CFA  Level  II  Mock  Exam  6  –  Questions  (PM)

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CFA Level II Mock Exam 6
June, 2016

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 CFA  Level  II  Mock  Exam  6  –  Questions  (PM)  

FinQuiz.com – 6th Mock Exam 2016 (PM Session)

Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Corporate Finance 18
13-24 Financial Reporting and Analysis 36
25-30 Equity Investments 18
31-42 Fixed Income 36
43-48 Derivatives 18
49-54 Alternative Investments 18
55-60 Portfolio Management 18
Total 180

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Questions 1 through 6 relate to Ethical and Professional Standards

Lucid Advisory (LA) Case Scenario

Lucid Advisory (LA) is an investment firm providing investment banking and brokerage
services. In the current year, LA established an in-house research department. In addition, LA
recently adopted the CFA Institute Research Objectivity Standards (ROS) and is now developing
policies and procedures to better comply with the standards.

In a report to LA’s existing clients and prospects, senior research analyst, Carl Nuvez, explains
why the CFA Institute-ROS were adopted and lists down three objectives the firm intends to
achieve by adhering to the standards:

Objective 1: To design investment processes in a manner such that client interests are placed
above the interests of the firm and its employees.

Objective 2: Require covered employees to undertake trading activities which align their
interests with those of their clients.

Objective 3: To provide general disclosures of actual and potential conflicts of interests which
are easy to follow and understand.

Three months ago, LA’s investment banking department participated in the market making of
Edge Corp’s stock earning a fee of $100,000. The activity was headed by Janet Morris, LA’s
senior investment banker and the firm’s compliance officer had taken stringent measures to
avoid all cross department conflicts by barring research analyst’s from participating.

Three months later, Nurez assigns Samantha Dale to cover the stock of Edge Corp. Given LA’s
past relationship with Edge Corp, Nurez restricts Dale from participating in conference calls
where Edge Corp management is present as well as restricts communication with company
personnel to emails. He believes such an action will prevent potential conflicts of interests.

After a detailed evaluation of Edge Corp, Dale rates the stock as a ‘hold’ based on an uncertainty
of the company’s future direction. She issues the report with the recommendation on June 1.

On June 2, Edge Corp’s management publically announces its intention to take the company
global starting with Paris, France where a building has been acquired for production purposes.
On the same day Dale revises the recommendation to ‘buy’ and issues a detailed
recommendation to clients and prospects. On June 4th, she seeks approval from LA’s compliance
department and purchases Edge Corp shares for her investment portfolio.

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After leaving Dale to cover Edge Corp, Nurez drafts policies which aim to address the
responsibilities required by LA’s research analysts and other covered employees with respect to
the CFA Institute-ROS. He mandates employees to attest annually, either in writing or orally,
their adherence to the Policy. In addition the drafted policies require employees to update any
issued recommendations every thirty calendar days.

1.   Which of the following explanations will Nurez most likely provide for implementing the
CFA-Institute ROS? To:

A.   fulfill a legal requirement.

B.   provide an appropriate working environment for their investment professionals.
C.   implement standards which are more superior in quality relative to the CFA
Institute Code and Standards.

2.   Which of the following most likely represents an objective of the CFA Institute-ROS?

A.   Objective 1
B.   Objective 2
C.   Objective 3

3.   In restricting Dale’s ability to communicate with Edge Corp’s management, has Nurez
violated any CFA Institute-ROS?

A.   No.
B.   Yes, to the extent of participation in conference calls only.
C.   Yes, to the extent of participation in conference calls and mode of
communication.

4.   Is Dale required to disclose LA’s market making of the Edge Corp stock in her research
report?

A.   Yes.
B.   No, because she is not involved.
C.   No, because she issues the report three months later.

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5.   By purchasing Edge Corp’s stock for her investment portfolio, has Dale violated the CFA
Institute-ROS?

A.   No.
B.   Yes, she is front running client trades.
C.   Yes, she has engaged in a personal trade.

6.   Are Nurez’s drafted policies with respect to the attestation of adherence and issuing
updates concerning research reports consistent with the requirements and
recommendations of the CFA Institute-ROS?

Attestation of Issuing
Adherence? Updates?
A.   No No
B.   Yes No
C.   No Yes

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Questions 7 through 12 relate to Corporate Finance

Legume Inc. Case Scenario

Legume Inc. is a grower and wholesaler of grains, lentils and rice. Ralph Gonzales, the CEO,
along with Marion Boyce and Frank Icke, two senior executives, are meeting to discuss
corporate policy reforms. The individuals present three recommendations during the meeting.

Recommendation 1: At present 30% of our employees are providing external field assistance to
self-employed farmers several of whom are our direct competitors. Legume must discourage this
practice by obliging employees to sign a noncompete agreement.

Recommendation 2: Legume’s capital budgeting department has a tendency to pitch project

ideas with heavy budgets and average expected returns on capital. To minimize the unnecessary
wastage of internally generated funds, project managers should be permitted to solely utilize
financial leverage as a source of project funding. By engaging in loan agreements with rigid
covenants, managers will have less freedom to unwisely spend cash.

Recommendation 3: The proposed enactment of the ‘Safe Food Act’ will bring drastic changes to
conventional farming practices. Under the act farmers will be required to monitor their usage of
pesticides and eventually convert to organic farming techniques. Legume is expected to
experience a significant increase in operating costs and reduced profitability for the foreseeable
future as farmers adapt to the act. A policy is required to address the risks faced by the company.

Also on the board agenda is the proposed acquisition of Miller Grains, a grower and wholesaler
of grains. The board’s main incentives behind the transaction are to increase market presence and
achieve economies of scale. Icke is concerned that the transaction may pose an anti-trust
challenge and collects market share data on all competitors in the grains industry for the purpose
of analysis (Exhibit 1).

The board concludes their meeting by analyzing Uta, a potential target for a friendly merger with
Legume. The board is debating on which payment method should be recommended to the
management of Uta. Details concerning the potential offers and Legume’s and Uta’s pre-merger
details have been collected by the board (Exhibits 2 and 3).

Based on the data presented in Exhibits 2 and 3, the directors conclude:

“The price paid for the target’s shares is lower in Offer 2 and so this method should be
recommended to Uta’s management.”

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The board employs the data in the exhibits to calculate the gains Legume’s shareholders should
expect from the proposed merger.

Exhibit 1:
Grains Wholesale & Grower Industry Market Share Data

Legume Miller Grains Uta AS Limited Ilium Corp

Market Share (%) 40 10 10 15 25

Exhibit 2:
Proposed Merger Offer Transaction Details
Offer 1 Offer 2
Mode of payment Cash Stock
Exchange ratio N/A 0.5:1
Cost of acquisition (millions) $960 $840
Present value of expected synergies (millions) $180 $180

Exhibit 3:
Pre-merger Financial Data
Legume Uta
Pre-merger stock price $18.00 $12.00
Number of shares outstanding (millions) 90 60

7.   The implementation of Recommendation 1 will lead to an increase in:

A.   residual costs.
B.   bonding costs.
C.   monitoring costs.

8.   Recommendation 2 most likely reflects the:

A.   pecking order theory.

B.   free cash flow hypothesis.
C.   Modigliani and Miller’s Proposition II.

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9.   The policy being proposed in Recommendation 3 will aim to reduce:

A.   legal risk.
B.   strategic policy risk.
C.   legislative and regulatory risk.

10.  Based on the data presented in Exhibit 1, the proposed acquisition of Grains Miller will
most likely:

A.   not pose an anti-trust challenge.

B.   pose a definite anti-trust challenge as the HHI increases by more than 50 points.
C.   pose a possible anti-trust challenge as the HHI increases by more than 100 points.

11.  Are the directors correct with respect to their conclusion derived regarding the
recommended mode of payment for the proposed merger?

A.   Yes.
B.   No, offer 1 should be the recommended method.
C.   No, offer 2 should be recommended as it generates higher gains for Legume’s
shareholders.

12.  Using the data in Exhibits 1 and 2, the stock offer will generate a gain for Legume’s
shareholders equal to:

A.   $60 million.
B.   $120 million.
C.   $1,800 million.

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Questions 13 through 18 relate Financial Reporting and Analysis

Widget Inc. Case Scenario

Widget Inc. is a manufacturer of clocks and other timing apparatus operating in the U.S. The
manufacturer operates with two entities in its structure; SC Publishers (SCP), a publishing firm
situated in France and Widget-Mount, a special purpose vehicle. Widget Inc. has a 25% equity
stake in SCP giving it significant influence over the investee’s business activities.

Louis begins her analysis by evaluating SCP’s financial statements. She tasks her subordinate
with collecting and translating selective financial statement information concerning the investee
for the fiscal years 2013 and 2014 (Exhibit 1).

Louis is concerned that the Widget Inc.’s net profit margin growth is not organic and that the
main driver behind the growth is SCP’s operating results. To determine if her suspicions hold
true, she calculates Widget’s net profit margin growth excluding the income from the investee.

Louis then proceeds to conduct DuPont analysis to evaluate the sources behind the 31.14%
growth in return-on-equity (ROE). She has determined that there is one factor which has failed to
contribute to this growth. For the analysis, she will be evaluating Widget Inc. as a whole.

Louis would like to isolate Widget Inc.’s market capitalization from that of the total company.
She recognizes that this is important in understanding the factors which influence share price as
the factors influencing stock valuation differ considerably from one stock exchange to the next.
She collects the necessary data to perform the calculations (Exhibit 2).

On January 15, 2014 Widget Inc. had sold $30 million worth of receivables to Widget-Mount.
Widget Inc had inappropriately treated the transaction as a sale on its balance when, in reality, it
was a securitization transaction.

Louis concludes her analysis by analyzing the reasons for the declining trend in SCP’s operating
cash before interest and taxes to operating income ratio. She determines the reason for this trend
is that the accruals component dominates earnings and is rising in significance each year. When
discussing the issue with Tim Gabbins, her colleague, he states, “The accruals trend observed
will eventually revert and the composition of SCP’s earnings gives us an idea of the speed with
which this will occur.”

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Exhibit 1
Selective Financial Statement Information for Widget Inc. (2013-2014) in $ Millions
2014 2013
Income Statement Data
Revenue 100 85
EBIT 90 80
EBT 65 50
Profit from continuing operations 54 38
Share of SCP’s income 15 12

Balance Sheet Data

Total assets 870 840
Shareholder’s equity 400 370

Exhibit 2
Market Capitalization Information – Widget Inc. And SCP on December 31, 2014
Share Price (SCP) €12.50
Exchange rate (EURO:US$) 1.13
Shares held by Widget in SCP 50,000
Widget Inc’s total market capitalization $1,000,000

13.  The translated financial statements, which the subordinate provides to Louis, are an
output to which stage of the financial analysis framework?

A.   Input data collection

B.   Processing the input data
C.   Analysis and interpretation of input data

14. By omitting SCP’s performance, Widget Inc.’s net profit margin growth will:

A.   increase.
B.   decrease.
C.   remain the same.

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15.   The factor which is not contributing to the growth in total ROE is most likely:

A.   leverage.
B.   efficiency.
C.   profitability.

16.  Using the data in Exhibit 2, the pro rata market value that investors are placing solely on
Widget Inc.’s operations is equal to:

A.   29.4%.
B.   37.5%.
C.   70.6%.

17.  If Louis corrects Widget Inc.’s financial statements to reflect the securitization
transaction, the absolute change in the company’s total liabilities-to-equity will equal to:

A.   3.45%.
B.   6.38%.
C.   93.6%.

18.  The composition of SCP’s earnings, which Gabbins is referring to, will:

A.   increase the speed of mean reversion.

B.   decrease the speed of mean reversion.
C.   have no impact on the speed of mean reversion.

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Questions 19 through 24 relate to Financial Reporting and Analysis

Delta-Mono Case Scenario

Delta-Mono (DM) manufactures artillery equipment for the U.S. armed forces. The company
prepares and presents its financial statements in accordance with the U.S. GAAP.

DM maintains a post employment health care benefit plan. The plan was created at the beginning
of the year 2013. DM’s investment officer, Daniel Pronzo, would like to compare the
reasonableness of the assumptions used to account for the plan in the company’s financial
statements. Pronzo plans to accomplish this by comparing DM’s assumptions with those of

Skylark, a competitor, and collects details relevant for the analysis (Exhibit 1).

Using the data collected Pronzo builds his analysis by estimating the impact of a 1% increase in
the initial inflation rate on financial leverage and return-on-equity. Details concerning the impact
on DM’s post-employment benefits expense and obligation as well as relevant financial
statement information have been summarized (Exhibit 2).

Pronzo prepares a report to summarize the results of his findings. He concludes his report by
drawing a comparison between the characteristics of defined benefit plans (DBPs) and other
employment post benefit plans (OPBs). Excerpts from the report are as follows:

Pre-Funding Requirements:

Sponsor companies are not required to pre-fund OPBs as these plans are insured by the
U.S. government. In contrast, sponsors are legally obliged to pre-fund a DBP.

Future Obligations versus Future Benefits:

DBP sponsors need to estimate the amount of future obligations. This contrasts with
OBPs where the amount of future obligations is pre-specified.

The amount of future benefits are defined for both types of post-employment benefit
plans thus removing the need for estimation.

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On January 1, 2014 DM sold an artillery machinery unit with a fair value of $2.00 million on a
finance lease. The lease was classified as a sales-type lease. On December 31, 2014, Jacqueline
Lee, DM’s senior financial analyst, obtains relevant financial details concerning the lease from
the company’s disclosures. Po believes the discount rate has been overestimated by 200 basis
points.

•   Lease receivable – 1/1/2014 = $2.60 million

•   Annual lease payment (due January 1 of each year) = $0.65 million
•   Discount rate = 12%
•   Lease term = 5 years

Exhibit 1
Health Care Benefit Plan Assumptions & Account Balances
DM Skylark
Initial inflation rate (2013) 8% 5%
Long-term inflation rate 6% 5%
Year long-term inflation rate is attained 2018 2020
Accumulated benefit obligation (2012) $980,000 $1,800,000
Periodic expense for benefits (2012) $145,000 $621,000
Total assets $7,200,000 $10,450,000
Total equity $4,100,000 $7,246,000

Exhibit 2
Impact of 1% Increase in Initial Inflation Rate
DM Skylark
Change in obligations + 122,000 + 112,500
Change in expense + 52,480 + 37,980

19.  If DM revises the year in which the long-term inflation rate is realized to 2017, which of
the following measures will increase?

A.   Liabilities
B.   Net profit margin
C.   Asset turnover ratio

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20.  Using the data in Exhibits 1 and 2, a 1% increase in the inflation rate will cause the
absolute percentage change in the financial leverage ratio (total assets/total equity) of:

A.   DM to be higher.
B.   Skylark to be higher.
C.   both companies to be the same.

21.  Considering the ‘Pre-funding Requirements’ excerpt from Ponzo’s report, he is most
accurate regarding the comments made on:

A.   OPBs.
B.   DBPs.
C.   both OPBs and DBPs.

22.  Considering the ‘Future Obligations versus Future Benefits’ except, Ponzo is least
accurate with respect to the comments made regarding:

A.   DBPs; the amount of future obligations is pre-defined.

B.   OPBs; the amount of future obligations is based on a plan formula.
C.   OPBs; the amount of future benefits depends on plan specifications.

23.Based on Lee’s concern regarding the discount rate, on December 31, 2014, DM’s total
assets balance will be overstated by:

A.   $0.11 million.
B.   $0.38 million.
C.   $0.54 million.

24. The ‘sales-type’ lease classification used by DM will imply that, relative to the lease
receivables balance on January 1, 2014, the fair value of the unit is most likely:

A.   equal.
B.   lower.
C.   higher.

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Questions 25 through 30 relate to Equity Investments

Blitz Technologies Case Scenario

Blitz Technologies is a bioengineering firm situated in Nemora, a developing country, with the
US$ as the reporting currency. A small province in the country has reported the emergence and
spread of a viral disease which is unheard of in the medical field. Although the symptoms of the
disease have been determined, the cities that will be affected and the external conditions and
circumstances which will exacerbate the present circumstances are highly uncertain and not
within the control of government authorities.

Blitz’s CEO announces that the company will undertake research which will be aimed at finding
a cure, developing drugs for treatment and diagnostic equipment. The CEO tasks Carl Hendricks,
head of research and planning, to prepare a report which will detail the strategy and plan of
action necessary to deal with the state of affairs. Hendricks begins the report by stating, “A
shaping strategy will be employed whereby fellow researchers from across the globe will be
engaged. Given that these individuals have successfully developed treatments for rare viral
diseases in the past, I am highly confident that as a team we will be able to achieve similar
results.”

Nemora’s bioengineering industry is one of the country’s most heavily regulated industries. A
growing population, changes in the external environment and demographics require industry
participants to remain actively involved in devising strategies for success. The most recent
government regulation has mandated participants to ensure any research report generated is
subject to a rigorous review procedure prior to public dissemination. Lyole Associates, a medical
research firm has identified the opportunity to be the first in the industry to offer review services.
Lyole will additionally provide its clients a unique access to highly qualified pharmacists and
medical professionals.

Sylvia Dwight is an equity analyst specializing in bioengineering firms. Dwight is undertaking

an investigation for the mere purpose of forecasting the impact of the new strategy on Blitz’s
sales revenue. Blitz has a 38% share in an industry with a forecasted increase in annual revenue
of 5%. Dwight anticipates Blitz’s sales revenue to grow 300 basis points higher than the industry
forecast as the company will be expected to employ superior technology in its research and
development processes which in turn is expected to enhance the efficacy of developed drugs.
In addition to the sales projections, Dwight is developing three alternative forecasts as outlined
below:

Forecast 1: Blitz will continue to enjoy the economies of scale it has experienced in the past.

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Forecast 2: $3 million has been classified as research costs in the current year’s income
statement. Tax authorities do not recognize these expenses as part of taxable income.
The company is forecasted to recognize a further $7 million as research costs over
the coming two years. The tax rate is expected to remain constant at 30%.

Forecast 3: Profitability is forecasted to remain relatively stable as highlighted in the exhibit.

However, Blitz is expected to face an increase in:

I.   working capital as manufactured drugs are not expected to be immediately sold until the
company secures the confidence of medical professionals; this will lead to a buildup in
finished goods inventory.
II.   financial leverage as any new technologies acquired will be financed with debt.

Exhibit
Current and Future Financial Information Concerning Blitz Associates (In $ millions)
2014
2016 2015 (Current)
Sales 70 55 45
Cost of sales 25 15 10
Selling, general and 19 15 12
administrative expenses
Operating profit 26 25 23
Profit before taxes 17 14 14

25. In context of the proposed ‘shaping’ strategy developed, the trap which Hendricks fallen
into can be best characterized as:

A.  unexamined habits.
B.  cultural mismatches.
C.  misplaced confidence.

26. Lyole Associates’ response to the new government regulation affecting the biotechnology
industry most likely demonstrates an attempt to:

A.  position the company.

B.  exploit industry change.
C.  shape industry structure.

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27. The approach used by Dwight to forecast Blitz’s revenues is most likely characterized as:

A.  hybrid.
B.  top-down.
C.  bottom-up.

28. Using the information in the exhibit, is Dwight correct with respect to Forecast 1?

A.  Yes.
B.  No, operating costs have not been managed efficiently.
C.  No, operating margins are positively correlated with sales.

29. Considering Forecast 2 in isolation and using the information in the exhibit, relative to
the company’s reported taxes, cash taxes paid in the current year will be:

A.   lower.
B.   higher.
C.   the same.

30. Considering Forecast 3 in isolation, Blitz’s return on invested capital (ROIC) will most
likely:

A.  increase.
B.  decrease.
C.  remain the same.

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Question 31 through 36 relate to Fixed Income

Stella Owens Case Scenario

Stella Owens is a fixed-income manager at Halo Analytics, a financial services firm providing
valuation and advisory services. Owens will be holding a seminar in which she aims to
demonstrate traditional theories of the term structure of interest rates. She intends to apply any
theories discussed to current and expected conditions in the bond market.

She begins her seminar by comparing the unbiased and local expectations theories by making the
following opening statement:

Statement 1: “Both theories assume that the one-period return will always equal to the one-year
risk-free rate regardless of the maturity of the bond. However, economic reality is
considerably different from theoretical assumptions.”

Next, Owens demonstrates how these traditional models can be used to explain the slope of the
current yield curve (Exhibit 1) and make projections for spot rates.

Exhibit 1: Current Yields

Maturity (Year) Yield (%)
1 22%
2 18%
3 15%
…5 5%
…15 2%

Based on the data collected and an expectation of deflation, Owens forecasts spot rates to decline
in the future. Her forecast for inflation is based on a recent announcement by monetary
authorities to cut down policy rates as part of a move to stimulate the national economy.

Owens concludes her seminar with a discussion of how modern term structure models describe
evolving interest rates. The manager summarizes the difference between the Cox-Ingersoll-Ross
(CIR) and Vasicek model, on the one hand, and the Ho-Lee model, on the other hand, in the form
of two statements:

Statement 2: “The Ho-Lee model generates a term structure which most closely matches the
current term structure while the other two models generate poor estimates of the
current term structure.”

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Statement 3: “Unlike the CIR and Ho-Lee model, the Vasicek model assumes constant volatility
over the analysis period.”

After concluding the seminar, Owens explores the presence of arbitrage opportunities for a three-
year, 8% annual coupon-paying bond issue. The issue is trading in three different exchanges.
Based on their exchange-quoted prices, she determines the profit (loss) generated on an arbitrage
strategy within each exchange (Exhibit 2). Owens uses the data in Exhibit 1 as part of a
bootstrapping process to generate spot rates (Exhibit 3).

Exhibit 2
Calculated Arbitrage Profit/(Loss) in Exchanges
NASDAQ LSE NORDIC
Arbitrage profit/ (loss)* 8.5000 5.1808 (7.590)
*Profit or loss is per 100 of par value

Exhibit 3
Spot Rates
Maturity Rate (%)
1 25
2 22
3 19
4 17
5 14

31. With respect to Statement 1, Owens is most likely:

A.   correct.
B.   incorrect; local expectations theory does not incorporate risk neutrality in the
short- or long-term.
C.   incorrect; local expectations theory predicts that the one-period return for long-
term bonds is higher than the risk-free rate.

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32. By referring to ‘economic reality being different from theoretical assumptions’, Owens is
implying that, relative to long-dated bonds, short-dated bonds are least likely associated
with higher:

A.   demand.
B.   actual prices.
C.   actual returns.

33. Combining Owens’ forecast for inflation and spot rates suggests that she most likely
believes liquidity premiums:

A.   are present.
B.   are nonexistent.
C.   cannot be determined due to conflicting forecasts.

34. Owens’ second statement is most likely:

A.   correct.
B.   incorrect; the Ho-Lee model does not attempt to describe the current yield curve.
C.   incorrect; all three models require short-term rates to follow a certain path and
thus the estimated yield curve does not match the observed curve.

35. With respect to Statement 3, Owens is most likely correct with respect to:

A.   all three models.

B.   the CIR model only.
C.   the Vasicek model only.

36. Using the data in Exhibits 2 and 3, which of the following statements most accurately
presents the current market price of the security in the relevant exchange?

A.   NASDAQ: 67.3638
B.   LSE: 72.5744
C.   NORDIC: 68.2738

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Questions 37 through 42 relate to Fixed Income

Luciana Waldwick Case Scenario

Luciana Waldwick is a fixed income analyst serving Yalt Advisors, an asset management firm.
YA offers a fixed income fund which is invested in a wide range of securities including
corporate bonds and asset-backed securities (ABS). Waldwick is particularly interested in a
residential mortgage-backed security (RMBS) which has a senior-subordinate tranche structure.
Each bond class in the structure has been downgraded by Lynch & Morry (L&M), a credit rating
agency

Waldwick expands her analysis by studying the similarities and differences between the credit
analysis required for ABSs and corporate debt. She draws the following conclusions:

Conclusion 1: “Unlike corporate debt, the complex cash flow structure of ABS tranches renders
the structural model an inapplicable valuation tool as it assumes a constant
riskless rate of interest.”

Conclusion 2: “Credit rating agencies use the same rating scales for ABSs and corporate bonds.”

In her correspondence with a credit analyst at L&M, the latter informs her that the issuer of the
ABS has entered into an agreement with the rating agency whereby the firm would receive its
agreed upon service fee of $40,000 in return for generating the credit rating.

Interest rates in the market have recently declined which has increased the probability of
borrowers exercising the prepayment option embedded in their mortgage loans. The expected
yield-to-maturity (YTM) quoted on the junior tranche is 8.5% and the yield curve is sloping
steeply downwards. Based on the recent changes, Waldwick concludes:

Conclusion 3: “Given the current shape of the yield curve and the revised probability of
refinancing, the expected rate of return will not equal to 8.5% and coupon
payments will be reinvested at a rate which differs from the YTM.”

Waldwick also analyzes the implication of the shape of the yield curve for nominal yields,
expected inflation and economic growth. In addition, she intends to use key rate duration to
measure the impact of the curve steepening on the price sensitivity of fund assets. She justifies
her choice by listing the strengths of the risk measure:

Strength 1: Captures shaping risk

Strength 2: Measures parallel yield curve shifts

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Strength 3: Models the price sensitivity of bonds with embedded options

In her professional studies, Waldwick learned how the forward rate can be interpreted as a
breakeven rate. She intends to use the forward rate model to determine how the rate agreed on
today for a two-year loan made five years from today can be viewed as the breakeven rate. For
her analysis, she assumes a hypothetical rising spot rate curve (Exhibit) and arrives at the
following conclusion:

Conclusion 4: “The no-arbitrage forward rate, f(5,2), of 5.45% can be viewed as the breakeven
rate if the investor is indifferent between:

I.   buying a seven-year zero-coupon bond at 4.50% or

II.   investing in a five-year zero-coupon bond at 3.60% and at maturity reinvesting
the proceeds for two more years at 1.00%.”

Exhibit:
Spot Rates for Forward Rate Model
Maturity Rate (%)
S(2) 1.00%
S(3) 2.50%
S(4) 3.00%
S(5) 3.60%
S(6) 3.90%
S(7) 4.50%

37. With respect to her conclusions concerning the similarities and differences of the credit
analysis of ABSs and corporate bonds, Waldwick is least accurate with respect to:

A.   Conclusion 1 only.
B.   Conclusion 2 only.
C.   both conclusions 1 and 2.

38. Which of the following conflicts is particularly associated with the process used by the
agency to generate credit ratings?

A.   Agency
B.   Incentive
C.   Stability versus accuracy

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39. With respect to Conclusion 3, Waldwick is most accurate with respect to her comments
regarding the:

A.   expected rate of return only.

B.   reinvestment rate only.
C.   both expected rate of return and reinvestment rate.

40. Considering nominal yields, the current shape of the yield is least likely associated with a
forecast of:

A.   lower future inflation.

B.   strong economic growth.
C.   risk premiums decreasing with an increase in maturity.

41. Conclusion 4 is most accurate with respect to the:

A.   forward rate used.

B.   reinvestment rate specified in ‘ii’.
C.   maturity of the bond specified in ‘i’.

42. Which of the following strengths most likely justifies Waldwick’s choice of key rate
duration as a risk measure?

A.   Strength 1 only.
B.   Strengths 1 and 2 only.
C.   Strengths 1, 2 and 3.

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Questions 43 through 48 relate to Derivatives

Alexei Orlov Case Scenario

AlxeiOrlov is the head of risk management at Marix Limited, a manufacturer of sporting
equipment. Marix is seeking to expand its business and client base by constructing
manufacturing facilities in different parts of the country. The company will need to borrow $2.5
million in a year’s time to fund the project. Orlov decides to engage in a one-year, quarterly
paying interest rate swap with Green Associates. The notional principal of the swap is $2.5
million and annual swap rate is 3.80%.

Orlov next collects data concerning the economy. A positive economic outlook accompanied by
economist projections of stable interest rates encourages Orlov to consider terminating the swap
position three months from today by engaging in a 0.25 × 1 swaption with Green Associates as
the counterparty on the original swap’s initiation date.

Orlov calls a meeting which is attended by Marix’s senior risk managers. Kelly Diop, a risk
manager, questions Orlov’s choice of counterparty to which the latter responds, “Engaging in a
terminating swaption with Green Associates, as opposed to another dealer, will help eliminate
credit risk.”

During the meeting Orlov also discusses the other possible uses of swaptions.

Use 1: “Swaptions can be used by arbitrageurs to exploit interest rate movements.”

Use 2: “Swaptions can be used by hedgers desiring to limit losses in a particular direction or, in
other words, those who require unilateral payoffs.”

Use 3: “Swaptions provide parties with the flexibility needed to remove interest rate uncertainty
from the underlying swap.”

Orlov demonstrates how the swaption will be valued using the projected LIBOR term structure at
expiration and details concerning the swaption (Exhibits 1 and 2 respectively).

Diop believes that an analysis of company expansion on Marix’s stock price is essential. Using
economic forecasts, she projects that if the company succeeds in increasing its market presence
following an expansion the share price should increase. However the extent of the percentage
increase is highly contingent on these two forecasts materializing. She recommends the purchase
of a one-year European call option to speculate on stock price movements.

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For her analysis, Diop has assumed three possible scenarios for the share price. Each of the three
scenarios is equally likely in occurrence. She aims to calculate delta for each scenario and a
probability weighted average new call by combining the delta from each scenario. Details
relevant to her analysis and the scenarios are summarized in an exhibit (Exhibit 3). She will be
using the Black-Scholes-Merton (BSM) model to value the call option by incorporating the 4%
dividend yield on the stock.

Exhibit 1:
Current LIBOR Structure
90-day 3.5%
180-day 4.9%
270-day 5.7%
360-day 6.9%

Exhibit 2:
0.25 × 1 Receiver Swaption
Settlement details Up-front cash payment
Notional principal $2.5 million
Payment frequency Quarterly
Term Nine months
Floating leg payment basis LIBOR

Exhibit 3:
Scenarios and Details Concerning Option Valuation

Scenario 1 Scenario 2 Scenario 3

Projected underlying price $65 $70 $88

Exercise price $65.00

Current underlying price $65.00
Option price $8.50
N(d1) 0.7356
N(d2) 0.2644

Orlov concludes the meeting by stating that the BSM model is subject to assumptions which
limit the usefulness of the analysis.

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43. With respect to the reason underlying his choice of Green Associates as counterparty to
the swaption, Orlov’s statement is most likely:

A.   accurate.
B.   inaccurate; credit risk can only be mitigated.
C.   inaccurate; credit risk can only be eliminated if the counterparty is not the same as
that to the original swap.

44. With respect to his identification of the use of swaptions, Orlov is least accurate with
respect to:

A.   Use 1
B.   Use 2
C.   Use 3

45. Using the data in Exhibits 1 and 2 and assuming the projection concerning the LIBOR
term structure materializes, the up-front cash payment at swaption expiration is closest to:

A.   $8,644.
B.   $25,300.
C.   $58,800.

46. Applying the BSM model to the stock option is most likely:

A.   inappropriate as European options cannot be valued.

B.   inappropriate if there are cash flows on the underlying.
C.   appropriate given the existence of the dividend yield and type of option.

47. Using delta as an approximation and the data in Exhibit 2, the probability weighted
average new call price is closest to:

A.  $12.53.
B.  $14.68.
C.  $15.36.

48. Which of the following assumptions most likely underlies the BSM model?

A.  Volatility is a model-driven variable.

B.  The risk-free rate follows a random pattern.
C.  Transaction costs are assumed to be negligible.

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Questions 49 through 54 relate to Alternative Investments

Baltic Enterprises Case Scenario

Baltic Enterprises (BE) is an asset management firm which has traditionally invested in fixed
income and equity securities. Senior portfolio manager, Dennis Peterson would like to expand
the firm’s investment universe and is considering private equity and commodities as potential
candidates.

For the private equity investment, Peterson narrows his selection to two funds - Stark-X, a
venture capital (VC) fund, which finances start-up software houses such as Alpha Tech (AT) and
a buyout fund. Peterson is particularly concerned about the potential valuation issues faced when
appraising the value of an investment in venture capital funds.

In a meeting with Stark-X’s fund manager, Peterson inquires about the exit strategy the fund
intends to employ for its investors. The fund manager responds by informing Peterson that an
IPO has been favored as an exit route due to its numerous advantages.

Peterson is unable to decide between Stark-X and a buyout fund and decides to consult Ali Khan,
an asset manager serving BE. Khan proposes Peterson opt for the buyout fund. He supports his
proposal with the following justifications:

Justification 1: Buyout funds require a lower degree of due diligence relative to their VC
counterparts.

Justification 2: Buyout funds do not exhibit performance persistence.

Justification 3: The risk of buyout funds is relatively easier to measure due to their long
operating history.

After considerable deliberation, Peterson opts for Stark-X and investment in AT. The company’s
management projects that it will raise $30 million from its IPO six years from today. To prepare
for its IPO AT will need to raise the requisite funds in two stages - today and four years from
today. BE will invest in AT at the beginning of the second stage. Details concerning the
investment have been summarized by Peterson:

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•   Investment by first round investors = $8 million

•   BE’s investment = $6 million
•   Percentage ownership of first round investors during first round = %
•   Dilution of ownership of first round investors =
•   Post-money value (T = 4) = $10 million.
•   Shares owned by company founders = 2 million

For BE’s exposure to commodities, Peterson is exploring gasoline as a potential candidate. He

contacts his old friend, Peter Walsh, an expert in commodities, to shed some light on the
investment decision.

Walsh recommends, “The global gasoline industry has been under considerable pressure from
environmental lobbyists over the past six months. If regulators respond to these pressures by
enacting stringent environmental regulations along with penalties for violation, the global price
of gasoline can significantly rise. I highly advise BE to undertake a long position in gasoline
futures. If the hoped for move materializes, it will be a win-win situation for the company.”

49. Which of the following options can Peterson most likely explore to value BE’s
investment in AT?

A.   Relative value approach

B.   Real option methodology
C.   Discounted cash flow methodology

50. The advantages of an IPO as an exit route for Stark-X investors most likely includes:

A.   cost effectiveness.
B.   high exit valuation.
C.   increased flexibility.

51. In context of his buyout fund investment proposal, Khan is least accurate with respect to:

A.   Justification 1.
B.   Justification 2.
C.   Justification 3.

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52. The number of additional shares to be issued by AT’s management to achieve BE’s
desired ownership stake is closest to:

A.   1.6 million.
B.   3.8 million.
C.   4.6 million.

53. AT’s pre-money valuation four years from today is closest to:

A.   $2 million.
B.   $4 million.
C.   $10 million.

54. By acting on Walsh’s recommendation, BE will participate in the gasoline futures market
as a (n):

A.   hedger.
B.   speculator.
C.   arbitrageur.

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Questions 55 through 60 relate to Portfolio Management

Rocky Asset Management (RAM) Case Scenario

Rocky Asset Management (RAM) provides investment advisory and asset management services
to private-wealth clients and institutions. Benjamin Walker is a senior asset manager serving
RAM. In a conversation with Bram Cloet, an investment officer at RAM, Walker explains the
firm’s policies with respect to the portfolio management process of private wealth clients.

Policy 1: Since RAM only accepts private wealth clients with a specific risk appetite, a single
investment policy template has been designed for all existing and potential clients.

Policy 2: Many of our private wealth clients have short-term investment horizons and therefore
we prefer to develop short-run expected risk-return forecasts for asset classes.

Policy 3: Capital market expectations, investment objectives and constraints are combined to
develop target asset class weights for client portfolios.

Cloet requests Walker to elaborate on Policy 3 to which the latter responds, “RAM prefers to
take a multi-period perspective in its strategic asset allocation process.”

Following his discussion with Cloet, Walker proceeds to evaluate the notes he has taken during
his meetings with two potential clients, Jim Young and Sasha Heeren. The notes read as follows:

Jim Young:
•   65 years of age
•   Has explicitly stated that he would like to achieve an average annual return of 30%.
•   Is the co-owner of a law firm
•   His income comfortably covers his living expenses
•   Any excess income is used to save towards retirement
•   Upon retirement, he will transfer his ownership rights to his son, who is an associate at
the firm.

Sasha Heeren:
•   56 years of age
•   Current income covers living expenses
•   Needs $3 million in fifteen years time to fund her son’s college education
•   Withdraws $20,000 from her portfolio to fund her mother’s medical treatment at the end
of each year
•   Current investable assets are worth $1.3 million.

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•   Subject to a tax rate of 35%

RAM’s institutional clients comprise a small proportion of the client base and are being managed
by Neil Jans. Jans manages the policy portfolio of Box Inc.’s defined benefit pension plan using
an active management mandate employing five distinct asset classes.

Jans would like to test the basic fundamental law on RAM’s portfolio given that asset class
returns are uncorrelated with each other. The expected active returns, weights, volatilities are
summarized in the exhibit below (Exhibit).

Exhibit
Active Returns, Active Weights and Volatilities
Expected Active Active Return
Asset Class Return (%) Volatility (%) Active Weight (%)
1 10 20 8
2 20 40 17
3 -8 50 - 10
4 - 12 65 - 20
5 6 14 5

Based on the data collected, Jans arrives at the following conclusions:

Conclusion 1: Assuming an information coefficient of 0.60 and uncorrelated asset class returns,
the equation specified by the fundamental law of active management will be
satisfied using the information in the exhibit.

Conclusion 2: If the pairwise correlations between the asset classes are positive, the breadth of
the investment strategy will be less than five.

55. Which of the following policies is most consistent with standard portfolio management
process logic?

A.   1
B.   2
C.   3

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56. The most appropriate response to Cloet’s question is that the multi-period perspective is:

A.   relatively less costly to implement.

B.   a relatively simple technique to implement.
C.   able to address the liquidity and tax consequences associated with portfolio
rebalancing.

57. Young’s return requirement can be described as:

A.   average.
B.   above average.
C.   below average.

58. The pre-tax required return on Heeren’s portfolio should be closest to:

A.   6.82%.
B.   8.82%.
C.   10.49%

59. The required return derived for Box Inc. is most likely:

A.   subject to an inflation adjustment.

B.   dependent on workforce characteristics.
C.   dependent on the stage of life of individual participants.

60. Is Jans correct with respect to his conclusions?

A.   Yes
B.   Only with respect to Conclusion 1.
C.   Only with respect to Conclusion 2.

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