Mock Exam 5 Ans

Overview for Questions #1-4 of 88 Question ID: 1509426
TOPIC: QUANTITATIVE METHODS
THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS
Joan Fisher and Kim Weatherford are economists responsible for modeling security
returns for Quincy Portfolio Managers, which is located in the southwestern United
States. Fisher is the firm's chief economist and Weatherford is her assistant.
In addition to financial assets, Quincy Portfolio Managers also recommends the use of
commodities as a portfolio diversifier. Weatherford has been examining price indices
for silver in an attempt to determine whether silver returns are predictable. As an
initial step, she uses an autoregressive first-order regression model on daily price data
for silver over the past two years. The plot of the raw data and the results of the
regression are shown in Exhibit 1: Time Series of Silver Prices and Exhibit 2: Silver
Price Regression Results.
Exhibit 1: Time Series of Silver Prices
Exhibit 2: Silver Price Regression Results
Regression Statistics
Multiple R 0.99
R-Square 0.98
Adjusted R-Square 0.98
Standard Error 123.81
Observations 522.00
Durbin-Watson 2.39
ANOVA
df SS MS F Significance F
Regression 1.00 365,730,065 365,730,065 23,859.63 0.00
Residual 520.00 7,970,771 15,328
Total 521.00 373,700,837
Coefficients Standard Error t-Stat P-value
Intercept 21.00 11.56 1.82 0.07
Slope 0.99 0.01 154.47 0.00
Fisher and Weatherford later discuss fluctuations in gold prices. Although the
arithmetic and geometric mean returns for gold were negative for much of the 1980s
and 1990s, Fisher and Weatherford believe that gold should perform better in the
future due to higher expected inflation. After appropriate transformation of the data,
they use an autoregressive first-order regression model to examine the characteristics
of gold returns, the results of which are shown in Exhibit 3: Gold Price Regression
Results.
Exhibit 3: Gold Price Regression Results
Regression Statistics
Multiple R 0.09
R-Square 0.01
Adjusted R-Square 0.01
Standard Error 123.95
Observations 520.00
ANOVA
df SS MS F Significance F
Regression 1.00 66,742 66,742 4.34 0.04

Residual 518.00 7,958,144 15,363
Total 519.00 8,024,887
Coefficients Standard Error t-Stat P-value
Intercept 2.00 5.44 0.37 0.71
Slope –0.09 0.04 –2.08 0.04
Question #1 of 88 Question ID: 1509427
Is the use of the Durbin Watson statistic in Weatherford's silver regression

appropriate and, if so, how should it be interpreted?
A) No.
B) Yes, and it appears that the error terms are serially correlated.
C) Yes, and it appears that the error terms are not serially correlated.
Explanation
The use of the Durbin-Watson statistic is inappropriate in an autoregressive
regression, which is what Weatherford is using. The Durbin-Watson statistic is
appropriate for trend models, but not autoregressive models. To determine whether
the errors terms are serially correlated in an autoregressive model, the significance
of the autocorrelations should be tested using the t-statistic. (Module 2.2, LOS 2.e)
Which of the following are the most likely problem in Weatherford's silver regression
and the most appropriate test for it?
Problem Test
A) Multicollinearity Breusch-Pagan
B) Multicollinearity Dickey-Fuller
C) Nonstationary data Dickey-Fuller

Explanation
Weatherford is using an autoregressive first-order regression model in which this
period's silver price is regressed on the previous period's price. The regression is of
the form:
Xt = b0 + b1Xt–1
The most likely problem in this regression is that the data is not covariance
stationary. In the plot of the data, the mean of the data does not appear to be
constant (it is much higher in the middle period). The estimate of the lag one slope
coefficient is close to 1.0, which also suggests that the data is nonstationary. To
definitively test this, the Dickey-Fuller test should be used, where the null hypothesis
is that b1 – 1 is equal to zero. If the null hypothesis is not rejected, we say that the
data has a unit root and is nonstationary. (Module 2.3, LOS 2.j)
To best model the silver price data using an autoregressive first-order regression
model, Weatherford should use:
A) first differences of the data.

B) the actual silver price levels.
C) the predicted silver price levels.
Explanation
Weatherford should use the first differences of the data in the regression. That is,
instead of using the actual price levels, she should use the change in the data rather
than levels:
Yt = Xt – Xt–1
Then, the appropriate regression will be:

Yt = b0 + b1Yt–1
The transformed time series data will have a mean-reverting level and be covariance
stationary. (Module 2.3, LOS 2.j)

Using the data for the gold regression, what is the mean-reverting level and what is
the two-step-ahead forecast if the current value of the independent variable is –0.80?
Two-step-ahead
Mean-reverting level
forecast
A) 1.83 1.75
B) 1.83 1.81
C) 2.07 1.75
Explanation
To determine the mean-reverting level, we divide the intercept by one minus the
slope coefficient:
b0 2.00
mean-reverting level = = = 1.83
1−b1 1−(−0.09)
The one-step-ahead predicted value is calculated by substituting the current value

into the regression equation:
ŷ = b0 + b1 (y ) = 2.00 + (−0.09) (−0.80) = 2.072
t+1 t
The two-step-ahead predicted value is then calculated by substituting the one-step-

ahead predicted value into the regression equation:
ŷt+2 = b0 + b1 (ŷt+1 ) = 2.00 + (−0.09) (2.072) = 1.81
(Module 2.2, LOS 2.d)
TOPIC: ECONOMICS
Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been
assigned to help Juanita Chevas, CFA, in the currency trading department. Together,
Wilson and Chevas are working on the development of new trading software designed
to detect profitable opportunities in the foreign exchange market. Obviously, they are
interested in risk-free arbitrage opportunities. However, they have also been
instructed to investigate the possibility of longer-term currency exposures that are not
necessarily risk-free. To test the logic of their new software, Wilson gathers the
following market data:
Spot JPY/USD exchange rate = 120.

Spot EUR/USD exchange rate = 0.7224.
U.S. risk-free interest rate = 7%.
Eurozone risk-free rate = 9.08%.
Japanese risk-free rate = 3.88%.
Yield curves in all three currencies are flat.
In addition to in-house currency transactions, the new software program is also

intended to provide insight into currency exposure and hedging needs for the bank's
major customers. These customers typically include large multinational firms.
Essentially, the bank wants to provide consulting services to its clients concerning
which currency exposures offer the most lucrative opportunities. In this process, the
bank will rely on deviations from international parity conditions as an indicator of
long-term currency movements. Several bank customers have engaged in a carry
trade with Bundovian Bunco (BU) as the investment currency and the USD as the
funding currency. The bank will provide risk management advice to customers as it
pertains to their FX carry trades.
Wilson obtains the following data from the econometrics department:
JPY/USD spot rate one year ago = 116.

EUR/USD spot rate one year ago = 0.7200.
Anticipated and historical U.S. annual inflation = 3%.
Anticipated and historical Japanese annual inflation = 0%.
Anticipated and historical eurozone annual inflation = 5%.
One of the bank's major customers has significant business interests in Japan and in
the eurozone and has long exposure to both currencies. The customer has
traditionally hedged all currency risk. However, the customer's new risk manager has
decided to leave some currency exposure unhedged in an attempt to profit from long-
term currency exposure.
According to relative purchasing power parity, the expected JPY/EUR spot rate two
years from now is closest to:
A) 150.
B) 158.
C) 183.
Explanation
We must start by calculating the JPY/EUR spot rate. This is a simple algebra problem.
We know that the JPY/USD spot rate is 120 and the EUR/USD spot rate is 0.7224.
Dividing JPY/USD by EUR/USD leaves us with JPY/EUR. Plugging in the numbers, we
get a JPY/EUR spot rate of 166.113 (= 120 / 0.7224). Next, we estimate the JPY/EUR
spot rate two years from now using the relative PPP formula (for two years), given
that EUR inflation is expected to be 5% higher (per year) than JPY inflation:
E(S1) = S0 × (1 – 0.05)2 = 166.113(0.95)2 = 149.92
(Module 5.2, LOS 5.g)
Are the Japanese and eurozone inflation forecasts provided by the econometrics
department consistent with the inflation rates implied by the international Fisher
relation, given a U.S. inflation rate of 3%?
A) Both forecasts are consistent.

B) Neither forecast is consistent.
C) One forecast is consistent and the other is not.
Explanation
Using the international Fisher relation, we can solve for the inflation forecasts in
Japan and Europe, given interest rate differentials and the U.S. inflation forecast:
R nominalA – R nominalB = E(inflationA) – E(inflationB)
For Japan: 7.00% – 3.88% ≠ 3% – 0%

For eurozone: 9.08% – 7.00% ≠ 5% – 3%
Both implied inflation rates are inconsistent with the forecasts from the
econometrics department. (Module 5.2, LOS 5.e)

According to the uncovered interest rate parity, in 12 months, the JPY/USD exchange
rate would most likely be closest to:
A) 116.
B) 118.
C) 124.
Explanation
Uncovered interest rate parity forecast:
U.S. interest rate is higher by 7% – 3.88% = 3.12%
120 × (1 – 0.0312) = 116.26
Based on the assumption that international parity conditions will hold in the long run,
should the JPY and euro currency exposures of the bank's major customer be left
unhedged?
A) Both currencies should be left unhedged.

B) Neither currency should be left unhedged.
C) One currency should be left unhedged and the other should not.
Explanation
This question requires you to look at deviations from international parity conditions
and then determine whether those deviations will tend to work to the advantage of
the customer. In this problem, you are given the necessary information to examine
parity conditions using relative purchasing power parity (RPPP). For the JPY, RPPP
tells us that, because the spot rate one year ago was 116 and U.S. inflation was 3%
higher than Japan's, the spot rate today should be:
Stoday(assuming RPPP held) = Slast year (1 − 0.03) = 116(0.97) = 112.52
Because the expected spot rate today, based on RPPP (i.e., 112.52), is not equal to
the actual spot rate today (i.e., 120), RPPP did not hold over the past year. Because
the actual rate is higher than the rate forecast by RPPP, the long-term trend based
on deviations from international parity conditions will be for the rate to fall and the
JPY to appreciate. Hence, using deviations from parity conditions as indicators of
future currency movements, the bank should recommend that the JPY exposure be
left unhedged.
Using the same RPPP process for the EUR exposure, we can calculate an RPPP spot
rate today of 0.7340 (given that the rate was 0.72 one year ago and that U.S.
inflation was lower by 2%):
Stoday(assuming RPPP held) = Slast year (1 + 0.02) = 0.72(1.02) = 0.7344
Again, RPPP did not hold (i.e., the actual rate today, 0.7224, is not equal to the RPPP
rate that should exist today given the inflation rates). However, for the EUR case, the
RPPP expected spot is higher than the actual spot, indicating that the EUR may be
currently overvalued and, thus, more likely to depreciate in the future. EUR
exposure should be hedged. (Module 5.2, LOS 5.g)
TOPIC: FINANCIAL STATEMENT ANALYSIS
Kevin Rathbun, CFA, is a financial analyst at a major brokerage firm. His supervisor,
Elizabeth Mao, CFA, asks him to analyze the financial position of Wayland, Inc.
(Wayland), a manufacturer of components for high quality optic transmission systems.
Mao also inquires about the impact of any unconsolidated investments.
On December 31, 2017, Wayland purchased a 35% ownership interest in a strategic

new firm called Optimax for $300,000 cash. The pre-acquisition balance sheets of
both firms are found in Exhibit 1: Pre-Acquisition Balance Sheets for Wayland and
Optimax.
Exhibit 1: Pre-Acquisition Balance Sheets for Wayland and Optimax

Balance Sheets as of Dec. 31, 2017 in Thousands Wayland Optimax
Assets
Cash $710 $100
Marketable securities 2,550 –
Inventory 2,000 400
Accounts receivable 3,000 500
Property, plant, and equipment 2,450 1,000
Total assets $10,710 $2,000
Liabilities
Accounts payable $3,310 400
Long-term debt 5,000 1,000
Equity 2,400 600
Total liabilities and equity $10,710 $2,000
On the acquisition date, all of Optimax's assets and liabilities were stated on its
balance sheet at their fair values except for its property, plant, and equipment (PP&E),
which had a fair value of $1.2 million. The remaining useful life of the PP&E is 10 years
with no salvage value. Both firms use the straight-line depreciation method.
For the year ended 2018, Optimax reported net income of $250,000 and paid
dividends of $100,000.
During the first quarter of 2019, Optimax sold goods to Wayland and recognized
$15,000 of profit from the sale. At the end of the quarter, half of the goods purchased
from Optimax remained in Wayland's inventory.
Wayland currently uses the equity method to account for its investment in Optimax.
Rathbun also notes that Wayland owns shares in Vanry, Inc. (Vanry). Rathbun gathers
the data in Exhibit 2: Share Transaction Data, Vanry, Inc. from Wayland's financial
statements. The year-end portfolio value is the market value of all Vanry shares held
on December 31. All security transactions occurred on July 1, and the transaction price
is the price that Wayland actually paid for the shares acquired. Vanry pays a cash
dividend of $1 per share at the end of each year. Wayland expects to sell its
investment in Vanry in the near term and accounts for it as fair value through profit or
loss security.
Exhibit 2: Share Transaction Data, Vanry, Inc.
Year-End Portfolio Year-End Year-End Transaction Price

Year
Value Shares Held Share Price (July 1)
2017 $1,875,000 25,000a $75 $85
2018 $2,280,000 30,000 $76 $78
aPurchased on July 1, 2017.
The amount of goodwill resulting from Wayland's acquisition of Optimax is closest to:
A) $20,000.
B) $70,000.
C) $90,000.
Explanation
The excess of purchase price over the pro rata share of the book value of Optimax is
allocated to PP&E. The remainder is goodwill.
Purchase price (in thousands) $300

Less: Pro rata share of
210 [$600 Optimax book value × 35%]
Optimax
Excess of purchase price 90
[($1,200 fair value − $1,000 book value) ×
Less: Excess allocated to PPE 70
35%]
Acquisition goodwill $20
(Module 8.3, LOS 8.a)
The amount that Wayland should report in its balance sheet at the end of 2018 as a
result of its investment in Optimax is closest to:
A) $345,500.
B) $352,000.
C) $380,500.
Explanation
Under the equity method, Wayland recognizes its pro rata share of Optimax's net
income, less the additional depreciation that resulted from the increase in fair value
of Optimax's PP&E.
Pro rata share of Optimax's net income $87,500 [$250,000 × 35%]

Less: Additional depreciation from PPE 7,000 [($200,000 / 10 years) × 35%]
Equity income $80,500
Wayland's investment account on the balance sheet increased by its equity income
and decreased by the dividends received from the investment.
Beginning investment account $300,000

Equity income from Optimax 80,500
Less: Dividends received 35,000 [$100,000 dividends × 35%]
Ending investment account $345,500
(Module 8.1, LOS 8.b)
Considering Wayland's intercompany sales transaction for the quarter ended March
31, 2019, the amount by which Wayland should reduce its equity income is closest to:
A) $2,625.
B) $7,500.
C) $15,000.
Explanation
Because all of the profit from the intercompany transaction is included in Optimax's
net income, Wayland must reduce its equity income of Optimax by the pro rata
share of the unconfirmed profit. Because half of the goods remain, half of the profit
is unconfirmed. Thus, Wayland must reduce its equity income by $2,625 [($15,000
total profit × 50% unconfirmed) × 35% ownership interest]. (Module 8.5, LOS 8.b)
As a result of its investment in Vanry, the amount of profit that Wayland should
recognize in its income statement for the year ended 2018 is closest to:
A) $15,000.
B) $25,000.
C) $45,000.
Explanation
The change in market value for the period and dividends received from the
investment are recognized in the income statement for fair value through profit or
loss securities. In 2018, there was a $25,000 unrealized gain on the original 25,000
shares [25,000 shares × ($76 – $75)] and a $10,000 unrealized loss on the shares
purchased in 2018 [5,000 shares × ($76 – $78)]. Wayland received $30,000 in
dividends from Vanry (30,000 shares × $1 per share). For 2018, the income
statement impact is a $45,000 profit ($25,000 unrealized gain on original shares –
$10,000 unrealized loss on increase in shares + $30,000 dividends received).
Overview for Questions #13-16 of

88 Question ID: 1509451
Ota L'Abbe, a supervisor at an investment research firm, has asked one of the junior
analysts, Andreas Hally, to draft a research report dealing with various accounting
issues.
Excerpts from the request are as follows:
"There's an exciting company that we're starting to follow these days. It's called
Snowboards and Skateboards, Inc. They are a multinational company with
operations and a head office based in the resort town of Whistler in western
Canada. However, they also have a significant subsidiary located in the United
States."
"Look at the subsidiary and deal with some foreign currency issues, including
the specific differences between the temporal and current rate methods of
translation, as well as the effect on financial ratios."
"The attached file contains the September 30, 2018, financial statements of the
U.S. subsidiary. Translate the financial statements into Canadian dollars in a
manner consistent with U.S. GAAP."
Snowboards and Skateboards, Inc. (U.S.)

(U.S. Dollars)
Balance Sheet as of 9/30/2018
Cash and accounts receivable 775,000
Inventory 600,000
Property, plant, and equipment (PP&E) – net 730,000
Total assets 2,105,000
Accounts payable 125,000
Long-term debt 400,000
Common stock 535,000
Retained earnings 1,045,000
Total liabilities and shareholders' equity 2,105,000
Income statement for the year ended 9/30/2018
Sales 1,352,000
Cost of goods sold (1,205,000)
Depreciation (140,000)
Net income 7,000
Other information to be considered:
Exchange rates (CAD/USD)
Fiscal 2017 (average) 1.44
Fiscal 2018 (average) 1.35
October 1, 2014 1.50
September 30, 2017 1.48
June 30, 2018 1.37
September 30, 2018 1.32

Beginning inventory for fiscal 2018 had been purchased evenly throughout fiscal
2017. The company uses the FIFO inventory value method.
Dividends of USD 25,000 were declared on June 30, 2018.
All of the remaining inventory at the end of fiscal 2018 was purchased evenly
throughout fiscal 2018.
All of the PP&E was purchased, and all of the common equity was issued at the
inception of the company on October 1, 2014. No new PP&E has been acquired,
and no additional common stock has been issued since then. However, they
plan to purchase new PP&E starting in fiscal 2019.
The beginning retained earnings balance for fiscal 2018 was CAD 1,550,000.
The accounts payable on the fiscal 2018 balance sheet were all incurred on June
30, 2018.
The U.S. subsidiary's operations are highly integrated with the main operations
in Canada.
The remeasured inventory for 2018 using the temporal method is CAD 810,000.
Costs of goods sold under the temporal method in 2018 is CAD 1,667,250.
Compared to the temporal method, which of the following financial statement

elements of the parent are lower under the current rate method?
A) Cash and accounts receivable.

B) Depreciation expense and cost of goods sold.
C) Common stock and dividends paid.
Explanation
Depreciation expense and COGS are remeasured at the historical rate under the
temporal method. Under the current rate method, depreciation and COGS are
translated at the average rate. Because the U.S. dollar is depreciating, depreciation
expense and COGS are lower under the current rate method. (Module 10.5, LOS
10.e)
Using the appropriate translation method, which of the following best describes the
effect of changing exchange rates on the parent's fiscal 2018 financial statements?
A) An accumulated loss of CAD 242,100 is reported in the shareholders’ equity.
B) A loss of CAD 31,200 is recognized in the income statement.
C) A gain of CAD 27,400 is recognized in the income statement.
Explanation
Because the subsidiary's operations are highly integrated with the parent, the
temporal method is used. Accordingly, a loss of CAD 31,200 is recognized in the
parent's income statement (see balance sheet and income statement worksheet
next). However, no calculations are actually necessary to answer this question. The
parent has a net monetary asset position in the subsidiary (monetary assets >
monetary liabilities). Holding net monetary assets when the foreign currency is
depreciating will result in a loss. Under the temporal method, the loss is reported in
the income statement. Only choice B satisfies this logic.
The Canadian dollar is the functional currency because the subsidiary is highly
integrated with the parent. Therefore, the temporal method applies.
Step 1: Remeasure the balance sheet using the temporal method.
2018 (USD) Rate 2018 (CAD)

Cash and account receivables 775,000 1.32 1,023,000
Inventory (given in Item 9) 600,000 Given 810,000
PP&E (net) 730,000 1.50 1,095,000
Total assets 2,105,000 2,928,000
Accounts payable 125,000 1.32 165,000
Long-term debt 400,000 1.32 528,000
Common stock 535,000 1.50 802,500
Retained earnings 1,045,000 (a) 1,432,500
Total liabilities and shareholders'
2,105,000 2,928,000
equity
(a) Retained earnings is a plug figure that makes the accounting equation balance
CAD 2,928,000 assets − CAD 165,000 accounts payable − CAD 528,000 long-term
debt − CAD 802,500 common stock = CAD 1,432,500.
Step 2: Derive net income from the beginning and ending balances of
retained earnings and dividends paid as follows:
CAD
Beginning retained earnings 1,550,000 Given Item 6
Net income (83,250) Calculate
Dividends paid in the year (34,250) (25,000 × 1.37 historical rate)
Ending retained earnings 1,432,500 From Step 1
Step 3: Remeasure the income statement using the temporal method.
2018 (USD) Rate 2018 (CAD)

Sales 1,352,000 1.35 1,825,200
Cost of goods sold (given Item 11) (1,205,000) Given (1,667,250)
Depreciation expense (140,000) 1.50 (210,000)
Remeasurement loss (b) (31,200)
Net income 7,000 From Step 2 (83,250)
(b) The remeasurement loss is a plug that is equal to the difference in net income
of −CAD 83,250 and income before remeasurement of –CAD 52,050 (CAD 1,825,200
sales − CAD 1,667,250 COGS − CAD 210,000 depreciation).
(Module 10.5, LOS 10.e)
As compared to the temporal method, the parent's fixed asset turnover for fiscal 2018
using the current rate method is:
A) higher.
B) lower.
C) the same.
Explanation
The local currency (the USD) is depreciating, so the historical rate will be higher than
the current rate. Fixed asset turnover (sales divided by net PP&E) will be higher
under the current rate method. Net PP&E will be translated at the lower current
rate, and because sales are the same under both methods, the ratio will be higher. If
you want to do the calculations, net PP&E under the current rate method is USD
730,000 × 1.32 CAD/USD = CAD 963,600, and fixed asset turnover is CAD 1,825,200 /
CAD 963,600 = 1.9 times. Fixed asset turnover under the temporal method is CAD
1,825,200 / CAD 1,095,000 = 1.7 times. (Module 10.3, LOS 10.d)
Suppose the parent uses the current rate method to translate the subsidiary for fiscal
2018. Will return on assets and net profit margin in U.S. dollars before translation be
the same as, or different than, the translated Canadian dollar ratios?
Return on assets Net profit margin
A) Same Different
B) Different Different
C) Different Same
Explanation
Return on assets prior to translation will be different than the ratio after translation
because the numerator (net income) is translated at the average rate, and the
denominator (assets) is translated at the current rate using the current rate method.
Net profit margin will be the same because both the numerator (net income) and
the denominator (sales) are translated at the average rate using the current rate
method. (Module 10.6, LOS 10.f)

TOPIC: CORPORATE ISSUERS
Alertron is a retail pharmacy chain with approximately $3.5 billion in annual sales.
After rapid expansion into new geographical markets, Alertron's same-store sales
have been shrinking, and the firm's nonpharmacy business has been a drag on the
company's bottom line. Alertron stopped making dividend payments last quarter, and
the company's stock is trading at a multiyear low of $11.
New accounting standards will impact the way Alertron reports leases on the
company's brick-and-mortar stores. These changes will reduce the company's fixed-
charge coverage ratio below the level specified in the company's debt covenants. The
market price and the ratings on the company's debt have accordingly dropped.
Analysis of the individual lease terms for new stores reveals that a building with a fair
value of $10.2 million (including the lessor's initial costs) is leased for 20 years for
annual payments of $1.08 million. The value of the building after 20 years is estimated
to be $4.6 million. Alertron's corporate tax rate is 15%.
Phillip Margos, CEO of the company, is preparing for a tough meeting with Alertron's
board of directors. One of the items that Margos drafts is a list of potential corporate
restructuring actions.

Which of the following would be the most appropriate approach for estimating
Alertron's cost of equity?
A) Gordon growth model.

B) CAPM.
C) Exapnded CAPM.
Explanation
We are given that the company's stock trades; hence, we should be able to estimate
the company's beta and apply CAPM to calculate the cost of equity. The Gordon
growth model is not appropriate here because the company has stopped making
dividend payments (and growth may not be constant, given the significant corporate
restructuring that may occur). Expanded CAPM is used for privately held companies.
The most appropriate cost of debt for Alertron is:
A) the YTM on the longest-maturity straight debt outstanding.

B) the interest rate on a new bank loan.
C) the RIIL.
Explanation
If the company's debt is traded, then the yield to maturity on the longest-maturity
straight debt should be used as the estimate of cost of debt. The rate on new bank
loans is only used for companies that rely on bank loans (not given in this case). The
rate implicit in the lease (RIIL) provides an estimate of the cost of lease obligations.
The rate implicit in the lease for new stores is closest to:
A) 8.14%.
B) 8.53%.
C) 9.58%.
Explanation
PV = -10.6, N = 20, PMT = 1.08, and FV = 4.6. CPT I/Y = 9.58%. (Module 17.1, LOS 17.e)
Which of the following corporate restructuring actions would be least appropriate for
Margos to include in his presentation to the board?
A) Acquisition.
B) Divestiture.
C) Cost restructuring.
Explanation
Alertron is facing potential violation of debt covenants. In a divestiture, Alertron
would sell a segment of the company (or group of assets) to an acquirer for cash,
which would allow Alertron to reallocate capital to debt reduction. A cost
restructuring could similarly help to fend off violations in debt covenants. An
acquisition, on the other hand, would involve expending scarce corporate resources,
which is likely to be inappropriate for Alertron at this time. (Module 18.1, LOS 18.a)

TOPIC: EQUITY VALUATION
Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized
investment firm operating in the northeastern United States. De Jong is responsible
for producing financial reports to use as tools to attract new clients. It is now early in
2019, and De Jong is reviewing information for O'Connor Textiles and finalizing a
report that will be used for an important presentation to a potential investor at the
end of the week.
Following an acquisition of a major competitor in 2002, O'Connor went public in 2003

and paid its first dividend in 2009. Dividends are paid at the end of the year. After
2018, dividends are expected to grow for three years at 11%: $2.13 in 2019, $2.36 in
2020, and $2.63 in 2021. The average of the arithmetic and compound growth rates
are given in Exhibit 1: O'Connor Textiles Dividend History. Dividends are then
expected to settle down to a long-term growth rate of 4%. O'Connor's current share
price of $70 is expected to rise to $72.92 by the end of the year according to the
consensus of analysts' forecasts.
O'Connor's annual dividend history is shown in Exhibit 1: O'Connor Textiles

Dividend History.
Exhibit 1: O'Connor Textiles Dividend History
Year Dividend ($) % Change
2009 0.76
2010 0.76 0.000
2011 0.76 0.000
2012 0.82 7.895
2013 0.91 10.976
2014 1.03 13.187
2015 1.16 12.621
2016 1.34 15.517
2017 1.52 13.433
2018 1.92 26.316
2009–2018 Arithmetic mean growth = 11.1%
2009–2018 Compound growth = 10.9%
De Jong is also considering whether or not she should value O'Connor using a free
cash flow model instead of the dividend discount model.
Charles Wang, De Jong's colleague, is of the opinion that O'Connor's growth rate will
be 11% but will decline linearly to a long-term growth rate of 4% over the next six
years. Wang also feels that the required rate of return for O'Connor should be 9.5%.

For this question only, assume that De Jong's estimate of the value of O'Connor stock
using a two-stage DDM is $75. Assuming the market has also applied a two-stage
DDM, and the market's consensus estimate of dividend growth and required return
are the same as De Jong's, the market's consensus estimate of the duration of the
high-growth period is most likely:
A) less than three years.

B) equal to three years.
C) greater than three years.
Explanation
De Jong's estimate of value of $75 (based on a high-growth period of three years) is
greater than the market's consensus of $70, which means the market's consensus
high-growth duration must be less than three years, all else equal. (Module 20.1,
LOS 20.b)
In what situation is it most appropriate for De Jong to employ these models?
Dividend discount model FCFE model
A) Noncontrol perspective FCFE aligned with profitability
B) Control perspective FCFE aligned with profitability
C) Noncontrol perspective FCFE aligned with dividend policy

Explanation
For the dividend discount model to produce a reasonable estimate of share price,
the investor should have a noncontrol perspective. For the FCFE model to be
appropriate, there should be a link between FCFE and profitability. (Module 20.1,
LOS 20.a)
The value of O'Connor stock using Wang's assumptions is closest to:
A) $43.64.
B) $48.75.
C) $52.35.
Explanation
H = 6 / 2 = 3, D0 = 1.92, r = 0.095, gS = 0.11, gL = 0.04
D0 (1+g ) D0 ×H×(g −g )
L s L
P0 = +
(r−g ) (r−g )
L L
1.92(1.04)
1.92×3×0.07
= + = $43.64
(0.095−0.04) (0.095−0.04)
(Module 20.3, LOS 20.n)
For this question only, assume that the market price of O'Connor stock is $48.00 and
the linearly declining high-growth period is five years. The required rate of return
implicit in the market price is closest to:
A) 8.86%.
B) 9.22%.
C) 10.81%.
Explanation
D0
r = [( ) × [(1 + gL ) + [H × (gS − gL )]]] + gL
P0
1.92
= [( ) × [(1.04) + (2.5 × 0.07)]] + 0.04 = 0.0886
48
(Module 20.3, LOS 20.i)

TOPIC: FIXED INCOME
Ted Thompson, CIO for Aplius Insurance Company, is evaluating the credit risk
management models for the company's fixed income portfolio. Thompson meets with
Nambi Musa, who is the head of Aplius's credit risk analysis department. Musa
assures Thompson that his team has updated the credit risk analysis models over
recent years and that these updated models have performed well over the past 12
months. Thompson, however, is not pleased with the losses incurred on Aplius's
municipal bond holdings in the last quarter.
Musa mentions that while the credit risk analysis department continues to use credit
ratings, they are also evaluating other analytical tools including structural models. He
specifically mentions credit valuation adjustment and expected loss as other credit
risk measures currently being used. Musa makes the following two statements:
"Company credit ratings are based on senior secured debt

Statement 1: issued by the company. Ratings on other issues by the same
company are adjusted by a process known as notching."
"The credit valuation adjustment on a bond is the maximum

Statement 2: amount an investor would be willing to pay to an insurer to
bear the credit risk of that security."
Musa further discusses the credit analysis metrics that are newly developed. As an
example, he illustrates the valuation conducted on 3-year, 5% Zeta Corp. $100 par,
senior unsecured bonds. Exhibit 1: Valuation of 3-Year, 5% Zeta Corp. Bond shows
the report.
Exhibit 1: Valuation of 3-Year, 5% Zeta Corp. Bond
Period Cash Flow LGD POD DF
1 5.00 32.648 1.500% 0.971
2 5.00 32.083 1.478% 0.943
3 105.00 31.500 1.455% 0.915
Thompson then tells Musa that the credit analysis department should focus on
reduced-form models. Thompson states that, "reduced-form models perform better
than structural models as they tend to impose assumptions on the outputs of the
structural model. However, reduced-form models require a specification of the
company's balance sheet composition."
Musa's Statement 1 is most likely:
A) correct.
incorrect because the process of adjusting ratings on issues by same issuer is not
B)
called notching.
incorrect because corporate credit ratings are based on senior unsecured
C)
debt of the issuer.
Explanation
Statement 1 is incorrect. Issuer rating for a company is typically based on its senior
unsecured debt. Ratings on other classes of debt by the same issuer may be
notched. (Module 28.3, LOS 28.b)
Musa's Statement 2 is most likely:
A) correct.
B) incorrect as the statement only considers credit risk.
incorrect as the statement should refer to expected loss and not to credit valuation
C)
adjustment.
Explanation
Statement 2 is correct. Credit valuation adjustment is the compensation an investor
receives for bearing the credit risk and is the maximum amount the investor would
be willing to pay to insure against credit risk losses. (Module 28.1, LOS 28.a)
Using information in Exhibit 1: Valuation of 3-Year, 5% Zeta Corp. Bond, the credit
valuation adjustment for the Zeta Corp. bond is closest to:
A) $1.34.
B) $1.86.
C) $2.72.
Explanation
Cash Prob. of Expected Discount

Period LGD PVEL
Flow Default Loss Factor
1 5.00 32.648 1.500% 0.490 0.971 0.475
2 5.00 32.083 1.478% 0.474 0.943 0.447
3 105.00 31.500 1.455% 0.458 0.915 0.420
CVA = 1.3418
Thompson's statement about reduced-form models relative to structural model is

most likely:
A) correct.
B) incorrect regarding assumptions imposed.
incorrect regarding specification of balance sheet composition being
C)
required.
Explanation
While Thompson's statement about reduced-form models imposing assumptions on
the output of structural models is correct, Thompson is incorrect about balance
sheet composition being required—reduced-form models do not require a
specification of the company's balance sheet structure. (Module 28.4, LOS 28.d)

TOPIC: DERIVATIVES

Jonathan Adams, CFA, is doing some scenario analysis on swaps ands forward
contracts. The process involves pricing the contracts and then estimating their values
based on likely scenarios provided by the firm's forecasting and strategy departments.
The contracts with which Adams is most concerned are those on interest rates.
The MRR spot curve is as follows:
30-day: 3.12% 60-day: 3.32% 90-day: 3.52%
120-day: 3.72% 150-day: 3.92% 180-day: 4.12%
Adams determines the price of a 2×5 FRA from the spot yield curve using the following
calculation:
Thirty months ago, Adams entered into a $1 million notional, 3-year, semiannual
settlement, 3% fixed-rate payer swap.
How many of the following terms are correct in the calculation of the FRA price:
0.0352, 0.0332, 60/360, 90/360?
A) Two.
B) Three.
C) Four.
Explanation
Adams used the 90-day rate (0.0352) and the time period (90/360) in the numerator
instead of the 150-day rate (0.0392) and the 150-day time period (150/360). The
denominator is correct, so two out of the four terms are used correctly. The correct
calculation is:
150
⎡ 1+0.0392( ) ⎤
360
360 1.01633
⎢ ⎥
⎢ − 1⎥ ( ) = [ − 1] (4) = 4.30%
⎢ 60 ⎥ 90 1.00553
1+0.0332( )
⎣ 360 ⎦
(Module 30.4, LOS 30.c)
After 30 days, Adams wants to value a $10 million short position in the 2×5 FRA. The
90-day forward rate in 30 days is now 4.14%, and the original price of the FRA was
4.30%. 120-day MRR has changed to 3.92%. The current value of the $10 million FRA to
the short position under this scenario is closest to:
A) $15,794.
B) $3,948.
C) –$15,794.
Explanation
(0.0430 – 0.0414) × $10 million × 90 / 360 = $4,000 (expected payoff in 120 days)
$4,000
PV of payoff is = $3, 948
120
1+0.0392( )
360
Immediately after the fifth settlement, the value of the swap to Adams is closest to:
A) $5,487.
B) $5,600.
C) $11,076.
Explanation
Original swap tenor is 3 years, semiannual. After 30 months, there is only one
settlement remaining. Hence: SFRnew = MRR corresponding to that settlement =
4.12% DF (180-day) = 1 / (1 + 0.0412 × (180 / 360)) = 0.9798
valuepayer = ΣZ × (SFRnew − SFRold) × (days / 360) × notional principal = 0.9798 ×
(0.0412 – 0.03) × (180 / 360) × 1,000,000 = $5,487
Suppose that Adams entered into the FRA as a short party and now wants to hedge
that exposure. The most appropriate way to achieve that hedge would be to take on
exposure to:
A) a long interest rate call and short interest rate put.

B) a short interest rate call and long interest rate put.
C) a receiver swap.
Explanation
A short FRA position can be hedged by a long position in an equivalent FRA. Long
FRA = long IR call + short IR put
(Module 31.6, LOS 31.j)

TOPIC: ALTERNATIVE INVESTMENTS
Julie Mariluz is a real estate analyst with Young Family Trust (YFT), a family investment
office. Aside from investment in equities and bonds, YFT makes direct investment in
diverse real estate properties. Mariluz has been asked to evaluate three potential
investment properties shown in Exhibit 1: Property Description
Exhibit 1: Property Description
Property 1: A multi-family residential building with high occupancy and in a

desirable location.
Property 2: An older office building with dated architectural features and in

an area that is undergoing significant improvements.
Property 3: A shopping mall with two anchor tenants.
Mariluz prepares a presentation for the members of the Young family. In it, she makes
the following statements:
Private real estate investments face demand and supply risks due to
Statement
changes in business conditions and demographics, and due to the
1:
potential for excess supply.
Statement Valuation related risk factors include illiquidity, management expertise,

2: and the availability and cost of capital.
Which property valuations are most likely to be heavily influenced by their unique
characteristics?
A) Property #1 and Property #2.

B) Property #1 and Property #3.
C) Property #2 and Property #3.
Explanation
While almost any private equity real estate investment will be unique (if for no other
reason than that they must be in different locations), residential properties tend to
have the fewest unique characteristics. This is why transactions-based indices tend
to be more useful for residential commercial property benchmarking than for
nonresidential commercial properties due to the large amount of data required for
many properties and the unique features of many nonresidential commercial
properties.
Regarding statements 1 and 2 made by Mariluz, which of the following is most

accurate?
A) Only statement 1 is correct.

B) Only statement 2 is correct.
C) Both statements are correct
Explanation
Statement 1 is correct.
Property demand and supply risks include the 3 risk factors identified in the
statement.
Statement 2 is incorrect. Management expertise is classified as an operational risk
factor and not a valuation risk factor. Valuation-related risk factors include: cost and
availability of capital, availability of information, lack of liquidity, and the interest
rate environment.
The least important step in the due diligence of property #1 is:
A) Review the local market to identify demographics, preferences and wage growth.
B) Review of the terms of tenants' leases.
C) Review of cash flow statements and maintenance expenses.
Explanation
For buildings with large anchor tenants that have multi-year leases (e.g., department
stores in shopping malls), the due diligence process should includes a review of
leases for major tenants. However, Property 3 is a residential building, so this best
practice does not apply directly. The other two risk factors are important elements
of due diligence to mitigate the investment risk for property 1.

YFT is considering the use of an index as a benchmark for measuring the performance
of the firm's private real estate investments. Compared to a transaction-based real
estate index, an appraisal-based real estate index is most likely to have higher:
A) lag.
B) volatility.
C) correlation with other asset classes.
Explanation
Appraisal-based indices tend to lag transaction-based indices, and will appear to
have lower correlation with other asset classes and lower volatility compared to
transaction-based indices.

TOPIC: ETHICAL AND PROFESSIONAL STANDARDS
Mike Zonding, CFA, is conducting a background check on CFA candidate Annie Cooken,
a freshly minted MBA who applied for a stock-analysis job at his firm, Khasko
Financial. Zonding does not like to hire anyone who does not adhere to the Code and
Standards' professional conduct requirements.
The background check reveals the following:
(i) While doing a full-time, unpaid internship at Kale Investments, Cooken

was reprimanded for working a 30-hour-a-week night job as a waitress.
(ii) As an intern at Lammar Corp., Cooken was fired after revealing to the
FBI that one of the principals was embezzling from the firm's clients.
(iii) Cooken performed 40 hours of community service in relation to a

conviction on a misdemeanor drug possession charge when she was 16
years old.
(iv) On her resume, Cooken writes, "Recently passed Level II of the CFA
exam, a test that measures candidates' knowledge of finance and
investing."
During the interview, Zonding asks Cooken several questions on ethics-related issues,
including questions about the role of a fiduciary and Standard III(E) Preservation of
Confidentiality. He asks her about her internship at Kale Investments, specifically
about the working hours. Cooken replies that the internship turned out to require
more time than she originally planned, up to 65 hours per week.
Zonding subsequently hires Cooken and functions as her supervisor. On her third day
at the money management boutique firm, portfolio manager Steven Clarrison hands
her a report on Mocline Tobacco and tells her to revise the report to reflect a buy
rating. Cooken is uncomfortable about revising the report.
Zonding prepared a research report with a buy rating on Orlando Stores, a discount
clothing chain. Khasko's investment banking department has completed transactions
for Orlando in the past 12 months and currently is working with Orlando to evaluate a
secondary offering; Khasko has a policy in place that separates the activities of
investment banking and research departments.
In the report, Zonding disclosed that Khasko has an investment banking relationship
with Orlando and that his wife holds Orlando shares. However, he forgot to comment
on the risk profile and suitability of investing in Orlando shares.
Zonding just entered into a brokerage agreement with Zeta Services. According to that
agreement, in exchange for client referrals from Zeta, Khasko would give Zeta its
brokerage business. Khasko advised its clients about the nature and extent of this
relationship in writing.
In the context of the Code and Standards, which of the items from the background
check would most likely indicate that Zonding should not have hired Cooken?
A) Item i.
B) Item ii.
C) Item iii.
Explanation
Item (i) is a likely violation of the Code and Standards. Working as a waitress is not a
conflict of interest for an investment analyst, but Cooken's employer can reasonably
assume that a 30-hour-a-week side job could be tiring, depriving the company of her
skills and ability during her internship, which would violate Standard IV(A) Loyalty (to
employer).
Cooken's description of the CFA exam is accurate, and she takes no liberties with a
title. Thus she has not violated Standard VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program.
One conviction as a teenager before working as an investment professional is not a
violation of Standard I(D) Misconduct. Standard IV(A) Loyalty (to employer) does not
hold when illegal activities are involved, and Cooken's willingness to talk to the FBI
would most likely not be considered a violation. The Standards do suggest, however,
that the member consult with his employer's compliance personnel or outside
counsel before disclosing any confidential client information. (Module 42.7, LOS
42.a)
Which of the following statements provides the least appropriate justification for
Cooken's caution about revising the report on Mocline Tobacco?
A) Cooken knows next to nothing about Mocline stock.

B) Cooken’s uncle, George Whates, is the CFO of Mocline.
In college, Cooken worked for Mocline, but never declared the income on
C)
her taxes.
Explanation
While Cooken's tax avoidance may represent a professional-conduct issue, it has no
bearing on her ability to write a report on Mocline. While Clarrison may be an expert
on Mocline, Cooken does not know enough about the stock to write about it without
taking the risk of being in violation of Standard V(A) Diligence and Reasonable Basis.
Because of Cooken's relationship to the CFO of Mocline and ownership of Mocline
stock, her objectivity might be questioned. (Module 42.8, LOS 42.a)
Was Zonding in compliance with CFA Institute Standards of Professional Conduct with
regard to the Orlando Stores research report?
No, because Zonding neglected to discuss Orlando’s suitability as an
A)
investment.
No, because Zonding failed to disclose Orlando’s plans to announce a secondary
B)
offering in the near future.
Yes, because Zonding disclosed his firm’s relationship with Orlando, his wife’s
C)
ownership of the shares, and the availability of his Orlando report.
Explanation
Zonding's research report failed to include sufficient information be included for
investors to assess the appropriateness of the investment for their own personal
risk profile violating Standard V(B) Communication with Clients and Prospective
Clients. (Module 42.8, LOS 42.a)
Did Zonding and Khasko follow the recommended procedures of the CFA Institute
Standards of Professional Conduct with respect to the brokerage arrangement with
Zeta?
A) Yes, because Khasko disclosed this arrangement to their clients.

B) No, because Khasko did not preserve confidentiality of their agreement with Zeta.
C) No, because the agreement inappropriately creates a conflict of interest.
Explanation
Zonding complied with Standard VI(A) in making disclosure about Khasko's
relationship with Zeta. Standard III(E) Preservation of Confidentiality is not
applicable here because Zeta is not a client. (Module 42.9, LOS 42.b)

Brandon Ratlieff, CFA, is a partner at Global Asset Management (GAM). CFA program
candidate Sarah Gunderson just completed her first year at GAM. Ratlieff is going over
Gunderson's annual evaluation completed by her supervisor Peter Jackson, CFA.
To supplement the meager income from her entry-level stock-analysis job, Gunderson
took a part-time position working three hours each Friday and Saturday night tending
bar at a sports bar and grill downtown. Gunderson did not inform her supervisor or
HR about the job.
During her first week, Gunderson has lunch with her former classmates, including
Taira Basch, CFA, who works for the compliance officer at a large investment bank in
town.
Basch arrives late, explaining, "What a day, it's only noon and already I have worked
on the following requests:
1. A federal regulator called and wanted information on potentially illegal activities

related to one of the firm's key clients.
2. A rival company's employee wanted information regarding employment
opportunities at the firm.
3. A potential client contacted an employee and wanted detailed performance
records of client accounts so he can decide whether to invest with the firm."
One of GAM's clients is Bluestar Inc. Several months ago, Ratlieff filed several
documents with regulators concerning Bluestar's IPO. A Bluestar official later provided
Ratlieff information that suggested that the financial statements GAM filed with the
regulator overstate the issuer's earnings.
Ratlieff seeks the advice of GAM's general counsel, who states that because Ratlieff
was not aware of the irregularity at the time of the filing, it would be difficult for the
regulator to prove that GAM has been involved in any wrongdoing.
GAM provides research coverage for ASE, a European retailer. Gunderson's mother
owns 30,000 ASE shares. As part of her estate planning, Gunderson's mother informs
Gunderson that she has created a trust in Gunderson's name, into which she has
placed 2,000 shares of ASE. The trust is structured so that Gunderson will not receive
control of the assets for three years. Gunderson is due to update the research
coverage of ASE within the next two weeks.
By not telling her employer about the bartending position, Gunderson has most likely
violated:
A) no Standards.
B) Standard IV(B) Additional Compensation Arrangements.
Standard IV(A) Loyalty (to employer) and Standard IV(B) Additional Compensation
C)
Arrangements.
Explanation
Standard IV(A) Loyalty (to employer) requires that members and candidates act for
the benefit of their employer and not deprive the employer of their skills and
abilities. In addition, members and candidates must not cause harm to their
employers. It's safe to say that a bar does not compete with a stock analysis/asset
management company, and a six-hours-a-week part-time job should not interfere
with her ability to perform analysis duties. Standard IV(B) Additional Compensation
Arrangements relates to additional compensation related to an employee's services
to the employer. The part-time work is not related to her analysis job and, as such,
does not violate the Standard. There is nothing inherently unethical about working
as a bartender, and working as a barkeeper does not compromise Gunderson's
professional reputation, integrity, or competence. Thus, Standard I(D) Misconduct
has not been violated. (Module 42.7, LOS 42.a)
Which of the requests, if fulfilled, is most likely to place Basch in violation of Standard
III(E) Preservation of Confidentiality?
A) Request 1.
B) Request 2.
C) Request 3.
Explanation
Request 3 is a likely violation. Potential clients are not entitled to performance data
beyond what the company chooses to disclose. Providing data, particularly client-
specific data, could be a violation of the clients' confidentiality.
Members and candidates must answer questions asked by CFA Institute's
Professional Conduct Program. Members and candidates may report illegal activities
(and in some cases may have a legal obligation to report such activities) on the part
of clients without fear of violating Standard III(E) Preservation of Confidentiality, so
Request 1 is not likely a violation. And unless the firm's policy requires silence about
job openings, answering questions about them is ethical, if not always wise, so
Request 2 is not likely a violation. (Module 42.6, LOS 42.a)
With respect to the information about Bluestar, Ratlieff's most appropriate course of
action would be to:
A) treat the information received from the company official as confidential.

B) seek independent legal counsel about his obligations under the law.
C) report the information to the regulator.
Explanation
Although it is recommended that members and candidates seek the advice of legal
counsel, the reliance on such advice does not absolve a member or candidate from
his responsibilities under Standard I(A) – Knowledge of Law. Ratlieff should
recognize that the recommendation of the firm's general counsel was not in
compliance with the law. There is no requirement under the Standards to report
violations to governmental authorities. (Module 42.1, LOS 42.a)
With regard to research reports on ASE, Gunderson should most appropriately:
advise her supervisor that she is not able to issue research recommendations on
A)
ASE.
disclose her holdings in the report, though she need not notify her supervisor
B)
because the shares are held in trust and are not within her direct control.
disclose the situation to her supervisor and, if then asked to prepare a
C)
report, also disclose the situation in the report.
Explanation
Standard VI(A) – Disclosure of Conflicts requires members to make all conflicts of
interests known to their employers and to comply with any restrictions placed on
members by their employers. Furthermore, members should also disclose these
conflicts in their reports to the firm's clients so that clients can fully evaluate the
report in the context of the conflict. (Module 42.9, LOS 42.a)

Andrew Carson is an equity analyst employed at Lee Vincent and Associates, an

investment research firm. Carson is responsible for following Samilski Enterprises
(Samilski), a publicly traded firm that produces motorcycles and associated
mechanical parts. Samilski reports under U.S. GAAP.
Exhibit 1: Selected Pension Plan Information for FY 20X9 shows selected financial
data pertaining to Samilski's employee pension plan.
Exhibit 1: Selected Pension Plan Information for FY 20X9
$ Millions
Current service cost 118
Past service cost 36
Beginning PBO 1,022
Ending PBO 1,198
Interest cost 82
Actual return on plan assets 214
Employer contribution 102
Beginning plan assets 896
During fiscal year 20X9, a change in actuarial assumptions regarding employee life
expectancy resulted in an actuarial loss of $128 million. Average employee service life
is estimated to be 20 years. In addition to the defined benefit plan, Samilski also offers
an executive stock option plan which vests equally over three years. The discount rate
and expected return on plan assets are 8% and 10% respectively. Carson believes that
rate of compensation increase will be 5% as opposed to the 4% assumed by the plan.
The amount of benefits paid during the year is closest to:
A) $76 million.
B) $132 million.
C) $188 million.
Explanation
Benefits paid can be determined by reconciling ending PBO to beginning PBO:
Beginning PBO 1,022

+ Current service cost 118
+ Past service cost 36
+ Interest cost 82
+ Actuarial loss 128
(–) Benefit paid 188
(=) Ending PBO 1,198
The ending fair value of plan assets is closest to:
A) $1,024 million.
B) $1,128 million.
C) $1,412 million.
Explanation
The ending fair value of plan assets
= beginning fair value + contributions + actual return – benefits paid
= 896 + 102 + 214 – 188 = $1,024 million
For this question only, if Samilski used a lower stock price volatility, the most likely
impact on return on ending stockholder's equity will be:
A) ROE will be lower due to the lower volatility assumption.

B) ROE will be higher due to the lower volatility assumption.
C) There will be no impact on ROE.
Explanation
A lower volatility estimate reduces the fair value of the options. Hence the amortized
amount (expensed to the income statement) will be lower and net income will be
higher. ROE = net income / shareholders' equity. Ending stockholders' equity will not
be affected because a higher retained earnings with a lower volatility assumption
would offset a lower share based compensation reserve.
The amount of periodic pension cost reported in P&L if Samilski reported under IFRS
would be closest to:
A) $144 million.
B) $152 million.
C) $166 million.
Explanation
Under IFRS, periodic pension cost reported in P&L would consist of current and past
service cost plus/minus net interest expense/income. Net interest income is
computed as the discount rate multiplied by beginning funded status (adjusted for
past service cost).
periodic pension cost in P&L = 118 + 36 – 0.08[896 – 1,022 – 36] = 166.96
Note that because the beginning funded status is negative, there is a net interest
cost.

TOPIC : QUANTITATIVE METHODS

Henke Malfoy, CFA, is an analyst with Alpha Securities. He is interested in forecasting
dividend increases in large-cap U.S. stocks. Malfoy starts out with a database of 500
stocks in the S&P 500 Index and formulates the following model:
div = b0 + b1 ΔFCFE + b2 growth + b3 D/E
where:
Div = 1 if the dividend increase, else = 0
ΔFCFE = % change in FCFE from prior year
Growth = growth rate in EPS over the past five years
D/E = debt-to-equity ratio
Exhibit 1: Regression Results shows the results of the model for the year 20X2.
Exhibit 1: Regression Results
Coefficient P-Value
Intercept -2.03 0.02
ΔFCFE -3.112 0.04
Growth -3.13 0.01
D/E -1.118 0.01
Malfoy's colleague, Beth Griner, comments that the usefulness of the output is
dependent on proper model specification. Griner is particularly concerned that
improper model specification may lead to biased and inconsistent model parameters.
Malfoy wants to use advanced algorithms to parse through MD&A in company 10-Q
reports to predict dividend increases. Malfoy starts by removing numbers,
punctuation, blank spaces, and HTML tags from the text data.
What is the change in probability of an increase in dividends when the growth rate in
EPS increases by 1%?
A) 3.13%.
B) 4.19%.
C) 4.37%.
Explanation
The change in ln(odds) for a 1% increase in growth rate = –3.13.
The change in odds = e-3.13 = 0.0437.

The change in probability = 0.0437 / (1 + 0.0437) = 0.0419, or 4.19%. (Module 1.4,
LOS 1.l)
Griner is most likely concerned with the model misspecification of:
A) inappropriate transformation.
B) data that is improperly pooled.
C) the omission of important independent variables.
Explanation
We are given that Griner is concerned with biased and inconsistent model
parameters. The omission of important variables could lead to biased and
inconsistent regression parameters. It may also lead to serial correlation or
heteroskedasticity in residuals. Improperly pooled data may lead to serial
correlation or heteroskedasticity in residuals. Inappropriate transformation may
lead to heteroskedasticity in residuals. (Module 1.3, LOS 1.g)
The most appropriate machine learning algorithm for Malfoy to use to analyze MD&A
is:
A) principal components analysis.

B) support vector machine.
C) random forest.
Explanation
Support vector machine can (among other uses) be applied to classify text from
documents into categories useful for investors. Principal components analysis is
used for unsupervised learning (where there is no target variable; here, we have a
qualitative target variable). A random forest is used with a continuous (rather than
categorical) target variable. (Module 3.2, LOS 3.c)
The step taken by Malfoy to transform the textual data would most appropriately be
called:
A) text preprocessing.
B) data wrangling.
C) text cleansing.
Explanation
The procedure described would most accurately be called text cleansing. Text
cleansing typically involves removing HTML tags, punctuation, white spaces, and
most numbers. The data wrangling (also called preprocessing) task performs
transformations on cleansed data to ready it for model training. Data wrangling or
preprocessing may include dealing with outliers, extracting useful variables, and
scaling the data. (Module 4.1, LOS 4.g)

Lorenz Kummert is a junior equity analyst who is following Schubert, Inc. (Schubert), a
small publicly traded company in the United States. His supervisor, Markus Alter, CFA,
has advised him to use the residual income model to analyze Schubert.
Kummert has determined Schubert's cost of equity, cost of debt, and weighted
average cost of capital (WACC) to be 12.8%, 8.4%, and 11.9%, respectively. Book value
of long-term debt and equity was $6,200,000 and $3,281,000 respectively on January
1, 2018. The stock price on December 31, 2018, is $36 per share and there are 130,000
shares outstanding. The relevant tax rate is 30%, and return on equity (ROE) is
expected to be 14%.
Summarized financial information about Schubert for 2018 is provided in Exhibits 1

and 2.
Exhibit 1: Schubert, Inc., Balance Sheet on December 31, 2018
Cash $125,000 Accounts payable $426,000
Accounts receivable 975,000 Accrued liabilities 774,000
Inventory 1,215,000 Long-term debt 6,211,000
Fixed assets (net) 9,277,000
Common shares 2,100,000
Retained earnings 2,081,000
Total assets $11,592,000 Total liabilities and equity $11,592,000
Exhibit 2: Schubert, Inc., Income Statement for the Year Ended December 31,
2018
Sales $9,423,000
Cost of sales 4,580,000
Selling, general, and administrative 1,230,000
Depreciation 1,745,000
Interest expense 522,000
Income tax expense 403,800
Net income $942,200
Based on his analysis of several years of financial statements, Kummert notes that
2018 was an exceptionally profitable year for Schubert, and that its dividend payouts
are usually low because the funds are mainly reinvested in the firm to promote
growth. Furthermore, there are very few nonrecurring items on the income
statement. Upon review of Kummert's preliminary report, Alter concurs with his
analysis of the financial statements but reminds him that Schubert's long-term debt is
currently trading at 95% of its book value. He also cautions Kummert that violations of
the clean surplus relation can bias the results of the residual income model.
The consensus annual EPS estimate for 2019 is $4.50, and the dividend payout ratio
for 2019 is estimated at 5%.
Which of the following amounts is the most appropriate forecast of Schubert's book
value per share and residual income, respectively, for 2019?
Book value per share Residual income
A) $36.43 $0.38
B) $38.00 $2.32
C) $36.43 $2.32
Explanation
Beginning book value = Total Equity

= Common shares + Retained earnings
= 2,100,000 + 2,081,000 = $4,181,000
Beginning book value (Bt–1) $32.16 ($4,181,000 / 130,000)
Earnings per share forecast (Et) $4.50 (given)
Dividend forecast (Dt = Et × payout ratio) $0.23 ($4.50 × 5%)
Forecast book value per share (Bt–1 + Et − Dt) $36.43
Equity charge per share (r × Bt–1) $4.12 (0.128 × $32.16)

Per share RIt[(Et − (r × Bt–1)] $0.38 ($4.50 − $4.12)

Which of the following amounts are closest to Schubert's economic value added (EVA)
for fiscal year 2018 and market value added (MVA) as of fiscal year-end 2018,
respectively?
EVA MVA
A) $179,361 $188,450
B) $23,455 $369,500
C) ($70,900) $369,500
Explanation
Economic value added (EVA) is calculated as follows:
$WACC = WACC × total capital (beginning of 2018)
= 0.119 × ($6,200,000 + $3,281,000) = $1,128,239
Note that total capital = net working capital + net fixed assets OR book value of long-
term debt + book value of equity
EVA = NOPAT − $WACC

= EBIT(1 − t) − $WACC
= $1,868,000(1 − 0.30) − $1,128,239
= $179,361
market value of the company (year-end 2018)

= market value of the equity + market value of the debt
= ($36 × 130,000) + (0.95 × 6,211,000)
= $10,580,450
market value added (MVA)

= market value − total capital
= $10,580,450 − ($6,211,000 + $2,100,000 + $2,081,000)
= $188,450

Which of the following amounts is closest to Schubert's implied growth rate in residual
income?
A) 0.34%.
B) 2.75%.
C) 12.63%.
Explanation
[B0 ×(ROE−r)]
g = r −
V0 −B0
B0 = [(2,100,000 + 2,081,000)] / 130,000 = $32.16
r = cost of equity = 12.8%
[32.16×(0.14−0.128)]
g = 0.128 −
36−32.16
= 0.0275 = 2.75%
Regarding Alter's caution about violations of the clean surplus relationship, examples
of items that can violate this relationship are most likely to include:
A) foreign currency gains and losses under the current rate method.
B) changes in the market value of debt and equity held as trading securities.
C) changes in net working capital.
Explanation
The clean surplus relationship (i.e., ending book value = beginning book value + net
income – dividends) may not hold when items bypass the income statement and
affect equity directly. Foreign currency gains and losses under the current rate
method bypass the income statement and are reported under shareholders' equity
as CTA. Changes in the market value of trading securities are included in net income
and do not violate the clean surplus relationship. Changes in working capital do not
bypass the income statement. [Usually, changes in working capital do not affect the
income statement. When they do (e.g., inventory write-offs, bad debts, etc.), the
income statement will not be bypassed.] (Module 23.5, LOS 23.k)
Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He
is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has
recently gone through extensive restructuring in the wake of a slowdown in the
economy that has made retailing particularly challenging. As part of his analysis,
Emery has gathered information from a number of sources.
Ferguson Department Stores, Inc.
FDS went public in 1979 following a major acquisition, and the Ferguson name quickly
became one of the most recognized in retailing. Ferguson had been successful
through most of its first 30 years in business and has prided itself on being the one-
stop shopping destination for consumers living on the West Coast of the United
States. Recently, FDS began to experience both top and bottom line difficulties due to
increased competition from specialty retailers who could operate more efficiently and
offer a wider range of products in a focused retailing sector. When the company's
main bank reduced FDS's line of credit, a serious working capital crisis ensued, and
the company was forced to issue additional equity in an effort to overcome the
problem.
FDS has a cost of capital of 10% and a required rate of return on equity of 12%.
Dividends are growing at a rate of 8%, but the growth rate is expected to decline
linearly over the next six years to a long-term growth rate of 4%. The company
recently paid an annual dividend of $1.
At the end of 2018, FDS announced that it would be expanding its retail operations,
moving to a warehouse concept, and opening new stores around the country. FDS
also announced it would close some existing stores, write-down assets, and take a
large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an
earnings-per-share forecast for 2019 of $0.90. He set a 12-month share price target of
$22.50. Immediately following the expansion announcement, the share price of FDS
jumped from $14 to $18.
Exhibit 1: Summary Income Statement, Ferguson Department Stores, Inc. (U.S. $

millions, except per share data and shares outstanding)
2018 2017
Sales $6,435.9 $6,322.7
Cost of goods sold, operating, administrative, and selling

6,007.9 5,875.9
expenses
Depreciation and amortization 148.7 146.6
Interest expense 59.8 59.5
Unusual items—expense 189.1 5.0
Earnings before tax 30.4 235.7
Income taxes—current 49.3 7.5
Income taxes—future (71.1) 93.5
(21.8) 101.0
Net earnings for the year $52.2 $134.7
Earnings per share: Basic $0.49 $1.26
Fully diluted $0.49 $1.26
Weighted average shares outstanding 106,530,610 106,530,610
In 2018, FDS also reported an unusual expense of $189.1 million related to

restructuring costs and asset write downs.
Exhibit 2: Selected Industry Information for 2018
Estimated earnings growth rate 0.10
Mean trailing price/earnings (P/E) ratio 22.50
Mean price/sales (P/S) ratio 0.50
The value of one share of FDS using the H-model is closest to:
A) $14.50.
B) $16.50.
C) $19.33.
Explanation
According to the H-model:
(Module 20.3, LOS 20.n)
Assuming that the cost of equity for FDS does not change, the present value of growth
opportunities in the share price following the announcement that the company would
be expanding its retail operations, using Emery's 2019 earnings forecast, is closest to:
A) $9.00.
B) $10.50.
C) $12.50.
Explanation
E1
The relationship we need to evaluate is V 0
= + PVGO.
r
This expression can be rewritten as

E1 $0.90
PVGO = V0 – = $18 − = $10.50.
r 0.12
Assuming a tax rate of 34%, the underlying earnings per share (EPS) for FDS in 2018 is
closest to:
A) $0.19.
B) $0.73.
C) $1.36.
Explanation
Earnings must be adjusted to reflect the nonrecurring extraordinary item
restructuring costs and asset write downs.
Adjusted 2018 earnings before tax = $30,400,000 + $189,100,000 = $219,500,000.
Adjusted 2018 after-tax earnings = $219,500,000 × (1 – 0.34) = $144,870,000.
2018 underlying EPS = $144,870,000 / 106,530,610 = $1.36
According to FDS's price-to-sales ratio for 2018, based on the post-expansion

announcement stock price, FDS is:
A) underpriced relative to the industry.

B) overpriced relative to the industry.
C) properly priced relative to the industry.
Explanation
FDS has a price-to-sales ratio in 2018 of:
$18 $18
= = 0.30.
$6,435,900,000
$60.41
( )
106,530,610
Because its price-to-sales ratio is less than the industry average of 0.50, FDS is
relatively underpriced. (Module 22.2, LOS 22.l)

Question ID: 1509486
88
TOPIC: FIXED INCOME
Sally Soikins, CFA, Chief Investment Officer at Greenvalley is reviewing the bank's
policies about credit risk management with Esha Leone, a senior analyst managing the
bank's fixed income portfolio.
Two years ago, when benchmark rates were flat at 4%, Greenvalley bank purchased
$3 million par of 7-year, 5% annual-pay coupon Newspace Inc. bonds. At the time of
the purchase, Leone had calculated the CVA on the bond as $7.71 per $100 par. A
5.76-year duration, 5% standardized coupon CDS on those bonds was available at that
time but was not purchased by the bank. Since the investment, the credit spread on
the bonds has widened by 80bps and the duration of the CDS has changed to 4.31
years.
Soikins observes that credit investment grade credit curves seem to be steepening.
Leone makes the following two statements about credit curves:
Statement 1: Lower rated sectors tend to have flatter credit curves due to
their higher sensitivity to the business cycle and greater
uncertainty.
Statement 2: When a company refinances a maturing debt with a new

longer-dated issue, the credit curve for that issuer may
experience an inversion due to higher liquidity of the new
issue.
If Greenvalley bank had bought protection on their investment in Newspace bonds,

their upfront cash flow would have been closest to:
A) a receipt of 4.6% of notional.

B) a payment of 18.2% of notional.
C) a receipt of 21.3% of notional.
Explanation
The following steps illustrate the computation of the credit spread on Newspace
bonds:
1. Calculate the value of the corporate bond assuming no default (VND):
N = 7, PMT = 5, I/Y = 4, FV = 100, PV = 106.00 = VND
Given CVA = 7.71, Bond price = 106 – 7.71 = 98.29
2. Calculate the yield to maturity (YTM) of the bond:
N = 7, PMT = 5, FV = 100, PV = −98.29, I/Y = 5.30%
3. Credit spread = 5.30% − 4% = 1.30%
Upfront payment (from protection buyer) = (credit spread – coupon) ×
duration = (1.3% – 5%) × 5.76 = −21.31%
If Greenvalley bank had purchased CDS protection on their investment in Newspace

bonds upon acquisition, the gain/loss on the CDS would have been closest to:
A) a gain of $103,440.
B) a loss of $344,800.
C) a gain of $413,760.
Explanation
The profit for protection buyer ≈ change in spread × duration × notional principal
= +0.008 × 4.31 × 3,000,000 = $103,440.
Leone's Statement 1 about credit curves is best described as:
A) accurate.
inaccurate regarding the shape of the credit curve for the lower rated
B)
sector.
C) inaccurate regarding sensitivity to the business cycle.
Explanation
Statement 1 is correct about lower-rated sectors having higher sensitivity to the
business cycle and greater uncertainty. However, Statement 1 is incorrect about the
shape of the credit curve: lower rated sectors tend to have steeper credit curves.
Leone's Statement 2 on credit curves is best described as:
A) accurate.
B) inaccurate about higher liquidity of the new issue.
C) inaccurate about inversion of the curve.
Explanation
Statement 2 is correct. Due to low liquidity in most corporate issues, the credit
curves are most influenced by more-heavily-traded bonds. Because newly issued
bonds are generally more liquid, when an issuer refinances a near-dated bond with
a longer-term bond, the spread may appear to narrow for the longer maturity
(possibly leading to an inverted credit spread curve). (Module 28.6, LOS 28.g)

TOPIC: FIXED INCOME
Nayna Shah, CFA, leads the fixed income department at Rodney Partners (RP). Shah
has recently hired Susan Reynolds, a new economics graduate. During a previous
meeting with Reynolds, Shah had mentioned purchasing a $12 million CDS on Welby,
Inc., bonds that is currently part of the RP's portfolio. While Welby has not declared
bankruptcy, it recently missed a coupon payment. Shah asks Reynolds to provide
details of RP's position and planned course of action. Exhibit 1: Welby Inc. provides
some of the information that Reynolds has collected.
Exhibit 1: Welby Inc.
RP's position: $12 million par, 6% senior unsecured maturing in five years.
CDS Protection buyer, standardized coupon of 5%
Current market prices of Welby bonds:
6% senior unsecured 55% of par
5% subordinated unsecured debentures 40% of par
5% senior unsecured 50% of par
Shah notes that RP has also purchased $10 million notional, index CDS position in
CDX-HY and that Welby is one of the 125 constituents in that index.
While discussing credit risk analysis, Reynolds makes the following two statements:
Statement 1: One of the assumptions of the structural models of credit

analysis is that the company has no off-balance sheet debt.
Statement 2: In the case of an ABS, credit analysis focuses on the credit

quality of the servicer.
Was there a credit event for Welby, and if so what settlement method is Rodney
Partners most likely to prefer?
A) Yes; cash settlement.

B) Yes; physical settlement.
C) No.
Explanation
Under the ISDA terms, a credit event occurs when the issuer fails to make a
scheduled coupon payment. RP would prefer a cash settlement because the
cheapest-to-deliver bond is the 5% senior unsecured bonds trading at 50% of par.
The bank would, therefore, receive 50% of notional (or $6 million) as cash
settlement and sell their holdings at 55% of par (or $6.60 million) for a total of
$12.60 million. Under physical settlement, the bank would tender its holdings of $12
million par bonds and receive a settlement of $12 million. (Module 29.1, LOS 29.b)
Assuming a default for Welby, the notional for RP's CDX-HY index CDS would be
adjusted to an amount closest to:
A) $9.92 million.
B) $9.99 million.
C) $10.00 million.
Explanation
The original notional would be reduced by 1/125th of the notional principal of $10
million or $80,000. New notional = $10,000,000 – $80,000 = $9,920,000. (Module
29.1, LOS 29.a)
Reynolds's Statement 1 is most likely:
A) correct.
incorrect as structural models can incorporate the risk of off-balance sheet debt as
B)
long as the assets of the company trade.
C) incorrect because off-balance sheet debt is a zero-coupon liability.
Explanation
Statement 1 is correct. Structural models assume a simple balance sheet. When
companies have off balance sheet debt, the default barrier under the structural
model (i.e., "K") would be inaccurate and therefore lead to inaccurate estimates of
credit risk. (Module 28.4, LOS 28.d)
Reynold's Statement 2 is most likely:
A) correct.
incorrect as credit analysis of ABS focuses on the quality of the collateral pool and
B)
the structure of the ABS and not on servicer quality.
incorrect as credit analysis of ABS focuses on the quality of the collateral
C) pool, the structure of the ABS, and servicer quality, and not on servicer
credit quality.
Explanation
Statement 2 is incorrect. Credit analysis of ABS is based on analysis of the collateral
pool, the structure of the ABS and servicer quality. (Module 28.7, LOS 28.h)

TOPIC: DERIVATIVES
Trent Black is a government fixed-income portfolio manager, and on January 1, he

holds $30 million of fixed-rate, semi-annual pay notes. Black is considering entering
into a 2-year, $30 million semi-annual pay interest rate swap as the fixed-rate payer.
He must first determine the swap rate. Black notes the term structure shown in
Exhibit 1: Term Structure of MRR (USD and CHF) on January 1:
Exhibit 1: Term Structure of MRR (USD and CHF) on January 1
CHF USD
Term (Days)
MRR Discount Factor MRR Discount Factor
180 –0.65% 1.0033 3.25% 0.9840
360 –0.55% 1.0055 3.35% 0.9676
540 –0.20% 1.0030 3.60% 0.9488
720 0.10% 0.9980 3.85% 0.9285
900 0.30% 0.9926 4.00% 0.9091
1,080 0.55% 0.9838 4.10% 0.8905
1,260 0.88% 0.9701 4.25% 0.8705
Black is also evaluating a USD fixed for CHF fixed, 3-year, semiannual currency swap
on a notional of USD 10 million. The current exchange rate is CHF/USD 0.97.
On July 1, immediately after the first settlement, Black observes that the 18-month
semiannual swap fixed rate is 4.62%. The term structure of MRR is given in Exhibit 2:
USD MRR Term Structure on July 1.
Exhibit 2: USD MRR Term Structure on July 1
Days Annual Rate (%) Discount Factor
60 3.31 0.9945
180 3.66 0.9820
360 4.21 0.9596
480 4.69 0.9411
540 4.74 0.9336
720 5.00 0.9091
The annualized fixed rate for the $30 million swap on January 1 is closest to:
A) 3.73%.
B) 3.80%.
C) 3.91%.
Explanation
The semi-annual fixed payment is calculated as:
1−0.9285
= 0.01867
0.9840+0.9676+0.9488+0.9285
When annualized, this works out to 3.73%.

For this question only, assume the annualized fixed rate on the $30 million swap is
3.80%. The amount of the first net payment due on this swap is closest to:
A) $82,500.
B) $165,000.
C) $285,000.
Explanation
The floating rate applicable for the first settlement was determined at the inception
of the swap (i.e., 3.25%). The net amount owed by the fixed rate payer of the swap
would be (0.0380 – 0.0325) / 2 × $30,000,000 = $82,500.
For this question only, assume that the original 2-year $30 million notional swap was
entered into at a fixed rate of 4.0%. Based on the information in the case and Exhibit
2: USD MRR Term Structure on July 1, the value of the swap on July 1 to Black is
closest to:
A) $267,390.
B) $270,000.
C) $346,572.
Explanation
After the first settlement date, there are three more settlements remaining, at 180,
360, and 540 days.
The sum of the discount factors for those three dates = 0.9820 + 0.9596 + 0.9336 =
2.8752. We are told that the original swap fixed rate is 4.0%, and the new swap fixed
rate is given as 4.62%.
Value to the payer = ΣDF × (SFRnew – SFRold) × (days / 360) × notional principal
= 2.8752 × (0.0462 – 0.04) × (180 / 360) × $30,000,000 = $267,394.

The CHF fixed payment to be made periodically by the USD receiver is closest to:
A) CHF 26,200.
B) CHF 52,381.
C) CHF 54,000.
Explanation
CHF notional = 0.97 × 10,000,000 = CHF 9,700,000
(Module 30.7, LOS 30.f)

TOPIC: ALTERNATIVE INVESTMENTS
Steven LaGrasse, CFA is the CIO for a large university endowment fund. LaGrasse
wants to add an allocation to commodities for the endowment's portfolio. LaGrasse
interviews the manager of the Alpha Fund, a fund specializing in energy trading that
seeks to profit from mispricing across international energy markets.
LaGrasse then interviews Beta Fund, which uses swap contracts to gain exposure to
commodity markets. Beta's manager presents an example of a current contract, which
involves a long position in an S&P 500 MSCI total return swap. With a notional of $100
million, the swap has monthly resets, and was initiated when short-term benchmark
rates were 2%. Exhibit 1 provides the relevant market data.
Exhibit 1: S&P 500 MSCI Index Levels
March (swap inception) 3922.50
April 3877.00
May 4123.75
Jim Myers, the head of Beta Fund, mentions that individual commodity sectors each
have their own idiosyncrasies. Myers makes the following 2 statements:
Demand for oil is relatively stable and independent of the
Statement 1: economic cycle, because people need to drive regardless of
economic conditions.
Demand for softs increases with increased in incomes in

Statement 2: developing economies, but is dependent on consumer tastes
as well.
Myers further notes that soybean contracts are currently in contango, and that the
convenience yield and storage costs for soybeans are equal at the present time.
Alpha fund is most likely participating in the commodity markets as a(n):
A) hedger.
B) speculator.
C) arbitrageur.
Explanation
Alpha Fund seeks to exploit mispricing in global markets and is thus acting as an
arbitrageur. Alpha does not have an underlying exposure to energy, and hence is
not a hedger. Furthermore, Alpha does not appear to be acting as a speculator; for
example, Alpha Fund is not taking naked positions based on their expectations
about future price movements.
The payment to be received (made) in April by Beta Fund related to the total return
swap is closest to:
A) ($1,160,000).
B) ($523,000).
C) $840,000.
Explanation
If the level of the index increases (decreases) between the two valuation dates (in
this case, between March and April), the long position (the swap buyer) receives
(makes) payment.
% change in index level = (3877 − 3922.50) / 3922.50 = −1.16%
Settlement amount = −1.16% of 100 million = −$1,160,000 (the negative sign
indicates a payment made by Beta Fund, the long party.)
(Module 32.2, LOS 32.i)
Regarding the statements made by Myers about the demand for commodities, which
of the following is most accurate?
A) Only statement 1 is correct.

B) Only statement 2 is correct.
C) Neither statements is correct.
Explanation
Statement 1 is incorrect. The economic cycles affect the demand for oil significantly:
demand is normally higher during expansions when credit is widely available. The
need for oil can decrease sharply when an economic contraction leads to reduced
consumption by businesses and consumers.
Statement 2 is correct.
The information provided by Myers about soybean contracts is most consistent with:
A) the hedging pressure hypothesis.

B) the theory of storage.
C) insurance theory.
Explanation
Hedging pressure theory would predict a contango market if the consumers (i.e., the
longs) are hedgers (and driving up the forward price of soybean contracts). We are
told that soybean contracts are normally in contango, however insurance theory
suggests that futures prices should be lower than spot prices (i.e., backwardation) to
compensate the speculator who is taking the opposite side of the hedge from the
producer. We are not provided with information about current inventory levels, and
hence evaluating this situation with respect to the theory of storage is not possible.
(Module 32.1, LOS 32.f)

TOPIC: PORTFOLIO MANAGEMENT
Neil Cernan set up his own investment management firm in 2005. Cernan Investment
Management LLC (CIM) is headquartered in Kansas City, MO, with eight offices across
the U.S. Midwest and East coast. While initial growth of the firm was relatively slow,
over the last six quarters assets under management have increased at their fastest
rate since inception.
Cernan now feels that the time is right to expand overseas to help sustain the pace of
the firm's growth. CIM's board has narrowed the expansion down to two possible
countries: Pangia and Isopia.
Cernan has historically tried to avoid investing in any country with low real GDP
growth or low interest rates, or inflation rates that are too high or volatile. He intends
to follow the same rules for CIM. Cernan's proposed screening process is shown in
Exhibit 1: Screening Criteria.
Exhibit 1: Screening Criteria
A country will not be considered a candidate for CIM's expansion if:
1. Forecast real GDP growth for the coming year is less than 1.5%
2. The real risk-free rate is less than 1.0%
3. Forecast inflation is greater than 1.5%
Cernan has gathered some information on Pangia because he is concerned that that
economy may not pass the screening process. The data gathered is shown in Exhibit
2: Pangia Data and Next Period Forecast.
Exhibit 2: Pangia Data and Next Period Forecast
1-year, zero-coupon government bond price (£100 par) £97.20
Forecast inflation rate 1.2%
Forecast premium for inflation uncertainty 0.4%
Forecast nominal GDP growth rate 2.4%
In addition to assessing macroeconomic data in each candidate country, CIM has also
researched potential investment managers. In Isopia, CIM staff have identified three
potential investment managers with the required skill set and experience. Cernan
presents this information to the board, including a definition of the information ratio,
plus key performance data for two of the managers as shown in Exhibit 4:
Information Ratio Definition and Isopian Candidate Data.
Exhibit 4: Information Ratio Definition and Isopian Candidate Data
The ex post information ratio is the actual correlation between

Information Ratio
active returns and expected active returns and may be positive
Defined:
or negative.
Candidate Data
Manager A Manager B
Transfer coefficient 0.70 0.50
Information coefficient 0.025 0.034
Information Ratio (constrained) 0.192 0.123
All three candidates work with constrained portfolios due to local laws and
regulations. However, Cernan intends to assess the managers by calculating their
information ratio had the portfolios been unconstrained. Cernan's screen calls for a
minimum unconstrained information ratio of 0.25.
A third candidate, Manager X, had an information ratio of 2.99. Although impressive,

this IR seemed too high to Cernan and hence Cernan does not consider Manager X.
When the CIM board asks Cernan why he did not consider this candidate, Cernan
provides the following two reasons why Manager X's information ratio may be too
high:
Reason 1: Manager X's information ratio suffers from cross-sectional

interdependence, whereby each decision made is not
independent.
Manager X's information ratio suffers from time-series

Reason 2: dependence, whereby decisions taken on securities may be
correlated over time.
Using the data in Exhibit 2: Pangia Data and Next Period Forecast, and the
screening process outlined in Exhibit 1: Screening Criteria, Pangia is most likely to:
A) fail only the screening criterion related to the real GDP growth rate.
B) fail only the screening criterion related to the real risk-free rate.
C) pass both the real GDP growth and real risk-free rates criteria.
Explanation
Pangia Data and Next Period Forecast:
Risk-free zero-coupon government bond price (£100 face) £97.20

Forecast inflation rate 1.2%
Forecast premium for inflation uncertainty 0.4%
Forecast nominal GDP growth rate 2.4%
Nominal risk-free rate as implied by the one-year zero-coupon government bond:

(100.00 / 97.20) − 1= 2.88%
Real risk-free rate
= nominal rate – forecast inflation – premium for inflation uncertainty
= 2.88% − 1.2% − 0.4%
= 1.28% (>1%; passes real risk-free rate screen)
Real GDP growth rate
= nominal GDP growth rate – inflation forecast
= 2.4% − 1.2%
= 1.2% (<1.5%; fails real GDP growth rate screen)
In Exhibit 4: Information Ratio Definition and Isopian Candidate Data, Cernan's

definition of the information ratio is best described as:
A) correct.
B) incorrect because the information ratio cannot be negative.
C) incorrect because it defines the information coefficient instead.
Explanation
The information coefficient measures the correlation between active returns and
expected active returns. When the information coefficient is multiplied by the
transfer coefficient and the square root of breadth, we get the information ratio.
Which of the candidates in Exhibit 4: Information Ratio Definition and Isopian

Candidate Data is most likely to pass Cernan's IR screen?
A) Only Manager A.
B) Only Manager B.
C) Neither Manager A nor Manager B.
Explanation
Manager A Manager B
Transfer coefficient 0.70 0.50
Information coefficient 0.025 0.034
Information ratio (constrained) 0.192 0.123
IR (unconstrained) = IRc / TC 0.192 / 0.7 = 0.274 0.123/0.5 = 0.246
As the IR screen specifies an unconstrained IR of at least 0.25, only Manager A would

be considered. (Module 40.3, LOS 40.c)

Which of Cernan's reasons for not relying on Manager X's information ratio are based
on actual limitations of the fundamental law?
A) Reason 1 only.
B) Reason 2 only.
C) Both reasons are limitations.
Explanation
Both cross-sectional dependence and time-series dependence may inflate the
information ratio. (Module 40.4, LOS 40.f)

TOPIC: PORTFOLIO MANAGEMENT
Steve Mason, CFA, is an analyst with Alpha Developers. While discussing backtesting
with a client, Mason states, "I am always skeptical when someone shows me a strategy
that has performed well based on past data. Did they find this strategy by sifting
through many different models and selecting the one based on how good it looked
statistically?" Mason then informs the client that the 5% monthly VaR of their portfolio
is $12,000.
Another client is concerned with longer term trends in Ruritania, a country where the
client has significant investments. A recent paper on consumption trends and that
country's position in the business cycle left the client with doubts about both
Ruritanian interest rates and bond performance.
The relevant extract from the paper is shown in Exhibit 1: Longer Term
Macroeconomic Forecasts for Ruritania – Extract
Exhibit 1: Longer Term Macroeconomic Forecasts for Ruritania – Extract
"Two distinct trends have emerged in the Ruritanian economy over the last
10 quarters. First, the level of wealth per capita has increased, and this
increase is only expected to accelerate over the next four years. Compared
to today, the average family can expect to increase their wealth at an
average of 0.5% per year over this period.
In addition, the reduction of restrictions on capital flows and international
trade under the current political regime (which is expected to remain in
power for at least four years) is expected to continue, leading to an
increase in both GDP and the volatility of GDP growth."
Mason draws two conclusions from the extract:
Conclusion The expected trend in personal wealth will decrease the utility of future
1: consumption relative to consumption today, reduce the inter-temporal
rate of substitution, and reduce the real interest rate.
Conclusion The increase in GDP growth is expected to increase real interest rates,
2: but this effect be offset by the impact of the increase in the volatility of
that growth.
The least accurate interpretation of the monthly VaR that Mason mentions is:
A) 5% of the time, the minimum monthly loss experienced by the portfolio is $12,000.
95% of the time, the minimum monthly loss experienced by the portfolio is
B)
$12,000.
C) 95% of the time, the maximum monthly loss experienced by the portfolio is $12,000.
Explanation
VaR can be interpreted as the minimum loss at the specified level of significance (5%
here), or as the maximum loss with a confidence level of (1 - the level of significance)
(=95% here) (Module 37.1, LOS 37.a)
Based on Mason's statement about backtesting, he is most likely to be concerned

about:
A) data snooping.
B) statistical anomalies.
C) survivorship bias.
Explanation
Data snooping is the practice of backtesting numerous strategies and then selecting
the best performing one, rather than constructing a portfolio based on sound
theory. A strategy chosen by data snooping is unlikely to deliver the same promising
results in later periods when the strategy is actually deployed. (Module 38.3, LOS
38.d)
Mason's Conclusion 1, in response to the extract in Exhibit 3 is least accurate

regarding the effect on:
A) the utility of future consumption relative to consumption today.

B) the inter-temporal rate of substitution.
C) the real interest rate.
Explanation
An increase in wealth will reduce the marginal utility of future consumption relative
to consumption today. As a result, the inter-temporal rate of substitution (ut/u0) will
also decrease. The price of a risk-free inflation-indexed bond is the expected inter-
temporal rate of substitution, hence it will fall and real interest rates will rise.
Mason's Conclusion 2, in response to the extract in Exhibit 3 is most likely:
incorrect, as both growth and volatility would increase real interest

A)
rates.
B) incorrect, as both growth and volatility would decrease real interest rates.
C) correct.
Explanation
High GDP growth reduces the utility of future consumption and, hence, the inter-
temporal rate of substitution, so real interest rates should be higher. Increased
volatility of growth, leading to uncertainty, will require a higher premium and,
hence, also increase rates. (Module 39.1, LOS 39.c)
Andrea Vrbenic, CFA, was recently promoted to supervisory analyst at Banke Gjigante,
a large brokerage firm that has investment banking and asset management
departments. Vrbenic will report to Tom Sheffield, a senior manager and director at
the firm.
Currently, Vrbenic manages the investment account of Bill Stallwell, a single retiree
who lives off his portfolio and is relatively risk averse. Stallwell's account has been
with the firm for over fifteen years. Last year, Vrbenic added a stock with a beta of 1.5
to Stallwell's portfolio. Since then, Vrbenic has also sold call options on these shares
as part of a covered call strategy for Stallwell's portfolio.
Sheffield passes on to Vrbenic a request from Amica Biotech, one of the firm's clients,
to write a research report on Amica. The research will be paid for by Amica, with a flat
fee plus a fixed bonus if Amica's IPO is fully subscribed.
Mike Callingly, CFA, a senior portfolio manager at Banke Gjigante, routinely distributes
performance reports on composite of portfolios managed by him. He claims that the
performance reports are GIPS compliant, except that the returns are equally-weighted
and not asset-weighted.
As part of communication with her clients, Vrbenic sends out a quarterly performance
report comparing the performance of clients' portfolios to the performance of a
broad-based market index. While doing some analysis, Vrbenic notes that her
performance would look more attractive if she used a target-date index fund for
comparison purposes. She also notes that the risk profile of her client portfolios is
more closely tracked by target-date funds than by the broad-based market index.
Starting with the first quarter of the current year, Vrbenic updates her client
communications, replacing the broad-based market index with target-date funds for
comparison purposes.
With respect to Bill Stallwell's portfolio, Vrbenic has most likely:

A) violated the Standards, both by buying the high-beta stock and by selling the calls.
violated the Standards by selling the options but not by purchasing the high-beta
B)
stock.
not violated the Standards because overall portfolio risk needs to be
C)
evaluated for the purpose of judging suitability.
Explanation
Standard III(C) – Suitability requires members to judge the suitability of investments
in the context of the client's total portfolio. (Module 42.5, LOS 42.a)
With regards to the research report on Amica, Vrbenic will most likely:
not be in violation of the Standards as long as the fact that the research is issuer-
A)
funded is disclosed.
not be in violation of the Standards as long as both the source of the funding and
B)
the nature of the compensation is disclosed.
be in violation of the Standards even if both the funding source and the
C)
nature of the compensation are disclosed.
Explanation
Issuer-paid research is fraught with potential conflicts. Analysts' compensation for
preparing such research should be limited, and the preference is for a flat fee
without regard to conclusions or the report's recommendations. As such, the
arrangement with Amica Biotech is a violation under Standard I(B) – Independence
and Objectivity. (Module 42.1, LOS 42.a)
With regards to performance presentation, Callingly's performance report is most

likely:
A) a violation of Standard III(D) – Performance Presentation.

B) not a violation.
C) a violation of Standard I(D) – Professional Misconduct.
Explanation
Callingly is in violation of Standard (III)D – Performance Presentation by claiming
GIPS® compliance even though one of the requirements of GIPS® is not complied
with. There is no partial GIPS® compliance. (Module 42.6, LOS 42.a)
With respect to Vrbenic's changes to quarterly performance reports for clients,

Vrbenic is most likely:
A) not in violation of the Standards because the change has a reasonable basis.
in violation of Standard III(D) because changes to an established performance
B)
benchmark are prohibited.
not in violation of the Standards if she discloses the change in performance
C)
presentation to her clients.
Explanation
Under Standard III(D) – Performance Presentation, members are required to
promptly disclose any changes in benchmarks used in performance presentation. To
avoid a violation of the Standard, the member must disclose this change to existing
and new clients. Vrbenic should explain the reasons for changing the benchmark
and present the performance reports using both the old and new methodologies so
that clients may compare them. (Module 42.6, LOS 42.a)

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Overview for Questions #1-4 of 88 Question ID: 1509426

TOPIC: QUANTITATIVE METHODS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Exhibit 1: Time Series of Silver Prices

Exhibit 2: Silver Price Regression Results

Adjusted R-Square 0.98

Standard Error 123.81

Regression 1.00 365,730,065 365,730,065 23,859.63 0.00

Residual 520.00 7,970,771 15,328

Total 521.00 373,700,837

Coefficients Standard Error t-Stat P-value

Intercept 21.00 11.56 1.82 0.07

Slope 0.99 0.01 154.47 0.00

Exhibit 3: Gold Price Regression Results

Adjusted R-Square 0.01

Standard Error 123.95

Regression 1.00 66,742 66,742 4.34 0.04

Total 519.00 8,024,887

Coefficients Standard Error t-Stat P-value

Intercept 2.00 5.44 0.37 0.71

Slope –0.09 0.04 –2.08 0.04

Question #1 of 88 Question ID: 1509427

Is the use of the Durbin Watson statistic in Weatherford's silver regression

Question #2 of 88 Question ID: 1509428

C) Nonstationary data Dickey-Fuller

Question #3 of 88 Question ID: 1509429

A) first differences of the data.

Then, the appropriate regression will be:

Question #4 of 88 Question ID: 1509430

The one-step-ahead predicted value is calculated by substituting the current value

The two-step-ahead predicted value is then calculated by substituting the one-step-

ŷt+2 = b0 + b1 (ŷt+1 ) = 2.00 + (−0.09) (2.072) = 1.81

(Module 2.2, LOS 2.d)

Overview for Questions #5-8 of 88 Question ID: 1509436

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

Spot JPY/USD exchange rate = 120.

In addition to in-house currency transactions, the new software program is also

Wilson obtains the following data from the econometrics department:

JPY/USD spot rate one year ago = 116.

Question #5 of 88 Question ID: 1509437

E(S1) = S0 × (1 – 0.05)2 = 166.113(0.95)2 = 149.92

(Module 5.2, LOS 5.g)

Question #6 of 88 Question ID: 1509438

A) Both forecasts are consistent.

For Japan: 7.00% – 3.88% ≠ 3% – 0%

Question #7 of 88 Question ID: 1509439

Question #8 of 88 Question ID: 1509440

A) Both currencies should be left unhedged.

Overview for Questions #9-12 of 88 Question ID: 1630916

TOPIC: FINANCIAL STATEMENT ANALYSIS

THE TOTAL POINT VALUE FOR THIS QUESTION SET IS 12 POINTS

On December 31, 2017, Wayland purchased a 35% ownership interest in a strategic

Exhibit 1: Pre-Acquisition Balance Sheets for Wayland and Optimax

Cash $710 $100

Marketable securities 2,550 –

Inventory 2,000 400

Accounts receivable 3,000 500

Property, plant, and equipment 2,450 1,000

Total assets $10,710 $2,000

Accounts payable $3,310 400