Level Ii, Question 1: Topic: Minutes: Reading Reference

LEVEL II, QUESTION 1
Topic: Asset Valuation

Minutes: 14
Reading Reference:
“Valuing a Firm–The Free Cashflows to the Firm Approach,” Ch. 12, Investment Valuation:
Tools and Techniques for Determining the Value of Any Asset, Aswath Damodaran (Wiley,
1996)
Purpose:
To test the candidate’s ability to calculate the value of a firm using FCFF and to evaluate the
appropriateness of using FCFF versus FCFE.
LOS: The candidate should be able to

“Valuing a Firm–The Free Cashflows to the Firm Approach” (Study Session 10)
a) explain how free cashflows to the firm (FCFF) is measured;
b) explain the stable-growth FCFF model and the two-stage FCFF model and use each model to
calculate the value of a company;
c) describe the type of company that each model is best suited to analyze.
Guideline Answer:
A. DCom’s total firm value at end of year 2000, based on the free cash flows to the firm (FCFF)
model, is calculated as follows:
n
FCFFt FCFFn +1 / (WACCn − g n )
∑ (1 + WACC)
t =1
t
+
(1 + WACC) n
where FCFF = EBIT × (1 – t) + Depr – (Cap Ex) – ∆wc
2002 Level II Guideline Answers

Morning Session - Page 1
FCFF for DCom 2001 2002 2003 2004
EBIT ($69.68) ($47.51) ($10.52)

After-tax rate = (1 – t) 0.7 0.7 0.7
Depreciation & Amortization = Depr $129.00 $136.50 $144.00
Less Capital Expenditures = (Cap Ex) $400.00 $50.00 $50.00
Less Change in Working

Capital = ∆wc $5.19 ($4.32) ($6.47)
Free cash flows to the firm = FCFF ($324.97) $57.56 $93.11 $107.08*
Growth Rate =g 50% 50% 50% 15%
Terminal Value2003 = FCFF2004 / (WACC – g2004) $5,354.00
PV of FCFF @ 17%** ($277.75) $42.05 $58.14

PV of terminal value at 17% $3,342.88
DCom’s total firm value at

end of year 2000 $ 3,165.32 million
*
FCFF2004 = FCFF2003 × (1 + g2004) = $93.11 × 1.15
**
WACC = 17%
B. The total firm value as determined by the FCFF model is not the appropriate measure of
value to estimate the contribution DCom should make to the market price of Jones Group
equity. To address the effect of DCom on Jones Group’s value, the value of DCom must first
be apportioned between bondholders and equity holders, which the FCFF approach does not
do. Because DCom has a positive amount of debt outstanding, using the total firm value as
determined by FCFF without adjustment for DCom’s debt will overstate DCom’s expected
contribution to the value of Jones Group’s equity.
The FCFF model could be used in this situation, but only if the market value of DCom debt
is deducted from the value computed using the model. Deducting the market value of the
debt effectively apportions the value of DCom between the bondholders and equity holders.


Minutes: 16
Reading References:
“Competitive Strategy: The Core Concepts,” Michael E. Porter, Competitive Advantage:
Creating and Sustaining Superior Performance (The Free Press, 1985), 2002 CFA Level II
Candidate Readings
Purpose:
To test the candidate’s ability to identify the competitive factors in an industry that influence the
performance of companies in that industry.

“Competitive Strategy: The Core Concepts” (Study Session 9)
a) analyze the competitive advantage and competitive strategy of a company and the
competitive forces that affect the profitability of a company;
b) analyze basic types of competitive advantage that a company can possess and the generic
strategies for achieving a competitive advantage.
Guideline Answer:
A.
Identify the competitive

strategy being used by Differentiation Focus
DCom
Describe two characteristics 1. The company seeks to focus on a segment or group of
of that strategy segments within an industry by tailoring its strategy to serve
that segment/group to the exclusion of others.
2. The company seeks to achieve a competitive advantage in a

target segment even though it does not possess a competitive
advantage overall.
3. The company does not seek to compete on price but on

tailored product offerings. As a result the company’s product
usually commands a price premium.
Identify two of Anderson’s Response 1 identifies the focused target market.

responses that support
that strategy Response 4 identifies the specific method of differentiation
(circle two numbers) (network reliability).

B.
Identify the competitive

strategy most likely to be
used by traditional Cost Leadership
telephone companies in the
long-haul data
communications industry
Describe two characteristics 1. A company decides to become the low-cost provider in the
of that strategy industry.
2. A company seeks to serve a broad scope of customers with

a generic product offering.
3. A company adopting this strategy believes that there is little

room to differentiate its products or services from those of its
competitors on any basis other than cost.
Identify two of Blume’s Observation 3 identifies extremely low cost base as a source
observations that support of potential competitive advantage for established service
that strategy providers.
(circle two numbers)
Observation 5 identifies removal of regulation as a means to
allow entry by established service providers with technology
and infrastructure in place to serve the broad market.


Minutes: 11
Reading Reference:
Analysis for Financial Management, 6th edition, Robert C. Higgins (Irwin, 2000)
B. “Managing Growth,” Ch. 4
Purpose:
To test the candidate’s ability to calculate the sustainable growth rate and to determine what
corrective actions should be taken in the event that the sustainable growth rate diverges from the
actual growth rate.

“Managing Growth” (Study Session 8)
a) explain the concept of sustainable growth and identify its determinants;
b) calculate the sustainable growth of a company, given balance sheet and income statement
data;
c) describe the courses of action that a company could take when actual growth exceeds
sustainable growth and the possible effects of those actions on the company;
d) describe the courses of action that a company could take when sustainable growth exceeds
actual growth and the possible effects of those actions on the company.
Guideline Answer:
A.
Profit Margin = Net income / Sales = P

= $122.69 / $1,833.45 = 0.066918
Retention Rate = 1 – (Dividends / Net income) = R
= 1 – $88.18 / $122.69 = 0.281278
Asset Turnover = Sales / Assets = A

= $1,833.45 / $3,100.85 = 0.591273
Financial Leverage = Assets / Equity = T

T = $3,100.85 / $1,475.16 = 2.102043
T* = $3,100.85 / $1,440.64 = 2.152411
g = P × R × A × T = 2.35%
g* = P × R × A × T* = 2.40%
* Calculated with beginning of period Equity

Alternate calculation 1:
Return on Equity = Net income / Average Equity = ROE
= $122.69 / $1,457.90* = 0.084155
Retention Rate = 1 – (Dividends / Net income) = R
= 1– ($88.18 / $122.69) = 0.281278
g = ROE × R = 2.37%
*Average equity = ($1,440.64 + $1,475.16) / 2
Alternate calculation 2:
g = (Shareholders’ Equity2003 / Shareholders’ Equity2002) – 1

= ($1,475.16 / $1,440.64) – 1 = 1.02396 – 1 = 2.40%
B. To remain on its desired growth curve, Jones Group management will need to make one or
more of the following policy changes:
• issue new equity

• increase debt ratio (leverage)
• reduce payout ratio (increase retention rate)
• generate cash through profitable pruning of business units
• increase prices
• reduce costs through outsourcing or other means (increase operating efficiency)
• merge with another company that can provide excess cash flow or increased debt
capacity
C.
i. Profit margin: In the short-term, excess capacity will result in low profit margins. Until
the excess capacity is utilized, the marginal revenues that DCom will generate as revenue
growth continues will have a marginal cost close to zero. This will cause the profit
margin of Jones Group to increase, which will result in a higher sustainable growth rate.
ii. Asset turnover: Because of the excess capacity, DCom’s asset turnover is very low. As
revenue growth continues and capital expenditures decrease, asset turnover will increase,
which will result in a higher sustainable growth rate for Jones Group.


Minutes: 11
Reading References:
“Valuing Zero-Income Stocks: A Practical Approach,” Barney Wilson, Practical Issues in
Equity Analysis (AIMR, 2000), 2002 CFA Level II Candidate Readings
Purpose:
To test the candidate’s ability to: 1) understand when a bimodal distribution may be a better
representation of the distribution of expected revenues for a high growth/high risk growth
company, such as an Internet company, and 2) recognize the importance of, and difficulties in,
establishing discount, growth, and fade rates when valuing high growth/high risk companies.

“Valuing Zero-Income Stocks: A Practical Approach” (Study Session 12)
a) explain why a bimodal distribution better characterizes the prospects of a high growth/high
risk company, such as an Internet related company;
b) discuss why it is difficult to apply a traditional present value model to the valuation of high
growth/high risk companies because of discount rate and fade rate problems;
c) describe how a multiple-scenario DCF method combined with reality checks such as price-
to-earnings ratios and market capitalization can improve an analyst’s ability to value high-
growth/high risk companies.
Guideline Answer:
A. The shape of the probability distribution in Exhibit 4-1 is bimodal. Given the bimodal
distribution of revenue growth rates, using the expected value of the revenue growth rate to
value DCom may not be appropriate because the expected value:
• will not be the most likely outcome, and

• is not a plausible outcome for a single iteration of a bimodal scenario.
B. Beyond Tooley’s statement that scenario analysis is only useful for studying various
alternative outcomes, Richardson’s scenario analysis is also useful in analyzing DCom,
because:
• it can help Richardson identify the key drivers of DCom’s success or failure, such as
revenue growth and market share, and
• as events occur that affect DCom, Richardson can evaluate how these events affect the
probabilities assigned to the different scenarios and hence the probability of the
company’s success or failure.

C. If the fade rate (the rate at which high or supernormal growth slows) is lower than forecasted,
then higher earnings growth will be sustained longer into the future, leading to higher
valuations. Specifically, revenues will be higher than forecasted, resulting in higher
profitability (all else equal) and higher valuations.

Minutes: 12
Reading References:
1. Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown (Dryden, 2000)
A. “Analysis of Financial Statements,” Ch. 12
2. “General Principles of Credit Analysis,” Level II, Ch. 9, Fixed Income Analysis for the
Chartered Financial Analyst Program, Frank J. Fabozzi, (Frank J. Fabozzi Associates, 2000)
3. “Credit Analysis for Corporate Bonds,” Jane Tripp Howe, Ch. 20, pp. 371–392, The
Handbook of Fixed Income Securities, 5th edition, Frank J. Fabozzi, ed. (Irwin, 1997), 2002
CFA Level II Candidate Readings
Purpose:
To test the candidate’s understanding of corporate credit analysis for a bond issuer by discussing
characteristics and issues with respect to financing rather than by calculating analytical data.

“Analysis of Financial Statements” (Study Session 9)
g) compute return on equity (ROE) using the duPont system and the extended duPont system;
h) use financial ratios for comparative analysis of a company over time and relative to its
industry or to the market.
“General Principles of Credit Analysis” (Study Session 14)
d) discuss sources of liquidity for a company and the importance of these sources in the credit
analysis process;
h) discuss why and how cash flow from operations is used to assess the ability of an issuer to
service its debt obligations and to identify the financial flexibility of a company;
j) explain the typical elements of the debt structure of a high-yield issuer, the interrelationships
among these elements, and the impact of these elements on the risk position of the lender.
“Credit Analysis for Corporate Bonds” (Study Session 14)
c) analyze the components of a company’s return on equity (ROE) and explain the importance
of expected earnings growth and ROE in determining credit quality.
Guideline Answer:
A. There are several effects on Jones Group’s creditworthiness if the one-year bank loan is
used:
1. The bank loan may have a priority lien on Jones Group’s assets, making most existing or
new-issue “senior” notes less secure. Less security implies a higher cost of funds in the
future.
2. The short one-year maturity of the bank loan subjects Jones Group to a refunding time
horizon that may be shorter than management considers optimal.
3. The variable interest rate on the bank loan subjects Jones Group to interest rate risk and
volatility at a time when management may prefer locking in the cost of funds.
4. Profits can be positively or negatively affected depending on whether rates are lower or
higher on the bank debt versus maturing debt. This will affect the earning capacity of the
firm, as well as financial flexibility and therefore creditworthiness.
5. Financial flexibility and hence creditworthiness can be positively or negatively affected
depending on whether and how covenants on bank debt differ from covenants on
maturing debt.
B. There are several issues relating to the sale of Jones Group assets:
1. There is a time constraint, in that Jones Group needs to execute the sale of assets prior to
the debt maturity to ensure that the funds will be available.
2. There may be a loss of control over operating assets required for the securitization for the
asset-backed securities.
3. The asset sale may involve a lower cost of capital than other sources of financing.
4. Total cost of issuance may differ substantially, higher or lower, than other sources of
financing.
5. Covenants on existing debt may limit/prohibit asset sales.
6. Effects of covenants on existing debt with respect to an asset sale, even absent violation,
and on the securitized debt may adversely affect financial flexibility.
7. Any over collateralization required by the rating agency to support securitization may
potentially result in an insufficient amount of funds to refinance the maturing debt.
C. Considering the components of after-tax ROE, there are several possible explanations for
after-tax ROE remaining constant while operating income was declining:
1. Decreasing operating income could have been offset by an increase in non-operating

income (i.e., from discontinued operations, extraordinary gains or income, gains from
changes in accounting policies) because both are components of profit margin (net
income/sales).
2. Another offset to decreasing operating income could have been declining interest rates on
any interest rate obligations, which would have decreased interest expense and allowed
pre-tax margins to remain stable.
3. Leverage could have increased as a result of a decline in equity from: a) writing down an
equity investment, b) stock repurchases, c) losses, or d) selling new debt. The effect of
the increased leverage could have offset a decline in operating income.
4. An increase in asset turnover would also offset the decline in operating income. Asset
turnover could increase as a result of the sales growth rate exceeding the asset growth
rate, or from the sale or write-off of assets.
5. If the effective tax rate declined, the resulting increase in earnings after tax could offset a
decline in operating income. The decline in effective tax rates could result from increased
tax credits, the use of tax loss carry forwards, or a decline in the statutory tax rate.

Minutes: 18
Reading References:
Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Aswath
Damodaran (Wiley, 1996)
A. “Dividend Discount Models,” Ch. 10
Purpose:
To test the candidate’s ability to calculate a two-stage DDM value for an established company’s
equity.

“Dividend Discount Models” (Study Session 10)
a) explain and calculate the value of a company’s equity using the dividend discount model
(DDM), the Gordon growth model, the two-stage DDM, the H model, and the three-stage
DDM.
Guideline Answer:
Because expected dividends exhibit two stages, a two-stage dividend discount model is
appropriate. In the first stage, which includes 2002 and 2003, dividends are expected to be level
at $0.74 which represents a 60 percent reduction from the 2001 dividend of $1.85. In the second
stage, beginning in 2004, the dividend will be restored to its former $1.85 level and will grow at
a constant 8 percent rate thereafter.
Terminal
2002 2003 2004
Value
Projected Dividend = Dn $0.74 $0.74 $1.85 $2.00

Dividend Growth Rate = g 8%
Required Rate of Return = r 11% 11% 11% 11%
Terminal Value = (D2004 × $66.67 Å
(1 + g)) / (r2004 – g)
Present Value of Dividends @ 11% $0.67 $0.60 $1.35
Present Value of Terminal Value @ 11% $48.75
Share price based on DDM $51.37


Minutes: 12
Reading Reference:
Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd edition,
Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (Irwin 1995)
A. “Minority Interest Discounts, Control Premiums, and Other Discounts and Premiums,” Ch.
14, pp. 300−303 and 316−326
B. “Discounts for Lack of Marketability,” Ch. 15, pp. 331−334, 342−359
Purpose:
To test the candidate’s understanding of minority and/or marketability discounts.

“Minority Interest Discounts, Control Premiums, and Other Discounts and Premiums” (Study
Session 11)
a) describe the concept and importance of control;
d) discuss the impact of state statute provisions on minority versus control value;
e) discuss the top down, horizontal, and bottom up approaches for valuing minority interests;
f) discuss the market evidence with respect to control premiums and minority discounts.
“Discounts for Lack of Marketability” (Study Session 11)
d) describe the major factors affecting the discount for lack of marketability.

Guideline Answer:
Indicate
whether each
of
Rutherford’s Justify your response with one reason
Statement
statements is (if incorrect)
correct or
incorrect
(circle one)
1. A common approach to
valuing minority interests uses
a “bottom up” valuation
method, which is similar to Correct
valuing publicly traded
common stocks using the
dividend discount model.
2. Statutes enacted by some Sovereign entity statute provisions that
sovereign entities that increase increase the power of the minority holder will
the rights of minority serve to reduce the magnitude of the discount
shareholders usually serve to Incorrect that must be taken for a minority interest,
increase the magnitude of the because such provisions effectively reduce the
minority discount. differences in status between controlling and
minority interests.
3. Of the “top down,” Only the “top down” method requires that the
“horizontal,” or “bottom up” entire enterprise be valued. The other methods
methods of valuing minority only require that the minority interest be
interests, both the “top down” Incorrect valued.
and “horizontal” methods
require an estimate of value
for the total enterprise.
4. In general, market control Entities that acquire control for strategic
premiums are lower for reasons should be, and typically are, able to
strategic acquisitions than for justify a higher premium than entities that
financial acquisitions. acquire control for purely financial reasons.
Incorrect This is because the synergies that attach to a
strategic acquisition are expected to result in
higher returns to the acquiring entity than the
returns that are to be obtained from a purely
financial transaction.

Topic: Portfolio Management

Minutes: 7
Reading Reference:
Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown
(Dryden, 2000)
B. “An Introduction to Portfolio Management,” Ch. 8
PURPOSE
To test the candidate’s ability to: 1) identify and briefly describe several measures of risk, and 2)
identify which measures are appropriate to measure the risk of a stand-alone asset versus a
portfolio.

“An Introduction to Portfolio Management” (Study Session 20)
b) identify several measures of risk and explain the circumstances in which their use might be
appropriate in both stand-alone and portfolio contexts.
Guideline Answer:
A. The measure of risk that is most consistent with the client’s statement is “range of returns.” A
major weakness of this measure is that it focuses on the extremes of the distribution,
attaching excessive importance to these values. The range of returns measure ignores the
shape of the distribution with respect to both expected value and volatility. In addition, this
measure does not utilize a benchmark or market portfolio for comparison purposes to assess
overall portfolio risk.
B. Portfolio A is more likely to achieve the client’s objective.
The client is risk averse and has strongly stated a minimum required rate of return or “floor”
relative to achieving his retirement goals. Thus, the risk measure for assessing which
portfolio is most appropriate for the client is one that focuses on downside risk. Exhibit 8-1
shows that portfolio A has a lower probability (27.54 percent) of failing to meet the client’s
minimum required rate of return (8 percent average annual return) over a ten-year holding
period, compared to portfolio B’s 45.92 percent probability of failing to earn 8 percent. The
one-year holding period probabilities are not appropriate measures given the longer-term
nature of the client’s objective.


Minutes: 15
Reading References:
(Dryden, 2000)
A. “Efficient Capital Markets,” Ch. 7
C. “An Introduction to Asset Pricing Models,” Ch. 9
Purpose:
To test the candidate’s ability to: 1) to distinguish between systematic and unsystematic risk, 2)
describe the role of the market portfolio, and 3) use the SML to determine whether a security is
undervalued, overvalued, or properly valued.

“Efficient Capital Markets” (Study Session 20)
a) describe the set of assumptions that imply an efficient capital market.
“An Introduction to Asset Pricing Models” (Study Session 20)
a) distinguish between the original capital market theory assumptions and the revised
assumptions that underlie the capital asset pricing model (CAPM);
b) explain how the presence of a risk-free asset changes the characteristics of the Markowitz
efficient frontier;
c) describe the market portfolio and the role it plays in the formation of the capital market line
(CML);
d) define and distinguish between systematic and unsystematic risk;
g) calculate, based on the SML, the expected return for an asset;
i) determine, based on the SML, whether a security is undervalued, overvalued, or properly
valued.
Guideline Answer:
A. Agree; Regan’s conclusion is correct. By definition the market portfolio lies on the capital
market line (CML). Under the assumptions of capital market theory, all portfolios on the
CML dominate, in a risk-return sense, portfolios that lie on the Markowitz efficient frontier
because, given that leverage is allowed, the CML creates a portfolio possibility line that is
higher than all points on the efficient frontier except for the market portfolio, which is
Rainbow’s portfolio. Because Eagle’s portfolio lies on the Markowitz efficient frontier at a
point other than the market portfolio, Rainbow’s portfolio dominates Eagle’s portfolio.

B. Unsystematic risk is the unique risk of individual stocks in a portfolio that is diversified away
by holding a well-diversified portfolio. Total risk is composed of systematic (market) risk
and unsystematic (firm-specific) risk.
Disagree; Wilson’s remark is incorrect. Because both portfolios lie on the Markowitz
efficient frontier, neither Eagle nor Rainbow has any unsystematic risk. Therefore,
unsystematic risk does not explain the different expected returns. The determining factor is
that Rainbow lies on the (straight) line (the CML) connecting the risk-free asset and the
market portfolio (Rainbow), at the point of tangency to the Markowitz efficient frontier
having the highest available amount of return per unit of risk. Wilson’s remark is also
countered by the fact that because unsystematic risk can be eliminated by diversification, the
expected return to bearing it is zero. This happens as a result of well-diversified investors
bidding the price of every asset up to the point at which only systematic risk earns a positive
return (unsystematic risk earns no return).
C.
Indicate whether each

stock is undervalued,
Common Stock Calculate the required rate of return fairly valued, or
overvalued
(circle one)
E(R) = Rf + Beta × (Rm – Rf)

= 5.0% + 1.5 × (11.5% – 5.0%)
Furhman Labs = 14.75% Overvalued*
E(R) = Rf + Beta × (Rm – Rf) Undervalued*

Garten Testing = 5.0% + 0.8 × (11.5% – 5.0%)
= 10.20%
*Supporting calculations:
Furhman: Forecast – Required = 13.25% – 14.75% = –1.50% (Overvalued)

Garten: Forecast – Required = 11.25% – 10.20% = 1.05% (Undervalued)
If the forecast return is less (greater) than the required rate of return, the security is overvalued
(undervalued).


Minutes: 6
Reading Reference:
(Dryden, 2000)
C. “An Introduction to Asset Pricing Models,” Ch. 9
Purpose:
To test the candidate’s ability to discuss the security market line (SML) and explain how the
SML differs from the CML.

“An Introduction to Asset Pricing Models” (Study Session 20)
b) explain how the presence of a risk-free asset changes the characteristics of the Markowitz
efficient frontier;
c) describe the market portfolio and the role it plays in the formation of the capital market line
(CML);
d) define and distinguish between systematic and unsystematic risk;
f) discuss the security market line (SML) and how it differs from the CML.
Guideline Answer:
A. McKay should borrow funds and invest those funds proportionally in Murray’s existing
portfolio (i.e., buy more risky assets on margin).
In addition to increased expected return, the alternative portfolio on the capital market line
(CML) will also have increased variability (risk), which is caused by the higher proportion of
risky assets in the total portfolio.
B. McKay should substitute low beta stocks for high beta stocks to reduce the overall beta of
York’s portfolio.
By reducing the overall portfolio beta, McKay will reduce the systematic risk of the portfolio
and therefore its volatility relative to the market. The security market line (SML) suggests
such action (moving down the SML), even though reducing beta may result in a slight loss of
portfolio efficiency unless full diversification is maintained. York’s primary objective,
however, is not to maintain efficiency but to reduce risk exposure; reducing portfolio beta
meets that objective. Because York does not permit borrowing or lending, McKay cannot
reduce risk by selling equities and using the proceeds to buy risk free assets (i.e., lending part
of the portfolio).

Minutes: 6
Reading Reference:
(Dryden, 2000)
D. “Extensions and Testing of Asset Pricing Theories,” Ch. 10
Purpose:
To test the candidate’s understanding of Roll’s concept of benchmark error.

“Extensions and Testing of Asset Pricing Theories” (Study Session 20)
d) discuss why Roll’s critique of the CAPM and Shanken’s challenge to the APT cause many
observers to consider the models to be untestable;
e) describe the concept of benchmark error.
Guideline Answer:
The effects of an incorrectly specified market proxy are that:
i. The beta of Black’s portfolio is likely be underestimated (too low) relative to the beta
calculated based on the “true” market portfolio. This is because the Dow Jones Industrial
Average (DJIA) and other market proxies are likely to have less diversification and a higher
variance of returns than the “true” market portfolio as specified by the capital asset pricing
model. Consequently, beta computed using an overstated variance (Betaportfolio =
Covarianceportfolio, market proxy / Variancemarket proxy) will be underestimated.
ii. The slope of the security market line (SML), i.e., the market risk premium, is likely to be
underestimated relative to the “true” market portfolio because the “true” market portfolio is
likely to be more efficient—plotting on a higher return point for the same risk—than the
DJIA and similarly misspecified market proxies. Consequently, the proxy-based SML would
offer less expected return per unit of risk.


Minutes: 9
Reading Reference:
Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. “The Swaps Market: Introduction,” Ch. 20, pp. 608−625 and pp. 632−643
B. “ The Swaps Market: Refinements,” Ch. 21, pp. 648−671
Purpose:
To test the candidate’s: 1) understanding of a plain interest rate swap and how it can be used to
efficiently manage the balance sheet of a corporation, and 2) ability to replicate a plain vanilla
swap with two bonds.

“The Swaps Market: Introduction” (Study Session 17)
a) discuss the characteristics of and motivations for swap contracts and differentiate swap
contracts from futures contracts, especially with respect to payment date versus expiration
date;
b) diagram (with a box and arrow diagram) and explain the cash flows between the parties to a
plain vanilla swap contract, including situations in which an intermediary participates;
e) illustrate the appropriate cash flow diagram for a swap and calculate the net
borrowing/lending costs for the two swap counterparties.
“The Swaps Market: Refinements” (Study Session 17)
a) demonstrate how swap agreements can be viewed as a combination of capital market
instruments.
Guideline Answer:
A. The instruments needed by Scott are a fixed-coupon bond and a floating rate note (FRN).
The transactions required are to:
• issue a fixed-coupon bond with a maturity of three years and a notional amount of $25
million, and
• buy a $25 million FRN of the same maturity that pays one-year LIBOR + 75 bps.
B. At the outset, Rone will issue the bond and buy the FRN, resulting in a zero net cash flow at
initiation. At the end of the third year, Rone will repay the fixed-coupon bond and will be
repaid the FRN, resulting in a zero net cash flow at maturity. The net cash flow associated
with each of the three annual coupon payments will be the difference between the inflow (to
Rone) on the FRN and the outflow (to Rone) on the bond. Movements in interest rates during
the three-year period will determine whether the net cash flow associated with the coupons is

positive or negative to Rone. Thus, the bond transactions are financially equivalent to a plain
vanilla pay-fixed interest rate swap.


Minutes: 17
Reading Reference:
A. “Option Payoffs and Option Strategies,” Ch. 11, pp. 316−346
C. “Option Sensitivities and Option Hedging,” Ch. 14, pp. 422−437
Purpose:
To test the candidate’s: 1) understanding of different option combinations, specifically strangle
strategies, and 2) ability to relate delta and gamma to the price of a call option.

“Option Payoffs and Option Strategies” (Study Session 18)
b) calculate the cost of the following option-trading strategies: straddle, strangle, bull and bear
spreads, and butterfly spread;
c) determine, using a profit/loss diagram, the profit or loss of an option-trading strategy for any
asset value.
“Option Sensitivities and Option Hedging,” (Study Session 18)
c) calculate the change in option price, given delta and the change in asset price;
d) calculate delta, given the change in option price and the change in asset price;
k) relate gamma to changes in an option’s delta and stock price.
Guideline Answer:
A. Donie should choose the long strangle strategy.
A long strangle option strategy consists of buying a put and a call with the same expiration
date and the same underlying asset. In a strangle strategy, the call has an exercise price above
the stock price and the put has an exercise price below the stock price. An investor who buys
(goes long) a strangle expects that the price of the underlying asset (TRT in this case) will
either move substantially below the exercise price on the put or above the exercise price on
the call. With respect to TRT, the long strangle investor buys both the put and call options for
a total cost of $9.00, and will experience large profits if the stock price moves more than
$9.00 above the call exercise price or $9.00 below the put exercise price. This strategy would
enable Donie’s client to profit from a large move in the stock price, either up or down, in
reaction to the expected court decision.

B. i. The maximum possible loss per share is $9.00, which is the total cost of the two options
= $5.00 + $4.00.
ii. The maximum possible gain is unlimited, if the stock price moves outside the breakeven
range of prices.
iii. The breakeven prices are $46.00 and $69.00. The put will just cover costs if the stock
price finishes $9.00 below the put exercise price ($55.00 – $9.00 = $46.00), and the call
will just cover costs if the stock price finishes $9.00 above the call exercise price ($60.00
+ $9.00 = $69.00).
The following diagram provides support for the answers above.
Long strangle
12
10
8 $46.0 $69.0
Profit/Loss($)
6
4
2
0
-2
-4
-6
-8
-10
35 40 45 50 55 60 65 70 75 80
Stock Price($)
C. The delta for a call option is always positive, so the value of the call option in Exhibit 13-1
will increase if the stock price increases. Specifically, if the stock price increases by $1.00,
the price of the call will increase by approximately $0.63:
∆Price call = 0.6250 × $1.00) = $0.625 increase
D. Gamma is the second derivative of the option price with respect to the stock price and
measures how delta changes with changes in the underlying stock price.
The gamma for the put option in Exhibit 13-1 would increase if the stock price decreases to
$57.00. Gamma is relatively small when an option is out-of-the-money but becomes larger as
the option approaches near-the-money, which is the case as the underlying asset value moves
down toward the put option’s $55 exercise price.


Minutes: 12
Reading Reference:
D. “Foreign Exchange Futures,” Ch. 9, pp. 261–266
Purpose:
To test the candidate’s ability to calculate the value of, and determine if there is an arbitrage
opportunity available in, a currency futures contract.
LOS: The candidate should be able to:

“Foreign Exchange Futures” (Study Session 17)
b) compute, using the cost-of-carry model, the theoretical futures price and determine whether
an arbitrage profit exists;
d) compute the profits from an arbitrage strategy.
Guideline Answer:
A. The theoretical futures contract price is ¥122.0645, calculated as follows:
(1 + interest rate in the local market)compounding period

Futures price = spot price ×
(1 + interest rate in the foreign market)compounding period
= ¥124.30000 × (1 + 0.0010)0.5 / (1 + 0.0380)0.5
= ¥124.30000 × (1.00049988 / 1.01882285)
= ¥122.06453
B. The yen arbitrage profit is ¥129,928.61, calculated as follows:
Borrow $1,000,000 for 3 months @ 3.50%

Repay principal + interest = $1,000,000 × 1.0350.25 = $1,008,637.45
Exchange the $1,000,000 borrowed @ ¥124.30 / $1.00 = ¥124,300,000
Invest the ¥124,300,000 for 3 months at 0.50%

Receive principal + interest = 124,300,000 × 1.0050.25 = ¥124,455,084.52
Sell 3-month futures to pay off US$ denominated loan

Payoff (in ¥) = $1,008,637.45 × ¥123.2605 / $1.00 = ¥124,325,155.91
Yen arbitrage profit = Proceeds from yen investment – repayment (in ¥) of the US$ loan
= ¥124,455,084.52 – ¥124,325,155.91 = ¥129,928.61


Minutes: 12
Reading References:
Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J.
Fabozzi Associates, 2000)
A. “Mortgage-Backed Securities,” Level II, Ch. 3
B. “Asset-Backed Securities,” Level II, Ch. 4
Purpose
To test the candidate’s understanding of the basic structures, cash flow characteristics, and
methods of analysis of mortgage-based securities (MBS) and asset-backed securities (ABS).

“Mortgage-Backed Securities” (Study Session 16)
m) explain why and how a collateralized mortgage obligation (CMO) is created and distinguish
among the different types of CMO structures (including sequential-pay tranches, accrual
tranches, floater tranches, inverse floater tranches, planned amortization class tranches,
support tranches, and support tranches with schedules);
o) explain, for planned amortization class (PAC) tranches, the initial PAC collar and the
effective collar;
p) explain why the support tranches have the greatest prepayment risk in a CMO structure.
“Asset-Backed Securities” (Study Session 16)
b) explain the difference between an external and internal credit enhancement;
c) explain the different types of external credit enhancements (corporate guarantees, letter of
credit, and bond insurance) and the problems associated with enhancing by means of third-
party guarantors;
d) explain the different types of internal credit enhancements (reserve accounts and senior-
subordinated structures);
g) describe the cash flow for securities backed by closed-end home equity loans, open-end
home equity loans, manufactured housing loans, student loans, and Small Business
Administration loans;
h) explain a prospectus prepayment curve for home equity loan-backed securities;
k) explain why prepayments that result from refinancing may not be significant for
manufactured housing-backed securities and automobile loan-backed securities.

Guideline Answer:
A. i. External credit enhancements take the form of third-party guarantees that provide
protection against losses up to a specified amount. The most common examples of
external credit enhancement are:
• corporate guarantees, in which another corporation guarantees the performance of the

underlying collateral,
• letters of credit from a bank, in which a bank issues a letter of credit supporting the
performance of the collateral, and
• bond insurance, in which an insurance company writes a policy to cover losses to
investors.
The underlying credit of the issue is only as good as the credit enhancement regardless of
the quality of the loans.
ii. Internal credit enhancements take the form of internal structures that provide a cushion or
support for credit losses. There are three common examples of internal credit
enhancements.
• Reserve funds take the form of either cash reserves or excess servicing reserves. Cash
reserves are created from issuance proceeds, and excess servicing reserves are
accumulated over the life of the issue from the difference between the net coupon and
the gross coupon. In either case a reserve is set aside for any possible future losses.
• Overcollateralization occurs when the issue is structured with collateral in excess of
the total par value of the tranches. The amount of overcollateralization can be used to
absorb losses, thereby shielding the tranches from losses up to the amount of the
overcollateralization.
• Senior/subordinated structure occurs when an issue is offered with more than one
tranche, where a senior tranche exists with a junior or subordinated tranche. The
junior or subordinated tranche acts as the first tranche to incur losses, which protects
the senior tranche.
B. The cash flows of the home equity loans will be much more affected (and the cash flows of
the automobile receivables much less afffected) by a decline in interest rates.
The cash flows of the home equity-backed ABS will be more affected because the home
equity ABS:
• exhibits high prepayment risk (those loans will be vulnerable to refinancing by

homeowners when rates decline), and
• is fairly new (short seasoning) and has not been exposed to a low rate environment.

The cash flows of the automobile receivable-backed ABS will be less affected because the
auto ABS:
• does not typically exhibit prepayment risk (individuals do not tend to refinance car
loans), and
• also has an 18-month lockout that will protect it from receiving principal early.
C. With a decline in interest rates, prepayments would likely increase, and the two types of
collateralized mortgage obligations (CMOs) would experience dramatically different effects.
i. Planned amortization class (PAC) CMOs are created to offer protection within a
designated band of Public Securities Association (PSA) prepayment rates. The PAC
tranche is protected from the initial stream of excess prepayments and thus should see
minimal prepayments.
ii. Support bonds are the class of CMO that takes the excess prepayment from the PAC
tranches to provide protection to the PACs. The support bonds will become very short in
average life and experience a rapid increase in the return of principal as the result of
accepting the excess cash flows from the PAC tranche.


Minutes: 12
Reading Reference:
Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J.
Fabozzi Associates, 2000)
B. “Valuing Bonds with Embedded Options,” Level II, Ch. 2
Purpose:
To test the candidate’s understanding of the characteristics and return profile of convertible
bonds compared to those of the associated common equity.

“Valuing Bonds with Embedded Options” (Study Session 15)
p) compute the value and explain the meaning of the following for a convertible bond:
conversion value, straight value, market conversion price, market conversion premium per
share, market conversion premium ratio, premium payback period, and premium over
straight value;
q) discuss the components of a convertible bond’s value that must be included in an option-
based valuation approach;
r) compare the risk–return characteristics of a convertible bond with the risk–return
characteristics of ownership of the underlying common stock.
Guideline Answer:
A. i. The current market conversion price is $39.20.
Market conversion price = convertible bond’s market price / conversion ratio

= $980.00 / 25
= $39.20
ii. The expected one-year return for the Ytel convertible bond is 18.88%.
Expected return = ((end of year price + coupon) / current price) – 1

= (($1,125.00 + $40.00) / $980.00) – 1
= 0.18878
= 18.88%

iii. The expected one-year return for the Ytel common equity is 28.57%.
Expected return = (end of year price / current price) – 1

= ($45.00 / $35.00) – 1
= 0.28571
= 28.57%
B.
Indicate whether the value of each component should

decrease, stay the same, or increase in response to the:
Name the two components
of the convertible bond’s
value i. Increase in Ytel’s common ii. Increase in interest rates
equity price (circle one)
(circle one)
1. Straight value Stay the same Decrease
2. Option value Increase Increase
Although not required to answer the question, the following explains the template entries:
The two components of the bond’s value are straight value (its value as a bond) and option value
(the value associated with the potential conversion into equity).
i. The increase in the equity price does not affect the straight value component of the Ytel
convertible but does increase the call option component value significantly, because the call
option becomes deep “in the money” when the $51.00 per share equity price is compared to
the convertible’s conversion price of $40.00 ($1,000.00 / 25) per share.
ii. The increase in interest rates decreases the straight value component (bond values decline as
interest rates increase) of the convertible bond and increases the value of the equity call
option component (call option values increase as interest rates increase), though this increase
may be small or unnoticeable when compared to the change in the option value resulting
from the increase in the equity price.


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LEVEL II, QUESTION 1

Topic: Asset Valuation

LOS: The candidate should be able to

where FCFF = EBIT × (1 – t) + Depr – (Cap Ex) – ∆wc

2002 Level II Guideline Answers

EBIT ($69.68) ($47.51) ($10.52)

Depreciation & Amortization = Depr $129.00 $136.50 $144.00

Less Capital Expenditures = (Cap Ex) $400.00 $50.00 $50.00

Less Change in Working

Growth Rate =g 50% 50% 50% 15%

Terminal Value2003 = FCFF2004 / (WACC – g2004) $5,354.00

PV of FCFF @ 17%** ($277.75) $42.05 $58.14

DCom’s total firm value at

2002 Level II Guideline Answers

Topic: Asset Valuation

LOS: The candidate should be able to

Identify the competitive

2. The company seeks to achieve a competitive advantage in a

3. The company does not seek to compete on price but on

Identify two of Anderson’s Response 1 identifies the focused target market.

2002 Level II Guideline Answers

Identify the competitive

2. A company seeks to serve a broad scope of customers with

3. A company adopting this strategy believes that there is little

2002 Level II Guideline Answers

Topic: Asset Valuation

LOS: The candidate should be able to

Profit Margin = Net income / Sales = P

Asset Turnover = Sales / Assets = A

Financial Leverage = Assets / Equity = T

2002 Level II Guideline Answers

g = (Shareholders’ Equity2003 / Shareholders’ Equity2002) – 1

• issue new equity

2002 Level II Guideline Answers

Topic: Asset Valuation

LOS: The candidate should be able to

• will not be the most likely outcome, and

2002 Level II Guideline Answers

2002 Level II Guideline Answers

LOS: The candidate should be able to

1. Decreasing operating income could have been offset by an increase in non-operating

2002 Level II Guideline Answers

LOS: The candidate should be able to

Projected Dividend = Dn $0.74 $0.74 $1.85 $2.00

2002 Level II Guideline Answers

Topic: Asset Valuation

LOS: The candidate should be able to

2002 Level II Guideline Answers

2002 Level II Guideline Answers

Topic: Portfolio Management

LOS: The candidate should be able to

B. Portfolio A is more likely to achieve the client’s objective.

2002 Level II Guideline Answers

Topic: Portfolio Management

LOS: The candidate should be able to

2002 Level II Guideline Answers

Indicate whether each

E(R) = Rf + Beta × (Rm – Rf)

E(R) = Rf + Beta × (Rm – Rf) Undervalued*