CFA LEVEL 2 - TEST BANK WITH SOLUTIONS

Question: Analyze the advantages and disadvantages of the various

financial and operating changes that a company can make to manage its
sustainable growth.
Answer:
The first step in solving the excess growth problem is to determine if the situation
is temporary or permanent. If temporary, further borrowing may be the simple
solution. If longer-term, some combination of the strategies described below will
be necessary:
1. Sell New Equity - If the company is willing and able to raise new equity capital
by selling shares, its sustainable growth problems vanish. The increased equity,
plus whatever added borrowing is possible as a result of the increased equity, is a
source of cash with which to finance further growth. The potential problems with
this strategy are:
A. Poorly developed or non-existent equity markets make equity difficult
to sell, basically make the shares illiquid.
B. Limited access to the services of an investment banker to sell the
shares, which is especially true for small concerns.
C. Many companies may prefer not to sell equity, opting instead for
internal sources, depreciation and increases in retained earnings as
sources of corporate capital.
2. Increase leverage - Increasing leverage raises the amount of debt the
company can add for each dollar of retained profits. There are limits to the use of
debt financing: all companies have a creditor-imposed debt capacity that restricts
the amount of leverage the firm can employ. Moreover, as leverage increases, the
risks borne by owners and creditors rise, as do the costs of securing additional
capital.
3. Reduce the Payout Ratio - A cut in the payout ratio raises sustainable growth
by increasing the proportion of earnings retained in the business. In general,
owners' interest in dividend payments varies inversely with their perceptions of
the company's investment opportunities. If owners believe that the retained profits
can be put to productive use within the company, they will forego current
dividends in favor of higher future ones. Alternatively, if a firm's investment
opportunities do not promise attractive returns, a dividend cut will anger
shareholders, resulting in a
stock price decline.
4. Profitable Pruning - Profitable pruning sells off marginally performing
operations to invest the money into the remaining businesses. This approach
recognizes that when a company spreads its resources across too many products,
it may be unable to compete effectively in any. Profitable pruning reduces
sustainable growth problems in two ways: it generates cash directly through the
sale of marginal businesses, and it reduces actual sales growth by eliminating
some of the sources of the growth.
5. Profitable pruning can also be applied to a single-product company. In this case,
slow-paying customers and/or slow-turning inventory is eliminated. This can
Norman Cheung

AllenResources_Q&A_Level 2

eliminate sustainable growth problems in three ways: It frees up cash; it increases

asset turnover; and it reduces sales.
6. Sourcing - This option involves deciding whether to perform an activity inhouse or to purchase it from an outside vendor. Sourcing more and doing less inhouse may increase sustainable growth rate. Sourcing releases assets that would
otherwise be tied up in performing an activity, and it increases asset turnover;
both of which serve to diminish growth problems. The key to effective sourcing is
determining where the company's unique abilities lie, and sourcing out tasks that
are not core to the business.
7. Pricing - An obvious inverse relationship exists between price and volume.
When revenue growth is too high in relation to a company's financing ability, it
may have to raise prices to reduce growth. If the higher prices increase the profit
margin, the rate of sustainable growth may increase.
8. Merger - When all else fails, it may be necessary to look for a partner. Two
types of companies are capable of supplying the needed cash: a mature company
(a cash cow) looking for profitable investments for its excess cash flow and a
conservatively financed company that would bring liquidity and borrowing capacity
to the cash needy firm.

Question: Explain the computation of a firm's effective tax rate.

Answer:
Permanent differences, which are difference between the way that the tax code
measures income and the way that financial statements report income that never
reverses itself, affect the provision for taxes in the income, the tax expense, which
is calculated as:
(Projected income before taxes - Permanent differences) x tax rate
Timing differences, which are difference between the time that the tax code
recognizes either an income or an expense item and the time at which the
financial statements record the item, appear in the balance sheet as Deferred
Taxes. Deferred taxes are tax obligations that are expected to be
paid when the timing differences are reversed. Deferred taxes in any fiscal year
are calculated as:
(Cumulative timing differences) x (tax rate)
A tax payment for a given year equals the tax expense minus the increase in the
deferred tax account.
When analyzing the tax accounts, the objective is to estimate three elements:
1. The permanent differences that the firm will have between its taxable
income and reported income.
2. The timing differences.
3. The tax rate to which the firm will be subject.
The first step in determining these elements is the calculation of:
Effective tax rate = Tax expense/Income before taxes
Norman Cheung

AllenResources_Q&A_Level 2

Question: Evaluate the most commonly found indenture provisions.

Answer:

UTILITY INDENTURES
1. "Security" specifies the property upon which there is a mortgage lien and the
ranking of the new debt relative to outstanding debt is specified. Generally, new
bonds rank equally with all other bonds outstanding under the mortgage. Certain
features of older provisions have become archaic,
hindering the efficiency of running a business. Therefore, a company will attempt
to retire old debt in order to eliminate the more restrictive covenants not included
in current offerings.
2. "Issuance of Additional Bonds" establish the conditions under which the
company may issue additional first mortgage bonds and is often based upon a
debt test and/or earnings test. The debt test generally limits the amount of bonds
that may be issued under the mortgage to a certain percentage of net property or
net property additions, the principal amount of retired bonds, and deposited cash.
The earnings test restricts issuance of additional bonds under the mortgage unless
earnings for a particular period cover interest payments at a specified level.
3. "Maintenance and Replacement (M&R) Fund" ensure that the mortgaged
property is maintained in good operating condition, thereby maintaining its value.
4. "Redemption Provision," or call provision specifies when and under what
prices a company may call its bonds. Refunding is an action by a company to
replace outstanding bonds with another debt issue sold at a lower interest
expense.
5. "Sinking Fund" is an annual obligation of a company to pay an amount of cash
to a trustee in order to retire a given percentage of bonds. This requirement can
often be met with actual bonds or with pledges of property. The obligation can be
met by the stated percentage of each issue outstanding, by cash, or by applying
the whole requirement against one issue or several issues.
6. Other Provisions. These include events of default, mortgage modification,
security, limits on borrowing, priority, and the powers and obligations of the
trustee.

INDUSTRIAL INDENTURES
1. "Negative Pledge Clause" provides that a company cannot create or assume
liens to the extent that more than a certain percentage of consolidated net
tangible assets without giving bondholders the same security.
2. "Limitation on Sale and Leaseback Transactions" provide protection for the
bondholder against the company selling and then leasing back assets that provide
security for the holder. This provision requires that assets or cash equal to the
property sold and leased back be applied to the retirement of the debt in question
or used to acquire another property for the security of the bondholders.
3. "Sale of Assets or Merger" protect bondholders in the event of the sale of
substantially all of the company's assets by requiring that the debt be retired or
assumed by the merged company.
Norman Cheung

AllenResources_Q&A_Level 2

4. "Dividend Test" establishes rules for the payment of dividends so bondholders

will be assured that the company will be not be drained by dividend payments.
5. Debt Test: This provision limits the amount of debt that may be issued by
establishing a maximum debt/assets ratio.

FINANCIAL INDENTURES
1. "Sinking Fund and Refunding Provisions" specify sinking fund and refunding
provisions. Generally, finance issues with a short maturity are non-callable,
whereas longer issues provide 10-year call protection.
2. "Dividend Test" is the most important provision for a bondholder of a finance
subsidiary. It restricts the amount of dividends that can be upstreamed to the
parent from the subsidiary, thereby protecting the bondholder from the parent
draining the subsidiary.
3. "Limitation on Liens" restrict the degree to which a company can pledge its
assets without giving the same protection to the bondholder.
4. "Restriction on Debt Test" limit the amount of debt the company can issue
and is generally stated in terms of assets and liabilities although an earnings test
is sometimes used.

Question: Compare market-based forecasts with model-based forecasts

of foreign exchange rates.
Answer:
In a fixed rate system, forecasters focus on governmental decision making,since
the decision to devalue or revalue a currency is political. In a floating rate system,
where there is little or no government intervention, currency forecasters use
market or model based forecasts. In a market-based forecast, exchange rates are
forecast by looking at interest and forward rates. In general, the forward rate is
used as the unbiased predictor for future spot rates. This can only be used to
predict exchange rates for up to a year in advance, since forward contracts
generally don't exist for periods beyond one year. Interest rate differentials are
used to predict exchange rates after one year.
The two main model-based forecasting tools are fundamental and technical
analysis. Fundamental analysis looks at macroeconomic variables and policies that
might affect a currency. These variables include inflation and interest rates,
national income growth and changes in the money supply. For example, if the
current inflation rates and spot rates for two currencies are known, then the future
spot rate can be predicted using PPP. The problem with fundamental analysis is
that it is difficult to predict which variables are the right ones, and then to predict
what these variables will do in the future. If the fundamental values the analyst
calculates are the same as the values that the market calculates, then because of
efficient markets exchange rates will already reflect these calculations. In addition,
there is generally a lag between the time that changes in variables are expected
to occur and when these variables actually impact exchange rates.
Technical analysis focuses on past price and volume movements to forecast
exchange rates. This can only be successful if there are price patterns that are
Norman Cheung

AllenResources_Q&A_Level 2

discernable and then repeated so traders can take advantage of them. In charting,
analysts look at graphs to spot price patterns and with trend analysis, trendfollowing systems are used to predict price trends.
Question: Identify factors and potential developments that would alter
investors' expectations.
Answer:
Equity market valuations should rise over time from lower inflation and longer
recoveries. Lower inflation boosts what investors are willing to pay for a dollar of
earnings by increasing the quality of earning and the confidence that future
earnings forecasts will be realized. Longer recoveries boost equity valuation by
causing peak or near peak earnings to persist for a longer portion of the
overall business cycle.
Real interest rates are likely to remain volatile, with larger increases needed to
slow an overheating economy and bigger reductions needed to generate
recoveries from recession.
On the upside of the cycle, Federal Reserve officials are likely to have to tighten
monetary policy by a greater increment to exert the same restraint on economic
activity.
On the downside, bigger reductions in real interest rates will be necessary to
generate a sustainable recovery. In addition, nominal rates will fall by an even
greater magnitude as disinflation will persist longer, pushing down nominal
interest rates. Cyclical reductions in bond yields should last longer. Bond yields
normally decline during recessions and drift down further during early expansions
as inflation continues to move down. As bouts of disinflation last longer, declines in
bond yields will also persist.
The average level of credit spreads will be lower over the entire cycle, but the
trough-to-peak changes in credit spreads will be larger. Lenders not expecting a
recession will ease up on credit standards and demand smaller default premiums
during the extended period of the recovery. However when the recession does
occur, the widening in spreads is likely to be sharper.
Two risks may prevent this business cycle from being the longest ever:
1. Higher than expected economic growth in 1997 risks a downturn in 1998
because wages would rise and monetary policy would tighten.
2. A shock from abroad such as unusually weak economic activity elsewhere or an
unusually strong dollar increases the chances of a recession in 1998.

Question: Describe the courses of action that a company could take when
actual growth exceeds sustainable growth.
Answer:
The first step in solving the excess growth problem is to determine how long the
situation will continue. If the problem is temporary, additional borrowing may be
the simple solution. When the actual growth rate falls below the sustainable rate,
the firm will be able to generate enough cash. If the problem is deemed to be
longer-term, some combination of the strategies described below will be
Norman Cheung

AllenResources_Q&A_Level 2

necessary.
1. Sell New Equity - If the company is willing and able to raise new equity capital
by selling shares, its sustainable growth problems vanish. The increased equity,
plus whatever added borrowing is possible as a result of the increased equity, is a
source of cash with which to finance further growth. The potential problems with
this strategy are:
A. Poorly developed or non-existent equity markets in some areas
of the world make equity difficult to sell, basically making the
shares illiquid.
B. Small companies may have limited access to the services of an
investment banker to sell the shares, making it difficult to place a
new issue.
C. Many companies may prefer not to sell equity, opting instead for
internally generated funds, such as depreciation and increases in
retained earnings, as sources of corporate capital.
2. Increase leverage - Increasing leverage raises the amount of debt the
company can add for each dollar of retained profits. There are limits to the use of
debt financing. All companies have a creditor-imposed debt capacity that restricts
the amount of leverage the firm can employ. Moreover, as leverage increases, the
risks borne by owners and creditors rise as do the costs of securing additional
capital.
3. Reduce the Payout Ratio - A cut in the payout ratio raises the sustainable
growth rate by increasing the proportion of earnings retained in the business. In
general, owners' interest in dividend payments varies inversely with their
perceptions of the company's investment opportunities. If owners believe that the
retained profits can be put to productive use within the company, they will forego
current dividends in favor of higher future ones. Alternatively, if a firm's
investment opportunities do not promise attractive returns, a dividend cut will
anger shareholders and result in a decline in stock price.
4. Profitable Pruning - Profitable pruning sells off operations that are performing
marginally to generate cash to invest in the remaining businesses. Profitable
pruning reduces sustainable growth problems in two ways: it generates cash
directly through the sale of marginal businesses, and it reduces actual sales
growth by eliminating some of the sources of the growth.
Profitable pruning can also be applied to a single-product company. In this case,
slow-paying customers and/or slow-turning inventory are eliminated. This can
eliminate sustainable growth problems in three ways: by freeing up cash, by
increasing asset turnover, and by reducing sales.
5. Sourcing - Sourcing more and doing less in-house may increase sustainable
growth rate. Sourcing releases assets that would otherwise be tied up in
performing an activity, and it increases asset turnover; both of which serve to
diminish growth problems.
6. Pricing - When revenue growth is too high in relation to a company's financing
ability, it may have to raise prices to reduce growth. If the higher prices increase
the profit margin, the rate of sustainable growth may increase.

Norman Cheung

AllenResources_Q&A_Level 2

7. Merger - When all else fails, it may be necessary to look for a partner. Two
types of companies are capable of supplying the needed cash: a mature company
(a cash cow) and a conservatively financed company that would bring liquidity and
borrowing capacity to the cash needy firm.
Question: Discuss the weaknesses and difficulties of using ratio analysis
to evaluate a company.
Answer:
There are three primary methods by which ratios are judged:
1. COMPARING RATIOS CROSS SECTIONALLY
This involves comparing a ratio in a particular firm to the same ratio in other
similar firms. The objective is to determine if the ratio that is being analyzed is
too high or too low in comparison to the norm. Since there are no completely
identical firms, an analyst decides how tight the criteria should be between
firms. The tighter the criteria the better. However, guidelines that are too
specific will eliminate many comparables.
If an abnormal ratio is discovered, it may simply be a result of the firm's unique
policies, and is thereby no reason for concern.
2. THE TIME SERIES OF THE FIRM'S RATIOS
As mentioned above, the problem with comparing ratios cross sectionally is that
no two firms are identical. One way to correct this problem is to the use the firm
to establish the norm for the different ratios, which is done by analyzing the time
series of the firm's ratios. This is accomplished by comparing a ratio over time
and examining its trend. The reasoning behind this method is that since each
firm's unique features determine its ratios, reviewing trends in the ratios can
identify changes in the firm's operations.
Although this method is an improvement over the cross sectional comparison
method, it still has the following problems:
First, intentional and unintentional changes in a firm's policies lead to the
changes in the ratio that cannot be unraveled by an outside analyst. For
example, a decline in a firm's gross margin may result from a variety of reasons,
and because financial statements summarize events, trends are not easy to
interpret.
Second, inflation may cause false trends among various ratios because financial
reporting is done on a historical-cost basis. For example, depreciation expense
will probably reflect the cost of assets that are several years old, and since the
cost of goods sold for an industrial firm includes these depreciation charges, the
gross-margin ratio may appear to "improve" over time.
Finally, the use of past ratios as the norm against current ratios may disguise
problems, or even strengths, of the firm.
Thus, a complete ratio analysis should include both a cross-sectional and a timeseries comparison of ratios.
3. THE ECONOMIC INTERPRETATION OF RATIO CHANGES AND DEVIATIONS
The ratios that are obtained for a firm should be compared to our economic
Norman Cheung

AllenResources_Q&A_Level 2

understanding of the firm's environment, business, policies, and effectiveness.

This is what differentiates a technically correct but uninformative financial
statement analysis from an analysis that provides insights into the firm's
operations and allows accurate prediction of its future financial performance.
Question: Compare and contrast the monthly prepayment option
embedded in an MBS with a callable or putable bond and with a noncallable bond.
Answer:
An investor's risk can be illustrated using the concept of convexity. When interest
rates decline sharply, convexity becomes negative. In a mortgage pool, an
increasing portion of the mortgages in the pool prepays. When interest rates
decline below the coupon rate, most people prepay and the price-yield relationship
experiences negative convexity in this area.
For higher interest rates, negative convexity also may occur, or there will at least
be less positive convexity than is the case with bonds. The reason for this is that
people who might want to upgrade their house or to relocate are discouraged to
do so because of the much higher payments on the new home. In this case,
prepayments are below what would normally occur, which is known as extension
risk. Duration of the instrument increases and if the term structure is upwardsloping, the value decline is more than occurs with a fixed-rate, stated-maturity
bond.
The possibility of negative convexity in a high interest environment makes
mortgage securities very different from a noncallable, fixed-income security for
which positive convexity prevails. With all other things constant, for significant
interest-rate changes, a mortgage security will perform more poorly than a fixedrate stated maturity bond.

Question: State and describe the two main model-based currency

forecasting tools.
Answer:
The two main model-based forecasting tools are fundamental and technical
analysis. Fundamental analysis looks at macroeconomic variables and policies that
might affect a currency. These variables include:
1.
2.
3.
4.

inflation
interest rates
national income growth
changes in the money supply

For example, if the current inflation rates and spot rates for two currencies are
known, then the future spot rate can be predicted using PPP. The problem with
fundamental analysis is the difficulty in predicting which variables are the right
ones, and then predicting what these variables will do in the future. If the
calculated fundamental values are the same as the values that the market
calculates, the exchange rates will already reflect these calculations. In addition,
there is generally a lag between the time that changes in variables are expected
to occur and when these variables actually impact exchange rates.
Norman Cheung

AllenResources_Q&A_Level 2

Technical analysis focuses on past price and volume movements toforecast

exchange rates. This can only be successful if:
1. There are price patterns that are discernable
2. Price patterns are repeated so traders can take advantage of
them
In charting, analysts look at graphs to spot price patterns. In trend analysis, trendfollowing systems are used to predict price trends.

Question: The idea that recessions will be more infrequent but will have
greater financial implications when they do occur has a number of
implications for U.S. markets. What are they?
Answer:
Equity market valuations should rise over time from lower inflation and longer
recoveries. Lower inflation boosts what investors are willing to pay for a dollar of
earnings by increasing the quality of earning and the confidence that future
earnings forecasts will be realized. Longer recoveries boost equity valuation by
causing peak or near peak earnings to persist for a longer portion of the overall
business cycle.
Real interest rates are likely to remain volatile, with larger increases needed to
slow an overheating economy and bigger reductions needed to generate
recoveries from recession. On the upside of the cycle, Federal Reserve officials are
likely to have to tighten monetary policy by a greater increment to exert the same
restraint on economic activity. On the downside, bigger reductions in real interest
rates will be necessary to generate a sustainable recovery. In addition, nominal
rates will fall by an even greater magnitude as disinflation will persist for longer,
pushing down nominal interest rates.
Cyclical reductions in bond yields should last longer. Bond yields normally decline
during recessions and drift down further during early expansions as inflation
continues to move down. As bouts of disinflation last longer, declines in bond
yields will also persist.
The average level of credit spreads will be lower over the entire cycle, but the
trough-to-peak changes in credit spreads will be larger. Lenders not expecting a
recession will ease up on credit standards and demand smaller default premiums
during the extended period of the recovery. However when the recession does
occur, the widening in spreads is likely to be sharper.

Question: What is the difference between capital market integration and

capital market segmentation?
Answer:
Capital market integration refers to the fact that real interest rates are largely
determined by global supply and demand for money. If capital markets are
segmented, then real interest rates are determined by local credit conditions.

Norman Cheung

AllenResources_Q&A_Level 2

In segmented markets, the real interest rate in the U.S. is based on national
demand and supply. The real rate in the rest of the world is based on the rest of
the world supply and demand. For example, suppose the U.S. real rate is higher
than the real rate outside the U.S.
If markets are integrated, this will cause capital to flow into the U.S., decreasing
the U.S. real interest rate and increasing the rest of the world real interest rate. In
integrated capital markets, the home real interest rate depends on economic
events around the world. Today's capital markets are well integrated, meaning
there are only small real interest rate differentials.
Real interest differentials are usually caused by currency or political risk. For
example, a real interest rate differential could exist if investors strongly desire
domestic assets to avoid currency risk, even if the expected real return on foreign
assets were higher.

Question: Distinguish between the spot and forward markets for foreign
exchange.
Answer:
Trading currencies occurs in foreign exchange markets, whose primary function is
to facilitate international trade and investment. A foreign exchange market is the
intermediary that allows trading of one currency for another.
In the spot market, currencies are traded for immediate delivery, generally within
two working days, while in the forward market currencies are bought or sold for
future delivery. About 60% of transactions are spot purchases and sales, about
10% are forward contracts, and the remaining 30% are swaps, which involve both
spot deliveries and forward contracts.
Major participants in the foreign exchange market include large commercial banks,
foreign exchange brokers, commercial customers such as multinational
corporations, and government central banks. Foreign exchange brokers are
specialists in matching clients' supply and demand needs. Brokers receive a
commission on all transactions and supply information about buy and sell rates.
In the forward market, the major players are arbitrageurs, traders, hedgers and
speculators. Arbitrageurs make the market more efficient by seeking out
differences in interest rates between countries. They use forward contracts to try
to make risk-free profits by exploiting these differences.
Traders use forward contracts to reduce risk on export or import orders by
purchasing or selling the currency that will be needed at some future date.
Hedgers, primarily multinational firms, use forward contracts to protect the home
currency value of foreign-currency denominated assets and liabilities on their
company balance sheets. These actions "lock in" a currency price, reducing, or
even eliminating risk. Speculators, on the other hand, actively
expose themselves to risk by buying or selling currencies forward to benefit from
exchange rate fluctuations.
Question: Discuss the characteristics of a swaption.

Norman Cheung

10

AllenResources_Q&A_Level 2

Answer:
A swaption is an option on a swap that can be either American or European in
form.
Receiver Swaption
A receiver swaption gives the holder the right to enter a particular swap
agreement as the fixed-rate receiver (pay floating).
A receiver swaption is similar to a call option a bond that pays a fixed rate of
interest. Assuming the option is European, the holder will exercise the option if at
expiration, interest rates are lower than the fixed rate of the swap. The owner then
receives a sequence of fixed interest payments in exchange for making a
sequence of floating rate payments at the new lower rate of interest.
Therefore, a receiver swaption is in-the-money if prevailing interest rates are less
than the fixed rate of the swap.
Payer Swaption
A payer swaption gives the holder the right to enter a particular swap agreement
as the fixed rate payer (receive floating).
A payer swaption is similar to a put option on a bond that pays a fixed rate of
interest. Assuming the option is European, the holder will exercise the option if at
expiration, interest rates are higher than the fixed rate of the swap. The owner
then receives a sequence of floating interest payments at the new higher rate of
interest in exchange for making a sequence of
fixed payments at the lower fixed rate.
Therefore, a payer swaption is in-the-money if prevailing interest rates are greater
than the fixed rate of the swap.
Question: Analyze the competitive advantage and competitive strategy
of a company.
Answer:
Competition is at the core of the success or failure of companies. Competition
determines the appropriateness of a company's activities and their ability to
contribute to its performance.
Two basic factors determine a company's choice of competitive strategy:
1. Its relative competitive position within its industry, and
2. the attractiveness of its industry with respect to long-term profitability and the
factors that determine it.
A firm in a very attractive industry may still not earn attractive profits if it has
chosen a poor competitive position. On the other hand, a firm in an excellent
competitive position may be in a poor industry that has little chance of being very
profitable.
Industry attractiveness and competitive position can be shaped by the firm, which
makes the choice of competitive strategy very challenging.
Norman Cheung

11

AllenResources_Q&A_Level 2

Michael Porter describes the competitive forces that determine the attractiveness
of an industry and how to implement the principal strategies to achieve
competitive advantage. Competitive advantage is created when the value a firm is
able to create for its buyers exceeds the firm's cost of creating it. Value is what
buyers are willing to pay for, and superior value stems from offering lower prices
than competitors for equivalent benefits or providing unique benefits that more
than offset a higher price. Porter's book describes two basic types of
competitive advantage:
1. Cost leadership, whereby a firm offers lower prices for the same product
benefits, and
2. Differentiation, whereby buyers are willing to pay more for unique benefits
that a firm offers.
Question: Differentiate between spot (cash) and futures prices and
explain the why the basis must converge to zero at expiration.
Answer:
The spot price, also referred to as cash price or current price, is the price of a good
for immediate delivery. The future price, that which will be paid at a specific future
date, is related to the cash price.
The basis is the relationship between the cash price of a good and the futures
price for the same good. The basis is calculated as the current cash price for a
particular commodity at a specified location, minus the price of a particular futures
contract for the same commodity at the same location.
basis = current cash price - futures price
Note that the basis calculated in considering futures prices may differ, depending
upon the geographic location of the spot price that is used to compute the basis.
Generally, the basis is used in reference to the difference between the cash price
and the nearby futures contract. There is, however, a basis for each outstanding
futures contract, and this basis will often differ in systemic ways, depending upon
the maturities of the individual futures contracts.
In a normal market, prices for more distant futures are higher than for nearby
futures. In an inverted market, distant futures prices are lower than for the prices
for contracts nearer to expiration. Even though the spot and futures prices may be
quite variable over time, the basis tends to have low variability. Understanding this
aspect of the basis is very important for
hedgers and speculators.
When a futures contract is at expiration, the futures price and the spot price of the
commodity must be the same (the basis must be zero), except for minor
discrepancies due to transportation and other transaction costs. This behavior of
the basis over time is known as convergence, and is consistent with the noarbitrage requirement.
Question: Analyze competitive forces that affect the profitability of a
company.
Answer:
Norman Cheung

12

AllenResources_Q&A_Level 2

The first fundamental determinant of a firm's profitability is industry

attractiveness. Competitive strategy must grow from a sophisticated
understanding of the rules of competition that determine an industry's
attractiveness. The ultimate goal of competitive strategy is to cope with and
change those rules in favor of the firm's. In any industry, whether it is domestic or
international, the rules of competition are embodied in five competitive forces:
1.
2.
3.
4.
5.

The
The
The
The
The

entry of new competitors

threat of substitutes
bargaining power of buyers
bargaining power of suppliers
rivalry among the existing competition

These forces determine the ability of firms in an industry to earn rates of return on
investment in excess of the cost of capital. The strength of these forces varies
from industry to industry. For example, in the pharmaceutical industry, all forces
are favorable so many competitors earn attractive profits. Yet in an industry where
pressure from one or more forces is intense, such as rubber or steel, few
companies earn attractive returns even with the best of management.
The five forces collectively determine industry profitability because they influence
the prices, costs and required investment of firms in an industry--the elements of
return on investment. All industries differ in the individual and collective strengths
of these forces and therefore, industries differ in inherent profitability. The strength
of each of the five forces is a function of industry structure, which is relatively
stable, but can change over time as an industry evolves. The industry trends that
are the most important for strategy are those that affect industry
structure.
Firms are not prisoners of their industry structure, however. Through their
strategies, firms can influence the five forces and therefore shape industry
structure, making it either more or less attractive. There have been many
successful strategies that have changed the rules of competition through this
method. Yet such strategies are a double-edged sword since a firm can destroy
industry structure and profitability as readily as it can improve it. For example, a
firm that creates an improved product may undercut entry barriers or increase the
competitive rivalry, but may undermine the long-run profitability of an industry.
Firms pursuing strategic choices without considering the long-term consequences
of industry structure are termed "destroyers." These firms are either: attempting to
find ways to overcome competitive disadvantage, have serious problems and are
seeking desperate solutions, or are firms that are so "dumb" that they do not know
their costs or have unrealistic assumptions about the future.
The ability of firms to shape industry structure places a particular burden on
industry leaders. Leaders' actions can have a disproportionate impact on structure,
because of their size and influence over buyers, suppliers and other competitors.
At the same time, leaders' large market shares guarantee that anything that
changes overall industry structure will affect them as well. Leaders, therefore,
must strike a balance between its own competitive position and the health of the
entire industry.
Question: List the common causes of a decline in earnings quality.
Answer:
Norman Cheung

13

AllenResources_Q&A_Level 2

One of the objectives of a quality of earnings analysis is to determine when there

has been a decline in the quality of earnings. The following items are some of the
more common causes of a decline in earnings quality:
1. Adoption of less conservative accounting principles. For example, switching
from LIFO to FIFO in an inflationary environment, or changing from accelerated
depreciation to straight line depreciation. This would also include capitalizing costs
that were previously expensed.
2. Adoption of less conservative accounting estimates, such as decreasing
estimates of warrantee costs, bad debts, etc.
3. One-time transactions resulting in a recognized gain, such as sale of real estate.
4. Early/aggressive revenue recognition - this is generally accompanied byan
increase in accounts receivable (beware of sale of receivables).
5. Reduction of costs which increase this year's net income and may affect future
earnings power - such as, research and development, advertising or maintenance
costs.
6. Increasing proportion of income arising from peripheral activities (not central
operations) - such as investment income.
7. Incurring extra costs to make sure a merger qualifies for pooling of interest, so
goodwill will not have to be recorded (goodwill results in lower future income as it
is amortized).
8. Decrease in inventory turnover, which may indicate production or marketing
problems not yet recorded in income.
9. Write-off of investments soon after they are made.
10. Increasing financial leverage to point where risk is significantly increased.

More CFA info & materials can be retrieved from the followings:
For visitors from Hong Kong: http://normancafe.uhome.net/StudyRoom.htm
For visitors outside Hong Kong: http://www.angelfire.com/nc3/normancafe/StudyRoom.htm

Norman Cheung

14

AllenResources_Q&A_Level 2