of year book values, Bt-1. As the table shows,
Bt = Bt-1 + Et – Dt
Year t 1 2 3 4
(See Exhibit 1, p. 581)
Bt-1 14.00 18.60 23.18 27.98
Et = ROEt × Bt-1 5.60 5.58 5.80 5.60
Dt 1.00 1.00 1.00 1.00
Bt = Bt-1 + Et – Dt 18.60 23.18 27.98 32.57
(See Exhibit 3, p. 585)
ROEt 40% 30% 25% 20%
r 10% 10% 10% 10%
(ROEt – r) 30% 20% 15% 10%
RIt = (ROEt – r) × Bt-1 4.200 3.720 3.477 2.798
4
1
00)1(t
t
t
r
RIBV
4320)10.1(
798.2
)10.1(
477.3
)10.1(
72.3
)10.1(
20.400.14V
0V = 14.00 + 3.818 + 3.074 + 2.612 + 1.911 = 14.00 + 11.416 = $25.416 = $25.42
52. In regard to Moore’s two observations about residual income models, it is most
accurate to state that he is:
A. correct with respect to both observations.
B. incorrect with respect to both observations.
C. correct with respect to observation (2) but incorrect with respect to
observation (1).
Answer: C
"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas
Robinson, CFA, and John Stowe, CFA
2010 Modular Level II, Vol. 4, pp. 590-591
Study Session 12-43-c, f
Calculate future values of residual income given current book value, earnings
growth estimates, and an assumed dividend payout ratio.
Calculate and interpret the intrinsic value of a common stock using a single-stage
(constant-growth) residual income model.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Moore is correct in stating that in residual income models the terminal value may
not be a large component of total value because ROE may fade over time toward
the cost of equity. In regard to his first observation, it is a drawback of residual
income models, not an advantage.
53. With respect to McDonald's two statements regarding residual income and
economic value added (EVA) approaches, she is most accurate with respect to:
A. statement 1 only.
B. statement 2 only.
C. neither statement.
Answer: C
"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas
Robinson, CFA, and John Stowe, CFA
2010 Modular Level II, Vol. 4, pp. 575-579
Study Session 12-43-a
Calculate and interpret residual income and related measures (e.g., economic
value added and market value added).
It is correct that the residual income approach provides for two methods for
computing capital charge – equity charge and total capital charge. However, as
demonstrated in Example 1 (pp. 575-576) and the related discussion, both
approaches give the same residual income. Therefore statement is not correct.
It is also correct that the economic value added uses only one method for capital
charge – cost of capital times total capital. But, it is incorrect to state that it is
superior to the residual income approach for equity valuation because EVA’s
focus is not equity valuation. It is one of a variety of commercial models which
are marketed primarily for measuring internal corporate performance and
determining executive compensation. Therefore, statement 2 is also incorrect.
54. With respect to Moore’s concluding statements, which of the following is most
accurate? Moore’s statement is:
A. correct with respect to operating leases but not clean surplus relationship.
B. correct with respect to the clean surplus relationship but not operating leases.
C. incorrect with respect to both operating leases and the clean surplus
relationship.
Answer: C
"Residual Income Valuation," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas
Robinson, CFA, and John Stowe, CFA
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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2010 Modular Level II, Vol. 4, pp. 600-601, 608-609
Study Session 12-43-d, o
Discuss the fundamental determinants of residual income.
Discuss accounting issues in applying residual income models (e.g., clean surplus
violations, variations from fair value, intangible asset effects on book value, and
nonrecurring items) and the appropriate analyst response to each issue.
Operating leases do not affect the amount of equity (because operating leases
involve off-balance sheet assets that offset the off-balance sheet liabilities) but
can affect an assessment of future earnings for the residual income component of
the value. Therefore, Moore's statement that both the amount of equity and the
future earnings of Coppa Enterprises need adjustments is incorrect. Changes in
market values of investments considered to be "available for sale" would be
reflected directly in stockholders' equity requiring no further adjustments. Those
changes are not reflected on the income statement and therefore require
adjustments. Thus, both the statements by Moore are incorrect.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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Castle Enterprises Case Scenario
The Castle Enterprises is a U.S. based pension plan (fund) and Vinesh Koh is the
chairman of its board of trustees. The trustees are having a meeting with Ashar Gupta, the
plan's financial advisor.
Gupta begins with a discussion of the plan’s current and potential investments and he
states the following:
* The plan currently holds a number of foreign stocks denominated in euros. From
these investments, the projected dividend and capital gains income over the next
year is €1.2 million and €2 million, respectively. In addition, for these
investments, the foreign countries’ tax authorities apply a withholding tax of
15% and follow the standard approach with respect to withholdings.
* To achieve best execution in its international investing, the fund emphasizes two
aspects related to execution costs:
(i) maintaining anonymity and
(ii) minimizing commissions & fees.
* The plan may want to consider exchange traded funds (ETFs) as an investment
alternative. He lists the following three characteristics as advantages of ETFs:
Tax efficiency
Excellent liquidity at a low cost
Redemption in cash at a known Net Asset Value (NAV)
Koh intervenes and asks Gupta why an ETF based on the J100 Index, which includes the
100 largest Japanese stocks, is trading below its official Net Asset Value (NAV)?
Gupta states that the Japanese ETF's discount is caused by the following three factors:
The recent U.S. Dollar strengthening relative to the Japanese Yen
The underperformance of the stocks in the J100 index, relative to the broader
stock index of the largest 500 companies (J500 Index)
The non-overlapping market hours between New York and Tokyo
Finally, Gupta suggests two international stocks, Kong Holdings and Akunuri Enterprises
for direct investment. Gupta recommends investment in Akunuri Enterprises on the basis
of its ex-ante alpha computed from the data in Exhibit 1.
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currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
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Exhibit 1
Estimated Information for Kong Holdings and Akunuri Enterprises
Kong Akunuri
Estimated rate of return 15.0% 12.0%
Beta 1.2 0.8
Total market return 13.0%
Risk free return 3.0%
Koh, however, argues that a portfolio approach should be taken in adding international
stocks to the fund instead of selecting individual stocks. He asks Gupta to use the
Treynor-Black (T-B) model and construct an optimal portfolio of international stocks.
Further, he makes the following two statements in support of the T-B model.
1) The model constructs the optimal risky portfolio as a combination of the passive
and active portfolios.
2) Each stock's weight in the active portfolio is determined on the basis of its alpha,
beta, and σ2 (e).
Gupta agrees to consider Koh's suggestion and the meeting ends.
55. Based on the projected income from its euro denominated investments, the total
amount of withholding taxes (€ millions) the fund will reclaim is closest to:
A. 0.18.
B. 0.30.
C. 0.48.
Answer: A
"Equity: Markets and Instruments," by Bruno Solnik and Dennis McLeavey, CFA
2010 Modular Level II, Vol. 4, pp. 65-66
Study Session 10-34-c
Calculate the impact of different national taxes on the return of an international
investment.
Withholding equals 0.15 x 1.2 million euros = 0.18 million euros; the standard
approach is that withholding is applied to the dividend income only.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
56. Which of the following trading techniques is most consistent with Gupta’s claim
regarding best execution in the firm's international investing?
A. Agency trade
B. Principal trade
C. External crossing
Answer: C
"Equity: Markets and Instruments," by Bruno Solnik and Dennis McLeavey, CFA
2010 Modular Level II, Vol. 4, pp. 74-77
Study Session 10-34-d
Discuss the various components of execution costs (i.e., commissions and fees,
market impact, and opportunity cost) and approaches to reducing these costs.
External crossing keeps execution costs very low and anonymity is assured.
57. Gupta’s list of the advantages of ETFs is least accurate with respect to:
A. taxes.
B. liquidity.
C. redemption.
Answer: C
"Equity: Markets and Instruments," by Bruno Solnik and Dennis McLeavey, CFA
2010 Modular Level II, Vol. 4, pp. 85-87
Study Session 10-34-h
Discuss the advantages of exchange traded funds (ETFs) and explain the pricing of
international ETFs in relation to their net asset value (NAV).
An ETF is based on the NAV computed one or a couple of days after the shareholder
commits to redemption. So, the redemption value is unknown when the investor decides
to redeem. For this reason, as well as an assessment of a large cash redemption charge,
redemption by individual ETF holders is discouraged.
58. Which of Gupta’s proposed factors best explains the discount on the J100-based
ETF?
A. Exchange rate movements
B. Market hours in different regions
C. Performance of the stocks in J100 Index
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying,
posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose.
Answer: B
"Equity: Markets and Instruments," by Bruno Solnik and Dennis McLeavey, CFA
2010 Modular Level II, Vol. 4, pp. 85-87
Study Session 10-34-h
Discuss the advantages of exchange traded funds (ETFs) and explain the pricing
of international ETFs in relation to their net asset value (NAV).
Non-overlapping market hours in different regions (here New York and Tokyo)
can lead to a timing difference between the pricing of the ETF and the pricing of
the underlying instruments. The ETF price in New York will indeed be affected
by expectations about future stock prices in Tokyo which could differ
significantly from the official NAV.
59. Is Gupta’s recommendation in favor of Akunuri stock most likely correct?
A. No, because Kong's ex-ante alpha > Akunuri's by 1%
B. No, because Kong's ex-ante alpha > Akunuri's by 3%
C. Yes, because Akunuri's ex-ante alpha > Kong's by 1%
Answer: C
"Return Concepts," by Jerald Pinto, CFA, Elaine Henry, CFA, Thomas Robinson,
CFA, and John Stowe, CFA
2010 Modular Level II, Vol. 4, pp. 103-105
"Portfolio Concepts," by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA,
Jerald E. Pinto, CFA, and David E. Runkle, CFA
2010 Modular Level II, Vol. 6, pp. 404-405
Study Session 10-35-a; 18-64-e
Distinguish among the following return concepts: holding period return, realized return
and expected return, required return, discount rate, the return from convergence of price
to intrinsic value (given that price does not equal value), and internal rate of return.
Explain the capital asset pricing model (CAPM), including its underlying assumptions
and the resulting conclusions.
Using the data in Exhibit 1:
Kong Ex ante alpha: CAPM suggests E(Ri) = RF + β[E(RM) - RF] = 3+1.2(13-3) =
15,
thus ex-ante alpha i.e. the expected return minus the CAPM expected return is 15-
15 = 0%.
Akunuri Ex ante alpha: CAPM suggests = E(Ri) = RF + β[E(RM) - RF] = 3+0.8(13-
3) = 11,
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
currently-registered CFA candidates. Candidates may view and print the exam for personal exam
preparation only. The following activities are strictly prohibited and may result in disciplinary and/or legal
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thus ex-ante alpha i.e. the expected return minus the CAPM expected return is 12-
11 = 1%.
Therefore, Akunuri is preferred to Kong.
60. Which of the two statements by Koh in support of T-B is most accurate?
A. Statement 1 only
B. Statement 2 only
C. Both statements 1 and 2 are accurate.
Answer: C
"The Theory of Active Portfolio Management Investments," by Zvi Bodie, Alex
Kane, and Alan J. Marcus
2010 Modular Level II, Vol. 6, pp. 530-531
Study Session 18-67-b
Discuss the steps and the approach of the Treynor–Black model for security
selection.
The Treynor-Black (T-B) model uses two portfolios – the passive index portfolio
and the active portfolio to determine the optimal risky portfolio. Each stock's
weight in the active portfolio is determined on the basis of its alpha, beta, and σ2
(e). Thus, both statements by Koh are correct.