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CFA Level II Mock Exam 2 Solutions (PM)
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CFA Level II Mock Exam 2
June, 2016
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FinQuiz.com 2nd Mock Exam 2016 (PM Session)
Questions Topic Minutes

1-6 Ethical and Professional Standards 18
7-12 Quantitative Methods 18
13-18 Financial Reporting and Analysis 18
19-30 Equity Investments 36
31-42 Alternative Investments 36
43-54 Fixed Income 36
55-60 Portfolio Management 18
Total 180

Questions 1 through 6 relate to Ethical and Professional Standards
Investopia Associates (INVEA) Case Scenario
Investopia Associates (INVEA) is a capital management firm in Miami, USA. Josh

Wiley is the chief investment officer (CIO) at the firm who heads the institutional wing
of INVEA. INVEA serves as the trustee for Alpha Manufacturings (APM) pension plan.
Walter White, the CEO of APM, recently called a meeting with Wiley to discuss a
takeover attempt by XLS Manufacturing. White advised Wiley to purchase APMs stock
in the open market for its pension plan to ward off XLS. Wiley believes that the stock is
undervalued and purchases a considerable amount of the stock for the pension fund. As a
result of the heavy stock purchases, APMs stock price rises significantly. This not only
increases the value of the pension fund, but also wards of the takeover attempt.
As a result of above-average performance of the pension funds that Wiley manages,

INVEA has managed to attract the pension accounts of a number of firms. One such firm
is Tick Enterprises (TICK), with a pension fund worth $25 million. During their first
client-advisor meeting, Wiley presented the performance of INVEAs existing pension
funds over the past ten years. Noticing a slight variation in the total returns of the funds,
the CFO at TICK inquired about the reasons. Wiley made the following comment:
According to our firms policy, nondiscretionary pension accounts and personal trust
accounts have a lower priority on purchase and sale recommendations than discretionary
pension fund accounts. This is why returns have been slightly lower for such accounts.
After the meeting, Wiley proceeded with an analysis of the stocks of two utility firms for
inclusion in his private wealth portfolios. After proper due diligence of each investment,
Wiley e-mailed the recommendation to all his clients for which the investment was
suitable. He then called two of his largest clients to discuss the recommendation in detail.
Wiley is also following The RedNeck Products (RNP), a firm in the electronics industry.
Wiley believes that a bond offered by RNP is suitable for five of his clients. Two of his
clients wish to purchase $40,000 each, and the other three request to purchase $10,000
each. The minimum lot size is established at $5,000 and it is believed that odd-lot
allocations below the minimum would affect the liquidity of the security. Wiley receives
only $65,000 for all the five accounts. He allocates $25,000 each to the first two
accounts, and $5,000 each to the remaining three accounts.

Wiley has been assigned responsibility for managing the accounts of two additional
private wealth clients. As a first step, Wiley developed each clients investment policy
statement (IPS). After six months, Wiley reviewed the IPS of each client. He made the
following additions to the IPS:
Client A: The client has received $80,000 as inheritance from his grandfather.
Client B: The clients brother passed away, and she is now responsible for taking
care of his only child. As such, her income needs have increased, and the
IPS provides for liquid investments only.
After reviewing the IPSs, Wiley increased the proportion of stock investments in client
As account. Realizing that client B needs greater growth in its portfolio due to the
emergence of a dependent, Wiley shortlisted a venture capital fund for her portfolio.
After extensive analysis, Wiley strongly believed that the fund would increase the
portfolios value up by 25% in just three years. He just invests 4% in this fund, investing
96% of the portfolio in highly liquid securities.
After his work for the day was over, Wiley met with one of his clients, Laura Winston,
who is also a portfolio manager at a reputable firm. During their conversation, Winston
told Wiley that she was leaving her current employer to open up her own investment
management firm. She stated that to minimize any conflicts of interest, she was not going
to solicit any current clients of her employers until she has left the firm. She added that
she was not going to take any of her employers property at departure, except the models
she developed on her own personal laptop.
As the conversation continued, Wiley told Winston that he was going to California with
his wife for the weekend. He added that the trip was paid for by one of his clients; the
client had gifted him two tickets to California for achieving above-average returns on his
portfolio.
1. With regards to the trade in APMs stock, has Wiley violated the CFA Institute
Standards of Professional Conduct?
A. Yes.
B. No, because he managed to increase the value of the fund for its
beneficiaries.
C. No, because he protected the beneficiaries by warding off the takeover
attempt.

Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session 1, Reading 2, LOS a
Wiley has violated the Standards. Wileys duties are to the beneficiaries of the
pension account and not to APM. He should have examined the takeover offer on
its own merits and made an independent decision. The guiding principle is the
appropriateness of the investment decision to the pension plan.
2. Is the firms policy regarding pension accounts, and Wileys actions regarding his
recommendation most likely in accordance with the CFA Institute Standards of
Professional Conduct?
A. No.
B. Only with regards to the pension accounts policy.
C. Only with regards to Wileys treatment of the recommendation.
Correct Answer: C
Reference:
The firms policy is not in accordance with the Standards. The policy does not
treat all customers fairly (discretionary accounts are given priority over
nondiscretionary accounts).
Wiley has not violated any Standards, since he widely disseminated the
recommendation and provided the information to all his clients prior to discussing
it with a select few. The largest clients are probably paying higher fees for the
additional service.

3. With respect to his allocation of the bond issued by RNP to his clients accounts,
has Wiley most likely violated the CFA Institute Standards of Professional
Conduct?
A. No.
B. Yes, because he offered preferential treatment to the two larger clients at
the expense of the three smaller clients.
C. Yes, because he failed to communicate his allocation policy to his clients
before allocating the security.
Correct Answer: A
Reference:
Wiley has not violated any Standards. Even though the distribution is not on a
complete pro rata basis because of the required minimum lot size, the approach
allowed the clients to efficiently sell the bond later if necessary.
4. Are Wileys portfolio modifications for Client A and Client B most likely correct?
A. Yes.
B. Only with respect to Client A.
C. Only with respect to Client B.
Correct Answer: B
Reference:
Since Client A has just received $80,000, he can probably bear more risk, and a
higher proportion of equities seems appropriate for the portfolio.
Client Bs IPS specifically provides for highly liquid investments, so a venture

capital fund (which usually has a lock-up period) is not suitable for the client.

5. Has Winston most likely violated Standard IV, Duties to Employers, of the CFA
Institute Standards of Professional Conduct?
A. Yes.
B. No, because she did not solicit any of her employers clients.
C. No, because she did not solicit any of her employers clients, and did not
take with her any of her employers property before leaving.
Correct Answer: A
Reference:
Winston violated the Standard because she took away with her models that she
developed during her employment at the firm. It does not matter whether she
worked on her personal laptop, home computer, or office computer; the models
are a property of her employer.
6. With regards to his trip to California, has Wiley most likely violated any
Standards?
A. Yes.
B. No, as long as he discloses, in writing, this compensation arrangement to
his employer.
C. No, as long as the trip is of short duration and does not affect his duties at
the firm.
Correct Answer: B
Reference:
If Wiley discloses in writing of this contingent compensation arrangement to his

employer, he would not have violated any Standards.

Questions 7 to 12 relate to Quantitative Methods
Hector Solanki Case Scenario
Hector Solanki is a fixed-income analyst at Pratt Associates, a global research house.

Solanki is the firms most prized analyst having considerable experience in fixed-income
securities issued in both developed and emerging markets.
For his current assignment, Solanki is working alongside Carla Rogers, the chief
investment officer of Motano Enterprises (ME) investment account. Solanki provides
ME with access to research reports, prepared by him, covering global fixed-income
markets.
Rogers has decided to expand MEs investment account to include four sovereign
emerging market bond issues. The companys investment account is presently invested in
developed market equities and bonds. Prior to offering any advice, Solanki believes it is
necessary to evaluate the sustainability of the debt issued in the four emerging market
countries identified by Rogers.
Solanki decides to employ simulation to evaluate the riskiness of the emerging markets.
When asked why he prefers simulation over other techniques, Solanki provides the
following reasons:
Reason 1: Simulations generate risk-adjusted expected values and consider the

probability of all possible outcomes.
Reason 2: Given the unpredictable nature of emerging markets, simulations are best
suited when confronted with new and unpredictable risks.
Solanki then proceeds to initiate the simulation process. He identifies five input variables
inflation, global (US) and local (emerging market) interest rates, foreign exchange
rates, and debt service costs. Using these variables Solanki aims to determine the impact
of a currency crisis, in each of the four markets, on the value of debt issues and project
their likelihood of default.

After specifying the variables, Solanki moves on to generate probability distributions of

expected bond values. Given the volatility in the foreign exchange markets and frequent
shifts in monetary policy, Solanki is unsure of the type of data he should use to generate a
probability distribution. In addition, the lack of depth in the fixed-income segment of
these markets means that Solanki will have few comparable bonds available for the
simulation.
Solanki proceeds to run the simulation using the input variables and suitable probability
distributions. He summarizes the simulated expected values and standard deviations in
values for the four issues in an exhibit (Exhibit). He has employed local risk-free rate to
calculate expected values for the issues.
Exhibit: Results of Simulation

Simulated
Simulated Standard
Risk-free Rate Expected Deviation in
Bond Issue (%) Value* Value
A 2 $150 18%
B 3 $170 25%
C 3 $150 22%
D 4 $190 30%
*Price per 100 of par value
Solanki recommends Rogers invest in bond issue A and supports his advice with the
following statement, Out of the two lowest priced issues, A and C, the former has the
lowest variation in simulated values making it the most suitable investment choice. A low
simulated standard deviation in value means that the issue will have the lowest marginal
risk.
Solanki concludes his analysis by demonstrating how simulation can be used as an

effective risk hedging tool. He explains to Rogers how he plans to introduce two
constraints into the analysis of the emerging market issues in order to judge the
effectiveness of this tool.
Constraint 1: The value of reserves available to pay down debt should not be allowed to
decline below a minimum level, as specified by loan covenants. Should
reserves decline below this level, the government will be denied further
loans on favorable terms.

Constraint 2: Indirect bankruptcy costs can be built into the valuation of each issue by
comparing the total value of available resources for repaying debt to
outstanding claims in all scenarios. This will assist in measuring and
modeling the costs of not meeting debt payments.
7. Which of the following reasons, provided by Solanki, accurately characterizes the

benefits of simulation over other risk assessment tools?
A. Reason 1
B. Reason 2
C. Neither of the two reasons.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS d & e
Reason 1 inaccurately characterizes the benefits of simulation. Although Solanki

has accurately pointed out that simulations consider the probability of all possible
outcomes, the values generated in simulations represent expected values which
are not risk-adjusted.
Reason 2 inaccurately characterizes a benefit of simulation. Simulations heavily

depend on the ability to assess probability distributions and parameters and so
work best in cases where there is substantial historical and cross-sectional data
available that can be used to make those assessments. Therefore, this risk
assessment approach is less suitable when confronted with new and unpredictable
risks where data may be insufficient or unreliable.
8. In context of the issues surrounding the emerging markets being studied, the most
suitable probability distribution should rely on:
A. historical data.
B. cross-sectional data.
C. statistical distributions and parameters.
Correct Answer: C

Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS b
C is correct. Since historical and cross-sectional data is insufficient and unreliable

(see below), Solanki will need to select a statistical distribution that best captures
the variability in the input and estimates the parameters of the distribution.
A is incorrect. Solanki cannot rely on historical data to generate probability

distributions. This is because market volatility will introduce structural shifts in
the market making historical data unreliable and obsolete.
B is incorrect. Solanki cannot rely on cross-sectional data to generate probability

distributions because, as stated in the case, there are few comparables (and thus,
insufficient data) available to generate the distributions.
9. Based on the steps followed, has Solanki correctly performed the simulations?
A. Yes.
B. No, he has failed to check for correlations across variables.
C. No, some of the variables he has considered may not be predictable.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS c
B is correct. Solanki has failed to consider correlations between the variables

employed. The variables being considered by Solanki are correlated for
example, both global and domestic interest rates are correlated with debt service
costs and foreign exchange rates. Ideally, Solanki should check for correlations
across variables after specifying probability distributions but before running
simulations and either build the correlations explicitly into the simulation or focus
on those inputs which have the bigger impact on value.
C is incorrect. None of the variable being considered by Solanki are

unpredictable.

10. Considering the data in Exhibit 1, Solanki is most likely treating the simulation
process as a:
A. substitute for risk-adjusted values.

B. complement to risk-adjusted values.
C. tool for calculating risk-adjusted values.
Correct Answer: A
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS f
A is correct. The data in the exhibit suggests that Solanki is treating the
simulation process as a substitute to risk-adjusted values; this is because cash
flows are being discounted at a risk-free rate to arrive at a value and the standard
deviation in simulated values is being used as a tool to select investments.
B is incorrect. When simulation is used as complements to risk-adjusted value, the

relevant discount rate is the risk-adjusted rate. The risk-free rate cannot be used to
discount expected cash flows.
11. The simulation technique used by Solanki to derive bond values:
A. ignores total portfolio risk.

B. considers total portfolio risk.
C. considers asset-specific risk only.
Correct Answer: C
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS f
Since standard deviation in simulated values is being used as the decision-making

tool, Solanki is assuming all of the risks included in the simulation are relevant
for the investment decision. In other words, Solanki has failed to distinguish
between diversifiable and asset-specific risk.

12. The constraints being employed by Solanki are most likely, respectively, classified
as:
constraint 1: constraint 2:
A. book value market value.
B. earnings and cash flow market value.
C. earnings and cash flow earnings and cash flow.
Correct Answer: B
Reference:
CFA Level II, Volume 1, Study Session, Reading 12, LOS e
Constraint 1 is an example of an earnings and cash flow constraint, which has

been externally imposed by lenders. The covenant imposes restrictions on the
ability of sovereign governments to use their available reserves (available cash).
Solanki can employ simulation to assess the likelihood that the covenant will be
violated.
Constraint 2 is an example of a market value constraint; this is because Solanki is

attempting to quantify the likelihood of distress and build in the cost of indirect
bankruptcy costs into valuation. Solanki is modeling the effects of distress on
expected cash flows and discount rates.

Questions 13 through 18 relate to Financial Reporting and Analysis
Lakeline Associates Case Scenario
Lakeline Associates is an audit firm. Senior auditor Kim Thomas and junior auditor
Gayle Cox are analyzing the financial statements of four corporations operating in
distinct industries. The auditors focus is on disclosures to the companys financial
statements. Based on their analysis, the auditors make four observations with respect to
the information disclosed in the financial statements.
Observation 1: The management of Borough Limited, an oil extractor, has been forced to
revise output prices downwards in response to an unexpected drop in
global oil prices. Weary of being unable to reach its annual operating
earnings target, the management has revised the corporate credit sales
policy at the beginning of the current fiscal year (2014). Under the new
policy customers will enjoy higher purchase discounts with a right to
return current year purchases at the beginning of the following year.
Observation 2: On June 1, 2012 Streak Corp acquired Manson Inc. by issuing 300,000 of
its common stock, which were trading at a market price per share of $50.
On the date of acquisition Manson Inc. had 250,000 shares outstanding
trading at a market price of $45 per share. The fair value of Manson
Inc.s net assets at the time of acquisition was $1.1 million. The goodwill
associated with the purchase is now believed to be overstated due to an
understatement of the identifiable assets at that time. No impairment
charges have been recorded since the date of acquisition and this is
expected to remain the case for the future periods.
Observation 3: Aerial Limited prepares and presents its financial statements in

accordance with the IFRS. The operating, investing and financing
sections of the cash flows statement as well as net income reported for
the fiscal years 2012 to 2014 are presented in the exhibit below:

Exhibit:
Cash Flows Statement and Net Income Information for
Aerial Limited (2012-2014) in $ Millions
2014 2013 2012
Operating cash flow 45.0 30.3 18.2
Investing cash flow 22.0 15.8 7.0
Financing cash flow 14.8 11.1 9.8
Net income 21.5 16.4 12.5
Operating cash flow variability relative to peers Low Low Low
In a recent conversation with Aerial Limiteds chief executive, Thomas concludes that
the firms operating cash flows are of poor quality.
Observation 4: The management of Grace Manufacturers has switched from the LIFO to
FIFO method of inventory accounting. This shift represents a response to
an unanticipated increase in the global price of a key input component.
In a discussion between the two individuals, Cox shares with Thomas that while the audit
opinion is used as a source of information about a companys risk, it can never be a
financial analysts first source of information.
13. A probable impact of the new sales policy (Observation 1) is that Borough
Limiteds:
A. revenues may increase faster than receivables.

B. accounts receivables turnover may be overstated.
C. number of days sales outstanding may increase each year.
Correct Answer: C
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS f

With a revision in credit sales policy, days sales outstanding may increase as
customers are induced to take advantage of purchase discounts and enjoy a
flexible return policy. Furthermore, revenues may increase faster than the
previous years as well as compared to peers in response to an increase in customer
purchases.
A is incorrect. By pulling future sales into the current period, a companys

receivables may grow faster than revenues.
B is incorrect. An increase in days sales outstanding signals a decline in accounts

receivables turnover. The credit policy may increase returns the following year
and reduce the amount of cash collections on credit sales as many of the
purchases are not converted into cash.
14. Using the information in Observation 2 and ignoring the impact of the
overstatement, the amount of goodwill reported on Streak Corps financial
statements on the date of acquisition is closest to:
A. $0.25 million.
B. $3.75 million.
C. $4.00 million.
Correct Answer: C
Reference:
Goodwill = FV of the stock issued fair value of Manson Inc.s net assets
= (300,000 $50) $11,000,000 = $4,000,000
15. Based on the misreporting on the date of acquisition, Streak Corps consolidated
earnings will most likely be distorted in the:
A. current period only.

B. future periods only.
C. both current and future periods.
Correct Answer: C

Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS d
The consolidated earnings in the current and future periods will most likely be
overstated as depreciation expenses will be understated due to an understatement
of the amount recorded as assets (depreciable base).
16. Which of the following reasons may justify poor cash flow quality?
A. Accelerating payments to payables

B. Improper capitalization of expenditures
C. Low cash flow volatility relative to peers
Correct Answer: B
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS j
Operating cash flows are higher relative to investing cash flow and net income.
The analyst may conclude that cash flows are manipulated and, comparing
operating with investing cash flows, may lead the analyst to conclude that the
company has improperly capitalized expenditures resulting in an overstatement of
operating cash flows and understatement of investing cash flows.
A is incorrect. Accelerating payments to payables will decrease operating cash

flows. However, given that operating cash flows are increasing from one year to
the next this is less likely of an explanation for poor operating cash flow quality.
C is incorrect. Low cash flow volatility relative to peers is a sign of high cash
flow volatility.
17. The impact of the policy change (Observation 4) will most likely lead to Aerial
Limiteds financial statements:
A. not being decision useful.

B. being non-GAAP compliant.
C. reflecting conservative accounting choices.
Correct Answer: A

Reference:
A is correct. The decision to change from the LIFO to FIFO method in the face of
rising inventory prices will result in lower cost of sales being reported and
consequently higher net income. This can be seen as a biased accounting choice
and the underlying objective may be to overstate reported earnings. In addition,
cost of sales reported under the FIFO method comprise older inventory purchases
is a less accurate reflection of economic reality in contrast to the figure reported
by the LIFO method. Biased accounting choices will lower the quality of financial
statements with respect to being decision useful.
B is incorrect. A change in the inventory accounting method does not render

financial statements as non-GAAP compliant as financial reporting standards
allow discretion with respect to the methods used to generate estimates.
C is incorrect. The decision to adopt the FIFO method reflects an aggressive

accounting choice, which will increase current period reported earnings.
18. Based on Thomass view, audit opinions will least likely be the first source of
information about a companys risk because they:
A. focus solely on historical information.

B. fail to consider a firms going concern status.
C. do not distinguish between generic and company-specific risks.
Correct Answer: A
Reference:
CFA Level II, Volume 3, Study Session 7, Reading 21, LOS m

A is correct. A shortcoming of using the audit opinion as a source of information

about a companys risk is that it is derived based on an analysis of historical
financial information and is therefore a less relevant source.
B is incorrect. When arriving at an audit opinion, auditors pay attention to the

going-concern status of a corporation by stating whether a companys financial
statements were prepared under the going-concern assumption.
C is incorrect. The failure to distinguish between generic risks which are relevant
to all company and risks which are specific to an individual company is a
shortcoming of using management commentary as a source of information about a
companys risk exposure.

Questions 19 through 24 relate to Equity Investments
Equity Planners (EQUIP) Case Scenario
Equity Planners (EQUIP) is an equity management firm run by a group of ten portfolio
managers, each specializing in a specific sector of the equity market. Due to above-
average returns earned by EQUIP on several invested funds, the firm has managed to
establish a firm standing in the financial community. EQUIP now offers professional
advice to prospective clients even if they do not wish to invest with the firm. Rebecca
Lee is one of the founding portfolio managers at EQUIP. Lee has long used residual
income models in the formulation of appropriate investment strategies. She is now
contemplating the application of momentum indicators to discover possible profitable
trading opportunities. To enhance her understanding of their application, Lee read an
article on Momentum Valuation Indicators, written by Don Levy, a statistical analyst.
The article made the following comments:
1. Earnings surprise is a valuation indicator that reflects the unexpected earnings over a
given time period. When used directly, earnings surprise is often scaled by a measure
reflecting the variability or range in analysts EPS estimates. This is referred to as the
standardized unexpected earnings (SUE).
2. The moving average oscillator or the trading-range break are examples of indicators
that are prone to data snooping and hindsight biases.
Lee decided to gather the earnings surprise history for HotSpot Inc. (HTSP). She
assembled information about the earnings surprise as a percentage of the consensus EPS
forecast, and the values of the standardized unexpected earnings for the past 10 quarters.
After reviewing the data, Lee formulated the following conclusions:
Conclusion 1: The percentage earnings surprise for the quarter ending March 2008 was
significantly negative. This shows that the company had worse results than
anticipated, resulting in an actual EPS that was lower than the consensus
forecast, i.e., a negative earnings surprise.
Conclusion 2: The SUE score for the quarter ending June 2009 was positive. This
indicates that the company outperformed analysts expectations.

Lee is assessing the stock of Cold Rocks Company Ltd. (CRC) for inclusion in EQUIPs
newly introduced equity fund. CRC is a small company with total assets of $5 million
financed with 60% debt at a cost of 8.5%. Even though the company is small in terms of
market capitalization, it managed to earn a return on invested capital of 13% in the most
recent year. The company is taxed at a rate of 25% and has a cost of equity of 11%. After
calculating CRCs residual income, Lee proceeded with estimating the firms enterprise
value added. While reviewing the firms financial statements, Lee decided to make
adjustments for the following items:
Item 1: CRC reports research and development costs in the current year. These costs are
expensed in the period in which they are incurred.
Item 2: The company reports deferred tax assets in excess of deferred tax liabilities.
Item 3: Operating leases are treated as capital leases.
When preparing her proposal, Lee made the following comment in the report:
Relative to the DD model, recognition of value typically occurs earlier in residual

income models. Hence, when calculating value using similar assumptions, the RI model
will yield a larger value estimate than the DDM due to the time value of money concept.
As the last assignment of the day, Lee is forecasting the residual income, for the year
ending 2011, of Zephyr Enterprises (ZEPH). Exhibit 1 displays some information
relevant to the analysis.
Exhibit 1
Zephyr Enterprises
Book value per share as of 31 December 2010 $15.68
Earnings estimate for 2011 $3.56
Earnings estimate for 2012 $4.50
Dividends per share forecast for 2011 $1.20
Dividends per share forecast for 2012 $1.35
Required return on equity 10%

19. The article is most accurate with respect to:
A. Comment 1 only.
B. Comment 2 only.
C. both comments 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS p
Comment 1 is incorrect. Earnings surprise scaled by a measure reflecting the

variability or range in analysts EPS estimates (like the standard deviation of
analysts earnings forecasts) is referred to as scaled earnings surprise. The
standardized unexpected earnings (SUE) scales the earnings surprise by a measure
of the size of historical forecast errors.
Comment 2 is correct. A moving average oscillator and a trading-range break are

trading rules (also known as relative-strength indicators) that are vulnerable to
data snooping and hindsight biases.
20. Lee is most accurate with respect to:
A. Conclusion 1 only.
B. Conclusion 2 only.
C. both conclusions 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 36, LOS p
Conclusion 1 is incorrect. A large negative percentage earnings surprise may not

necessarily be due to a negative earnings surprise. It may well be that the
consensus EPS forecast for the firm was negative and the firm outperformed
market expectations. The % earnings surprise would be negative due to a negative
EPS forecast.
Conclusion 2 is correct. A positive SUE score means that the firm outperformed
expectations and a negative SUE score means the opposite.

21. The residual income for CRC for the most recent year is closest to:
A. $238,750.
B. $251,165.
C. $331,250.
Correct Answer: A
Reference:
The effective capital charge is:

Equity charge: 2 million (0.11) = $220,000
Debt charge: 3 million [0.085 (10.25)] = $191,250
Effective capital charge = 220,000+191,250/5,000,000 = 8.225%
Residual income = (13%8.225%) 5,000,000 = $238,750
22. Considering each adjustment in isolation, how will adjustments for the items
presented for CRC affect its economic value added?
A. Adjustment for item 1 will increase EVA, and adjustments for items 2 and
3 will have no effect.
B. Adjustment for item 1 will increase EVA, and adjustments for items 2 and
3 will decrease EVA.
C. Adjustment for items 1 and 2 will increase calculated EVA, but
adjustment for item 3 will have no effect.
Correct Answer: C
Reference:

Research and development costs should be capitalized rather than expensed. This
means that the R&D expense should be added back to earnings to compute
NOPAT. This will increase EVA.
Deferred taxes should be eliminated. Since deferred tax assets are in excess of
deferred tax liabilities, removing them from total capital will have the net effect of
reducing total capital (add DTL back and subtract DTA). This will increase EVA.
Operating leases are treated as capital leases for calculating EVA. Hence, no
adjustment is necessary for item 3.
23. Lees comment in her proposal contrasting the DDM and RI models is most
likely:
A. correct.
B. incorrect, because they will yield equivalent results.
C. incorrect, because the value produced by the dividend discount model can
be higher or lower.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS i
The two models are fundamentally similar; hence, given consistent assumptions,
they both will yield equivalent results.
24. Based on the information provided in Exhibit 1, the per-share residual income for
the year ending 2012 is closest to:
A. $1.992/share.
B. $2.381/share.
C. $2.696/share.
Correct Answer: C
Reference:

3.56 1.20 + 15.68 =$18.04 (ending BVPS for 2011)

Equity charge for 2012 = 18.04 (0.10) =$1.804
Residual income for 2012 = 4.5 1.804 = $2.696/share

Questions 25 through 30 relate to Equity Investments
Lenora and Finesse Products Case Scenario
Vincent Oswald, a stock analyst and earnings forecaster, has been asked by his supervisor
to revise the valuation estimates of two firms: Lenora Products Ltd. and Finesse Products
Incorporated. Lenora Products has a current book value per share of $22.89 and a current
market price per share of $120.09. Oswald expects long-term growth to be 9.0% and
long-term return on equity to be 29%. The cost of equity for the firm is 12%. Oswald
plans to use the single-stage RI model for valuation purposes.
Finesse Products operates in an industry that is characterized with high profit margins
and above-average growth. For these reasons, Oswald expects new firms to enter the
industry and erode the firms current market leadership position. He deems it appropriate
to estimate value under the following two scenarios:
Scenario 1: If competitors enter the industry slowly, the firms ROE will decline
gradually towards the required return. In this case, the persistence
parameter would equal 0.80.
Scenario 2: If competition rises more quickly, the firms ROE will decay faster and
the persistence parameter would equal 0.4.
Oswalds forecast horizon is 15 years. He expects earnings per share at the end of the
horizon to be $34.56 and ending and beginning book value to equal $89.05 and 68.15
respectively. The required return on equity is 13% and long-term growth is expected to
be 8%.
When presenting his estimates to his supervisor, Oswald posed the following question:
If market value added is presented as a ratio, will it be equivalent to the Tobins q?
Oswald has also been asked to value Privico Manufacturing, a private company that is
being acquired by Publico Manufacturing, a large public firm considering expansion in
its industry. After an analysis of guideline public companies, Oswald generated the
estimates displayed in Exhibits 1 and 2.

Exhibit 1
Privico Manufacturing
Equity risk premium 7.5%
Risk-free rate 5.6%
Small stock premium 3.5%
Beta 1.54
Industry risk premium 4.0%
Company-specific premium 1.5%
Current debt to total capital 5%
Optimal debt to total capital 12%
Tax rate 35%
Cost of debt 8.5%
Exhibit 2
Publico Manufacturing
Beta 1.12
Cost of debt 7.0%
Ratio of debt to total capital 30%
While talking to his friend, Audrey Jonas, about it, Oswald stated:
Even though the build-up method makes no beta adjustment, the required rate of return
of Privico calculated using the method is exactly equivalent to the rate of return
calculated using the expanded CAPM.
Jonas then posed the following question to Oswald:
For valuation concerning the possible sale of Privico, if we use the CAPM to determine
cost of equity, what will be the appropriate estimate of the firms WACC?

Jonas decides to use the guideline public company method to develop a value estimate of
Privico. Oswald stated that, unlike the method Jonas selected, the use of other market
approach methods of private company valuation would not require an estimate of a
control premium. Jonas agreed, and stated that a control premium is most uncertain when
derived from transactions involving the exchange of stock or from transactions that
occurred at a date significantly before the valuation date.
25. With regards to Oswalds estimate of the intrinsic value of Lenora Products
stock, the stock is most likely:
A. fairly valued.
B. overvalued.
C. undervalued.
Correct Answer: C
Reference:
V0 = 22.89 + (0.29 0.12)/0.12 0.09(22.89) = $152.60
This estimate is greater than the current market price, and hence, the stock is
undervalued.
26. Relative to scenario 2, Finesse stocks terminal value under scenario 1 will most
likely be:
A. 88.90% higher.
B. 121.20% higher.
C. 135.40% higher.
Correct Answer: B
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 37, LOS h

EPS = 34.56(1.08) = $37.3248
The ending book value in year 15 will be the beginning book value of year 16.
Hence,
Equity charge: 89.05(0.13) = $11.5765

Residual income: 37.3248 11.5765 = $25.7483
Using the persistence parameter, terminal values under the two scenarios is:
Scenario 1: $25.75/(1+0.13 0.8)(1.13)15 = $12.476

Scenario 2: $25.75/(1+0.13 0.4)(1.13)15 = $5.640
27. The most appropriate response to Oswalds question is:
A. yes.
B. no, because if inflation has been high over the years, the estimate under
Tobins q would be lower.
C. no, because if total assets remain constant, but liabilities increase at a high
rate, the estimate under Tobins q would be lower.
Correct Answer: B
Reference:
The Tobins q is a ratio of the market value of debt and equity to the replacement
cost of total assets. The MVA, if presented as a ratio, will equal the market value
of capital to the book value of capital. If inflation is high, the replacement cost of
assets will be higher than their historical accounting costs, and the Tobins q will
be lower.

28. With respect to his comment about the required rate of return of Privico, Oswald
is most likely:
A. correct, because both methods yield a required return of approximately

22%.
B. incorrect, because the expanded CAPM yields a required rate of return that
is 4% higher.
C. incorrect, because the build-up method yields a required rate of return that
is 4% higher.
Correct Answer: A
Reference:
Required return using expanded CAPM:

5.6+1.54(7.5)+3.5+1.5 = 22.15%
Required return using build-up method:

5.6%+7.5%+3.5%+4.0%+1.5% = 22.10%
29. The best response to Jonass question is that the WACC will be closest to:
A. 13.662%.
B. 15.755%.
C. 16.569%.
Correct Answer: B
Reference:
For valuation concerning the possible sale of Privico Manufacturing, the

appropriate debt and equity weights to use are those that reflect the firms optimal
capital structure. Also, we would not use the acquiring companys cost of capital
or capital structure for the analysis. Hence, WACC is:
Required return on equity = 5.6% + 1.54(7.5%) = 17.15%

WACC: 0.12[0.085(1 0.35)] + 0.1715(0.88) = 15.755%

30. With regards to the control premium, are Oswald and Jonas correct?
A. Only Oswald is correct

B. Only Jonas is correct
C. Both Oswald and Jonas are correct
Correct Answer: C
Reference:
CFA Level II, Volume 4, Study Session 12, Reading 38, LOSd
Oswald is correct. For the valuation of a controlling interest, a control premium is

necessary if the value is derived from the GPCM. The trading of interests of
public companies reflects small blocks without control of the entity. Hence, the
resulting pricing multiples do not reflect control of the entity.
Jonas is correct. Transactions involving the exchange of significant amounts of

stock might be less relevant as a basis of measuring a control premium. The same
is true for control premiums measured at a date significantly before a valuation
date.

Questions 31 through 37 relate to Alternative Investments
Walnut Brothers Inc. (WBI) Case Scenario
Walnut Brothers Inc. (WBI) is an asset management firm that operates in the alternative
investments sector of the capital market. Stephanie Blanchet is the chief financial analyst
at WBI, and is responsible for the management of the WBI Real Estate Fund, a fund that
invests exclusively in the private real estate market. Josh Freeze, a real estate research
analyst, is part of the team that manages the fund. Freeze is worried about the funds
investment in commercial real estate located in an emerging economy. At the time the
fund invested in the property, it was still in its developmental stages and the market was
strong and rents were high. But since then, the market has weakened and interest rates
have increased significantly. In addition, due to high vacancy rates and low rents in the
region, new construction is not feasible. When Freeze discussed this changed scenario
with Blanchet, Blanchet stated that this increased the risk of their investment
considerably. She decided to value the investment using the sales comparison approach to
determine the loss that had been incurred on the investment.
Blanchet advised Freeze to invest a portion of the fund in an investment property in

Illinois, USA. Freeze decided to use the sales comparison approach to value the property.
For this purpose, he gathered relevant data about comparables. Exhibits 1 and 2 display
this information.
Exhibit 1
Sales Comparison Data for the Property
Variable Property Sales Comp 1 Sales Comp 2 Sales Comp 3
Age (years) 15 10 20 25
Condition Good Average Excellent Good
Location Secondary Prime Secondary Prime
Size (square feet) 20,000
Sales price psf $600 $500 $535

Exhibit 2
Adjustments
Adjustments Sales Comp 1 Sales Comp 2 Sales Comp 3
Age (years) 10% 10% 15%
Condition 15% 15% 0%
Location 10% 0% 10%
Although the fund invests exclusively in private real estate, Blanchet is now
contemplating the addition of publicly traded real estate securities to the fund. After a
thorough analysis, Blanchet shortlisted an apartment equity REIT for investment
purposes. She instructed Freeze to obtain a net asset value estimate of the REIT based on
the REITs financials. Exhibit 3 displays the information she provided to Freeze for this
purpose.
Exhibit 3
Net Asset Value Estimate (in thousands)
Pro forma cash NOI for last 12 months $345,349
Assumed cap rate 8.00%
Next 12 months growth in NOI 2.00%
Cash and equivalents $85,039
Land held for future development $56,000
Goodwill $35,000
Deferred taxes $62,193
Other liabilities $145,555
Shares outstanding 65,430
When Freeze presented his estimate of the NAVPS to Blanchet, she stated the following
trading strategies that used this measure as an input:
Strategy 1: The NAV estimate can be used as a relative valuation measure. An

investor can benefit by purchasing a REIT that trades at a discount to
NAV and selling those trading at a premium to NAV, since the NAV can
be viewed as the intrinsic value of the security.

Strategy 2: If all REITs are trading below NAV, then an investor can benefit by
selling the REIT trading at the smallest discount to NAV.
To confirm the valuation of the REIT, Blanchet decided to use the discounted cash flow
approach to obtain another value estimate. She knew that the REIT distributed a
significant portion of its income to investors and reinvested the free cash flow, hence, the
DCF approach was appropriate. When Freeze inquired about the estimation methodology,
Blanchet stated that estimating the long-term growth rate of the REIT is one of the major
challenges in accurately measuring the intrinsic value. She stated that a number of factors
affected the growth rate of the REIT including:
Factor 1: A focus on developmental projects rather than acquisitions
Factor 2: An increased use of financial leverage
Factor 3: A higher rate of depreciation allowed under tax laws
31. WBI Real Estate Funds investment in commercial real estate is most likely
subject to:
A. long lead time risk, cost of capital risk and unexpected inflation risk.
B. long lead time risk and cost of capital risk but not inflation risk because
real estate values are positively affected by inflation.
C. changing business conditions risk and long lead time risk but not cost of
capital risk because easy access to debt capital will increase real estate
prices.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 39, LOS c
During the time between conception and the development of the property, market
conditions changed adversely. This reflects the long lead time risk. In addition,
interest rates have increased which will lower real estate prices and their demand.
This reflects the cost and availability of capital risk. Lastly, because of a weak
market with high vacancy rates and low rents, and when new construction is not
feasible, values may not increase with inflation. This introduces inflation risk.

32. With regards to using the sales comparison approach to valuing the commercial
real estate, Blanchet is most likely:
A. correct.
B. incorrect, because the replacement cost approach would be more reliable.
C. incorrect, because the income approach to valuation would be more
reliable.
Correct Answer: C
Reference:
The market for the commercial real estate property is weak, and hence, would be
characterized by few transactions. Therefore, the sales comparison approach
would be difficult to apply. Since new construction is not feasible, economic
depreciation can be hard to estimate, which makes the replacement cost approach
also difficult to apply. If the property generates income, a value can always be
calculated using the income approach. Thus, in this kind of market, the income
approach is likely to be most reliable.
33. Based on Exhibits 1 and 2, the estimated value of the property using the sales
comparison approach is closest to:
A. $10,143,333.
B. $10,711,667.
C. $11,500,000.
Correct Answer: B
Reference:

Adjusted prices:
Property 1: 0.95(600) = $570

Property 2: 0.95(500) = $475
Property 3: 1.05(535) = $561.75
Average price psf: $535.583

Appraised value: 535.583 (20,000) = $10,711,666.67
34. The net asset value per share of the apartment equity REIT is closest to:
A. $66.013.
B. $66.812.
C. $67.227.
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS e
Plus next 12 months growth in NOI: 345,349,000 (1.02) = $352,255,980

Estimated value of operating real estate: 352,255,980/0.08 = $4,403,199,750
Plus cash and equivalents and land held for future development: $4,544,238,750
Less liabilities (145,555,000) = $4,398,683,750
Divided by number of shares outstanding: NAVPS = $67.227
35. Blanchet is most accurate with respect to:
A. Strategy 1 only.
B. Strategy 2 only.
C. both strategies 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS e

Strategy 1 is incorrect. A REIT may be trading at a premium to NAV because the

management team of the REIT has a stronger track record and better opportunities
to grow the NAV compared to a similar REIT trading at a discount. This justifies
the premium of the REIT.
Strategy 2 is correct. If all REITs are trading at a discount to NAV, an investor

would benefit by selling the REIT trading at the smallest discount to NAV.
36. Which of the factors mentioned by Blanchet will most likely affect the estimate of
long-term growth in a dividend discount model?
A. Factor 1 only
B. Factors 1 and 3 only
C. Factors 1, 2, and 3
Correct Answer: C
Reference:
Factor 1 will increase growth: the return on invested capital is greater for
developmental projects than for acquisitions. Capital structure also has an impact
on growth, particularly in the short term as companies raise or lower their
leverage. High rates of depreciation allowed under tax laws will allow the
retention of enough cash flow without incurring current income taxes. This will
increase growth.

Questions 37 through 42 relate to Alternative Investments
Red-Salt Investments Case Scenario
Keith Welch was just hired by Red-Salt Investments (RESA), a firm that invests in the
four major quadrants of the real estate market: private equity, public equity, private debt
and public debt. Welch has been assigned the position of senior analyst at the firm, and is
responsible for the analysis of all four quadrants of the real estate market. Currently,
Welch is evaluating the performance of international commercial real estate REITs.
Welch focused his analysis on a specific sub-sector of an emerging economys real estate
market. He noticed several characteristic activities in the market, including:
Activity 1: Significant leveraged buyout activity with LBO sponsors attempting to

buy REITs
Activity 2: An increase in IPO activity and stock issuance.
Activity 3: The public markets attracting above-average management teams because
of an increase in the size of organizations.
After his evaluation, Welch met with the board of WaterSky Enterprises (WASKY), one
of RESAs prospective clients. When discussing publicly traded real estate markets and
their potential growth, Welch presented the board of WALE with information about U.S.
based Residential Equity REIT Incorporated. Exhibit 1 displays this information.
Exhibit 1
Residential Equity REIT incorporated (values in $ thousands)
Gross rental revenue 650,385
Other operating costs 234,309
Depreciation expense 102,500
General and Administrative expenses 85,399
Interest expense 75,450
Non-cash rent 31,675
Leasing commissions 25,000
Adjusted funds from operations 123,052
AFFO per share 2.46

During the meeting, the CEO of the board inquired about how the P/FFO and P/AFFO
multiples could be used as a basis for valuation of REITs and REOCs. While explaining,
Welch made the following comments:
Statement 1: Neither FFO nor AFFO based multiples take into account differences in
leverage among REITs. Hence, their use in relative value analysis should
be used in conjunction with adjustment for leverage levels.
Statement 2: Land does not produce income and hence, does not contribute to FFO or
AFFO. For this reason, land held for development does not affect the
value of FFO or AFFO based multiples.
To further explain relative value analysis based on FFO and AFFO multiples, Welch
displayed information about two equity REITs. Exhibit 3 displays this information.
Exhibit 3
Return on
AFFO Payout Est. annual
P/NAV P/AFFO reinvested
Ratio AFFO growth
cash flow
REIT A 102% 13.5x 85% 5.5% 8.0%
REIT B 98% 14.0x 45% 6.5% 8.0%
Welch then stated the factors that positively affected FFO based multiples, including:
Factor 1: An increase in the concentration of properties in primary locations

Factor 2: A decrease in recurring maintenance-related capital expenditures
Factor 3: An increase in gains on sale of properties
37. Assuming appraisers are using the NAV approach to valuation, which of the
activities in the real estate market that Welch was analyzing are least consistent
with each other?
A. Activities 1 and 2
B. Activities 2 and 3
C. Activities 1, 2 and 3

Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOSe
Increased LBO activity, with LBO sponsors buying REITs implies that REITs are
trading at large discounts to NAV. Conversely, when REITs are trading at large
premiums to NAV, IPO activity and stock issuance activity increases because the
public markets are essentially ascribing more value to the real estate than private
markets are. Also, the public markets attracting above-average management teams
also implies that REITs should trade at a premium.
38. Based on the information in Exhibit 1, the REITs funds from operations per share
is closest to:
A. $3.05.
B. $5.10.
C. $7.15.
Correct Answer: B
Reference:
Net operating income: 650,385-234,309 = $416,076

Less general and administrative expenses: $330,677
Less interest expense = FFO: $255,227
FFO/share: 255,227/50,021 = $5.1024
39. Based on Exhibit 1, the capital expenditure needed to keep the underlying
properties operating smoothly is closest to:
A. $75,500,000.
B. $150,950,000.
C. $178,000,000.

Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS f & g
123,052 = 255,227 31,675 25,000 x

198,552 x = 123,052
x = $75,500 thousand
40. Welch is most accurate with respect to:
A. Statement 1 only.
B. Statement 2 only.
C. both statements 1 and 2.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 13, Reading 40, LOS g
Statement 1 is correct. Neither FFO nor AFFO take into account differences in
leverage.
Statement 2 is incorrect. Although land may not produce income that contributes
to FFO or AFFO, the land has value and represents a source of greater internal
growth.
41. All else equal, using the information in Exhibit 3, which of the following REITs is
most attractively priced?
A. REIT A
B. REIT B because it is trading at a discount to NAV
C. REIT B because it is trading at a discount to NAV and has a higher growth
in AFFO
Correct Answer: A
Reference:

REIT A is cheaper because it is able to generate almost the same growth in AFFO
as REIT B while retaining only 15% of AFFO compared to 55% for REIT B.
Because return on reinvested cash flow is the same, REIT A has much more
growth in returns coming from its existing portfolio.
42. With respect to the factors affecting the P/FFO multiple, Welch is most accurate
with respect to:
A. Factor 1 only.
B. factors 1 and 3 only.
C. factors 1, 2 and 3.
Correct Answer: A
Reference:
An increase in the concentration of properties in primary locations is likely to

increase expected growth and the value of the multiple.
FFO is not affected by maintenance-related capital expenditures (they are used in

calculating AFFO). The same is true for gains on sales of properties.

Questions 43 through 48 relate to Fixed Income
Peter de Silva Case Scenario
Peter de Silva is a fixed income trader at North Traders, a broker-dealer firm situated in
the United Kingdom. While de Silva has always been aware of the importance of the
arbitrage-free process in valuing fixed-income securities, he has never applied the
approach in practice. To learn more about the technique, he engages in a discussion with
his colleague, Kim Young. During their discussion Young makes the following
comments:
Comment 1: The arbitrage-free valuation approach derives security values using a

process known as stripping and reconstitution.
Comment 2: The arbitrage-free valuation framework is based on the notion that two
otherwise identical assets must trade at prices which represents fair value in
their respective markets.
Comment 3: The arbitrage-free valuation free approach, which involves discounting cash
flows using individual spot rates, is restrictive in the sense that the process
cannot be applied to a category of fixed-income securities.
The trader concludes the discussion by inquiring about the conditions, which create the
potential for arbitrage opportunities.
De Silva proceeds to practically apply the techniques learned. He selects three corporate
bonds issued by ARC Manufacturing, a global conglomerate. All three issues mature at
par, are mispriced, trade on the LSE, and differ with respect to credit rating. De Silva has
collected relevant details with respect to the three issues and aims to explore potential
arbitrage opportunities (Exhibit 1).
Next, De Silva would like to explore how interest rate volatility affects the valuation of
fixed-rate option-free bonds. For his analysis the trader selects a four-year, 10%, annual
coupon-paying bond issued by Dutch Inc. He proceeds to calibrate a binomial interest
rate tree (Exhibit 2), which corresponds to the benchmark yield curve. He is particularly
interested in deriving the value of the bond if interest rates follow the designated path:

Year 1 Path: Highest interest path

Year 2 Path: Middle interest rate path
Year 3 Path: Second highest interest rate path
Dutch Inc. has actively traded mortgage-backed securities. De Silva is exploring which
valuation technique will be most appropriate for this security category.
Exhibit 1:
Option-free Corporate Bonds Issued by ARCManufacturing
Credit rating A-rated BB-rated B-rated
Price per 100 par ()* 99.050 97.145 94.145
Maturity (years) 5 5 5
Coupon (%) 6.0 6.5 7.0
Yield-to-maturity (%) 6.3 7.2 8.1
*Represents current market price
Exhibit 2:
Calibrated Binomial Interest Rate Tree to Match Benchmark Yield Curve
Year 0 Year 1 Year 2 Year 3
1.000% 5.639% 7.546% 9.734%
4.616% 6.178% 7.211%
5.058% 5.904%
4.373%
43. Considering her first two statements, Young is most accurate with regards to:
A. Statement 1 only.
B. Statement 2 only.
C. neither Statement 1 nor Statement 2.
Correct Answer: C
Reference:

Young is inaccurate with respect to both her statements. The arbitrage free
valuation approach derives security values based on the notion that the value of a
financial asset is equal to the present value of its future cash flows. Stripping and
reconstitution is a process whereby dealers will separate a zero-coupon bond and
trade the individual cash flows in an attempt to earn arbitrage profits.
The arbitrage-free valuation process is based on the law of one price, which
asserts that the two otherwise identical assets must trade at the same price
regardless of the market being represented. The fair value of the asset may differ
from one market to the other and is thus not necessarily equal to the value
suggested by this law.
44. In the context of Statement 3, spot rate discounting is restrictive because the
technique cannot be used to value:
A. corporate bonds.
B. zero-coupon securities.
C. bonds with embedded options.
Correct Answer: C
Reference:
Arbitrage-free valuation can be derived by discounting each securitys cash flow

by a spot rate which is relevant to its maturity. However, this technique cannot be
applied to valuing bonds with embedded options as their cash flows are subject to
change with interest rate movements. Therefore, a limitation of this technique is
that it does not consider interest rate volatility which is vital when valuing
securities generating cash flows dependent on the path of interest rates (such as
bonds with embedded options).
However, the technique can be applied to zero-coupon bonds as well as corporate

bonds as long as they do not include embedded options.

45. The most appropriate response to De Silvas query is that:
A. the value additivity principle must not hold.

B. a financial asset with a risk-free payoff must trade at a neutral price today.
C. traders are required to commit a net amount equal to a fraction of the asset
value.
Correct Answer: A
Reference:
In order for a trader to earn arbitrage profits, the value additivity principle must
not hold. In other words, the value of the entire portfolio should not equal to the
sum of its individual cash flows or component securities values. If this is the
case, an investor can buy the overpriced component and sell the underpriced
component.
B is incorrect. The statement reflects an absence of the arbitrage opportunity

known as dominance. This opportunity requires a financial asset with a risk-free
payoff trade at a positive current price.
C is incorrect. An arbitrage opportunity allows traders to earn riskless profits with

a zero net investment. Therefore, the option statement is contradictory to the
process by which arbitrage profits are generated.
46. Using the data in Exhibit 1, which of the following bonds will maximize arbitrage
profits?
A. A-rated
B. BB-rated
C. B-rated
Correct Answer: C
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 44, LOS b
The most mispriced security will maximize arbitrage profits. To determine the
amount of mispricing, the intrinsic value of each security will be calculated and

compared to market value. Note all prices, present values and future values are
stated in per 100 of par value
Securities
A- rated BB-rated B-rated
Market price 99.050 97.145 94.145
(given)
N 5 5 5
I/Y 6.3 7.2 8.1
PMT 6.0 6.5 7.0
FV 100 100 100
PV 98.747 97.145 95.620
Amount of Overpriced Fairly priced, 0 Underpriced by

mispricing by 0.303 1.475
Comparing the securities, the B-rated security is the most mispriced and will
maximize arbitrage profits. The trader can purchase the security today at the
current market price and sell it at intrinsic value upon the correction of the price
misalignment.
47. Using Exhibit 3 and information on the Dutch Inc issue, the present value of the
security along the designated path is equal to (in per 100 of par value):
A. 90.568.
B. 109.855.
C. 118.668.
Correct Answer: C
Reference:

Using the path designated by De Silva, the present value of the Dutch Inc bond
issue is 118.668 per 100 of par value.
The interest rate path followed and the value of the security at each node is
illustrated below. Note that PV does not include the current years coupon
payment.
Year 0 Year 1 Year 2 Year 3

r = 5.639%
r =1.000% PV = 109.855 r =7.546% r = 9.734%
PV = 118.668 Coupon = 10
r = 6.178% r = 7.211%
PV = 106.050 PV = 102.601
Coupon = 10 Coupon = 10
r = 5.058% r = 5.904%
r = 4.373%
A is correct. The calculated value does not include annual coupon.
B is incorrect. The calculated value represents the value of the bond at the
beginning of Year 1 and needs to be discounted back one more period after
including the annual coupon.
48. The most suitable technique for valuing mortgage-backed securities is:
A. pathwise valuation.
B. Monte Carlo simulation.
C. binomial interest rate tree.
Correct Answer: B
Reference:

While pathwise valuation and binomial interest rate trees can be applied to the
valuation of securities with embedded options Monte Carlo simulation is most
suitable for valuing mortgage-backed securities; this is because the value of these
securities is dependent on the prepayment rate which in turn depends on the path
of interest rates. The Monte Carlo method assists in the valuation of these
securities by simulating a large number of interest rate paths which allows for a
more detailed analysis of the impact of interest rate volatility on security value.

Questions 49 through 54 relate to Fixed Income
Lyon & Claire Case Scenario
Lyon & Claire (LC) is a portfolio management firm with a specialized fixed-income
department. Based on past in-house analyst forecasts, LC has always preferred callable
bonds to other option embedded bond for its client investment portfolios.
The exhibit below provides details of three callable bond issues currently managed by its
fixed income portfolio managers (Exhibit 1). The bonds are identical with respect to
maturity, credit rating, and are redeemable at par. A 15% volatility assumption is used for
the analysis.
Exhibit 1:
Callable Bond Issues in LCs Investment Portfolio
Annual Z-spread OAS
Coupon Current (basis (basis
Issuer Rate Price First Call Date points) points)
Sans Inc 5.1% 103.00 One month from today 56 25
Harp Limited 4.2% 102.03 Two years from today 65 35
Belle-Monte 6.5% 103.98 Three years from today 69 34
Ali Mehmet is LCs fixed income analyst. He has made the following two forecasts with
respect to interest rates and changes in the yield curve.
Forecast 1: Interest rates will decline from their current level to 4.9%
Forecast 2: With the decline in interest rates the yield curve will invert.
Mehmet is seeking to expand the firms portfolio by including putable bonds. The issue
being evaluating is a four-year, 5.3% annual coupon-paying bond. He is comparing
various duration measures reported for the bond. The exhibit below summarizes the
results of his analysis (Exhibit 2).
Exhibit 2:
Analysis of Putable Bond Issue
Current value of bond 98.50
Effective duration 3.1
One-sided up duration if interests rates
increase by 50 basis points 1.6

Mehmet concludes his analysis by comparing the impact of Forecast 1 on the bonds
under evaluation. He arrives at the following conclusions:
Conclusion 1: The effective duration of the putable bond issue will exceed that reported
for the underlying option-free bond.
Conclusion 2: For a further 1% decline in rates callable bonds will have a relatively lower
price appreciation potential.
49. LCs preference for callable bonds in its investment portfolio reflects a forecast
whereby interest rates are expected to:
A. rise.
B. decline.
C. remain relatively constant.
Correct Answer: C
Reference:
As an investor of callable bonds, LC would prefer if the issuer (holder of the call
option) does not call the bond. The call option is exercised if interest rates decline
relative to the coupon rate such that the issuer can benefit from the lower market
rate. On the other hand, an investor would prefer constant interest rates over rising
interest rates as the latter will decrease the value of the bond resulting in a capital
loss for the investor.
50. Using the information in Exhibit 1, which of the following bond issues will report
the highest OAS at zero volatility?
A. Sans Inc.
B. Harp Limited
C. Belle-Monte
Correct Answer: C
Reference:

The Z-spread corresponds to the OAS at zero volatility. Belle-Monte reports the
highest Z-spread.
51. Considering Forecast 1 and the information in Exhibit 1, the security with the
lowest price appreciation potential will be:
A. Sans Inc.
B. Harp Limited.
C. Belle-Monte.
Correct Answer: A
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS l
When interest rates decline the call option moves in the money and the upside
potential of the callable bond is limited. This is because the callable bond exhibits
negative convexity, which results in the securitys price being capped by the call
option particularly if the bond is near the exercise date. Out of the three issues
being analyzed, the Sans Inc. bond will experience the lowest price potential if
interest rates decline. This is because the call option 1) now has value as interest
rates have declined below the coupon rate and 2) is nearest to its exercise date.
If the forecast materializes, the difference between the coupon rate and interest
rates level will be the greatest for the Belle-Monte issue. However, the upside
potential will not be as significantly restricted as the Sans Inc. issue because the
call option is not exercisable for another two years; this reduces the impact of the
interest rate decline on upside potential.
The option embedded in the Harp Limited issue will continue to remain out of the
money as the coupon rate is higher relative to the forecasted interest rate. The
price appreciation potential of this issue will be the least severely affected by the
forecast.

52. Which of the following observations is most likely consistent with Forecast 2
(using the information in Exhibit 1)? There is an increased likelihood that the
issues will:
A. exhibit positive convexity.

B. move closer to being in the money.
C. respond similarly to the change in rates as their underlying.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS e & l
An inverted yield curve will result in the decline in forward rates, which are a
component of the binomial interest rate tree used to value bonds with embedded
options. Lower rates will increase the probability of the issues being called. As a
result, there is a higher likelihood of the issues moving closer to being in the
money.
B is incorrect. With an inverted yield curve, there is a greater possibility of the

level of interest rates declining below the coupon rate and each issue exhibiting
negative convexity.
C is incorrect. The option-free underlying will exhibit positive convexity despite

the change in yield curve shape. Unlike their underlying, the three issues will
exhibit negative convexity and the percentage increase in price in response to a
decrease in rates in lower relative to that of the option-free underlying bond
(which exhibits positive convexity).
53. Based on the information in Exhibit 2, relative to the one-sided up duration, the
one-sided down duration will indicate that the price sensitivity of the putable bond
to interest rate changes is:
A. lower.
B. higher.
C. the same in absolute terms only.
Correct Answer: B

Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS k
When interest rates decline, the put option is unlikely to be called and the putable
bond behaves similarly to a straight bond with respect to the impact of rate
changes on price. Therefore, the duration will be higher indicating greater price
sensitivity to interest rate changes.
C is incorrect. The down-sided duration is not symmetrical to the up-sided

duration and is higher indicating greater price sensitivity for putable bonds when
interest rates decline.
54. Mehmet is most accurate with respect to Conclusion (s):
A. 1 only.
B. 2 only.
C. 1 and 2.
Correct Answer: B
Reference:
CFA Level II, Volume 5, Study Session 14, Reading 45, LOS j & l
Mehmet is accurate with respect to Conclusion 2. When interest rates decline,

callable bonds have less upside potential than putable bonds; this phenomenon is
attributable to negative convexity whereby the increasing value of the embedded
call option decreases the value of a callable bond relative to an option-free bond.
Mehmet is inaccurate with respect to Conclusion 1. While the duration of the

putable bond will increase in response to a decline in interest rates as the put
option moves out of the money, the measure cannot exceed that reported for the
straight bond. Therefore, the effective duration of the putable bond will be very
similar to the underlying option-free bond.

Questions 55 through 60 relate to Portfolio Management
Linda Harris Case Scenario
Linda Harris is a portfolio manager at South Solutions (SS), a wealth management firm,
which caters to individual and institutional clients. Freight Foundation is Harriss newest
client. Harris is selecting fixed-income and equity securities to include in the portfolio.
The exhibit below summarizes details of the fixed-income investments being considered
for FFs portfolio (Exhibit 1).
Exhibit 1: Potential Fixed-Income Securities for FFs Portfolio

Investment Grade Credit Risk
Classification Maturity Expected Premium
Type of Sector (Years) Loss (%) (in bps)
Issue
Corporate Investment-grade Cyclical 20 3 75

Non-investment Non-
Corporate grade cyclical 12 7 158
Not
Default-free Not applicable applicable 5 0 0
Not
Default-free Not applicable applicable 15 0 0
Scott Trance is a junior portfolio manager who has recently joined SS. Trance is working
alongside Harris and is assisting her in the evaluation of the potential securities. Upon a
careful study of the data presented in Exhibit 1, Harris makes the following statements:
Statement 1: Assuming the bond issues are comparable, risk-neutral investors would
expect the yield on a 12-year default-free bond to equal 7.00%.
Statement 2: If I were to construct a portfolio solely comprising of the two corporate

issues, I can be reasonably assured that the portfolio will be well-
diversified across industrial sectors, maturities, and investment grades.
Investors opting to invest in this portfolio can minimize their exposure to
market risk.

Next, Harris combines the fixed-income data collected with economic growth forecasts.
Based on the current slope of the yield curve, she learns that economic analysts have
forecasted that a recession is highly anticipated. She would like to determine what this
implies for business credit demand and expected inflation.
Harris then moves on to evaluate potential equity securities for FFs portfolio.
Information concerning these securities is outlined in the exhibit below (Exhibit 2).
Exhibit 2: Potential Equity Securities for FFs Portfolio

Forecasted
Dividend Yield Current Price Per Earnings Growth
Stock (%) Share ($) (%)
A 0.2 45 20
B 3.0 50 4
C 0.8 60 2
Harris concludes her analysis by extending the recessionary forecast to the identified
equity securities. She anticipates that a recession will lead to a decline in the P/E ratios of
the identified stocks.
55. Is Trance correct with respect to statements 1 and 2?
Statement 1: Statement 2:
A. Yes No
B. No Yes
C. Yes Yes
Correct Answer: A
Reference:

Trance is correct with respect to Statement 1 but incorrect with respect to

Statement 2.
Where investors are risk-neutral, the expected return on a government bond will
equal to the loss-adjusted expected return on a comparable corporate bond with
the same maturity. Therefore, the expected return on a 12-year default-free bond
will equal to 7.00% (which is equal to the expected loss on a 12-year corporate
bond).
Trance is incorrect with respect to Statement 2. Even if Trance is of the opinion

that a portfolio comprising investment-grade, noninvestment grade, cyclical and
noncyclical bond issues is well diversified, investors will continue to be exposed
to considerable market risk; this is because defaults tend to cluster around
downturns in the business cycle.
56. Which of the following factors most likely supports the economic forecast?
A. Upward sloping yield curve

B. Higher inflationary pressures
C. Diminished business credit demand for long-term bonds
Correct Answer: C
Reference: CFA Level II, Volume 6, Study Session 18, Reading 55, LOS d
C is correct. When the yield curve is inverted, there is often a diminished business
credit demand for long-term bonds.
A is incorrect. An inverted yield curve is often read as being a predictor of

recession.
B is incorrect. Recession is characterized by lower inflation rates and thus, weaker

inflationary pressures.
57. In light of the economic forecast, when allocating the fixed-income securities
(Exhibit 1) to FFs portfolio, Harris will:
A. prefer the non-cyclical issue.

B. prefer the non-investment grade issue.
C. be insensitive to investment grade classification.

Correct Answer: A
Reference:
During economic recessions, the credit spreads quoted on bonds tend to rise.
However, certain sectors of the bond market are more sensitive to changes in
spread than others.
A is correct. Compared to cyclical issues, noncyclical issues will be less sensitive

to cyclical shifts. Therefore, their credit spreads will rise less compared to cyclical
issues. The price of the cyclical issues is expected to decline less in response to a
widening in spreads. Investors will prefer this sector.
B is incorrect. Due to higher credit risks, non-investment grade issues quote larger
spreads compared to investment-grade issues. Therefore, the spread of a non-
investment grade issue is expected to rise more leading to a larger decline in
price. In this scenario, an investment in the non-investment grade issue is
inappropriate.
C is incorrect. Only when credit spreads are narrowing will investors be less
discerning among issuers with weak and strong credit credentials.
58. Considering the data in Exhibit 1 and the economic forecast, which of the
following issues will provide the best hedge against poor consumption outcomes?
A. 1-year default-free issue

B. 15-year default-free issue
C. 20-year corporate issue
Correct Answer: A
Reference:

A is correct. A 5-year default-free issue is the best hedge against bad consumption
outcomes. This is because of the relative certainty about the real payoff from a 1-
year default-free issue and thus the certainty about the amount of consumption
that an investor will be able to undertake with the payoff. The issues payoff has a
low, probably zero, correlation with bad consumption outcomes and is thus the
most effective hedge.
B is incorrect. The payoff from a long-term default free issue will be less certain
compared to the 1-year default-free issue. This is because investors will have less
confidence in their ability to form views about inflation over the term of the issue.
Therefore, the greater uncertainty in payoff of the issue will result in this issue
being a less effective hedge against poor consumption outcomes.
C is incorrect. A corporate bond issue is the poorest hedge against bad

consumption outcomes because inflation uncertainty and default risk will increase
the uncertainty of the resulting payoff.
59. Using the data in Exhibit 2, which of the following stocks can most likely be
classified as a value stock?
A. A
B. B
C. C
Correct Answer: B
Reference:
A value stock is characterized by high dividend yields and low forecasted

earnings growth. Stock B classifies as a value stock because it has a low
forecasted earnings growth and high dividend yield.
60. Which of the following factors will most likely contribute to a decline in the P/E
ratios, as forecasted by Harris?
A. Rise in real interest rates

B. Fall in unexpected inflation
C. Decline in GDP growth volatility

Correct Answer: A
Reference:
Based on the formula below, the P/E ratio will decline with a rise in:
real interest rates,

unexpected inflation, and
GDP growth volatility.
Pit
=
[
Et CF i t + s ]
E
s
E
( i i
s =1 1 + lt + s + t , s + t , s + t , s + t , s )

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CFA Level II Mock Exam 2 Solutions (PM)

Copyright 2010-2016. FinQuiz.com. All rights reserved. Copying, reproduction

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FinQuiz.com 2nd Mock Exam 2016 (PM Session)

Questions Topic Minutes

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Questions 1 through 6 relate to Ethical and Professional Standards

Investopia Associates (INVEA) Case Scenario

Investopia Associates (INVEA) is a capital management firm in Miami, USA. Josh

As a result of above-average performance of the pension funds that Wiley manages,

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Client Bs IPS specifically provides for highly liquid investments, so a venture

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If Wiley discloses in writing of this contingent compensation arrangement to his

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Questions 7 to 12 relate to Quantitative Methods

Hector Solanki Case Scenario

Hector Solanki is a fixed-income analyst at Pratt Associates, a global research house.

Reason 1: Simulations generate risk-adjusted expected values and consider the

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After specifying the variables, Solanki moves on to generate probability distributions of

Exhibit: Results of Simulation

Solanki concludes his analysis by demonstrating how simulation can be used as an

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7. Which of the following reasons, provided by Solanki, accurately characterizes the

Reason 1 inaccurately characterizes the benefits of simulation. Although Solanki

Reason 2 inaccurately characterizes a benefit of simulation. Simulations heavily

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C is correct. Since historical and cross-sectional data is insufficient and unreliable

A is incorrect. Solanki cannot rely on historical data to generate probability

B is incorrect. Solanki cannot rely on cross-sectional data to generate probability

B is correct. Solanki has failed to consider correlations between the variables

C is incorrect. None of the variable being considered by Solanki are

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A. substitute for risk-adjusted values.

B is incorrect. When simulation is used as complements to risk-adjusted value, the

11. The simulation technique used by Solanki to derive bond values:

A. ignores total portfolio risk.

Since standard deviation in simulated values is being used as the decision-making

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Constraint 1 is an example of an earnings and cash flow constraint, which has

Constraint 2 is an example of a market value constraint; this is because Solanki is

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Questions 13 through 18 relate to Financial Reporting and Analysis

Lakeline Associates Case Scenario

Observation 3: Aerial Limited prepares and presents its financial statements in

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A. revenues may increase faster than receivables.

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A is incorrect. By pulling future sales into the current period, a companys

B is incorrect. An increase in days sales outstanding signals a decline in accounts

A. current period only.

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A. Accelerating payments to payables

A is incorrect. Accelerating payments to payables will decrease operating cash

A. not being decision useful.

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B is incorrect. A change in the inventory accounting method does not render

C is incorrect. The decision to adopt the FIFO method reflects an aggressive

A. focus solely on historical information.

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